2012 Dogs of the Dow Outperforming Slightly

Thursday, October 4th, 2012

by Bespoke Investment Group

The “Dogs of the Dow” is a popular passive investing strategy that says investors should simply buy the ten highest yielding stocks in the Dow at the start of each year.  So how have this year’s Dogs done so far?

As shown below, the average total return (dividends reinvested) of the ten highest yielding Dow stocks at the start of the year is +16.16%.  This is 136 basis points better than the average YTD total return of the 20 non Dogs, so the strategy is outperforming the index as a whole.  The two best Dogs so far this year have been General Electric (GE) and AT&T (T).  Both of these stocks have posted YTD gains of more than 30%.  Only one Dog is down so far this year — Intel (INTC).

While the ten highest yielding Dow stocks are doing better as a whole than the other twenty stocks in the index, it’s the stock with the lowest yield in the Dow that is up the most in 2012.  As shown below, Bank of America (BAC) — with a yield of 0.72% at the start of the year — is up 61.24% year to date.

Copyright © Bespoke Investment Group

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Investors Becoming Defensive, Markets Wait For Catalyst

Thursday, October 4th, 2012

Upcoming US Events for Today:

1. Challenger Job Cuts for September will be released at 7:30am.
2. Weekly Jobless Claims will be released at 8:30am. The market expects Initial Claims to show 370K versus 359K previous. Continuing Claims are expected to reveal 3273K versus 3271K previous.
3. Factory Orders for August will be released at 10:00am. The market expects a decline of 6.0% versus a gain of 2.8% previous.
4. Minutes from the latest FOMC Meeting will be released at 2:00pm.
5. Chain Store Sales for September will be released throughout the day.

Upcoming International Events for Today:

1. Bank of England Rate Decision will be released at 7:00am EST. The market expects no change at 0.50%.
2. The ECB Rate Decision will be released at 7:45am EST. The market expects no change at 0.75%.
3. Canadian Ivey PMI for September will be released at 10:00am EST. The market expects 59.4 versus 62.5 previous.

The Markets
Markets pushed higher on Wednesday following favourable reports pertaining to employment and the service sector. ADP reported that private payrolls rose by 162,000 in September, beating estimates of 140,000. As well, a report on the services sector showed gains for the month of September as new orders jumped to one of the strongest levels since March. ISM Services reported a stronger than expected 55.1, beating estimates of 53.5. The reports gave lift to stocks as investors shifted focus toward domestic fundamentals and away from Euro-zone debt concerns. The S&P 500 remained within the almost 3 week old triangle pattern, although equity futures at the time of writing are implying a breakout from this zone as early as Thursday, potentially bringing to an end this period of consolidation.

Although the headline equity benchmark numbers finished in the green, underlying weakness remained evident. Oil showed extreme destabilization following a report that was bearish for the commodity. According to Bloomberg, “crude output rose 11,000 barrels a day to 6.52 million last week, the most since December 1996, while total fuel demand fell 0.3 percent to 18.3 million barrels a day in the four weeks ended Sept. 28, the lowest level since April.” The suggestion of increased supply and decreased demand sent the commodity lower by 4% as investors shed bullish bets. Shares of Energy companies were negatively impacted as a result, making it the worst performing sector during Wednesday’s session. Extreme instability within the Oil market has been known to precede equity market weakness as investors are forced to sell assets in order to cover margin calls and raise cash, a scenario that cannot be ruled out this time as well. Oil is presently within a period of seasonal weakness that runs through to December now that summer driving season has come to an end and hurricane season nears conclusion in November. Note the lower significant high in the price of Oil at the September peak compared to peaks of previous years. The fact that recent price action could not overcome resistance derived from previous peaks is a bearish mark for the commodity. Significant support can be found around $77, a break of which would set the stage for a long-term decline, potentially leading to a retest of levels last seen in 2009.

As Oil sold off, investors ran to the safety of the US Dollar and, to a small degree, Gold. Both saw gains on the session with the US Dollar opening and closing above its 20-day moving average for the first time since the end of July, just prior to ECB President Mario Draghi presenting his “Save the Euro” speech. The US Dollar remains a key risk-off trade, primarily deriving value from the movement of the Euro as investors express their satisfaction of the debt situation within the region. Dollar strength could equate to further commodity weakness into the month of October, a scenario that is seasonally typical as the dollar realizes flat to positive tendencies through the month of November. Gold reaches an average seasonal peak within the first 10 days of October. Momentum indicators for the metal have already started to roll over, hinting of the seasonal peak that is common for this time of year. The metal resumes a positive path through the end of the year, although returns are typically less than equities over the same time period.

