Uh Oh... Maybe it Will be a Red October After All...

Gold holds above $1,000 – why you should care

Themes: Gold investing, inflation

London , England

Two important things happened yesterday, both of which cast a crimson light on things.

First, the Dow dropped again; it has only gone up once in the last seven days. It went down 203 points. Could be nothing. Could be something big... the beginning of the long awaited ‘next leg down’ for the bear market... the opening day of a bloody Red October.

Charts of oil, commodities, copper, the dollar and Treasury bonds tell us the same story. The greed investments are topping out. The fear investments are heading up.

What’s a ‘greed investment?’

It’s anything that benefits from an improving outlook for the economy and inflation – oil, commodities and stocks, mainly.

What’s a ‘fear investment?’

It’s something that goes up when people begin to suspect the boom is a phony – namely the dollar and US Treasury bonds.

The dollar is rising. So are Treasuries. Yesterday, 30-year US Treasury bond yields fell below 4% for the first time since April.

And what about gold?

Well, that’s the other important thing that happened yesterday. Gold held above $1,000.

So what?

So what?? Well, dear reader, you are in a prickly mood this morning, aren’t you?

This is important because gold could go either way. Gold is a refuge in times of fear – especially when people fear inflation or a falling dollar. Gold is also a target of greedy speculators sometimes, even when the going is good.

According to a study done by the World Gold Council, you never know what gold will do. That study was a great comfort to us here at the Daily Reckoning; we thought we might have missed something. But no. We may not know what gold will do, but neither does anyone else.

Looking around, we see no sign of consumer price inflation. So gold’s recent rise must have been driven by optimistic speculation – along with oil and stocks. Now, when oil and stocks go down... we have to wonder whether gold will go down too. The answer, given yesterday, was what we expected – yes, but not as much.

There’s substantial risk in gold as well as stocks. The ultimate low for the Dow should be below 5,000. That is, let’s say, about a 50% haircut from current levels. And let’s assume that gold does what it did yesterday... let’s suppose that it goes down only 40% as much as stocks. That would still be a drop of 50% of 40%, or 20% – to the $800-an-ounce level.

If you would be gravely upset by a drop of that magnitude, you probably shouldn’t buy gold at this level. And, of course, you should have sold your stocks already. Stick to cash – and gold, if you’re long-term oriented – until this next phase is over.

The economic news was mixed, as usual... with nothing to make us think that our basic outlook is wrong.

On the optimistic, bullish side... consumer spending rose in August. Pending homes sales went up too.

But on the pessimistic, bearish side... “September auto sales plunge,” says a Reuters headline. Yes, car sales drove off a cliff last month – just like we said they would. GM reported a 47% drop.

What happened?

The clunkers programme was an economic fraud. Like all attempts to boost consumption, it merely shifted sales from the future to the present (now the past). Which is a big reason why August consumer spending looked good too.

But wait a few weeks for the September consumer spending numbers. Especially if the stock market continues to fall... Then we’ll find out how sustainable those retail sales numbers really are.

As you know, here at the Daily Reckoning headquarters... in the building with the gold balls on the south side of the Thames... we are often accused of ‘pessimism.’ We deny it.

We’re optimistic about the fate of mankind. But we are pessimistic about many of its current pretensions – such as health food, enlightened central banking, contemporary art, mass education, global climate control and progressive democratic government.

But maybe we are wrong to be optimists. Pessimists always have the last laugh – when the optimists die. “I told you so,” they say, under their last breath.

More news… and a warning against funds…

“I just don’t understand why people invest in ‘tracker’ funds,” writes Mike Tubbs. “Why pay someone to merely replicate the performance of the index?”

In fact, Mike’s point is really this: why invest in funds at all? He’s been studying how index funds compare with actively managed funds… and finds that over the long term, they rarely beat the market.

“John Bogle, who founded the well regarded Vanguard Group of index tracking funds, has done a detailed comparison,” Mike notes.

“He followed all 355 equity funds existing in 1970 over the period 1970 to 2005. Of these, 223 did not survive to 2005 and only 24 of the remaining 132 beat the market by at least 1% per year. Just nine of those 24 beat the market by at least 2% per year and 2 beat it by 3% or more.

