Archive for March, 2010

It’s all in the price

This is a common saying on Wall Street. It seems simple enough but actually it means different things to different investors. From the highly mathematical (today’s price equals future discounted cash flows) to the gut feeling that we take with us shopping (this looks cheap/expensive). Almost all financial research is deployed to determining the correct or intrinsic value of an asset. That calculated “intrinsic” value is then compared to the current market price. Either the current price is cheaper than our calculated value, about the same or more expensive. From there, come the Buy, Hold and Sell recommendations from the research department.

In a perfect world, that should be the end of the process. The difference between the market price and the intrinsic value represents the time value of money plus a risk premium. There are several schools of valuation so a market should be able to exist as adherents place bets on the accuracy of their respective research efforts.

Unfortunately, the world is far from perfect and final prices are actually determined by two emotions: Fear and Greed.

So, as investors, how do we deal with this situation? How can we remove the emotions of Fear and Greed which end up costing us money? We work from the slightly different starting point that prices contain information. Do they contain perfect information? Sadly, no. But, as we move forward in time, changes in price certainly can tell us about changes in the market’s perception of value.

In practice, this sets up three price trend conditions which can be described as :

“Climbing the Wall of Worry”

This is how most investors describe a bull market and it is a money maker. We should be willing to trade our cash (a very safe but low yielding asset) for an asset that is “climbing the wall of worry”. But we need to remove the Fear emotions that hold us back from making the investment. We also need signals to tell us when the trend has changed to one of the other two conditions. Identifying a positive price trend can address both of these concerns. As long as the price trend is strongly positive, we can participate. When that trend fails, it is time to switch horses.

“Sliding down the Slope of Justifications”

This condition is also known as a bear market. When prices are falling, we tell ourselves that the investment will come good despite the evidence of the negative price trend. It is a money loser. In these circumstances, we should trade the investment in for cash or an asset that is in a rising trend.

And, “Bouncing around Trendlessly”

This third condition is also a money loser because opportunities are missed while our investments fail to grow. We should look to trade a trendless and risky investment for one that is in an uptrend or, if we cannot find an upward trending investment, we should trade it for a low yielding but non-risky asset like cash.

So where are we now?

Unfortunately, we have been moving from “Climbing the Wall of Worry” to “Bouncing around Trendlessly” since the beginning of the year. The trends of all the asset classes we track have been weakening steadily over the past three months as fund flows have remained largely static.

Will we return to the “Wall of Worry”? There is certainly plenty to worry about. Interest rates are extremely low and given the fiscal situation in the US and Europe, they are very likely to rise. Growth in the US has been pushed forward by a combination of government spending and inventory restocking, not consumption and/or business investment. Europe is trying to come to terms with a strong, competitive Germany in the middle of a monetary union that includes many weak, uncompetitive players around the edges. In the emerging markets, the BRICs countries (Brazil, Russia, India and China) are still posting above average growth but there are signs of overheating in China which may have global repercussions.

In our global portfolios, we see strength in Emerging Europe (GUR, with Russia RSX looking stronger than Turkey TUR), Biotech (XBI, and Medical Devices, IHI, in the US) on the back of ObamaCare, India (EPI), High Yield (HYG, most of the bad news is in the price) and Japan (EWJ, a perennial laggard).

Are any markets ready for a slide?

Our models are showing some movement out of Asia and into the US in general and the US dollar (UUP) specifically. If interest rates rise in the US, we would expect to see more funds flowing to take advantage of the higher yields. In our Asian Long/Short Portfolio, shorting Hong Kong has moved into the 4th slot. With cost of office space running triple the rate of Singapore, Hong Kong looks frothy. The Hang Seng has bounced around 1500 points to either side of the 21,000 mark for the last seven months so, at the very least, it qualifies as trendless. If interest rates rise in the US but are held down to protect the property market in Hong Kong, we could see a large liquidity drain as hedge funds set up an HK$/US$ carry trade. That would not bode well for equity prices in the Fragrant Harbor (EWH). If interest rates are allowed to rise with the US rates via the peg, the frothy property market becomes vulnerable to a correction.

China to post a trade deficit in March?

China is signaling that the March trade figures may show a deficit of as much as US$8bn. If true, that would make it the first monthly trade deficit since 2004.

