The Value of Gold

A child of Zeus, neither moth, or rust devoureth it, but the mind of man is devoured by this supreme possession.
                                Pindar, 5th century BC Greek poet, describing gold.
 

After two decades of nearly continuous appreciation, the price of gold topped in August of 2011 at 1889.7 an ounce and have since retreated to the 1600 per ounce level. However, interest in the shining yellow remain high. Tuesday, on CNBC's "Future Now" program, RBC precious metal strategist spoke of the misconceptions of gold.

Gold is one of the most widely held financial assets - but that doesn't mean everyone understands the catalysts that drive gold higher or lower. On Tuesday's "Futures Now," RBC Precious Metals Strategist George Gero set out to clear two of the biggest misconceptions people have about gold.

Misconception One: If Gold Falls for a While, That Gives You a Good Chance to Buy It

This one sounds pretty obvious. Gold is worth a given amount, so if people keep selling it, than it will fall to a level at which it's a good value - right?

Well, not exactly. As Gero explains, "Asset managers look for performance - and performance has not been with gold." This explains why the major stock market rally has presented a serious headwind for gold. As stocks have seriously outperformed bullion, managers moved their money out of bullion and into what was working.  

That's why trends in the gold market can be far more important than any sense of inherent value - meaning that, paradoxically, falling gold prices are bad news for people who are looking to buy in.

Whatever merits or lack there of are in what the "expert" had to say, is not the object of this post. However, the assertion that professional asset managers who try to profit from changes in the value of gold had nothing better to go on other than the price of gold itself speaks loudly to the nature of the value of gold. Financial assets derive their value from actual and potential cash flow. Holding gold generates none. In this sense, gold doesn't even qualify as a financial asset. Gold is a good, much like food and shelter which derive their value from utilities. Gold serves primarily two functions, one as adornment and the other as media of exchange or money.

Gold is used as jewelry. The reasons are of course self evident. However, gold also serves its other purpose better than any material in the world. Gold is found on every continent, yet rare enough and hard enough to dislodge from the rocks that surround it to be valuable. Gold is inert, malleable and infinitely divisible. Other materials have been used as money throughout history, but none more universally recognized and successful as gold. So in gold, not only lies the perfect attributes of money, but also the brand equity of universal acknowledgement.

On this earth, there are two universal currencies, gold and the US dollar. Gold priced in US dollar has been stalled because the US dollar has been strengthening against other major earthly currencies such as the Euro and the Japanese Yen.

Who is Jeroen Dijsselbloem

Jeroen Dijsselbloem, a name investor better get used to, made news yesterday by saying the Cyprus bank recapitalization plan serves as a template for future Eurozone bank rescue plans.

(Reuters) - A rescue programme agreed for Cyprus on Monday represents a new template for resolving euro zone banking problems and other countries may have to restructure their banking sectors, the head of the region's finance ministers said.

"What we've done last night is what I call pushing back the risks," Dutch Finance Minister Jeroen Dijsselbloem, who heads the Eurogroup of euro zone finance ministers, told Reuters and the Financial Times hours after the Cyprus deal was struck.

 

"If there is a risk in a bank, our first question should be 'Okay, what are you in the bank going to do about that? What can you do to recapitalise yourself?'. If the bank can't do it, then we'll talk to the shareholders and the bondholders, we'll ask them to contribute in recapitalising the bank, and if necessary the uninsured deposit holders," he said.

Later on, Mr. Dijsselbloem attempted to retract his statement by tweeting that Cyprus was merely a "specific case." One can only guess if his recantation was made after seeing markets trade off after his comment or because the template idea was only his own thought, not the consensus among European finance minsters. Arguable, Mr. Dijsselbloem's slip was much less damaging than his predecessor, Jean-Claude Juncker, who famously quipped,"when the going gets tough, you have to lie." However, Mr. Dijsselbloem must quickly learn that the markets hates surprises. If Cyprus were to serve as the template, then by all means let the market know and be prepared. If it is indeed a "specific case," those in charge must be adamant even if you are not so sure you can really guarantee such outcome.

Meanwhile, in the US, home prices are up and durable goods orders were robust. As the world burns, will the power of US consumers extinguish the flames abroad or will the US economy fall victim to world contagion? Many have offered guesses, but only time can tell.

Experts on Cyprus

Upon hearing the last minute deal for the re-capitalization plan for the two troubled Cyprus banks, a Reuters article optimistically declared,"Cyprus deal to bring US stock rally, experts say."

