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RECESSION? NO, IT IS A D-PROCESS, AND IT WILL BE LONG
Ray Dalio sees a long and painful depression.
Nobody was better prepared for the global market crash than clients of Ray Dalio’s Bridgewater Associates and subscribers to its Daily Observations. Dalio, the chief investment officer and all-around guiding light of the global money-management company he founded more than 30 years ago, began sounding alarms in Barron’s in the spring of 2007 about the dangers of excessive financial leverage. He counts among his clients world governments and central banks, as well as pension funds and endowments.
No wonder. The Westport, Connecticut-based firm, whose analyses of world markets focus on credit and currencies, has produced long-term annual returns, net of fees, averaging 15%. In the turmoil of 2008, Bridgewater’s Pure Alpha 1 fund gained 8.7% net of fees and Pure Alpha 2 delivered 9.4%.
Here is what is on his mind now.
Barron’s: I cannot think of anyone who was earlier in describing the deleveraging and deflationary process that has been happening around the world. [Note: We can think of quite a few, not that we would expect Barron’s to have been taking any great note of them. In any case, Dalio was early enough, and his results last year speak for themselves.]
Dalio: Let us call it a “D-process,” which is different than a recession, and the only reason that people really do not understand this process is because it happens rarely. Everybody should, at this point, try to understand the depression process by reading about the Great Depression or the Latin American debt crisis or the Japanese experience so that it becomes part of their frame of reference. Most people did not live through any of those experiences, and what they have gotten used to is the recession dynamic, and so they are quick to presume the recession dynamic. It is very clear to me that we are in a D-process.
Why are you hesitant to emphasize either the words depression or deflation? Why call it a D-process?
Both of those words have connotations associated with them that can confuse the fact that it is a process that people should try to understand.
You can describe a recession as an economic retraction which occurs when the Federal Reserve tightens monetary policy normally to fight inflation. The cycle continues until the economy weakens enough to bring down the inflation rate, at which time the Federal Reserve eases monetary policy and produces an expansion. We can make it more complicated, but that is a basic simple description of what recessions are and what we have experienced through the post-World War II period. What you also need is a comparable understanding of what a D-process is and why it is different.
You have made the point that only by understanding the process can you combat the problem. Are you confident that we are doing what is essential to combat deflation and a depression?
The D-process is a disease of sorts that is going to run its course.
When I first started seeing the D-process and describing it, it was before it actually started to play out this way. But now you can ask yourself, OK, when was the last time bank stocks went down so much? When was the last time the balance sheet of the Federal Reserve, or any central bank, exploded like it has? When was the last time interest rates went to zero, essentially, making monetary policy as we know it ineffective? When was the last time we had deflation?
The answers to those questions all point to times other than the U.S. post-World War II experience. This was the dynamic that occurred in Japan in the 1990s, that occurred in Latin America in the 1980s, and that occurred in the Great Depression in the 1930s.
Basically what happens is that after a period of time, economies go through a long-term debt cycle – a dynamic that is self-reinforcing, in which people finance their spending by borrowing and debts rise relative to incomes and, more accurately, debt-service payments rise relative to incomes. At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce are not adequate to service the debt. The incomes are not adequate to service the debt. Then begins the reversal process, and that becomes self-reinforcing, too. In the simplest sense, the country reaches the point when it needs a debt restructuring. General Motors is a metaphor for the United States.
As goes GM, so goes the nation?
The process of bankruptcy or restructuring is necessary to its viability. One way or another, General Motors has to be restructured so that it is a self-sustaining, economically viable entity that people want to lend to again.
This has happened in Latin America regularly. Emerging countries default, and then restructure. It is an essential process to get them economically healthy.
We will go through a giant debt-restructuring, because we either have to bring debt-service payments down so they are low relative to incomes – the cash flows that are being produced to service them – or we are going to have to raise incomes by printing a lot of money.
It is not complicated. It is the same as all bankruptcies, but when it happens pervasively to a country, and the country has a lot of foreign debt denominated in its own currency, it is preferable to print money and devalue.
Is the process of restructuring not under way in households and at corporations?
They are cutting costs to service the debt. But they have not yet done much restructuring. Last year, 2008, was the year of price declines; 2009 and 2010 will be the years of bankruptcies and restructurings. Loans will be written down and assets will be sold. It will be a very difficult time. It is going to surprise a lot of people because many people figure it is bad but still expect, as in all past post-World War II periods, we will come out of it OK. A lot of difficult questions will be asked of policy makers. The government decision-making mechanism is going to be tested, because different people will have different points of view about what should be done.
What are you suggesting?
An example is the Federal Reserve, which has always been an autonomous institution with the freedom to act as it sees fit. Rep. Barney Frank [a Massachusetts Democrat and chairman of the House Financial Services Committee] is talking about examining the authority of the Federal Reserve, and that raises the specter of the government and Congress trying to run the Federal Reserve. Everybody will be second-guessing everybody else.
So where do things stand in the process of restructuring?
What the Federal Reserve has done and what the Treasury has done, by and large, is to take an existing debt and say they will own it or lend against it. But they have not said they are going to write down the debt and cut debt payments each month. There has been little in the way of debt relief yet. Very, very few actual mortgages have been restructured. Very little corporate debt has been restructured.
The Federal Reserve, in particular, has done a number of successful things. The Federal Reserve went out and bought or lent against a lot of the debt. That has had the effect of reducing the risk of that debt defaulting, so that is good in a sense. And because the risk of default has gone down, it has forced the interest rate on the debt to go down, and that is good, too.
However, the reason it has not actually produced increased credit activity is because the debtors are still too indebted and not able to properly service the debt. Only when those debts are actually written down will we get to the point where we will have credit growth. There is a mortgage debt piece that will need to be restructured. There is a giant financial-sector piece – banks and investment banks and whatever is left of the financial sector – that will need to be restructured. There is a corporate piece that will need to be restructured, and then there is a commercial-real-estate piece that will need to be restructured.
Is a restructuring of the banks a starting point?
If you think that restructuring the banks is going to get lending going again and you do not restructure the other pieces – the mortgage piece, the corporate piece, the real-estate piece – you are wrong, because they need financially sound entities to lend to, and that will not happen until there are restructurings.
On the issue of the banks, ultimately we need banks because to produce credit we have to have banks. A lot of the banks are not going to have money, and yet we cannot just let them go to nothing. We have got to do something.
But the future of banking is going to be very, very different. The regulators have to decide how banks will operate. That means they will have to nationalize some in some form, but they are going to also have to decide who they protect: the bondholders or the depositors?
Nationalization is the most likely outcome?
There will be substantial nationalization of banks. It is going on now and it will continue. But the same question will be asked even after nationalization: What will happen to the pile of bad stuff?
Let us say we are going to end up with the good-bank/bad-bank concept. The government is going to put a lot of money in – say $100 billion – and going to get all the garbage at a leverage of, let us say, 10 to 1. They will have a trillion dollars, but a trillion dollars’ worth of garbage. They still are not marking it down. Does this give you comfort?
Then we have the remaining banks, many of which will be broke. The government will have to recapitalize them. The government will try to seek private money to go in with them, but I do not think they are going to come up with a lot of private money, not nearly the amount needed.
To the extent we are going to have nationalized banks, we will still have the question of how those banks behave. Does Congress say what they should do? Does Congress demand they lend to bad borrowers? There is a reason they are not lending. So whose money is it, and who is protecting that money?
The biggest issue is that if you look at the borrowers, you do not want to lend to them. The basic problem is that the borrowers had too much debt when their incomes were higher and their asset values were higher. Now net worths have gone down.
Let me give you an example. Roughly speaking, most of commercial real estate and a good deal of private equity was bought on leverage of 3-to-1. Most of it is down by more than 1/3, so therefore they have negative net worth. Most of them could not service their debt when the cash flows were up, and now the cash flows are a lot lower. If you should not have lent to them before, how can you possibly lend to them now?
I guess I am thinking of the examples of people and businesses with solid credit records who cannot get banks to lend to them.
Those examples exist, but they are not, by and large, the big picture. There are too many nonviable entities. Big pieces of the economy have to become somehow more viable. This is not primarily about a lack of liquidity. There are certainly elements of that, but this is basically a structural issue. The 1930s were very similar to this.
By the way, in the bear market from 1929 to the bottom, stocks declined 89%, with six rallies of returns of more than 20% – and most of them produced renewed optimism. But what happened was that the economy continued to weaken with the debt problem. The Hoover administration had the equivalent of today’s TARP [Troubled Asset Relief Program] in the Reconstruction Finance Corp. The stimulus program and tax cuts created more spending, and the budget deficit increased.
At the same time, countries around the world encountered a similar kind of thing. England went through then exactly what it is going through now. Just as now, countries could not get dollars because of the slowdown in exports, and there was a dollar shortage, as there is now. Efforts were directed at rekindling lending. But they did not rekindle lending. Eventually there were a lot of bankruptcies, which extinguished debt.
In the U.S., a Democratic administration replaced a Republican one and there was a major devaluation and reflation that marked the bottom of the Depression in March 1933.
Where is the U.S. and the rest of the world going to keep getting money to pay for these stimulus packages?
