The great euphoria emanating from these near-record-high stock markets is breathtaking. Traders are again convinced stocks do nothing but rally indefinitely. That everything-is-awesome mindset has stunted gold’s latest upleg, since there’s no perceived need for prudently diversifying stock-heavy portfolios. But that psychology can change fast, as we saw a half-year ago. Gold investment roars back as stocks roll over.
The word “euphoria” is widely misunderstood, often confused with “mania.” The latter is when stocks rocket vertically in blowoff tops, and is defined as “an excessively intense enthusiasm, interest, or desire”. The US stock markets certainly aren’t in a mania. At its latest high last Friday, the flagship U.S. S&P 500 broad-market stock index (SPX) had only edged up 1.2% over the past 14.5 months. That’s not parabolic.
The closest thing to a mania seen in recent years was the SPX’s 18.4% surge over just 5.3 months that led into its initial January 2018 peak. Traders were ecstatic about Republicans’ coming major corporate tax cuts, and aggressively piled into stocks. While euphoria accompanies manias, it is entirely different. It is simply “a strong feeling of happiness, confidence, or well-being”. That psychology is universal today.
Traders have fully persuaded themselves that these stock markets have virtually no material downside risks. Like all sentiment, that’s the direct result of recent price action. These beliefs were last seen in late September and early October. The SPX had just hit a dazzling all-time record high, extending its monster bull market to 333.2% gains over 9.5 years. That was the second-biggest and first-longest in U.S. history!
Gold was deeply out of favor near that last SPX topping too. As a rare counter-moving asset that tends to rally when stock markets weaken, gold investment demand wanes when stock euphoria grows extreme. The whole discipline of portfolio diversification is based on acknowledging that stock markets rise and fall. Since investors can’t know when the next major stock-market selloff will erupt, they keep some non-stock holdings.
But euphoria blinds traders to long centuries of financial wisdom. They tend to extrapolate present conditions out into infinity, assuming they will last indefinitely. But betting any trend will run forever is just plain foolish, as markets are forever cyclical. “Complacency” always accompanies euphoria, “a feeling of contentment or self-satisfaction, especially when coupled with an unawareness of danger or trouble”.
Soon after traders overwhelmingly believe major selloffs are extinct, the next one pummels them. The endless stock-market cycles reassert themselves with a vengeance, punishing the scoffers. The severe correction after late-September’s peak is a textbook example. Over the next 3.1 months into Christmas Eve, the SPX plunged 19.8%! That was right on the verge of confirming a new bear at its -20% threshold.
Traders were confronted with the painful truth that stock markets don’t rally forever, that major selloffs are inevitable. So gold investment demand surged as investors rushed to start diversifying their bleeding stock-dominated portfolios. Major stock-market plunges are always followed by big and sharp rebound rallies. Just 5 weeks after those deep near-bear lows, the SPX had blasted 15.0% higher by the end of January.
That’s when euphoria and complacency started to return. These perilous herd emotions strengthened with every daily SPX rally over the past several months or so. The higher the stock markets bounced, the more selloff fears faded. That left portfolio diversification and gold investment increasingly out of favor again. The result is today’s extreme euphoria resembles late September’s, traders don’t have a care in the world.
While euphoria and complacency are ethereal and unmeasurable, they can be inferred. The classic VIX fear gauge is the most-popular way. It quantifies the implied volatility options traders expect in the SPX over the next month, as expressed through their collective trades. While a high VIX reveals fear, a low one shows the direct opposite which is complacency. Last Friday the VIX slumped under 12.0 on close.
The SPX’s massive rebound rally had extended to 23.7% over 3.6 months, recovering over 19/20ths of the preceding severe-correction losses. The SPX had soared back to within just 0.8% of its record peak of 6.7 months earlier! The stocks-to-the-moon zeitgeist had returned in an extreme way. The VIX hadn’t been lower since early October, when the SPX still lingered merely 0.2% under its unprecedented crest.
So per the leading approximation, traders’ current euphoria and fear have reverted right back to their very same high and low levels just before the last major SPX selloff! That’s why gold has slumped in recent weeks. Investors forget about it when they come to believe stock markets’ downside risks have vanished. When they buy into that peaking delusion that stocks can rally indefinitely, there’s no perceived need for gold.
