Stock Euphoria Stunts Gold

The great euphoria emanating from these near-record-high stock markets is breathtaking. Traders are again convinced stocks do nothing but rally indefinitely. That everything-is-awesome mindset has stunted gold’s latest upleg, since there’s no perceived need for prudently diversifying stock-heavy portfolios. But that psychology can change fast, as we saw a half-year ago. Gold investment roars back as stocks roll over.

The word “euphoria” is widely misunderstood, often confused with “mania”. The latter is when stocks rocket vertically in blowoff tops and is defined as “an excessively intense enthusiasm, interest, or desire”. The US stock markets certainly aren’t in a mania. At its latest high last Friday, the flagship US S&P 500 broad-market stock index (SPX) had only edged up 1.2% over the past 14.5 months. That’s not parabolic.

The closest thing to a mania seen in recent years was the SPX’s 18.4% surge over just 5.3 months that led into its initial January 2018 peak. Traders were ecstatic about Republicans’ coming major corporate tax cuts and aggressively piled into stocks. While euphoria accompanies manias, it is entirely different. It is simply “a strong feeling of happiness, confidence, or well-being”. That psychology is universal today.

Traders have fully persuaded themselves that these stock markets have virtually no material downside risks. Like all sentiment, that’s the direct result of recent price action. These beliefs were last seen in late September and early October. The SPX had just hit a dazzling all-time record high, extending its monster bull market to 333.2% gains over 9.5 years. That was the second-biggest and first-longest in US history!

Gold was deeply out of favor near that last SPX topping too. As a rare counter-moving asset that tends to rally when stock markets weaken, gold investment demand wanes when stock euphoria grows extreme. The whole discipline of portfolio diversification is based on acknowledging that stock markets rise and fall. Since investors can’t know when the next major stock-market selloff will erupt, they keep some non-stock holdings.

But euphoria blinds traders to long centuries of financial wisdom. They tend to extrapolate present conditions out into infinity, assuming they will last indefinitely. But betting any trend will run forever is just plain foolish, as markets are forever cyclical. “Complacency” always accompanies euphoria, “a feeling of contentment or self-satisfaction, especially when coupled with an unawareness of danger or trouble”.

Soon after traders overwhelmingly believe major selloffs are extinct, the next one pummels them. The endless stock-market cycles reassert themselves with a vengeance, punishing the scoffers. The severe correction after late-September’s peak is a textbook example. Over the next 3.1 months into Christmas Eve, the SPX plunged 19.8%! That was right on the verge of confirming a new bear at its -20% threshold.

Traders were confronted with the painful truth that stock markets don’t rally forever, that major selloffs are inevitable. So gold investment demand surged as investors rushed to start diversifying their bleeding stock-dominated portfolios. Major stock-market plunges are always followed by big and sharp rebound rallies. Just 5 weeks after those deep near-bear lows, the SPX had blasted 15.0% higher by the end of January.

That’s when euphoria and complacency started to return. These perilous herd emotions strengthened with every daily SPX rally over the past several months or so. The higher the stock markets bounced, the more selloff fears faded. That left portfolio diversification and gold investment increasingly out of favor again. The result is today’s extreme euphoria resembles late September’s, traders don’t have a care in the world.

While euphoria and complacency are ethereal and unmeasurable, they can be inferred. The classic VIX fear gauge is the most popular way. It quantifies the implied volatility options traders expect in the SPX over the next month, as expressed through their collective trades. While a high VIX reveals fear, a low one shows the direct opposite which is complacency. Last Friday the VIX slumped under 12.0 on close.

The SPX’s massive rebound rally had extended to 23.7% over 3.6 months, recovering over 19/20ths of the preceding severe-correction losses. The SPX had soared back to within just 0.8% of its record peak of 6.7 months earlier! The stocks-to-the-moon zeitgeist had returned in an extreme way. The VIX hadn’t been lower since early October when the SPX still lingered merely 0.2% under its unprecedented crest.

So per the leading approximation, traders’ current euphoria and fear have reverted right back to their very same high and low levels just before the last major SPX selloff!  That’s why gold has slumped in recent weeks. Investors forget about it when they come to believe stock markets’ downside risks have vanished. When they buy into that peaking delusion that stocks can rally indefinitely, there’s no perceived need for gold.

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