It’s make or break time for the shiny metal – since the 2011 high of $1920, gold has dropped -33% and now it’s challenging the six year downtrend.
The bullish and bearish case for gold centers around interest rates and inflation, or in Wall Street speak “real interest rates”. The real interest rate is calculated by subtracting the rate of inflation (CPI) from the interest rate observed on government bonds. For the mathematically challenged there is an easier way – just look at inflation protected Treasuries or TIPs rates.
The following chart illustrates the relationship between gold and real rates.
BK will make the explanation really simple: if the blue line (real rates) is going down then the red line (gold) should be going up. This happens because gold costs money to store, so as the real amount of money earned on bonds drops the incentive to hold gold increases.
So what does this mean for our inflection point? And what is the signal coming from the price of gold?
If gold breaks the six year downtrend, then the signal is that bond yields will be lower than inflation. Either inflation will increase or bond yields will drop…or both.
The fact that the 10 year US Treasury rate just dropped below a key support level makes BK lean toward the falling yield explanation for gold strength.
For BK’s part he is already long of gold betting that it will break the six year downtrend. Of course market validation is the only arbiter and BK is hyper-vigilant that the downtrend is respected and gold could reverse course.
This might seem like a shocking headline from BK, but it is inspired by Warren Buffett suggesting the US stock market is cheap when compared to 10 Year Treasury yields. To be clear -BK is not, and does not, make a determination of cheap v rich valuations – BK’s investment style is rooted in human behavior rather than valuation. BK is simply pointing out what a few investors may be using as a “reason” to buy stocks.
In the past, Buffett has championed a valuation metric based on Total Market Cap to GDP – and by this metric the US stock market is significantly overvalued. The website Gurufocus does a great job of tracking this metric – currently total market cap to GDP is 130% or significantly overvalued.
The only other time the market was more overvalued was in 2000, when the metric reached 150%. So why is Buffett saying the market is still cheap?
It all has to do with rates. Using the Fed Model, which compares S&P 500 Earnings Yield to the 10 year Treasury rate, one finds that there is a lot of room for stock to run. Forward S&P 500 earnings are $134, when we divide this by the current price of the S&P 500 (2376) we get an earnings yield of 5.6%. It is easy to see that earning 2.3% on a 10 Year note is less desirable than earning 5.6% on stocks. BK suspects this is why Buffett is still buying stocks.
Assuming the earnings yield remains stable, then one might say that stocks are cheap until the 10 year rate rises to 5.6% – at this point stocks would be fairly valued.
BK will leave you with a little food for thought…When was the last time the 10 Year Yield was above 5.6%? A: In 2000.
In the last 24 hours, bitcoin has hit an new all time high on speculation that the Winkelvoss Bitcoin ETF (COIN) will be approved by the SEC. The new high above $1220 surpasses the 2013 high when an algo associated with the now defunct Mt Gox exchange went haywire. Over the last 4 years, bitcoin has passed multiple milestones and tests – it has come out the other side a strong, stress tested currency. It’s resilience is likely contributing to the speculation that an ETF “approval” is likely. The SEC has until March 11, 2017 to deny the application for the Winkelvoss ETF – if the SEC does nothing then the ETF is implicitly “approved”.
Investors are speculating that a last minute update to the ETF filing is a sign that an SEC blessing is forthcoming. The update concerned what is known as a “hard fork”, which is akin to a software upgrade. However, there is a huge difference with a digital currency upgrading software vs something like Microsoft Word. If Microsoft updates Word and some users choose not upgrade its not a big deal – but with a digital currency if all users do not upgrade then there is the potential that the currency splits into two versions – this could have a detrimental impact on the value.
The market euphoria over the ETF is not consistent with analysts estimates and prediction markets. There is one thinly traded prediction market that is indicating a 45% chance of an ETF approval.
On the other hand, Needham estimates that the chance of approval is 25%. IBKHO the argument against approval of an ETF is not very strong. It has been argued that bitcoin to too thinly traded to support an ETF – but bitcoin liquidity is similar to a mid-cap stock and there are plenty of ETFs that contain mid-cap stocks. There is a strong argument to be made that initially $300m could flow into the ETF and that would have a disproportionate impact on price – this is the only argument that actually holds water, but its unclear if this matters to the SEC.
