Gold vs. Stocks…..So Far This Year

January 28, 2012

The S&P500 ended the week virtually unchanged. Volume was very light…..much lighter than the same week last year. Volatility crept higher and yet it’s still at very low levels, levels that are usually associated with complacency.

Macro news took a turn for the worse in the US.  Pending home sales were much lower than expected. The same thing happened with new home sales. This suggests that the recovery in housing—the recovery that’s been predicted by the “experts” every year starting in 2008—is simply not happening, and nowhere in sight. Initial jobless claims were worse than predicted, as were the leading economic indicators. Durable goods orders were the sole bright spot of the week: they beat estimates. And finally, the first estimate of the fourth quarter 2011 GDP, at 2.8%, came in well below expectations. What’s worse is that almost all of the growth came from a build-up of inventory, as opposed to a rise in final demand for goods and services. This is bad because it suggests that, in the absence of an immediate boost in final sales, a reversal of this inventory build is coming soon. Another name for such a reversal? A recession.

Technically, the S&P500 is very oversold, and is showing signs of waning momentum. While the uptrend on the daily charts is not formally broken, further gains from these levels would mean that the oversold conditions would simply become even more extremely oversold. Possible? Of course. But it’s becoming more and more likely that a pullback will soon occur.

A few weeks ago, we commented on the performance of gold relative to stocks (the S&P500) over the course of the entire year in 2011. And the surprising result was that gold vastly outperformed the S&P.

It’s interesting to note now, fully one month into 2012, how the two assets classes have fared.

As mentioned in the earlier post, Wall Street experts tend to promote stocks, sometimes blindly in the face of all adversity and risks.  At the same time, Wall Street tends to dismiss ownership of gold as a cult-like activity best left to be performed by a tiny and strange minority of devout followers. After all, who else would invest in a barbarous relic?

Well as it turns out, the S&P500 is up an impressive 4.7% year to date.

How did the barbarous relic do?  Up 10.%.  So gold has outperformed stocks by almost 130%.

What’s even more interesting, is that poor man’s gold, also known as silver, is up 22% year to date. So silver has outperformed stocks by a whopping 368%.

Yes it’s been only one month. But isn’t it amazing how something so despised by Wall Street (and let’s remember, it’s despised mainly because is doesn’t earn nearly the same amount of fees for Wall Street that trading in stocks does), has blown away the always-favored, the always-peddled asset class called equities?

What’s equally amazing is how Wall Street has suddenly become so silent with respect to gold. Despite such a massive out-performance, Wall Street has simply looked the other way, hoping that the public will simply not notice.

Finally, what’s most amazing is that if gold continues to outperform stocks and rises far more—relative to stocks—than it has so far, only then will Wall Street finally embrace the precious metals….precisely after they’ve risen to much higher price levels, precisely when they’ll become a far riskier and less promising investment.

The bottom line:  do your own analysis. Don’t follow the herd. And whatever you do, don’t listen to Wall Street.

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Examples of Bargains in Pricey Markets

January 21, 2012

While volume is FAR lower than it was during the first three weeks of January 2011, the S&P500 managed to climb another 2% last week. The lack of volume makes the price appreciation very difficult to accept as a solid foundation for further gains. It’s akin to climbing up the side of a tall building using scaffolding made of balsa wood: can you climb higher and higher? Sure. But anyone with a brain would be concerned about the flimsy structure underpinning the climb. And to add more risk, complacency has fully set in—the volatility index is back to “what, me worry?” levels, suggesting that traders have removed a great deal of insurance protecting them from downside moves.

The US equity markets are quickly moving into a very fragile condition—the slightest “disturbance” could set off a huge wave of selling, selling with little near-term bullish support that would break the fall.

On the macro front, the news flow was light due to the holiday shortened week.  Empire State manufacturing, although still very weak by historical standards, did beat estimates. But industrial production missed. Both headline producer prices and core figures were lower than expected. Consumer prices were slightly lower than expected. So on the inflation front, there seems to be very little to be worried about—in the most recent month to month comparisons. In housing news, the results continue to disappoint: both existing and new home sales were lower than predicted. And more importantly, median prices continue to grind lower. While initial jobless claims were better than expected, the Philly Fed survey missed.

Last week, we took the temperature of today’s markets and investor psychology. The verdict was that prices and spirits are on the high side.

The problem is that most investors would simply shrug their shoulders, declare there’s nothing they can do about high prices, and simply go with the flow by staying broadly invested in stock markets.

And that’s exactly how these investors—most individual and even institutional investors—unknowingly assume huge risks of big losses in the near future. Instead of employing tactics to guard against price drops, they compound risk by continuing to buy more stocks at inflated prices, specifically at prices that are above intrinsic values.

