Toro's Running of the Bulls Market Blog

China's Coming Financial Crisis

I would suggest you pop on over to Zero Hedge and read the article published a few days ago from SocGen on the coming crisis in China.

I am currently reading the book, This Time is Different, which details eight centuries of financial crises.  The authors note that financial crises are usually presaged by an explosion in credit growth, like what now occurring in China.  Throw in an antiquated and opaque banking system priced to perfection, enormous imbalances particularly in foreign reserves, overcapacity, too much fixed investment, too heavy of a reliance on exports to the West, and reports of housing bubbles, and this will ultimately not end well.

That does not mean that China is about to roll over right away, nor that the country's future is not bright.  The United States went through many financial crises in its development.  China will as well, and we must be aware of this.

Gold v Stocks, 1971 to Present

In an article on Monday, Bloomberg compared the returns on gold to CDs since gold hit its last peak.

Gold’s best year in three decades has yet to match the returns of an interest-bearing checking account for anyone who bought the most malleable of metals coveted for at least 5,000 years during the last peak in January 1980.

Investors who paid $850 an ounce back then earned 44 percent as gold reached a record $1,226.56 on Dec. 3 in London. The Standard & Poor’s 500 stock index produced a 22-fold return with dividends reinvested, Treasuries rose 11-fold and cash in the average U.S. checking account rose at least 92 percent. On an inflation-adjusted basis, gold investors are still 79 percent away from getting their money back.

Generally, buying and holding assets at peak valuations is not a prudent investment strategy, as anyone who has continuously owned stocks this past decade knows.  Gold, of course, is no different.

Comparisons between asset class returns are very end-point sensitive but illustrative nonetheless.  So how has gold done relative to stocks?

One comparison is gold to equities since the United States abandoned the last vestiges of the gold standard.  On August 15, 1971, President Nixon suspended convertibility of dollars held by foreign central banks into gold, thus setting in motion the greatest orgy of credit creation the world has ever seen, arguably culminating in the credit crisis of 2008.

Using end of month levels, at the end of August 1971, the S&P 500 was 99.03 and gold was $42.73.  At the end of November 2009, the S&P 500 was 1095.63 while gold was $1173.52.  Over that time period, the S&P 500 price index returned 1006%, or 6.5% annually, whereas gold rose 2646%, or 9.0%.  On a price basis, gold has handily beaten stocks.

Of course, price appreciation is only a part of the return on equities.  Stocks pay dividends.  If one includes dividends reinvested, stocks returned 4192%, or 10.3%, besting gold, although not by as much as one might expect.

More interestingly, there have been long time periods when stocks and gold have outperformed relative to each other.  Upon suspending gold convertibility, gold began outperforming stocks almost immediately.  From September 1971 through September 1980, stocks returned 27% including dividends reinvested, or 2.6% per year.  Gold rose 1460%, or 35% per year.

Stocks started to outperform gold in October of 1980, and did so for two decades until August 2000, returning 2429% including dividends reinvested, or 17.6% per year.  Gold was a dog, declining 58%, or 4.3% per year.

Relative performance turned once again in September of 2000 and has continued ever since.  Total returns including dividends for equities up to the end of November of this year has been -18%, or -2.1% per year.  Gold has been a big winner, rising 323%, or 16.9% per year.

Everything has its time and place.  Wall Street will tell you that you should always be in stocks.  They are dead wrong.  Stocks have been horrible investments at various times throughout history.  Likewise, there have been great times to own gold and other times when you do not want to own an ounce of the stuff.

Gold may be topping.  I do not think it is, but we must be aware that it might be.  When it does top, you want to be as far, far away as possible, just like any other asset, including stocks.

UPDATE  Going back to September 1971, I constructed a portfolio of stocks and gold, investing half in stocks and half in gold at the beginning of each year.  If stocks outperformed gold in the previous year, at the beginning of the next year, stocks were sold and the corresponding amount was bought for gold such that the portfolio was rebalanced to an equal weight between the two.

This portfolio out-gained both stocks and gold, rising 5620%, or 11.2% per year.  Volatility was less at 15.4% for the portfolio whereas volatility for stocks was 18.3% and for gold 29.1%.

There were only seven years when the portfolio generated a loss, and only two a double-digit loss; -18.5% in 1981 and -16.7% in 2008.  The average loss for the seven negative years was -8.2%.

