Don Coxe has updated his popular webcast on Friday, October 14, 2011 – good news for his followers. You can access the recording here or from the sidebar of the Investment Postcards site (the column on the right-hand side) by clicking on Don’s photograph.
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Back in 2005 I bought a house. I knew then, as I know now, that I have no ability to predict the future. But that is not the same as lacking expectations. One of mine was that rising home prices in Toronto's residential real estate market would not continue for much longer, and that in the not-too-distant future my house would be worth less than I paid for it. My thinking was dominated by a belief that housing markets were cyclical, and Toronto's boom was getting long in the tooth.I was dead wrong, of course. The Teranet-National Bank House Price Index (coincidentally set at 100 in July 2005) now sits at 133.5 in the Greater Toronto Area, meaning prices have increased on average 33.5% in the past six years. The Canada-wide index is up even more. Canada is one of a few developed countries in which housing markets weathered the recession and continue to advance. (Others include Australia, Belgium, Netherlands, Sweden and Switzerland.) Elsewhere, such as the U.S., Britain, Spain and Ireland, prices are in retreat. Call me stubborn, but I still believe Canada's housing market rests on a precarious foundation and will not escape a correction, anymore than did America's or Britain's.
How long can this madness continue? Philippe Bracke, of the London School of Economics, recently shed light on that question. Bracke noted that home prices have exhibited cyclical behaviour for centuries. "Available historical records show that this recurring sequence of house price expansions and contractions has been a constant feature of industrialized economies at least since the 17th century," he writes in a recent working paper. Bracke reviewed 40 years of housing data from 19 countries to determine how long these cycles typically last.
Of note, Bracke's data shows that the mean duration of an upturn is about 28 quarters (i.e., seven years), while downturns last 18.4 quarters (about four and a half years). Readers will note that this suggests upturns tend to last longer than downturns. However, the most recent, largely synchronized boom (the one Canada's still in) has been unusually long; when Bracke excluded it from the data this difference largely evaporates.
The data also revealed that the longer a boom continues, the more likely it will end. This may seem blazingly obvious, but in fact it isn't: that doesn't happen with downturns. Bracke hypothesizes that speculation and overbuilding help explain why booms become increasingly unsteady as they persist. Citing theories of boom-bust cycles in home prices, Bracke writes: "As expansions get longer, they are increasingly likely to terminate, signaling a progressively unsustainable departure from fundamental price valuations."
Although Bracke primarily studied duration of booms and busts, he also considered amplitude—that is, the magnitude of price changes. Here the data is somewhat encouraging for Canada. Prices here since 1998 have risen 86.9%, which is quite extraordinary by historical standards. Still, it's nothing compared to 286% increases in Ireland between 1994 and 2006, or the 200% witnessed in Norway between 1993 and 2007. Then again, one should note that America's famous housing madness between 1995 and 2006 saw an increase of just 64%.
In Canada prices peaked in 1976, troughed in 1985, peaked again in 1989, troughed in 1992, peaked in 1994 and troughed in 1998. The run-up since then is now 13 years old (about double the mean duration of run-ups in developed countries over the past 40 years) and still going strong. There's no magical rule that because something has gone on for an atypically long time that it must reverse. However, of the 19 countries Bracke studied, "no nation has ever lived through a perennial house price expansion or contraction." Statistically speaking, I have to be right one of these days.
Food Shock
Many pundits are loudly proclaiming that a recession is unavoidable in the United States. Despite the prominence that these predictions are given in the media, a number of public companies seem to be defying this forecast, and seeing strong results and demand for products and services. Business Travel
Marriott International (NYSE:MAR) reported an upside earnings surprise, and strong demand in the most recent quarter. The company said that revenue per available room (RevPAR) was up by 8.7% worldwide, in the third quarter of 2011 and by 6.9%, in North America. The company also guided 2012 worldwide RevPAR growth to a range from 3 to 7%.
Auto Sales
In September 2011, new automobile sales in the U.S. rose 10%, as consumers seemed unconcerned with the dark economic clouds on the horizon. The increase was led by three domestic car companies, with Chrysler leading the pack with a 27% increase for the month.