As mentioned, energy was the weakest sector during Wednesday’s session, exacerbating a trend of underperformance within cyclical sectors as of recent. And as cyclicals continued to show signs of struggle, defensives continued to strengthen with the Health Care ETF (XLV) and Consumer Staples ETF (XLP) closing at the highest levels in the history of the products. Staples and Health Care have outperformed the market since mid-September as investors accumulate lower beta assets while waiting for a resolution to some key overhanging issues, such as the Spanish debt situation and the presidential election. Health Care and Consumer staples tend to perform well through the fourth quarter as investors maintain defensive exposure until the start of the new year.

Sentiment on Thursday, as gauged by the put-call ratio, ended bullish at 0.92. The ratio has jumped around over the past couple of days as investors place bets pertaining to a breakout or breakdown from the present consolidation range within equity markets.

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: $12.68 (up 0.24%)
• Closing NAV/Unit: $12.66 (down 0.02%)

Performance*

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

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Circle the Wagons (Smead)

Thursday, October 4th, 2012

by William Smead, Smead Capital Management

We spoke to two small groups in Spokane on September 21st, 2012. For better or worse, when I think of Spokane I think of my cousin Gary. It was 1981 and yours truly was a young stockbroker at Drexel Burnham Lambert. Gold had been in a wonderful bull market ride in the prior five to ten years. Gary was interested in participating in gold through a gold-mining stock traded on the Spokane Stock Exchange. Spokane’s proximity to the Northern Idaho mining towns and closeness to the Canadian border made it a natural place for commodity traders and mining enthusiasts to gather to transact business. The stock was around $2 per share and based on a bullish outlook for gold, seemed to be headed higher. Gary was a willing buyer.

An article dated September 28, 2012, at Marketwatch.com triggered me to expound on 1981. It explains which entities are the largest owners of gold in the world.

If exchange-traded products backed by gold were a central bank:
Gold reserves, in metric tons
United States: 8,133 metric tons
Germany: 3,396 metric tons
International Monetary Fund: 2,814 metric tons
Exchange-traded funds and notes: 2,579 metric tons (includes SPDR Gold Trust)
Italy: 2,451 metric tons
France: 2,435 metric tons
SPDR Gold Trust GLD-0.34%: 1,321 metric tons
China: 1,054 metric tons

Source: Barclays Plc., which tracks 47 gold-related exchange-traded funds and notes. Holdings as of Wednesday, September 26, 2012.
– Claudia Assis

In this same article, titled “SPDR Gold Trust tops China in Gold Reserves”, Claudia Assis wrote an incredibly revealing statement:

So, with gold firmly back on the limelight, it’s time to revisit that interesting comparison that illustrates so well how gold has captured the imagination – and pockets – of investors around the globe. That is, how massive individual and professional investors’ gold holdings have grown versus the reserves sitting in the vaults of central banks, which historically held gold as a standard for their currency.

The key line in the paragraph is “how gold has captured the imagination – and pockets – of investors around the globe”. Gold caught the imagination of my cousin, Gary, in 1981. We at Smead Capital Management (SCM) like to think of it as “extrapolation” rather than “imagination”. The rearview mirror is busy at work. Gary was looking backwards at the move in gold prices from the beginning of 1976 to the beginning of 1981. Those price increases caught his imagination. In our opinion, the circumstances which created the interest in gold were unsolvable economic problems with seemingly no end (historically high inflation).

We view Harvard’s John Kenneth Galbraith as the best economist and thinker about speculative episodes. In his book, “A Short History of Financial Euphoria”, Galbraith explains the features of a speculative episode:

The more obvious features of the speculative episode are manifestly clear to anyone open to understanding. Some artifact or some development, seemingly new and desirable— tulips in Holland, gold in Louisiana, real estate in Florida, the superb economic designs of Ronald Reagan—captures the financial mind or perhaps, more accurately, what so passes. The price of the object of speculation goes up. Securities, land, objects d’art, and other property, when bought today, are worth more tomorrow. This increase and the prospect attract new buyers; the new buyers assure further increase. Yet more are attracted; yet more buy; the increase continues. The speculation building on itself provides its own momentum.

We know that cousin Gary invested at the wrong time in the wrong asset class with the wrong mining security. The company he owned went out of business and the exchange it traded on has been gone for many years. Today, we believe the “well known fact” is that the US and a number of other major countries are debasing their currency by printing money. Therefore, every time the Federal Reserve Board announces a new version of QE, it stimulates a new group of investors to pile into gold and gold-related investments. Notice that ETFs and notes in Gold, combined with the SPDR Gold Trust, are approaching the size of the International Monetary Fund. Also, notice that the SPDR Gold Trust now dwarfs the Chinese Central Bank/Government holdings.

