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Magic Trees
Imagine an island on which magic trees grow. These trees, as it turns out, are exactly like the trees everywhere else, except for three things. First, these trees never die. Second, the trees always grow to exactly 100 feet tall eventually. And third, to pass time on this boring island the villagers place bets on which specific trees in a given acre of land (on which all trees were planted at the same time) will grow the fastest over the next ten years.
Right after an acre is planted, there is much activity that can only be termed purely speculative. Without any obvious difference in the first shoots, the villagers place their bets based on which of the tree-market brokers tells the best story about a particular tree. These brokers do tend to change their minds frequently, however, so it turns out that there is rapid trading.
After a few years, some trees have clearly started to grow faster than other trees. Villagers tend to invest more on these trees that have “momentum.” And this trend continues, because the further in the lead a given tree is over its rivals, the more momentum it clearly has. There is, however, a class of investors who like to invest in the smaller trees, since the bet is on the rate of growth over time, and these investors think that the smaller trees are likely to revert to the mean (indeed, because all of these magic trees end up at the same height, they are correct on average).
The villagers who “own” the taller trees are generally happy, since their trees are “in the lead.” They don’t much care for the villagers who “own” the smaller trees, because they think these folk are just negative ninnies. The value-villagers are fairly confident, though, because they understand the math; and many of them are dismissive of the momentum-villagers and call them “lemmings.”
The odd thing is that both of these “investors” have their time in the sun. Early on in a tree’s growth pattern, the ones quickly out of the gate do tend to grow more rapidly. Consequently, momentum is a viable strategy. But the bigger the lead gets for these trees, the worse the bet becomes that the rate of growth will continue. Once the tree reaches 99 feet, for example, there are not many ways that it can beat a 20-foot tree going forward (remember – all of these magic trees always grow to be exactly 100 feet in time). And yet, the momentum-villagers remain true to their investment style, saying “the 20-foot tree must just be sick. And it can’t get as much sun because the 99-foot tree is shading it. The 99-foot tree may only grow 1 foot over the next ten years, but the 20-foot tree might not grow at all.” And, after all, it is fun to have your bet on the biggest tree in the forest. However, the value-villagers almost always win that bet.
This allegory isn’t really about growth versus value in equity investing. It is about asset class performance and, more specifically, the performance of equities versus commodities. There is a significant amount of history to suggest that over long periods of time, the average growth rate of equities and the average growth rate of commodity indices is approximately equal. This happens because the basic sources of both asset classes are fairly steady: aggregate economic growth, in the case of equities, and collateral return plus rebalancing effect, plus some other smaller sources of return, in commodities. So regardless of what you think about equities or commodities, in general when equities are dramatically outperforming commodities, you should be selling them to buy commodities, and vice-versa. But that isn’t how most investors bet. Most investors make up a story about why the tree is stunted, and will never grow, will never catch up, and then turn to bet on the tall tree.
It is a mistake.
It is a mistake, though, that the Street actively encourages because where the broker makes his money is on frenzy. Rallying markets tend to produce more volume and excitement, and that means more money for the broker. This is especially true when the market is equities, since there isn’t much underwriting of commodities to be done but there is quite a lot of underwriting of new equity issues.
Frankly, this over-exuberant cheerleading sometimes results in lies being disseminated to investors. Consider the following snapshot of a Bloomberg page describing the characteristics, including the P/E ratio, of the Russell 2000 index. You will see it says the Price/Earnings ratio is about 18.41. We all know that means that if you pay $18.41, you will get a set of stocks that will have $1 in earnings, collectively. Right?
Well, the following chart is also from Bloomberg, and you get it if you type RTY<Index>FA<GO>. What it says is that the Price/Earnings Ratio is actually 54.86, which means that your $18.41 actually only gets you $0.33 of earnings! What’s going on here? Well, the next line shows you that what Bloomberg considers the “real” P/E ratio – important enough to have on the front page – is really the Price/Earnings ratio if we only count the positive earnings.
So, that $18.41 does in fact get us $1 in earnings. Wall Street doesn’t want us to focus on the fact that it also gets us $0.67 in losses, so that the net is only $0.33. Because surely, those losses were one-time events, and obviously all 2000 companies will make money next year, right?
It may be that stocks are a great bargain here, and that multiples will expand further, the economy will surge in a way we haven’t seen in a decade or two, in an environment of tame inflation but ample liquidity. If that is the case, then equity investors will win over the next five years because they’re betting on the trees that have grown the most in the last two years. But in all other cases, commodity indices should grow faster than stocks as both revert to their long-term growth rates.
Not So Fast on the Deflation Talk
I wonder how quickly all of the calls of “deflation!” will turn into calls of “hyperinflation!”
After gold was pummeled $200 in two days on April 12th and 15th, there was a proliferation of commentators who suddenly declared that inflation fears were in full flight. Although the decline in inflation swaps to that point was mainly attributable to the decline in energy prices (subsequently, some air has indeed come out of implied core inflation, but still there is no deceleration in inflation, much less deflation, priced in), the chorus of “I told you so’s” was deafening and many were encouraging Chairman Bernanke and other central bankers to take a victory lap. After the disastrous 5-year TIPS auction on April 18th I could almost hear Darth Vader saying “strike down the 5-year breakeven and the journey to a deflationary mindset will be complete.”
Well, not so fast. Since that point, gold has recovered about $100 in rallying six out of the last eight sessions. The 5-year breakeven has recovered from 1.94% to 2.15% (although to be fair about half of that was due to the roll). The 10-year breakeven also bounced 14bps, and is back above 2.40%. Today, every commodity in the DJ-UBS index, with the exception of Coffee, rallied.
