Gold Will Offer Protection When Stocks Decline

by: Dante Caruso

James Chanos, the hedge fund manager that exposed Enron nearly 13 years ago, reportedly said last week that there are more stocks trading above 3 times book value than in March 2000.

There are plenty of other statistics that show that stocks are at precarious levels, and I outlined a few reasons here. The amazing thing about market tops is their ability to disguise the danger and fool investors every time. For example, the S&P500 price-to-earnings ratio of 17.7 is widely cited as a reason stocks are reasonably valued, but it does not take into account the cyclical nature of corporate earnings, which are 70% above normal. In other words, stocks can fall 30% in the next 3 years and still be more expensive than today, if corporate profits cycle back to the average range of 6% to 6.5% of GDP.

Yet, the public is clamoring to get on board this market, as reported by CNBC on August 4, 2013:

U.S. equity funds saw a record inflow of $40.3 billion in July, according to data from TrimTabs, as the S&P 500 and Dow Jones Industrial Average scale new heights in what some are calling an "invincible summer" for the country's stocks.

The record inflow of July exceeds a record-breaking month from earlier in 2013, where retail investors dumped $39.3 billion into U.S. mutual funds and exchange traded funds, as reported by Fortune.

Do you want to guess when the previous record for public investment into mutual funds was prior to January 2013?

In February of 2000, investors poured $34.6 billion into stock mutual funds- setting a record right at the top.

In 2000, The Federal Reserve Bank was raising interest rates to cool the economy and the rate hikes were a headwind on dividend paying and value stocks. Legendary value investors like Jeremy Grantham were passed over. Investors charged into technology because it was a new era and because technology stocks were insulated from rate hikes because they had no debt. Those were the reasons analysts were touting stocks, but the public needed no prodding. Investors withdrew from conservative investments and charged into the high-flyers.

Although the 2000 stock market bubble was limited to mostly technology; particularly Internet stocks, the whole market suffered from excesses and the S&P500 (NYSEARCA:SPY) fell 50% by October 2002.

Rambus (NASDAQ:RMBS) was one of the leaders of frenzied buying that marked the top of the bubble:

One of the misconceptions of bubbles is that most stocks participate. It really only requires enough excitement to captivate the public, and encourage them to charge into the market. This happened once again in 2007.

In 2007, investors rushed into stocks with frenzied buying that nearly matched the insanity of 2000. That top was even more surreal because the fallout from a burst housing bubble was becoming more apparent with each passing month. Investors thought that stocks were the only game in town since investment in real estate was eliminated as a viable investment option.

Investors charged into stocks with recklessness that was reminiscent of the top in 2000, blowing bubbles in everything from solar to shipping. NYSE margin debt again exceeded 2% of GDP in 2007, matching the modern record of 2000.

Companies like Dryships (NASDAQ:DRYS) dominated the insanity, despite being in a boring industry as old as printed words. Dryships surged from 10 to 130 in just over a year:

In August of 2013, NYSE margin debt is again above 2% of GDP, matching levels only seen in 2000 and 2007. Corporate profits, which have a notoriously cyclical nature, are elevated 70% above normal, and yet investors once again not only are charging into stocks on margin and pouring record amounts into stock mutual funds, but blowing bubbles like Tesla (NASDAQ:TSLA):

Whether or not Tesla ultimately proves to be a game changer in the automotive market is irrelevant. These types of advances are symptomatic of a late-stage market bubble. This type of price action is an indicator that investors are overcome with greed.

It is not worth too much effort to convince investors that stocks are dangerous, as they are most determined to be invested right at the top. For those who can remain objective about what is happening, the question is: how do you protect your wealth in the inevitable sell-off?

I have already reasoned in a previous article that cash and cash-like investments are preferable in this environment, and more experienced and risk-tolerant investors can look to make short bets - most safely after momentum loss has been identified. I have also been holding silver (NYSEARCA:SLV) (NYSEARCA:PSLV) for a few months, but noted recently that I am concerned that silver could drop even further if stocks start to plunge, and gold (NYSEARCA:GLD) could fall as well. That concern stems mainly from the 2008 liquidation that affected stocks more than anything, but also led to serious losses on precious metals.

Further consideration of how investors treated gold in the liquidation of 2008, and how they have reacted since, have led me to a different conclusion. First, a look at the liquidation of 2008:

Although the S&P500 is not evident on the above chart, there is a notation to show the top in October 2007. If an investor had sold out of the S&P500 at that time and placed their money into gold, they would have been insulated against the 50% drop in stocks, as gold only briefly returned to the October 2007 level during the sell-off in 2008. Furthermore, gold quickly recouped its losses and was nearly at an all-time high even as the S&P500 was again plunging to lows in March 2009. Gold went on to break out and trade at much higher levels.

There have only been two serious stock market sell-offs since 2009. The first began on May 6, 2010, with a 1,000 point flash-crash in the Dow Jones Industrial Average. Market instability followed for a period of 2 months, as most investors had no idea how destabilizing HFT programs could become during a market decline. Gold rose during that decline in stocks, ending above $1,250/oz in June 2010.

The next, more significant drop in stocks began in July of 2011. The S&P500 dropped from nearly 1,350 to 1,075 by October 2011. Gold surged from $1,550/oz in July to a high over $1,900 by September, before giving some of the gains back. Gold traded near $1,650 as the S&P500 bottomed. Charts of the S&P500 and gold are shown below, to display the resilience of gold during steep declines in stocks:


It is truly fascinating that the general public is most interested in buying stocks at the top of every stock market cycle. Public demand for stocks at this level should concern anyone with a handle on history. It is exactly that interest and reckless buying by the public that creates the excesses that form a top.

Current stock valuations and sentiment levels leave cautious investors with few options. Investors who are concerned about preserving wealth during a steep decline in stocks typically switch to cash and bonds.

Bonds in recent years have been referred to as a "safe haven" and also a "flight to quality" for the simple reason that the bull market in bonds has been going on for long enough for people to forget just how dangerous they can be. U.S. Treasury securities held by the Federal Reserve Bank now total $2 trillion dollars. Despite assurances by the Federal Reserve Bank regarding tapering of QE, Treasury bond prices have been weak recently. Investors may finally be concerned as to what these pieces of paper represent.

Meanwhile, gold has emerged increasingly as a flight to safety. In the last 2 major declines in stocks in 2010 and 2011, gold was an immediate beneficiary. Investors are increasingly turning to gold in the face of stock declines. With the outlook for government bonds increasingly suspicious, the safe-haven trend toward gold in future stock declines may become even more intense. Silver will trend with gold, and may exceed returns from gold, as it typically does on rallies.

While many have pondered what the eventual trigger will be to the next gold advance, it appears the answer may be as simplistic as the next stock market decline.

Disclosure: I am long SLV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: long silver futures