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Tough Start

It is never easy getting back to work after the holidays, but this year has been particularly tough for traders. In the first five trading days of 2016 the S&P 500 lost 6% while the Dow fell 6.2%. That represents one of the worst starts to a year ever.

The US isn't alone. The STOXX Europe 600 is down, Japan's Nikkei is off, and China has had to halt trading twice because of sudden market drops of 7% or more.
My general takeaway is: I'll take it! The US markets have looked thin (in terms of breadth) and overvalued to me for some time. And any US market downturn would encourage investors to start looking elsewhere for value, a rotation that would almost certainly bring interest to gold.

I talked through the situation in more depth in my last Maven Letter, sent to subscribers on Wednesday. Below, a snippet from that discussion. This week I will get back to commenting on industry news - there was simply little news on which to comment over the holidays!

From the Maven Letter: January 6th, 2016

Why the drops? Because economic numbers out of China disappointed. Because the end-of-year market rally failed. Because investors spent the holidays reading about fundamental weakness in the US economy. Because market transitions are marked by volatility and I think the US markets are in transition.

Remember August, when the S&P lost 11% in six trading days? It wasn’t enough to officially end the broad bull market – to meet that definition takes a 20% decline – but it was significant. And since then, two developments deserve note.

First, the US market has not managed to reach a new high since the August selloff. That comes in the context of an S&P 500 Index that dropped well below its 200-day moving average several times in the second half of 2015, a classic sign of weakness.

The next chart shows the S&P 500 since 2009 and while it does not confirm that the bull run is over – the index has dropped below its 200-day moving average a few times (mid-2010 and second half of 2011) – it certainly suggests the up-trend has weakened. The longer this weakness persists, the less likely the bull will re-establish.

Second, the Santa rally failed completely. The classic definition of the Santa period is the last five trading days of the year plus the first two trading days of the New Year. Others take a broader approach, assessing December as a whole. Both are pretty consistent over recent years and both were negative this time around.

As you can see, the Santa rally is pretty reliable…but simply did not happen this year. In response, investors fled.

All sectors of the S&P 500 dropped in the January 4th selloff. Notably Facebook, Amazon, Netflix, and Google, the heavyweight group known as FANG whose fantastic share price performances in 2015 made the index look much better than it was, dropped more than the average.

In other words, the biggies that have been pulling the average up stumbled.

That matters because, as I have said before, narrowing market breadth is a symptom of the end of a bull run. And the run ends when the few biggies that have been carrying all the weight stumble.

I don’t know if the US markets will turn down tomorrow, next month, or in year, but I do know that the current bull market has lasted much longer than bull markets usually last. I also know US stocks are more expensive than usual – the average price-to-earnings ratio in the S&P 500 is currently 30, almost twice its usual average. And the gain in this bull market has been almost 200%, significantly more than the 136% gained on average in a US bull market run.

There’s also the fact that S&P sales growth has fallen to almost zero. And that credit spreads just keep widening, as the level of risk investors are attributing to junk bonds climbs and climbs. As my friend Eric Coffin put it so nicely the other day: “Problems in the credit markets always show first at the risky end of the spectrum.”
Short story: while there is no one glaring deficiency that shouts “The bull market is ending!” there are numerous historic and current data points that suggest the end is nigh.

What has gold been doing amidst all of this? Not a lot, though the last few days have seen a nice move up.

Did gold rise because North Korea claimed a successful hydrogen bomb test? That would fit the classic gold-as-a-safe-haven argument, but (1) I don’t believe a single word that comes out of Kim Jong Un’s regime and I am not alone and (2) falling stock markets are a more reliable reason for gold to gain than unlikely and unsubstantiated claims from an insane Pinocchio autocrat.

Reason (2) gets stronger when you remember the date: it’s early January, the start of gold’s strongest season of the year.

It is impossible to predict how strong gold’s season will be, but it is getting off to a good start. If US markets continue to decline, added interest will turn to gold. If North Korea keeps making threats, if Saudi Arabia keeps picking a fight with Iran, if the fragile web of friends and enemies surrounding Syria becomes more fraught, if China continues to push for power in the South China Sea, if oil continues to fall despite significant tensions in the Middle East, if China keeps letting the Yuan slip in value – all of these would encourage a stronger gold price.

As for the US dollar, gold benefits no matter which way it goes. A stronger US dollar would crimp US manufacturers and exporters, pushing the US into a recession; that would be good for gold. A weaker US dollar would benefit gold directly, simply because the price is US-dollar denominated.

It’s interesting days, my friends. That China just experienced its second stock market mess in a week is pretty interesting. Can’t wait to see how traders react tomorrow morning.

Interest Rates Addendum

When Yellen raised rates I said it was significant because it marked a change in direction, from loosening to tightening, from endless access to cheap money to an end to access to cheap money. That change matters to companies in need of debt, to the rate of share buybacks (which have been largely fueled by debt), to firms needing to renegotiate debt packages, and to investors assessing the impact of the rate raise.

When it comes to gold what really matters is not the nominal interest rate that Yellen just raised, but the real interest rate. The real rate is the nominal rate minus the rate of inflation. In other words, it is the actual interest one earns on cash after accounting for inflation’s impact on each dollar’s value.

Gold struggles against cash when real interest rates are high or rising, because cash pays but gold does not. When real interest rates are low or falling, however, gold shines. We had a great example of this in the 1970s: gold jumped a ridiculous 1,780% over ten years while nominal interest rates also rocketed up, from 2% to 17%. However, inflation was also on a tear, so much so that real interest rates stayed low – people were not able to make money by holding cash, so they bought gold.

What is going on with real rates today? The complicated part of that question is getting a handle on inflation. The official line is that inflation is a measly 0.5%; others have it higher. Comparing that with today’s 10-year bond yield of 2.2% gives a real rate of less than 1.7%. That ain’t much. Importantly, it is even lower in other parts of the world. In Japan real rates are negative, with estimates as low as -1%; rates are also negative in Germany and France and are near zero in Canada.

It’s hard to know what will happen to real rates going forward. For starters, it’s hard to know what will happen with nominal rates – the scatter plot suggests the Fed wants to keep inching up all year, but the market doesn’t see that happening. Inflation is also hard to predict, though I would side with low inflation if pressed.

The sum of it suggests that, despite all the rate talk we’ve endured, rates will not be the most significant influence on the gold price this year. They could well be pretty boring, in fact, leaving gold free to react to more general financial concerns or geopolitical tensions or investor interest.

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