Why? What has changed over the last week and a half? Nothing important; if anything, the data has been weaker than the data preceding the washout. And that fact, I continue to think, is a fact the salience of which remains ungrasped by central bankers. Unless it’s by sheer coincidence, global growth simply isn’t going to explode upward while incentive structures are so bad and governments consume such a large part of the economy. And as long as growth doesn’t explode higher, central banks will keep easing, because – despite almost five years of contrary evidence – they think it helps growth. I believe the only way that global QE stops is if central banks come to understand that they aren’t doing any good on growth, and are doing much harm on inflation, though with a lag.
I am not terribly optimistic that such a eureka moment is nigh, especially when the economics community is so subject to confirmation bias that a technical washout in gold can provoke hosannas.
An April 12 article in the Washington Post highlighted recent research that indicates a one-percentage point increase in unemployment makes us feel four times as bad as a one-percentage point increase in inflation. This is not particularly surprising, at some level, although I greatly suspect that the results are non-linear – but I am not shocked that it feels worse to see people lose their jobs (or to lose one’s own job) than to absorb slightly higher price increases.
But the article goes on to argue that “Such findings could have significant implications for monetary policy, which until the most recent recession has primarily been concerned with controlling inflation. But now some central banks are speaking of allowing inflation to rise or stay slightly above their usual targets in hopes of bringing down unemployment.” The idea the article is proposing is that it is incorrect to balance evenly the (inherently conflicting) mandates the Fed is tasked with to seek lower inflation and lower unemployment; they should favor, according to this argument, lower unemployment.
There are several flaws in this argument, but I believe it is likely that the Fed more or less agrees with the sentiment.
One flaw is that the damage to inflation comes in the compounding. If unemployment is 6% now and 6% next year, there has been no change. But if inflation is 6% this year and 6% next year, then prices are up 12.4%. And if it’s for three years, it’s 19.1%. How many years of that 1% compounding inflation do you trade for 1% incremental change in unemployment?
A bigger flaw, in my view, is that central banks don’t have any important control over the unemployment rate, while they have important control over inflation. It may also be the case that a 1% rise in background radiation levels makes people feel even worse than a 1% rise in unemployment, but that doesn’t mean the Fed should target radiation levels!
Moreover, even if you think the Fed can affect growth, it is still true that for big moves in these numbers (because we really don’t care so much about 1% inflation change or 1% unemployment change, after all) the central bank’s power to cause harm is clearly much larger in inflation. It is possible to get 101% inflation, and in fact many central banks have done so. No central bank has ever managed to produce 101% unemployment.
I doubt that commodities and breakevens will go higher in a straight line from here. And every time there is a break lower, the deflationists will call for the surrender of the monetarists. But I do wonder if this latest break is the worst we will see until there is at least some sign that QE is going to end.
Preparedness
The sine qua non for a disaster is that no one is worrying about the disaster. Earthquakes are less damaging in Tokyo than the same earthquake would be in New York, because in Tokyo buildings are designed to be earthquake-resistant. This is also true in markets; if investors are guarded about purchasing equities because of all the bad things that can happen, then prices of equities will be very low and it will be difficult to effect a true crash in such a circumstance.
The opposite doesn’t necessarily follow in the physical world (if you don’t prepare for an earthquake, it doesn’t increase…so far as we know…the probability of it happening), but it occasionally does in the financial world. I pointed out in January the work by Arnott and Wu which indicates that a company which enjoys “top dog status” in terms of having the greatest market capitalization in its sector tends to underperform the average company in the market by 5% per year for a decade. This is largely because investors in such companies are not prepared for adverse surprises, so that any such surprises tend to be taken poorly. Similarly, problems in Cyprus had an outsized effect on markets because (remarkably) no one was prepared for there to be problems in Cyprus that the rest of the Eurozone wouldn’t simply write a check to cover.
By this standard, inflation is growing more dangerous by the day, as more and more investors and pundits start talking – incredibly – about deflation. St. Louis Federal Reserve President Bullard today told an audience at the Hyman Minsky Conference in New York that it is “too early” to worry about deflation. That statement must hit most readers of this column as hysterically funny, given how many readers typically complain that the CPI is far lower than their personal experience of inflation. Bullard also noted that he favors an increase in the pace of QE if inflation falls further. Since core inflation is currently at 1.9%, Bullard is essentially putting a floor on inflation near where we once thought the ceiling was.
I read somewhere today that the recent declines in copper and gold are “signs of deflation.” I disagree. At best, they are signs of fears of deflation, right? But even that, I don’t buy. While breakevens in the TIPS market have declined recently, they are still not particularly low by any historical standard (see chart of 10y BEI, source Bloomberg). Moreover, a not-insignificant part of that decline represents a direct response to energy’s retracement and isn’t a reaction to a softer opinion about core inflation.
In fact, the core inflation implied by the 1-year inflation swap, once energy is extracted, is above the current level of core inflation and near the highs that have been seen since early 2011 (see chart, source Enduring Investments).
So I suspect, rather, that the causality runs the other way: the decline in copper and gold has caused an increase in chatter and vocal concern about deflation. But the people who are investing directly on whether deflation will happen aren’t seeing it. This is somewhat comforting, as it’s the people with actual money (rather than pundits and economists) who determine whether their institutions are ready.
Now, to the extent that the increased chatter actually leads to renewed relaxation in inflation expectations (ex-energy), it sets the stage for worse damage when it inevitably happens. Inflation, like earthquakes, is more injurious when societal institutions have not prepared for it. Median inflation in the U.S. over the last decade is about 2.5%. But in South Africa, it is 5.7%. In the U.S., a 5.7% inflation rate would cause major havoc, but South Africans would be amused at that since they deal every day with that pace of price change (as did Americans, in the 1980s). In Turkey, median inflation has been about 9.5%, but there again the society has adapted to it. To the extent that there is any fear in the U.S. about inflation rising to 5% or to 10%, institutions will prepare for it, and they will eventually learn to deal with it. It’s the shift to that new reality that can be especially painful.
