My guess is that you’re probably not paying attention to the markets this week. And that’s totally fine. There really isn’t a whole lot to talk about.
There are just a few bits of significance. I’ll be quick and direct and send you on your way.
Your obligatory Europe update
You may or may not have heard about the ECB’s announcement that it was going to take a page directly out of the Fed’s playbook and lend directly to European banks, accepting dodgy sovereign bonds (or whatever else) as collateral.
This is a really big deal. For weeks and weeks I’ve been listening to all sorts of strategists call for this as a short-term solution to Europe’s woes. ”The ECB has to expand its balance sheet to avoid a banking crisis! They have to print money like the Fed!”
Well, they finally did it and the market said, “meh.” Perhaps the market knew the ECB’s hand was forced and had been pricing this action in already. Or perhaps the market is just tired and can’t summon the energy to get excited.
Whatever the case, this is significant action, the most significant to have emerged so far in the ongoing EU Debt Tragedy. Europe still has massive problems ahead — the biggest of which is the existential challenge of coming to terms with the philosophically flawed foundation upon which the whole EU was built — and it’s going to be a long, hard decade for our friends on the other side of the Atlantic. But I’m a whole lot less concerned about a banking crisis over there than I was a couple of weeks ago. I don’t see much headline risk in the coming weeks either.
This is a good thing for the obvious fundamental reasons. And it’s also a good thing because the market is now free to fixate on other narratives. I’m cautiously optimistic that the period of being forced to guess and trade around the European news headlines is behind us. Barring additional whammies that pop up out of nowhere, I’d expect a period of generally lower volatility in the weeks and months to come.
So score one for Europe. They followed the U.S.’s lead and made a big exchange of short-term, acute pain for long-term, chronic suffering. We won’t know for a decade or so if this was the right move. It’s every bit a moral and philosophical decision as it is an economic one. Questions like that are always complicated to answer.
The one thing we do know today that Europe is well past the point of easy, obvious decisions. Navigating their menu of choices involves selecting the lesser of multiple evils. The more time that elapses, the more evil those choices become and the more difficult it is to select the one that carries the least amount of pain.
Oh yeah. No surprise, the Euro dropped accordingly on this central bank action:
U.S. markets… unchanged
It looks like the stock market is going to limp to the finish line essentially flat for the year. Almost every analyst on the Street (except guys like David Rosenberg) thought that this was going to be a great year for the market. A year ago, all I heard about was 1400+ on the S&P.
What did all these people get wrong?
The obvious answer is underestimating the ugliness of Europe or thinking the U.S. debt wouldn’t get downgraded. But those are easy mistakes to make and, honestly, are quite forgivable. Tough to predict that stuff.
I think the consensus made two unforgivable mistakes a year ago. The first is that it overestimated the growth cycle, biased by a little too much Fed-fueled economic optimism. This year was a reminder that the secular backdrop of deleveraging is still intact and will be a headwind for years to come. A lot of folks out there thought that we were on the way towards the next major growth boom and that was just plain wrong.
The second mistake was less specific in nature but was definitely more egregious. So many analysts made the same general mistake they’ve made so frequently before. They looked at the recent past and assumed it would continue linearly into the future. The history of the market and the history of economies is not linear in nature. It’s cyclical. It’s about reverting towards mean from a local extreme.
There are two ways to apply this to today’s economy and today’s markets. The first is the big reversion of the secular trends of the Long Boom. This is the grand backdrop of deleveraging that I’m always talking about. It’s the macro foundation of the book that I wrote, The Trade of the Decade. (Shameless plug!!) This secular reversion began with the unwind of the housing boom and it’s going to last a long time. Every long-term investment decision needs to be made inside this framework.
The second application for investing is that this is a reminder that economic growth and market action is going to be lumpy. It’s going to move in fits and starts. We’ll grow and things will start to look better and just when we start to feel really good about it things will take a turn for the worse. We’ll be reminded that, oh yeah, it’s tough out there.
If you are a skilled tactical asset allocator, you actually have a lot to look forward to in the coming decade. Never before in your career has your skillset been of greater importance. Being able to spot the short-term cycles, knowing which assets to ride and when will be the way to succeed. This is a lot harder to do than most investors think. It requires true market agnosticism and a willingness to change one’s mind frequently. Every short-term investment decision needs to be made in this framework.
As we head into the new year, it’s worth asking, “what are most people getting wrong right now?”
To me, the obvious one is the assumption that volatility will stay high throughout the coming year. It certainly might, but I’m not convinced that what we saw between July and December will continue for much longer. It may even be over now. Make no mistake, there will be some crazy days in the year ahead and general volatility will probably be higher than it was during the Long Boom, but I think the local extreme of the market rallying 10% one week and crashing 10% the next is behind us or will be soon.
In fact, the VIX is probably already telling us this:
The market is telling us one thing, but consensus opinion is telling us another. I don’t know about you guys, but I’m listening to the markets.
Anyway: don’t use 2011 to frame your expectations for 2012.
The Silent Night
If you’re of Christian faith or any of its numerous offshoots, “Silent Night” obviously has very powerful meaning. This is a time of year to celebrate the birth of Jesus Christ. It is a profound, reflective time.
Even if that’s not your thing — if you adhere to Buddhism, Judaism, Islam, Hinduism, Atheism, or whatever else, there is something that we all have in common and seem to collectively share a little more explicitly during this part of the calendar. The close of the year a celebration of peace.
Personally, I love the concept of the silent night.
“All is calm. All is bright.”
It might just be a northern hemisphere thing.
Night falls earlier, the temperature drops further, and the outside world seems to settle down, even if it’s out of geographic necessity. We light our fires and tuck our loved ones in to the sound of silence.
I’m glad there’s nothing happening in the markets this week. It makes it easier to seek and celebrate the idea that unites us all.
Peace.
Time to finish scoring the predictions I made at the beginning of the year. Click here to read part one of the recap.
6. Inflation fails to show up. Again. — WRONG.
Through October, the CPI is up 3.3%. It’s up 3.5% for the trailing twelve months, a whisker above the 100-year average of 3.24%.
Inflation did show up. I was wrong.
This is the one I’m angry about because almost all of it was attributable to just a couple of months in the spring. And at that point, most of us were saying, “Hooray! Finally a little bit of normal inflation!” Come summer, inflation had completely dropped off the radar. Most of the chatter through the second half of the year was about how to fight off a new round of deflationary fears. Investors rose up and demanded that the Fed do something. Stimulate!
Mathematically, there has been close to zero inflation for the second half of the year. The yield on 5-year TIPS is negative right now. Negative! The spread on those with straight Treasuries is in the neighborhood 75 basis points. Nevermind the CPI. The bond market is forecasting inflation to average 0.75% per year for the next five.
Since the dawn of this po-dunk little newsletter, I’ve been pushing against the crowd that keeps calling for crazy high inflation. ”From all this money-printing, you know.” Thus far, none of that has materialized. It’s why I call it The Inflation Chupacabra. You’ve got a few skittish farmers out there that get the rest of the village all riled up with their stories.
Heck, the Chupacabra might exist. I have an open mind. We may still get some nasty inflation if these excess bank reserves leak uncontrollably and unchecked into the system. But like the Chupacabra, I’ll believe it when I see it.
Still, I missed this one. I thought inflation would stay depressed all year. It didn’t.
