Sunday, October 24, 2010

Stimulative Fed Policy and Historical Financial Asset Analysis Good for Gold Versus Both Bonds and Stocks

Right now, the economy looks like more of the same-old, same-old mode: stagflation for the foreseeable future.

This past week, the Conference Board reported a modest uptick in its monthly Leading Economic Indicators and said:

Says Ataman Ozyildirim, economist at The Conference Board: “The LEI remains on a general upward trend, but it is growing at its slowest pace since the middle of 2009. There isn’t any indication of a relapse into another downturn through the end of the year.”

Says Ken Goldstein, economist at The Conference Board: “More than a year after the recession officially ended, the economy is slow and has no forward momentum. The LEI suggests little change in economic conditions through the holidays or the early months of 2011.”

The Economic Cycle Research Institute (ECRI) reports weekly to the public on its intermediate-term leading indicators via its Weekly Leading Index. This number remains becalmed around 122. It first reached this level 12 1/2 years ago.

It turns out, however, that most of the time slow growth and easy monetary policy is a good combination in the short term for the pricing of financial assets.

Where are the values, such as they are?

It has been noted that for every percentage point for which the 3-month Treasury bill is less than two points above the consumer price index, the price of gold has risen 8% annualized. In other words, neutral has been 2 points above the CPI. Thus in the 1990s, the price of gold trended down, and a review of the data (click HERE for CPI and HERE for T-bill rates through 2000) are consistent with that. The post-9/11 monetary world has been stimulative of the gold price.

1990 is a useful year to judge return rates on various assets. It was about a decade after the inflation fever peaked as judged by the action of gold and silver prices and was, not coincidentally, the year that short-term interest rates peaked.

It was also a decade before the stock market bubble peaked and the gold price bottomed. And of course following the extremes in interest rates on the upside in 1980, we now have what would at that time been an absolutely unthinkable extreme in interest rates at the low end of about zero percent on the short end.

So, as the sports announcer Warner Wolf might have said, let's go to the tape. In 1990, a 30-year Treasury bond yielded about 8%. Gold averaged about $400/ounce. Let us say that for all of 2010, gold averages about $1250/ounce. The average annual compounded return on gold from 1990 to 2010 then can be computed as 5.9%. Thus a financial asset of infinite duration, gold, has underperformed a similar high quality, long-term asset, the plain old boring long Treasury bond, by about 2 points per year.

Let us now apply the above-mentioned 8% rule. CPI is running about 1% per year. Of course, official CPI may well understate the average rate of consumer price increases. The statistical relationship between gold and the CPI is what it is, with the imperfections in the CPI understood.

If monetary conditions as measured by the 3-month T-bill continue to be one percent below the CPI (i.e., three points below neutral) for 4 more years, then this relationship predicts that gold will rise an average of 24% yearly. I'm going to calculate matters assuming 20% appreciation yearly rather than 24$.

How can we judge whether that would put gold into the severely overpriced category.

How overpriced would gold be if goes from a suggested 2010 average price of $1250 to a 2014 average price of $2500?

To get an answer, let's go back to 1990's average price of about $400/ounce of gold.

If it rose from $400 to $2500 over that span of 24 years, the compounded yearly appreciation would compute to 7.93%.

So over that time frame, the return from gold and a long Treasury bond since 1990 would be . . . identical.

So-- there would be no bubble in gold even if its price doubled. (Louise Yamada agrees.)

Isaac Newton comes into play here. He pointed out that a body in motion tends to stay in motion until it is opposed by a force that blocks said motion. He also was involved in 1717 in Britain going on a gold standard (please excuse gold ads at the top of the link; the writeup is quite interesting and based on other reading I have done, I trust it is accurate).

So, we have a Fed that is focusing on its second mandate, that of full employment, with some Fed leaders stating that if anything, prices are not rising fast enough to allow the Fed to do its job; the President wants 2012 to be another Morning in America so he can be re-elected; and Congress always wants jobs. So all of Washington that matters wants prices to rise if that is "necessary" to help the employment situation; and so do the states, as they want more revenue.

Thus I see no special reason for the above-mentioned general relationship of a Fed that keeps rates at or below the CPI rate not to continue at least until there is a more serious question of fundamental overvaluation of gold. That gold has functioned as such a leveraged play on negative real interest rates without the owner of gold having any leverage is quite interesting.

Of course, past performance need not predict future performance, etc.

