An update on gold (but not frankincense or myrrh)

Mid-week market update: There is not much that can be said about the stock market that I have not already said. The small cap seasonal Santa Claus rally that I wrote about appears to be proceeding as expected, though the tape is thin and most professionals have shut down their books for the year.

Next week is Christmas. It is said that the three kings visited the infant Christ with gifts of gold, frankincense and myrrh. While there is no active and liquid market for the latter two gifts, gold is still traded and an update on the outlook for gold would be timely.

Gold is getting intriguing. Analysis from Nautilus Research indicates that we are entering a period of positive seasonality for gold.

At the same time, gold stocks are testing a key relative downtrend line. Should it rally further, it would be a signal of possible further future strength.

The full post can be found at our new site here.

Overbought USD = Commodities posed to rally?

I received a fair amount of feedback to my recent post highlighting the weakness of commodity prices (see A tactical sell signal, but no signs of a major top). The key point raised is that since commodity are priced in US Dollars, the recent strength in the greenback is going to pose a headwind for commodity prices. On the other hand, China has been the major marginal consumer of commodities and Chinese demand is going to have a major effect on pricing.

So what is more important to commodity prices, the China effect or the USD effect?


An inverse correlation to USD
Let us consider each effect, one at a time. The chart below shows the CRB Index (black) and the USD Index (in green, inverted). The bottom panel shows the rolling correlation of the CRB with the USD. There is no question that there is a major inverse correlation between the CRB Index and the USD Index.

China effect equally important
What about China? One way of distilling the China effect is to watch the AUDCAD exchange rate. Both the Australian and Canadian economies are resource sensitive, with Australia more China-sensitive and Canada more US-sensitive. The chart below of the CRB Index (in black) and the AUDCAD rate (in blue) shows a higher level of a high level of correlation as well.

Which is more important? My conclusion is that they are different, but important in their own way.


A possible commodity rebound?
Recently, commodity prices have been battered by the double whammy of a strengthening USD and Chinese slowdown, but those headwinds may be changing.

The chart below shows that the USD Index is testing a key technical resistance level. The 14 week RSI, shown in the lower panel, shows an extended and overbought condition. I have marked with dotted vertical lines previous instances when these overbought readings have occurred and these kinds of readings have marked an interim USD top on every occasion.

As well, the latest BoAML Fund Manager Survey shows excessively bullish on the USD, indicating a crowded long:

The outlook for commodity prices based on the China effect is more mixed. The recently announced stimulus program by the PBoC represents a Rorschbach test for investors, according to this Bloomberg report:

As economists in China woke up to overnight news from website Sina.com that the People’s Bank of China was extending 500 billion yuan ($81 billion) of credit to the country’s five largest lenders, their interpretations of the step diverged. Without a PBOC statement to explain policy makers’ motive or intentions, there was little from officialdom to go on.

The PBOC’s maneuver drew attention to a mechanism called the standing lending facility, introduced last year as a collateralized provision of funds to meet large-scale demands for financial institutions’ long-term liquidity. The central bank has referred to it in official statements on steps to address fluctuations in money-market rates.

That's because investors are less certain about the intent of the PBoC's actions. Is this intended to be a stimulus like an RRR cut, or just a temporary liquidity injection for technical reasons? The Street is divided in its opinion:

Shen Jianguang, chief Asia economist at Mizuho in Hong Kong, wrote in a note that the measure was “stealthy easing” and “may help to support the economy, which faces rising risk of a hard landing.” Goldman analysts including Beijing-based Song Yu wrote that the injection marked “the first clear policy response to weak August data.”

By contrast, Chang Jian, chief China economist at Barclays Plc in Hong Kong, said it was “a normal liquidity operation,” in the title of her note on the news.

“We think the latest SLF is mainly aimed at providing liquidity to pre-empt potential liquidity shortages in the banking system in the coming weeks,” Chang wrote. Cash needs for the coming National Day holiday, along with initial public offerings of stock, are among the reasons she cites. Pressures for stimulus that stem from the deceleration in growth mean investors may interpret the news as a form of easing, she said.

