Price of Gold

Being patient with the market is not all that stimulating to write about.

Looking at the price of gold over the past five days, it has been extremely volatile. The 5-day chart (for December gold delivery) is here:

As always, timing is everything. Although I believe gold is vastly overpriced, it is very difficult to compete against momentum and psychology, especially when the US government is still running deficits north of a trillion dollars – currency erosion (including that of most global currencies, not just including the US dollar) is playing a large part in the increase of the price of gold.

To get an idea of traditional valuation it is good to look at marginal cost of extraction in various gold mining companies. Of course, traditional commodity valuation methods only tend to be valid for a long term projection in terms of decades – the gyrations witnessed inbetween are gut-wrenching for most commodities.

An omnious market sign

The following headline graphic on CNNfn is something that you will not be finding at a market bottom:

VIX might be at 43%, but it seems that it could get even higher to flush out any bullish sentiment left in the marketplace.

This week and the next will continue to be dominated by noise while the key decision-makers have their portfolios on algorithmic autopilot. I believe after the labour day long weekend is when things will get interesting again. Most pension fund managers are probably scratching their head and wondering how they heck they can achieve their expected return on plan assets when their equity components have tanked.

Fixed rate mortgage rates will drop

Attached is a 1-year chart of the 5-year government benchmark bond yield:

5-Year Canadian Government Bond Yield

With a yield of 1.41%, this is the lowest the 5-year yield has been for decades. The lowest reached during the last economic crisis (January 14, 2009) was 1.54%.

The quick implication is that the 5-year fixed mortgage rate will likely drop. Although we are completely bathed in the midst of a European financial crisis (causing collateral damage domestically, just as the US economic crisis caused damage in Canada), banks are apparently solvent.

What will be an interesting question is whether this recent crush in the markets will cause a decrease in real estate prices or whether prices will continue to remain strong, especially in the Vancouver area. Real estate, gold, and government treasuries are three asset classes that have managed to hold value, while everything else has been dumped. If real estate prices are compressing then banks may tighten credit requirements (e.g. higher down payment, higher rate, etc.)

Still not buying anything

Despite having over a 70% cash position at present, I still remain highly skeptical of the marketplace. Although I am happy to see things dive down another 4% on the major indicies (2% on the TSX), the root causes of this mayhem have not been addressed at all yet. I still highly suspect there is more to come. There will continue to be gut-wrenching rallies up and crashes down and today is an example of a crash down. The next two hours of trading can change everything, but the mid-term trend is clearly down. Although mathematically volatility is “up and down”, it strongly correlates with a down market when buying volatility futures!

However, when looking at the numbers, today’s dump feels less liquidity-inspired than the previous dump (where everything was getting thrown out the window if there was a bid). I do notice that certain fixed income products have been able to outperform (by falling less) and also Canada has fallen less unless if you are invested in the natural resource sector (commodities have been hammered). Typical defensive issues (e.g. consumer staples) have also fallen less than commodity-linked products.

My entire premise for this market drop is a combination of a grave concern on a macroeconomic scale (i.e. a pending devaluation of the US dollar) with a deleveraging of portfolios – you can only borrow at 1-2% and purchase income-oriented securities for so long before the capital value of such income-oriented securities suddenly take a plunge and then you have to deal with the margin call of the decade to truly pay for it.

While we are on the topic of interest rates, Canadian short term implied rates have also projected a chance of a rate cut by years’ end:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 11 SE 98.780 98.785 98.755 0.025 5322
+ 11 OC 0.000 0.000 98.725 0.000 0
+ 11 NO 0.000 0.000 98.805 0.000 0
+ 11 DE 99.020 99.030 98.910 0.110 16290
+ 12 MR 99.120 99.130 99.000 0.120 21771
+ 12 JN 99.150 99.160 99.010 0.140 11273
+ 12 SE 99.140 99.150 98.980 0.170 4853
+ 12 DE 99.130 99.140 98.950 0.190 2782

A December BAX rate of 99.02 corresponds to a rate of 0.98%, which should be compared to a 1.18% rate for 3-month Bankers’ Acceptances – the markets are predicting a higher chance of a rate cut than not.

The week ahead

In what promises to be a less exciting week coming up in the market as it continues its summer doldrums, market participants should be aware that most of the brains behind the heavy money funds will be on vacation in August.

It would not surprise me in the least to see some sort of bounceback in the S&P 500 to levels about 5% higher than here, but there are larger undercurrents going on that may continue having the computer traders pound anything that is offering liquidity – mainly the well-known European sovereign debt crisis.

Back in 2008 when Bear Stearns, Merrill Lynch and Lehman Brothers were collapsing, everybody knew what was causing the financial crisis, but nobody had a clue when the damage would stop – in this case, it was in March 2009 when the ultimate lows were reached. I suspect that something like this will be happening again, but it is difficult to tell whether it will be a few months after a main triggering event, or even a few years.

Either way, the root cause of most financial problems stem from debt and leverage. Right now, the problem is that certain banks assumed that their assets (debt in less than reputable soverign nations) were worth as much as they are on their balance sheets, but ultimately they are not.

Looking a little less globally, when less knowledgeable people listen to their “financial advisors” and borrow money at prime (3%) to invest in some bond or index fund which will make them a “long term stable return” of 6%, they will also discover the urge for liqudiation when their leverage factor imparts huge losses on their net worths.

I do not believe it is time to start buying things yet, but the valuations look compelling. Rather, now is the time to research things that will be worth buying when the market decides to take another deleveraging-induced dive.

Something I have consistently found puzzling is that there are a variety of companies that are selling under projected P/Es of 10, which makes them seem infinitely more attractive than the 10-year government bonds that are giving out a yield of 2.24%. Just to use an arbitrary example of Dell (Nasdaq: DELL), we have a company that has a market cap of $28 billion, about $7 billion net cash on the balance sheet, and for the past two years has generated about $3.5 billion in free cash flow (about $1.87/share) and trading at a stock price of $14.87, or roughly 8 times free cash flow generation.

What the bond market is effectively betting is that companies like Dell aren’t going to make as much money as they have been, or that the risk premium afforded to common shares of Dell is quite high. It is not like the company is in the pharmaceutical industry where you have to worry about patent expirations and other time-sensitive risk. It is quite difficult to conceive of scenarios where you would see the diminution of the business – perhaps Amazon will compete? An investor would have to answer this question in order to consider owning the stock, otherwise they are playing poker without looking at their own cards.