RMG Investment Bulletins
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Let's start with a bullish thought to begin 2018. We, among others, have recently been pointing to the potential for higher inflation in 2018. To be clear, we are not calling for a massive shift upwards, more a gentle acceleration that has the potential to impact valuations in fixed income and equity markets. In this environment, we believe there is the potential for commodities to outperform. Chart 1 below (courtesy of Nautilus) has been doing the rounds in various guises in recent months.
Chart 1 - Commodities relative to US equities
In relative terms, commodities don't really get much cheaper relative to equities, and as shown Nautilus ask the question whether a 15.5 year cycle is at play, opening a window for a great opportunity to switch from equities to commodities. Our own work supports this general thesis.
Of course, commodities cover a wide variety of "stuff", all with different characteristics and supply/demand balances. We covered soft commodities (Sugar, Cocoa and Coffee) briefly last summer, and we still think that these commodities are broadly building a big price base at historically cheap levels. The agricultural commodities (Corn, Soybeans and Wheat) are displaying similar patterns. We will likely discuss these in more detail at some point in coming weeks.
Gold has been a core holding for us in the last couple of years, and here also, price appears to be building a big base that we believe is the prelude to a strong upside move. We have shown what we believe to be an important resistance line, which if broken, should allow price to start trending nicely higher. We have also shown how we think price may trade in the next few months, i.e. sideways to lower for a bit, before embarking on a sustained move higher.
Chart 2 - Weekly gold price chart
With our view that inflation is likely to move modestly higher this year, but remain at relatively low levels compared to truly inflationary periods, we are not necessarily looking for "massive" gains in commodities. Thinking back to chart 1, if commodities are about to embark on a sustained relative out-performance over US equities, we strongly suspect that equities have to decline a lot in the next few years to help this relative relationship - this will hardly be new news to our regular readers!
This week, Jeremy Grantham of asset manager GMO, released a paper speculating whether US equities are in the process of melting up. Mr Grantham is a highly respected value investor whose firm has been cautious of equities for some time. Yet, there is logic in his melt up argument. He is not suggesting that US equities are cheap; he still thinks they are absurdly valued. His argument is that we have not yet seen the true madness of the crowd that is usually associated with bubbles.
When we say that there is logic to the melt up argument, we say this in the context that anything is possible in markets, especially bubbles. Plenty of research exists to illustrate how the investment crowd latches onto bullish narratives late in the cycle (and especially in bubbles), that may seem logical at the time, but in hindsight, is nothing but madness. So the narrative today for a melt up seems to be that economic growth is just fine, corporate earnings growth is reasonably strong, central banks will not let anything bad happen and there is simply no alternative to stocks. Even long term investors who may be worried about generally expensive valuations say that as long as you buy good stocks and hold them, you will be alright.
What is missing from the bullish argument is any discussion on whether today's price offers an attractive opportunity or not. Frankly, we fear greatly that investors today are buying into the bullish narrative (the madness of the crowd) and totally ignoring the current valuation and what potential future returns will be over the longer term. This is an all too easy trap to fall into. Even Ben Graham, the Grandfather of value investing lost pretty much everything during the great depression. Later, in 1934, in his book "Security Analysis", we wrote about the 1929 period, and how investors ignored expensive valuations, eventually at great cost (emphasis ours and h/t to John Hussman);
"During the latter stage of the bull market culminating in 1929, the public acquired a completely different attitude towards the investment merits of common stocks... Why did the investing public turn its attention from dividends, from asset values, and from average earnings to transfer it almost exclusively to the earnings trend, i.e. to the changes in earnings expected in the future? The answer was, first, that the records of the past were proving an undependable guide to investment; and, second, that the rewards offered by the future had become irresistibly alluring.
"Along with this idea as to what constituted the basis for common-stock selection emerged a companion theory that common stocks represented the most profitable and therefore the most desirable media for long-term investment. This gospel was based on a certain amount of research, showing that diversified lists of common stocks had regularly increased in value over stated intervals of time for many years past.
