What If Anything Is Gold Saying?
Despite a small setback in the stock market at the beginning of September and the short lived media frenzy of how September has been historically the worst month of the year for investors, the S&P500 returned a positive 3.57% in September 2009, extending the rally for the 7th consecutive month this year.
The 2009 market rally has been a breath of fresh air among a pollution-infested financial environment during the past 3 years. As much as we long for this rally to continue, looking down our checklist of macro market factors, we are generally not encouraged. Let us review them quickly:
• Cost of Capital – We do not see any catalysts to lower the equity market costs of capital in the near future. In fact, factors are aligned to increase the equity cost of capital as taxes will increase in 2011 on both income and capital gains.
• Economic – While Armageddon for financial institutions has been averted, the economy remains stubbornly weak. With unemployment likely to reach 10% by the year-end, and higher if you add discouraged workers that quit looking for jobs, that bodes very poorly for the consumer sector of the economy, which accounts for over 70% of GDP. Further, the US Dollar continues to weaken against other currencies and real assets.
• Geo Political Environment – It is very difficult to be optimistic about the current Geo Political Environment, as tensions in the Middle East continue to rise; North Korea increasingly rattles its saber on its march to nuclear weapons; America’s debtor nations are becoming more adamant in calling for replacing the dollar as the world’s reserve currency.
• Valuation – We were very bullish on buying the market when expectations were absurdly low during September ’08 and March ’09. But today, market valuations while not obscene are no longer compelling.
All told, we do not find the current environment constructive for equities. While there are many technical reasons to support the current market rally, and we also readily admit we are not market timers, as long term investors we believe simply that US equity markets are likely to disappoint investors as a result of too many negative factors, combined with valuations that do not reward investors for such possibilities. This places a premium on stock selection rather than simply owning equities as an asset class. With that in mind we will explore the issues with the dollar further this month.
With that in mind, let us explore what we think is the most interesting story in September and October, namely the heated talk by many countries to move towards a new global currency. There are two charts we are presenting below, which depict an interesting tale. For Chart 1, the yellow line represents calendar year closes for a company’s common stock (left axis) while the pink represents the ratio of its total debt to revenues each year (right axis) for the past 10 years. Can you guess which entity Chart 1 represents?
Notice how this company dramatically increased its leverage relative to what it was capable of producing and selling in 10 years’ time. Clearly this was an untenable position, although it did last quite long. In the end, the company’s share price dropped to below $1 and it declared bankruptcy. This firm is General Motors. (GM Financial’s debt is excluded from its total debt displayed in the chart. Total debt is defined as short-term debt, long-term debt, and other liabilities.)
Let us examine another chart.
In Chart 2, the green line depicts prices (left axis), while the blue line captures debt to revenue (right axis), during a time horizon of 40 years. Notice how Chart 2 looks a lot like Chart 1? Prices (green line) have been falling consistently over the 40-year time span, while leverage continued to climb. How sustainable is this entity’s position? Would you be a buyer or seller? Can you guess the entity Chart 2 represents?
Answer: The United States. Specifically, the green line represents the Yen/USD exchange rates, and the blue line represents total federal debt to GDP. Chart 2 depicts a steady decline of the US dollar against the Japanese Yen since 1970, accompanied by a consistent increase of our country’s leverage. As a nation we have been borrowing more and more to finance our government’s consumption needs. With our total federal debt to GDP ratio expected to exceed 90% in the near future, unless our trajectory changes significantly the question is when a currency crisis will hit our shores, not if.
While it is possible that the dollar has weakened against the Yen due to Japan’s rise, the dollar has generally weakened against most major currencies and the majority of real goods in the global economy. For example, the dollar lost nearly a quarter of its value to Euro in the past decade and when priced in dollar terms, gold is 28 times higher than in 1970. Over the past 5 years, the price of oil has increased significantly causing economic dislocations throughout the US economy, leading to calls for laws to curtail energy consumption via increased car fuel economy standards and higher taxes. But has the price of oil increased significantly in real terms? The chart below shows the number of barrels of oil required to buy an ounce of gold.
* Gold and Oil prices used for 1971-2008 are annual averages. 2009 prices used are based on Oct 6 close.
Notice that while there have been some ups and downs, the price of oil in gold terms today is basically the same as it was in 1972, right after the US abandoned the gold standard. It takes approximately 16 barrels of oil to purchase an ounce of gold. In real terms, the price of oil has not changed too much over the past 40 years when measured in gold terms, but has increased 20 fold when measured in terms of US Dollars. This systematic weakness in the Dollar combined with the US having exploding net trade deficits, is prompting many emerging countries around the world to intensify their efforts to move away from the dollar as the functional global currency.
