While the stock market has been on a roll since October 2023, there are bearish signs on the horizon that indicate now would be a good time to start hedging those stock portfolios with precious metals like gold and silver.
Even though the price of gold has risen 40% since I first suggested it on July 14, 2022, it is not too late to benefit from a long position as stock market fundamentals grow increasingly fragile.
Gold and silver are generally a safe bet when the dollar is under pressure. Currently, the dollar is one of the strongest currencies in the world. But it is still a fiat currency, and the US government is becoming increasingly over-extended as both the federal budget and the debt to GDP are rising to ever riskier heights. The US debt currently stands at $34.6 trillion, while the US Debt-to-GDP has risen to 123%, higher than it was at the close of WWII.
Yield Curve Inversions – The Most Reliable Indicators For Recessions
A historically long, deeply inverted yield curve suggests there is a recession in our future. If size and breadth are any indications, it could be severe. Notice in the chart below, the graph line has created a long pennant formation. This type of formation usually results in the stock breaking in the direction of the flagpole, in this case upward. Whether this breakout sets a new trend or is just another wave on the graph line remains to be seen.
Fig. 1
Some analysts argue that the inverted yield curve indicator is broken because it’s been inverted for over two years, a historically unprecedented length of time. However, a closer look at the graph below indicates that recessions arrive after the yield curve de-inverts. Notice that the gray vertical bars indicating recessions occur shortly after the graph rises above the zero line – when the yield curve de-inverts – though sometimes it can take as long as 6 months, as happened in the lead-up to the 2007-09 recession.
Fig. 2
Based on the reliability of this indicator, it would be wise to proceed with caution, even as stock market indexes soar to new highs.
Quantitative Easing May Be Close To The End Game
The Fed has tinkered with interest rates and QE for so long, bailouts for troubled banks and corporations have become routine. But resorting to QE to ward off every recession that comes our way is risky. The Fed might create a spring-loaded recession that won’t be contained by QE. Any attempts to do so could cause serious damage to our currency.
Those fully invested in the stock market may assume they are safe from a steep downturn. The recent past has convinced investors that in the event of a recession, the Fed will hit the QE Easy Button, reverse the stock market’s downhill slide, and send it higher than ever. Over the past quarter-century, this has indeed been the case. The chart below shows the Fed dramatically lowered rates in response to an oncoming recession in 2000, 2007, and 2019-2020.
Fig. 3
The S&P tends to respond quickly to these shifts in the Federal Funds rates. When businesses were shuttered in response to the COVID-19 pandemic in Feb. 2020, the S&P 500 dropped 34% in just weeks. But when the Fed announced another round of QE in March 2020, the markets instantly snapped back, reinforcing the old adage “Don’t fight the Fed.” When the Fed announced the reversal of QE in December 2022, the S&P dropped 27%. Fast-forward to the 2nd quarter of 2023 when the Treasury Department announced bailouts for several failing investment banks in April of that year. The S&P resumed its steep upward climb and soared to a new all-time high.
Fig. 4
While this was great news for investors, such remedies may have created a reckless environment in the stock market, wherein investors weight their portfolios far too heavily toward stocks without proper hedging with Treasury bills and precious metals.
A History of Quantitative Easing
As the US financial system sails further and further into the uncharted waters of quantitative easing, neither the Fed nor Treasury Department seems to know what lies beyond.
However, though the QE moniker is new, there is some historical precedent regarding the use of fiat currency to pay for either a government budget that exceeds receipts or bail out large corporations that have easy access to the top levers of government. In the past, major governments have done both. Investigating the results of those financial policies can be instructive.
The Yuan Dynasty and the world’s first experiment with fiat currency
The first half of the Yuan Dynasty, which lasted from 1271 to 1368, was marked by legendary wealth and luxury, as depicted in the stories of Marco Polo. We can practically gauge when the tide began to turn by the date that Marco Polo’s party left China in 1292. Having realized the emperor had no intention of allowing them to leave his service, Marco Polo and his traveling party volunteered to escort a Mongolian princess to the Persian Khan to whom she had been betrothed. The Italian explorers were an obvious choice, considering they were experienced travelers. After a grueling journey, they delivered the princess to Persia and then quickly made their way back to Italy.
Fig. 5
From the time of their departure, the Yuan Dynasty devolved further into war. Inflation spiraled as Emperor Yuan printed ever more fiat currency to pay for his war tours. As a result, the once thriving Chinese economy tanked. Millions of Chinese found themselves in extreme poverty, and the emperor was held to blame. The Yuan Dynasty did manage to last roughly 90 years before it fell to a powerful Chinese warlord. But the dynasty was short-lived nonetheless. Only two Chinese dynasties of the Common Era were shorter.
The Mississippi Company and the world’s first stock market bubble
Fast-forward to the dawn of the 18th Century, wherein a charismatic and highly successful Scottish gambler by the name of John Law comes to France under a cloud of scandal. For want of a better way to make a living, Law gravitated toward the finest casinos in Paris, where he quickly established a reputation as an extraordinarily lucky and extremely charming gambler. Considering card games were the most popular forms of gambling in that era, and no one ever caught John Law cheating, he was likely a card counter – a sign of high intelligence, particularly in regard to memorizing numbers and calculating probabilities.
