S&P 500, Commodities, and Inflation Reach ‘Make or Break’ Point

Wednesday, October 3rd, 2012

by Don Vialoux, Timingthemarket.ca

Upcoming US Events for Today:

1. ADP Employment Change for September will be released at 8:15am. The market expects 140K versus 201K previous.
2. The ISM Services Index for September will be released at 10:00am. The market expects 53.5 versus 53.7 previous.
3. Weekly Crude Inventories will be released at 10:30am.

Upcoming International Events for Today:

1. German PMI Services for September will be released at 3:55am EST. The market expects 50.6 versus 48.3 previous.
2. Euro-Zone PMI Services for September will be released at 4:00am EST. The market expects 46.0 versus 47.2 previous.
3. Great Britain PMI Services for September will be released at 4:30am EST. The market expects 53.0 versus 53.7 previous.
4. Euro-Zone Retail Sales for August will be released at 5:00am EST. The market expects a year-over-year decline of 2.0% versus a decline of 1.7% previous.

The Markets
Markets traded around the flat-line on Tuesday as investors continue to wait for news pertaining to a potential bailout of Spain as well as an update of the employment condition in the US. The ADP employment report is due out today, followed by the important monthly employment report on Friday, among the last major economic reports before the presidential election, which takes place in just over one month’s time. Apple played an influential role in the Tuesday’s market activity, yet again. The stock fell by as much as 1.3% at the session low before touching it’s 50-day moving average line at $650, initiating a flurry of buying pressures at this important technical level. As Apple rebounded, so too did the market. Of course Apple is one of the most important stocks for investors as not only is it the the largest single security weight within a number of benchmarks, but it is also one of the most widely held securities in the stock market. Any opportunity to accumulate the stock during periods of weakness, it is likely that investors will pursue it. Momentum indicators for Apple are increasingly becoming bearish now that the stock has reached oversold levels with regards to Stochastics. Expect escalated selling pressures should the 50-day moving average fail to hold as support, implying that escalated negative pressures would also be felt within broad equity benchmarks.

Just a quick update to a chart posted yesterday of the 15 minute activity of the S&P 500. The index briefly broke down below the previously mentioned triangle pattern, trading back within the range by the closing bell. This pattern remains key to watch as it is presently the battleground for the intermediate-term trend.

A definitive breakout above resistance just under 1455 could set the stage of the next leg of the bull market rally. A breakdown below support around 1445 could likely sway undecided investors to take their profits and stand aside until clarity from earnings and the election (among other things) is provided.

The chart of the S&P 500 doesn’t hold the only triangle pattern out there.

The long-term charts of the CRB commodity index and the ratio chart of the TIPS Bond Fund (TIP) versus the 7-10 Year Treasury Bond Fund (IEF), an appropriate measure of inflation, shows that the price action of each is reaching a critical point within a triangle pattern. A break in either direction will define the next major trend for commodities and inflation, likely influencing equity and bond markets in the process.

Obviously, with US enacting easy money policy for an indefinite period or time and other central banks seeming very accommodative as well, the bias is to the upside, but a breakout is still required in order to confirm.

Sentiment on Tuesday, according to the put-call ratio, ended overly bullish at 0.74. The ratio continues to suggest complacency amongst investors given the uncertainties within the market. Employment reports offered through the remainder of the week will likely provide indication of whether this complacency is warranted.

S&P 500 Index

Chart Courtesy of StockCharts.com

TSE Composite

Chart Courtesy of StockCharts.com

Horizons Seasonal Rotation ETF (TSX:HAC)

• Closing Market Value: $12.65 (down 0.08%)
• Closing NAV/Unit: $12.67 (down 0.04%)

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* performance calculated on Closing NAV/Unit as provided by custodian

Click Here to learn more about the proprietary, seasonal rotation investment strategy developed by research analysts Don Vialoux, Brooke Thackray, and Jon Vialoux.

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Eric Sprott: Investment Outlook (October 2012)

Wednesday, October 3rd, 2012

Investment Outlook – October 2012

Do Western Central Banks Have Any Gold Left???

by Eric Sprott, Sprott Asset Management

Somewhere deep in the bowels of the world’s Western central banks lie vaults holding gargantuan piles of physical gold bars… or at least that’s what they all claim. The gold bars are part of their respective foreign currency reserves, which include all the usual fiat currencies like the dollar, the pound, the yen and the euro.