General Motors (NYSE:GM) reported a 20% increase for September, and said that it expects full-year industry sales in the U.S. to be at the lower end of the company's guidance of 13 million to 13.5 million vehicles. This forecast implies that demand will increase in the final quarter of 2011.
Ford (NYSE:F) trailed behind Chrysler and General Motors, and reported that sales were up by 9% in September. (For help on valuing auto stocks, see Analyzing Auto Stocks.)
Monsanto (NYSE:MON) reported a strong upside surprise on the top line, reporting $2.2 billion in sales for the fourth fiscal quarter, compared to consensus estimates of $1.89 billion. This report was not that reassuring for U.S. economic growth, as the company attributed the stronger sales to higher demand from Latin America. During the conference call, the management of Monsanto said that "Brazil and Argentina will be one of the single largest sources of new growth in the next few years."
Investors who want to invest in this growth should take a look at an exchange traded fund that tracks the performance of markets here. The iShares MSCI Brazil Index (NYSE:EWZ) seeks to replicate this index and invests 95% of its assets in stocks listed on exchanges in Brazil.
Perception and Prominence
So what's really going on here? There is a perception held by the general public and media that the stock market is a perfect mechanism for detecting trends in the economy; a modern day Delphic oracle that can see into the future with uncanny accuracy.
The public also pays more attention to the stock market, as it has become more important on the balance sheets of the American people over the last thirty years. In 1980, only 13% of the public owned stocks directly or through mutual funds, compared to 54% in 2011.
The Bottom Line
Economist Paul Samuelson is credited with the saying that "the stock market has predicted nine out of the last five recessions." Investors should take this quip to heart and not give much credence to short term stock movements, as the track record of the stock market in predicting economic activity, is not very good.
The University of Michigan Consumer Sentiment Index final preliminary for October came in at 57.5, an unexpected decline from the 59.4 September final report. This level is most commonly associated with deep recessions and is the lowest level since June 1980, over 31 years ago. The Briefing.com consensus expectation and its own forecast was for 60.0.
See the chart below for a long-term perspective on this widely watched index. Because the sentiment index has trended upward since its inception in 1978, I've added a linear regression to help understand the pattern of reversion to the trend. I've also highlighted recessions and included real GDP to help evaluate the correlation between the Michigan Consumer Sentiment Index and the broader economy.
To put today's report into the larger historical context since its beginning in 1978, consumer sentiment is about 33% below the average reading (arithmetic mean), 32% below the geometric mean, and 16.8% below the regression line on the chart above. The current index level is at the 1.9 percentile of the 406 monthly data points in this series.
The Michigan average over since its inception is 85.7. During non-recessionary years the average is 88.3. The average during the five recessions is 69.3.
For the sake of comparison here is a chart of the Conference Board's Consumer Confidence Index (monthly update here). The Conference Board Index is the more volatile of the two, but the general pattern and trend are remarkably similar to the Michigan Index.
And finally, the prevailing mood of the Michigan survey is also similar to the mood of small business owners, as captured by the NFIB Business Optimism Index (monthly update here).
Consumer and small business sentiment remains at levels associated with other recent recessions. The trend in sentiment since the Financial Crisis lows has been one of slow improvement. The October preliminary number from the Michigan survey is consistent with deep recessions.
Silver appears extremely bullish from a structural point of view, something that myself and others have been talking about the last 12-14 months. We first saw this in the vast reduction in the adjusted open interest (reference to spread positions) by about half followed by 2 monster rallies beginning in Sept 2010 and again in February 2011. From personal experience, gauging physical investment demand, paper (ETF) demand, shape of the futures curve and the Commitment of Traders report, silver will likely see a monster rally to at least the $40-$43 area before year end and possibly a breakout pushing the $50 level. In any case, Silver would be the one commodity I would want to own for the next 12-24 months.
From talking to various bullion dealers around the world as well as hearing stories from others, investors appear to have become savvier, loading up on silver following the 3 day orchestrated takedown from $40 to the sub $30 level. Of those I’ve been able to obtain details from, the demand for silver on the investment side outweighs that for gold, at least in dollar terms. This speaks volumes when you look at the amounts available for investment demand in both metals.
