2009-09-13

When they are only half way up they are neither up nor down!

GOLD (GC) S&P500 (ES)

goldvsnp130909 The markets are always divided into two camps, bulls and bears. The bear camp for a long time has been calling the top in the stock markets and wants to see S&P500 dropped much below the March 2009 lows whereas the bull camp is calling for bears blood. In between we have analysts who have created an alphabet soup of recovery (or expected recovery) U, V, W, L are quite common.

There is a case by bears for “Grand Super Cycle” of stock market reaching an end and a catastrophic drop coming in not so near future to take out all excesses since the Industrial Revolution. Bulls seem to discount that as “gibberish” and keep putting their faith (and money) on unstoppable expansion of global economies (barring timely set backs but not catastrophe) as human race has managed so far since the day they walked out of African plains as apes.

A minor flaw in Bear analysis is that it relies on S&P 500 as measured in US Dollar terms. This is good for few years but for longer term data, the effects of inflation, deflation and other effects starts creeping in distorting the picture. For the danger of valuing a market in a debasing currency, just look at the performance of Zimbabwe Stock Exchange. It might look great in local currency terms but would be pathetic if you take into account inflation and foreign currency terms.

A reasonable alternative would be to pay attention to S&P500/Gold ratio, assuming (and a separate discussion required on this assumption) GOLD as stable store of value. I had written a note about this subject late in March 2009 here discussing the S&P500/Gold ratio. There I posed the following questions

a) Stocks are very cheap relative to GOLD (i.e. at the level they were nearly 20 years ago) and time to buy stocks.

b) Stock have dropped like stone and there is no faith left in these pseudo measure of wealth and time to pile into "real" assets like GOLD.

c) At least one of S&P or GOLD is overvalued relative to the other and therefore an inflexion point can be in offing.

Since then the ratio has started heading up, after hitting low in March 2009 indicating a faith in Stocks (over Gold). However over longer term perspective the current trend in S&P50/GOLD ratio is down (since 2000). On Elliot Wave perspective, the 5-3 wave correction appears to be over and therefore there is a point in the case that March 2009 was indeed the longer term bottom for the stock markets (in Gold terms) and even if a severe correction is in pipe line, the current direction points to stocks outperforming GOLD for some time (until the ratio is 1.81 – 3.125 range). That could mean Gold is due a severe correction and/or stocks are due a severe ride up (at current price of Gold, it implies S&P 500 at 1810 at least – taking out its all time high).

These appear certainly “mind boggling” at current stage but just to get the perspective, imagine this analysis in 1984 when the ratio was .45 and people who were long S&P short Gold made 12.10 times return in GOLD terms. I (accidently or by good fortune) was able to ride a very small part of this curve in 2007-2008 being long GOLD, short S&P500 and still managed to do very well in that trade.

So what appears as next steps: There are the following trades:

i) Sell Gold, Buy S&P500  and put stop loss at S&P500/GOLD ratio of 0.86

ii) Buy Gold, Sell S&P500 and put stop loss at S&P500/GOLD ratio of 1.81

iii) Buy GOLD, Buy S&P500. Even in the severe down turn in stock, this trade has only lost 4% since 2000 peak.

iv) Sell Gold, Sell S&P500. This is opposite of trade iii) and therefore with inverse performance.

Like before, I still do not have a firm bias as to which trade to take but I know that there is money to be made in this trade if traded correctly. I will take a cautious position on trade ii) with some hedges built with options in case it goes against me. I would also like to do more analysis on this subject. I could only get data up to 1984. I am sure the truth is out there if I try harder to get data going back a lot further but my laziness is getting better of me. Any readers want to present a table of closing numbers for GOLD and S&P500 for years before 1984?