The last-ditch effort to save the banking system in Cyprus should bring a rally when U.S. stock markets open on Monday, according to several investment managers.  

Cyprus secured a 10 billion euro ($13 billion) package of rescue loans in tense, last-ditch negotiations early Monday, In return for the bailout, Cyprus' second-biggest bank, Laiki, will be restructured, and holders of deposits exceeding 100,000 euros will have to take losses.

It was unclear just how big of a hit big depositors will have to take, but the tax on deposits was expected to net several billion euros.

U.S. investors won't care too much about who takes losses in Cyprus, as long as there's a bailout that stops the run on banks in the Mediterranean island nation and keeps the eurozone stable, said Karyn Cavanaugh, market strategist at ING Investment Management in New York.

"If this works out, regardless of the terms, this is going to be good for the market," she said Sunday night.

Around 10:40 AM east coast time, as the market turned negative, another Reuters article delivered the not so optimistic news, "Stocks cut gains, Dow turns negative."

NEW YORK (Reuters) - Stocks cut their gains on Monday, with the Dow turning negative as initial optimism over a deal to keep Cyprus afloat faded.

What has been called a rescue package were in fact a recapitalization package. The aid from EU to Cyprus were to be used for fiscal control, not bank rescue. The banks were recapitalized with money seized from uninsured depositors. The new capitalization plan merely shifted the source of seizure from both insured and uninsured depositors to uninsured depositors alone. The new plan achieved the goal of protecting small depositors, but will not succeed in the objectives of maintaining Cyprus's business model of international destination for attractive Euro deposit and the capital flight from Cyprus banks for those depositors who are not forcibly tethered by capital control. The idea that depositors including insured depositors can be seized has been released. It can not be put back into the bottle again. Should the financial condition of another European peripheral nation take a turn for the worse, bank depositors will remember that speed means safety.

  

 

 

The Cyprus Breach

Stocks around the world reacted negatively to the proposal by Cyprus government to impose losses on depositor in order to bail out the two most troubled banks. Here is just one report from the Wall Street Journal:

U.S. stocks followed overseas markets lower as a Cyprus bank-deposit tax sparked renewed fears about Europe's debt crisis.

The Dow Jones Industrial Average was down 38 points, or 0.3%, to 14376 in midmorning trading. The Standard & Poor's 500-stock index dropped eight points, or 0.5%, to 1553 and the Nasdaq Composite Index shed 16 points, or 0.5%, to 3233.

The euro tumbled versus the dollar. The price of the 10-year U.S. Treasury note surged as investors sought haven assets, pushing the yield down to 1.949%. 

So far the US investors have acted more nonchalantly than their Asian counterparts where Nikkei closed down 2.7% and Shanghai was off by 1.7%.  We may casually dismiss the importance of Cypress as an economy, but the coherence of the world today owes more to ideas than machinery. When the government of Cypress acquiesced to the German demand that depositors pay part of the bail out, it breached an idea that the governments around the world have instilled within the financial world since the days of great depression. idea is bank deposits are absolutely safe.

The widespread adoption of fractional banking system has provided ample fuel for the modern economy. The strength of such system lies with its ability to increase money supply and provide additional capital for your hungry entrepreneurs. As the Greeks had noted long time ago, the strength of most things also tended to be their inherent flaw. In a fractional banking system, no bank can meet the demand of redemption if sufficient depositors demanded them simultaneously. This flaw proved fatal for a large number of banks during the great depression. Even since then, government deposit insurances have propped up in various forms to protect depositors during time of distress. After 75 years, the disease of run on the bank has virtually been wiped out. So we thought.

The Cyprus Breach has once again raised the specter of bank run. If the Cyprus levy was indeed implemented, what is to prevent the depositors from taking their money out after the pilferage on the vary rational thought that this may not be a one time deal? What is to prevent depositors from yanking their money out of Spanish or Italian banks on the possibility that such practice may eventually be applied to them as well?

The Euro is now at a crossroad. The German's desire to punish the irresponsible is certainly understandable. However, the choices before them is either to shoulder the entire responsibility of bailing out their less assiduous brethren or time to declare failure on the Euro experiment.

The Cyprus decision will be a big deal.