7. The Ascension of Paul Ryan — RIGHT
In 2011, this guy went from a relatively obscure Republican Congressman from Wisconsin to Chairman of the U.S. Budget Committee. He was even picked to give the official Republican response to the state of the union address. I thought he might show up on the list of potential Republican presidential candidates by the end of the year, but I overestimated his ambition (or underestimated his pragmatism). In any case, his is probably a career worth watching. At least for now.
Around these parts, my contempt for politicians is well known. Anytime I think these two parties and our democratic system can’t possibly disappoint me any further, they find a new way to exploit the system for personal electoral gain and piss off regular people.
That being said, I do believe there are some legitimately interesting figures in the political space. Paul Ryan is one. Chris Christie is another. I was impressed to the point of shock by the quality of work done by everybody on the bipartisan Bowles-Simpson commission, particularly the bold, honest language of the two co-chairs. I wish Erskine Bowles and Alan Simpson were more active in politics. But perhaps it’s because they’re not that enables them to speak so freely about how messed up things are and how difficult the choices are that we must make to fix this mess.
For all you Democrats looking for a real rising star in your party, look at Elizabeth Warren. I think she’s interesting because a lot of people are afraid of her. She makes people nervous. People like that always attract my interest. She’s going to run for Senator in Massachusetts. Early polls show her trailing. We shall see. I may or may not have a prediction about this in 2012.
8. Mystery Country (Australia) — RIGHT
I mentioned last week that I didn’t make any real investments based on any of these predictions. But this was one that I wish I did make an actual bet on, however small. In fact, there’s probably still time to and I’ll let you know if I do anything.
It just seemed so obvious. A year ago in Australia:
- Median home prices in metropolitan areas were eight times the median income.
- The entire economy was heavily leveraged to the commodity boom and thus highly susceptible to deflationary shocks and economic slowdowns.
- The private sector debt-to-GDP ratio was among the highest of all nations. Their 160% household debt-to-income ratio was the highest in the world. Credit frenzy!!
- Their largest banks were trading at all-time highs, despite aggressively pushing for higher leverage ratios and looser mortgage standards.
Honestly, I think I might have been a little early on this prediction. Seldom do stories like this play out in rapid fashion. But consider what has transpired in the year since:
- The median home price in Melbourne is down almost 10%.
- House prices have fallen 5% nationwide and the supply of existing properties is up around 30% from a year ago.
- Home building activity dropped over 14% in September and fell another 10% in October. Housing starts are down 30% year over year.
- Moody’s recently placed Australia’s entire mortgage insurance industry on negative watch. They said that Australian house prices are not sustainable.
- The Australian Dollar peaked in July and since then has been charting steadily lower highs and lower lows.
- The Australian stock market, as measured by the ASX200, is down around -12% for the year. The S&P 500 is essentially flat for the year.
- None of the major Australian banks have imploded, but all have made progressively lower highs and lower lows throughout the year.
Check out this recent story from Bloomberg. Builders are dramatically shrinking the size of the house/lot packages they sell. Apparently, Australian houses are the biggest in the world and now there’s a major move towards re-urbanization. Dwellings with smaller footprints closer to city centers are getting more popular. (This is also exactly what we saw in the early phase of the U.S. housing collapse.)
Down there they also have “The Great Australian Dream” which is basically the same as the American Dream — you know, owning your own home, land, a pool, and all the perceived freedom and wealth that goes along with it. This too was part of the psychology that guided how the U.S. house bubble played out and ultimately fell apart.
So let me ask again:
This is happening, people.
It’s happening on the other side of the world, but if you get out your spotting scope, you can watch another one of these nasty housing collapses play out in real time. Nobody was talking about it a year ago, and few people are talking about it today. There’s a lot of money to be made and a lot of losses that early movers can avoid.
What’s going on right now in Australia is very similar what was taking place to the U.S. in 2006-2007. It remains to be seen whether the country and banking system devolve into complete chaos the way that it did here. The good news about Australia’s economy is that it has a large amount of valuable natural resources. A lot of this iron, gold, and uranium is dug up and shipped to China, who has needed all the resource inputs they’ve been able to get their hands on.
But what if that slows? What if China takes a breather for a couple of years? Will the internal economy be enough to prevent economic disaster?
That’s why the housing bubble in Australia is such a big deal. We have a lot of good data about how consumers consume in the wake of a housing collapse. China may be their only chance, and the Hang Seng index is down over -20% this year.
It could be a really ugly decade for Australia, which is a shame, because it’s a beautiful country full of beautiful people.
9. The VIX spikes above 30 — RIGHT
30 on the VIX sounds trite right now, but keep in mind that it takes a lot of volatility and fear to get up to these levels. The VIX opened the year down around 17, caught in the grips of a seven month downtrend.
Then this happened:
For context, the volatility index closed at 31.7 on the Monday that Lehman Brothers failed. That was a scary day in the markets. This August, the volatility index got up to the highest levels we’ve seen since the meat of the financial crisis. That was when we were all convinced that Citigroup was insolvent and going to zero and Washington D.C. wouldn’t be able to get its act together in time to save it.
Here’s a funny bit I wrote a year ago about the VIX spiking to new highs:
My guess is that it coincides with the Spain- or Italy-phase of the still-unfolding EU debt drama.
I went on to say:
Bullish or bearish, this is a prediction that you can put to good use. With the VIX at these low levels it means that the price of put options (basically an insurance policy for your stocks) is super cheap. If you’re concerned about surprises that may stun the markets in 2011, take advantage of the current level of complacency in the markets and shop for some options. Don’t do it during the shakeup! That’s when the price of these options skyrocket.
Honestly, I had no idea that it would all play out like this. It was luck. But I bring this up because it’s a good time to remind everybody of a lesson they can actually put to use. Buy insurance when it’s cheap. The wrong time to shop for that policy is when your house is burning down.
10. ETFs are affecting the markets in ways that people don’t fully understand — ????
At the time I mentioned that this wasn’t really a prediction. I just wanted to officially get on the record about it and do it way before everybody else.
This has been a year of abnormally high volatility. Any trader on the Street will tell you that what we’ve witnessed in the market this year is beyond the realm of what we typically expect. Strange phenomena seem to appear every day.
A few months ago, Doug Kass wrote an excellent, high-profile article about the danger of ETFs. He called them new “financial weapons of mass destruction.”
Financial super-journalist Andrew Ross Sorkin of the NY Times wrote a dynamite follow-up to Kass’ incendiary volley. It’s worth a read. He took an informal poll of some major league fund managers and virtually all agreed with Kass that these ETFs are messing with the markets in dramatic fashion.
This story still has a ways to go before it enters the mainstream. In order for that to happen, the story has to be easy enough to communicate to the average guy on main street. This could be a problem. Here’s my best, easy explanation of this bizarre and destructive phenomenon:
Nearly every exchange traded fund is pinned to a index. The goal is for the fund to replicate the index. The indexes themselves are just composed of individual stocks who do their own thing and move in their own ways. But at the end of every trading day, the ETFs have to settle up against the index. The ETF portfolio has to match the index portfolio exactly.
What this means is that these exchange traded funds have to buy and sell boatloads of shares in a matter of minutes. It’s called “re-balancing.” If you’ve ever followed the market action through the course of an entire trading day, you know about the volume spike. Daily ETF re-balancing is the single best argument I’ve heard anyone put forth explaining the massive spike in volume and volatility we see in the last hour of every trading day.
