The Bitter Irony Of Stan Druckenmiller's Mistakes On Gold & TrumpMonday December 05, 2016 14:50
Stan Druckenmiller surprised the world last week by saying he had sold his gold on election night and spewed nothing short of ebullient praise on the equity markets. Gold began selling off on the news and continued dramatically lower into recent sessions, as we wrap up this historic presidential week since voters took to the booths.
Druckenmiller is obviously brilliant; however, there are a few points investors should consider before replicating his move. First and not to be underappreciated, Druckenmiller is a trader and not speaking as an investor – he happily took profits on a multi-sigma move in gold volatility during an election aberration when the metal was trading $60 higher. Selling at that moment, even for a trade, is a very different proposition than selling now, considering where we are today with gold trading notably lower since its election night spike. Make no mistake, Druckenmiller sold his gold before he told you and he will buy it back before he tells you as well – if he hasn’t already.
As we write this, recent momentum indicators, sentiment indicators and relative strength indicators all suggest this is a better time to be buying rather than selling gold as a trade, let alone as an investment. The collapse in the VIX with gold’s sell-off corroborates this view – the world sees nothing but blue skies today, and the idea that some kind of storm could appear is suddenly taboo on Wall Street.
Trumping the attractiveness of gold as a trade, however, is the paramount importance of gold as an investment. To this end, Druckenmiller is ironically making a mistake similar to what kicked off his career. In the late 1970s, the current equity bull market cycle was about to commence, fueled by several pillars, not the least of which was the rocket fuel of declining rates. Druckenmiller’s sage boss promoted young Stan to portfolio manager, concluding the older professionals in the office were too jaded by years of watching an aging equity bear market to ever catch the cyclical turn. The graybeards would ignore the import of cyclical reason and percolating data points, weighing their collective recent experiences too heavily. Druckenmiller’s boss correctly reasoned that without the battle wounds born from years of equity declines in the ‘70s, young Druckenmiller would catch the turn in the interest-rate cycle and the markets.
Druckenmiller’s boss proved prescient, catapulting the young star’s career and creating a scenario last week that seems scripted from a Hollywood drama: 35 years later it could not be more ironic that Druckenmiller himself may be punctuating the other end of this generational market cycle, now himself cast as the manager in denial about the cyclical turn. Druckenmiller is being widely referenced with soaring optimism given his allocation change, encouraging investors to disregard the extraordinary problems ahead, as he told listeners the equity bull market cycle is ready to begin its next glorious chapter. Druckenmiller’s words were covered in Kool-Aid as he spoke: Trump will ignite growth and overcome our problems so swiftly investors needed to sell their gold and buy stocks now. That was, after all, what he just did. This time Druckenmiller’s advice will prove ill-advised and investors will wish they had done the opposite with their gold. Let’s make the generous assumption that Druckenmiller was sincere and that he wasn’t trying to drive gold prices lower so that he could buy gold cheaper or stocks higher – or even that he could short them above. So if he was sincere, let’s unpack what likely went into his sell-your-gold-now call and why it will prove to be poor advice.
First, Druckenmiller is surely expecting a stronger dollar based on improved U.S. growth under the leadership of Trump. It is also plausible that Druckenmiller expects a stronger dollar to feed on itself as it creates incremental pressure on emerging markets. This could cause more demand for dollars in a world where all fiat currencies are fatally flawed, but the dollar is perceived as least so. It is certainly true that a stronger U.S. currency is a headwind for dollar-denominated gold – but dollar strength should not be the only consideration for gold allocations.
Another consideration investors must weigh is the battle between demand for U.S. equities and valuations. Prior to the election, family office investor Howard Cooper stated that, based on his relationships in Asia, a massive flow of investable money is eager to exit China and allocate to U.S. equities. Cooper believes the restraints keeping Chinese money in China are slipping. Again, Cooper’s call was before capitalism won the U.S. election. Cooper envisions a wave of Chinese money flowing to the U.S. that is so large, it could impact U.S. equity markets more than what we saw with American baby boomers when they institutionalized stock market investing through retirement vehicles. Indeed, this view has surely become more prevalent now that China endowed its “president” lifetime dictatorial powers. However, the S&P P/E is already nearly three times what is was at the start of the cycle, when young Stan made his bullish equities call. While on the one hand it may be plausible to expect multiple expansion, given how low growth expectations have been amidst the Obama-stranglehold on capitalism, valuations are not rock bottom and will face the gating factor of higher inflation. For stock markets to move materially higher as Druckenmiller clearly envisions, equity multiples will likely need to expand from their current levels.
While we hope Druckenmiller’s positive view comes to pass, hope is not a constructive strategy for portfolio construction – beyond the euphoria of election week, there are many issues President-Elect Trump must tackle. Recall also the euphoria precedent we saw when President Reagan was elected to replace the liberal Jimmy Carter, triggering a 10 percent rally in the S&P within weeks. But within a month of Reagan’s inauguration, the markets were lower than pre-election, as investors’ attention returned from blue skies to pragmatic reality. Today Trump’s realities include Social Security, entitlements, terrorism and a hostile macro. It took 10 years to put many of the regulations in place that weigh on the economy now – it will take time to undo them. Immigration will take time, and trade deals invariably take years to finalize. After he builds a cabinet, Trump must make friends with Congress, virtually none of whom supported him. But for the sake of this discussion, let's ignore those major concerns and just reflect on one headwind stock bulls are dismissing – stronger than expected inflation as opposed to Wall Street's conviction that deflation is our only worry.
