Related posts:

1. What a Human Being Really Is: Why Economics Has Gone So Wrong
2. Pricing Dilemmas: How to Charge the Most for Your Product
3. Where are Oil Prices Heading?

I was formerly a manager & analyst of public securities in emerging markets for one of the big pension funds. We had people in the PE departments working on this. My experience with single-purpose public infrastructure securities (i.e. shares in one airport, one port, one road) had disappointing performance but securities of companies that developed, operated, and invested in portfolios of these things for growth performed well. I wanted Cheung Kong Infrastructure, but not Shekou Port, for example.

Related posts:

1. The Question of Capital Flight
2. SEC Short Sales Ban Did More Harm Than Good
3. Bubble Top Indicators

THE TREASURY BUBBLE

A year ago I discussed how the Treasury bubble was the largest of all and explained both how and why it would burst.  I prognosticated:

However, as more capital piles into them it drives rates lower and lower.  Eventually Treasury Bill rates reach 0% or even go negative.  This presents a problem.

Why hold a Treasury Bill with a bank, broker, custodian bank or the Federal Reserve itself when you could take possession of physical Federal Reserve Notes?

Taking possession eliminates at least two types of risks.  First, is any potential counter-party risk with whoever is holding the Treasury Bill for you.  Second, ‘political risk’ which is a much larger threat. …

As the yields on Treasury Bills approach 0% they have the return of cash but do not have the benefits of cash as they may be impregnated with counter-party risk or have decreased liquidity.  In other words, Treasury Bills and cash have the same benefit profile but not the same safety and liquidity profile.  This analysis also applies to demand deposits with the bank such as checking accounts or CDs.  All the downside but none of the upside.

Predictably the Treasury bubble burst.  Poof!

PILING INTO ONE MONTH TREASURIES

The one month Treasury has recently traded with negative rates.  This portends another round of the credit crisis which could very easily have its catalyst in either another sovereign debt downgrade of either Japan or Portugal or in Austria with banks owning a large amounts of primarily mortgage assets denominated in foreign currency in primarily Slovakia but also the Czech Republic, Hungary and Croatia.

The last few weeks shows just how close the rates are towards 0%.  Of course, real interest rates are already negative.  But a weak FRN$ would help meet Obama’s goal to double exports which would not be helped by his proposed discretionary spending freeze.

MONEY MARKET FUNDS

One tool many investors use as a proxy for their cash are money market funds.  Many view these as like-cash vehicles just like many viewed auction-rate securities as like-cash vehicles for 25 years.  On 18 September 2009 I explained that I closed my Paypal money market fund because money market funds had lost government backing.  On 27 January 2010 Nasdaq.com reported:

The U.S. Securities and Exchange Commission approved by a 4-1 vote Wednesday rules designed to shore up the resiliency of money- market mutual funds, with general support from the industry, although fund representatives are uncomfortable with a few points. …

The rules also would permit a money-market fund’s board of directors to suspend redemptions if the fund is about to “break the buck” by having a net asset value fall below $1 per share. Currently the board must request an order from the SEC to suspend redemptions.

“The halting of redemptions will stem the motivation for runs. It also will eliminate the need for a failing fund to sell securities into a potentially de- stabilized market and further drive down prices,” Schapiro said.

For those with too much time on their hands who want to see what the proposed rule looked like I would direct you to page 32,714 of the 8 July 2009 Federal Register under proposed rule 22(e)-3.  I find the discretion of the Director of the Division of Investment Management in this instance to be particularly egregious.

Treasuries are below money market funds in the liquidity pyramid because there is more safety and liquidity.  If a money market fund has redemptions suspended then that asset is not very liquid and will likely find their value evaporate.  This is precisely what happened with auction-rate securities and in some cases overnight investors went from thinking they held a like-cash instrument to finding themselves holding 40 year student loans that received no payments for several years.

WHERE IS REAL SAFETY AND LIQUIDITY

On May 20, 1999 Alan Greenspan testified before Congress, “And gold is always accepted and is the ultimate means of payment and is perceived to be an element of stability in the currency and in the ultimate value of the currency and that historically has always been the reason why governments hold gold.”

During the 1990’s Mr. Rubin had devised the gold leasing scheme with the intent being elucidated by Dr. Greenspan’s testimony in 1998, “Nor can private counterparties restrict supplies of gold, another commodity whose derivatives are often traded over-the-counter, where central banks stand ready to lease gold in increasing quantities should the price rise.”