Another argument is that since most of the trading occurs in China the SEC would be reluctant to approve an asset that trades in a potentially unfriendly location. However, in the last few weeks the PBoC has reduced leverage at Chinese exchanges and Japan has now become the top trader of bitcoin. In fact, it is widely expected that major Japanese financial institutions will begin trading bitcoin in 2017.
BK’s bet is that the ETF gets approved – but to be clear I am not making a specific bet on that outcome. To BK, bitcoin and other digital assets are a new asset class for investors that are grossly undervalued relative to their potential use cases. In my view, this is a once in a generation investment opportunity that warrants a long term perspective.
Yep, that’s right – despite record high stock prices and reports that the economy is accelerating the truth is the economy stagnated in January. The latest release of the Chicago Fed National Activity Index (CFNAI) indicated a decline in economic activity led by industrial production.
The 3-month moving average of the CFNAI was -0.3, down from -0.2 in December. A reading near zero indicates that the US economy is growing at trend – which appears to be near 2% over the last few years. While this is not a disaster it does indicate a deceleration in the economy. BK has developed a GDP forecast from the CFNAI which still is indicating GDP growth above 2.7% over the next 4 quarters.
This forecast is broadly consistent with the 10 year yield at 2.4% and the Atlanta FED GDP now which is indicating 2.4% growth. The problem for stock market investors is that the consensus estimate for S&P 500 eps growth from 2017-2018 is +12% – it is going to be very difficult to achieve 12% eps growth in an economy that is only growing at 2.4-2.7%.
The bottom line: now is the time to be cautious and taking profits rather than initiating new positions.
Late on Tuesday February 21, 2017, the Mexican central bank (Banxico) announced a $20b currency swap arrangement designed to stop the Peso from collapsing. The first swap auction will occur on March 6, 2017 and will have a similar effect as Banxico selling US Dollar futures up to 12 months out. The immediate impact was a 2% spike in the USDMXN rate.
The reason Banxico chose the swap, as opposed to direct intervention, is because the swap is a leveraged agreement which means it won’t deplete FX reserves at the same pace as direct intervention. Technically these swap agreements are not a claim on Mexican FX reserves BUT in reality Banxico is not going to default on the swap as long as they have FX reserves.
This type of levered quasi-government backed arrangement can work for a long time, until it suddenly doesn’t. The breaking point comes when Banxico’s short dollar position becomes so large that counter-parties issue a margin call. Mexico is a LONG way from having this happen, but this is how the movie ends.
In the short to medium term, this move should prove to be successful in halting the decline of the Peso. The unknown is the long run impact. For BK’s part, he will be waiting for the trade to turn against Banxico before committing sizable capital to a Peso trade.
Passive investors don’t care about President Trump. This is the only conclusion that BK can draw after watching the US equity market shrug off a disturbing, albeit entertaining press conference yesterday. BK was confounded by how “the market” could still think that President Trump will get any of his agenda off the ground with the chaos surrounding him – but then he realized passive investors are nihilists man, they believe in nothing.
The relentless charge higher in US equity indexes makes a lot more sense when you realize all the money pouring into passive index funds doesn’t care about valuation, tax reform, protectionism, Obama Care or anything else. As long as the money keeps flowing into index funds the stock market can chug higher. The risk, of course, is that the price becomes more and more detached from reality. It’s only a matter of time before somebody declares that index investing has created a permanently high plateau.
Eventually this will all end – probably when the great migration from active to passive investing is complete. The trick for the active investor is to step off the nihilist ride just before you get a bowling ball to the groin.
Everyone and his brother and his brother’s cousin’s hairdresser – are expecting the Chinese currency to weaken. But what if it doesn’t? There are three reason’s why it is in China’s best interest to have a strong currency:
1.) Capital Flows
The outflow of capital has been well documented and with FX Reserves below $3 trillion China is perilously close to a currency crisis. The IMF estimates that a country of China’s size needs approximately $2 trillion in reserves to operate the economy. This means the cushion for China is less than $1 trillion – this may seem like a lot, but with $100b month outflows it would take less than 10 months for China to reach a crisis. In short, China needs a strong currency to stem capital flows.
With inflation picking up China may indeed get a strong currency. The most recent reading on both CPI and PPI show inflation at 5 year highs.
