Ah, the Power of Mean Reversion.

June 21, 2014

by Frank

of U.S. Global Investors

The chatter this week has been gold. The precious metal flew up $45 an ounce on Thursday, surprising investors, the media and markets alike.

If we look back just six months ago, gold was sitting at record lows, signaling that it was in extremely oversold territory. This was the time that many investors let fear take over and dismissed the fundamental reasons for owning gold: as a portfolio diversifier and store of value.

With the price spike this week, however, some of the perpetual gold naysayers suggested the metal had shifted to overbought status. Spot gold is up nearly 3 percent for the week, while gold stocks are up around 7 percent. So is gold overbought?

Some see gloom and doom. We see the bounce we said was coming. Based on our historical observations and the math of the markets, gold is not overbought, in our opinion, but is simply reverting to its mean. This mean reversion has shown that eventually, both gold stocks and gold bullion will move back to their historical averages.

Right now, as you can see from the chart below, gold stocks have seen a reversal to the long-term mean, but we are still waiting for gold bullion to do so as shown in the second chart.

Total-Foreign-Direct-Investment-Into-Colombian-Commodity-Sectors Mean Reversion
Mean Reversion
Total-Foreign-Direct-Investment-Into-Colombian-Commodity-Sectors Mean Reversion
Mean Reversion

Similarly, for gold bullion to reach overbought territory it would need another 20 percent move, and for gold stocks to be overbought they would need another 30 percent move.

There is always an emotional bias against gold, whether it is soaring high or dipping low, and that is why it’s important to manage these emotions when positioning a portfolio. At U.S. Global Investors we look objectively at the action of both gold stocks and gold bullion by monitoring these long-term data points and paying attention to buy and sell signals based on the trend of mean reversion.

Additionally, I remind investors that moderation is key when it comes to gold. Your exposure should be 5 percent to gold stocks, 5 percent to gold bullion, while rebalancing annually.

Another reason that gold is moving is it’s beginning its seasonal cycle, driven by cultural gold buying. The demand of gold reflected over the next several months and characterized by the purchase of the metal for cultural celebrations and religious holidays, I refer to as the Love Trade.

If you look at the chart below, you will see that July marks the beginning of the Love Trade with the celebration of Ramadan.

Total-Foreign-Direct-Investment-Into-Colombian-Commodity-Sectors Mean Reversion
Mean Reversion

The Indian Festival of Lights comes after, followed by wedding season and, of course, Christmas.

This seasonal pattern is one of the most powerful drivers for gold demand. Monitoring this pattern, while remaining aware of other fundamentals to gold, such as mean reversion and a prudent 10-percent portfolio weighting (5 percent in gold stocks and 5 percent in gold bullion, while rebalancing annually), are imperative to understand when investing in gold. These trends allow us to manage short-term swings, small or large, that usually cause more concern than they are truly worth in the long term.

If you’re curious to learn more about the trends in resources, I will be speaking July 22-25, at the Sprott Vancouver Natural Resource Symposium. You’ll be able to take a front row seat to learn why experts in the field believe next year will be one of the most opportune times in history to invest in natural resources.

Index Summary

Major market indices finished higher this week. The Dow Jones Industrial Average rose 1.02 percent. The S&P 500 Stock Index advanced 1.38 percent, while the Nasdaq Composite gained 1.33 percent. The Russell 2000 small capitalization index jumped 2.21 percent this week.

The Hang Seng Composite fell 0.90 percent. Taiwan gained 0.84 percent while the KOSPI fell 1.14 percent. The 10-year Treasury bond yield was unchanged at 2.61 percent.

Domestic Equity Market

The S&P 500 Index bounced back sharply this week after last week’s pause. Interest rate sensitive areas tended to outperform with utilities, health care and consumer staples among the leading groups. Energy also performed well on the back of continued geopolitical uncertainties, even though oil rose only modestly.

S&P Economic Sectors

Strengths

  • The utility sector experienced a broad-based, macro-driven rally, with every constituent of the S&P 500 Utility Index advancing for the week. The results of this week’s Federal Open Market Committee (FOMC) meeting went more or less as expected, but with a slightly more dovish tone, pushing prospects of interest rate hikes further into the future.
  • The energy sector was also a strong performer this week with refiners and oil service names particularly strong. Energy has been the best performing sector over the past one-month and three-month periods on rising oil prices and geopolitical risk ranging from Ukraine to Iraq.
  • Covidien was the best performer in the S&P 500 Index, rising 25.1 percent this week. Medtronic bid $42.9 billion for Covidien to gain scale and position the company as the largest provider of numerous medical devices.

