SLV has had a nice run since breaking north of $30 in the middle of February. That is not news but a checkable fact. For those investors who noticed that SLV was at the top of their rankings since July 12th of last year (when SLV closed at $17.62), it was a good opportunity to make money in a relatively non-correlated asset class. The only time it got sticky was at the beginning of this year when the price corrected.

The reason that we bring this up is not to brag. While SLV has done well, other investments that have made it into the top rankings have fared less well. The point is that most of those investments were eventually replaced by new market movers while SLV has hung in at the top of the lists despite the 10% correction that we saw in January. While we may have worried in these posts that the rerating between Gold and Silver may have run most of its course, the System kept pointing out that there was strong momentum behind the asset and that there were not that many more promising assets out there at the weekly measurement points.

My only slight regret…not swapping GLD for SLV a few weeks back when I was adjusting my Seeking Alpha ETF Portfolio. I would have looked very clever. But, in calmer moments, I realize that the regret and the emotion behind that regret is precisely why one should use an unemotional system to help execute one’s investment plan.

So, should you buy SLV now? Well, that all depends. Does it make sense as part of your universe? And, if it does, ask why? Make sure that you are not adding at this point because of past performance. Make sure that it is in there because you think other investors are worried about the US dollar or you think there is a chance that the Biomedical uses of silver are poised to go through the roof. In short, remember to separate the Asset Selection process from the Asset Trading process. And what happens when something better comes along in your universe? That’s easy, switch.

A Tarnished Example

Now that PIMCO has finally gotten it through to folks that, yes, they really are not keen on US Government paper (no link…too many choices), let’s look at how two bellwethers fared in the Fund King System.

TLT (which tracks 20 year plus US Treasuries) has been at or near the bottom of the US Sector ETF Universe since the beginning of November 2010. And less long term TLH (tracking 10-20 year Treasuries) has joined the bottom of the pile in another ETF portfolio since the end of November.

So, whether you were in the “Don’t Fight the Fed” or “Hyperinflation Around the Corner” camp, the Fund King System told you to steer clear of the asset class for the last three months. Even the FED could not buy up enough long dated Treasuries to keep TLT from dropping 10% over the period. Mr. Gross, the head of PIMCO noted in his newsletter that the FED has been buying as much as 70% of the newly issued Treasuries of late.

What does it mean?

There is nothing wrong with SLV , TLT or TLH in absolute terms. Each of these ETFs represents claims on perfectly good assets. The deep meaning to take away from these two examples is that it does not pay to fight the trends. If investors (on balance) are shifting money out of US Treasuries and into hard assets like Silver, there is little point in trying to stand in the way. At some point, the tides of money will change directions and other asset classes will get swept up or down. When interest rates rise a couple hundred basis points, Bill Gross and his PIMCO colleagues will be back on the bid side. Why? Because they are in the business to make money; and money is made by buying low and selling high.

An interesting read

Supporters of Ron Paul can sometimes be a prickly bunch. But, they occasionally come up with very thought provoking concepts.

I like a good bash so when I came across an article entitled: “How to End the Federal Reserve System” by Gary North, I was prepared for a rehash of the old arguments about an evil cabal on Jekyll Island in 1910. But the real strength of the article comes about halfway through when Mr. North analyzes the demise of a government agency which had also been granted monopoly powers: the US Postal Service. He draws some interesting parallels about what technology could do to the Federal Reserve System long before Ron Paul and his supporters in Congress are able to rescind the Fed’s legal mandate.

Basically, the ability to move into other currencies with a few well place computer key strokes or even to develop new mediums of exchange means that even an institution as powerful and influential as the Federal Reserve is not immune from obsolescence.

Part of the appeal of ETFs like GLD and SLV is that they are theoretically redeemable into a fixed amount of Gold and Silver respectively. While pitched as a new idea, the concept of convertibility into precious metals was once the cornerstone of the US dollar’s value (and most other currencies before that). In an interconnected world that can work with services like PayPal, it’s probably only a matter of time before someone reinvents a multinational global fractional banking and payment system backed by gold, silver or some other store of value. If it is tied into Visa, Mastercard and American Express, one need not worry about carrying about sacks of heavy metal to the grocery store. Just as email eclipsed the first class letter (something that was unthinkable as recently as 20 years ago), there is a risk of a new currency system taking the premier spot occupied by the US dollar today.