That’s an intra-day, 5-minute chart of the S&P e-mini contract. The e-mini is a very popular trading vehicle used in conjunction with all sorts of other trades. Notice the steady, heavy volume near the open and slow decline in the hours after that. That’s normal. But check out the huge spike volume just before the close. This was November 30th, the day that Kyle and I stood aghast in front of our trading desk as the volume in the final half hour completely dwarfed all the action of the day.
Some of these ETFs are very heavily traded products. Part of me wonders how much this tail is responsible for the strange wagging of the dog.
I should explicitly point out that most ETFs are just fine. They’re a good, fast, inexpensive way for the average investor at home to get diversification. They’re really no different than a regular ol’ passive mutual fund and they have the added benefit that you can get in and out of them during the middle.
But some of them really do concern me.
Can somebody tell me what societal benefit a daily 3x leveraged short Latin America ETF offers? Or how about this: does it even offer more marginal societal benefit than a mortgage-backed CDO-squared? (I would argue, actually, that the CDO-squared is the more beneficial investment product.)
Is it a coincidence that the tremendous rise in popularity of ETFs coincides with a dramatic increase in intra- and inter-market correlation? With so many hedge funds and RIAs getting their exposure via exchange traded funds now, are most people just investing in sectors or countries these days instead of companies? What are the unintended consequences of this?
Is it a coincidence that the rise of high-frequency trading has dovetailed perfectly with the rise of exchange traded funds, and particularly, the freaky-deaky leveraged ETFs? These ETFs must create monumental opportunities for hyper short-term arbitrage, the kind of trading that only a supercomputer could exploit.
I like the gold ETFs as much as the next guy, especially since they’re all backed by the physical commodity. That’s a must when you’re evaluating commodity ETFs. But right now, GLD holds over 2,300 metric tons of gold. A disturbingly large percentage of it is owned by one guy, John Paulson. Is it a coincidence that the 20% drop in gold prices coincided with a period where Paulson was reducing his funds’ gold holdings by a third? He dumped over 1 million ounces of gold via the GLD ETF. How much more gold is he going to have to sell to meet withdrawal requests from his hedge fund which is having an awful year? How will that selling affect the gold price? What are the side effects of opening a market like gold up to a dramatically larger investor base?
Honestly, I don’t have the answer to these questions. Nor can I answer whether or to what extent these freaky ETFs are to blame for additional market craziness. I’m not sure anyone has that answer. In fact, I’m not even sure the data exists in which to begin a search for an answer.
All I know is that a whole lot more people in the industry are talking about this issue now than there were a year ago. Hopefully somebody much smarter than I will figure this thing out.
Hopefully they’ll do it before it’s too late.
—
On balance, I’d say these predictions went rather well. There’s no way I’ll get this many right about 2012.
My major mistake this year was under-estimating that capacity for Europe to stay relevant to the U.S. and even get worse. It didn’t affect the economy so much as the global financial markets. And it dominated the headlines.
The big lesson I learned from this one is that the fundamental story of the U.S. economy right now just isn’t very interesting and it’s actually rather easy for the market to discount. The S&P is at the same level today where it was a year ago and the same spot it was before 2008 became an all-out crisis. In the meantime, all of these other global narratives will create a lot of noise and whether they’re economically relevant or not, they will move the markets in dramatic fashion.
My biggest victory this year was nailing the economic backdrop. There was a whole lot of bullishness and economic optimism at the end of last year, and that wound up being just plain wrong.
The lesson I learned from this one was that in this new normal economy, it’s not a smooth ride. Both the economy and the markets have moved in fits and starts and I don’t see any reason for that to change. When everybody is bullish, start asking questions about what they might be missing. And when everybody is bearish, ask if the panic or depression is truly justified.
Hanukkah starts today, and I wish you a very happy one! And to the rest, a very merry Christmas!
This is a wonderful time of the year. I hope each and every one of you indulge heavily in good food, good friends, loving family… and some holiday beverages of your choice!
This is my favorite newsletter of the year. The yearly recap!
I love travelling back in time and revisiting what I was thinking in the moment and why. One of the things that this annual exercise has taught me is that it’s less about the prediction and more about the methodology. Recapping these honestly helps me understand where there are flaws in my logic. Figuring out where those chronic flaws are leads to better decision making in the present and future.
As expected, I got some right and some wrong. One I got spectacularly wrong! That’s usually how it goes when you make predictions.
SPECIAL HOLIDAY PUBLISHING SCHEDULE: We’re going to do this in two parts and because of the upcoming Christmas holiday, do it under a modified schedule. The first part of these will go out today, a normal Thursday. Part two will come out next Tuesday. We’ll have a brief market update after the break on Thursday the 29th, wish everybody a happy New Year’s, and then get started with some 2012 predictions in early January. It should be a fun couple of weeks. I love this time of year.
Make sure you sign up for the newsletter by email if you haven’t already. That way this stuff all goes automatically into your mailbox. Our policy is one email per week. No ads. No spam. I hate it when people take my email address and do naughty things with it and so I have a moral imperative to vigorously protect our readers’ privacy and personal information.
Or download our free iPhone app and read it that way. And if you want to start a conversation, follow us on Twitter or Facebook. Send me a message, and I promise I’ll respond.
Recapping the predictions
This year, I got most of the economic backdrop correct. But my major miss was Europe. Shame on me for missing that. We’d been talking about the massive debt troubles in Europe since the end of 2009, pretty much right after Dubai defaulted and a few people noticed that – whoah – Greece kinda has a lot of debt too.
So, shame on me for thinking at the beginning of 2011 that Europe wouldn’t continue to get uglier and turn into a global concern. At least we got on that story early again in 2011 and corrected the error of my lack of foresight. The bad news is that all you readers have bigtime Euro fatigue now. Sorry about that too.
On balance, I’d have to say that I’m a rather surprised at how many of these predictions actually did materialize. 7 out of 10 is pretty good. I was expecting something closer to 50/50. In fact, when you’re making contrarian predictions, if you can get more than 40% right, I’d say you’re doing fine.
As we go through these, keep in mind that most of them did push against conventional wisdom at the time. That’s part of the reason why I made these predictions. Where’s the fun in simply going along with the consensus? None of these seem like way-out-there predictions today, but a year ago, many of them did. You’ve probably forgotten about all the crazy bullishness that existed between late Summer 2010 and late spring of 2011.
Those were good times, huh?
Lastly, keep in mind that I didn’t trade off these predictions. I sure hope you didn’t. And I hope you don’t trade off my 2012 predictions because I won’t be doing that either. My real investment strategy is pretty simple. I like to buy stuff that’s cheap and I always want a larger-than-normal portion of my portfolio in alternative strategies. Roughly 80% of my personal investment portfolio is in our firms’ own products, and those investments are so long-term in nature that yearly predictions are an irrelevant, unimportant exercise. That could be why I have so much fun doing them.
All right, buckle up.
Let’s do this.
1. Good but below-consensus economic growth, rising rates, and a schizophrenic stock market — RIGHT
Well, mostly right, at least. I was dead wrong on rates. Rates did not rise. They did for a little bit and then they went down. And then they went down some more. Then Europe happened and interest rates cratered. So I’ll give myself only 2/3′s credit for this first prediction.
This is what I wrote way back in January:
What we’re seeing now — strengthening economic data, an increased willingness for consumers to spend, and a rising stock market — should continue for a little while. But I think that the second half of the year is a different story. It’s where we are reminded that the economy won’t be as consistent as we all came to appreciate in the last few decades. Economic growth will be lumpy with GDP moving in fits and starts.
