Fool’s Gold? Know Thy Enemy!

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In this week's Weekly Insights:

– Fool's Gold? Know Thy Enemy!
– Equities Bull Goes On A Diet
– Foreigners Selling Versus Dividend Support
– The Big Transformation In One Graph
– Time To Highlight All-Weather Stocks
– FNArena Sponsors ASX Investor Series
– Buy-Backs Rule
– Rudi On TV: The Week Ahead
– Rudi On Tour

Fool's Gold? Know Thy Enemy!

By Rudi Filapek-Vandyck, Editor FNArena

An oft repeated mantra is that gold is the natural protector against value erosion through inflation. However, one quick glance at historical price movements instantaneously shows this is not always the case.

Gold can experience prolonged periods of price weakness and when it does, not only is there no protection against inflation, there's no safe-guarding of your capital either.

So is gold the ultimate safe-haven, or not? It depends. Under the right circumstances, gold can be whatever its owners want it to be: protector against price inflation, safe-haven guardian against capital loss, an insurance policy for whatever black swan is hiding around the next bend in the road. But if circumstances are not right: none of this applies.

Since the price of gold peaked near US$1900/oz in 2011 circumstances haven't been right. That's a pretty easy observation to make. How come, I hear many investors ask? Printing of money by central bankers is still ongoing. War is breaking out in Syria/Iraq. Central banks in Russia and China are believed to be increasing their reserves. How can it be that gold has lost 35% over the past three years?

The answer lies in the fact that gold has many different and often conflicting influences, illustrated by the fact some people consider it part of the commodities sector, a precious metal, while others talk about it as a currency. Not all factors influencing gold are equal in strength and history shows there's a clear order of importance for the masters that influence the direction of the price of gold.

Contrary to popular belief, price inflation is not one of the important factors. This only applies when the circumstances are right and modern history shows a rather chequered and inconsistent track record, at best.

Consider the following conundrum for everyone who likes to think gold is (one of) the ultimate protector(s) against inflation: global inflation peaked in the early eighties, but it was still high throughout the decade and it definitely had not completely evaporated in the nineties. Yet, for those two decades, gold only declined, and declined further in price.

Clearly, the circumstances weren't right. Higher forces were in play. More important factors.

Historically, gold has had a close relationship with the US dollar, but in opposite direction. The eighties and nineties experienced a revival of the greenback. Clearly, a strong reserve currency can be a problem for gold.

The eighties and the nineties combined also represent the longest and strongest bull market for global equities. We might draw the conclusion from this that when everybody is having a good time because of accumulating gains in the share market, nobody is genuinely interested in gold and so it languishes and disappears out of sight, until circumstances turn right again.

Enter: meltdown of TMT mania in March 2000 or global GFC-sell off in late 2007 until early March 2009.

While it cannot be denied there has been an overwhelmingly negative correlation between gold and the USD as well as with equity bull markets, there are times when gold can rise alongside a stronger USD and we have seen between 2004-2007 and between 2009-2011 how both gold and equities can both have a good time at the same time.

There is, however, one iron clad relationship that has not seen one single exception, not ever, and that is between negative US real interest rates and gold. Both always move in opposite direction of each other. No exception to the rule. Never.

As a matter of fact, I suspect this relationship is today responsible for the widespread myth that gold is the ultimate safe-haven against inflation. Gold proved an excellent inflation guard in the seventies, when inflation soared out of control, but maybe that was only the case because higher inflation pushed high bond yields in the negative on inflation-adjusted basis ("real" yield)?

The chart below shows the relationship between gold and negative real bond yields in the US, until 1980-1981. When subsequently US bond yields moved back into the positive, inflation-adjusted, there was nothing else around to stop the gold price from sliding lower and lower, and lower.

Add a resurgent US dollar plus an awakening equities bull and gold simply stood little chance. The circumstances, clearly, were no longer right. Two decades long.

Take a look at the title above the chart: "strong correlation". Now have a look at where US real interest rates were back in 2011. That's when gold soared, one more time, towards US$1900/oz.

(I don't want to even add more to conspiracy speculation, in particular because there's no shortage of it when the subject is gold, but charts like the above have become rare since 2012).

What happened since? US bond yields normalised to a level whereby their yield now exceeds annual CPI inflation in the US. Ouch.

