4 reasons why gold has entered a new bull market Schroders

Market complacency is key to gold bull market say Schroders

Investors are currently pricing inthe most benign risk environment in history as seen in the VIX

History showsgold has the potential to perform very well in periods of stock market weakness (see chart)

You should buy insurancewhen insurers don’t believethat the risk event will happen

Very high Chinese gold demand, negative global interest rates and a weak dollar should push gold higher

This week gold broke through the key resistance of $1,300. For some time market commentators have been signalling this level as the point of entry for a new bull market.

Often price can be distracting when it comes to trying to figure out what is going on. Two Schroders fund managers called the new bull market in gold about a week before the price broke through the key level.

Gold has entered into a new bull market. As we have discussed previously, there are four main reasons for our stance:

  1. Global interest rates need to stay negative
  2. Broad equity valuations are extremely high and complacency stalks financial markets
  3. The dollar might be entering a bear market
  4. Chinese demand for gold has the potential to surge (indeed, investment demand in China for bar and coin already increased over 30% in the first quarter of 2017, according to the World Gold Council)

Whilst they offered up four key reasons for the strength in gold, they highlighted the issue of broad equity valuations and market complacency as the most ‘pertinent’ of the four drivers.

Given the current state of play in the world, James Luke and Mark Lacey ‘strongly believe gold could turn out to be an underowned and well-priced insurance policy.’

Extremely high broad equity valuations look precarious

Starting with the S&P500, Luke and Lacey believe that it is currently very expensive based on a variety of measures.

The S&P500 made an all-time high of 2478 in July and is now up just under 11.5% year-to-date (source Bloomberg, 17 August 2017).

The valuation of this index is expensive on a variety of measures. Whether we look at simple price/book, trailing price/earnings or enterprise value/cashflow (each of which are different ways to value a company), the index is trading on valuation multiples which are 60% to 100% higher than the historical median over the last 90 years.

Whichever your preferred metric, historical regression analysis suggests expected returns for equities, from today’s starting point, are very low.

Why is the S&P500 so overvalued? This is something we have covered previously. There is an almost infallible belief that future earnings growth will be supported byTrump’s drive to cut corporate tax and the the fact thatcompanies’ cost of capital is at an all-time low.

US companies may well receive a welcome reduction in the corporate tax rate, but the low cost of capital argument is flawed. Increasing interest rates are not supportive for equity valuations that are already high (versus history) as companies’ cost of capital increases. As unemployment continues to fall, inflation will start to pick up at the margin, regardless of the lag. Like it or not, we are firmly in a cycle of increasing nominal (not real) interest rates.

Gold and weak equity environments have history

As much as gold’s safe haven status is disputed in the mainstream, history cannot be ignored. This is something we admittedly bang-on about on a regular basis. It is something which is so simple and yet is refuted with the most complicated arguments.

Luckily Luke and Lacey agree on gold’s historical performance as evidence for it’s safe haven status.

If we look back at gold price performance between 1961 and July 2017 (see chart above), it is very clear that gold price annual returns were positive, particularly during periods of high inflation, while stock market returns were negative.

We don’t see any argument as to why gold’s previous performance against a weak stock market will not repeat itself once markets wake-up to the real story.

What is the real story? As Luke and Lacey point out, stock market performance is not reason alone to argue that a gold bull market is in play. It is overall market complacency.