Stocks Disconnect From Economy…And Gold Responds

July 22, 2020
Founder of Adrian Day Asset Management

Given the current uncertainties and recent market moves, money manager Adrian Day offers some thoughts on the macroeconomic environment.

Global stock markets zooming ahead amid historic unemployment and economic contraction is surreal. Half of the U.S. has been locked down, with economies virtually shut, a second virus wave appears underway and yet the stock market is almost back to February's all-time highs.

And this is not only in the U.S.; stock markets have rallied strongly around the world. We know that central bank money creation is the primary cause, but this dichotomy cannot continue indefinitely, at least without a meaningful correction. Meanwhile, gold—for sounder reasons than stocks—has outperformed and, notwithstanding anticipated volatility, will, we think, continue to do so.

The economic outlook is uncertain

The keyword for the economic outlook is uncertainty. The economy cannot resume the level of January after months of closures, not in anything like the near term. Some sectors will do well, but others will be very slow to recover—office space, for example, or malls. Many small businesses, such as restaurants, will try to do the job with fewer people.

Real unemployment is probably higher than the headline numbers suggest, as furloughed workers are counted as "employed." And it will get worse as restrictions from layoffs in the government payroll protection loans end. There's uncertainty about a second wave of the virus and potentially resumed restrictions on businesses. Already, over half of the U.S. population is seeing announced reopenings on hold or reversed.

There is as much uncertainty on the supply side of the equation as the demand. Both will shrink, which is why I do not think we shall see deep and sustained deflation as much as a shrinking economy, with the possibility of inflation later.

Fed policy will destroy the capitalist economy and more

One cannot discuss the economic outlook without discussing the Federal Reserve and other central banks. The dramatic decline in short-term interest rates; the huge explosion in the Fed's balance sheet, moving from $3.8 trillion to $7.1 trillion over the past year; and the moves by the Fed in rapid succession to buying investment-grade bond funds, then junk bond funds, then individual bonds, raise the question of what comes next. Are negative rates ahead on the next downturn? Where does QE (quantitative easing) Infinity take us? And is the Fed going to start buying equities next? And then we shall start to see selective "debt jubilees," with the government forcing different lenders to forgive certain types of debt.

The Federal Reserve is buying bonds of companies such as Coca Cola, Apple and Berkshire Hathaway. Why does the government need to lower Warren Buffett's cost of capital? And they are buying bonds of some foreign companies, including Daimler. Why? This unprecedented—and illegal, by the way—move by an arm of the government into the private financial markets is not receiving sufficient attention, in my view. It is the beginning of a very slippery and dangerous slope indeed.

More and more credit needed to sustain the boom

As with the drug addict who needs ongoing and increased injections to keep the high going, so too with a market dependent on easy money. The longer this continues the more devastating will be the consequences. Fed apologists will say the epidemic was unforeseen and they had to respond. But the truth is that the Fed was already boosting credit recklessly when Corona was just a Mexican beer. From September to February, Fed credit was growing at the fastest rate ever. We would have reached the current state eventually. When thinking of the Fed, one is put in mind of nothing as much as the saying, "When you are a hammer, everything looks like a nail."

Each Fed easing, never cut back in the good times, leads to the next crisis. The housing bubble was fueled by the easy money of the early 2000s, just as surely as the easy money policy following the credit crisis—and the failure to pull back after the recovery—led to the bubble in bonds and equities that greeted the start of the year. It was a bubble in search of a pin, and had the virus not come to these shores, there surely would have been another crisis and the Fed would surely have reacted similarly.

And if the Fed was unable (or unwilling) to return to normal after the dot-com bust, and despite pledges as early as 2014 to "return to normal," pitifully unable to do anything like that after QE1, 2 and 3, how can we possibly think they will do so after QE Infinity, and after buying bond funds and junk bonds, without causing massive distortions if they tried?

MMT fuels unrest and leads to chaos

All of this has dramatic effects not only on the economy and investments, but on society itself. It will lead to reduced economic activity and eventual inflation; further erosion of the value of the dollar and destruction of savings; a further explosion in debt. More and more the economy will be dependent on government spending, and individuals on government transfers. Monetary policy will distort prices, and therefore distort asset allocation, lead to excess risk taking and further debt. It increases government power, and with it the tendency to abuse that power, and reduces individual freedoms.

And it will, as it has in the decade after the credit crisis, further exacerbate the wealth gap, leaving behind a growing underclass and destroying the middle class, leading to protest, radicalized politics and social unrest. "Modern Monetary Theory"—not modern, not purely monetary, and not much of a theory—which is now firmly ensconced as government and Fed policy, leads ultimately to social division, violence and chaos. In extreme cases, it ends in war—either a war of aggression, or (by so weakening a society) by invasion, or (by so dividing a society) by civil war. Extreme debasement of the currency always, and everywhere throughout history, has done so, from the last Roman emperors, to the Jin Dynasty, the Stuart Kings and the aftermath of the Weimar Republic.

Reduced economic activity everywhere

The U.S. is not alone. Around the world, economies have experienced reduced economic activity on the different restrictive measures introduced. East Asia generally has fared better than the rest of the world. In Europe, the impact of the virus has varied widely among countries; Europe has the weakest banking sector of any major region while the single-currency Eurozone reduces flexibility. In Latin America, where different countries have their own problems, the virus has been particularly virulent.

In most countries, governments have responded with aggressive monetary and fiscal stimulus. Programs differ, but everywhere governments have introduced measures that are extreme by that country's standards.

