Gold Investors: Let This Cycle Be Your Guide

June 14, 2014

by Frank Holmes

of U.S. Global Investors

U.S. Global Investors recently welcomed Doug Peta, an economist from BCA research, to our offices. He presented some interesting research regarding the Fed Funds Rate Cycle, and in turn, what that research could mean for gold. I wanted to share points from his presentation, as well as our own in-house research, to help you understand the positivity we see for the precious metal looking towards 2015.

Where are we now?
Below is a chart from BCA showing the Fed Funds Rate Cycle. In essence, this chart neatly illustrates what the interest rate cycle imposed by the U.S. Federal Reserve looks like. The red circle indicates where we are right now: Phase IV, also known as the “easing” phase of the monetary policy that was enacted in 2008 in the U.S., better known as quantitative easing (QE).

The Fed Funds Rate Cycle Gold Investors
Gold Investors


click to enlarge

As we know, the Fed enacted QE to stimulate our nation’s economy. Right now we’re benefitting from our placement in Phase IV of this cycle because it is in this phase that the Fed is able to keep interest rates low, keep reserve requirements low and continue printing money. Similarly, when money is “easy,” businesses can find funding for projects and consumers have easier access to credit.

Historically, Phase IV (as well as the shift towards Phase I) are the best for equity investors because stocks usually rise during these two positions in the cycle.

Why these phases are good for gold, too.
We have been in Phase IV of the Fed Funds Rate Cycle for a few years now, and are expected to remain here into 2015. Eventually the Fed will have to start tightening again and raise rates, although the numbers should remain relatively low for a while. Once this begins, we will move into Phase I.

When it comes to the performance of gold and gold stocks, history indicates good times are ahead based on where we are in the cycle. Take a look at the tables below showing median returns during the cycle dating back to 1970 and 1971. You’ll see that for gold and gold stocks, Phase IV and Phase I both show the highest median returns.

Returns During Fed Funds Rate Cycle
Spot Gold, From June 1971 TSE Gold Miners, From July 1970
Phase Median Phase Median
Phase I (Easy, Hiking) 11.8% Phase I (Easy, Hiking) 16.2%
Phase II (Tight, Hiking) 2.2% Phase II (Tight, Hiking) -8.8%
Phase III (Tight, Cutting) -4.3% Phase III (Tight, Cutting) -15.9%
Pase IV (Easy, Cutting) 9.2% Phase IV (Easy, Cutting) 24.2%
Note: Excluding the two-month Phase II period spanning the October ’87 stock market crash.
Past performance does not guarantee future results.
Source: BCA, U.S. Global Investors

The reason for the high returns during these two phases is because of “easy money.” Tight money, which is what Phase II and III are based upon, is typically bad for gold investors. When money is tight, we don’t have inflation, and investors don’t need to turn to gold as a hedge against inflation. Without inflation there is no need to hedge.

Another reason we’ve traditionally seen gold investors benefitting during Phases IV and I of the cycle is that when money is easy, interest rates are low, meaning less opportunity cost for holding the precious metal. To help illustrate, imagine putting your money in a savings account and earning 5 percent on it. Well, the opportunity cost of keeping gold under your mattress would be giving up that 5 percent that you could be earning elsewhere. When your savings account yields next to nothing, some reason, why not just buy some gold?

This pattern is worldwide.
The trends we see in the Fed Funds Rate Cycle are not only U.S. specific. This same idea carries through to the stimulative policies of the European Central Bank and Japan. More countries around the world are applying monetary stimulus programs much like the U.S., while moving away from more restrictive policies. Remember that restrictive policies relate to tightening, which is bad for gold, and stimulative policies relate to easing, which is good for gold.

Right now, gold could use a pick-me-up, and here’s why. Over the last several years we’ve seen slowing money supply growth in many E7 countries. E7 refers to seven countries with emerging economies including China, India, Brazil, Mexico, Russia, Indonesia and Turkey. It’s these countries that drive the Love Trade for gold, primarily China and India, which purchase the metal for religious and cultural celebrations.

Money Supply Growth Has Slowed in E7 Countries
click to enlarge

With less money being spent or borrowed, not only did the Love Trade begin to slow, global GDP growth also began to slow as you can see below.