Collectively, the governments/central banks of the United States, United Kingdom, Japan, Switzerland, Eurozone and the International Monetary Fund (IMF) are believed to hold an impressive 23,349 tonnes of gold in their respective reserves, representing more than $1.3 trillion at today’s gold price. Beyond the suggested tonnage, however, very little is actually known about the gold that makes up this massive stockpile. Western central banks disclose next to nothing about where it’s stored, in what form, or how much of the gold reserves are utilized for other purposes. We are assured that it’s all there, of course, but little effort has ever been made by the central banks to provide any details beyond the arbitrary references in their various financial reserve reports.

Twelve years ago, few would have cared what central banks did with their gold. Gold had suffered a twenty year bear cycle and didn’t engender much excitement at $255 per ounce. It made perfect sense for Western governments to lend out (or in the case of Canada – outright sell) their gold reserves in order to generate some interest income from their holdings. And that’s exactly what many central banks did from the late 1980’s through to the late 2000’s. The times have changed however, and today it absolutely does matter what they’re doing with their reserves, and where the reserves are actually held. Why? Because the countries in question are now all grossly over-indebted and printing their respective currencies with reckless abandon. It would be reassuring to know that they still have some of the ‘barbarous relic’ kicking around, collecting dust, just in case their experiment with collusive monetary accommodation doesn’t work out as planned.

You may be interested to know that central bank gold sales were actually the crux of the original investment thesis that first got us interested in the gold space back in 2000. We were introduced to it through the work of Frank Veneroso, who published an outstanding report on the gold market in 1998 aptly titled, “The 1998 Gold Book Annual”. In it, Mr. Veneroso inferred that central bank gold sales had artificially suppressed the full extent of gold demand to the tune of approximately 1,600 tonnes per year (in an approximately 4,000 tonne market of annual supply). Of the 35,000 tonnes that the central banks were officially stated to own at the time, Mr. Veneroso estimated that they were already down to 18,000 tonnes of actual physical. Once the central banks ran out of gold to sell, he surmised, the gold market would be poised for a powerful bull market… and he turned out to be completely right – although central banks did continue to be net sellers of gold for many years to come.

As the gold bull market developed throughout the 2000’s, central banks didn’t become net buyers of physical gold until 2009, which coincided with gold’s final break-out above US$1,000 per ounce. The entirety of this buying was performed by central banks in the non-Western world, however, by countries like Russia, Turkey, Kazakhstan, Ukraine and the Philippines… and they have continued buying gold ever since. According to Thomson Reuters GFMS, a precious metals research agency, non-Western central banks purchased 457 tonnes of gold in 2011, and are expected to purchase another 493 tonnes of gold this year as they expand their reserves.¹ Our estimates suggest they will likely purchase even more than that.² The Western central banks, meanwhile, have essentially remained silent on the topic of gold, and have not publicly disclosed any sales or purchases of gold at all over the past three years. Although there is a “Central Bank Gold Agreement” currently in place that covers the gold sales of the Eurosystem central banks, Sweden and Switzerland, there has been no mention of gold sales by the very entities that are purported to own the largest stockpiles of the precious metal.³ The silence is telling.

Over the past several years, we’ve collected data on physical demand for gold as it has developed over time. The consistent annual growth in demand for physical gold bullion has increasingly puzzled us with regard to supply. Global annual gold mine supply ex Russia and China (who do not export domestic production) is actually lower than it was in year 2000, and ever since the IMF announced the completion of its sale of 403 tonnes of gold in December 2010, there hasn’t been any large, publicly-disclosed seller of physical gold in the market for almost two years.⁴ Given the significant increase in physical demand that we’ve seen over the past decade, particularly from buyers in Asia, it suffices to say that we cannot identify where all the gold is coming from to supply it… but it has to be coming from somewhere.

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Fight the Inflation Boogeyman (Merk)

Wednesday, October 3rd, 2012

by Axel Merk, Merk Funds

Investors are concerned about inflation. But how can investors attempt to inflation-proof their portfolios? Buy TIPS? Short Treasury bonds? Stocks? Real Estate? Commodities? Gold? Currencies? Or should investors regard those warnings about inflation as fear mongering?

Indeed, as the Federal Reserve (Fed) announced its latest round of quantitative easing (“QE3”), gauges of future inflation expectations spiked. In our assessment, the market reacted strongly as it became apparent that the Fed is moving away from its focus on inflation to a focus on employment. We believe the Fed wants to raise the price level so as to bail out millions of homeowners that are ‘under water’, i.e. owe more on their homes than they are worth. Fed Chair Bernanke considers a healthy housing market to be key to healthy consumer spending (see our Merk Insight Don’t worry, be Happy).