"These statements sound innocent and plausible. Yet they concealed two theoretical weaknesses that could and did result in untold mischief. The first of these defects was that they abolished the fundamental distinctions between investment and speculation. The second was that they ignored the price of a stock in determining whether or not it was a desirable purchase.
"The notion that the desirability of a common stock was entirely independent of its price seems incredibly absurd. Yet the new-era theory led directly to this thesis... An alluring corollary of this principle was that making money in the stock market was now the easiest thing in the world. It was only necessary to buy 'good' stocks, regardless of price, and then to let nature take her upward course. The results of such a doctrine could not fail to be tragic."
- Benjamin Graham & David L. Dodd, Security Analysis, 1934
So although we agree with the bulls that economic and corporate earnings growth are both doing well at the moment and that central banks do not want to do anything to overly disrupt the party, we do believe that the current price that investors have to pay is absurd, and implies negative nominal total returns over the next decade or so, with the high potential for a crippling bear market in the next 1 to 3 years. We would add that the only other potential bullish factor to consider on top of the increasing madness of the crowd is that companies may well increase their share repurchases now that they can repatriate overseas profits at a lower tax rate.
We have illustrated numerous times in recent months why we think that US equities are overvalued, but let's look at one more here. Warren Buffett, disciple of Ben Graham, famously explained how and why he uses stock market capitalisation to GDP as a great short hand for measuring the value of the equity market. Specifically, the Federal Reserve releases a quarterly flow of funds report in which the data for the value of all domestic non-financial equity (quoted and unquoted) is measured. With data available up to Q3 2017, the ratio of US domestic non-financial companies value relative to GDP stands at 132.2%. We have updated our model (chart 3 below) for the fact that the S&P 500 rose by 6% in Q4 2017, and also projected a 1% increase in nominal GDP over the same period (4% annualised).
We think this is as close an approximation we can get to where US stocks are valued today by this measure. As shown, the ratio now stands at 138.4% compared to the all-time high of 151.3%.
We would just take the time to point out here that with the above data series being quarterly, there have only been three observations higher than that apparent at the end of 2017 - Q4 1999 at 143.3%, Q1 2000 at 151.3% and Q2 2000 at 140%. As can be seen in chart 1, this indicator made a spike up to the high point, followed by a swift reversal. By Q1 2001, a year after the peak reading, the ratio was back at 99%. The point being that in the previous examples, when markets were this expensive, any short term gains (measured in months back at the time of the dotcom bubble) were enjoyable for only a short period of time, and were given back pretty quickly, and then some.
Chart 3 - US non-financial corporate value relative to GDP
For those that read Mr Grantham's paper closely, you will see there is a second part to his melt up thesis. He says that if the melt up happens, then he believes there is a 90% chance that it will be followed by a 50% bear market. This perfectly describes the dotcom bubble experience, and basically every other bubble experience in history. Bubbles end in a spike higher, followed by a crash. The only question is whether we are in the early or later stages of the spike higher at the moment.
To put Mr Grantham's lower S&P 500 target of 3400 in 9 months' time in perspective, we have projected this increase in our model together with quarterly growth rates of 1.5% (6% annualised). For those that want to hang on for the melt up, you are simply betting that the market will move to the most extreme valuation ever in history, greater than at any bubble peak like 2000 and 1929, or other peaks like 1907 or 1966 that all preceded a decade or more of zero nominal returns.
Chart 4 - US non-financial corporate value relative to GDP projected forward for a melt up scenario
So to wrap up this week, with equity markets enjoying a great start to the year, the bullish narrative is fully intact. In fact, even the bears are admitting that there is logic behind a melt up in the months ahead - when noted bears capitulate, history shows that the end of the bull market is relatively near.
Predicting the end of the post GFC bull market has been a mugs game. All we can say is that solid valuation techniques are all in the vicinity of previous bubble peaks, and that a melt up would require valuation to reach the highest of all time - the mother of all bubbles. We are not saying that the melt up cannot happen, we are simply trying to point out what rising prices would do to these solid valuation techniques.
