Chart Snapshot: S&P 500, Gold, Crude, VIX

Risk appetite firmed over the week with equities benefiting from better than expected corporate earnings data, improving investor confidence, technical buying on resistance levels and an International Monetary Fund upgrade to global growth forecasts for 2010. Gold, like equities, also rallied whilst volatility, measured by the VIX index dipped again after temporarily spiking on poor jobless data from the 2nd which sparked last week’s decline.

Oil also stabilised near $60 after a brief sell off but remains rangebound with improving global sentiment offsetting growing US inventories.

Risky asset prices are not yet stretched (RSI) following the week’s progress and with most key corporations surpassing earning predictions further gains can not be ruled out in the short term.

S&P 500 Daily Chart

SPY Daily to 17th July 2009

Gold Weekly Chart

Gold Weekly Chart to 17th July 2009

Crude Oil Weekly Chart

Crude Oil Weekly to 17th July 2009

VIX Weekly Chart

VIX Weekly Chart to 17th July 2009

Gold. Long-term Robust, Short-term Vulnerable

Gold has benefited greatly over the past 18 months as investors sought a safe haven from the economic and financial turmoil. Since the worst of the banking crisis eased earlier in 2009, buying pressure has lessened slightly and gold has drifted closer to $900, returning from its brief journey above $1,000. Whilst the long term case is secure and attractive to many speculators, the near-term scenario appears to offer further downward potential, and a return to the 50-week moving average circa $875 looks highly likely.

Gold Chart to 11th July 2009

Only 2 Assets Classes: Cash, & Everything Else

We are in truly unique times. The depression of the 1930’s shares the most traits with the current recession. Both periods suffered systematic failures, rather than just being ‘bubble’ recessions, but there are key differences. Over the past 75 years ago, financial instruments have increased exponentially both in terms of their complexity and breadth of international distribution. Risky assets such as equities, corporate bonds, property, commodities, higher yielding currencies and the infinite number of alternative investments were previously thought to offer strong diversification benefits, when combined, through all stages of the economic cycle. The past year has proved that theory wrong.

The correlation (similarity in performance and volatility) of all risky assets increases substantially in periods of systematic stress. It always has. Also the correlation of risky assets has increased generally since the mid 1990’s, through all stages of the economic cycle due to globalisation and the ability to trade any asset class online from any location. The efficient circulation of information also means buyers and sellers can act simultaneously creating additional momentum in price volatility across all markets.

Add into this high-correlation equation the lack of liquidity suffered by investors in times of turmoil, particularly those exposed to more exotic instruments previously marketed as having absolute return characteristics, and I would suggest in times of recession and economic turmoil, there are not a plethora of asset classes, there are two: risk free assets and all risky assets. If you really pressed, I would be sympathetic to the view that gold can represent a third asset class in such times.

I would also suggest future recessions are inevitable. Governments and central banks are committed to using monetary policy as the primary tool to stimulate or cool down the economy. This blunt instrument distorts the nominal supply of money relative to the real economic wealth of society. During periods of monetary easing a large proportion of this excess supply of money is consistently misallocated to consumption and financial transactions. Inflation and asset price bubbles are the result. Higher interest rates follow, confidence weakens, demand falls, prices collapse, liquidity fades and the circle of boom-bust remains intact.

In summary:

1. The performance characteristics of constituents within risky asset portfolios are increasing in correlation over time.
2. That correlation jumps higher when the benefits of diversification are most needed, in times of market turmoil.
3. Traditional diversification techniques used today do not work.
4. We will suffer more recessions and renewed market turmoil in the future.

Is it fair to conclude the current framework of the investment industry is therefore flawed?

Does Gold Always Go Up in Recessions?

Gold Weekly to 18th June 09

By Robert Prechter, CMT. The following article is adapted from a brand-new eBook on gold and silver published by Robert Prechter, founder and CEO of the technical analysis and research firm Elliott Wave International.

I have often read, “Gold always goes up in recessions and depressions.” Is it true? Should you own gold because you think the economy is tanking? Whenever we hear some claim like this, we always do the same thing: We look at the data.