The Federal Reserve is going to have to print money. The deficits will be greater than the savings. So you will see the Federal Reserve buy long-term Treasury bonds, as it did in the Great Depression. We are in a position where that will eventually create a problem for currencies and drive assets to gold.
Are you a fan of gold?
Have you always been?
No. Gold is horrible sometimes and great other times. But like any other asset class, everybody always should have a piece of it in their portfolio.
What about bonds? The conventional wisdom has it that bonds are the most overbought and most dangerous asset class right now.
Everything is timing. You print a lot of money, and then you have currency devaluation. The currency devaluation happens before bonds fall. Not much in the way of inflation is produced, because what you are doing actually is negating deflation. So, the first wave of currency depreciation will be very much like England in 1992, with its currency realignment, or the United States during the Great Depression, when they printed money and devalued the dollar a lot. Gold went up a whole lot and the bond market had a hiccup, and then long-term rates continued to decline because people still needed safety and liquidity. While the dollar is bad, it does not mean necessarily that the bond market is bad.
I can easily imagine at some point I am going to hate bonds and want to be short bonds, but, for now, a portfolio that is a mixture of Treasury bonds and gold is going to be a very good portfolio, because I imagine gold could go up a whole lot and Treasury bonds will not go down a whole lot, at first.
Ideally, creditor countries that do not have dollar-debt problems are the place you want to be, like Japan. The Japanese economy will do horribly, too, but they do not have the problems that we have – and they have surpluses. They can pull in their assets from abroad, which will support their currency, because they will want to become defensive. Other currencies will decline in relationship to the yen and in relationship to gold.
Now we have the delicate China question. That is a complicated, touchy question.
The reasons for China to hold dollar-denominated assets no longer exist, for the most part. However, the desire to have a weaker currency is everybody’s desire in terms of stimulus. China recognizes that the exchange-rate peg is not as important as it was before, because the idea was to make its goods competitive in the world. Ultimately, they are going to have to go to a domestic-based economy. But they own too much in the way of dollar-denominated assets to get out, and it is not clear exactly where they would go if they did get out. But they do not have to buy more. They are not going to continue to want to double down.
From the U.S. point of view, we want a devaluation. A devaluation gets your pricing in line. When there is a deflationary environment, you want your currency to go down. When you have a lot of foreign debt denominated in your currency, you want to create relief by having your currency go down. All major currency devaluations have triggered stock-market rallies throughout the world. One of the best ways to trigger a stock-market rally is to devalue your currency.
But there is a basic structural problem with China. Its per capita income is less than 10% of ours. We have to get our prices in line, and we are not going to do it by cutting our incomes to a level of Chinese incomes.
And they are not going to do it by having their per capita incomes coming in line with our per capita incomes. But they have to come closer together. The Chinese currency and assets are too cheap in dollar terms, so a devaluation of the dollar in relation to China’s currency is likely, and will be an important step to our reflation and will make investments in China attractive.
You mentioned, too, that inflation is not as big a worry for you as it is for some. Could you elaborate?
A wave of currency devaluations and strong gold will serve to negate deflationary pressures, bringing inflation to a low, positive number rather than producing unacceptably high inflation – and that will last for as far as I can see out, roughly about two years.
Given this outlook, what is your view on stocks?
Buying equities and taking on those risks in late 2009, or more likely 2010, will be a great move because equities will be much cheaper than now. It is going to be a buying opportunity of the century.
ANOTHER YEAR OF SHOCK AND AWE
Doug Casey looks around and, well, proclaims what he has always proclaimed. It is just that this time he is reporting rather than predicting, more or less. He thinks gold stocks are the cheapest asset class around. Relative to the price of gold, they are at their cheapest level in history.
The $1.1 Trillion Budget Deficit
My reaction is that the people in the government are totally out of control. A poker player would say the government is “on tilt,” placing wild, desperate bets in the hope of getting rescued by good luck.
The things they are doing are not only unproductive, they are the exact opposite of what should be done. The country got into this mess by living beyond its means for more than a generation. That is the message from the debt that is burdening so many individuals. Debt is proof that you are living above your means. The solution is for people to significantly reduce their standard of living for a while and start building capital. That is what saving is about, producing more than you consume. The government creating funny money – money out of nothing – does not fix anything. All it does is prolong the problem and make it worse by destroying the currency.
Over several generations, huge distortions and misallocations of capital have been cranked into the economy, inviting levels of consumption that are unsustainable. In fact, Americans refer to themselves as consumers. That is degrading and ridiculous. You should be first and foremost a producer, and a consumer only as a consequence.
In any event, the government is going to destroy the currency, which will be a mega-disaster. And they are making the depression worse by holding interest rates at artificially low levels, which discourages savings – the exact opposite of what is needed. They are trying to prop up a bankrupt system. And, at this point, it is not just economically bankrupt, but morally and intellectually bankrupt. What they should be doing is recognize that they are bankrupt and then start rebuilding. But they are not, so it is going to be a disaster.
The U.S. Economy in 2009
My patented answer, when asked what it will be like, is that this is going to be so bad, it will be worse than even I think it is going to be. I think all the surprises are going to be on the downside. Do not expect friendly aliens to land on the roof of the White House and present the government with a magic solution. We are still very early in this thing. It is not going to just blow away like other post-war recessions. One reason that it is going to get worse is that the biggest shoe has yet to drop ... interest rates are now at all-time lows, and the bond market is much, much bigger than the stock market. What is inevitable is much higher interest rates. And when they go up, that will be the final nail in the coffins of the stock and real estate markets, and it will wipe out a huge amount of capital in the bond market. And higher interest rates will bring on more bankruptcies.
The bankruptcies will be painful, but a good thing, incidentally. We cannot hope to see the bottom until interest rates go high enough to encourage people to save. The way you become wealthy is by producing more than you consume, not consuming more than you produce.
Deflation vs. Inflation
First of all, deflation is a good thing. Its bad reputation is just one of the serious misunderstandings that most people have. In deflation, your money becomes worth more every year. It is a good thing because it encourages people to save, it encourages thrift. I am all for deflation. The current episode of necessary and beneficial deflation will, however, be cut short because Bernanke, as he is so eloquently pointed out, has a printing press and will use it to create as many dollars as needed.
So at this point I would start preparing for inflation, and I would not worry too much about deflation. The only question is the timing.
It is too early to buy real estate right now, although a fixed-rate mortgage could go a long way toward offsetting bad timing. It would let you make your money on the depreciation of the mortgage, as opposed to the appreciation of the asset. Still, I would not touch housing with a 10-foot pole – there has been immense overbuilding, immense inventory. And people forget: A house is not an investment, it is a consumer good. It is like a toothbrush, suit of clothes, or a car; it just lasts a little bit longer. An investment – say, a factory – can create new wealth. Houses are strictly expense items. Forget about buying the things for the unpaid mortgage. Before this is over, you will buy them for back taxes. But then you will have to figure out how to pay the utilities and maintenance. The housing bear market has a long way to run.
The U.S. Dollar and the Day of Reckoning
It is very hard to predict the timing on these things. The financial markets and the economy itself are going up and down like an elevator with a lunatic at the controls. My feeling is that the fate of the dollar is sealed. People forget that there are 6 or 8 trillion dollars – who knows how many – outside of the United States, and they are hot potatoes. Foreigners are going to recognize that the dollar is an unbacked smiley-face token of a bankrupt government. My advice is to get out of dollars. In fact, take advantage of the ultra-low interest rates; borrow as many dollars as you can long-term and at a fixed rate and put the money into something tangible, because the dollar is going to reach its intrinsic value.
This is not a recession. It is a depression. A depression is a period when most people’s standard of living falls significantly. It can also be defined as a time when distortions and misallocations of capital are liquidated, as well as a time when the business cycle climaxes. We do not have time here, unfortunately, to explore all that in detail. But this is the real thing. And it is going to drag on much longer than most people think. It will be called the Greater Depression, and it is likely the most serious thing to happen to the country since its founding. And not just from an economic point of view, but political, sociological, and military.
For a number of reasons, wars usually occur in tough economic times. Governments always like to find foreigners to blame for their problems, and that includes other countries blaming the U.S. In the end, I would not be surprised to see violence, tax revolt, or even parts of the country trying to secede. I do not think I can adequately emphasize how serious this thing is likely to get. Nothing is certain, but it seems to me the odds are very, very high for an absolutely world-class disaster.
Gold’s Performance in 2008
The big surprise to me is how low gold is right now. It is well known that even if we use the government’s statistics, gold would have to reach $2,500 an ounce to match its 1980 high. I do not necessarily buy the theories that the government and some bullion banks are suppressing the price of gold. Of course, with everything else going on, the last thing the powers-that-be want is a stampede into gold. That would be the equivalent of shooting a gun in a crowded theatre. It could set off a real panic. But at the same time, I do not see how they can effectively suppress the price. Either way, the good news is that gold is about the cheapest thing out there. Remember, it is the only financial asset that is not simultaneously someone else’s liability. So I would take advantage of today’s price and buy more gold. I know I am doing just that.
Gold will remain volatile but trend upward. I don’t pay attention to daily fluctuations, which can be caused by any number of trivial things. Gold is going to the moon in the next couple of years.
