Gold v Shorting The market

“In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.”

Such were the wise words of the late economist Rudiger Dornbusch.

For many observing current financial markets this quote resonates acutely.  The following excerpt from a recent interview with Raoul Pal succinctly puts the current situation into perspective:

“Just to quickly recap, the market is record long retail investors, record long trading in pink sheet speculative stocks, record long call options. The market makers are record short option gamma. Bond traders are record short 30-year bonds. The market is record short the US dollar. Mutual fund managers are record low cash allocations. The hedge funds are record long net and gross exposure. The market has the lowest on record short interest as a percentage of market cap in history”

Since the crash in March last year and the recession with it, we have seen this epic run up in financial assets all off the back of central bank and fiscal stimulus and the ‘hope’ rather than reality of a real structural recovery.  Approaching 1 year on we are seeing all those record positions outlined by Pal above, but very real signs of a faltering recovery in the US.  Pal himself has just recently gone short the S&P500.  Such bets, particularly off leverage can be extremely painful if the timing is wrong and you don’t know how to manage them like Pal could. Another famous economist, indeed one of the most famous, is John Maynard Keynes who in the 1930’s said, "The market can remain irrational longer than you can remain solvent".

And so whilst you might have a strong conviction that a massive crash is ‘imminent’, markets have a way of proving your convictions, or more particularly the timing of them, wrong and one way bets can hurt.  That said when you count the use of the word ‘record’ in Pal’s summary above, there appears to be a feeling of ‘this time if different’ in the market.  So here’s yet another quote, courtesy of Lance Roberts of Real Investment Advice:

“There remains an ongoing bullish bias that continues to support the market near-term. Bull markets built on ‘momentum’ are very hard to kill. Warning signs can last longer than logic would predict. The risk comes when investors begin to ‘discount’ the warnings and assume they are wrong. 

It is usually just about then the inevitable correction occurs. Such is the inherent risk of ignoring risk.”

So what is one to do about this clear and present risk?  To short the S&P500 may be spectacularly profitable…. or wipe you out.  Gold has enjoyed a remarkable negative correlation with shares in times of crisis.  Therefore as a hedge on the sharemarket it presents an historically safer yet still profitable proposition than trying to short that market with options.

That negative correlation is by virtue of gold’s ‘safe haven’ hard asset role.  However gold also presents an historically proven role as an inflation hedge, strongly performing in times of rising inflation.  That it is inflation itself, playing out via higher nominal and yet more deeply negative interest rates, that could be the trigger for the next market collapse.  That in essence presents a double catalyst for higher gold prices.  It is worth noting to that Pal is also long gold.  We’ve discussed before that he sees gold in a giant cup and handle pattern with explosive price growth potential ahead.

And so, as so often we end such discussions, balance is the key.  One way bets can be dangerous.  An allocation of gold balances any portfolio.  That allocation now just comes at a time where the very same catalyst driving up shares in the short term is structurally supportive of much higher gold prices both now and most definitely beyond.  Simply put, it is now almost an each way bet.  Balance doesn’t come any better than that.