FED Tightening and this Stock Market

With the Alibaba IPO out of the way,  with gold and silver languishing at 2010 levels, and with equity markets at new all time highs, I would argue that extreme complacency– if not euphoria– has crept into the thinking of Wall Street and its assorted army of asset gatherers and brokers.

Over the past several months, we have been treated to several arguments for why this stock market can’t go down, and why global turmoil is not a return of the deflationary problems of 2008-2011, but instead the beginning of a renaissance in the US economy (read stock market). As the thinking goes, money will flow to these shores without speculators caring for perceived safe havens like T bonds and, of course, the oft-maligned and left for dead precious metals in response to black swans overseas. Finally, according to the market cheerleaders, the ability of the FED to not only stop quantitative easing  but raise the FED Funds rate should be of no concern to anyone thinking about joining the party in the S&P 500 after the index is up more than three times in a little over five years. No, instead, the taking away of the punch bowl will finally signal that the stock market can stand on its own two feet and just keep chugging along ever higher.

It really is tails I win, heads I win with this analysis, and even if we are in a secular bull market in both the US market and the US dollar, it is the intermediate term trend that I am concerned about.

Of particular interest to me is the argument that tightening is a non-event in the context of a stock market that has done nothing but gone vertical for the last 5 and a half years.

I would beg to differ. Two of the last times that the S&P 500 was this stretched above its 200 day moving average (according to some the US stock market hit a record this summer in terms of time spent above this average) came in 1987 and 2000. And guess what? Around that time, the Federal Reserve was either in or had been in the process of hiking the FED Funds rate– or put differently, tightening.

In 2000, we all know how that ended, and that it turned out to be the beginning of the secular bear market in stocks that, at least, for now, ended last year when the S&P finally took out its prior all time closing high. However, I am more interested in 1987, since the stock market did eventually turn higher– but only after losing nearly 30% in the space of a few weeks, and, more importantly, spending several years doing nothing.

For those who believe that secular bull markets in stocks just move along a straight line, I would politely remind them about 1987. The stock market was, at best, dead money for the subsequent five years, give or take. It also wouldn’t hurt to remind the cheerleaders about 1994, when the markets also experienced a nasty- though admittedly much shorter- 20% pullback. 1994 was another one of these years when the FED had been in tightening mode. How many stock bulls out there are prepared for the S&P to potentially test 1600 within the next year?

My point here is that expectations are always most out of place at market turning points, and that value investors would do well to look elsewhere– at least temporarily– for positive 3 to 5 year returns.

After yesterday’s smackdown in the precious metals– coupled with IPO euphoria– you may want to revisit the history of FED tightening, and what it could mean for your conventional stock investments. Everything I have learned and experienced about markets tells me that most people think they have an exit strategy when complacency is as high as today, but in reality, most end up looking for a door blocked by those formerly so certain that markets only move in one direction.

Precious Metals and the Dollar

The bear market in gold, silver and mining shares continues as we start the month of September. We have recent calls from investment banks for ever lower prices, perhaps more a symbol of how out of favor this sector is, than any accurate comment on future values. We also have news this week pointing towards more monetary easing in Europe at the same that (supposedly) central bankers in the US are going to be able to begin tightening. Other apparently bullish news for the US economy and its currency comes from those calling for an age of American energy independence. While the greenback has hardly exhibited the kind of bullish moves higher one would expect during a secular bull market in stocks (the dollar is basically stuck in the same range as that of the last 6 years), hope springs eternal for those bulls who want to make the case that a new era of a strong dollar is going to be the final nail in the coffin for the precious metals.

However, I would describe most of the exuberance regarding the dollar as wishful thinking at best.  The news just this morning about the American job market, for one, hardly justifies any great faith in the underlying power of the US economy. And the fact that the ECB feels the need to adopt the same kinds of radical monetary policies practiced by other western nations like the US and Japan, only confirms the view of many dollar bears that the West is on the decline, and other powers (most notably China) do have reason to seek at least some diversification away from the world’s reserve currency.

Now let me be clear, the continued choice of non-western nations to try to bypass the greenback does not mean the dollar is going to collapse, or even that its share of global trade is going to decline significantly. But since prices are set at the margin, I still take seriously all of the talk about currency diversification, and I still believe that said diversification will put a lid on any dollar rally in the years ahead. I should  also add that with all of the talk about America’s energy renaissance, the United States is still running a current account deficit with the rest of the world, a deficit that as recently as the second quarter of 2014 was actually increasing, not decreasing.

While the prices of metals like gold or silver can rise without a significant drop in the dollar index, it is likely that a resumption of the dollar’s decline will signal that new highs for gold and silver, and therefore a resumption of the secular bull market in the metals, is underway.

When comparing the two longest (though not necessarily deepest) bear markets in gold, silver, and mining shares, 1987-1992, and 1996-2001, it is important to note the dollar’s role in determining whether or not new highs were in store for the metals. In the first example, gold and silver were able to rally significantly (roughly 30% and 50%) within the first two years after putting in bottoms in 1991 and 1993, respectively. But those rallies stalled and rolled over around the same time, 1995, as the US dollar index began to climb meaningfully higher in the context of an emerging strong dollar policy by the Clinton administration.

