Volatility Explosion Just Provided A Huge Entry Signal For Gold

Benjamin A. Smith
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Planets Starting to Align As Volatility, Technicals Flash Buy Signals

It seems counter-intuitive. Despite the much-awaited short volatility armageddon which delivered max pain to various vol/asset pair strategies on Wall St., gold prices actually declined. This belied the widely-held notion that high volatility should send prices soaring. So, with gold reacting sheepishly to the vicious correction in stocks (and VIX), are gold prices destined to languish? On the contrary, we posit the fun is just beginning.

To buy into this thesis, we must first confront the belief that gold is a hedge against fear and uncertainty. The evidence suggests it is not. At least, not the majority of the time. While there have been periods when gold/VIX move in tandem, it’s more of a case of the tail wagging the dog. If we take a macro view of the gold’s relationship with VIX going back to 1990, a decidedly inverse-correlation is apparent.

The one exception happened during the green-circled period, pre/post Great Recession. It was then gold and VIX rose together, foreshadowing the great monetization which was to occur.

To stem economic collapse, the Federal Reserve unleashed massive programs such as the Troubled Asset Relief Program (TARP) and Quantitative Easing 1 (December 2008 to March 2010). eventually bloating the Fed’s balance sheet from $800 billion to $4.4 billion. Crashing interest rates added kerosene to the fire. A specific ecosystem existed where both assets could rise in tandem.

But that was the exception, not the rule. Contrary to market perception, gold investors should strive to position themselves opposite of expected future volatility trends.

And that’s exactly what makes gold such a compelling trade right now.

 

Volatility Spikes Often Provide a Reliable (If Delayed) Buy Signal

Related to the above thesis, we note how extreme VIX readings often provide prescient gold entry points. They’ve often foreshadowed sustained, multi-year moves higher. It’s almost as if investors had to experience equity capitulation firsthand before rediscovering gold’s invaluable store of value.

Although sometimes lagging, extreme VIX readings have a knack of bottom-ticking prices for a sustained reversal. Take a look:

On no less than 3 separate occasions since 2002, a VIX reading above 30 presaged an important technical event in gold.

August 2007 – VIX broke 30 as investor angst about the U.S. housing bubble rapidly approached. Shortly thereafter, gold broke through an 18-month consolidation on its way to braking all-time nominal highs. The final destination point was around $1,011/oz.

October 2008 – VIX broke 80(!) as peak housing bubble insanity dominated. Gold dumped (along with all assets) into the low $700’s. But the sale was short-lived. Less than four month later, gold was already retesting all-time highs. Less than a year later, the glass ceiling cracked and went vertical into the $1900’s by fall 2011.

August 24, 2015 – Shanghai equity contagion (-8.5%) triggered by economic slowdown fears spread to America. The DOW dropped 1000-plus points at the open (flash crash), and finished down 588 points on the day. VIX flashed over 40.

How did gold do? Before Christmas, prices had bottomed. By February 2016, a brutal 4-year bear market was confirmed over. From Dec. 2015-July 2016, gold gained about 30%, peak-to-trough.

While correlation doesn’t equal causation, the trend toward diverging gold/VIX movement is compelling. It makes sense from a logical perspective. After an mass asset purge (including gold) caused by an extreme event or sentiment shift, gold’s safety characteristics start sticking out like a sore thumb. It becomes as asset everyone wants to own to preserve wealth. Thus, it’s one of the first assets bid as VIX meanders towards lower norms.

There’s also no avoiding the indiscriminate selling of asset sales to cover margin calls and short term liabilities. It doesn’t matter whether you’re talking gold, diamonds, equities, bonds or crypto. When market turmoil strikes, everything can selloff in tandem. Vicious bear markets are about the only force which can move all cross-asset correlations in the same direction.

 

The Next Round Of CB Monetization Is Closer Than You Think

If you think Central Banks (CB) will stand idle while when the next global recession arrives, you aren’t paying attention. As we’ve seen twice since 2000, CB’s will conjure up unlimited fiat to avert a crisis. ECB President Mario Draghi spoke for all central bankers when he uttered the infamous “whatever it takes” statement in 2012. It worked: soaring Eurozone bond yields quickly came to heel, and in fact, started going negative just a couple years later.

With the U.S. economy in the very mature state, recession can’t be far off. It may not seem so with Trump’s economic revival in full swing, but this business cycle is already the second longest ever. By the second half of 2019, it will be the longest. Recession may be delayed by pro-economic policies emanating from Washington, but it can avoid it. I’m confident that in the next two years, it will have arrived.

The problem is, the crisis is bigger than ever. Much more debt has been accrued and past structural issues continue to fester. Facing its own debt quagmire, it’s unlikely China can pull the world out of economic malaise the next time around. It’s much more likely to be part of the problem than part of the solution. For the first time in recent memory, the world could see twin economic superpowers entering recession (if China only ‘grows’ at 5%, it’s akin to recession) at the same time. There’s no way world CB’s will sit idly by while Rome burns. QE 4… it’s happening.

The only debate is actual amount. How much fiat will be required to stabilize the economy next time around? $3 trillion? $5 trillion? $10 trillion? If recession happens quickly/forcefully enough, I believe the Fed will reverse course and resume bond purchasing programs in earnest. Yes, that means more QE.

The amount of monetization, along with the direction of rates, will help determine gold’s ultimate upside potential.

 

The Technical Take

I don’t buy into technicals as much as I used to. I tend to view opportunities from a thematic macro perspective based on anticipatory analysis and past trends. But from a traditional technical perspective, gold looks great.

Prices are currently above both 50/200 day moving averages. Each successive close below the MA’s have been more shallow than prior breaches. Prices recently challenged 18-month highs despite the selloff in bonds. And the Relative Strength Index (RSI) and MACD show plenty of blue sky above.

On the flip side, gold’s performance relative to the fall in $USD since last April hasn’t been especially impressive. The rise is cryptocurrency interest has also siphoned off investment capital. This may be a lasting trend dogging gold inflows.

 

Conclusion

All things considered, gold is looking buoyant and appears poised to test $1,400/oz in the coming months. Gold has several things working it its favor: upcoming monetization (within 2 years), great technicals, possible sentiment shift in equities, and now the volatility trigger.

I don’t necessarily expect an imminent run-up in prices. But if you purchased gold here and revisited your investment 3 years later, I think you’d be quite satisfied with the returns.

Benjamin A. Smith

Benjamin A. Smith

Ben is a research analyst and capital markets professional with nearly 20 years of experience. His areas of expertise are broad-based, and include extensive knowledge of macro economics, stock/derivative trading, commodity complexes, cryptocurrencies and technical/quant analysis. He also maintains an particular affinity for U.S. politics and the macro-regulatory environment facing...
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bsmith@midasletter.com |

Midas Letter is provided as a source of information only, and is in no way to be construed as investment advice. James West, the author and publisher of the Midas Letter, is not authorized to provide investor advice, and provides this information only to readers who are interested in knowing what he is investing in and how he reaches such decisions.

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