Gold Prices Continue to Climb

So far in 2009, the S&P 500 is up 21%, while gold is up nearly 25%. Gold and stocks have been moving in tandem for much of the year, an unusual situation, to say the least.

The rising stock market has been one of the few bright spots of the economy. While it’s difficult to say what causes short-term movements in stock prices, the year’s increases in the stock market is probably not connected to the performance of the economy, actual or perceived.

I say this because the rally has not been driven by outside events. At the low of the market, in March 9, 2009, the sentiment was bleak. Analysts who had previously been known as solid bulls began to say, “the sky is falling!” News since then has been solidly bad, with continuing job losses, rising unemployment, trade deficits, budget deficits, and a rising disillusionment with the Obama Administration. Now sentiment has reversed; everywhere the talk is of green shoots and growth; all experts agree: the recession is over. They point to the performance of the stock market and the recent rise in GDP (mostly driven by debt-funded government consumption).

It seems more likely that the rally is a correction of the long slide in stock prices that took the Dow down 7500 points over a period of about 17 months. The nature of markets is action and reaction, movement followed by countervailing movement. The stock rally of 2009 is simply a long counter-movement, where the market recoups a portion of its losses. The general rule to look for is a counter-movement of 50%, though it may be as large as 75%. The former has basically been achieved. That means extreme caution is warranted about future market moves. Indeed, it seems to me that the sentiment has become so uniformly bullish that the only possibility is a sharp downward movement, even an eventual violation of the lows of March 2009. This possibility is not driven by sentiment alone, but by the fundamentals of a weak economy coupled with the multiple threats to the dollar’s reserve currency status.

Right now it seems unthinkable to nearly all observers that the dollar could be displaced. That alone should give us pause. The last two years have been a time when most observers have been disastrously wrong. Most did not foresee the crash of October 2008. Most did not foresee the rapid downturn of February 2009, nor the rally that began in March. Early in 2009, when oil prices dove to below $40, most analysts predicted they would stay there; instead, they doubled within the year, in the face of worsening economic deterioration.

Yet India’s purchase of 200 tonnes of gold from the IMF at near-record prices shows that nations are increasingly distrustful of the dollar. Individual investors should take note.