As I sit here in front of my computer contemplating yet again my Fed-induced rally thesis (QE/not QE), I can’t help but wonder about the market’s next black swan type of event. Admittedly, my tone has become more neutral/bullish for risk-on markets over the last several weeks. Listening to the financial news outlets and reading many market opinions/research from recognized financial gurus, I conclude that market participants have become more bullish too. In some cases, the bullishness seems exuberant with a “melt-up” scenario being painted by several. That having been said, I do think that risk-on markets are poised to o higher even if they suffer a near-term pull back due to their current overbought status (read more about this in the US Equities section below). If you’ve spent time over the last 6-9 months rotating more defensively like I have in my own portfolio, I wouldn’t try and re-adjust because I still think we are in the later innings of this cycle. If you haven’t rotated at all or only partially, then I think it makes sense to continue to shift to a more defensive posture slowly over the coming months, taking advantage of rising prices along the way. Now would seemingly be a good time to make part of that adjustment. The last two week’s market action proves that new all-time highs in the equity markets are achievable in the current declining corporate earnings environment.
As far as this past week is concerned, the most important events for anyone holding a gold investment or silver investment were continued news flow regarding US-China trade talks and economic data releases. Early in the week, markets feared that the US-China trade talks were losing momentum. Why? Last Saturday, President Trump downplayed reports of an imminent lifting of tariffs on Chinese goods and stated that the United States would only make a deal with China if it was the right one. On Tuesday, he followed that with a comment that the United States would “substantially” raise tariffs on Chinese imports if a deal was not reached. Of note, these negative headlines only had a mild impact on markets. On Friday, however, risk-on markets benefited from late Thursday comments by US trade adviser Larry Kudlow who said that a deal with China is in its final stages. Clearly, there was an asymmetric upside reaction to this news flow.
As far as economic data is concerned, the winner of the week was Friday’s US retail sales which came in at 0.3% growth month over month versus a 0.2% consensus estimate. This was more than enough to offset the disappointment from the US industrial production numbers which were released the same day. Industrial production was down 0.8% on a month over month basis versus a consensus estimate of a 0.4% decline. This brings industrial production to a year over year decline of 1.1% and further demonstrates the tale of two economies in the US: a strong consumer on the one hand and a weak manufacturing economy on the other. This theme has been consistent since the trade war ratcheted up in the middle of the summer. Of note, both releases had a negative impact on the Atlanta Fed GDPNow as shown in the chart below. The current NowCast is dangerously close to break-even growth in Q4.
Moving on to corporate earnings, the earnings season is largely complete with 92% of S&P 500 companies having reported – this will likely be my last comment on this earnings season. The Q3 earnings decline is now projected at 2.3% versus a 2.5% decline last week per FactSet Insight. Revenues are still projected to grow 3.1%. Revenue growth remains key for the projected rebound in 2020 earnings that the market and analysts currently anticipate and as I’ve said previously, “the market will be able to digest both results and guidance…in the context of a currently accommodative Fed”. The 12-month P/E ratio stands at 17.5x and its inverse, the S&P earnings yield is currently 5.71%. Compared to 10 Year US Treasuries, today’s equity risk premium is 387bps – this comparison is known as the Fed Stock Valuation Model. Remember, there is much debate over this model given the change in correlations between the two asset classes around the turn of the century. On this note, I’d like to bring back an updated chart that I first showed you in my Precious Metal Market Update – 11 August 2019.
In re-examining this chart more closely, you can see how the spread stayed pretty constant after the correlation broke around the turn of the century until the financial crisis hit. Fed rate cuts plus quantitative easing drove these spreads to their wides around the end of 2013. This coincides with the Fed tapering program which was announced at the December 2013 Fed meeting. Tapering was still an expansion of the Fed balance sheet but at a slower rate. In 2018, you can see how this spread started to shrink as the Fed embarked upon quantitative tightening (i.e. a reduction of its balance sheet). And now, this spread is widening again given the Fed’s current QE/not QE program.
Consistent with last week, none of my other indicators are flashing incremental warning signs at this point. US Treasury – German Bund spreads are firm. Copper prices continue to stay well above the dangerous $2.50 / high $2.40s technical level that I’ve discussed previously. In general, recent data and price action indicates a decline in near-term risk.
With that, I’d like to remind readers that anyone who is thinking about buying gold as an investment or silver as an investment and who is worried about initiating a new position at current prices should carefully develop their own view and consider their expected holding period. A gold long term investment or a silver long term investment is very different from investing in precious metals on a short term basis. Depending on one’s objective, when investing in gold and silver, there are several drivers of precious metal price that investors need to be mindful of that will drive gold investment returns. In support of developing that view, let’s review the major markets that precious metals take their cue from.
With the exception of Monday’s very modest decline, the S&P inched forward Tuesday through Thursday before Friday’s stellar 0.8% gain. For the week as a whole, the S&P increased just under 0.9% to finish at a new all-time high of 3,120. So what made Friday so good? First, the retail sales number mentioned in the overview gave investors confidence that the consumer, the linchpin in this weak manufacturing environment, was still holding the economy together. This was further bolstered by the positive comments made regarding the US-China trade talks.
