Monday, December 28, 2009

Sometimes you can't save the world

There have been a number of diatribes in the blogosphere about why Bernanke shouldn’t be re-confirmed as Fed Chairman. Examples include Simon Johnson’s Should Bernanke be Reconfirmed? and comments from Cunning Realist such as Bernanke responds, Man of the Year and An Inadequate Answer.

Who bells the cat?
There was once a children’s story about the mice getting together and deciding that it would be great idea that the cat should wear a bell. The problem was, who bells the cat?

That’s the fantasy world that we live in now. I wrote back in July that there were few alternatives to Bernanke. If you get rid of him, who are the alternatives? The leading candidates at the time were Janet Yellen (an apologist for inflation) and Larry Summers (another disaster).

The corruption of Washington culture
In a perfect world, we would have a better replacement for Fed Chair, but we don’t. Dean Baker, co-director of the Center for Economic and Policy Research, wrote an article entitled Bernanke and the corruption of Washington culture where he railed on about how Bernanke actively encouraged and abetted the creation of the excesses that created the mess in the first place. He then concluded with:

How on earth can you do worse in your job as Fed chair then bring the economy to the brink of a total collapse? If this is success, what does failure look like?

But, in Washington no one is ever held accountable for their performance. The economic collapse is treated like a fluke of nature – a hurricane or an earthquake – not the result of enormous policy failures.

When Bernanke was first appointed to the Fed Chair, I told friends and colleagues that he was the Second Coming of Arthur Burns, the Fed Chair in the 1970's who had a head in the sand attitude about inflation. In fact, Burns was instrumental in the adoption of the core inflation (ex-food and energy) measure that is widely in use today. My investment conclusion at the time of the Bernanke appointment was to buy gold.

As individuals, sometimes we have to recognize that we can’t save the world and we can only save ourselves. My inner investor tells me to get long commodities but to be prepared for extreme volatility. My inner trader tells me that this will be a time of financial and economic instability and to rely on tactical timing models such as the Inflation-Deflation Timer.

Friday, December 25, 2009

A different kind of White Christmas

Here on the Wet Coast, we tend not have White Christmases. This morning I woke up to a different kind of white Christmas as a white fogbank enveloped Vancouver:

(Click to enlarge picture)

Tuesday, December 22, 2009

The greatest threat to capitalism

For many people, this is a time of year for reflection (instead of year ahead forecasts which I already touched upon here). So let me share with you my personal concerns about those who are less fortunate.

A growing class-based chasm?
This is a theme that I have expressed concerns about in the past. A fraying social fabric and a threatened middle class which endangers political stability.

Who is in the middle? Consider the following video, which depicts income distribution in the United States. While there are some inaccuracies, median household income is about 50K, not 40K, it does make the point about inequality.

The social elite these days is mostly Wall Street. Consider the I-am-more-deserving-than-you attitude in this Barrons article when bankers were asked as to whether they owed a social debt to society because of the bailouts (if you don’t have a Barrons subscription, see some excerpts here).

The greatest threat to capitalism are the capitalists themselves
In the past, this kind of let them eat cake mindset has led to peasant revolts. Already Moody’s has picked up on this theme and warned of social unrest. The UK is calling the bankers’ bluff to pick up and move elsewhere, but the US has caved to virtually every of the bankers’ wishes. Yves Smith at Naked Capitalism has suggested that the proper response by the UK government would be a combination of harassment or punitive tax policy for the likes of Goldman or any other investment bank who leave.

Policy bias favoring Wall Street is already institutionalized, the New Republic has an interesting article which indicates that the US may not be able to revitalize its manufacturing base because business schools are turning graduates oriented towards finance, not operations or manufacturing.

What’s more, no less than former Federal Reserve Chairman Paul Volcker has picked up a pitchfork and appears ready to join the peasant revolt. Joseph Stiglitz believes that banking troubles are worse than pre-Lehman crisis.

Others, like John Hussman, are outraged at the bailouts:

It's clear that financial institutions have made a mad dash to repay TARP money in hopes of being able to pay year-end bonuses, but what is not so clear is what happens after the year actually ends. Various policy makers (particularly Ben Bernanke, who is currently up for reappointment) have begun to take on a self-congratulatory tone, suggesting that the recent crisis is not only behind us, but that it has been resolved at a profit. What is not evident from these comments is how small these “profitable” inflows have actually been, in relation to what has been spent.

