Crude Oil And Gold To Correct On A Strong Dollar

Includes: BP, GDX, GLD, UDN, USO, UUP
by: Disruptive Investor

I have a bullish view on precious metals and the energy sector for the long term. I discussed the fundamental view on gold and crude on two separate articles earlier: "Justifying Gold Prices From A Money Creation Perspective" and "3 Long-Term Bets On Crude Oil".

In this article, I will be discussing the reasons to be bearish on gold and crude for the near term. Needless to say, considering the long-term outlook, any meaningful correction would be a great time to buy gold and energy stocks.

As the headline suggests, there is a strong relation between a strong or weak dollar and asset classes. Also, there is a strong relation between economic activity and the dollar trend. In general, as economic activity weakens, there is a shift of liquidity from risky asset classes to relatively risk free asset classes or cash. In such a scenario, there is a relative tightening of global liquidity. This, in turn, leads to a stronger currency. In other words, a strong dollar is a symptom of tightening global liquidity and decline in risky asset classes.

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This conclusion brings us to the next important question -- Why will the dollar strengthen in the current scenario?

There are several reasons for expecting a relatively stronger dollar in the near term. The first relates to corporate earnings in the U.S. and global economic activity. As witnessed over the last few days, several large companies have missed on their estimates, and this has lead to a decline in equities. Weaker earnings have been a result of a sharp slowdown in global economic activity and a manufacturing recession globally. Investors are increasingly moving towards more "Risk Off" trade than "Risk On" trade in the current scenario. This sentiment is reflected in the 10-year Treasury bond yields, which have declined from a high of 1.89% in mid-September 2012 to 1.75% at the time of this writing. Clearly, liquidity is flowing to relatively risk free assets.

One might argue that gold would also fall in the risk free asset category, and should trend higher instead of correcting. The key point to understand here is that weaker economic activity leads to deflation fears, and a stronger dollar also compliments the deflation fear trade. In such a scenario, gold will trend down.

The relation between gold prices and currency is significant, as indicated by gold price appreciation in dollar terms and in terms of currencies making up the dollar index. Over the last two months, gold has appreciated by 3.5% in dollar terms, while it has just appreciated by 0.9% in terms of currencies making up the dollar index. This difference in returns is even more pronounced when looking over a period of five to 10 years.

The point I am trying to make here is that I do expect a stronger dollar in the near term, and gold will underperform as long as the dollar remains strong. The same holds true for crude oil. Of course, crude oil prices are a function of many other factors, such as the demand-supply scenario and geopolitical tensions. However, with weak global economic activity, there is no reason to be bullish on crude oil prices in the near term, unless someone is expecting an Iran conflict over the next two to three months. In such a scenario, crude might go ballistic, leading to a deep global recession.

Leaving the geopolitical tensions aside, I do expect crude oil to continue its phase of correction amid a recession in the eurozone and a sharp slowdown in the U.S., China and India. As mentioned earlier, a stronger dollar will additionally contribute to the correction in crude prices.

If we are really headed for a global recession as suggested recently by Stanley Fischer, it would not be surprising to see Brent crude trading below $90/barrel levels. Mr. Stanley might be right in his prediction, as the global economy is already in a manufacturing recession, and is afloat due to the expansion in the services sector.

Besides the current economic scenario leading to a stronger dollar, I also expect the fiscal cliff event to be positive for the dollar and negative for risky asset classes. I certainly don't expect tax increases in the coming few months. However, market participants will witness a phase of extreme nervousness and uncertainty before the tax cuts are extended further. During this period, the dollar will strengthen meaningfully. The same expectation holds true for the next debt ceiling discussion due in the next to three months. It is certain that the debate on another increase in the debt ceiling will lead to "Risk Off" trade.

Considering these factors, it would be a good idea to avoid fresh exposure to crude and gold at these levels. A 10-15% correction or more would be a great long-term buy opportunity for these hard assets, as I do expect central banks to continue with their expansionary monetary policies, leading to weaker currencies over the long term. For now, a short-term trade on Treasuries might not be a bad idea.

For the long term, I would consider exposure to the following stocks and ETFs:

SPDR Gold Shares ETF (NYSEARCA:GLD): The ETF seeks to replicate the performance, net of expenses, of the price of gold bullion. The ETF has an expense ratio of 0.4%, with net asset holdings for the fund at $65.26 billion.

Market Vectors Gold Miners ETF (NYSEARCA:GDX): The ETF seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the NYSE Arca Gold Miners Index. The ETF holdings have an attractive P/E ratio of 13.8 and an equally attractive price to cash flow ratio of 5.59.

BP Plc (NYSE:BP): Long-term exposure to oil exploration companies is a must if one is bullish on the energy sector. Geopolitical tensions, weaker currencies and demand from emerging markets will be the key growth drivers for energy stocks. I personally like BP, which provides a dividend yield of 4.5%, besides looking promising for long-term capital appreciation. The company is an attractive long-term buy for several other reasons as well. It has an excellent and diversified asset base, presence across the value chain, and presence in alternative investment themes. Further, the TTM P/E is at an attractive level of 7.7. Overall, BP is well-positioned to take advantage of the long-term appreciation in crude oil prices.

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