Perfect 10

Stocks, of course, continue their hot streak. With gains today, the Dow Jones Industrial Average has now been up 10 days in a row. The titled "Dow Winning Streak Captivates Traders, Tests Statisticians" appeared on Yahoo Finance's Breakout segment.

By now you've surely heard that the nine-day winning streak on the Dow Jones Industrial Average (^DJI) is its longest since 1996. If it succeeds today in extending its run for a tenth day, it would be the 25th time it has achieved this feat in the past 70 years.

 

To gain the all-time longest streak title, the Dow Industrials will have to topple a 14-day streak set back on June 14, 1897, according to Rebecca Patterson of S&P Dow Jones Indices. The longest modern day streak was 13 days in January 1987.

Even though I am not a statistician, I would like to take a crack at the statistical problem of market streak. We know that on any given day, there is about a 2/3 probability of stocks being up and 1/3 probability of stocks being down.  We may ask given such probabilities, what are the odds of a 10 day up streak in a given year.

Since stocks go up 2/3 of the time on a given day, then the probability of stocks going up 10 days in a row should simply be (2/3)^(10), or 1.73% of the time. Let us also assume that there are 300 trading days in a year as a result, we have 291 separate 10 day periods. During the first 10 trading days, we know there is a 1.73% of chance stocks will all appreciate. However, if that fails to happen, it may then happen on the second 10 day period or from day 2 to day 11. The probability of that is the probability of streak failing on the first 10 days which equals to 1-1.73% or 98.27%, multiplied by the probability of 10 up days in a row or 1.73%. This yields 1.70%. Of course, if both of these scenarios don't work out, the streak could happen on the third 10 day period or from day 3 to day 12. The probability of that is the probability of first two scenarios both failing at 1-1.73%-1.70% or 96.57% multiplied by the probability of 10 up days in a row. So the odds of day 3 to 12 producing a streak after day 1-11 have failed is 1.67%. Thus, we can recursively compute the probability of all 291 10-day periods after all the proceeding periods have failed. By adding up all those possibilities, we can arrive at the probability of a 10 streak within a given year.

By my computation, the odds of a 10 day up streak for any random year is 99.38%.

Most readers are likely surprised by such high odds of streak. I recall reading a professor (sorry for the lack of source) who asked his students to toss a coin 10 times in a row and record their results. Those students who genuinely did the experiments were far more likely to record streaks of 3 or more in their data. Those who fudged their data most often did not contain such streaks. Rare events will occur given enough trials such as the same lottery number appearing consecutively. The fact that most people under-estimate such occurrences is the reason why this world in general and stock market in particular are full of myths and superstitions.

The Dow Jones Industrial Average only had 25 such 10 day streaks over the past 70 years, which works out to be a probability of only 35%. Furthermore, the longest streak is only 13 days. This to me indicates that stock returns are in fact serially correlated. What happened yesterday does have an impact on what happens today, which will impact what will happen tomorrow.

VIX and Stock Market Performance

As the stock market spiking to new heights, the volatility index, being inversely correlated with stock indices, has been descending to new lows. Today, it took an 8% tumble and fell to 11.56. It is the lowest close since February 26, 2007. As luck would have it, on the very next day, February 27, 2007, S&P 500 fell 3.5% on concern over slowing growth in China, which was then the growth engine of the world economy. Those who would like a refresher on that fateful day six years ago, can read this article from CNNMoney.

The fact that the VIX is at a six year low worries many market participants. We all know that volatility index is inversely correlated with stock indices. So as low volatility inevitably revert to the mean, there must be a subsequent drop in stock price. To assuage my own uneasiness, I downloaded the historical VIX data from Yahoo Finance and decided to find out what actually happened when VIX had fallen to such low levels.

There had been 5844 trading days since Jan 2, 1990. There were 372 days on which VIX closed between 11 and 12. VIX closed between 10 and 11 on 106 days and below 10 on only 9 occasions.
During those 22 plus years, in any given 90 days, there is a 33% chance that S&P 500 would record a negative price return. For 45 day periods, the odds of negative return for S&P 500 increased slightly to 36%. On the day that VIX closed between 11 and 12, there were a 31% chance of S&P 500 incurring a loss during the next 90 days and 28% chance of such events for the next 45 days. For VIX closing between 10 and 11, the odds of loss over the next 90 days was 17% and over the next 45 days was 31%. So the empirical results did indicate that on days VIX closed at a level between 10 and 12, the subsequent returns were in fact not worse off compared to any random days.