So what should an intelligent value investor do?

First, after recognizing the frothy price environment, one could sell down a 100% invested portfolio to increase the cash percentage. Another, tactic for the smaller investor would be to make sure that carefully considered stop orders are put in place to protect unrealized gains from the last two years.

Third, the intelligent investor must be prepared to look for bargains outside of the mainstream large cap pools like the S&P500.  This way, the investor will never be temped to break the cardinal rule of value investing—buying a stock at prices below its true value.

Where can you find such bargains today, at a time when the S&P500 is more than fully priced?

In the US, you’ve got to dig through the small to mid cap firms in the Russell 2000. For example, you could consider a stable, unglamorous medical products maker called Invacare.  Down from $34 just six months ago, you can today buy shares at about $16, which represents an astoundingly cheap 4 times free-cash-flow valuation.  This is about 7 times projected earnings, and only 8 times EBIT for the entire enterprise value. Why did prices fall so much? The firm suffered a technical problem at one of its wheelchair manufacturing plants. Most likely, this is a temporary setback, creating a temporary hit to price (not a permanent hit to value) resulting in a short-term opportunity to buy shares at prices about 50% below true value. Even if share prices were to double, this would bring price-to-free-cash-flow up to only 8……still not over-priced by most standards today.

Other similar bargains abound…..but in Europe, for example, which has taken a beating in market prices over the last six months. Today, large cap, stable drug and telephone companies can be purchased at price-to-free-cash-flow multiples that are near 5. That’s cheap. In many cases, only months earlier, prices were 100% higher.

The bottom line is that there’s NO reason to break the value discipline. In today’s frothy US stock markets, it’s much harder to find screaming bargains. But they do exist. It simply means that an investor must look harder and more widely to find them.


Taking the Temperature

January 14, 2012

The S&P500 inched up 0.88% in another low volume week, despite a scary final session, when many of the eurozone’s leading nations were downgraded by Standard & Poor’s rating agency. Volatility, interestingly, moved slightly against the price rise and moved up slightly, about 1.4%.

US economic news took a turn for the worse, disappointing on multiple fronts, starting with wholesale trade, which barely grew, instead of rising at a strong 0.5% rate. Initial jobless claims roared back to the 400,000 level associated with economic recessions. Retail sales were horrible. Instead of rising 0.4% as expected, they managed to creep up only 0.1%. What’s worse, the more important retail sales ex-autos results collapsed. Instead of rising 0.4%, they fell 0.2%. Business inventories (a key driver of GDP growth) rose far less than predicted. International trade was far more negative than expected, and export prices were far weaker than consensus estimates. Both of these results suggest that the economy was growing more slowly in the fourth quarter of 2011.

Technically, the S&P is very overbought on the daily charts. And it’s showing signs of losing momentum.  It seems that it wouldn’t take much for the upside momentum to stop completely and reverse to the downside. Greek default, anyone?

Last week, we reviewed the insightful investment advice that was provided by Howard Marks in his new book, “The Most Important Thing: Uncommon Sense for the Thoughtful Investor”.

The key insight noted here was the need to take the market’s temperature periodically, to assess if the markets were too optimistic, too pessimistic, or somewhere in-between (or neutral). This type of analysis is much easier to do, and it’s far more accurate, that what almost every professional investor does instead–forecast the near future, place his bets, and hope that the actual outcomes match the predicted future. Because in the predicted future comes to be, then the bets should pay off handsomely. But if the predicted future fails to arrive, then the bets will not pay off.

Marks noted that most professional investors and even most professional economic forecasters have a horrible track record with their forecasts.

So instead of betting on consistently inaccurate forecasts, investors would be better off if instead they focused on reading the present, on taking the temperature of today’s markets.

And today, we can easily rule out that idea that markets are pessimistic. After rebounding smartly off their 2009 lows, equity and credit markets are certainly not running scared today as they were back then.

In fact, by several measures that Marks uses, markets are more optimistic than they are neutral. Equity investor surveys are decidedly more bullish than they are bearish. In the credit markets, interest rates are very low; money is eager to lend at tight spreads, especially for investment grade bonds. Corporate profits aren’t just high, they are near record high levels (as a percent of sales). Asset owners are happy to hold; certainly they’re not rushing to sell. Asset prices are on the high end of multi-year ranges.

As a result, Marks would conclude that since, today, prices are on the high side, that risk is also on the high side. Therefore prospective returns are on the low side.

It bears repeating that “taking the temperature” today is not a forecast for tomorrow.  Instead, it is a determination that being fully invested today raised the odds of lower future returns.

