“Gold has peaked for the year” Revisited

By Steve Saville

The great thing about believing that market trends have almost nothing to do with “fundamentals” and almost everything to do with manipulation is that you never have to be wrong

I published a blog post in late-June titled “Gold has peaked for the year“. In this post I argued that relative to other commodities (as represented by the Goldman Sachs Spot Commodity Index – GNX) gold’s peak for 2016 most likely happened in February. As evidenced by the following chart, I was correct.

gold_GNX_291216

The reason for this follow-up post is not to give myself a public ‘pat on the back’. I’ve made my share of mistakes in the past and I will make mistakes in the future. The sole reason for this post is the vitriolic response that my earlier article received.

My earlier article should not have been controversial. After all, the February-2016 peak for the gold/GNX ratio wasn’t just any old high, it was an all-time high. In other words, at that time gold was more expensive than it had ever been relative to commodities in general. Furthermore, it is typical for gold to turn upward ahead of the commodity indices and to subsequently relinquish its leadership.

With gold having outperformed to the point where it was at its highest price ever relative to the prices of other commodities and with other commodities likely to recover, saying that gold had probably peaked for the year in commodity terms should have been viewed as a statement of the bleeding obvious. It would have taken a financial crisis of at least 2008 proportions during the second half of 2016, that is, it would have taken an extremely low-probability financial-market outcome, to propel the gold/GNX ratio to new highs during the second half of the year. That some readers took my “Gold has peaked” article as an affront was therefore remarkable.

Remarkable, but not really surprising given that in the minds of some gold devotees the gold price is always too low. It doesn’t matter how high the price is or what’s happening in the world, the price is always about to skyrocket. The only obstacle in the way is a cabal of evil market manipulators that will soon be overwhelmed by the forces of good. And in any case, a financial crisis of at least 2008 proportions is always about to happen.

Gold’s poor performance during the second half of 2016 was consistent with what I refer to as the true fundamentals*. This means that it wasn’t the result of downward manipulation. That being said, the great thing about believing that market trends have almost nothing to do with “fundamentals” and almost everything to do with manipulation is that you never have to be wrong. If any market goes against you it was due to the distortive effects of manipulation rather than a fatal flaw in your analysis.

*The true fundamental drivers of the US$ gold price are, in no particular order: US credit spreads, the US yield curve, the real US interest rate, the relative strength of the US banking sector, the US dollar’s exchange rate and the general trend in commodity prices.

Zero Fear-O?

By Tim Knight

Happy Winter, everyone! Yes, it’s the winter solstice. As we wind down the last few trading days of the year, volatility is collapsing to levels hardly ever seen before in financial history. It actually reached a 10-handle this morning. Incredible.

1221-vix

For those wanting to jump into this “risk free” equity market, I can only offer this headline from this morning:

1221-gart

Another Line to Cross Before Reflation; Nuns and Neutrality

By Jeffrey Snider of Alhambra

Talking with my colleague Joe Calhoun yesterday, he was eager to share with me something he found in the (virtual) pages of the Wall Street Journal, a perfect sign of the times. In a story about a group of nuns in Germany taking their financial future into their own hands, Joe couldn’t help but shake his head at what surely is just another example of how “we” don’t learn.

“I started by googling what a swap is,” Sister Lioba says, referring to a derivative that allows an investor to exchange the income stream of one asset with that of another.

I’m not sure what’s the worse transgression here, the Sister’s entry into what will someday be the same kind of lore as daytraders of dot-coms gone by, or the Journal’s description of a swap that is, understandably for a media article, technically correct but still inappropriate in so many ways. Joe was right to chuckle as nothing could possibly go wrong here.

The 54-year-old then began studying the financial pages of German newspapers and her bank’s research notes.

“I now understand every third sentence instead every 10th when I started,” she says.

The chief economist (it’s always economists, isn’t it?) of the bank that services the nuns’ portfolio is bullish on the Sisters anyway, saying “they have actually proven themselves to be quite the savvy investors.” It’s not savviness that is required, a deficiency often laid bare in the aftermath of almost all prior assurances from economists, nor is technical proficiency a fastidious guard against getting in over your head. The Belgian bank Dexia was both savvy and proficient, and it still wound up like so many others in the unsteady hands of its government.

We haven’t even finished up with the last round of swaps gone awry and still we are to celebrate the fortitude of those who venture into that same unknown? As I wrote back in May:

If Japanese banks were heavily into obtaining dollars via basis swaps especially right after QQE, they would have determined not just the rate of both legs of the swaps but likely factored the expected future direction of JPY. Since it was on a multi-year down-trend that QQE was thought to only fortify, there was undoubtedly considerations as to what the future state of rollover costs would be – addressed directly through further means and hedging like swaptions or, in the likely case of JPY at that time, intentionally left completely unhedged. It’s not as absurd as it sounds when something becomes entrenched conventional wisdom; once something happens (like JPY devaluation) that is expected to happen it is not uncommon for rational humans to simply believe it will always happen. Belgian bank Dexia was bailed out for a second time in October 2011 because it was funding a “carry trade” via total return swaps that essentially shorted German bunds. Because they never thought that interest rates would decline and do so as much as they did, the bank was totally exposed when the (modeled) impossible did happen.