The rest of the week has only minor economic data releases, with the Philly Fed report on Thursday (Consensus: 3.0 vs 2.0 last) the most important of them. A few Fed speakers will be on the tape. But the real market concern is concern in the market: the VIX has risen to 16.5 after having receded slightly on Tuesday; the dollar today retraced all of Tuesday’s decline and then some. Gold and commodities have not fallen further after the washout on Monday, but neither have they rejected the lower levels and rallied back. The S&P has support at 1540 or so but below that level there could be a substantial further fall. All of these markets have potential for important moves, and in the meantime there is the potential for renewed headlines out of Cyprus where there is consternation over the new demands from the EU. The trader in me would guess (stress: guess) at further weakness in equities, an attempt made by energy markets to hold near these levels, a halting rally into resting sell orders in precious metals markets, steady nominal bond markets but with some rebound higher in long breakevens. But here are the problems: (1) these are all connected – so I could easily miss on every one of these guesses; (2) any big move will affect sentiment on the others, so that there are copious feedback loops; (3) much of what happens will depend on the next quantum of news to hit the screens, and (4) Wall Street is less and less in a position to take risk and maintain orderly markets, as it has in the past. We might even simply tread water into the weekend and take our volatility on Monday. But I’m fairly convinced that more volatility is coming before markets calm down again.
But that’s not a problem, if you’re prepared for it!
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Big Trade, Little Door
In ordinary times, the terrorist attack at the finish line of the Boston Marathon (officials are being careful not to call it “terrorism,” but I’m not an official so I can operate in the reality sphere) would absolutely trump anything that happened in the markets today and, in fact, would likely have been the cause of any market movement that actually occurred. That’s because most of the time markets echo the framework of the rest of reality: most of the universe is space, and most market activity is just empty noise.
This is the reason that traders who are continuously transacting in the markets are called “noise traders.”
But on Monday, there was plenty of market action and it had nothing to do with Boston, nor with the slightly-earlier ultimatum from North Korea to South Korea, which stated that military action would “start immediately.” (N.b.: There were many losers today, but one of them surely must be reckoned as Kim Jong-un. A tin-pot dictator makes a threat, and is almost immediately knocked off the front page of the New York Times by events in Boston. That must really annoy him.)
Before the attack in Boston, however, there was already plenty of financial pain. The carnage in the precious metals pits came right on cue after the negative sell-side reports of late last week had a chance to work on the psyches of investors. Gold fell 10%, and silver nearly 14%. This represents the worst two-day fall in gold in thirty years. And, while yesterday I pointed out that the commodity “super-cycle” certainly doesn’t look like one, I can understand how the picture of gold in real terms looks like it may be completing something big (see chart of gold expressed in December 2012 dollars using CPI, source Bloomberg).
There is considerable concern tonight that these losses may provoke selling in related markets as investors raise funds to meet margin calls. This is possible, although significant thumpings in the past in precious metals (it isn’t like this is the first time we’ve seen volatility in a commodity) didn’t provoke dramatic related-market action. To be sure, the avalanche is much more loaded now than it has been in the past, with equity markets sharply overvalued and investors already reaching a level of disgust with commodities. But I don’t think it goes too far. (Those may be my famous last words!)
What happened in gold and silver is a function of the big trade/little door syndrome, more than anything else. News outlets blamed the weak data yesterday in the U.S. and the small miss in Chinese GDP (7.7% versus 8.0% expected, but keep in mind that we all know these are made-up numbers) for setting off the wave of selling, but that’s just the latest straw. The break of technical levels on Friday, combined with the suddenly-burning desire of hedgies to not be the last one through the little door, is what led to such a dramatic move today. It may well continue until everyone who wants to get through the little door has done so. Or, it may not – but I would admonish an investor who wants to buy gold here to think like a trader rather than a playground monitor: don’t try to break up the fight. If the hedgies want to eat each other in a fight to get to the door, let them.
And, incidentally, remember that the big trade/little door syndrome is not limited to gold and silver. Think about equity exposures too. If you’re long by policy, fine. But if you’re long stocks and feeling uncomfortable about it, then “sell down to the sleeping point” at least.
The irony of the timing of the gold rout is potentially juicy, with CPI tomorrow. The decline in precious metals is happening partly because so many investors are abruptly convinced that inflation has truly been defeated. It is incredible to me that this belief is so widespread, but perhaps this is the sine qua non for the next washout in financial markets and the setup for the long-awaited up-move in commodities (for, although the “super-cycle” is evidently just now ending according to some observers, commodities prices have been in general decline for the last two years).
Growth is falling short of expectations, but that doesn’t have any implications for inflation. Tomorrow’s CPI is forecast to be flat and +0.2% on core, holding core inflation constant at 2.0%. Sentiment appears to be favoring a shortfall in those figures, but it is my belief that we are on the cusp of the next sustained move higher in core inflation, to be led by housing. Remember that the last two CPI figures haven’t exactly been soothing. Two months ago, core inflation was +0.3% when the market was expecting +0.2%. Last month, all eight major subgroups of CPI accelerated on a year-on-year basis, the first time that has ever happened since the current 8 subgroups have been in existence. I am loathe to pick the month where we’re going to see Owners’ Equivalent Rent finally break higher, because econometric lags are not written in stone. But it ought to be soon.
When it happens, expect sell-side economists and pundits of all stripes, to say nothing of the Federal Reserve, to downplay the significance of it. I wouldn’t expect a sudden rally in commodities or a rebound in breakevens (10-year breakevens are at the lows of the year, mainly because rates on the whole are declining – 10y TIPS yields are also within 3bps of the year’s low), but it might help stop the bleeding.
This ‘Cycle’ Certainly Hasn’t Been Super
Five years into the biggest money-printing exercise of all time, and commodities are (incredibly) approaching the status of being universally loathed. On Friday, gold provided a great illustration of one reason I always say that investors should have a position in diversified commodity indices. A Goldman Sachs report released a couple of days ago (with gold 20% off the highs) suggested that prices may have further to fall; more important to Friday’s rout, though, was the increase in the European assessment of how much more money Cyprus will have to raise for itself (€6bln, or about 35-40% of annual Cypriot GDP) to complete the bailout, and the speculation that Cypriot gold reserves will have to be sold.
