We’ve got a lot to cover today so I’ll just get straight to it. This one will print a little long because there are a bunch charts, but they’re good ones. This is fun stuff today!
A checkup on consumer health
Ken Chenault, the CEO of American Express, gave an interview in the most recent issue of Fortune magazine. He became CEO a year before 9/11 so he has some experience and a pretty good track record at guiding a company through difficult times. His is a voice worth listening to.
The interview is an outstanding look into the US consumer. It might just be me, but I feel like reads on the health of the U.S. consumer are really dominated by anecdotal evidence right now. It seems like most people’s perceptions of that aspect of the economy have been driven by their own experience, or what they’ve heard from their friends, or maybe even what they’ve seen on TV. There’s nothing wrong with that per se, but when it comes to investing, a huge mistake that investors make is that they assume that their beliefs and experience are the same as the rest of the marketplace.
This is what intrigues me about an interview like this. A company like American Express is in a perfect position to actually know what consumers are doing. Sure, they know exactly how much money consumers borrowing and spending, and also how long they are taking to pay or if they’re even paying at all. But they also know exactly what people are buying. They know what people have stopped buying and what they’re buying instead. They know exactly where you’re shopping now and where you’re no longer shopping.
You can read the whole interview here but I’ve lifted the most interesting bits. A lot of it is about President Obama’s Credit Card Reform Act of 2009, and I wish they’d spent more time in the interview discussing the state of the consumer. Credit card reform might be very relevant for American Express shareholders, but consumption data is more relevant for me and you.
I can only fantasize about the data that American Express has collected on consumer behavior patterns.
Anyway, if Ken Chenault tells me that consumers are spending less money on this and more money on that, I believe him.
Total billings are down
Here’s a chart from that interview. You can see that the decline in total billings is moderating, but still down considerably from last year.
American Express also did a survey of some of their card members, and – remember this for later – only about 25% felt that the worst of the recession was over. But check out what else Chenault had to say:
We then asked, “If you had found $500, how would you spend it?” They said they’d pay off regular bills and pay down debt.
Not that I ever gave much credence to the theory that consumers would rebound and lead the economy back to growth, but this not the kind of thing you want to hear if you think consumer spending will be what gets GDP back to historical norms. That is what has driven GDP growth for so long. Check out this chart of retail sales courtesy of the St. Louis Fed:
Ouch! That chart only goes back to 1992, but here’s what it looked like in the 45 years prior:
The party is over. We’ve never seen a post-war recession where consumers cut back their spending so much. This recent data is not pretty.
Now, the market looks forward, so what is it saying about all this? Let’s take a look at the retail index:
The RTH is saying that the consumer is back, baby!
But let’s hold our horses for a second. The RTH is an exchange traded fund that is over 80% composed of the following companies: Home Depot, Lowe’s, Wal-Mart, Costco, Amazon.com, Target, TJ Maxx, Gap, CVS, Walgreens. There are some fun, frivolous things to buy at those stores, but those places are also where people go to when they need to spend money. Those stores sell a lot of boring stuff i.e. stuff which gets consumed in any economic environment. As you can see from the chart, these aren’t exactly companies that are big growth engines.
Incidentally, if you like those companies and think they are good investments for the future, you can just buy RTH through your brokerage and get direct exposure to those names. It pays about a 1.6% dividend, too. All the ETFs that I talk about here can actually be purchased straight through your brokerage and they’re a great tool to get quick, inexpensive diversification within the world of equities. ETFs are the best thing to happen to investors (and traders) in a long time.
XLY is an exchange traded fund that contains a few “more-discretionary” names like Disney, Comcast, News Corp, and Ford. I think it tells a slightly more interesting story:
From here it looks like discretionary spending is definitely back from the brink, but maybe it won’t quite get back to where it was before the big recession any time soon. Maybe it’s now back in a more normal range.
You might also be wondering what happens if we move a step further up the ladder of discretion. How about the luxury retailers?
I now present to you the Claymore/Robb Report Global Luxury Index (yes, it’s that Robb Report). This one is composed of companies like Swatch, Wynn Resorts, Daimler, BMW, PPR, Christian Dior, Porsche, and Coach.
First of all there’s not a lot of data for this one, so it’s tougher to put recent movement into historical context. But in the luxury space, it appears that things may not be as bad as we all thought back in March (duh!). The world, apparently, has not ended for luxury retail.
That being said, this luxury index is still about 52% from its highs while the consumer discretionary index is about 40% from its highs. The broader RTH is only 15% from its highs. The relative forecast is pretty grim.
State Street even offers an exchange traded fund for consumer staples, XLP. In addition to the Wal-Marts and Walgreens we’ve seen above, XLP also includes companies like Procter & Gamble, Coca Cola, Philip Morris, and Kraft. These companies sell the stuff like shampoo, macaroni & cheese, soda, and cigarettes – relatively inexpensive things that are a big part of life even in big economic recessions. Let’s see how that one has done:
As you can see and as you would expect, it’s a bit more steady. This one is also only about 10% from its prior highs.
Back to our interview with Ken Chenault, when asked what consumers were buying, this is what he had to say (emphasis mine):
Spending is focused on nondiscretionary items — people are buying things that they have to. On the balancing side for us, the number of transactions has remained relatively stable while billings have declined.
We certainly have seen an increase in the savings rate, and from a societal standpoint, that’s good. But that affects people’s spending capacity — our borrowing fueled the growth.
His comments are completely validated by both past data from the US Department of Commerce and also expectations of the future as told by the stock market.
This is a large component of the new normal. It’s our opinion (and not just ours) that consumer borrowing is undergoing a permanent reduction from a variety of factors from systemic risk reduction and deleveraging to changes in consumer psychology. All that epic borrowing was a major part of the robust economic growth we enjoyed for the last few decades, and the next few decades will be ones where individuals will be generally borrowing less.
In fact, Chenault even bluntly adds:
The economy is going to grow slower than it did before the downturn, even when we recover.
He is certainly in a position to know.
What about the wealthy?
I’ve written before about our position in the hedge fund industry and how we tend to be a leading indicator for both the financial sector and the broader economy. We were among the first to feel it when the fault lines began shifting back in August of 2007, we correctly identified the beginning of the recession that December, and we were at the forefront of the chaos last October. I still think that our call that the recession officially ended in July of this year will be correct with a month or so margin of error. For more information on that and some strategies on how to invest through it, check out our article What the Recovery Will Look Like in the archive section.
(Brief side note: it’s worth mentioning that early this summer things started getting better for us – not just the second derivative story where things were still getting worse but at a declining rate. Things actually started improving for our business. As an early indicator, we’re hopeful that other businesses will begin to feel improvement throughout 2009 and into 2010. It might only be modest improvement for the US consumer, in accordance with the slower growth of the “New Normal”, but some improvement will be a nice change of pace from no improvement.)
As we’ve talked about at numerous occasions in the past, this has been a “top-down recession” in that affluent consumers – consumers who had traditionally kept right on consuming through previous recessions – cut back on their spending the most. Because of the crashes in both housing and the stock markets, the rich experienced a disproportionate share of global wealth destruction.
If we turn to the world of economic theory, there are two major things that drive consumer spending behavior. The first is the wealth effect, which simply posits that as individuals perceive themselves to be more wealthy, they spend more money. It’s tough to measure quantitatively, but it seems to make sense, right?
Let’s now turn back to Ken Chenault (emphasis mine):
[Question:] The conventional wisdom at the beginning of the recession was that affluent consumers — American Express customers — would always have money and would continue to spend. It turned out just the opposite — high-end consumers cut back the most. How come?
This is one of the most surprising developments, because in the past two recessions you did not see this level of decline of highly affluent customers.
In our franchise, the highly affluent customer, spending drops were deeper than for the average customer. Some of the reason was the precipitous decline in housing prices, particularly in two states, California and Florida, where you have a high percentage of affluent people.
Plus, obviously, the impact of the stock market on their overall portfolios. These customers have capacity to spend, but they had to draw back.
So was it the reverse wealth effect — they felt poorer and spent less because of that?
It was the wealth effect, and events happened that impacted the level of uncertainty that they had. For all of us, things were happening that we just couldn’t imagine. I think that had a profound psychological effect.
Remember what we noted at the top? That in their survey only about 25% of their card members felt the worst of the recession was over.
The second major theory to explain spending patterns is Milton Friedman’s permanent income hypothesis. This is related to an old idea of Keynes’: as income rises, so does spending. That might sound like common sense, but hey, in the world of economics this is the sort of thing that passes for a revolution. Keynes even had a nifty formula to describe that simple concept.
C = c0 + c1Yd
Leave it to an economist to make something simple more complex than it needs to be.
Anyway, Friedman added an extremely important twist to that theory with his permanent income hypothesis. Friedman said that the relationship between income and spending is a little more nuanced and consumers actually spend based on their expectations of future net income.
Where have you gone, Doc Hollywood?
