Gold Strong Signal For A Secular Bull Market / Commodities / Gold & Silver 2020

As shown in the graph below, the firsthalf of 2020 produced an unusual change in the relationship between goldprices, stock prices and recessions, something that has only happened twicebefore in the last fifty years. Each of the two previous times this hasoccurred after a long run up in stock prices, it has been part of acyclical change to a cycle favoring gold over stocks for a decade or morethereafter.

What the graph shows is the rolling 2year advantage to gold over stocks on a monthly average basis, expressed inpercentage terms. (So that monthly average prices for June of 2020 werecompared to prices for June of 2018, average prices for February of 1982 werecompared to those of February of 1980, and so forth). Where the area of thegraph is gold, there is a two year running advantage to gold, and where thegraph is green, there is a two year running advantage to stocks.

As developed in previous analyses, thepurpose behind this medium term measure is not day trading, or monthly trades,or even annual trades. Instead it is used to knock the statistical noise outfrom shorter term measures, and to identity secular cycle swings between stocksand gold, where the advantage shifts from a long term cycle strongly favoringone asset, to a long term cycle strongly favoring the other asset.

As we will develop in this analysis,what we are now seeing with the new height of the gold area in 2020, and thesharp contrast with 2013-2019 has never happened outside of a secular cyclestrongly favoring gold over stocks - with one exception, consisting of tenmonths in 1987-1988.

However, there was no recession at thattime. So when we also take into consideration the factor of the red bars of historicalrecessions, and the circumstances associated with the current recession, thenwe can indeed say that what we are currently seeing has only happened twicebefore after a long cycle favoring stocks over gold (at least within the fiftyyears studied).

This analysis is part of a series ofrelated analyses, which support a book that is in the process of being written.Some key chapters from the book and an overview of the series are linkedhere.

Understanding The Contracyclical Relationship

This analysis is an important marketupdate, but it is not intended to be a stand-alone explanation of the two yearrolling end value ratio, the secular cycles, or the extraordinary swings inprofits or losses that can produced from the contracyclical relationshipbetween stocks and gold. That information is developed in Chapter Nineteen (linkhere), and that is the place to go if you have any questions about themeasures, the methodology, or the many implications for investment purposes.

As developed in the analysis linkedhere, a major gap developed between gold prices and stock prices (asrepresented by the S&P 500 index) as the coronavirus pandemic enveloped theworld, and the resulting shutdowns devastated economies and employment. Theprices are shown in percentage terms, relative to the prices of gold and theS&P 500 on February 14th, shortly before the breakout occurred.

In that analysis, we started with aninvestor on February 14th, and compared how much their gold would be worth oneach day thereafter if they had been invested in gold, compared to what the valueof their stocks would have been if they had invested in the S&P 500. As anexample, if gold was up 5% to 105%, and stocks were down 5% to 95%, theinvestor would have been 10.5% better off if they were in gold instead of instocks (105% / 95% = 110.5%)

Looking at the actual numbers, someonewho chose gold over stocks would have been 10% better off by February 24th, 20%better off by March 6th, 30% better off by March 9th, and would have peaked at being46% better off on March 23rd, the same day the S&P 500 bottomed out at 2237.

This was a very clear cut, real time exampleof what my research has led me to believe is actually the most valuable use ofgold for investors, which is not to use gold solely as a hedge for inflation,but to at the same time also use gold as a contracyclical asset relative tostocks, with a particular value in times of crisis (and crisis is not the samething as inflation).

Gold over those weeks and monthsperformed exactly as the last fifty years indicated it was supposed to, incomparison to stocks. This happened without any spike in inflation, and indeedthere was a bit of deflation if we compare the Consumer Price Indexes for thosesame months of February to May that are shown in the graphs (before partially recoveringwith a bit of inflation in June).

However, there is a problem with relyingtoo heavily on price movements over a period of a few months. When I studiedthose shorter term price movements over the fifty years - I just didn't findthem to be all that useful or reliable. Looking at the shorter term pricemovements, there was a lot of randomness and "choppy" pricemovements, where sometimes gold and stocks would move the same direction, and sometimesthey would move opposite directions. It was really hard to say whether a relativemovement of gold versus stocks over a month or a few months would be at all reliablewhen it comes to anticipating how gold would perform relative to stocks overthe next few years, or five to ten years.