Add to this the fact that Friday’s economic data was weak with ex-Auto Retail Sales -0.4% and the Michigan Confidence figure showing a surprising drop. Clearly, investors believe this to be a death knell for inflation (as opposed to the “death bell” – I’m not sure what that is – that Citigroup says has been sounded for the commodity supercycle).
But all of the data, and the European sovereign crisis, apparently does support rapidly rising home prices and equities at disturbing multiples of 10-year earnings!
Considering that commodities have been around far longer than equities, bonds, or even money itself, it is incredible how little understanding there is about them.
One misunderstanding, and key to understanding the current situation, is not peculiar to commodities. It is simply the common confusion of nominal and real quantities. In a nutshell, the change in any good’s nominal price over time consists of two things: a real price change, and a change in the price that recognizes that the value of the currency unit measuring stick has changed – that is, inflation. We’re familiar with this construction in the form of the Fisher equation, which tells us that nominal yields represent the combination of a real return that is the cost of money plus a premium (or, less frequently, a discount) for the expected change in the price level over the holding period. But that construction applies to all price changes.
So if the price of your ham sandwich rises 3% this year, is there a bull market in ham sandwiches? Well, in all likelihood not – it’s just that the overall price level is rising by roughly that amount. What about if the price of the ham sandwich rises by only 1%, because ham is becoming cheaper? Then we would say that there was a 2% decline in the real price of the ham sandwich, plus 3% inflation.
Now, if prices instead rose 15%, the ham sandwich in this latter scenario would not still be only rising in price by 1%. It would likely rise by 13% or so: the 15% inflation, minus the 2% decline in the real price of a ham sandwich. Even if a ham sandwich glut was forcing a 10% decline in real prices, the nominal price of a ham sandwich would still be rising in that case.
So, when groups trumpet the “end of the commodity cycle,” they seem to be confused. It is possible that they are saying that real commodity prices should decline over time, but I wonder whether their clients would be awed by that prediction since it has been the norm for hundreds of years. Moreover, if they were referring to real prices, then if CPI goes up 10% and commodity prices go up 5%, they will be right – but clients might not see it the same way.
But I don’t think that’s what they are saying. If it is, then those groups are also a bit late to the party – commodity indices, which include additional sources of return, have underperformed inflation by 28% since 2004 and are down about half from the 2008 highs. Frankly, in the chart below (Source: Bloomberg), which shows the DJ-UBS commodity index divided by the NSA CPI, I don’t see anything which looks like an up-leg of a supercycle, except perhaps the doubling from 2003-2008. Is a 100% gain over five years a “supercycle”?
Now, in the SP-GSCI, which has a much greater weight in energy, it looks plausibly like a “supercycle,” as prices tripled in real terms off the lows in 1999 (see Chart, source Bloomberg), and admittedly the chart looks a little feeble at the moment. But that difference is, as I just suggested, mostly due to energy. And if you think the energy supercycle has ended…just short energy, don’t paint all commodities with the ugly brush!
And, by the way, it seems like a pretty wimpy supercycle if the peak in real terms doesn’t even approach the earlier peak.
In nominal terms, all of these charts look different, with the downswings being dampened and the upswings accentuated, because of inflation. But that’s certainly not the right way to look at commodities (or any asset) over time. We don’t care about the nominal return. We care about the real return. And viewed through a real return lens, commodities are much closer to being really cheap than to being really rich!
Obviously, I disagree with all of these groups when it comes to commodities generally. About gold I have no firmly-held opinion about its valuation at the moment, but commodities generally we see as cheap – in fact, we expect triple the real returns from investing in commodities indices over the next ten years compared to equity investing. This is a function of both the very rich absolute valuations of equities and the very cheap absolute valuations of commodities indices.
Moreover, if inflation does in fact accelerate – something which has nothing to do with the weak Michigan or Retail Sales numbers – then commodities will also have terrific nominal returns while equities might well have negative nominal returns.
Whose Move Is It?
Markets have been surprisingly quiet over the last few days. Some of that, no doubt, is due to the NCAA basketball tournament, to the Good Friday/Easter Monday holiday in the U.S. and in Europe, and to baseball’s Opening Day.
We also had Japanese year-end and the end of Q1 in the U.S., and to the extent that the last week has brought any market moves of interest at least a portion of that can be put on the account of the calendar. On Thursday, the S&P set a record month-end close, although a higher intraday print was established in October of 2007. But while news accounts attributed the almost-record to an “easing of Cyprus fears,” it is much more likely that it was due to the normal (and well-known) quarter-end “mark ‘em up” machinations of less-scrupulous fund managers in illiquid market conditions.
In a similar vein, the quirk of having the quarter end on a Thursday three days before the calendar turns helped exaggerate a massive move in grains, especially corn, on a mildly bearish crop report. Those who are invested in commodities for tactical reasons are being flushed because they’re tired of waiting, as an article in today’s Wall Street Journal made clear. The investors who are leaving do not have comfort in the asset class because they don’t understand the drivers of the asset class; the result is that they become performance chasers. So, when crop reports suggest that the real price of corn should fall a little bit, investors slash nominal prices 10% in ‘get me out’ orders.
But as I said, these investors don’t understand the fundamental drivers of the asset class. The article cited above regarded the breakdown of the correlation between commodity indices and equity indices as something sinister, saying that the correlation is at its lowest level since 2008 and suggesting that this means that one of the two markets is wrong. As it turns out, though, the correlation of stocks and commodities is a relatively new phenomenon. Over the last 5 years, the correlation of monthly changes in the DJ-UBS index and the S&P is 0.61. However, for the 17 years prior to that, the correlation was 0.04 (see chart, source Bloomberg).