I also wrote this:
To throw some numbers and dates out there, I think the market makes its high in the first part of the year and I think it closes the year at least 10% below peak. It might even have a flat or down year, a prediction which flies so far in the face of consensus estimates — somewhere around 1400 on the S&P — that you might be wondering just what, exactly, I am smoking.
Want an old school investment strategy that hasn’t really worked in recent years that everyone has sort of forgotten about? One that I think returns to glory in 2011?
Sell in May and go away.
That’s pretty much exactly what happened.
If I was the kind of guy who took this stuff seriously, I might prance around on my high horse, drunk on my own kool aid.
I'm awesome. AWESOME, I say.
But, in the past I’ve also said:
Here comes the VAT.
Interest rates will rise.
Big financial institutions will get smaller. (LOL, silly me for ever thinking this.)
The Fed will not embark on QE2.
The Fed will not embark on QE3.
Interest rates will rise.
So I never get too excited when anything I predict comes true. I’m as surprised as you are when this stuff works out. Most of the time it’s just luck. And clearly I should stay away from forecasting interest rates altogether. If you ever hear me say anything about interest rates, ignore or invert it.
My economic thesis at the beginning of the year was that stimulus is fine in the short run, but at some point the market would wake up to the volatility and uncertainty associated with real-life fundamentals. Europe was something of a wake up call, a catalyst and a reminder that it’s a hard world out there and it’s going to stay hard. To quote Wallace Stevens,
XIII
It was evening all afternoon.
It was snowing
And it was going to snow.
The blackbird sat
In the cedar-limbs.
Like the mysterious blackbird, we sit and watch while the economy does what it does. The best each of us can hope for is the wisdom to accept that it’s all beyond our control. Economic winter is here and nothing we do will make it go away.
On the GDP front, the U.S. is up +2.89% for the first three quarters of the year. In real terms, which is how most people think of GDP, it’s around 1%. Tack on what will probably be a decent 4th quarter, and we should clock in right in the range where I thought we’d be. 2% is OK growth. It’s positive. But it’s not what the economy needs and it’s well below the +3.5% (real) consensus that existed at the beginning of the year.
I don’t think I really need to say anything about the schizophrenic stock market this year. It’s safe to say the stock market experienced pretty much every emotion in 2011. Sometimes all on the same day. I suppose I could have been more precise with my psychiatric language. Technically, what the stock market experienced this year was bipolar disorder, not schizophrenia. I’m sure there are two or three psychiatrists on this newsletter who appreciate the distinction.
2. Municipalities under duress is the dominant issue of 2011 — WRONG
This was another misstep. But municipal duress was a bigger story than you might have thought.
Just a few short months after mentioning this there were major protests in Madison and other cities about state budget cuts. Chris Christie stole most of these headlines this year as he made draconian cuts to whip New Jersey’s budget into shape. That angered a whole lot of people and strained a lot of state workers. Talk to any of your friends who are teachers or state employees and ask them how 2011 went. It was a tough year for these folks and the reason why it was tough is because the municipalities have it rough right now.
Just a month ago we saw the biggest municipal bankruptcy in history. Jefferson County. Though, as I mentioned at the beginning of the year, Meredith Whitney’s forecasts on the muni-bond front wound up being way too high. In fact, Whitney’s to blame for (wrongly) placing the focus on municipal bonds instead of the municipal structure more generally.
If we’ve learned one lesson from the subprime and EU sovereign debt crises, it’s that bondholders don’t get screwed. Back in the old days, when you lent money to someone, you accepted the risk that you might not get paid back. But creditors seem to have more power these days. Employees and taxpayers are the ones that take it on the chin, in yet another display of Capital trumping Labor. It may frustrate you to learn that while your teacher friends and other state workers are struggling to cope with a rough financial reality, municipal bonds had a great year.
This is one thing I wish I’d delineated more clearly at the beginning of the year. The thing with the municipalities isn’t about their debt, it’s about their budgets. It’s about firing who they have to fire, cutting salaries that need to get cut, and severing contracts where they need to be severed. And after that, it’s about bailouts and finagling any sort of credit extension possible. The one thing it’s not about is going to their bondholders and saying, “sorry guys, we can’t pay.”
And just how far is the Occupy Wall Street movement from the spirit of our struggling public sector? One of the key themes of #OWS is that normal people feel like they’re getting a raw deal. They feel like they’re being forced to make sacrifices while those at the top of the food chain — ahem, bondholders – accrue unfair benefits.
Anyway, this was a big story that played out in diverse ways, but it wasn’t the biggest. Europe was. So I scored a zero on this one.
Unfortunately, Europe will continue to play a role in 2012. Behind the scenes, U.S. cities, states, and counties will continue to struggle quietly. Whether protesters can successfully articulate these struggles to the rest of the world remains to be seen.
3. Higher Commodity prices are the other major story in 2011. Crude Oil shoots through $100/barrel. People feel it. — RIGHT
This was actually the biggest story for the first half of the year, before EuroMania took the world by storm. Remember how much everybody was complaining about gas prices back in June? The national average price for gas got up to almost $4/gallon. All the inflation bugs were going bananas. Food prices were up and everybody was complaining about their grocery bills too.
2010 was a very range-bound year for commodity prices. Most analysts were forecasting continued stability through 2011. That’s how most analysts derive forecasts, you know. They look at the recent past and project it into the future.
I know it sounds kind of crazy to say this now, but at the beginning of 2011, there wasn’t a whole lot of fear about a potential spike in gas prices. Most forecasts at the time were for the range to remain pretty much intact. But it’s funny how quickly outside-consensus calls become consensus calls.
This year NYMEX Crude went on to touch $115/barrel, a run of almost 27% from where it opened the year. Today it seems to be resting comfortably closer to $100/barrel.
Things are OK now, of course. I mean, prices are still higher. But we’re coming to terms with the realities of Peak EasyOil. It should be pretty obvious to anyone who looks at the fundamentals of the market right now that the Malthusian oil apocalypse is not an acute risk. Oil prices aren’t going to go to $200 or even $150 any time soon.
If there’s one lesson to take home from the year’s action in commodities, it’s that we can stop worrying about prices just as quickly as they can become a problem. When there are spikes in prices, it isn’t always correct to assume that they’ll keep rising or stay high.
4. Real Estate makes a new low, a final low. – RIGHT…?
At least I think so.
I totally botched this one because we won’t actually know for certain if this is the final low for a while. That’s my fault for defining bad parameters for this prediction. I’ll dock myself half a point for that.
But real estate did indeed make a new low in 2011 and it did it in both the Case/Shiller and CoreLogic indices. So I got that part correct. The post-crash bounce was indeed a fakeout. I’m not sure out there if anybody was actually buying into the over-bullish, NAR-fueled view that the rally in prices between the middle of 2009 and summer 2010 was the beginning of a recovery. But that was wrong. Prices went back down and made a new low.
That part of my prediction was definitely consensus. But the more general thrust of this prediction is that the bottom is happening. Technically, the jury’s still out on that, but this is what bottoms look like. I don’t see any indication that prices are set to fall off another cliff. The major downtrend is behind us and I think we’re now in a period of flatlining.
Even as recently as this spring I was hearing a lot of people call for a further 10-15% drop in home prices. That could happen, but I don’t think it will. The median home price / median income ratio is down around its long term average, and quite a ways below the levels of the last three decades.
