Déjàvu? Let's Hope Not!
By Chris Puplava, September 17, 2008
Back on August 27th I wrote a Observation entitled, “The Worst is Yet to Come.” There are a few reasons why I made this statement, with an excerpt from the article provided below:
Falling Earnings & Profit Margins = Falling Markets
Mr. Rogoff is probably correct that we aren’t even half way through the credit crisis, and I would also add that we are not even half way through the market correction, nor what will undoubtedly be declared a recession that began in either December of last year or January of this year. I agree 100% with the analysis of David Rosenberg, North American Economist for Merrill Lynch, presented in his article, “The Elusive Bottom.” Mr. Rosenberg doesn’t see the recession ending until mid-2009 and says that we could see S&P 500 operating earnings below $50, and also a price-to-earnings (P/E) multiple of 12…
So, with the credit crisis still in full swing and analyst estimates way behind the curve, the markets are likely to go through some serious disappointments ahead, disappointments that are not likely priced into the market currently. Thus, the markets will likely be much lower by year end and any positive strength should be used to increase defensive positions. The worst is likely to come…
I mentioned in the article that I agreed 100% with the analysis of David Rosenberg, North American Economist for Merrill Lynch, presented in his article, “The Elusive Bottom.” Mr. Rosenberg’s overall macro call is an end to the recession in the second half of 2009 and a market bottom roughly four months before that as markets are discounting mechanisms. My overall macro thoughts echo Mr. Rosenberg’s, and my call is also a bottom in the markets in the second or third quarter of next year as the markets discount an end to the current recession in the third or fourth quarter of 2009. As that is my overall big picture view, my mouth dropped when I received an e-mail from a co-worker who sent me a chart he saw from Minyanville’s Kevin Depew, who had a link to a chart showing the similarities between the current market’s movements and the early 1970s bear market (click for link to chart). The path of the early 1970s market corresponds perfectly with my view of a bottom in the markets in the first half of 2009. I recreated the chart with the S&P 500 from both time periods normalized with their respective peaks corresponding to 100, with the 1970s experience overlaid with the current timeline. The similarities intrigued me enough to where I used the same time frame but with different variables and the results are shown below, with the current data updated through Monday’s close.
Then versus Now
I believe the time comparisons are quite relevant as the overall economic and financial environments between the two periods are fairly similar. The early 1970s saw an increase in inflation and rising commodity prices, a bear market in stocks, as well as a nasty recession from November 1973 to March 1975 (17 months), with our recession likely starting in December of last year and probably ending in the third or fourth quarter of next year (20+ months). As such, it’s not surprising to see the similarities in other variables move in close concert as the general stock market did in the time frames used in Figure 2 above. For example, using the same time frames shows that gold is tracking with the same twist and turns as it did in the early 1970s, though the degree of movement is not as strong as what was seen in the 1970s example. (Note: Gold was indexed to 100, with 100 corresponding to the first peak in the gold advance in the early 1970s, which would correlate to 100 for the peak seen in March of this year.)
As the directional movements in gold where similar between the current and early 1970s episode, it’s not surprising to see similar movements in the USD Index over the same time frames, though the degree of fit is uncanny! Interestingly enough, the USD Index in the 1970s had a major spike lower followed by a “V”-spike northward and then a “V”-spike back down. The current experience is slightly different, with a bottoming action in the USD Index rather than a “V”-spike northward, though the size of the bounce is roughly in line with what was seen in the 70s.
The current backdrop supports the USD Index continuing to track the early 1970s experience with a possible sharp correction in the near future. The USD Index moved up so sharply that it was the most overbought it has been in years, after being the most oversold in years. The commercials position (those who hedge their currency exposure by going long or short the USD) is currently the most net short they have been in more than five years. The last time they were this net short was after the large 2005 rally in the USD Index, which marked the intermediate top in the USD since the secular bear market began in 2001. The commercials have been great market timers as seen below, with the only exception being their net long position in 2007 as they expected the 80 level to hold. Once the USD Index broke support at 80 they quickly covered their long positions and went net short with the recent bounce back up to 80. They are betting for a correction in the USD and they're likely to get it in this current financial storm where company blowups and bailouts are becoming a daily occurrence.
Moving on, there is also a strong directional movement in headline inflation rates seen between the two periods, with inflation likely to moderate in the coming six months, an event I have eluded to occurring in an earlier WrapUp (“Be Careful What You Wish For - Good Cop”), which wouldn’t be surprising considering the drop in crude oil prices.
Lastly, our overall economic growth in terms of real GDP on a year-over-year (YOY) rate of change basis is also tracking fairly well, with the exception of Q1 GDP in 2007 that saw a spike downward largely due to a difficult comparison in net exports with Q1 2006 and a large decline seen in Q1 2007. Outside of that data point the current path is likely to follow the same trend seen in the early 1970s experience with the current recession ending in the third quarter of next year.
The figures above compared various current variables with the time frame of the early 1970s, and the charts below are of intermarket relationships and how they played out in the early 1970s and the current experience. We saw in the early 70s that gold moved inversely with the S&P 500, where peaks in the S&P 500 generally corresponded to troughs in the price of gold and vice versa. The major advance seen in gold that began in late 1972 into early 1973 corresponded with the top in the stock market. The first major intermediate peak in the secular gold bull market in the 1970s corresponded with the stock market trough in late 1974, with gold correcting roughly 50% and the stock market rallying by a similar amount.
