Blog 2 Columns

One of the past month’s interesting stock-market developments was the strength of the banking sector in both nominal terms and relative to the broad market. The strength in nominal dollar terms is illustrated by the top section of the following weekly chart, which shows that the US Bank Index (BKX) is threatening to break out to the upside. The strength relative to the broad market is illustrated by the bottom section of the chart, which reveals a sharp rebound in the BKX/SPX ratio since the beginning of September.

Bank stocks tend to perform relatively well when long-term interest rates are rising in both absolute terms and relative to short-term interest rates. This explains why the banking sector outperformed during September and also why bank stocks generally have been major laggards since early last year.

Valuations in the banking sector are depressed at the moment, as evidenced by relatively low P/Es and the fact that the BKX/SPX ratio is not far from a 25-year low. This opens up the possibility that we will get a few quarters of persistent outperformance by bank stocks after long-term interest rates make a sustained turn to the upside.

On a related matter, the relative performance of the banking sector (as indicated by the BKX/SPX ratio) is an input to my “true fundamentals” models for both the US stock market and the gold market. However, when the input is bullish for one of these markets it is bearish for the other. In particular, relative weakness in the banking sector is considered to be bullish for gold and bearish for general equities.

Until recently the BKX/SPX input was bullish in my gold model and bearish in my equity model, but there was enough relative strength in the banking sector during the first half of September to flip the BKX/SPX input from gold-bullish to equity-bullish. As a consequence, during the second week of September there was a shift from bullish to bearish in my Gold True Fundamentals Model (GTFM). This shift is illustrated on the following weekly chart by the blue line’s recent dip below 50.

The upshot is that the fundamental backdrop, which was supportive for gold from the beginning of this year through to early-September, is now slightly gold-bearish. My guess is that it will return to gold-bullish territory within the next two months, but in situations like this it is better to base decisions on real-time information than on what might happen in the future.

[This blog post is an excerpt from a commentary published at TSI on 1st September 2019.]

It’s well known that the US$ gold price often trends in the opposite direction to the US real interest rate. This relationship is illustrated by the following chart in which the real interest rate is represented by the yield on the 10-year TIPS (Treasury Inflation Protected Security).

Notice that the 10-year TIPS yield has just gone negative and that the previous two times that this proxy for the real interest rate went negative the gold price was at an important peak. Specifically, the real interest rate going negative in August-2011 coincided with a long-term top in the gold price and the real interest rate going negative in July-2016 coincided with an intermediate-term top in the gold price. If gold tends to benefit from a lower real interest rate, why would the gold price reverse downward shortly after the real interest rate turned negative?

Considering only the 2016 case the answer to the above question seems obvious, because in July-2016 the TIPS yield reversed course and began trending upward soon after it dipped into negative territory. In other words, the downward reversal in the gold price coincided with an upward reversal in the real interest rate. However, in 2011-2012 the real interest rate continued to trend downward for more than a year after the gold price peaked.

We think there are two reasons why the gold price didn’t make additional gains in 2011-2012 after the real interest rate turned negative. First and foremost, the real interest rate is just one of several fundamental gold-price drivers (the 10-year TIPS yield is one of seven inputs to our Gold True Fundamentals Model), and after August-2011 the upward pressure exerted by a falling real interest rate was counteracted by the downward pressure exerted by other fundamental influences. Second, in August-2011 a further significant decline in the real interest rate had been factored into the current gold price.

The risk at the moment is that on a short-term basis the bullish fundamental backdrop, including the potential for a further decline in the ‘real interest rate’, is fully discounted by the current price. This risk is highlighted by the fact that the total speculative net-long position in Comex gold futures is very close to an all-time high. It is also highlighted by the fact that the RSI displayed in the bottom section of the following weekly chart is almost as high as it ever gets.

The relationship between short-term market interest rates and the interest rates set by the Fed is a complicated one. The market makes predictions about what the Fed is going to do and moves in anticipation, but at the same time the Fed’s interest-rate settings are influenced by what’s happening to market interest rates. Also, market interest rates are determined by factors other than what the Fed is doing or expected to do to its official rate targets, and as a result there are times when the market and the Fed seem to be at odds with each other.

At the moment there is no doubt that the market is leading the Fed. In particular, the Fed has been swayed towards rate cutting partly by the fact that the market has discounted rate cuts. This can be established by comparing recent movements in market interest rates with changes in the Fed’s interest rate targets, which I’ll get to shortly. It can also be established by referring to the Fed’s own statements. For example, the minutes of the July FOMC meeting included the following assessment:

“Participants observed that current financial conditions appeared to be premised importantly on expectations that the Federal Reserve would ease policy to help offset the drag on economic growth stemming from the weaker global outlook and uncertainties associated with international trade as well as to provide some insurance to address various downside risks.”