The problem in general terms is not acquiring knowledge; that is to be celebrated in any form or context. It is pushing boundaries without any appreciation for what is not known, or in many cases is not knowable. Appreciating the unknown, to paraphrase Donald Rumsfeld, is something they don’t do well (by definition) in modeled swaps or econometrics, largely because of these stubborn conventions that are believed to have it all figured out.

The Journal tells us that the reason the nuns of Mariendonk have entered the realm of high finance is because the ECB had ruined the conditions of their previous financial existence.

For over a century, Mariendonk financed itself by selling milk and candles, and through income on its bank deposits. After the European Central Bank began cutting rates, eventually going all the way below zero to their current -0.4%, Sister Lioba realized her convent needed extra income to survive.

Orthodox economics persists with the notion of monetary neutrality when we have any number of real world examples to refute that theoretical boundary. Neutrality asserts that changes to the stock of money will not affect real variables such as employment and consumption, affecting at most prices and rates. But the nuns as well as Dexia, Merrill Lynch, MF Global, Wachovia, Lehman, the house flippers of the 2000’s and their forerunner daytraders of the 1990’s show that there is a real effect of at least perceptions of monetary policy.

Most of the behavior that led to the events of 2008 was acting out under false assumptions, the ability of the Fed (or ECB) to extract those daring firms and individuals from trouble being the primary one. How many houses were built in the US last decade because “you couldn’t lose?” Dexia failed because there was just no way that central banks would “allow” it to get so bad that German bunds would get close to 2%, let alone 1%, and now negative. Nobody looked at the downside because it was convention that there wasn’t any, or at least not much before it would trigger the heroics of the printing press. What we got instead was central bankers standing upon the burning embers of a financial system nearly collapsed and proclaiming themselves heroic due to bank reserves because it wasn’t worse.

It’s a far different range of scenarios under that reality than what somehow survives today. Perceptions matter because they drive behavior, and behavior matters because it does have real effects. This is what central banks are actually counting on with QE and all the rest, to be “stimulus” of emotion whether or not there is actual money printing; to get people to act like the money is coming before it ever does, and therefore jump starting the process where it will. The nuns are in one way acting out the intended “portfolio effects” of monetary policy, pushing them into risky behavior that they clearly don’t fully understand because economists believe in efficient markets that said behavior proves likewise is absurd.

By relating it all back to rational expectations and thus efficient markets, economists believe that behavior drives prices and therefore reality. If the nuns buy more swaps because they can’t get a good rate on their CD’s, then the growth and prices of swaps or stocks or whatever other risky asset will be taken as real and therefore a sign of better days. From that, economic participants will act on those prices as if those better days are about to become real because markets are, under the efficient market hypothesis, never wrong – even when a German convent is on the other side of your swap.

Traditional havens such as bonds offer such low returns that Mariendonk now invests around a third of its money in stocks, which are typically more volatile than fixed-income investments. Before rates fell below zero in 2014, the nunnery invested less than a quarter of its portfolio in equity.

Though a human interest story, and an admittedly interesting one, the article was meant to be reassuring. In many ways it is reductio ad absurdum to accomplish that goal, meaning that if nuns can do it so can you, but that absurdity works in both directions; if even the formerly stoic nun portfolio is now under the thumb of “portfolio effects” then what is it that stocks are actually pricing? An actually better future or a misunderstood coping from within the current undesirable circumstance?

Again, we have to circle back to risk. These portfolio effects at least now are not even what most people believe they are. By that I mean low bank rates may be a direct consequence of Mario Draghi’s orthodox views, but the rest of the funding and credit markets are not; the interest rate fallacy driving global rates lower is a much different condition than viewing low rates as “stimulus.” It is, in fact, the same mistaken behavior as “you can’t lose” in housing during the housing mania. Low rates are low because there is everything wrong in the global economy, but stocks may be higher because so many believe in the opposite as being brought about by what already was proved a myth (and a disastrous one).

In 1998, Ben Bernanke wrote a paper with Ilian Mihov for the NBER setting out to prove empirically long run neutrality. The reason for it was that though it had been an accepted theoretical component of the orthodox canon for decades, back to the early 1970’s, many who had gone looking to prove it especially in the 1990’s had instead come to the opposite conclusion. As Bernanke and Mihov wrote:

Cochrane (1995) notes that the output response to money innovations in a VAR context is “puzzlingly protracted”, a finding he uses to motivate his argument that anticipated as well as unanticipated changes in money may affect output. Gordon and Leeper (1994) similarly find that monetary policy shocks affect output over long horizons, accounting for over 30% of the unforecasted variation in output three years after the policy shock.

