Toro's Running of the Bulls Market Blog

Gold - A Bubble but Not Yet & Why Warren Buffett is Wrong

First, full disclosure.  I am talking my book.  I own a lot of gold.  Since I have a large position, I am biased.  Always consider the position of the proponent when assessing the validity of the argument, me included.

Also be extremely aware that I may change my mind tomorrow and not tell you.  I own both gold ETFs and call options on gold ETFs.  If I feel that I am wrong or gold is rolling over, I may blow out my entire position.  Owning call options implies an element of timing.  I am not dogmatic and will sell everything if I think the market is turning against me.

Brett Arends had two articles in the Wall Street Journal last week.  The first article was on why gold probably has some ways to go.  I agree.

First, the recent rise [in gold] is deceptive. Yes, gold has risen from around $250 an ounce to $1,200. But that rise started at very depressed levels. Gold had been falling in price for two decades. In 2000-01, it was at the bottom of a very deep bear market. It had touched historic lows compared to consumer prices or other assets like shares. A lot of the past decade's boom has simply seen it recover toward longer-term averages.

Second, before we assume the gold bubble has hit its peak, let's see how it compares with the last two bubbles—the tech mania of the 1990s and the housing bubble that peaked in 2005-06.

The chart is below, and it's both an eye-opener and a spine-tingler.

It compares the rise in gold today with the rise of the Nasdaq in the 1990s and the Dow Jones index of home-building stocks in the 10 years leading up to 2005-06.

They look uncannily similar to me.

So far gold has followed the same path as the previous two bubbles. And if it continues along the same trajectory—a big if—gold today is only where the Nasdaq was in 1998 and housing in 2003.

In other words, just before those markets went into orbit.

Maybe the smart money is out of gold today. But how easily we forget that the smart money got out of these past bubbles way too early. The really smart money knows you make the most money in a bubble right at the end, when it goes manic.

In fact, the rise in gold looks fairly measured.  This is a logarithmic graph of the price of gold since 2001.  Gold has risen at a fairly steady rate in the nine-year bull market thus far.

The top of a bull market / bubble is usually marked by a final surge that explodes higher.  There have been times of frothiness in the gold bull market, but after mild corrections, the price has resumed it's upward trajectory.

Compare gold to the Nasdaq, which exploded higher in 1999 and topped in 2000.  This is a logarithmic of the Nasdaq from 1998 to the top in 2000.  The slope of the final move is steeper than the previous increases in the index.

If Arends's chart is a rough approximation of where gold is headed, it will top out at $2500 to $3000 within a few years.  On some measures of inflation, the real price of gold topped out around $2300 nearly 30 years, so a $2500-$3000 price target is not unrealistic.

Arends's second article was more critical of gold. 

In Part One of this series, when I argued that gold might be about to go vertical, I made a whole bunch of new friends among the gold bugs.

And now I'm going to lose them all.

That's because even though I think gold might be about to take off, I don't recommend you rush out and put all your money into gold bars or exchange-traded funds that hold bullion.

And this is for one simple reason: At some levels, gold, as an investment, is absolutely ridiculous.

Now I can respect someone who says that they will not invest in something they do not understand.  I stay away from biotechnology like the plague because I am utterly clueless about biotech.  I also agree that at some point, gold as an investment will become absolutely ridiculous.  There will be a time when you will want to be far, far away from gold. 

However, I disagree with Arends's premise regarding why gold is ridiculous as an investment.  He makes a mistake, I believe, many people make, including Warren Buffett, whom Arends quotes.

Warren Buffett put it well. "Gold gets dug out of the ground in Africa, or someplace," he said. "Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. [Emphasis added]  Anyone watching from Mars would be scratching their head."

Now, it is a rare occasion when I disagree with the world's greatest investor and richest man, but Buffett is making a fundamental mistake regarding utility. 

Gold bears often argue that gold has no fundamental use or intrinsic value.  This is what Buffett implies in his argument - "We don't use it.  We just pay people to guard it.  What good is that?"  

Well, let us look at a product of one of Buffett's most famous investments, Coca-Cola. 

Buffett made a fortune in Coke.  When he bought the stock decades ago, Buffett realized that Coca-Cola was a powerful and ubiquitous brand that had tremendous global appeal and, at the time, significant cost cutting opportunities.  Plus, the stock was dirt cheap.  Coke was the perfect Buffett investment.

