Befriend the trend...

"There is nothing new under the sun”, said the wise man. It’s true; history repeats itself. Often people shape their expectations of future returns from the recent past. Currently the stock markets have got all the attention of investors as they are surging. This behaviour is described as trend following.

However most investors fail to view history in totality and instead focus only on the recent past, chasing recent good performances. Such trend investors consciously or subconsciously seem to believe in a saying- “The trend is your friend”. However, in the real world, this adage seems to be only the half truth. The phrase needs to be modified to “The trend is your friend, until the end when it bends.”

Sometimes the underlying structure of the world changes rapidly with disastrous consequences for trend-following investors. Especially markets plagued with intervention, like liquidity infused by central banks, are not supported by a fundamental foundation. When the artificial support goes off, it all comes down like a house of cards. . When you dig deeper into the underlying factors, it will be apparent that it’s a bubble waiting to burst.

Central banks seemingly changed the underlying structure of the world 2010-11 onwards with the magical wand that opened the taps of liquidity. The aghast / risk averse state of markets suddenly changed to a fearless, aggressive, risk loving state. There were a series of monetary infusions by central banks across the globe, and in addition interest rates in many countries spiraled down close to zero levels and this reignited the appetite for risk.

Table: Liquidity measure by major central banks since 2010

If you notice, there were a series of quantitative measures aka money printing programs intiated by major central banks around 2011-12. The liquidty propelled a move towards risk and a search for yield. And this is exactly the time when gold topped and started correcting as a result of movement of money towards risk assets.

The comparison of asset markets and unprecendented advances seen in Fed balance sheet provides a strong evidence of the great rotation marking a move towards risk assets (represented by U.S equities).

Chart: Equities, Gold and the Fed balance sheet

Source: Bloomberg

Past Performance may or may not be sustained in the future

A closer look from 2012 onwards shows the lockstep movement in Fed balance sheet expansion and the surge in equity markets.

Source: Bloomberg

Past Performance may or may not be sustained in the future

Going forward:

Equities are likely to get corrected soon as they are getting increasingly expensive by the day. Asset markets which have risen on the back of liquidity infused by central banks will feel the impact of lower money on the table as the U.S. QE finally tapers and finishes likely by October, 2014. The markets have been reactive of geo political developments across the globe. Any flaring of these issues or any surprises from the upcoming U.S. by-elections in early November this year could potentially serve as the tipping points for any ensuing correction. Weaker prices in equity markets could trigger some renewed investor buying in gold.

Investors should avoid chasing markets just by looking at recent performance of a particular asset that is not backed by strong fundamentals and are rising just on the back of sentiment. Markets driven by artificial liquidity are nothing but frothy markets which will sooner or later turn to nasty corrections.

It will be advisable to remember the full quote “The trend is your friend, until the end when it bends.”

Data Source: Bloomberg, World Gold Council

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Above article is authored by Quantum.

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