Just because the risk exists, however, does not mean it will come to pass. The biggest difference between the US Post Office and the Federal Reserve is that the latter is a privately owned, profit seeking entity. Long before we are all paid in PayPal credits or Googles, the Federal Reserve (which is owned by and represents the largest US banks) will feel compelled to take steps to shore up the value of the US dollar. That more than anything else will lead to a change in policy that will likely see higher interest rates in the not too distant future.

While you are pondering your long term investment strategy, make sure to include a plan for higher interest rates.

What happens to Japan now?

The earthquake and tsunami that hit Japan on Friday will impact the country and the economy in ways that are hard to foresee at the moment. Despite the shocking video and photos, however, the natural disasters are unlikely to have a significant long term impact on the economy. As long as the authorities can keep the nuclear fallout to a minimum, the biggest issue will be reconstruction and who will buy the fresh batch of JGBs. That points to another force for higher than near zero interest rates in the world’s #3 economy.

From an investors’ point of view, the Nikkei 225 was the best of a weak bunch (Asia has lagged since November of last year) in our universe of 11 Asian indices as of Friday’s rankings. The earthquake and tsunami do not significantly change the long term public finance fundamentals of the country and most of the familiar exporting names have transferred significant portions of their manufacturing base to locations around the world in the last few decades.

Should you buy? If your universe is only Asian Equities: then perhaps. But, if you are looking at a broader range of asset classes, there are quite a few commodity based ones that look more attractive. As Japan is import dependent for almost all of its commodity needs, there are better places to invest your money.

When the Energy ETF (XLE) worked its way into the top 3 of the US Sector ETF portfolio in the first week of December, the protests in Tunisia were still almost two weeks away (Mohamed Bouazizi set fire to himself on December 17th).

XLE cracked into the top 5 on November 15th so depending on whether you were buying the top 5 or top 3 of this 20 ETF portfolio, you would have made 25% (top 5 methodology) or 18.5% (top 3 methodology).

At the time, the prospect of higher energy prices appeared to be driven by inflationary pressures, a potentially weaker dollar, seasonal demand for heating fuel in and the usual arguments surrounding Peak Oil.

This was not an isolated incident. In the Fidelity Equity Portfolio, the Energy (FSENX) and Natural Resources (FNARX) funds both jumped into the Top 3 on the December 7th reading, Vanguard’s VGENX the following week, and the S&P Global Energy Index (IXC) popped into the top 3 of the Seeking Alpha Portfolio in the first week of January. The Russian ETF (RSX) which is heavily weighted with Oil and Gas producers has been lurking near the top of its respective portfolios for a while now.

The reason we mention this is not to tout the Fund King System as some sort of crystal ball that was somehow able to read the fate of North African and Middle East dictatorships and monarchies in the late November/early December price action. What we would like to point out is that the seeds for higher energy prices were already planted in the market place when the proverbial “Arab Street” decided to actually pitch tents out on the street. Therefore, even though the rebels in Benghazi are determined to keep the oil flowing and Saudi Arabia has pledged to boost production to make up for any shortfalls in Libyan deliveries, a quick resolution to the protests and revolutions may not solve the underlying market dynamics.

Watch the trends

Therefore, the time to take your trade off may not be the one or two day dip in oil once the Mainstream Media loses interest in the story. The price of energy may be closely related to the inflationary pressure we are also seeing in the agricultural space (DBA, for example). If that is the case, the stronger consumer confidence numbers combined with a massive arsenal of reserves ready to be written into sizzling fast credit expansion may be what is driving investor assets into the energy sector.

What about Gold and Silver?

Silver has had a burst of activity in the last two weeks. SLV closed just over $30 at the end of 2010 and then languished below the $30 line for most of January and the first half of February. Gold, by comparison, has risen much more modestly. Part of the reason is a rerating of the Gold/Silver parity level. In a previous post, we worked through that relationship a bit. But the other factor is that Silver is much more of an industrial metal than Gold. The relative strength of Silver could be a confirming indicator on the more positive numbers coming out of the US.

What else looks good?

To round out the list, US small caps (IWC, VB), mid-caps (IWM,MDY) and Technology (PRGTX), are ranking highly across the portfolios that we watch. The shift from emerging markets to developed markets followed the usual seasonal patterns (ie. January Effect) but there may be more behind the shift in market sentiment. If the gap between developed and emerging markets (particularly Asia) continues to grow in the coming month or two, we will want to watch for a shift back towards Emerging Markets in the mid to late Spring.

