Monday , 19 November 2018

Gold: A Perfect Hedge Against Today’s Bubbly Stock Market – Here’s Why

At the Strategic Investment Conference 2018, David Rosenberg of Gluskin Sheff warned investors of the coming mean reversion in the stock market, which can push down equity prices by 20% or more…He thinks that a breaking point is a year away and so investors should start taking precautions.

The original article has been edited here for length (…) and clarity ([ ])

Smart Money Is Pulling Back

…“I don’t always try to seek out corroborating evidence but there are some serious people out there saying some very serious things about the longevity of the cycle,” said Rosenberg.

  • Sam Zell, a billionaire real estate investor…predicted the 2008 financial crisis—eight months early, though – but essentially, he was right. Today, his view is that valuations are at record highs and easy money has been made…
  • Howard Marks, a billionaire American investor who is the co-founder and co-chairman of Oaktree Capital Management seconds Sam Zell’s view that valuations are unreasonably high.

Data Suggests That Equities Are Poised for a Major Correction

…Rosenberg shifted from quoting high-profile investors to showing actual data, which paints the same ominous picture.

1. Only 9% of the time in history have US stocks been so expensive.

2. [Below is a table that]…with GDP growth figures in the last nine bull rallies…[which] reveals a dire trend where each subsequent bull rally in the last 70 years generated less GDP growth. Essentially, that means we are paying more for less growth.

“Historically, you get a 17% growth rate in a bull market with nominal GDP at 7 and real GDP almost at 4. This time around, we did it with…3.6% nominal GDP, and…2.1% real GDP. We basically had a typical bull market in the context of economic growth that was barely half of what it normally was.”

According to…Rosenberg’s calculations, the S&P 500 should be at least 1,000 points lower than it is today based on economic growth. In spite of this, equity valuations sit at record highs.

3. Another historically accurate indicator that predicts the end of bull cycles is household net worth’s share of personal disposable income [and], as you can see in the chart below, the last two peaks in this ratio almost perfectly coincided with the dot-com crash and the 2008 financial crisis.

…The ratio is [now] at the highest level since 1975, which is another sign that reversion is near.

4. As another strong indicator that recession is around the corner [is the fact that]…The Federal Reserve Bank of San Francisco…points out that…

  • current valuation ratios for households and businesses are high relative to historical benchmarks…[and the]
  • current price-to-earnings ratio predicts approximately zero growth in real equity prices over the next ten years.

Basically, the Fed is giving investors an explicit warning that the market will mean revert but, when we revert, we don’t stop at the mean, warns Rosenberg. He gave an example of how mean reversion in the household net worth/GDP ratio would create a snowball effect.

  • According to his calculations, if the household net worth/GDP ratio reverted to the mean, savings rates would go from 2% to 6%. As a result, GDP would go down 3%, which would have nasty consequences for the economy and, in turn, stocks.

5. …Rosenberg thinks that new Fed Chair Jerome Powell…will be more hawkish than people think….

  • “For people to think he’s only going to go three times this year, I think he’ll go four. He may go more, depending on the circumstances.”
  • Rosenberg also thinks that Powell will not cut interest rates, even if we get a 20% sell-off. That’s how determined Powell is to normalize interest rates, according to him.

In other words, we are in the middle of the Fed tightening cycle. As history shows, a tightening cycle is almost always followed by a recession.

Bottom line: All signs point to a recession, which, Rosenberg predicts, is a year away. As such, he suggests de-risking your portfolio. That means raising cash and investing in asset classes that are not correlated to the stock market.

A Time-Tested Hedge That Withstood Most Stock Crashes

Finding assets uncorrelated to the stock market is not easy.

  • Generally, bonds do well, but they are reaching historical highs. Plus, they are threatened by rising interest rates and excessive US debt.
  • Dividends can cushion a fall in equity prices, but only to an extent.
  • That leaves us with gold, a time-tested hedge against recessions that is largely uncorrelated to stocks and many other asset classes. This means when the markets tumble, gold tends to rise. Here’s proof:

There have been seven recessions since 1965.

  • In five of the seven previous recessions, the gold price rose. This makes sense when you think about the nature of investing in gold. Gold is called a fear trade, meaning that when investors worry about instability in the market, they tend to buy gold, such as liquid sovereign gold coins or gold bars.
  • Not only that, gold’s correlation to stocks drops during a recession.

Look at the chart below to see what happens to gold’s correlation to other asset classes when the economy tumbles:

(A “1” correlation means assets always move in the same direction; “0” means they move together 50% of the time; and “-1” means they never move together.)

Gold already has a negative correlation to the S&P during periods of growth. In an economic collapse, the correlation grows even more negative. That makes it a perfect hedge against the bubbly stock market that we have today.

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