“Choosing one of the few outperforming funds also proved to be difficult. Bogle looked at the 20 top performing funds in each year from 1995 to 2005. He found that the average rank of these top 20 funds in each following year was 619!”

So why the underperformance of these funds?

“One of the reasons is their high costs. And these costs are compounded over the years. Another reason is that funds advertise most strongly when the markets are reaching a peak. That means most investors invest more at a time when shares are expensive rather than cheap.

“Finally, large funds find it difficult to invest in the stocks that are most likely to show the best share price growth. The reason for this is also one reason that stock picking works for the intelligent individual investor...”

Mike has his own unique way of picking stocks. They have to meet certain strict criteria…

“The company needs to have a sustainable edge in its market. This usually means it re-invests in its own future. Put another way, it is sufficiently profitable to be able to invest a sizeable proportion of its revenues in new products and services coming out of R&D. This kind of re-investment can have a dramatic positive impact on the share price down the line.

“In the Research Investments newsletter, we picked out Immunodiagnostic Systems (ticker: IDH) in February based on these criteria. It’s risen 199% since then. Alterian (ticker: ALN) is another which is up 103% from its recommended price in April.”

Those are seriously market-beating performances. The FTSE, for example, is up some 22% over that time. Most of Mike’s portfolio of shares shows similar, market-beating returns, so he’s on to something…

“What’s the common factor for these and many of the other successful shares we’ve recommended? It’s that these companies invest in their own research... their expertise... their development.

“They invest in their future and the future of their investors. And as a result they will do far better on the stock market than companies that don’t.”

Meanwhile, from Phoenix comes news that a new wave of defaults is about to slam into the mortgage industry. Commercial properties, retail space, office complexes, apartment buildings are hard to rent. You can see why.

In 2007, America was already outfitted with far more retail space than it actually needed. Americans had gone on a shopping spree for the previous ten years... prompting builders to add more and more space.

By 2006, the US had ten times as much retail space per person as France. This was the bubble phase of a boom in consumer credit that began in 1945.

When you get to the bubble phase, few people stop to ask questions. Instead, everyone assumes that the trends in place will remain... and even intensify. So even into 2008, in Phoenix as well as other growing areas – principally in the sand states – the building continued.

And now it is 2009.

Where are the shoppers? Where are the renters?

Alas, they are thinner on the ground than anticipated... and the developers are having trouble paying their mortgages. Commercial mortgage-backed securities are carrying five times the unpaid balances they had in June ’08, says Bloomberg.

Imagine how disappointed lenders will be when these loans default. And then, imagine how American investors will feel when a new wave of mortgage defaults and repossessions hits the commercial property market.

A new wave of repossessions and falling house prices may be approaching the housing market too. Alan Abelson, in this week’s Barron’s, reports on the outlook as described by Amherst Securities.

The research group estimates an overhang of ‘hidden inventory’ of some seven million units. These are properties owners would like to sell – if and when the market strengthens.

Trouble is, the market may not strengthen soon enough. Then, many of these hidden properties could come right out in the open, as mortgages are reset, marriages break up and people move on.

Amherst says these people are in the ‘delinquency pipeline’ which eventually flushes out the market. And it calculates that another 300,000 properties enter the pipe every month.

Falling prices have reduced ‘owners’ equity’ – the part of the house the homeowner owns free and clear of a mortgage – to only about 43%. This number includes people who have no mortgage at all – more than 50 million of them.

Abelson speculates that the actual equity in the hands of the ‘owners’ of mortgaged houses must be substantially less. Pushed by joblessness... not to mention many of life’s other, normal hazards... many of these people are surely going to default.

Of those in the ‘delinquent pipeline’, nearly 10% haven’t made a payment in more than two years. Sooner or later, the banks and mortgage holders will be forced to take action... and more houses will come onto the distressed property market.

Eager to put this recession behind us? Hey, don’t be in such a hurry. Recessions do good work. Depressions are even better (see below...).

More and more people get something from government. Fewer and fewer are net taxpayers.

This is the basic formula that bankrupts democracies.

The political system becomes skewed towards spending; then, there’s no stopping it. Once the majority of voters and special interests have an interest in increasing spending – even by borrowing – rather than in limiting taxes and debt, the game is practically over.