When US bond yields change direction from sharply negative back to positive, gold follows in the opposite direction. No questions asked.

The irony is that even on this, what seems a pretty straightforward relationship, the gold community remains divided about how exactly to determine "real US interest rates". Until recently there was no problem simply using the US 10-year bonds as benchmark, but they have now moved back in positive territory. Some argue US real interest rates are still in negative territory and certainly this holds true for shorter dated bonds, say 2-3 year US government debt. Since the Federal Reserve hasn't raised the Fed Funds rate as yet, it also still applies on that measure.

However, and this is the important point I am trying to make, if you believe the US economy is strong enough to allow Janet Yellen and Co at the FOMC to start raising interest rates from next year onwards, and to continue lifting rates for subsequent years to follow, then it'll be only a matter of time before all measures for US real interest rates/bond yields will move into positive territory on inflation adjusted measures. (Not having a discussion about "real" inflation versus "official" inflation).

If the above unfolds, no matter at what speed or pace, this will provide a constant head wind for gold, at the very least. If a normalisation in US interest rates were to go hand-in-hand with a stronger US dollar plus an ongoing bull market for equities, I think gold investors should prepare for the worst. History might not necessarily repeat itself, but it does often rhyme. The last time all three major influences occurred, sustainably, at the same time was between 1981 and 2000. Just saying…

Of course, there is an alternative and this should be the only "real" reason as to why investors should consider owning gold: it aint gonna happen.

If it turns out Yellen and Co find themselves in a situation whereby they cannot lift interest rates, for whatever reason, but a weaker than expected US economy and/or labour market come to mind as potential impediments, then gold remains poised to make a come-back with a vengeance. Any delay to current market expectations will have the same effect, temporarily.

The above is my personal view, based upon data analysis from the past and on market observations over the past fourteen years or so. Regardless, I wouldn't consider myself the uber-analyst for all things that concern gold and its future outlook. That title is more suitable to someone like Martin Murenbeeld (Dundee Capital Markets) who dedicates most of his time to analysing gold and its many features, and has been doing exactly that for a long while. When Martin speaks, many listen.

I recently received the slides of Murenbeeld's presentation at the Denver Gold Conference and it is but fair to say that -bottom line- Murenbeeld does not disagree with any of the above. He does question whether US real interest rates can turn positive again before 2016 (but I am sure he'll agree the direction is what ultimately counts) and he even adds one more clear negative: there's still plenty of gold in ETFs that is ready to be sold. On the positive side are rising consumer demand in Asia and central banks adding more gold to their reserves.

Ultimately, governments in developed economies still have a debt crisis to deal with as populations grow older and entitlements are simply too costly, in particular if economic growth is to remain benign. I don't disagree, but I doubt whether investors, short-sighted and one-dimensional as ever, will be taking any future problems on board before it actually features in daily news headlines.

On this basis I remain of the view that gold risks more downside if current expectations for higher interest rates in the US from next year onwards prove correct.

One interesting theory in Murenbeeld's presentation is that, maybe, gold's fall from US$1900/oz has already accounted for the change in US interest rates?

That theory will certainly be put to the test in the years ahead, assuming a first hike by the FOMC next year, in a series of many more to follow.

The chart below shows one more comparison to close of this assessment. Gold bulls are hoping the pendulum swinging back in favour of US equities since 2012 is about to reverse, just like it did in the late 1930s and in the 1970s. Observe how gold has had the upper hand, relative to US equities, from 1999 until 2011. Back in the 1970s the Arabs would create turmoil, and nasty oil price inflation, by turning off the petroleum tab in response to Western support for Israel. Just saying…

FYI: Murenbeeld's price scenarios for gold in the years ahead suggest a mostly sideways pattern, on balance.

Equities Bull Goes On A Diet

Cast your mind back to late 2006. Global equities have experienced three years of healthy returns and a number of market experts starts getting cold feet, calling for caution and restraint. But the bull had no intention of lying down.There was a brief China hiccup in February, but once past the scare, markets continued their upward momentum. Then mid-year Bear Stearns appeared with subprime-related hedge funds troubles. There was a quick sell-off, but still the bull wouldn't die. A swift and violent rally ensued. Only then, gradually and slowly, the seriousness of what was happening started sinking in.

Still, it wasn't until January the selling genuinely took shape and pushed equity markets into a relentless spiral downwards.

