Stock Market Euphoria Stunts Gold / Commodities / Gold & Silver 2019

The great euphoriaemanating from these near-record-high stock markets is breathtaking.  Traders are again convinced stocks do nothingbut rally indefinitely.  That everything-is-awesomemindset has stunted gold’s latest upleg, since there’s no perceived need forprudently diversifying stock-heavy portfolios. But that psychology can change fast, as we saw a half-year ago.  Gold investment roars back as stocks rollover.

The word “euphoria” iswidely misunderstood, often confused with “mania”.  The latter is when stocks rocket verticallyin blowoff tops, and is defined as “an excessively intense enthusiasm, interest,or desire”.  The US stock marketscertainly aren’t in a mania.  At itslatest high last Friday, the flagship US 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 amania seen in recent years was the SPX’s 18.4% surge over just 5.3 months thatled into its initial January 2018 peak. Traders were ecstatic about Republicans’ coming major corporate taxcuts, 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 psychologyis universal today.

Traders have fullypersuaded themselves that these stock markets have virtually no materialdownside risks.  Like all sentiment, that’sthe 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-timerecord high, extending its monsterbull market to 333.2% gains over 9.5 years. That was the second-biggest and first-longest in US history!

Gold was deeply out of favornear that last SPX topping too.  As arare counter-moving asset that tends to rally when stock markets weaken, goldinvestment demand wanes when stock euphoria grows extreme.  The whole discipline of portfolio diversificationis based on acknowledging that stock markets rise and fall.  Since investorscan’t know when the next major stock-market selloff will erupt, they keep somenon-stock holdings.

But euphoria blindstraders to long centuries of financial wisdom. They tend to extrapolate present conditions out into infinity, assumingthey will last indefinitely.  But bettingany trend will run forever is just plain foolish, as markets are forever cyclical.  “Complacency” always accompanies euphoria, “afeeling of contentment or self-satisfaction, especially when coupled with anunawareness of danger or trouble”.

Soon after tradersoverwhelmingly believe major selloffs are extinct, the next one pummelsthem.  The endless stock-market cyclesreassert themselves with a vengeance, punishing the scoffers.  The severe correction after late-September’s peakis a textbook example.  Over the next 3.1months into Christmas Eve, the SPX plunged 19.8%!  That was right on the verge of confirming anew bear at its -20% threshold.

Traders were confrontedwith the painful truth that stock markets don’t rally forever, that majorselloffs are inevitable.  So goldinvestment demand surged as investors rushed to start diversifying theirbleeding stock-dominated portfolios. Major stock-market plunges are always followed by big and sharp reboundrallies.  Just 5 weeks after those deepnear-bear lows, the SPX had blasted 15.0% higher by the end of January.

That’s when euphoriaand complacency started to return.  Theseperilous herd emotions strengthened with every daily SPX rally over the past severalmonths or so.  The higher the stockmarkets bounced, the more selloff fears faded. That left portfolio diversification and gold investment increasingly outof favor again.  The result is today’sextreme euphoria resembles late September’s, traders don’t have a care in theworld.

While euphoria and complacencyare ethereal and unmeasurable, they can be inferred.  The classic VIX fear gauge is the most-popularway.  It quantifies the implied volatility options traders expectin the SPX over the next month, as expressed through their collective trades.  While a high VIX reveals fear, a low oneshows the direct opposite which is complacency. Last Friday the VIX slumped under 12.0 on close.

The SPX’s massiverebound rally had extended to 23.7% over 3.6 months, recovering over 19/20thsof the preceding severe-correction losses. The SPX had soared back to within just 0.8% of its record peak of 6.7months earlier!  The stocks-to-the-moon zeitgeisthad returned in an extreme way.  The VIXhadn’t been lower since early October, when the SPX still lingered merely 0.2%under its unprecedented crest.