The first thing to point out is that gold did not make a nickel of U.S. money for anyone in any of the recessions and depressions from 1792, when the gold-based dollar was adopted, through 1969, a period of 177 years. Well, to be precise, there was a change in the valuation in 1900, when Congress changed the dollar’s value from 24.75 grains of gold, the amount established in 1792, to 23.22 grains, a devaluation of just six percent total over 108 years. The government did raise the fixed price from $20.67/oz. to $35/oz. in 1934, but that action occurred during an economic expansion, not during the Depression. In 1968, gold finally began trading away from the government’s fixed price. Even then, it slipped to a lower price of $34.95 on January 16 and 19, 1970. So the idea that gold always goes up in recessions and depressions is already shown to be wrong. It did not go up in terms of dollars in any of the (estimated) 35 recessions or three depressions during that period.

What almost always does happen during economic contractions is that the value of whatever people use as money goes up as prices for goods and services fall. When gold is used as money, its value in terms of goods and services goes up. But gold can’t go up in dollar terms when gold and dollars are equated. So no one “makes money” holding gold under these conditions. It is a fine point: What tends to go up relative to goods and services during economic contractions is money, and when gold is officially money, that’s how it behaves. What we want to know is how gold behaves in recessions and depressions when it is not officially accepted as money.

Many gold bugs say that because gold was a good investment during the Great Depression, it is a “deflation hedge.” We addressed this topic in At the Crest of a Tidal Wave (1995, p.357) and Conquer the Crash (2002, pp. 208-209). At the time, government fixed gold’s price, so it didn’t go up or down relative to dollars. Gold was a haven during that time, the same as the dollar was, since they were equated by law. But gold served as a haven because its price was fixed while everything else was crashing in price during the period of deflation. Gold bugs like to claim that gold would have gone up during that period had it not been fixed, but the crashing dollar prices for all other things suggest that in a free market gold, too, would have fallen. It would have fallen, however, from a higher level given the inflation of 1914-1929 following the creation of the Fed. So gold became worth more in dollar terms than it was in 1913, which is why it began flowing out of the country. In 1934, the government finally recognized the new reality by raising gold’s fixed price. Since 1970, markets have been in a large version of 1914-1930, except that gold has been allowed to float, so we can clearly see its inflation-related, pre-depression gains.

Observe that gold’s price remained the same for a Fibonacci 21 years after the Fed was created in 1913; it was revalued in 1934. [Ed. Note: For a full chapter on Fibonacci time considerations for gold, download the 40-page Gold and Silver eBook.] Then it held that value for 35 (a Fibonacci 34 + 1) years, through 1969. So aside from the revaluation of 1934, the inability to make money holding gold during recessions, depressions, or any time at all save for the day of the revaluation in 1934 held fast for 56 (a Fibonacci 55 + 1) years following the creation of the Fed. So even after Congress created the central bank, no one made money holding gold in a recession or depression for two generations.

In 1970, things changed dramatically. Investors lost interest in stocks and preferred owning gold instead, for a period of ten years. The same change occurred again in 2001, and so far it has lasted seven years. But, as we will see, recession had nothing to do with either of these periods of explosive price gain in the precious metals.

The period of time one chooses to collect data can make a huge difference to the outcome of a statistical study. If we were to show the entire track record from 1792, gold would show almost no movement on average during economic contractions. If we were to take only 1969 to the present, it would show much more fluctuation. To give a fairly balanced picture, combining some history with the entire modern, wild-gold era, I asked my colleague Dave Allman to compile statistics beginning at the end of World War II. This is what most economists do, because they believe “modern finance” began at that time and that things have been “normal” since then. It’s also when many data series begin. So our study fits the norm that most economists use. It also provides results entirely from the Fed era, making it relevant to current structural conditions.

[Ed. note: To study the six tables revealing gold's performance record vs. stocks and T-notes since WWII, download the 40-page Gold and Silver eBook.]

Table 1 shows the performance of gold during the 11 officially recognized recessions beginning in 1945. Although one could make a case for different start times, we took the 15th of the starting month and the 15th of the ending month as times to record the price of gold. The results speak for themselves. Even though it is accepted throughout most of the gold-bug community that gold rises in bad economic times, Table 1 shows that such is not the case.

The only reason that the average gain for gold shows a positive number at all is that gold rose significantly during one of these recessions, that of 11/73-3/75. The average gain for all ten of the other recessions is 0.16 percent, almost exactly zero. The median for all 11 recessions is also zero. If we omit the five recessions during which the price of gold was fixed, the median gain is 3.09 percent.

For long-term forecasts and more in-depth, historical analysis for precious metals, including the six revealing tables mentioned in this article, download Prechter’s FREE 40-page eBook on Gold and Silver.