In terms of trying to find any value in a world where every asset appears expensive, we do think there is value to be had in selected commodities. Even if we are correct in this, we suspect that investors may need to be patient in allocating capital here, especially in the melt up scenario. However, we do strongly believe that in a few years, we will look back and see the current time period as a great time to make a switch from equities to selected commodities.
We wish all our readers a happy and prosperous new year.
To view a PDF copy of this report, click here.
From time to time, we show charts drawn from the Commitment of Traders report to show when speculators (hedge funds and CTAs) are holding extreme positions, either long of short, of say a fixed income or FX instrument. Indeed, we showed one last week when explaining why we felt that the Euro was at an interesting juncture. This week, we want to draw attention to a set up in soft commodities that has not been seen for several years, if not a lot longer. Our work has indicates that soft commodities may well be forming a major low, and we have bought a modest exposure to Cocoa, Coffee and Sugar in our multi-asset fund. Let us explain our thinking.
Usually when we show charts from the commitment of traders report to illustrate our analysis of financial futures, we show what speculators have been doing. However, when it comes to commodities, it is often more interesting to look at what the other main type of futures trader has been doing; the commercial traders. When we talk about commercial traders, we are talking about traders who need to trade in the underlying commodity (mostly for hedging purposes), whereas speculators choose to trade in particular commodities.
So let's start with Cocoa. Who might these commercial traders be? We can split them into two camps. First, we have those that effectively produce or sell Cocoa. These traders need to sell at some point, and they may choose to sell/hedge their production by selling in the futures market to either secure a price that guarantees a nice profit or when they think the price has gone too high. Second, we have commercial traders who use Cocoa in say the production of chocolate. These traders need to buy Cocoa at some point, and they may choose to buy/hedge in the futures market to guarantee a price that ensures they can make a profit in selling their chocolate or when they think the price is too low.
These commercial traders are at the sharp end of the market. Collectively, they will know far more than any single hedge fund can about the supply/demand of a particular commodity. Furthermore, when a good portion (perhaps even the majority) of speculators base their decisions on trend following rules only, and trade without any knowledge of the fundamentals of supply and demand, we have to respect what commercial traders are doing in their trading activity when it comes to judging the fundamentals for a particular commodity.
Chart 1 below shows the current activity of these commercial traders for Cocoa. In terms of reading this chart, the white line is the price of Cocoa and the blue bars show the net positions held by all commercial traders combined. In the lower panel, we illustrate separately the number of long and short contracts held by these commercial traders.
Chart 1 - Cocoa price and Commercial Traders positions on IMM
So, what do we see in this chart? Well, first, we see that commercial traders collectively are holding the biggest long position ever in Cocoa. This is interesting as not only does this indicate that this group think that the price of Cocoa is too low, but they also have a pretty decent track record when they make these kinds of bet. Historically, not long after commercial traders have accumulated a net long position, the price of Cocoa begins to rise. Furthermore, price having fallen from above $3000 to below $1900 is approaching levels that have historically been seen as cheap.
If we analyse the long and short positions in the lower panel, we can see that commercial traders have been steadily accumulating Cocoa on the way down in recent months, and their long holdings are the largest on record. Perhaps these guys have bought/hedged a lot of their future needs as they see the price as being attractive to do so.
We can also see that in recent weeks, commercial traders short positions have been reduced. Remember, these are the guys who sell/hedge future production. When their short positions fall (outside of contract expiry), they are probably closing out their hedges, a) at a nice profit after a large price decline, and b) because they think the price is too low now and they no longer want to have their production hedged - they are willing to accept whatever price is available in the future, because they think it will be higher than today.