Some of you may have always wondered about the archetypical young doctor, fresh out of medical school with a few hundred thousand dollars of student loans and a small patient base, who immediately goes and buys a nice house and a BMW. Friedman has the answer for why: our young doc is expecting enough income in the future to justify today’s purchases. It also explains why he takes out all those loans to go to medical school in the first place. He can’t pay them off just yet, but he believes at some point down the road he will be able to.
Whether that road leads him by chance to a small southern town where he discovers that life is less about fancy material possessions than it is making meaningful connections with fellow people is another story…
Within the context of this current recession, Friedman’s permanent income hypothesis gives us another reason why individuals (businesses, too) have cut back so much on their spending. They’re expecting less income in the future and therefore consume less in the present. You might have noticed that’s a big-time negative feedback loop.
Finally, it bears mention that the almost-immediate reduction in spending we saw last fall preceded the actual firings, furloughs, or straight-up salary cuts we’ve seen since then.
You see now why our expectations of the future are so important and why it’s so important that we feel good about our economic future. If we are worried about misery in the future, it can actually make the present miserable.
Anyway, I mention this because the rich today have had both their current income and their prospects for future income reduced by a larger relative amount than the middle class. The rich today feel significantly poorer, and by a greater magnitude than others in less-affluent economic strata. That’s not to say the middle class isn’t struggling – by plenty of measures they are. They just haven’t been impacted to the extent that the affluent have.
Don’t shed too many tears for the wealthy, though, they’re still doing OK. And they’re a notoriously adaptive and resilient bunch – part of how they got to be wealthy in the first place. They’ll figure things out and adopt a new pattern of behavior that matches their expectations of the future. The better they feel about things, the more they’ll consume. In this era of rising populism, it’s even more important to keep watch of the wealthy to get a read on where the market may be heading.
I know this newsletter goes out to a lot of high net worth investors, so let me know if I’ve got it straight or all backwards.
Also, if you have an interesting story about your reaction to the recession, I’d love to hear it. Send me an email at Feedback@TheDraconian.com. I work hard to answer each and every email.
As you’ve noticed, I enjoy checking in on the American Consumer from time to time to see how he’s doing. It’s fun and I have a good time with it. But it’s not all fun and games. Our economy is dominated by consumption, so every investor really needs to keep his finger on the pulse of American Consumer.
This is incredibly useful information and when used properly, it can be valuable information.
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Updated 6/30/2010
Gold has become a bigger and bigger story over the last several years as it’s steadily surged toward new peaks above $1,200 per ounce. This has dovetailed in perfect synchronicity with increasing fears about long-term inflation, concern about the strength of our national currency, and uncertainty about our collective economic future.
Now’s as good a time as any to drill down and separate myth from reality. As usual, what we have to say may not be what you’ve heard elsewhere. We like to take a contrarian perspective on the world, though certainly not just for the sake of being contrarian. Fundamental correctness is absolutely paramount to any contrarian viewpoint. We are firm believers that when it comes to macro investing, the best way to make real money over the long run is with a stance that is both contrarian and fundamentally correct. Being contrarian is easy (though not as easy as you might think), but being correct is hard. There is a lot of money to made from situations where most of world has it wrong and you have it right.
Gold is probably the one thing we get asked about the most. When we meet people out in the world that find out that we trade commodities, they almost invariably ask us what we think about gold. Most people that you talk to tend to have an opinion about it. Unlike stocks and especially bonds, investor sophistication has little to do with an individual’s opinion of gold. Quite simply, everybody wants it. They have for millennia. What’s more is that they understand it innately. The want is almost primal.
Gold has been demanded and desired by basically every civilization in history. It’s been used as a store of wealth throughout the ages. At various times in various economies in history it’s been used as a medium of exchange, either directly, or indirectly as a hard asset backing a paper currency.
Understanding all this historical and psychological context is important before we get down to the nitty gritty. When we begin looking at gold, and more importantly, begin using gold as a tool, it’s important to keep all the noise at bay.
So here we go, what you need to know about gold:
1) It’s not the inflation hedge you think it is.
In the past gold hasn’t actually correlated very well with inflation. Gold went pretty much straight down from the frenzy peak in 1980 until about 2001. That was a period of unquestionably positive, albeit modest, inflation. If you bought gold in the 80’s to hedge against future inflation, you lost money on both sides – not exactly the kind of result one is looking for in a hedged trade. Even if you waited years after the bubble before buying, it still declined while inflation rose.
Over the long, long run gold has worked as an inflation hedge. But a lot of things have gone up in value over the last century and have thus have correlated positively with inflation. In the 20th century, just about everything that was denominated in dollars went up in value as the value of the dollars denominating them went down. So over the long, long run, it’s not really much better a hedge against inflation than equities or real estate or other physical assets (except during bouts of hyperinflation).
You might also be curious if gold can predict future inflation.
The below chart looks a little confusing at first but it really isn’t so bad. All it does is run back through history, stopping at each month to look back at the previous 12 month change in the price of gold and chart it against the next 12 month change in the inflation rate (as measured by the CPI).
So each dot represents one month and it measures the prior year’s change in the gold price versus the coming year’s change in inflation. I also did it for a 6-month interval as well.
Make sense? We now can ask:
The answer is… sort of.
It’s pretty clear to see that the slope of the regression lines are both positive which means that there is indeed a positive correlation between past movements in gold and future movements in inflation.
But during normal times i.e. annual inflation between zero and 5%, movement in gold does a very poor job predicting the rate of inflation. Perhaps because normal times are boring. Nobody cares about inflation in the low single digits. That is what the Fed is actively shooting for, after all. Central bankers around the world sleep soundly and have happy dreams if inflation is positive and low.
What investors want to know is if there’s a way to forecast hyperinflation. And here you can see that when gold has really gone wild, increasing by 100% or more in 6 months, it has usually meant that high single-digit or double-digit inflation has followed in the next 6 months. It does a little better job as a predictor here, but keep in mind that just about all of those data points towards the top right corner in that chart were from the late 70’s and early 80’s. The gold market was held in the grips of a speculative frenzy and the country had already been experiencing double-digit inflation for years. So none of those data points would have been particularly useful in practice.
The take-home point here is that one should be careful when looking at the gold market and using its movement to divine the future. Yet again, we bump up against the ubiquitous conclusion that past performance is not indicative of future results.
Gold’s up over 30% in the last 12 months which is a gigantic move, but nobody in their right mind expects significant inflation in the coming year. Even without that economic forecast, very little should be excluded from our expectations of the change in coming the inflation rate. Pretty much any outcome is in play.
2) It’s best thought of as a “neutral currency”.
The most important thing to understand about currencies is that they are a relative value proposition. Currencies don’t have an independent, absolute value the way other assets do. Instead they are globally priced in terms of other currencies. Or even other assets, which can be a little counter-intuitive. Last Halloween I went to the grocery store yesterday and there was a big box of pumpkins outside where they were strangely pricing dollars in terms of pumpkins. The sign said $1/4lbs pumpkin. Apparently one dollar is actually worth 4 pounds of pumpkins. How many pounds of pumpkins does one ounce of gold cost? About 5,000 pounds of pumpkin!
As I’m sure you’ve noticed, economists have a strange sense of “humor” and one thing we like to do for fun is price one thing in terms of another thing.
It’s especially interesting to use gold for this. For example, let’s price the stock market in terms of gold. The first chart is log scale, the second is linear scale:
There are a lot of ways to interpret those charts.
When priced in terms of a “neutral currency”, the dot-com market bubble really stands out. That was an epic bubble, folks. What’s interesting is that the stock market’s second run back towards new highs in 2007 wasn’t really an equity bubble at all. It wasn’t even really a bull market. To somebody that used gold as their currency – or even a lot of other foreign currencies – the highs in 2007 were just another stop on the way down in a gigantic bear market. That second little peak in the stock market was actually due to dollar weakness!
Here’s a chart of the Dollar Index (DXY) which measures the value of the US Dollar against a basket of foreign currencies:
Kind of remarkable, no? The dollar is on balance about 35% less valuable relative to a basket of other major currencies than it was at the beginning of this decade.
In the summer of 2001 I went backpacking through central Europe, pretty much at the exact peak in the USD. At the time I was astonished at how cheap everything was over there. Hostels in Germany and Austria were only $5-10 dollars per night, while a very nice bed & breakfast in Venice cost me about $60. Greece was ridiculously cheap and the (wonderful) food was only slightly more expensive than “free”.
I returned to Europe in the summer of 2007 – not quite the low in the US Dollar, but pretty close. Needless to say, the experience was substantially more expensive. My dollars didn’t take me nearly as far, but fortunately I had a couple more of them to offset their loss in global purchasing power.
Unless you traveled beyond US borders, you probably haven’t noticed such a drastic change in your own purchasing power in the last decade. Most people don’t have a very good sense of how valuable the dollars we hold in our bank accounts are relative to other currencies and assets. But if you’ve owned gold, effectively a neutral, global currency, you’ve noticed it trend straight up and a big reason is the decrease in value of the dollars in which it’s denominated.
