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May 2013 PCM Report
Volume 4, Issue 5
Copyright © 2013 Peak Capital Management, LLC
Where Did the Luster Go?
John Lennon famously sang about “strange days” in his 1984 hit song, “Nobody Told
Me”. We would echo those thoughts today, proclaiming strange days indeed. Is it time to
pronounce an official end to the gold bubble (if there was in fact a bubble). After
watching gold fall $243/ounce between Friday morning April 12 th and Monday
afternoon the 15th, the biggest drop since 1983, many commentators (and hopeful
Central Bankers) were ready to declare an end to the gold era. This month we look not
only at the tumultuous events surrounding gold but what is causing the markets to act so
strangely.
As holders of gold in the portfolios we manage, we were obviously concerned and faced
with the decision to sell or ride through the current volatility. We devoured as much
information as possible from around the world trying to determine if the rapid drop was
the beginning of an extended selloff or an overreaction by the market (and yes, was
there any conspiracy behind what occurred). We have come to the conclusion, at least
for now, that the drop was the result of a combination of factors, some clearly
manipulated, but the purpose for holding the yellow metal remains strong.
We have become closely acquainted with the conceptual difference between the “price of gold” and the “gold price”. If you
are scratching your head that is understandable but try to stay with us. The “gold price” is what is quoted daily based on
futures contracts or what we call paper gold. The “price of gold,” on the other hand, is what you pay to buy physical gold (coins
and bars). The gold price has fallen nearly 30% from its high including the nearly 9% shellacking over two days in April.
Surprisingly, while paper gold was crashing, physical gold was not. One gold dealer we have worked with said a 1-ounce
Canadian Mapleleaf never sold below $1,630, a 21% premium to the price of paper gold.
It did not take long to find out that from Beijing to Bangkok, Sydney to Toronto, and right here in the U.S., people were lining up
to buy the barbaric relic. The Hang Seng bullion counter, one of the largest and most active in the world, reported they sold
more physical gold in 24 hours than they had sold in the previous 3 months. In Perth Australia people created a near stampede
rushing to buy gold. Gold dealers from Shanghai to Mumbai decided to close rather than face fierce crowds trying to buy gold
bars. One discreet buyer in Hong Kong casually purchased $1,000,000 in bullion bars paying with U.S. cash before strolling
out. Even some Central Banks didn’t seem fazed as the head of the Bank of Korea stated their intention to buy more gold was
part of their long-term strategy to diversify currency reserves.
Paper gold’s precipitous drop does not appear to represent a fall in demand,
so what happened? We may never know for sure but we have identified
many questionable events. First, the Comex is a warehouse and depository
for physical gold and mysteriously went offline causing panic among some
gold futures traders. It has been well documented that physical gold has been
leaving at an alarming rate from Comex so going “offline” was very
suspicious. Equally intriguing was a report issued by Goldman Sachs just days
before the collapse. Analyst Jeffrey Currie boldly recommended clients
“short” gold (basically make a bet that gold would fall). That seems
marginally insane given global central bank policies. An instant celebrity,
some referred to Currie as a human Magic 8 Ball. However, when news
surfaced that Fed meeting minutes were prematurely leaked to a handful of
banks, including Goldman, something began to smell of stale fish.
The Fed and other Central Banks would love to see the value of gold plummet to take the focus off their methodic destruction of
paper or fiat money. The “financial intelligentsia” around the world despises gold. Charlie Munger, vice-chairman of Warren
Buffet’s Berkshire Hathaway, was recently quoted: “If you’re capable of understanding the world, you have a moral obligation to
become rational. I don’t see how you become rational hoarding gold. Even if it works, you’re a jerk.”
To Charlie, Central Bankers, Wall Street analysts, and media commentators we can only say beware; not everyone is as
gullible and easily manipulated as you think.
Fundamental
The “strange days” are not limited to the trading in gold but extend to the broad market and economy as well. April
saw the S&P 500 hit a new all-time high, exceeding the 2007 peak of 1,565, signaling the market’s confidence in the
strength of the economy and corporate earnings. At the same time, we witnessed bond yields fall back in the range
they traded during the economic slowdown in the summer of 2012, finishing April around 1.65% on the 10-year U.S.
Treasury. Falling bond yields signal bond traders believe the economy is slowing and the threat of recession is
increasing. Strange days indeed.
