From a piece I originally wrote and sent out 11th August 2011.  For various reasons I did not want to include the charts in this posting, and it was not accepted by the editors without charts.  At this stage (end of 2011), I would focus my view on being bearish Gold in dollars rather than being bullish Gold in foreign currencies.

Following that piece, Gold saw a blow-off rally followed by a reversal.  It's too early to be certain this is the end of the uptrend, but I certainly would use bounces to exit stale longs and on confirmation from longer-term Ichimoku chart start to establish bearish positions in the precious metals complex.

I focused on gold rather than the other precious metals since it is the benchmark.  In fact other precious (and base) metals are likely to be better shorts.

Gold – is the bullish trend getting tired?

First of all, in the Gold market, there has been since last year an outstanding annual (!) Demark TD Combo sell signal on the spot Gold price.   This is a signal that identifies certain repeating patterns in markets in order to identify a potential exhaustion of the previous trend.  The longer the time frame, the more significant, and the longer-lasting a reversal in price might be.  News about the increase in margin requirements by the Chicago Mercantile Exchange came out just as Gold was testing the risk level (dotted purple line on the chart below).

Markets top when the last buyer has bought – they don’t wait until sellers arrive en masse and so it is often the case that the high is made amidst good news for the underlying asset and the low is made amidst terrible news.  (In the case of Gold, the cash low  of 251.95 was made amidst news of ongoing central bank sales and a mass enthusiasm for equities – particularly US technology stocks.  This was a time when it was said that Warren Buffett was ‘past it’, and gold bugs were less even than figures of fun).

I mention this because the flow of fundamental news over the past few years has been relentlessly negative for mass belief in fiat money and positive for Gold. Everybody is aware that the credit worthiness not just of many European states, but also of the US sovereign is in question and of course the concern about a possible technical default on Treasury coupon payments drew a great deal of attention. Superficially it seems positively reckless not to have a substantial asset allocation to the Gold market, but to the trained eyes of a contrarian analyst, what everybody knows is probably wrong, at least from a market timing perspective, and such news items are the stuff of major tops.

From a more prosaic perspective, I note that since 2006 real yields in US two years have fallen from a high of 3.5% to -2.0% back in April, and according to “Gibson’s Paradox” this has been tremendously supportive for the Gold price (since the real yield is the opportunity cost of holding specie).  The chart below demonstrates the relationship between real yields (inverted) and the Gold price – I use the five year point, since this has a better series than two years.

In the flight to safety, Gold has held up very much better than other hard commodities – the chart below shows performance of Gold, Copper, Crude Oil and Wheat:-

In the event we are truly in for an imminent repeat of 2008, with a disintegration of financing markets for sovereign issuers in Europe, and an acceleration of the silent run on banks across Europe that has in recent days been drawing attention, then there is no saying how Gold might go in extremis.

But should that not be the case (and our research has put forward some compelling arguments as to why we might expect a stabilisation from here) then Gold is beginning to look expensive against every other asset, and some of the fundamental factors that have been underpinning its valuation might start to become less supportive.

Despite the rally in the two year note contract, two year real yields have actually risen since they made a low of -2.10% in April this year (they are currently -86 bps).  Over this period nominal yields have actually fallen from 86 bps to 22 bps.  It’s relatively unusual to see nominal and real yields move in opposite directions and this has occurred because breakeven inflation expectations have been crushed.  A chart of two year real yields follows:-

What would lead to a fall in real yields?  With Fed Funds at 25 bps, two year notes have pretty much run out of room to rally.  On the other hand, a further slowdown in growth expectations would lead to downside to commodity prices and would likely lead to a further decline in inflation breakeven expectations.  So it is possible that real  yields may be running out of room to decline much further.  If this is the case, then one key factor that has been supportive of Gold may be disappearing.  Should we see some stabilization in risk assets then there could potentially be a very significant correction indeed ahead for the Gold price.

If Gold were indeed to correct, would this mean the end of the bull market?  Not at all.   In the last previous secular bull market we saw a 44% correction from the high of 185.25 in Feb 1975 to the August 1976 low.  That must certainly have shaken the faith of many Gold bulls,  but after this period of consolidation Gold went on to make a new high of 835 in Jan 1980.  Charts of this move follow over the page.

