A series of unfortunate events
The last few weeks have witnessed the volatility created when the market is spooked by events that are at face value detached from or irrelevant to factors which are conventionally believed to drive market performance. These distant events – geo-political risks – have the ability to undo the comfortable and justified progress made in sound economies. We have seen what can happen when there is no genuine market-related bad news, so what happens if these external tribulations combine with other things that we know can affect the market, and that we know are coming.
The UK has a solid, stable recovering economy. In July this year GDP finally surpassed its pre-crisis levels, albeit a year after Japan, three years after France, Germany and the US, and four after Canada. But the UK recession was the joint second deepest of the G7, as depicted in Figure 1 overleaf. And the recovery looks stronger and more sustainable, even compared to Germany, which is starting to see declines in growth again. And the US, the nation whose economic performance is most likely to influence our own, is also performing extremely well.
But the UK performs less well by some measures of comparison: GDP per capita for example. Because our population has risen faster than other economies, the UK statistics show a slower per capita recovery. That is one of the reasons that people say they are not “feeling” a recovery that is developing soundly if slowly.
But don’t read too much into the time taken to recover. As far back as 2009 the Organisation for Economic Cooperation and Development (OECD) predicted that the depth of the UK recession meant it would take longer than other similar economies to get back on track, at the time criticising the then Labour government for having no coherent plan to address the problem. But UK Plc has recovered in line or ahead of expectations.
But if a small or distant unforeseen event is to mark the apogee of the market, the chances are that it will occur when something else has already dealt the market a blow. That will likely be something closer to home and more connected to the financial markets. Some of these may seem quite contrarian given the undoubted strength of the economy. For example, the ending of quantitative easing – known as QE – in the US. The economy is strong and the bond buying stimulus is no longer needed, yet its removal may lead to market falls. This is in spite of many confident benchmarks in consumer confidence, output and employment, their contributions pushing stockmarkets close to all time highs. But markets in 2014 have been illogical and reactive. If several factors combine, based on the effects they have had in the past, it may cause a decline worthy of being called a correction. Or worse. Here are just a few of the sticks that might prod the bear.
- October 2014. Ending of US “QE Infinity” through the taper
In December 2013 the Federal Open Markets Committee (FOMC) decided to start reducing its bond and treasuries buying program through a gradual reduction known as the “taper”. As long as nothing interrupts that schedule the asset purchases will have reduced from $85bn per month to zero by October. Everyone knows that it’s going to happen, just like they did with QE1 and QE2 in the past. But knowing didn’t stop market corrections happening on both occasions, to the tune of 10 per cent or so.
A major market decline in the US will influence the UK stockmarket perhaps to a similar extent.
This strategy bought a total of $85bn in US treasury & mortgage bonds each month since September 2012, but has been reduced since December 2013 by $10bn each month towards an eventual end. If that pace continues – $10bn at each FOMC meeting – then it will be finished by October.
The market reacted adversely to the announcement of the tapered reduction, but not to each individual $10bn reduction. Figure 2 opposite shows how on the previous occasions that QE was suspended the US markets fell well into correction territory.
At the end of QE1 the S&P 500 dropped 9 per cent. After QE2 and before QE3 – or QE “infinity” as it was dubbed as there was no planned end – it fell 11.65 per cent.
- 18 September 2014. The vote on Scottish independence
There are a number of companies that will be directly and negatively affected by a Scottish “yes” vote. Scotland only accounts for about two per cent of the FTSE 350, but that includes some of the companies most vulnerable to change. They include banks RBS, and Lloyds, BG Group, Diageo and BAE Systems. The matter of a Scots currency – so far unresolved and not likely to be pretty – threatens all the banks in the UK. With the BOE removed from its responsibilities the question would be whether a Scottish Central Bank could provide the required funding backstop.
Some companies may benefit, including airlines, as there is a pledge to cut passenger air duty; and some property companies such as Derwent, Greta Portland Estates and Berkeley Group. But TSB floated recently, and chose not to be domiciled in Scotland citing the vote as a reason why.
A yes may also see the Scotland based fund industry under pressure through a resurgence of English loyalty. Uncertainty is the thing that might cause trouble, and the closer a yes gets, the more uncertain it becomes.
- Emerging economies showing a declining rate of growth
After years of phenomenal growth many are slowing. Logically this is only to be expected, but the UK and US markets may react adversely to lower figures. China will only grow by 7.4 per cent in 2014. “Only”. But that is a reduction against earlier forecasts of 8.2 per cent in a country where a recession has been defined as growth under eight per cent – and not entirely as a joke.
The same applies to India and Brazil. Fellow BRIC Russia has become somewhat of a political outcast and economic output will inevitably suffer.