Last year, it seemed to me that we were still climbing the Wall of Worry and that the next stage would be the Mania. But what I failed to read was the public’s indirect involvement through the $2 trillion in hedge funds. On top of that, while the prices of gold stocks were not that high, the number of shares out and the number of companies were increasing dramatically. Finally, the costs of mining and exploration rose immensely, which limited their profitability.
The good news is that relative to the price of gold, gold stocks are at their cheapest level in history. I still have my gold stocks and the fact is, I am buying more. I am not selling, because I think we are starting another bull market. And this one is going to be much steeper and much quicker than the last one. I am not a perma-bull on any asset class, but in this case I am forced to go into the gold stocks. They are the cheapest asset class out there, and the one with the highest potential.
FLYING HIGH, CAUTIOUSLY
Sometimes, money not lost counts more than money earned.
The hedge fund industry’s reputation has taken a major hit thanks to its overall mediocre performance last year – far short of what was expected given the high management fees. Some funds, however, more than earned their keep. The Argonaut Aggressive Global Partnership fund was up 12.3% last year while the S&P 500 was falling 37%. Putting this in perspective, an investment with Argonaut would have ended 2008 worth about 75% more than an equal investment in an S&P index fund. Now that, friends, is outperformance.
Argonaut uses a “global macro” investment strategy, which entails looking for macro trends around the world and betting on them. That someone can actually do this successfully is interesting enough. That it can be done consistently – Argonaut has been up every year since its founding in 2000 – is even more so. Currently, the fund has about half of its $460 million in assets committed to 50 positions. We would suppose this means it is 50% or so in cash. It seems like a lot of smart players are holding on to their cash these days.
Nearly a decade ago, when he heard the details of the airplane accident that took John F. Kennedy Jr.’s life, hedge-fund manager David Gerstenhaber had an immediate sense of what might have gone wrong. “There are many ways to regain control of an aircraft once you feel the least bit disoriented,” he says, before running through a checklist of steps that could have been taken, involving an immediate shift to instrument readings over visual reckoning. His comments are more than mere speculation. Gerstenhaber is a certified twin-engine aircraft pilot, and he knows how to handle risk, in the air or on Wall Street. That has helped him turn in market-thumping results.
Last year, his Argonaut Aggressive Global Partnership fund, which uses a global macro strategy, gained 12.3% while the Standard & Poor’s 500 fell 37% and the Credit Suisse/Tremont Global Macro Index slid 4.6%.
That was hardly an outlying performance. The New York-based fund has never had a down year since it was started in the summer of 2000. Through 2008, its 3-year average annualized return was 11.7%. During the same span, the S&P was down more than 8% a year, and the global macro index was up 8.3%. Since inception, the fund has soared 18.4% annually, versus a broad market decline of 3.8% and a 12.7% gain by the average global macro fund.
Global macro funds search for investment trends in stocks, bonds, commodities, interest rates and currencies, then bet on them in markets around the world. Says the 48-year-old Gerstenhaber: “We study macroeconomic data, central-bank policies, and government and market data that is maintained in a real-time global proprietary economic database.” But unlike some other global macro-fund managers, he also drills down into individual market behavior, searching for value that is not fully reflected in market prices.
This is a big factor driving the fund’s outperformance, according to Gerstenhaber, a Yale graduate who received a master’s in economics from Cambridge University on a Fulbright scholarship.
“If we do not have a strong conviction about interest rates or the trend of the S&P 500, we will then look at the performance of the oil or aluminum markets to find a more compelling investment,” he says. And he has no problem bulking up in cash if his team of 10 researchers cannot come up with enough strong ideas. Currently, the fund has about half of its $460 million in assets committed to 50 positions.
Gerstenhaber attributes part of his consistent performance to first-hand analysis. “Even the best data is always dated,” he explains, “but what you see on the ground is [in] real time.”
He learned the value of such observation when he was working in Tokyo. “In 1987, there was much talk of the soaring Japanese yen, pending deflation and slowing industrial growth,” he recalls. But one evening when his regular squash game was canceled, he went out for a run and saw a remarkable number of flatbed trucks transporting huge I-beams to dozens of construction sites around the city. This led Gerstenhaber to look deeper into economic conditions, and to adopt a more bullish short-term outlook than other economists. As it turned out, Japan’s economy did not slow down for another two years.
Now married with four kids, Gerstenhaber does not travel as much as he did. But his staff stays on the road – each employee globe-trotting 25% of the time.
The fund, which is open only to investors who meet certain financial requirements, including the ability to invest at least $2 million, has shone particularly brightly during the past year.
In fact, its outperformance was more likely attributable to money not lost, rather than to money earned. Jarrett Posner, Argonaut’s chief operating officer and risk-oversight manager, says “there will be plenty of times when we will make a wrong bet or get into a position too early, but we protect ourselves through aggressive risk management.”
This includes setting stops across nearly all positions, closely monitoring them and altering them when necessary. Investments are largely limited to liquid positions to ensure efficient pricing and the ability to exit immediately. To avoid excessive risk, the fund tries to determine how investments would behave under various scenarios – including the most adverse. And it generally prefers to hit lots of singles and doubles, rather than home runs.
Gerstenhaber also systematically takes money off the board as targets are hit and constantly reevaluates targets to avoid being hurt by unrealistic expectations. The fund seeks to limit daily losses to no more than 2.5%. If losses mount in any calendar month to 7%, positions are sold or completely hedged to prevent further damage.
“This not only prevents losses from spiraling,” explains Gerstenhaber, “but creates an automatic ‘time out’ that forces us to reevaluate all positions.” At the start of the next month, after the team figures out what drove the losses, some positions are reinstated, while others are replaced.
Another line of defense is the fund’s risk committee. Any member can call an immediate meeting if he fears a position is at excessive risk. The procedure got the fund out of commodities last June, right before they peaked.
Winning positions over the past year included a bet that U.K. interest rates would fall. That investment peaked in size late last summer at nearly 35% of the fund’s net asset value. (The use of derivatives actually limited the total of assets at risk to just 3.6%.) “We saw Britain going through a severe slowdown,” recalls Gerstenhaber, “and thought it was virtually impossible for the country to sustain its high interest rates.” By year end, the Bank of England had slashed rates by 350 basis points, or 3.5 percentage points. And it recently cut them another 50 basis points.
Also, with investors leaving emerging markets, and with their economies’ current-account deficits climbing, Gerstenhaber saw their currencies, and especially the South African rand, coming under increasing pressure. He established a 5% short position in that currency in the third quarter. After trading at about 8 to the dollar in July, the rand closed the year at 9.5.
On the losing side, Argonaut took a slight hit with its December 2007 investment in a basket of Mideast stock markets. With soaring petrodollars and a concerted effort by many local governments to diversify their economies into real estate and consumer-growth industries, Gerstenhaber saw the region benefiting from very strong long-term trends. He built up a position that peaked at 12% of the fund’s net assets. But early in 2008, when the equity slowdown started spreading globally, he began to sell. And when soaring oil prices suddenly reversed course at midyear, the fund closed out its exposure, limiting its loss.
By September, with the global economy sliding deeper into recession, demand falling, and speculators fleeing commodity contracts, Gerstenhaber shorted crude at $87 a barrel, wagering 5% of the fund’s assets on that position. He sold later in the fall when oil slid to his target price of $58. Oil tumbled further. But when it rallied to the high $40s in late December, he re-established a short position. Crude is now in the low $40s.
CHINA THE BEST OF THE BRICS, SAYS STANDARD & POOR’S
This looks like a pretty level-headed analysis of the relative prospects of the four BRIC countries – Brazil, Russia, India, and China. Goldman Sachs invented the acronym in 2001. Whether there was more obfuscation than illumination obtained from relating to the countries as a group is open to quesition. In 2001 it was still relatively early in what became an emerging markets mania.
Standard & Poor’s deems China to be the most promising due to its lack of need for external financing and its potentially huge domestic market, but still sees the situation as fraught with danger.
In 2001, Goldman Sachs bundled Brazil, Russia, India, and China together into an emerging market basket in deference to the four countries’ size and economic potential. The BRIC acronym has stuck.
Against the rapidly worsening global economic backdrop, however, ratings service Standard & Poor’s examines whether the BRIC countries ever shared much in common, other than scale and high portfolio inflows.
Some excerpts from today’s report:
For various reasons – not least its strong public finances, relatively less exposed financial system, low levels of private sector leverage, and potential to raise consumption’s share in GDP – we believe that of all four BRICs, China is probably best positioned to find endogenous solutions – in particular fiscal stimulus – to withstand an externally driven crisis. On the other hand, Russia, due to the collapse in its terms of trade, the falloff in financial account inflows, the distress in its banking system, and the absence of excess capacity on the supply side, has access to fewer endogenous cures to the external gloom, although amid all the current difficulties, the Russian Federation can still boast some important ratings strengths, in particular relatively low levels of general government debt.
While China and India stand to gain from falling input prices, which should help to protect margins in key export sectors, Russia and Brazil are in our view net losers from lower energy, metals, and agro prices. Since the beginning of the decade, we see the investment boom in these two middle-income countries as closely correlated with commodity price developments, and hence has been interrupted by recent commodity price declines. We believe that second round effects of declining terms of trade on growth and public finances in Russia and Brazil will be similarly adverse, particularly for the less diversified Russian economy, where the gap between exports and imports in volume terms has widened from a large positive differential as recently as 2006 to negative 16% of GDP last year, versus close to zero for the more balanced Brazilian economy.