What does this mean for investors?

While there are plenty of dark clouds on the horizon and no doubt a number of hot issues that could flare up to spook investors, the market seems to be pointing to stronger economic performance in the coming few quarters. There is nothing wrong with stashing a few gold bars into the safe deposit box but looking at the current readings across the portfolios, one should be looking to maintain and add to selective risk positions.

Seeking Alpha Portfolio

This week the portfolio fell 0.94% with EWT the biggest drag on performance. Over the last 15 weeks, we are still looking at a loss of 1.17% (which does include all commissions and other fees).

There were no changes in the ranking this week so there will be no trading on this Monday.

The only thing I am a bit concerned about is the weakness of Taiwan. After breaching the 9,000 mark on the TWSE Index (^TWII on Yahoo Finance) the market has been very soggy. Although first quarter is traditionally a slow period, the system was indicating that this year would be different and a number of sources appeared to confirm that US Corporates were looking to increase their IT budgets significantly this year.

We will continue to watch this closely as it could impact the Technology investments that are ranked highly in several other portfolios.

Disclosure: I own shares in several of the investments discussed in this post (FSENX, FNARX, IXC, DBA and SLV) which I hold by employing the Fund King System across two portfolio universes.

As long time readers will know, I have a particular fondness for Silver. I was fortunate enough to buy a small stack of one ounce silver bars as a kid just before the Hunt brothers tried to corner the market. The story even has a happy ending as I managed to sell most of my stash very near the top at $42-45 an ounce (my average price was around $12).

So, it did not take too much encouragement from the feverish doomsayers to get me to dabble in Silver once again last year. Rather than loading up on coins or bars, I decided to participate in the shiny metal this time by buying the SLV ETF.

For those of you who do not spend too much time on the internet researching investment ideas, SLV has been at the center of an email, newsletter and pundit campaign which sees dark forces (JP Morgan was assumed to have been over-exposed on the short side of the futures market) surrounding the market for silver. I remember reading several reports from otherwise credible websites that cast doubt on whether there was actually much silver backing the ETF.

So how did it work out and why?

Obviously, Silver went up alot last year. SLV closed 2009 at $16.54 and finished 2010 at $30.18. I did not pick up until about halfway through the rally (I was using the discipline of the System) but that still left me with a smile on my face. If you check out SLV on the Steam Gauge, it is still ranking pretty highly. The question one should ask is why?

Relationship with Gold

Both Gold and Silver have served as money and store of value for thousands of years. Their value as precious metals for jewelry goes back even further. And, often Silver is found as a bi-product of Gold mining (as well as copper, lead and zinc mining). However, there are also important differences. The first is that gold is nearly indestructible despite its industrial applications. Almost all of the gold ever mined in human history can still be accounted for. Silver, while much of it is recycled over the centuries, has many industrial uses that cause it to be used up.

For investors the question is: what is the “fair” or “proper” relationship between Gold and Silver? While most of the research that I have read argues persuasively for a 30:1 price relationship, the fact is that over the last 100 years, the ratio has fluctuated between 100:1 and 15:1. Whatever the proper relationship, there is no question that most of the performance last year came from a rerating of Silver vs. Gold. In the chart below, we have charted the price of GLD divided by SLV over the last two years. Remember that GLD is meant to represent 1/10th of an ounce of Gold vs. a full ounce of Silver for SLV.

Will it continue?

There is probably a bit more left in Silver because it has two drivers. The stronger driver is the relationship to Gold (which will rise in conjunction with general investor anxiety and fall if confidence in economies and currencies returns). If Gold goes up, Silver will follow. Silver may close the “valuation gap” a bit more this year but most of the revaluation is history now. The lesser but still significant driver is Silver’s role as an important industrial metal. Like Aluminum, Copper and Zinc (which one can gain exposure to through DBB), it may rise in line with general inflationary pressures.

As we pan across our portfolios, we notice a definite lowering of the numbers that the System is throwing out in the rankings. The last time this happened was in April/May of 2010 and it definitely foreshadowed a weak stretch for assets at the higher range of the risk spectrum. The numbers remained flat through the summer and started to recover in September of 2010, which coincided with a strengthening of sentiment that carried through until recently.

But what about all the reports of bullishness?

