Stock Market Decline Ahead…Should You Buy Gold?

The US stock market fell sharply this week, down 4.6% as represented by the S&P500 index. The market is now down nearly 10% from its all-time high set in late-September.

We can see below that as stocks have sold off, gold has not only held its value, but has provided a 3.3% return. Gold has, over the past 10 weeks, served as a safe store of value, its time-honored traditional role:

What is next for both the stock market and gold? Is now the time to buy gold for protection against a stock market crash?

Let us evaluate the structure of both these markets and discuss protection strategies.

Stocks to Continue Falling

First, how much further could the stock market fall? While no one can predict the future, our model shows that there is the risk of approximately an 11% further decline in US stocks over the next several months. This would bring the total decline to near 21% from the peak.

Below we show the US S&P 500 since the crash lows of the year 2009. Note the well-defined upward channel of the bull market that has been ongoing for nearly 10 years, shown in the magenta color. This has been a broad and methodical advance in US equities.

However, note how US stocks began a disorderly parabolic rise in 2018, shown by the red callout. Such an acceleration after a long-term orderly advance is a tell-tale sign of a market which is taking on bubble-like characteristics, as investors chase prices ever higher at faster and faster rates, succumbing to what is known as “fear of missing out” on the previous advance.

Parabolic rises tend to be unstable in nature, and sure enough we can see that the market was unable to hold up after stocks attempted to break higher from the long-term linear channel (red callout).

Having failed to break out, our next target for stocks to find buying support is at the lower channel boundary. Note how this lower trend has seen buyers emerge every several years, from 2009 through 2011 and again in 2016. Our expectation is that – having failed to maintain a parabolic breakout – stocks should find support again at this lower channel. Such would come in at 2350 on the S&P 500, or about 11% lower from this week’s close of 2633.

Will Gold Provide Protection?

Will gold continue to do what it has done in recent months, and at least maintain its value, if not rise further as stocks fall? It is likely: we observe no evidence that the inverse correlation that is visible on the first chart will cease anytime soon.

The idea here is that gold is an insurance policy against wealth destruction in other asset classes. Clearly, everyone should own at least some insurance, the exact amount of which will depend on a host of factors including time horizon, level of wealth, and risk tolerance.

Even so, when we discuss insurance, we must also talk about the premium one must pay. With gold, we can call its premium the price in US dollars. As with anything, the more demand there is for wealth insurance, the higher the price. And the fact that we have seen gold rise 7% from its August low of $1,167 to $1,252 as of this writing means that others have already been bidding this insurance policy higher.

The adage to “buy house insurance before smoke is visible” applies here. With the US market, smoke is already visible, especially with the strong decline this week.

So should investors still diversify somewhat into gold?

Yes: some gold will be better than no gold over the months ahead.

Structure of the Gold Market

However, investors should be careful about allocating too much to gold quite yet. When we switch over to analyze the trend in prices for this wealth insurance, we can see that the recent rise since August appears to be a counter-trend rally to the support breakdown which was observed in July (red callout):

Having observed this support violation last summer, we expect that as gold approaches the former trend, sellers will emerge, and the price may fall below $1,167 again into 2019.

What is the fundamental backdrop which would explain this scenario? It appears that gold, which is still over $100 below its 2017 high, is not pricing in a full-blown collapse in the stock market, but rather only a cyclical decline. This fits in well with the model of the S&P 500 finding support over the coming months above 2350.

Takeaway on Stocks and Gold

Again, we encourage investors to have some protection in the form of gold. We must always attempt to identify our own blind spots, and on the chance that the present decline in stocks does materialize into a full-blown crash, gold will offer a level of safety. However, the message of the past three years in gold prices indicates that lower prices should arrive again by 2019, and so investors seeking protection should either stay nimble or allocate only a reasonable portion of their assets to gold at this juncture.

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