Losing Their Religion

From the February 26, 2016 HRA Journal: Issue 247

The markets have certainly stayed interesting and have been a happy place lately if you’re bullish on gold.  We’ve seen bounces before, especially this time of year so it’s no surprise that resource stock traders need more convincing.  Q2 can be a weak time for gold and we’ve all seen the “PDAC curse” too many times to count.

There’s a bit of a pullback going on now. So far $1200 has been strong support for gold prices which is pretty impressive given where we were a couple of months ago.  We’ll see if it keeps holding but as you already know I do think the bottom is in for gold.  It’s more a question of what the rally looks like and how long it goes.

New York has been having its own rally and fear gauges and investor surveys show bullishness is coming back quickly.   I still think we have a bear market before this is over.  It’s impressive how well gold is holding up but I think that is a measure of the growing distrust in central bankers.  That isn't good as those bankers were the main underpinning for the bull market.  Without that faith I don’t know what keeps NY trading at current valuation levels.  That’s a big reason I’m still bearish.

There have been a few heavily seasonally adjusted metrics that should please the Fed.  One real danger is that I still think the odds of another rate increase are higher than Wall St is pricing in.  That could be a trigger for another leg down.  Stay vigilant.

***

Markets are rallying again, for now.  You can almost hear the sighs of relief from Wall St as traders assure themselves that, surely, this time the day has truly been saved.  Perhaps, but I wouldn’t be breaking out the rally caps just yet.

We’ve seen a nice bounce in the past few sessions and bulls are getting confident again but this sort of rally is just as common, indeed more common, in bear markets than bull.

During the 2001-2003 and 2007-2009 bear markets there were almost as many up days as down days.  Both bearish periods also featured 40 trading days with one day gains of two percent or more.  Some of those rally days were huge. In the midst of the post-Lehman swan dive in the last quarter of 2008 there were no less than six days that featured 5% plus one day gains.

The message here is to be careful not to get seduced by sharp rallies in downtrends.  They are common and, until we get a change in the larger trend it’s far safer to assume the market will go lower rather than higher.  We’re still in a downtrend and will be until the SPX gets to at least the upper 1900s and successfully tests those levels as support during a pullback.  That’s the technical requirement.  At a practical level what’s required is a change of heart by traders worldwide when it comes to the central bankers they have become so dependent on.

Bad news for the general equity indices has been good news for gold.  As I predicted over the past three months we’re seeing the US Dollar roll over and money move into the gold space as traders seek a safe haven.

The chart above is impressive to say the least.  We’ve seen massive buying and massive short covering in the past three weeks. 

Things have moved even faster than I expected.  In part, I think this is evidence that “outside money”, retail and institutional traders that don’t generally pay attention to the gold space, are moving in.  This is potentially very significant since the deployable funds held by generalist traders are orders of magnitude larger than the depleted funds of mining diehards. 

Keep in mind this is money that views gold as just another asset class.  I’m fine with that view myself but the gold bugs in the audience should not assume they are getting new “converts”.  By and large this new money will be fickle and we should expect higher than average volatility. Indeed, the gold market is pretty overbought short term so a pull back to some sort of higher support level should not be a surprise. That said, the trends that I believe are creating this new demand could easily be medium to long term ones.   This looks like it’s the start of a new bull market and it could definitely have legs.

What changed in the past month that had traders who had avoided gold for years, maybe forever, suddenly decide they had to own some?  I’ve seen lots of explanations.   I’m sure you have too.  I made some predictions on that score myself in recent issues, discussing a possible topping of the $US and continued weakening of major markets.

To be sure, both of those are factors and there seems to be a marked increase in the negative correlation between the SPX and gold. You can see the correlation on the bottom of the SPX chart below.  As the SPX neared its last couple of lows the correlation with the gold price became almost perfectly negative (gold rising by a similar percentage as the SPX was falling) which looks like good old fashioned fear to me.

Fear is a double edged sword of course.  If the SPX manages to rally higher we should expect a correction in the gold price.  Waiting to see if that happens would be wise before entering in a big way at this point.  The move in the past month has been very steep and moves like that tend to see corrections even if the underlying trend has changed, which I think it has. 

Fear is a perfectly reasonable short term explanation for the gold move but the larger issue that is driving many markets, gold included, is a general loss of faith in central banking. 

The central bank “put” has been a defining feature of the equity bull market from 2009 to 2015.  Traders had great faith that central banks, especially the Fed, had their backs and the confidence that gave them made it a great few years for risk assets. Lower interest rates certainly drove risk assets higher.  That move was made even stronger by the implicit belief that the bet was asymmetric.  Traders were convinced that every time the market went against them (as bulls) central banks would step in and “do something” to put a floor under things.

That was a completely rational assumption since that’s exactly what central bankers did.  Normally it was done because central bankers were worried about systemic risks to growth but the net effect was the same, support for equities and high risk debt.

It looks like that’s all changed now.  Traders are “losing their religion” when it comes to central banks and that has many far reaching negative implications.

