If this was the start of the great rally than everyone has been hoping for; it might be time to light some candles, say a few prayers or sacrifice a goat because today’s action was decidedly disappointing for large cap domestic stocks. After three days of strong selling pressure, the S&P 500 got off the mat early in day only to fall back on the ropes heading into the close. Take a quick look at the chart below; the S&P 500 closed below the open of the day and only slightly off the low as sellers took charge around midday. It looks like we’re going to retest the consolidation channel that held the market in irons from March to May.
But that’s not what I want to talk to you about tonight. Instead we’re going to spend some time with an old love, gold, which has had a surprisingly strong October, with GLD up over 2%, GDX at breakeven and the S&P 500 down 4.8%. I’m sure the regular readers out there know that I have a complicated relationship with precious metals. I’ll admit to being a sucker for shiny things and a certain amount of drama in my relationships, but I’ve been burned by gold and silver on more than a few occasions and I’m not ready to fall in love again. However, with the recent performance I’m willing to forgive and at least have coffee.
So what the heck has been going on with the metals lately? First thought looking at this chart of GDX is that we’re just bouncing off the lows set in late 2013, shorts are being closed out, or that the miners are going back to their old role as the equity alternative for when equities start having trouble. Trust me, I’ve done the research; the only way to make money in the gold miners between 1982-2001 was to buy them when the broader market was breaking down and to sell them the second the bulls took charge.
This time, I think it might actually be different and it has nothing to do with inflation. In fact, gold is a terrible inflation hedge unless you plan to hold it for 30 years. No, what could be giving a lift to the oldest inflation hedge in the world is its opposite, deflation.
I’m not doing the math here, but when rates are hugging the zero bound and there’s at least some inflation, what happens to the real cost of money which you can define as the borrowing costs minus inflation? It goes negative. If you can borrow $100 for ten years at 2.21% and the 10 year expected inflation rate is say 2.5%, the cost to borrow is a negative .29%. Why wouldn’t you take all you could, invest in practically anything and expect everyone else would do the same? Well with commodities in 2010 and 2011, that was pretty much the case and a lot of dollars went around the globe and got into all sorts of trouble with commodities, emerging markets, and of course, gold. Of course that’s what the FED wanted, Ben Bernanke made no bones about it.
Check out the chart below I whipped together using data from FRED. It’s the anticipated cost of money over the next five years and you can see that up until QE3 and it’s supposed commitment to creating inflation, it went only one way. But with the recent optimism here in America, investors began anticipating inflation and sending the price of all commodities lower. It’s been a tough few years for the miners but guess what, things have changed in 2014. I mentioned that recent survey of the Primary Dealers where they think within 2 years of the first rate increase, the FED will be right back in the same situation at the zero bound. Yup, the people who make a market for the Treasury have no confidence that the FED will be able to raise rates while keeping the economy churning and actually creating inflation.
They are, to use a very crass expression…pushing rope and a few souls are stepping back into the metals market in case the FED does fail. GDX tried playing catch up to GLD, but why buy a leveraged play for such a small speculative position? Better to go with the lower volatility of the metal itself. The Yinzer Analyst isn’t buying (and certainly isn’t telling you too either just FYI), but he has to ask, can you do this again?