US stocks gained 8.9% in September (best September result in 71 years) and 11.3% for the quarter (5th best quarter of the last 10 years.) As stocks rise, our clients are actually becoming more fearful. "How," they ask, "are stocks still rising when the economic news is so bad! Shouldn't we take our profits and go to cash?" "What about gold? Shouldn't we buy some gold? Everyone on TV is talking about gold!" To which we reply, "Steady on stocks, and gold looks like another bubble to us."
What do we see that our clients don't see? We take seriously the advice of 18th century British nobleman and banker Baron Philippe Rothschild to "buy when there's blood in the streets, even when the blood is your own!" We went fully invested with our clients' stock allocations in March 2009 when the world seemed days away from total economic collapse. We continued to move money into stocks during the April-June selloff of this year. Even now, we remain cautiously bullish, even though the market is only about 3.4% below our 2010 target of 8% gains. Contrast that to our anxiety about stocks back in late 1999, when US stocks made record levels daily, unemployment was about 3.5%, housing prices were rising steadily the US had a huge budget surplus, and the biggest concern of average Americans was whether President Clinton did or did not have "sexual relations with that woman."
However, the narrative that the average American sees on the 24 hour cable news services (who reads the paper anymore?) is relentlessly pessimistic. Fear generate high ratings, which sells a lot of ad-time!
What do we mean by "narrative?" An authority figure, whether a journalist, economist, politician or think tank guru, has a certain conclusion in mind, and then seeks only those "facts" that confirm the conclusion. Some narratives are silly - "Obama was born in Kenya!" Others are dangerous to your wealth - "all Americans should own houses because housing prices only go up." Ever since the demise of the FCC "Fairness Doctrine" and the advent of Fox News, television news has devolved from hard information to "edutainment with a current events focus." CNN has the liberal bias, Fox the conservative bias, MSNBC the wishy-washy bias, and who knows what CBS, NBC and ABC stand for.
Why is narrative so attractive? Because narrative dumbs down complex issues into simple sound bites. It seems like all news producers are taught to find two "experts" with violently opposed opinions, put them in little boxes in the screen, and have them scream at each other for exactly 3 ½ minutes. CNBC, the financial network, has taken this concept to an extreme - up to 10 little heads in 10 little boxes at a time. The image is amusing, but the information content is zero.
"Facts" are hard. We look at several hundred economic reports a month. Often the data is late, imprecise, seasonally adjusted, subject to revision and most of all subject to contradiction (e.g. the ADP jobs numbers were lower than expected, but the Bureau of Labor Statistics jobs numbers, which come out two days later, were higher than expected and not consistent with the ADP numbers.) We have often referred to the "mosaic" model of data analysis - individual tiles are valueless when observed from inches away; thousands of tiles seen from 10 feet back can be a masterpiece! We don't act or react to every morning's reports. The minimum useful time frame, we think, is a month, preferably a quarter.
Narrative versus Facts: Gold Prices
The narrative to buy gold is that, because the United State and European central banks have lost control of their monetary systems, chaos, currency collapse and hyper inflation are just around the corner. In that environment, only gold would be a tangible store of value.
The facts about gold:
- Current above ground store of gold are 140,000 tons representing $5.8 trillion in value at $1300 oz.
- About 25% of that gold is in central bank vaults, 65% in jewelry and electronics, 10% privately held as coins and bullion. Let's assume that the last 10% or $580 billion in value is the current "float."
- At present, open interest on CME Gold contracts (100 oz/contract) is about 620,000, for a value of about $80 billion. Each contract has a buyer (a speculator or investor in the current market) and a seller (could be a speculator, also likely to be a gold miner locking in the price of future production.) The CME alone trades about 14% of the current Gold "float."
- Gold exchange traded funds (ETF's,) which did not exist 10 years ago, represent another $80 billion of gold in vaults.
- Central banks, particularly China and India, have been net buyers of gold in recent years. During the 1980's and 1990's, central banks were net sellers of gold, and the price went nowhere for two decades.
- Gold produces no income stream and indeed, costs money to own (vault costs, insurance costs, cost of foregone income in other investments.)
- Gold, unlike oil, is never used up but recycled time and time again. Aside from losses in shipwrecks and hoards still hidden underground, every oz of gold ever mined is still in circulation.