But what is Coca-Cola?  It is flavored sugar-water.  It has no nutritional value.  It makes you fat and it gives you diabetes.  It is loaded with caffeine.  Coke is bad for you.  It is unhealthy.  What "intrinsic value" does Coke have? 

Turns out, it has intrinsic value because it tastes good.  People like it.  From a health standpoint, nobody should ever drink a drop of Coca-Cola, but that does not matter.  We want it.  It appeals to people's tastes.

Fact is, most of what we consume is related to taste.  We do not need to own a big house or an expensive car or nice clothes.  We choose to do so.  Most stuff people buy is not necessary.  We buy most stuff because we like it.  We do not need to eat a restaurant.  We can make things at home.  We do not need to eat steak or drink wine.  We can find nourishment in cheaper foods.  Instead, we do so because we want to, because eating steak and drinking wine appeals to us.  We like it.

Most gold is consumed as jewelry.  Jewelry has utility because it is shiny and pretty and appeals to our tastes.  What intrinsic value does jewelry have other than we like it?  How is that any different from liking a good steak, a fine wine, a nice suit or a Coca-Cola?  

This is all utility.  Utility is the satisfaction something gives us.  We don't need to buy a steak, we can eat lentils and rice instead.  We don't need to end the day with a nice merlot, we can drink water.  We don't need to dress in nice clothes, cheap suits from Sears will do.  We don't need to drink Coke since we will probably live longer if we don't.  But eating steak, drinking wine, wearing nice clothes and craving Coke all gives us utility.  And we get the same utility from owning gold.

"Ah, Toro," you might be saying, "you are talking about jewelry, not gold as an investment.  What utility does gold as an investment give us?"  It gives us the same utility that property insurance or a home security system gives us - peace of mind.  It is money to protect us from the debasement of fiat currencies by governments.  And the debasement of fiat currencies has been occurring at an alarming pace for the past decade.

In his book, Money Mischief, Milton Friedman describes a society in the south Pacific whose money was giant limestone rocks at the bottom of the ocean that nobody had ever seen.  It did not matter that nobody had possession of or even had seen these rocks.  What mattered was the value assigned to those rocks.  The inhabitants used those unseen rocks as a medium of exchange and a store of value.  The submerged rocks were money because people believed they were money.  This unseen money had value, and thus utility, to Micronesians.

Gold is money because people believe it is money.  There is no doubt that gold is money, given the recent scramble to buy gold in Europe because of the Greek debt crisis.

Thus gold, indeed, does provide utility to its owners.  Gold is shiny and pretty and it appeals to our tastes.  And it is money. 

One final word - gold is in a bull market.  There are very few assets in the world today that are in a bull market.  Gold is one of them.

If you don't get it, fine, don't buy gold. You should never invest in anything you don't understand anyways.

But otherwise, don't overthink it.  Gold is in a bull market.  And it is much easier to make money in a bull market than in a bear market.

Canadians' Indebtedness Continues to Rise

As regular readers of Running of the Bulls know, I'm pretty lazy.  That's why I am just now getting around to posting on a report published by the Certified General Accountants Association of Canada (CGA) a few weeks ago on Canadian household debt entitled Where Is the Money Now: The State of Canadian Household Debt as Conditions for Economic Emerge.  And that debt is growing.

Since inception, Running of the Bulls has highlighted the nutty Canadian housing market.  It is the position of this blog that home prices in Canada are bubbly, at least in some cities, and that The Canadian Housing Bubble will end like all bubbles, badly.

Upon making this argument to disbelieving Canadians, pushback one receives is that "there is not much subprime lending in Canada."  My retort is, "So?"  There was no subprime lending during the last housing boom in Canada either, when home prices in Vancouver and Toronto were cut by a third from their 1990s peaks.  Subprime debt is not a necessary precondition to fuel a housing bubble.  What fuels asset bubbles is debt, and a lot of it. 

And a whole of credit is flowing in the Canadian economy, according to the CGA.  From the report.

• The level of debt adjusted for inflation and population growth shows a continuous upward trend over the past two decades, as well as in 2008-2009. In fact, if household debt was to be evenly spread across all Canadians, each individual would hold some $41,740 in outstanding debt in 2009, an amount 2.5 times greater than in 1989.