But when I used the six stages ofanalysis laid out in Chapter Nineteen - then most of the noise dropped out, anda very clear and strong contracyclical relationship emerged, with one criticalaspect being moving to a two year rolling end value advantage being a muchbetter indicator for the secular cycles and changes in the cycles.

Because the first half of 2020 is alittle hard to see on the fifty year graph, I'm including the same graph above,but am now just covering the period from January of 2000 through June of 2020.On a monthly basis, the change in the two year rolling average is now veryclear cut and easy to see.

The two year rolling advantage  jumped up to 22% when we compare March of 2020to March of 2018, and then it was 21% for the Aprils, 22% for the Mays, and 20%for the comparison between June of 2020 and June of 2018.

It is very important to note that thisis a relative relationship, not juststocks, and not just gold. The 22% two year rolling advantage to gold was stronglyinfluenced by the precipitous decline in stock prices in March of 2020 down to2652 (monthly average) - but it was also based on the two year increase in goldprices from an average of $1,325 an ounce in March of 2018 to $1,592 an ounceby March of 2020.

The importance of the relative relationship can be seen whenwe look at the average monthly index price for the S&P 500, whichstrongly  recovered back to 3105 in Juneof 2020. This meant that it was back to the previous all time monthly high levelof 3105 that had been set in October of 2019, and well above the index level of2754 from two years before in June of 2018. Yet, gold still outperformed by20%, even as stocks had substantially gained over the two years, and what madethe difference was the two year move in gold prices from an average of $1,282an ounce in June of 2018 to $1,732 an ounce in June of 2020.

There is nothing like that clear, bold twoyear advantage to gold during the 2013 to 2019 period that so strongly favoredstocks. To see that relationship, we have to go back to the secular cyclefavoring gold over stocks that lasted from 2000 to 2012. And the only exactmatch for a bold gold bar surging up in the red zone of a recession after along green period of stocks dominating gold - is the June to September periodof 2001, which was when the long term cycles turned from the stock cycle of1980 to 2000, to the gold counter-cycle of 2000 to 2012.

When we return to the fifty year graph,then we see a lot of relative advantage to gold during the secular cycle of1970 to 1980, including a similar surge up in the gold two year end valueadvantage area on the front end, even as the recession of December of 1969 toNovember of 1970 was in progress.

The Single Exception & Comparing The Fundamentals

Out of all the monthly two year rollingaverages for entire fifty years, there is only one place where somethingcomparable with the first half of 2020 happened, with even a 10% or more gainfor gold relative to stocks on a two year rolling average, that was notassociated with a secular cycle of gold outperforming the S&P 500 on aprice basis. This was the ten months from November of 1987 through August of 1988.

While the timing may sound a bit obscurefor younger readers, people of an age will of course recognize thecorrelation with one the biggest investment market moves of a lifetime, theBlack Monday crash of October 19, 1987, with the S&P 500 falling 20% in asingle day, the DJIA falling 22%, and much worse moves in many foreign markets.

Gold had already been trending upwards,and was trading at its highest levels since 1981 (1983 in inflation-adjustedterms). Gold jumped a bit higher still, stocks took a while to recover, and therewas about a 20% two year advantage to gold that persisted for less than a year,with the advantage being similar to today.

With the benefit of many years ofhindsight - Black Monday was a panic and not a crisis. There was no fundamentalchange in the economy in the form of a recession, there was no huge surge inunemployment, and there was no major decline in corporate earnings.

However, at the time, investors in bothgold and stocks thinking and acting like there really was a crisis, produced ananomaly not seen at any other time over the last fifty years - a brief butsignificant (>20%), rolling two year advantage to gold over stocks, thatexisted outside of a secular cycle favoring gold over stocks.