- Gold and silver are at present the only commodities making record highs. The average commodity, while 50% higher than the lows of March 2009, is still down 40% from the peak of July 2007.
We look at all those facts and apply classic "supply and demand" reasoning. Supply from mining grows modestly at about 2%/year. Demand from futures contracts and ETF's is unprecedented. Central banks are net buyers but could become net sellers to address other financial needs. Expanded demand meets limited supply, so the price can only go up (for a while anyway.) Every bubble we have seen of the last 10 years, which includes Internet stocks in the late 1990's, housing prices through 2006, oil prices through July 2007 includes a period of high demand/limited supply, leading to euphoria, then "profit-taking," then crash. Gold can certainly go higher ($1400? $1500?) but there's no way we'd risk our clients' money to pick up a potential 7-15% gain when we also see the potential of a 50-80% loss.
Facts we're looking at right now
- US employment: at 186.6 million is still 14.6 million below the May 2008 peak of 201.3 million, and about the same level as during the 2002 recession trough. Barely any gains over the last year, defying the usual post recession bounce. Hard to boost consumer confidence and spending when 1 out of 10 workers is jobless, more are discouraged from even looking for a job. Latest jobs report surprised to the downside with more government workers laid off than expected (cuts in state and local government) and less private workers hired. The US unemployment rate is expected to remain between 9-10% for all of 2011.
- Housing starts at half boom levels, but new construction still adding more properties to a market already choked with distress and foreclosure sales. Mortgage standards raised back to historic norms, which means far fewer qualified buyers. We see far more supply than demand. Hard to imagine anything but flat prices for the next 10 years, could even see another leg down.
- Interest rates near post-war lows. Fed on record as being accommodative, so next Fed funds increase at least a year away
- Commodity prices beyond gold have firmed since this summer. Oil jumped from $72.66 just two weeks ago to $83.50 earlier this week. Part of that increase is due to a 7% slide in the US dollar over the last month, but we also observe that worldwide demand is heading up.
- Federal stimulus programs for home purchases, car purchases and "shovel ready" infrastructure spending now over.
- US income taxes likely to rise in 2011. The Bush era tax cuts expire at the end of 2010. We have no expectation those cuts will be extended before year end. It's possible that Congress will restore the cuts retroactively in 2011, but higher taxes are needed to limit expansion of the US National Debt.
- Following a big "flight to safety" rally in April as the Greek fiscal crisis heated up, the dollar is sliding again.
- Despite all this, US corporate earnings are expected to show solid growth - 16.3% for Q3 2010, 24.1% for Q4 2010, 15.6% for 2011, which leaves US stocks undervalued by 24-39% according to the Fed Model
We could go on, but the point is made: yes, there are a lot of problems, but US stock prices have more than fully discounted the "facts," creating value for investors who do their homework. Those traders who simply shorted the markets based on "narrative" are now facing a short squeeze which will carry stocks higher through year end. We'll have to reevaluate in January.
We're thrilled to see volatility falling in stock and bond markets. Earlier this summer, the stock market swung 1-3%/day, now more like 0.1-0.5%/day. About 20% of hedge funds will close this year, while others will struggle because 55% are below the "high water mark" that allows them to deduct performance fees. Private equity firms, the darling investment class of 2000-2008, are also struggling with illiquid investments and the inability to finance new purchases. Real estate looks flat line for the next decade. Gold looks like a bubble, most other commodities at reasonable levels. Venture capital activity is at about the same level as 1995. Investors chasing yields have bid up the prices of corporate bonds and preferred stock, while treasuries, near post-war lows, barely yield more than inflation. Emerging markets stocks and bonds are doing well, but don't expect to see the 2008 returns again.
Could it be, could it be? After a decade of pariah status, perhaps the only asset class that offers a reasonable risk adjusted return is US stocks. Even so, we expect no more than 8% returns (including dividends) in US stocks until the debt deflation process is complete (another 5-10 years.) 8%/year, however, is good enough to cover our clients' annual draws of 4-6% or double their portfolios every 9 years.
As the year winds down, we'll be making modest rebalancing adjustments to clients' portfolios and taking tax losses where necessary. A quarter of calm would be in everyone's best interest.