Fast forward seven years or so to 2002-3, and the dollar moved in a different direction (down), thus signalling a renewed secular bull market in the precious metals, as well as in commodities generally. Unlike the example of the mid-1990s, the precious metals stunned the skeptics into silence as they embarked on a powerful move to new high after new high that, at least, for now, ended in 2011.

In the years ahead, gold and silver bulls should pay attention to the dollar chart. There is nothing particularly unusual about a bear market in precious metals lasting 3-5 years, but whether or not the recovery in gold or silver can take each respective metal back above 2000 and 50 dollars, remains an open question.

Silver’s Malaise Could Be Ending Soon

At a time when gold and silver continue to languish, when they cannot seem to rally in response to news that would normally send them substantially higher (geopolitical unrest just being one example) and when a lot of people have walked away from this market to chase anything else higher, it is important to learn the habits of successful investors, who do actually buy low and sell high.

The 27 million ounce sales figure year to date for American silver eagles, while down from last year’s torrid pace, is still impressive when set against earlier years. This sales figure should also been seen in context with news out of Shanghai that inventories at their silver bullion exchange are in dire need of refreshing. Meanwhile, I don’t see the same ability on the part of speculative shorts to knock the stuffing out of paper silver this year– in stark contrast to last year.

Rather than give in to the prevailing despair among many former bulls in this space, it simply looks to me that silver is continuing in its large basing, or coiling pattern from earlier in the year. Yes, the mining stocks are enduring a correction as we speak, but many of them were also up nearly 50% in six months– a correction is a natural and necessary process. To some, the fact that the stocks have been leading the bullion over the course of this year is actually a sign of encouragement.

Remember that August is a weak month for metals like silver, but that by September a big change could be in the offing (you should review what happened in 2010, as just one example of several.) It has rarely been as difficult as today to buy at the bottom- but to me this is a great contrarian indicator for silver and the precious metals in general.

Finally, and as I’ve said all year long, you have a clear choice between buying into a conventional stock market near all time highs, or an asset like silver that has been left for dead. This should not be a difficult choice except for the fact that most investors try to buy high to sell higher, chasing the newest, hottest investment trend. Rarely has their been such a large divergence in three and five year performance between the precious metals and the S&P 500. The fact that most people can’t see this for the opportunity that it is simply demonstrates how strong– and unprofitable– the human herd instinct is.

Silver Keeps Chugging Along

Earlier in the week, several online sources that I follow were convinced that silver and gold were about to implode based on a supposedly bearish Commitment of Traders Report from the CFTC. To a certain subset of gold and silver followers, these reports are taken as gospel proof of a concentrated short side manipulation being undertaken by the Commercial Banks. Leaving aside the issue of whether or not I like the paper precious metals game played at the COMEX (which I don’t), I think it can be dangerous to one’s wealth to read so much into these COT reports. You might have better luck with tarot cards.

The dominant discussion I heard this week was that the increase in the Commercial short position meant that gold and silver were destined to drop, and drop hard. What many of these analysts failed to recognize was that there has been a strong increase in speculator long positions.  It is these speculators who are often the ones who drive gold and silver prices higher on the futures exchanges, and it was these speculators who did in fact play a dominant role in the price surge from 2003 to 2011 in silver, as opposed to commercial short covering– even as there was some of that as well toward the end of silver’s cyclical bull move in 2011.

I feel that the silver market is still suffering from the after effects of a brutal three year bear market. Sentiment is still not great; many former bulls in this space have been shocked and stunned into silence. Many theories about dollar collapses or the end of the COMEX were overstated; the prophets of doom and gloom have seemingly been silenced by a stock market that has blown through prior records and made all time high after all time high.

But– and this is the important point— when a market is as oversold, underloved, and underfollowed as silver, you should actually be expecting some big moves to the upside.  Recoveries from the kind of oversold positions we have seen with the white metal are normally vertical in nature– and yes I know everyone is tired of the bullish case, but that is precisely my point. At the exact same time that everyone thinks the bears can’t be beaten, the market turns decidedly bullish. Put differently, when a trade or an investment thesis feels easy it is wrong, and when it is difficult or hard to believe, you should back up the truck.

 

For Gold and Silver, No Summer Doldrums Yet

After the price action of the past few sessions, gold is back ahead of the S&P 500 year to date, with gold up roughly 9% and the conventional markets up around 6.5%. The real winners year to date continue to be the junior gold mining stocks: even after today they are still up nearly 30%. According to many, the mining stocks lead the metal and this is one more feather in the cap for the precious metal bulls.

Another piece of constructive news for precious metals bulls comes from an asset that is actually in record territory– when using its average annual price– and that is WTI crude oil. While we are still off of the intraday high hit 6 years ago, we are nonetheless higher than the average price of 2008 for black gold. This fact is not widely reported, and is perhaps the biggest tell regarding the future direction of precious metals prices.

I’ve noticed that the narrative of central bank omnipotence is coming back, coupled with an incredible amount of confidence that foreign policy headaches in Syria, Israel, Ukraine, Afghanistan, and Iraq can just be ignored the way they have been for the last several years. As the complacency builds, and as many continue to ignore the very real possibility of surging oil prices in the months and years ahead, gold and silver may surprise many of us who expected this summer to be a boring one devoid of much action.