Weaknesses

  • The S&P 500 Health Care Index was among the worst performers this week, driven lower by Express Scripts. It was disclosed that its CEO sold 26 percent of his stock position, which spooked some investors.
  • The S&P 500 Apparel Accessories Luxury Goods Index was also hit hard as Coach was the worst performer, falling 11.8 percent after slashing its forecast at the company’s analyst day.
  • Other poor performers in the S&P 500 this week included Conagra Foods, Yahoo! and Whole Foods.

Opportunities

  • Earnings reports for companies in the S&P 500 pick up some next week with key consumer names reporting such as Nike, Walgreens and CarMax. The reports, combined with next week’s consumer confidence data, should provide good reading on the near-term direction of the economy.
  • Quite a bit of housing data will be released next week, such as new home sales, existing home sales and S&P/Case-Shiller Home Price Index data. This data is an important read on the economy. To round out the color on the sector, homebuilder Lennar reports next week along with Bed Bath & Beyond.
  • The market seemed to really respond to the dovish Fed positioning and it appears the path of least resistance is higher.

Threats

  • The second quarter is closing fast and we haven’t had the seasonal correction that we experienced the past few years.
  • At almost 18 times trailing earnings, the S&P 500 is not cheap. Valuation may be a headwind for future market gains.
  • Focus will shift to upcoming earnings, and we are in the pre-announcement season when negative news will likely be divulged.

The Economy and Bond Market

Treasury yields changed little this week. A FOMC announcement and a fair amount of potentially market-moving data were released this week. The Federal Reserve announcement came and went, and while there was a flurry of mid-week activity and volatility, we ended up not far from where we began. The Fed delivered what was expected, if not slightly dovish. Housing starts and the Consumer Price Index (CPI) were the other big data points out this week. Housing starts disappointed a little while inflation picked up, but the net effect on the market was minimal. The chart below depicts the relative calm in 10-year treasury yields over the past year, essentially range bound between 2.50-3.00 percent.

Gold-Mining-Stocks-Have-Strengthened-Recently

Strengths

  • The Federal Reserve delivered no surprises this week: $10 billion in additional “tapering” but slightly more accommodating in its stance toward inflation and the prospects of higher interest rates in the future.
  • Industrial production rose 0.6 percent in May, beating expectations, while April’s data was revised higher.
  • The Conference Board’s index of leading economic indicators rose 0.5 percent in May with strength seen in virtually every category.

Weaknesses

  • Consumer price inflation rose 0.4 percent in May and now stands at 2.1 percent year-over-year. On a year-over-year basis, this is the highest reading since October 2012.
  • Housing starts and building permits were a little weaker than expected, with single family starts falling for the first time in four months.
  • Mortgage applications fell 9.2 percent for the week ending June 13. The housing market continues to flash mixed messages and cannot seem to regain the momentum from last year.

Opportunities

  • More housing data is scheduled for release next week with new home sales, existing home sales and S&P/Case-Shiller Home Price Index data all scheduled for release. This is a crucial time for the housing market. If we don’t see an uptick soon, we probably won’t see one this year. This could actually be a positive for the bond market as a weak housing environment likely keeps the Fed from shifting to a tighter policy.
  • The Consumer Confidence Index (CCI) and the University of Michigan Consumer Sentiment Index are scheduled for release next week and will be key indicators of the strength of the economy.
  • With key global central banks back into easy policy mode and inflation trending lower in many parts of the world, the path of least resistance for bond yields is likely down.

Threats

  • If housing indicators come in weak, that does not bode well for a robust economic expansion in 2014.
  • Bonds have posted strong returns so far year-to-date. With economic data looking supportive, a modest sell off wouldn’t be surprising.
  • While the European Central Bank (ECB) is moving toward easing, UK policymakers at the Bank of England are considering raising interest rates as the housing market and retail sales have been very strong.

 

Gold Market

For the week, spot gold closed at $1,314.85, up $37.96 per ounce, or 2.97 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, rose 7.12 percent. The Trade Weighted U.S. Dollar Index fell 0.25 percent for the week.

Date Event Survey Actual Prior
June 17 Germany ZEW Survey Expectations 35.0 29.8 33.1
June 17 U.S. May CPI 2.0% 2.1% 2.0%
June 17 U.S. May Housing Starts 1030K 1001K 1072K
June 18 U.S. Federal Reserve FOMC Rate Decision 0.25% 0.25% 0.25%
June 22 China June HSBC Manufacturing PMI Preliminary 49.7 49.4
June 25 U.S. May Durable Goods Orders -0.2% 0.6%
June 25 U.S. GDP First Quarter Third Reading -1.8% -1.0%
June 26 China May Gold Imports from Hong Kong

Strengths

  • Gold rose almost 3 percent this week after Fed Chairwoman Janet Yellen stated interest rates will remain low for an
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