It was indeed very rare for VIX to close below 10. On the 9 occasions that it did over the past 22 years, the subsequent 90 day return were negative on 5 of them and positive on only 4, which meant the odds of adverse development is over 50%. For 45 day returns, there were 6 negative occurrences and only 3 positive ones. However, for the 90 day periods, the average of the negative returns was about 4% and non of the returns was worse than 5%. These were hardly calamitous. Furthermore, of the 9 days VIX closed below 10, there were really only two clusters. All the single digit VIX numbers were produced either during the end of 2006 and beginning of 2007 and the end of 1993 and the beginning of 1994. So we really only have two data points from which no statistically meaning conclusion can really be drawn.

When market is doing well and investors are calm, VIX is low; when market is in turmoil and investors are nervous, VIX is high. These are simply two different aspects of the market and even though VIX is inversely correlated with stock indices, history shows that one can not use VIX to predict market return. Just as rainy days and sunny days are two different types of weather conditions, the fact that sunny days inevitably follow rainy days, does not make rain a predictor of Sun since rain itself can not forecast the during of rain thus the subsequent ascent of the Sun. In the market, turmoils do always follow calm, but we can not use calm to predict turmoil as calm can last for a long time. So VIX as a market timing tool is simply not all that useful.

Retail Anecdotes

Of the retailers reporting same stores comparisons or quarterly earnings today, the results seem to be mostly negative. Ross Stores, a discount clothing retailer, reported tepid same store sales growth that missed wall street estimate.

NEW YORK (MarketWatch) -- Ross Stores Inc. said Thursday that its February same-store sales fell 1% after a 9% gain a year earlier. The most recent month's result missed the 1.1% increase analysts surveyed by Thomson Reuters were looking for. "We believe the slight decline in February same store sales was mainly due to the delay in income tax refunds," said Chief Executive Michael Balmuth.

In addition, Big Lot, another discount retailer reported a good quarter beating Wall Street estimates, but indicated that current quarter sales have been challenging. Shoe Carnival, a discount retailer of footwear, reported 4th quarter results and stated that sales suddenly fell during the last 2 weeks of January. PetSmart, which has appreciated 50% over the past 2 years on strong sales and earnings growth, also allowed forward sales guidance in its earnings announcement.

It seems that the effect of high payroll tax and the delayed tax refund due to government operating under continuing resolution are starting to wield its effect. Going forward, we will also have the additional headwind of the gradual implementation of the sequester to contend with. The profitable trade in stocks continues to be buying Bernanke and selling Washington.

Boundary Value Problems and Equity Valuation

One of my favorite classes in college was boundary value problems. It was essentially about solving differential equations under certain constraint. For example, if you stick one end of a steel rod into a giant bath of boiling water, the temperature of that end must adapt to equal the boiling point of water. That would be out fixed boundary. The heat from the water bath would gradually travel lengthwise to the rest of the rod and effect its temperature as well. Since the rest of the rod is exposed to the normal environment, an equilibrium is reached when the temperature is such that the heat supplied by the hot bath equals the heat dissipated to the normal environment.

As Dow has crossed its historical highs and S&P is nearing such a feat, there is a palpable nervousness among investors and pundits alike. Today, the entire financial market is immersed in the fixed boundary of zero interest rate. Slowly but surely, the asset value levitating effect is permeating to the rest of the investment world.

The business of private equity is essentially capital arbitrage. They take advantage of cost of capital differential between equities and bonds. When fixed financing is abundantly available at a cheap rate, private equity transactions will be most active. That equities, despite reaching new heights, are cheap compared to bonds is evident by the increasing PE activities. The large deals like Dell and Heinz of course catch most of the attention. But smaller deals is also happening. Today, teen retailer Hott Topic is being acquired by Sycamore Partners.

Normally, bond investors tend to be more conservative as bonds have limited upside and 100% downside, while stock investors are more sanguine as stocks have unlimited upside. Today, the opposite is true. Bond market is trading at the level it is at not because bond folks have lost their minds, it is because the boundary conditions imposed are so overwhelming. In mathematics, fixed boundary is assumed to lessen the complexity of the ensuing equation. In the real world, powerful forces tend to have powerful side effects. This is why equity investors are so nervous.

The Next Decade

Today, the headline on CNBC's website cheers "Dow Smashes Record: End of the 'Lost Decade'?"

