The Link Between Gold And Equities

Includes: GLD
by: Matthew Claassen

In recent commentary we discussed the fact that the bull cycle from the 2009 low has not experienced normal sector rotation. This would seem logical because sector rotation models are based on economic behavior as a typical four year cycle ages. The current cycle has not been a normal cycle by any measure. In addition, consistent sector leadership based on an economic driver, a theme, is missing. The most recent commentary mentioned gold and that investor enthusiasm for precious metals may be based on fearing the consequences of monetary policy (an economically unhealthy state of mind), not some new innovations in technology that have resulted in a greater demand for gold, which would be part of a healthy expansion of demand. Because there has been no theme based on a top-down economic influence, it would seem logical to examine the potential for a bottoms-up theme, similar to the "Nifty-Fifty" theme, by examining a composite of those stocks for which investors have shown unusual enthusiasm during this bull cycle.

Since 2010 we have been keeping and building a list of stocks we refer to Market Generals. These Generals are individual equity issues that at one time during this bull cycle had a "story" that investors fell in love with and that carried the stock higher with greater consistency than the broad market. [The names of the Market Generals are provided at the bottom of this article.] We felt these issues would make a perfect index that we expected would lead us to a bottoms-up type theme to the current bull cycle. So we generated and charted the index and compared it to the S&P 500 ...

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Generals Index vs. S&P 500 Index

The first and most obvious observation is that this index of Market Generals peaked in October of 2011, just three weeks before the S&P 500 bottomed. Since then, as the S&P 500 had worked higher into mid-September, our index of Market Generals held in a sideways trading range clearly underperforming. This is not what we expected. It was then that a second observation hit us; this chart of generals looks a lot like our chart of the price of gold. It was a simple enough process to compare, and so we did ...

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Gold vs. Equal Weighted Generals Index Weekly

This is where the puzzle gets very intriguing. Why would an equal weighted index of equities that had unusual investor enthusiasm at one time or another during this cycle, correlate so closely to the price of gold when the broad market index didn't?

Until this observation we thought that gold simply traded to the beat of its own drummer. Gold has shown very little correlation to the S&P 500 index and at times a poor correlation to the commodity index. What does gold and our General's index have in common that the S&P 500 does not?

Gold and our General's index are static and unweighted, where the S&P 500 is weighted and is far from static. On a capitalization weighted basis the S&P 500 has nearly a 15% turnover since the 2009 low and nearly a 55% turnover since the secular bear trend started in 2000. [Obviously the S&P 500 is far from a "Buy and hold" index. But then I digress]

What about institutional influence? Did our list of market generals accidentally represent institutional equity interest that also related to the demand for gold? In the chart below we compared our general's index to Goldman's Sachs VIP list as of January, 2012. The VIP list is just those stocks with the most institutional interest (purple line on chart). We also compared our general's index to the "New Nifty-Fifty"; a group of fifty stocks with the most consistent technical and fundamental performance (green line). There has been no meaningful correlation between these two indices and the price of gold.

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Market Generals Index & Measures of Institutional Interest

What we now know is that there is a link between equities and gold, and that link can be explained by what that list of market generals represents. When constructed, the list simply represented individual stocks that investor's believed in and had confidence that their story would carry the stock price to consistent gains. Because of the central bank involvement in supporting equity prices, the market trend has been less predictable, which has led to less investor faith, confidence and participation in this bull cycle. These stocks were the exception.

The reason why gold and the index of these Market Generals are linked is open to interpretation and debate. It could be nothing more than an improbable coincidence. But, it seems that when investors have faith that something in the equity market can reward them, that faith may spread to the potential for gold to reward them as well, or maybe an increased position in gold was intended as a hedge. With equities, in each case the story eventually unraveled, as it has done now with Apple (OTC:APPL) and we, for now, can find no new stock to add to the list, and when the market has no leadership, it is in a very vulnerable position. Still, it may be that the link between equities and gold is the faith of the individual investor that there is something this market offers them, something they believe in strong enough that is worth the risk of venturing into a new world where central bank market intervention is the norm. But when that faith is gone and there is nothing new to replace it, the correlations suggest gold will be as much a victim as equities.

The list of equities in the Market Generals index includes; Amazon (NASDAQ:AMZN), Amgen (NASDAQ:AMGN), Apple, Baidu (NASDAQ:BIDU),Chipotle (NYSE:CMG), Dollar Tree (NASDAQ:DLTR), EBay (NASDAQ:EBAY),F5 (NASDAQ:FFIV),Google (NASDAQ:GOOG),Green Mountain Coffee Roasters (NASDAQ:GMCR), Home Depot (NYSE:HD), Intel (NASDAQ:INTC) ,IBM (NYSE:IBM), Intuitive Surgical (NASDAQ:ISRG), Netflix (NASDAQ:NFLX), Priceline (NASDAQ:PCLN), (NYSE:CRM), SodaStream Intl. (NASDAQ:SODA) and Wynn Resorts Limited (NASDAQ:WYNN).

Disclosure: I am short SPY, QQQ. 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.

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