Because of massive governmental intervention for decades through either patent activities such as legal tender laws, the tax code, etc. or latent activities such as surreptitious leasing of gold into the market the result is a massively suppressed gold price.

The tremendous amount of evidence accumulated by the Gold Anti-Trust Action Committee ought to be examined by any serious investor or money manager.  As Mr. Robert Landis, a graduate of Princeton University, Harvard Law School and member of the New York Bar, asserted years ago, “Any rational person who continues to dispute the existence of the rig after exposure to the evidence is either in denial or is complicit.”

Nevertheless it is very difficult to assess an accurate value of gold, silver or platinum in this era and for a specific time period where almost all financial professionals are infected with the financial insanity virus, the system is riddled with chronic fingers of instability and it somehow muddles along like a terrifically abused zombie.  There is already a one world currency, gold, and it poses a mortal threat to fiat currency.

CONCLUSION

As the next round of the credit crisis plays out it may be worse than the earlier iterations.  All of the interventions have not addressed the root causes and are actually textbook responses for someone who would want to intentionally exacerbate the greater depression.

As Ludwig von Mises predicted decades ago in chapter 20 of Human Action, ‘The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. … But then finally the masses wake up. … A breakdown occurs. The crack-up boom appears.’

New credit creation is nearly non-existant, banks are hoarding reserves so they can win the Friday bank failure lottery and the velocity of currency has slowed to glacial speeds.  Because gold and the FRN$ abut in the liquidity pyramid they tend to have an inverse correlation.  Buying gold and other tangible assets, I particularly like the extremely rare and useful platinum, is the only place to go for safety from the specter of the FRN$ evaporating through hyperinflation because of all the quantitative easing.

After all, with a gold coin in hand, or with a reputable third party like the company GoldMoney, I can remain solvent longer than the market can remain irrational.  Gold is not an investment but real cash because it is ‘risk-free’ and an instrument for wealth preservation not wealth generation.  Far into the future and long after these money market funds are frozen, retirement accounts are nationalized to buy FRN$s that are evaporated into nothing via hyperinflation the gold or platinum coin will still have value because they are tangible assets that are not subject to counter-party risk.

DISCLOSURE:  Long physical gold, silver and platinum with no interest TLT, the problematic SLV or GLD ETFs or the platinum ETFs.

Related posts:

1. Retirement Accounts Could Boost Treasuries
2. Political Risk Is Evaporating Treasuries
3. Gold Rising As A Currency

VALUE CALCULATION

Commodities are produced because they add value to society.  Wheat is to eat, oil is for fuel, steel is for building and platinum is mainly for catalytic converters in automobiles.  Why is gold produced?  There are plenty of tons of it in aboveground stockpiles, decades based on annual consumption, so why burrow miles into the earth to bury it in a vault?

The value gold adds to society is in its ability to assist us in performing mental calculations of value.  When using gold as the numeraire a much more accurate assessment can be made when allocating capital.  The third round of this gold upleg is just starting.

TECHNICAL ANALYSIS

In July 2009 the platinum to gold ratio was below 1.2 and currently it is around 1.41.  The extrinsic value of platinum has risen about 17.5%, when priced in FRN$ about 45% and when compared to the earlier upleg in April platinum is looking pretty expensive.  But as Professor Jastram explained in The Golden Constant all commodities tend to return to orbit around gold.  So where is platinum’s natural orbit?

The natural orbit for platinum is around 1.8 to 2.1 ounces of gold per ounce of platinum.  But this is just a cursory technical analysis.  To be sure of one’s assertion an analysis of the fundamentals under the Austrian school of economics is also important to undertake.

FUNDAMENTAL ANALYSIS

Platinum is an extremely rare but widely used precious metal.  For example, the annual worldwide platinum mining production is valued at about $7.8B compared to about 75M ounces of annual gold production or the FDIC’s $0 of reserves and a $500B line of credit with the Treasury to cover $4,831B of insured deposits.  In other words, platinum is a lot rarer than gold and gold is a lot rarer than little colored coupons.

According to the USGS 2006 Minerals Yearbook of the 239 tonnes of refined platinum sold in 2006, 130 tonnes were used for automobile emissions control devices, 49 tonnes were used for jewelry, 13.3 tonnes were used in electronics, and 11.2 tonnes were used by the chemical industry as a catalyst. The remaining 35.5 tonnes produced were used in various other minor applications, such as platinum jewelry, platinum rings, electrodes, anticancer drugs, oxygen sensors, spark plugs and turbine engines.  Platinum uses, like uses of silver, are multitudinous.