Meanwhile, the initial AUDCAD market reaction was positive initially but ended the day on a negative note. As the chart below shows, this cross rate fell below technical support from a well-defined trading range:

My personal opinion is that the jury is still out on the intent of the China "stimulus" and we won`t know the true effects of this new program for a few more days. Net of all effects, however, the medium term outlook for commodity prices has moved from highly negative (rising USD and slowing China) to mildly positive (possible downward USD retracement and neutral on China).

In addition, the BoAML Fund Manager Survey shows that managers were aggressive sellers of commodities in September, which is contrarian bullish:

Positioning in commodities is well below average, though readings are supportive of a tactical rally but not a definitive bottom:

Commodities testing support
As I write these words, many major commodities are currently testing key support. Here is the chart of crude oil:

Gold is starting to look washed out, as it tests a support level in the context of a downtrend. (Is Joe Wiesenthal's comment that gold looks like death contrarian bullish?)

The technical condition of silver, the poor precious metal cousin to gold, looks even weaker:

However, with a more favorable macro conditions, I expect these key support levels to hold and the commodity complex to stage a robust rally in the near future.

By implication, a hard asset price rebound has the potential to throw a scare into the equity market as rising inflationary expectations could create the impression that the Fed`s dot plot will rise faster than expected.

Key risk
The one key risk to this trade is that the USD could continue move higher in the short-term. An overbought USD doesn`t mean that it can`t get more overbought.

There are many reasons to be bullish on the greenback.The 10-year US Treasuries currently yields 2.6% compared to 1.0% for Bunds. Notwithstanding the differential in monetary policy between the Fed and the ECB, that kind of rate spread between so-called "risk-free" instruments has the potential to attract funds into USD assets and push the EURUSD rate lower. As well, stories touting a short JPYUSD position as the "trade of the decade" could see more hot momentum players piling and pushing the USD up further. Star bond manager Jeffrey Gundlach recently advocated this trade on CNBC:

Dollar-yen could double, according to Jeffrey Gundlach, noted bond guru and founder of DoubleLine Capital, who predicts we'll see the dollar strengthen to 200 yen in three to five years. That's an 87 percent move.

"I think this breakdown in the yen has pretty high momentum. I wouldn't be surprised to see the yen get substantially weaker," he told "Squawk on the Street" this week.

While I am bearish in the USD intermediate term, my crystal ball is too cloudy to call the exact top. I would therefore be inclined to either buy commodities with a tight stop or wait for the USD Index to turn before putting on a position.

Another step down the road to Argentina

I have written before about how U.S. may be making the same mistakes as Argentina did a century ago. Now there is one more worrying data point that America is going down the Argentina road.

The New York Times is reporting that American firms are offshoring high tech research jobs to China. As an example, Applied Materials built its biggest lab in China, and Chief Technology Officer Mark R. Pinto plans to move there. Another disturbing sign of the loss of competitiveness: Some US companies are licensing technology from Chinese developers for use in the US.


Is America innovating?
Michael Mandel, former chief economist for BusinessWeek magazine, recently wrote that “Innovation makes up the main comparative advantage for the U.S., since we can’t compete on cost with lower-wage countries (at least not yet).” Unfortunately, American leading edge industries haven’t been creating jobs.

Policy makers have to get out of their ideological straitjackets if they are to make a significant headway on innovation. Standard macro drivers such as lower tax rates don’t seem to have a significant impact on innovation. In fact, there are indications that higher innovation regions have higher tax rates.

I believe that other factors espoused by Michael Porter, such as industry clustering, infrastructure availability, etc., have a much higher impact on how creative and high value-added industries locate themselves.


Disaffected youth?
At the heart of innovation is a country’s education system. The top American universities remain the envy of the world, but troubling statistics indicate that youth labor participation rates have been falling.



Is innovation even the answer?
Even worse, Andy Xie argues that innovation may not save an economy [emphasis mine]:

Many economists argue for freer and cheaper economic structure to stimulate innovation. But, in the Internet era, innovations rapidly disseminate around the world. It's not clear if innovation benefits can be contained in any country anymore. For example, even though the United States is more innovative than Europe, it hasn't outperformed by much. Its celebrated prosperity during the Greenspan era turned out to be an old-fashioned bubble, not a reflection of superior innovation.