There have been a number of recent articles in all the right papers which have pointed to a general bullish sentiment in the market. These reports are couched in caveats but generally reveal that asset allocators are overweighting equities and bonds and underweighting cash. But the market is not all one way; there are still magazines to sell and as we approach the second anniversary of this strange bull market, we get think pieces like this in Barron’s. Unfortunately, the thinking is not terribly original or prescient.

The problem with these approaches is that they either measure what people say (asset allocation intentions, bullish/bearish sentiment polls) or the way they think things should be (articles bemoaning the historically high CAPE, the Cyclically Adjusted Price Earnings ratio or why Gold should be trading at $5,000). They are not measuring what people are actually doing with their money.

Let’s think about how this works. If one owns equities (or property, or bonds, or gold bars), one is by definition bullish. But this is a lagging indicator because the actions surrounding the bullishness have been taken in the past and are unlikely to contribute to further upward price action in the short and medium term (unless the market has been cornered). So, after a run up, which by definition must mean a bunch of new investors have been bidding up prices and filling their portfolios with the asset-du-jour, one would hardly expect those avid collectors to “talk down” the price of their newly acquired assets. The trend can continue only with new money being attracted to the asset in question. That money can come from other asset classes, from the real economy via savings or, in the case of QE1 and QE2, from credits which materialize from FED activity on bank balance sheets. Once the new buying abates, the market pauses and often corrects.

While we make no claims that the Fund King System has any “crystal ball” properties, one of the things it will measure is the momentum of money as it flows into and between the various financial asset classes.

In this week’s survey, the assets still attracting investor favor are Energy, the US, Small Caps and Agriculture. Silver appears to have topped out after rushing to catch up to a more traditional valuation against Gold. It still ranks highly in some of the longer term portfolios but it has been dropping down with Gold on the shorter focused portfolios.

Our advice? It is time to watch the numbers a bit more closely than usual. We could be at the start of a larger correction in risk assets or it could just be a pause to see how some of the latest events turn out. The big issues are, in order of importance from an investment point of view, the level and sustainability of growth in the US, the risk of a slowdown in China induced by inflation fears and an ugly resolution to the Egyptian unrest which would upset the balance of power, peace and trade arrangements in the Middle East.

Inflation Sneaking In?

While trolling through the 24 hour news channels, one thing to watch out for is the quiet risk of inflation. The fact that the best looking assets are in the energy, agricultural and materials sectors leads one to conclude that there is more inflation running through the system than government statistics might suggest. There is no way to properly quantify how much inflation because the two most common measurements (Government Statistic and Personal Observation) are both flawed. The former is flawed because Governments collect and report the data which they use as a yardstick of successful governance. There is no question that the BLS has changed the rules over the past few decades to make the data as flattering as possible. The latter is flawed because our personal viewpoint is too narrow and we tend to focus on the things that are causing us the most anxiety. We tend to overlook those prices which are going down (unless it is our salary or house).

But how can we have inflation if growth is only in the 3-4% zone? Most of us have been schooled on the idea that inflation can only come about when the economy gets overheated (too much money chasing too few goods). When the economy is well below potential, there is little risk of inflation creeping in, right? That is the crux of the FED’s stimulative policy argument. But there is more than one way to create a bit of inflation. If we look at Zimbabwe, for example, its bout of hyperinflation did not come about from extremely robust economic growth. It came from printing up too many pieces of paper (too much money chasing too few goods).

One might be tempted to take comfort in the relatively low yields on long dated US Treasuries. But then again, one needs to look carefully at who is buying the paper. The FED is hardly going to demand an inflation premium on the US Treasuries it is buying with newly created money it created when one of its two mandates is to maintain price stability. I am not accusing anyone of “window dressing” but there is little incentive for the FED to haggle for the best price while it fills its shopping cart with long dated Treasuries.

Shadowstats has an interesting take on inflation by taking the 1990 methodology and contrasting that with the current BLS methodology. There is no doubt that some spending patterns have changed since 1990 but it is interesting that the adjustments to the methodology have served to consistently show the US inflation picture in a flattering light.

After 30 years of a mummified political existence, the Egyptian political scene exploded into protests and unrest last week, threatening to destabilize the Arab world’s largest country.

Although the Egyptian financial markets barely register from a global perspective, the unrest reminded investors that the world remains a risky place. The US dollar rose, gold perked up and oil, which is not a big Egyptian export, was back on the rise.