Could prices and this ratio slide another 10-15%? Anything is possible, but I do think these ridiculously low mortgage rates offer legitimate cushion against that. The price-to-income ratio was much lower before the long boom because mortgage rates were so much higher back then.
If you bought a house in 2011 and plan to live in it for a decade or so, I think you’ll be just fine. You didn’t pay a lot of money and you got a historically low mortgage rate. If you picked up some investment properties, they probably pencil out at a very competitive rate. I don’t see that changing in the decade to come.
Here’s a crazy, informal prediction: there’s a chance that somewhere around 2020 we look back on this period between late 2010 and late 2012 where everybody says, “Man! I wish I loaded up on real estate back then!”
I’m giving myself a tentative “RIGHT” on this one because the data support it. I believe that as this down leg bottoms out, this final low will become more clear. Then, when you see Case/Shiller turn, it will all look very obvious in hindsight. None of this is to say that real estate won’t continue to suck for a few years, because I think it will. It’ll just flatline for a while before the inevitable, slow uptrend.
Still, I feel dirty about cheating on my parameters, so I’m only going to award myself partial credit for this one. You’d better believe I’ll have a 2012 real estate prediction, so maybe if this does turn out to be a legitimate bottoming process I’ll award myself extra credit next year.
5. Gold bubbles on! – RIGHT!
I’m on record as saying that what’s happening in gold right now is a speculative bubble. Not everybody agrees with me about that, and that’s cool. That’s a totally separate prediction than saying it will keep rising in price. Bubbles can go a long way before they burst. I am neither smart enough nor stupid enough to predict when that’ll happen.
To put a finer point on this prediction, I originally defined the following parameters:
- It ends the year above $1500/oz and makes an honest run toward $1600 at some point.
- We get a major fakeout along the way (a >20% correction)
Right now gold is trading in the high $1500′s.
And get this. The gold price touched $1,920 on September 6th. On September 26th it touched $1,528/oz.
That was a drop of exactly 20.4%.
There’s not a single thing in this year’s gold chart that surprises me. But things could be changing. Up until a couple of months ago sentiment about gold was universally bullish. It’s still extremely bullish, but as the reality of what’s happened since September starts to sink in, sentiment may change.
I also wrote this a year ago:
I know that a lot of you that read this newsletter really like gold. Every single one of you are either rolling your eyes right now or getting ready to shoot off an angry e-mail. I’m not saying that the party is over. I’m saying pat yourselves on the back for keeping the faith and make sure that what you’ve still got on the table won’t kill you if it goes *poof*. I’m saying that as we move further away from $1,000/oz and closer to $2,000/oz, it’s time to start asking questions about why you really own gold or are buying more of it.
I think that’s very relevant advice for today as well. Personally, I own gold coins. It’s a small portion of my investment portfolio, but unless you really know what you’re doing, I don’t think gold should ever represent more than 5 or 10% of an individual’s total portfolio.
Take a moment to think about why you really own gold. Are you buying it just because it’s going up in price? Because everybody else is buying it? Do you own it because it’s a unique, uncorrelated asset? You don’t still think of it as an “inflation hedge” or “safe harbor”, do you? Do you own some physical gold because, hey, you never know? Zombie Apocalypse! Are you buying gold because of its astoundingly strong technicals? Do you own gold because you distrust paper currencies? Do you like it because it’s shiny?
The time to ask these questions is right now. Make sure you have answers. Remember, the time to get your risk management strategy in place is before the building catches fire, not once you’re already coughing from the smoke.
Figure out what you want to do about your gold today. Map out a variety of possible scenarios and have responses ready.
—
That’s it for part one! Check back for part two next Tuesday. Or sign up for it by email and get it automatically.
Raise your hand if you have Euro Fatigue.
Yeah, me too. I’m burned out. Let’s talk about something else.
Would anybody like to know which way the market may go in the next few months? Yes? Let’s do it!
No guarantees on how entertaining or informative this issue will be. But I have a feeling you may find it useful. First, let’s lay the philosophical foundation for how we’ll do this.
Listen to the markets.
One of my heroes in this industry is Richard Russell, the legendary publisher of Dow Theory Letters. I don’t always agree with what Ol’ Russell has to say, but the respect I have for him is immeasurable. He’s been writing about the markets for over 50 years. He does it because he loves it. I love writing about the markets too and I hope to still be doing it 50 years from now.
He was also a child of the Depression. There aren’t many of those left. The perspectives that these rare individuals have — not just on the financial markets, but on life – are fascinating and valuable. I’ve never met Richard Russell personally, but I could probably talk to him for days straight. There’s so much to ask. So much to learn from our elders like him. Watching all this experiential wisdom slowly, inevitably disappear into the fog of history always makes me a little sad.
Anyway. It was through Russell’s writings that I learned one of the most important lessons one can learn about investing: Listen to the markets.
Listening is hard.
It’s not entirely natural and the process of listening feels progressively less natural the more self-interested the individual. Every human being is self-interested to a certain degree, and the difficulty we have listening to other people is one of the things we all have in common. It’s more difficult for some than others. But it’s hard for each of us.
Good listening is also a philosophical principle that we can all agree on. Every last one of us understands on at least some level that, yes, it’s important to be a good listener and it’s important that we all work harder at it. It requires tremendous patience, discipline, and most importantly, an open mind. Good listening is about the slow, careful process of climbing inside inside someone else’s shoes.
Bias is the enemy of listening. If you want to be a good listener, you have to understand bias — not just your own bias, but the bias of he who is speaking to you. When dealing with other humans, it’s tricky to ferret out and eliminate this. It’s hard to listen to a drug addict or a convicted murderer tell their story without some sort of naturally negative judgment. What they say may sound completely different after it’s run through your personal filters. Personal bias is a big reason why all sorts of content winds up getting misinterpreted.
And it’s also hard to get the real message when whoever you’re listening to is severely biased. When listening to the electronics store salesman talk about purchasing an extended warranty, you may get hung up on the superficial details of the benefits. But if you understand his bias (he gets a huge commission if you purchase one) before you listen to his pitch, it’s a lot easier to extract the real message.
Listening can go awry in a lot of other places. The granddaddy communication model in social science is the Shannon-Weaver Model. A message is developed, encoded, sent (where it may be affected by noise), decoded, and then interpreted by the recipient.
Look at all the places where the true content of the message can get messed up.
Listening to the markets isn’t any different than listening to your wife, your parents, or your kids. It’s no different than listening to radio broadcast.
It starts by knowing the language. You can’t listen without knowing the vocabulary. The financial industry is full of jargon. It gets a bad reputation. But this is an inevitable, impermeable aspect of the industry. If you want to listen to another English speaker, you have to learn English. If you want to listen to the investment markets, you have to learn the unique language. Under the Shannon-Weaver model, if you don’t have the tools to decode the message, you’ll never be able to properly interpret it.
But listening to the financial markets carries an extra layer of difficulty. The problem is that it can’t listen to you. It doesn’t care.
The market is like your crazy Uncle Al who just rants and rants and rants at Thanksgiving dinner and couldn’t possibly have any less interest in your opinions or those of the rest of the family. Crazy Uncle Al is a nut. He never combs his hair and smells strange — not bad, but strange. You tolerate him politely and you do it by pouring another three fingers of scotch and tuning him out. Everybody snickers about crazy Uncle Al behind his back. What a loon!