“Don’t worry,” was the mantra last week. “Four percent GDP growth and 2 percent inflation is fine for valuations!” While that would be true should it come to pass, there is nothing guaranteeing that those numbers can’t invert – or that the inflation/growth gap couldn’t be even worse. “Inflation isn’t going to move materially higher – nothing is significantly going up in price” was the claim of equity bulls last week.
Tips spreads, gold/silver spreads, 10-year/two-year spreads, closed end muni carnage and rapidly rising yields all suggest, however, that inflation is mounting. As of Friday, the dividend yield on the S&P is now on a par with the 10-year treasury, signifying how market expectations for inflation are changing quickly, as well as removing an incremental reason that income-oriented investors have owned equities.
Inflation naysayers should recall that few envisioned strong inflation in the early 70s either and what ensued, coincident with a very weak economy, was the most severe inflation in modern American history. What could possibly trigger materially higher inflation? When one considers that Fed stimulus in the current cycle is literally hundreds of times bigger than it has been to avert other modern crises, it is easy to see how a powder keg has been lit. And when one considers that the velocity of money has been at record lows, just a small change in velocity could provide more than a spark. And what of the impact President Trump’s policies will have on reducing the supply of inexpensive migrant labor from Mexico? Increasing wage pressure was a significant element in our last inflationary cycle. And what of the impact around his pledges to raise tariffs on Chinese imports and the ensuing impact this will have across a broad stretch of America? Or how about a new president who, for the first time in years, creates confidence and enthusiasm among the working class in America, encouraging them to dust off their wallets and dreams – and borrow and spend in a world where banks have parked mountains of cash?
Consider what the slightest change in inflation means to fixed income. If rates increase 1 percent on 30-year bonds from recent levels, investors would endure an 18 percent loss. If rates on 50-year Italian bonds were to increase 2 percent, such a relatively trivial move for a hopelessly indebted sovereign would result in a 37 percent loss of capital. Do you really want to go all in that strong inflation won’t appear when, just since Trump’s election, bond investors have already lost over $1 trillion? Do you really want to bet that gold owners won’t partly benefit from the exodus out of gargantuan fixed income markets and into the tiny market cap of physical gold?
Before selling their gold, investors may also want to consider the implications of the strong dollar Druckenmiller foresees on foreign investors and the derivative impact on gold demand from those regions. A strong dollar will clearly equate to incremental pain for most other currencies and emerging markets indebted in dollars. Under such a scenario, do you think it reasonable to believe that, as foreigners see rates increasing, they will desire to decrease their exposure to fixed income and local fiat currencies? If so, do you think they will desire to invest 100 percent of those proceeds into U.S. equities for safety and liquidity? Surely you don’t think the nearly 80 percent of the world’s population in these emerging markets is ready to short non-dollar bonds as their hedge for inflation like Druckenmiller suggested? Likely not, so the logical question in emerging markets becomes, “What assets thrive alongside currency weakness and rising inflation?”
A consistent answer is gold and silver. A key reality that I believe Druckenmiller underappreciates is, and as HSBC has alluded to, if just one-half of 1 percent of equity and fixed income money reallocate to gold, the metal would trade to multiples of its current price given how scarce it is relative to an investment world awash in fiat currency and fixed income. Even if all things go blissfully for the Trump administration, such bliss will likely be coincident with rising rates in emerging markets and increased gold demand from those regions seeking inflation protection. If Japan alone, which dutifully sits holding Japanese Government Bond grenades, should desire to increase its gold allocations from 0 percent, gold’s performance could astound the street.
This is also true for other developed western nations such as Italy and France, where votes on the horizon seem more likely to align with Trump/Brexit fever and where trillions in wealth are tucked inside hopelessly flawed Euros. Does it seem likely to you that some Western European investors may also choose to allocate even a small portion of their wealth away from Euros and incrementally to gold as EU breakup pressures move center stage?
In conclusion, while gold may not be the number one performing asset in the years ahead, it's lack of correlation to other assets that are widely owned in America, it's strength in periods of hurricanes, it's positive returns during inflationary environments, it's scarcity combined alongside 0 percent Western allocations, its declining production … all combine to make gold far too attractive to hold 0 percent today, as Druckenmiller suggested. Since the ’08 crisis, central banks have increased allocations to gold at a pace not seen in decades – what could they know? Gold’s record versus other currencies has been stellar – up 65 times since the creation of the Fed in 1913, while the dollar has lost 98 percent of its value since then. And with U.S. debt already double 2008 levels and going notably higher in the years ahead, the day will come when gold will even have some strong tailwinds courtesy of the debased dollar.
Stan made a fortune when he launched Duquesne and bought 30-year bonds yielding 14 percent. With rates now at 2 percent, gold is the bookend and concluding chapter to that cyclical trade and offers a very attractive risk-reward from these levels. If Trump were to lead us away from Fed-induced dislocations, realize the dollar to gold ratio from 1913 is over $9,000 today. And silver? Dollar to silver, which was $2.72, would need to trade to $993 to reach parity. Not bad for two assets that have never defaulted and carry dramatically better risk profiles than equities. Against this backdrop, I suggest – as a default – you move physical gold allocations to a minimum of 10 percent, rather than Stan’s recommendation of 0 percent, now that bonds have likely peaked and equity enthusiasm is near its highs. Should inflation ever exceed our expectations again, or if gold allocations move to even 1 percent globally, you will be disappointed you didn't have an even larger allocation.
Director of asset management at international wholesaler
Dillon Gage Metals,