The year began with generally positive trends in place for most broad economic measures creating hope by many
economists that the Fed policy of quantitative easing (printing lots of money) was working. Even though the employment
picture remained weak, there were signs the economy might be nearing the place where growth could be sustained
without massive levels of government stimulus. By most measures, the trends have turned lower with both March and
April showing high levels of weakness. From the Purchasing Managers Index (PMI) to the Institute for Supply
Management (ISM) these key measures of economic strength are trending lower. Perhaps most damaging, the growth
of private sector payroll fell sharply in the last month indicating only 95,000 jobs were created compared to more
than 254,000 the previous month.
The economic weakness is another sign the Fed is shooting blanks and has no real ammunition to generate aggregate
demand in the economy that leads to job creation and corporate revenue growth. It has been puzzling to many how
the equity markets can be reaching new highs in light of deteriorating fundamentals and question how long the current
rally in stocks can last. The S&P 500 is higher by nearly 10% in 2013 but the market seems to be narrowing
significantly. For example, most of the gains year-to-date can be found in Healthcare (up 21%), Consumer Staples (up
19%), and Utilities and Telecom (up 18%). Traders have favored large dividend paying companies driving their prices
higher. We believe we are near the top for many of these leaders. Kimberly Clark is a good example. The company is
trading at 19 times their trailing 12 month earnings and are only forecasted to increase their earnings by 3% in 2013.
KMB is a great franchise but we question whether their Price/Earnings to Growth ratio (PEG) over 6 can be sustained.
Consensus estimates Operating Earnings on the S&P 500 stand at $110
for 2013 after coming in at $100 for 2012. We believe consensus is
too high and that actuals for 2013 are more likely to be between $98
and $100. We see stocks priced to perfection so any disappointment is
likely to lead to a downward correction that could be very steep. The
chart on the left shows the market is not only expecting an acceleration
of earnings this year but an even greater growth rate for 2014. While
this may explain why the market is rallying, the market is always
forward looking, making the rick of correction much higher We have
difficulty believing double-digit earnings growth is possible in the
growth-constrained environment of the macro economy.
An insightful study by Smithers & Co analyzed corporate profit margins over the last 60 years. They conclude profit
margins are currently at 36% of output, the highest level since World War II. There are only two ways in which
companies can increase their earnings: (1) generating higher margins and (2) increase sales or revenues. Looking at
the data from Smithers along with dramatic economic slowdowns in every region tracked by the Federal Reserve, we
see 2013 earnings flat or slightly lower than 2012.
The one data point that does support current valuations is the market’s
book value. Corporate America has done “such” a good job reducing
debt and stockpiling liquid assets that book value continues to trade at
the bottom end of its historical range (chart on right). We tend to view
the low book value as more of a buffer against the severity of the
next market correction more than compelling justification for further
market gains.
The father of value investing, Benjamin Graham, tells us the market resembles a voting machine in the short-term,
revealing who is popular, but a weighing machine in the long run, revealing the substance of the economy. Adherents to
this philosophy are understandably remaining cautious.
Technical
It is impossible to ignore the technical significance of the S&P 500 breaking above the 2007 high of 1565 and its ability
to close the month above resistance. Portfolio values are not driven by what is rational or can be understood but only on
the price of securities. The strength of the market is bringing cash that has been on the sidelines as evidenced by the
increase in bullishness identified in investor sentiment surveys. Technical analysis is an important tool in our portfolio
management process but is always balanced against fundamentals as we are followers of Benjamin Graham’s investment
principles.
Historically, we have viewed markets as “undervalued” or “overvalued” based on standard deviation, using this as a
guide in our risk management models. Establishing fair value on the basis of average valuations over the last 60 years we
move out +1 and -1 standard deviations to put outer bands on where we expect the market to trade. One standard
deviation above fair value today on the S&P 500 is 1783. Conversely, one standard deviation below fair value is 932.
Using this as a guide we are approximately 11% below a dramatically overvalued market and 41% above a similarly
undervalued market. Put another way, there is nearly four times the downside risk today than upside potential using
mathematical standard deviation.
Ned Davis Research tracks investor sentiment polls and compares these results against market performance to forecast
market returns at differing levels of optimism and pessimism (see chart below). The market recently moved into a level of
extreme optimism that has historically occurred less than 15% of the time. NDR indicates there is a statistical probability
the market will be lower over the coming 12 months.
