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John Kozey is Director of Research at KnowVera, LLC, where he oversees research and trading of algorithmic trading strategies. Prior to that, as a Senior Analyst at Thomson Reuters, he produced reports blending fundamental and technical analysis for actionable ideas. John was also Equity... More
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  • Gold-On Might Be A Better Bet Than Risk-On For QE3 0 comments
    Sep 19, 2012 4:50 PM | about stocks: GLD, SPY

    Abstract: When the Federal Reserve announced its prior rounds of quantitative easing, one of the consequences was a slump in the price of gold relative to stocks. The early response to QE3, however, suggests that this time may be different, and that it's possible gold may still shine.

    See the video and read the text article here:

    link.reuters.com/sum72t

    If you still find yourself struggling whether you're more comfortable being "risk on" or "risk off" in the stock market these days, it might be time to consider something entirely different: the "Gold on" trade. "Gold on" - being long gold- has proven to be a strategy that has beaten the S&P 500 ever since the financial crisis began in 2007.

    Investors have struggled in vain for centuries to pin some kind of real value to gold. While that still isn't possible - gold's value is in the eyes of investors - one picture sums up its importance to investors since stock prices peaked in October 2007. That is the yellow line in the chart below, which plots the performance of the precious metal in absolute terms (indexed to 100) as represented to by the SPDR Gold Trust ETF (GLD.N) over that period. Gold has marched upward in a nearly steady line, while the green line representing the performance of the S&P 500 index has straggled along, only recently returning toward 2007 levels. Only the interventions by central banks and sovereign government in the economy have interrupted gold's advance, and then only temporarily.

    Now, four days after the latest Federal Reserve intervention - an open-ended commitment to stimulus as long as the jobless picture is as gloomy as it appears today - something seems to be different. In contrast to prior periods during which the Fed intervened - depicted on the chart below - stocks do not appear to be outperforming gold. Perhaps this is a signal that this onetime obstacle is no longer a factor to which investors must give as much weight as they once did?

    Figure 1.

    To represent the performance of gold, we selected the SPDR gold ETF; had you invested $100 in this exchange-traded fund five years ago, it would be worth about $225 today. Meanwhile, the same $100 invested in the S&P 500 would leave you with, well, pretty much nothing more than the same $100 - and then only if you reinvested all the dividends you earned over that period, as Datastream charts suggest.

    To get further insight into the periods during which gold outperformed stocks during this five-year time frame, we dug more deeply. The chart below displays the result of our inquiry, with a rising orange line identifying points where gold was beating the S&P 500, while a falling line signals a period when that trend was reversed.

    Figure 2.

    Going back to late 2008, when the Federal Reserve announced its first round of quantitative easing (an event marked by the first vertical red line), it's easy to see that gold was trouncing the S&P 500 up until that point; even though the price of gold was actually declining in absolute terms, the fact that stocks were in the midst of a rout made gold's performance look relatively strong. The announcement of the first round of quantitative easing in late November - a $600 billion package - reversed the trend for about a week. After that, investors resumed their aggressive buying of gold, spurring a sharp jump in the gold/S&P 500 ratio. That ended on March 18 2009, when the Fed announced a $900 billion expansion of QE1. That kind of significant announcement often causes strong trends to reverse, although that is most clearly seen in hindsight. But after the end of QE1 on March 31, 2010, financial markets got nervous once more - and once more, gold outperformed stocks.

    Then came Fed Chairman Bernanke's famous speech hinting at a second round of quantitative easing at the Fed's annual conference in Jackson Hole, Wyoming, in late August 2010. In the wake of that event, gold and the S&P 500 generated roughly even returns - until QE2 itself ended on June 30, 2011. Then, once again, gold ruled the roost - at least until the central bank announced Operation Twist, an attempt to drive down longer-term interest rates. That program's debut marked the recent peak in gold prices.

    Other factors have been contributing to the stock market's gains since Operation Twist began earlier this year, ranging from the stronger dollar to fresh hope that European Union politicians and policymakers might save nations on the eurozone's periphery such as Greece and Spain from complete economic collapse, while preserving the European Union.

    A stronger U.S. dollar buys more gold (or, alternatively, it takes fewer dollars to buy the same quantity of gold) and a Reuters poll of the three-month forward Euro versus the dollar earlier this month shows that the dollar continues to hover at around a median $1.22 per euro, not radically different from the rate seen in July before ECB president Mario Draghi issued his now-famous pledge to defend the euro at all costs.

    Reuters Poll: three-month forward Euro vs. U.S. dollar

    That kind of dollar/euro exchange rate doesn't augur well for economic trends in Europe as compared to the U.S., with a stronger dollar forecast for today and into the new year. To the extent that the Reuters poll is correct in suggesting that the euro will be weaker next year, that sentiment may well help support the price of gold. But what about the upside for U.S. stocks? The current forward P/E ratio for the S&P 500 according to Datastream is 12.6, and just below its 12.9 median value over the past five years of the financial crisis (Figure 3). One may well wonder how much more the P/E may expand in this environment, in the absence of some sort of topline revenue growth.

    Figure 3.

    There are a number of reasons that it makes sense to own gold at today's prices. The precious metal is perceived to be a store of value in the event of a financial market meltdown or an economic collapse. Gold also is an asset that typically gains ground alongside inflation (the logical ultimate consequence of so much stimulus) and a weaker U.S. dollar (ditto).

    Counter-arguments for stocks continuing to outperform gold include the Federal Reserve's open-ended commitment to stimulus ("non-sterilized QE") and its willingness to continue printing money until employment levels are satisfactory once more. Moreover, there are signs of some economic improvement from around the globe, including Europe and China.

    Over the last five years, gold has beaten stocks in periods preceding major fiscal and financial announcements by central banks and sovereign governments. In light of the fact that the S&P 500 has climbed 15% since its low June 4, 2012, the signs seem to indicate that gold may continue to outperform stocks in the future - at least, as long as we continue to see none of the responses to central bank interventions that have characterized other Federal Reserve quantitative easing measures, which in previous interventions took the gold versus S&P 500 ratio lower.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Themes: Gold, Stocks, S P 500, QE, QE3 Stocks: GLD, SPY
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