Need evidence?  Look no further than the three currency charts above and below.  The USD chart on the bottom is a bit of a red herring.   Yes, the buck has rolled over as I said it would but it’s the other two charts of the Yen and Euro I find more interesting.

If you looked at those two currency charts in isolation you’d be shocked to find out what Japan’s and the EU’s central bankers have been up to lately. 

Haruhiko Kuroda and Mario Draghi have been doing everything in their power to increase liquidity, move inflation higher and cap any strength in their home currencies. The charts, especially that of the Japanese Yen, show that central bankers have lately failed miserably when it comes to leading and shaping the markets. 

The Yen is the most glaring example of the trend.  The Bank of Japan moved to negative rates on reserve deposits at the end of January in an attempt to both weaken the Yen and give a lift to equities.   The desired move lasted less than two days before the Nikkei swooned and the Yen rocketed higher.  There has been some reversal of that move but the Yen is still about 6% higher than it was before the B0J announcement, a huge move for one of the world’s reserve currencies.

The run up in the Yen was a combination of lack of faith in the BoJ and overall nervousness, as the Yen is considered a “defensive” trade and it often rises when other markets are falling.  It was a vote of non-confidence in other words.

The situation is similar in the EU.  A look at the Euro chart shows a couple of strong upward moves immediately after ECB meetings that detailed new policy initiatives,  specifically rate cuts and increased quantitative easing.  Markets clearly expected more as the reaction was immediate and strongly negative, with the Euro rising three percent each time.  I warned we could see that sort of disappointment especially before the December meeting which was hugely overhyped.

The USD-Euro is a big currency trading pair and the lifts in the Euro are reflected in corresponding drops in the USD.  The Euro’s rises trace back directly to Mario Draghi who’s developed a habit of over-promising and under-delivering.  Whether Draghi should promise, much less deliver, even more by the way of negative rates and QE is open for debate but the point is that traders have lost their trust in both the ECB and BoJ.

The Fed is in slightly better shape but only slightly.  Comments I’ve made in recent issues about bond yields moving against Fed policy is just another example of a market that doesn’t trust or believe its central bankers.

All three central bankers are trying to reverse what they see as a potential deflationary spiral and induce some inflation to improve “animal spirits” and stop consumers delaying purchases.  So far the moves have been complete failures, though there is some recent evidence that inflation may have bottomed in the US.

While I’m not personally sold on the idea that the US Fed will move to or below zero interest rates again it’s clear plenty of traders are.  The last CPI measure was higher, as I said it might be early this year.  We’ll see the PCE Deflator, a preferred inflation measure for the Fed, announced on February 26th and that should increase slightly as well.  It should still be below the Fed’s target but it may put a March rate increase back on the table.  That, and a continued countertrend rally in NY may strengthen the USD a bit though bond traders remain skeptics.

So where does this leave us?  I think it’s going to be tremendously difficult for central bankers to restore the market’s faith now.  That’s a significant problem.  Outside forces like an acceleration in growth in China or a big run in oil prices could come to the rescue but traders probably won’t credit central bankers with a win.  There is plenty of evidence the world economy is slowing and markets could use a confidence boost.  I’m not sure where they get one if they no longer believe there is a magic bullet.

As I’ve noted many times before gold is, as much as anything, a vote of non confidence in the financial system.  I think that is the main reason for the strength of the recent move.  Currency movement helped but those were also defensive moves and “anti-central bank” trades.  

I don’t know what central banks can do at this stage other than let some of these things run their course. I’m skeptical they will be able to overcome their natural tendency to meddle in the markets even when it’s not working.  We could see more negative rates which will increase gold demand in areas where they are in effect even if they don’t immediately move the gold price in US Dollars.

Loss of faith has increased volatility and it’s going to make traders much quicker to exit areas now seen as risky.  Bank stocks have gotten hammered and higher risk debt remains under pressure.  Expected correction aside there is room for gold and gold stocks to move a lot higher as long as negative rates and heightened risk aversion prevail.

As for the main equity indices, I still think a bear market sized drop in NY is the most likely outcome.  Maybe the Fed has one more rabbit to pull out of its hat but I can’t imagine what it might be.

Without the Fed Put we’re back to relying on earnings.  The last chart of this editorial is instructive on that subject.  It shows changes in each year’s SPX earnings estimate as the year progresses and reality sets in, starting in 2012.  Note that Wall St analysts start each year too optimistically and the estimates fall until the end of the year when most of the actual earnings are reported.  2015 shows a particularly large drop with the estimate falling from $137 to $104 by year end.  Is it any wonder the SPX traded the way it did?

That didn’t deter Wall St though.  They started with a 2016 estimate of $137 again.  We’re part way through February and that has already fallen to $120.  What are the odds it ends the year below $100?  Pretty good I think, which implies a forward P/E of over 19, pretty rich for a weak market.  Until we see a change in the market’s tenor assume NY lower and Gold higher.

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