Chances are high that the S&P500 is in the process of making a huge top. We will discuss our rationale in this article, based on the gold to equities ratio, as well as current market conditions.
The extremely interesting fact is that spot gold has topped at exactly the same level as the S&P500 top (to date, on a closing basis). Compare the following data:
The following chart shows both assets over the last three years. Chart courtesy: Stockcharts.
Gold to S&P 500 ratio from 2011 to 2014
Both assets have traded visibly inversely correlated since mid-2011:
The following chart shows looks at the gold to S&P 500 ratio in the last 100 years. Note that the red arrows and blue ovals are own additions. Chart courtesy: Macrotrends.
Gold to S&P 500 ratio from 1914 to 2014
The last three years are marked in the blue oval at the right. One of the following two statements must be true:
The second scenario would be a replay of the 70ies. Back then, the secular uptrend in gold corrected significantly and equities experienced a cyclical uptrend. As the chart points out, the cyclical trends lasted for three years.
We cannot exclude the first scenario indicated above. However, we estimate the probability to be very low, in the range of 5% to 15%, based on the “set of circumstances” we see in equities and in the economy.
Of course, the fact that the S&P 500 and gold have reached the same (price) level and is merely a chart observation. It does not tell anything as such. The more important point is the set of underlying market conditions. In that respect, we currently observe conditions which, in our belief, confirm the chart observation.
The “set of circumstances” we discuss in the remainder of the article are related to the equities market, in particular the US, but also the broader economic context and even the monetary system.
First, US equities are rising for 5 years now. Technically, the current bull market is +270 days old. This is the second longest bull run in the last 80 years, being beaten by the bull run which started in October 1990 with a duration of 406 days. Source: Standard & Poors.
Second, based on the Crestmont P/E ratio, the S&P Composite is trading at very high levels, only beaten twice in the last +100 years, i.e. in 1929 and 2000.
Third, margin debt in US equities is at all time highs. SeekingAlpha released an article which explains that “margin debt at the New York Stock Exchange rose to an all-time high of about $465.72 billion in February from its previous record high of about $451.30 billion in January. There is a strong positive correlation between NYSE margin debt and SPY.” Although the equities bull run is currently still intact, at least from a technical perspective, the risk of speculation is getting higher as well. The more speculation, the sharper the inevitable correction.
Fourth, IPO fever has popped up again, in a similar fashion as during the highs of the dot com era. According to Sentimentrader, the share of money losing IPO’s (i.e., IPO’s with negative earnings) stands at a remarkable 83%. This is just a hair’s breadth away from the all-time record from mid-March 2000, when 84% of the companies that insiders were selling to the public could not prove their business models.
Fifth, according to ShortSideOfLong, in the last 140 years, there have only been 7 prior events where markets gave investors returns in excess of 100% over 5 years. The chart below shows that 6 out of the 7 instances have led to serious corrections or outright crashes, while the one in 1956 lead to only a mild pull back. The chart also shows that equity market trends with 1.5 standard deviations above the 140 year historical mostly mark an intermediate or long term top. “The market has only ever traded at these overextended levels 8.6% of the time or 143 months in the last 140 years (with the outright majority of that during the late 1990s tech bubble).” It is very likely that the run into 2014 is going to produce another major decline.
Sixth, the following chart shows that the average small investor portfolio has a 70% allocation to stocks, a level. Although not visible on the chart, the remaining capital is evenly allocated to bonds and cash. Zero interest rate policy (ZIRP) inflates capital to risk assets, leading to asset inflation. Participation of small investors typically peaks at the end stages of a bull run.
Investor allocation to stocks : 1987 to 2014
In the broader economic context, we observe some worrisome facts. Leverage in the financial system is at all time highs. As we noted earlier, “Global derivatives have a notional value of around $700 trillion (latest official BIS data from mid 2013), the highest point historically.” We believe this has the potential to accelerate a downward move in whatever asset class. In that respect, we believe that the crash of precious metals in April 2013 was a shot across the bow in increasingly distorted markets, courtesy of the central bankers’ policies of this world. Other asset classes will follow with the same vengeance.
Meantime, the debt bubble is growing bigger, especially in the US, Japan and China. A credit crisis seems to lure around the corner. The Chinese credit bubble is showing signs of cracking. The housing market in the US is propped up mostly by speculators (think Blackrock) while the real owners of houses account for a minority in the “housing recovery” of the last years. A credit induced economic recession would be similar to the 2008 collapse.
The most worrisome fact, however, lies in the monetary system. On the one hand, the central bank narrative is showing signs of cracks. As we all know, a narrative is extremely powerful … until it stops working. The insight that central bank stimulus does not contribute to productive effects in the real economy but only leads to specific asset price inflation, is spreading around. Increasingly, data out of Japan and the US underpin this insight.
On the other hand, of higher importance in our view, is the cracking dollar reserve currency. It is widely accepted that the US has enjoyed an exceptional privilege having a world reserve currency. The US has been able to grow its debt mountain to a level never seen before in history of mankind because it had a universally accepted currency which was used in the most traded asset classes, in particular oil (the petrodollar). However, the end of the dollar reserve currency seems to be imminent. Based on historical standards, world reserve currencies have lived on average 27 years. Note that the current dollar hegemony is ongoing for 43 years. Prior threats to the petrodollar have been laughed away by the use of military force. The Ukrainian case, however, has the potential to become a pivot point. Clumsy sanctions against Russia by the West point to retaliation right to the core of the monetary system: the petrodollar. Russia is about to sign energy contracts with its major trading partners in non-dollar currencies. We believe this will act as a precedent, and several Asian and emerging countries will follow. It will result in a loss of trust in dollar denominated assets, undoubtedly affecting US equities. Needless to say, this should also be a major catalyst for precious metals.
In the short run, we do not exclude that equities could go higher. However, several factors confirm the longer term view. We see a three double top forming, a huge trading range which is lasting 2 months (very unusual since the bull run of November 2012), and a huge distribution in the RSI and market breadth.
Again, it is the combination of all circumstances described in this article, as well as the point of maturation of each, that confirm a major decline in US and European equities is very close. One could argue that the stock market will climb a wall of worry. However, that is what has been going on for five years now, and any historical standard shows that its duration is already stretched.
Courtesy: Gold Silver Worlds
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