Andy Xie does have a point. Innovation isn't enough, by itself, to insure success. Even if you build a better mousetrap, the world will not beat a path to your door. To be successful, you need marketing, distribution channels, reliable manufacturing processes, etc. Your resulting wealth also depends on your relative bargaining power within the value chain. We have had this private running joke in our family. Where other parents may have wished for their child to discover the cure for cancer, ours was that our child would commercialize the cure for cancer.

Nevertheless, until the US begins at least reverse itself on the innovation front, the loss of position on the innovation front has to be regarded as long-term negative for the US Dollar and long-term bullish for commodities.

Pax Americana at dusk

As gold breaks above the magic $1,000 level and the US Dollar weakens, more and more headlines are coming across that suggests that the center of gravity is shifting away from the United States.

• The UN wants to replace the US Dollar with a global currency.
• The World Economic Forum's competitive report now shows that Switzerland has moved ahead of the US as the world's most competitive economy.
• Profit generated by China's 500 largest firms outstripped earnings of the 500 biggest companies in the US for the first time.
• Time magazine is asking Is Asia forming a new trade bloc?
• Speaking of China, isn't fascinating that the market now listens and even convulse based on the utterance of leading members of the Chinese Communist Party?
• The blogger Cynicus Economicus posted on the Dire position of the US economy. In addition to all the data points indicating the sad state of the American economy, he shows that foreigners are pulling funds out of the US.
  

I recently became a member of the Board of Advisors to Qwest Investment Management, an investment management firm which specializes in identifying, structuring and managing investment products. The firm is currently focused on investments in the natural resource sector. One of my tasks is to write a monthly newsletter, known as Qwest for Returns. the first edition asks whether the US is becoming Argentina. Here is the synopsis:

In this issue we explore if the U.S. is making the same mistakes as Argentina did a century ago. Will the U.S. see its competitiveness erode, its economy weaken further and the U.S. Dollar continue its decline? A weakening of the U.S. Dollar could be bullish for commodities.

You can see the newsletter here.

The Grand Experiment

The long term outlook for the USD continues to look dire. As the story broke that the G8 failed to reach a consensus on policy, but believed that the world economy is too weak to withdraw stimulus, and the developing economies rose to challenge the G8, the BoE surprised by halting the expansion of its quantitative easing program.

As I have written before, Britain is the canary in the coal mine for the US. The UK, unlike the US, has a very similar range of problems as the US but does not have the luxury of being the issuer of a major reserve currency.

As Macro Man commented yesterday (before the BoE announcement):

[I]t's worth noting that today sees an announcement from one of the few CBs in a tighter spot than the Fed....the Bank of England. Inflation has consistently exceeded expectations, and a prior raft of better-than-expected activity data has recently receded into sharp declines. Oh, and the fiscal situation is worse than that in the US, and adminsitered by a government that's now utterly bereft of credibility.

The BoE is embarking on a grand experiment with its QE policy.

Watch this space for what may follow if the Fed follows this path.

Could the GBP be the canary in the mine?

Further to my last post about the inevitability of inflation in the U.S. because of the massive fiscal and monetary stimulus, CynicusEconomicus points out that the UK suffers from a similar problem:

[I]n the UK (and the same could be said of the US), there had been no real growth in what I considered to be wealth creating assets over the last ten years which could explain GDP growth; manufacturing, commodity extraction, export of services, and tourism (no net growth).

Instead I pointed to the growth in debt, and asset inflation (real estate) as the source of all of the GDP growth of the last ten years. This debt, in conjunction with the multiplier effect, along with upwards levers such as immigration, created an illusion of growth in wealth. It led to the 'post industrial', 'service economy'. My argument was that this was completely unsustainable, and that a collapse in asset prices would signal a self-reinforcing downward spiral in the economy, driven by a collapse in consumer sentiment (a massive belt tightening) leading to the collapse of the service economy, higher unemployment, more belt tightening and so forth into a downward spiral.

Because virtually all governments around the world are pursuing similar fiscal and monetary policies, it is possible that the USD does not fall against other currencies. Instead, inflationary expectations show up in commodity prices, inflation-indexed bonds and the long end of the yield curve.