While imbalances in Brazil still may not be material, the country in our view nevertheless remains vulnerable to the volatility of the commodity and credit cycles. Due to its oil dependency and the legacy of its three-year domestic credit boom, we see Russian imbalances as far more glaring, although this susceptibility is, in our view, largely offset by Russia’s superior public finances. Even these, however, may well suffer during 2009-2011 as a portion of the Russian Federation’s sovereign contingent liabilities becomes explicit and as a contracting economy drives the general government budget into deficit for the first time in over a decade.
We see the challenge for India as being to consolidate public finances in order to reduce its debt burden. We see China, on the other hand, as being able to boast of both a strong balance sheet and a diverse and competitive economy. With negative external financing needs, China is, in our view, less sensitive to generalized risk aversion than the other BRICs--including Russia, which for the first time since 1997 is set to run a current account deficit during 2009. China also, we believe, stands to gain the most from its fiscal stimulus program given the potential to raise domestic consumption’s role in the economy.
Nevertheless, without sufficient and protracted stimulus, we think China’s economy could potentially suffer a severe shock, which could enflame social pressures with political repercussions. Recent announcements from Prime Minister Wen Jiabao suggest a strong understanding of these risks and a willingness to access China’s considerable assortment of domestic tools to steer the economy through the external crisis.
A CANADIAN BANK PLAYS IT SAFE ... AND SMART
Bank of Nova Scotia largely avoided mistakes made by its U.S. peers.
Not all bankers are as reckless as most of them are. You may have to look north of the U.S. border to find a truly conservative one, however. By avoiding doing anything stupid, Bank of Nova Scotia has ended up looking pretty smart. BNS is a bank, and we are in a deflation, so one does not want to lose one’s head here, but the bank’s stock does look pretty cheap. And you get paid 6%+ a year to wait, assuming things do not get so bad that the dividend gets cut.
During each ephemeral rally in financial stocks, hope springs anew for U.S. banks, whose shares keep getting battered. Investors pore over the same, ever-cheaper names, hoping to discover a diamond under the TARP – the Troubled Asset Relief Program. Yet most of these banks seem to suffer similar afflictions: exposure to a decomposing economy; tens of billions in “toxic-asset” write-downs, with more to come; dividends cut or eliminated; and the need for huge capital infusions.
North of the border, however, there is a nice alternative: Toronto-based Bank of Nova Scotia (BNS), a big lender mostly free of the woes afflicting its U.S. peers. Scotiabank, as it is called, is Canada’s 3rd-biggest bank by assets, but is not as well known as its similarly sized red, white and blue cousins. BNS, with a market capitalization of U.S. $25 billion, did not leverage up the way American banks did, and sports a strong capital base, with a Tier 1 ratio of 9.3%. [The ratio, which measures shareholders’ equity plus preferred stock as a percentage of total assets, reflects balance-sheet strength.] BNS also has a solid domestic-banking business, a 6.4% dividend yield, and a diversified geographic base.
What BNS lacks is even more attractive: Among big Canadian banks, it is the least exposed to assets south of the border, with no U.S. subprime residential debt. It does not need billions in government aid to survive, and will not have to take huge write-downs on exotic instruments gone bad. Thus, it should sail relatively smoothly through today’s choppy seas, and shine when the global economy rebounds.
It does not hurt that the bank is tight-fisted and old-fashioned, and has boosted its earnings and dividends consistently for more than a decade, in part from traditional loans. Even without much of a pickup in lending, its Toronto-traded shares could generate a total return of 20% to 25% in next 24 to 30 months, rising to C$36 from the current C$30. A Canadian buck is worth about 81 U.S. cents. ...
Many big U.S. banks have taken charges in the tens of billions of dollars on bad investments such as collateralized debt obligations (CDOs) tied to subprime mortgages. Markets fear that billions more are on the way. In comparison, Scotiabank charged off $822 million of soured assets, after tax – mostly stemming from the Lehman Brothers bankruptcy and CDOs unrelated to subprime mortgages – in the fiscal year ended October 2008. Charge-offs this year could be of similar magnitude.
Despite the bank’s relative health, its shares have slid 45% from their record high of C$54.50, hit in May 2007. “Investors have convinced themselves that a bank is a bank is a bank,” says Dom Grestoni, a portfolio manager with QV Investors in Calgary, which owned about 50,000 shares at the end of the third quarter. “Opinions have soured” on BNS because of its international operations, which are mostly in Latin America and contribute about 32% of net income, Grestoni says. (Scotia Capital, BNS’s wholesale and investment bank, kicks in another 21%, with a significant portion of that earned outside Canada.) Investors fret that loan losses will rise this year in Mexico, Peru, Chile and other countries, as the global economy worsens.
Jackee Pratt, a fund manager with Toronto-based Mavrix Fund Management, notes that the bank’s after-tax loan losses were C$630 million in 2008. She says that they could hit C$1 billion in 2009, though some analysts think the number could be higher. Even so, Pratt says, this should be counterbalanced by BNS’s having avoided the subprime and derivatives write-downs afflicting other banks. Mavrix owns 24,500 Bank of Nova Scotia shares.
Bank of Nova Scotia’s CEO, Rick Waugh, will not be specific, but says there will be a “significant but manageable” increase in loan-loss provisions, which are incorporated into BNS’s guidance for earnings per share to rise 7% to 12% in 2009.
Emerging-market economies are slowing, but geographic diversity, along with the quality of loans, contributes to the bank’s ability to provide a “secure dividend,” he adds. The bank currently pays C$1.92 a share.
Its global reach should help BNS shine in an economic recovery, particularly because some of its markets are under-penetrated. “Having that diversity is not a bad thing long-term, and it is certainly better than being in the U.S.,” says Peter Jackson, a portfolio manager at Toronto-based Cumberland Private Wealth Management, which has about 29,000 BNS shares.
Canada’s economy is inextricably linked with that of the U.S., and has slowed appreciably. It, too, could soon be in a recession. Yet, the Canadian housing market is in far better shape. Moreover, the northern nation’s banking industry is much more consolidated than that in the U.S., notes Colum McKinley, a portfolio manager with Sionna Investment Managers in Toronto. There are just five major Canadian banks, and some have direct and significant exposure to the U.S. Only 7% of BNS’s loans, however, have been made to American customers.
So far, McKinley adds, BNS’s focus on Latin America has played out well and has helped the bank to avoid many of the problems that have emerged in the U.S. There could be a “spillover effect” in emerging markets from weakening commodity prices, but Bank of Nova Scotia is a better relative risk than some of the other Canadian banks, McKinley says. In fact, BNS is the only bank that Sionna rates “overweight.” In the longer term, it could pick up share in Latin America at the expense of U.S. competitors.
In the year ended October 2008, BNS derived about 58% of its net income from its Canadian operations and the rest from its international units – it had a small loss in the U.S. Overall, it posted net profits of C$3.14 billion, or C$3.05 per share. That is down from C$4.05 billion, or C$4.01 in fiscal 2007.
To boost profitability, BNS can cut costs. Waugh expects to ratchet down the bank’s productivity ratio – costs as a percentage of revenue – to 58% from an already stingy 59%, with such a drop worth “hundreds of millions.”
“It has a frugal culture,” says Matt McCormick, a portfolio manager at Bahl & Gaynor Investment Counsel, in Cincinnati, which owns about 68,000 shares and has been buying more. “It is low-risk, and one of the few banks we own,” he adds.
McCormick fondly recalls an initial visit to meet BNS management: “There was no food spread, and I was asked to share a bottle of water. ... It is the kind of place that reuses paper clips.” McCormick expects the stock to return 20% to 25% in the next two or three years.
“Coming out of this [global recession], BNS has to make up less ground, has no TARP-related restrictions on its activity and does not have to reinvent the model,” he says. Analysts’ expectations of C$3.50 a share this fiscal year are probably still too high in his view, but McCormick figures that BNS can make about C$3 a share, while most big American banks will be in the red.
Mavrix’s Pratt puts BNS’s real value at roughly C$36 – 20% above its recent price – not including dividend returns. Although the bank’s 10-year average price/earnings ratio is 13 to 14 times, she thinks it should sell for a more conservative 11 times analysts’ fiscal 2009 estimates of c$3.25 to c$3.85 a share.
One worry for BNS is its auto-loan exposure of C$15.6 billion. A good chunk – C$6.6 billion – is from General Motors Acceptance Corp. (GMAC), “where we took credit enhancements,” Waugh notes. That means the loans carry better collateral than normal car loans. Much of the remaining exposure involves consumer-auto loans and lending to car dealers. Although adequately reserved and performing in line with Bank of Nova Scotia’s expectations, such assets tend to produce increased provisions during recessions. Yet, Sionna’s McKinley thinks that the bank is unlikely to generate “big surprises on the balance sheet and write-downs.”
So long as investors hate banks and their shares, Bank of Nova Scotia may continue to trade on emotions. But it is likely to remain nicely profitable – and profitable enough to cover its lush dividend. When the global economy perks up, BNS will be ahead of the game, and so will its shareholders.