Judging from the market reaction to QE3, fears about future inflation are warranted. Having said that, market fears about looming inflation have calmed down a bit since the initial flare up. Could it be this calming of the market is due to the fact that the Fed is intervening in the TIPS market? TIPS are “inflation protected” Treasury securities that are linked to the Consumer Price Index. Investors buying TIPS do so in the hope that their purchasing power might be protected. When the Fed intervenes in the market to buy TIPS (or any other security for that matter), such securities are intentionally over-priced, raising doubt as to whether investors are truly “protected” from inflation. It’s not just investors that now have more limited access to measuring inflation expectations – it’s also the Fed itself. By managing the entire yield curve (short-term through long-term interest rates), we believe the Fed has blindfolded itself, as it has taken away one of the most important gauges about the health of the economy. Aside from the Fed’s intervention in the TIPS market, the government is free to change the inflation adjustment factor employed in TIPS before the securities mature. TIPS payouts are adjusted using the consumer price index (CPI), which has seen methodology changes many times. When the recent debt ceiling impasse was discussed, both Republicans and Democrats talked in favor of changing the CPI definition so that it would nominally live up to inflation linked entitlement promises while clearly eroding the purchasing power of such payouts. Even without such gimmickry, the CPI may not be reflective of the basket of goods and services consumed by investors as they approach retirement given, for example, that healthcare may comprise an ever-increasing part of one’s spending. Alas, much of investing is about trying to preserve purchasing power and, alas, buying TIPS may not provide adequate protection.

If one is negative about the inflation outlook, why not simply short Treasuries, either directly or through ETFs? While we are pessimistic about the long-term outlook of Treasuries, it can be very costly to short them, given that – as a short seller – one has to continuously pay the interest of the securities one shorts. If one buys an ETF shorting Treasuries, the cost of the ETF is to be added. Shorting Treasuries might make sense for investors that are good at market timing. However, calling the top in major bubbles is rather difficult, just reflect on former Fed Chair Alan Greenspan’s “irrational exuberance” speech years ahead of the stock market collapse in 2000; similarly, those that saw the bubble in the housing market coming didn’t necessarily get the timing right.

If TIPS don’t provide enough bang for the buck, and shorting Treasuries can be costly, what about buying stocks? Bernanke appears to use every opportunity possible to praise the benefits QE has on rising stock prices. While we agree that QE has pushed stock prices higher, it may be dangerous for the Fed to praise this link given that it raises expectations of more Fed easing whenever the markets plunge (see Merk Insight: Bernanke Put). For example, how many investors buy Cisco ¹ shares because of the great management skills of CEO John Chambers as compared to those who buy because of QE3? We pose this question because stocks are rather volatile; not only are stocks volatile, but the volatility of stocks can be all over the place. Historically, the annualized standard deviation of the S&P 500 index hovers in the mid 20% range, with outbursts into the 40% range in 2008. So why are investors taking on the “noise” of the stock market, when the reason they invest is because of QE? Indeed, our analysis shows that investors appear to be ever more chasing the next perceived intervention by policy makers rather than investing based on fundamentals. That’s not only bad for capital formation (these misallocations are summarily referred to as “bubbles” these days), but also suggests that we might want to look for a more direct way to take a position on what we call the “mania” of policy makers.

Talking about policy makers: you might not agree with them, but if there is one good thing to be said about our policy makers, it is that they may be quite predictable.

“If there is one good thing to be said about our policy makers, it is that they may be quite predictable” – Axel Merk

What about real estate? In the U.S., depending on where one lives, the real estate market has bottomed out or appears to be bottoming out. With what appears to be the Fed’s razor sharp focus on real estate, it might be foolish to bet against the Fed. Indeed, yours truly bought a property in Palo Alto in late 2009. Unlike other real assets, keep in mind that real estate is often purchased with borrowed money; as such, it is prone to speculative bubbles such as the most recent episode. Investing in REITs might allow one to allocate a smaller share of one’s portfolio to real estate; a downside of REITs is that they tend to be highly correlated with equity markets. As policy makers steer equity prices, everything appears to be ever more highly correlated, investors may want to look for something that offers low correlation to other investments.

That brings us to commodities. In a world where policy makers appear to favor growth at just about any cost, commodity prices have been beneficiaries. As we have seen in recent weeks, it is not a one-way street, as dynamics within the market can be rather complex. The dynamics for commodities within agriculture differ from those in metals or energy. There are special considerations in storing and delivering many commodities, creating challenges for investors. We agree that commodities might do well in the long run, but urge investors to consider all the risks that come with investing in commodities. Notably, commodities can have stretches of low volatility, luring investors to jump in, only to be greeted with a jolt that can be rather hazardous to one’s wealth. As a simple rule of thumb: if you can’t sleep at night with your investment, you own too much of it.

