Thursday, March 24, 2016
The Markets “Graduate” to Commodities
The retracement move in gold gathered downside momentum Wednesday, falling in morning trading by more than 2.5 percent and below 1220 for the first time in four weeks. With gold looking to test support from its February breakout, our near-term target of around 1190 appears in play. All things considered, we remain open minded towards the timeframe and ultimate magnitude of the retracement and would generally expect a sharper and more extreme move down (as our yen comparative suggested) to complete quicker. A close below 1190 and we would be looking for another large capitulation reversal over the immediate sessions.
Hindsight 20/20, the upside in the S&P 500 appears limited even as breadth has markedly improved – which we’d argue is primarily due to rising inflation expectations and the broadening performance in the commodity markets, rather than an underlying improvement towards equities overall. And while the economy today may benefit from a boost in inflation expectations (see Here), the corresponding cyclical pivots in the commodity and equity markets harkens back to the late 1940’s when the Fed and Treasury ended their active support after undertaking similar large scale asset purchase programs.
- The cyclical move higher in equities that corresponded in 1942 with the beginning of the Fed and Treasury’s LSAP programs – exhausted in 1946 as they ended extraordinary policy support.
- The cyclical move lower in equities corresponded with a return of inflation, another move lower in real yields and a cyclical move higher in the commodity markets.
- Despite rising inflation, Treasury yields remained historically low as real yields fell sharply.
- From a total return perspective, the S&P 500 fell back to its breakout levels from around 1945 and remained range bound for nearly 3 years before the secular move higher in yields and equities began as the decade came to a close.
- The exhaustive highs in the yield cycle (21′ & 82′) corresponds to the valuation troughs in the ratio.
- The valuation range of the ratio appears proportional to the size of the long-term yield cycle. I.e., the greater yields were pulled (higher) – the higher the valuation range was subsequently extended. To this point, we note the congruence and timing between the two broader cycles – with the yield peaks made in 21′ and 82′ (Jan 1st data) and the lagged reflex and explosive drive higher of the ratio directly following the pivot lower in yields. Yields rose for 20 years leading up to the peak in 21′ and the equity market subsequently exploded higher for ~ 8 years leading up to the 29′ high. In the most recent cycle, yield rose for ~ 40 years to a peak in 82′ and the equity markets enjoyed the historic disinflationary open road for ~ 18 years leading up to the valuation peak in 00′.
- One way to look at the relationship and lag between the series is that the ratio trends with the yield cycle for a period until higher yields and inflation expectations put downward pressures on equity prices, thus creating the pressure differential described above that’s eventually released with proportional inertia subsequent to the cycle high in yields.
- Similar to what is found in other wide-angle asset panoramics, the relative range of Shiller’s PE isn’t static, but broadening with a rising lower and upper range. We would argue the drift higher in valuations is primarily a result of the expanded range of the current yield cycle.
- As often the case with major crashes, the outlier effect to the broader cycle muddles the interpretive tea-leaves going forward. Having said that – and although they didn’t occur at the same point or present with equal magnitude (33′>09′), we view the extended dislocations from the equity market crashes (29-33′ & 08-09′) as relative outliers with respect to the ratio calculation – but view them nonetheless with wide peripheral vision to the broader flow and bearings of equity valuations within the respective cycle. Moreover, it doesn’t make much sense to us to compare absolute valuations between cycles – because of how the ratio is calculated based on a smoothed 10 year inflation-adjusted metric and the difference in size and magnitude between the respective yield/inflation cycles.