In evaluating gold, we consider the following:
1. The Fundamental Case – Should we own gold? If so, how should we size it?
2. The Technical Backdrop – How is gold currently trading? Where is the technical resistance and support?
3. Sentiment – How does the market currently feel about gold? Who is buying and selling?
4. Portfolio Construction – What is the risk of a major inflation or currency crisis? Is gold trading in a correlated or uncorrelated manner to the other assets in our portfolio? In what environments does owning gold enhance portfolio diversification? What does the symmetry—the upside vs. downside—look like?
continue reading below…
60 Minutes did a great segment the other night on China’s Real Estate Bubble that echoed our views published last October following our trip to China (see One Giant Epcot Center). The episode features Gillem Tulloch, founder of Forensic Asia (who we also met up with on our trip) and features many of the actual locations we referenced. Also, below are a handful of pictures from the trip:
South China Mall (Dongguan, China) – the largest mall in the world by gross leaseable space and infamous for its lack of tenants
A new ‘ghost town’ south of Guangzhou
High-end condos being erected in Danyang, China where per capita income is approximately $6,000
One of Danyang’s two train stations
Mall in Shanghai
One of our internal research pieces on Japan’s “Attempted” Reflation (apologies for not posting it earlier) has been making the rounds on Business Insider and Zerohedge. I wanted to re-post it here given Cullen was recently on Squawk Box Europe reiterating our views on Japanese equities (click here).
“SO BASICALLY CHINA IS ONE GIANT EPCOT CENTER,” were the words uttered by Chris Pavese, himself unsure of whether they formed a question, a tongue-in-cheek comment, or an apt summary of what we had witnessed touring nearly a dozen Chinese cities this past spring…keep reading below…
We have a confession; we’re bullish! On U.S. Housing, that is…See our latest thoughts below.
While we are sympathetic to “Europe fatigue” (see Bloomberg Business week cover in the below pdf), we wanted to send out a quick note to discuss our perspective on Europe and how it relates to our investment decisions. We hope it provides a useful framework for how we think about the crisis. This quasi-road map has been helpful for us in digesting Europe’s core issues, as well as for judging the likelihood of success of the many proposed solutions.
See below for our most recent Commentary, which discusses how complex systems, such as political, economic and financial structures, are inherently fragile, often leading to unpredictable (and abstract) outcomes.
This morning I had a call with one of our London based consultants who has a particular focus on Europe. Before joining his current firm, he spent several years at the UK Treasury, the last two of which he was tasked with “understanding the lessons of the crisis.” Below are my notes from the call (with my comments in italics):
- Banks are still under tremendous funding pressures. Europe is already in recession, however, he expects considerable tightening in credit (exacerbating the situation)
- Expect a new Stability and Growth Pact, despite the first SGP being completely discredited (with Germany being one of the worst offenders on budget deficits prior to the credit boom, which substantially benefitted German exports)
- The new pact will likely include sanction and veto authority. He expected more resistance from France on this. In effect, budgets will have to be presented to Euro technocrats prior to their own parliaments. Ireland attempted this following their bailout and it was a disaster
- The austerity packages being put in place are 15 years too late. )Austerity in a fixed-currency regime is destined to be disastrous and will do nothing to alter the situation with debt levels remaining too high)
- He doesn’t believe the ECB will push the “nuclear button” (i.e. massive unsterilized bond purchases). While they are likely to step up their purchases, the members of the ECB’s Government Council is still very resistant to this, including the non-Germans. The statement from the ECB will likely be along the lines of “we’re prepared to do more.” (Germans remain fundamentally opposed to Anglo-Saxon style QE)
- Any plan from Dec. 9th is unlikely to clarify “who is going to pay” for the previous excesses. There will still be no direct transfer union
- Greece’s deficit is running around 10.5% (so clearly austerity isn’t working). It will never fall below 3% while in the euro so default is nearly inevitable. While the market may be comforted temporarily by a new plan, expect contagion to increase when Greece exits the euro. (Consider the impact on banks, etc.)
