Superman’s Wardrobe Malfunction. And Gold.

It’s a bird —

It’s a plane —

It’s Superman!

No. Rather, it’s just a flashy red "CAPE."

Although this CAPE doesn’t belong to the Man of Steel. Nor Donald Trump.

Yet it could still save the day … if you heed its warning.

I’m going to go out on a limb here and say many investors have been surprised by the "Trump rally."

To a degree, I have been too.

Mostly because I think what’s at the core of the market’s rationales — Trump’s infrastructure spending plan — is too unpredictable.

Whether there are major beneficiaries, and just how big they can benefit, remains to be seen. (Consider a recent headline that suggests U.S. Steel (X) is going to hire 10,000 workers. The company has a slightly different take.)

As for investors like you and me, it seems like the market is setting itself up for disappointment … in the near term at least.

Last week, in reading the market’s tea leaves, I said this about the S&P 500:

A price pattern from decades ago makes me want to bet that the S&P 500 will continue to replicate that pattern by falling sharply between now and the end of Q1 2017.

I have been watching for that outcome during the second half of this year, but so far it has not come to pass. Ultimately, it looks as though the S&P could gain as much as 17% from current levels in the next 12+ months.

So I am not surprised that the market can head higher under new expectations for the Donald Trump economy.

But I am a little concerned in the nearer term, considering how the recent price action smells of capitulation.

Capitulation is a sign of a positioning extreme.

In this case, investors are capitulating to buying pressure.

And there is a long-run gauge that smells of capitulation, too.

It’s called the CAPE. And some commentators point out that it’s currently flashing red …

This Red CAPE Won’t Protect You

You’ll have to protect yourself.

CAPE is the Cyclically-Adjusted Price-to-Earnings ratio covering the last 10 years.

It’s often used as a contrarian indicator. But sometimes too often.

What traders and investors tend to do is be too early. When investors are too early to get out, they see prices continue to go in a way that favors the position they abandoned.

This generates a feeling of missing out. And the feeling of missing out is what eventually leads to capitulation.

So, investors — who have for years seen CAPE, being well-above average, as a rationale for getting out — probably feel like they are missing out on the continued bull market in stocks.

That’s why I think the Trump rally might simply amount to capitulation.

Now, however, CAPE is at an extreme. It currently registers 27.9.

Over the last 150 years, instances where CAPE exceeded 27.6 proved the stock market to be a very bad investment.

For good measure, consider another measure of corporate valuations (above chart) as well as household financial asset leverage (below chart):

If you’re not seeing it, these are two more extremes that suggest we’re currently facing the heightened risk of a market downturn.

What’s a Damsel in Distress to Do?

Call your knight wearing the shining armor … or the red cape.

Then buy gold.

But why?

Well, presumably for the safe-haven appeal that would arise if the stock market does indeed roll over. That might be the initial catalyst — or a sustaining catalyst — for a rise in the price of gold.

But there might be more, considering that risk aversion in asset prices would very much beep on the Federal Reserve’s radar …

This week gives us the next Federal Open Market Committee meeting, where the Fed is expected to announce an interest-rate hike.

What the Fed will need to do — besides pray that GDP growth can stabilize — is see that interest rates don’t outpace the rate of inflation.

Right now, the Fed has room to hike because inflation is rising. And they have a desire to hike because they’d like to avoid market dislocation.

But how long will inflation keep rising … and how sensitive is the world (indebtedness and market speculation) to rising interest rates at the lender of last resort?

If higher yields are attracting investors to dollar-based assets … and supporting the U.S. dollar exchange rate … then capital flows could hurt foreign economies that are investment-intensive and exposed to U.S. dollar loans.

Of course, everyone knows the story about how gold cannot compete in an environment where fixed income is offering respectable yields.

Well, the story has another piece to it.

Those "respectable yields" depend on the rate of inflation.

  If inflation is rising faster than yields, then real yields are negative (or moving that way) and tend to support gold’s investment appeal.

  If yields are rising faster than inflation, then real yields are positive and tend to tarnish gold’s investment appeal.

So, interestingly, now that the expectations for a Fed rate hike have weighed down the yellow metal, new optimism about U.S. economic growth may generate increased inflation expectations and, thus, inflation.

And this type of inflation, when the Federal Reserve is playing catch-up, is the kind that can support the price of gold … especially when investors least expect it.

With gold at existing levels, I say "Bring on the rate hike!"

The Fed just might inject enough confidence to bolster inflation expectations and create a "new old" narrative for gold prices.

And if the rate hike hits risk appetite, gold is a likely refuge.

Get ready.

Do right,
JR Crooks

“JR” specializes in trading commodities, currencies and options. He has spent nearly 10 years analyzing financial markets and writing about global economics. JR honed his trading techniques and global-macro worldview alongside his father, Jack Crooks, at Black Swan Capital. JR also…