EMC COMPETITOR NETAPP’S CHEAP PRICE BECKONS
The ever-growing need for data storage plays to NetApp’s strengths.
NetApp (ex-Network Appliance) is a legitimate growth company selling at 12-13 times 2010 earnings estimates. Back-up-the-truck cheap? Not really, but getting there. And very cheap for a growth stock where the growth story looks pretty robust – cheap enough to draw the attention of some value buyers, apparently. For what it is worth, NetApp’s stock is 90% off its dot-com mania high.
The economy may be receding, but the tsunami of digital data swamping corporate computer networks is not. “Just because companies are struggling, don’t think that they do not need more storage infrastructure,” says NetApp Chief Executive Dan Warmenhoven.
That plays to NetApp’s (NTAP) strength. The company provides data-storage technology and related software that allow companies to manage their data centers more efficiently, sometimes cutting storage usage by as much as 50%. The savings come primarily from lower power bills and more fully utilized hardware that can handle more capacity than older or less nimble systems. Because of the cost savings, data-storage technology remains on most corporate and government shopping lists, even as they scrimp elsewhere.
Data storage is not recession-proof. It just will not see the 10% decline that items like personal computers could suffer in 2009. Sushil Wagle, a senior vice president at money manager Seligman Technology Group, thinks storage sales can stay positive and might post growth in the mid-single-digits. NetApp, however, will outpace the industry, he says. Though the 5-year compound annual sales-growth rate is 23%, revenue is expected to slow for the year ending in April, rising to $3.62 billion from $3.3 billion a year ago. Yet future growth of 15% to 20% “would not be out of the question,” says Wagle.
Why? NetApp is the #2 storage outfit in terms of capacity share for the open-systems networked storage market, behind EMC (EMC). It specializes in shared data-storage devices that attach to computer networks, and store data such as documents, e-mails and digitized video. Beyond just storage, they can retrieve and move data quickly, which has made them essential. One use: a quick retrieval of e-mails, should the Securities and Exchange Commission come knocking.
Competitors like IBM (IBM), Hewlett-Packard (HPQ) and Hitachi’s (HIT) data-systems unit offer storage devices of nearly all shapes, sizes and price points, but their storage arrays are usually based on different types of software platforms, or architectures. NetApp’s line is all based on “unified” software, allowing it to be more efficient and offer more storage bang for the buck.
“Customers appreciate vendors who come up with ways to save them costs,” says Warmenhoven, a former IBM engineer. “We have an opportunity during this downturn to gain new accounts and gain market share.”
NetApp’s competitive advantage and potential growth rate are not reflected in its $16 share price. After going public in 1995, NetApp, then known as Network Appliance, rode its fast sales growth to flirt with 150 in October 2000. As recently as May, it was trading above 27. The shares now fetch only 12.7 times consensus earnings estimates for fiscal 2010, below EMC’s 14 multiple.
As a result, the shares have begun to attract value-oriented tech investors like Seligman; corporate buyers might not be too far behind.
Not including $1.2 billion in net cash, NetApp’s enterprise value (market valuation plus debt) of $5.3 billion is five times cash flow, says Paul Wick, who runs the Seligman Communications & Information Fund. He pegs NetApp shares at 25 to 30, or at least 25% higher.
NetApp has other things going for it, like one healthy core client base: the government. It accounted for about 16% of NetApp’s $3.3 billion in 2008 revenues (which overall are up 17.8% over 2007’s), and is its biggest customer segment. Warmenhoven will not disclose specific agencies but said that NetApp works closely with military and security operations.
Of course, a company that competes successfully with larger rivals and has a cheap stock can become an attractive takeover target. “Take-out value is part of fundamentals,” says Wick, noting that acquisitions of solid companies sometimes fetch prices that exceed even the most optimistic brokerage price targets. A takeover could fetch as much as 30 a share, he contends.
NetApp seems ripe for the picking. Aside from IBM, HP and Dell (DELL) an EMC reseller, other potential acquirers include software giant Oracle (ORCL), which has sustained robust growth via acquisition, and networking gear behemoth Cisco Systems (CSCO), which plans to enter the server market. Storage analyst Brian Marshall of Broadpoint AmTech Research speculates that Net-App would be appealing to HP, IBM and Cisco.
NetApp is in a quiet period prior to its earnings release and Warmenhoven could not comment.
In the interim, NetApp may have to do a little personnel trimming to cope with the slight downturn in its growth rate. Prior to the recession, the company had started to increase its sales force by 25%. Wick suspects that NetApp cannot avoid laying off some employees outside the sales force. (Most of its rivals already have cut their payrolls.) Warmenhoven says he is committed to the larger sales force.
THE REAL LONG-RUN VALUE OF GOLD, PART I
Adrian Ash takes us on a long and entertaining tour of the history of gold. Or, rather, a history of the real value of gold. Bottom line is that it pretty much delivers a real investment return of exactly zero ... if you choose your starting point correctly. It has actually declined in real value since the Bank of England first pegged the gold price in mid-19th century.
Why the decline? The widespread availablity of alternative stores of value which have some hope of growing in value as well, like common stocks. So why bother with gold? Because there are times when a real return of zero looks pretty good, especially when the asset which promises to deliver said return is not someone else’s liability when so many of those liabilities are going into default. Like now. Or, as Ash asks: “What else will you hold as stock earnings tumble, bonds are over-supplied and threaten default, and the value of money itself is forced ever-deeper into genuine crisis?”
“Gold must hit $2,200 an ounce to match its real peak of Jan. 1980. Or so almost everyone thinks ...”
What’s in a number? Ignoring the day-to-day noise, more than a handful of gold dealers and analysts reckon gold will hit $2,200 an ounce before this bull market is done.
Why? Because that is the peak of 1980 revisited and re-priced in today’s U.S. dollars.
Simple, right? Too simple by half, in fact.
First, betwixt spreadsheet and napkin, there is often a slip. Several targets you will find out here on the net put the old 1980 top nearer $2,000 in today’s money. One gold dealer puts the figure way up at $2,400 an ounce.
Maybe they got the jump on this month’s Consumer Price data. Maybe $200 to $400 an ounce just will not matter when the next big gold top arrives. But maybe, we guess here at Bullion Vault, an extra 20% gain (or 20% of missed profits) will always feel crucial when you are looking to buy, sell or hold. Perhaps that is the problem.
Either way, having crunched (and re-crunched) the numbers just now, even we cannot help but knock out a target ...
To match its inflation-adjusted peak of $850 an ounce – as recorded by the London PM Gold Fix of January 21, 1980 – the price of gold should now stand nearer $2,615.
Two’s up therefore, the lag between current gold prices and that old nominal high scarcely looks a good reason to start buying gold today. “Ask the investor who rushed out to buy gold precisely 29 years ago, at $845 an ounce, about gold as an inflation hedge,” as Jon Nadler – senior analyst at Kitco Inc. of Montreal, the Canadian dealers and smelters – said on the 29th anniversary of gold’s infamous peak last week.
“They could sell it for about $845 today ... [but] they would need to sell it for something near $2,200 just to break even, when adjusted for inflation.”
This lag, of course, can be turned any-which-way you like. For several big-name gold investment gurus, including Jim Rogers and Marc Faber, it mean gold has got plenty of room-left-to-soar, compared at least with the last time investors began swapping paper for metal in a bid to defend their savings and wealth.
But for the much bigger anti-gold-buggery camp – that consensual mob of mainstream analysts, op-ed columnists, news-wire hacks and financial advisors – gold’s inflation-adjusted “big top” just as easily stands as a great reason not to buy gold. Ever.
“An investor in gold [buying at the end of 1980] experienced a reduction in purchasing power of 2.4% per annum,” notes Larry Swedroe, a financial services director at BAM Services in Missouri, writing at IndexUniverse.com and recommending Treasury inflation-protected TIPs instead.
“[That was] a cumulative loss of purchasing power of about 55% ... Even worse, that does not consider the costs of investing in gold ... [and] while gold has provided a slightly positive real return over the very long term, the price movement is far too volatile for gold to act as an effective hedge against inflation.”
Volatility cannot be denied. Indeed, it is the only thing we ever promise to users of Bullion Vault. (They do not need to take our word on security, cost-efficiency or convenience.) Traditionally twice as volatile as the U.S. stock market, gold prices have become five times as wild since the financial crisis kicked off.
But price volatility has also leapt everywhere else, not least in the S&P 500 index – now 8 times wilder from the start of 2008. The Euro/Dollar exchange rate is more than four times as volatile as it was back in August 2007 ... just as the banking meltdown began. Even Treasury bonds have gone crazy, making daily moves in their yield more vicious still than even the gold price or forex!
So putting sleepless nights to one side (if you or your pharmacist can manage it), the key point at issue is in fact the “long term” and inflation.
Gold’s Purchasing Power
Why look back to the real purchasing power of gold from 1913 onwards? [Chart here.] Besides the fact that its monthly average since – when deflated by the official U.S. consumer price index – comes in at 97.8 ... pretty much right where it started.
Well, that is when official Consumer Price data start (hat-tip to Fred at the St.Louis Fed). It is also when the Federal Reserve was first founded, with the easy-as-pie task of giving the United States an “elastic currency.”
Okay, so it ain’t quite made of rubber just yet. But the Dollar’s own value in gold – by which it used to be backed, pre-1971 – just keeps brickling and bouncing around like it is being used as a squash ball.