Galbraith described what the basic attitudes are of the investors who participate in speculative episodes:

This process, once it is recognized, is clearly evident, and especially so after the fact. So also, if more subjectively, are the basic attitudes of the participants. These take two forms. There are those who are persuaded that some new price-enhancing circumstance is in control, and they expect the market to stay up and go up, perhaps indefinitely. It is adjusting to a new situation, a new world of greatly, even infinitely increasing returns and resulting values. Then there are those, superficially more astute and generally fewer in number, who perceive or believe themselves to perceive the speculative mood of the moment. They are in to ride the upward wave; their particular genius, they are convinced, will allow them to get out before the speculation runs its course. They will get the maximum reward from the increase as it continues; they will be out before the eventual fall.

At SCM, we very much like to avoid speculative episodes. In the current fascination with Gold and commodities in general, it is interesting to consider who represents the two kinds of participants in today’s mania. First, you have those who watch the thousands of advertisements on TV and/or hear them on radio to buy gold and act on their imagination. Second, you have some of this era’s most highly thought of money managers running hedge funds, who have stated their belief in the success of major long gold positions. We would add a third category which didn’t exist before Galbraith wrote the last update of his book. They are wide asset allocators, who participate for diversification purposes in gold and would argue that their ownership of gold is price direction agnostic. As institutional and individual investors adopted wide asset allocation, we believe it automatically increased the demand for gold, gold-related securities and commodities in general.

We as a company have no idea how long this episode will last. Here is Galbraith’s take:

For built into this situation is the eventual and inevitable fall. Built in also is the circumstance that it cannot come gently or gradually. When it comes, it bears the grim face of disaster. That is because both of the groups of participants I the speculative situation are programmed for sudden efforts at escape. Something, it matters little what—although it will always be much debated—triggers the ultimate reversal. Those who had been riding the upward wave decide now is the time to get out. Those who thought the increase would be forever find their illustration destroyed abruptly, and they, also, respond to the newly revealed reality by selling or trying to sell. Thus the collapse. And thus the rule, supported by the experience of centuries; the speculative episode always end not with a whimper but with a bang. There will be occasion to see the operation of this rule frequently repeated.

We do, however, have a vision of what it will look like when the mania dies. If history is any guide, the hedge funds will be the first to flee, the individual investors will be in denial for awhile, but will ultimately give up in panic. Lastly, the price-agnostic asset allocators will sell when threatened with unemployment or as the clients liquidate to go elsewhere. We at SCM like the reaction which Galbraith describes to protect you and/or your clients from being damaged by a speculative episode:

Let the following be one of the unfailing rules by which the individual investor and, needless to say, the pension and other institutional-fund manager are guided: there is the possibility, even the likelihood, of self-approving and extravagant error-prone behavior on the part of those closely associated with money.

A further rule is that when a mood of excitement pervades a market or surrounds an investment prospect, when there is a claim of unique opportunity based on special foresight, all sensible people should circle the wagons; it is time for caution.

Cousin Gary and I had neither the experience nor a copy of Galbraith’s book in 1981 to draw from. We at SCM do.

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.

Copyright © Smead Capital Management

Tags: ETF, ETFs
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Bill Gross: Investment Outlook (October 2012)

Thursday, October 4th, 2012

Damages

October 2012

by William H. Gross, PIMCO

• The U.S. has federal debt/GDP less than 100%, Aaa/AA+ credit ratings, and the benefit of being the world’s reserve currency.
• Studies by the CBO, IMF and BIS (when averaged) suggest that we need to cut spending or raise taxes by 11% of GDP and rather quickly over the next five to 10 years.
• Unless we begin to close this gap, then the inevitable result will be that our debt/GDP ratio will continue to rise, the Fed would print money to pay for the deficiency, inflation would follow, and the dollar would inevitably decline.

I have an amnesia of sorts. I remember almost nothing of my distant past – a condition which at the brink of my 69th year is neither fatal nor debilitating, but which leaves me anchorless without a direction home. Actually, I do recall some things, but they are hazy almost fairytale fantasies, filled with a lack of detail and usually bereft of emotional connections. I recall nothing specific of what parents, teachers or mentors said; no piece of advice; no life’s lessons. I’m sure there must have been some – I just can’t remember them. My life, therefore, reads like a storybook filled with innumerable déjà vu chapters, but ones which I can’t recall having read.