The most serious threat on this front is the major oil producing countries, which are rumored to look to establish a basket of currencies and possibly including gold to set the price of oil. These countries understand that continuing to hold dollars is too expensive. China holds approximately $2 trillion in US Dollar reserves. Year to date, the dollar’s depreciation has cost China $400 billion measured against gold, and $100 billion measured against the Dollar index. Little wonder that China is becoming increasingly vocal in its displeasure regarding US financial affairs.
If the dollar is ultimately replaced as the global functional currency, the US Dollar will likely suffer additional significant devaluation as demand for the US Dollar based reserves plummets. This illustrates the folly of those that argue a weak dollar is bullish for the stock market. Does anyone really think that the dollar losing its place as the world’s reserve currency will benefit the US economy and the stock market? John Tamny, Economic Advisor to Toreador Research and Trading and Editor of Real Clear Markets, offers the following points to illustrate how a falling dollar hurts the US economy and ultimately the US consumer. First, he explains how in times of a falling dollar investors tend to put their money into hard assets such as real estate and collectibles, rather than the financial assets which fuel economic growth and job creation. This was clearly the case in the 1970s as the dollar suffered massive depreciation against currencies and gold. Secondly, he adds that as the dollar falls, consumers have to pay more for imported goods – in essence a hidden tax on their purchasing power.
Both of these factors bode poorly for the economy, the market, and the consumer. While we do not think such an event is imminent, we also do not feel the market should ignore its possibility. Last week, Robert Zoellick, the president of the World Bank, warned the United States would be mistaken to take for granted the dollar’s place as the world’s predominant reserve currency. Deepening our worries is the notion that investors seem to have forgotten again the concept of risk and return. While the return portion of the equation is always nice, the risk part tends to become inconvenient at the worst times.
In the past months, cash flew out of money market funds and safe government bond instruments, and poured into riskier equity and high yield bond markets. Specifically, money funds held just under $3.4 trillion as of Oct. 5, down from a peak of $3.9 trillion in mid-January. In addition, high yield bonds (NYSEARCA:JNK) returned nearly 50% since the March low, and is just 10% below its pre-Lehman (OTC:LEHMQ) level. For the bond market, the Moody's Seasoned Baa Corporate Bond Yield dropped from 9.5% in October 2008 to the current 6.2%, comparable to the levels in early 2006 and is quite close to the historical lows of 5.8% level in the 2005 bubble period. On the equity side, the S&P500 ended September at 1057, implying sales growth of 5.7%, and EBITDA margins of 16% each year for 2010-2013, assuming a 10% drop in 2009 sales from 2008. Such levels do not necessarily imply a bubble, but combined with the current macro environment, make for a market that is not very investor friendly.
September’s economic news was, while not bullish was neither bearish. Early in September, a monthly compilation of 31 retailers' results by The International Council of Shopping Centers and Goldman Sachs showed sales in established stores fell 2.1% in August compared from a year ago, better than the 3.5 to 4% drop expected. The winners were mainly discounters, but declines were less than expected in the specialty apparel and department store sectors as well.
Later in the month, the Commerce Department reported that retail sales rose a seasonally adjusted 2.7% in August after falling 0.2% in July, the largest gain since January 2006 and easily beating analysts' expectations. Auto sales were up 10.6%, mainly as a result of the Cash for Clunkers program. Gas station sales increased 5.1%, as prices at the pump rose. Excluding those two categories, retail sales rose 0.6%, the most in six months. Consumer sentiment also improved. The Reuters/University of Michigan preliminary index of consumer sentiment increased to 70.2 in September from 65.7 in August, higher than the forecast 67.5. Separately, the Institute for Supply
Management said its services index rose to 48.4 in August, slightly above the 48.0 median forecast by economists, although still suggesting contraction. For the financials, S&P said the losses among the bank card trusts in its U.S. Credit Card Quality Index slipped to 9.8%, from a record high of 10.4% in June. However, S&P said the decline might reflect banks' moves to impose stricter lending standards, and a more cautious consumer. In addition, it expects losses to rise again in the next few months, and remain high for the next year or two, because of the persistent high employment rate and rising delinquency rates. For the month of September (August 31 to September 30, 2009), the returns are the following:
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