- The base rate
In the UK the Monetary Policy Committee meets around the first week of each month, and with interest rate rises the proverbial elephant in the room, the bad news is really only a matter of “when” not “if”. That said, Mr Osborne did originally suggest that rising rates would only be a response to sustainable jobs growth. Then he said it might be a response to signs of sustainable jobs growth. But there are real fears that even the smallest increase in the base rate might tip the economy backwards as consumers cut expenditure to ensure mortgage payments are covered, something that the UK homeowner has been very robust in maintaining throughout the recession. The reduction in rates may have helped to otherwise stave off an increase in levels of mortgage default.
Even though the MPC are independent, it is thought that the chances of an increase beyond the current 0.5 per cent rate before the election are slim, though the most recent MPC minutes show a 2-7 vote that demonstrates that it is getting closer.
- The general election in May 2015
This could be a UK election without Scotland, but without the Scots seats it may actually be good for the Conservatives. While the coalition has done so much better than expected overall – accepted that we all still feel somewhat poorer – the uncertainty of another term of government by bartered agreement with the LibDems – or worse UKIP – won’t go down well. The worst case may be if Labour can find a way back, when some major market declines would be likely. The best outcome for the markets would be for a government with a solid mandate, and one that will continue to let the public finances recover.
- Tipping’s Mathematical Ratio
But there is another reason to be worried. In the August issue of The IRS Report Dr Roy Tipping predicted declines for UK indices from March 2015. Or even sooner. Using analysis from his mathematical stock picking program, TMR, he has successfully predicted significant market movements in the past, and so there is reason to heed his words.
The primary UK stockmarket index – the FTSE 100 – has not managed to make new index highs as we have seen in the US, but rather it has plateaued after a very bullish 2013. In spite of being just a fraction of a percentage point below the all time high set back in 1999, resistance has held and the FTSE 100 has not breached 6,900, and has fallen back from 6,850 on seven occasions in the last six months.
The combination of a seemingly impenetrable ceiling, some significant macro economic factors and the warnings of Dr Tipping ringing loud all say “be prepared”.
Roy Tipping accurately predicted the 2008 falls, to the gratitude of many investors and readers of The IRS Report. You can see his predictions at TheIRSReport.co.uk.
Even while the major economies and most of their partners continue to recover from the events of 2008, there is an air of uncertainty present that needs only a trigger to cause investor panic. No-one knows what that event might be, but if it happens during times of known uncertainty then the reaction and its effects may be amplified. We have seen what euro debt contagion fears did, we have seen pull backs because of Syria, Ukraine, Israel and now Iraq.
These events threaten investment values, so make plans to protect your positions by moving to cash, hedge or counter positions.
Is it time to look at gold again?
The failure of equity markets worldwide to emulate America’s all time records lead some to conclude that the current equities bull run is running out of steam. And even if it weren’t, the mere talk about slowing down may have just that effect. It is the effect of actions on the market which determines prices, not the market that controls the price.
But other factors also influence the price of gold. Confidence in the centuries old London Spot Fixing price system was dented after Barclays were fined £26m for manipulating the price. The subsequent investigation led to the World Gold Council hosting a discussion on pricing overhaul. Some analysts believe the price may rise because of it.
Gold has always been regarded as a long term store of value – see Figure 1 – and the traditional safe haven as a countercyclical investment to shares. But is gold still the counterbalance asset for when stocks start going down?
When share prices start falling rapidly with no early perceived prospect of recovery, nimble investors dump some or all of their shares in favour of cash, gold and silver. There is no reason to think that won’t happen again next time, but it’s the “when” that is still vague.
While there is so far no real sign of share prices turning, there is a growing realisation that it’s a very long way back to the last significant bottom. Investors are hesitant with new US market highs every week since the spring, and the feeling is building that a correction is due. At the same time the price of gold appears to have bottomed out and turned upwards, in spite of the price fixing scandal.
Many factors drive the gold price
Gold is also the traditional hedge against a falling dollar, and with the exchange rate at over $1.70 to the pound that may also be a reason that gold is on the rise. More than with most other commodities, the dilemma is that it is usually impossible to pinpoint a precise reason for a rise in the value of gold since its price is driven by a combination of fundamental supply and demand plus a huge dollop of unpredictable emotion. It may not be as simple as the possible peaking of the stock markets. Making the wrong move may take away chances of more equity profits.
A gold price rising because of exchange rate hedging may be misinterpreted as a counter rise to a turning stock market. For a few years after the last major bear stockmarket in 2009, the euro crisis and the US government squabbles effectively combined to stop the share markets from overheating, but at the same time the gold price was depressed.
