Seeking Alpha

Major Asset Class Rotations Toward Gold

|
Includes: GDX, GLD
by: Paul Wong
Summary

Each asset class performs better than others only for a duration.

It is timely to denominate all our financial assets in gold instead of currencies.

Many reasons behind gold’s ascent since last August are strengthening.

Miners enjoy improved profitability because of rising gold prices.

Hypothesis:

Data processing can transform the complex data set to a format in charts that are easier to view and understand, about the benefits of asset class rotations.

Introduction

The recent article by Ray Dalio, about Paradigm Shift to increase gold in diversifying risk, is noticeable.

I wrote two articles on the same subject name with the same conclusion in here and here, the last one on 01/31/2018 which was at the peak of the global stock market. Gold rose for 3 months afterwards, but then went down due to the strong USD because of trade wars and the Fed's quantitative tightening. The slide hit bottom on August 16. Gold has resumed the upward path after the hiatus and rebound to a 6 year high now.

USD and gold as money

The following chart illustrates the different major asset classes, and the likelihood of appreciation of each asset class verses currencies due to another round of money expansion. Of courses, the future performance of each class in complex and tenuous and will depend on global events and policies. The picture below is a simplification to briefly describe the concept of wealth growth among asset classes.

The 180-switch of the Fed from quantitative tightening (QT) to quantitative easing (QE) changes the outlook of all major asset classes, US dollar, bonds stocks and gold. The complete alignment of all central banks to begin another round of easing policies will affect each asset class differently. This article aims to provide some tools as charts to track the relative changes, by rotating the asset classes in a timely manner. The Fed's new easing policy is especially positive for gold.

Congress approved the creation of the Fed in 1913. The circular backing of the USD by the Fed and US bonds by the Treasuries ties both together with the same government. The fact that they are easily convertible with similar ratings as risk -free assets means both have the same status as liquid assets for investment purposes.

With increasing issuance of based money plus treasuries, the USD will devalue against an asset class, such as physical gold, over time. Gold has appreciated against USD at a 7% compound rate for a 50 and a 20-year time frame, from $35 and $250 respectively to $1400 today. Lately, gold achieved a 9% rate from the low in 12/2015 as shown in the chart below.

Stocks

The increases of macro inputs such as gold, interest rates, oil prices and the US dollar, are usually negative for stocks. A composite (summation) of the inverse of the above inputs can track the macro conditions for stocks, and potentially serves as a leading indicator.

The composite appears to be quite adequate in showing the deteriorating macro conditions, in divergence with stocks, for the past 3 stock drops. The similar divergence pattern is appearing again as warnings. Some of the following discussions will address the timing of the next stock correction.

The US Dollar Index (NYSEARCA: UUP) is the value of the US dollar (USD) relative to a basket of foreign currencies. The dollar value of an asset is simply the product of the asset with UUP (UUP*Asset or $Asset).

SPY in orange and $SPY in beige below are at higher peaks again. $SPY rises much more since April 2018 due to the strength of the USD or UUP in light blue.

The 49-month chart below shows UUP, $SPY and $TLT as dollar long-term bond in gray. Each asset class can drop substantially, such as -22% for $TLT and -13% for UUP in 2018. The strong rebound in all 3 asset classes traced back to the start of the trade war in 04/2018 and the Fed's QT which since then has been reversing. Lately, UUP slows its upward move.

The last 3 stock peaks were preceded by the rolling peaks of UUP and $TLT in purple color line, possibly expressed as lessening confidence of the dollar and rising interest rates of long-term bonds. This pattern of rolling peaks is forming again as both UUP and $TLT are weakening lately, suggesting another stock peak is forming.

The tri-polar chart of the 3 asset classes is a good representation of the US financial system composed of the dollar, bonds and stocks. Each asset class usually behaves differently from others most of the time. The rise of all 3 asset classes from 04/2018 to 09/2018 due to the trade war was really remarkable.

Another way to show the previous topping patterns of UUP and $TLT preceding the fall in stocks is presented below. Assuming the summation of $TLT and $SPY as pseudo-financial market in blue color, as compare to the sum of TLT and SPY in green, this blue indicator peaked one month or a few days before the peaks of the stock market for the past 2 years. The current reversal on 07/09 serves as a warning flag for the next stock peak.

