I am a great believer in divergence when it comes to the talking about the economy and her markets because it allows you to take a slightly more nuanced perspective than the risk off/risk on debate that has dominated the discourse for the past two years now.
The Global Economy
Still, there is much to suggest that when it comes to global economic discourse whatever your take on things is it follows an easily identifiable framework (click for better viewing).
It is my bet that whatever your position is on global growth, markets, the future of the Eurozone, the prospects of a bubble in China, inflation in India, the price of base commodities (etc etc) you will find yourself comfortably positioned somewhere in the matrix above. In fact, it is hard to form an opinion today on the global economy and its sub-components without taking a decisive stands along the spectrums above. Naturally though, there is more than meets the eye.
Note in particular that I take “excessively” loose monetary policy as given since here we find another case of divergence. Essentially, the debate is currently raging between those who advocate fiscal austerity as a precondition to securing future growth and those see it as a repetition of the same mistakes that were made in in 1937 as policy makers in the US assumed that the recovery was already a reality. Yet, when it comes to monetary policy it is taken as given that rates will stay near zero in the G3 for at least the next 8-12 months. Again, we have divergence here; divergence between policy positions and debates, but also divergence between global monetary policy regimes since you can just ask Reserve Bank of India Governor Duvvuri Subbarao what he thinks of loose monetary policy as he recently headed a 0.5% upward move in the base rate which widens the spread to the G3 even further.
Divergence here of course plays to the disadvantage of both monsieurs Trichet/Bernanke and Subbarao since the money created by the former won’t stay to help their ailing economies but, in stead, race off to India (and elsewhere) fuelling an already raging inflation bonfire. Recently, the IMF downgraded its forecast for global growth (relative to pre-crisis levels) and thus in some sense lowered the bar for the natural speed limit of the global economy. It would however be too pessimistic to interpret this as secularly bad news since divergence will be the key word going forward on the macro level. Especially, the divergence between those economies with sufficient domestic demand capacity to reach “escape velocity” and those whose domestic economic momentum is essentially deflationary is a key theme.
To Pick or not to Pick
Another case of divergence which I recently picked up on is the growing discomfort among value investors that the gains from stock picking is being traded away. This is a long running theme on FT Alphaville and this week it is running two stories which push this point of view. The first is the coverage by Izabella of this piece in which Toronto-based money manager Friedberg Mercantile describes the pain of seeing its long time old and faithful market neutral strategy collapsing due to the correlation of everything. Of course this is not a cry-baby defence piece and it tracks its issues to a lack of dispersion between stocks due, in part, to the rise of exchange traded funds (ETFs) designed to mimic an index or specific asset class.
But this is not all and Ms Kaminska continues her coverage on this by pointing to a piece from Barclays Capital equity research people which lays out the same story. I especially like the point that while equity correlation remains a function of volatility the increasing run to index traded products increases the base level of correlation.
To summarize, in our opinion, while equity correlation continues to be highly dependent on volatility, the rise in indexation has led to a permanent increase in its “base” level. Thus while we do believe that the current high levels of realized and implied correlations are unsustainable, the eventual drop is not likely to be as high as some market participants might expect.
I think this is a very interesting point.
I do also find it almost ironic since one could arguably point to the fact that an increasing focus on buying the market (or a specific asset exposure/class) would mean that value investors got better prospects of carving out niches for them to excel in.
As for the divergence in all of this, you should by no means think that the value investor narrative is dead and buried. Today, Greg Donaldson (the director of Portfolio Strategy of Donaldson Capital Management) has penned a story over at Seeking Alpha in which he specifically suggests that retail investors go for single stocks and not “the economy”.
What retail investors may be missing is that they are not investing in the economy. They are investing in companies. And, some – even many – companies can do quite well even during weak economies.
This point was recently given a run in the always excellent research from BCA (no link available) where they made a classic analysis of the SP500 sectors adjusting weightings based on valuation metrics and thus that positive returns were to be found in a market which traded sideways or even corrected downwards. Of course, they did talk about sectors but still the message was very much one of divergence based on fundamentals despite overall head winds to the economy. Similarly and despite the almost non-event of the recent Eurozone stress test one theme which emerged was indeed that investors could now discriminate between banks based on on their disclosure of sovereign debt holdings. Intuitively, this makes sense too I think, but if everything is correlated should you willingly allocate funds to such a strategy?