- Once Greece begins to recover following an exit from the euro, other peripheral countries will be tempted to do the same
- Issuance in 2012 will be far greater and treacherous than 2011. Italy has significant funding pressure in Feb so overall funding pressures will resurrect even if they fade in the near term
- The ECB may cut to 50bps, which they were highly resistant to do in 2008 (for fear of a liquidity trap). (This may help the periphery some via lower mortgage rates)
- However, inflation is still uncomfortably high in Europe, complicating the ECB’s decision making. (As a philosophy, the ECB is deeply concerned about inflation and does not believe in the output gap model the Fed and BOE relies on)
- He has noticed more investors becoming concerned about the UK (for good reason). The UK shares many of the same domestic imbalances as Europe in addition to massive financial vulnerability. Banks have enormous exposures to France. Also, UK housing prices entered the ’08 crisis at very high levels—they fell 10%, then rose 15%. Now many homeowners are refusing to sell since they can’t receive the pricing they would like. Lower prices could create significant problems for the UK banks and strains in the global economy, particularly the US, will create strains in UK housing (assets in the UK are highly correlated with the US)
- The BOE has done two rounds of QE, however, the most recent round has been in isolation (whereas the previous was coordinated alongside the Fed and other central banks). It’s unclear how effective this has been
- If Europe were to just have a recession, the UK (and the US) could arguably be okay. However, if we have a European financial crisis, both will be engulfed
- Investors are only now realizing the huge influence of European banks in the US. French banks in particular have borrowed massively via MMFs and recycled the proceeds back into US assets
- In terms of the endgame, we’ve essentially been operation with 2 material currency blocks, which have been a disaster for the global economy:
- US-China, which the US has been an involuntary participant as a result of China’s peg
- Northern & Southern Europe (via the euro), which was voluntary
- Stage 1 of the crisis was subprime (i.e. the result of the first currency block) and Stage 2 is now clearly Europe. He believes Stage 3 will be China
- His final comment was that you must be “quite brave to believe policymakers will ultimately stem contagion in Europe”
I was building out some internal charts recently and ended up creating a spread between the bull and bear sentiment indices (using the AAIIBULL and AAIIBEAR Index). Basically it shows investors bullish sentiment in 6 months time (the higher the number the more bullish).
Extreme sentiment tends to be a contra indicator, but it’s interesting to see the actual data. Five out of the last six times the indicator was above 20 we’ve sold off over the next 6 months. When the index was sub -30 (ie bearish) it’s a little less predictable (3 out of the last 5) and returns were much more volatile, but still interesting. Now that we’re breaking above 20 again it could be telling. Also, notice the one time it was wrong was early Sept ’10…when QEII changed the rules of the game.
The markets definitely seem excited about the euro-zone plan to hair-cut Greek debt and lever the EFSF (basically levering debt to solve a debt problem with money you hope to raise from Asian investors who you’re already indebted to…interesting), but the upward move past few weeks has been truly historic. Month to date the S&P 500 and the Russell 2000 are +13.53% and +18.82% respectively. I know there are still 2 business days in this month, but I thought I’d put the move into some historical perspective.
The S&P 500 has only closed the month greater than +13.5% once since 1940 (I only went back as far as the 40s because of the extreme volatility in the 30s; I have some mind blowing stats on the 30s below). The only time the S&P has had a greater positive move than this month was in October 1974 when it rallied +16.3%. What were the events leading up to the October ’74 rally? The markets had collapsed 46% during the ’73-’74 recession before bouncing in October of ‘74. The 70’s recession was born out the Vietnam war ending (which proved very costly), the fall of the Bretton Woods system (in Aug-71 the US terminated the convertibility of dollars into gold, basically collapsing the monetary system) and the OPEC Oil Embargo which quadrupled the price of oil (occurred when the US re-supplied the Israeli military during the Yom Kippur war). It was also helped along by a healthy dose of stagflation (high unemployment and inflation). Ironically, do you notice any similarities between then and now?
I highlight the Russell’s +18.82% appreciation this month because it’s the largest monthly increase in the history of the index (which began in 1979). The previous record was +16.4% in February 2000, a month before the tech bubble imploded. Another head scratching fact is the rally this month kicked off barely 20% from its recent high and over 60% from its lows in ’09. In other words, we weren’t even starting from a low base.
While I’ve looked at the monthly returns from the 30s several times in the past, I’m always blown away by the sheer amount of volatility that lasted for an entire decade. Below are the monthly returns for the S&P 500 between 1929 and 1939. I’ve only included months that had moves +/-10%. If you would have invested $1,000 in May 1929 you would have lost 50% of your money by the end of the decade (as well as gone through about a case of TUMs). You wouldn’t have gotten back your initial $1,000 investment until 1952! It’s no wonder why this decade caused many of our parents and grandparents to stay out of the equity market for years.
Bottom line, the markets are currently playing by a different set of rules and it doesn’t seem to be ending any time soon. Patience, flexibility and focus are more important than ever.