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

Mainstream Thinking as Contrary Indicators: Unemployment and Gold

In its current above-the fold online article Poll Reveals Depth and Trauma of Joblessness in U.S., the New York Times may be ringing a bell for the (sort of) end of the jobless recovery and the (sort of) beginning of the "jobful" recovery. To date, there has been much more diminution of firings/lay-offs than there has been new hiring. Basic economic knowledge says that can only take business so far (and it takes it not very far). A year ago, the MSM was full of pictures of people in bread lines from the 1930s. Now, two years after the Great Recession began with a whimper, it is a bit late for the Times to run this sort of story and have anyone think that it has any predictive value (not that there is anything wrong with the content of the story). Let the hiring begin!

The yang to the above yin is that I believe that small business is going to "under-hire" in this expansion because of such factors as healthcare reform mandates, assuming that a bill passes, along with significant state and Federal marginal income tax increases. Having been a small business owner at one point, happily with substantial ability to earn more or less income by working harder or less hard, I can verify that the current level and trend of marginal tax rates had a real effect on my work effort, expansion plans, etc. Thus I suspect there will be a bit of a Potemkin quality to the Dow and S&P 500 indices, wherein the companies comprising those indices will tend to have better business results than average for the economy.

I personally exited the stock market at Dow 13,000, 28 months ago. I resumed stock investing in a modest way this summer at Dow 8500 or so. But my heart was with gold, as regular readers know. Strong companies that have not been directly involved with credit creation look to be sensible investments on a multi-year basis, though in the context of what I believe to be an overvalued stock market on an asset and dividend-paying basis. (Reported earnings don't matter all that much, FYI, when assessing fair value to a minority investor in a publicly-owned company.)

That brings us to gold. Randall Forsyth has a poorly-argued screed against gold in Barron's online today titled Nostalgia for the Gold Standard is Misplaced. He gets it wrong early on by saying:

The fundamental force behind the surge in gold is, of course, the economic crisis from which we may (or may not) be emerging.

Not so. Gold started rising after 9/11 and briefly quadrupled from its 2001 low in early 2008. It then stagnated/digested its gains until as late as 2 months ago, when it broke out not due to the crisis but due to the zero interest rate recovery. Too much credit chasing too few real goods and services. In other words, financial speculation is back, as the Fed and the Feds have more or less successfully reflated without an intervening general deflation of the overall price level.

Forsyth concludes:

Impassioned adherents of the gold standard gloss over the inability to counter deflation. Modern democracies simply will not tolerate the Dickensian unemployment and suffering brought on by debt deflations, however, which is why the Federal Reserve was created during the Progressive Era that also had previously brought anti-trust laws and the beginnings of other government regulation of business.

What we gold investors say is that there is nothing inherent in modern democracy that requires excessive credit creation in the first place. Without that debt creation, there cannot be a debt deflation; and let us consider all the price inflation that has occurred since indexing of tax rates for inflation brought the Federal government larger and larger deficits (inter alia) in the early Reagan years and coincided with more and more debt/income in the private sector. In other words, modern policy is to print money. Helicopter Ben, remember? Keynesians still believe in the price illusion, strange though it is for this blog's sophisticated readers to believe. Give a worker a raise of 5% and have him/her pay 5-7% more for what he/she buys is supposed to make the worker happier than providing no raise and having what he/she buys drop 2% in price. Supposedly this deflation must be "fought" by printing money. But deflation in price is good for consumers. When the MSM brings out debt deflations as a straw man, hold onto your wallets. Inflation is in the works.

There are many, many good points to be made against investing in gold. As someone who came into his first investable money in 1979, I stayed away from gold until 2001. My focus was on growth and disinflation; stocks only till 1997-8, then stocks and bonds.