Then fears of crisis receded. Stocksresumed a march upwards all the way to the heights of 2000, and an annualaverage inflation-adjusted S&P 500 index price that was about 2.7 timeshigher than it was in 1987. Gold would resume its downwards march towards thedepths of an inflation-adjusted price per ounce in 2000 that was about 61%lower than it was in 1987. Investors would be about 7X better off being instocks than gold over the next 13 years, even on a price only basis, as one ofpart of the secular stock cycle that would favor stock investors over goldinvestors by a whopping 26 to 1 margin over the full 1980 to 2000 cycle (ascovered in Chapter Nineteen).

Factoring In Genuine Crisis

That was the single exception - and therecord is quite different when there is an actual crisis, as opposed to fearsthat a crisis could develop.

We have only two other instances ofseeing a 10%+ two year rolling advantage shifting to gold after a long bullmarket in stocks, those were both associated with genuine crises that wouldbecome a series of crises - and each one of those did indeed call thebeginnings of a secular shift in the cycles to gold strongly outperformingstocks for the next decade or more.

By the early 1970s, inflation washeating up, and Bretton Woods was breaking down, meaning the last link betweenthe value of the dollar and the price of gold was collapsing. The next decadewould bring stagflation and economic "malaise" with the combinationof the highest rates of U.S. inflation in the modern era, as well as a seriesof recessions with high unemployment. Many thought that the U.S. economicmiracle had ended for all time.

After major gains in the 1960s, the DowJones Industrial Average peaked in inflation-adjusted terms in May of 1968, andwould fall for the next 14 years, bottoming out with a 70% loss ininflation-adjusted terms by November of 1982. This was by far the worst damagethe stock market took outside of the Great Depression, but most investorsaren't even aware that it happened, because the destruction of the purchasingpower of stocks was being covered over by inflation and the destruction of thepurchasing power of the dollar, as explored in the analysis linked here.(This is something that it seems retirement investors should be keenly aware of,this 14 year destruction of the purchasing power of stock portfolios, but it isnot part of the usual financial education and most people relying on stocks inretirement seem unaware.)

Put together the explosion in the valueof gold as inflation shredded the dollar, and the destruction of much of thepurchasing power of the stock market, and we have a secular cycle favoringgold, where gold investors would outperform stock investors on a price basis bya more than twelve to one margin over the 10 years from 1970 to 1980.

What started that major change in thecycles - was a 15% advantage to gold over stocks on a two year rolling basis,in the midst of the red bar of a recession, as shown in the graph repeatedbelow.

That same pattern of a rolling two yearadvantage to gold over stocks during the red bar of a genuine recession wouldreappear again - for the first time since September of 1981 - in April of 2001.The tech bubble was in the process of bursting, there were massive stocklosses, a recession was underway, and by July of 2001, gold had outperformedstocks over two years by about 20%, which is very similar to the numberstoday.  Gold would then soar for the nexteleven years, as the tech bubble collapse would be followed by the real estatebubble collapse and the financial crisis of 2008, with gold investorsoutperforming stock investors on a price basis by about 6 to 1 over the 2000 to2012 secular cycle.

In some ways, 2020 could be called thecomplete opposite of 1987, and the Black Monday panic that turned out to lackan underlying fundamental crisis. This time around, the underlying fundamentalsare some of the worst we have seen in our lifetimes. Unemployment has exploded,and much of the economy remains shutdown.

The recession is global, and revenuestreams based on foreign markets could be lower for years to come. Millions ofjobs in travel related industries may no longer exist. Potentially millions ofrestaurants, bars, shops, and other small businesses who came into thegovernment ordered shutdowns of their businesses with few cash reserves, andwho lacked the easy access to the Federal aid provided to medium and largecorporations, may never open their doors again.

In contrast to 1987 - stock prices haveremained high, not because of economic or natural market conditions, butbecause of the Federal Reserve creating record sums of money to support marketsand to fund extraordinary Federal government deficit spending.

However, when we look not just at stockprices, and not just at gold prices, but at gold prices relative to stockprices over the medium term using a two year measure (thereby removing much ofthe short term statistical noise), then we see something that is quite rare.Out of the 603 two year holding periods studied, ranging from April of 1968 toApril of 1970 on the front end, and June of 2018 to June of 2020 on the backend, investors have never favored gold to this degree over stocks in the midstof underlying fundamental problems, without it being part of a secular cyclefavoring gold over stocks.