• Starting in 2003, the dynamic of household debt has changed significantly, shifting towards a high growth rate. For more than six years, the rate of credit expansion has been higher than the long-term average of 4.5%. Unlike the 1990s though, the accelerated extension of household debt was no longer supported by a similar magnitude of economic growth in the mid and late 2000s.

• The debt-to-income ratio reached a new record high of 144.4% at the end of 2009. Debt-to-assets reached 19.4% at the end of 2009, while its average for 1990-2007 stood at 15.2%. Although the debt-to-assets ratio did not deteriorate further in 2009, this stability was mainly attributable to the increase in market value of financial assets in the second and third quarters of 2009.

• The degree to which residential mortgages were backed by residential assets continued to deteriorate over the past two years. This erosion pushed the mortgage-to-residential assets indicator to 65.4% at the end of 2009, a level much higher than the 55.0% average observed between 1990 and 2007.

• The decline in interest rates and lower effective interest paid (expressed as a ratio of interest paid to outstanding debt) did not help households to reduce the share of their income dedicated to debt servicing. Instead, mortgage and consumer credit debt service ratios stayed unchanged in 2009, but were somewhat higher compared with the levels observed in the mid-2000s.

• The true cost of supporting mortgage debt may be significantly understated because debt-service ratio does not take into account such compulsory obligations as mortgage principal, property tax, mortgage insurance premiums and condominium fees. For instance, in Alberta, property taxes and condominium fees added some 27% to an average debt-service ratio for mortgages in 2008.

• The amount of outstanding consumer credit per each dollar of consumption of goods has increased significantly over the past years, suggesting that households are either using increasingly larger amounts of credit to buy the same quantity of durable goods, or that households may have increasingly adopted a practice of using consumer credit for purchasing non-durable goods.

• Some 79% of household assets may be affected by the changing dynamic of real estate or financial markets. The composition of household assets over time has become riskier, less diversified and somewhat less liquid. Stocks and mutual funds accounted for 19.2% of all household assets in 2009, more than double when compared with the level seen in 1990. Holdings of lower risk cash and deposits, in turn, decreased to 12.3% of household assets, down from 18.0% in 1990.

• Households’ exposure to rising interest rates increased. The proportion of household debt with variable rates increased from 14% in 1997 to 25% in 2007. This proportion is even higher for mortgages: in 2009, some 27% of mortgages had variable-rate terms while another 6% employed a combination of variable and fixed rates.

• If the mortgage interest rate goes up by two percentage points, mid-income and mid-to-high income families may be required to tighten their budgets by cutting an estimated 9%-11% from ‘other expenses’ if they are to maintain the current levels of spending on food and transportation. The ‘other expenses’ includes household furniture and equipment, clothing, health and personal care, education, recreation, personal insurance, pension contributions, etc.

Rising debt continues to be primarily caused by consumption motive rather than by asset accumulation. Some 56% of respondents said that day-to-day living expenses are the main cause for the increasing debt; 4 percentage points higher than the 52% reported in 2007. In turn, outlays that could potentially attract a return, such as purchasing of a residence, enrolling in an educational program or spending on healthcare, were among the least likely causes for increasing debt. ...

Some good news.  Debt to income was middle of the pack compared to the OECD.  But, given the problems in the global economy, that is hardly comforting.  Canada ranks first in consumer debt, however.

From 2006 through 2009, consumer credit rose 41.7%, or 9.1% per year.  Mortgage debt rose 46.3%, or 10% per year.

That is more than double nominal GDP growth of 18.8% from 2006 through 2009, or 4.4% per year.

Meanwhile, home prices are at all time highs.

 

And have gone nutty in some provinces.

 

Canadians used to be good savers.  Not any more.

Canada has done a lot of things right over the past 20 years. The country has been a major benefactor of both secular changes in the global economy as well as major imbalances in global financial markets.  Those imbalances only partially corrected during the past recession, while new imbalances have been created and there have been few fundamental changes in the Asset-Driven Economy.  Ultimately, when the imbalances re-balance, Canada will be hit. I do not want to own assets supported by low interest rates and excessive debt, no matter how cool the country or how good the hockey team.