It would be imprudent to try and identify a Gold top with high conviction in this kind of commentary, but given the determination of the authorities to fight the forces of disintegration in the financial system and the tremendous overbought condition in the Gold market (the _quarterly_ RSI is currently over 95!), it would not be surprising to see a repeat performance.  Given the underlying imbalances in the developed world, any large correction is no doubt a buying opportunity but the prospective return on risk to establishing new long positions in Gold here is far from attractive.

All of this being said, it is possible that although Gold may be tiring in dollar terms that we could see further upside against other currencies should the US dollar continue to rally.

I will focus here on the outlook for economic growth.

There will be opportunities in forthcoming letters to set out my views more clearly, but in brief I believe that we have mistaken a stutter in economic growth for the end of the cycle.  In summer 2008, it was the view of many respectable market commentators (if my memory serves me correctly, notably Gavekal) that the slowdown in growth was simply a mid-cycle pause, and that the real estate-induced slowdown in US growth was a positive thing because of its anti-inflationary consequences and would in fact serve to extend the life of the expansion; this idea proved to be sadly mistaken.  In summer 2011, there is an emerging consensus that the recent string of growth disappointments should be taken very seriously indeed and in fact represents the resumption of the depression that never really went away (since payroll growth was very disappointing).  I suspect that this idea, too, will again prove mistaken.

I remarked in May on the rarity of the pre-2008 environment for growth internationally.  It has been unprecedented to see all important regions in the world integrated into a single global economy and all experiencing strong synchronized growth.  I expect the future to see much more divergence between regions and sectors.

Since 2009 we have seen strong growth in the emerging world (and in regions that export to them) accompanied by weak growth in the non-commodity-producing, non-exporting developed world.  In part this is because the emerging world has bid away resources from the developed world via the high price of gasoline and food.  When there is a financial market dislocation in outright terms, the hoo hah often tends to conceal a more profound transition in leadership beneath the surface.  I think this is the case today – so although I think global growth is basing, I think its composition from here will be tilted more towards the US, Eurozone and UK and away from Canada, Australia, Latin America, Russia etc.  One should await technical confirmation, but this is my bias.  Job growth has been held back by the weakness of non high-end consumption and by regime uncertainty – lower gasoline prices and the nascent shift in the political tide can potentially help to shift these factors and if the present horrible mood can improve, one could see a sharp move lower in unemployment to catch up with the picture in initial jobless claims.

Should we rush to buy risky assets today and sell fixed income?  No - I think that would be premature.  Seasonality for risk assets is weak from now until early-mid October, and fixed income tends to do very well in September.  But in the bigger picture one should focus on finding opportunities to get long over the next 6 months, and I suspect that long the broad dollar will be a higher quality trade than being outright short risk assets.  One should also be very cautious about piling into defensive stocks, as currently seems to be the fashion amongst retail investors.  (See recent front cover of Investors Chronicle - which, whilst ostensibly about momentum as a strategy, ending up by suggesting investors purchase defensive stocks at present levels).

Contrarian analysis is helpful in arriving at a potential variant perception, but a robust conclusion depends on a balanced assessment of evidence for and against the thesis.  I have done this work and here choose to note the following (which are not intended to be exhaustive – please contact me if you would like me to clarify or defend my overall thesis or any of the observations supporting it):-

1.      The Citibank index of Economic Surprises in the US (CESIUSD) topped at 97.50 6^th March 2011, and yields topped .  The index collapsed into a low of -117.20 on 3^rd June 2011 and, despite the widely-publicized concerns over European sovereign funding, over the European banking system, and over the outlook for the US credit rating, has climbed since then.  It broke out of the daily cloud 23^rd August 2011, and the lagging span has just now confirmed the breakout of the cloud.

2.      The year-on-year change in real personal consumer expenditure has historically been a good way to identify major turning points in the business cycle.  This remains near cycle highs in solidly positive territory, and ticked up in July to 2.3% yoy from 2.0% in June.

3.      The growth rate for the ECRI Weekly Leading Index for the US remains subdued, far below the Oct 2009 peak.  But for now we have held the summer 2010 lows, and we have technical signs of exhaustion of the recent pullback.

4.      The Citibank Index of Economic Surprises in the Eurozone (CESIEUR) topped at  130.2 on 28^th May 2010, and has since then pulled back sharply – notably strongly in August – to a low of -104.20 on 26^th August 2011.  Although the index remains at its cycle low, it is holding the basing level of August 2008-March 2009.  From a Demark technical perspective we have on a weekly chart five waves down complete, and a 13 combo signal indicating exhaustion of the recent down move.