Seeing The Fundamentals

Why would this would be such a rareoccurrence, and why would it be a good signal of something real, a fundamentalchange?

For purposes of clarity - I'm afundamental analyst, not a technical analyst. "Fundamental" versus"technical" are two quite different schools of investment analysis,and while they can overlap - just seeing a pattern in a chart isn't good enoughfor a fundamental analyst.

Fundamental analysts look at things likethe economy, corporate earnings, debt coverage ratios, inflation-adjusted interestrates, future values and present values, and other such factors. Trackingeconomic and financial history can be just as important to a fundamentalanalyst as a technical analyst, but price changes aren't enough, things have tomake sense in terms of the underlying economic and financial fundamentals.

So why would this measure matter? Thisparticular measure is based on years of quantitative research (there areunderlying reasons for choosing two years), but let me provide an intuitiveexplanation as best I can.

Markets move in long cycles, when itcomes to the valuation of shares of stocks, as well as the inflation-adjustedprice of gold. Over the course of a long stock cycle, which is often dominatedby economic prosperity, the amount of corporate earnings rises, AND the valuethat investors place on each of those dollars of corporate earnings rises, AND theoptimism that investors have about future earnings rises. This three waycombination of more earnings, more value being placed on each dollar ofearnings, and more confidence in pricing in today that future earnings will bestill higher, can lead to much higher stock prices than can be justified byjust the underlying earnings alone.

The more the time that passes since thelast major crisis or inflationary bout, the less the degree of fear that theaverage investor feels, the less the demand for gold, and the lower the priceof gold falls in inflation-adjusted terms.

What history shows us is that thiscontinues over time, and we get secular (long term) cycles. In a stock cycle,investors grow increasingly confident even as the underlying economicfundamentals continue to be positive, and gold prices can continue tounderperform or slide as fears of inflation and crisis continue to recede. Sowe get not just a single two year cycle, but a long string of two year cycles,each one favoring the relative performance of stocks over gold.

Then something rare happens. There is amajor, fundamental change, that includes an actual economic downturn. But thereis more to it than that, there have been many economic downturns.

The market as a whole, looks at thesituation - and through its actions, freaks out a bit. It is as if thecollective market says " Oh geeze, this is bad, the party's over."The reaction is so strong that theprevious two full years of gains for stocks relative to gold are all given up,and then the price of gold goes substantially above that (relative to stocks).

Now, markets go up and down based on theongoing battle between greed and fear all the time, there is a great deal ofnoise and clutter all the time, particularly when we look at daily, weekly ormonthly changes.

But when we look at the combination of1) being in a long term cycle favoring stocks; 2) the nation entering in an actualeconomic downturn; and 3) the market's evaluation of that particular downturnbeing so bad that two full years of stockgains relative to gold are given up - and quite a bit more (10%+) - that isnot at all normal or common. Indeed, an investor who had been in the market forfifty years, would have only seen that combination two times before in all of thoseyears, before this spring.

Each time - the market turned out to beright. Each time, there was a secular change in the cycles, and thecontracyclical asset of gold would strongly outperform stocks on a price basisfor many years to come.

A Collection Of Unprecedented Events

I'm not a believer in infallibility, butI am a believer in information value. 

So, just because we've never seensomething before doesn't mean it couldn't happen.

It could.

The secular cycle favoring stocks couldindeed resume. To my mind, saying that couldn't happen and we know that with100% confidence there will be a secular cycle favoring gold, is simply far toohigh of barrier in the real world, it just isn't reasonable to say that wecould know something like that for sure.

This is particularly the case in ainvestment world of pervasive and unprecedented central banking interventionsdominating the markets. Indeed, a very strong case could be made that theentire rebound in stocks is being driven by massive Federal Reserveinterventions as part of a cycle of the containment of crisis - which was notpart of the long term historical record. The battle between the current levelof economic collapse and the unprecedented degree of monetary creation to fundextraordinary economic and market interventions will take us into completelynew territory.

However, there is information value whenit comes to making and assessing investment plans that are dependent onsomething happening that hasn't happened before. When we take that perspective,then the impossible task of knowing with certainty is removed. Instead, the"burden of proof" flips and we can simply say that we have never seensomething before, so now we have to make a case for something happening for thefirst time (or at least in the last fifty years).