The point here is that since it’s priced in dollars, gold is very dependent on the relative value of those dollars and the future price of gold is inextricably linked to the fate of the world’s paper currencies. Dollar-denominated gold will perform much better when the US Dollar is under substantial pressure. Dollar strength typically tends to be a fairly large headwind for gold.
The difference is subtle, but Gold is your hedge against dollar weakness, not inflation.
3) Trading it will drive you bonkers.
Like I said a few months ago: Gold never moves the way you think it will. It never tells you what you think it’s telling you. And it does strange things for even stranger reasons that no sane person can hope to understand. Investors who own gold for the long haul love it, but I’ve yet to meet the trader who hasn’t been driven completely insane by the gold market at some point in his career.
The reason why it’s so tough to trade is that it’s so difficult to predict where gold is heading over the short run.
Does that chart keep moving higher over the next few months? Do you really trust gold to adhere to follow pattern? It looks like an easy answer, and were it anything other than gold, I might take a shot at answering it.
Over the long run, it’s easy. Gold will exhibit inverse correlation with the dollar and over the long, long run the dollar is a sure bet to get weaker relative to the amount of goods (or other currencies) that it can purchase. I think the single best bet an investor can make today is that 100 years from now each US Dollar will buy substantially fewer goods & services and be worth substantially less against a hard asset like gold.
Check this out:
The red lines measure the trailing 1-year inflation rate. The green line, measured on the right axis, shows the purchasing power of the dollar. Today each US Dollar is worth about 96% less than it was worth in 1900. You can see that dollars are a bad investment over the long run, and incidentally, this is why people demand interest when holding dollars on deposit at a bank. If I’m going to let you hold one of my dollars for the next year, you’d better give me more than my one dollar back a year from now because I can be fairly confident that that one dollar will be a little less valuable relative to what it can purchase.
The more inflation that’s expected, the more interest that’s demanded. This is why it’s usually a little better to look at something like the bond market to get a read on future inflation than the gold market.
Gold doesn’t necessarily go up when inflation is expected and it won’t necessarily rise to the degree to which inflation is expected. Sometimes it does. But usually it doesn’t.
Interest rates are a much better indicator here. They typically go up when inflation is expected, and the more they go up, the more inflation the market’s expecting. Predictable reactions like this make bonds a whole lot easier to trade than gold.
4) We’re nowhere near the real peak back in 1980.
One of the most famous events in the gold market was its run to $850/oz back in 1980.
Almost three decades later, gold finally made a new all time high, but it was an all-time high in nominal terms. Adjusted for inflation, we’re still nowhere close to what we saw in 1980.
Here’s a chart adjusting the price of gold for inflation (using today’s dollars):
That being said, it’s important to keep in mind that the 1980 peak was a speculative bubble and comparing today’s price, in either real or nominal terms, to that speculative peak is nearly worthless. It’s like saying that home prices can go up another 100% from here because that’s where prices were in 2005. Or like arguing that JDS Uniphase stock could go back to $1,000 per share because that’s where it was trading during the heights of the dot-com bubble.
The price of gold is, however, at the high end of what has basically been a 40-year trading range. Movement beyond this range will be contingent upon steadily increasing demand or a weakening dollar which, given the mess we’ve got up ahead, is certainly within the realm of feasibility. There are much better theses on which to base a bullish case for gold than clinging to a prior peak.
As for what might happen to gold should another speculative bubble develop, the below chart may give you some idea. I’ve charted some of the major bubbles in history against each other, using the beginning of each bull market as a starting point:
It’s important to understand that what we’ve seen in the gold market since 2001 is not a bubble. Not yet, at least, though we may be getting close. Nearly every super-bull market in history has concluded with a final phase of speculation and hyperactive demand, and whether or not we’re currently in that phase seems to be the debate du jour.
That’s not to say gold is empty of short-term upside. Should another speculative frenzy develop, that chart may give you a sense of how crazy things can get. Gold could double from here, or triple. It’s up to you whether or not you want to make that shaky bet, and whether you think you can get out at the top and avoid the nastiness that follows each one of those bubbles in the chart above.
Keep your eye on both the investing public for hints at speculative demand and the Federal Reserve for guidance on monetary policy. Should the Fed start taking some of these dollars out of the system and tightening up monetary policy to bolster the strength of the dollar, it would very likely be very bad for gold.
Since Europe started freaking out about its sovereign debt, the Dollar has grown stronger. Despite that, gold has powered forth. Is that indicative that we’re now in the bubble phase, that nothing can drive down gold prices until we make it to the end of the line where the world wakes up from its collective hysteria and says, “whoah, maybe this has gotten out of control?” Perhaps.
All those gold ads on TV are probably another indicator that we’re moving into that realm.
5) Sorry, Tea Party. We’re not going back to a gold standard.
And take away Obama, Bernanke, Geithner & Co.’s ability to keep printing more dollars on demand? puh-lease!
They might be fighting a noble fight, attempting to combat the effects of a nasty recession, but know that each dollar that gets printed or pumped into the system via quantitative easing runs the risk of decreasing the relative value of all the other dollars in the system. It’s simple supply and demand.
There’s been substantial easing already, but we haven’t seen many signs of price inflation. One of the big reasons why is frequently overlooked: there has been a total collapse in monetary velocity.
The velocity of money is just the average frequency with which a dollar is spent within an economy. For example, if I have $1 and use it to buy a cup of coffee from you, and you then take that $1 and use it to buy a donut from me, we’ve created $2 of Gross Domestic Product for the little economy that exists between you and me. Our $1 of total money supply has turned over twice. With this, we can actually rewrite GDP another way:
GDP = M (the money supply) * V (the velocity of money)
So when the velocity of money in a big economy like the US drops because people slow down their spending, The Fed needs to increase the money supply to prevent a subsequent drop in GDP. It typically does this by purchasing government bonds out in the market which increases the reserves at banks which means they can turn around and loan more money to people.
Here’s a monetary velocity chart for M2, which consists of things like paper currency, bank checking deposits, traveler’s checks, savings & time deposits, and money market funds:
The big reason for that sharp drop in velocity has been banks’ unwillingness to lend out money because of shakier capital foundations and stricter lending standards. There’s a reason the banking system in particular has been so aggressively targeted with stimulative efforts. Imagine a giant network of gears – the banking system is the big gear in the middle that turns a whole bunch of smaller gears around it and so The Fed has spent the majority of its efforts getting that central gear turning again.
This is all relevant for gold because, as you can see, we’ve needed to aggressively grow the money supply lest that collapse in velocity seriously impact GDP. But the great economist Milton Friedman warned we shouldn’t ever increase it by too much. Increase the money supply by too much and you do get inflation. It’s a tight rope act. And like any tight rope act, it’s incredibly captivating because so much is at stake – the life of the rope walker or the fate of our currency.
There’s a very common false argument out there that simply “printing money” (via quantitative easing) will destroy the dollar, create inflation, and therefore drive the price of gold sky high. This isn’t always the case. There are times when good old fashioned money printing is what’s called for, especially when we want to make a nasty recession a little less nasty. A gold standard would throw a monkey wrench in The Fed’s ability to do that. It also would make it much more difficult for the US to pay back its creditors, but that’s a whole ‘nother can of worms. We’ll explore that rabbit hole in another letter.
The US paper dollar has value because we can always use these dollars to settle our debt with the government (aka income taxes). So long as everybody needs to pay taxes then paper dollars will have some sort of value. I know that if I offer my services in exchange for your dollars, I will accept your dollars because I can use those to settle my tax bill next April.
That being said, the track record of fiat currencies throughout history is very poor. Many have involved spectacular collapses from the late Romans to John Law’s 18th Century France to Weimar Germany to more recent collapses in the Mexican Peso, Thai Baht, and Russian Ruble. There has never been a major fiat currency that has lasted very long. I’d like to think our track record will be better here, but really bad things have happened in the US before and really bad things will happen again.
A currency crisis could be one.
Which brings me to…
6) Every investor needs to own gold.
If you have an investment portfolio of significant size, some of that portfolio needs to be allocated to gold.
If you’ve ever met with a financial advisor, you’ve surely heard something about building a “balanced portfolio”, something like 60/40 or 70/30 stocks and bonds depending on your age. Target Date funds are very popular now with mutual fund companies; these are funds that start out aggressively with allocations to riskier equities and then slowly get more conservative and add more fixed income as they move towards a “target date” at which one will presumably retire. They’d be a neat idea if that was the way investors actually invested.
But how many financial advisors have seriously urged you to add gold to your portfolio? Where’s the 40/40/20 portfolio? Or where’s the “six dimensional portfolio” that allocates across cash, equities, bonds, gold, real estate, and alternative funds? That’s real diversification for you.
Anyway, let me be clear: own gold.
The reasons for owning gold are numerous, but only one reason matters. The only reason that should ever matter when adding any new investment to your portfolio. Gold is different and it moves in totally different ways.
