Diary of a Financier

Gold/SPX correlation breakdown: An accurate & telling signal

In Capital Markets on Wed 19 Dec 2012 at 13:51

This morning, I commented over at Business Insider, where an article was posted concerning Mark Dow’s [blithe] attribution regarding precious metals’ recent woes.  The piece was generally uninformative–a penetrating glimpse of the obvious in that it passed off the mere observation of a “correlation breakdown” in Gold & Silver relative to equities as an insightful, forensic discovery.  That obvious occurrence (the correlation breakdown) is an important development that I myself noted¹ earlier this week, and it deserves more attention and more analysis.

Recall for a moment that our portfolio owns 2.5% exposure to the Gold ETF (GLD), which had tightly tracked an analogue to 2009 until recently.  In fact, we added 50bps in exposure to the Silver ETF (SLV) ahead of the FOMC’s QE4 announcement on December 12.  Both precious metals rallied for the remainder of the trading day after QE4 was unveiled, but they gave it up (and then some) in the days since.  That classic pattern, a Cup & Handle in both GLD and SLV, broke down and failed this week, leaving me holding the bag.  However, the 2009 analogue remains.

Yes, GLD & SLV are responding (predictably negatively) to the improvement in negative real interest rates, but that improvement is pretty marginal. The fiscal cliff is a more material development, in that the recent launch of QE3 and QE4 in quick succession–$1T in easing/year that’s otherwise a magnanimous upside catalyst for hard assets–is mostly offset by the fiscal cliff’s spectre of fiscal contraction.  (For what it’s worth, in retrospect, I realize that’s why Ben Bernanke was able to launch QE4 despite 5y5y inflation tipping the scales at 2.8%.)  The math:

QE3+QE4 = +$1T annual easing
vs.

Fiscal cliff sequestration = -$577B tightening²
or
Fiscal cliff deal = -$312B tightening³

My attributing this dynamic to the fiscal cliff gives birth to an inherent argument between the unabated equity rally and the precious metal pullback: The former not only treats a fiscal cliff deal as inevitable, but it also suggests the subsequent fiscal consolidation won’t impact growth; the latter says that the glut of fiat (especially since 2008) is being addressed. I call that an argument because the economy has not shown any signs of being able to stand on its own without monetary policy’s reflationary stimulus.  In fact, fiscal policy has been pumping stimulus too. Further, the research of academics like Mr. Bernanke and Richard Koo points to premature fiscal tightening during the Great Depression, which cast a fragile recovery into a double dip.  That begs the question: can these two arguments coexist?

I think there’s a more important development here that may settle the score: the SPX/GLD ratio (S&P 500 priced in Gold) is hammering out a long term bottom. SPX/Gold ratioA continuation in this reversal higher sends a clear signal that there’s organic growth underway–growth devoid of the exogenous, artificial stimulus of reflationary monetary policy.  That requires a correlation breakdown between the assets, which happens to be a signal I’ve been awaiting for years now, and it’s bullish for both the stock market and the economy.

~~~~

I still haven’t sold either of my metals holdings.  If I had noticed what was underway technically and fundamentally last week, I would’ve pulled the trigger to evade this short-term bust.  At this point, I think GLD & SLV have bottomed.  This relapse was predicted by my 2009 analogue, but I try not to rely on the short-term oscillations forseen by such historical guides, because history only rhymes (it’s never exactly the same twice).  Intraday fractals led me to purchase SLV due to a bull pennant that ended up failing.  I wanted as much as a 2% SLV position, which I would’ve scaled into upon the pattern’s development, so I decided to hold the 50bps of exposure in case of an unexpected reversal.  Lesson learned.

Now, Gold (GC/) has hit a potential short term double bottom at 50% Fibonacci retracement support.  Along with indicators, this aligns well with 2009:

GC 2012 v 2009 analogue (daily)

GC 2012 v 2009 analogue (daily)

…and 2009 suggests both metals will meander higher from this correction, breaking out in a parabolic run higher after around one quarter (~11 weeks):

GC 2012 v 2009 analogue (daily, extended)

GC 2012 v 2009 analogue (daily, extended)

The biggest difference between 2009 and today is the short term chart patterns.  In 2009, a short term falling wedge formed over almost a full month, and this provided the ultimate support for the longer term Cup & Handle.  That means GLD might slip a bit lower into a vertex of this falling wedge.  So, I’m a buyer of SLV if we get a bounce; I’m a seller if GLD breaks down below $158.30 (38.2% Fibonacci support, as in 2009) on a closing basis.

–Romeo

¹Two tweets: here and here

²Sequestration will cost ~3.7% of GDP, so = 0.037 * $15.59T

³A deal might reduce the cost to ~2.0% of GDP, so = 0.02 * $15.59T

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  1. […] which all suggest a deep correction is due in 1q13. That includes historical precedents governing precious metals (2009), tech (2007), volatility (2011), the US Dollar (1996), and politicians (2008 & 2011). As […]

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