USA Today reports on the number of children whose lunches are furnished partly at taxpayer expense. The figure rose from 24 million in 1990 to 31 million today. That is, the welfare program increased by a third during the biggest boom in history. Think what will happen during the bust.

Hooray, it’s a depression!

I have a deep respect for the perverse gods ruling over the world of finance. With these mischievous beings, you may not get wine from water, but you are likely to results just as fantastical.”

Hail the gods of mischief

The God of Abraham may rule the Vatican. But another group of gods rules finance. They are like the Greek gods... playful and mischievous, with a keen sense of humour. They look down from heaven not like a benevolent shepherd watching his flock, but like a cackling gawker betting on mud-wrestlers.

Here at the Daily Reckoning, this is not the first time we’ve paid homage to these lesser deities. Nor is it the first time we’ve mentioned their perverse method: Those whom these gods wouldst destroy are first cursed with good luck. Today, we look at the bright side; later, they are blessed by misfortune.

According to a pair of researchers from the University of Michigan, a depression does more for longevity than diet or exercise. Life expectancy during the worst years of the Great Depression increased from 57.1 years in 1929 to 63.3 years in 1933, says the report by Jose A Tapia Granados and Ana Diez Roux.

It didn’t matter whether you were a man or a woman, black or white. And it didn’t matter if you were in the US during the Great Depression or in Spain, Japan or Sweden during their economic downturns. The results were the same.

By contrast, life expectancy declined during the boom years. For most age groups, “mortality tended to peak during years of strong economic expansion (such as 1923, 1926, 1929 and 1936-1937)”, they wrote in the Proceedings of the National Academy of Sciences.

Conventional wisdom holds that recessions are times of stress. People do not eat as well. They skip medical check-ups. They should drop dead earlier. Instead, they live longer.

Perhaps it is because the economy slows down, allowing people to live at a more comfortable pace. Maybe the unemployed get more sleep. We don’t know. But if you want to live an extra six years, nothing works like a slump.

When it comes to economic health too, nothing beats a depression.

Last week, World Bank president, Robert B Zoelick, explained to Washington how the dollar made Americans wealthy:

“The United States is incredibly fortunate that the dollar enjoys this special status as the world’s reserve currency.”

It made it possible for Americans to buy things abroad with dollars and then, rather than come back to the US as a claim against US assets, the dollars stayed in foreign central bank vaults.

It was as if the US, and the US alone, could issue IOUs and never have to pay up. An “exorbitant privilege”, Valery Giscard d’Estaing called it.

Since the end of WWII, the world had no real alternative. It had to use the dollar in its international transactions, just as it once used gold.

This had a marvellous effect on world trade and roughly the same effect on America as a winning lottery ticket.

And like a lottery winner, she was ruined by it.

With no effective limit on the number of IOUs they could issue, Americans issued far too many. From a low of around 2% of disposable income in 1945, US debt service rose to nearly 15% in 2007.

In terms of total debt/GDP, the ratio was only about 150% in 1945, but that was with public debt from the war years at 120% of GDP. By 1950, the war debt had been cut down to about 70% of GDP, with private debt still at about 35%. At the height of the bubble years – 2005 to 2007 – total debt in America hit 360% of GDP, only 60% of it owed by the federal government.

Of course, most economists saw nothing to worry about. Instead, they set to work proving that such a ‘dynamic’ and ‘flexible’ economy would never fail.

They even won Nobel Prizes for elegant formulae that showed investors how to beat the market, year in and year out.

Then, the bottom fell out of asset prices in ’07-’09. In March of this year, Americans found that their stocks had fallen back to real values not seen since 1968. Their houses were sinking fast too.

By May, 2009, one out of every four US homeowners was ‘underwater’ – with a mortgage greater than the value of his house. Incomes and profits were falling, along with the net worth of the typical American household. Everything was falling – except debt.

How the gods must have roared when they saw the looks on their faces!

In the biggest, longest boom of all time – even with a monopoly on the world’s reserve currency – Americans had lost ground.

But while Americans were once damned by good fortune, they are now blessed by bad luck.

“Looking forward, there will increasingly be other options to the dollar,” says Mr. Zoelick. Thank the rascal gods. Americans are saving again... rebuilding their balance sheets... and, eventually, their economies. They can even look forward to living longer.

And with a little more bad luck, maybe their moron economists will wise up too.