“With the right confluence of economic and geopolitical developments we should see gold break through $1,500 and then $2,000 and then possibly still higher round numbers in the next few years,” said Jeffrey Nichols, M.D. of American Precious Metals Advisors, at the 3rd Annual China Gold & Precious Metals Summit in Shanghai last month – “particularly if we get the type of buying frenzy or mania that often occurs late in the price cycles of financial and commodity markets.
“This is hardly an audacious forecast when looked at relative to the upward march in consumer prices over the past 28 years. After all, the previous high of $875 an ounce in January 1980, when adjusted for inflation since then, is today equivalent to more than $2,200.”
Audacious or not, as Nichols points out, the thing to watch for would be a “buying frenzy” – a true “mania” amongst people now ready to buy gold that sent not only its price but also its purchasing power shooting very much higher.
Because for gold to reach $2,200 an ounce in today’s money (if not $2,615 ...) would mean something truly remarkable in terms of its real long-run value.
“I own some gold,” said Rogers, for instance, in an interview recently, “and if gold goes down I will buy some more ... and if gold goes up I will buy some more. Gold during the course of the bull market, which has several more years to go, will go much higher.”
- Inflation-adjusted, that peak gold price of 21 January 1980 saw the metal worth more than 5 times its purchasing power of 1913;
- In March 2008, just as Bear Stearns collapsed and gold touched a new all-time peak of $1,032 in the spot market, the metal stood at its best level – in terms of U.S. consumer purchasing power – since December 1982;
- Touching $2,200 an ounce (without sharply higher inflation undermining that peak), gold would be worth almost 6 times as much as it was before the Federal Reserve was established in real terms of domestic U.S. purchasing power.
But “much higher” in nominal Dollar terms is not the same as “much higher” in terms of real purchasing power, however. More to the point, that previous peak of $850 an ounce – as recorded at the London PM Gold Fix on January 21, 1980 – lasted hardly two hours.
Defending yourself with gold is one thing, in short. Assuming gold is the perfect inflation hedge is quite another. And taking peak profits in gold – as with any investable asset – is surely impossible for everyone but the single seller to mark that very top price.s That does not diminish gold’s real long-term value to private investors however, as we will see in Part II – to follow [below].
“Gold-backed money retained its real value for 350 years in the United States and Great Britain. It has only just clawed back to that level for investors today ...”
By the time the War of the Spanish Succession was finished in 1715, the French King – who admitted that he “loved war too much” – owed the equivalent of £300 million.
Across the Channel, Great Britain owed only £49 million. Which might have looked a little like financial victory. But then, the United Kingdom’s population was only 1/3 the size of the French. And those debts – priced in “hard money” weights of gold or silver, both in even tighter supply than they are today – were almost 20 times the sum England had defaulted on four decades before.
But hey, that is inflation for you! Or more properly, that is inflation as it is commonly understood – an absolute rise in the price level. In this case, the cost of running the state and murdering Frenchmen.
Whereas in 2009, three centuries later, the UK Treasury will extend its debts by £118 billion this year alone. That is not only 2,500 times what it owed in 1715 in nominal pounds. It is also twice the entire national debt that forced the last Labour government to beg an emergency loan from the International Monetary Fund (IMF) 33 years ago.
Now that is real inflation for you! And for everyone else too, unfortunately.
“From the time the United States went off the Gold Standard in 1933 the wholesale price level has gone up by 760%,” noted Professor Roy Jastram, author of The Golden Constant, in December 1981. “Since England abrogated the Gold Standard in 1931, her price index number has risen by over 2,000%.”
Both in the US and UK, the general price level since Jastram spoke to the Security Analysts Society of San Francisco has more than tripled again. All told, here in London, the British Pound has lost 98% of its purchasing power since that fateful September day when the UK government lost its nerve, and the world lost Sterling’s gold standard forever.
“Before that, the two countries had a combined history of 350 years of long-run price stability,” Jastram went on. “The price level was the same in the United States in 1930 as it had been in 1800. In England the price index stood at 100.0 in 1717 (the first year of her gold standard) and it was at that figure again in 1930.”
And all thanks to the magic of gold – that “golden constant.” Right?
To be sure, the gold-backed Pound did a phenomenal job of preserving its purchasing power for the 200 years starting when Sir Isaac Newton – he of the Laws of the Motion, but also Master of the Royal Mint in 1717 – established the Pound Sterling as a certain weight of silver.
Newton thus, since the two were interchangeable as cash payment, also set the Pound as a smaller weight of gold (“a pound weight of fine gold is worth 15 pounds weight 6 ounces 17 pennyweight and 5 grains of fine silver” to be precise) which over time, won out over silver as the arbiter of currency value worldwide.
As our chart shows (hat tip to Statistics.gov.uk for the long-run inflation data), tying money to gold delivered ups and downs in the price level. But overall, costs stayed remarkably steady for the 70 years starting in 1844 – back when the Bank of England was granted monopoly power to issue the currency.
Then the guns of August blew a hole in the Pound’s convertibility. Despite a brief rally after the ill-advised move to restore the old Gold Standard in 1926, Sterling’s long-run value just continued to tumble, as Jastram points out.
As for gold, its purchasing power also suffered during Europe’s second “Thirty Years War” (in Winston Churchill’s phrase), at least when held outside of government hands. Banned from owning it in the United States, private individuals could scarcely trade it for profit in London. Pretty much all of Britain’s bullion had already been nationalized long before (right as the gold standard reached its zenith, in fact) and now it was needed to buy arms and munitions from across the water.
Don’t you know there was a war on? Or as Marc Faber put it in his Gloom, Boom & Doom Report last fall (Is there a way to preserve wealth?, 10-08), “I can see the gold bugs jumping off their seats and protesting that gold has kept its value (purchasing power) over the course of history. But the problem is that the owners of the gold also changed over time.
“So, when Timur sacked Aleppo and Damascus in A.D. 1400, it did not help to have your savings in gold,” the Swiss private-client fund manager adds. “You lost your life and your gold. Women had a better chance of survival and got a one-way ticket to Samarkand.”
Luckily for investors and savers with something less than their lives or liberty to lose 500 years later, the U.S. and UK governments liberalized gold ownership just in time for gold prices to shoot higher on a tide of government-wrought inflation in the 1970s. (It is also worth noting that, in line with how gold owners could survive the 4-decade U.S. ban starting at the depths of the Great Depression – and actually benefit from the revaluation of gold that accompanied it – Marc Faber advises holding physical gold overseas, free from the political and/or social risks of your own domestic jurisdiction.)
Finally cut free from artificial government values by Richard Nixon in 1971, gold broke back above its old Gold Standard par in terms of UK purchasing power in 1973. It then spent almost 16 years – after accounting for inflation and changes in gold prices – worth more than it had been throughout the late 19th century, the high-water mark of gold’s international power as the only true, single, irrefutable currency.
And amid the current bull market in gold, its real value for UK investors only just broke back above that level again, just as 2008 turned into 2009. For U.S. investors, gold recovered its 1900 value at the start of 2007. [See “Gold Purchasing Power in U.S.” chart.]
That’s the nature of a mean-reverting asset, of course. It reverts, if given time (and free ownership, priced in a free market) to its long-run average value. But that does also mean that the average itself will have to revert as well.
Because the starting point of any particular data series – not least if pegged by mankind, even the genius brain of Sir Isaac Newton way back in 1717 – might not necessarily be “correct” for the long run that follows. We cannot judge the “true” value of gold simply from its historical start.
What if that apple bruised more than Sir Isaac Newton’s head? Conclusions to follow in Part III ... [below]
“Gold is demonstrably not the ultimate inflation hedge. Nor is it anything much compared to stocks, bonds or real estate ...”
“The twilight of gold appeared to have arrived,” wrote Niall Ferguson – now a Harvard professor, then an Oxford scholar – of the metal’s 20-year bear market at the end of the last century.
“Gold has a future of course,” he added, “but mainly as jewelry.” And it’s a common enough long-term view of the metal, repeated every so often by economists, historians, columnists and analysts.
“The stuff has a historical place in the money market,” as one New Zealand advisor put it in a note to her clients in 2003. “But gold is just that – historical.” So historical, in fact, it deserves to be scorned – along with human sacrifice, living in mud huts and VHS tapes – as primitive, brutish, uncivilized.
“Was it not I,” asked John Maynard Keynes, man of the moment when the world’s financial system needed re-booting in 1945, “who wrote that ‘Gold is a barbarous relic’ ...?”
Man of the moment once more today, Keynes was hardly first to disdain the metal as money, however – even if he was part of the Bretton Woods’ team which replaced it with U.S. dollars. Printed at will, the dollar would prove so much more flexible, more available than tightly-supplied gold. Amid the Great Depression of the late 1920s and ‘30s, Keynes called for Great Britain and then the rest of the world to stop redeeming its paper notes for gold coins or bullion. The supply of money and credit could then start flowing freely once more, boosting demand for goods and services and sparking an inflation in prices that would make the value of outstanding debts evaporate. Yet the scheme was nothing new. More than two centuries earlier, John Law – another visionary economist – had proposed and attempted the very same thing.
