Risk Off, Gold On

Precious Metals Commentary

Gold remains range bound this week. After hitting highs of US$1,990 we traded lower to $1,932 with silver falling back to $26.60. Both metals are consolidating sideways after the recent rally with profit-taking halting any gains for now.

Platinum has dropped back to US$888 and Palladium has started to trend higher back above US$2,300 this week. Platinum physical demand remains quite strong at ABC with more and more investors turning to platinum as an alternate safe haven given its relatively low value compared to gold.

The AUD/USD has pulled back to 72.6c this week after a bigger than expected economic contraction in the second quarter of 6.3%, which would put us at the deepest slump since the Great Depression.

An Absurd Stock Market

All eyes this week are on US tech stocks as the ongoing movie of the most absurd stock market bubble in history continues to entertain. The Nasdaq was pummeled -5% last night as the irrational behavior of the past few months is coming to a head. Picking a top in a bubble is incredibly difficult to do, but there were a few hints that we have seen a peak in stupidity in the past few weeks.

Those watching closely could see that the US economy is currently facing the biggest challenge since the Great Depression whilst inexperienced retail traders are pushing valuations to new absurd extremes for all the wrong reasons. When Apple and Tesla add hundreds of billions to their market caps with the apparent reason being an upcoming stock split, it is quite clear the average investor over in the US has lost their mind completely.

Exacerbating the rally and the risk of a ‘down the elevator’ moment is the spike of notional volumes in more risky derivatives such as call options. Newbie retail traders have been absolutely loading up on call options of the major tech stock names that appeal to young inexperienced traders.

The chart below shows there is an underlying bubble in call options of the major tech names to the tune of $190 Billion this year which completely dwarfs previous volumes. The appetite for big returns in a small space of time is at an extreme.

What is interesting about the 2020 bubble (which we are sure will go down in history) is that usually a stock market bubble coincides with a booming economy, and a depression/recession is what follows the burst, but right now we have a global depression somehow fueling the bubble further to new highs. It is getting harder and harder for the media to explain reasons behind certain movements in the indexes, but ‘mass psychological hysteria’ is probably the only good explanation.

We think this complete dislocation between the stock market and reality combining with a lack of knowledge around how share prices should be valued will most likely coincide with a peak in the market that won’t be exceeded for a long time.

The higher the market travels in the short-term, the worse the shock will be, and we can see how extended the Nasdaq is currently in the chart below. We are happy to go out on a limb here and call it how we see it. We think there is a decent chance the US stock market and the Nasdaq has now peaked in 2020 and expect from here and into 2021 to be one of the worst periods for the stock market ever in terms of dollar value lost. It will be interesting to see where the Nasdaq is in twelve months compared to this week’s peak above 12,000.

It is reminiscent of the crypto bubble in 2017-2018 whereby ‘investors’ were completely oblivious to what they were buying and what price they were paying. The explosion in popularity in retail trading social media accounts in 2020 is a very strong indicator that we may have finally seen a top, as this was exactly the case in the crypto peak of 2018 if you track brokerage account openings.

These events of mass hysteria are not sustainable in the long term, and nor are they unusual. Just go to the 29 minute of Bron’s webinar from last week to see a history of bubble behaviour across many markets and over the centuries.

The E in PE is for Extended

One valuation method that really puts things into perspective is the price/earnings ratio, or PE. Advisor Perspectives say that taking the total price of the US stock market (the S&P500) and dividing it by its earnings over the last 10 years gives a very long-term view of the market relative to previous significant peaks.

By this measure one can see we are in the 96% percentile of how expensive the market is relative to historic valuations, and only surpassed by the peak of 1929 and the original tech bubble of 1999.

Brisbane private investment firm Leithner & Company argues that the All Ordinaries Index is overvalued by at least 33% based on an analysis of our market’s PE ratio.

Leithner note that as “earnings (and attitudes towards them that PEs reflect) are a key driver of indexes” it is important to look at the trend of earnings. Their chart below of the stock market’s earnings since 1974 shows that the All Ords’ earnings are much lower today than they were on the eve of the global financial crisis (GFC), down 50% adjusted for the Consumer Price Index and they have been sideways since. That is not a sign of a healthy stock market (or economy).

With flat earnings the driver of stock returns has been an increase in the All Ords’ PE ratio from a GFC level of 9 to a peak of 20 in February. Leithner argue that to be bullish on stocks means one must think that earnings will not fall (unlikely given the impact of COVID) and/or the market’s PE ratio will rise to its recent high of 20.

They say that even that bullish case results in an All Ords index level below where it is now and that a 10% earnings drop and a PE around its long-term average results in a 33% drop in the index.

Another under/over valuation measure is to work out the All Ordinaries index in terms of ounces of gold. The chart below shows that following the GFC the All Ords has moved sideways for over a decade when looked at in ounces of gold.

If Leithner’s 33% drop occurs with a modest 12% gain in Australian gold prices (charted in hot pink) then one will be able to buy the All Ords with 1.4 ounces of gold, a level last seen in the early 1980s.

We note that the Ohio Police & Fire Pension Fund followed Buffett’s lead and added a 5% allocation to gold to give their portfolio “a strong diversifier to its growth oriented investments as well as provide an effective hedge against inflation”. One can read “diversifier to growth” as “worried about a stock market fall and we think gold will offset that”.

PIMCO, an investment firm with nearly $2 trillion under management, also joined the gold club saying that even with the recent run up in prices, “__gold remains attractively valued – one might even say cheap – in the context of historically low real interest rates”.

To our mind, it would be prudent for investors to consider reallocating capital to gold and away from risk right now given the behavior, experience (or lack thereof) and psychology of those involved in this latest melt-up in stocks.
 
Until next time,

John Feeney and Bron Suchecki
ABC Bullion
 
If you have any questions or feedback about this week’s report, we would love to hear from you. You can contact John Feeney (@JohnFeeney10) and Bron Suchecki (@bronsuchecki) directly on Twitter, otherwise please feel free to send us an email at [email protected], or call us during trading hours on 1300 361 261.

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