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What drives financial markets? - Myth busting!

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Over the years I have observed a lot of rationalising of market direction based on what I consider to be false or fussy logic.  There are loads of them.  For example, we had a ding-dong on the forum over the famous Santa Claus rally in the run up to Christmas 2018.  In the case of a pre Christmas rally (define it? Not clear...) the stats showed that stock markets are more likely to rally into Christmas than not (I think it was something like 65% that someone posted, although the period seems to be movable).  I take no issue with stats on this, my point at the time was simply that you can find other times of the year where the same stats (or better) hold without any specific justification and therefore I can't use the concept of a Santa Claus rally as a reason to trade Long stock.  I took the opposite view then, based on my analytical method, and was proved right that time, well the thing about probabilities is that in order for the 65% stats to be true 35% of the time the Santa Claus rally doesn't happen.  It falls into the "So What?" category for me but them I am not a short term trader so it is perhaps more relevant to day traders, fair enough.

Another classic is the "sell in May and go away, don't come back til St. Ledger day", which is all about pre electronic, pre 24/7 trading when stock market makers all took long Summer holidays.  Clearly this is no longer the case so that particular saying is surely defunct?

Anyway these are just examples, I am not seeking to reopen the Santa Claus rally debate, we did that one to death in December 18.  I am interested in discussing any and all other items of "received wisdom" that may or may not be true.  This isn't just for fun, there is a serious point here.  If retail traders are buying into certain received wisdom being espoused by multiple sources and not fact checking this then they are likely to make the wrong assessments and trade for the wrong reasons.  This stuff falls into the Daniel Kahneman territory of thinking fast, thinking slow.  It is all to easy to just follow the "rational" received wisdom because it kinda makes sense, at least superficially.  So let's see if we can get some things straight!

I will open with a classic, that is getting a particular airing these days, unsurprisingly.  That is that Gold (and Silver) respond to USD and/or stock market moves.

The received wisdom, as I understand it, is that:

  1. Gold/Silver are typically priced in USD and therefore if USD goes up then the value of Gold/Silver goes down (i.e. it is more expensive to buy Gold/Silver).
  2. Gold/Silver are safe havens in a time of market meltdown so when stocks in particular are falling investors switch to Gold and vice versa

My opinion is that #1 does not hold true, even though at times it looks like it may do and that while #2 could be true, in the sense that precious metals could be seen as a safe haven in times of trouble, especially in times past when gold/silver was actually money, there is no clear relationship between this and stock bear markets.

Lets look at #1 first (I'll look at #2 in a separate post), the following are the justifications I have for my opinion in contrary to the received wisdom:

  • First of all the USD pricing of Gold is not global.  If I buy gold in the UK I pay GBP for it.  Who are the big buyers of gold right now?  China and Russia and Switzerland holds a lot of gold.  The Saudis appear to be buying up gold too.  So while it was true in the past that the US held the lions share of physical gold (think Fort Knox and the reasoning behind Bretton Woods) this is no longer the case.  Therefore it is more important to think of gold in multiple currencies.  A lot of precious metals expert money managers say that for a Bull run in gold you need gold to be rising in all currencies (amongst other indicators).  It seems we have this right now...
  • Secondly, and related to the above point, in 1973 Richard Nixon removed the USD Gold standard that broke the 1944 Bretton Woods agreement, which had effectively made the USD the world reserve currency (at least among US WW2 allies) thereby replacing the gold standard.  The US owned 3/4 of the worlds gold at that time so to effect this the USD had to be gold backed, or pegged to a set physical quantity of gold.  When this was removed the price of gold shot up (see chart from macrotrends.net below) effectively breaking the pegging of Gold and USD.
  • Lastly, and more importantly, the price charts do not support the assertion.  Let's look at the data (USD DX chart in separate post due to size restrictions):
    • From 1973-1980, after the decoupling, Gold rallied and USD dropped, which is what Nixon wanted
    • From 1980-1985 this pattern reversed, so far the received wisdom is holding true...
    • But then from 85-95 USD retraced the full length of the previous rally to double bottom while Gold went sideways.  Hmm surely a weak dollar of that magnitude would produce a wild Gold rally if the received wisdom held true.
    • Then from 1995- 2000/01 USD rallied again, not as hard as before but still significantly and Gold went down, slightly, well sideways again really.  Maybe there was something else going on?
    • Then the big one!  From 2000/01 Gold entered a massive rally up to the ATH in 2011 (coincidental with many other commodities and precious metals).  And the USD did indeed go down, but nowhere near as dramatically as before and no where near as dramatically as Gold went up.  It is worth noting that the Greenspan Put was well and truly underway at this point.  Could central banks monetary policy be the real underlying factor here..?
    • 2011 - 2015/16: USD rises, gold falls, in line again?
    • Currently Gold has been in consolidation but has broken out to the up side while USD remains at the top of its recent rally (i.e. not falling).  The Gold/Silver breakout is not therefore as a result of USD weakness, although USD may yet fall.  But surely it is not the other way around?  That USD moves up and down in response to Gold?  Nah!

Conclusion: while there appear to be times that USD and Gold move in opposition to each other the relative strengths of the moves are not aligned.  At a minimum this means that something else is going on either instead of or as well as the received wisdom relationship.  One postulation is #2 above but I discount that (see analysis of #2 in the next post).  The other big thing that was/is going on is central bank monetary policy.  It started with the Greenspan Put and was continued by Bernanke and all Fed policy makers since.  I believe it is this that under pins both the moves in USD and Gold, which is why there is a similarity to the moves (in inverse) but it is not consistent because of other market forces separate to each of these markets.  The other factor of note is that the Fed is not the only central bank operating in this way, all of them are, including China.  So this is a cross currency phenomenon, it is a Fiat currency issue globally rather than a USD issue.  So it is central bank policy that moves Gold and Silver and not the USD in and of itself.