The good news is that commodity prices have been fairly stable to soft over the last few months so this switch from surplus to deficit shows that China is serious about raising domestic consumption. If this trend continues, China will provide a much needed growth opportunity for the Asian region.

The bad news is that the US Treasury still has to fund record fiscal deficits and will need China as an enthusiastic bidder for some US$2 trillion in paper due to be auctioned in the coming months. With a balanced or slightly negative trade balance, it is unlikely that China will be able to add to its already substantial pile of US debt.

As Senators pile on the pressure to name China as a currency manipulator in April, and the Fed winds down it’s US$1.25bn Quantitative Easing program in March, we could see some serious political sparks flying in the coming few weeks.

A World of Change

The world is changing right before our eyes. Most of the time, one hardly notices the changes as we are conditioned to adjust to new quarterly data, the latest little white gadget from Apple or the next set of elections. But, sometimes, the change hits you right between the eyes.

Nobel Prize Winning Economist Paul Krugman wrote a blog outlining a strategy for how to compel the Chinese Government to revalue the RMB. His argument rested on the success of a short term tariff imposed on Germany and Japan back in 1971 of 10% which helped those two countries realize the errors of their ways. His conclusion? What worked then could work again now…only perhaps we should make the tariff 25% to show the Chinese that we are serious. Why should we consider doing this? Because the undervalued RMB is a drag on global economic recovery and it has negated the positive effects of the US stimulus program.

As a fan of the Austrian Economic School of thinking (, I tend to find flaws in many of Mr. Krugman’s policy proposals. However, this one appears to cut across all schools of economic thought. The last time someone came up with a gem like this, we ended up with the Smoot-Hawley Tariff Act of 1930. The list of intended and unintended consequences has been well documented in the blogosphere. Stephen Roach may win the “most quotable” prize for suggesting that a baseball bat be employed to sort out Mr. Krugman’s advice.

However, sometimes one needs to take a step back and see the bigger picture. In this case, the big picture comes in the form of a cartoon from Jim Morin of The Miami Herald.

The level of indebtedness is the real issue. The US will soon have debt outstanding equivalent to 100% of GDP. As the IMF points out in a Bloomberg article, only Germany and Canada look likely to stay under the 100% mark by 2014. Mr. Krugman is correct that our stimulus policies are not delivering the promised goods (a “liquidity trap”). And he is probably correct that China’s trade surplus is not helping (an “anti-stimulant”). But the real problem with his Keynesian stimulus prescription is that we are at the end of the Debt Super Cycle. China’s currency manipulation is not the biggest problem the US or other G-7 nations will face in the coming 5 to 10 years. Growing out from under a mountain of government debt is the real challenge.

Why is the US Government loading up on debt? Because the usual sources of credit demand are sitting on the sidelines.

The US consumer is tapped out. Double digit underemployment and underwater mortgages have taken their toll on this once mighty sector which made up 72% of GDP at the peak.

Non-financial corporates are taking a pass on new loans as the sector chokes on idle excess capacity. Corporations are also facing an uncertain tax, pension and healthcare future.

The only private demand for credit is from financial firms which line up at the Fed to take Quantitative Easing (QE) money with which they purchase two year US Treasuries. The financial firms do this because:

  1. They have privileged access to the FED’s near zero cost funding and
  2. The interest rate differential is helping them to rebuild capital.

But, with the Fed’s US$1.25 trillion buy program of Mortgage Backed Securities due to expire at the end of the month, that last source of private demand for credit may dry up as well.

Perhaps this is a good time to look at and reweight your portfolio. What should you be looking for?

  1. Since governments (and the US in particular) are the only segment of the market still piling on debt, one should avoid their longer dated paper at these extremely high prices (low yields). The shape of the yield curve is not telling us that much about inflation at this point. Default is unlikely but a sharp rise in interest rates demanded may not be too far in the future. Keep your durations short.
  2. On the flip side, the US government will be increasing its already substantial spending on Pharmaceuticals (XPH) and Medical Equipment (IHI) over the next 10 years now that the Health Care Reform Bill has jumped another hurdle.
  3. Global Growth will continue to be concentrated in the Emerging Markets, especially those with raw materials and energy to sell. Russia and Brazil still look attractive. China will continue to be challenged to find sources of growth that do not ultimately depend on the US consumer.
  4. Corporate bonds, particularly high yield, still offer some upside potential.

