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What Gold Is Telling Us About the Direction of Equity Markets

By

Fear has returned.

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All that is gold does not glitter.
-- J.R.R. Tolkien, The Fellowship of the Ring

Gold. Because of it, wars have been fought, leaders have been assassinated, and countries have been destroyed. Possessing an alluring shine and seemingly superlative qualities, it's the most highly sought-after metal on the planet. But, is there more to this longing of ownership? Otherwise stated, can investors in today's world derive an inference of the US equity markets' direction from its price action (demand)?

For many years, since gold broke above its long-term secular channel in 2005 around $460, this topic has been controversial. The dispute is based on timeframe. It also depends on the stance of the evaluater. To clarify -- and head off any potential challenges to today's assessment -- The analysis illustrated here is intended to show a shift in market psychology and potential direction in the near term (monthly).

It all comes down to the fear trade, which occurrs when investors shift their stance on gold from considering it an asset class to seeing it as a safe haven. The first evaluation question to ask is: How can you determine the shift? And following right behind is: Does this transition shed light on the underlying strength of the equity markets?

Determining when this change in stance, or reassessment , occurs is rather simple. Investors can evaluate gold and the markets' action through convergence/divergence (positive and negative correlation coefficients). For simplicity, I used the SPDR Gold Trust (GLD) and the SPDR S&P 500 (SPY). The following chart is a weekly comparison.


Click to enlarge

Since the 2009 market bottom, there have been two to three times when gold and equities have had very identifiable negative correlation periods. This occurred just before the ~20% downturn in 2010 and just before the ~20% 2011 downturn. In both instances, when the negative correlation ended (became positive), the majority of the equity market's decline was concluded. As of Friday this idiosyncrasy began to appear once again. To better observe this, I add the daily chart comparison.


Click to enlarge

The action on Friday, June 1 was the first time since August of 2011 when the divergence was this pronounced. I believe, when adding this analysis to the weight of evidence I already have, that it provides a powerful message on general market psychology: Fear has returned, and there are strong bearish undertones in the short-term.

I hope this helps and finds you well.

Editor's Note: Read more at Tesseract Asset Management.

Twitter: @TAM_News
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No positions in stocks mentioned.

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