Getting back to my point, the recent structural change in the net commercial position coupled with the banks containing the largest net short positions (See Bank Participation Report) appear to have reached the conclusion that this game of knocking down silver at will is close to an end. The physical market has become so tight, it could easily cause these commercial banks to lose billions especially when one takes into account the size of this market.
Points worth noting:
Selling appears to be exhausted on both the speculative side and the commercial side (commercials have tended to pile on short positions prior to a takedown and cover on the way down, which they have done over recent weeks). The commercial traders who essentially control price via the paper market are positioned in such a way that bodes well for silver. Continued backwardation, signaling a supply constraint remains and should intensify over the coming weeks and months. With mine and secondary market supply growing a few percent a year, investment demand is growing much faster and has been accelerating. In other words, demand is outstripping supply, which should lead to higher prices as dictated by the laws of supply and demand. While there is no certainty silver will head higher in the weeks ahead, it looks more likely than not, and this presents investors with a period of time to accumulate. If I we’re a bettin man I wouldn’t bet against a potential double to $60/oz in 6-12 months. With the monetary problems intensifying around the world, those who fail to take advantage of these attractive prices will surely be kicking themselves down the road.
4 Bearish Mega Trends:
U.S. Deficit
For a moment, take a mental journey with me back in time. We are now in early 2008. The major indexes a la S&P (SNP: ^GSPC), Dow Jones (DJI: ^DJI), and Nasdaq (Nasdaq: ^IXIC) are slowly coming off their all-time high, but the collapse of Lehman Brothers has not yet hit the news.
Unbeknownst to most, the perfect financial storm is brewing. Once the storm hits, it is much worse than anyone expected. But, the eventual damage is limited. Why? Because, the government steps up and does what it takes to prevent the financial system from failing.
Today has the feel of early 2008. Another perfect storm may be brewing. Will the government be there to do what it takes to support 'too big to fail?' No! In 2008 financial companies were in trouble. In 2011 entire countries (look at Europe and the U.S.) are struggling to escape the grip of delinquency.
A Decelerating Generation
Starting in 2011, more than 10,000 baby boomers a day will turn 65, a pattern that will continue for the next 19 years. This dry humor cartoon encapsulates the problem retirees' face today:
Two older gentlemen are having a drink. One says: 'As a Baby Boomer, I never thought the boom would be the sound of my retirement accounts collapsing.' He'd like to sip on a nice Scotch while enjoying a steak, but has to settle for water and free bread sticks at Olive Garden.
Most retirees still haven't recovered from the lost decade. Let's make the term lost decade more personal. A 55 year old with $100,000 in his retirement account at the beginning of the year 2000 and a 6% projected rate of return, would have $201,419 today.
The S&P trades 20% below its 2000 level. Courtesy of the lost decade, that $100,000 in the year 2000 has turned into $80,000 today (perhaps less if invested too aggressively). In other words, many retirees may have to get by on less than half of their expected nest egg. In addition, their home, rather than being an asset (many considered it an ATM a few years ago), has turned into a liability.
It doesn't take much imagination to see that strapped retirees are bad for economic growth. When the focus is on survival rather than pleasure, sectors like technology (NYSEArca: XLK - News), retail (NYSEArca: XRT - News), and consumer discretionary (NYSEArca: XLY - News) suffer.
In addition, baby boomers that have been buying stocks for decades (think of all the 401k money) are now turning into sellers of stock.
Low Interest Rates
Low interest rates are great for the U.S. government because it reduces debt payments on Treasuries and businesses wanting to expand. Unfortunately, businesses don't feel like expanding or even hiring and for pretty much everyone else low interest rates are negative.
Some try to sell the idea that low interest rates are good for stocks (NYSEArca: VTI - News) because money will flow from low interest bonds into stocks in an effort to get a better return.
The chart below plots the Nikkei against Japan's version of the discount rate. The discount rate has been below 1% since 1995. At the same time the Nikkei has dropped from above 20,000 to below 10,000. Much of this happened during a raging global bull market. Imagine what a global bear market can do to U.S. stocks.
Low interest rates are a double negative because they reduce available spending for retirees who need to get as much income as possible to survive.
