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October 01, 2009

Bucking The Trend?

Bucking The Trend?...It should be absolutely plainly obvious to everyone at this point that the direction of the dollar and many an alternative financial and physical asset class have been very highly negatively directionally correlated for some time now. This has been especially true over the last year of economic and financial market volatility and has been nothing but reinforced lately with the dollar assuming the role of global carry trade vehicle (notice how much foreign sovereign debt has been dollar denominated lately?). It should be no surprise as the US government has coincidentally been in the process of betting the fiscal and monetary ranch with its historic and unprecedented stimulus efforts. And at least according to the CBO (Congressional Budget Office) estimates for the forward US deficit released a number of weeks back, this is not about to stop any time soon. So the rise in many an asset class nominal price is as much about adjusting to and reflecting the reality of a declining dollar as it is about anticipating improving asset class specific fundamentals.

From a global perspective, in June we watched China sell the greatest dollar amount of Treasuries in one month on record, albeit a somewhat less than stunning 3% of their total holdings. So far, this is a one off event. Also on the global scene, the election in Japan last month may also mark a shift in policy regarding Japanese holdings of US dollars; we'll just have to see how it all works out. In Japan , the landslide election of the DPJ (Democratic Party of Japan) was more a refutation of the LDP (Liberal Democratic Party) than an overwhelming affirmation of the DPJ, but the fact is that the DPJ has made noises about wanting the US to repay its borrowings from Japan in Yen. The DPJ has long criticized the LDP for its "closeness" to the US. Not exactly a dollar positive comment or political backdrop, now is it? And lastly as it pertains to the near relentless "adrift on a sea of government-sponsored liquidity" US equity rally of the moment, the very simple chart below simply confirms the importance of this negative directional correlation to the dollar. Although this relationship may be broken some time ahead for all we know, it sure seems to imply US equities require a weakening dollar for further northward movement.

It's time we get to the point of the discussion - gold. We all know that the dollar peaked in early March of this year and has been declining since. Accompanying this decline has been the rise in equities, commodities, etc. But the one asset class that most folks certainly would have expected to run counter to the very meaningful dollar decline since March, gold, has effectively gone nowhere over this period. The chart below is pretty darn clear on the subject. And we're pretty sure gold investors far and wide are plainly aware of these circumstances.

This has prompted a number of folks to begin to question whether this divergence means gold may be topping? Is the negative correlation linkage with the dollar being severed? Is this more than evident divergence a major warning sign for gold as an asset class? As we see it, there are two issues occurring here. First, we need to realize that over the last year, gold as an asset class has been part of the "safety trade". Believe it or not, very much the same role US Treasuries played amidst the deleveraging and panic move to supposed safe asset classes late last year and early this. The chart below exemplifies this a bit. We're looking at the yield on the 30 year US Treasury alongside gold itself.

Very highly directionally correlated since the March-April period of this year. So in one sense gold has really acted like a champ in the broader context of market movement given that safety trade assets such as Treasuries have done very poorly this year as investors have quickly moved back into risk assets as the key thematic macro trade. Although it may sound crazy, gold essentially standing still while the world rushes back to risk oriented assets and shuns safety/panic trade investments has been a major win. After all, if the global economy, credit markets and financial markets are now in the midst of confirmed healing, why hold the "insurance policy" that is gold? With the pun clearly intended, gold has been one of the few, if not the only, assets bucking the trend of the movement away from the safety trade. We believe this is a very important message.

And this leads us to our final and hopefully meaningful observation of the moment concerning what may or may not be to come over the next six months or so in terms of gold. As we see it, gold is running smack into two very important historical trends dead ahead, one seasonal and one cyclical. Although this is not new news to anyone, the historical calendar period of seasonal strength for gold the metal is the September through February six month period. That begins now. Four decades of average monthly historical price experience lie below.

This is more than well known.