Against the background of all this, some market analysts had noted the number of stocks that were left carrying indices higher had steadfastly shrunk since late 2006. In Australia, if my memory serves me correctly, eight stocks pretty much provided all the returns above the zero line that final year before the Grand Sell Off.

Two easy conclusions should be drawn from that experience:

1. healthy bull markets have a broad platform, as in many, many stocks participate, not just a handful to fool the (ignorant) masses
2. no matter how narrow the base, bull markets can last a lot longer than you or I think is possible, even on sharply deteriorating internals

I am not predicting a repeat of the 2008 experience, but it is increasingly clear to market observers and analysts the current equities bull is growing thinner and thinner as 2014 unfolds. It's like the Big, Monstrous Bull has decided to go on a diet. Here's what the always insightful Dave Rosenberg (formerly BA-ML, nowadays Glushkin Sheff in Canada) had to share about it over the weekend:

"For every piece of confirmation for the rally, there is a divergence worth noting".

"Breadth continues to lag in this latest leg of the rally and that is a problem. With each passing peak in the major averages, fewer stocks are trading above their 200-day moving averages… New highs are increasingly limited to the largest of the big cap names – the "privates" are in retreat even as the "generals" forge ahead…

"A more holistic view of the market reveals that the "average" S&P stock is already down 7.2% from the 52-week high!… As well, one third of the Russell 2000 index is down at least 10% year-to-date (not merely from the nearby highs)."

"Let's consider where we are coming from as well. This is the fourth longest bull market in recorded history (2012 calendar days and up around 200%). And we have now gone more than 700 sessions without so much as a 10% dip – again, just the fourth time in history that so much time has passed without a healthy correction…"

"Even 20% pullbacks are not altogether that uncommon – they tend to occur in one-fifth of all years over the past seven decades."

"The longer we go without a stock-market pullback, the harder it will be for investors to handle when it inevitably occurs. A stable market breeds complacency. Complacency breeds bad investing behaviour. Bad investing behaviour breeds regret."

Again, I am not predicting we've landed back in late 2007, though the foreign selling that is hitting Australian large cap shares this month certainly creates a similar atmosphere. Absorb the information above and take it on board.

Foreigners Selling Versus Dividend Support

Surely, for investors who've just joined the crowd, as well as for those who thought they were sitting safe in large cap, defensive stocks, US interest rate and USD-inspired selling hitting Australian equities is somewhat sickening this month. How come those Yanks always manage to get hold of the shiny end of the stick?

One way of looking at the share market is through dividend yield. While this is by far not exact science, it does, in my experience, assist with the notions of "valuation" and "support" and this month it simply confirms nobody is selling because of the lack of upside or of returns; the selling simply has nothing to do with Australian equities per se. How do I know this?

Three of the Big Four banks in Australia now yield 6% or more on forward looking consensus estimates (FY15) while BHP Billiton ((BHP)) and Rio Tinto ((RIO)) both are yielding more than 4%. All these dividends are fully franked. None of these dividends are currently under any credible threat.

I know there are market experts out there that have declared the end of the yield era, but I wouldn't bet my money on it. JP Morgan in the US has just issued yet another report on Baby Boomers moving into retirement in the years ahead. If the general view is correct that this phenomenon is going to keep GDP growth rates in developed economies around 2% in the decade ahead, then yield is by far not dead. Not by a long stretch.

Regardless, even in a less-yield hungry market, the level of fully franked dividends available through Australia's largest cap stocks would instantaneously bring out the buyers. As share prices weaken further, those yields will only attract more attention. I predict we shall see a swift rebound from the moment this inconsiderate selling stops.

But when, oh, when?

The Big Transformation In One Graph

While reading and skimming through hundreds of pages of research, every so now and then I discover what poet Keats would describe as "a things of beauty [that] is a joy forever". This time the honour goes to BA-Merrill Lynch. I certainly intend to include it in my upcoming on-stage presentation.

Essentially, what BA-ML's basic summary implies is that two main factors investors should watch are interest rates and corporate profits. We are ending the ultimate sweet spot when rates are falling and profits growing. Moving into the phase when interest rates start rising should not be a problem, as long as corporate profits continue improving. Worst case scenario is when both move in opposite direction when rates are on the up.