For the GSCI commodity index, the last-5-years correlation is 0.65, but for the 38 years prior to that (the GSCI has a longer history) the correlation was -0.02. In short, there is no reason to read a whole lot into the recent decoupling of stocks and commodities, except that it may suggest the hot money is finally leaving commodities. The correlation breakdown is also a good thing for anyone who believes – as I do – that stocks are overvalued. And, since a good portion of commodities’ long-run return comes from a rebalancing effect that is larger when the inter-commodity correlations are lower, this is more good news.
The choppy melt-up in stocks on Thursday was partially reversed by the new-quarter blues today, but all of this is mere detail. Over the last week, while authorities in Europe have encouraged investors to put the Cyprus issue to bed additional details have emerged that deserve mentioning. For example, it turns out that the larger depositors (over €100,000) investors in one of the Cypriot banks will not get a 10% haircut, or a 20% haircut, but something close to a 100% haircut – 37.5% of the deposit balance in excess of 100k will be converted to equity in the bankrupt bank. There are some reports that certain deposits belonging to “EU funds” will be exempt from the haircut. There are of course the stories that capital controls implemented in Cyprus were ignored in non-Cyprus branches of Cypriot banks, and one Cypriot newspaper is claiming that relatives of the president withdrew substantial funds from Laiki bank just before the bank was shut down.
While the worst of the immediate crisis has surely passed, it seems madness to me to pretend that it never happened or that it will have no knock-on effects. For that matter, it seems madness to conclude that since the knock-on effects were not immediate, that no such effects exist. On the other hand, when events are no longer going bang-bang-bang in rapid succession, it is reasonable to ask “whose move is it?” Will bank deposits begin to flee from periphery countries, or wait to see what assurances European officials give? Are central bankers already injecting liquidity into shaky banks, or are they waiting for the invitation from the banks in-country? Are investors reducing risk and diversifying away from European assets, or are they waiting to see if other investors do so first? All of these actions entail costs, and so there is a natural desire of every party to delay action…but to not delay action so long as to cause those costs to rise substantially.
As a trader, my inclination is to hit a bid and get out, and not worry about the bid/offer spread or those other costs. But I am not dealing with billions of Euros when I do that. Still, the insight is that when bad things might happen, the here-and-now transactions costs are usually a poor reason not to seek protection. This is why T-Bills over the last couple of years have occasionally had negative nominal yields (see the chart of 3-month T-bill yields below, source Bloomberg). Yes, it’s clearly dumb to pay $1.01 now to receive $1 in the future. But is it dumber than the alternatives?
Gold, and Dilemmas
At the start of another Employment week, the same refrain echoes: higher equity markets, soft commodities markets (because changes in China’s policies will hurt the demand for commodities…but I suppose that it will not hurt the profitability of U.S. shares?), and continued negative news from Europe that is mostly ignored during Employment week.
Actually, maybe the news from Italy is being mostly ignored here because it is hard for Americans to truly fathom what is going on. Remember that the basic issue is that a majority of Italians voted for one or another party that favored ending austerity measures and/or leaving the Euro, but left no single party controlling both houses of parliament. Until this morning, it appeared that no single party would be able to form a government, which meant that a new election would likely be called soon. But now it appears that the Five Star Movement (Beppe Grillo’s party) is offering to stage a walk-out from the senate. Now, that sounds negative, right? Well, actually it’s progress (and Grillo’s party would have to be given some policy concessions in exchange for walking out, which sounds like “lovely parting gifts” to me) since Five Star doesn’t have enough delegates to prevent a quorum from being established if they leave (with no quorum, the body cannot conduct business) but their absence would allow a majority to be established on a lower number.
In the U.S., the approach would be different: the Senators would reach a deal and then vote on the deal, with no one having to manipulate the process in an arcane Robert’s-Rules-of-Order fashion. On the other hand, they had a senate in Rome about 2,500 years before we had one, so who are we to question their parliamentary process?! And our institutions are no less clownish at times…such as right now, since despite so many dire threats the world apparently did not end over the weekend once the budgetary sequester went into effect.
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Since the markets were quiet today (and likely will remain relatively quiet until the Employment report on Friday, if recent patterns hold true), I thought I’d take up a topic I’ve been meaning to discuss for a while: a look at the relative value of gold and a link to an interesting new paper on gold.
First, let me say that our systematic metals and mining strategy is currently approximately neutral-weight on gold itself, overweight on industrial metals, and deeply underweight on mining stocks. But that strategy relies on metrics I am not discussing here; nothing, moreover, that I discuss here should be taken as an indication of whether Enduring Investments would suggest an investor should add or subtract to his or her particular exposure.
Disclaimer completed, let’s look at the yellow metal relative to other assets, as I first did in this space back in August of 2010 when I concluded that gold did not look particularly overvalued. Gold subsequently rallied another 60%, then slid (in case you haven’t heard!). It is currently still 30% above where it was in August of 2010. So is it overvalued?
Some observers have noted that the ‘real price of gold’ (that is, gold deflated by the current price level) has recently risen to levels not seen since the peak of the gold market in the early 1980s (see chart, source Bloomberg, which shows gold in constant December 2012 dollars).
This is true, of course, but measuring the ‘real’ price of gold is a funny concept. The gold price relative to the cost of the consumption basket is a metric that has meaning, because it tells you how much consumption you displace to buy an ounce of gold, but unless you’re evaluating the consumption of gold I am not sure that’s a relevant metric.
On the other hand, it makes more sense to me to look at investments relative to gold, since that’s what is likely to be displaced by a purchase of gold. Some of these relationships are not particularly useful analytically, though, or at least appear at first blush not to be. For example, looking at gold versus the stock market (see chart, source Bloomberg) you can’t tell very much except that gold was rich or stocks were cheap (or both) in 1980 and gold was cheap or stocks were rich (or both) in 2000. Or, so I wrote in 2010.
