When The Music Stops: Why Gold (GLD $111.85) Is Going To $170 by Tedee Valley

The current bull market has lasted 2,407 days, the third longest in history behind the run from 1949-1956 (2,607 days) and 1987-2000 (4,494 days). This continued move, in my view, has conditioned the beliefs of market participants that prices move in one direction, as it is all we have seen for the past six and a half years, in turn leading to justifications for why the market will move higher. Here are some examples:

  • Equities are cheap relative to bonds. Where am I going to put my money? It’s the only game in town.
  • Bears have been saying we are going to have a crash for years and have been wrong.
  • The market trades at a 16-17x multiple, fairly in-line with historical valuations.
  • Ex energy, ex dollar.

Trends are subject to negative tests that either reinforce or weaken participants’ perceptions. Since 2009, each pullback has been bought and the market has moved higher, in turn reinforcing the inherent trend. At some point though, the divergence between market prices and reality becomes so far removed that participants realize a misconception is involved and doubt grows, but the prevailing trend is continued through inertia, referred to by Soros as a twilight period.

In my opinion, we’re currently in that period and are on the verge of a significant re pricing of the S&P as the market begins to look at the underlying fundamentals and domestic economic data continue to deteriorate. This will likely lead to:

  • The Fed putting an indefinite hold on rate hikes, and possibly experimenting with negative rates / embarking on another round of quantitative easing.
  • A bid for bonds, sending yields lower and possibly negative.
  • Capital that has been forced into stocks moving into gold, as minimal yield exists elsewhere and there is “nowhere else to put your money.”

I outline this thesis below.
It is my view that prices currently fail to reflect market fundamentals due to excess liquidity provided by the Fed and the hope for more, evidenced over most of the past year by poor economic data sending the market higher. While this seemed to change following the Fed’s decision in September to hold rates at zero (market sold off), it re manifested last week as the market rallied 6%+ off the lows following September’s brutal non-farm payrolls miss and August’s downward revision, illustrating the market’s appetite for more.

The aftermath of the financial crisis led the Federal Reserve to embark on the most accommodative monetary policy in its 102 year history, as it purchased bonds and moved the fed funds rate to zero. For reference, the Fed has never set the federal funds rate at zero or purchased bonds, so in turning to history as a guide of the future, there is no reference point. While the initial move stabilized markets, the Fed continued easing through the majority of 2014 and still holds its zero interest rate policy today. Through these cumulative programs, $3.5 trillion was injected into the financial system, which found its way into the equity market illustrated below by DoubleLine Capital.

Gold

It is my view that prices currently fail to reflect market fundamentals due to excess liquidity provided by the Fed and the hope for more, evidenced over most of the past year by poor economic data sending the market higher. While this seemed to change following the Fed’s decision in September to hold rates at zero (market sold off), it re manifested last week as the market rallied 6%+ off the lows following September’s brutal non-farm payrolls miss and August’s downward revision, illustrating the market’s appetite for more.

The Fed’s liquidity injection has created an artificial bid for equities. Below Morgan Stanley outlines cumulative maximum drawdowns from 2009 to 2015. As you can see, periods without QE resulted in healthy drawdowns; however, during periods of QE, the drawdowns were significantly less, which to me indicates the market’s willingness to take on additional risk with the backing of the Fed. Given that QE is now on hold, the lack of Fed support subjects the market to significant drawdowns, as we saw on August 24th. This to me was a very significant event, as it shocked participants and led them to start questioning their current perceptions.

Gold

While QE sent capital into the market, the Federal Reserve’s prolonged zero interest rate policy pushed participants’ farther out on the risk curve in search for yield, leading to aggressive market behavior. This has been evident in speculative biotechs, momentum plays such as GoPro, and cloud based players like Netsuite, for example. Company earnings have taken the back seat to growth as liquidity flooded the market and participants found ways to justify prices or cared not to.

This changed recently, as market leaders such as the SPDR XBI biotech index fell ~28% from highs, momentum names such as GoPro and Shake Shack touched or closed near 52-week lows, and cloud/internet security highfliers like Netsuite, FireEye, and Barracuda networks continue to fade. By no means is this an indication that momentum is dead (NFLX, CRM, AMZN all still strong) however, it is a signal to me that participant’s perceptions are changing and the trend has significantly weakened – indicative of the aforementioned twilight period.

Personally, I think the Fed has lost all credibility. The failure to hike rates over the preceding few years after seemingly strong economic data, and September’s no hike is concerning. They are clearly seeing something that the market isn’t, or failing to see what the market is, leading me to believe they will NOT raise rates this year or in 2016. In my mind, the odds favor further quantitative easing or experimentation with negative rates (recently in Fed officials’ commentary). Here is why.

The Fed has stated in normalizing policy it is looking for inflation to return to its 2% objective and for the economy to return to full employment, which at 5.1% is consistent with their view. My question is if we are moving closer to raising rates, why are inflation expectations moving farther from the Fed’s 2% target (shown below)?

Gold

Meeting this target will be increasingly difficult due to China’s slowing growth weighing on commodities and technology’s deflationary nature. In addition, how is it that we are at or near full employment with the labor force participation rate (employed or actively looking for work) at levels not seen since 1977 and falling? Note: the 5.1% unemployment rate fails to capture those who leave the workforce. All things equal, discouraged workers leaving the labor force reduce the unemployment rate, illustrating why the participation rate is preferable gage of the labor market.

Gold

September’s non-farm payrolls miss and August’s downward revision showed that the labor force may be losing steam and proved the Fed missed its window to hike. While these are only two data points, the 59k (+43% MOM) announced layoffs in September according to Challenger, Gray & Christmas, will put additional pressure on forward numbers.

Gold

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