And I’ve got good news. It’s a lot easier to add gold to your portfolio than you might think.
The easiest way to get it is through a gold ETF. There are several gold ETF’s (exchange traded funds), but GLD is what I use. You can learn about The SPDR Gold Trust here, but the key thing to know is that it holds physical bullion. A lot of commodity ETFs – you might be familiar with UNG (natural gas) or USO (crude oil) – just hold or trade the futures contracts which is problematic because futures contracts expire and before they do, new ones need to be purchased.
Without getting too technical and dropping crazy terms like “backwardation” and “contango” (two of my all time favorite words) you simply need to be aware that the values of these ETFs won’t perfectly track the underlying commodity. Sometimes they’ll go up more than the underlying commodity, but because of the nature of commodity markets, they usually underperform.
So if you buy GLD, you’re technically buying shares of a trust that holds a whole lot of physical bullion. GLD will move in almost perfect lockstep with the actual price of gold.
Owning gold through a trust is cool, but owning physical gold is really cool. Show someone a 1oz gold coin and watch how they react. It’s a great party gimmick and is guaranteed to impress your friends. You can buy gold coins through the US Mint or through a local coin dealer or an online dealer like Monex. You can even buy gold coins on eBay. There are all sorts of places to get it, but the most important thing here is that you should always expect to pay a premium for physical gold. When you see the price of gold on the news expect to pay a bit more than that for some coins or bars.
Another way to own physical gold is by buying jewelry. No joke! It’s definitely not the most efficient way to get it, and it’s probably one of the least liquid forms of gold, but it does happen to be the most fun. Your wife will thank you for it, too. And surely that’s worth the extra cost? Wives, if you’re the one reading this – kudos, by the way – have your husband study this newsletter top to bottom and tell him it’s a good way to diversify your investment portfolio. Really!
Just make sure the jewelry is of good quality – as an investment, more pure gold is better, but my mother-in-law has informed me that 24 carat gold (99.9% pure) doesn’t make for the best jewelry. So the two of you will need to compromise. But hey, that’s marriage.
If you’re looking for a little more kick, try picking up some stocks of companies that mine gold.
These are familiar names here in Nevada. Most of you, especially those of you between Lovelock and Elko, are familiar with the Newmont (NEM), Barrick (ABX), and Coeur d’Alene (CDE). You can also check out Randgold (GOLD), AngloGold Ashanti (AU), Agnico-Eagle Mines (AEM), Goldcorp (GG), or Kinross (KGC).
Traditionally, these have been a more “leveraged” way to invest in gold; these gold stocks typically go up more than gold if gold’s rising, and fall farther than gold if gold’s going down. They don’t typically move with the broader market to the extent that other economically-dependent stocks do, so if you’re building a simple portfolio of stocks, gold miners are a great way to get equity diversification. I’m not a mutual fund manager, but if I were, I would absolutely own gold stocks in my fund. You can buy a straight basket of all the gold miners in one easy purchase with GDX, an ETF that mirrors the NYSE Arca Gold Miners Index.
If you don’t mind the extra layer of fees, you can also pick up a gold mutual find like Tocqueville (TGLDX) or Gabelli Gold (GOLDX). They’ll hold a mix of actual gold and gold stocks and sometimes some related positions. Sometimes it can be worth it to have a professional fund manager’s expertise.
I feel as though I need to make one final thing clear. It’s subtle distinction, but when I say that every investor needs to own some gold, I’m not saying that I think that gold is necessarily going up in price.
I do think that a decade from now it will be higher than it is today, but I’m a lot less sure about where it’s headed over the short run. Unfortunately, that’s a call you’ll need to make on your own. But if you’ve made it this far in this article, you’re certainly equipped to do so, and with confidence.
Caveat Emptor
As you’ve listened to me pontificate about gold, you need to understand who I am in order to put my comments into proper context. As with any advice you hear dispensed from any fountain of so-called expertise, you need to develop an understanding of the source before blinding accepting its ideas as your own. You need to be aware of my biases and predilections.
I am a second generation native Nevadan. I was born here, raised here, then ventured out into the world only to return here. I love living in Nevada, and not only that, feel spiritually bound to the region. As a kid I spent many a summer vacation in the South and would later live and work for 6 years in Los Angeles. So I understand powerful local cultures, to be both a part of them and exist within them as an outsider.
Nevada is who I am, and Nevada itself is a composite of others like me, individuals from present and past.
Gold is a key part of our state and our history.
Nevada produces a whopping 80% of all the gold mined in the United States. Those of you readers from other states or outside the country might not understand how proud we are of our mining heritage. The discovery of the massive Comstock Lode underneath Virginia City was one of the most influential factors in Nevada being admitted as an official Union territory. Abraham Lincoln saw the opportunity and welcomed us to the Union, ensuring that our silver riches would assist their cause and not the Confederate’s.
As a state of no-frills pragmatists, Nevadans understand mineral wealth. To us these metals are not “bling”. They’re not a fad, nor are they for speculatin’. These metals are practical, useful. Necessary, even. They are hard assets.
What kind of person holds gold through a 40-year rollercoaster from $100 to $850 back to $250 and onward above $1000?
Nevadans do.
Like Tolkien’s Dwarves of Moria, we are transfixed by gold’s eternal, timeless worth. We are the ones who work so hard to pull it up from deep in the earth only to re-bury it in our vaults for subsequent generations.
Perhaps we do have an innate understanding of gold that others don’t. But we couldn’t possibly be considered objective – which isn’t to say you should regard this aspect of our regional culture with complete skepticism.
All I’ve really given you thus far has been facts.
—
Disclosure: Long GLD, long TGLDX, GOLDX
Welcome back! This week we’ve got a few more very important things that you need to understand about gold. This is the second part in this series and you can find the first three things you need to know about gold here.
But first, a brief announcement:
If you’re part of a business that’s looking to hire or is looking for ways to optimize your workforce, check out our recent article that was published in the Northern Nevada Business Weekly. You can go straight to their website and read the article here, though you may have already found it in this week’s print edition available to subscribers and on newsstands throughout Reno.
The article is a little different than the content we typically publish here on The Draconian. After managing a fund of hedge funds for so long, we’ve learned a thing or two about “hiring” high-quality talent. The decisions of who to hire and fire are among the most important choices that any business makes, and in the brief article we outline a couple of strategies to help you build a happier, more productive, lower-cost workforce.
In fact, if you’re someone who is looking for a job right now or at least thinking about a new job, you should probably also give it a read – it might give you a tip or two on how to really stand out amidst other candidates for an opening.
Again, you can find the article online right here.
We’re honored and excited to be published in the Northern Nevada Business Weekly. We’ve been big fans of their newspaper for a long time. If you’re a local small business owner or just want to stay plugged in to the local business community you simply have to read it. The NNBW is to local business what the Reno News & Review is to the local arts & culture scene – a respected authority on an important local niche. Head on over to NNBW.biz for information on how to subscribe.
On with our scheduled programming and things you need to know about Gold.
4) We’re nowhere near the real peak back in 1980.
One of the most famous events in the gold market was its run to $850/oz back in 1980.
Almost three decades later, gold finally made a new all time high, but it was an all-time high in nominal terms. Adjusted for inflation, we’re still nowhere close to what we saw in 1980.
Here’s a chart adjusting the price of gold for inflation (using today’s dollars):
That being said, it’s important to keep in mind that the 1980 peak was a speculative bubble and comparing today’s price, in either real or nominal terms, to that speculative peak is nearly worthless. It’s like saying that home prices can go up another 100% from here because that’s where prices were in 2005. Or like arguing that JDS Uniphase stock could go back to $1,000 per share because that’s where it was trading during the heights of the dot-com bubble. We might still be a long way from the real highs in the gold market, but there are much better theses on which to base a bullish case for gold.
It’s important to understand that what we’ve seen in the gold market since 2001 is not a speculative bubble. As we mentioned last week it’s been due to a steadily weakening dollar coupled with increasing demand from both investors and foreign central banks, particularly China who needs gold for both financial and industrial applications.
The price of gold is, however, at the high end of what has basically been a 40-year trading range. Movement beyond this range will be contingent upon steadily increasing demand or a continually weakening dollar which, given the mess we’re in today, is certainly within the realm of feasibility.
It seems like there are advertisements for gold everywhere you turn and gold has had a heck of a run since it’s lows back in 2001. But anybody that claims that gold is in the midst of speculative frenzy right now 1) doesn’t understand the history of the market, 2) doesn’t grasp the relationship it has with paper currencies, and 3) clearly has never looked at an inflation-adjusted gold chart. If gold moves to $2500/oz in a year or two, then I might call “bubble.”
Keep your eye on both the investing public for hints at speculative demand and the Federal Reserve for guidance on monetary policy. If investors around the world do start really speculating on gold, you can see from that chart how high it might go. There have been an awful lot of great bull markets in history that have ended in speculative frenzies. But should the Fed start taking some of these dollars out of the system and tightening up monetary policy to bolster the strength of the dollar, it would very likely be very bad for gold.