Don’t worry, however, because Bernanke and Mihov find that long run neutrality does, in fact, hold and “in a robust sense.” And what money variable did they use to define this “robust” evidence? Bank reserves.

Even if President Trump were to ask for Janet Yellen’s resignation on January 21, she would be replaced by just another empty suit for whom bank reserves still count as relevant money and all that would follow from it – right down to nuns in Germany investing in ways that they never would have otherwise no matter how hard the Wall Street Journal and regular economists cheer their moxie.

A Strange Sentiment Conflict

By Steve Saville

[biwii comment:  We noted in NFTRH several weeks ago that the AAII had been much better at not being a contrary indicator over the last 15 years than they were in the run up to the 2000 market top.  Further, we speculated that this bull may not end until the AAII capitulates and becomes 100% ‘dumb’ again, closing a loop of sorts.]

This blog post is a excerpt from a recent TSI commentary.

As the name suggests, the weekly American Association of Individual Investors (AAII) sentiment survey is an attempt to measure the sentiment of individual investors. The AAII members who respond to the survey indicate whether they are bullish, neutral or bearish with regard to the US stock market’s performance over the coming 6 months. The AAII then publishes the results as percentages (the percentages that are bullish, neutral and bearish). The Consensus-inc. survey is a little different in that a) it is based on the published views of brokerage analysts and independent advisory services and b) the result is a single number indicating the bullish percentage. However, the results of both surveys should be contrary indicators because in both cases the surveyed population comes under the broad category affectionately known as “dumb money”.

In other words, in both cases it would be normal for high bullish percentages to occur near market tops (when the next big move is to the downside) and for low bullish percentages to occur near market bottoms (when the next big move is to the upside). That’s why the current situation is strange.

With the S&P500 Index (SPX) having made an all-time high as recently as last month and still being within two percent of its high it would be normal for sentiment to be near an optimistic extreme. As evidenced by the blue line on the following chart, that’s exactly what the Consensus-inc survey is indicating. However, the black line on the following chart shows that the AAII survey is indicating something very different. Whereas the Consensus-inc bullish percentage is currently near the top of its 15-year range, as would be expected given the price action, the AAII bullish percentage is currently near the BOTTOM of its 15-year range. According to the AAII sentiment survey, individual investors are only slightly more bullish now than they were at the crescendo of the Global Financial Crisis in November-2008.

The conflict between the AAII survey results and both the price action and the results of other sentiment surveys (the AAII survey is definitely the ‘odd man out’) suggests that small-scale retail investors have, as a group, given up on the stock market and are generally ignoring the bullish opinions of mainstream analysts and advisors. We are pretty sure that a similar set of circumstances has not arisen at any time over the past 40 years, although it may well have arisen during an earlier period.

The lack of interest in the stock market on the part of small-scale individual investors could be construed as bullish, but we don’t see it that way. To us, the fact that the market has come this far and reached such a high valuation without much participation by the “little guy” suggests that the cyclical bull market will run its course without such participation. It also suggests to us that the cyclical bull market is more likely to end via a gradual rolling-over than an upside blow-off, because upside blow-offs in major financial markets require exuberance from the general public.

NAAIM Exposure Highest in a Year

By Tom McClellan

NAAIM Exposure Index Highest In A Year

NAAIM Exposure Index, market sentiment
April 22, 2016

The rally off of the February 11 low for the SP500 has been called “the most hated rally” by some in the financial media.  But it does not appear to be hated according to a lot of the sentiment indicators.

The National Association of Active Investment Managers (NAAIM) publishes its NAAIM Exposure Index weekly, and is a survey of its members concerning their average exposure to US equity markets.  In theory, it could range from -200 to +200, if all managers were leveraged short or leveraged long.  In practice, however, its lifetime range (since 2006) is 3 to 104.

This week, it jumped up to its highest reading since April 2015, showing that these market-timing managers are now at the most fully invested in a year.  The SP500 has equaled the magnitude of its move off of the low following the August 2015 minicrash, but these managers are more bullish on this rebound than they were on the last one.

This matches the rapid swing we have seen in the Investors Intelligence bull-bear spread:

Investors Intelligence Bull-Bear Spread, market sentiment

It too has now eclipsed the high it saw in November 2015, although it is a long way from getting back to the high range which persisted from 2013 to early 2015.

When sentiment swings rapidly from one extreme to another, it can leave a bit of a vacuum in its wake, opening up an opportunity for prices to move back against that trend just to run the overly tight trailing stops, and create a bit more fear.  That can be a healthy development for the uptrend.  Having everyone get too bullish too fast exhausts all of the fuel needed to keep an uptrend going.