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Why Gold's Collapse Does Not Signal an End to Reflation

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Gold's decline does not mean the reflation theme is over. The message of gold's price is distorted because of an unusual period of strength in August 2011.

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Every wave, regardless of how high and forceful it crests, must eventually collapse within itself.
-- Stefan Zweig

I've stressed in many of my writings that the intermarket analysis I perform suggests a strong possibility that 2012 will be a year of reflation similar to 2003 and 2009, whereby risk assets perform much more strongly than the crowd initially thinks they will.

Reflationary periods are generally created when the most recent past is defined by deflation scares, after which central banks push liquidity in the system to bring back inflation expectations. Federal Reserve Chairman Ben Bernanke and central bankers worldwide are affecting expectations through inflation targeting and various forms of quantitative easing.

My colleague Ed Dempsey recently put up a video update explaining this further. I was also on Bloomberg's "Chart Attack" the other day talking about inflation expectations in a video.

I have noted before that gold likely will react positively to the reflation theme, but not to the same extent that equities would. With gold now having the biggest drop of the year, there are some looking at the decline and asking if the weakness is a signal of another deflation pulse to come.

I don't think it is whatsoever. Take a look below at the price ratio of the SPDR Gold Trust ETF (GLD) relative to the S&P 500 (IVV). As a reminder, a rising price ratio means the numerator/GLD is outperforming (up more/down less) the denominator/IVV.



I've annotated the chart to make my point clear. In August 2011, as the Summer Crash began to express itself, there was an unusually high correlation occurring between the performance of gold to US Treasuries. I addressed this on Barry Ritholtz's The Big Picture, making the observation on August 18 that gold suddenly became the alternate Treasury trade.

The move at the time was significant, and outperformance in many ways was out of character since gold is "supposed" to be behave well in inflationary scares, and not deflationary periods like what happened in the latter half of last year.

The outperformance of gold in August to stocks because it moved like Treasuries to the deflation trade was so strong that I would argue it de-synced with its historical price behavior to inflation/deflation conditions. Notice the re-syncing that is happening now.

While gold prices are up in absolute terms, they are underperforming stocks. The re-syncing now appears to be undoing the unusual deflation price ratio spike of August 2011. This likely means that the message of relative weakness to stocks does not mean anything just yet and that the signal is distorted by prior unusual price behavior.

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No positions in stocks mentioned.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

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