I had a family reunion of sorts a few weeks ago when my sister and I traveled to Sacramento to visit my failing brother – merely 18 months my senior. After his health issues had been discussed we drifted onto memory lane – talking about old times. Hadn’t I known that Dad had never been home, that he had spent months at a time overseas on business in Africa and South America? “Sort of, but not really,” I answered – a strange retort for a near adolescent child who should have remembered missing an absent father. Didn’t I know that our parents were drinkers; that Mom’s “gin-fizzes” usually began in the early afternoon and ended as our high school homework was being put to bed? “I guess not,” I replied, “but perhaps after the Depression and WWII, they had a reason to have a highball or two, or three.”

My lack of personal memory, I’ve decided, may reflect minor damage, much like a series of concussions suffered by a football athlete to his brain. Somewhere inside of my still intact protective helmet or skull, a physical or emotional collision may have occurred rendering a scar which prohibited proper healing. Too bad. And yet we all suffer damage in one way or another, do we not? How could it be otherwise in an imperfect world filled with parents, siblings and friends with concerns of their own for a majority of the day’s 24 hours? Sometimes the damage manifests itself in memory “loss” or repression, sometimes in self-flagellation or destructive behavior towards others. Sometimes it can be constructive as when those with damaged goods try to help others even more damaged. Whatever the reason, there are seven billion damaged human beings walking this earth.

For me, though, instead of losing my mind, I’ve simply lost my long-term memory. It’s a damnable state of affairs for sure – losing a chance to write your autobiography and any semblance of recalling what seems to have been a rather productive life. But I must tell you – it has its benefits. Each and every day starts with a relatively clean page, a “magic slate” of sorts where you can just lift the cellophane cover and completely erase minor transgressions, slights or perceived sins of others upon a somewhat fragile humanity. I get over most things and move on rather quickly. The French writer Jules Renard once speculated that “perhaps people with a detailed memory cannot have general ideas.” If so, I may be fortunate. So there are pluses and minuses to this memory thing, and like most of us, I add them up and move on. If that be the only disadvantage on my life’s scorecard – and there cannot be many – I am a lucky man indeed.

The ring of fire

In last month’s Investment Outlook I promised to write about damage of a financial kind – the potential debt peril – the long-term fiscal cliff that waits in the shadows of a New Normal U.S. economy which many claim is not doing that badly. After all, despite approaching the edge of 2012’s fiscal cliff with our 8% of GDP deficit, the U.S. is still considered the world’s “cleanest dirty shirt.” It has federal debt/GDP less than 100%, Aaa/AA+ credit ratings, and the benefit of being the world’s reserve currency – which means that most global financial transactions are denominated in dollars and that our interest rates are structurally lower than other Aaa countries because of it. We have world-class universities, a still relatively mobile labor force and apparently remain the beacon of technology – just witness the never-ending saga of Microsoft, Google and now Apple. Obviously there are concerns, especially during election years, but are we still not sitting in the global economy’s catbird seat? How could the U.S. still not be the first destination of global capital in search of safe (although historically low) prospective returns?

Well, Armageddon is not around the corner. I don’t believe in the imminent demise of the U.S. economy and its financial markets. But I’m afraid for them. Apparently so are many others, among them the IMF (International Monetary Fund), the CBO (Congressional Budget Office) and the BIS (Bank of International Settlements). I hold on my lap as I write this September afternoon the recently published annual reports for each of these authoritative and mainly non-political organizations which describe the financial balance sheets and prospective budgets of a plethora of developed and developing nations. The CBO of course is perhaps closest to our domestic ground in heralding the possibility of a fiscal train wreck over the next decade, but the IMF and BIS are no amateur oracles – they lend money and monitor financial transactions in the trillions. When all of them speak, we should listen and in the latest year they’re all speaking in unison. What they’re saying is that when it comes to debt and to the prospects for future debt, the U.S. is no “clean dirty shirt.” The U.S., in fact, is a serial offender, an addict whose habit extends beyond weed or cocaine and who frequently pleasures itself with budgetary crystal meth. Uncle Sam’s habit, say these respected agencies, will be a hard (and dangerous) one to break.

What standards or guidelines do their reports use and how best to explain them? Well, the three of them all try to compute what is called a “fiscal gap,” a deficit that must be closed either with spending cuts, tax hikes or a combination of both which keeps a country’s debt/GDP ratio under control. The fiscal gap differs from the “deficit” in that it includes future estimated entitlements such as Social Security, Medicare and Medicaid which may not show up in current expenditures. Each of the three reports target different debt/GDP ratios over varying periods of time and each has different assumptions as to a country’s real growth rate and real interest rate in future years. A reader can get confused trying to conflate the three of them into a homogeneous “fiscal gap” number. The important thing, though, from the standpoint of assessing the fiscal “damage” and a country’s relative addiction, is to view the U.S. in comparison to other countries, to view its apparently clean dirty shirt in the absence of its reserve currency status and its current financial advantages, and to point to a more distant future 10-20 years down the road at which time its debt addiction may be life, or certainly debt, threatening.