Richard Russell is a legend in our eyes and has a well-deserved seat among the true market sages of our time. He has
published the Dow Theory Letters for 55 years and has provided advice that has been right far more than it has been
wrong. His technically-slanted model focuses on the Dow Industrial and Transportation indices using volume to confirm
trends. He recently wrote:
“After weeks of flirting with a new high in the Industrial Average, the Dow finally confirmed the previous
record high of the Transportation Average. With the Industrials and the Transports both in record high
territory, I think being in the market is justified under the Dow Theory. My PTI (Proprietary Trend Index) sees
the market heading higher. My associate, Jon Strebler, sees the market heading higher. It’s clear that come
hell or high water, Ben Bernanke will do everything in his power to send this market higher.”
There is one very concerning technical development that was brought to our
attention this month by the venerable James Stack of Investech. Using Ned
Davis Research, Investech published the chart on the right showing margin debt
in the equity market over the last 50 years. When margin debt spikes it does
not bode well for the market and he rightly identifies the market could be at
risk if margin debt continues its upward trajectory.
Lennon sang “Everybody’s runnin’ and no one makes a move”. The market feels
a bit like a rubber band in that we’re getting more stretched with each
advance. When the technical strength leaves this market we expect to see a
mass exodus of investors runnin’ for the exits.
Fixed Income
They are “strange days” when domestic stocks and U.S. Treasuries both hit high water marks in the same month.
Traditionally, the drivers of gains in stocks and bonds are very different making it unusual for both to strengthen at the
same time. When the yield on the 10-year Treasury bond broke through strong resistance at the 1.84% level, it continued
moving lower to the 1.65% level near the end of April. We discuss some of the reasons why this strange and unique
pattern occurred and where we think we go from here.
The most obvious explanation of the rally in bonds was the renewed crisis in Europe with Cypress nearly being booted
from the Euro. Treasuries are still considered the primary “safe haven” in the world and will see assets flood in when
uncertainty spikes. While the Cypriot economy is extremely small, the threat to confiscate portions of bank accounts above
a certain threshold was a wake up call for the wealthy in Europe. The most rational response for anyone with over
$100,000 in any European bank would be to move the money to another jurisdiction. U.S. government bonds were the
obvious recipients of many such transfers.
Bond prices are predominately influenced by two factors: (1) future inflation expectations driven by the pace of economic
growth and (2) the balance between supply and demand for bonds. If the supply of bonds exceeds the demand, rates
are forced higher until equilibrium is found. In the same way, if demand for bonds exceeds the supply, prices rise (yields
fall) until supply is consumed. Our research indicates that new issuance (supply) of bonds in 2013 will slightly exceed $1.1
trillion. When we consider that the Fed is on pace to complete nearly $1
trillion in bond purchases that leaves a meager $100 billion of supply
for mutual funds, ETF’s, banks, and foreign buyers. There is no reason to
think there will be upward pressure on yields from a lack of demand,
leaving our focus squarely on inflation expectations. Since the Fed’s
actions scream they are concerned with deflation, we expect yields to
remain in historically low ranges.
The Japanese are making policy moves that are catching our attention in
the global fixed income markets. Finance Minister Taro Aso is following
through on the pledge to double the size of the Bank of Japan’s balance
sheet in their attempt to drive the Yen lower to help raise competitiveness. As you can see from the chart on the left, the
yield on the 40-year Japanese Government Bonds (JGB) appears to have fallen off a cliff. Given the challenges being
experienced in Europe and risk of sovereign default, it seems likely
U.S. Treasuries will be the beneficiary. A similar move to lower
yields in the 30-year U.S. Government bond would generate
substantial capital gains.
The economic weakness identified in the Fundamental section of this
report will also serve to keep downward pressure on bond yields.
The level of financial repression around the world is higher than at
any time in history. Financial repression occurs when governments
implement policies that aid their ability to service debt while
harming the private sector. The suppression of interest rates below inflation levels punishes savers and people living on
fixed incomes while benefitting speculation and risk taking. We expect such repression to continue for an indefinite period
of time.