For more specific ideas, go to the Portfolios Page.

Should you buy Gold?

If you pay attention to the infomercials played on financial news channels, watch the banner ads on websites or listen to certain well known hedge fund managers, you might think the answer is yes. But before you start filling your vault, you might want to consider the nature of Gold as an investment.

The first thing to look at is supply and demand.

There are two sources of supply for gold: existing holders and gold miners. Gold is a unique commodity because almost all of the gold ever mined is still in existence (estimated at 161,000 tons). Gold is hard to consume and easy to recycle and refine into different grades and alloys. As such, nearly all of the gold in existence is potentially for sale. Adding to that supply are the gold miners. Every year, approximately 2500 tons are mined (although that number can vary dramatically given high extraction costs).

There are three sources of demand for gold: jewelry, industrial uses and investment. India is often cited as the biggest consumer of gold at around 25% of an average global demand of 3,200 tons. This number inflated to 3,800 tons in 2008 and fell back to a still high 3,400 tons in 2009, as a result of increased demand for Gold ETFs, the largest of which is GLD. In addition to its traditional usage as “hard money” and jewelry, gold is an industrial metal due to its electrical, chemical and optical properties. However, demand for gold as jewelry and as an industrial metal is highly price elastic.

So, we have a commodity where the potential supply is over 40 times the size of even inflated annual demand. What makes it a good investment? Not inflation. Despite the chestnut of a well tailored suit always costing the equivalent of an ounce of gold, the price of gold has fluctuated wildly in the past 40 years. As an asset which produces no income (and in fact costs money to store), gold is actually a pricy store of wealth rather than a productive investment.

So when should you buy gold in your portfolio? Of course, whenever you will be able to sell it for much more in the not too distant future. How likely is gold to rise from current levels? Will we see the yellow metal double to US$2,200-2,400 an ounce in the next few years? Probably not.

We should not let our recent experience of the Global Financial Crisis (which hasn’t ended) color our perception. While it is true that the price of gold has doubled during the GFC (from US$600 to a recent peak of US$1,200), it is also true that the price of gold doubled from just under $260 in early 2001 to an average of $600 in 2006.

The first doubling was driven by new demand from India and China as both countries saw big gains in middle class wealth and income. Over the past decade, economic reforms in those countries have created several hundred million new potential buyers of gold. At the same time, there was a lag in new gold production as most miners have extraction costs in excess of US$300 per ounce.

The second doubling was driven primarily by investment flows as investors looked for return of capital instead of return on capital (hence the near zero interest rates on short term US treasury paper). Gold has been a store of wealth for at least 5,000 years and has often served as the backing of government issued currency. Now that governments have charged in with taxpayer commitments to bail out the financial system, investors have already reverted to a search for returns (as evidenced by the strong showing of high yield assets).

But how likely are either of these circumstances (or another gold doubling catalyst) to occur in the next three to five years?

With no new India or China on the horizon and the worst bits of the Global Financial Crisis exposed for all to see, gold bugs are falling back on the inflation argument. However, with the velocity of US dollars collapsing from just over 2.12x to the long term mean of 1.67x (via John Mauldin), industrial spare capacity around 30% and unemployment well over 10%, there are two problems with that argument. First, we may not see all that much inflation (although as we have noted in the past, hyperinflation and currency debasement is not impossible in weak economic times). And second, gold has not always served as a good inflation hedge.

So that brings us back to the beginning. Why are the Soros’ and Paulson’s of the world signaling their big positions in gold ETFs (through 13-F statements)? At this point it might help to remember the “peak oil” call in the middle of 2008 when oil touched US$140 a barrel. Goldman Sachs analysts, amongst many other “smart money” players, were calling for Crude Oil to rise to over $200 while placing bets in the other direction. That “peak oil” story ended a few months later with the price of oil just below US$40. Even though prices have since recovered to US$80, listening to “smart money” at the time would still have made for a disastrous trade.