I’ve compiled all three studies into a picture chart perhaps familiar to many Investment Outlook readers. Several years ago I compared and contrasted countries from the standpoint of PIMCO’s “Ring of Fire.” It was a well-received Outlook if only because of the red flames and a reference to an old Johnny Cash song – “I fell into a burning ring of fire –I went down, down, down and the flames went higher.” Melodramatic, of course, but instructive nonetheless – perhaps prophetic. What the updated IMF, CBO and BIS “Ring” concludes is that the U.S. balance sheet, its deficit (y-axis) and its “fiscal gap” (x-axis), is in flames and that its fire department is apparently asleep at the station house.

To keep our debt/GDP ratio below the metaphorical combustion point of 212 degrees Fahrenheit, these studies (when averaged) suggest that we need to cut spending or raise taxes by 11% of GDP and rather quickly over the next five to 10 years. An 11% “fiscal gap” in terms of today’s economy speaks to a combination of spending cuts and taxes of $1.6 trillion per year! To put that into perspective, CBO has calculated that the expiration of the Bush tax cuts and other provisions would only reduce the deficit by a little more than $200 billion. As well, the failed attempt at a budget compromise by Congress and the President – the so-called Super Committee “Grand Bargain”– was a $4 trillion battle plan over 10 years worth $400 billion a year. These studies, and the updated chart “Ring of Fire – Part 2!” suggests close to four times that amount in order to douse the inferno.

And to draw, dear reader, what I think are critical relative comparisons, look at who’s in that ring of fire alongside the U.S. There’s Japan, Greece, the U.K., Spain and France, sort of a rogues’ gallery of debtors. Look as well at which countries have their budgets and fiscal gaps under relative control – Canada, Italy, Brazil, Mexico, China and a host of other developing (many not shown) as opposed to developed countries. As a rule of thumb, developing countries have less debt and more underdeveloped financial systems. The U.S. and its fellow serial abusers have been inhaling debt’s methamphetamine crystals for some time now, and kicking the habit looks incredibly difficult.

As one of the “Ring” leaders, America’s abusive tendencies can be described in more ways than an 11% fiscal gap and a $1.6 trillion current dollar hole which needs to be filled. It’s well publicized that the U.S. has $16 trillion of outstanding debt, but its future liabilities in terms of Social Security, Medicare, and Medicaid are less tangible and therefore more difficult to comprehend. Suppose, though, that when paying payroll or income taxes for any of the above benefits, American citizens were issued a bond that they could cash in when required to pay those future bills. The bond would be worth more than the taxes paid because the benefits are increasing faster than inflation. The fact is that those bonds today would total nearly $60 trillion, a disparity that is four times our publicized number of outstanding debt. We owe, in other words, not only $16 trillion in outstanding, Treasury bonds and bills, but $60 trillion more. In my example, it just so happens that the $60 trillion comes not in the form of promises to pay bonds or bills at maturity, but the present value of future Social Security benefits, Medicaid expenses and expected costs for Medicare. Altogether, that’s a whopping total of 500% of GDP, dear reader, and I’m not making it up. Kindly consult the IMF and the CBO for verification. Kindly wonder, as well, how we’re going to get out of this mess.

Investment conclusions

So I posed the question earlier: How can the U.S. not be considered the first destination of global capital in search of safe (although historically low) returns? Easy answer: It will not be if we continue down the current road and don’t address our “fiscal gap.” IF we continue to close our eyes to existing 8% of GDP deficits, which when including Social Security, Medicaid and Medicare liabilities compose an average estimated 11% annual “fiscal gap,” then we will begin to resemble Greece before the turn of the next decade. Unless we begin to close this gap, then the inevitable result will be that our debt/GDP ratio will continue to rise, the Fed would print money to pay for the deficiency, inflation would follow and the dollar would inevitably decline. Bonds would be burned to a crisp and stocks would certainly be singed; only gold and real assets would thrive within the “Ring of Fire.”

If that be the case, the U.S. would no longer be in the catbird’s seat of global finance and there would be damage aplenty, not just to the U.S. but to the global financial system itself, a system which for 40 years has depended on the U.S. economy as the world’s consummate consumer and the dollar as the global medium of exchange. If the fiscal gap isn’t closed even ever so gradually over the next few years, then rating services, dollar reserve holding nations and bond managers embarrassed into being reborn as vigilantes may together force a resolution that ends in tears. It would be a scenario for the storybooks, that’s for sure, but one which in this instance, investors would want to forget. The damage would likely be beyond repair.