5.      The Citibank Index of Economic Surprises in the UK (CESIGBP) topped at 112.50 in May 2010 and has since pulled back sharply to new recovery lows, and close to the all-time low of -81.1 on 28^th April 2006.  We are very oversold and in a region from which historically surprises have tended to come in a positive direction.

6.      Sentiment from the American Association of Individual Investors (Net Bulls) reached the -23.25 oversold region in June and in August that is possibly consistent with selling exhaustion (although buying opportunities in summer 2010 and March 2009 did see much  worse levels).

7.      Bullish Treasury sentiment reached 98% bulls on the DSI survey measure, an extreme only previously reached at the end of December 2008, at which point sentiment reached 99% bulls amidst predictions and market pricing across assets of a new Great Depression.

8.      September is the best month for fixed income seasonal, but the cycle tends on average to be positive for bonds until early December.

9.      Conference Board Consumer Confidence registered a monthly buy signal in Feb 2009 at 25.30.  It qualified for the end of wave 1 higher in February 2011 at the level of 72.00 and then needed to pull back in a corrective wave 2 in order to complete a basing structure consistent with a sustained recovery in confidence.  Since February 2011 we have achieved this with a sharp pullback of almost 62% to a level of 44.50 in August amidst a very depressing public mood (ideal for a wave 2).  The buy signal from February 2009 remains intact.

Research work by Ned Davis shows us that on long time horizons, investments in the US equity market undertaken when consumer confidence is depressed tend to do very much better than average.   The recent trough in Feb 2009 was the lowest seen in the history of the sample (going back to 1967), and we remain today at levels below that of all previous recession years except 1974/75.  So this is a longer-term very bullish sign.

10.  Michigan Consumer Sentiment registered five waves down complete with a confluence of price reaching the wave target at the low in 2008, and the increase until Jan 2011 registered as a wave 1 up, with the decrease since then registering as a wave 2 pullback.  We were at 55.7 in August, with the all-time low in Nov 2008 at 55.3  Holding the low would be constructive.

11.  Conference Board Consumer Expectations remains in wave 5 down, with outstanding projections of 45.5 and 40.4 (vs current level of 51.90).  We are likely to have a buy signal by November 2011.

12.  Presidential approval ratings  are at new record lows.  44% approval for his job overall; 37% approval for his handling of the economy; 54% think Obama is ‘facing a longer-term setback from which he’s unlikely to recover’ (vs 39% at the beginning of the year); 19% think the country is heading in the right direction these days.  Disapproval of Congress is at a record 82% disapproval.  Whilst there may be idiosyncratic factors at work, these ratings tend to be a good reflection of the overall public mood.  A very negative rating suggests a very negative mood, implying high eventual prospective returns on risk assets bought under such conditions.

13.  Since 2008 there has been a great deal of agonizing over the depressed male participation rate (offset in the overall numbers by a rising female participation rate) even though this is a trend that has been in motion since the 1950s.  Trends tend to catch the public imagination just as they are overdue for a reversal, and I suspect this case is no exception.  We have 5 waves down complete, having reached the Dwave target and both monthly and quarterly buy signals.

In the Chicago Tribune of January 1894, the following article by H. Allaway appeared under the headline “Better Times Ahead “ (an article that proved to be prescient given the ‘Great Depression’ of 1873 ended within the year, giving rise to a long boom that was to bring the US to ascendancy).


“It is related that in the old days of the Commune in Paris a panic-stricken investor turned up in the office of M. de Rothschild and exclaimed:

“You advise me to buy securities now.  You are my enemy.  The streets of Paris run with blood.”

And Rothschild’s answer was this: “My dear friend, if the streets of Paris were not running with blood do you think you would be able to buy at the present prices?”

Nature has smiled on us, and we have seen a wondrous rally in German fixed income, with the Schatz rallying 210 cents and the Bund fifteen points since I pointed out the fundamentally-supported breakout in May.  Commodities overall have been stable, with sharp declines in crude and copper being offset by continued strength in agriculture and precious metals.  The S&P was off a peak of 17% from the breakdown point to its August trough, with the DAX off almost 30%, and the FTSE off almost 20%.  The short US/long Germany trade that I favoured in two year fixed income has moved 106 basis points.