Where do you belong?
As ever, picking the right strategy or formulating your own and informed opinion on global economic and financial matters is just as much a question of where you don’t fit in as where you fit in. Be it a question of the main fault lines of the global economy, the right between loose/tight monetary and fiscal policy or the right investment strategy divergence is the name of the game and choosing the right side of the fence is not only important for your own intellectual satisfaction, but also may be important for your portfolio.
My last blog was ultimately about trust and that maybe the basis is telling us that there is still trust in the system. After writing it I remembered the presentation I made to the 2009 Gold Standard Institute seminar in Canberra. Below is the conclusion from that presentation, where I proposed four phases, or degrees of distrust:
We start to see increasing investment in gold reflected by increasing balances in COMEX or ETFs or GoldMoney etc, but the majority of people still hold fiat and stocks/shares. In respect of gold, people have no problem with storing their metal in “the system”.
We start to see occassional backwardation which comes and goes and it usually only between cash and shorter futures/maturities – 1 to 2 months. This backwardation is arbitraged away by longs who still have belief in the system(s) so are willing to take the risk to make a profit. Gold is still held in the system but growth in reported balances is slowing.
We see more backwardation periods, prolonged and now not just shorter maturities but maybe 3 month going to small backwardation. It demonstrates less interest by longs to take the risk. Possibly start to see reported balances of ETFs and less reputable custodians starting to stablise even though gold price still rising, which would puzzle ignorant commentators. A physical squeeze is developing.
Now backwardation persists, it is a permanent state in shorter maturities, increasing to longer maturities. Reported ETF balances are declining. A clear signal not all is well. Gold is being pulled and stored outside the system. The strong hands are in the majority, the squeeze is really on.
I’d say we are just starting in the 2nd Phase.
At 8:30 AM EDT, the Employment Cost Index for the second quarter of 2010 will be announced. The consensus is an increase of 0.4%, which would be a decline of 0.2% compared to the first quarter of 2010.
Also at 8:30 AM EDT, the advance GDP report for the second quarter of 2010 will be announced. The consensus is an increase of 2.5% in real GDP and an increase of 1.0% in the GDP price index. The real GDP estimate is slightly lower than the final estimate for the previous quarter, but these levels indicate moderate economic growth.
At 9:45 AM EDT, the Chicago PMI Index for July will be announced. The consensus index value is 56, which is 3.1 points lower than June, but is still well above the break-even level at 50.
At 9:55 AM EDT, Consumer Sentiment for the second half of July will be announced. The consensus is that the index will be at 67, which would be a 0.5 improvement from the beginning of July, after a 10 point drop from the second half of June.
At 3:00 PM EDT, the Farm Prices report for July will be released, giving investors and economists an indication of the direction of food prices in the coming months.
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My answers to FOFOA’s response
I think an accurate definition of “paper” and “physical” is important to the accuracy of your statement: “I am reasonably confident that paper and physical are bound together.”
“Physical” to me means real physical gold that has been delivered in settlement. Anything else I deem “paper”. Note that my definition of physical includes Allocated or GoldMoney for example, as they purchase real physical gold and store it, ie it comes off the market and is unable to be lent/fractionalised.
“Physical” does not include the near month futures contract. There is a place for buying 3 month and selling 6 month in which case you are arbitraging paper “gaps”, but what we are interested in is the effect on the real physical cash price.
But what if you could play the arbitrage (closing the gap) game without actually putting any physical at risk of delivery? Would this change the accuracy and credibility of the basis signal?
I assume you are talking here about using unallocated. OK so lets scenario it. Assume a stable supply/demand for both cash and futures so without the actions of an arbitrageur the cash price would remain at $1200 and Dec futures at $1195 for a period of 6 months. Hedge fund notices this and wishes to profit from it but it does not want to (or have) physical gold it wants to risk.
Hedge fund contacts their friendly bullion banker and asks to lend gold. Bullion bank conjures out of thin air some fake unallocated gold, merely recording an asset in its books (loan to hedge fund) and a liability (unallocated owed to hedge fund). Let us assume the amount of ounces is enough to move the price in our otherwise stable market by $3.