A world-famous gambler, convicted murderer and exiled Scot, Law gave the world its first modern bubble and bust. His grand system – first proposed in his book, Money & Trade Considered (1705) – sought to revoke state bankruptcy by replacing gold money with arable land, paper notes, stock-market shares, future tax revenues, the Mississippi Delta ... anything but more metal.
“It is in the interests of the King and his people to guarantee bank money and to abolish gold specie,” wrote Law as he applied his theory to France’s very real financial crisis. Giving monetary power to, say, the stock of his Mississippi trading company, would “diminish the value of gold by taking away its usage as money.”
But those dumb Frenchmen! Whenever they took profits by selling Mississippi stock as it doubled, trebled and rose 10-fold, they “thought they might turn it into heaps of gold and silver, which they call realizing,” spat Law.
Could they not see?
“The lands of France are worth more than all the gold which still lies hid in the mines of Peru,” Law declared. “The stocks [of his Mississippi venture] actually surpassed in value all the gold and silver which will ever be in the kingdom.”
Yet still the French crowded out of his stock and into gold as the bubble burst in 1720. Come May, John Law banned the use of monetary metal altogether on pain of fines, imprisonment and even death – stealing a march on U.S. president F.D.Roosevelt by some 213 years.
Make no mistake; Law would have been right to price Mississippi stock far above money ... if only his Compagnie de l’Occident had held any real value at all. Instead, it owned a million miles of disease-ridden swamp, plus a sick colony of ex-beggars and thieves lost in Louisiana. Whereas gold offered then just what it offers today: very little of productive value, but a time-honored bolt hole when nothing else pays.
Gold’s only value, you see, comes in owning it – whether for adornment, to escape the risk of counter-party default, or as a defense from inflation. Any other class of financial asset, provided it offers a yield, income or growth, should win out over gold. Just so long as they it keeps delivering that yield, income or growth. Because gold, a raw lump of metal, will pay nothing and do nothing besides holding its value across the very longest of long terms.
How long is the long term? “It is said that an ounce of gold bought 350 loaves of bread in the time of Nebuchadnezzar, king of Babylon, who died in 562 BC,” wrote Stephen Harmston – then an economist at Bannock Consulting – for the World Gold Council (WGC) just when Niall Ferguson was condemning gold as mere frippery 10 years ago.
“The same ounce of gold,” Harmston went on in his study, gold as a store of value, “still buys approximately 350 loaves of bread today.” Which seems an odd swap to us, unless you are very hungry indeed. But “across 2,500 years, gold has in other words retained its purchasing power, relative to bread at least.”
Crucially for long-term investors – especially for those with 2,500 years to wait – “Gold has had a real rate of return of zero,” as Harmston observed. Meaning it does not beat or lag inflation or deflation. Not across the very long run, that period in which “we’re all dead” as John Maynard Keynes, himself now very dead for six decades, once said.
To get this straight, it bears repeating. Gold is NOT the ultimate inflation hedge, not compared with dividend-paying, growth-dependent stock investments. Not unless you keep your entire savings tied up in gold bullion in, hedging your very existence against a loss (or gain) in the value of money. And not unless you get to exist for an awfully long time to come as well.
Long Run Purchasing Power of Gold
Across the slightly-less long run – say, a mere one-and-a-half centuries, rather than two-and-a-half millennia – the inflation-adjusted value of gold remains well below where it started on average.
The value placed on gold when the Bank of England set the international gold standard in motion in 1844 has rarely been seen since. And on the historical view (and gold is “just that – historical” as our Kiwi advisor noted above) it is in fact slipped by 15%, slowly declining before turning decisively lower throughout the 20th century.
Why would the world (the best proxy for which, we guess at Bullion Vault, is the well-attested British experience) put progressively less value on gold amid the murder and mayhem ... bubbles and busts ... of the last 100 years? Why did gold lose purchasing power – and then continue to lose value – both during and then for a long while after total war swept Europe, Africa, Asia and the Pacific? Surely such death and destruction should force gold to a premium?
The fact is, however, that the 20th century also brought fresh competitors for investment wealth ... competitors rapidly offered to every class of investor as the Second World War receded and then the “Big Bang” of deregulation began under the Thatcher and Reagan administrations.
Yes, it may seem heretical (if not blindingly obvious, depending on where you start), but like charcoal and shire horses, steam trains and gas lamps, the 20th century subjected gold to a sharp loss of relative utility and thus value. Gold’s only use comes in its ownership, remember; so its value as a store of wealth necessarily depends on the supply of alternative holdings. And the 20th century brought a flood of competition for that role.
The upshot today, almost a decade after Gordon Brown’ infamous gold sales marked not the high-point of anti-gold sentiment but also the very nadir of its 20-year slump? Free from default risk and inflating supply, gold suddenly looks very attractive to fund managers, investment advisors and private individuals who only a few years ago mocked the idea that metal might be worth owning.
Sure, the time may soon come when gold’s one single use is matched and bettered again, beaten by other, more productive investments. But until then – and as gold’s current price action suggests – what else will you hold as stock earnings tumble, bonds are over-supplied and threaten default, and the value of money itself is forced ever-deeper into genuine crisis?
CASH IN ON OUR REDISCOVERED LAYAWAY CULTURE
Before there was instant gratification there were layaway plans, where you made major purchases on the installment plan – not taking possession until the final payment. Imagine that. Cheap credit made layaway obsolete. Expensive credit may bring it back, in some form or other. That form may be the rent-to-own segment of the retail industry, of which there are two major public names.
In today’s market, there is plenty of pain to go around. In fact, a much-maligned retail tactic is making a comeback: layaway.
We all thought the age of easy credit killed layaway for good late last century. There simply was not the need to put a new television on layaway for $15 a week when you could just buy now ... and pay later. But with credit markets frozen and the average consumer swamped with leftover debt, retailers have grabbed back onto their old layaway strategies.
K-Mart pushed a revamped layaway program during the Christmas shopping season. But America’s retail Goliath continues to hold out – Wal-Mart discontinued its layaway program several years ago ... and its showing no signs of bringing it back.
In fact, we seriously doubt that layaway will ever again become as popular as it once was. Regardless, cheap, payment-oriented retail methods should flourish while the average and below-average income shopper retreats to survival mode.
What the consumer needs now more than ever are options – especially when it comes to the purchase of big-ticket items. That is why we are taking a close look at the rent-to-own industry.
Two small-cap names come to mind in this field. There is industry leader Rent-A-Center Inc. (RCII) and close competitor Aaron Rents Inc. (RNT). Their business models are simple: both stores rent and sell furniture, appliances and electronics.
This earnings season has been downright poor across the board. But these rent-to-own firms are one of the few bright spots in today’s market. Rent-A-Center posted a Q4 profit and finally seems to be benefiting from a recent restructuring plan that reduced its store count to 315 locations. Aaron Rents posted strong Q4 numbers and raised 2009 guidance.
Both RCII and RNT have been solid post-crash performers. Aaron Rents is hovering near break-even since the beginning of November, while Rent-A-Center is up nearly 50%. These two firms have actually benefited from the growing ranks of unemployed workers. The connection is clear: If you have no job, you will be hard pressed to get store credit. But you will still need to replace a broken appliance ...
According to Cowen and Co. analysts, Aaron Rents in particular is helping customers who have not been able to get credit at Best Buy or Sears but still have to replace a broken fridge or other large appliance.
Will major retailers like Best Buy and Sears try new layaway or rent-to-own plans in an attempt to boost slumping sales? In our opinion, the economy will have to get much worse for this scenario to unfold.
BHP: Best Long-Term Bet Among Crushed Miners
The once-booming mining sector has been savaged by the global slowdown and the swan dive in commodity prices. The world’s biggest miner has not been spared. BHP Billiton’s (BHP) half-year net profit ... fell 56.5%, to U.S.$2.6 billion from US$6.02 billion a year earlier, on asset write-downs and sagging earnings in base metals. And the Melbourne-based miner is in for more short-term pain.
Yet BHP has scored plaudits for ditching a hostile takeover of rival Rio Tinto (RTP), and is uniquely placed to endure a long downturn, using balance-sheet strength to cement its #1 position. BHP’s iron-ore, coking-coal and manganese operations have helped maintain underlying earnings at US$6.13 billion, on contract prices struck in better times. John Sevior, who helps manage A$15 billion for Sydney-based Perpetual Asset Management and holds BHP, sees it as a long-term play: “If you want to hold one mining stock, BHP would be it.”
BHP trades near A$32 (equivalent to about US$21), and its market cap is about $100 billion. ... The abrupt end to the commodities boom in mid-2008 sent the stock tumbling 58%, from a high of A$49.55 last May, to a low of A$21.02 November 20. It has revived smartly since BHP’s Nov. 25 decision to abandon its bid for Rio, which has US$38.9 billion in debt, thanks to its top-of-the-cycle purchase of Alcan in 2007.
BHP’s diversified global portfolio of long-life, low-cost, high-grade assets, with commodities from iron ore to oil to diamonds, has kept it from being as hard hit as some higher-cost operators. Still, it faces sharp price drops in the second half, with BHP’s steelmaking customers holding the whip hand in the current round of contract-price renegotiations. ... Cash and cash equivalents at December 31 stood at US$7.2 billion, net debt is now US$4.2 billion, and BHP’s debt-to-equity ratio has fallen to 9.5%.