Still Cheaper to Rent

At least in some cities.

From The Financial Times.

 

 

The good news is that one of America's nuttiest markets during the Housing Bubble, Miami, is now back to trend.

By our estimation, US land is among the most attractive investments in the world.  Any appreciable inflation, asset or otherwise, will benefit land prices.  However, it is still cheaper to rent than to buy, at least in elevated markets such as New York and LA.

Ignore Analysts' Forecasts

We here at Running of the Bulls pay some attention to analysts' forecasts for company earnings, but not a whole lot because forecasting is less of an exact science than handicapping football games and predicting the weather.  Via Paul Kedrosky, the green line is analysts' forecasts of future earnings while the blue line is actual earnings.

Euro Bailout Bullish for Gold, Bearish for the Euro

I never understood the arguments of those who said the dollar was going to "collapse."  Collapse against what?  The euro?  The yen?  The pound?  The yuan?

As the world's reserve currency, the dollar acts as an anchor to which all other fiat currencies are attached.  The euro replace the dollar?  Please.  We already see the structural deficiencies of the euro, but Europe grows slower than America and is generally more politically hostile towards capital.  The yen?  Japan still has enormous structural problems and will have serious demographic issues in the future.  The pound?  Sterling is merely the dollar on steroids.  The yuan?  Can you freely convert your Chinese currency into dollars yet?  I thought not.  Plus, there's this wee issue of the massive housing bubble in China.

No, if the dollar were to collapse, it would take all other fiat currencies with it, the euro included.

It should be painfully obvious why the euro isn't about to replace the dollar anytime soon.  A currency union can only work if the union has a valve that releases economic pressure for weak regions.  If one region is economically stronger than another within the currency union, then there must be some mechanism which alleviates the economic pain in the weak region at the expense of the strong region.

There are two ways of doing this - free movement of labour and/or direct monetary transfers from the strong region to the weak region.

In America, there has been a migration away from the Rust Belt to the South.  The former manufacturing powerhouse of America, which encircled the Great Lakes from Wisconsin to New England, was gutted in the 1970s and 1980s as manufacturers re-located to the cheaper South.  As plants shut down in the Northeast and Midwest, labour migrated out of the Rust Belt and into the South.  Also, because of social programs, money paid by taxpayers in the economically strong states flowed to the weaker states.  The pressure valves in the dollar currency union were the free movement of labor from the Rust Belt to the South, and the wealth transfers of social program payments via the government.

Canada offers an even more stark example of how a monetary should work.  The richest provinces in Canada have generally been Ontario, Alberta, BC and sometimes Saskatchewan.  The poorest provinces have generally been Quebec, Manitoba, sometimes Saskatchewan and the Maritime provinces.  The flow of labour has been from east to west, as lack of employment opportunities in the Maritimes has prompted many Maritimers to move to Ontario and the West, alleviating excess labor capacity in Eastern Canada.  Canada also has a mechanism of direct wealth transference from the rich provinces to the poor provinces known as Equalization.  Based on a formula, every year wealthy provinces directly transfer funds to the poorer provinces, much of which is used for social programs and job creation in the poorer provinces.

In theory, the Eurozone has both wealth transfers and free movement of labor.  In the EU, poorer countries are subsidized by richer countries, and any EU citizen can freely work in any EU member country.  In practice, the subsidies are not great enough and there are barriers to the movement of labour.  Theoretically, a large number Greeks could migrate to Germany or Sweden.  However, it is difficult for Greeks to easily assimilate in those countries, and the subsidies from the rest of the EU are not large enough to release the pressure from an over-valued currency in Greece.  Greek labour was over-priced relative to German labour, so the Greek government borrowed to maintain the country's standard of living given that Greece could not devalue its currency relative to Germany.  But this is untenable over the long-run and thus we have a currency crisis in Europe.

The actions of the EU are unequivocally bearish for the euro.  German and French banks are large owners of Greek bonds.  Debt - Greek debt - is being transferred from German and French banks to the German and French states as well as to the European Central Bank.  This is what happened in the US and the UK.  American and British bank liabilities were transferred directly from the banks to the state after the housing collapse.  When the state takes on a greater amount of liabilities relative to GDP, it weakens the currency.  The core nations of the EU are now devaluing the euro by hoisting more liabilities onto the currency by absorbing the debt of Greece via French and German banks.