The current experience hasn’t been any different, with the major advance in gold beginning with the market top last year, with gold moving inversely with the stock market. The recent large plunge in the S&P 500 has corresponded with large moves in gold, with today’s $84/oz move in gold the single largest daily move ever.
Like gold and the stock market, gold moved inversely to the USD in the early 70s experience and it has done so in the current period. One difference between the two periods as mentioned above is the USD Index plunged in 1970s followed by a violent spike northwards and a short-term sell off in gold. The current experience witnessed a multi month bottoming period in the USD rather than a single peak in gold corresponding with a “V”-spike in the USD Index, we saw a divergence in gold with a lower high July corresponding with a slightly higher low in the USD.
A positive relationship seen in the 1970s was the movement in gold and inflation rates, with the directional similarity showing a tight fit. We’ve seen a similar pattern in the current experience, though the sell off in gold recently was overdone when compared to the headline inflation rate, which hasn’t fallen off as much as gold has in the past month.
What could be different?
While the similarities shown above have been a bit of déjà vu, not everything is entirely the same. For starters, the U.S. average savings rate was 10%, and it’s closer to 0% currently if you back out the economic stimulus checks. Moreover, total debt to GDP was roughly 145% with the current reading coming in at 337%, quite the precarious position relative to the early 1970s experience.
Source: BEA/ FRB
Because the state of the U.S. financial system, the housing market, as well as the debt-ladened consumer is so fragile currently, the government might not be able to afford a major collapse. With a major decline in household net worth resulting from the worst housing depression since the Great Depression, coupled with a bear market in stocks that is likely to continue into next year, the Federal Reserve and government might pull out all the stops. Right now the SEC can reinstate the up-tick rule, the Fed can cut the 50 basis points like the market was clamoring for on Tuesday, and the Federal Reserve can begin expanding its balance sheet to inflate our way out of this. These measures might help prevent a decline in the stock market to the extent that the early 1970s experienced, or even my own expectations for further declines into next year. An all out effort by the powers that be will be absolutely, unequivocably bullish for gold and devastating for the USD.
It is likely that we are seeing the first signs of an expansion of the Federal Reserve's balance sheet as the Fed tries to counteract the massive asset deflation currently underway (falling home and stock prices). Former Federal Reserve Chairman Greenspan pumped money into the system at a 10% YOY rate to pull us out of the last recession, and Chairman Bernanke looks like he has finally done the same as his other creative measures have failed to arrest stock and credit market upheaval.
Source: Federal Reserve
If Helicopter Ben Bernanke begins to accelerate the printing presses, we could see an explosive move in gold, with today’s advance a kick off start as commodities were a coiled spring ready to explode. Heading into summer of this year we saw the two-month rate of change (ROC) in the CRB Index advance to more than two standard deviations above its 38 year average, an event that should be seen roughly only 5% of the time. As such it was no surprise to see commodities decline sharply into August. However, the decline continued as speculation worked against commodities, this time pushing them to the downside as we witnessed a MAJOR statistical extreme. The two-month ROC in the CRB Index fell more than 20%, which is more than four standard deviations below its nearly four decade average. This is an event that should be seen only 0.63% of the time! With such a major statistical extreme it's not surprising to see gold and other commodities begin to recover.
Source: Bloomberg, (Hat-tip: Brian Pretti, ContraryInvestor.com)
Source: Bloomberg, (Hat-tip: Brian Pretti, ContraryInvestor.com)
As mentioned above, if the Federal Reserve and government decide to pull out all the stops we could see an explosive move in gold, well north of the $1,000/oz mark. When looking at previous gold bull markets, with the current episode the third experienced over the last 100 years, we have yet to reach levels that have marked prior gold bull market peaks. The current Dow Jones Industrial Average to gold ratio still favors hard assets (commodities) relative to paper assets (stocks, bonds), with a reading of 12.11 as of August 25th.
In terms of calculating price objectives for gold we can use the ratio seen at the end of the two prior secular bull market moves in gold. Assuming the Dow Jones Industrial Average falls to the psychological level of 10,000, or a 5.75% decline from today’s close, and using the prior to ratio lows, gold could head to $4,808 per ounce (1932 ratio) or even $7,407 per ounce (1980 ratio).
Table 1. Dow Jones Industrial Average to Gold Ratio
|Long Term Average||11.52083||10,000||$867.993|
If the Fed indeed begins to aggressively expand its balance sheet, the current inflation rates may be mild in hindsight. Comparing the Dow Jones to gold ratio example seen in the last gold bull market with inflation shows a very strong correlation, and a major advance in the current gold bull market will not benefit the U.S. consumer collectively as our standard of living will fall, while investing in precious metals will help protect against a massive devaluation of the USD.
Whether the markets follow the script of the early 1970s or deviates will be determined by how aggressive the Federal Reserve and government become. Either way, whether another down leg in the stock market or a move to renewed inflation by the Federal Reserve will not be a positive outcome for the U.S. as a whole. Our citizens as well as government have gone on a lavish lifestyle over the past three decades and there has been a price to pay for that lavish lifestyle, and now that price is being paid. The best measure to protect one’s standard of living in this type of environment I believe, is to own gold and silver bullion. It appears savvy investors have anticipated this outcome as mints all over the world are sold out, with some having several month delivery waiting periods. With mints already sold out and the public at large out of the gold market, prices will undoubtedly head higher as the public piles in during the upcoming mania phase… GOT GOLD?
© 2008 Chris Puplava