Hooray For The Fear Trade

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Includes: AAAU, BAR, DGL, DGLD, DGP, DGZ, DZZ, GDX, GLD, GLDI, GLDM, GLDW, GLL, IAU, IAUF, OUNZ, PHYS, QGLDX, SGOL, UBG, UGL, UGLD
by: Clif Droke
Summary

Fear, not currency factors, are behind gold's latest rally to new highs.

Stock market strength is no longer a deterrent to gold demand.

Gold mining stocks still have a strong tailwind this summer.

The impressive summer rally for gold and silver continues to gain strength, even as the U.S. broad equity market remains on a firm footing. The main reason behind the rally in the mining sector has nothing to do with stock market volatility, however. Instead, it’s based primarily on the persistent fears for the future safety of the global economy. In this report we’ll examine this important psychological driver behind the latest push toward yearly highs in the gold price and why it’s not likely to abate anytime soon. We’ll also examine the continued surge in the gold mining stocks as I show why the bulls still enjoy an advantage.

In recent reports I’ve highlighted the strong correlation between heightened levels of fear and uncertainty among participants and rising gold prices. I’ve also argued that fear has been the main catalyst behind gold’s rally this summer, as opposed to it being a currency-driven move. My thesis is that as long as investors are apprehensive about the global economic picture and are fearful of another setback in the U.S. financial market, gold and gold mining stocks should continue to outperform.

That assumption isn’t likely to change anytime soon, and gold’s latest surge toward a new yearly high only serves to underscore the metal’s relentless strength. The demand for safety among investors around the world is keeping gold’s upward trend intact, and the latest news headlines have done nothing to diminish their fears.

Among the latest worries are continues fears over the U.S.-China trade war, as well as lingering concerns over the economic health of the European Union in the form of the latest U.S.-EU tariff threat. Recent military and economic tensions between the U.S. and Iran also have investors worried. Then there is the perpetual fear about whether or not the Fed will lower interest rates in the coming months. Clearly, then, there is no shortage of things for investors to worry about, and this bodes well for the gold “fear trade.”

Added to the growing list of concerns is a worry is the possible threat that oil prices will again commence an upward surge toward levels which might undermine economic growth. It has been said that every $10/barrel increase in the price of crude oil reduces global growth by two-tenths of a percentage point. With the oil price (below) closing in on a $10 gain since bottoming last month, investors can expect to see increasing worries on the part of economists.

Crude Oil

Source: BigCharts

Along these lines, the head of the International Monetary Fund, Christine Lagarde, stated that risk to the global economic outlook “remain serious” and that the global economy has “hit a rough patch.” This underscores the apprehension that even economists and institutional analysts are feeling right now, a feeling that is even greater among individual investors.

Earlier in this report I noted that the stock market’s strong performance this summer obviously isn’t the main reason behind the demand for gold. Yet by the same token, fears pertaining to the stock market’s future performance are one reason why gold is in such high demand. There’s a growing sense that another major stock market decline is imminent as investors remain on edge after last December’s market plunge.

Indeed, several analysts and commentators have recently played up the possibility of another broad market decline. One such example was provided by Elia Lattuga, a researcher at UniCredit. He told MarketWatch in a recent article that he foresees a U.S. economic recession by 2020, with “significant” signs that it will happen by the end of this year. He also said that a 10% drop in the stock market is possible, especially if there is additional deterioration in the U.S. growth outlook.

The above-mentioned concern over a stock market correction has arguably been one of the biggest supports for gold’s “fear factor” in recent months. It is this persistent dread of another steep decline in the benchmark S&P 500 Index (SPX) which has largely served to increase gold safety-related demand even as stock prices continue to trend higher.

The following graph illustrates the point I’m making here. In the last few years there was an inverse correlation between gold prices and stock prices. Shown here is the continuous contract gold price (GC00) versus the SPX. As recently as last autumn you can see the inverted performance between gold and the broad equity market.

Gold vs. S&P 500 Index

Source: BigCharts

Yet the dynamic between stocks and gold changed beginning earlier this year. For much of 2019, there has been a tendency for both stocks and gold to rally together without undermining the demand for each. Stock investors have been content to hold onto their investments while also hedging against global uncertainty by owning gold. This again suggests that it is the fear of the unknown, more than any single factor, which is behind gold’s rise. It also suggests that a rising stock market is no longer a deterrent to increased gold demand. That's good news for bullion investors from a long-term perspective.

That fear is driving demand for gold is even more manifest when comparing the strength and stability of the U.S. dollar index (DXY) with the metal’s price. Even as the dollar index has drifted higher for most of the past year, gold has been able to largely ignore these currency-related headwinds thanks to the intense safe-haven demand for the precious metal.

Gold vs. U.S. Dollar Index

Source: BigCharts

Along with boosting the gold price outlook, fear is also one of the big drivers behind the recent surge in the gold mining stocks. With the PHLX Gold/Silver Index (XAU) having hit a new yearly high on July 10, it’s clear that investors are buying gold stocks to leverage the fear trade in physical gold. The XAU, which is the benchmark for U.S.-listed precious metal mining stocks, has gained nearly 23% since the end of May. That’s the best 6-week performance for the mining shares in years.

PHLX Gold/Silver Index

Source: BigCharts

This bullish performance isn’t likely to end anytime soon, either. The internal momentum structure of the 50 most actively traded mining stocks continues to support rising prices. Shown below is the 4-week rate of change (momentum) for the new highs and lows of the actively traded gold stocks. As I’ve argued in recent commentaries, as long as this indicator is rising the near-term path of least resistance for gold stocks remains up. And with investors still very much worried about the global economic outlook, the demand for both gold and the companies that mine it will continue.

Source: NYSE

With fears over the global economic and geopolitical outlook still very much alive, investors can expect gold’s “fear trade” to remain intact this summer. Even if investors’ worst fears fail to come to pass, memories of last year’s scary stock market decline are still fresh and will keep the flight-to-safety impulse toward for months to come. Gold mining stocks should also continue to see increased demand based on these lingering fears. In view of the factors discussed here, investors are justified in maintaining longer-term investment positions in gold and gold ETFs.

On a strategic note, I’m currently long gold via the VanEck Vectors Gold Miners ETF (GDX). For this ETF I’m using the $24.40 level as a stop-loss on an intraday basis. Participants who haven’t done so should also book some profit in GDX after its impressive run of the last few weeks.

Disclosure: I am/we are long GDX. 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.