"It was the best of times, it was the worst of times,
it was the age of wisdom, it was the age of foolishness,
it was the epoch of belief, it was the epoch of incredulity,
it was the season of Light, it was the season of Darkness,
it was the spring of hope, it was the winter of despair,
we had everything before us, we had nothing before us,
we were all going direct to Heaven, we were all going direct the other way..."
--Charles Dickens, A Tale Of Two Cities
And so it has been these last few years since the outbreak of the financial crisis. Rare is the analyst or commentator today that speaks of how the markets are set for lackluster results. Instead, our heads are filled with the duality of voices proclaiming the greatest of possible extremes. On one side is the light that we are well on the path to recovery and leaving the throes of the financial crisis in the path. On the other side is the darkness warning that the worst of the market turmoil may lie ahead. It remains to be seen which side is correct. But as we travel the path along the way, it is important to avoid biasing our views to heavily to any one extreme. And such is the circumstance we find ourselves in today.
Stocks are the light in capital markets. They are the Lucie Manette in the eyes of politicians, the media and the public. If stocks are rising, all must certainly be well and on the right path to future growth. Never mind that they have twice guillotined investors by half since the start of the new millennium, for all is forgotten and forgiven. And the light of stocks is shining strong thus far in 2013 with the winds of the Fed's latest stimulus program firmly at their backs.
Gold, on the other hand, is the darkness. It is the Madame Defarge of policy makers, the press and darling investors including Warren Buffet. A rising gold price presumably discredits the judgment of the Federal Reserve and other central bankers working to foster full employment and price stability. And it is sometimes suggested that those owning gold will only emerge from their caves to take physical delivery of the metal along with their border passes and emergency rations. And since the beginning of 2013, the performance of gold has also been cloaked in darkness despite a hot running Fed printing press that brings cries of foolishness and incredulity from many corners of investment markets.
Thus, the hope is outperforming despair by a wide margin so far this year. Stocks are up +6%, while gold is down -6%. Does this suggest that we now have everything before us? Or is the winter of despair set to return? Or is this simply just the latest in an ongoing cycle?
To answer these questions, it is worthwhile to explore a dark side debate that has lingered for years over financial markets.
Is Gold In A Bubble?
The answer here is definitely no. The following long-term perspective is just one of the many reasons.
"Crush humanity out of shape once more, under similar hammers, and it will twist itself into the same tortured forms. Sow the same seeds of rapacious licence and oppression over again, and it will surely yield the same fruit according to its kind."
--Charles Dickens, A Tale Of Two Cities
History has an amazing way of repeating itself in various forms. And no matter how hard policy makers work to defy nature, the inclination toward excess among those who participate in investment markets during times when all is well unfortunately leads to extended periods of cleansing when all is not. In the end, there is little that policy makers can do to thwart this cycle from playing out in one way or another. All of this is evidenced in the long-term interplay between gold and stocks.
First, the fact that gold has performed so strongly over the past decade is no surprise. Just as it is not surprising in retrospect that stocks performed so well during the period from 1982 to 2000, or gold in the decade prior from 1971 to 1982. Just as periods of light and darkness come with each passing day, the same holds true for stocks and gold over time. Capital markets have experience secular phases throughout history that last roughly 17 years on average. During those secular phases defined by consistently strong economic growth and price stability such as 1982-2000, 1949-1968 and 1921-1929, stocks perform well and gold goes overlooked. But during contrasting secular phases characterized by economic uncertainty and pricing instability such as 2000-Present, 1968-1982 and the Great Depression, gold is in strong demand and stocks struggle. At present, we are only in the latest phase of capital market darkness, as gold remains in a long-term uptrend while stocks continue to trade at inflation adjusted levels first reached nearly two decades ago.
Gold is not in a bubble. In fact, it is simply still in the process of playing catch up following nearly two decades of steady declines in the 1980s and 1990s. The real price of stocks as measured by the S&P 500 Index (SPY) and gold (GLD) have crossed paths roughly every two decades dating back over the last 40 years since the collapse of the Bretton Woods agreement in 1971. Gold just crossed back above stocks only a few years ago, and they still remain effectively converged on par with one another. And if the path of markets over the past 40 years is any guide, we may see the gap of gold over stocks widen substantially before the next phase finally begins.