There are two profoundly important andquite practical implications for individuals when we flip that perspective, andlook at using investment strategies that are dependent on something happeningthat hasn't happened before.

The first implication is that we shouldthink through just what is the evidence that is so overwhelming that we can betour future financial security on something happening for the first time - forsure?

It is very rare for the markets to makea call of this magnitude, it has only happened twice before in the last fiftyyears, stocks have strongly underperformed for a decade or more each timethereafter - what is the compelling argument for why we can be so sure, in themidst of what may be the worst downturn yet, that this time will be different,and that we can build our entire retirement investment strategy around thatassumption?

That can be a difficult standard ofproof - as it should be, when it comes to asserting that a first time event isthe only reasonable possibility.

The second implication is perhaps themore important one, even if it is one that most individual investors seek toavoid. This implication is the introduction of doubt, in the form of at leastreasonable doubts, and perhaps very strong doubts.

When something like this happened in theearly 1970s, what would follow was not only recession and inflation, but whatwould become a 70% inflation-adjusted loss in the purchasing power of the DowJones Industrial Average (1968-1982). Between 1970 and 1980, on a price basis,an investor in gold over the secular cycle would have ended up with 12X the networth of someone who invested in stocks (and yes, dividends mattered, but theyare nowhere near where they used to be, particularly on an inflation-adjustedbasis).

The employment blow the United Statesjust took over the matter of a few months was far harder than anythingexperienced in the stagflationary 1970s - can we really make our plans withconfidence based on assuming that the 2020s will be a much better decade forstock investors relative to gold investors - or should we have our doubts?Strong doubts?

When the tech bubble popped in2000-2001, gold was languishing at near two decade lows, and the idea that goldcould outperform stocks would have seemed laughable to many investors,particularly those who had been day trading the creation of the stock bubble.Yet, as part of the collapse of the tech bubble, the collapse of the realestate bubble, and then financial crisis of 2008, gold would outperform stockson a price basis by 6 to 1 in the 2000 to 2012 era.

We already have a hit to the globaleconomy that exceeds what we saw in 2008, with a financial system that is only beingheld together by monetary creation and deficit spending on a scale far greaterthan what was seen in even the depths of the prior financial crisis. Can wereally just make a base case assumption that what happened before won't happenagain (or worse)? Or should we have doubts? Strong doubts?

Perhaps the most interesting part aboutunderstanding the contracyclical relationship between stocks and gold, is thatit provides both signals and solutions. We have just seen a rare but strongsignal, that has happened only twice before after long stock market run ups andwhile a recession in process. Each time, there has been a change to a secularcycle favoring gold over stocks by very large margins over the long term.

But we don't need to know that willhappen for sure. Because gold and stocks are contracyclical assets. That meansthat using the two in combination in targeted strategies can be a very goodtool for dealing with (well-justified) doubts. As introduced in ChapterNineteen (link here), when we understand the historical mathematicalrelationship between gold and stocks, this opens up an entire range of riskreduction strategies, including rebalancing strategies, ratio strategies andcombinations thereof.

Gold can be a wonderful investment forinflation. It can be an even better tool for financial crisis, or when deployedinside of combined strategies with stocks for risk reduction while stillmaintaining positive inflation-adjusted returns. What is best of all - isunderstanding both uses, and hopefully the free book and the series of goldanalyses have been helpful to you in that regard.

Learn more about thefree book.

Daniel R. Amerman, CFA

Website: http://danielamerman.com/

E-mail:  mail@the-great-retirement-experiment.com

Daniel R. Amerman, Chartered Financial Analyst with MBA and BSBA degrees in finance, is a former investment banker who developed sophisticated new financial products for institutional investors (in the 1980s), and was the author of McGraw-Hill's lead reference book on mortgage derivatives in the mid-1990s. An outspoken critic of the conventional wisdom about long-term investing and retirement planning, Mr. Amerman has spent more than a decade creating a radically different set of individual investor solutions designed to prosper in an environment of economic turmoil, broken government promises, repressive government taxation and collapsing conventional retirement portfolios

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