The problem is that you can’t tune the market out. Not if you want to make money. Not if you want to keep your investment portfolio from rolling over a landmine. You have to sit there and listen. You can’t just nod politely, either. You have to actively listen to crazy Uncle Al. You have to understand what he is saying and why. And you have to make peace with the fact that the exchange is totally one sided.
Because it’s crazy Uncle Al who sets the terms. Not you. It doesn’t matter if you agree with him or not. It’s not a conversation with Uncle Al. It doesn’t matter what you think. The only thing that matters is if you can understand what he is saying. He holds all the cards.
As I said, it’s hard work. But if you can pull it off, crazy Uncle Al will tell you where the landmines are. He’ll tell you how to make money.
Buried within Uncle Al’s crazy ramblings are the signals for what you should do and when you should do it.
Once you adopt this philosophy of listening, all the other pieces will fall into place.
From there you can start to build the proper psychology for investing. You can train your brain how to do the things it needs to do set itself up for success.
You can start developing tactics and strategies. The success of every tactic and every strategy is contingent upon properly understanding the environment. That’s impossible to do without knowing how to listen.
You can even get a better night’s sleep.
You can do all that and more. But first, you have to listen.
Use the options.
I’m a huge fan of the options markets. They are a brilliant invention for a lot of reasons. They give investors a huge menu of tools for enhancing their portfolios, everything from providing insurance protection to offering the flexibility to express very nuanced theses.
You don’t even have to trade options for them to be useful. You can use them purely to get a read on which direction the market may be going.
It all has to do with how options are priced. The valuation of an option is a very complex process, but the underlying philosophy is very simple. It’s all about probability. If you’re going to pay a certain amount of money for something at a certain price on a certain date, probabilities really matter.
Here’s an example. The odds that my house will burn down are very small. Because I know that, I’m not willing to pay a lot of money for an insurance contract (an option) that protects me from that. Conversely, the odds that the Green Bay Packers win the Super Bowl are fairly high. So if I want to offer insurance against the Packers winning the Super Bowl, I’d better charge a lot for that policy. Odds are, I might have to pay out.
Now, if you’re sneaky, you can run through this whole process in reverse. You can look at the prices of these options and back into the probabilities. Clever, huh?
Here is what the options market is telling you about which way the stock market will go.
We’ll tell this story using pictures.
The first chart is an extreme example. I looked at two places, 100 points above the market and 100 points below the market. The date I’m interested in is December 17th, which is the end of next week.
The market right now is telling you that there is a 97% chance the market stays above 1160 and a 95% chance that the market stays below 1360.
Slim odds we break out of that range in the next week. But I bring this extreme case up first just because we’ve seen some extreme moves lately in the market. I’m actually surprised that there’s still a 5% chance the market may rally 100 points, but there you go. Apparently, the odds of an extreme move in either direction are slightly tilted towards the upside.
The other reason why I bring this up is that the EU leaders are supposed to have a major meeting on the 9th. Depending on which headlines you follow, this is the kind of meeting where everything will get fixed or fall apart. But you can see that the market isn’t really pricing that in. It’s telling that the odds of a totally earth-shaking EU summit are small.
Something big may happen, though. Let’s stay on that same date, December 17th. But let’s bring our levels in a little closer. Let’s only look up and down 50 points, which is about 4%. Let’s also redefine our probabilities as the chance that the market will get there.
Right now, the options markets are telling you that there’s a 22% chance of a 50 point rally in the S&P in the next six trading days. And there is a 16% chance of a sell-off of equal magnitude. Here, the bias to the upside is a little more clear, and perhaps is a little more likely that the news to emerge from or around that EU summit will be good.
Let’s push our date back a little bit, though. Let’s look at February. This will take us through the holiday season. Will we get a Santa Claus rally? Will we get a new year’s bounce? Will the first six weeks of the year be great like they always seem to be or will they be terrifying like they were in 2009?
Again, the market is clearly tilted towards the upside. That’s not to say it will or will not move in one direction. It’s simply telling you that the odds of a sustained rally are bigger than those of a sustained decline. If you’re bearish on the market for the next couple of months, you’re officially in the contrarian camp.
All of this data gets extra interesting if you have legitimate forecasting skill. The market isn’t always right. It might be suggesting a 31% chance of a 100-point rally by February 18th, but maybe you have special knowledge of something that will change that. You can use that information to make trades with better risk-reward characteristics.
One of the ways that I frequently hear traders talk about these probabilities is “where the risk lies.” Right now, the risk lies to the upside. There’s greater risk betting against a rising market than a falling one.
And finally, just because we can, let’s look one entire year out.
Similar story. There’s a 36% chance we get to 1,460 on the S&P and a 22% chance we get down to 1,006 on the S&P. Regardless of the directional leaning, the last comment I’d like to make is that those probabilities seem quite high on both ends. That, of course, is a function of volatility. You can see we’re still living in a world where pretty much anything can happen.
Caveat emptor
Now, don’t go using this information to bet the family farm. This is purely informational. Use it as one tool among many. I mentioned at the top how important it is to listen to what the markets are telling you. That’s all we’re doing here. We’re just listening to the markets. Right now they’re saying that if there’s a big move, most likely, it’ll be higher. But the odds of a sharp correction are also high.
These probabilities are very dynamic. They change every day. This is what they were yesterday afternoon and tomorrow they’ll be different. (EDITOR’S NOTE: The range has changed this morning but still shows the same slant to the bullish side.) They may change a lot, too. If Aaron Rodgers gets injured this Sunday, all the casinos in Las Vegas will dramatically shift their Super Bowl odds.
But the philosophy of what this kind of study represents is constant. At any specific moment in time, this is the aggregation of all the information that’s out there. Markets aren’t perfect, but they are rather efficient at incorporating all the news and information and generating a price. New information hits the market every day and this is one of the reasons why prices never stay fixed for long.
Listen to lots of markets
One of my other favorite markets to listen to is the credit market. The LIBOR-OIS spread is my go-to metric in this space. Basically, it measures how much banks trust each other. LIBOR is a floating rate that goes up or down depending on how risky one bank feels about another bank. While an overnight indexed swap (OIS) is a fixed rate, set by your friendly central bank. Looking at the two in conjunction tells you how skittish one side is relative to the other.
If you’re a regular reader of our newsletter, you’re already good friends with Mr. LIBOR-OIS. Normally, it doesn’t do anything. But when it starts moving, you’d best pay attention.
This concerns me.
For heightened dramatic effect, here’s a 6-month chart.
Like a freight train, this thing keeps going and going. Every day that goes by, banks trust each other less.
Here’s another analogy that will help you understand more deeply what LIBOR-OIS means right now. Think about your sketchy coworker in the cubicle next door. Imagine he comes to you at the end of the workday and asks to borrow $10. You say, “no problem, just pay me back $11 tomorrow morning.” You’re no schmuck, after all. He agrees to your terms. And the next morning he pays you back $11. Awesome.
You’re happy to do this for a couple weeks — lending him $10 at the end of the workday and collecting $11 the following morning. He’s happy too. Who knows why he needs the money. You never ask. But he’s an employee of your firm and you know he gets a paycheck so he’s probably good for it. Plus, you enjoy this new little stream of cash flow. Why mess with a good thing?
