I wish I may I wish I might,
Have this wish I wish tonight
I want that star and I want it now
I want it all and I don't care how
Careful what you wish - Careful what you say
Careful what you wish you may regret it
Careful what you wish you just might get it
Then it all crashes down - and you break your crown
And you point your finger - But there's no one around…
Metallica, "King Nothing" (1996)
Very rarely does one have the opportunity to quote heavy metal band Metallica in a financial article, but we think that now is actually a perfect time as markets are roiled by a strong jobs report.
The reason for the big market drop on Friday was due to concerns that job gains will lead the Federal Reserve to raise interest rates sooner than expected. While we are not going to get into the accuracy or quality of the jobs report which we have serious questions about (Former Assistant US Treasury Secretary Paul Craig Roberts does a good job deconstructing it), but we will assume that the Fed takes this into consideration when it makes its interest rate decisions, which evidently the market seems to believe.
It is a strange financial environment that we live in where strong jobs growth which supposedly means a stronger economy, leads to the biggest drop in stocks in months - after all isn't a stronger economy GOOD for stocks? But that is not coincidence and it is telling us something very important, that the market is not rising because of economic fundamentals - It is rising because of financial engineering.
This is critical because if markets are rising because of financial engineering, but the Fed thinks that they are rising because of a strengthening economy (with the belief buoyed by a strong jobs report) and they raise rates - then there is big trouble ahead. The Fed better be careful what they wish for because they just may get it.
A Strong Economy or Just Financial Engineering?
We will get to gold soon, but let us now go into why we believe that the risings markets are not signaling a recovery, but rather are the result of extraordinary financial engineering due to historically low interest rates.
Goldman Sachs came out with a very telling table that supports our theory about why markets have been rising.
As investors can see, corporate buybacks have been steadily rising over the past few years and are expected to rise even higher in 2015 with a $450 billion dollars of net inflows into the market. Not only is that a huge number, but that is actually more than DOUBLE the total inflows expected for 2015 - that means that corporations better continue to buy back their stock or that total inflow number we see will become negative very quickly!
In fact according to Bloomberg, S&P 500 (NYSEARCA:SPY) companies will spend 95 percent of their FY2014 earnings on stock buybacks and dividends. That is great for investors and stock indexes, but there is appoint where a business has to invest in the actual business - which obviously cannot be done with a mere 5% of earnings. This should be a big red flag because it signals that economically attractive investment opportunities are simply not there. In case you are wondering what the insiders are thinking, many of them are selling their own shares at the heaviest pace in at least 8 years.
If all of this were due to a sustainable strategy of companies returning money to investors because operations are "cash-cowing", that wouldn't be a very worrisome thing. But the problem is that this is sustainable - it is due to companies leveraging themselves because of the historically low interest rates we see today.
Investors should note that net debt levels (total debt minus total cash) have reached the highest point ever. Corporations are gorging themselves with record low interest rates, but they are not using that money to increase future profitability and build their businesses - they are buying back their stock and returning the money to investors.
That is very dangerous because when we have a downturn in the economy, then all of that money spent on buybacks will be gone without any long-term benefit for the company - but the debts will not disappear. Thus the companies will be burdened with long-term debts and no long-term benefits, which is all the result of short-term thinking due to an artificially low interest rate environment.
The worrisome thing is that it is not just US corporations levering up - it is being done globally.
Source: McKinsey Global Institute
This is something we covered in an earlier article that we think all gold investors should read, but as is clear from the McKinsey chart above, debt is not only growing nominally but it is growing as a percentage of global GDP - the world is leveraging not deleveraging.
It is time to return to the Fed. If the Fed starts to raise rates because it thinks we are seeing a stronger economy, then what will happen may be devastating to markets and the whole financial system.
When rates start rising then all these debt loads of corporations, governments, and individuals will become much more onerous. That in turn will cause a pullback in spending of all three of these categories as corporations stop buying back stock, individuals dedicate more discretionary income to debt payments, and governments are forced to spend more on maintaining large debt loads. This in turn will lead to a cycle of declining stock prices as corporations are no longer holding up markets, followed by investor fear and pullback, and so on.
We want to emphasize that what is really dangerous about this is not that markets would decline as that is nothing new, but that it would happen as both interest rates are rising and leverage is at all-time percentage highs. This is an extraordinary situation that we have never seen before - pre-2007 textbooks never imagined a world where some governments and corporations would be issuing debt at NEGATIVE interest rates.
Extraordinary environments lead to extraordinary events, so we do not think we will have a nice soft landing here but something much more troublesome.
Money Everywhere, But Where Will It Go?