We would make the point that commercial traders net activities are pretty much the mirror image of speculators net activities, as can be seen in chart two below. Collectively, speculators have been net short of Cocoa during a significant price decline; they must be very happy with this. But these guys are only motivated by profit, whereas commercial traders, because they are hedgers, are motivated by the profit margin on their production and therefore somewhat less sensitive to shorter term swings in the price.
Chart 2 - Cocoa price and Speculators positions on IMM
If we look at the long and short positions held by speculators separately, we can see that during the decline from last summer, speculators have been increasing their short positions markedly. In recent weeks, long positions have been cut back; possibly a sign of capitulation by those speculators who have been playing for a bounce? The real question is when will the speculators holding short positions take profits? Well, as noted these guys are motivated by profit and we doubt they will want their profits to evaporate, and so they will start to buy when price starts to rise. Furthermore, with many of these guys being trend followers, they will cover their shorts when their models tell them the down trend is over. Indeed, if price rises enough, they may switch quite quickly from being short Cocoa to being long.
So, the real crux of the matter is that even if commercial traders are positioned correctly, and Cocoa is cheap, we need to see the price moving higher to force speculators to buy. Chart three below shows the daily chart of Cocoa. We have also shown the 14 and 21 day moving averages and in the lower panel the daily volume. What we think we have developing here is a multi-month base building pattern. Support appears to be coming in just below $1800 and resistance is about $2100 and then again at $2200.
Chart 3 - Cocoa September '17 futures contract price
Now, we may be jumping the gun before price starts breaking out of this base building or bottoming pattern. However, on the most recent test of $1800 the volume stayed relatively muted compared to when price last tested resistance at $2100. This hints at selling pressure abating.
This base building pattern has been developing for at least three months now, arguably a bit longer, so clearly downside momentum is dissipating. Is this loss of momentum enough to force the trend following speculators to buy back their shorts? Probably not, we suspect that a price break above $2100 would be the real trigger. But given the record bullish positioning of commercial traders, we are willing to dip a toe at current levels. We are thinking that Cocoa could be near the start of a major bull market, and if price can get above $2100 we will be adding to our current modest position. If price breaks below the recent lows just below $1800 then we are wrong and we will sell out our position.
As for coffee and sugar the setups are very similar. Commercial traders are holding record long net positions after a significant price decline towards historically cheap levels. Chart 4 shows the commercial traders positions.
Chart 4 - Coffee price and Commercial Traders positions on IMM
Chart five shows the daily price graph for coffee. Price has clearly fallen a long way, and if we squint hard enough, we can argue that an inverse Head & Shoulders bottom has just been completed. Nothing in trading life is perfect, and we would like to have seen higher volume on the break above the neckline of the Head & Shoulders bottom pattern. However, given the record long position held by commercial traders, we are again willing to dip a toe here, and will not hang around if the low around $115 is broken.
Chart 5 - Cocoa September '17 futures contract price
And finally onto sugar. Chart six shows the position of commercial traders activities and they are holding record net long positions.
Chart 6 - Sugar price and Commercial Traders positions on IMM
In chart seven we show the daily price chart for sugar. Similar to coffee, price has seen a significant decline and if we squint hard enough we can argue that an inverse Head & Shoulders pattern is close to completion. Again, we have dipped a toe here hoping that the commercial traders record net long position is a sign that a new bull market will soon begin. If price trades below the recent low around $12.75, we will be wrong and will exit our position.
Chart 7 - Cocoa October '17 futures contract price
Taking a step back, we have never written about soft commodities in our weekly commentaries, and perhaps some of you may think we have taken leave of our senses. What possible edge do we think we can have in trading these commodities? Well, we would make the following argument.
First, central bank monetary policy has led to such distortions in mainstream assets. These assets are in a bubble that refuses to break, and it is difficult to make money whilst also controlling risk. We strongly suspect that commodity markets, outside of the energy and metals markets, are some of the least manipulated by central bank policies, and therefore easier to understand in terms of judging supply and demand and price discovery.