In essence, the Fed has admitted here to being worried that if it doesn’t cut rates like the market expects then financial conditions could get a lot worse. The implication is that if the market expects the Fed to cut rates, then to avoid disappointing the market (and risking the deterioration of financial conditions) the Fed will cut rates.

I mentioned above that the market’s current leadership can be established by comparing recent movements in market interest rates with changes in the Fed’s interest rate targets. Displayed below is a chart that makes this case. The chart shows the performance of the 2-year Treasury yield and indicates the last two interest-rate changes made by the Fed. Notice that:

1) The 2-year market interest rate began trending downward in early-November of 2018.

2) The Fed made its last rate hike during the second half of December 2018, that is, the Fed was still in rate-hiking mode six weeks after a short-term market interest rate began trending downward.

3) The Fed made its first rate cut at the end of July 2019. By that time, the 2-year market interest rate had been trending downward for almost 9 months.

It’s reasonable to assume that additional Fed rate cuts are on the way. Bear in mind, however, that a few additional rate cuts have already been factored into market prices, so market prices won’t necessarily respond in the obvious way to future Fed rate cuts. Also bear in mind that market interest rates probably will begin trending upward while the Fed and other central banks are still in rate-cutting mode.

[This post is a modified excerpt from a recent TSI commentary]

Gold tends to lead the industrial metals sector at intermediate-term bottoms, that is, the US$ gold price tends to make an intermediate-term bottom and commence a multi-quarter (or multi-year) upward trend in advance of the Industrial Metals Index (GYX). Evidence of this can be found on the following chart comparison of the US$ gold price and GYX. Specific examples are:

a) The gold price reversed upward in April of 2001 and GYX did the same in November of that year.

b) The gold price reversed upward in October-November of 2008 and GYX did the same in February-March of 2009.

c) The gold price reversed upward in December of 2015 and GYX followed suit in January of 2016.

Gold’s most recent intermediate-term bottom was in August of 2018. It has since trended upward and over the past two months the trend accelerated. GYX, however, continued to make lower lows until June of 2019. It’s too early to tell if GYX’s June-2019 low was the intermediate-term variety, but regardless of whether or not it makes a new low within the next couple of months the performance of the gold market suggests that the industrial metals sector will commence an intermediate-term rally before the end of this year.

The Baltic Dry Index (BDI) is also predicting an industrial metals rally

The BDI is an index of dry bulk shipping rates. I generally don’t use it as an economic or a financial-market indicator, because it is influenced as much by changes in the supply of shipping capacity as by changes in the global demand for commodities. However, intermediate-term trends in the BDI often match intermediate-term trends in the Industrial Metals Index (GYX). Also, large short-term divergences between the BDI and GYX tend to be important, with one or the other subsequently making a big catch-up move in quick time.

As illustrated by the following chart, a large divergence has opened up over the past four months due to the BDI rocketing up to a 5-year high while GYX languishes near a 2-year low. This divergence could be closed by either a dramatic plunge in the BDI or a substantial rally in the industrial metals sector. I suspect it will be the latter.

The euro may well gain in value relative to the US$ over the next 12 months, but three differences between the monetary systems of the US and the euro-zone guarantee that the euro will collapse (cease being a useful medium of exchange) before the US$ collapses.

The first difference is to do with the euro-zone system being an attempt to impose common monetary policy across economically and politically disparate countries. This is a problem. A central planning agency imposing monetary policy within a single country is bad enough because it generates false price signals and in so doing reduces the rate of economic progress. However, when monetary policy (the combination of interest-rate and money-supply manipulations) is implemented across several economically-diverse countries the resulting imbalances grow and become troublesome more quickly.

As an aside, money is supposed to be a medium of exchange and a yardstick, not a tool for economic manipulation. Therefore, it is inherently no more problematic for different countries to use a common currency than it is for different countries to use common measures of length or weight. On the contrary, a common currency makes international trading and investing more efficient. For example, there were long periods in the past when gold was used simultaneously and successfully as money by many different countries. However, if a currency can be created out of nothing then there is no getting around the requirement to have an institution that oversees/manages it. The euro therefore could not be ‘fixed’ by simply eliminating the ECB. The ECB and the one-size-fits-all monetary policy it imposes are indispensable parts of the euro-zone system.

The second difference is linked to the concept that a government with a captive central bank cannot become insolvent with respect to obligations in its own currency. For example, due to the existence of the Fed the US government will always have access to as much money as it needs to meet its obligations, regardless of how much debt it racks up. Putting it another way, should all other demand for Treasury debt disappear the Fed will still be there to monetise whatever amount of debt the US government issues. Consequently, the US government will never be forced to directly default on its debt.