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Following on from the first post above to cover received wisdom #2 on Gold, that Gold rallies when stock markets crash and vice versa, I do not agree with this one for the following reasons:

  • Just need to look at the charts for this one:
    • Prior to 1934 the price of gold was fairly stable at between $20-22/oz despite the early 1920 depression (known as the forgotten depression) and the infamous 1929 crash and Great Depression.
    • Price jumped up to the $35 mark in 1934 and pretty much stayed there until the 1973 abolishing of Bretton Woods.  Note this jump happened after the Great Depression and price fluctuated little despite multiple recessions (the grey vertical bars on the chart mark recessions)
    • in 1973 through to end 1974 there was a recession and stock market crash where the SP500 lost about 40%.  This was consistent with a strong rally in Gold.  However, as discussed in the previous post, the rally in Gold is largely attributed to the removal of the USD peg.  Clearly the recession and stock market crash could have had some impact.
    • A more likely explanation that the "at face value" one is connected to the 1973 oil shock.  The back drop here was the OPEC oil embargo against nations supporting Israel in the Yom Kippur war.  In addition, in September 1971, OPEC issued a joint communiqué stating that from then on, they would price oil in terms of a fixed amount of gold.  All positive impacting factors on the price of Gold.
    • In 1974 the crisis ended and Gold price dropped for a couple of years while stocks rallied but from 76-80 both rallied, however Gold rallied far harder and faster, appreciating more than 5X, but wait there was no recession and stocks were also rising, hmm...
    • Then at the beginning of the 80s we got a recession, and another oil shock (79) and stocks fell a bit but not as badly as the early 70s and Gold also fell, hmm...
    • There then ensued a 20 year stocks rally through to the end of 2000 and the first tech bubble burst, with the now minor blip of the Black Monday crash in 1987, and Gold went into retrace mode during this time period, giving up a little over half the gains since 1976.  Fits stocks up,Gold down theory in the main.  Then again this was the roaring 80s/90s when stocks and bonds were kings and all else was out of favour, including Oil and base metal commodities.
    • And then we hit the noughties and while stocks go through a series of boom and busts (tech bubble and credit crunch) Gold goes parabolic (as do a lot of other commodities).  Stocks now look a bit like they were in consolidation on a long term chart but at the time that would not have been the experience.  Interestingly, during the meat of the credit crunch crash in stocks Gold also fell, this during what people now refer to as the "Great Recession".  Anyone around during the later 80s/early 90s recession will tell you that compared to this the so-called Great Recession, wasn't really.
    • Which brings up nicely to 2009 and the Bernanke Put.  Central Banks go nutty bananas with policy and we get stocks turning and rallying while Gold, which had dropped off during the credit crunch, turned and put in the mega rally we saw top out in 2011.  Again stocks and Gold moving up together.
    • Since 2011 Gold, and many other precious metals and base metals and Oil have dropped significantly while stocks have continued up in the longest running bull phase, I think, ever.
    • Now Gold and Silver are rallying again and stocks?  Well remains to be seen.  Currently they are not collapsing, although there are signs of recession.
  • That's it really, except maybe for the notion, erroneous probably, that you should have 5-10% Gold in your portfolio as a hedge, which would suggest Gold is bought in proportion to stocks and other assets.  The above shows why that is not necessarily a good thing, although given the performance of Gold since 1929 I would it is not a bad long term investment vehicle, at least since 1973.

Conclusion: I think this one is even clearer than the USD to Gold relationship.  There seems to be no material benefit in holding Gold during recessions or market crashes, except perhaps that as was the case in 1929, Gold at least held its value while stocks were crashing.  In the credit crunch though this was not so much the case.  Anyway, just as with the USD/Gold relationship situation I think both stocks and Gold are being driven by central bank policy rather at present rather than more intrinsic factors.  Still Gold could be in for a boost if the proverbial does hit the fan in due course.  For now though it seems to be more about what the Fed will do at the end of July and thereafter rather than anything else.

So net I do not see any truth in the 2 received wisdom Gold drivers oft quoted.  Rather I see Gold responding to the idea that there may be another phase of nutty bananas central bank policy in an attempt to stave off a massive monetary crisis (i.e. depressionary deflation).  The believe that this is on the card is driving a surge in Gold and more latterly Silver, as investors position themselves to ride a wave that may be similar to the 2009-2011 rocket and this one would take us beyond previous highs to complete a 1-5 super cycle.  Gold at 2500, Silver at 6500 anyone?


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Chart of the historic SP500 to go with the previous post courtesy of macrotrends.net.

One additional point that can be drawn out form this chart is in relation to a long held investment tenet that states buying and holding is a strategy for riding out recessions.  This will have worked like a charm since 1934 perhaps, assuming you didn't get caught out retiring during a recession, but what about if a depression hits?  The chart shows that the 1929 stock market crash took 3 years to bottom out, they are usually shorter lived these days, the Black Monday one only lasting 1 month!  More pertinent is that it wasn't until 1954 that the index regained the 1929 levels, 25 years!  Or basically a working lifetime.  If you are in your 20s today then no sweat, you probably don't have much invested anyway.  However if you are in your 40s-60s and a depression hits then buy and hold will not help you, your children may benefit, assuming we are talking investments and not pension funds...


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