Hedge fund’s first step is to buy the Dec futures at $1195 but in doing so its price increases to $1198 (lets say that is the next offer price). Secondly they have to sell spot. Say they find a trusting investor who is willing to accept a transfer of the fake unallocated gold for $1200. Again, this action decreases the spot price to $1997 (next marginal bid price) and the market is now in contango. So far so good.
But what happens in six months? The hedge fund only has two choices – cash settle or physical settle.
If they cash settle then they have to sell back their Dec futures contract, but doing so will cause the price to decrease from its new equilibrium price of $1198 to $1195. Likewise, they have to buy unallocated to repay the loan to the bullion banker, but that will increase the spot price from $1997 to $1200. All that cash settling has done is delay the appearance of backwardation but not eliminated it.
If they physical settle then they get their gold from COMEX and deliver it to the bullion bank to repay their loan. Now this would have no effect on prices. However, the bullion bank now has physical 1:1 backing its unallocated liability to the trusting investor. If that investor asks for delivery, it will have no effect on price because the bullion bank has the physical. In a roundabout way the hedge fund eventually did sell real physical gold to the trusting investor.
Now your retort may be that the fact that the trusting investor was willing to accept fake unallocated allowed the manipulation of the basis to turn backwardation into contango. You would be correct, and that is the point of my scenario. The basis is therefore reflecting reality, the reality that there are idiots prepared to accept paper gold.
The basis IS telling the truth. It is not the hedge fund or the bullion bank who have “manipulated” the basis, it is the trusting investor. But in a sense the basis has not be manipulated, arbitrage is ensuring it reflects reality, that there are idiots who are prepared to bid dollars for paper gold.
If that trusting investor was not so trusting, then the hedge fund would not have been able to execute their arbitrage because there would be no one willing to accept their paper gold. The cash price would have remained at $1200 and the market in backwardation, and the basis would reflect reality, the reality that people were only willing to bid dollars for real gold.
You said “If gold stops bidding for dollars (low gold velocity), the price (in gold) of a dollar falls to zero. This is backwardation!” My reply would be that even if all (real) gold stops bidding for dollars, but there is plenty of paper gold bidding for dollars which are being accepted, then there is no backwardation.
My logic therefore leads me to the conclusion that the basis does not lie, that it cannot be manipulated. Professor Fekete was right all along, long live the basis. However, I don’t feel totally confident in this statement, as I said I’m not an expert in futures so there is probably a flaw in my scenario and logic. If so what is it?
Over time, group 1 will swell and end up holding most of the above-ground physical gold in the world. Group 2 will shrink and end up holding mostly paper gold. Group 3 will be financially sucked dry by the vampires in group 4. And group 4 will ultimately find it has no more markets to churn.
This is the theoretical process that gold backwardation should represent. A healthy and REAL gold contango SHOULD send this process into reverse, perhaps slowly at first, but reverse nonetheless.
So the question I am asking is which direction are we heading right now in this process? How close are we to the end of this process? And why aren’t the market signals matching the rest of the picture?
If group 1 already has most of the physical gold and is now a one-way flow, is that not the state-of-the-market that backwardation should signal? And if the state is present but not the signal, what does that say about the signal?
Following from my conclusion that the basis does not lie, then the “signal” must be correct, which means “the state” of group 1 strong hands having most of the physical gold is not correct and we not close to the end of the process you describe. This is consistent with the defence by goldbugs to claims we are in a gold bubble that investment in gold is still a fraction of portfolio allocations and the mass market is not buying gold. Dollars are not being bid for gold, real or paper.
If you don’t like the conclusion, then you must find a flaw in my logic about the basis. I am more than happy to be proven wrong. Well, maybe not just yet, I’d like to pick up some more cheap gold
FOFOA has hit me with a lot of questions in this comment
. It is 11pm in Perth, so this will be brief, but they are interesting questions and I will cover off on them over the next few days.