Why are stocks ignoring the economic damage?

The market (per S&P) had the fastest 30% drop in history, followed by the strongest 50-day move ever, back very close to all-time highs. The dichotomy between a contracting economy—with high unemployment and business closings—and the zooming stock markets around the world is stark. The reasons are clear:

  • With interest rates so low around the world, traditional places to put money for safety and income, such as bank CDs and bonds, do not look attractive; stocks benefit.

  • Some are looking ahead and see a recovering economy. They think the worst is behind us. Stocks are forward looking.

  • And most importantly, when central banks create excess liquidity (by definition, liquidity in excess of the requirements of the economy) that money must go somewhere; there is excess liquidity beyond the wildest dreams of Greenspan and Bernanke. It has gone largely into equities.

Arguing against higher stock prices are two simple related issues. We will see weak economic news for the second quarter, and the economy, particularly employment, may not recover to where it was at the start of the year any time soon.

And stock market valuations are high. They were already high in February, but, despite reduced analysts' expectations, the U.S. market (per S&P) is selling at 26 times forward earnings. That would be a high number in the strongest of economies, but now, with sharp declines likely to be reported in coming weeks, with sluggishness for the next several months and with a great deal of uncertainty, that number is extreme.

The market decline we saw in March, though rapid, is mild compared with declines in periods of economic contraction in the past. And even at the March lows, the market was by no means cheap. It is possible that central bank liquidity trumps all other considerations. That may be true over the medium term. But it is almost inconceivable to think that the decline we saw in mid-March is all we are going to experience.

We agree with Mohamed El-Erian, astute chief economist for Allianz, who says, referring to central bank money printing, "I don't feel comfortable investing on that basis."

Near-term volatility expected

The truth is that the market has been very dependent on Fed stimulus for years now, both expecting and demanding it. Each attempt, however timid, at tightening has been met by a market hissy fit and more stimulus. In the near term, second-quarter corporate earnings season, coming soon to a theater near you, could produce some shocks and provoke a sell-off in stocks. At minimum, we expect individual stocks to be hit hard, and we anticipate volatility over this period.

And further out, we would not be surprised to see further, more protracted declines to new lows, perhaps after a year or more. This is not an unusual pattern after very sharp short-term rallies, as experienced most notably following the 1929 crash.

Resources have been hurt by shutdowns

Not surprisingly, most resources took it on the chin from the contraction in economic activity following the lockdowns and restrictions. Oil was the most hard hit, as demand was slashed amid a glut in production. Copper, "the metal with a PhD in economics," has not been as weak as one might have thought looking only at the economy. Prices did drop to their lowest level in three years, but for the year to date are down only 3%. The main reason has been the significant supply interruptions, particularly from Chile.

Gold, however, is a different story. Completing a seventh consecutive quarterly gain, concluding with the best quarter in four years, gold is above $1,800 for the first time since 2012.

Gold is undervalued—relative to the money supply, and relative to financial assets—and it is underowned. Given that gold is a very small market relative to global stocks and bonds, even a small move by investors into gold will have a significant effect on the price. That is what we are beginning to see now, with emphasis on "beginning." As more and more investors, small individual investors and large institutions alike, decide to put a part of their assets into gold, the price will move up significantly.

Gold stocks are still cheap; corrections are to be bought

As gold is undervalued, gold shares are undervalued against gold itself. And, despite the recent strong rally, they remain in the lowest 25 percentile in terms of price and valuations. As gold moves up, especially in an environment of low oil prices and generally low currencies (the two largest cost inputs in a mining operation), much of that increase flows to the bottom line. Mining companies, with a newfound discipline and a more favorable environment, are generating free cash flow for the first time in many, many years.

We remain somewhat concerned about the possibility of a pullback in the price of gold. I do not anticipate that such a correction would be particularly deep or long-lasting, but a pullback in gold itself would see meaningful corrections in the mining stocks, particularly after such strong short-term appreciation.

Will gold stocks fall if the broad market does?

Certainly, if we see a broad stock market decline in coming weeks, the gold stocks could initially fall with the market. Generally, gold stocks have been more vulnerable when the following conditions are present: the market drops sharply in a short period of time; there is a liquidity panic; gold drops; and the stocks are expensive entering the correction.

Generally, gold stocks have been less vulnerable when the broad market decline is slow and protracted; when it is more selective; when gold does not decline; and when gold stocks are not overvalued.

Based on those criteria, we may see a relatively short and shallow pullback, but it will be neither a crash nor the start of a long period of lower prices. Our list of "Current Recommendations" already emphasizes gold and silver stocks, but we would use any near-term pullback to add to positions.

Buy now? Sell now? It all depends

A newsletter provides one-size-fits-all recommendations: "buy this"; "sell this". (We try to differentiate by saying X is appropriate for conservative investors, Z for speculators.) But money management is not like that, whether you have an outside manager or are doing it yourself. One investor might say he has sufficient exposure to gold and silver even if there never is the opportunity to buy any more, whereas another investor, new to the sector, should step up now and at least take initial positions.


Adrian Day

Adrian Day is London-born and a graduate of the London School of Economics, heads the money management firm Adrian Day Asset Management, where he manages discretionary accounts in both global and resource areas. Day is also sub-adviser to the EuroPacific Gold Fund (EPGFX). His latest book is "Investing in Resources: How to Profit from the Outsized Potential and Avoid the Risks."

A one-ounce gold nugget is rarer than a five-carat diamond.

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