Devaluation of fiat currencies is ultimately bullish for real assets.  It is good for stocks, commodities, real estate, art, wine, stamps, you name it.  And it is best for real assets in structural bull markets, such as gold.

It is difficult for a value investor such as myself to invest in assets hitting all-time highs, but I do not see how the policy responses by governments are anything but bullish for gold over the intermediate-term.  Countries have assumed massive liabilities, and the coming demographic problems regarding state-funded pensions and medical systems will only make the situations worse.  I do not know how gold is going to do anything but rise over the next several years.

During the past few months, gold has decoupled from its inverse relationship with the dollar.  This is the ultimate end game.  Because the dollar is the anchor for all fiat currencies, a falling dollar eventually leads to all fiat currencies falling against real assets. This is now happening.

How will the gold bull market end?  I see three ways. 

One way is through increased supply.  Gold output rose last year but has been falling for the past decade.

Another way is through significant monetary tightening.  And I mean "significant," where the real rate of interest is substantially positive.  The Fed funds rate was 6.25% in 2007 and the price of gold was double what it was five years earlier.  Given all the problems in the world today, it is hard to see central banks jacking up interest rates significantly for some time. 

Finally, the price of gold will get so stupid that it eventually falls under it's own weight.  But we aren't there yet.

Ultimately, I think it will be some combination of the three that kills the gold market, with the price ultimately getting really stupid being the biggest reason.

I am long gold.  I own calls on the GLD, to which I added my position today.  I am expecting a pullback in the price of gold followed by a successful re-test of the highs, leading to new highs in the future.  But the price action today was fantastic, and new highs may come sooner than I am expecting.

Crash

I have no idea what caused the collapse intra-day today, whether it was a bad trade or the withdrawal of liquidity by the machines or what.  What I do know is that it was amazing to watch.  At one point, the Dow was down nearly 1,000 points.  I have never seen anything like it.

I got lucky.  On Monday near the close, I hedged out all my equities positions to net flat.  I had also been buying gold calls the past week and have been long the dollar since the beginning of April.  So my book since Monday's close has been long gold, long the dollar.  

I closed out most of my dollar long position and have kept only a small position.  That does not mean the euro is going to rise.  In fact, it will probably keep melting down.  Remember, it was 85 cents several years ago.  And on a purchasing power parity basis, it is worth $1.15-$1.20, so it is still expensive.

I am a long-term bull in gold but have traded in and out of the yellow metal over the past eight years.  I started buying a week ago when the price action was acting very well.  I expect that we will go back and re-test the $1225 highs, back off a bit, then blast through it.  I expect to add to positions on a break to new highs or on a light pullback.

My equities book right now looks primarily like this - long small banks, long semiconductors, short the S&P 500 and Russell 2000. 

Over the past year, I have been buying banks, primarily very small banks.  My criteria for banks has been to buy stocks trading below tangible book value that made money through the crisis and are forecasted to make money this and next year.  I own 14 banks, most that trade by appointment.  I hope to add to my bank position during this sell-off.

My semiconductors position is now a residual of a basket that I began building in 2008, and continued to buy through the end of the year and into the Spring of 2009.  At one point, I owned 18 different chip companies.  I have sold most of my basket and now own six names.  I will sell into strength.

The hedges I own are the Direxion Russell 2000 3X Bear ETF, ticker TZA.  I own the double inverse Horizons S&P 500 Bear Plus ETF in my Canadian RRSP account, ticker HSD.TO.  I also hold the double inverse Horizons S&P/TSX 60 Bear Plus Fund, ticker HXD.TO for other accounts I manage in Canada. 

My intention in buying the leveraged inverse ETFs was not to short the market but to eliminate equity beta.  Since Monday afternoon, my net position became net short, so I peeled a small part of my hedge.  Interestingly, during the 600 point 20-minute plunge this afternoon, I tried to sell some TZA, which is normally pretty liquid.  However, it did not get filled, even though I kept it open for 20 minutes. I pulled the order as the market bounced.

I have been expecting a 5%-10% correction for some time now.  Today, we got it, with the S&P 500 down 13% intra-day from the highs of a few weeks ago.  I had thought it would merely be a correction in the midst of a cyclical bull market. I'm not so sure now.  This may be a correction within a cyclical bear market but I must respect the action, and the market action today was just horrible, no matter what the reason for the sell-off. 