Quad-polar asset class rotations with Gold

The following table describes the reasons behind gold's ascent since last August:

Reasons

Timing _ comment

Rising budget and trade deficits depress USD

ongoing

The Fed's 180 to dovish tone

confirmed after 7 months

The administration prefers weaker USD

ongoing

Money printing and more sovereign debts encourage inflation in commodities

ongoing

Paradigm shifts of money managers adding safe tangible asset- Gold

ongoing

Basel III from BIS promotes Gold closer to risk-free asset

confirmed

Developing countries reduce demand for dollars in global trade

ongoing

Many central banks are accumulating more Gold

accelerating

M&A in Gold mining to improve profitability

accelerating

Socialism is rising to increase budget deficits

accelerating

Physical Gold combines with new money transaction technology will add demand

emerging

Hedge against global financial market turmoil with counter party risk

emerging

The rapid rise of gold to a 6 year high since April 26 has been impressive. Many of the reasons above are actually strengthening, to the point that more investors are piling on as indicated by higher volumes in physical gold ETF.

As gold becomes more important to a portfolio, mainly due to the weakening of currencies with more easing moves by the major central banks, gold is added to the above tri-polar plot to form the quad-polar plot below. The 49-month chart displays the polar nature of each asset class, which acts mostly opposite to others at any one time. Also, each asset class reacts quite differently to geopolitical events and the Fed's policy changes. The future burden of more US debts due to the increasing twin deficits will exert more pressure in lowering USD, to drive gold prices higher.

The similar chart below simply transforms the above chart by dividing the daily average of the 4 asset classes over the same 49-month period. The idea is to lay the overall asset classes flat for easier viewing and comparisons. Over the four years, stock is the big winner. Long-term bonds and gold are average, and USD is the lone loser. This analysis does not include dividends and yields from stocks and bonds, so the actual returns are higher for both.

The idealized holding periods for each asset class suggest that rotations among assets are highly advantageous, as each asset class performs better than others only for a duration. The holding period of each asset class ought to be finite with a stop order before the following bigger losses. This critical point will be even more important if the markets become more volatile.

Another easy way to observe the merit of rotation for each asset class is to divide itself by gold as shown below. Gold out-performs other asset classes since May 6. Of course, stock has been the winner the past 4 years but is trending down against gold since last August, and so are long-term bonds and USD. USD is falling rapidly in depreciation against gold, reflecting the progressive easing of the Fed since December. USD descends to the tune of about 4% per year against other asset classes. The color arrow bars are ways to show the idealized holding periods of each asset class, which generally do not march with the same rhythm nor occupy the same holding time. It is helpful to see the development and relations of the asset classes with this chart. The quad-polar aspect of the asset classes means that there is at least one asset class that performs better than others at any one time. The best profits potential over time will be to hold only the ones that gain, and to sell the rest aggressively.

The chart above also makes a good point to denominate all our financial assets in gold instead of currencies, which have more likelihood of devaluation. Tracking the performance from the gold vantage point, as the chart illustrates, offers an extra dimension about asset classes. If the idea is put into practice, the liquidity pool holds mostly gold ETF and the currencies are kept to a minimal. Conversion of some savings accounts into gold is sound too.

The chart below applies the same composite concept to gold, by summing the inverse of basic inputs, USD, interest rate as LIBOR and SP500. Because core inflation has been low for the past years, oil does not correlate so it is skipped from the composite. Falling LIBOR and slowing USD ascent are the factors of the basics condition for gold's uptrend in the past months. The composite pinpoints the date of the reversal on April 26 which in retrospect was a very good entry point.

Miners

$gold in brown color, UUP*gold, is higher than gold by about 5%. $gold represents the real or global value of gold that has been strong since last August. As QT is transitioning to QE around the world, faith in the Fiat system will be fading away slowly. This set up is favorable for gold to repeat the 2011 run.

I think the profitability of gold should depend on $gold instead of US gold price, especially for the international gold companies. Rising gold means much better earnings for miners. As the earnings reports come, both gold and silver miners have sprung higher in anticipation.

Silver finally woke up for the past 2 weeks after crossing 93 in the gold to silver ratio, indicating extreme undervaluation in comparing to gold. The upside for silver is huge if gold continues its uptrend. The chart below is an update of the miners.

Conclusion

The proliferation of money and credit of the past eleven years resulted in enormous private profits in financial assets such as stocks and bonds, based on low interest rates and more public debts to the governments. The instability will cause paradigm shifts in major asset classes, to diversify more to a tangible asset class such as gold, which is risk free with no counter party risk. Banks may do the same by replacing bonds with physical gold.

Adding gold to the traditional major asset classes offers more flexibility to rotate among each other. As volatility increases on each asset class, active switching can be very profitable.

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. I have no business relationship with any company whose stock is mentioned in this article.