It’s a different story in the euro-zone, however, because the ECB is not beholden to any one government. The provision of ECB financial support to one euro-zone government therefore requires the acquiescence of other governments. This hasn’t been a stumbling block to date and the ECB has provided whatever support was needed to prevent financially-stressed euro-zone governments from directly defaulting on their debts, but eventually a point will be reached when the governments of some countries balk at their interest rates and money being distorted as part of an effort to prop-up the finances of other governments. At that point there will be direct default on euro-zone government debt or the disintegration of the monetary union.

Once it becomes clear that direct default on government debt is a risk to be reckoned with, ‘capital’ will flee the euro-zone at a rapid rate. This is because the main (only?) reason to own government bonds is that they are supposedly risk free.

The third critical difference between the US and euro-zone monetary systems is similar to the second difference. In the US there is a symbiotic relationship between the Fed and the government, with one institution always prepared to support the other in a time of crisis. One consequence of this relationship is the impossibility — as discussed above — of the US government ever being forced to directly default on its debt. Another consequence is the impossibility of the Fed ever becoming bankrupt.

Several years ago there was much speculation that the Fed would go broke due to large losses on the bonds it was buying in its QE operations, but this speculation was never well-informed. Up until now the Fed has made out like the bandit it is on its ‘investments’ in Treasury and mortgage-backed securities, but even if these securities had collapsed in value it would not have resulted in the Fed going bust. It simply would have led to a line being added to the Fed’s balance sheet to keep the books in balance.

Again, though, it’s a different story in the euro-zone. Should the ECB begin to incur large losses on its bond portfolio there is no certainty that it would be able to keep going about its business as usual. To do so would require the support of governments/countries that never benefited from and never whole-heartedly agreed with the programs that led to the pile-up of low-quality bonds on the ECB’s balance sheet.

Summing up, the US monetary system is problematic in that it gets in the way of economic progress, but it is much less fragile than the euro-zone monetary system. That’s why the euro-zone system will be the first to collapse.

Below is an excerpt from a recent TSI commentary.

An investment’s true fundamentals exert pressure on its price. It is not unusual for the price to trend in the opposite direction to the fundamentals for a while, but if fundamentals-related pressure consistently acts in one direction then the price should eventually fall into line by trending in that direction. Our “true fundamentals” models for gold, the US stock market, the Dollar Index and commodities (the GSCI Commodity Index) are attempts to quantify the magnitude and direction of fundamentals-related pressure.

We have a lot of confidence in our Gold True Fundamentals Model (GTFM), because we understand why it should work and we know that it has worked well over a long enough period to rule out luck/randomness. It isn’t a short-term timing indicator, but all intermediate-term trends in the US$ gold price over the past 17 years* have been in line with the fundamentals as reflected by the GTFM. However, we have less confidence in our other true fundamentals models.

We recently have given more thought to the construction of our Equity True Fundamentals Model (ETFM), which is designed to indicate the direction and magnitude of fundamentals-related pressure on the US stock market (as represented by the S&P500 Index).

The version of the ETFM that we have been using takes into account credit spreads, the yield curve, the real interest rate (as indicated by the 10-year TIPS yield), the relative strength of the banking sector and the G2 monetary inflation rate, with the monetary inflation rate given a greater weighting than the other inputs. However, we now think it was a mistake to put extra emphasis on monetary inflation. This is because although the rate of change in the money supply is the most important long-term driver of the stock market, the time between a trend change in monetary inflation and the effects of this trend change becoming evident in the stock market is long and variable.

In an effort to make the ETFM more useful over the intermediate-term (6-18 month) periods that are of primary interest to us we have made two changes to the Model’s construction. First, we have reduced the emphasis on monetary inflation so that it has the same weighting as the Model’s other inputs. Second, the ISM New Orders Index (NOI) has been added as an input to the Model. This input will be set to 1 when the NOI is 55 or above and set to 0 when the NOI is below 55. This is being done because a) the stock market tends to perform much better when the NOI is greater than 55 than when the NOI is less than 55, and b) there is a strong tendency for the NOI to fall below 55 PRIOR to periods of significant stock market weakness, meaning that weakness in the NOI is not simply a reaction to weakness in the stock market.

The above changes didn’t make a big difference to the historical performance of the ETFM, but they did make the Model a little more sensitive to shifts in the fundamental winds. This is a plus, because the original model wasn’t sensitive enough. Note, as well, that these changes did not alter the current signal. Both the original ETFM and the new/improved ETFM switched from neutral to bearish on 19th April 2019.