William H. Gross
Managing Director

Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Pacific Investment Management Company LLC. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are registered and unregistered trademarks of Allianz Asset Management of America L.P. and PIMCO, respectively, in the United States and elsewhere. ©2012, PIMCO.

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GOLD – The Simple Facts (PIMCO)

Thursday, October 4th, 2012

GOLD – The Simple Facts

by Nicholas J. Johnson, Mihir P. Worah, PIMCO

• For more than a millennium, gold has broadly managed to maintain its real value, even as various currency regimes have come and gone.
• The supply of gold is constrained, and we see demand increasing consistent with global economic growth on a per capita basis.
• Given current valuations and central bank policies, we believe investors should consider including gold and other precious metals in a diversified investment portfolio.

When it comes to investing in gold, investors often see the world in black and white. Some people have a deep, almost religious conviction that gold is a useless, barbarous relic with no yield; it’s an asset no rational investor would ever want. Others love it, seeing it as the only asset that can offer protection from the coming financial catastrophe, which is always just around the corner.

Our views are more nuanced and, we believe, provide a balanced framework for assessing value. Our bottom line: given current valuations and central bank policies, we see gold as a compelling inflation hedge and store of value that is potentially superior to fiat currencies.

We believe investors should consider allocating gold and other precious metals to a diversified investment portfolio. The supply of gold is constrained, and we see demand increasing consistent with global economic growth on a per capita basis. Regarding inflation in particular, we feel that the Federal Reserve’s decision to begin a third round of quantitative easing makes gold even more attractive.

We see the Fed’s actions in the wake of the financial crisis as a paradigm shift whereby the Fed is attempting to ease financial conditions and encourage risk-taking by increasing inflation expectations. Its policies will likely result in continuous negative real interest rates because nominal rates will be fixed at close to 0% for the foreseeable future.

To be sure, gold isn’t the only asset with the potential to hold its value in inflationary times. For U.S. investors, at least, Treasury Inflation-Protected Securities (TIPS) offer an explicit inflation hedge. What’s more, TIPS tend to be less volatile than gold and, if held to maturity, are guaranteed to receive their principal back – barring a U.S. government default (which we see as incredibly improbable). Still, history shows that gold is highly correlated to inflation and has unique supply and demand characteristics that potentially lead to attractive valuations.

A unique store of value
For more than a millennium, gold has served as a store of value and a medium of exchange. It has broadly managed to maintain its real value, even as various currency regimes have come and gone. The reason is that the supply of gold is not at the whim of any governmental power; it is fundamentally supply constrained. Total outstanding above-ground gold stocks – the amount that has been extracted over the past few millennia – are roughly 155,000 metric tons. Each year mines supply roughly 2,600 additional metric tons, or 1.7% of the outstanding total. This is why gold can be thought of as the currency without a printing press.

The downside of gold is that it generates no interest. One ounce of gold today will still be only one ounce next year and the year after that. Because of this, gold is sometimes referred to as a non-productive financial asset, but we feel this characterization is misleading. Rather, we believe gold should not be thought of as a substitute for equities or corporate bonds. These have equity or default risk and therefore convey risk premiums.

Instead, gold should be thought of as a currency, one which pays no interest. Dollars, euro, yen and other currencies can be deposited to receive interest, and this rate of interest is meant to compensate for the decline in the value of paper currencies via inflation. Gold, in contrast, maintains its real value over time so no interest is necessary.

Today, the forward-looking return on holding U.S. dollars, and most other major currencies, has been artificially lowered by the Fed’s commitment to keep interest rates pegged at near zero for the next few years; real yields on U.S. government bonds are negative out to 20 years. In such a world, we believe the desire and willingness of investors to hold gold relative to other currencies increases dramatically, creating the potential for continued price appreciation.

The real price of gold

Of course, investors must also consider valuation, especially since some believe gold is overpriced. Figure 1 shows the inflation-adjusted value of gold since 1970. There is no doubt that gold prices, which averaged $1,630 in August, are high. However, in inflation-adjusted terms, gold is 12% below its 1980 peak. Inflation in 1980 hit 15% year-over-year, and inflation today is running much lower so some may question the validity of comparisons to 1980. While we believe that inflation over the next several years is likely to be higher, on average, than it has been over the past 20 years and that the tail risks are for much higher inflation, this speaks more to the outlook for the nominal price of gold.

The price of gold in real or inflation-adjusted terms is less affected by the rate of inflation and more impacted by the level of real interest rates because as discussed previously, it is the real interest rate that drives the relative attractiveness of holding gold relative to other currencies. With real interest rates negative on average for the next 20 years, it is of little surprise that gold is trading near its all-time inflation-adjusted high.