But then Janet Yellen, the most powerful woman in the world, has promised she won't move too fast.

Time To Highlight All-Weather Stocks

Many among you, I have little doubt, still remember FNArena standing tall in late 2007 and throughout 2008, when just about everyone kept saying: stick with the banks, they're safe havens. Remember this one: Subprime debt only represents a micro part of the world's largest pool of mortgages. Oh, how foolish and how inaccurate such views turned out to be.

It was only a few months later and I was at it again, warning: don't buy oil stocks, you are going to regret it. And then there was that warning in late August 2008: don't stand in front of a running train, resources stocks are about to become much, much cheaper.

We never queried our database about any of this, but I have a strong suspicion all these clarion calls, at key turning points, are at the very least one reason as to why FNArena today has kept a loyal following of readers and paying subscribers.

Our list of achievements is much longer than these three prominent calls and there's so much more forthcoming, still. A big part of my market research post-GFC has been about how to identify stocks that simply are better than most, even if it isn't apparent from the outset. I labeled them "All-Weather Performers".

To my utmost satisfaction, five weeks of share price weakness in Australia has now triggered requests from the database to receive the latest update on All-Weather stocks, including from financial planners. One of them wrote me an email last week: Hey Rudi, we are currently reviewing our clients' portfolios. Would you mind sending us your latest update on All-Weather stocks so we can include those in our review?

Instant gratification. It is this kind of emails that makes it worthwhile; all the weekends getting up early, reading reports, making calculations and studying data. Not to mention the many evenings that have accumulated over time. I do feel an update, maybe two, on All-Weather Performers is overdue, and probably has been for a while, but time hasn't been on my side, and then there's the ever so annoying flu.

We will continue updating price information for my list of All-Weather Stocks. End of the month is approaching, so we will have another latest update available soon (see also further below).

FNArena Sponsors ASX Investor Series

ASX Investor Series, Sydney October 16, ASX Auditorium, 12:30 pm

Starting this October, ASX are launching a regular program of company presentations open to the public. Held monthly at ASX over lunch (12:30 – 2pm) up to 8 companies will present followed by an informal meet and greet session with CEOs over light refreshments. FNArena support these events and see them as a great opportunity to hear directly from companies.

Attendance is free however registration is required as places are limited.

Buy-Backs Rule

I've labeled it the Americanisation of the Australian share market. Economic momentum might be patchy, and the Aussie dollar still very much too high. No real help can be expected from Canberra and top line growth is still a demanding target. But none of this stops boards rewarding shareholders, just like their corporate peers have done on Wall Street in years past.

International research suggests a strong causation between companies who buy in their own capital and share price outperformance. At the very least, share buy-backs provide support to the downside in case of a defensive policy.

Here at FNArena, we've put together a list of companies that have announced buy backs:

Ansell ((ANN))
Cape Lambert Resources ((CFE))
CSL ((CSL))
Donaco International ((DNA))
Helloworld ((HLO))
Hills ((HIL))
Karoon Gas ((KAR))
Telstra ((TLS))

Companies believed to potentially announce buy backs in the not too distant future:

Aurizon ((AZJ))
BHP Billiton ((BHP))
GWA Group ((GWA))
Rio Tinto ((RIO))

If you know of any more companies, do tell us and we'll investigate and add them to the list. Our address, as per usual, is info@fnarena.com

Rudi On TV: The Week Ahead

On request from readers and subscribers, from now onwards this Weekly Insights story will carry my scheduled TV appearances for the seven days ahead:

– Wednesday – Sky Business, Market Moves – 5.30-6pm
– Thursday – Sky Business, Lunch Money – noon-12.45pm
– Thursday, Switzer TV – between 6-7pm

Rudi On Tour

I have accepted an invitation to present to the Sydney chapter of the ATAA, in Sydney, on November 17th.

(This story was written on Monday, 29 September 2014. It was published on the day in the form of an email to paying subscribers at FNArena).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July 2013 forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

My previous eBooklet (see below) is also still included.

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January last year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

This eBooklet is included in FNArena's free bonus package for a paid subscription (excluding one month subscription).

If you haven't received your copy as yet, send an email to info@fnarena.com

For paying subscribers only: we have an excel sheet overview with share price as at the end of August available. Just send an email to the address above if you are interested.

Click to view our Glossary of Financial Terms