However, I subsequently noticed another chart that looked somewhat similar. Below (source: Enduring Investments) I have put the data from the chart above alongside a measure of the volatility of inflation expectations, as taken from the Michigan Sentiment Survey. (As I’ve written previously, surveys of sentiment are not satisfying ways to measure true inflation expectations, but they’re all we’ve got and they might nevertheless be valuable in measuring the volatility of inflation expectations, which is what we’re trying to do here).
The notion is this: when inflation expectations are becoming both lower and more stable, then stocks become more valuable and gold less so as an investment item. But, when inflation expectations are rising and/or becoming less-stable, then stocks become less valuable and gold more so as an investment item. I haven’t worked very carefully to refine this relationship, but the Michigan series begins in 1978 so that’s the main limitation. Yet, without any lags nor tweaking of period lengths, the R-squared here (on levels, not changes) is 0.745, which is firmly in the “interesting” category.
Having said that, unless we’re able to forecast the volatility of inflation this isn’t particularly helpful in assessing whether gold is rich or cheap relative to stocks (although on the regression, not shown, the ratio of gold/S&P is 1.04 but ought to be more like 1.07, so gold looks slightly cheap to stocks). The main thing we can do with this is explain why gold prices have risen relative to stock prices over the last decade, and it makes sense. In this context, the recent slide in gold/rally in stocks can be attributed to a soothing, perhaps temporary, in consumers’ concerns about inflation.
The champion relationship, although less creative, is the ratio of gold to crude. Over a long period of time, an ounce of gold has bought between 15 and 20 barrels of crude oil (West Texas Intermediate), with occasional spikes wider and at least one lengthy period between 7 and 12. The chart below (source: Bloomberg) shows this classic relationship. It makes some sense that two hard commodities, both exchange traded and having no natural real return to them, ought to broadly parallel each other over time. Again, this isn’t a very good trading relationship but it is a decent sanity check.
By this measure, gold is approximately at fair value, although an argument could be made that WTI is no longer the fair price for crude. In terms of Brent Crude, Gold is only 14.3 barrels and so arguably slightly cheap.
None of this will delight the gold bulls, but it also won’t delight the gold bears. Gold, at least the way I look at it, seems to me to be somewhere between slightly cheap to roughly fair value versus a pair of comparables. Of course, it may be that stocks and crude oil are slightly expensive, on the other hand!
Gold bulls and bears also will both find things to like and things to dislike in a paper by Erb and Harvey called “The Golden Dilemma.” Given that gold bulls tend to be more, er, passionate about the subject, they will likely be more strident in their disagreements but it is a capable attempt to tackle many of the well-known arguments for owning gold and put them to logical and empirical test.
These gentlemen (who have some serious chops in commodities research) conclude that as an inflation hedge, gold is (1) not an effective short-term hedge, (2) not an effective long-term hedge, (3) might be effective over the very, very, very long-term, and (4) probably effective in a hyperinflationary situation. Although this depends somewhat on your meaning of “hedge,” I concur that gold is not a hedge. It can, with some work, be made into a smarter hedge, which works better (especially in conjunction with other metals, and mining stocks). But they make a fairly powerful argument that if there’s even a teensy chance that hyperinflation happens, a high gold price can be rational since the tail of an option contributes quite a bit to its value.
Incidentally, a slide-show version of the paper is here and is pretty good even if you didn’t read the paper.
Gravity Still Works, After All
Mild weakness in housing data (Housing Starts fell to only the second-highest level since 2008) seemed to be a sufficient excuse today to send stocks lower, but really the main culprit was gravity. We will have to see if the market corrects more than the 1.25% it dropped today, but it shouldn’t be all that surprising!
It actually looked a little bit like one of the classic “risk-off” trades we have seen in recent years. Commodities fell, especially precious metals, energy, and industrial metals while agriculture rallied. The dollar leapt to the highest level since November. Inflation breakevens declined a touch, and interest rates slipped a couple of basis points. What’s more, the VIX jumped to match its highest closing level of the year.
Searching for a new story on why commodities fell, a rumor passed along the market (memorialized by Bloomberg here) that a hedge fund was being flushed out of commodities positions. But that made little sense, unless the fund had been long energy and short agriculture – and if they had been, they would have been winning over the last several months, not blowing up! More likely, it was just gravity, which seems to operate more heavily on commodities than on stocks these days. I guess stocks are from Mars, commodities from Venus.
I think this is all part of a corrective move, but the corrections are a bit out-of-sync and that makes me nervous. In the article I wrote on January 31, I pointed out that the dollar index, 5-year inflation breakevens, and commodities were all nearing critical breakout or breakdown levels. I thought they were all about to break those levels and continue trends, but what actually happened was quite the opposite: the dollar index is up significantly (back to near the November highs, as I said), 5-year breakevens are a couple of basis points cheaper (although not much) and commodities have done what commodities have done all too often over the last year: slid to lower nominal, and even cheaper real, levels. Although I didn’t show it on January 31st, the 5y CPI, 5y forward – an important metric for the Fed – has also declined slightly from 3.09% to 3.04%.[1]
I expect the markets to return to the levels they held at January month-end, however. The FOMC minutes out this afternoon showed that while there continue to be dissenting, hawkish voices at the Fed (notably, Esther George cast the lone dissenting voice this month – how I like this Fed President!), they continue to be completely drowned out by the doves. Again looking for an angle to explain the stock market decline – which started this morning, long before the minutes were released and probably even before they were leaked to Goldman[2] – market headlines bleated about how the “Fed Minutes Show Debate Over Stimulus,” about how the Fed is “uneasy” over QE, and about how several officials suggested varying the pace of QE over time.