Putting the Times unemployment article together with the Barron's anti-gold article as representative of an important segment of Establishment New York thinking, here's one scenario to consider:

The economy picks up speed just as it did in 1975-6. Federal and Fed policy are pro-cyclical, as they were then. The Fed does its usual thing and does not raise rates until the unemployment rate has declined a good bit. Price increases pick up steam, and the same inflationary psychology not only of the Carter years but of 1936 return. P/E ratios for stocks fall; long-term interest rates do not fall; and investors go with the inflationary hedges based on "fundamentals" and strong, self-fulfilling chart patterns.

A final bit of history. Gold went from $35/ounce to over $700/ounce in ten years, from 1969-79. It then lost almost all its value vis-a-vis cash or long-term T-bonds in the intervening 20+ years. Timing is everything with this asset.

The NASDAQ index (IXIC) went up about 15 times from its October 1990 recession low to its March 2000 high.

If gold were to have a lesser, ten-fold move from its 2001 low to an upcoming high, that would take it to about $2500. This amount happens to roughly equal its inflation-adjusted high of 1980. But in a broader sense, since gold appears to be in some rough equilibrium with other financial assets, over many years, I suspect that it will rise roughly in line with the general price level (or fall less than any unexpected general decline in the price level).

In a world where "cash is trash" in that we know that even forgetting about taxes on interest, government policy is for inflation rates to exceed bank rates on cash, one can hold gold and forgo essentially no interest income, and one knows that Establishment thinking notwithstanding, gold is likely to be a monetary metal longer than Barron's is likely to have any influence.

So for me, having adequate gold reserves, some physical but mostly in ETFs (GTU preferably), provides speculative upside with a long-term buy-and-hold comfort level that I currently lack for the general stock market, cash, Treasuries, and real estate.

Copyright (C) Long Lake LLC 2009

Market Analysis

As real world data continues to pour out showing a dismal consumer economy (click HERE for data from Gallup), the financial markets in general and the stock market in particular have finally begun to decouple from reality. Financial stocks with essentially no yield and uncertain asset value are surging month after month. Worse, Ford Motor now has a greater market cap than the far stronger dividend-payer, General Dynamics. A company called Commvault (CVLT) came out with earnings after the market close that beat expectations and saw the stock drop after hours, reminiscent of the bubble era where stocks moved on "whisper" numbers.

David Rosenberg reports that 20% of personal income in the U. S. now comes from the Government.

The Establishment wants people to forget about the extraordinary financial events of last summer and fall, and the AIG conduit that continued this year to enrich Goldman Sachs and many firms it promised insurance to despite holding no reserves. It is no wonder that a substance with no current use to individuals but that is "money" or "wealth" to nations-- gold--rises in a controlled manner with little pause. At least gold is "real" and has survived as a perceived store of wealth for millenia, long after mere issuers of currency such as monarchs or countries have come and gone.

Probably the true contrarian investment is a "growth at a reasonable price" large cap international stock. Numerous of those are selling at 10-13X earnings (or less) and with historically rising dividend yields that exceed the yields from 2-5 year Treasuries. But after a 50% move off the lows despite 3rd quarter earnings estimates materially lower than they were at the winter market bottom, anyone who is not now invested in the stock market is psychologically frozen out. The gamblers who went long and are winners know this. Eventually most markets reach some sort of fair value, but nowadays the term "fair value" takes politics into account. Ultimately that fact is bad for all markets and good for gold.

Another worry that is good for gold: the news just out that those in the know are pushing the Administration to send many more "advisers" to Afghanistan to train the vaunted Afghan Army for an expanded war. Another Viet Nam or even another Iraq would certainly use up some spare industrial capacity, would it not?

Copyright (C) Long Lake LLC 2009

NASDAQ Not Worth the Bother

Courtesy of basic charting tools from Yahoo/Finance, the NASDAQ Composite provided a 6.5% compounded annual return from August 1994, before the greatest bull move since the 1920s and after the recent 50% or so move off the bottom.

The boring 30 year Treasury bond had a current yield of 7.4% in August 1994. If one bought and still held it, one would have had the stated annual cash return and would be sitting on a significant capital gain.

