Gold, Small Caps and the Dollar Look Ready to Part Ways
Monday, November 09, 2009
Gold, small caps and the U.S. dollar have had a stable three-way relationship for the better part of the 2009 rally. Now the three could be parting ways.
Dr. Marc Faber is one of the few market wise men whose thoughts are worth pondering. His monthly “Gloom, Boom & Doom Report” is always a good read. He is an active, Asia-based investor with decades of experience, hundreds of millions under management, and many prescient calls under his belt.
Faber has stated firmly and clearly what he thinks of the U.S. dollar. As you might expect, his opinion is not too flattering.
In the long run, Faber assigns the buck a value of “zero.” In the manner of all fiat currencies, America’s scrip is slowly being turned into toilet paper. The present cast of clowns in Washington seems bound and determined to accelerate this process as Wall Street cheers them on.
But that’s the long term, mind you. In the shorter term – i.e. for at least the next quarter or so – Faber is bullish on the buck. So bullish, in fact, that he is now on record as a buyer of $USD.
“As of today, I will be long in dollars,” Faber told Bloomberg last week. (Perhaps he is buying from my colleague Adam Lass, who professed on Thursday his intent to remain short.)
“Maybe the dollar has made a turn; it can easily rebound by 10 percent,” Faber further opined. “It may have started already since the asset markets started to go down 10 days ago.”
For, say, a Chinese Internet stock, a 10% move is ho-hum fare. For a major currency, however, 10% would be huge.
So why would Faber, a man who has foreseen and foretold the dollar’s ultimate destruction with as much table-pounding force as anyone – and who still very much believes in his forecast – decide to go long a doomed instrument?
Perhaps because the dollar, at this point, looks like not just a prime short squeeze candidate, but a bad house in an even worse neighborhood. The fiat currency game is all about relative strength, and the dollar’s key competitors are in a ramshackle state.
Mike Shedlock, aka “Mish,” puts it well on his Global Economic Trend Analysis blog:
Might the US dollar blow up? Yes it might. But so could the RMB if China floated it, and so could the British pound. No one seems to see the crisis brewing in Japan with a huge demographic problem, a shrinking population, falling exports, and no way to pay back its national debt.
There is seldom a mention of the problems in European banks who foolishly lent money to the Baltic States in Euros or Swiss Francs and now those Baltic country currencies have collapsed and the loans cannot be paid back. European banks also lent to Latin America and those loans are also suspect. Arguably, European banks are in worse shape than US banks, but no one talks about it, at least in the US…
Ah, but what about the debt-issuing insanity spewing forth from Washington? What about the fact that Bernanke, Geithner et al. are printing like there is no tomorrow? Does this not speak to dollar doom?
In the long run, yes. That is why Faber (and yours truly) see the dollar as well and truly destined for confetti-hood.
But in the mean time, nothing goes in a straight line. Markets need to breathe… and markets tend to discount widely known facts and broadly anticipated events. At this late date, it is no surprise that calling Congress a bunch of drunken sailors is an insult to sailors (and perhaps to drunks).
A Fraying Illusion
Add to the above a deep correlation between pumped up stocks and a falling dollar – in essence, the dollar as a scrawny Atlas holding up the global carry trade – and you get a recipe for a revival in the buck as equities falter.
Consider the perspective of the overseas investor. For anyone whose home currency is not dollars, the rally lost its mojo months ago.
From the view point of, say, a Canadian investor with a taste for small caps, the picture looks even worse.
While the S&P 500 has mostly churned sideways from a non-dollar perspective, small caps look broken…
Concerns are growing. Richard Russell, another grand old man of markets, went on record last week with furrowed ursine brow:
I don’t believe most investors understand the significance of the possibility that the March to October rally was an upward correction in a bear market. The majority of analysts believe that the advance that started from the March lows represented the beginning of a new bull market. I disagree, and I’ve explained in detail why I do not believe March marked the start of a new bull market.
For the sake of argument, let’s just assume that I’m right and that what we’ve seen since March was a bear market rally. If that’s true, we’re in a very dangerous situation. It appears to me that the rally is in the process of topping out. Again, let’s assume that we’ve been in a bear market rally. If the rally is indeed topping out, then the stock market will soon be again in the grip of the bear.
Is Russell in fact right?
Let’s put aside the utter carnage in the real economy for a moment. Perhaps Mr. Market does not care that unemployment has now topped 10% (the highest level since 1983), or that small banks continue to fail at a rapid clip, or that Fannie Mae just lost $19B in one quarter, or that a tsunami of “shadow” foreclosures is building up, or that pension funds are headed for an epic crisis, or that commercial real estate still teeters on the precipice and so on.
Ignore all that for a second. What is Mr. Market saying in his actions? For your editor, one of the biggest red flags at this juncture is the clear divergence between small caps and large caps.
For the bulk of the 2009 rally, small caps led the way. This makes sense because small caps have more growth potential – and also more embedded risk. Small caps are superior speculation vehicles versus large caps, and thus a natural go-to when investors are feeling frisky.
Large caps, on the other hand, are more stodgy by nature. You don’t expect to shoot the lights out with high quality blue chips. They are a place to earn modest yields… to take refuge from inflation by way of pricing power… a means of conserving wealth more so than growing it.
And thus it is notable that, in the past few weeks, large caps have dramatically outperformed small caps. In boxing terms, large caps now dance around the ring on fresh legs, while small caps lean exhaustedly against the ropes. This is a clear and present sign of growing risk aversion – not what you want to see in a rally that was built on risk.
Gold Stands Alone?
So if Faber, Russell and others are right, the dollar is likely to rise… and speculative areas of the market are likely to fall.
And yet, what about gold and gold stocks? Here we have a rather interesting development.
The case for gold (and gold stocks) is compelling and has long been so. We have made the case repeatedly in these pages. (From September, for example: “Gold Stocks – Poised for an Epic Bull Run?”)
And yet, up until recently, gold and gold stocks had not really been trading on their own fundamentals. Instead, the yellow metal had mainly responded to the great waves of liquidity washing into the market.
Gold stocks, in other words, were acting like small caps – just another risky asset to pump up while the pumping was good. This was evidenced in the way gold stocks would rise and fall in synch with the “animal spirits” of the broader market.
Your editor hypothesizes that this was due to a lack of vision on Mr. Market’s part. When Mr. Market looked at gold and gold stocks, he saw another indiscriminate liquidity bet (with mild inflationary overtones) and not much more.
But the Reserve Bank of India’s 200 tonne gold purchase – the largest purchase of its type in decades – may have shaken Mr. Market out of his slumber.
Investors can now see with fresh eyes that, in a world of competitive currency devaluation – one where pricing mechanisms grow more distorted by the minute and crisis could break out at any time – gold looks incredibly attractive in simple supply and demand terms.
Given the risks and the long-term realities, the central banks of the world do not have enough gold in their coffers. They do not have anywhere near enough. And as India’s central bank has made clear in snapping up half the IMF’s offering in one bite, the big buyers of gold can no longer afford to say “After you, my dear Alphonse.”
This means it now becomes possible, if not flat-out likely, for gold and gold stocks to stand alone… supported by their own powerful supply and demand drivers, even as the dollar firms up and equity risk appetite declines.
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