This wild and crazy debate, this uprising of the inflation hawks, produced (I note again for the record) one dissenting vote. Remember, even non-voters can participate in debate and appear in the minutes even if they don’t vote. In this case, the “several members” likely included George and Richard Fisher of Dallas (non-voter), with some chance that a third, also non-voting, member joined them (maybe Plosser?) But they are arrayed against a very dovish core of the FOMC, and the minutes contain a clear indication that the Committee prefers to err on the side of keeping accommodation too long rather than remove it too soon:
“A number of participants stated that an ongoing evaluation of the efficacy, costs, and risks of asset purchases might well lead the Committee to taper or end its purchases before it judged that a substantial improvement in the outlook for the labor market had occurred. Several others argued that the potential costs of reducing or ending asset purchases too soon were also significant, or that asset purchases should continue until a substantial improvement in the labor market outlook had occurred. A few participants noted examples of past instances in which policymakers had prematurely removed accommodation, with adverse effects on economic growth, employment, and price stability; they also stressed the importance of communicating the Committee’s commitment to maintaining a highly accommodative stance of policy as long as warranted by economic conditions. In this regard, a number of participants discussed the possibility of providing monetary accommodation by holding securities for a longer period than envisioned in the Committee’s exit principles, either as a supplement to, or a replacement for, asset purchases.”
I similarly wouldn’t read much into the “number of participants” asking for ongoing evaluation of the efficacy, costs, and risks of asset purchases. This sort of debate has been occurring in the minutes of almost every meeting since the Fed first began QE, and it would be striking if there was not any discussion of efficacy, costs and risks – especially considering that the efficacy of this unprecedented policy action has been fairly unimpressive, to be kind.
I see no reason to doubt the Fed’s word that they will keep accommodation until the Unemployment Rate improves or inflation moves enough higher to concern them. But there is certainly no concern, even among the hawks, about the current level and trajectory of inflation:
“Nearly all participants anticipated that inflation over the medium-term would run at or below the Committee’s 2 percent objective.”
Unless you’re talking about the vague concern expressed by “a few” participants about inflation over the long run:
“Participants generally saw recent price developments as consistent with their projections that inflation would remain at or below the Committee’s 2 percent objective over the medium run. There was little evidence of wage or cost pressures outside of isolated sectors, and measures of inflation expectations remained stable. However, a few participants expressed concerns that the current highly accommodative stance of monetary policy posed upside risks to inflation in the medium or longer term.”
This continues to be where the whole house of cards is vulnerable. A series of bad inflation numbers (and I am sure it would take a series, not just one or two) could alter the debate later this year. Tomorrow’s release of January CPI (Consensus: +0.1%/+0.2% ex-food-and-energy; +1.6%/+1.8% y/y) is not likely to be the first of those bad numbers, but it is coming soon. The consensus expectations are quite soft, essentially +0.05% on headline inflation (the energy spike didn’t really start until February) and +0.16% or 0.17% on core CPI.
But the housing price data are unequivocal: a large portion of the consumption basket is going to see prices rising at an accelerating rate, soon. Our models seem to suggest the inflection point could be another couple of months away, but it is dangerous to get too caught up in model minutae. The big message from the models is that the unambiguously higher home prices (in Existing Home Sales, New Home Sales, the FHA’s Home Price Index, the Case/Shiller index) are leading to higher rents (judging from surveys of apartment rents from REIS and CBRE) and this reflects higher shelter costs that will show up in core CPI within a few months. If it happens tomorrow, then stocks are vulnerable – but if not, then Martian gravity isn’t going to be enough to hold down stocks for very long.
We know that in low-gravity environments, human skeletal structure gradually weakens so that a return to normal gravity can be very dangerous for someone who has been in space for a long time. The stock market has been in space for a very long time. At some point, when “normal gravity” (in the form of a neutral Federal Reserve policy) returns, equities will have a rough transition to make. But that day isn’t yet, so while I don’t have expectations of much higher equity prices from here I also wouldn’t get too excited about looking for a 20% decline, either.
[1] Technical note: when looking at breakevens, and especially forward breakevens, over a long period of time, it is important to use inflation swaps whenever they are available because there are fewer idiosyncrasies with the structure of the inflation swaps curve than with the breakeven curve. As a case-in-point, while 5y inflation, 5 years forward taken from inflation swaps has fallen 5bps since January 24th, Bloomberg’s 5y, 5y BEI has dropped some 30bps over the same period, due to changes in which TIPS and nominal bonds make up that index.
[2] I’m kidding, sorta.
Too Much Fuel Will Extinguish The Fire
Stocks continue to climb inexorably: 21 of the 33 trading days this year have seen stocks end the day higher. About the only market that is doing appreciably better is gasoline. Retail gasoline prices have risen 33 of the past 33 calendar days, and front Unleaded has risen 22 of the 33 trading days in 2013.
This brings us, of course, to the question: if gasoline rises every day, then how long will it be until higher gasoline prices start to affect equity prices?
The question is not quite as straightforward as it appears. On the surface, we have two competing effects: first, stronger economic activity will tend to support both gasoline prices and corporate earnings, giving a lift to equities. And some recent data, such as last Friday’s hefty upside surprise in the Empire Manufacturing figures for February (+10.04 when -2.00 was expected), suggests that growth in Q1 may not be slowing too much further although the European, Japanese, and US economies each contracted in Q4.
(By the way, did you realize that? Each of the three biggest First World economies contracted in Q4 and the US equity markets declined -1.0%).
Not that equities necessarily must pull back when growth lags (if they did, then all good economists would also be good traders), but when you’re talking about markets that are pricing in a continuation of historically wide margins and historically high price-earnings multiples, it would seem that a pullback when there is weakness economically is as good a time as any. Stocks can’t go up in a line forever, can they?
Actually, they can, but we’ll get to that in a minute. I mentioned two competing effects that are apparent, with one of these being the stronger economic activity will tend to support both gasoline prices and earnings. The other is that higher gasoline prices have a depressing effect on discretionary expenditures. Along with the higher payroll taxes which manifested in January and the lower Q1 incomes as a result of dividends being pushed into Q4, the higher gasoline prices may have contributed to what a finance VP at Wal-Mart described as “a total disaster” start to February. This is an “automatic stabilizer” effect at work: higher growth tends to produce higher energy prices, which tend in turn to dampen economic growth – and vice-versa.