Because gambling was extremely popular with aristocrats, John Law found himself rubbing elbows with the Duke of Orleans, who was soon appointed France’s regent as his nephew, the child King Louis XV, awaited the age of majority. Like so many others, Philippe II, the Duke of Orleans, was taken with the Scottish gambler. John Law instantly saw a lucrative opportunity in his budding friendship with the most powerful man in France.
Law had been born into a family of goldsmiths and bankers. He entered the family business at the age of 14 and became an adept accountant. He was considered a prodigy until his father died, whereupon he succumbed to the lure of gambling.
Thanks to his extensive knowledge of finance, John Law convinced the Duke of Orleans to combine a sizable portion of his wealth with Law’s to form a private bank called Banque Generale. A year later, Law convinced his patron to nationalize the bank and rename it the Banque Royale, which became France’s first national bank, with John Law at its head with the title Controller General of Finances.
At first, John Law made a respectable central banker. All banknotes were backed by gold, silver, or real estate. He instituted fiscal reforms, including the elimination of tolls on well-traveled roads and canals to free up commerce. He also financed road construction and made low-interest loans available to start-up businesses. Within two years, industry had increased by 60 percent and the number of merchant ships setting sail from French ports went from 16 to 300.
But Law unwittingly set himself up for a fall when he consolidated all French-owned trading companies in North America into the Mississippi Company. While many of Law’s financial experiments were successful, his experiments with the Mississippi Company stock shares were disastrous.
His first mistake was allowing investors to buy stocks on credit, quickly leading to an over-heated market. He doubled down on that mistake by paying a generous dividend of four percent per share (as opposed to a fixed amount of money per share), such that the dividends became increasingly generous as the stock price rose. This set off a devastating feedback loop.
Over the months that followed, dozens of people were crushed to death in the packed crowds that milled around John Law’s mansion, clamoring to buy stock in the Mississippi Company. The stock price soared far beyond the actual value of the company, creating the first stock market bubble in history.
Fig. 6
Like all bubbles, the price of Mississippi Company stock shares eventually peaked and then crashed as investors discovered getting their money back was far more difficult than buying in.
Many powerful noblemen had poured their fortunes into the Mississippi Company. Their fury was a force to be contended with. The Duke of Orleans had no choice but to allow John Law to print up enough unsecured currency to buy back the shares of the stock. This action devalued the French currency and sent inflation soaring, roiling the French marketplace.
France eventually regained its financial footing but mostly stumbled through the 18th Century right up to the French Revolution.
The Weimar Republic’s Great Currency Collapse
Fig. 7
Faced with the massive cost of WWI in addition to forced reparations, the German central bank began buying hard currency (backed by metal) in exchange for fiat currency. The central bank printed all the money they needed to buy up as much hard currency as citizens and expats would sell. The sellers had no idea their German marks would soon be worthless. In early 1922, one US dollar was worth 320 marks. By November 1923, one US dollar was worth over 4.2 trillion German marks. The Weimar government was dissolved by an act of Parliament and a new German government reset the currency in 1924, replacing the mark with the Reichsmark, which was backed by mortgage bonds. They also stopped the German national bank from printing more currency. The German currency stabilized, and German society returned to some semblance of normality. However, the Germans had so completely lost faith in the former regime, they made ripe pickings for a demagogue named Adolf Hitler. In 1939, the Nazi Germans invaded Poland and kicked off WWII. Six years later, they surrendered – a nation twice defeated in the new century.
Where Our Economy Stands Today
As of June 2024, our nation’s Debt to GDP ratio is at 121% after rising to a historic high of 133% in 2020. Meanwhile, US Consumer debt has risen from $14.3 trillion to $17.69 trillion since 2020 Q1, a 24% rise.
Fig. 8
While the government insists worker paychecks are keeping up with inflation, those paychecks are steadily falling behind in their share of corporate profits. The chart below shows that while worker compensation as a percentage of corporate income tends to vacillate between 77%-84%, since 2010 it has remained below 77% and is currently hovering around 73%.
Fig. 9
In the meantime, bank and business defaults have been on the rise since the Fed began tapering in 2022. So far, they don’t appear to be in a danger zone, unless the current upward trend is the beginning of a new spike. These tend to coincide with oncoming recessions.
Fig. 10
Why Gold and Silver ETFs make an excellent hedge
While there is still money to be made trading stocks, a steady drumbeat of market signals foreshadows a recession. In the immediate aftermath of the last two recessions, gold and silver bullion soared.
Fig. 11
Since October 2022, gold bullion and silver have risen sharply, most likely the result of experienced investors hedging their portfolios. If you feel you have missed the boat on gold, here’s some good news. You might be able to catch up with silver. Notice in the chart below that when gold and silver are in an upward trend, silver tends to overtake gold in terms of overall percentages.
Fig. 12
Caveats
Gold and silver have risen dramatically over the past year, and as you can see from the chart above, both have significant pullbacks along the way. Moreover, gold and silver tend to dip at the onset of a recession, before their dramatic rise. An investment in gold and silver today could possibly lose money before it makes money. A long-term hold would be advisable.
Summary
There are numerous indications that a recession may be looming. Since gold and silver perform extremely well both during and immediately after a recession, both metals make an ideal hedge against the stock market.
If you’d like to see why I recommend gold and silver ETFs over gold and silver mining companies, please see my article “GLD: Gold is Spring-Loaded For An End-Of-Summer Bounce”.
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