But let’s say one day he comes to you and he seems nervous and disheveled. He asks for his usual $10, but you, being the savvy risk manager that you are, smell something fishy. So you ask for $12 tomorrow. Take that Tony Soprano! Your coworker happily agrees to your tougher terms.
And lo, he comes through the following morning with your $12. Sweet!
But let’s say his nervous behavior continues to get worse. Let’s say you start hearing rumors down the hall that he’s going to get fired. Or maybe he already walked away from his mortgage and he’s going to declare bankruptcy. What do you do when he comes back to you at the end of the day and asks to borrow $10? What if it’s – gulp – a Friday? Will he make it through the weekend?
How much do you charge him? $15? $20? How much risk are you willing to take with your ten bucks?
This is what’s happening in the banking system right now. We’re not a crazy levels yet, nowhere near the highs we saw during the crisis when we were pretty sure our sketchy coworker wasn’t going to come into work the following morning with the $10 we’d loaned him. But the market is at the highest level since then.
Plus, there is zero indication of it getting any better.
It’s not a signal that something crazy is about to happen. Nor is it a guarantee that anything will happen at all. It’s simply something worth listening to. And now you have the tools to do so.
- Listening is one of the most important things for an individual to do, and this applies to the markets as well.
- Probabilities derived from the options market suggest a bias to the upside i.e. the odds of a rally are greater than the odds of a sell-off of similar magnitude.
- The credit markets are suggesting that banks are getting progressively more nervous about lending each other money. Hopefully it won’t lead to 2008-style chaos, but keep your eyes peeled and ears open just in case.
Any Elvis fans in the U.S. Congress?
A little less conversation, a little more action please
All this aggravation ain’t satisfactioning me
A little more bite and a little less bark
A little less fight and a little more spark
To understand the current state of the markets, you need to understand the political environment. And when it comes to the political environment, you need to understand only one thing. It’s all about getting elected in 2012.
This is why the basic policy response to nearly every mini-crisis that’s emerged since 2008 has been short-term in nature. It’s all about, “what can we do right now that will produce some kind of results — nevermind the long-term costs.” For the most part, human beings everywhere eat this up because they’re psychologically wired to prefer chronic, modest suffering to short term, acute pain. Even if the politicians aren’t explicitly cognizant of this fact — and let’s be honest, thoughtfulness and introspection aren’t among the talents of most of them — they are at least intuitively aware of this.
Like it or not, politics is a team sport. It’s also a spectator sport. In a world where policy makers are chiefly concerned with their own job-security, the game that gets played has frustratingly little to do with sound policy decisions and more to do with attracting more members to your own team and making them hate the other guys with greater ferocity. This is why you get so much conversation and so little action. So much aggravation and so little satisfaction.
And you can’t really blame these guys for it, either. They’re simply playing the game in which they are players. I wrote a few weeks ago about all the lessons I learned from a lifetime of playing games. Here’s another one: don’t try and play the game that’s not the one in front of you. If you try and play Chess like it’s Bohnanza you’re going to get whupped. It’s a totally different set of strategies. Were I to be picked up and randomly dropped into a high political office, I’d want to be like Jimmy Stewart’s Mr. Smith as much as the rest of you idealists. But if played that game, I would lose.
If, as a country, we truly want to make the decisions that fix what’s broken, then we need to have people making them who are more interested in our long-term collective success than they are in their own re-election. It’s that simple. There is a massive, gigantic misalignment of incentives that exists between the American people and those we’ve elected to make policy decisions on our behalf. Little will change until that condition is reconciled. So keep your eyes peeled for these guys acting in politically courageous ways.
That’s the foundation. That’s the thing that everything else will need to be built upon. We won’t get another sustained period of real growth until that foundation gets poured. Every rally until then will be largely illusory and transitory. It’ll be cyclical.
I know it’s hard to be optimistic about that. Another natural human tendency is to look at the recent past and project it indefinitely into the future. And when you look at the highly-fractured, divisive, and dysfunctional atmosphere of modern politics, it’s hard not to get depressed and fatigued with worry that this’ll never stop.
But it will change. It will eventually get better. I am more certain of this than anything. To use a word that has quietly been retreating into the background from overuse: the current political environment is unsustainable.
Go ahead and call me naive. Label me an idealist like Jefferson Smith. I don’t care. Washington may never look the way that Frank Capra imagined it could. But it will be better than it is today, if only marginally. It may take a while or it could be the kind of revolution that happens overnight. But it’ll happen. You’ll see some bite and some spark. A little less fight and, to use a politically dirty word, you’ll see some compromise.
I think that this atmospheric shift in Washington D.C. will be one of several factors that all coincide — like when the de-leveraging has been done, when we started constructing new houses again, and when the labor market begins to naturally strengthen — to lay the foundation for the next secular growth boom.
This will have investment implications, too, though it won’t be apparent until years after the shift has begun. And when this shift finally does happen, you are going to want to be long stocks. You’re going to want to own risk assets, and I warn you, it’ll be tough, because after all the mess of the last couple decades, risk is going to look mighty unappealing.
You can play cyclical rallies, too. You don’t have to wait forever to play in the markets. It just means you have to be honest about the data and be willing to change your stance when the environment shifts. You have to understand which way the momentum wants to go and when to stop pushing against it.
It’s funny, a few weekends ago I was at one of those fancy cocktail parties that terrify introverts like me. But off in a corner I was talking with another guy about investments and investors. He was no dummy and rather well-to-do. He asked what kind of advice financial advisors should be dispensing in this environment. I gave him my usual spiel, the kind of stuff we talk about in this newsletter on a weekly basis. And he said, “How on earth do you explain that to an entire generation of people who, for their whole lives, have been told that you buy stocks in the market, hold onto them, and eventually make money? How do you tell them that this principle that’s been beaten into them is wrong?”
My reply was that you really can’t. You can tell them to do things like avoid the stock market as a long-term investment, to make peace with a fundamentally lower rate of return rather than extend themselves further out the risk curve. You can tell them to be quick and tactical and to explore diversified alternatives to traditional investments. You can tell them that they have to work harder at it now than they used to. But it’ll only take them so far. You just have to let them go through it for themselves. You have to let all the data and the experience do its work.
And the grand irony is that these biases won’t fully be worked out of our national psychology until it’s time to adopt them once again.
Speaking of alternatives, Gold!
I haven’t written much about gold this year, mostly because it’s done what I thought it might. At the beginning of the year, our gold prediction was that it would rally onward and have a few major corrections along the way. Which reminds me, it’s almost time to recap those annual predictions! That’s always my favorite newsletter of the year. Trust me, I get just as big a kick as you do looking back at what I got spectacularly wrong.
Anyway, so far Gold has played out according to script. There is not one single thing in this chart that surprises me:
The reason why I bring up gold today is because the action of the last few months has disturbed me. I was excited to see gold rally when the market was falling apart in early August. That’s exactly what investors want to see in their well-diversified portfolios. But since then, gold has been correlating with the markets.
Check it out:
Gold has been acting as a “risk on” asset that goes up when everything else goes up and goes down when everything else goes down. The real reason why you want to own gold is because gold does its own thing. Remember the #1 rule from portfolio strategy? Things that are different add value.
Hopefully this phenomenon doesn’t last for long. Hopefully it’s just random happenstance. The last thing that portfolio managers like us need is another asset that correlates with every other asset. I still have faith that gold will go back to doing its own things for its own reasons. There are four decades of data to fall back on. But as I watch gold right now, I’m paying attention to correlation, not price movement.