When does Mr. Market realize that inflation becomes a problem?

I have no idea. One way would be to watch Pound Sterling. If the UK suffers from the same problems, then one way that these pressures manifest themselves would be a fall in the GBP, which is not a significant reserve currency the same way the USD is.

Liquidity or Solvency?

The equity markets sold off hard on Monday on the news of the collapse of the bailout deal. No doubt the authorities will try to cobble together another rescue package soon.

There is no shortage of suggested solutions. For me, the key issue of evaluating the next deal is how the power shifts between investors, bankers and taxpayers.


Fed and other central banks desperately injecting liquidity
Right now, the credit markets have seized up. In response, the world’s major central banks are desperately trying to inject liquidity into the financial system.

Is it enough? Some have even suggested that a bailout isn't needed.


...but the system is insolvent
Brad Setser summarized the issues best in when he questioned whether $700b is enough. The issue is what price any bailout fund pays for the distressed securities, book value or market value (however you define it):

If [the US Treasury] pays a high price for various dud assets, it won’t move nearly as much off the banks’ balance sheet — which may leave residual questions about the health of key institutions. On the other hand, if the Treasury pays a low price, it may leave a lot of banks in trouble and in desperate need of new equity.

Paying a high price (likely book value) for the toxic paper bails out investors and bankers, but does little for taxpayers. Paying discounted market value is favorable for taxpayers but leaves the financial system insolvent.

Book or market value for the toxic paper?
I heard that the calls, emails and faxes to Congress were running at about 200 to 1 against the defeated deal. The predominant feeling among the electorate was that it wasn’t fair for taxpayers to be bailing out big investors and investment bankers. With an election not that far away, Congress listened.

Many have suggested that the key component of any deal be the payment of a highly discounted value for the toxic paper clogging up the system. If that is done, then the financials would have take massive writedowns which would render them insolvent (see John Hussman’s analysis here). John Berry has suggested that this would be the granddaddy of all carry trades. Buy high yielding assets (at 10-12%) and finance it at 3-4%. The key issue, in that case, is what is the “hurdle” default rate that makes the Treasury money?


How will foreigners react?
I have indicated before that many of the components of the failed deal, which seemed to favor investors, was quite likely the result of Chinese pressure. Yu Yongding, a former advisor to the Chinese central bank, recently acknowledged the pressures on China and on the US by stating that Asia needs a deal to prevent panic selling of U.S. debt. However, China wants something in return:

Yu said China is helping the U.S. ``in a very big way'' and added that it should get something in return. The U.S. should avoid labeling it an unfair trader and a currency manipulator and not politicize other issues, he said.

``It is not fair that we are doing this in good faith and are prepared to bear serious consequences and you are still labeling China this and that, accusing China of this and that,'' he said. ``China knows what to do. We don't need your
intervention.''

He also indicated that this may be a tectonic shift in China’s future policies:

``Our export-growth strategy has run its natural course,'' he said. ``We should change course.''

China should stop intervening in the foreign currency markets and thus allow rapid appreciation of the yuan, he said. While this would cause pain for exporters, China could ease the transition by using its strong fiscal position to aid those who lose their jobs. It also should stimulate domestic demand to offset lower income from overseas sales.

Without yuan appreciation, China will continue to accumulate foreign reserves, which means further accumulating ``IOUs from the U.S.,'' said Yu. ``This is paper and it may default and it will not increase China's national welfare.''

In other words, China stands ready to help the US through this crisis. However, there is a political price to be paid. Moreover, this may signal the beginning of the end of the US Dollar as the premier reserve currency in the world.


Not just Big Bad China making waves
Before anyone jumps on Big Bad China, understand that China has been the most vocal of the foreign lenders. No doubt others, such as the oil producing states in the Middle East that are big holders of USD paper, are thinking along the same lines. For instance, Germany's Finance Minister Peer Steinbrück was quoted in Der Spiegel as saying:

There will be shifts in terms of the importance and status of New York and London as the two main financial centers. State-owned banks and funds, as well as commercial banks from Europe, China, Russia and the Arab world will close the gaps, creating new centers of power in the financial world.

