Market Slides Matter
The broad markets are clearly the topic of the day, after yesterday’s slides took major US stock indices into negative territory for the year. Is it a correction or a crash? Consensus is pretty solidly on the side of ‘correction’ and I agree, but there are a few points worth noting.
The percentage of stocks in a bear market pushed above 40%, which is one sign of how significant the damage. Significant damage creates fear, even when few actually think a crash is coming, and of course fear of an increasingly volatile market is one foundation for a bullish outlook on gold.
The other foundation is real rates. By way of reminder: real rates are interest rates minus inflation, a calculation that captures the real benefit (or cost) of holding dollar-based investments.
When interest rates stay ahead of inflation, dollar-based investments collect interest, at the real rate. That reliable income pulls big money to bonds.
When that changes, when inflation gets ahead of interest rates, dollar-based investments lose money. That setup has long pushed investors towards gold, which may not pay interest but doesn’t sit 2 there eroding in value.
The argument also works because, if real rates are negative, then we’re either seeing:
Strong inflation: weaker dollar--> stronger gold, or
Economic struggles sufficient to prompt the Fed to cut rates: economic anxiety --> good for gold
The most common data points to use are the yield on the 10-year US Treasury for interest rates and the 5 Year 5 Year Inflation Swap, which estimates inflation over the 5-year period starting 5 years from now, for inflation.
10-Year Treasury Yield – 5Yr5Yr Inflation Swap = Real Rate of Interest
3.06 – 2.13 = 0.93%
To get an immediate capture of real rates, you can use current numbers: the Federal Funds interest rate and the 12-month CPI.
2.25 – 2.1 = 0.15%
Real rates are clearly still positive, which is one reason why gold hasn’t gotten very far yet. But I’m bringing this all up now because, after two months of volatile and negative markets, investors are starting to question whether the Federal Reserve will stick to its plans to keep raising rates.
It’s a real question. In recent tightening cycles, stock market weakness was a key factor in stopping the cycle. The market looks ahead, so a sliding stock market says investors see more reasons for things to get worse than to get better.
Of course, higher rates amplify economic slides by discouraging borrowing. Less borrowing means less business spending. The share buybacks that have fueled this bull market have also been funded by debt; as debt gets more expensive buybacks will decline, erasing an important factor for this bull.
The tech stocks that have led this big bull market – the famed FAANG group – have bought back oodles of shares. That has helped maintain gains so strong and steady that everyone piled in, got comfy, and profited. Now that group is stuttering. I mentioned this last week and it’s only gotten worse since:
It’s important to pay attention to the group of stocks that have led a bull market. In 2000 the market had just enjoyed a huge tech boom; the Fed stopped its rate hiking cycle when the NASDAQ was down 35%. In 2006 the market had been soaring for years on real estate and housing; the Fed backed off on rate hikes once homebuilders were down 46%.
The FAANG stocks are currently down 26%.
In both 2000 and 2006, the Fed stepped back from tightening after 2-Year Treasury yields broke below their 100-day moving averages. Today 2-Year Treasuries yield 2.79% against a 100-day moving average of 2.74% (thanks to Martin Roberge, a portfolio strategist at Canaccord, for drawing these 2000, 2006, and today comparisons and creating the above charts).
The market is still giving 72% odds that the Fed will hike in December. If it happens, it’ll be business as usual – investors will have priced the move in, so reaction will be muted. (We’ve moved past the point of gold bouncing hard on a rate hike after being oversold going in.)
If the hike doesn’t happen, though, it will light a fire under gold. It would legitimize concerns about the market and about growth, since only a Fed concerns about exactly those things would step back from its telegraphed hiking path, an abundance of concern would send investors flocking to gold.
And they would do so just when there are more bets against gold than at any time in the last decade.
This chart shows the net difference between investors betting for and against gold. It’s hard to believe, but positioning is more bearish now than it was during the bear market! (Thanks to Mauldin Economics for the chart.) Big bear positions matter if a price moves up significantly because all the bears have to buy gold to cover their bad bets. That short covering can propel a rising price even higher. I’m not saying this is all about to happen. I’m just saying that what’s going on in the stock market matters. If things remain volatile or slide notably again before the December 19th Fed meeting, odds of a rate hike will diminish. And gold investors will want to be aware and prepared for that possibility. All told, I feel I am prepared. I have been positioning in gold stocks for the last several years in preparation for the next gold run. That said, if you enjoy short-term trading, the gold rally that will happen if the Fed alters course would provide some nice quick profits.