Although in May I explicitly confessed my concerns over the possibility that the ECB was mistakenly hiking into a severe slowdown, just as it did in July 2008, and thought that there were other reasons to fear the possibility that the coming slowdown represented something more like a 1937-like resumption of a depression, this was never my primary scenario, and I now believe that there are other reasons to think this was more like a terrifying nightmare whose memories will fade as the present atmosphere of extreme gloom dissipates.

In our age, very few market participants have a strong grasp of financial, economic and societal history.  For most of us, history tends to begin with the first point on a Bloomberg chart, and whilst we may avidly consume pre-digested financial histories by econometrically-oriented historians, these are a poor substitute indeed for developing a sense of what it was actually like to live through past episodes.  It is easy to scorn the apparent naivete and ignorance of past generations when one knows how the story ended and is unaware of the prior history that led them to form such rudely-falsified expectations.

I have believed since late 2008 that the years ahead would not constitute a depression exactly, or at least not in the modern sense of the word that disproportionately emphasizes the experience of the US in the 1930s and unduly under-weights previous long-lasting ‘difficult periods’ that were a repetitive feature of growth for the previous century and a half in the industrialized world.  It was also my view that neither would it be something like a repeat of the Japanese experience – there were particular idiosyncratic features of that episode and I considered it foolish to make very wide inferences with much confidence from a single sample.

Instead, I thought that the period following the ‘Great Moderation’ would be characterized by short, sharp fluctuations in the business cycle somewhat reminiscent of the ‘stop-go’ experience of Britain in the post-war period.  In the case of Britain in the past the ‘stop’ episodes were induced by skill shortages and a balance of payment constraint but the years ahead may face rather different constraints.  Going forward, the ‘stop’ episodes may perhaps be induced by a variety of factors: supply chain disruptions (as we have seen post the Japan quake), geopolitical concerns (as we have saw following turmoil in the Middle East), earth changes (Icelandic volcano disrupting European air travel) and fluctuations in animal spirits.

During periods of long booms, animal spirits are elevated and credit growth is quick to ‘fill the gap’ in global aggregate demand when there are setbacks of some sort; during extended periods of busts, animal spirits are more subdued and entrepreneurs and consumers are not as confident in increasing borrowing to ‘fill the gap’ in global aggregate demand when a setback arrives.  Policy can only truly respond with a significant lag, and if the shortfall in demand is large and sustained, so it makes sense to expect demand to be much more violent in its fluctuations.  The very fact of greater fluctuations tends to mean that small moves are less damped (whereas the building in of more insurance via greater inventory and the like will perhaps tend to be effective in damping larger moves).  Since we are not yet used to these kind of setbacks, every one of them for now feels like a near-death experience.  The future belongs to those who are sufficiently resilient and organized in such a manner that they can look beyond such setbacks towards ultimate goals rather than becoming distracted by the noise; those who are used to responding in a more fluid manner to circumstances as they unfold will risk becoming thrown off course by the unaccustomedly violent disturbances in the tide.

Whatever the precise drivers of a regime change, I think the very predictable, smooth and uninterrupted expansions that in the post-war US experience we became accustomed to treating as the norm will not be repeated for some time.  If I am right, then there are very interesting implications for appropriate structures and policy across the business and investing world and many developments that we have come to think of as best practice will need to be revisited.

One notable lesson is that the fashion for managing money under very tight and focused constraints will encounter the realization that in the new regime there are very much greater opportunity costs for behaving in this manner.  Tight, monthly stop-losses introduce brittleness and extreme path-dependency into the investment process that the wilder markets in our future will not treat kindly.  Instead one will have to adapt to operating with lower leverage, scaling into and out of positions, managing to a longer-time horizon and having less precision about the path that equity might take along the way to the longer-term.  If one cannot control risk as tightly, it becomes much more important to be discerning in manager selection and in identifying ahead of time the market environment that one is in.

Changes to the nature of the business cycle constitute one reason for greater wildness in the new regime.  Another is the more or less complete replacement of the specialist and other system-created stabilizing sources of speculation with high-frequency trading algorithms.  (See the recent speech by the Bank of England’s Haldane on this topic).   The bargain we have made is that in normal times we pay a significantly lower turn in transacting orders of normal market size, but that in the absence of the specialist we have many more instances of wild moves in markets, the flash crash of 2010 being just one headline-catching example of a phenomenon that takes place at all time horizons, from the very short term to the medium term.

