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Recent gold prices have created a storm in a tea cup. Behavioural finance teaches us that the brain tends to focus more on recent events than on the past. This explains the short-term approach of traders in the markets, which is called “recency bias" in behavioural science.
Recent gold prices have created a storm in a tea cup. Behavioural finance teaches us that the brain tends to focus more on recent events than on the past. This explains the short-term approach of traders in the markets, which is called “recency bias" in behavioural science.
Peering past the recency bias and taking a 360° worldview of the financial markets, let’s look at what to expect in gold–aka God’s own currency.
Peering past the recency bias and taking a 360° worldview of the financial markets, let’s look at what to expect in gold–aka God’s own currency.
Are the best days of gold a thing of the past? Or is this what followers of the point-and-figure system of trading call “catapult action?" This refers to the act of pulling the elastic bands of a catapult and letting go of the projectile at ballistic speed. This kind of catapult price action is far more rampant in the financial markets than “experts" would like to believe.
Going by the cause and effect theory, I would start by examining the cause of the decline in Indian gold prices to gauge the extent of the fall in terms of both price and time.
In the Indian context, it was the cut in import duty that resulted in the off-the-cliff kind of decline in bullion prices. However, a savvy player would have observed a noticeable decline in bullion prices in the international markets at least a week before the budget.
Fait accompli
To the rank-and-file investor, it appeared that the approaching US Federal Reserve meeting offered a fair probability of an interest rate cut. Gold, which does not offer interest and/or dividend, tends to underperform in a higher interest rate regime. If the Fed were to announce a rate cut, gold ought to have risen. Yet, it was slipping ahead of the meeting.
Why? Because the cheque writers who actually move the needles and gauges in the financial markets are refusing to write cheques at these abysmal and/or negative inflation-adjusted rates. Central banks are done printing unbacked currency. Any more of this printing and you have hyper-inflation knocking on your doors.
Big-ticket cheque writers know this. They also know the only way central bankers can raise money is via the bond markets. The relentless fait accompli that central bankers have been dishing out to cheque writers since 9/11 is resulting in a blowback. Cheque writers are fighting back in the only way they can–they are not writing cheques.
Retail traders raised on mistaken economic theories that “central banks determine interest rates" look forward to Fed meetings with nail-biting anticipation. In reality, whether a bond float, a corporate fixed deposit, commercial paper, or certificate of deposit will get subscription is determined in clubs, gymnasiums, saunas, and steam and Jacuzzi baths.
The long and short of the story–gold prices slipped internationally ahead of our budget because interest rates haven’t peaked yet. Why? Cheque writers haven’t locked in large enough amounts for long enough tenors and therefore are not done asking for higher rates. They will ask for, and get, higher rates. The tables are turning after almost two decades. Any rate cuts in the US ahead of the November election will be a political decision rather than economic.
So if coupon (interest) rates are expected to stay higher, why should gold prices rise from current levels?
Dick Stoken’s work on the cost of funds (interest rates) and the resultant impact on financial asset prices is still the gold standard in financial market education. Higher coupon rates will induce the memory of gravity that the financial markets have forgotten after 2020.
Mean reversion
Traders will recall how factories and offices were shut in early 2020 but stock prices were notching up jaw-dropping rallies. This phenomenon of asset prices diverging from economic realities is called counter-cyclicality in advanced economics. We have been in this counter-cyclical phase for over four years now.
Mean reversion should be around the corner, as per the law of probabilities. Ever noticed a man walking a puppy with a leash around its neck? The frisky puppy tends to gyrate from extreme left to extreme right while walking ahead of its owner. This process of moving from one extreme to another is mean reversion. The puppy’s movement is limited to the extent the leash allows, in either direction.
We are headed for mean reversion in financial markets in 2025.
Why 2025?
This gets even more interesting because it is in-your-face all the time, yet outright ignored. So when an arrogant newbie trader tells me I’m wrong and that the markets will only zoom from here, I smile inside.
Calendar year 2024 is unique in the history of the financial markets globally, with over 5 dozen nations holding general elections. A little under two-thirds of the human race will choose who governs their lives.
