Diary of a Financier

Followup: SPX/Gold Ratio, Trough Awaits a Reversal in Monetary Velocity

In Capital Markets on Tue 5 Jun 2012 at 09:03

In light of recent decoupling between Gold & stocks, I wanted to followup on a few of my latest notes on the yellow metal.¹

Recall my latest discussion about equities priced in Gold (SPX/Gold ratio):

SPX/Gold has fallen from that peak of 5.4 to 0.797, not far (or further than we think?) from the 1979 low of 0.15. 1979: before Volcker, before the Great Moderation, before disinflation became the wind at our back… SPX/Gold troughs in 1980 when inflation, interest rates, and a host of other macro factors hit their peak; but SPX/Gold peaks in 2000-01, while macro factors were mid-stride in their secular downward trends… What was an inverse relationship through the Great Moderation has become positively correlated since the Tech Bubble burst…

Since our economy has achieved substantial real & organic growth over the last 30 years, SPX/Gold shouldn’t logically return to 0.15, but I suppose that depends on the growth outlook. I’ll continue to track this ratio, because I’m convinced that a bull widening in the SPX/Gold spread (i.e. equity multiple expansion) will lead the coming bull market and policymakers’ reaction.

SPX v Gold (1974-2012)- has it already reached its secular low in real terms (priced in Gold)?

On May 24, Citi’s Tobias Levkovich took a look at the SPX/Gold Ratio through an even wider lens (1886-2012) and found the relationship at trendline support ~1 standard deviation:

I included that research in my Top Newsstuffs a few weeks ago, and I even drafted up a post about it, because I disagreed with Mr. Levkovich’s conviction in his buy signal. He reads this 1-sigma extreme as equities’ historic buying opportunity, evidenced in similar setups from the 1980s & 1933-45. I’m more skeptical, noting the trade’s decade-long development during the Great Depression and its overshot of the downside in the early-’80s–the very periods Mr. Levkovich cites.

In the end, I didn’t publish my antagonizing entry; I just didn’t think SPX/Gold was at a juncture worth the attention. The ratio has continued to slide, nothing new there. But, through the recent risk selloff, Gold finally managed to unhinge itself from the strong correlation to stocks–a relationship that reemerged in the short-term upon the market’s 2012 high in March.

Here’s my updated, long-term SPX/Gold chart, complete with a rolling 52-week correlation (blue):

SPX/Gold Ratio (1971-2012)- correlation topping out.

Looks like the correlation is reaching a secular high, a point at which markets have historically undergone corrections. Importantly, there’s a big difference in the way SPX/Gold has emerged from corrections in the 2000s vs. the 1900s. Toward the end of the last century, recoveries were characterized by monetary intervention that yielded multiples in SPX (and economic) growth. Around the Tech Bubble, SPX/Gold peaked, and now stimulus rears decreasing marginal returns–a topic I covered over at SeekingAlpha in 2009:

M2/M1 Ratio- slope is indicative of the yield, which has decreased over the decades.

So, in the new millennium monetary stimulus has changed its cohort, being fully discounted in the price of Gold since 2000, whereas equities once reflected such interventions before 2000.

That’s what led me to my conclusion from my last entry about SPX/Gold:

[T]he chart above is an artist’s rendering of a liquidity trap, wherein our economy has passed its sustainable growth rate and incremental liquidity yields decreasing marginal growth. The secular wave ends with a period of deleveraging, which I’d have to say our modern policymakers have handled famously, compared to historical precedents.

…which is another reason why I disagreed with Mr. Levkovich’s call to arms. A trough in SPX/Gold will mark the secular bottom for America’s lost decade, accompanied by multiple expansion to reverse the trend of eroding valuation multiples (PEs, etc.). Once that’s happened, you will have missed the better part of the rally unfortunately, so one of the high-conviction indicators I’m on the lookout for is an increase in Monetary Velocity²:

20120605-014130.jpg

–Romeo

¹I’m an owner of the Gold ETF (GLD) right now, and I’m adding to the position to bring the allocation to a meaningful level.  I also built a Silver ETF (SLV) long today as a short-term, tactical trade.

²GDP/M2

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