Second, we made the argument above that no single hedge fund or money manager is going to know more about the fundamentals of these commodity markets than the collective knowledge of the commercial traders. Of course, commercial traders aren't perfect, and being hedgers, their motivation is slightly different than that of pure speculators. Yet, they have a very canny track record of being right shortly after they have accumulated big long positions especially when price has fallen to historically cheap levels.
Thirdly, historical analysis proves that the best time to side with the commercial traders is not only after a significant price decline during which they have accumulated long positions. We also need to see price form a base building pattern and turn around to the upside. We think we are on the cusp of new bullish trends in these commodities as price has either been building multi-month bases, or is already displaying technical signs of reversing the previous downtrends.
Finally, managing money is as much about managing risk. Or put another way, it's not necessarily about how much you make on your winners, it's about how much you lose on your losers (and all money managers make losing trades - let's not kid ourselves). So, as long as we know how much we are risking, and that we believe our potential gains are significantly more than our potential loss, then it makes sense to put the trades on.
So here we go. We have dipped a toe in the Cocoa, Coffee and Sugar markets, risking a bit less than 1% of our fund's capital. We put the trades on in the markets on Friday morning and by the close we are a bit more than 1% in profit across the three trades. As price patterns develop, we not only hope to tighten our stops, we hope to add to the trade if it looks like new multi-month bull markets are developing. We will of course keep you updated on how this trade progresses.
To view a PDF copy of this report, click here.
We last wrote about oil on 23 April (see here) in which we said "With the best will in the World, OPEC and Non OPEC production cuts are barely making a dent in bloated stockpiles and there is a significant risk that price needs to correct further as the market rebalances, and further price declines would surely lead to bullish hedge funds capitulating, forcing price lower quite quickly." The price of front month (June 2017) WTI was $49.62 at that time.
As at the close of trading last week, the front month (August 2017) WTI price had fallen to $43.01 and the net hedge fund long position had declined by just over a quarter. It's nice to get something right in these markets!
Chart 1 - Front month WTI with 8 day moving average
The decline in oil prices is occurring at a time of some increased political uncertainty in the region and news this week that the young Prince Mohammed bin Salman has been appointed Crown Prince of Saudi Arabia. With the situation in the Middle East best described as "fluid", the appointment of Mohammed bin Salman (MbS for short) brings with it a few interesting angles to consider.
First, MbS is taking a very hard line with Iran. The standoff between The Gulf Countries (lead by Saudi and orchestrated by MbS) and Qatar is part of the complex ongoing battle for supremacy in the Middle East, and it would appear that, post the Trump visit, the Saudi regime believes it has US backing to be openly more assertive, at the same time that the US is reversing course on the Obama negotiated engagement with Iran. We view the increasingly assertive move to isolate Iran as a potentially destabilising move for the region.
Second, Saudi has started to look seriously at reforming the country and reducing its reliance on oil since MbS was brought onto the scene a few years ago. Arguably the flagship piece of this reform programme is the upcoming Initial Public Offering of Saudi Aramco in 2018. It has been very clear that the Saudi/OPEC production cut last November was designed to help move the oil price higher in part so that the Aramco IPO valuation would be higher. The lower oil price is becoming a problem for the IPO process and therefore the overall reform programme.
Chart 2 - Saudi Reserves vs WTI Oil Price
Third, the powershift and appointment of MbS to Crown Prince appears to have been smooth so far, but risks do remain. The proxy war (against Iran backed rebels) in Yemen has been much costlier and long lasting than it should have been, and this was orchestrated by MbS and therefore risks been seeing as his failure. If public sentiment were to shift against this war at a time of economic difficulty at home (caused by the weak oil price), then it is possible that the conservatives will agitate against the young prince.
So, we have a new regime in charge in Saudi that needs to consolidate its power, and a nice policy success would certainly help. We also know that Saudi must diversify its economy away from oil to survive in the longer term. The investment needed for this comes from privatisations and reserves/revenues which are being depleted by the low oil price. We also know that Saudi are very keen to isolate Iran to increase regional power, and this battle with Iran (via regional proxy wars) is also draining their reserves (defence is a large and fast growing part of the Saudi budget). It would appear that something has to change for any sort of success to be more attainable, otherwise the risks of either a Saudi or a regional problem increase.