The Global Economy 26th April 2009

The Global Economy Despite further poor economic news over the week, investors have continued to steadily allocate funds away from cash to risky assets. Gold bears, in particular, were forced to sit-up and re-examine their strategy. China, long thought to be committed to hoarding US Treasuries to build its reserves, advised the International Monetary Fund (IMF) that it had aggressively increased its holdings of gold since 2003, the last date the Peoples Republic disclosed its interest. China now has the 5th largest holding at 1,054 tonnes up from 600 tonnes previously. The move makes sense and is an effective hedge against USD depreciation as the commodity is denominated in dollars. The China Gold Association, even taking their own invested interests into consideration, put the magnitude of the increase into perspective suggesting the PRC should accumulate up to 5,000 tonnes, a figure, it suggested, which would be in proportion with Chinas status as the worlds 3rd largest economy, behind Japan and the US. A number of commentators predict that Chinese GDP will overtake Japan’s output shortly and the US within 20 years.

Also on the global stage, the IMF released a comprehensive report on the global economy and commented on the measures taken by governments in recent months to accelerate the pace and strength of the recovery.The IMF report is summarised as:

• The intervention taken by governments, to date, has made a positive impact reducing the severity of the recession, prevented a meltdown in the banking sector, improved corporate confidence and stimulated growth.
• However, further measures are needed to stimulate the global economy, achieve positive growth and to strengthen the banking sector.
• The current process of bank de-leveraging needs to be pursued more aggressively to both reduce systematic risk and strengthen the balance sheets of banks.
• A number of key banks may need to further increase their capital adequacy by either issuing equity or via government support.
• A combination of failing businesses and falling asset prices may result in write-downs in the US of $2.7 trillion (revised up from the previous January 2009 IMF prediction of $2.2 trillion).
• Globally, $4 trillion of asset write downs may be required, of which approx 2/3rds relates to vulnerable assets on bank balance sheets.

The IMF also speculated that if a global recovery occurs earlier and with more momentum than currently predicted these forecasts might be bettered (smaller asset value write-downs). However, as the recession is both highly synchronised across developed and emerging nations and largely caused by systematic failures in the banking and financial sectors, the recession is likely to be both longer and deeper than most recessions of the past 100 years.

With the themes of ‘recession’ and ‘Obama’ dominating the news for some months now, investors have been distracted from other key-geopolitical issues and none is more significant than the growing tension between Israel and Iran and the implications for all asset classes especially gold, oil and equities in the event of an Israeli attack on Iranian nuclear facilities. The recent destruction of a Sudanese convoy carrying weapons destined for Gaza is widely accepted to have been authorised by the Tel Aviv government and executed by the Israeli Air Force. The Israeli authorities are also planning a nationwide drill next month to prepare residents in the event Iran retaliates, which it surely would if attacked. Most tellingly, key Israeli spokesmen are increasingly stressing they can’t and won’t wait much longer before taking action as “when Iran secures a nuclear weapon, it will be too late”. Iran is expected to finalise its weapon program possibly within 2 years. The only external influence capable of preventing an Israeli attack is President Obama who is determined to pursue peace across the region and handle the Iranian state more sympathetically than the previous Bush administration. But if Obama fails to make significant diplomatic progress in the very near term traders would be well advised to keep fingers poised to sell equities, buy oil and buy gold.

Closer to home, Spain has reinforced its status as the weakest major Euro-zone economy. The property market has near-collapsed. Unemployment, traditionally one of the highest in the Euro-zone even in stronger economic periods, has reached an all-time high since organised records began. Economic activity has fallen of a cliff, with a 3% GDP contraction in 2009 probably the best that can be hoped for. Economists therefore awaited the recent update on employment data with apprehension, but even the most pessimistic forecaster must have been shocked on confirmation more than 800,000 lost their jobs in the 1st quarter bringing the total to a staggering 4 million (17.4%). Deflation, a curse on investment, is also an ongoing risk with falling consumer and input prices. The governments previously announced stimulus package amounting to Euro 50 billion is wholly insufficient given the scale of the problem. February’s industrial output, down 22% on the same month a year earlier, further reinforces Spain’s dilemma with the demand for capital goods and exports likely to remain weak for at least another 6-9 months, possibly deep into 2010. Like the UK, Spain will now suffer a multi-year budget gap, the difference between tax receipts and government expenditure, which a traditional cyclical upturn in GDP growth will be inadequate to fix. That ‘place’ in the sun, the 2nd home that Europeans aspire to buy, is going to get a lot cheaper.