There’s another thing I keep hearing about gold that disturbs me. Every time I hear someone on TV or on the internet describe gold as a “safe haven,” I cringe. I like gold as much as the next guy and I understand all the reasons why investors need to own it. But apparently these folks have a different definition of “safe haven” than I do.
In my book, assets with a lifetime annualized standard deviation of 23% don’t meet the criteria for “safe haven.” But that’s just me. What I want in a safe haven is stability. I need to feel confident that the asset isn’t going to lose a quarter of its value in a short span of time.
If you don’t know what annualized standard deviation is, it doesn’t matter. Just think of it as volatility. Now allow me to add one additional data point for context: the annualized standard deviation of the S&P 500 over that same forty-year period is around 16%.
That should let you know exactly how much more volatile gold is than the stock market. Yet still, people call it a “safe haven.”
I guess it comes from dollar fears? In a world where paper currencies lose all their value, then maybe gold becomes a safe store of wealth? But in a hyper-inflationary apocalypse, any physical good would become a store of wealth. There’s no better, more recent example of a hyper-inflationary apocalypse than Zimbabwe. When you look at what happened there, there wasn’t a lot of transacting in gold. Gold didn’t really play a role, though there’s no question it would have been better to have one’s wealth (to the extent that average Zimbabweans had “wealth”) tied up in gold than Zimbabwe Bucks. Instead, black markets were what dominated. Ordinary physical goods like soap and salted beef acted as a store of wealth and were exchanged for other physical goods.
If you’re one of those people that hoard gold in the event we all sit down and experience a hyper-inflationary disaster movie, my guess is that you’ve also got a pantry stocked full of food and bottled water. You probably also own some guns. Maybe you have a bunker and emergency radio. So you’re likely covered on all fronts.
Which is a good thing! Seriously. I’m an advocate for that. Always be prepared. That’s one of the hugely important lessons I learned hanging around a bunch of Mormon friends as a youth (Nevada has one of the highest populations of LDS church members outside of Utah). It’s not just about having a supply of tangible, non-dollar goods “just in case,” it’s about being properly prepared for anything that may come your way.
That’s an important life lesson but it’s also an important investment lesson. Being prepared is wisdom that transcends all sorts of cultural and topical boundaries.
Crude Oil update
And finally, a few quick words about crude oil. Oil prices were a huge story in the first part of the year, but haven’t been in the second half.
Lately, the price has been chopping around a bit which makes for a rather boring story. But I’ve actually been hearing quite a bit of behind-the-scenes chatter about the energy markets.
The most sensible, data-driven, and least-politicized story I can tell about oil is the one I’ve been telling for a few years. It’s called “Peak EasyOil.”
“Peak EasyOil” is not the neo-Malthusian doomsday scenario where the supply rapidly dwindles towards an unavoidable crisis. It’s not a political story of environmentalism or how we need to get switched over to alternative energy tomorrow, though that will be a major necessity for the next century. It’s also not about blindly soldiering on and consuming the way we have been because who cares about what lives up in the ANWR.
“Peak EasyOil” is simple and logical:
- All the easy oil, the stuff that’s cheap and quick to pull out of the ground is either gone or disappearing rather quickly.
- There’s still a ton of oil out there, even here in the U.S..
- The problem is that it’s much more expensive to get at.
- The solution and end result for companies and consumers is simple: higher prices.
Now, Peak EasyOil does not mean $6/gallon high. Basically, say goodbye to national average gas prices under, say, $2.50/gallon. Get used to paying what you paid this morning for your fill-up, plus or minus fifty cents. You’ll be paying something in that range for a long time and if the price does drift outside that range, it probably won’t stay there for very long. Go ahead and make a little adjustment to that range every year to account for normal worldwide price inflation, of which there isn’t much right now.
This isn’t dogma. It’s not blind partisan faith or drill drill drill or “prices are going to $200/barrel, maaan!” It has nothing to do with value-based judgments like whether we should even use fossil fuels or not.
This is simply the way the current market is. There’s oil out there. We need it. We have the technology to get it. It just costs more.
When most people think of oil and where it comes from, they think of the Ghawar field in Saudi Arabia, or those pumping Texas wells in Giant, or maybe even Prudhoe Bay. It’s, like, cold up there? And there’s some sort of pipeline?
That world is over. That world has, without question and disagreement, peaked. You used to be able drill a simple well in Kuwait and pull oil out at a cost of like $10/barrel. That world was cool while it lasted, but it’s time to say goodbye if you haven’t already. The new world is about extracting oil from places you never would have expected using methods beyond John D. Rockefeller’s wildest dreams.
Between the oil sands of Canada, deep-sea fields like the Tupi reserve off the coast of Brazil, and new shale reserves like North Dakota’s Bakken formation, the supply side of the oil equation is looking substantially less dire than it did when we all started freaking out about what $100 crude might mean.
Nobody in the world agrees on exactly how big these reserves are. Quite frankly, I wouldn’t expect anybody to. Measuring the amount of oil under the ground is a difficult enough engineering endeavor before you start running it all through the political and media filters. There’s also a lot of conflicting views about how expensive it’ll be to pull this oil out and what kind of environmental impact it’ll have. Again, I expect a lot of disagreement about the details of that.
But there are a few things that everybody should be able to agree on. The first is that there’s a lot of oil in these places. Even with all the disagreement, we’re still talking about significant numbers here. And apparently it’s worth it to go after these reserves and it’s worth it to do it at today’s range of oil prices. If it wasn’t, you wouldn’t see all these oil companies spending boatloads of money going after them. Petrobras wouldn’t spend hundreds of billions of dollars to pump oil 6,000 feet below the ocean surface and then another 20,000 feet below that.
This entire story has already been baked into the oil market. Wanna guess why oil prices have traded inside a big range between $70 and $100/barrel? The answer is because the oil in these crazy new places is commercially viable somewhere north of $65/barrel. And it won’t get easier to extract, either. Yes, oil companies will get more efficient with their technology and cost structure. But the story of Peak EasyOil is a long, slow, global march higher, with periodic fits of volatility.
At some point the slowly rising price will converge with the decreasing cost of alternative fuels and The Big Switch will officially be on. That’ll take some time too. There’s a lot of infrastructure that needs to get reconfigured.
Gasoline won’t be powering the majority vehicles in the year 2075, but it probably still will in 2030.
- yawn -
Sorry about all that. I guess Peak EasyOil is a more boring story than you were expecting.
Awesome. Today we talked about politics, Gold, and the future of the Oil market. I even mentioned religion in two different contexts. I suppose I could have sprinkled in some talk about global warming or taxing the rich and really made this an update for the ages!
I jest, of course. I see very little that’s controversial about any of what we talked about today. I don’t expect to ruffle any feathers with these perspectives, despite the fact that these are the topics that tend to generate the most debate. They’re also the ones I get the most mail from. Feedback@TheDraconian.com is where that goes.
- A new political environment where the focus is on making difficult, necessary choices and making long-term investments in the country, will be one of the important pillars of the foundation of the next secular growth boom. The growth boom won’t happen without it.
- Right now I’m watching the correlation between gold and other risk assets and hoping it’ll stop. I’m pretty sure it will, but am still watching it nonetheless. Also: if you hear someone describe gold as a “safe haven,” ask them why they think that.
- I think the Peak EasyOil thesis is probably the most sensible, middle-of-the-road story that can be told about the oil market right now. Agree? Disagree?