The second and probably more important "cyclical" issue that gets little to no headline attention involves investor perceptions and behavior also in the period directly ahead. As we have been harping on in many a recent discussion, one would have to be living on a desert island not to know that the US will print a positive GDP number for 3Q. We've been detailing all the specific reasons why (car sales, car manufacturing, improving trade numbers, etc.), so we will not drag you through them again. That being said and directly to the point, history also tells us that in terms of economic cycles, gold does not perform so well in post recessionary environments. Big surprise? Hardly. Again, in economic recovery environments, safety trade assets are shunned in favor of risk assets. Isn't that what 2009 has been all about? Simply institutional investment management 101. The following table details exactly what we are describing. We're marking the price performance of gold the metal in the three, six, nine and twelve month periods following each official US recession conclusion since 1975.

As is clear, except for the post 2001 experience, gold has been lower in every twelve-month period following recession conclusions. As you'll remember, post the 2001 recession, the economy and financial markets remained very weak until early 2003, so we can understand the strength in gold post 2001 recession end as a continuation of the safety or insurance trade during the period of continued economic and financial market weakness that followed. But in the bulk of historical post recession cases, gold moved markedly lower. We fully realize that post the recessions of the early 1980's, gold was still descending from its prior cycle spike price peak, in sympathy with a US economy moving from an inflationary to a disinflationary macro environment. But by the time the 1980 recession came to a finale, gold had already fallen close to 30% from its prior peak. The table delineates the fact that in the twelve months post the 1980 recession, another 35% was lopped off the price of the yellow dog, so we take the post recession experience of gold in the early 1980's as being a valid historical marker of investor behavior regarding the metal in post recessionary environments.

So in the six months ahead, gold encounters calendar based seasonal strength. Running counter to favorable seasonal tendencies is theoretical price pressure in a post recessionary economic environment. Our thought here is that over the next six months-plus gold may indeed be a key marker of the character of the supposed post recession economic environment. IF gold prices continue to remain firm, or perhaps even indeed move higher, gold will be suggesting to us something is very different relative to historical post recessionary cycle experience. This will be the first post recessionary environment to occur amidst very meaningful global economic change, early glimpses of this being found in the post 2001-recession period. We're entering an environment where the emerging and BRIC economies will have much more of a meaningful impact on global economic outcomes than at any time in modern history. A period where the large industrialized economies are to a point marginalized on a comparative basis.

Although these are our personal "guesses" at this point, gold possibly marching to new highs would be a warning regarding a number of potential outcomes. New breakout highs on gold would be suggesting financial sector deterioration/disruption has not concluded. You'll remember our last month's discussion wherein we described the commercial real estate issues that surely are bearing down on financial sector balance sheets. Gold ascending counter to a post recession weakness pattern would be suggesting US authorities have overstepped their fiscal and/or monetary bounds. Or perhaps gold would be clearly signaling by price divergence that the inflationary seeds the Fed/Treasury/Administration have certainly planted will soon turn to "green shoots" themselves. Although we did not do this on purpose, one post recessionary period for gold we omitted in the table above was the post 1970 recession (ended November 1970). You'll remember that in August of 1971, Nixon closed the gold window. In the three, six, nine and twelve month periods post the 1970 recession, the gold price rose 3.9%, 9.3%, 8.9% and 16.7% respectively. Did gold see the inflation of the 1970's coming head on at the time? Sure seems that way. In short summation, stay tuned. Watch gold and its price reaction in the post recession environment to come. It's in the divergences relative to historical experience, if they occur, that the important messages will be found for the current cycle. In fact, this is one of our primary focal points of the moment - divergences. Gold just may become quite the very meaningful macro economic character marker that few seem focused upon for this reason. But if indeed gold tells us something very different is afoot in the current cycle, it will also have direct implications for equities, fixed income assets, etc. and the investment community in general that have been trying to discount a typical post recessionary outcome for a good number of months now already. Gold as the very important report card? Exactly.

Market Observations
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