If you read Stratfor.com’s excellent coverage of the crisis, you will note that the most likely outcome for this crisis is a fresh face from the military who will rapidly move to:

1. close down the Muslim Brotherhood,
2. shore up the US alliance, and
3. quietly assure Israel that the 1977 Peace Deal is still in effect.

But the fireworks along the Northern bit of Africa are not the only worry in the world.

US Growth

In a detailed letter this week, John Mauldin takes apart the latest US GDP numbers and finds that there were more statistics than recovery in the numbers. It makes for interesting reading, especially when one considers how the inventory numbers change because of the change in oil prices over the quarter. The issue of US growth is tremendously important because much of the world’s monetary policy (in particular, the fast growing developing markets like China) are tied to the FED through fixed or nearly fixed exchange rates. Weak growth means that the FED will continue to err on the side of accommodation, which means that US interest rates will remain low until the bond market rebels and/or inflation becomes too obvious to hide.

The US economy is starting to pick up but at a growth rate well below that of previous post recession recoveries.

Inflation

Related to the sluggish US growth rates and resultant accommodative monetary policy, it looks like we will see commodities surge ahead once again. In this week’s rankings, Silver (SLV) and Food (DBA) score highly with Base Metals (DBB) and Oil (OIL) putting in lower but respectable scores. Commodity Related ETFs like Russia (RSX), Global Energy (IXC), and Fidelity Funds like Select Energy (FSENX) and Natural Resources (FNARX) are also near the top of our various portfolio lists.

The strength is due to the solid demand for these commodities which is driven in no small part by the massive supply of dollars floating around the globe. The desire to turn the seemingly unlimited supply of dollars into more supply restrained commodities looks set to remain a theme for the foreseeable future. Higher prices will eventually entice more suppliers onto the market but the lag should be prolonged enough to make some money from the next leg of the commodities rally.

Sovereign Debt Crisis: Japan

Another story that should have caused more concern than it did was the downgrade of Japan’s long term debt by S&P. The rating drop from AA to AA- doesn’t seem momentous compared with some of the sovereign crises we have experienced over the past couple of years. However, two things bear watching. The first is that ratings agencies historically have been behind the curve in downgrading sovereign debt. If S&P is downgrading now, this may be the start of a more serious cycle. The second question to ask is: “Who will buy Japanese debt?” In the past, this was not a terribly interesting question because the bulk of JGBs (around 94%) were absorbed domestically. With the aging of Japan, it is not unreasonable to expect that the robust savings rate, which allowed Japan to self fund its government debt, will shift into reverse. Last year the Japan Post Bank (the biggest owner of JGBs at more than 20% of the total) announced that it would no longer be a net buyer from 2011. According to the Economist, gross debt to GDP is an eye watering 190% and rising (although other sources already quote figures in the 200% plus range) so having a major buyer like the world’s largest bank (by deposits) pull out of the market is not a small issue. The pricing mechanism for JGBs looks set to change as foreign investors are asked to bid for bigger slices of Japanese debt. On the negative side, it will not take much of an interest rate hike to overwhelm Japan’s fiscal budget with interest expenses. On the positive side, the pressure from the bond market could be enough to spur Japan to enact much needed but unpopular reforms that could set the stage for an escape from two lost decades. However, any good news will only come after a period of painful adjustment.

So what should an investor do?

We think the best approach is not to run away from risk but to manage it. The recovery from the Global Financial Crisis has been rocky and looking around at some of the overheating in China, the rolling sovereign debt crises along the rim of the EU and now the turbulence in the Arab world, it is obvious that some of these trends will lead to trouble down the line. We think the solution lies in identifying and monitoring a fairly broad universe of asset classes and recognizing that the institutional money in the market will be draw towards and scared away from different asset classes at different times. By deploying one’s investment funds in the asset classes that are benefitting from the rising tide and avoiding those where sentiment is draining away, we think one can achieve a solid return on one’s portfolio despite the generally directionless but highly volatile overall direction of the financial markets.

CIVETS anyone?

We have received a number of questions about the CIVETS market (Columbia, Indonesia, Vietnam, Egypt, Turkey and South Africa) and how they compare to the previous emerging markets grouping, the BRICs (Brazil, Russia, India and China). We decided to see how far along in the cycle we might be by using the System to pick when and where to invest in each grouping.

So, if you were wondering if it was too late to jump on the bandwagon, this chart suggests that there is still some money to be made in CIVETS.