But what justifies the current price of gold anyway? After all, since it does not produce a cash flow, it cannot be valued and its price is purely unpredictable, right? On the contrary, this is absolutely incorrect.
Gold is an ultimate long-term store of value against inflation. Now this may not necessarily appear to be true if one relies upon aggregate price index statistics such as the Consumer Price Index. But not all consumers are impacted equally by changes in price for each of the 300 goods and services in the basket used to compute this measure. Thus, gold need not protect against all forms of inflation, as long as it is providing an important store of value against the price swings of those components that are particularly volatile and of importance to consumers and investors. And this is particularly true in the case of oil and gasoline, which not only makes up a meaningful percentage of consumer expenditures for virtually all Americans, but is also an inflation reading that is hardly ever subject to debate since it is announced daily on well-lit service station signs all across the country.
Over the last 40 years, gold has provided a near perfect long-term store of value against highly volatile oil and gas prices. As oil and gasoline prices have risen, so too have gold prices. And when oil and gasoline prices have fallen, so too have gold prices. In aggregate, gold has generally purchased an average of 15 barrels of oil or 300 gallons of gas regardless of the violent underlying price swings of these petroleum products, which is a far more consistent store of value in this regard than offered by the stock market over this same time period. Thus, oil and gasoline prices almost perfectly explain the price movements in gold, and owning gold provides protection against the price swings in these necessary commodities.
In short, gold is not in a bubble. Instead, the price movement over the last 40 years through today makes good sense when considered in the context of highly volatile energy prices. And this has important implications for total returns expectations going forward.
Stocks And Gold: A Regression To the Mean
So what, then, explains the contrast between stocks and gold thus far in 2013?
Both stocks and gold are following a familiar pattern seen during past QE programs that involved outright Treasury purchases. During QE1, stocks advanced first, while gold got off to a slow start. Eventually, gold found its footing and moved steadily higher along with stocks.
Under QE2, stocks once again surged higher, but gold quickly cooled after an initially strong start, plunging by -7% to start 2011. But once gold found its footing in late January, it outperformed for the remainder of the program to fully close the performance gap.
We find ourselves at a similar juncture now under QE3. Gold has once again stumbled out of the gates since Treasury purchases were added on January 4. But what is now notable is the following.
(click to enlarge)
First, gold has fallen sharply at the same time that gasoline prices have skyrocketed. This disconnect is not likely to last into the long-term. And the fact that a primary driver of the increase in gasoline prices is the money printing associated with QE3 suggests that if anything, gold is likely to catch up to the upside in the months ahead.
Also, gold is now trading at extremely depressed levels relative to stocks at present, and is overdue to recoil back toward normal readings. For example, the Gold-to-S&P 500 Index price ratio reached a Relative Strength Index of 18.48 just this past week, which marks by far the lowest reading for this ratio since the beginning of the latest secular phase between gold and stocks that began over a decade ago. While short-term forces may continue to dampen the price performance of gold in the near-term -- monitoring the rapid deterioration in price movements between 8 a.m. and 8:30 a.m. on any given trading day is particularly informative in this regard -- this recently weak price activity is bound to relent in the near-term, particularly given the fact that COMEX Gold short contracts reached record all-time highs in recent trading days.
Thus, at minimum, a regression to the mean for gold relative to stocks is long overdue at this point. And a period of strong outperformance for gold relative to stocks is not at all out of the question sometime over the coming months.
What Lies Ahead For Stocks and Gold?
"Not knowing how he lost himself, or how he recovered himself, he may never feel certain of not losing himself again."
--Charles Dickens, A Tale Of Two Cities
"Vengeance and retribution require a long time; it is the rule."