Coming to a Head
The above three bearish trends were highlighted in detail in various 2011 ETF Profit Strategy Newsletters. Due to those, and other mega trends, the Newsletter has been expecting a major market top.
For much of 2011 however, the expectation of a major market top was postponed until the ideal target range was reached. The April 3 ETF Profit Strategy update included a precise range for a major market top: 'In terms of resistance levels, the 1,369 - 1,382 range is a strong candidate for a reversal of potentially historic proportions. '
Why was S&P 1,369 - 1,382 a candidate for a reversal of historic proportions? The chart below, published by the ETF Profit Strategy Newsletter in March and many times since, has the answer.
What you see is a giant M, or head and shoulders top. The right shoulder was made up of the parallel trend channel that connects the 2002 and 2009 low, with the 2000 high. In April/May the upper line of the trend channel ran through 1,377. Additional resistance was provided by Fibonacci levels at 1,389 and 1,369.
On May 2, the S&P briefly spiked as high as 1,370.58 before retreating and eventually dropping 18% in twelve trading days (July 25 - August 9). Once the S&P dropped below the 200-day SMA it entered free fall territory.
The July 28 ETF Profit Strategy update warned that: 'A break below the 200-day SMA and the trend line may trigger panic selling.'
Why Stocks Will Rally
From top to bottom (once the bottom is in), the S&P will have fallen more than 270 points. No doubt this kind of move validates a counter trend rally. October has a reputation as bear market killer and even though I don't think October will 'kill' this bear market, it should be the spring board for a nice year-end rally.
Sentiment and various technical indicators and studies also suggest that a price low is close. End of original article.
Updated Short-term Forecast
The S&P bottomed at 1,075 on October 4. A couple days before (October 2) the ETF Profit Strategy update recommended to sell short positions at 1,100 - 1,090 and buy long and leveraged ETFs as soon as the S&P moves back above 1,088. The ideal bottom pattern was described as follows:
'The ideal market bottom would see the S&P dip below 1,088 intraday followed by a strong recovery and a close above 1,088.'
Even though higher highs are expected before year-end, I recommended to sell long positions at 1,204. The S&P has simply moved too far to fast (which has been great for our long positions, but there's no need to get greedy). A correction is now likely.
Now that we already had one notorious bond bear in the house with a late afternoon appearance by Bill Gross, who in a very polite way, apologized and said that while he may have been wrong in the short-term, he will be proven correct eventually, it is now time for the second uber-bond bear to make himself heard. In a CNBC interview with Jim Rogers, the former Quantum Fund co-founder, who back in July said he was had shorted US Treasurys, exhibited absolutely no remorse, instead reiterated a 100% conviction in his "bond short" call: "Rogers said when there is a bubble, such as the one being experienced in U.S. Treasurys, prices could go up for long periods of time. Bill Gross of Pimco, who also had a bearish view on Treasurys, threw in the towel earlier this year. But Rogers is sticking to his opinion that Treasurys will eventually fall. "Bernanke is obviously backing the market again and the Federal Reserve has more money than most of us - so they can drive interest rates down again. As I say they are making the bubble worse." The reality is that while Bill Gross has to satisfy LPs with monthly and quarterly performance statements (preferably showing a + sign instead of a -), the retired and independently wealthy Rogers has the luxury of time. And hence the core paradox at the heart of modern capital market trading: most traders who trade with other people's money end up following the crowd no matter how wrong the crowd is, as any substantial deviation from the benchmark will lead to a loss of capital (see Michael Burry) even if in the longer-term the thesis is proven not only right, but massively right. Alas, this means most have ultra-short term horizons, which works perfectly to Bernanke's advantage as he keeps on making event horizons shorter and shorter, in the process killing off any bond bears which unlike Rogers can afford to wait, and wait, and wait.
On whether the US is becoming a deflationary Japanese-style basket case:
"A difference is when Japan did that they were the largest creditor nation in the world, America is the largest debtor nation - not just in the world - but in the history of the world and the U.S. dollar has been - and is the world's reserve currency. So there are some factors that might not keep the interest rate down in the U.S.
Ok, so no deflation. What then?