I will be convinced that the crisis has been resolved at a profit when the Fed disgorges the $1.5 trillion in Fannie Mae and Freddie Mac securities it has bought for us, and if the U.S. government does not end up having to bail those securities out because the cash flows from the underlying mortgages prove inadequate. Having no such assurance, the smug “mission accomplished” remarks of Bernanke and Geithner are reminiscent of a veterinarian who walks out of the operating room saying “I saved the life of your rabid dog … by giving it the vital organs of your children.”

The rebirth of the American Dream, or end of Pax Americana?
Most people who read a financial blog like this belong in the top 10% and a considerable in the top 1%. I believe that those of us who are in the top distribution of society must realize that unless America acts to restore the American Dream and dismantle the nascent class system that was formed with financiers at the top, the end of Pax Americana is at hand.

Monday, December 21, 2009

A sentimental warning for equity bulls

This is just a quick note, as blogging will be light until the New Year:

The latest reading from AAII shows the bull-bear ratio at a bullish extreme, which is contrarian bearish for the market.

Add to that came the news that Rydex timers really bullish. These readings serve as a warning for equity bulls that the upside for the market may be limited.

Thursday, December 17, 2009

I can handle (Rosenberg's) Truth!

In a special report entitled Year Ahead: Can You Handle the Truth, Gluskin Sheff chief economist & strategist David Rosenberg wrote [my emphasis]

Suffice it to say, we believe that the dominant focus will be on capital preservation and income orientation, whether that be in bonds, hybrids, hedge fund strategies, and a consistent focus on reliable dividend growth and dividend yield would seem to be in order. To reiterate, I see the range of outcomes in the financial markets and the economy to be extremely wide at the current time. But one conclusion I think we can agree on is the need to maintain defensive strategies and minimize volatility and downside risks as well as to focus on where the secular fundamentals are positive such, as in fixed-income and in equity sectors that lever off the commodity sector.

Rosenberg's observation before about the wide range of forecasts, is not new. I wrote about his comment about the huge range in the Fed's economic forecast in my post Get ready for Extremistan. As I understand it, Rosenberg's investment solution is to be defensive and preserve capital, while staying flexible enough to capitalize on opportunities as they arise.

Models for times of macroeconomic instability
Here is a better idea. The trend following principles of the Inflation-Deflation Timer model is the ideal tool for this kind of unstable environment. This class of model can identify changes in macro-economic expectations and investors can then profit from them.

Interview with Arjun Rudra

I was interviewed by Arjun Rudra of, where I talked about my views on:
  • Gold stocks
  • Stock market valuation
  • Inflation and deflation macro trends
  • Peak Oil

You can read the interview here, Seeking Alpha.

Wednesday, December 16, 2009

Another dovish FOMC statement?

With the news yesterday that producer prices came in at 1.8%, which was well ahead of market expectations of 1.0%, the markets should have been spooked. Instead of the DJIA being down 200 points, the market finish down only 49 on the day.

Perhaps it was in reaction to the news that China indicating that inflation was not likely to be a serious problem in the near future. Federal Reserve Chairman Ben Bernanke also had a very relaxed attitude towards inflationary expectations and asset prices. In a written response to Senator Jim Bunning (KY-R), Bernanke wrote:

The bulk of the evidence indicates that resource slack is now substantial. I continue to expect slack resources, together with the stability of inflation expectations, to contribute to the maintenance of low inflation in the period ahead.

In addition, the Fed Chairman doesn’t believe that there is an asset bubble:

Responding to questions about asset prices, Bernanke said “there is not much evidence to suggest that the stock market is currently in a bubble.” The Standard & Poor’s 500 Index has rebounded 28 percent in the past year while remaining 30 percent short of its high in October 2007.

Well, we can more or less guess that the FOMC statement will have a dovish tone.

A commodity and asset inflation friendly environment?
This sort of attitude by the Fed and the Chinese are ingredients for another Bubble and should continue to be bullish for commodity prices and bearish for the USD. The chart below shows the ratio of Amex Gold Bugs Index (HUI) to the S&P 500, indicating that gold stocks remain in a relative uptrend relative to the general market.

Dave Rosenberg explained yesterday why inflationary expectations are creeping higher:

It could have more to do with government mandated cost-push inflation than anything related to consumer demand-pull inflation. But we did see in today’s Investor’s Business Daily an article, which stated that governments have enacted 297 protectionist trade measures in the past year. (Amazingly, it was just over a year ago when the G-20 meeting was held in Washington when it was agreed that no such anti-trade measures would be taken.) The number of ‘planned measures’ has risen by 50 (!) in just the past three months — the pipeline keeps growing. This is why gold is a buy on pullbacks … like the one we have on our hands right now.

