It has been a tough October for stock investors, unless those investors were shorting the market. As I write this, October still isn’t quite over, and we don’t know if Halloween will be a trick or treat.

October has historically been a tough month for U.S. stocks.  Crashes and recessions seem to come to fruition in October more frequently than any other month.

The S&P 500 dropped more than 10% below its record peak set in September, which officially puts it in correction territory.  But a 10% correction in stocks doesn’t necessarily mean that we are in a recession, or even that the bull market is officially over.

I can recall other bubbles such as silver in 2011 or technology stocks in late 1999 and early 2000.  When you look at a graph of these bubbles before they burst, they go parabolic.

That is why I am hesitant to say that stocks have already peaked and are now in the early stages of a bear market.  While it wouldn’t surprise me if this were the case, it also wouldn’t surprise me if we see one more grand move upward.

Things got rocky back in January 2018.  It became a roller coaster, and the higher volatility did not look promising for those holding stocks.  But then things calmed down, and stocks resumed their climb.

I have been watching the yield curve carefully.  On the big down days this week, there is no question that long-term rates went down.  Short-term rates were more mixed.  But overall, the yield curve has only slightly flattened for October.  The 10-year yield is right about where it started the month, and the 3-month yield is about .10% higher than where it started.

While the yield curve has flattened quite a bit over the last year, it is still not yet inverted.  If it inverts, I think there is little question that a recession is imminent.  The only thing is, it might already be apparent by the time it inverts. If stocks keep falling and go down another 10 to 20 percent, then things aren’t looking good for the short-term economy.

To be clear, I think we need a major correction/ recession to clear out all of the malinvestment. It is not something I am wishing for in terms of the short-term pains that go with recessions.  But the damage has already been done, and a recession is the best way to repair that damage and reallocate resources in accordance with consumer demand.  Life is too expensive, particularly for middle class America, and a correction will help alleviate that if the Fed and the federal government do not react too drastically to the inevitable correction.

Bonds are Safe for Now

In a post I wrote on October 10, 2018, I said that the cure for higher yields is higher yields.  When the 10-year goes up too high too fast, stock investors react negatively and we see a sell-off in stocks.  Then when stocks sell off, the 10-year yield tends to fall back.

I said that, “the fact remains that most investors view U.S. government bonds as a safe haven investment.  As long as price inflation is seen as contained, then bonds will continue to be a refuge for those seeking safety.”

That was basically confirmed to me the last couple of weeks since I wrote that.  There is no serious threat of price inflation right now, or at least very few people view it as a threat.  Therefore, when stock markets crash, people look for safety, and U.S. government debt is viewed as safe.  There is a small inflation premium and virtually no premium for risk.  The U.S. government is highly unlikely to default any time in the near future (not counting the hidden default of inflation).

Therefore, whether the bear market just started, or it starts in 6 or 12 months, we should expect investors to flock to long-term government bonds.  Yields will fall, and bond prices will rise.

This is a reason that I recommend the permanent portfolio, and it also illustrates why holding long-term government bonds is an important aspect.  Even though libertarians tend to hate holding bonds, they are there in the portfolio for a purpose.  In a recession and stock market crash, the permanent portfolio, which is made up of just 25% stocks, should fare rather well. The people who are heavy in stocks are going to pay a big price, while permanent portfolio investors may just see a slight decline.

Gold Rises

The one other interesting aspect of the last few weeks is that gold actually rose in terms of U.S. dollars.  It has been a tough market for gold investors.  There is just very little interest in gold by individual investors.  Some foreign central banks still like gold, but it hasn’t been enough to keep the price up.  After gold fell below $1,200 per ounce, it actually had a good couple of weeks in the face of the downturn in stocks.

It is interesting to look at the Dow-to-gold ratio.  There is nothing that says this ratio has to stay in any particular range or return to its long-term average.  But it is still useful in looking at what is possible.

The Dow-to-gold ratio is currently about 20 to one.  It takes about 20 ounces of gold to buy the current price of the Dow Jones Industrial Average.  In early 1980, this ratio actually was briefly close to one to one.  In other words, it took just over one ounce of gold to buy the Dow.  This was a time when stocks were down and gold was in its biggest bubble ever, so I am not saying we should necessarily expect to see this ever again.

However, if we did see a return to a one to one ratio, even if briefly, we would have to see a huge rise in gold, or a huge drop in the Dow, or some combination of the two.

If the Dow lost 50% to about 12,500, then the price of gold would have to rise from its current level just about $1,200 per ounce to $12,500.

Again, I am not predicting this, but just stating what is possible.

In the 2008/ 2009 financial crisis and downturn in stocks, gold went down for a brief period of time with stocks.  Gold does not tend to do well in recessions, unless there is a threat of high price inflation as was seen in the 1970s.

I have no idea what will happen to gold in the next recession.  But in the last couple of weeks, gold went up in the face of crashing stocks.

Again, this lack of correlation just shows the strength of the permanent portfolio, particularly in tough economic times.  It has been a boring and rather lackluster portfolio for the last several years, but you will be glad to have it when things get tough.