But markets react to what people do, and so an increase in gold interest will result in prices moving up which will in turn generate more interest, in particular from those gold investors who bought in late 2011 as the tide turned.
Here are the facts.
- There are concerns that stock markets are over valued and overdue a correction.
- That does not mean that a meaningful correction will actually happen.
- If the market does correct itself – a five to ten per cent fallback – what happens in the UK is likely to be a reaction to a possible future correction in the US, where the market has been making new highs all year, unlike in London.
- There are worries that gold could still come down further.
- As Figure 2 shows, gold also displays a seasonal price increase trend – certain months of the year – every year – when it historically rises more.
- A more robust and transparent gold pricing regime may bolster confidence and the price.
Some of these points are easier to address than others. Gold may well go up in value, but as a long term holding it is just as likely to come back down. And the FTSE 100 may still go on to new highs; there is unfinished business with the December 1999 high of 6,940. Many investors will use a breach of that 1999 high or new high beyond 7,000 as the measure that its time to get safe.
In the US the NASDAQ and S&P have been making new highs for months. Admittedly the DJIA has dragged its heels, for reasons to do with its construction and weighting that would pass most investors by, finally breaching 17,000 for the first time in early July. This may also signal a turn.
New market highs form resistance
Milestones are an important psychological element that the smart investor uses as a signal to take some profits, while perhaps keeping an eye on what might fuel more upward movement.
Other geopolitical influences have to be considered. The Middle East, Iraq, China and Russia are all simmering pots that may boil over. Anything that suggests a threat to stability or energy supplies will be reflected in the equity markets. But equally good economic news from the new superpowers China and Russia, or upturns in Japan that reflect global recovery, will see share prices moved higher on optimism.
The gold price has turned up from 4 year lows set in December 2013, gaining 15 per cent only to see most of it drift away again. But as you can see from Figure 2, the gold price has a tendency to move up in the second half of the year. Thirty years of cumulative data shows that buying gold or gold derivatives in July offers the best chance of buying an appreciating asset.
On the other hand respected investors have voiced their concerns that gold has further to drop. Quantum fund co-founder Jim Rogers says that every market should correct by 50 per cent every three to four years. Gold has not done that since 1999. In fact it had risen year on year for 12 years before 2013. He thinks gold has to get to $1,000 per ounce before an upturn can be firm. On the other hand, he says, if Iraq War Three starts he’ll be buying at $1,600.
Metals broker Kitco suggest that the gold cycle serves up a low every 8 years, and the last one was November 2008. That suggests that there will be another low point in 2016. It does not mean though that it will be lower than it is today.
In Figure 3 you can see the relationship between the S&P 500 tracking ETF, the SPDR Gold Trust ETF and the Market Vectors Gold Miners ETF with their prices rebased to the end of 2010. In 2011 the gold price peaked shy of $1,900 at the same time the S&P 500 was falling. Since then stocks have climbed away while gold languished. Throughout this period the gold miners index has faltered, mainly through low production and higher costs.
The rebased chart shows that gold is down 30 per cent since its peak while equities are up 70 per cent. Miners are down 60 per cent. The extended plateau for gold and the miners suggests that it should be closely monitored, but also that this latest uptick may be just another false dawn.
And so a sensible strategy might be to take some profits out of equities and buy gold. Of course it does not have to be physical gold, or even gold based. Companies that mine gold may equally mimic the patterns of the gold price.
Physical gold has security implications, but a few Krugerrands under the floorboards might suit those with a “survivalist” nature.
Buying gold or silver based ETFs – or ETF options – enables you to hedge quickly within the same share trading environment: no need to compare gold brokers. There are unit funds and investment trusts available, which might suit individual trading facilities, but ETFs now offer the most diverse choices for hedging with metals.
Conclusion: It makes sense to have a degree of preparedness, or protection. Checking and adjusting the balance of your investments as one market sector rises should be part of the regular management of a portfolio. Asset allocation reflects the market, the optimism and global stability. But the short answer is that it makes sense not to have all your eggs in one basket. Have something that can act as an insurance policy. Conventional wisdom is a range of 5- to 10 per cent in gold.
Until something absolute happens, equities seem most likely to stumble up and gold will stumble along. The balance of probabilities says gold will have another rise again soon. Beware predictions of massive gold values. In 2013 Goldman Sachs predicted $1,600 by 2014, but then revised it down. They were still far too optimistic. Back in 2011 figures as high as $5,000 were being freely bandied about.
When sentiment suggest that equities are overdone, gold will start to rise. And those who believe gold will always be a long term store of value will be cheered by the chart showing its minimal real return against the Swiss franc over the past 34 years.