The Treasury can talk tough with the Dollar, resurrecting all that bogus “strong dollar policy” rhetoric, but the fact of the matter remains that the US is quite dependent on a weaker dollar right now to help out exports and get the current account (trade) deficit back in line. The economic fundamentals simply aren’t there to justify a strong currency. I have a hard time imagining any kind of significant dollar rally that is not accompanied by another global crisis and a worldwide flight-to-safety or definitive indication from the Fed that they are interested in cranking interest rates back up. What other reason could the dollar possibly have to rally?
Plus, as you’ll see in the next item, when not enough dollars are moving around, the Fed needs to keep more of them into the system:
5) We’re not going back to a gold standard.
And take away Obama, Bernanke, Geithner & Co.’s ability to keep printing more dollars on demand? puh-lease!
They might be fighting a noble fight, attempting to combat the effects of a nasty recession, but know that each dollar that gets printed or pumped into the system via quantitative easing runs the risk of decreasing the relative value of all the other dollars in the system. It’s simple supply and demand.
There’s been substantial easing already, but we haven’t seen many signs of price inflation. One of the big reasons why is frequently overlooked: there has been a total collapse in monetary velocity.
The velocity of money is basically just the average frequency with which a dollar is spent within an economy. For example, if I have $1 and use it to buy a cup of coffee from you, and you then take that $1 and use it to buy a donut from me, we’ve created $2 of Gross Domestic Product for the little economy that exists between you and me. Our $1 of total money supply has turned over twice. With this, we can actually rewrite GDP another way:
GDP = M (the money supply) * V (the velocity of money)
So when the velocity of money in a big economy like the US drops because people slow down their spending, The Fed needs to increase the money supply to prevent a subsequent drop in GDP. It typically does this by purchasing government bonds out in the market which increases the reserves at banks which means they can turn around and loan more money to people.
Here’s a monetary velocity chart for M2, which consists of things like paper currency, bank checking deposits, traveler’s checks, savings & time deposits, and money market funds:
The big reason for that sharp drop in velocity has been banks’ unwillingness to lend out money because of shakier capital foundations and stricter lending standards. There’s a reason the banking system in particular has been so aggressively targeted with stimulative efforts. Imagine a giant network of gears – the banking system is the big gear in the middle that turns a whole bunch of smaller gears around it and so The Fed has spent the majority of its efforts getting that central gear turning again.
This is all relevant for gold because, as you can see, we’ve needed to aggressively grow the money supply lest that collapse in velocity seriously impact GDP. But the great economist Milton Friedman warned we shouldn’t ever increase it by too much. Increase the money supply by too much and you do get inflation. It’s a tight rope act. And like any tight rope act, it’s incredibly captivating because so much is at stake – the life of the rope walker or the fate of our currency.
There’s a very common false argument out there that simply “printing money” (via quantitative easing) will destroy the dollar, create inflation, and therefore drive the price of gold sky high. This isn’t always the case. There are times when good old fashioned money printing is what’s called for, especially when we want to make a nasty recession a little less nasty. A gold standard would throw a monkey wrench in The Fed’s ability to do that. It also would make it much more difficult for the US to pay back its creditors, but that’s a whole ‘nother can of worms. We’ll explore that rabbit hole in another letter.
The US paper dollar has value because we can always use these dollars to settle our debt with the government (aka income taxes). So long as everybody needs to pay taxes then paper dollars will have some sort of value. I know that if I offer my services in exchange for your dollars, I will accept your dollars because I can use those to settle my tax bill next April.
That being said, the track record of fiat currencies throughout history is very poor. Many have involved spectacular collapses from the late Romans to John Law’s 18th Century France to Weimar Germany to more recent collapses in the Mexican Peso, Thai Baht, and Russian Ruble. There has never been a major fiat currency that has lasted very long. I’d like to think our track record will be better here, but really bad things have happened in the US before and really bad things will happen again.
A currency crisis could be one.
Which brings me to…
6) Every investor needs to own gold.
If you have an investment portfolio of significant size, some of that portfolio needs to be allocated to gold.
If you’ve ever met with a financial advisor, you’ve surely heard something about building a “balanced portfolio”, something like 60/40 or 70/30 stocks and bonds depending on your age. Target Date funds are very popular now with mutual fund companies; these are funds that start out aggressively with allocations to riskier equities and then slowly get more conservative and add more fixed income as they move towards a “target date” at which one will presumably retire. They’d be a neat idea if that was the way investors actually invested.
But how many financial advisors have seriously urged you to add gold to your portfolio? Where’s the 40/40/20 portfolio? Or where’s the “six dimensional portfolio” that allocates across cash, equities, bonds, gold, real estate, and alternative funds? That’s real diversification for you.
Anyway, let me be clear: own gold.
The reasons for owning gold are numerous, but only one reason matters. The only reason that should ever matter when adding any new investment to your portfolio. Gold is different and it moves in totally different ways.
And I’ve got good news. It’s a lot easier to add gold to your portfolio than you might think.
The easiest way to get it is through a gold ETF. There are several gold ETF’s (exchange traded funds), but GLD is what I use. You can learn about The SPDR Gold Trust here, but the key thing to know is that it holds physical bullion. A lot of commodity ETFs – you might be familiar with UNG (natural gas) or USO (crude oil) – just hold or trade the futures contracts which is problematic because futures contracts expire and before they do, new ones need to be purchased.
Without getting too technical and dropping crazy terms like “backwardation” and “contango” (two of my all time favorite words) you simply need to be aware that the values of these ETFs won’t perfectly track the underlying commodity. Sometimes they’ll go up more than the underlying commodity, but because of the nature of commodity markets, they usually underperform.
So if you buy GLD, you’re technically buying shares of a trust that holds a whole lot of physical bullion. GLD will move in almost perfect lockstep with the actual price of gold.
Owning gold through a trust is cool, but owning physical gold is really cool. Show someone a 1oz gold coin and watch how they react. It’s a great party gimmick and is guaranteed to impress your friends. You can buy gold coins through the US Mint or through a local coin dealer or an online dealer like Monex. You can even buy gold coins on eBay. There are all sorts of places to get it, but the most important thing here is that you should always expect to pay a premium for physical gold. When you see the price of gold on the news expect to pay a bit more than that for some coins or bars.
Another way to own physical gold is by buying jewelry. No joke! It’s definitely not the most efficient way to get it, and it’s probably one of the least liquid forms of gold, but it does happen to be the most fun. Your wife will thank you for it, too. And surely that’s worth the extra cost? Wives, if you’re the one reading this – kudos, by the way – have your husband study this newsletter top to bottom and tell him it’s a good way to diversify your investment portfolio. Really!
Just make sure the jewelry is of good quality – as an investment, more pure gold is better, but my mother-in-law has informed me that 24 carat gold (99.9% pure) doesn’t make for the best jewelry. So the two of you will need to compromise. But hey, that’s marriage.
If you’re looking for a little more kick, try picking up some stocks of companies that mine gold.
These are familiar names here in Nevada. Most of you, especially those of you between Lovelock and Elko, are familiar with the Newmont (NEM), Barrick (ABX), and Coeur d’Alene (CDE). You can also check out Randgold (GOLD), AngloGold Ashanti (AU), Agnico-Eagle Mines (AEM), Goldcorp (GG), or Kinross (KGC).
Traditionally, these have been a more “leveraged” way to invest in gold; these gold stocks typically go up more than gold if gold’s rising, and fall farther than gold if gold’s going down. They don’t typically move with the broader market to the extent that other economically-dependent stocks do, so if you’re building a simple portfolio of stocks, gold miners are a great way to get equity diversification. I’m not a mutual fund manager, but if I were, I would absolutely own gold stocks in my fund. You can buy a straight basket of all the gold miners in one easy purchase with GDX, an ETF that mirrors the NYSE Arca Gold Miners Index.
If you don’t mind the extra layer of fees, you can also pick up a gold mutual find like Tocqueville (TGLDX) or Gabelli Gold (GOLDX). They’ll hold a mix of actual gold and gold stocks and sometimes some related positions. Sometimes it can be worth it to have a professional fund manager’s expertise.
I feel as though I need to make one final thing clear. It’s subtle distinction, but when I say that every investor needs to own some gold, I’m not saying that I think that gold is necessarily going up in price.
I do think that a decade from now it will be higher than it is today, but I’m a lot less sure about where it’s headed over the short run. Unfortunately, that’s a call you’ll need to make on your own. But if you’ve made it this far in this article, you’re certainly equipped to do so, and with confidence.
Caveat Emptor
As you’ve listened to me pontificate about gold, you need to understand who I am in order to put my comments into proper context. As with any advice you hear dispensed from any fountain of so-called expertise, you need to develop an understanding of the source before blinding accepting its ideas as your own. You need to be aware of my biases and predilections.