Here is a chart comparing the new ETFM (the blue line) with the SPX since the start of 2002. Stock market fundamentals are considered to be bearish when the ETFM is below 50, neutral when the ETFM equals 50 and bullish when the ETFM is above 50.

The true fundamentals are equity-bearish at the moment. If they remain bearish then the price eventually WILL fall into line. Furthermore, the longer the price trends upward or stays elevated in parallel with a bearish fundamental backdrop, the faster the eventual downward price move is likely to be.

*For some of the GTFM inputs we don’t have data prior to the early-2000s, so we can’t compare the GTFM and the gold price during earlier periods.

There is no simple relationship between interest rates and the stock market. In particular, a lower interest rate doesn’t necessarily lead to a higher stock market and a higher interest rate doesn’t necessarily lead to a lower stock market.

The conventional wisdom on this topic is based largely on what happened over the past few decades. Clearly, US equities generally fared well after interest rates embarked on a long-term downward trend in the early 1980s and generally fared poorly when interest rates were in a rising trend during the 10-14 year period prior to the early 1980s. Also, the inverse relationship (a lower interest rate leads to a higher stock market and a higher interest rate leads to a lower stock market) seemed to make sense and was incorporated into a popular stock market valuation tool called “The Fed Model”.

The Fed Model compares the earnings yield of the S&P500 Index (the reciprocal of the S&P500′s P/E ratio, expressed as a percentage) with the 10-year T-Note yield to determine if the stock market is over-valued or under-valued. The higher the S&P500 yield relative to the 10-year T-Note yield, the better the value supposedly offered by the stock market. An implication is that if the 10-year yield is very low, the S&P500 can have a very high P/E ratio and still not be over-valued. For example, according to the Fed Model the S&P500 is attractively valued today. This is because even though the current P/E ratio is almost as high as it ever gets (excluding the 1999-2000 bubble period), the current earnings yield is well above the current 10-year T-Note yield.

However, the simple relationship between interest rates and the stock market only makes sense at a superficial level. It doesn’t hold up under deeper analysis. The reason is that the current value of a company is the sum of all of that company’s future cash flows discounted at some rate, and in most cases it will not be appropriate to use today’s interest rate to discount cash flows that won’t happen until many years or even decades into the future.

When picking a rate at which to discount distant cash flows it would be more reasonable to use a long-term average interest rate than to use the current interest rate. Furthermore, there is no good reason why the change in the interest rate over the next 12 months should significantly affect the interest rate used to discount cash flows that are expected to occur 10-20 years into the future.

But if it is wrong to assume that the stock market should trend inversely to the interest rate over long periods, then why did this assumption prove to be correct over the bulk of the past 50 years?

The first part of the answer is that over the very long term the stock market swings from under-valued to over-valued and back again and that in the early 1980s a bond market under-valuation extreme happened to coincide with a stock market under-valuation extreme. The second part of the answer is that financial market history goes back much further than 50 years and the simple relationship on which the Fed Model is based is not apparent prior to 1970. In essence, the theory that a lower interest rate leads to a higher stock market and a higher interest rate leads to a lower stock market is an artifact of the past 50 years.

The above statement is supported by the following charts. The charts show the Dow Industrials Index and the 10-year T-Note yield from the beginning of 1925 through to the end of 1968.

The US stock market (as represented by the Dow Industrials in this case) was in a secular bearish trend from 1929 until 1942. Apart from an upward spike due to fear of government default in 1931, the 10-year yield was in a downward trend during this bearish stock market period. The stock market then embarked on a secular bullish trend that didn’t end until the late-1960s. The 10-year yield was in an upward trend during this bullish stock market period. That is, the long-term relationship between interest rates and the stock market during 1929-1968 was the opposite of what it was over the past 50 years.

A large divergence between two fundamentally-correlated market prices is important because such a divergence usually will be closed via a big move in one or both prices. However, divergences sometimes build for an inconveniently long time before they start to matter.

The gold/commodity ratio (the US$ gold price divided by the GSCI Spot Commodity Index) and the T-Bond are strongly correlated over the long term. They also tend to be well correlated over shorter timeframes, but significant short-term divergences sometimes occur. One such divergence has been developing since the beginning of this year, with the T-Bond making a sequence of higher highs while the gold/commodity ratio stays below its late-December high. Note that even the recent surge to a new 5-year high by the US$ gold price was not enough to push the gold/GNX ratio above its late-December high.

The current divergence and previous similar divergences (higher highs for the T-Bond in parallel with lower highs for the gold/commodity ratio) are illustrated by the following chart. The previous similar divergences led to large declines in the T-Bond price and I can think of no reason to expect that it will be different this time.