This psychology creates an inverse relationship between stock-market levels and gold. It becomes most-pronounced when stock markets are near record highs generating great euphoria. This chart shows how the SPX and gold have traded over the past several years or so. Ever since that mania-like SPX surge into late January 2018 on corporate-tax-cut hopes, gold has generally meandered in opposition to stock markets.
The greater stock-market euphoria, for the most part the weaker gold investment demand and thus gold prices. And of course euphoria is a direct function of how high the stock markets are. The SPX has surged to record and near-record levels 3 times over the past 15 months or so. It peaked at 2872.9 in late January 2018, 2930.8 in late September 2018, and has shot as high as 2907.4 so far in mid-April 2019.
These two confirmed major toppings along with today’s likely third averaged 2903.7, so call it 2900. The SPX is now trading just slightly above January 2018 levels, despite last year being one of the greatest in history for corporate-profits growth. The underlying earnings of the 500 elite SPX companies soared well over 20% in 2018! The SPX should’ve surged proportionally on such strong underlying fundamentals.
But it didn’t, mostly grinding sideways to lower. The U.S. stock markets were already wildly overvalued, spending most of last year trading literally in bubble territory. That’s 28x+ in trailing-twelve-month price-to-earnings-ratio terms, twice historical fair value at 14x. Stocks were already far too expensive to bid to major new highs, a dangerous problem which persists in their latest quarterly results. And 2018 was one-off.
Its four quarters were the only ones comparing pre-tax-cut and post-tax-cut results. That unprecedented discontinuity is the only reason earnings growth was so enormous last year. Profits are expected to stall out this year at best, and likely shrink. All quarterly comparisons going forward already include those big corporate tax cuts. So if the SPX couldn’t materially rally even in 2018, it’s in a world of trouble this year.
In December 2017 just before the corporate tax cuts kicked in, the 500 SPX stocks traded at a simple-average TTM P/E ratio of 30.7x. At the end of March 2019, that had merely retreated modestly to 26.3x which is still just under perilous bubble territory. Without strong double-digit earnings growth, such rich stock valuation levels won’t be sustainable for long. That’s great news for gold’s investment demand and prices.
The first time the SPX topped in January 2018, gold’s powerful upleg stalled just shy of breaking out to new bull-market highs. Gold held those strong levels until the SPX started powering higher again, which quickly rekindled euphoria dousing portfolio diversification. Gold suffered a major correction as the SPX challenged and exceeded new records into September 2018. Gold languished near lows as the SPX peaked.
Gold investment demand didn’t flare again to force gold higher until the SPX decisively rolled over from those all-time record highs. Once the stock markets started falling long enough and far enough to scare traders into remembering stocks can fall too, gold investment demand surged pushing this metal’s prices much higher. Gold was nearing another breakout before stock-market euphoria grew extreme again.
That’s why gold’s latest upleg stalled in recent weeks, why its price has slumped after nearing another major bull-market breakout. Gold has actually shown remarkable resiliency considering stock euphoria soaring right back up to early-October extremes. Last Friday when the VIX fell under 12.0 on close, gold was trading near $1291. That was way better than early October’s $1198 the last time the VIX traded that low.
Stock-market psychology’s primary impact on gold is sentimental. The higher stocks and the greater the herd belief they will keep rallying, the more gold interest and investment demand fade. But there’s also a way to measure capital flows into and out of gold from American stock investors. That is through the gold-bullion holdings of the world’s leading and dominant gold exchange-traded fund, the GLD SPDR Gold Shares.
GLD is a behemoth, holding 752.9 metric tons of physical gold bullion in trust for its shareholders this week. According to the World Gold Council, GLD is the world’s biggest gold ETF by far. At the end of Q4’18 its gold holdings were 2.8x larger than its next-biggest competitor’s. GLD commanded nearly 3/7ths of the total gold bullion held by the world’s top-10-largest physical-gold-backed ETFs, a vast amount!
GLD’s mission is to track the gold price, to give stock traders easy access to gold exposure. This is only possible if GLD can vent excess supply and demand for its shares directly into the global gold market, as the supply and demand for GLD shares is independent of gold’s own. GLD prices can’t mirror gold prices unless this ETF is able to buy and sell physical gold bullion to equalize supply and demand, which it does daily.
