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Stock Market Passes Midterm Exam

Pop quiz: Which investment category performed the best during the first six months of 2017? Gold, oil or large-cap stocks?

That’s a bit of a trick question since it turned out to be a virtual tie, with both large-cap stocks and gold up nearly 8% at the halfway mark of the year. Meanwhile, oil took a beating declining more than 15% due to excess supply.

Of course, the much tougher (and more meaningful) question is which of these three asset classes will perform the best during the second half of 2017. Although I have never been a “gold bug,” my guess is the yellow metal will temporarily jump in value over the next six months if we get the stock market correction I am anticipating.

At its June meeting, the Federal Open Market Committee (FOMC) not only raised interest rates for the third time in six months, but also revealed its intention to begin purging the $4+ trillion inventory of debt accumulated over the course of several years of QE, or quantitative easing. The Fed has been maintaining a constant level of Treasury securities and residential mortgages since the Great Recession to avoid flooding the bond market with too much debt.

But now that employment and inflation are well within the Fed’s target range, the central bank no longer feels the need to prop up the economy. However, the U.S. Treasury might need to issue more debt over the next couple of years, to finance President Trump’s ambitious spending programs for infrastructure and defense. If that’s the case, the combined weight of those actions could push the dollar down and the price of gold up as bond prices fall.

That’s not necessarily a bad thing because it would help the stock market create a solid base from which to climb. But it could create panic over the near term, which is why I think many investors will flock to gold until the bond market stabilizes.

Gold has a long and at times fractious relationship with the stock market. Once viewed as the purest of inflation hedges due to its former status as the basis for the U.S. dollar, it now serves a less dignified role as the panic button for nervous investors to hit anytime the global financial system hits the skids.

When the stock market plunged more than 50% ten years ago gold increased by a similar amount. As the Fed pursued its ZIRP, or zero interest rate policy, in the wake of that crash the price of gold spiked nearly 200%. Since then, both gold and the stock market have converged as the Fed discontinued both ZIRP and QE to allow the economy to resume a state of normalcy.

If we do get a stock market correction this year, I don’t expect the Fed to pursue any form of intervention other than perhaps delaying its next rate hike and/or slowing down the rate at which it liquidates its bond portfolio. For that reason, any spike in gold prices should be mostly attributable to investor panic and not due to a fundamental shift in macroeconomic factors.

The good news for self-directed investors is that participating in gold’s price movements is much easier now than it was twenty years ago thanks to the proliferation of exchange-traded funds, such as the SPDR Gold Trust (NYSE: GLD). If you don’t have any gold in your portfolio yet, you may want to consider adding it as a hedge in case the stock market has another summer meltdown.  

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