And the thing that needs to change to help Saudi is a higher oil price. Assuming that this is not achieved because of heightened supply concerns due to regional conflict, then we have to see further significant cuts to OPEC production, probably including Non OPEC countries as well. If Saudi fails to engineer a higher oil price, then we suspect that their finances will deteriorate much further and the young MbS will pursue even more aggressive foreign policies to deflect domestic criticism. Either outcome has importance for financial markets.
Perhaps we will see increasing jawboning in the weeks ahead about more OPEC production cuts. If so, they would have to follow through otherwise the market will lose complete faith in them. If this were to lead to a higher oil price, this would help inflation move higher (allowing more hawkish central bank policies) and help assets directly linked to the oil price. If OPEC does not cut further, then we have to suspect the oil price remains low enough to see further deterioration in Saudi finances.
We are open to both scenarios. We are modestly long of Canadian Dollars and Norwegian Krone in our portfolios which look cheap and would obviously benefit from a resurgent oil price. We are also short of Saudi Riyals. With the Riyal being fixed to the US Dollar, any devaluation will have to be politically sanctioned and would likely be from a position of weakness. This could be after a further drawdown in their reserves, and perhaps some backlash from Washington if MbS' foreign policies prove to be one step too far.
Perhaps the biggest message we can leave you is that Middle East risks are on the rise, and there is no simple solution. Ordinarily, we would expect some sort of premium to be built into financial prices, and yet volatility remains low everywhere with the trajectory lower as well. Collectively, investors seem to be ignoring Middle East risks just as they seem to be escalating and perhaps becoming more intractable.
This is yet another example of investors collectively being asleep at the wheel. Low oil prices are bad for Saudi and regional stability. High oil prices are bad for developed central banks who will feel compelled to tighten policies, possibly hurting financial markets in time. So, investors had better hope that somehow the young prince keeps his nerve politically and engineers an economic revival with only modestly higher oil prices. We are fascinated by what seems to be an unsolvable conundrum and one being mostly ignored in mainstream markets.
Having discussed the Fed extensively in recent weeks, we wanted to tackle a different subject, and Gold seems as good as any other at the moment.
The price of Gold has fallen from the all time high of US$1,921 in September 2011 to low of US$1,180 this week, a fall of nearly 40%. Year to date, Gold had fallen by 30% at the low point, a quite spectacular fall for what was once the darling of the investment community. What went wrong?
Back in early January, Mario Draghi spoke of positive contagion (did he really say that and will any journalist ever ask him for any evidence to back this up?) and this not only boosted the Euro but encouraged the further unwinding of safe haven trades such as long gold and long Swiss francs. With the bull market in risk assets energised, encouraged by central banks, investors went on a massive hunt for yield and jettisoned anything without yield (e.g. Gold and Swiss Francs). In recent weeks, inflation expectations as measured by 10 year US breakeven rates have collapsed, which is a very hostile environment for assets that traditionally benefit from higher inflation.
Then in April, the price of Gold collapsed with the cause being attributed to a combination of negative recommendations from big banks as well as the gold bugs claiming a large amount of market manipulation. This collapse clearly caused a great deal of pain to those investors holding gold and it would appear that the liquidation of those holdings continues until the present time - including commodity funds that we suspect are being hit by a wave of investor redemptions. It is this type of forced liquidation that can provide opportunities.
The 30% fall in Gold this year must have cleared out a very large number of holders who either joined the party late and/or could only be described as loose holders. Ironically, the period post the launch of QE infinity from the Fed saw many commentators proclaiming Gold to be a perfect hedge against a coming inflation. The Fed launched open ended quantitative easing on 14th September and Gold peaked a few weeks later on 5th October. Almost a classic case of investors buying the hype, only to regret it later.
