Why Gold Markets Went One Way and US Stocks the Other

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Congratulations to the S&P500…another record closing high on Friday! The financial media loves round numbers, and the big US stock market index obliged by closing at 1,900.53. It didn’t quite take out the intra-day high reached earlier this month, but a few words from Janet Yellen should do the trick.

Closer to home, the going isn’t as easy. Japan’s Nikkei is down 12% this year and Hong Kong’s Hang Seng index is down 1.5%. According to the Wall Street Journal, investor interest in these markets is tepid:

In Tokyo, stock-trading volume has fallen each month this year, while in Sydney turnover remains more than 30% short of its monthly average with a week to go in May. In Hong Kong, turnover is also running below average 2013 levels and set for a monthly drop. The three markets are Asia’s biggest excluding mainland China, which is largely closed to foreign investors.’

Perhaps it’s the lure of the ‘resilient’ US market that is seeing investors turn away from the Asian region? We think it has more to do with the Fed’s ‘taper’, which began in December last year. As the US Federal Reserve winds down its quantitative easing (QE) program, global liquidity slowly dries up.

While it’s true the Fed is still injecting US$45 billion per month in additional liquidity, it’s down from the US$85 billion monthly rate of late 2013. They are slowly turning the tap off.  As we wrote to our subscribers last week, if the Fed keeps reducing QE at its next few meetings, by July there will likely be a liquidity deficit in the US market too.

Why? We won’t go into the detail, but it has to do with the funding of the US current account deficit and the drop off of net foreign capital flowing into the US over the past six months. The US Federal Reserve is funding US deficits! QE withdrawal is impacting markets peripheral to the US now, but within a few months the impact will flow through to the big US markets.

In fact, the impact has already started. You’re just not seeing it in the big indices. But there is weakness elsewhere. The Russell 2000 (small cap index) and the Nasdaq (tech index) are both well off their highs, which suggests to us the nascent effect of tighter liquidity at work.

What about the gold market… it’s been pretty quiet there lately. Well, we think you’re about to see some fireworks in the sector. We sent the following chart around the office on Friday and asked whether the next move in gold was likely to be up or down.

Gold — ready for a big move…

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click to enlarge

As you can see in the chart, over the past month or so gold has traded in an ever narrowing range. These trading patterns do not persist for long, and very soon you’re going to see gold move violently out of that range. It’s either going to surge higher or plunger lower.

So we asked some of the people in the office for their thoughts. The votes came back. Eight people said gold would head lower and four thought the next move would be higher. Hmmm…

In recent weeks, we’ve read commentary from a number of investment banks predicting the next move in gold would be down. There are not (m)any predicting a move higher. The majority of people at The Daily Reckoning HQ reckon the price is going lower…and these folks are generally bullish!

Nearly three years of a relentless bear market has completely demoralised sentiment. Very few can see light at the end of the tunnel. Most just see another train coming. For many, the path of least resistance is down.

Here’s another chart we sent to our colleagues last week. It shows the S&P500 (blue line) versus the gold miners index. For most of the time (the chart starts in 2005) gold equities pretty much tracked the S&P500 — there was a high level of correlation.

Massive divergence between gold and stocks

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click to enlarge

But the correlation ended violently around September 2012. Gold tanked and equities soared.

What happened?

Our guess is this was when the market latched on to the narrative of the central banker as monetary hero and chief risk underwriter. In other words, investors (read hedge funds) realised that the world’s central bankers were basically telling them to take on risk…to buy, buy, buy and don’t worry about the repercussions, because they would be there to sort it out if anything went wrong.

Why at that time?

Well, in July 2012 ECB Chief Mario Draghi told the world he would do whatever it takes to save the Euro. This was code to stop shorting Italian/Spanish/Greek/Portuguese bonds and start buying them. Then Japan’s Abe came out and launched ‘Abenomics’, an economic plan to fast track Japan’s demise, which in the meantime gifted torrents of liquidity to global speculators.

And in September 2012, Ben Bernanke (now scoring around US$400,000 a pop on the talking circuit…getting back a small fraction of what he gave to the investment banks during his tenure) launched another round of QE.

Taken together, this was a powerful signal from the world’s largest monetary authorities. Global speculators responded by selling insurance (gold) and buying risk (the S&P500). That trade produced the wild divergence you see in the chart above.

So the question is, does the divergence continue or began to narrow? We guess narrow. Gold is so beaten down and out of favour, and the S&P500 is so proud and popular, that the balance is completely out of whack.

We’re not sure what the catalyst will be to end the divergence, but the way the world is looking today, there is no shortage of candidates.

Regards,

Greg Canavan+
for The Daily Reckoning Australia

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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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3 Comments on "Why Gold Markets Went One Way and US Stocks the Other"

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kees
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Some say gold has not followed equities because the hyperinflation caused by QE did never occur, people bought gold in 2011 to protect themselves from this. But now it seems no longer necessary looking at the side-effects abenomics in Japan and QE in US.

slewie the pi-rat
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people still do not believe that tapering is NOT tightening [dammit], while swallowing the camel that China has grabbed all the available AU and will NEVER give it back to the West, because [apparently] the West’s banksters suppressed the price of gold so successfully that they LOST it all via the ol’ reverse paper-ponzi-palooza. the gold chart now lO^Oks like the Squirrel On A Limb Pattern. w/ lower highs and the 50 DMA heading south toward the 200 DMA, the people selling AU puts are doing a good business. with inflation numbers now coming in higher due to food and… Read more »
Harquebus
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So, the Fed is continuing to taper. Yeah right! “According to Paul Craig Roberts and Dave Kranzler, “The Fed Is The Great Deceiver” – it has not been tapering, but pumping more funds into the markets than ever before.” “The strange aspect of the data is that in the published figures, the tiny country of Belgium with a GDP of only $509B, somehow managed to purchase $40.2B in Treasury securities in the month of March. The purchases follow a six-month barrage of purchases by Belgium in which $214.6B in Treasuries were added to security accounts held in the country.” Google:… Read more »
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