I am a second generation native Nevadan. I was born here, raised here, then ventured out into the world only to return here. I love living in Nevada, and not only that, feel spiritually bound to the region. As a kid I spent many a summer vacation in the South and would later live and work for 6 years in Los Angeles. So I understand powerful local cultures, to be both a part of them and exist within them as an outsider.
Nevada is who I am, and Nevada itself is a composite of others like me, individuals from present and past.
Gold is a key part of our state and our history.
Nevada produces a whopping 80% of all the gold mined in the United States. Those of you readers from other states or outside the country might not understand how proud we are of our mining heritage. The discovery of the massive Comstock Lode underneath Virginia City was one of the most influential factors in Nevada being admitted as an official Union territory. Abraham Lincoln saw the opportunity and welcomed us to the Union, ensuring that our silver riches would assist their cause and not the Confederate.
As a state of no-frills pragmatists, Nevadans understand mineral wealth. To us these metals are not “bling”. They’re not a fad, nor are they for speculatin’. These metals are practical, useful. Necessary, even. They are hard assets.
What kind of person holds gold through a 40-year rollercoaster from $100 to $850 back to $250 and onward to $1000?
Nevadans do.
Like Tolkien’s Dwarves of Moria, we are transfixed by gold’s eternal, timeless worth. We are the ones who work so hard to pull it up from deep in the earth only to re-bury it in our vaults for subsequent generations.
Perhaps we do have an innate understanding of gold that others don’t. But we couldn’t possibly be considered objective – which isn’t to say you should regard this aspect of our regional culture with complete skepticism.
All I’ve really given you thus far has been facts.
—
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—
This week we take a hard look at gold.
Gold has become a bigger and bigger story over the last several years as it’s steadily surged toward new peaks, just a week ago summiting an all-time high of $1,058 per ounce. This has dovetailed in perfect synchronicity with increasing fears about inflation, concern about the strength of our national currency, and uncertainty about our collective economic future.
Now’s as good a time as any to drill down and separate myth from reality. As usual, what we have to say may not be what you’ve heard elsewhere. We like to take a contrarian perspective on the world, though certainly not just for the sake of being contrarian. Fundamental correctness is absolutely paramount to any contrarian viewpoint. We are firm believers that when it comes to macro investing, the best way to make real money over the long run is with a stance that is both contrarian and fundamentally correct. Being contrarian is easy (though not as easy as you might think), but being correct is hard. There is a lot of money to made from situations where most of world has it wrong and you have it right.
Gold is probably the one thing we get asked about the most. When we meet people out in the world that find out that we trade commodities, they almost invariably ask us what we think about gold. Most people that you talk to tend to have an opinion about it. Unlike stocks and especially bonds, investor sophistication has little to do with an individual’s opinion of gold. Quite simply, everybody wants it. They have for millennia. What’s more is that they understand it innately. The want is almost primal.
Gold has been demanded and desired by basically every civilization in history. It’s been used as a store of wealth throughout the ages. At various times in various economies in history it’s been used as a medium of exchange, either directly, or indirectly as a hard asset backing a paper currency.
Understanding all this historical and psychological context is important before we get down to the nitty gritty. When we begin looking at gold, and more importantly, begin using gold as a tool, it’s important to keep all the noise at bay. We need to look at it objectively.
So here we go, the first three things you need to know about gold:
1) It’s not the inflation hedge you think it is.
In the past gold hasn’t actually correlated very well with inflation. Gold went pretty much straight down from the frenzy peak in 1980 until about 2001. That was a period of unquestionably positive, albeit modest, inflation. If you bought gold in the 80’s to hedge against future inflation, you lost money on both sides – not exactly the kind of result one is looking for in a hedged trade.
Over the long, long run gold has worked as an inflation hedge. But a lot of things have gone up in value over the last century and have thus have correlated positively with inflation. In the 20th century, just about everything that was denominated in dollars went up in value as the value of the dollars denominating them went down. So over the long, long run, it’s not really much better a hedge against inflation than equities or real estate or other physical assets.
You might also be curious if gold can predict future inflation.
The below chart looks a little confusing at first but it really isn’t so bad. All it does run back through history, stopping at each month to look back at the previous 12 month change in the price of gold and chart it against the next 12 month change in the inflation rate (as measured by the CPI).
So each dot represents one month and it measures the prior year’s change in the gold price versus the coming year’s change in inflation. I also did it for a 6-month interval as well.
Make sense? We now can ask:
The answer is… sort of.
It’s pretty clear to see that the slope of the regression lines are both positive which means that there is indeed a positive correlation between past movements in gold and future movements in inflation.
But during normal times i.e. annual inflation between zero and 5%, movement in gold does a very poor job predicting the rate of inflation. Perhaps because normal times are boring. Nobody cares about inflation in the low single digits. That is what the Fed is actively shooting for, after all. Central bankers around the world sleep soundly and have happy dreams if inflation is positive and low.
What investors want to know is if there’s a way to forecast hyperinflation. And here you can see that when gold has really gone wild, increasing by 100% or more in 6 months, it has usually meant that high single-digit or double-digit inflation has followed in the next 6 months. It does a little better job as a predictor here, but keep in mind that just about all of those data points towards the top right corner in that chart were from the late 70’s and early 80’s. The gold market was held in the grips of a speculative frenzy and the country had already been experiencing double-digit inflation for years. So none of those data points would have been particularly useful in practice.
The take-home point here is that one should be careful when looking at the gold market and using its movement to divine the future. Yet again, we bump up against the ubiquitous conclusion that past performance is not indicative of future results.
Gold’s up around 20% in the last 12 months which is a big move, but you can see that very little should be excluded from our expectations of the change in coming the inflation rate. Pretty much any outcome is in play.
2) It’s best thought of as a “neutral currency”.
The most important thing to understand about currencies is that they are a relative value proposition. Currencies don’t have an independent, absolute value the way other assets do. Instead they are globally priced in terms of other currencies. Or even other assets, which can be a little counter-intuitive. I went to the grocery store yesterday and there was a big box of pumpkins outside where they were strangely pricing dollars in terms of pumpkins. The sign said $1/4lbs pumpkin. Apparently one dollar is actually worth 4 pounds of pumpkins. How many pounds of pumpkins does one ounce of gold cost? About 4,260 pounds of pumpkin!
As I’m sure you’ve noticed, economists have a strange sense of “humor” and one thing we like to do for fun is price one thing in terms of another thing.
It’s especially interesting to use gold for this. For example, let’s price the stock market in terms of gold. The first chart is log scale, the second is linear scale:
There are a lot of ways to interpret those charts.
When priced in terms of a “neutral currency”, the dot-com market bubble really stands out. That was an epic bubble, folks. What’s interesting is that the stock market’s second run back towards new highs in 2007 wasn’t really an equity bubble at all. It wasn’t even really a bull market. To somebody that used gold as their currency – or even a lot of other foreign currencies – the highs in 2007 were just another stop on the way down in a gigantic bear market. That second little peak in the stock market was actually due to dollar weakness!
Here’s a chart of the Dollar Index (DXY) which measures the value of the US Dollar against a basket of foreign currencies:
Kind of remarkable, no? The dollar is on balance about 35% less valuable relative to a basket of other major currencies than it was at the beginning of this decade.
In the summer of 2001 I went backpacking through central Europe, pretty much at the exact peak in the USD. At the time I was astonished at how cheap everything was over there. Hostels in Germany and Austria were only $5-10 dollars per night, while a very nice bed & breakfast in Venice cost me about $60. Greece was ridiculously cheap and the (wonderful) food was only slightly more expensive than “free”.
I returned to Europe in the summer of 2007 – not quite the low in the US Dollar, but pretty close. Needless to say, the experience was substantially more expensive. My dollars didn’t take me nearly as far, but fortunately I had a couple more of them to offset their loss in global purchasing power.
Unless you travelled beyond US borders, you probably haven’t noticed such a drastic change in your own purchasing power in the last decade. Most people don’t have a very good sense of how valuable the dollars we hold in our bank accounts are relative to other currencies and assets. But if you’ve owned gold, effectively a neutral, global currency, you’ve noticed it trend straight up and a big reason is the decrease in value of the dollars in which it’s denominated.
The point here is that since it’s priced in dollars, gold is very dependent on the relative value of those dollars and the future price of gold is inextricably linked to the fate of the world’s paper currencies. Dollar-denominated gold will perform much better when the US Dollar is under substantial pressure. Dollar strength typically tends to be a fairly large headwind for gold.
The difference is subtle, but Gold is your hedge against dollar weakness, not inflation.
3) Trading it will drive you bonkers.
Like I said a few months ago: Gold never moves the way you think it will. It never tells you what you think it’s telling you. And it does strange things for even stranger reasons that no sane person can hope to understand. Investors who own gold for the long haul love it, but I’ve yet to meet the trader who hasn’t been driven completely insane by the gold market at some point in his career.
The reason why it’s so tough to trade is that it’s so difficult to predict where gold is heading over the short run.
Does that chart keep moving higher over the next few months? It looks like an easy answer, and were it anything other than gold, I might take a shot at answering it.
