Stocks at record highs look vulnerable, Goldman warns in urging gold, cash

Fueled by last weeks successful U.S. jobs report, stocks have roared ahead this week, led by the S&P 500 and the Dow Jones Industrial Average, both of which hit brand-new record highs. Given the surge in risk-on assets, the pullback in gold prices was no surprise.

Still, the metal continues to show resiliency, trading well above the $1,300 level. Not too long ago, gold prices would have withered on prospects of higher stock prices, but not this time around; investors are thinking that the spate of monetary easing is likely to persist for some time to come, keeping both gold and equities fairly well supported, INTL FCStone analysts noted.

Key earnings season under way

Now that stocks have broken through to new highs, the questions investors must ask themselves include: Are the gains justified by the underlying economic fundamentals? And where do stocks go from here?

As the INTL FCStone analysts observed, low and negative interest rates continue to prop up the equities markets. But what about corporate earnings? Second-quarter results are only starting to be revealed, but for about the past year, U.S. corporations have been mired in an earnings recession. Although Alcoa just reported strong results, profits from S&P 500 companies are expected to drop by 5% for this quarter.

The depth and breadth of the current earnings slump is quite rare outside of an economic recession, said Russell Investments strategist Paul Eitelman. Indeed, the flattening of the yield curve continues to suggest conditions indicative of a slowing economy, if not a recession, according to experts such as Bill Gross of Janus.

A simple look at a chart of S&P 500 earnings versus the indexs overall performance shows a clear disconnect. Its pretty easy to conclude that either earnings dont matter anymore or stocks are in a bubble, observed Financial Sense analysts.

P/E ratios are ballooning

Even so-called safe and defensive stocks (such as utilities and others big dividend payers) are starting to look frothy, concluded JPMorgan analysts. This style is now up 74% relative to the market since the beginning of this cycle in 09, pushing its valuation to reach a new record high, said strategist Dubravko Lakos-Bujas. Additionally, low volatility has become even more correlated to momentum, a vulnerable trade that has become increasingly crowded. This suggests low volatility may be in a bubble and subject to negative tail risk.

And price-to-earnings ratios for the overall S&P are suggesting bubble territory. The P/E ratios on both trailing and forward basis, at 18.2 times and 16.9 times earnings respectively, are well above five- and 10-year averages, MarketWatch reported, citing data from FactSet. Meanwhile, Nobel-winning economist Robert Shillers cyclically adjusted metric, called CAPE, is at its highest level since 2007.

In contrast, although gold has returned about 25% this year, its still well below the nominal high above $1,900 set in 2011. And at around $20.25, silver, which has outperformed the yellow metal this year, also is significantly below its record price of about $50. Therefore, the precious metals arguably have significant upside even if they undergo near-term corrections or consolidations.

U.S. bonds continue to attract investors because they offer positive yield, however low, in a world increasingly set by negative-yielding sovereign bonds. Gold remains an attractive alternative. Theres an 80% chance of making 10% in gold; the probability of a 10% gain on Treasuries is 20% at best", noted DoubleLine Capitals Jeff Gundlach.

Goldman sees stock, bond selloffs

Because it sees the stock and bond markets as overly inflated and ripe for corrections, analysts from Wall Streets high-profile gold-bearish firm, Goldman Sachs, continue to surprise investors with their bullish forecasts for the metal.

The Brexit fallout has driven yield-chasing investors into U.S. assets such as stock and bonds and that joint rally has raised concerns about its viability, given that risk-on and risk-off assets shouldnt be moving in the same direction at once.

Therefore, Goldman analysts see the potential for blowback.

Markets have become very dovish relative to what central banks might deliver and against the current macro backdrop, they wrote. Bonds could sell off sharply as a result of central bank disappointment, positive inflation and data surprises and/or illiquidity, which would likely drive weakness in equities and other risky assets, at least initially.

Meanwhile, equities could sell off owing to negative growth surprises and with yields at all-time lows, bonds are unlikely to be good hedges. This leads to a lack of diversification and higher portfolio risk at a time when return potential is already limited.

Firm assumes defensive stance

As a result of these risks, Goldman is recommending traditional safety plays in not only gold but also cash. We remain defensive in our asset allocation and believe the positioning-driven recovery of risky assets, in particular for equities, post-Brexit is likely to fade, its analysts wrote.

Other analysts agree, noting that the roughly $12 trillion flood of negative-yielding bonds are upending market fundamentals by building up investment bubbles.

Ultimately, there will be a day of reckoning, MFS Investment Management chief economist Erik Weisman warned. When that will be remains very much to be seen.

Weisman said. Theres no doubt that there are and will continue to be unintended consequences, and the further we move away from something conventional into unconventional, the ratio of unintended consequences to intended consequences will rise.

In the end, the record levels reached this week in the major stock indexes can be attributed to unprecedented and ongoing central-bank easing and accommodation. What goes up eventually must fall down, and precious metals are there as the ultimate safety net for investors.

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