The U.S. economy is likely to experience a period of stagflation worse than the 1970s, which would cause bond yields to spike, commodity bull Jim Rogers told CNBC on Friday in Singapore. Rogers said governments were lying about the inflation problem and the recent rally in Treasurys was a bubble.
"As the inflation numbers get worse and as governments print more money and as governments have to issue many, many more bonds - somewhere along the line we get to the point when (bond prices) go down."
Between 1974 and 1978 average inflation in the U.S. was at 8 percent, while unemployment hit a peak of 9 percent in May 1975. Currently, unemployment is at 9.1 percent while CPI is at 3.8 percent.
"This time is never different" and why the mother of all stagflations is coming soon:
Rogers believes inflation will get much worse this time because, he
said, in the 1970s only the Fed was printing money, whereas now many
global central banks have been easing monetary policy.
So yes: he will be right eventually... But what about in the interim?
"Bernanke is obviously backing the market again and the Federal Reserve has more money than most of us - so they can drive interest rates down again. As I say they are making the bubble worse."
For now though Rogers is playing it safe and avoiding bonds. Instead, he's betting on stagflation by being long commodities and currencies (such as the Chinese yuan) and shorting stocks.
Rogers even has some career advice for up and coming bond mavens:
"I wouldn't advise anybody to buy bonds, I would advise you to sell bonds," he said. "If I were a bond portfolio manager, I would get another job."
Ok, well, make that anti advice.
As to where the money will be made...
"In the 70s you didn't make much money in stocks, you made fortunes owning commodities," Rogers added.
By almost any measure, gold stocks are undervalued. Should we load up?
After completing my research on this question, I’m convinced that as gold stock investors, we’re in the right place. See if you agree…
Let’s first get a handle on the degree of undervaluation. The more undervalued, the lower the buying risk. A fairly valued stock, on the other hand, requires added caution.
Gold accelerated higher in August and September, peaking around $1,900/ounce, while gold stocks lagged. Here’s a chart of the HUI-to-gold ratio (HGR). In a rising gold environment, a climbing HGR indicates that gold stocks are outperforming the metal; a falling HGR means they’re trailing gold.
(Click on image to enlarge)
Today’s 0.32 HGR means gold stocks as a group have not been this cheap, relative to their underlying metal, since January 2010. And a lower ratio hasn’t been seen since February 2009, when it was recovering from the 2008 global meltdown.
I think there’s a more compelling situation that demonstrates the undervalued nature of gold stocks. It’s hard to read a mining company’s quarterly report these days without hearing about “growing margins.” The gold price has risen faster than operating costs across our industry, which has lifted profit margins of the better-run producers.
Higher margins are key to increasing earnings and cash flow, which in turn lead to rising stock prices. Have gold mining equities kept pace with ever-increasing margins?
(Click on image to enlarge)
Gold mining companies are earning record margins, averaging a whopping $1,268 per ounce last quarter. In both nominal dollars and percentage above costs, margins have never been this high for gold producers. Stock prices, however, have not responded in similar fashion.
This is a potentially significant point, because margins of this magnitude will be ignored only so long. When the broader investing community begins to take notice, investors will snap up these highly profitable stocks and push prices higher. The “catch-up” in gold stocks could be tremendous.
The conclusions from these data seem clear: Gold stocks, as a group, are undervalued. The incredible profit margins generated by our sector will attract investors – sooner or later. We also have data that indicate that picking the better stocks – like most of those in BIG GOLD – is more profitable than buying a gold stock fund.
We’re in the right place.
The question, of course, is timing. We don’t know when gold stocks will begin to catch up. And the data don’t suggest that they must rise right now nor that they’ve hit bottom. We’re convinced they’ll someday hit lofty levels, but for now we maintain the same refrain: keep one-third of assets in cash. This reduces risk and gives us a nice pile of funds to deploy during selloffs.
In the big picture, gold has ratcheted steadily higher throughout the rallies and corrections, a trend we’re confident will continue for some time. As the price sets new highs and margins remain robust, our sector will attract more attention. We must patiently stay the course until those new realities begin to set in.
Make sure you have exposure to gold stocks, but it’s not yet time to jump in yelling “Geronimo!”