Over the long run, it’s easy. Gold will exhibit inverse correlation with the dollar and over the long, long run the dollar is a sure bet to get weaker relative to the amount of goods that it can purchase. I think the single best bet an investor can make today is that 100 years from now each US Dollar will buy substantially fewer goods & services and be worth substantially less against a hard asset like gold.
Check this out:
The red lines measure the trailing 1-year inflation rate. The green line, measured on the right axis, shows the purchasing power of the dollar. Today each US Dollar is worth about 96% less than it was worth in 1900. You can see that dollars are a bad investment over the long run, and incidentally, this is why people demand interest when holding dollars on deposit at a bank. If I’m going to let you hold one of my dollars for the next year, you’d better give me more than my one dollar back a year from now because I can be fairly confident that that one dollar will be a little less valuable relative to what it can purchase.
The more inflation that’s expected, the more interest that’s demanded. This is why it’s usually a little better to look at something like the bond market to get a read on future inflation than the gold market.
Gold doesn’t necessarily go up when inflation is expected and it won’t necessarily rise with to the degree to which inflation is expected. Sometimes it does. But usually it doesn’t.
Interest rates are a much better indicator here. They typically go up when inflation is expected, and the more they go up, the more inflation the market’s expecting. Predictable reactions like this make bonds a whole lot easier to trade than gold.
Market Recap
Along the subject of a weaker currency, the Big Dollar Trade – selling short the US dollar – is back on in a big way in Hedge Fund Land. A lot of hedge funds made a lot of money on this trade from 2002-2004 and they’ve been putting it back on this year in a variety of different ways. Some funds like John Paulsen have been acquiring gold, others have been buying foreign currencies, while others like Jim Rogers have been loading up on physical commodities.
Housing
This caught my eye the other day.
"Hundreds of thousands of home buyers have come off the sidelines because of the [new homebuyer] credit, and if we lose it we risk losing the stability that is creeping backing into the housing market and the economy overall," said Robert Story Jr., a Seattle mortgage banker and the incoming chairman of the Mortgage Bankers Association.
Wow. That sounds strangely like the twisted logic of drug addict. “Don’t take away my drugs, man! I need my drugs, man! You wouldn’t like me without my drugs!”
My generally skeptical view of a robust housing recovery aside, I have mentioned several times over the last few months that we are all becoming dangerously addicted to and uncomfortably reliant on government stimulus to consume. This is something that should make people concerned about the true state of the economy instead of optimistic.
At some point the drugs have to be taken away, right? I mean, we can’t perpetually give people free money to buy a house. Eventually we’ll have to stand on our own and deal with the effects of withdrawal. And what do we know about withdrawal? It’s painful.
But there’s serious talk about extending that new homebuyer credit, and the smart money says it probably will be. Thank goodness – looks like we’ll get one more hit!
That’ll be a good thing for the housing market over the short run, but probably a bad thing for the long run as it works through the withdrawal symptoms. You can read more about my thoughts on housing here.
Dow 10k Redux.
The last week has been a great one for stocks and the Dow crossed above 10,000 yet again. Who in the world back in 1999 would have thought that the Dow would cross above 10,000 for a fourth time over ten years later? Something tells me that this won’t be the last time we cross above or below this meaningless milestone.
Traders, I certainly wouldn’t get short at this point in the market, but I’d take any profits from trades I’d put on in the last two weeks and look to reload on any significant pullback. Fighting the trend at this point is foolish, but don’t mistake that for an endorsement of stock returns over the next several years. The recession is over and the market has rejoiced at that prospect. But winter isn’t over yet.
That’ll do it for this week. Next Thursday we’ll return with Three More Things You Need to Know About Gold. I can’t wait – this is exciting stuff!
See you then,
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This week we cover some interesting ground and begin with a short lesson on economics. If the mere thought of an economics lesson makes you drowsy, stay awake! Go pour yourself another cup of coffee. This is extremely important stuff to understand because in this lesson are the answers to a very important question: “Is another crash coming?”
Now I’ve got your attention! Don’t worry, I promise not to let things get too technical.
Welcome, new readers from the Reno Gazette Journal. The Draconian is being syndicated in the blog section over at RGJ.com. Those of you readers who aren’t yet familiar with our firm can learn a little bit about us here and this website there.
We’re also developing a dedicated iPhone app, but in the meantime I installed a backend iPhone application in WordPress. If you direct your iPhone Safari browser to TheDraconian.com you will see a specially formatted web view that’s really easy to read when you’re on the go. You’ll even get a snazzy orange dragon and one-touch access if you bookmark it to your home screen.
Away we go…
Market Recap
One week ago exactly I mentioned that it was a great time to buy the market for a short term trade. Had you bought the market on Thursday’s close at about 1030, you’d be up almost 4% on that trade through today. Not bad for one week.
Sometimes I get lucky and nail these things spot on, but the fact remains that the secondary trend in the market is bullish, which means that traders should be buying on weakness. In practice, it’s a lot harder to actually buy into weakness than it sounds. On days when everything seems to be going down it’s very tempting to “wait and see” – emotion is a lot tougher to ignore than many give it credit for. Often, the toughest trade winds up the best one.
We actually did buy the market on Friday’s open in one of our funds, and I’ll admit it was a little hard to do because so many talking heads were thinking that the market was on the verge of rolling over. Fortunately as systematic traders, we’re able to place a lot of faith in our signals and can avoid much of the emotion of trading. We grabbed the low, sold at the high a few days later, and it wound up being a dynamite trade. Now we patiently wait for the next opportunity.
It doesn’t always go so smoothly. We certainly have our share of stinkers too. But bad trades are a whole lot easier to deal with if you clearly define your risk before entry and set precise targets and conditions for exit. Making the occasional bad trade is a simple fact of life as a trader. Nobody gets ‘em all right. However, not allowing bad trades to fester into disastrous trades is something a trader can control, and this discipline is what separates the good traders from the bad. The classic example is Average Joe, who buys stocks in the midst of a speculative bubble, holds onto them through the peak, and refuses to sell as the market falls further and further, all the while thinking “things have got to come back eventually!” The poor guy had no good reason for getting in and no plan for getting out.
Also of interest in the markets this week was the 10-year TIPS auction (Treasury Inflation Protected Securities) on Monday which showed very strong demand with a bid-to-cover ratio of 3.12. It’s not an immediate indicator that inflation is on the horizon, but it is indicative that there is strong demand to pick up some insurance against future inflation just in case.
TIPS are a great hedge against inflation because their principal adjusts with the consumer price index. If you own TIPS and the CPI goes up, the face value of your bonds go up! Pretty cool, huh?
The bad news about using TIPS as an inflation hedge stems straight from the CPI. The CPI is the most popular way of measuring inflation, but to say that it’s criticized by certain folks out there in the market is a massive understatement. Critiques range from a simple understatement of true inflation to some radical voices that claim it’s outright fraudulent in its methodology. The Bureau of Labor Statistics take a lot of heat for the way they calculate it and the numbers they come up with.
There’s usually more grumbling about the CPI during inflationary periods, especially when the prices of things like gasoline and physical goods rise sharply. Individuals and small businesses feel the effects of those price changes very acutely and when the CPI doesn’t keep pace with those increases, these folks perceive it as though a great injustice is being perpetrated against them. When inflation is low, nobody seems to have any beef with the CPI.
Anyway, we still think that price inflation will run cooler than a lot of people are expecting. Of course that thesis is predicated on a tepid recovery or even a double-dip recession. If the GDP growth we see in in Q3 and Q4 this year really takes hold and it looks like the economy will definitively firm up in 2010+, it will certainly be time to revisit that forecast. But right now the bond market is telling us that the economy is weak and the Inflation Chupacabra is nowhere in sight.
A fresh look at Capitalism
One of the side effects of the changing political tide of the last year and historic government intervention is that capitalism is being reshaped before our eyes. It’s still all about the pursuit of profits and taking risk, but part of what makes Capitalism work in both theory and practice is that failure carries real penalties. When the penalties are paid by somebody else – as they have been in the case of bailouts past and present – then the costs associated with taking risk disappear. Everyone (or everyone large enough to qualify for a bailout) immediately develops the incentive to take a lot of risk.
“Capitalism without failure is like Christianity without hell.”
– Warren Buffet
Free market capitalism isn’t free market capitalism if there’s a net.
This isn’t actually a bad thing, per se. It just means that our capitalism in practice is intellectually impure. Again, that’s not a bad thing on its own. It just means that it won’t work the way it works in the textbooks and nobody should expect it to. Capitalism with a net sounds like a self-sustaining, self-regulating, stable system, but it’s actually inherently unstable.
For the reason why, we turn to the economist Hyman Minsky. I’ll boil down Minsky’s view of capitalism as follows:
Imagine a brand new economy, one starting from scratch or maybe getting back up on its feet in the wake of a depression. You and I found our businesses on sound business plans, with well thought out methods for generating profits and free cash flow. Our businesses and others are pretty conservative as a whole. Borrowers and lenders steer clear of risky stuff. Profits arrive on time in a predictable manner and what debt there is in the system always gets repaid. Our imaginary economy grows steadily.