Even the inflation-adjusted value of gold doesn’t tell the whole story, however. Thanks to productivity gains and economic growth, per capita GDP is significantly higher today than 30 years ago. Thus, the average person today has more wealth and, all else being equal, can afford to pay relatively more for gold.

To Chinese, gold has never seemed less expensive
Figure 2 shows the ratio of gold prices to per capita GDP in the U.S. and China. In dollar terms, gold is still 34% below its 1980 peak, as U.S. per capita GDP is higher today. Furthermore, this is a relatively U.S. centric view, and considering that China represents the largest source of global gold demand, we believe investors take an overly myopic view at their peril. Chinese per capita GDP has grown at an 18% annualized rate for the past 10 years, compared with just 3% per year in the U.S. Thus, while gold might seem quite expensive to those of us in developed economies, its price seems much less expensive to those in faster-growing emerging economies like China.

Another way to think about the relative value of gold is to consider what a return to the gold standard might look like. In other words, what if the entire world’s gold were used to back the global supply of fiat currency? Globally there are roughly $12.5 trillion in physical and electronic currency reserves. Given that there are 155,000 metric tons of gold above ground, this equals an approximate price of $2,500 per ounce if all of the world’s reserves were to be backed by the entire stock of above-ground physical gold.

Not really so pricey
These points lead us to believe that gold valuations are not as stretched as a naïve look at its nominal price might suggest. Central banks globally are seeking to depreciate their currencies in a beggar-thy-neighbor attempt to stimulate their domestic economies (the Swiss National Bank is a prime example). Therefore, we believe investors should consider owning gold, precious metals and other assets that store value as long as central banks continue to print and maintain negative real interest rates.

Disclaimer:

Past performance is not a guarantee or a reliable indicator of future results. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.

This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Copyright © PIMCO

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French Economy Implodes

Thursday, October 4th, 2012

As expected, at least in this corner, the French economy has started to implode. Service sector business activity is dropping at fastest rate since October 2011.

More importantly, the Markit Composite PMI sports the steepest rate of contraction since March 2009 with job losses accelerating at the fastest pace in 33 months and output plunging at the fastest rate in 42 months.

Key points:

Final Markit France Services Activity Index at 45.0 (49.2 in August), 11-month low.
Final Markit France Composite Output Index at 43.2 (48.0 in August), 42-month low.

Summary:

French service providers reported a steeper decrease in business activity during September. The latest fall in activity reflected a considerable drop in incoming new work. Companies adjusted staffing levels down accordingly, leading to an accelerated drop in employment. Input prices rose at a sharper rate but output charge discounting gathered pace, highlighting a deepening squeeze on companies’ margins. Future expectations meanwhile dipped into negative territory for the first time since February 2009.

The seasonally adjusted final Markit France Services Business Activity Index – which is based on a single question asking respondents to report on the actual change in business activity at their companies compared with one month ago – posted 45.0 in September, down from 49.2 in August. The latest reading pointed to a marked rate of contraction in activity and the fifth decline in the past six months.
The seasonally adjusted final Markit France Composite Output Index – which measures the combined output of the manufacturing and service sectors – registered 43.2 in September, down from 48.0 in August. The latest reading was indicative of a substantial decline in activity and the steepest rate of contraction since March 2009.

Service sector activity declined in response to a further fall in new business during September. The rate of contraction in new work accelerated to the fastest in five months, with anecdotal evidence pointing to lacklustre demand conditions and clients delaying decisions on projects. Combined with a steeper decline in new orders in the manufacturing sector, overall new business across the French private sector fell at the steepest rate for 41 months.

Reduced workloads prompted French service providers to make further cutbacks to employment during September. The rate of job shedding accelerated to the sharpest for 33 months, with panellists indicating that staffing levels were lowered in response to declining activity and as part of cost-cutting efforts. Composite data signalled the sharpest reduction in employment since December 2009.

Right On Time

If that does not accurately describe implosion, what does? Looking for who or what to blame? Look no further than inane work rules and regulations made worse by the socialist government of president François Hollande.

On June 16, in “France Has At Most Three Months Before Markets Make Their Mark” I wrote …

If socialists take control of both houses in French parliament as expected, president François Hollande would have free rein to carry out his stated policies such as hire more public workers, raise taxes on the rich, and Wreck France With Economically Insane Proposal: “Make Layoffs So Expensive For Companies That It’s Not Worth It”

Well, three months have passed and the French economy is clearly imploding and Hollande has not even fully followed up on his economically insane promise regarding layoffs, but he has pressured companies to not do so, and he has also massively raised taxes (a splendidly stupid thing to do in recession).