So per the leadingapproximation, traders’ current euphoria and fear have reverted right back to their very same high and low levels justbefore the last major SPX selloff!  That’swhy gold has slumped in recent weeks.  Investorsforget about it when they come to believe stock markets’ downside risks havevanished.  When they buy into thatpeaking delusion that stocks can rally indefinitely, there’s no perceived needfor gold.

This psychology createsan inverse relationship between stock-market levels and gold.  It becomes most-pronounced when stock marketsare near record highs generating great euphoria.  This chart shows how the SPX and gold havetraded over the past several years or so. Ever since that mania-like SPX surge into late January 2018 on corporate-tax-cuthopes, gold has generally meandered in opposition to stock markets.

The greater stock-marketeuphoria, for the most part the weaker gold investment demand and thus goldprices.  And of course euphoria is adirect function of how high the stock markets are.  The SPX has surged to record and near-recordlevels 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 confirmedmajor toppings along with today’s likely third averaged 2903.7, so call it2900.  The SPX is now trading justslightly above January 2018 levels, despite last year being one of the greatestin history for corporate-profits growth. The underlying earnings of the 500 elite SPX companies soared well over20% in 2018!  The SPX should’ve surgedproportionally on such strong underlying fundamentals.

But it didn’t, mostlygrinding sideways to lower.  The US stockmarkets were already wildly overvalued, spending most of last year trading literally in bubble territory.  That’s 28x+ in trailing-twelve-monthprice-to-earnings-ratio terms, twice historical fair value at 14x.  Stocks were already far too expensive to bid tomajor new highs, a dangerous problem which persists in their latest quarterly results.  And 2018 was one-off.

Its four quarters werethe only ones comparing pre-tax-cut and post-tax-cut results.  That unprecedented discontinuity is the onlyreason 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 alreadyinclude those big corporate tax cuts.  Soif the SPX couldn’t materially rally even in 2018, it’s in a world of troublethis year.

In December 2017 justbefore the corporate tax cuts kicked in, the 500 SPX stocks traded at asimple-average TTM P/E ratio of 30.7x. At the end of March 2019, that had merely retreated modestly to 26.3x whichis still just under perilous bubble territory. Without strong double-digit earnings growth, such rich stock valuationlevels won’t be sustainable for long.  That’sgreat news for gold’s investment demand and prices.

The first time the SPX toppedin January 2018, gold’s powerful upleg stalled just shy of breaking out to newbull-market highs.  Gold held those stronglevels until the SPX started powering higher again, which quickly rekindled euphoriadousing portfolio diversification.  Gold suffereda major correction as the SPX challenged and exceeded new records intoSeptember 2018.  Gold languished near lowsas the SPX peaked.

Gold investment demand didn’tflare again to force gold higher until the SPX decisively rolled over from those all-time record highs.  Once the stock markets started falling longenough 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 beforestock-market euphoria grew extreme again.

That’s why gold’slatest upleg stalled in recent weeks, why its price has slumped after nearinganother major bull-marketbreakout.  Gold has actually shownremarkable resiliency considering stock euphoria soaring right back up to early-Octoberextremes.  Last Friday when the VIX fellunder 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’sprimary 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 ofgold from American stock investors.  Thatis through the gold-bullion holdings of the world’s leading and dominant goldexchange-traded fund, the GLD SPDR Gold Shares.

GLD is a behemoth,holding 752.9 metric tons of physical gold bullion in trust for its shareholdersthis week.  According to the World GoldCouncil, GLD is the world’s biggest gold ETF by far.  At the end of Q4’18 its gold holdings were2.8x larger than its next-biggest competitor’s. GLD commanded nearly 3/7ths ofthe total gold bullion held by the world’s top-10-largest physical-gold-backedETFs, a vast amount!

GLD’s mission is totrack the gold price, to give stock traders easy access to gold exposure.  This is only possible if GLD can vent excesssupply and demand for its shares directly into the global gold market, as thesupply and demand for GLD shares is independent of gold’s own.  GLD prices can’t mirror gold prices unlessthis ETF is able to buy and sell physical gold bullion to equalize supply and demand, which it does daily.