Global GDP Growth Expected to Rise in Second Half of 2014
click to enlarge

The good news is, as we see various countries applying monetary stimulus, including emerging markets, we can expect this to contribute to global GDP growth. In 2014, global GDP is expected to grow by 3.2 percent, according to the World Bank’s latest projections.

Similarly, the money supply of the United States has been a steady grower and the money supply in the E7 countries is also expected to reverse course; right now it is growing again but at a slower rate. The U.S. data suggests that a new easing cycle is starting in Europe, Japan and emerging markets.  A pickup in economic activity in the E7, especially the big gold consumers, is yet another positive sign for the yellow metal.

Real interest rates are headed lower for most of the world as well. As money supply grows, countries eventually feel inflationary pressures. This will hold true in the U.S. as we move into 2015 and back into Phase I. All of these changes can lead to a declining confidence in paper money, yet another good sign for gold.

An interesting side note.
I have noticed that recent articles in both Money Magazine and the New York Times use an array of gold images to illustrate wealth. It seems that while some may debate whether gold is money, gold remains an enduring symbol of wealth.

Index Summary

  • Major market indices finished lower this week.  The Dow Jones Industrial Average fell 0.88 percent. The Standard and Poor’s 500 Stock Index dropped 0.68 percent, while the Nasdaq Composite declined 0.25 percent. The Russell 2000 Small Capitalization Index fell 0.22 percent this week.
  • The Hang Seng Composite Index rose 1.44 percent. Taiwan gained 0.68 percent while the KOSPI fell 0.23 percent. The 10-year Treasury bond yield rose 2 basis points to finish the week at 2.61 percent.

Domestic Equity Market

The S&P 500 Index sold off this week as geopolitical events flared up in Iraq, sending oil prices higher and giving investors a reason to take profits after three weeks in a row of solid gains.

S&P Economic Sectors
click to enlarge

Strengths

  • The energy sector was the only positive performer this week as oil prices rose to $4 after an al-Qaeda-affiliated group took control of Mosul, Iraq’s second largest city. Observers fear the potential for a civil war, similar to what is currently ongoing in Syria, the key difference being a disruption to global oil supplies. The S&P 500 Oil and Gas Drilling Index and the Exploration and Production Index both rose by more than 3 percent this week in broad-based rallies.
  • The technology sector was near breakeven this week as semiconductor and semiconductor equipment stocks were strong after Intel raised its second-quarter revenue forecast on improving business demand for personal computers. Intel rose 6 percent for the week.
  • International Game Technology was the best performer in the S&P 500, rising 26.8 percent this week. The company, the world’s largest slot machine-maker, announced on Monday that it hired an investment bank to explore a sale, and by Friday multiple potential bidders and interested parties had been identified. Interest appears very robust.

Weaknesses

  • The consumer discretion sector was the worst performer this week as homebuilding and auto-related groups sold off as higher oil prices caused concerns among investors that consumers would be forced to scale back activity. Homebuilders, home improvement retailers and automotive retailers were hit the hardest.
  • The industrial sector was also an underperformer as airline stocks came under pressure on higher oil prices and Deutsche Lufthansa’s profit warning this week, citing tough competition for long-haul international flights.
  • Tyson Foods was the worst performer in the S&P 500, falling 11.7 percent. The company won the bidding war for Hillshire Brands, but investors are concerned that the price may have been too dear.

Opportunities

  • FedEx reports next week and is often looked at to provide a read on the direction of the overall economy. Hopefully FedEx will confirm the economic strength we are seeing in the macro indicators.
  • We have several technology companies reporting next week, with bellwether Oracle the headliner, but also Adobe Systems, Red Hat and Jabil Circuit.
  • The S&P 500 suffered its first loss in three weeks, and the winning strategy for the past 18 months has been to buy the pullbacks.

Threats

  • Sell in May has not worked so far this year, but with a dearth of significant earnings or market moving economic data, a June swoon can’t be ruled out.
  • At almost 18 times trailing earnings, the S&P 500 is not cheap. Valuation may be a headwind for future market gains.
  • Any hawkish comments out of next week’s Federal Open Market Committee (FOMC) meeting could make the markets jittery and the inclination would be to sell first and ask questions later.
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