Is Gold’s Bullish Turn Sustainable?

Gold has been outperforming both stocks and long-dated Treasuries in recent weeks. Below are four possible scenarios for the yellow metal looking out several weeks:

1. A short-lived rally induced by Syria
2. An inflation-fueled and sustainable push higher
3. A rally shot down by increasing fears of deflation
4. A sharp no place else to hide rally

War - What Is It Good For?

One scenario that could disappoint the gold bug community is a flash in the pan rally just prior to U.S. military action in Syria. Under this scenario, gold could spike just before the U.S. begins to attack. The spike could be quickly followed by an intraday reversal as traders lock-in gains. From CNBC/Reuters:

Gold climbed 1.4 percent on Tuesday after President Barack Obama won the backing of two top Republicans in Congress in his call for limited U.S. strikes on Syria to punish President Bashar al-Assad for suspected use of chemical weapons against civilians.

Inflation – A Bug’s Best Friend

Gold bugs could pick up a significant tailwind if the billions of dollars injected into the economy via the Fed’s quantitative easing programs eventually lead to inflation. The chart below shows the performance of gold (GLD) relative to Treasuries (TLT). When the ratio is rising, inflation fears are greater than fears of deflation. Since late June, investors have preferred GLD over TLT.

Deflation: Drag On Stocks and Gold

The best case rally scenario for gold probably involves a combination of sustainable economic expansion coupled with rising inflation. Under those conditions, at least in the short-run, stocks would most likely benefit as well. Rising inflation expectations, especially when inflation is low, tend to support stocks and commodities. Conversely, rising expectations of slower economic growth tend to fuel fears of deflation. Deflationary scenarios are typically unfavorable for stocks and commodities. This week’s video paints a picture that currently is more supportive of the risk-off or deflationary case, which may be driven by fears of Fed tapering.

No Place Left To Hide

All investing involves opportunity costs. If the markets experience an interest rate related 1994-like event as the Fed tries to back away from unprecedented stimulus, stocks and bonds could fall simultaneously. Under those conditions, gold could be the “nowhere else to go” beneficiary as money looks for a safe haven. We noted earlier that gold has been outperforming Treasuries in recent weeks. The same can be said for stocks (see below). Notice how the demand for gold has caused a bullish “moving average crossover” (blue > red) for the first time in 2013. If the chart below has a similar look late this week, gold may have earned a spot on our ETF roster.

Investment Implications

Which scenario above is most likely to play out? It will be difficult to rule out the “flash in the pan” scenario until the U.S. comes to a decision and/or takes action in Syria. Throwing military action aside as a potentially shorter-term driver of gold, the markets are currently favoring the “no place left to hide” scenario, but not in a convincing manner. Having strong convictions when the charts show a lack of conviction can put a dent in your brokerage balance.

Our market model has called for five incremental reductions in our allocation to stocks in recent weeks. The model has both inverse stock ETFs (SH) and gold (GLD) on its radar; although neither has passed all the “you can buy it” tests yet. Therefore, until some clarity arrives, the conservative side of our allocation will be made up of cash. If gold is still trending relative to stocks and bonds near the end of the week, the odds are good we will take a position based on our allocation rules. As shown below, the S&P 500 still faces overhead resistance in the form of the pink triangle.