Stocks had nine losing years, with five years of double-digit losses, including -25.9% in 1974, -21.7% in 2002 and -38.5% in 2008.  The average decline was -15%.

There were more negative years for gold at 14 in total but the average decline was less than stocks at -11.8%.  There were six years of double-digit losses, including -23.7% in 1975, -32.6% in 1981, and -22.2% in 1997.

Gold and Interest Rates, 1979-80

Gold was hammered on Friday as investors stampeded out of a crowded trade, me included.  The impetus for the sharp decline was the stronger than expected jobs report, and a fear that the Fed would start raising interest rates and withdrawing quantitative easing sooner than expected.

But does higher interest rates automatically mean lower gold prices?  The answer eventually is "yes" but not necessarily immediately.  In the last peak during the 1979-80 run-up, yields on the 10-year T-bond rose from 9% to 11% as gold rose from $200 to $850.

This does not mean that gold is impervious to rising interest rates in the short-term.  Gold may have topped.  However, it does not mean that gold has topped.

Remember, tech stocks kept rising when interest rates rose in the late 1990s, and housing prices went up this decade as the Fed tightened.  Asset bubbles usually do not pop at the beginning of the tightening cycle.  Asset bubble usually pop near the end of the tightening cycle.

Again, that does not mean that gold has not popped.  Gold may have.  These are not usual times.  The amount of monetary and fiscal stimulus in the economy is unlike anything we have experienced before, which is almost certainly changing the dynamics of asset markets.  However, do not assume that simply because interest rates may start rising soon, the gold run is over.

Aaannnddd I'm Back Out Again.

Making my broker happy, I blew out of my gold position Friday.  Had I not sold my position on Friday, November 27, I still would have sold it anyways. 

Gold was down 5.7% intra-day. One difference Friday compared to the Friday over Thanksgiving was that volume was huge. This is worrisome. Another big difference is that there was no intra-day reversal as there was over the Thanksgiving holiday.

So I blew out my position. We bounced a little at the close, but we ended the session near the day’s lows, which is usually a sign of more selling to come.

I don’t think this is the end of the gold bull market. I think that we are going to get to $1500-$2000 eventually. But I might be dead wrong. This may be the top in gold. Large declines on huge volume after a parabolic run is not a good sign.

If you study past parabolic moves, there is often a correction and a period of consolidation. This may be such a period. If gold behaves in a similar manner, I expect a period of backing and filling for 2 to 6 weeks and then another move higher. However, when you trade, you have to be intellectually flexible. If we run immediately back up on light volume, then begin to roll over, that might signal the top and a shorting opportunity.

Momentum Works

As an investor that had Graham and Dodd drilled into my DNA, it took me many years to reconcile that you could make money in momentum stocks.  More importantly, it took even longer to learn how to deal with the emotional aspects of being a value investor investing in momentum names.  ("I've got to sell! It is hitting new highs!")

The analytical and emotional dynamics of value and momentum investing are very different.  However, it is all about making money, not dogmatically dismissing something that works.  In the end, the only thing that matters is the size of my account.  And if my account can grow investing in momentum names, I am going to do it.

Motivated by both statistical and psychological evidence on under and over-reaction, we propose two proxies for the degree to which traders under- and over-react to news, namely, the nearness to the Dow 52-week high and the nearness to the Dow historical high, respectively. We find that nearness to the 52-week high positively predicts future market returns. We further show that our proxies contain information about future market returns that is not captured by traditional macroeconomic variables and that our results are robust across G7 countries. In cross-sectional analysis, for stocks that have more likely experienced underreaction (to either good news or bad news) in the past, the momentum effect is about 3 times stronger. For stocks that have more likely experienced overreaction in the past, the value premium is also much stronger.

Canada v US Housing

The Cleveland Fed has written why it believes Canada's housing market did not collapse the way America's did.  They conclude that it was because lending standards were not as lax in Canada as they were in America, and financial "innovation" had not been adopted in Canada to the same extent as it had been south of the border, though that may have been because Canada tends to adopt innovation a few years after the States, and thus Canada may have been somewhat "lucky" in that the US market collapsed before Canada could fully adopt American financial "innovation."

 
I expand on why I believe Canada's housing market has behaved differently than America's here.

Back In

After selling my gold position two days ago, I have re-established my position.  I may be doing this totally wrong, but following Friday's sell-off, it appears gold wants to go higher.