UK I hate to sound like a husband, patronising the wife over the household finances, but Darling, you have got your sums wrong. I am, of course, referring to the would-be intellectual colossus, the ex-Transport Secretary, Alistair Darling, who on promotion to the Exchequer was left holding the ‘parcel’ when the music of markets, liquidity, stopped. Just a first few months after moving into Downing Street, Darling has found himself Chancellor of a UK balance sheet ruined by bank bail-outs and 12 years of the government spending beyond its means.

So last weeks confirmation that UK GDP contracted 1.9% in Q1 after falling 1.6% the previous quarter was the final nail in the coffin of Darlings forecasting credibility. In fact, the government’s official predictions for growth differ so much from the forecasts of the IMF and other respected institutions; you could fit one of Darling’s late trains between them, from his ineffectual time at the Department of Transport.

The contraction in the first quarter was the worst 3-month decline in economic output for 30 years with manufacturing, down a deeply worrying 6.2% despite the weakness of Sterling over the quarter, relative to the year before, which should have aided exports.

As soon as the data was being described as “dreadful” by seasoned commentators, you could just sense the government’s public relations machine repackaging the latest batch of Labour clichés; “global recession” and “unprecedented times”. I know there’s a recession Darling, but did you or your neighbour, Gordon Brown, think to save any pennies over the past 12 years, when the country was enjoying growth, so you had a bit saved away for when the household finances worsened?

The GDP data followed the budget announcement earlier in the week, the headlines being:
• Income tax on earners above £150k per annum to increase from 40% to 50%.
• Pension tax relief for highest earners to fall from 40% to 20%.
• UK GDP forecasted at negative 3.5% in 2009, positive 1.25% in 2010.
• Debt to GDP to rise to 79%. Ratio unlikely to improve until 2015.
• Current tax year government borrowing to be approx £175bn.
• ISA allowance to increase to £10,200 p.a.
• Child tax credit increased.
• Duty on cigarettes and alcohol to rise 2p.
• Further rises on fuel duty of 2p, then 1p above inflation.
• Banks to increase mortgage lending by a further £20bn.
• More financial support to assist the unemployed under 25 to secure training or work.
• £2,000 subsidy for new car buyers, when trading in vehicles more than 10 years old.
• Financial support to boost house-building and green industries.

Unimpressed with the budget, gilts prices retreated as investors sold out of UK government debt on concerns over the credibility and accuracy of the budget economic growth forecasts. Further gilt price declines, and therefore higher yields, are predicted as commentators suggest the UK government will have to offer a higher income stream in future to persuade investors to buy its debt as supply is likely to outpace demand at current yields. Some economists are speculating up to £220bn in gilts may have to be issued in the current year up from a pre-budget consensus of £175bn. The Bank of England is likely to come under renewed pressure to increase the purchase of gilts via the recently confirmed quantitative easing policy to help reduce yields and therefore the cost of borrowing.

Company Focus
Barclays Bank PLC (BARC) 236.00p
When we reviewed Barclays just a few weeks ago, on 16th March, the shares were loitering at a miserable 74p and investors had yet to enjoy the sharp market-wide rally that has helped take Barclays stock to 236p. A lot has changed in these few weeks to help drive the price. Barclays passed the FSA stress test, market sentiment has improved towards banks, though concerns over bad debt exposure persist and a number of global players in the sector have released better than expected Q1 earnings data (Credit Suisse, Goldman Sachs and Citigroup in particular). Despite the recent rally, the annual general meeting held on Thursday was bound to be an interesting event with shareholders looking for guidance on the dividend policy and clarification over strategy; whether the bank would lean towards the pursuit of earnings growth or strengthening the balance sheet. Marcus Agias, the Barclays chairman, tackled the issues head-on, first with an acknowledgement of “sincere regret” over the share price volatility and then reassuring shareholders seeking growth that the bank would increase lending by a further £11bn, split equally between home buyers and business loans. Agias also confirmed Q1 2009 was “well ahead of the prior-year period” and that the bank was keen to pay a dividend next year though the pay-out would be more conservative than the historical average payout which adopted a dividend cover of 2 (around 50% of attributable earnings paid to shareholders). The Barclays CEO, John Varley, also took the opportunity to articulate his optimism for both Barclays and the UK economy predicting borrowing and consumption by both companies and consumers would stimulate growth during the latter part of 2009 and in to 2010. The AGM followed a significant sale of BARC shares by the banks largest shareholder, Qatar Holdings, who took advantage of the recent rally to reduce their holding from 6.4% to 5.8% of BARC equity.