Last week, I talked about how clearly the technical picture had changed with stocks hitting new all-time highs. The psychological 3,100 level proved no match for this current bull but this week’s gains put us even deeper into overbought territory. With a relative strength index (RSI) that has climbed even further since last week and trading levels hugging the upper end of the bollinger bands (see chart below), a near-term pull back seems even more likely. That said, I still believe that the previous ceiling of 3,025 now provides a floor to the market with the 50-day moving average of 3,005 not far behind it. Again, I would note that while not a 100% fit, the timing of this latest rally aligns with the Fed’s QE/not QE launch that I discussed in my Precious Metal Market Update – 20 October 19. If we do get a near-term pull back and China trade negotiations remain on track, the dip will likely be shallow (3-5% decline) with the Fed back to increasing its balance sheet. Remember, Fed purchases will last at least into the second quarter of 2020 so the safety net underneath the market has some time to run.
Moving on to the VIX, last week I mentioned how “at these levels, it becomes incrementally harder for the index to move lower.” This week’s trading proved that point as the VIX finished essentially unchanged at 12.05 vs. 12.07 last week despite the continued rally in equities. The index continues to be more than one standard deviation from its long-run average (since January 1990) using log normal data and briefly dipped below 12 on to an intraday low of 11.92 on Friday. For a few week’s now, I have pointed out how any dip below 12 on the VIX this year has been quickly met with a reversal and that this fact, for me, gives additional credence to the theory that we are currently overbought and due for a pull back. Along the way, I became curious as to what a long-term view of the VIX standard deviation looks like. The results of that curiosity are below.
Bunched together over at the right hand side of the chart, you can see how mini reversals have occurred just below one standard deviation this year. This equates to levels just below 12 currently. Longer-term, you see how major reversals occur as the VIX approaches two standard deviations below the long-run average (since January 1990). I will monitor this data as an additional tool to try and decipher the next major market top which seems to have been pushed further out by recent Fed actions, particularly the expansion of the balance sheet.
In typical QE fashion, both equities AND government bonds rallied this week. While one week does not make a trend, we will see if the market starts to build a case for this type of environment. 10-year Treasury Notes rallied with yields falling 10 bps from 1.94% to finish the week at 1.84%. When 10-year yields broke through the September 13th cycle high of 1.90%, I felt as though a yield level of 2.15% was the new upper end of the trading range. While I still believe that to be the case for the time being, it is interesting that 10-year Treasury Note yields dropped below 1.90% again so quickly.
Conversely, 3-month T-bill yields (the best barometer of future Fed action) actually increased slightly. 3-month T-bills closed at a yield of 1.57% vs. 1.55% last week. With the Fed’s most recent target Fed Funds range of 1.50% – 1.75%, a yield of 1.57% indicates uncertainty over additional moves by the Fed. Fed Fund futures, on the other hand, started to price in a wider variety of outcomes by the end of next year expanding. Last week, the highest probability outcome was no action by the Fed at a little over 50%. Now, as shown in the chart below, the highest probability outcome is a 25bp cut and chances of cumulative easing have risen to 61.3%. Interestingly, the market has now also priced in a slim 6.3% chance of an interest rate increase. On balance, I would say that the market believes the Fed will turn out to be more dovish but the uncertainty , given the wide dispersion of probabilities, has one up.
The combined moves in the 10-year Treasury and the 3-month T-bill adds up to 12bps of curve flattening on the week. This is somewhat of a pull-back in the re-steepening trend that has gripped the yield curve since the end of August/beginning of September. At the moment, I don’t read anything into this.
2-Year Treasury Notes also rallied this week with yields falling 7bps to end the week at 1.61%. With Precious Yield continuing to offer 2-year physical gold term deposit rates of 2%, the US Treasury – Precious Yield spread* remains in Precious Yield’s favor. That spread became even more favorable to Precious Yield this week, increasing from -.32% to -.39% given the decrease in 2-Year Treasury note yields. Note that a negative spread favors Precious Yield while a positive spread favors US Treasuries. Since Precious Yield offers investors in gold the opportunity to earn interest, the US Treasury – Precious Yield spread is tighter than the US Treasury – gold yield spread. To remind our audience, the gold yield is negative in most other holding forms outside of Precious Yield. This includes paying for storage of physical metal whether investor-owned or via a physically -backed storage program and paying management fees for GLD or similar ETFs. See our how to gold investment white paper for a more thorough discussion. Precious Yield (whether hedged* or unhedged) provides a much needed yield alternative in this environment of ultra-low / negative global bond yields. I believe yield alternatives continue to be a major investor focus.