Sovereign debt crises are very serious, and must be respected.  I expect more downside pressure in the near-term.

Las Vegas Offended by Wall Street Comparisons

Who wouldn't be?  From the FT.

In a week in which Goldman Sachs executives were hauled over the coals for allegedly structuring a deal that they expected to fail, angry members of a US senate committee invoked a city that had little to do with the bank but everything to do with negative public attitudes towards Wall Street.

Goldman, which has argued throughout that it did nothing wrong, “had less oversight than a pit boss in Las Vegas”, said Claire McCaskill, a Democratic member of the committee. Mark Pryor, a fellow Democrat, was more damning. “You’re marketmakers but you’re also playing in that market,” he told the Goldman executives. “In-stead of Wall Street, it looks like Las Vegas.” America’s gambling mecca is known for many things: garish buildings, excessive behaviour, Elvis Presley and all-you-can-eat buffet breakfasts. But the people who live in the city and work in gambling resent the comparison to Wall Street’s latest fraud case.

“It’s very offensive,” said Shelley Berkley, a Democratic congresswoman whose district covers the city’s gaming strip and casinos ranging from the luxurious Bellagio to the rather down at heel Binion’s Gambling Hall & Hotel.

“Las Vegas casinos might not have clocks but we have rules, we have regulations, we have odds for sports betting,” she said. “Everyone knows what the rules are and no one is getting ripped off.” ...

“When you come to Las Vegas you know you’ll lose some money,” said Cheryl Westland, who was visiting from California and playing slots in the Tropicana. “What I’m not prepared to do is lose half the income on Wall Street that I’ve spent my life saving – but that’s what happened.”

Europe, a Parable

There are two neighbors who live in a subdivision.  One neighbor is Hans, the other is Nikos.  They both bought similar houses next to each other at about the same time for the same price.  Hans put 20% down to buy his house and borrowed 80%.  It has a fixed interest rate and his payment is well within his means. Nikos also has a mortgage, but he put 5% down and borrowed 95% with a variable interest rate.  Nikos stretches to meet his mortgage payment every month.

Hans is an automobile engineer.  Nikos is a clerk for the government.  Hans is more productive than Nikos and earns more money.  Hans works 50 hours a week while Nikos works 35 hours a week and gets every third Friday off.  Nikos could work longer, but the weather’s nice so he chooses not to.  Hans plans to retire at 67 and is saving for retirement.  Nikos plans to retire at 57, but he doesn’t have much savings and is running up his credit cards buying lots of stuff.

But Nikos is putting too much on his credit card. He can no longer maintain his lifestyle and pay his debts.  One day, Nikos skips a mortgage payment.  The bank decides to check his credit rating.  It has fallen dramatically.  The bank then checks Nikos’s income.  The bank discovers that Nikos lied about how much money he made on his mortgage application.  So the bank calls Nikos and tells him they have to either raise his interest rate or cancel the mortgage.  This is a problem for Nikos because he’s maxed out his credit card and can’t borrow from anywhere else.

So Nikos goes to his neighbor, Hans, and asks him for a loan.  Hans, who likes Nikos but disapproves of his free-spending ways, says OK, but on the following conditions

• Nikos has to get a higher paying job, which would require him to work longer and not take a long weekend every three weeks.
• Nikos can’t retire at 57.  He has to work to 67.
• Nikos has to start paying down all his other debt.
• Nikos has to start saving more.

Nikos says “No way.  I like my lifestyle.  I’m not giving it up.”  

Hans replies, “Well, I work hard for my money. If you aren’t willing to alter your lifestyle, I’m not lending you anything.  Why should I lend you my hard-earned savings if you aren’t willing to change your free-spending ways?”

“But I deserve to live this way!”  Nikos yells.

“Sorry,” says Hans.

Nikos goes across the street to Francois.  Francois and Nikos have always gotten along pretty well, so Nikos asks for Francois for a loan.  Francois is afraid that Nikos may have to sell his home and move.  Francois doesn’t want Nikos to move because he is having an affair with Nikos’s beautiful Greek wife, so he lends him the money.

And that is the eurozone.