That means promises of reforms, gravy-covered economic data, massaging of future projections and tall promises about improvement in standards of living. The peak will be in the November 2024 US elections. This is the largest financial market in the world and this is where the biggest feel-good factor will be created. Lullabies, fairy tales, swan songs and soothing country music – you will hear it all.
Under the hood, there will be the usual presidential cycle at play. The playbook hasn’t changed in over five decades – boost the US dollar, subdue bullion prices (to force inflows towards equities), cut oil prices at fuel pumps and trigger a bull market in equities. Look around you – see anything different? Now do yourself a favour – Google search the term “US presidential election cycle in financial markets." Which is why I wrote earlier its in-your-face, you only have to look.
What Happens in 2025? A celestial confluence of different outcomes is highly likely.
First, the prevalent counter-cyclicality phase will be replaced by pro-cyclicality. Then you have the usual mean reversion in asset prices. Pro-cyclicality occurs when financial asset prices move in the same direction as the real economy. The switch from counter-cyclicality to pro-cyclicality is predictable. There is a euphoria and reckless arrogance in markets.
Anxiety build-up
Students of Dick Stoken (yours truly included) start noticing sluggishness in interest rate-sensitive stocks in particular and leveraged stocks in general. Chinks start appearing in high market-wide position limits (MWPL) F&O stocks. MWPL doesn’t just indicate the build-up of financial exposure but also greed, hope, desperation and potential anxiety, if not panic.
A real world trader will tell you that buying stocks at sky-high prices in the leveraged segment is like walking with a lit stick of dynamite in your pockets. In the Indian context, you pay nothing less than 18-20% as rollover costs (financing costs for leveraged trades) and execution costs are extra.
Come 1 October and you have securities transaction tax being hiked sharply. If you think you can pay these exorbitant charges in excess of 25-30% per annum and still earn profits from present levels, good luck! Former Reserve Bank of India governor YV Reddy writes in his book Global Economic Crises and Uneven Recovery: “A good host knows when to take the punch bowl off the table, before his guests get drunk at a party."
What happens to the excess build-up as indicated by the very high MWPL in select stocks? Heard of “crowded exits" and “stampede?" Did you notice which stocks fell the most on 4 June 2024, the day of the Lok Sabha election results? Do the math – these had the maximum build-up of MWPL.
When I hear the words “This time it’s different!" from a perma-bull, I often think of Mr Reddy.
Even through adversity thou shalt keep thy faith and thou shalt rise from the ashes like a phoenix!
Never has this divine wisdom applied better to another asset class as it may to bullion investors from 2025 onwards.
Sagacious central bankers who know their proverbial onions are stepping up gold purchases. They are invariably in the east, led by China, India, South Korea and Turkey. Western central banks continue with their orgy of loose fiscal policies. They should be excused, after all they did not have Reddy as central bank governor.
The World Gold Council said central banks bought over 290 tonnes of gold in the first quarter of calendar 2024–that’s the highest on record.
Cascading effect
The history of the financial markets shows that any spectacular fall in asset prices triggers a cascading effect on all asset prices. This is logical.
When traders are hit with losses on leveraged trades, they usually don’t know what hit them. They tend to sell – everything. After all, they need the money to meet margin calls.
Any dip in gold at these times can give you percentage returns that go beyond the dreams of riches or even avarice. For over 3,500 years, people have depended on gold as a store of value and shelter from economic distress. That hasn’t changed yet.
In the near term, you have the US elections, ahead of which the Fed will try to subdue prices. So it’s a crapshoot (playing an uncertain hand at the craps table). But the long-term horizon is crystal clear.
Would I bet long on gold in 2025 and beyond? Yes – 100% on every single day of the week and twice as much on weekends.
Vijay L. Bhambwani is the author of the first official commodities trading guide in India. He designs statistical and behavioural trading models for his family owned prop trading outfit. He stays at South Mumbai and has been trading in the markets since 1986. He tweets at @vijaybhambwani and has a video blog at www.youtube.com/vijaybhambwani
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