It also reports its totalgold holdings daily, allowing traders to see whether American stock-market capitalis flowing into or out of gold.  When GLD’sholdings are rising, investors are buying gold. When they are falling, investors are selling gold.  The capital flows into and out of GLD areheavily influenced by stock-market fortunes, stunted when euphoria grows extreme.  Gold investment has suffered with the SPX sohigh.

Understanding how thesecapital flows work is important.  Whentraders buy GLD shares faster than gold itself is being bought, GLD’s pricethreatens to decouple from gold to the upside. GLD’s managers avert this by shunting that excess GLD-share demand directlyinto gold itself.  They issue enough new GLDshares to offset that differential demand, and use the proceeds to buy morephysical gold bullion to hold in trust.

Conversely when GLDshares are being sold faster than gold, GLD’s price will soon break away fromgold on the downside.  GLD’s managersstave that off by buying back its shares to sop up that excess supply.  The capital necessary to finance those repurchasesis obtained by selling some of GLD’s physical-gold-bullion holdings.  So rising and falling GLD holdings showstock-market capital migrating into andout of gold.

This chart superimposesGLD’s daily gold holdings in metric tons over the closing gold price.  They are well-correlated with gold, showingAmerican stock traders’ GLD trading heavily influences how gold is faring.  Each calendar quarter’s gold-price percentagechange, and both the percentage and absolute changes in GLD’s holdings, arenoted.  Over the past year in extreme SPXeuphoria, GLD has driven gold.

Incredibly GLD’s andthus American stock traders’ huge impact on the gold price is often not understood.  Overlooking it is a grave error, greatlyhobbling chances of multiplying wealth in gold. To show how dominant GLD is, consider some of the larger quarterly goldmoves of this young bull born from deep 6.1-year secular lows in mid-December2015.  GLD’s holdings languished near7.3-year lows at that same time.

In Q1’16 gold surged16.1% after the first SPX corrections in 3.6 years made traders remember gold’scrucial role in portfolio diversification. They flooded into GLD shares at dizzying rates, catapulting its holdings27.5% or 176.9t higher that quarter!  Perthe latest comprehensive fundamental data from the World Gold Council, GLD’sbuild accounted for 84% of the year-over-year growth in total global gold demand!

In Q2’16 that massivegold upleg continued, pushing gold another 7.4% higher.  GLD’s holdings surged another 16.0% or 130.8thigher on heavy differential buying by American traders.  That GLD build alone ran 106% of gold’s totalYoY worldwide demand growth!  Had USstock-market capital not been flowing into gold via GLD, this gold bull never would’ve existed.  Q4’16’s gold plunge drove home that criticalpoint.

After Trump won thepresidency that quarter, stock markets surged on hopes for big tax cuts soonwith Republicans controlling the US government. Euphoria soared with the SPX, leading investors to jettison gold andchase 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 totalYoY decline in global gold demand that quarter!

While American stocktraders certainly aren’t the only gold investors, they command vast capital thathas really moved gold in recent years. Gold’s price behavior in each quarter of this bull has generally beenquite proportional with capital flows into and out of GLD.  That’s certainly proven true in this pastyear as well, when SPX euphoria ran rampant other than deep in Q4’18’s severenear-bear correction in the SPX.

After that initial SPXpeak 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’tenough to push gold much higher, it only climbed 0.4%.  Differential GLD-share trading isn’t gold’sonly driver, gold-futures trading also plays a major role for different reasons.

But as the SPX poweredhigher out of that initial post-topping selloff, so did investors’ stock euphoria.  So they again started to pull capital out of GLDfaster than gold was falling, forcing a major holdings draw.  Between late April to early October soon afterthe SPX’s second topping and new all-time record highs, GLD’s holdings plunged16.2%.  That gold-investment exoduspushed gold prices 9.0% lower in that span.