In addition, the Washington Post recently reported that:

Ibuki, the Finance Minister, said Friday that Japan would consider funding the International Monetary Fund or other international lending agencies to help with bad debt.

IMF mandated adjustments would be extremely painful for America. Note that these last two comments were from America's closest allies. In addition, an opinion piece in the Telegraph in the UK notes that a default by the US government is no longer unthinkable.

Years ago when I managed international equity portfolios, our international and emerging markets teams used to irk our US colleagues with the comment that the US is only 1 of 50 markets. That comment is now coming true in more ways than one.

This bailout is destined to end in tears

As of the time of this writing, the Emergency Economic Stabilization Act of 2008 is scheduled to be introduced in House of Representative on Monday September 29th. As I had no special insights on the bailout, I have so far avoided commenting on the situation.


Was foreign pressure the REAL reason for the bailout?
However, there is something that not many have talked about that makes me compelled to speak up. While some have pointed to the breakdown in the credit markets as the compelling reason for a bailout, there is gathering evidence that the US authorities succumbed to Chinese pressure to “make them whole”, so to speak, on China’s investments in US paper. The Washington Post recently reported [emphasis mine]:

As U.S. officials were deciding in August whether to take over Fannie Mae and Freddie Mac, the Treasury Department held informal talks with officials from the People's Bank of China, the country's central bank. At that time, investors in Fannie Mae and Freddie Mac in China were dramatically reducing their holdings. The U.S. side told China that a cash infusion was in the works; China said that it expected the U.S. government to "do whatever is necessary" to protect the investments.

As an indication of further pressures, China also signaled that it could shift away from USD assets. Given the size of the US current account deficit, a buyer’s strike of USD paper would send long rates soaring and the economy would nosedive into a serious recession, if not another Depression. In that case, the US authorities may have caved into Chinese pressure and chosen to bailout Agency paper.


Two unpalatable choices
To finance the bailout, the United States has two choices. It can either monetize the debt or go to its lenders, hat in hand, to finance the bailout at whatever terms it can get. As any first year economics student can tell you, any monetization of debt of this size would be inflationary. If it chooses the latter path, the Washington Post article reported that:

Ibuki, the Finance Minister, said Friday that Japan would consider funding the International Monetary Fund or other international lending agencies to help with bad debt.

IMF mandated adjustments have always been very painful. Whatever path is taken, this bailout is destined to end in tears.

A decade-long low return environment for equities?

The chart below shows the Dow Jones Industrials Average from 1947 to the present. This brief history of the Dow has been marked by two eras of rallying markets, followed by a long sideways market. We could be moving into another period of sideways markets for another decade or so.Poor macro-economic backdrop
There are valid fundamental reasons for these sideways markets. The last sideways pattern has been marked by rising inflationary expectations that begun with LBJ’s guns and butter policy in the Vietnam War. The macro-economic backdrop is not dissimilar to that of the late 1960s and 1970s. America is involved in a war with no end in sight, the fiscal deficit is spiraling out of control and the US Dollar is falling.


Excessive equity valuations
Some investors, like John Hussman, believe that the market is excessively priced. In a recent commentary he wrote that “the S&P 500 remains priced to deliver probable total returns of about 2-4% annually over the coming decade”. Using the methodology described here, Hussman indicates that the market’s cyclically adjusted P/E based on peak earnings is very high. Profit margins are elevated at this point of the cycle and there is the market is not pricing in any room for margin mean reversion (read analysis here).


Pension funds asset mixes likely to favor more bonds
Corporate treasurers are likely to move towards a asset-liability matching framework in defined benefits plans given the advent of changes in accounting policy such as FASB 158 and IAS 19. In Europe there are already suggestions to extend the Solvency II standard to corporate pension plans, which would further accelerate this trend (and has created scare stories like this).

We saw this effect in the UK a few years ago when companies moved towards an asset-liability matching framework. Investors drove the yield on the long-dated gilt to unbelievably low levels as they reached for duration in their portfolios. This asset shift came at the expense of equity weightings and other assets in the pension portfolio.

Sheep can make money too!

As a counterpoint to my post Channeling my inner contrarian I thought that I would write about being a sheep and the advantages of following the crowd.