Gold is worth singling out as the one commodity that has arguably the least industrial use. Rather than writing gold off as a barbaric relic, we like gold: its relative simplicity might make it the investment purest in reflecting monetary policy. In the medium term, we believe gold may be a good inflation hedge. But, again, keep in mind that price movements can be rather volatile. Even staunch gold bugs rarely have all their assets in gold.

This leads us to currencies as a potentially attractive way to diversify beyond gold. The Chinese have long diversified their reserves to a basket of currencies, in an effort to mitigate their U.S. dollar exposure. Some say currencies are difficult to understand. We argue that it is far easier to understand the dynamics of ten major currencies, as well as others worth monitoring, than to understand the dynamics of thousands of stocks. Importantly, we believe the currency markets might be an ideal place to take a position on the mania of policy makers. Indeed, as we believe that the Fed might want to debase the U.S. dollar (Please see Fed may want to debase dollar), why not express that view in the currency markets? Unlike their reputation, currencies are far less volatile than equities: if one does not employ leverage, a move in the euro by 1 cent is rather small on a percentage basis. The U.S. dollar index has historically had an annualized standard deviation of returns in the low teens; in 2008, that volatility rose a tad, approaching the mid-teens. For investors looking for predictability on the risks in a portfolio, the currency markets have historically shown a far more consistent risk profile than equities or many other asset classes. A corollary is that during market downturns, unlevered currency strategies may offer some downside protection given the lower risk profile. This clearly doesn’t mean an investment in currencies is safe; but managed currency risk can be seen as an opportunity given the purchasing power risk taken by holding U.S. dollars.

“Hedging inflation risk isn’t about being right about the future; it’s about the risk of being right. “ – Axel Merk

If investors agree that the Fed: a) may want to have – or at least accept – higher inflation; and b) may not readily see the warning signs of higher inflation, then it appears to us prudent to take the risk of higher inflation into account. Indeed, for those managing money on behalf of others, it might be their fiduciary duty to take that risk into account. Those that ignore the risk of inflation might do so at their own peril. Many investors might feel they can take action once inflation is obvious. “Obvious” is in the eye of the beholder: just as we preferred to be early in warning about the crisis in 2008, it appeared rather challenging to reposition one’s portfolio in October 2008. Gold has gone up by a factor of about 7 since its lows. The dollar has fallen relative to a basket of currencies over the past 10, 30 and 100 years: in our assessment, we simply have the better printing press. Hedging inflation risk isn’t about being right about the future; it’s about the risk of being right.

Please sign up to our newsletter to be informed as we discuss global dynamics and their impact on gold and currencies. Engage with me directly at Twitter.com/AxelMerk to comment on Merk Insights and to receive provide real-time updates on the economy, currencies, and global dynamics.

Axel Merk

Axel Merk is President and Chief Investment Officer, Merk Investments
Merk Investments, Manager of the Merk Funds.

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Volatility … versus What? (Bradley)

Wednesday, October 3rd, 2012

By Tom Bradley, Steadyhand Investment Funds

October 2, 2012

In last Saturday’s Report of Business, Rob Carrick wrote an article about low volatility mutual funds (The Hidden Dangers in Playing it Safe). The Steadyhand Equity Fund was one of six funds he highlighted as having a positive return over the last five years and a beta of less than 0.75.

Beta measures the volatility of a security or fund in comparison to the market as a whole. A beta of 1.0 means a fund’s movements are exactly in line with the index. A number under 1.0 means the fund is less volatile and over 1.0 means more volatile.

At Steadyhand, we’ve designed our funds and hired managers with the hope of providing a slightly smoother ride for our clients – i.e. gentler ups and downs. Beta is one measure of that ride.

Coincidentally, Rob’s article followed on the heels of a meeting I had with a consultant last week. In the course of the conversation, he told me he liked our Small-Cap Equity Fund, but it was too volatile to put on his recommended list. In this case, the volatility he was referring to wasn’t beta (which is a low 0.48 over 5 years), but rather tracking error – a measure of how closely the fund tracks the BMO Nesbitt Burns Small Cap Index.

His take on the Small-Cap Equity Fund was interesting, because while it has performed much differently than the index over its 5+ years (i.e. high tracking error), it’s been considerably less volatile than the index. It has held up better in weak periods (and in some cases gone up) and risen less in hot markets. The manager, Wil Wutherich, has done exactly what we wanted him to do, which is to provide good long-term returns and be a counterbalance to the other securities in our clients’ portfolios.

The consultant’s comment and Rob’s article are good reminders that we have to be clear as to what we mean by risk and volatility. The industry measures everything against the index. Our clients measure their comfort factor and how they’ve done by comparing their return to what they could have earned if they’d left their money in the bank.

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