Gold vs DOW & 'Don't Fight The Fed'...yet!
A: Sorry for the off-topic discussion here as I got some motivation to talk about this topic from a client I chatted with earlier in the day. In this case, one of my clients was bullish on equities since the fed started cutting rates because of the old mantra 'Don't Fight The Fed'! "That old saying can hurt you if you follow it too soon...", I tried to explain. I brought up my feelings about rate cuts (as I discussed last year as well) and what that tells us, and also the effect it has on our currency and commodities that are priced in the resulting weakening dollars. I told her to compare a chart of stocks vs gold over the past 5 or 6 months, a few weeks after the fed first started to cut the fed funds rate. While this is not your normal situation, it still shows you the basic conclusion! When the fed cuts and they say the bias shifted towards growth concerns, chances are you should wait to not fight them!
The fed's first rate cut was on September 18th, from 5.25% to 4.75%. Since then, we have had 4 additional rate cuts totaling an easing of 1.75%, or 175 basis points. We currently stand at a FFR of 3%, and it certainly appears to be going lower. During this time, I have had numerous discussions and arguments about why this is not good for stocks.
First off, let me say this: If you are going to follow the mantra of 'Don't Fight The Fed', be VERY cautious with the timing of any investment decisions when the fed is EASING! Why?
When the fed cuts the funds rate, it is doing so because there are perceived risks with economic growth that require stimulus. Stocks generally trade on near term profit expectations and confidence; lets say 6 months out. The accepted valuation models for whether the stock of a corporation is cheap (lack of confidence and low expectations) or expensive (plenty of confidence and high expectations), is the P/E ratio! Now, if the fed is cutting rates because there are risks to economic growth, and stocks trade on confidence and profit expectations, then chances are you will see pressure in stock markets as the fed eases. The more the fed eases, the higher the perceived risks to economic growth by our monetary policy setting body. In this cycle, hindsight shows that the fed was a bit late but aggressive so far with rate cuts. Stocks are now seeing pressure to profits and are re-adjusting equity prices to be more in line with lowered profit expectations.A side-effect of aggressive fed easing is inflation; especially in commodities. Every time the fed cuts rates and/or economic data comes in weak, our currency goes down. Commodities that are priced in US dollars, in turn, get more expensive. With the case of gold, a few other dynamics are contributing to the metals latest attractiveness; gold is widely viewed as a safe haven & inflation hedge play. This was perfect for the environment that was in place when the fed first started cutting rates in mid September; fed easing + uncertainty about economic risks + fed fueled inflation.
The uncertainty element comes from a combination of so many forces at once; housing deflation, de-leveraging, seizing up of secondary trading markets, major credit-related losses, commodity inflation, and a weakening US economy. Its a perfect storm. But if you do not believe me, just look at the charts and you will see the re-allocation of money a few weeks after the fed started their rate cuts:
Since October:
GOLD ---> up $234/oz or about 31%
*DJIA ---> down 1,517 pts or about 11%
*does not include Friday's fall of 2.5%
These are the moves that happened a few weeks AFTER the fed started cutting rates. So be very cautious how you put your hard earned money to work in any environment when the fed is known to be aggressively easing because the economy is expected slow; which we knew in this latest easing campaign. 'Don't Fight The Fed' nah! Perhaps it should be, 'Don't Fight The Fed YET' instead!
When the fed tells us that they are no longer biased towards 'risks to economic growth', it will be a sign that inflation is now the focus and rates are likely to head higher in the near term; a good time to start observing the mantra of 'don't fight the fed' as the full effects of the easing cycle work through the system. That is when the US dollar will probably bottom and some speculative commodity trades will take their profits off the table.
PS: Something to keep in mind. Another way our currency will rebound is if our fed EXITS a rate easing campaign and STARTS a rate hiking campaign at the same time foreign central banks deal with the lagging slowdown that is a result of largely the same issues we are facing and our economic slowdown. It's widely accepted that the US economy leads the world economies; so our central bank will generally be AHEAD of other central banks. If Europe is to see a lagging slowdown, their ECB will likely cut rates and focus on growth concerns; and that could occur as our fed is nearing the END of our rate easing cycle! The combination of expectations of US rate hikes at the same time foreign central banks are easing, should certainly cause a rebound in the greenback and a slowdown in commodities that are priced in dollars!
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