The relentless slump inGLD’s holdings reversed sharply on a very telling day.  American stock traders finally startedaggressively buying GLD again on October 10th, forcing a major 1.2% daily holdingsbuild.  What happened?  That was thefirst day the SPX sold off hard after its recent record high, plunging 3.3%to shatter complacency.  That budding sentimentshift was evident in the VIX, which soared 39.7% to 22.6.

The more that seriousQ4’18 SPX selloff intensified, the greater gold investment demand grew.  This was most evident in December, when thestock markets plunged a brutal 9.2% alone! That pain really helped investors remember the wisdom of having goldallocations in their stock-heavy portfolios. Gold surged 4.9% that month on a 3.4% GLD-holdings build.  Gold investment was strong with stockeuphoria gone.

Investors’ interest ingold continued well after the SPX started rebounding, as GLD’s holdings peakedin late January 2019 about 5 weeks after the SPX had bottomed.  But with the SPX already soaring 15.0% off itslows, euphoria was mushrooming rapidly.  Betweenearly 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 latestinterim high of $1341 came a couple weeks later in mid-February, American stocktraders’ 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 resurgentstock euphoria continued to this week. Since late January, GLD’s holdings have shrunk another 8.7%.

Though gold has been fairlyresilient considering the lofty stock-market levels, it still slid 3.3% in thatspan.  Gold’s upleg was stunted by stock markets’powerful rebound rally.  It rekindled thesame levels of extreme euphoria and complacency seen near the SPX’slate-September record peak.  Witheveryone once again convinced stocks can rally indefinitely with no materialselloffs, gold investment demand withered.

While wearying forlong-suffering contrarian investors, this is actually quite bullish for gold.  Backin early October GLD’s holdings slumped to 730.2t in extreme stock-bull-peakingeuphoria.  Gold fell as low as $1188 asGLD’s holdings bottomed before the SPX started dropping again.  Forced way back down to 752.3t this week, GLD’sholdings are only 3.0% above those deep early-October lows.  Yet gold was way higher.

At $1276, gold wasfully 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 thesedangerously-overvalued stock markets inevitably roll over again, American stocktraders will again remember prudently diversifying with gold.  Their big capital inflows will again drivegold much higher.

That has real potentialto fuel a major bull-marketbreakout for gold above its $1365 bull-to-date peak seen way back in July2016.  This is even more likely becausegold-futures speculators aren’t very long as I discussed in last week’s essay.  Justlike American stock traders, they have lots of room to buy gold aggressively asit resumes marching higher.  Gold investmentdemand only grows as gold prices climb.

Realize gold’s big problemright now is universal stock-market euphoria at extreme stock-bull-peakinglevels.  But that won’t last, it neverdoes.  Once the SPX inescapably starts slidingagain in its next material selloff, gold demand will surge back.  These lofty overvalued and overbought stockmarkets near record highs look exhausted. They are likely to turn back south any day, bleeding away euphoria andrekindling gold.

The biggest beneficiariesof gold uplegs are the gold miners’ stocks, which tend to leverage gold’s gainsby 2x to 3x.  Back in essentially thefirst half of 2016 when gold surged 29.9% higher in response to back-to-backSPX corrections, the leading GDX and GDXJ gold-stock ETFssoared 151.2% and 202.5% higher in roughly that same span!  When gold starts powering higher again, thecoming gold-stock gains will be big.

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The bottom line isstock-market euphoria has stunted gold’s upleg. With US 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 believingstocks 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 loftystock markets inevitably roll over decisively again, gold demand will comeroaring back just like in Q4.  Investorswill remember the wisdom of prudently diversifying their stock-dominated portfolioswith counter-moving gold, and start shifting capital back in.  That will push gold prices much higher, withreal potential for a major bull-market breakout.  The gold stocks will amplify those gains likeusual.

Adam Hamilton, CPA

April 19, 2019

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Adam Hamilton, CPA

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