Is Gold Counter-Cyclical?

There are generally two types of investment or reserve demand relevant to gold: safehaven demand and inflation hedge. Since 2008 gold has benefitted largely from the former: safehaven demand; because of how fragile the markets have looked up until recently.

As you can see in the charts above and below, sometimes the two assets are coupled, sometimes they aren’t. When they are decoupled they are countercyclical, which usually occurs in periods of higher than average stock or bond market volatility.

One could argue that the big shakedown in gold that occurred this year (the last shaded column on the right in the graph on the prior page) was the product of upside volatility – note that it was triggered by new all-time highs in the DJIA in fact – and effectively represented a liquidation of the safehaven inflows that occurred in both 2010 (May-Aug) and during the last half of 2011.

The other thing to note is that the countercyclical relationship appears to have ended. The assets have been more or less aligned since summer. They fell together in June, and bounced together in July, reverted back to a countercyclical relationship in August and September, but re-coupled in October.

Some have pointed to the relationship in 1976, which has behaved similarly so far. In 1976 (see above graph on this page), gold did not turn up until after the Dow peaked.

Following the Dow’s correction then, the two assets re-coupled into the later seventies.

However, if the Dow continues to soar today, I have to question the validity of the 1976 model, because that new high did not sustain.

In fact, it has already deviated with respect to the S&P 500 since that index did not confirm the Dow’s new high in 1976, while it has in the current advance. Another difference is that back in the 1970’s the two assets remained countercyclical for the entire recovery in the Dow, which was just half as long in duration as the current one. In the end, there are enough differences here to question the premise about gold and the Dow remaining decoupled.

We know that in the long run both asset classes are inflation hedges, and that they tend towards counter-cyclicality only when there is great volatility in stocks. Let’s keep it that simple. Why assume too much more based on historical movements alone?

I think the key will continue to be the US  dollar, and the Dow/Gold ratio may offer clues here. I think the Dow’s valuation relative to earnings, to foreign multiples, and to gold historically argues against continued outperformance of Dow/Gold.

Dow/Gold Calculus

Based on data provided by our good friend  Nick at Sharelynx (http://www.sharelynx.net/), which goes back much further than 1976, I would concede the possibility the Dow/Gold ratio adds 2 points, to 14x (currently at 12x).

What could support the gold bearish combination of strength in the Dow AND the USD? I see only two possibilities.

The first includes a material improvement in real earnings and rising real interest rates.

This is possible anomalously if the current uptick in earnings continues into the next quarter and bond yields rise too sharply too quickly. Although I don’t know if higher yields would support a high PE. So this has trouble, I think. Another way to get the stock market up, the dollar up, and gold prices down.

We’ve been hinting at it: MORE QE! If that happened (not currently predicting it) I would concede that the Dow might roar, gold would sink, and the USD gets a boost. It would be temporary and would ultimately improve gold’s prospects, but it is still really the only thing that could push gold prices down to the bears’ targets at $1000 or lower.

Technically, the market is oversold and there is too much bearish sentiment to sustain lower lows, despite the continued attempts by the bears to shake out more bulls. That’s why I can’t see lower lows without at least a rally to sucker in fresh short-term traders. My bet is that the remaining longs are here to stay.

But that won’t stop the bears from trying to raid the stops below 1250 here if they get the chance. If they do, I wouldn’t wait to buy it because it would not be a sustainable leg. Our fundamental view is that fair value for gold today rests at around the $1600-1700 level without anticipating future inflation.

(Source:  Ed Burgos:  [email protected] -- Precious Metals Equity Research)