Fast forward to today’s gold trade and perhaps the “smart money” investors, having executed on the first half of their strategy (Buy Low), are looking to execute the second part of their strategy (Sell High). Unless you have very good reasons for helping these investors liquidate their trade, nothing we see on the economic landscape or within our models suggests that you should be buying gold at this point.

Curb Your Enthusiasm

The reason we are so excited about Fund King’s quantitative system is that it allows us to wade through the conflicting datapoints that wash across our desk every day. The rally is a year old and in the case of the US has been good for a 70% rebound (more in select emerging markets). Anniversaries are a good time to reflect on where we are heading in the coming few months.

The broad answer is that we are not going anywhere quickly.

The Central Banks and their political masters are committed to pumping enough liquidity and credit guarantees to keep the markets from falling dramatically. They are collectively known as the Plunge Protection Team or “PPT”. The net result of their actions will be the largest transfer of debt from private to public accounts in modern history and that will reshape investing in the years to come. The “Greek Tragedy” is only the first episode in what promises to be a long running series. But for now, “PPT” actions put a floor of support under the markets.

The resistance in the markets comes from a lack of growth combined with a risk of inflation. The lack of growth comes from the US consumer and China tapping the brakes on its wild stimulus program of 2009.

The US consumer has started to spend again but will not reach the heady levels of 2007 for several years. While that is good news for the Consumer Sector ETFs (VCR & XLY), the momentum readings are not strong and we would advise watching these new positions carefully. A strong recovery in consumer spending will coincide with an economy that is adding jobs. Last week’s jobs report was better than expected but it would be imprudent to extrapolate a strong uptrend from here.

As for China, it is really a question of how well it can fine tune its stimulus withdrawal. Historically, the implementation of cooling measures has overshot the target.

In debt markets, the room for maneuver is tight. The main game globally is an insider’s game between the Federal Reserve and a select group of large banks who enjoy favorable access to nearly free short term money. The bet in the market today is borrow at nearly 0% interest rate, buy short term treasuries at 2% interest rates, earn the difference and hope that interest rates fall further to 1% as economic growth remains weak. What about inflation? Very little of this money is actually finding its way into the private sector (unless you count government contractors). This is a program for recapitalizing and reliquifying the banks. At this point, there is not enough leaking out of the closed loop to stem private sector job losses.

That said, not all inflation stems from overly strong demand. Zimbabwe did not tip over into hyperinflation (04-09) because of overly strong economic growth. The same can be said of Argentina (75-91), Brazil (86-94), Weimar Republic Germany (early 20’s) and Hungary (46) when each of those economies suffered hyperinflation. The root cause in each case was aggressive use of the printing press. Today, money is created by credit creation at the tap of a keyboard. The massive explosion of high powered money at the Fed has been contained inside the program to rebuild bank balance sheets. However, if the Fed is not aggressive about withdrawing that credit when the market actually starts to pick up, we could face an uncomfortable debasement of the US dollar. For residents of dollar linked economies that will feel very much like inflation and bond vigilantes (who are sharpening their skills in Greek paper today) will make sure that interest rates rise to compensate. The steep yield curve is not without logic…but it may not represent “free money” for too long.

What to do this week?

Emerging Europe still looks good with Russia (RSX) as the strongest prospect. Biotech has bubbled up once again in some of our portfolios but Pharmaceuticals (XPH) and Healthcare (XLV) might prove a bit more reliable. Investors are betting that Healthcare 2.0 will be more favorable to these sectors, especially considering the financing needs some members of congress may have for mid term elections.

Asia actually looks pretty quiet. Taiwan (EWT) comes out on top of the long only portfolio and China (FXI) at the top of the long short portfolio but neither have particularly strong momentum behind them for now. There is a big Asian broker conference in the US but that is unlikely to generate more than a blip in the short term.

The Euro (FXE) has bounced with France’s announcement of solidarity with the Greeks. However, Germany is still very cold to the idea of a bailout so it would not be surprising to see the Euro slide once again. As we noted in our mid-week flash, several Scottish investors are calling for the British Pound (FXB) to drop significantly on an unsustainable fiscal position and an unclear election prognosis.

On the commodity side, Oil (USO) and Gasoline (UGA) are showing some short term strength but we would wait a few weeks to see if a trend develops.

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