As well, my Inflation-Deflation Timer model continues to sport an “inflation” reading, which has been in place since July.

Financials signaling risk ahead
On the other hand, the relative behavior of the banking and financial sector is a warning sign for the longevity of this equity rally. The BKX made a plateau relative to the S&P 500 in the August to October period and has been falling since.

Watch the market reaction
If we do get the dovish statement, then I would watch how the market reacts. Does the “risk trade”, i.e. equities, commodities, etc., rally? If so, then how big is the rally?

I will be watching how commodities, exchange rates, equities and the financial sector reacts to the FOMC announcement for clues of future market direction.

Monday, December 14, 2009

Why you shouldn't buy gold stocks

My last post an embarassing question for gold bugs got a fair number of comments - which is to be expected whenever I write anything negative about gold or gold stocks.

My post then deserves a clarification. Supposing that you had a crystal ball that told you the price of gold were to triple within two years. Given this piece of information, what should you buy in order to maximize your gain?

Buying gold by itself will give you a gain of 200%. Buying a two-year call on gold with a $600 strike will give you a projected gain of about 300%. If you change the strike to $900, the projected gain is about 550%.

If you buy gold stocks given its poor fundamentals of rising production costs and their resultant pattern of disappointing leverage, gains are likely to be 200% or less. An investor would be taking on more volatility risk but at the price of little or no incremental gain.

Gold stocks are like leveraged ETFs
There are, however, times that gold stocks can be good trading vehicles. As many readers pointed out, they were a screaming buy compared to bullion early this year. Unfortunately, gold stocks are trading vehicles in the same way leveraged ETFs are trading vehicles. For longer term investors, their risk-reward characteristics are bound to disappoint.

Thursday, December 10, 2009

An embarassing question for gold bugs

Here is an embarrassing question for gold bugs. The chart below shows that price of gold decisively moved to all-time highs in early October, notwithstanding the recent pullback:

Meanwhile, the Amex Gold Bugs Index (HUI) barely challenged its old highs. What happened to the thesis that gold stocks are a levered play on the price of gold?

In case you thought I was cherry picking gold stock indices, the failure to make new highs is not exclusive to HUI, just look at XAU:

…and GDM, which is the base index for the GDX gold stock ETF:

Barry Sargent, writing at Mineweb, attributes the poor performance to the negative cash flows generated by the major gold miners:

Since the start of 2007 (and excluding the fourth quarter of 2009), eight of the world's Tier I gold stocks - AngloGold Ashanti, Barrick, Goldcorp, Newmont, Yamana, Kinross, Harmony, and Gold Fields - have generated negative free cash flow of USD 3.2bn (for the first nine months of this year, in line with rising bullion prices, generation of free cash flow has been positive to the tune of USD 1.1bn).

I believe that the story is simpler than that. I showed before that gold mines can be modeled as a series of call options on the gold price and production costs are rising at the major mining companies. Who knows, maybe the era of peak gold has arrived (see articles here and here).

I posted on this topic before and got a lot of hate mail for it. Now it’s time to revisit that issue again. For gold bulls who insist on a levered play on bullion, I would rather buy a long-dated deep in the money call option on gold than holding gold stocks.

Fool me once, shame on you. Fool me twice, shame on me.

You have been warned more than once. Gold bugs have no one else to blame if they underperform if there is another upleg in gold prices.

Monday, December 7, 2009

Consensus shifts ahead of Copenhagen

There are many crowded trades in life and in finance. One crowded trade that I am comfortable with is “the earth is spherical” trade. If the consensus was to shift off that paradigm, analysts would, after the fact, label that view a “bubble” and the market fallout from such a change would be extremely ugly.

After the hacker break-in at CRU, I speculated on what the possibilities might be should the consensus change. Today, as the world looks forward to the Copenhagen summit, the market consensus seems to be starting to shift as a result of the CRU incident. Avner Mandelman recently voiced his skepticism about climate change thesis and the issue of researchers either fudging data or denying others access to data:
Say that a pharmaceutical company's researchers were caught fudging their tests to make their drug look effective; then, when found out, conveniently lost the non-fudged data. If a doctor prescribed for your child the fraudsters' drug, would you let her take it? If you said yes, would we not be justified in saying you are acting irrationally?
If you missed the controvery, the issue isn't about just how a researcher might have used some "trick" to fudge data so that it would agree his model, but the distressing lack of discipline in the scientific method. Judith Curry, an American climate scientist and no skeptic of the climate change thesis, was appalled [emphasis mine]:

What has been noticeably absent so far in the ClimateGate discussion is a public reaffirmation by climate researchers of our basic research values: the rigors of the scientific method (including reproducibility), research integrity and ethics, open minds, and critical thinking. Under no circumstances should we sacrifice any of these values; the CRU emails, however, appear to violate them...