To stem the tide of rising prices, China may need to raise interest rates – which could result in a strong Yuan. Moreover, a strong Yuan would help keep import prices down and in turn could reduce inflation.
Finally, with the approval of Steve Mnuchin as Treasury Secretary, the door is wide open for Trump to declare China a currency manipulator. The claim would be that China has been artificially keeping its currency weak. Of course, the opposite it true, but alternative facts are in vogue. If China strengthened its currency then there would no basis for a Trump attack.
What would this mean for asset prices? Gold would likely be the biggest beneficiary as a weak dollar would be the order of the day. Equities and commodities would also benefit. But there is a dark side to a stringer Yuan. China is in the middle of a credit bubble – if rates increase then the entire bubble could pop.
Is the Stock Market Heading Toward a Blow-off top and If So What Does That Look Like?
The good news is, we have a tool to measure extreme market moves; the bad news is because the future is dependent upon unknown decisions made today it is unknowable. However, we can observe fear and greed, and we can define when those distinctly human emotions reach extremes. There is a plethora (yes, a plethora) of research on financial market bubbles, but for BK’s purposes he likes research that is objective, can be replicated and can be tested. Those who want a deep dive should read the work of both Jeremy Grantham and Cliff Asness, both have done groundbreaking work.
In the simplest terms, the extremes of fear and greed can be observed when markets stray far from equilibrium. We can define equilibrium as the trend and the extremes as a 2 standard deviation move from the trend. Armed with these definitions we can look back at bull markets and look for similar patterns of human behavior.
If the research and BK’s thesis are valid then what we should observe is that major stock market tops occur when the price reaches an extreme (defined as 2 standard deviations from the trend). Let’s go to the charts.
BK used the Dow Jones Industrial Average because of its long history. The following charts are of every major bull market since 1921 overlaid with a regression channel. The middle line of the regression channel is the trend and the upper and lower lines mark a 2 standard deviation from the trend.
What do every single one of these bull markets have in common? They all ended with a blow-off top that resulted in the price breaching 2 standard deviations from the trend.
What does the DJIA look like today?
2009 – 2017
Based on this single indicator one might conclude that the DJIA would need to breach 21k before we could define this move as a blow-off top. To repeat what BK wrote earlier – the future is unknowable – but if the DJIA breaches 21k AND we see a deteriorating economic landscape then the conditions would replicate every other blow-off top.
Oil is the big mover today after the IEA said that OPEC is strictly complying with the production cut agreement. BK’s comment: No Sh!t. Saudi Arabia is in the long process of launching and marketing the Saudi Aramco IPO that is expected to trade in 2018. During this process it is in Saudi Arabia’s best interest to keep the front month oil contract relatively high.
This short term chart shows today’s price move.
But when we zoom out to a weekly chart it is easy to see that oil has really gone nowhere since breaking above $50. This actually suits the Saudis just fine.
If the price of oil rises too much then the US producers will flood the market with supply and make it more difficult for Saudi Arabia to keep the price elevated. The trick is to keep the front month elevated while keeping the back months depressed so that US producers cannot hedge future production. So far this game has worked, but in the IEA report that caused the price spike, it was also noted that in the second half of 2017 supply is expected to increase without a commensurate increase in demand.
Bottom Line: oil remains range bound, but when it breaks it will have global implications.
A year ago Saturday marks the bottom in oil – this means the base effect of low oil prices will begin to recede from inflation/reflation indicators. The broader US equity market has climbed on the back of the materials, industrials and various infrastructure plays – this is the so-called reflation trade. While this equity rally occurred the bond market was pricing in higher inflation. Interestingly, the 5 year break-even inflation rate was indicating almost no YoY growth in November 2016, since then inflation expectations have soared.
The following chart shows the YoY % change in 5 year inflation expectations and the YoY% change in WTI Crude Oil Prices. As you can see there is a very close relationship.
This means that the direction of the price of oil is probably more important than any other single factor when trying to determine if the reflation trade will continue. On February 11, 2016 crude oil hit the lowest price since the financial crisis.
This means that moving forward the effect of low oil prices will be muted and likely result in falling inflation expectations. In turn, this could make the bonds bears decidedly bullish. BK is long of TLT.