The implication of this is that patient, long-term, reflective capital has the opportunity to earn very significantly enhanced returns from engaging in market-stabilizing transactions.  These sharp, wild moves allow discerning investors to accumulate already-cheap assets at even cheaper prices and to sell already-expensive ones at even richer ones.  But one has to have done the analysis previously and to be able to identify propitious moments and levels to fade such market moves whilst understanding that it may be impossible to achieve perfection in timing.

Unfortunately, this change in market infrastructure occurs at a time when such investment capital seems to have become especially scarce.  When I started working in this business in the early 1990s, I originally believed that markets were relatively efficient but it made perfect sense to me that hedge funds were able to earn superior returns because they clearly had tremendous advantages over then-sleepy real money, being able to act much more quickly, able to be very flexible and opportunistic in the instruments and strategies traded, and to be much harder-working, more diligent and more able than the management of very large pools of assets that were run in a less-aggressive fashion.

It is in the nature of social change that ideas start on the fringe, attract a following by the success of their earliest adopters, and eventually grow to encompass the whole arena, being taken to the largest point at which they make sense and then well beyond that point.

Well, I do believe we are at this stage now with hedge fund strategies as they are popularly characterized.  Today, real money, retail and even university endowments try to trade in a hedge fund-like manner; very high quality, timely information is available at very low cost to a broad audience, and the traditional sources of advantage once available to those who pioneered the hedge fund industry are in many cases depleted.

Yet if I ask myself whether this means that no sources of opportunity remain, this is clearly not at all the case.  The game has come full circle, and the advantage is actually now with those who rely not on special sources of fast-moving news but rather on their ability to reflect on and integrate widely available public information to arrive at a variant perception of valuation and then who have the patience to await attractive junctures to express these views in the marketplace (and critically to recognize such junctures as opportunities rather than to become distracted by the tremendous gloom that accompanies a bottom and the exuberance that accompanies a top).  We have returned once again to “masterful inactivity” as the ideal of the portfolio manager.  Rather than keeping up with all the trades that pop up on one’s radar, the greatest challenge in the period ahead may be _not to trade_ until the opportunity is extremely compelling.

In contrast to this ideal model for future investment strategy, we find today that people are very much lacking in belief and faith in anything.  During the years up till 2007, most investors paid very little attention to the business cycle, but held an underlying non-rational belief that the Fed was in charge of the business cycle, that inflation-targeting policy would ensure that the era of extreme booms or bust was confined to the distant barbarian past (preceding the Bloomberg first data point) and that one could focus on asset-specific ‘fundamentals’ in making decisions about which assets to own.  Since prosperity and the underlying dynamism of the American economy justified the expectations of strong growth out into the future, one could feel confident in expecting very satisfactory returns on equities and could hold a portfolio heavily weighted to equities provided one was a ‘long-term’ investor.

The experience since this past era ended has been traumatizing for such faith.  The disappointing performance of hedge funds, macro hedge funds included, led people to favour strategies whose mechanics they felt they could tangibly comprehend.  For the rest, investors are still no closer to having fundamental, robust and grounded beliefs about the nature of macroeconomic reality.  As a result, we see a tremendous instability and lack of coherence in the beliefs market commentators and investors hold regarding the economic outlook.  In July 2008, otherwise perfectly sane, experienced and well-respected market participants calmly assured one that there was a real risk the US would enter hyperinflation very shortly.  Only six months later, some of those same participants were concerned about the possibility of a new Great Depression, only much more extreme.  And a couple of years after that we heard again about the necessity of holding hard assets against the inevitability of hyperinflation some way down the line.  In other words market participants have very few stable beliefs and tend to become very whipped around by the dramatic swings in valuation – when the market has rallied a lot people turn bullish, and when it has sold off a lot they turn bearish.  So much for Milton Friedman’s argument that speculation in financial markets would tend to be a stabilizing influence!

Having devoted more than twenty years to the study of business cycles, mass psychology and financial markets, I have over time arrived at quite a stable (albeit still developing) set of beliefs about how the economy and markets operate and  intend in this service to offer a counter-balance to the nihilistic tendency of our era to hold only a view consistent with the most recent market move, and to help my clients to perceive and act on the dislocations created by the lack of market liquidity so that they become predators rather than prey.