All this success now starts to breed a little more risk as businesses hope to boost their profits. We are reminded of Ricky Jay’s memorable line in Mamet’s The Spanish Prisoner, “we must never forget that we are human, and as humans we dream, and when we dream we dream of money.”
There is no better framework in the world to pursue that dream than capitalism. After years of prolonged success, more and more of us forget that failure is a possibility and we all get more and more comfortable taking more and more risk. The economic profits now really start to roll in.
Eventually our hypothetical economy and all its success starts attracting what Minsky termed “speculative borrowers,” people or businesses who take on lots of debt to participate and whose income might be able to meet the interest payments on that debt but not the principal. All these profits also start attracting “Ponzi borrowers,” people or businesses who rely on financing to participate and whose income isn’t sufficient to cover either interest or principal payments. Instead, these folks rely on ever more borrowing to pay their bills and service their debt.
What was once a conservative, soundly profitable economy has now become a very risky one dependent on cheap, easy credit. Our economy might still be very successful, and it might only have been possible in a capitalistic framework, but it is now extremely vulnerable to shock and panic.
The famous “Minsky Moment” occurs when an exogenous shock leads to an economy-wide pullback in credit. Speculative and Ponzi borrowers are the first to implode as their credit is pulled and their sole means of participation vanish. More conservative individuals and businesses suffer too as they start selling assets to pay off debt, the sales of which drive prices lower and lead to further reduction in systemic credit. Legitimate businesses start blowing up and everybody stops spending money at once. Now the broader economy starts suffering as its thrown into recession.
Sound familiar?
Solutions to the problem
It shouldn’t surprise you to hear that Hyman Minsky – an obscurity for his entire career – is suddenly, almost magically, quite popular.
He did most of his work in the 1960s, a time of stable economic success, so it’s no wonder people thought he was crazy. Everybody thought he was nuts in the late 90s as well.
Now that he has the world’s economic ear, let’s examine his proposed solutions for these inevitable crises of capitalism.
First, Minsky believed that the Fed would need to step in and act in accordance with its mandate as “lender of last resort”, loaning money on generous terms to pretty much anything of significant size that needed it. Mission accomplished.
Second, he thought that the government, which he actually referred to as – Republicans, cover your ears – “Big Government,” should step in and act as the employer of last resort, handing out a job to basically anyone who wanted one at a pre-set wage. Today the government has done what it can within the realm of political feasibility to create some new jobs, but guaranteeing a job to anyone able and willing to work is a pretty radical, socialistic idea. As you may have noticed, we’ve taken the Keynesian path instead. I talked about that here in case you missed it.
Ultimately, Minsky believed that there was no answer, no cure for the inherent ills of capitalism. Stability, profitability, instability, and loss are as unavoidable as the seasons. Here in October we all know that winter is coming, but instead of trying to rig up a false world of permanent summer, we simply brace ourselves for the change in weather. We know winter eventually passes and so next spring we’ll sow seeds in our garden with the confidence that they’ll grow.
It’s tough breaking free from the linear frameworks that dominate Western/Judeo-Christian thought, but during times like these, we all might derive a little peace from simply appreciating the cyclicality of life and the world that surrounds us.
Before I drift off into philosophical reverie, let’s bring it back to reality…
The Minsky Moment happened already
The crisis already happened last fall. Credit contracted, speculative borrowers wiped out, and it dragged the economy deep into recession. To get a historical read on that, we take a look at the LIBOR-OIS spread.
I know – “LIBOR-OIS spread” sounds complicated and wonkish, but it’s basically just a measure of how banks feel about each other. When it’s high, it means that banks doubt each others’ creditworthiness and won’t lend each other money. When it’s low it means that banks trust each other and they’re happy to loan each other money.
(Techie note: LIBOR-OIS measures the spread between the London Interbank Offered Rate and an overnight indexed swap of the Fed Funds rate. It’s used with its more-friendly named cousin, the TED Spread, which is the difference between the interest rate on 3-month U.S. Treasury Bonds and 3-month Eurodollar contracts.)
It’s a great measure of risk and liquidity in the markets. When used in conjunction with the VIX and VIX futures (the CBOE Volatility Index) even a novice investor can get a very accurate, very sophisticated read on the level of risk and fear in the marketplace.
It’s really simple to interpret these things too. When they go up it means more risk and when the go down it means less risk.
In the chart above you can see that last October banks were pretty freaked out about each other. Historically freaked out. The stock market crashed as a result and the financial system ground to a halt.
You’ll also notice that there were indications of stress and an increase of risk in the credit market as early as August 2007.
I’ve mentioned before that our real business is actually not newsletter-writing (no surprise!) but portfolio management. We conduct our own proprietary trading and also manage a fund of hedge funds. You can find information on all that here. August 2007 was exactly when we started noticing strange behavior in Hedge Fund Land. Many of the most highly-leveraged hedge funds suffered disastrous performance that month and several of their managing firms were put out of business as a result. These hedge funds were the proverbial canaries in the coal mine.
But today things look OK on the credit front. Hedge funds as a whole lost money in 2008, but dramatically outperformed the market. They’ve underperformed a bit in 2009, but as a whole they have been making decent money and we haven’t noticed any anomalous behavior, anything outside the realm of what one should normally expect in a normal environment.
Rest assured, I’ll inform you all immediately if I see anything potentially scary happening in the Hedge Fund Land.
Reading between the lines, you might take all that as an endorsement of the market. But let me be clear, it’s more of a gentle reminder that this crisis has passed. It’s over. That’s not to say that a separate crisis isn’t lurking around another corner later this decade or that the stock market won’t deliver disappointing returns over the next several years. I think those are both likely possibilities in 2010 and beyond. It’s also very likely that should another crisis transpire, it will be of a very different type. It could involve emerging markets, another war, a total breakdown in global trade, maybe even a shift in domestic fiscal policy – who knows. I wish I could tell you what it will look like.
Winter consists of many storms. The first might drop several feet of snow. That snow will melt and the next storm might bring icy rain or possibly a dry week of sub-zero temperatures. No two storms are exactly the same. If we can be sure of one thing it’s that the next crisis will look a little different than the last.
This is tremendously relevant because if you think the market or the financial world is going to completely fall apart tomorrow or next week the way it did last year, know that the odds at present are slim. Trying to trade around that thesis could prove dangerous.
Investors should be using this current reprieve to consider alternative investments and rebuild their portfolios in a manner that’s much better equipped to deal with range-bound markets and slower economic growth than we’ve grew accustomed to during the long boom. Stick a fork in “buy ‘n hold.” At least for a substantial while. (How’s that for a vague forecast?)
Viva la Revolución?
Yes, a major populist movement is underway. Yes, the next twenty years will be about rebuilding the middle class – not totally to the detriment of the rich or to the benefit of the poor. Yes, the government is flexing its muscles amidst an epic bull market in politics that will likely run for the next decade at least.
But captalism isn’t going away. There is basically zero talk in academic circles about serious alternatives. Michael Moore can call it “evil” and tug at all the heartstrings he wants in his own ironically-capitalistic pursuit of profits, but competition, economic individualism, and free-ish markets are here to stay. Did we learn nothing from the era of glasnost? It wasn’t that long ago! Free economies are superior to centrally planned ones.
The future will be about ways to make capitalism safer. And we’ll do it, too. I know this because we’ve done it before, back in the 1930s. More regulation and more stable markets will eventually emerge and systemic credit will pull way back.
When stability does re-emerge it will immediately start to breed – you guessed it – more risk. It’s hard to fathom today, but a decade or two from now the good times will return and we’ll all feel more optimistic about the future of our country than we have since the 1950’s, or even the post-Civil War Reconstruction. But once we get there, the slow march towards the next Minsky Moment will be on. The cycle of re-regulation and de-regulation will continue. Stability breeds instability.
Intellectually pure capitalism does avoid this endless cycle, but pure capitalism is pretty tough to stomach in practice. Hardcore Libertarians like myself may love it, but the sad truth is that it’s too darn scary for most people. The cost of failure can be total and the variance in wealth distribution can be extreme. Instead we have capitalism with a net and a bunch of regulation, which isn’t so bad, provided we understand how and why it works and gauge our expectations appropriately. Many difficult problems in life aren’t intrinsically difficult, but rather generate a lot of difficulty because we had inappropriately aligned expectations. For the curious, the world of Eastern philosophy does offer plenty of guidance on that, but alas, this is not a philosophy newsletter.
Here in the Sierras, we are highly attuned to the weather. There’s probably a deeply-rooted biological reason for that, but we know the instant we feel that first chill in the air that change is coming. We might not know if its our snow parkas or our galoshes that will be needed in the coming months. A fuzzy sweater may even suffice. But we get our expectations ready.
We put the shorts and sandals away until winter has passed in full.
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