Tuesday, November 11, 2014

Dollar, gold, commodities, stocks, and bonds dance to the same tune

What is the tune? It's a mix of declining risk aversion, rising confidence, less uncertainty, and continued growth. That's not to say that everything is just peachy. Rather, it is the result of things turning out somewhat better than the market's gloomy expectations. This tune has repeated in dozens of blog posts here over the past 5 years.

The dollar is rising because the outlook for the U.S. economy is improving, and the U.S. economy is doing better than most other developed economies, and that in turn inspires confidence where before there was despair. Gold is falling because inflation remains under control, the dollar is strengthening, and civilization as we know it remains intact; gold had been priced to all sorts of calamities (e.g., massive monetization of debt, a collapsing dollar, geopolitical turmoil, double dip recessions) which have failed to materialize. Commodities are falling because the dollar is rising, and because commodity prices had risen to such a degree that increased exploration and production kicked in. Bond yields, particular the real yield on 5-yr TIPS are rising, as the market gains more confidence in the economy's ability to grow, and as investors become less risk averse—unwilling to accept negative real yields in exchange for protection against rising inflation and a slumping economy. Rising real yields and falling gold prices tell us that the world's demand for safe assets is declining, because risk aversion is declining and confidence is rising.

The prices of gold and 5-yr TIPS have been moving in unison for many years (I use the inverted real yield on TIPS as a proxy for their price). Both are "safe" assets in the sense that they offer protection against certain kinds of risk. Gold is a traditional safe harbor for those who worry about currency debasement and geopolitical risk. TIPS are guaranteed by the U.S. government, and they offer explicit protection against inflation. Moreover, they are the only instrument that can promise a guaranteed real rate of return. Gold has declined from a high of $1900/oz to now just under $1200. It's still trading way above its long-term, inflation-adjusted price of about $600, so it's still "expensive," only less so now that it was a few years ago. Real yields on 5-yr TIPS are about zero, which means investors are willing to give up any hope of a real rate of return in order to be compensated for inflation. This tells me that the market is still quite risk averse, only less so than it was a few years ago. Declining prices of gold and TIPS are a direct indication of declining risk aversion and rising confidence.

The dollar and commodity prices have been negatively correlated for a long time. Commodities are a proxy for real (tangible) assets that tend to preserve their value in times of currency weakness (as is gold). So when the dollar weakens, commodities (and gold) tend to strengthen. Recent dollar strength has contributed to a moderate decline in commodity prices, and as the chart suggests, commodities may continue to soften. But they are still well above the levels of 13 years ago, and the dollar is still well below its former highs.

Gold and commodity prices have been positively correlated for decades. But gold tends to be much more volatile: note that the range gold prices (the right y-axis) is about about 2 ½ times the range of commodity prices (left y-axis). Gold "overshot" commodity prices a few years ago, and has been gradually coming back into line with commodities. This suggests to me that gold could decline to $900/oz or a bit less over the next year or two.

The ratio of the Vix index to 10-yr Treasury yields (the red line in the above chart) is a good measure of the market's fear, uncertainty and doubt regarding the future of the U.S. economy. Bouts of fear have been the driving force between stock market corrections, not any actual weakness in the economy. But the market is still somewhat nervous and cautious. 10-yr yields are still very low, which tells me that the market does not believe the economy can grow much faster than it has in recent years (2 - 2.5%), and is more at risk of slowing down, than speeding up.

This chart of consumer confidence sums things up nicely. Confidence has been rising for the past five years, but it is only now about equal to its long-term average. Conditions have improved, but it's hard to find evidence of exuberance. Consumers are still concerned about the health of the economy. The recent elections confirm that people are unhappy with the way things are going. The economy could be a lot stronger, and incomes could be a lot higher, if only government would get out of the way.

UPDATE: I should have included the chart below before. It also confirms what is going on. PE ratios are up from very low levels (a sign of a great lack of confidence in future earnings), but they are only slightly higher than average. There is no sign as yet of any "irrational exuberance." Stocks are doing well because earnings are doing very well and investors are gradually regaining their confidence in the future.


Benjamin Cole said...

Hard to argue with such an insightful wrap-up.

I think the worry is this---inflation and interest rates are dead, and we are five years into "recovery."

Any slowdown, and we see deflation pretty quickly...I would prefer some boomtimes

William said...

OECD Composite Leading Indicators

12/11/2014 - Composite leading indicators (CLIs), designed to anticipate turning points in economic activity relative to trend, point to continued weak growth in Europe but stable growth in most other major economies and in the OECD as a whole.

Amongst major economies stable growth momentum is anticipated for Canada, the United States, Brazil, China and Russia.

The CLI points to growth losing traction in Japan though this may be related to one-off factors.
Within the Euro Area, the CLI continues to point to a loss of growth momentum, with stronger signals of a slowdown in the case of Germany and Italy. In France however the outlook continues to suggest stable growth momentum.

The CLI for the United Kingdom indicates that growth may ease, albeit from relatively high levels.
India is the only major economy where the CLI points to a pick-up in growth momentum.

William said...

The Wall of Worry is Passe'

Dr Ed Yardini recently asked the question: "Is Sentiment Too Bullish?" pointing out that Schaeffer's Investor's Intelligence Bull/Bear Ratio hit a recent high of 4.22 during the week of September 2. During the week of October 21 it fell to a low of 1.94 during the correction but rebounded to 3.62 by the week of November 6th. Bearish sentiment has averaged just 15.4% since the start of September, the lowest since 1987.


Meanwhile, over at WellsCap Dr James Paulson wrote that "for the first time in this recovery, investor 'complacency' has become a problem." His complacency indicator is the product
of two stock market characteristics—consistency (a stock market which is too predictable and too stable) and volatility (the standard deviation of monthly change in the stock market).

Since 1870, there have only been three other periods (late 1920s, late 1950s, and late 1990s) when the stock market has proved more
consistent. In the last five years, stock market volatility has been near the lower end of its historical range since 1870.

CONCLUSION: There is no sense of giddy optimism in today’s stock market. Nonetheless, as shown in Chart 3, investor complacency has only been higher than it is today a few times since 1870!


Frozen in the North said...

What's interesting is that the reason people are not feeling good about economic growth is that for most of them there is a stronger sense of uncertainty. The reality is that mean income (not average) keeps on falling, today the top 1% own as much as the bottom 90%, new jobs are part time or low skills/low wages -- the average new job pays 30% less than it did 5 years ago!

How can Americans feel good about their economic prospects when most of them are and feel worse off. Sure the rich are doing well, and America's psyche is geared to think of the success as proof that they too can make it. However, it remains that for most the daily reality is otherwise -- in terms of income and security. This is not about Dems and GOP its about raw data, and the raw data is poor for the average american.

I am not preaching any solution, in fact, I don't think there are easy solutions here. But for most Americans who really live from paycheque to paycheque there is no solution on offer.

William McKibbin said...

Scott, do you agree that real working wages, real home values, and the employment to population ratio will not improve over the balance of the 21st century?

Scott Grannis said...

I believe there is significant upside potential in the U.S. economy that can be unleashed by intelligent, pro-growth policies. And I believe there is a decent chance that we will see such policies in the years to come.