We have made significant changes to our fixed income models in light of recent economic weakness. New to our allocation
are Dim Sum bonds (bonds denominated in the Chinese Yuan and issued in Hong Kong). In the global race to currency
debasement we believe the Chinese see an opportunity to raise the stature and acceptance of their currency in global
markets. Yields are attractive, durations are mostly less than 5 years, and credit quality is strong. We also continue to
favor senior secured bank debt as the sector of the bond market that is least overvalued at current levels. If our
assumptions for economic growth (or lack thereof) prove true, the bond market may represent the least “strange” of all
asset classes.
Gold & Commodities
We clearly asserted our views on gold in the Introduction of this report. In many respects we view gold as “Central Bank
insurance” as governments and policy makers around the world are involved in a grand experiment that they have no
idea what the outcomes are going to be. We think the attempts to solve problems through currency manipulation, interest
rate suppression, and massive deficit spending will cause imbalances that may take decades to unwind.
We feel safe in stating the Fed would like to make the insurance referenced above as expensive as possible for holders
of gold. One analyst called what happened to gold in April a 9 standard deviation event. To put this in perspective,
scientists have said that an event that causes the end of the world would be an 11 standard deviation event. We believe
the Fed desires to mask the impact of their policies and driving gold prices lower achieves that if people no longer look
at the yellow metal as a currency alternative.
The correlation between the price of gold since 1999 and the Federal Reserve balance sheet is nothing short of shocking.
The correlation of coefficient (how much of the movement of gold can be attributed to changes in the Fed balance sheet)
between gold and the Fed’s balance sheet is .96. In other words, 96% of gold’s rise over the last 14 years is attributable
to Fed actions. We wonder how Mr. Munger (see Introduction), Mr. Buffett, and the numerous other gold critics would
explain the chart below.
While the manipulated selloff in “paper gold” was overdone, there are legitimate headwinds to gold and other
commodities. First, global deleveraging is going to continue for probably another decade and is deflationary by
definition. Gold is sensitive to inflation and our outlook does not include any serious rise in inflation for at least the next 3
years. Commodities around the world are priced in U.S. dollars and are thus sensitive to changes in the value of the dollar
compared to other major trading currencies like the Yen and Euro.
As the chart on the right indicates, we are in a clear upward trend
in the U.S. dollar that we expect to continue for the foreseeable
future. We expect the dollar index to move up to resistance at the
90 level before the end of the year. Longer term, if our
expectations for the Yen/Dollar (125) and Dollar/Euro (1.15)
materialize the dollar index will rise near 100 by the end of 2014.
Our view that gold holds a legitimate place in portfolios is
unchanged by the events of the last 30 days even if it negatively
impacts values in the short term. For goldbugs, the events of April
were more painful than strange but we feel they are likely to be
validated in the long run. The curious trading in gold paper forced
us to seriously defend our gold position through analysis and
research and we are more educated as a result.
Policy
Our in depth global research on the events impacting the plunge in the price of paper gold revealed just how desperate
many policymakers are in today’s environment. What Central Bankers thought would amount to a “shock and awe” reply
to the credit crisis and economic slowdown, reversing the down trend and stimulating sustainable growth, now looks more
like attempts to plug holes in a dam using toothpicks. One analyst we follow described Bernanke’s attempts to jumpstart
growth in the economy and add jobs as “shooting blanks.”
The biggest policy mistake we have witnessed in our lifetimes is unfolding in Europe with the confiscation of bank deposits.
Bank deposits serve as the lifeblood of capitalism and the banking sector. When politicians and policy-makers arbitrarily
decide that people or companies with large bank deposits should bear the cost of fiscal mismanagement it sends a signal
that money in banks is not safe. As we have quoted previously, Mervyn King, Chairman of the Bank of England, “It is not
rational to start a bank run but rational to participate once it has started.” Bank deposits are leaving Europe by the
billions and could ultimately end up being what precipitates the collapse of the Euro.
Societe Generale recently published a shocking report that documents how big the sovereign debt issue has become and
what the future holds if major changes are not made (see chart below). They brilliantly distinguish between “Official
government liabilities” and “Total government liabilities.” What is reported in the financial media represents the amount
of issued debt for each country or the amount of money they have formally borrowed. What this figure does include is
the promises that have been made by each country, often referred to as off-balance sheet debt.