If climate science is to uphold core research values and be credible to public, we need to respond to any critique of data or methodology that emerges from analysis by other scientists. Ignoring skeptics coming from outside the field is inappropriate; Einstein did not start his research career at Princeton, but rather at a post office. I’m not implying that climate researchers need to keep defending against the same arguments over and over again. Scientists claim that they would never get any research done if they had to continuously respond to skeptics. The counter to that argument is to make all of your data, metadata, and code openly available. Doing this will minimize the time spent responding to skeptics; try it! If anyone identifies an actual error in your data or methodology, acknowledge it and fix the problem.
Meanwhile, the financial market consensus appears to be starting to shift. Donald Coxe, former Global Portfolio Strategist at BMO Capital Markets, also indicated his doubts about the global warming thesis. In reporting on Coxe, a reporter commented:
My purpose here is not to weigh in on Mr. Coxe's theory of climate change (which mostly has to do with sunspots) or those of the scientists who disagree with him. But he is worth listening to in this respect: The big money is always, always made by those willing to bet against a deeply held consensus. So if, five or 10 years from now, new evidence has thrown theories of global warming into doubt, enormous profits will be made by those putting their cash on that outcome now.

Quantitative finance = science
While I have my own personal opinions about climate change, I have learned to be flexible and open-minded about my beliefs as an investment and quantitative analyst.

Quantitative finance is much like science. We observe, we form our hypothesis, we test our hypothesis and we try to apply them. If the evidence changes, our models have to change too.

I have observed situations in the past where people have been dogmatic about models and investment processes despite evidence to the contrary. In the short term, these people may be successful in the short term. In the long term, the market will punish them for their views if they are wrong. Some of these models were built by analysts with incredible stature. Not only do some of these people have Ph.D.s from top universities, published in leading peer-reviewed journals, a few are even Nobel laureates.

In fact, why don’t we start a hedge fund with some Nobel laureates, we’ll call it Long Term Capital Management….

Here’s another idea. Let’s take some of these models of mortgages and apply them to how we package mortgage backed securities. We’ll slice up the mortgages into different tranches, from senior to junior and…

Oh, I remember how that turned out.

Good quantitative modelers observe, form hypotheses, test and apply them. So do good scientists.

We all need to thimk and watch out for errors in our data set and assumptions.

Thursday, December 3, 2009

A (Fed) house divided

Abraham Lincoln famously said that “a house divided against itself cannot stand.”

Today, we may have that exact state at the Federal Reserve. I finally go around to reading the last FOMC minutes. While there was great debate between the hawks and the doves, here is the position of the hawks about inflation risks [emphasis mine]:

But others felt that risks were tilted to the upside over a longer horizon, because of the possibility that inflation expectations could rise as a result of the public's concerns about extraordinary monetary policy stimulus and large federal budget deficits. Moreover, these participants noted that banks might seek to reduce appreciably their excess reserves as the economy improves by purchasing securities or by easing credit standards and expanding their lending substantially. Such a development, if not offset by Federal Reserve actions, could give additional impetus to spending and, potentially, to actual and expected inflation.

Wait a minute, did they just say that? The Wall Street Journal reported that there is around $1 trillion of excess reserves sloshing around in the banking system, which is indicative that banks don’t want to lend, and these guys are afraid of bank lending?

Maybe I am just dense but the position of the hawks appear to be inconsistent to me. Why did they vote for quantitative easing?

The current situation reminds me of the old Steve Martin/Lily Tomlin comedy All of Me, where Tomlin’s character was trapped inside Martin’s body but neither has complete control.

Meanwhile, you have the likes of
Bullard of the St. Louis Fed asserting that the recent commodity price spikes are not inflationary. No wonder there are such differences of opinion about the outlook at the Fed.

What's more, I see that Sen. Bernie Sanders said that he has placed a hold on the nomination of Ben Bernanke for a second term as chairman of the Federal Reserve.

A (Federal Reserve) house divided indeed, what does that say about its policy?