An interesting way to look at matters is to ask what price would have been a fair price for the NASDAQ Composite 15 years ago if today's index value of 1978 was the "fair" value today. Given that the total return from a riskless Treasury was over 8 %, let's say a 10% total return prospectively was appropriate. Certainly that looked puny after going up more than 7 times in 5 1/2 years! In any case, the actual value for the NASDAQ Composite in August 1994 was 766. The proper starting value to have yielded a 10% compounded annual return (assuming no dividends) was actually 474.

Thus the NASDAQ was markedly overvalued 15 years ago vs. today, and that ignores all the costs of actually owning the index, all the volatility, etc. Furthermore, I believe that the NASDAQ is overvalued today relative to Treasuries, adjusted for risk.

What is Microsoft doing this far into the green shoots era and 50%+ off its lows having its September quarter earnings guided massively lower?

The NASDAQ is mostly Vegas without either the travel or the fun. The brokers and underwriters who
traffic in most NASDAQ inventory laugh at people who take the stock valuations seriously.

Copyright (C) Long Lake LLC 2009

Is Larry Kudlow a Contrary Indicator?

This spring and a number of NASDAQ and S&P points lower, EBR pointed to a Ben Stein opinion piece in the New York Times that was ridiculously bearish and suggested that based on Dr. Stein's track record in recent years, this was probably an actionable buy signal (and yours truly started buying stocks). Unfortunately, another prognosticator of a different type-- a permabull, is back-- and he's snorting more than I have seen him. Dr. Lawrence Kudlow writes in It's a New Bull Market: resilient capitalism pushes back against Obama:

Let’s call this what it is: A new bull market in stocks has emerged from the ashes of the financial meltdown and the deep recession that followed. And it’s signaling the onset of economic recovery. Free-market capitalism is more durable, resilient, and self-correcting than its detractors would have us believe.

This is not just a summer rally — although a 12 percent market rise since July 10 is absolutely splendid. There’s a lot more going on here. Over the last five months, since March 9, the broad-based S&P 500 is up 46 percent. If I’m not mistaken, a 20 percent rally that is not quickly reversed constitutes a bull market. We are more than double that, and there will be no total reversal.

He goes on to snort as a snorting bull should. Another snorter is the Economic Cycle Research Institute (ECRI), which was brave in calling a recession but was clueless as to how bad it would be just as it was getting horrible. For example, on August 29, 2008, the face of ECRI, Dr. Achuthan, gave an interview to the BBC which was titled Mild Recession Despite Positive GDP and in which he explained "that even with more than 3% growth the U.S. is in a mild recession".

And the ECRI is good at forecasting, far better than Dr. Kudlow has been lately!

The S&P 500 was in fact priced for a mild recession that would, it was expected, give rise to another expansion. It was 1t 1300. It is now a little under 1000. It would be cut virtually in half within only 6+ months from the date of that interviewer. Here is the ECRI today:

The index's annualized growth rate continued to soar, reaching a new five-year high of 8.8 percent from 7.7 percent the prior week. . .

ECRI Managing Director Lakshman Achuthan has said the recession is already beginning to wane, and that increased stimulus from Washington is not necessary for economic growth.

"Not only is the U.S. recession set to end this summer, but the recovery is apt to be stronger than many expect."

The weekly index rose in the latest week due to firmer housing activity, said Achuthan.

Now, how could $23.7 trillion worth of support to the financial system, with specific massive support to the housing industry, not fail to produce "firmer" housing activity given that new home construction fell to its lowest level since the 1940s? But so what? You may have seen a Seinfeld episode about whether certain prominent features on a young woman were natural and if so, you will recall that they were real. But this housing firmness feels fake.

The depression that is probably ending is the longest since the Great D and the most severe in many ways since then, as well. The NASDAQ rally is fundamentally and technically suspect. Treasury bonds are acting better. ECRI's bullishness is long in the tooth. The snorting and chortling by Dr. Kudlow could be the sign of at least an intermediate top.