You reap what you sow, and the implosion of France is now underway. Odds of France making its budget projections are in my estimation close to zero, but time will tell.

Mike “Mish” Shedlock
http://globaleconomicanalysis.blogspot.com/

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If It’s All About Macro These Days, Why Haven’t EM Stocks Done Well?

Thursday, October 4th, 2012

by Morgan Harting, AllianceBernstein

It doesn’t seem to make sense. Superior macroeconomic fundamentals in emerging countries have not led to stronger—or even positive—equity returns over the last two years. Since the beginning of 2011, the unhedged return in US dollars of the MSCI Emerging Markets (EM) Index has been (10)%, while the MSCI World Index has delivered 6.5%. What’s going on?

The answer is simple: Even in a time when the markets are highly sensitive to news about macroeconomic developments and government policy in developed markets, investors still pay attention to earnings. And while economic growth and corporate sales and profit growth rates remain higher in emerging markets than in developed markets, the sharper economic deceleration in emerging economies has led to an even sharper deceleration in earnings.

Emerging-market sales growth has generally kept pace with economic expansion, but profit margins have shrunk due to rising costs, particularly for commodities and wages. In developed economies, by contrast, sales growth has been sluggish, but companies have been better able to sustain margins. Their greater orientation to service industries and higher value-added businesses have made developed-market companies less susceptible to commodity-price pressures, while their stronger bargaining power with labor has allowed them to keep a lid on wage growth.

Investors in emerging markets have still been able to profit from superior macroeconomic fundamentals—if they’ve owned bonds as well as stocks. The JP Morgan Corporate Emerging- Market Bond Index (denominated in US dollars) has returned 25% since the beginning of 2011. Investors have rewarded emerging-market corporate bonds’ appealing combination of lower balance sheet leverage and higher yields. Lower leverage is great for bondholders, but not necessarily ideal for shareholders.

What’s ahead? Recent PMI surveys above 50 across emerging economies as diverse as Brazil, Mexico, India, Russia and Turkey point to favorable near-term momentum. But the sustainability of growth in these and other emerging countries will hinge on a recovery in global growth, in our view. There are also signs in some countries that domestic credit expansion is hitting its limit.

With the consensus estimate calling for 13% earnings growth in emerging markets next year and the MSCI EM trading at just 10 times 2012 earnings, investors could reasonably expect annualized returns in the low double digits over the next several years, if the consensus estimate proves accurate. To the extent that corporate debt issuance in emerging markets continues to be heavy, increased financial leverage could drive even faster earnings growth and stronger equity returns.

This increased leverage, if it occurs, would not necessarily hurt emerging-market bonds. Since corporate balance-sheet leverage in emerging markets is generally reasonable, additional debt issuance needn’t undermine the creditworthiness of emerging-market corporate debt. Strong expected demand is likely to keep corporate bond yields relatively low, allowing issuers to reduce their interest expenses.

With the yield on emerging-market corporate bonds currently at about 5%, it’s hard to imagine returns rising much higher, but the lower expected volatility of bonds would still make the asset class an important complement to equities. A wider range of new issues also creates an opening for investors in emerging-market stocks and bonds to make opportunistic plays on individual companies’ capital structures.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Morgan Harting leads the Emerging Markets Multi-Asset portfolio team at AllianceBernstein.

Copyright © AllianceBernstein

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4 Years After TARP – Winners, Losers, Bubbles, And Troubles

Thursday, October 4th, 2012

Four years ago today, the Troubled Asset Relief Program was signed into law. We thought it timely to take stock of different asset price levels with respect to that magnificent day in the history of our country as well as how a broad cross-section of global asset markets have performed relative to their pre-crisis peaks. Of the major US banks, Wells Fargo has done the best (-2.3%) while BofA and Citi are worst (down ~80%). As Goldman notes, two features stand out when we look at the broad markets: asset markets that have outperformed and are closer to pre-crisis peaks are either ‘defensive’ in some way, or have benefited inadvertently from the ‘Great Easing’ in response to the crisis. From precious metals and Swedish and Canadian house prices at the top to European bank stocks and US Growth at the bottom; ‘hard assets’ and ‘defensives’ combined with central bank yield compression has, as we would expect, dominated performance.

US major financials…since TARP (10/3/08)

Cross-asset-class retracement of pre-crisis peak…

and drilling down…

Equities – DM Defensive and Smaller EMs have surpassed pre-crisis peaks, and Majors nearing those peaks…

Bonds & FX – well above their pre-crisis peaks…

In the case of some of these nominal recoveries, it’s as if the crisis had never happened – just how the central planners had ‘planned’ it – though the evidence of newly forming bubbles is clear.

Source: Goldman Sachs

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