So, that's the recent past. What of the future? Well, nothing moves in a straight line, and we get the feeling that Gold is getting ready to bounce. Firstly, the bullish sentiment towards Gold has collapsed to a record low as measured by the 10 day average of the bullish sentiment measure of small traders. This is no guarantee that prices must bounce, but with virtually no bulls around who is there left to turn bearish (and sell)?
Another way of trying to gauge sentiment is to look at the commitment of traders report that provides information on long and short holdings of "non-commercial" or speculative accounts on the futures exchange. The chart below shows the net positions of such speculative accounts (mostly hedge funds) in black plotted with the price of Gold in red. Hedge funds now hold their lowest exposure to gold in 8 years. Although this is by no means a guarantee that the price of Gold must rise from here, price has usually been very near to the start of some sort of rally after hedge funds have liquidated the amount they have in recent weeks.
As noted above, one of the primary reasons for the recent price decline in Gold is the collapse in inflation expectations. The chart below illustrates the relationship between Gold (in black) and the 10 year US breakeven rate (in red) as a measure of inflation expectations. This may not be a perfect correlation, but it is close enough and makes sense, as Gold is surely one of the quintessential inflation hedges available.
Of course, inflation is one of the Fed's key mandates and at the moment there is at least one voter on the FOMC who is concerned that inflation is too low and QE should be at least maintained so that inflation does not fall further. Although we very much believe the Fed will start to reduce QE before year end, if inflation expectations continue to fall perhaps the Fed will maintain or even increase QE. If this is the case, and inflation expectations rise as a result, we expect that to benefit Gold. We have in the past illustrated a strong correlation in recent years between the same breakeven rate in the US as shown here and the performance of the US equity market - until recently at least when US equities ignored the collapse in the breakeven rate. The chart below shows this relationship.
Although these charts would indicate that if the Fed prints enough to generate higher inflation expectations, both Gold and equities should rise, perhaps Gold will rise as much as equities for a period of time. As noted above, Gold was down 30% year to date at Friday's low of US$1,180 per ounce compared to the S&P 500 up by over 14% in total return terms. If both have a correlation to inflation expectations, perhaps Gold can at least hold its own for a bit compared to equities. If the Fed reduces stimulus as we expect, and inflation expectations remain relative low, then perhaps equities will fall more than Gold, catching up with Gold's recent collapse.
In conclusion, we think that Gold is offering a trading opportunity and relative to equities should begin to perform much better.
We are in the process of preparing for our internal quarterly investment meeting and will share some of our long term thoughts and analyses in the next few weeks. In the meantime, we will offer some thoughts on the price action of commodities and Gold in particular as well as equities.
Commodity markets have had a terrible start to the year compared to equities. A quick glance at our commodity futures page shows Gold down 11.5%, Silver down 14.3%, Aluminium down 8.4%, Copper down 9%, Brent crude down 7% (WTI is 0.6%), Corn down 6%, Soybeans flat. Out of the major commodities, only Natural Gas is up, by 26%. The simplest message from this performance is that either global (or Chinese) economic growth is insufficient to drive prices higher or investors are just giving up on commodities, or a bit of both.
The S&P 500 and Dow Jones Industrials hit all time highs this past week - ah, the power of funny money! In fact, developed markets were up 2% or so in general over the last week, Japan rose by 5% (the benefit of more funny money), and emerging markets generally lagged with Asia ex. Japan up by only 1.5% (perhaps these guys should consider printing some funny money!). We continue to believe that quantitative easing is encouraging excessive risk taking and the continued strength in equities is a manifestation of this excess.
We hear arguments from the bullish camp that equity markets are cheap and that corporate earnings justify a bullish position. We showed two charts a few weeks ago courtesy of John Hussman and Soc Gen ( see link here) that illustrate that corporate profit margins lead future profit growth and that current profit margins are being massively boosted by a record wide combined deficit between Government and the household sector. We strongly believe that this combined deficit at the Government and household level is unsustainable. If correct, then corporate profits will actually be lower over the next several years as opposed to the widely held belief that they will be higher. As a result, equities are simply not cheap. Indeed, they are very expensive, with a couple of reliable long term models suggesting the US equity market is some 40% to 50% overvalued.