--Charles Dickens, A Tale Of Two Cities
While the performance of stocks thus far in 2013 does not come as a surprise, it remains shrouded in considerable uncertainty going forward. It was on January 4 of this year that the U.S. Federal Reserve added Treasury purchases as part of its QE3 stimulus program. Since the outbreak of the financial crisis, stocks have traditionally performed well during the period immediately following the addition of Treasury purchases by the Fed. But none of this implies that we are now entering a perpetual spring of hope for stocks. After all, stocks have now risen by over +24% on the S&P 500 Index over the past year, yet operating earnings on this same index fell vastly short of expectations, with a paltry +0.53% increase over this same time period. In other words, the gains in stocks over the past year came almost purely from an expansion in valuation. Looking ahead, the fact that operating earnings are projected to increase by +15% in 2013 seems wildly optimistic in an environment where economic growth is sliding into recession both in the U.S. and globally with rising taxes, spending cuts and corporate profit margins already falling from historic peaks. Even quantitative easing has its limits in its ability to levitate stocks, and this is likely to become an increasing challenge for stocks as we move forward in the program. And investor memories are still fresh from being burned by stocks a number of times over the past decade, so they could reasonably be expected to flee once again at the next signs of instability.
As for gold, it boils down to a few fundamental questions.
First, if one believes that gasoline prices will sustainably return back below $2.00 per gallon in the near-term, then yes, the outlook for the gold price is poor. On the other hand, if one thinks instead that gasoline prices are set to rise further from here, gold may represent an attractive investment opportunity. While it remains to be seen, the fact that gasoline prices have risen nearly 20% in the first two months of the year suggests that the pressure may remain to the upside for some time to come.
Also, additional liquidity continues to be added to the marketplace thanks to the latest balance sheet expanding stimulus programs from global central banks. Such activities are negative for fiat currencies and favorable for alternative currencies like gold that represent long-term stores of value. To this point, the additional liquidity has spurned gold and favored stocks. But recent Treasury purchase programs by the Fed have demonstrated that eventually, this preference can find its way into gold in a meaningful way.
Lastly, the threat of crisis continues to loom large. Despite all of the belief that we have everything before us and that capital markets are set to climb to Heaven, the fact of the matter remains that little has been fixed from the structural problems that sparked the outbreak of the financial crisis several years ago. Instead, new structural imbalances have been formed with long-term consequences that remain to be seen.
"I see a beautiful city and a brilliant people rising from this abyss, and, in their struggles to be truly free, in their triumphs and defeats, through long years to come, I see the evil of this time and of the previous time of which this is the natural birth, gradually making expiation for itself and wearing out."
--Charles Dickens, A Tale Of Two Cities
The darkness that descended on investment markets several years ago is not something that is quickly cast aside. The cleansing process from a financial crisis can take years to play itself out, and in many respects this process has not yet been allowed to get underway in earnest. Once it does, we will finally be on the path toward a new secular phase in the stock and gold cycle. And this will likely be a beautiful time marked by another phase of sustained economic growth and impressive new technological triumphs. But it is likely to take at least a few more years for things to play out to arrive at this new dawn.
In the meantime, investors remain well served to avoid going to extremes. It is worth recognizing that we are now in a period marked by fresh monetary stimulus that is supportive of stock prices. Thus, it is worthwhile to maintain an allocation to stocks through such positions as the S&P 400 Mid-Cap Index (MDY) for higher beta exposures, along with low volatility stocks (SPLV) for counterbalancing stability. Individual names that can benefit from the rise in oil and gasoline prices as well as other commodities prices such as BHP Billiton (BHP) and Occidental Petroleum (OXY) are also worth consideration. It is also worthwhile, however, to not ignore the fact that we are not yet out of the winter of despair and that major challenges remain. And the ability to establish allocations to gold at a time when it is currently trading at secular cycle extremes relative to stocks may present a particularly attractive opportunity. Specifically, the fact that the high quality Central GoldTrust (GTU) is trading at an oversold extreme relative to the price of gold, which in its own right is trading at a oversold extreme relative to stocks, suggests a doubly attractive entry point may be presenting itself today.
With diverse opportunities like these, investors can position themselves properly, regardless of whether it is indeed the best of times or the worst of times.
This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.