When it comes to COMEX FOFOA, I also am a “conceptual thinker and a fundamental analyst-blogger”. This is because my gold market experience has only been with the Perth Mint and the Perth Mint has never traded on COMEX, and nor can I see any reason why we would in the future. It is a position you can take I suppose when you refine 300 tonnes of physical per year. I mention it so it is clear where my expertise lies and where it does not. This won’t stop me from theorising however, because that wouldn’t be any fun.
You question the reality of COMEX. Certainly the fact that one does not have to put down full cash and only margin means that there may well be many technical traders playing with computer digits, and they may be in the majority. However there are also real physical players like miners and manufacturers.
However, I am reasonably confident that paper and physical are bound together. To make that statement I rely on one thing – arbitrage, or greed. Greed as a motivator is something I feel pretty confident relying on. I just don’t consider it believable that a bullion bank or hedge fund or other big trader would leave profit on the table.
We cannot discount manipulations or games being played with cash or future prices. But to manipulate one of those means that the gap (ie the basis) between the market you are manipulating and the one you aren’t widens or shrinks. If the manipulation goes too far then that will present an arbitrage opportunity to other players, which if we rely on greed as a motivator, they will take. That action closes the gap.
Now as one can “trade” the basis (for another day) as distinct from the price, it must therefore be possible that the basis itself can be manipulated. However trading the basis involves two “legs” – eg buy spot, sell futures or sell spot, buy futures – which again widens or shrinks the gap/basis, presenting arbitrage opportunities to others.
The game of trading to my mind is a “base” of real price setting physical deals with that price pushed and pulled by competing manipulators, speculators and arbitragers, of both paper and physical price. Price may go up, it may go down. Both cash and futures prices may go up, but the gap widen. Or both prices go up and the gap shrinks.
I see it like an elastic/rubber band being stretched and then bouncing back. That stretching is the “noise” I mentioned in my last post. It is fun to watch and I’m sure such watching can give you an insight into the games being played, but what matters is when it is stretched to far, and breaks.
At 8:30 AM EDT, the U.S. government will release its weekly Jobless Claims report. The consensus is that there were 460,000 new jobless claims last week, which would would be an slight decrease in claims from last week’s number.
At 10:30 AM EDT, the weekly Energy Information Administration Natural Gas Report will be released, giving an update on natural gas inventories in the United States.
At 4:30 PM EDT, the Federal Reserve will release its Money Supply report, showing the amount of liquidity available in the U.S. economy.
Also at 4:30 PM EDT, the Federal Reserve will release its Balance Sheet report, showing the amount of liquidity the Fed has injected into the economy by adding or removing reserves.
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FOFOA started a little excitement with his post
on backwardation. Professor Fekete responded
and Zero Hedge weighed in
I would not be surprised that for many this backwardation thing makes their head hurt and perceive it as all very theoretical and of no practical use. But this is not true and backwardation is a potential profit opportunity for those holding gold. However, it is also being overplayed.
Backwardation is when the future price is less than the cash (spot) price. Consider you are a long term holder of gold expecting to sell it in a couple of years when the price peaks. One day you wake up and note that the price of gold six months into the future is being quoted on COMEX at $1150. You check with your local coin dealer and he is quoting to buy your gold at $1200. What does this “backwardation” mean to you? See below (numbers for purposes of calculation simplicity, not real costs).
You work out that it will cost you $100 to ship your 100oz to the dealer. He will pay you $120,000. You deposit $20,000 of that with your broker as margin (plus extra to cover fluctuations) and buy the $1150 futures contract, plus brokerage fee of $50. You deposit the remaining $100,000 cash in the bank for 6 months at 0.5%. On maturity of the futures contract you stand for delivery and incur $50 brokerage and $100 shipment cost. Your profit on this is $4950, composed of
* Sale of gold: +$120,000
* Purchase of gold: -$115,000
* Interest on cash: +$250
* Brokerage and shipment costs: -$300
Now this is a great deal. At the end of the 6 months you still have physical gold but you have earned additional money while you wait for your eventual sale in a couple of years. Why would you not take up this opportunity?
Well, the deal is saying “Sell us your gold now and (trust us) … we will have it to sell back to you in the future for less!” You are exchanging your current physical gold for a future claim to gold. You have “counterparty risk”, to COMEX, to the short on the other end of your 6 month futures contract.