So what’s a professional investor to do….with this type of temperature reading?

Marks would offer several pieces of actionable advice. First, don’t take on much more risk when it’s so high today. In fact, consider reducing risk, by selling it down. And certainly don’t break the golden rule of value investing (of buying assets below their intrinsic values) by overpaying for assets. Another related part of this advice would be to increase the percentage of your portfolio that’s held in cash, to be ready for times when prices (and risks) are lower, and to lessen the damage that could result from market corrections, corrections that are more likely to occur in overly optimistic markets (than in overly pessimistic markets).

Again, without knowing anything about the near future—and without making any attempts to forecast it—our temperature reading of TODAY’S markets is flashing a caution sign. It’s telling us to be careful about higher risks today, but also to be prepared to accumulate assets, at lower prices and lower risk levels in the future, should they become available.

Words of wisdom indeed.


Words of Wisdom

January 7, 2012

On volume far lower than we saw in the first week last year, the S&P500 rose 1.6%. Volatility declined.    Yet, the retail investor has been fleeing—and continues to flee—the stock market. According to the ICI (a firm that monitors retail money flows), the retail investor has pulled money OUT of the US stock market for 34 out of the last 35 weeks, ending the year with one of the largest total net outflows in years.  Yet somehow the US (unlike pretty much every other major stock market in the world) is holding up admirably.

Economic news in the US was mixed. In Europe, on the other hand, a serious recession has started to bite.  From Italy, to Spain, to France and even to Germany, most leading and coincident indicators are pointing down. In the US, ISM manufacturing, while weak, was slightly better than expected. ISM services, on the other hand, disappointed. Factory orders also disappointed. Initial jobless claims matched expectations. The big number of the week, the jobs report, beat expectations, at least on the surface. Headline unemployment dipped to 8.5%, while the broadest measure (U-6) was still at a horrific 15.2%. The broader–and thus harder to manipulate–measures were grim. The labor force participation rate and the employment to population ratio both came in at or near multi-decade lows. Also, the workforce dropped by about 50,000 people—not a sign of an improving job market (which would show a growing workforce). Finally, as economist Dean Baker pointed out, the positive surprise on jobs was misleading and all of it had to do with season hiring that will promptly be reversed in the next two jobs reports.

Technically, the S&P is at the upper end of the declining trend first established in May and June of last year. Seemingly, while the rest of the world’s equity markets have deteriorated between 10% and 25% from their 2011 highs, the S&P has massively outperformed the rest of the world. In the upcoming weeks, we’ll see if the US markets (about 25% of global market capitalization) or the rest of the developed and developing markets (about 75% of global market cap) are correct. One of these two groups is “wrong” and will very likely converge with the other.

Last year, Howard Marks (the founder and chairman of an investment fund with $80 billion under management) released a book titled “The Most Important Thing: Uncommon Sense for the Thoughtful Investor”.

As a value investor, with over 40 years of investment management experience, Marks assembled a series of tips for investors who wish to succeed over the long-term, as he has.

And coming from the Graham & Dodd (Warren Buffett) school, Marks builds on the hugely successful (yet so difficult to replicate) foundation established by them almost 100 years ago.

Marks goes on to add several critically important pieces of advice, advice that he’s used to build his 40 years of success.

One that stands out is the importance of taking the temperature of the economy, the markets, and investor psychology. Even if only once or twice a year, it’s imperative that investors determine if these three areas are too hot, too cold, or just right. Notice that Marks is NOT suggesting that it’s important to determine where the markets are going in the FUTURE. Most of such forecast research is not consistently accurate; in short, it’s not possible to do this consistently. Instead, Mars is suggesting that it’s important to determine where things stand RIGHT NOW; in short, this is very doable–consistently and accurately.

If they’re too hot, investors must reduce risk, by selling risky assets such as stocks. If they’re just right (which is much of the time), then investors can stay invested. If, finally, they’re too cold, then investors must, add risk, by purchasing assets such as stocks.

Marks observes that almost all market participants will do the exact opposite—they’ll buy when things are booming (hot), and they’ll sell when things are gloomy (cold).

This presents the astute investor a huge opportunity:  to buy low and to sell high……as most participants claim they actually want to do.

But Marks also adds some words of caution. He points out that by following such a “contrarian” investment strategy, an investor must be prepared to spend long stretches of time looking like he was wrong, before the markets (and the economy and psychology) revert back to more normal levels…..proving that the astute investor was ultimately doing the right thing.

These can be lonely times for such investors. But history suggests—very clearly—that although they don’t capture most of the gains in up markets, they do avoid most of the losses in down markets. And by doing so, they manage to stay in the game, and ultimately….over the long-term….have superior track records.