Rob Patterson, managing director of Adelaide-based Argo Investments, says this puts the company in the driver’s seat for bargain-hunting in the depressed market. “If assets do become available, they have the firepower to buy them,” asserts Patterson, who holds BHP, and is positive on its long-term outlook, despite the short-term uncertainty buffeting the sector. ... BHP’s price/earnings multiple is 13.9 times, based on 2009 forecasts, says UBS, versus Rio Tinto’s 6.4 times. Hence, some analysts see better value in Rio – but many remain wary of its vast debt.
After years of surging demand and soaring prices, belief in a decades-long, China-powered commodities supercycle had become orthodoxy. Yet the theory that China and other emerging nations had decoupled from Western markets is now shattered and base-metals prices have been hit hard. Industry-bellwether copper is down more than 60% from its 2008 peak. ... Most commodities analysts believe urbanization and industrialization in China and other emerging economies will continue to drive long-term demand, but the big question is: When?
[A]nalysts expect volatility and many false dawns, such as the brief rally in commodity prices in the first days of 2009. Speculative investment in junior miners will be a dangerous game, but by picking major diversified outfits with low-cost production and little debt, long-term investors should benefit from the eventual return of demand.
A Blast of Energy and Commodity Stocks
Gain exposure to these sectors with two closed-end funds trading at discounts.
The economic outlook may be bleak for the next year or so. But that reality obscures the long-term bull cycle for natural-resource investments, thanks to a rising global population and limited supplies.
Investors have already stepped into the valuation gap created by the collapse of commodity prices and related stocks in the second half of 2008. A number of oil, natural gas, coal and other natural-resource stocks have rebounded from lows touched late in the 4th quarter. These stocks are still trading at 50% to 70% of the value they were going for a year ago. Yet, trying to figure out which individual stocks present the best opportunity is fraught with challenges.
For investors who want to play the sector, we suggest a pair of closed-end funds that continue to trade at a discount to the net asset values (NAVs) of their baskets of natural-resource stocks
Shares of the DWS Global Commodities Stock Fund (GCS), which closed at $5.92 Wednesday (2-11), are down 42% since testing record highs last July. It is trading at a 9.6% discount to NAV, which has narrowed from 13% over the past week. The fund focuses mostly on large-cap stocks, including integrated oil and gas producers and service companies, fertilizer producers, and metal-mining firms.
For a mid-cap alternative, consider the BlackRock Global Energy & Resources Trust (BGR). At $17.50, the fund, managed by the highly respected Dan Rice, is down 53% since touching its high of last June. The discount of the shares to net asset value have compressed from 8% to 3.2% this month.
Amid the downward spiral, discounts for both funds expanded to more than 20% last October. These funds continue to trade at discounts to their NAVs, but they tend to be a bit volatile. Still, the two funds are both attractively priced based on the expectations that their net asset values appear to be bottoming out and should rise to higher levels over the next year.
Mariana Bush, closed-end fund and ETF analyst at Wachovia Securities, says one of the main questions investors should be asking is, “Do I truly believe NAV is going to be rising or in most cases will be stable? ... If I am bullish on NAV, I do not mind paying just a 5% discount.” ...
Unlike exchange-traded funds, or ETFs, which passively track an index, closed-end funds are actively managed, with market values that often trade at a premium or discount to their underlying values of the securities in the portfolio. But not all managers are particularly competent. Both DWS’s and BlackRock’s funds are managed by portfolio managers with solid track records for navigating tough cycles and coming out well ahead of their benchmarks.
“You can get the expertise of professional managers at a time when nobody else wants it, which has been historically the best time to gain exposure,” says Howard Punch, chief investment officer of boutique firm Punch & Associates Investment Management.
So buying into these funds with their depressed NAVs and discounted shares around what appears to be the bottoming of a cycle offers investors a double discount into commodities and related stocks.
BlackRock’s Rice is focused on income and the fund pays a regular dividend: It currently yields 9.2%. The DWS fund, by contrast, does not pay a regular dividend, but it has a very low expense ratio, says Punch.
Time to Visit the Meat Bin
If you are shopping to pick up a steak for Valentine’s Day dinner, throw an extra in the cart. While you are at it, toss in some meat-company shares for good measure, because, for now, at least, bargains abound.
As of early February, Department of Agriculture wholesale prices for choice-grade beef, the better-quality grade found in grocery stores, are down about 2.5% from levels a year ago, and pork prices are off 6%. Choice beef fell 3.5% on the week, to $136.87 per hundredweight, while pork slipped 0.2% to $56.83.
So enjoy: The seasonal demand trends for both protein categories are higher into the spring and summer. Production cuts resulting from last year’s high feed costs have lightened supply, too, bringing higher wholesale and retail prices.
The meat industry, like so many others, is reeling from declining global demand. But unlike other commodity sectors where someone can flip a switch and cease operations, animal life cycles prevent livestock producers from reacting speedily to market signals. Thus, meat producers who were scaling back production in response to record-high feed costs must keep cutting.
Yet supplies of meat and poultry are still ample – even with those production cutbacks – because exports have slowed. That hurts producers and processors, but is good for consumers’ pocketbooks. Supermarkets and other retailers are expected to offer good deals at the meat counter during February to boost sales until spring, when the backyard-grilling season starts.
“The cure for low prices is low prices,” says Don Roose, analyst with brokerage and advisory firm U.S. Commodities in West Des Moines, Iowa. The liquidation of breeding animals that already has occurred is bringing meat production down to a level that will match lower demand, Roose says. ...
Shares of meat-company stocks, meanwhile, are on the rise from late-2008 troughs, reflecting better times ahead for processors, too. Smithfield Foods’ (SFD) stock price was $11.27 at the end of last week, more than double the 13-year low of $5.40 hit in November. Hormel Foods (HRL), at $31.41, was well above Dec. 3’s 5-year low of $24.81.
And Tyson Foods (TSN) closed the week at $9.72 a share, up from a 20-year low of $4.40 hit in late November. Credit Suisse research analyst Robert Moskow wrote in a recent note that the latest quarter “looks more and more like a bottom.” Rising chicken-breast prices should aid the ailing poultry sector. Moskow says Tyson has “huge upside, if restaurant demand improves again and if producers remain disciplined in supply” – but he notes that grain costs and unpredictable export markets “are bumps in the road.”
Payouts Get Pummeled – With Two Exceptions
A 62% payout cut by the nation’s #1 department-store chain, Macy’s , and a suspension of disbursements by the world’s #3 cellphone manufacturer, Motorola, set the tone for last week’s dismal dividend activity.
Making matters worse, Standard & Poor’s Index Services announced Friday that it expects 2009 S&P 500 dividends to plummet 13.3% from 2008’s total. That would be the worst annual drop since 1942. “Unless companies believe that their financial future will improve, their need to conserve cash will outweigh their desire to pay dividends,” said Howard Silverblatt, S&P’s senior index analyst.
Macy’s (M) and Motorola (MOT) are both S&P 500 components. Macy’s slashed its quarterly common payout to a mere nickel a share from 13.25 cents, for an annual savings of $138 million. Yield: 2.04%. It initiated dividends in 2003, and had been upping them every year.
Motorola, meanwhile, eliminated its quarterly common payout of five cents a share, which it had been distributing since mid-2006. That will save it $450 million annually. Motorola had paid dividends without interruption since 1942. (For more on Macy’s and Motorola, see the Follow-up section.)
Last week’s dividend bloodletting also included Bassett Furniture (BSET), whose retail strategy is to custom-build and deliver affordable furniture to customers within 30 days. Bassett halted its payout, ending a 74-year skein of continuous disbursements, but saving it about $4.4 million a year. Bassett also suspended its share-repurchase plan. ... The company closed 18 stores in fiscal 2008, and will shutter another 10 this year. Traded on Nasdaq, Bassett shares fetch a mere $2 and change.
There were a few rays of hope amid the clouds. Two companies that serve women – Avon Products (AVP) and Meredith Corp. (MDP) – each added a penny to their payouts.
With more than $10 billion in annual revenue and 5.8 million independent sales reps, Avon is the world’s #1 direct seller of beauty products, fragrances and fashion jewelry. ... This is Avon’s 19th annual dividend boost. Payouts have been ongoing since 1919. Share repurchases in 2008 totaled $172 million, down from $667 million in 2007. “We have a solid balance sheet, an operating model that generates healthy cash flow and a continued commitment to our dividend,” declared CEO Andrea Jung. Avon finished 2008 with $1.1 billion in cash, versus $973 million in 2007. Yielding 3.66%, the stock was recently quoted around 23; its 52-week range is 45.34 to 17.45.
Des Moines, Iowa-based Meredith will pay a new quarterly of 22.5 cents a share. Meredith, one of the nation’s top media and marketing companies, published magazines including Ladies’ Home Journal, Fitness and More. ... Meredith has paid dividends for 62 consecutive years, and has boosted them for 16 years in a row. CEO Stephen M. Lacy cited its conservative financial structure and strong cash flow in announcing the increase, which puts the stock’s yield at 5.61%. That high figure reflects a gruesome reality: Like most media stocks, Meredith’s has been battered. It is down more than half over the past year.
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