Of course, such a wide difference between cash and futures prices does not normally occur, because faster and bigger players see the profit opportunity and get in first. Their action of selling lowers the $1200 cash price and their buying of the 6 month futures increases the $1150 price and thus eventually the gap (and profit) disappears. That is arbitrage.
But if you did see such a big difference in prices, it means the big players aren’t taking up the deal. The cash-futures gap is telling you that people don’t trust COMEX, they don’t think they’ll get their gold back in the future. What backwardation is telling you is that people don’t want to give up their gold, even for a little while. As FOFOA says: “gold stops bidding for dollars”.
This leads to my closing point, which is best summed up by Tom Szabo’s December 2008 comment: “Let’s talk if and when the backwardation is large enough that the arbitrage was there and yet still nobody chose to go after it. That would be truly something!”
For example, if the cash price was $1200 and 6 months futures $1199.25, in my simplistic (and unrealistic from a cost point of view) example, that would mean a profit of $25. That is technically backwardation and technically a profitable one. But could you (or the big players) be bothered with all the work involved in selling gold, buying futures and then taking delivery, all for $0.25 per ounce profit?
Therefore, the only backwardation that matters to me is backwardation that:
a) means reasonable profit and
b) no one is willing to take that profit (that is, it is persistent).
Any other backwardation is just noise and has no “information value” by itself.
If this topic interests you, the following two services specialise in tracking the gap between cash and futures (known as the “basis”):
The Metal Augmentor (Tom Szabo)
Gold Basis Service London (Sandeep Jaitly)
These services look at the bigger picture and don’t get distracted by instances of technical backwardation. They look at the trend in the basis, trying to identify in advance when significant and persistent backwardation will occur.
On Tuesday Aetna Inc. lifted its 2010 earnings forecast a second time after the firm reported milder-than-expected flu season. The good news about flu this year tacked one more positive in an earnings season that has been dominated by profit results and increasingly positive projections.
The firm now projects that their operating earnings may reach $3.05 to $3.15 a share in the upcoming quarter. That’s significantly up from their earlier forecast of $2.75 to $2.85 in April.
In further positive economic stimulus, Aetna’s Chief Financial Officer Joseph Zubretsky said that in addition to healthy profit for the firm in the second half of 2010, the company will also increase their spending to upgrade computer systems.
For the 2Q 2010, net income rose 42 percent to $491 million easily topping most medical market analyst expectations.
The Mortgage Bankers’ purchase index was released at 7:00 AM EDT, and there was a week to week increase of 2.0% in the Purchase Index and a week to week decrease of 5.9% in the Refinance Index as the housing market showed a slight improvement for the second week in a row from the weakness shown since the second financial stimulus program for home sales came to a close at the end of April.
At 8:30 AM EDT, the Durable Goods Orders report for June will be released. The consensus is that there was a increase of 1.0% from May, which still be below the strong number reported in April.
At 10:30 AM EDT, the weekly Energy Information Administration Petroleum Status Report will be released, giving investors an update on oil inventories in the United States.
At 2:00 PM EDT, the Beige Book report will be released, giving us more information about economic conditions in each Federal Reserve district in advance of the next Fed meeting.
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When allocating capital a successful method for increasing wealth is to buy cheap valuable assets and if you ever sell them then do so when the assets are expensive or very expensive. But how can one accurately perform mental calculations of value? I recommend using gold as the numeraire. This allows one to get a clearer view of the relationship between price and value.
When allocating capital for longer than a millisecond or two, like the parasitic high frequency trading operations, one of the key metrics I use is the 200 day moving average.
In the financial markets, the 200 day moving average exerts a force much like gravity on the current price.
WHAT IS THE 200 DAY MOVING AVERAGE
The 200 day moving average is actually fairly simple. The sum of the close from the previous 200 trading days divided by 200.
WHY THE 200 DAY MOVING AVERAGE
The decision to use 200 days instead of 199, 50 or 500 is fairly arbitrary and dependent completely on the preferences of the capital allocator. I like the 200 day moving average because (1) the numeraire par excellence is so heavily manipulated that price and value are bifurcated, (2) a static point with an undefined entity like the FRN$ is meaningless, (3) a moving average provides a dynamic figure and (4) two hundred days is long enough to filter out short term abnormalities providing objectivity.
