Gold: Don't Be Mistaken For A Bottom Yet

by: Nitin Gulati

Gold (NYSEARCA:GLD) suffered its largest-ever drop in 2013, falling 28%. The huge drop in gold was triggered by fears that the Federal Reserve would begin tapering soon, and that future inflation levels would stay low. The crash in gold prices during 2013 shattered the myth among global investors that gold prices would always go up. Precious metal buyers are using this retreat in gold as a bargain-hunting opportunity. However, before taking any new positions, bargain-hunters in gold should understand the key macro drivers that influence its price.

Figure 1 below presents the price of gold and the S&P 500 price index since 1968. This time period includes phases of strong economic growth, recession, and the inflationary shocks in the US economy during the 1970s. An analysis of gold's price behavior during the growth period, and the recession after the late 1990s, helps to place gold's current price behavior in proper context.

Figure 1. Price of S&P 500, gold, since 1968 (Chart Source: St. Louis Federal Reserve)

Recessionary Phase

A strong rally in gold prices starting in August 2000 coincided with the beginning of the bear market in the S&P 500. The inverse behavior of the two asset classes since the 1970s supports an argument that during recessions, investors seek the safety of gold. During recessions, investors demand more return for the risks they take, pushing equity risk premiums higher. Figure 2 shows how variation in the risk premium impacts gold prices. The strong correlation between risk premium and gold underpins the premise that investors rush to gold's safety when they see more risk. The same price behavior in gold emerged during the financial crisis of 2008.

Figure 2. Gold Prices & Equity Risk Premium since 1970

Growth Phase

After the end of the bear market in 2003, gold moved in the direction of the S&P 500. A similar behavior in gold prices surfaced again after the end of the credit crisis of 2008. Inspecting the price movement of gold with the growth in GDP confirms the interconnectedness between the two, as shown in Figure 3. Inflationary pressures emerged for a short time after 2004, but these pressures were eased by productivity gains in the economy. Investors, expecting higher inflation in the future, triggered a gold buying spree. Figure 4 displays the US inflation rate since the 1970s.

Figure 3. Gold Prices & percentage change in GDP (Chart Source: St. Louis Federal Reserve)

Figure 4. CPI Index, percent change from previous year (Chart Source: St. Louis Federal Reserve)

Unfortunately, economic recovery after 2003 failed to create robust job growth, depressing wages and investment demand in the economy. The abnormal rise in gold prices since 2005 has been a result of this sub-par economic growth. In order to understand the effect of subpar economic growth, a review of real interest rates and their impact on the economy is helpful.

To meet its mandate of price stability and maximum employment, the Federal Reserve employed monetary policies that effectively lowered real interest rates, as shown in Figure 5. These policies have, in effect, increased profit margins by reducing the cost of business borrowing. Figure 6 displays the share of corporate profits in the US economy.

Figure 5. Ten-year real interest rate (Chart Source: St. Louis Federal Reserve)

Figure 6. Share of Corporate Profits in the US Economy

Since 2003, subpar economic growth has forced corporations to engage in cost-cutting. Corporations lowered their operating expenses by slashing their workforces, causing a reduction in profit reinvestment. Figure 7 presents the sharp decline in private investment as a share of corporate profits since 2000. Declining investments, supplemented by slow wage growth, deleveraged balance sheets have helped profit margins reach their highest levels. Figure 8 shows the relationship between the S&P 500, gold, and corporate profits.

Figure 7. Gross Private Domestic Investment as a share of corporate profits

Figure 8. Gold, S&P500, and corporate profits

Why gold tracks corporate profits

Rising corporate profits indicate a company's increased profitability, which contributes to overall economic growth. Acceleration in total profits, combined with rising aggregate demand in the economy, drives real interest rates higher. Moreover, increased economic activity reinforces future inflationary expectations, driving gold prices higher. In an environment of low inflation, gold follows rising real rates only up to the point when a rising dollar with a declining equity risk premium begins to offset the increase in gold prices. At this point, gold resumes its inverse relationship with real interest rates.

Where we Stand Now

Corporate profits' share of GDP increased to 11.1% during the third quarter, and the S&P 500's profit margin increased to 9.7% during the last quarter. Internationally since 2000, corporate profits have been rising, and the gap between international and domestic profits is widening. The path these high margins take from here depends on global economic growth. A slowdown in emerging markets, combined with the beginning of tapering from unconventional monetary policies in United States, will drive real interest rates higher. These economic factors will lead to declining profit margins in the future. Additionally, the Fed's new chairman alluded to the existence of high equity risk premium in the markets. If, in the future, the Fed pushes for a decline in equity risk premiums, downward pressure will be created on gold prices.

Recognizing the historical patterns of similar price and momentum behavior sheds more insight into this analysis. Figure 9 shows the price behavior of gold during the late 1970s to the late 1980s, and Figure 10 displays the price behavior of gold since August 2011 to its price behavior during the late 1970s to 1980s.

Figure 9. The price behavior of gold in the late 1970s (Chart from

Figure 10 . Gold prices since August 2011 (Chart from

After reaching a low in the early 1980s, gold bounced back, followed by a resumption of an existing downward trend. It remained range-bound until 2001, before embarking on an unprecedented rally. Current economic conditions, such as a tapering from QE, the strengthening global economy, and low inflation, will create more risks for gold. Investors should recognize the structural shifts underway, which could support high corporate profits in the future. From a technical perspective, gold should find support between $1050- $1100 before it embarks on another rally.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in GLD over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.