We wouldn't be able to do a proper macroeconomic look without mentioning the fact that all of that money that the Fed created (more than $3 trillion), the Bank of Japan, the ECB (starting March 9th), and now possibly the Chinese central bank has not disappeared. Instead it has gone straight to banks, which have lended this money to hedge funds and speculators, and which has gone into stock markets (evidenced by all-time highs all over the world) and bond markets (evidenced again by all-time high bond prices all over the world). This is what has produced our financial world recovery without an equivalent Main Street recovery.
As we have mentioned in a previous article, the growth in financial assets has been tremendous - there is A LOT of money out there.
Source: Deutsche Bank
Here is the rub: when interest rates rise and stock markets fall then both bonds and stocks will underperform.
We already know that without massive corporate buybacks the stock market would fall, but what about the bond market? Investors need to remember that you can lose a lot of money in bonds without a default - if interest rates rise then the price you can sell your bond in the market drops.
Source: Rodgers and Associates
Above is an excellent table from Rodgers and Associates, which shows the effects of an increase in interest rates on the value of a bond. Notice that there are big losses in the value of a bond with only small increase in rates when bond yields are low. For example, an investor that bought a $10,000 30 year bond yielding 1.5%, would lose close to 12% over one year with a small 50 basis point increase in interest rates. Thus his bonds would only be worth $8876 after one year - a close to $1200 loss in a single year on one of the most conservative investment classes!
Of course you could hold that 7, 10, or 30 year bond to maturity, but with record low interest rates, it is a guaranteed loss after inflation - shouldn't be a very appealing scenario. The faster investors get out BEFORE interest rates start to rise the better.
Thus we think we will have a scenario where money will come out of both stocks AND bonds - and it will need to find a home, and we think one of those homes will be the gold market.
The Oldest Safe Haven in Human History
Are we really suggesting that gold and gold miners will do well in a collapsing stock market? That is not what happened in 2008, why would it happen in 2015?
The answer is that while miners did drop, gold actually ended up rising on the year. But there is another big difference because in 2008 when we were going into the financial crisis, gold and gold miners were RISING with the stock market - the correlation was pretty high. But over the past three years gold and gold miners have DROPPED while stocks have risen - it is not the same environment that it was back then.
Secondly, and more importantly, back in 2007 and 2008 investors fled into government bonds, and falling interest rates made this a smart choice as they got safety ad capital appreciation. With the Fed raising rates and bond prices at historic lows, bonds may be an absolutely ugly investment as investors will lose money as yields are lower than inflation AND they will see the value of their bonds drop.
Finally, let's remember that gold miners may not have done well in 2008, but it other periods of history they did quite well in an ugly environment when stocks tanked. An excellent table by Casey Research shows it quite clearly.
Source: Casey Research
As investors can see, the two largest miners in Canada and the US actually rose during the Great Depression - one of the worst periods in US financial history. As Jeff Clark, Senior Precious Metals Analyst at Casey Research puts it, "During a period of soup lines, crashing stock markets, and falling standards of living, investors fled to the only gold with liquidity they could own at the time."
Conclusion for Investors
If the Federal Reserve raises rates, then they are about to make a huge mistake because they are mistaking the market's rise with improving economics, while it may be due to financial engineering. The consequences of this will hurt both stock and bond markets, and money will flee to one of the oldest safe havens throughout human history: gold.
With financial markets growing by the trillions every year due to central bank money-printing (or quantitative easing for the more sophisticated), that is a lot of money that will be searching for safety and only a small amount of that can truly change a battered gold market. As we have stated previously, to put the possible implications of this shift into perspective, the $9 trillion that McKinsey estimates that global financial assets grew by in 2014, would buy every single ounce of gold ever mined - and have enough left over to buy every single miner listed on US stock exchanges.
Thus we still think this is a great time for investors to prepare and beat the herd there by accumulating physical gold and the gold ETFs (SPDR Gold Shares (NYSEARCA:GLD), PHYS, and CEF) - though be very careful as ETFs work well in certain circumstances, but in others physical gold is much more desirable and investors should own both. For investors looking for higher leverage to the gold price, they may want to consider miners such as Goldcorp (NYSE:GG), Newmont Mining (NYSE:NEM), Agnico Eagle Mines (NYSE:AEM), or even some of the explorers and silver miners such as First Majestic (NYSE:AG) or Pan-American Silver (NASDAQ:PAAS). We're not suggesting these companies specifically (though we did recently issue a piece detailing our top five gold picks for 2015) - only suggesting them for further investor research.
While we don't think the Fed will raise rates, the market surely does as evidenced by Friday's jobs report plunge, and the Fed will be making a big mistake. If they do they better be careful when they wish for higher interest rates, and investors better watch out - and buy some gold.
Disclosure: The author is long SGOL, PAAS.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.