It also reports its total gold holdings daily, allowing traders to see whether American stock-market capital is flowing into or out of gold. When GLD’s holdings are rising, investors are buying gold. When they are falling, investors are selling gold. The capital flows into and out of GLD are heavily influenced by stock-market fortunes, stunted when euphoria grows extreme. Gold investment has suffered with the SPX so high.
Understanding how these capital flows work is important. When traders buy GLD shares faster than gold itself is being bought, GLD’s price threatens to decouple from gold to the upside. GLD’s managers avert this by shunting that excess GLD-share demand directly into gold itself. They issue enough new GLD shares to offset that differential demand, and use the proceeds to buy more physical gold bullion to hold in trust.
Conversely when GLD shares are being sold faster than gold, GLD’s price will soon break away from gold on the downside. GLD’s managers stave that off by buying back its shares to sop up that excess supply. The capital necessary to finance those repurchases is obtained by selling some of GLD’s physical-gold-bullion holdings. So rising and falling GLD holdings show stock-market capital migrating into and out of gold.
This chart superimposes GLD’s daily gold holdings in metric tons over the closing gold price. They are well-correlated with gold, showing American stock traders’ GLD trading heavily influences how gold is faring. Each calendar quarter’s gold-price percentage change, and both the percentage and absolute changes in GLD’s holdings, are noted. Over the past year in extreme SPX euphoria, GLD has driven gold.
Incredibly GLD’s and thus American stock traders’ huge impact on the gold price is often not understood. Overlooking it is a grave error, greatly hobbling chances of multiplying wealth in gold. To show how dominant GLD is, consider some of the larger quarterly gold moves of this young bull born from deep 6.1-year secular lows in mid-December 2015. GLD’s holdings languished near 7.3-year lows at that same time.
In Q1’16 gold surged 16.1% after the first SPX corrections in 3.6 years made traders remember gold’s crucial role in portfolio diversification. They flooded into GLD shares at dizzying rates, catapulting its holdings 27.5% or 176.9t higher that quarter! Per the latest comprehensive fundamental data from the World Gold Council, GLD’s build accounted for 84% of the year-over-year growth in total global gold demand!
In Q2’16 that massive gold upleg continued, pushing gold another 7.4% higher. GLD’s holdings surged another 16.0% or 130.8t higher on heavy differential buying by American traders. That GLD build alone ran 106% of gold’s total YoY worldwide demand growth! Had U.S. stock-market capital not been flowing into gold via GLD, this gold bull never would’ve existed. Q4’16’s gold plunge drove home that critical point.
After Trump won the presidency that quarter, stock markets surged on hopes for big tax cuts soon with Republicans controlling the U.S. government. Euphoria soared with the SPX, leading investors to jettison gold and chase stocks. Gold plunged 12.7% that quarter, driven by a huge 13.3% or 125.8t draw in GLD’s holdings. That selling was a whopping 112% of the total YoY decline in global gold demand that quarter!
While American stock traders certainly aren’t the only gold investors, they command vast capital that has really moved gold in recent years. Gold’s price behavior in each quarter of this bull has generally been quite proportional with capital flows into and out of GLD. That’s certainly proven true in this past year as well, when SPX euphoria ran rampant other than deep in Q4’18’s severe near-bear correction in the SPX.
After that initial SPX peak in January 2018 and the subsequent sharp-yet-shallow-and-short correction, gold investment demand grew as euphoria wavered. Between mid-January to late April that year, GLD enjoyed a 5.1% holdings build. That wasn’t enough to push gold much higher, it only climbed 0.4%. Differential GLD-share trading isn’t gold’s only driver, gold-futures trading also plays a major role for different reasons.
But as the SPX powered higher out of that initial post-topping selloff, so did investors’ stock euphoria. So they again started to pull capital out of GLD faster than gold was falling, forcing a major holdings draw. Between late April to early October soon after the SPX’s second topping and new all-time record highs, GLD’s holdings plunged 16.2%. That gold-investment exodus pushed gold prices 9.0% lower in that span.