Legal & General PLC (LGEN) 50.30p
Legal & General, like Prudential and Aviva, straddles the sectors of life assurance, insurance and asset management. Dozens of years of steady asset accumulation has provided each with a large slice of the consumer savings and pension fund cake. Relative to the investment banks, all three err on the side of caution with a relatively conservative approach to managing money and a healthy diversified mix of assets including equities, fixed interest securities and commercial property. L&G also near-dominates the retail tracker product space offering investors a cheap and cheerful way to track equity markets down, or of course up when risk appetite is so inclined. Having such breadth and depth of exposure to the stock market, and therefore exposure to the health of corporations and the wider economy it is no surprise that L&G felt pain over the past year. So how did it cope relative to the leading competition? Firstly, it cut the dividend in a pretty unpopular move with the City and shareholders. If the grandfather of UK finance, with its cautious approach to fund management had to cut its pay-out to shareholders, it didn’t bode well for the rest of the sector. But then analysts took a glance over at the Pru, with their more ambitious and presumably capital intensive expansion into Asia to cope with. Not only have the Pru maintained their dividend, they actually increased it 5%. Cue sharp fall in L&G stock. Investors who felt obliged to have exposure to the sector reallocated cash from L&G to Prudential. And who can blame them. As well as announcing a dividend cut, L&G also confirmed a fall into the red for the year with a IFRS operating loss of £189m (2007: profit £658m) whilst IFRS shareholders equity per share fell to 61.2p for 2008, relative to 86.5p for the prior year. In an effort to defend the balance sheet from further deterioration L&G sold £1bn of equities and transferred the capital to liquid instruments, which improved balance sheet strength but will hold back returns in the event of a sustained stock market recovery. More logically, L&G also lifted its provision for non profit annuity credit defaults to £1.2bn and described the measure as necessary, despite the relative high quality of its bond portfolio, in case the default rate worsened further to a 70 year high (since the Great Depression). Looking forward the firm is committed to further building balance sheet strength, conserving cash and de-risking the business model, primarily by moving away from capital intensive products. But the damage is already done and is reflected in a weak stock price of 47p compared to a 12-month high of 130p.

US Company Focus
Yahoo & Morgan Stanley
Reflecting the global significance of key US corporate updates, and as we are deep into the Wall Street Q1 reporting season here’s a brief look at two of the headline reports from New York over the past week.

Yahoo, the online email, news and search engine provider announced late on Tuesday its Q1 net income fell to $117.6 million, or 8 cents a share, from $536.8 million, or 37 cents a share in the same period a year earlier. Net revenue fell to $1.2 billion for the period ended in March. The Q1 report is in line with the consensus forecasts provided by leading analysts. The Yahoo CEO, Carol Bartz, also indicated the group may narrow its product range in an effort to streamline the business and improve financial performance in response to the global recession, increasing online competition and lower advertising revenues. Looking forward, sales for Q2, Yahoo predicts, will come in between $1.43bn to $1.63bn, slightly more pessimistic than anticipated. 700 job cuts were announced though Bartz stressed the lay-offs may be off-set by ongoing recruitment in key areas of the business. The company reduced 1,600 workers in Q4, prior to Bartz joining the internet corporation. The update also demonstrates the implications for revenue of the growing consumer trend away from traditional internet players such as Yahoo, (but also Google), towards to new platforms such as Twitter and Stumbleupon which offer real time messaging and more creative search functionality, respectively. In the US financial sector Morgan Stanley, the investment bank and brokerage, cut its dividend to 5 cents a share (from 27 cents) to hoard cash as earnings per share fell significantly short of analyst predictions with a loss of 57 cents, relative a consensus forecast of a 8 cents loss. The worse than expected data is a result of continued asset write downs and bad debt exposure on residential and commercial real estate. The Q1 loss, of $177m, was driven primarily by $1 billion in real estate losses. Noticeably, Morgan Stanley reported much weaker figures relative to other key global players in the same sector; Goldman Sachs, Citigroup and Credit Suisse.

Mike@tradinghelpdesk.com
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