In the short term, with the Bank of Japan trying out print the Federal Reserve, it is very possible that equity markets remain at elevated levels and perhaps even move higher. However, given our longer term concerns (and assuming they are valid), we have to believe that short term gains only detract from future returns. We view further gains as only temporary and continue to believe that European equities will underperform, if only because the ECB is allowing its balance sheet to shrink, but also because the economic data remains very disappointing.During the first quarter, the bullish camp were drooling over the US economic data that seemed to show a more robust environment despite tax rises and upcoming spending cuts. We worried that the data was being embellished by favourable seasonal adjustments. Over the last couple of weeks, the data in the US has generally been disappointing (and in Europe indicative of ongoing recession). Does this weaker data matter? Well, the chart below shows the Citigroup economic surprise index overlayed with the S&P 500 90 day rate of change. The fit is reasonable, although overshoots and undershoots on either indicator can be seen. At the moment, the economic surprise indicator (in blue) suggests that the S&P 500 is somewhat outperforming. Unless data begins to beat expectations, the upside in the S&P is likely capped for a while, and the risk of a market decline is perhaps increasing.
Another correlation that appears to indicate the US equity market is outperforming its own potential is the relationship between the S&P 500 and the 10 year breakeven rate (a market measure or guess of what inflation will do over the next 10 years). As can be seen in the chart below, the market seems to wax and wane with inflation expectations. Perhaps this should not be surprising considering the effort that policymakers are putting in to try and generate some inflation. We have highlighted the recent divergence with the S&P (in black) rising smartly of late even when breakeven rates (in red) have been declining. Perhaps this relationship is breaking down orit is another sign that the US equity market is currently in overshoot territory.
We will keep this week's note relatively brief and also take this opportunity to wish you a happy holiday and a successful 2013. We are working on our year ahead piece for 2013 which we will send out in early January. By way of prelude, we believe there are two probable scenarios for 2013 for equity markets.
Scenario 1 sees equity markets trend higher with returns in the 7% to 10% range for the year with periods of short and sharp corrections. This is the likely outcome assuming that economic growth is positive and central bank money printing programmes continue to be seen as supportive of risk assets. Our alternate scenario is that markets suffer heavy declines driven by a combination of poor economic performance and, more importantly, central banks either turning off the printing presses or investors losing faith in their policies. If this should happen then risk assets are likely to be down heavily and not just a few per cent points. Markets are driven by fear and greed, and if they do start going down next year, then fear will very quickly dominate after a reasonable period of complacency. Our full year ahead piece will explain our thinking in more detail.
Back to the short term, it is interesting to note that the price of Gold has fallen by nearly 3% despite equity markets rallying this week (even as the fiscal cliff negotiations remain acrimonious). There is clearly a seller or two who are keen to reduce or eliminate their Gold exposure before year end. Given our 2013 scenarios we don't believe Gold will fall too far because real interest rates will remain negative around the world which has supported Gold in the last four years or more.
Bullish sentiment towards Gold has collapsed as can be seen in the chart below. We have highlighted the previous recent times when bullish sentiment has been this depressed, and all of them have proved to be decent times to buy Gold (even if only for a quick trade). It may be a little too early to buy Gold today, and perhaps the price will drop down to the support range indicated on the chart, but we do believe we will look back in a few weeks or months and say that it was better to be buying today rather than selling.
The bottom line is that wemaintain our bullish view on Gold for 2013. With central banks bursting at the seams with all the cash they have printed, and with real interest rates firmly in negative territory and likely to remain there for several years to come, the long term trend should be higher for Gold. We are using the current pullback in the price of Gold to top up our holding.Merry Christmas and a happy New Year.
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