Since the burst of the tech bubble in March 2000, stocks of course have shown investors the most stingy of returns. Hence, the past dozen of so years have been loosely dubbed the "lost decade." But the decade is only lost in the narrow sense of equity investments. In the world of bonds, commodities and real estate, it is anything but lost. Bonds of every kind, Treasury, high grade corporate, high yield and emerging market, all thrived. Oil, Copper and Gold have all enjoyed significant appreciation. Even Real Estate, despite the drubbing it received during the 2008 financial crisis, still sits on a much higher plateau than the start of 2000.

More aptly, the decade of 90's is the equity decade; the decade of 2000's is the bond decade; the decade yet to come will, I believe, be the lost decade.

To suppress interest rate is to raise asset value. To raise asset value without commensurate rise in cash flow beyond the rate of inflation is to suppress real future return. To buy a 10 year Treasury bond at 1.9% yield is to lock in a return of 1.9% over the next 10 years. That is the very definition of a lost decade. Equities do have a fighting chance as the possibility of technological advancement and productivity gains could propel corporate earnings growth speedy enough to justify current level of valuation or compensate for a somewhat lower level of asset value.

For the past 30 or so years, investments in general have enjoyed relatively healthy gains thanks in part to the tailwind of receding interest rate and upward leverage of both governments and consumers. For the decade to come, we will see at best flat interest rate and possibly a rising rate environment. Governments and consumers alike are now de-leveraging. As a result, the decade to come will prove to be difficult of assets of all classes.

Market Pullback Ahead?

Sam Stovall, the well respected chief strategist at S&P Capital IQ, was on Yahoo Finance's Breakout segment and pronounced that stock market will likely have a 5-10% modest pullback.

"You're better off watching for a tsunami than you are an earthquake because the lack of volatility usually indicates that it's a matter of when, not if, we're going to have a market decline of 5% or more," says Sam Stovall, the chief equity strategist at S&P Capital IQ, in the attached video. The good news, however, is that although we're overdue for a shakeup, he says "I don't think it's going to turn into a bear market."

He says, a check of economic, monetary, sentiment, earnings and more all suggest a shallower, more subtle pullback is in store, rather than something more sinister.

Thus, Mr. Stoval joins a chorus of pundits calling for a modest decline including Liz Ann Sonders of Charles Schwab, who stands out for her modesty and composure among the pantheon of market prognosticators who clamor for your attention. Here is what she wrote:

Headwinds have reemerged and investor concern is heightened yet again. We still believe stocks can run further, but a pullback is more likely in the near-term. 

My investment experience is perhaps modest compared to some of the strategists out there. It did however encompass 20 years, including both bull and bear markets. I have come to believe that a pullback of 5-10% can happen anytime in the stock market. Those of us in the market long enough knows how difficult it is to predict future movements. However clairvoyant we may be, we have all been wrong so often that we start to speak of Mr. Market in personified and reverential terms as if it is the embodiment of wisdom. However, even those who profess such respects for the market can not constrain their desires to know her evanescent whimsy. If the market is to have a pullback and only to reverse course in short order, who are then the suckers selling into such ephemeral doldrums? It is difficult enough to predict a downturn, but to predict a downturn and a reversal seem to me have crossed some kind of boundary of modesty.

  

Risky Business

Joel, you wanna know something? Every now and then say, "What the heck." "What the heck" gives you freedom. Freedom brings opportunity. Opportunity makes your future.

That is a dialog between Miles played by Curtis Armstrong and Joel Goodsen played by Tom Cruise in the 1983 movie "Risky Business." The original quote of course used certain other four letter word which has been changed for the purpose of good taste. This might as well be the utterance of Ben Bernanke to Mr. Market.

Today, Mr. Market pretty much said "what the heck" to the so called sequester. The dysfunction of our national government in its failure to reach a sensible solution to our mounting debt problem did not seem to perturb the market much. Stocks was down perhaps for two hours in the early trading hours and by a little more than a half a percent. Then it merrily went its upward ways. Investors now seem to heavily vested in the idea of a Bernanke put. Whatever happens, the Fed will be there to rescue the market. For Joel Goodsen in "Risky Business," he was able to regain control of a chaotic situation and obtain admission to the college of his choice, not to mention the girl of his desire.

Will the easy money policy of the Federal Reserve spin out of control and lead to unforeseen consequences? Will investors be agile enough to exit the party when the Fed eventually takes the punch bowl away? The plot thickens.