As you can see, the official government debt is only a small fraction of the actual obligations that each country is currently
responsible for. Sadly, only France, with obligations of 549% of GDP (Gross Domestic Product) is higher than the U.S. with
541% of GDP in future commitments. Harvard professors Reinhart and Rogoff published research that indicates that
sovereign nations are unable to recover if their debt exceeds 90% of GDP as permanent damage is done to the ability
to achieve economic growth. One can only imagine how dire the outlook if more than 500% of GDP in debt had to be
accounted for.
Central Bank policy at home and abroad appears reminiscent of teenagers and homework. Most teenagers prefer to put
off the pain of studying or writing papers preferring to spend time with friends, computer games, or generally being
lazy. Only when the pain of failure is so great do they find the motivation to study and it often turns out to be too late to
excel. We fear that policy-makers similarly have put off implementing necessary reforms that would inflict pain in the
short-term and we have already entered a period when only bad options remain. The opportunity for an A (reversing
imbalances and reducing debt levels) is long past and the question now is whether we can muster a C or if an F is
inevitable.
We realize it is easy to find fault with policy-makers as the economic problems the world faces are both complex and
diverse. There are no easy or obvious answers and unknown consequences abound with any strategy. The financial
markets hate uncertainty and that is what much of the economic policy today is creating. Our risk models tilt more towards
capital preservation because we anticipate the true cost of ill-conceived policy has yet to be realized.
Outlook
This report began with an analysis of the curious events surrounding the sudden and steep decline of the paper gold and
the strange reaction of the markets. When the gold price fell people around the world saw an opportunity and rushed to
take advantage. Whether that decision was prescient or hasty remains to be seen but the principle of buying something
of value when the price is being discounted is timeless.
Our approach to the markets is to draw upon our extensive research and experience and determine what markets, or
asset classes, are trading with exceptional value. If we were strictly technical traders we would allow patterns and charts
to dictate investment allocations. History has shown that strategy can work for a period of time but eventually even the
best trading systems fall prey to their own success as increasing numbers of people try to implement them. Our focus is to
identity value then overlay a tactical implementation strategy.
This causes us to be more capital preservation minded than some of our peers. This means we will occasionally take less
risk and forego some gains in the market. The benefit is that at market inflection points, when volatility spikes and the
trend reverses, we are prepared to take advantage of extreme value when the opportunity presents itself. Our portfolios
have been more defensive even as equities have hit new highs. Our analysis indicates valuations are stretched and risk
today is pronounced.
It is unfortunate when some of our perceived safe havens, like gold, underperform in the short-term but we are confident
that if we stay the course and remain true to our methodology we will be rewarded over a 2-3 year time horizon. When
others are selling after experiencing steep losses we will be buying at levels deeply discounted from today’s prices.
Some of the analysts we follow accurately identified heightened risk levels in 2007 before the Great Recession
devastated the global economy and brought about a financial crisis. We see many similarities in 2013 from what was
present in 2007 (see chart on right). As you can see almost every measure of economic health is weaker today than it was
in 2007. The markets seem a bit like a tinder box in search of a spark. We have no way of knowing what that spark may
be but with speculation on the increase and optimism hitting excessively high levels we are moving to increasingly
defensive positions.
Benjamin Graham wisely stated that you can manage risk but cannot manage returns. We see an environment where risk
management is more critical than it’s been over the last 5 years. Our disciplined approach is designed to avoid being
swayed by market euphoria or panic and deliver consistent returns over entire market cycles. We realize that patience is
sometimes required but have learned that prudence is often more important than valor when approaching the markets.
Gold has already begun to rebound from its lows and the bond market is telling us to be prepared for a severe
slowdown in the economy. Our limited equity exposure continues to perform in line with the broad market with our
emphasis on healthcare and energy. The strong U.S. dollar will hurt export-dependent companies whose margins are
already being compressed, yet the markets trade near all-time highs. If only Lennon’s lyrics were possible: “Everyone’s a
winner and nothing left to lose.” Strange days indeed.
All of us at Peak Capital Management are grateful for the trust and confidence you place in us each day and vow to do
everything possible to help navigate the challenging years ahead.
Ross Wagle
Financial Analyst
Geoff Eliason
Chief Operations
Officer
Brian Lockhart
Chief Investment
Officer
15455 Gleneagle Dr Suite 100
Colorado Springs, CO 80921
Phone: 719.203.6926
Fax: 719.465.1386
Email: [email protected]
Website: www.peakcapitalmgt.net
Sherri Sturgeon
Relationship Manager