Copyright (C) Long Lake LLC 2009

Procter & Gambling

This blog is devoted to matters of equity, in both the moral and financial senses of the word. We are not interested in providing stock analysis, except where such is relevant to broader economic, financial and related policy considerations. That said, we live in a world where stocks are major actors in our economic system, one which is unbalanced. It is no longer news that our large financial companies are troubled. It is also not news that General Electric is at least half a financial company, and that that half is troubled. What may be news is the extent to which a prototypical consumer non-durable company is an emperor that also has no clothes.

Consider Procter & Gamble. The company has been around longer than you or me. It seems as secure as the Royal Bank of Scotland seemed not long ago. It raises its dividend yearly. Yet what we have learned in the past year and a half is to ignore dividends (yes, they can lie) and restrain our enthusiam for the value of profit and loss statements. What we need to really focus on is a company's balance sheet. It will surprise many that Procter & Gamble basically reports that it is in a sense running on fumes. This writeup relies on P&G's SEC filing of its September 2008 quarter, as reported on Yahoo's Finance site.

Consider:

Total current assets: $25 B
Total current liabilities: $38 B

Therefore net working capital is negative $13 B. (Ed.: This is real money, even for a bank!)
Worse, cash plus receivables are $4 B less than payables.

Surely, a rich old company such as P&G must have lots of long-term assets. Well, not exactly.

Property, plant and equipment plus "other assets" are $24 B.
Long-term liabilities are $38 B.

Excluding intangible and good-will assets, the Company has a long-term asset balance sheet that is valued at negative $14 B.

The tangible net worth of "PG" is negative 26.7 billion dollars.

Now, what are its business prospects? I have no idea, neither do you, and really neither does the company. The U.S. and the other parts of the world where P&G makes the bulk of its profits are slow-growth/no-growth sectors at best, but are currently experiencing a new era of frugality. In the current environment, people will buy store brands like crazy. I hear that local dentists are laying off receptionists and struggling to pay their bills, people are deferring getting their teeth cleaned, etc. In that environment, people will definitely save a buck or two buying cheaper toothpaste (which doesn't do much for you other than lubricating a toothbrush when it removes stuff from your teeth, anyway, I am told by my dentist), cheaper toothbrushes, cheaper household goods . . . and thus P&G is, you can be certain, either experiencing margin pressure and/or sales volume pressure.

I have no idea whether the stock market has discounted all this and for purposes of this blog I have no interest in whether PG is a good investment or not. The point here is that there is really less "there" there in the company beyond its current turnover than one would think. PG is yet another example of financial engineering; it has a stock market value of $172 B against its -$27 B of tangible net worth. If economic times stay bad and business goes downhill, there is little obvious asset base behind this company. Contrast that with Apple Computer, which in a down-cycle for its business prospects several years ago was a financial fortress, with massive amounts of cash and no debt.

As long as Apple got a mention and some praise (and it remains debt-free), consider also the venerable AT&T, which markets Apple's IPhone. "T" is a twin to P&G financially: negative $23 B in tangible net worth (much of which may be overstated due to technologic innovation) against a stock market value of $149 B.

When we look hard at these behemoths, there's less "there" there than we think. That's a trend that goes on and on, in differing degrees, to IBM, GE, the Dow Transports, most NASDAQ stocks (check out Oracle's $4 B negative tangible net worth), etc. We all want to hope for the best, but Dr. Taleb of the Black Swan keeps pointing out that we have to look out below.

To change metaphors, we may be in a sort of eye of the storm. We know we've been battered, but we see stability and help from low money rates and other central bank maneuvers, and know (or think) we can repair the damage to date. As a Floridian, I know to fear the winds that come from the other direction after the eye passes at least as much as the first blow. And I fear that the next blow will be from an unexpected direction. It may be that the P&G's and AT&T's of the world will blow up next.

Not a prediction, certainly not a hope, but definitely a caution.

Copyright (C) Long Lake LLC