Gold bears and gold skeptics often make much of the alleged explosion in ads about it and allege a bubble. Yet anyone who sees Gordon Liddy pitch gold on TV gets the wrong impression. Gold is the metal of kings, not crooks. There is a reason why every currency the past several years has declined against gold. Something that is "golden" is good.

The more that politicians and their minions in central banks create "money" that does not tie to something physical, the more that owners of paper wealth will want to transform that to something tangible. "Uncle" Warren Buffett may prefer farmland or Exxon Mobil (which does not meet its crude oil needs via its own reserves) to gold; or he may have been dissing gold to get a chance to buy it cheaper when he addressed the topic recently. It doesn't matter. As we have seen the past few years, the pols in the Western world and very possibly in China have gotten in bed with the speculative financial interests (a charitable phrasing), which have created a worse disaster with depositors' money on a larger scale--by far-- than ever happened in the 1930s. Without knowing an MBS from a CDO, the public gets it.

The brokers want what sells easily. They want a "story". They also want something to sell that generates enough profit to make it worth their while. Who knows, but it's just possible that the new gold bull market really began just one year ago, with the validation of the breakout above $1000/ounce that briefly happened in 2008, and that stock brokers will be given more and more precious metals products they can sell. In other words, you ain't seen real selling of a financial asset until the Street and its allies in the mainstream media jump aboard.

And though I'm no Steve Jobs-- one more thing. If you want to know what a real extended bull market/bubble is, consider the NASDAQ. In October 1974, at the end of an extended bear market for risky stocks (and only a few years after NASDAQ was created as an exchange with Bernie Madoff as a co-founder), it was around 55. By the end of 1998, it was 2344. Over that 24 years, the compound annual return of the index was 17%, which far exceeded any Treasury rate available in 1974. But that was of course just prelude. The index more than doubled in the next year and two months, reaching about 5100, giving a return of almost 20% annually for that quarter century since the bear market bottom.

Even now, from its bear market bottom 36 years ago, the compound annual return of the NASDAQ is 11% annually.

Now that's a bull market!

And just one more thing. Gold ended 1974 at around $180/ounce. That gives it a mere 5.70% compound annual return since then. There was no 30-year bond issued then, but since the 10-year yield at the same time was 7.40%, we can assume that gold has substantially underperformed both long Treasuries and stocks.

That does not mean that it should "make back" that underperformance, but it rebuts the charge that gold is in a bubble, that it has gone up "too much", etc. The point is that gold is forever and is best viewed the way I have presented it here, not whether it has gone up a lot over the past year or has had one up year after another after two decades of woeful performance.

After all, when the NASDAQ fell by a full 50% from its bubble peak in 2000, it was still wildly overvalued. Sometimes time shows that assets get substantially above or below either fair value or at least a sustainable market value, and based on those criteria, gold's price might rise quite a bit in dollar terms and still be reasonably valued by multiple criteria. Not that it will do so, but I'm spilling a lot of digital ink because I think it may do so over the next several years and have invested accordingly.

Meanwhile, one final thing-- a chart (click on it to enlarge) from Andrew Smithers-- to put matters in a final perspective. At the end of 1974, traditional analysis of stocks based on asset value ("q") and cyclically-adjusted price-earnings (CAPE) ratio suggested that stocks were fully 60% undervalued. The same analysis today suggests that they are about 60% overvalued (note that the chart was drawn when the S&P 500 index was much lower; fair value was calculated at about 725 on that index).

So there's nothing intrinsic in stocks that they will do better than something as boring and unproductive as gold. Time will tell, but I continue to see gold as tracing out a chart pattern eerily similar to the NASDAQ pre-1999.

In a totally different investment sphere from gold, I continue to believe that AAPL is a unique and potentially seriously undervalued growth stock. The combination of AAPL stock and ownership of gold is quite a diverse twofer. Pure growth and innovation with financial strength; and pure money/value with no growth aspect.

Philosophically, I believe that all the Fed intervention in the economy is horribly misguided. It is Soviet-style central planning and cannot possibly work well in a nation as huge and complex as the United States; plus even if the Fed gets it "right" now and then, a free people and free banking system can do better and have the right to interact as they see fit. Whatever level of economic activity people and their businesses wish to transact is the "right" level.

(In any case, if one is fortunate enough to have investable funds, one has to separate philosophy from the "don't fight the Fed" principle of investing. So that's enough of a rant for a discussion of investments.)

As usual, this discussion represents my thinking as of the time written; accuracy of facts and calculations are intended to be of high quality but cannot be guaranteed; and nothing herein represents actual investment advice to anyone.

Copyright (C) Long Lake LLC 2010

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