The relentless slump in GLD’s holdings reversed sharply on a very telling day. American stock traders finally started aggressively buying GLD again on October 10th, forcing a major 1.2% daily holdings build. What happened? That was the first day the SPX sold off hard after its recent record high, plunging 3.3% to shatter complacency. That budding sentiment shift was evident in the VIX, which soared 39.7% to 22.6.
The more that serious Q4’18 SPX selloff intensified, the greater gold investment demand grew. This was most evident in December, when the stock markets plunged a brutal 9.2% alone! That pain really helped investors remember the wisdom of having gold allocations in their stock-heavy portfolios. Gold surged 4.9% that month on a 3.4% GLD-holdings build. Gold investment was strong with stock euphoria gone.
Investors’ interest in gold continued well after the SPX started rebounding, as GLD’s holdings peaked in late January 2019 about 5 weeks after the SPX had bottomed. But with the SPX already soaring 15.0% off its lows, euphoria was mushrooming rapidly. Between early October to late January, GLD’s holdings surged 12.8% driving a parallel 9.7% gold rally with stock euphoria not stunting gold investment demand.
Though gold’s latest interim high of $1341 came a couple weeks later in mid-February, American stock traders’ capital outflows from gold were well underway. As the SPX powered ever higher that month, GLD suffered draws on fully 13 of its 19 trading days! That differential GLD-share selling on resurgent stock euphoria continued to this week. Since late January, GLD’s holdings have shrunk another 8.7%.
Though gold has been fairly resilient considering the lofty stock-market levels, it still slid 3.3% in that span. Gold’s upleg was stunted by stock markets’ powerful rebound rally. It rekindled the same levels of extreme euphoria and complacency seen near the SPX’s late-September record peak. With everyone once again convinced stocks can rally indefinitely with no material selloffs, gold investment demand withered.
While wearying for long-suffering contrarian investors, this is actually quite bullish for gold. Back in early October GLD’s holdings slumped to 730.2t in extreme stock-bull-peaking euphoria. Gold fell as low as $1188 as GLD’s holdings bottomed before the SPX started dropping again. Forced way back down to 752.3t this week, GLD’s holdings are only 3.0% above those deep early-October lows. Yet gold was way higher.
At $1276, gold was fully 7.4% above its own early-October low! This is a much-higher base from which to launch its next surge higher, with gold-investment buying potential via GLD shares almost fully reset! When these dangerously-overvalued stock markets inevitably roll over again, American stock traders will again remember prudently diversifying with gold. Their big capital inflows will again drive gold much higher.
That has real potential to fuel a major bull-market breakout for gold above its $1365 bull-to-date peak seen way back in July 2016. This is even more likely because gold-futures speculators aren’t very long as I discussed in last week’s essay. Just like American stock traders, they have lots of room to buy gold aggressively as it resumes marching higher. Gold investment demand only grows as gold prices climb.
Realize gold’s big problem right now is universal stock-market euphoria at extreme stock-bull-peaking levels. But that won’t last, it never does. Once the SPX inescapably starts sliding again in its next material selloff, gold demand will surge back. These lofty overvalued and overbought stock markets near record highs look exhausted. They are likely to turn back south any day, bleeding away euphoria and rekindling gold.
The biggest beneficiaries of gold uplegs are the gold miners’ stocks, which tend to leverage gold’s gains by 2x to 3x. Back in essentially the first half of 2016 when gold surged 29.9% higher in response to back-to-back SPX corrections, the leading GDX and GDXJ gold-stock ETFs soared 151.2% and 202.5% higher in roughly that same span! When gold starts powering higher again, the coming gold-stock gains will be big.
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The bottom line is stock-market euphoria has stunted gold’s upleg. With U.S. stock markets once again back up challenging all-time-record highs, traders have forgotten the hard lessons from late September’s peak. They’ve deluded themselves into believing stocks can rally indefinitely, that near-bubble valuations don’t matter. Thus gold investment demand has withered, which is normal when stock markets are topping.
But once these lofty stock markets inevitably roll over decisively again, gold demand will come roaring back just like in Q4. Investors will remember the wisdom of prudently diversifying their stock-dominated portfolios with counter-moving gold, and start shifting capital back in. That will push gold prices much higher, with real potential for a major bull-market breakout. The gold stocks will amplify those gains like usual.
Adam Hamilton, CPA
April 24, 2019
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