Consequently, while gold may be extremely volatile day to day the 200 day moving average shows a completely different picture; a nice gently sloping bullish trend line. In the financial markets, the 200 day moving average exerts a force much like gravity on the current price.
HOW TO USE THE 200 DAY MOVING AVERAGE
The 200 day moving average is merely a technical tool in the capital allocator’s arsenal. For example, on 14 July 2009 in Platinum Liquidity Increases I argued the case for why platinum was undervalued, a good buy and made a recommendation to purchase it. Of course, the foundation was the market fundamentals; low worldwide production, scarcity, lack of stockpiles, durability, fungibility, industrial demand and legal tender status. Then came the technical factor, the 200 day moving average of the platinum to gold ratio.
THE RELATIVE PRICE
One way I use the 200 day moving average is to calculate the relative price of an asset which is the 200 day moving average divided by the current price. Then I look at the relative price over time to determine when an asset is cheap or expensive.
I have found that during this secular bull market, gold in relation to FRN$ is valued by the market as cheap when its relative price is around .99, average value between 1.00 and 1.25, expensive between 1.25 and 1.35 and very expensive above 1.35. This can be accomplished by looking at the relative price and using standard deviations to form trading ranges.
Money is made when you buy not when you sell.
APPLYING THE RELATIVE PRICE AND 200 DAY MOVING AVERAGE
Back in July 2009 platinum was trading at $1,118 per ounce with a 200 day moving average of 1.21 ounces of gold per ounce of platinum and a historical ratio closer to 2.0. Thus, with bullish fundamentals and being cheap relative to gold based on the 200 day moving average relationships I purchased platinum and it is currently at $1,540 per ounce with a 200 day moving average of 1.31. The trade has resulted in the goal: an increase of net worth when measured in gold ounces, the numeraire.
CHARTS TO HELP YOU QUICKLY VALUE PRECIOUS METALS
To be honest, I got tired of having to click a few times in order to quickly determine the 200 day moving averages for the various precious metals. Consequently, I had a gold price chart, silver price chart and platinum price chart (all three charts are available on this precious metals price page) created that contains the spot price, 200 day moving average and relative price along with a legend stating whether the metal is cheap, average value, expensive or very expensive based on historical trading ranges.
PLATINUM IS CURRENTLY THE BEST VALUE
With the precious metals I recommend accumulating physical metal on a regular basis, either monthly or quarterly. I recommend using a reputable coin dealer like Gainesville Coins for smaller purchases like a single Silver American Eagle or a trusted third party vaulting service like GoldMoney for larger amounts when you do not want the headache of guarding it yourself.
But how does one quickly determine whether they should buy gold, silver or platinum? As you can see from the charts, currently gold with a relative price of 1.0366 is the most expensive relative to its 200 day moving average while silver is in the middle at 1.0267 and platinum is the cheapest at 1.0109. This is confirmed with the platinum to gold ratio which is currently 1.303 compared to 2.0. Thus, if you were to purchase any of the precious metals then I would recommend purchasing platinum because it currently appears to be the best value.
Remember, at all times and in all circumstances gold, silver and platinum remain money and currency. Consequently, you can always trade platinum for gold or gold for silver. The capital allocator’s goal is not necessarily to have the most amount of gold ounces but instead the highest net worth using gold as the numeraire.
When it comes to allocating capital I like to focus on intrinsic value. Buy low and sell high and I think money is made when you buy not when you sell. To accurately perceive value I use gold as the numeraire and the 200 day moving average to filter out daily noise and aberrations. Sure, as The Great Credit Contraction grinds on and being able to secure and multiple one’s wealth has become more difficult.
But there are always opportunities and deals to be made. The issue is whether you buy valuable assets on the cheap or when they are expensive. These precious metal price charts will allow you to quickly and easily discern the current prices of the metals and their relative value over the previous 200 days to determine whether to buy gold, silver or platinum.
DISCLOSURES: Long physical gold, silver and platinum with no position the problematic platinum, SLV or GLD ETFs.