The US dollar weakened a bit this week as far as the US dollar index (Ticker: DXY ) is concerned. The index fell 0.35% to finish the week at 98 even. Let’s look at the major index components. While the dollar weakened 0.3% against the Euro (57.6% index weight) and 0.5% against the Yen (13.6% index weight), the big winner of the week was the Pound (11.9% index weight). It gained a little over 1.0% against the greenback. After the EU agreed to a further Brexit extension to January 31st, 2020 at the end of October, I felt as though volatility in the Pound would temporarily ebb. However, this past Monday’s headline that Brexit Party leader Nigel Farage said he did not want anti-Brexit parties to win and therefore, was standing down candidates in seats won by the Conservatives in 2017, moved the currency sharply. To be fair, my expectation that volatility would ebb was temporary. Volatility in the currency pair will likely pick back up between now and the end of January.
As has been typical for awhile now, whatever direction the dollar heads as measured by the dollar index usually means the complete opposite for the dollar trading against the Chinese Yuan. This week was no different: The dollar was weaker versus the dollar index constituents but stronger vs. the Chinese Yuan. Without having run the math, I would guess that the dollar index and the USD/CNY currency pair have been inversely correlated (partially) during the trade dispute. This makes sense to me intuitively because as the trade war gets worse, other developed market currencies become more attractive versus the dollar but by the same token, it’s also pretty clear that the trade war has a greater negative impact on China than it does on the US. In total, the dollar was just under 0.2% stronger against the Yuan this week to finish at 7.0083:1 despite Friday’s positive comments on progress in the negotiations. As discussed last week, I still believe that 6.75:1 (levels last seen in early May) is a good target for the successful completion of a Phase One trade deal.
Lower Treasury yields and a weaker dollar barely outweighed rising equity prices and decreased volatility, as the US dollar price of gold in ounces inched up a bit this week. As measured by the LBMA afternoon fix (11:00AM EST), the gold per ounce price increased from $1,464/oz to settle at $2 higher at $1,466/oz. Spot gold prices held essentially steady going into the NY close (4:00PM EST). At these prices, we are 5.2% below the recent cycle high of $1,546/oz. and my $1,400-$1,425/oz second downside trading range price target remains firmly in play. I would note that the 200-day moving average sits just below this trading range at $1,393/oz. Much as the breakthrough of 1.9% on the 10 Year Treasury Note yield drove gold prices to my initial downside target, I would expect an increase in yields above 2% will put my next downside targets in play. These targets look reasonable when looking at gold prices concurrently with the last time 10 Year Treasury Note yields were above 2% in the late June/early July time frame.
Checking in on gold volatility, the “Gold VIX” decreased to 11.23 from 12.27 last week. Looking at both the AM & PM LBMA fixes over the course of this past week, the gold price per ounce trading band shrank significantly, fluctuating $15/oz. between the high and the low (vs. $45/oz. last week). I use these price bands to better understand the movements in the “Gold VIX” (Ticker – GVZ ) levels from above. A shrinking price band (1.0% between the high and low LBMA fix) is consistent with a decrease in volatility. As shown in the chart below, the recent cycle high in gold prices happened in late August/early September when gold volatility was also peaking. Current gold volatility levels are much lower.
To remind our readers, the Gold VIX measures the market’s expectation of 30-day volatility of gold prices by applying the VIX methodology to options on SPDR Gold Shares (Ticker – GLD ). As I have stated previously, looking at the price band of spot gold prices alone will not capture the supply/demand dynamics that take place in GLD options but at least it is an additional tool. GLD is an exchange-traded fund that represents a fractional, undivided interest in the SPDR Gold Trust, which primarily holds gold bullion. As such, the performance of GLD is intended to reflect the spot price of gold, less fund expenses.
While gold and silver investing has historically been associated with negative carry, a Precious Yield precious metal account offers investors the opportunity to earn a yield on gold and silver instead. If you are a long-term holder, turning gold and silver as an asset for diversification purposes into an alternative investment and yield alternative with Precious Yield allows for some cushion against price movements via the gold and silver yield. To learn more, please browse our website. Alternatively, contact us directly for more information or to answer your precious metal investment questions. For up to the minute thoughts, please follow me (@CIORobPerry) or Precious Yield (@PreciousYield) on twitter.
* Note that while I use the US Treasury – Precious Yield spread as a relative value metric, a better apples to apples comparison of similar instruments would be US Treasuries vs. a fully hedged gold position. For more information on a fully hedged gold position as a yield alternative, please visit our www.kilofutures.com website and read about The Cash and Carry Trade.
Gold price per ounce 1-Month Chart
Silver price by ounce 1-Month Price Chart
Platinum price per ounce 1-Month Price Chart
Palladium price per ounce 1-Month Price Chart
About the Author
Rob Perry is an avid student of the markets and an aspiring tennis player. He is currently Chief Strategist for Precious Yield as well as Chief Investment Officer of Pecan, a single-family office based in San Diego, CA. Most recently, he was located in New York City working as Chief Strategist of and a Portfolio Manager for Kingsland Capital, a multi-billion dollar boutique asset management firm focused on below-investment grade corporate credit. Twitter: @CIORobPerry
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