Analysis of the investment markets is a two part story this week. It starts with gold and ends with stocks.
Gold took a nose dive this week, dropping 5% on Friday and 7% for the week. Why such a dramatic move?
Speculation.
Gold is widely used as an indication of inflation. The thinking here is that periods of inflation will cause the value of gold to rise; and when there is no threat of inflation, the price of gold will drop.
I don’t buy into the mindset. Inflation is a possible symptom – not a definite cause – of a move in gold.
This week gold speculators overreacted to a drop in the Producer Price Index, a measure of wholesale inflation. Relative price stability also appeared on the consumer front as falling gasoline prices diluted the effects of rising food costs. In short, speculators saw these falling price indicators as a reason to sell their gold positions – because inflation seems far away, or presents no immediate risk to economic vitality.
There were also reports this week indicating that many traders are speculating about the possibility that the Federal Reserve will soon curb its QE activity; such a move, the thought goes, would strengthen the dollar (which would be bad for gold.)
This speculation is just as far out. Fed chairman Ben Bernanke believes that large cash infusions via QE help or improve the job market. He is convinced as such, or so he testifies.
So why would Bernanke discontinue a QE program, that under his ascertain, will achieve his self imposed dual mandate of low inflation and low unemployment?—especially now that inflation appears not to be a problem and the job market remains weak. Why would he change now?
And why, also, should we believe that American QE will end when the current U.S. Treasury Secretary, Jacob Lew, is parading around Europe pushing them to do more of it?
From one side of his mouth Mr. Lew pressed Euro Zone leaders for more monetary stimulus – codeword for easy money and QE type activity – and less fiscal restraint to "help" the struggling economy. In other words, he urged them to continue weakening their currency to make things "easy."
Then out of the other side of his mouth Lew chided Japan and China for doing just that – weakening their currencies – to make things easier for themselves.
First of all, telling other countries what to do is not leadership – it’s arrogance. And secondly, advocating two different positions to two different regions is not diplomacy – it’s hypocritical. But I digress…
The point here is simple: poor central government policy and/or management are not ingredients to strong currencies and economies. Fair minded investors must acknowledge this as the current state of affairs.
To expect a Federal Reserve under an easy money and big government bias to shift strategies without an impetus to change seems a little far-fetched right now – especially when unemployment is high and inflation is "hard to see."
That said, speculating on what the Fed will do should not be part of your gold decision if you are a long-term investor. Let speculators speculate on that. The decision now for long-term investors isn’t to determine whether gold is cheap or still too high to buy, but whether or not the dynamics of gold have changed.
And the answer to that question is no, they haven’t.
Gold is a currency hedge – not an inflation hedge. Gold rises when currencies weaken – when they depreciate. When money is strong, gold devalues because more people trade money than gold. Because of this, sound monetary policy will always produce more demand for money. Currency is easier to use, exchange, and lug around. As a result, the exchange value of gold is always limited because it is less efficient, and less desired.
But when currencies collapse, are impotent, and/or worthless – gold becomes a necessity and demand rises. It is needed, if for nothing else, to back trade. That’s why gold always has value. It’s the world’s de facto reserve currency.
People use gold only when they need to use it. The perception of need, therefore, drives its value. The general rise in prices, a.k.a. inflation, has little to do with it.
To prove this, let’s take modern day Japan as an example. Japan recently made good on their previously announced shift in policy and began devaluing their currency to "help" their economy. But let’s be fair, they did so to make their currency more globally competitive. They did so to follow the U.S., Europe, and China, in doing the same thing. They did so to play the same game – in their own way.
And who could blame them.
Japan should do what is best for Japan. And for Treasury Secretary Lew to do condemn this while advocating the same devaluing policies to Europe, is, well, arrogantly hypocritical.
Par for the course.
Doubters of gold should take note that the recent weakening of the Japanese dollar (the Yen) caused gold prices to skyrocket there. As a result, many of the Japanese people are digging out their gold and cashing it in (see Wall Street Journal article: Japanese Rush to Sell Gold, April 9, 2013). Once again, a weak currency market caused gold prices to rise.
If you ask whether or not that new money in the hands of those consumers will cause inflation there – I say, maybe – but not definitely. That really depends on what other government policies are implemented to manage the economy.
So to say that gold is a reliable indicator of broad-based economic inflation – nope, I don’t buy it. The drop in gold this week was a false indication by a broken system – short positions of gold are at record highs (which adds downward pressure on its price), and speculators are gambling that money and economies aren’t as bad as they seem.
All of this sounds so much like 2008.
If markets didn’t offer mixed signals then no one would be surprised by their severe correction. Markets inflate and correct all the time. In the 90’s it was a technology boom; in the 2000’s it was housing; and now it’s money and debt. This one, too, will burst. And when that happens gold, the consummate money hedge, will benefit.
So forget about inflation when making your gold decisions. Use instead actual market conditions and whether or not you have enough of it to achieve your financial objectives. You will be better served.
And then there’s the second part of this week’s story – stocks.
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Poor monetary policy kept air pumping into the stock market balloon this week. The Dow Jones Industrial Average ended the week at 14,865, up 13% for the year (3 ½ months), 12% in the most recent 12 months, and 20% in the last two years. The Dow’s value can now be considered irrationally exuberant, reaching the action zone high point for the first time this year.
That’s always a good time to take a piece off the table. I say this knowing full well that giving buy and sell advice is quite difficult. Everyone has their own plan and objectives, risk tolerances, growth postures, and different points of entry and exit to profit. But as the saying goes, it's buy low and sell high - and stocks are definitely "high" at these levels.
And that includes the 15-51 strength Indicator, which has corrected 22% since hitting its all-time high in September 2012. Where it sits today, the P/E ratio for stock market strength is 18 versus revenue and income growth rates of 8% and 6% respectively. That’s still kind of pricey – and still irrationally exuberant. See the two year chart below.