We are in a melt-up in gold, and I believe one must be quick on the trigger if you want to play it here, because when it does sell off, you are not going to want to hang around.  It will be ugly.

I have not re-established my long position in stocks, though I may do so if we break to the upside.

Of course, I could change my mind tomorrow and sell gold again, making my broker happy.

Out of Stocks, Gold

I liquidated my gold position on Friday.  A large down day after strong upside momentum like the sell-off Friday is usually met with either consolidation or selling.  I will be watching gold closely and hope to re-establish my position in the not-too-distant future.

This bull leg in the gold market is acting remarkably similar to the upswing in 2007 and 2008.  We had a similar sharp pull-back in November 2007, followed by a consolidating bullish wedge formation, which broke out a few months later and moved to $1032 in March 2008.  I will watching closely to see if a similar pattern develops over the next few weeks.

I have been selling down positions in the stock market this month and hedged out my remaining positions on Friday.  I am now actually slightly net short, primarily because I apparently can no longer do math.  Having said that, I am happy to be net short, and will be looking to get even more short in the near-term.

As long-time readers of this blog know, I could change my mind tomorrow and completely reverse my positions once again.  Thus, it is best not to trade and invest solely on what I write.  (Oh, they know that. - ed.)

More Credit Growth, More Financial Crises

Surely, we know this, right?

The crisis of 2008–09 has focused attention on money and credit fluctuations, financial crises, and policy responses. In this paper we study the behavior of money, credit, and macroeconomic indicators over the long run based on a newly constructed historical dataset for 12 developed countries over the years 1870– 2008, utilizing the data to study rare events associated with financial crisis episodes. We present new evidence that leverage in the financial sector has increased strongly in the second half of the twentieth century as shown by a decoupling of money and credit aggregates, and we also find a decline in safe assets on banks' balance sheets. We also show for the first time how monetary policy responses to financial crises have been more aggressive post-1945, but how despite these policies the output costs of crises have remained large. Importantly, we can also show that credit growth is a powerful predictor of financial crises, suggesting that such crises are “credit booms gone wrong” and that policymakers ignore credit at their peril. It is only with the long-run comparative data assembled for this paper that these patterns can be seen clearly.

Should You Go to Law School? Probably Not.

For most people, it makes more sense economically to not go to law school.

[B]y undertaking some straight-forward analysis of the factors that come into play I hope to spur future generations of potential law school attendees to think about the question rationally, as one of making an investment. If your law school education were a stock or a bond, offered in the marketplace, would you buy it? Should you buy it? Why or why not

My methodology is as follows. First, I identify the costs of attending law school. These are two: the opportunity cost of not entering the workforce immediately after graduation from college, and the out-of-pocket costs, primarily tuition, fees and books, inherent in attending law school. Based on these costs, I calculate the annuity-like return that must be achieved to recover the costs. This process is more complicated that it might seem, as it importantly requires isolation of the true benefits in terms of compensation offered by a law degree and the identification of an appropriate discount rate for converting such incremental compensation to net present value.  ...

Suppose we convince ourselves that 17% is the appropriate discount rate for the incremental earnings generated by a law degree. Then Solid Performer would need to expect to earn, on average, $33,121 more in his first year of legal employment than he would have earned had he not gone to law school. Given that his hurdle compensation is $80,035, it follows that he must expect to earn $113,156 in his first year. Moreover, the $33,121 wage differential would need to be maintained, and indeed increased at a rate of 3.5% per annum, throughout the remainder of his career. ...

For the Class of 2008, the last year for which statistics were available, the median salary of a fledgling lawyer was $72,000. That salary obviously does not stack up very well against the required salaries set forth in my table. But that median salary tells a hopelessly deceptive story. The distribution of salaries was in fact bi-modal, with fully 42% of salaries falling between $40,000 and $65,000, and a smaller but still very significant number clustered at the elite Biglaw starting salary of $160,000. ...

With the tiniest bit of twenty-twenty hindsight, it is possible to identify, already in the third year of law school, some of the students who have made what has turned out to be not only an ex ante bad investment but an ex post losing investment. Thus, consider the 50% of hypothetical Solid Performers who do not end up with a job offer from a Biglaw firm. They begin their legal careers at a salary that is no higher, indeed is actually lower, than the one they could have obtained without having gone to law school. They are unlikely ever to dig themselves out of that hole.