So which effect dominates? Can gasoline prices and stock prices keep going up together?
The answer is that their nominal prices can absolutely continue to rise together, but their real prices cannot. If I double the price level, then no matter what happens to growth or the marginal rate of substitution between gasoline and all other discretionary goods and services, both nominal gasoline prices and nominal corporate earnings (and therefore, quite likely equity prices) will both rise. However, higher real energy prices imply lower real equity prices eventually. But that’s not a day-trade; in the fairly short run (say, several months) the price level is roughly constant so that one of these two markets is likely to decline in nominal terms.
Frankly, the odds in my mind are on stocks breaking first. But as the chart below (source: Bloomberg) shows, the ratio of gasoline to stocks is not really out-of-whack one way or the other. This is unleaded regular gasoline divided by the S&P level…and what’s fascinating to me is how regular the relationship has been (especially in 2010!).
By the way, the distinction about nominal and real prices also is relevant for the observation some have made that gasoline inventories are reasonably adequate, but prices continue to rise. Gasoline prices are high in nominal terms, but not as high in real terms. In nominal terms, unleaded has risen 105% since the second Bush inauguration, but only 65% in real terms. That still sucks, mind you, and is one reason that growth hasn’t been robust in a while. As of December 2004, gasoline was 3.934% of the average consumption basket; according to the BLS (new numbers are out today!) that became 5.274% as of December 2012.[1] Therefore, we spend about 1.34% less of our total consumption on other things than we did in 2004.
With gasoline, medical care, and college tuition all squeezing us (not to mention taxes, which is not a consumption item and therefore not in the CPI), it isn’t surprising that we’re spending a smaller proportion of our consumption basket on apparel and housing than we used to (for a longer-term view, see my comment from a couple of weeks ago “Fun With the CPI”). These are long-term, secular trends. What could hurt the market in the shorter-run is that when there is a significant move in energy prices, we can’t change the amount of housing we consume to compensate. We stop buying the Wal-Mart things. And we save less.
And eventually, we stop buying stocks. Don’t we?
[1] N.b.: that doesn’t mean we spend 35% more on gasoline now; as noted, gasoline has doubled in price. But 35% more of our consumption is spent on gasoline, than we spent previously. It is interesting that with a 65% increase in the real price of gasoline, our gasoline consumption has only risen 35% (due to smaller cars, better gas mileage, more air travel, more mass transit, etc).
Increasingly Wary
Monday’s decline in global equities wasn’t exactly a wrenching selloff, except for one thing: it seemed to be completely unexpected. While the S&P only fell 1.2% – reversing almost every penny of that decline today – European equities was where the pain really was. The Eurostoxx 50, representing a pan-European collection of big firms such as Siemens, Volkswagen, Nokia, etc (about 25% Financials, 18% Consumer Goods, and other sectors weighted 10% or less), fell 3.1% on Monday and rebounded only 1% on Tuesday.
Don’t go to sleep, Americans! We have not necessarily heard the last of the crisis in Europe!
In the U.S., stocks remain up 6% since December 31, but on Monday’s close the Eurostoxx was actually down for the year. And don’t blame it all on Spain’s Prime Minister Rajoy and the scandals currently swirling about him; Italian 10-year bond yields are also up 30bps in the last week and a half. It isn’t entirely clear where the sudden case of the jitters is coming from, but it certainly doesn’t help the global economic recovery that Brent Crude is nearing $120/bbl again, up nearly 30% from the June lows realized in the teeth of the crisis.
(Incidentally, Carlo Rosa at the New York Fed just published an interesting paper that argues “monetary policy news has economically important and highly significant effects on the level and volatility of energy futures prices and trading volumes.” He finds that the Fed’s LSAP1 and LSAP2 programs “have a cumulative financial market impact on crude oil equivalent to an unanticipated cut in the federal funds rate of 155 basis points.” I have no confirmation of the rumor that Mr. Rosa has been disinvited from the Fed’s President’s Day bash this year.)
Now, economic data has been weaker in January than in December, at least in the U.S., but so far at least not by as much as I thought. Still, stock markets are priced for something more than “not as bad as I thought,” and having February gasoline prices at record highs (see chart, source Bloomberg) for this time of year – albeit not by much above last year’s record, yet – is a buzzkill for anyone hoping for a 2013 blastoff.
It also is a buzzkill for Federal Reserve members, I am sure. While the Fed concentrates on core inflation, since it is less volatile (and better-related to 2-year forward inflation than headline inflation), consumers notice and set their expectations based on the whole consumption basket. The best possible outcome for the Fed would be that both core and headline inflation decline, while they work to juice the system. The second-best possible outcome is that core rises, but headline stays low as lower fuel prices help both growth and inflation perceptions. The absolutely worst outcome is that core rises because Fed easing is pushing asset prices (for example, in homes) higher while headline prices scream past even faster because of higher energy prices…and those higher energy prices also serve to retard growth.
One-year headline inflation swaps are currently priced at 2.03%. While core inflation is currently at 1.9%, for reasons I’ve cited here before that is very unlikely to persist for any length of time, and if energy prices sustain any kind of rise at all, a 2.03% headline inflation over the next year seems optimistic to me. To be fair, I should note that the gasoline futures curve is reasonably backwardated, so an easier way to make the same trade is probably to buy March 2014 gasoline futures at $2.69 compared to $3.04 for prompt March.
Although it seems all is well in the U.S. stock market, investors should be increasingly wary. I wrote last week that there are signs some markets are catching the scent of inflation; while growth in the U.S. looks okay and our stock market is riding high, let this note be a warning that other markets are catching the scent of something still stinking in Europe. Implied volatilities are still low, and this may be a good time to buy protection.