A few years ago, I managed equity market neutral portfolios at a firm that was mainly known for commodity trading using trend following techniques, which are well described by Michael Covel in his book. During my tenure there I noticed that while the commodity positions were spread out among various futures contracts they often amounted to a few macro bets (i.e. on interest rates, on the US$, etc.) I came to the conclusion that these models were identifying macroeconomic trends that are persistent and exhibit serial correlation, which creates investment opportunities for patient long-term investors. For example, if the Fed is raising rates the odds are they will continue to raise rates until they signal a neutral or easing bias, i.e. there is a trend to interest rates, which is information that investors can use. The key risk in this class of models is knowing when to exit the trend, as short and long term reversals can be devastating to the bottom line.

With those principles in mind, here are some of the big macro trends that could be investment opportunities (and this shouldn’t be a surprise to most people):

• The falling US Dollar
• Worldwide inflation, especially in commodity prices
• Growth in China

The falling US Dollar

The accompanying chart shows the US Dollar Index in a multi-year downtrend (this is where technical analysis is useful as it spots long term trends). The currency is reflective of investor concerns of the current account and fiscal deficits going out as far as the eye can see and no meaningful policies to reverse them. The recent Fed actions of rescuing the system from collapse have led to some to question the Central Bank’s inflation fighting credentials, which have resulted in additional Dollar weakness. In the short term, however, the US Dollar is near the bottom of its channel and seems to be poised for a counter-trend rally.


Worldwide inflation, especially commodity inflation
Inflation is everywhere and spreading. You just have to read stories like Stop the inflation in the US and Workers strike at Nike contract factory and demanding 20% raises in Vietnam, a low-wage country that had previously been a source of deflation.

Commodity inflation is not just restricted to headline commodities like gold and oil, but is very broad based can be seen in foodstuffs (which begs the question of whether Core CPI = CPI ex-food and energy is a good indicator of inflation). The accompanying chart shows the Continuous Commodity Index (CCI), which is a continuation of the old equal-weighted CRB Index before its re-constitution to a liquidity-weighted index in 2005. The CCI has been advancing in the major non-US currencies as well as US Dollars, indicating that the commodity advance is 1) broad based and 2) independent of US Dollar weakness.





Similarly, gold prices have also been showing a similar pattern to the other commodities. Gold appears to be regaining its former status as the alternative reserve currency. As I indicated before, the US Dollar is likely to rally in the short run and gold and other commodities would run into a headwind under such a scenario.




"Peak Oil" is an additional possible bullish dynamic for oil prices
Crude oil has a possible bullish dynamic of its own in addition to the rising trend in commodity prices: Peak Oil. Much has been written about peak oil by the likes of Matt Simmons, various contributors at the Oil Drum and by many others at APSO so I won't repeat them here. If the peak oil theory is correct and world oil production is indeed rolling over, then we are in for a period of very tough adjustments in not only energy usage but in the pattern of economic growth.

Growth in China
The China growth story is well known and likely to persist. However, direct investment in China is problematical because of an ill-formed culture of corporate governance. A recent article in the FT indicates that:

Board structures at Chinese companies can lead to “confusion, ambiguity and potentially ... undermine the board of directors”, according to a study [by Risk Metrics] of the corporate governance risks faced by investors in China.

Even Hong Kong has its problems:

Risk Metrics noted minority shareholders in the two jurisdictions [Mainland China and Hong Kong] do face some common risks. The state’s firm grip over China’s largest industrial and financial companies is mirrored in Hong Kong by the influence of tycoons and their families.

Instead of investing directly into China, I would suggest vehicles such as the Korean market (EWY: iShares MSCI South Korea) as a way of participating in Chinese growth. Countries such as Japan and Korea supply China with capital goods to facilitate growth in the Chinese economy. The accompanying chart shows the relative returns of the South Korean KOPSI Index in US Dollars relative to the S&P 500. The Korean market bottomed out relative to the S&P 500 in 1997 and has been in a relative uptrend since. A trend following investor would look at that chart and say “stay with the trend!”



The key risk to this trade is that the South Korean market is generally thought as as being highly sensitive to world growth and a significant slowdown in the US could affect it disproportionately.