The giant wealth destruction team headed by the Vampire Squid In Chief Obama thinks that destroying perfectly functioning automobiles, with perfectly functioning catalytic converters, is a recipe for economic prosperity.  Additionally, billions of dollars of federal funds are being directed towards the Green Economy.  What do new cars and the green economy need?  Lots and lots of platinum.

And we all know the giant wealth destruction machine known as government always buys at a good price.  As their little colored coupons continue evaporating in The Great Credit Contraction holders of capital will continue scrambling for tangible assets.  But evaporating platinum takes a lot of effort because its melting point is 1,768.3 °C or 3,214.9 °F compared to gold’s 1,947.52 °F, silver’s 1,763.2 °F and it is important to remember that paper ignites at 451°F.

Because of the rising demand for platinum from both public and private parties, the shortage of alternatives for little colored coupons, platinum’s excellent monetary attributes and the ability to easily function as currency through innovations like GoldMoney therefore the future looks bright for the silvery-white metallic element.  The same principles for buying gold or silver safely apply when considering how to buy platinum.

PLATINUM PRODUCTION

Platinum producers are extremely rare.  There have been chronic problems with open cast deep underground platinum mining in South Africa.  There is Angloplat (AMSJ.J) which produced 2.5M ounces in 2007, Impala Platinum (IMPUY.PK) which produced 1.9M ounces for year ending 30 June 2008 and is up about 50% since I recommended platinum, Lonmin and Norilsk Nickel (GMKN.MM).  Stillwater Mining Company (SWC) is the only one domestic United States platinum producer, are majority owned by the Russian Norilsk and up about 137% from when I recommended platinum in July.

With commodity producers there tends to be a leveraged effect on earnings relative to the commodity price.  Consequently, a significant rise in platinum without hedging will tend to exponentially affect their bottom line either positively or negatively.

CONCLUSION

Platinum has had a tremendous run over the past 6 months and I am pleased with the performance.  Platinum is not nearly the incredible value today as it was then and the 50dma and 200dma are not at strategic entry points.  Nevertheless, it is a prime substitute for little colored coupons, goes into the cash portion of the balance sheet, is easily purchased with low margins, is extremely rare relative to the other precious metals, has bright demand prospects and still appears to be undervalued relative to gold by about .4-.7 ounces of gold per ounce of platinum.

So I recommend doing what I have done since being bitten by the platinum bug:  accumulating fully paid for physical metal on a consistent regular basis.  While I have not exchanged my gold or silver for platinum, largely because of tax considerations, I have shunted most of my gold and silver demand into allocated physical platinum.  After all, platinum, like gold and silver, can never become worthless.

DISCLOSURE:  Long physical gold, silver and platinum with no interest the problematic SLV or GLD ETFs, the platinum ETFs or in the Angloplat, Impala Platinum (IMPJ.J), Lonmin and Norilsk Nickel (GMKN.MM) or Stillwater Mining Company (SWC).

Related posts:

1. Platinum Liquidity Increases
2. Silver ETF League Table
3. Gold ETF League Table

This piece was written before Christmas and will appear in the first 2010 edition of the Forex Journal. The data covers the market up until mid December.

—

Old Maid is a card game where the simple task is to avoid holding a given card (often the queen of spades) at the end. Even in the company of good friends however, holding Old Maid at the end is not fun. Often, you have to buy the drinks, drop a piece of clothes, or endure other travails. And as it turns out, the global FX market is not unlike this good old game of cards where the Old Maid is proxied by having a strong currency on whose shoulders the correction of global macroeconomic imbalances must invariably fall. In this way, and although one sometimes get the feeling that everyone believes that everybody may actually export their way out of their current misery, buying one country’s currency means selling another and thus, someone (be it an individual economy or a group/basket of economies) must end up holding Old Maid.

The discussion on global imbalances has many faces, but in the context of currency fluctuations and FX markets the focus tends, one way or the other, to gravitate towards the need for the US dollar to fall. This was evident before the crisis and still is. However, if this seems obvious to the most ardent dollar bears as well as to those who still see a structurally important role for the buck going forward, it has been far less evident who should pick up the slack if the dollar is to correct to the new global fundamentals. In this way, key emerging economies are still pegging their currency to the green back and in general; while most claim to see the benefit of a strong currency they just don’t want it to be their currency.

The interesting point here for economists and FX traders alike is then that whoever might appear to hold Old Maid today may not hold it tomorrow and in fact, this game, as it were, of Old Maid will ultimately have to give way for a structurally more lasting setup in which a so far unspecified group of economies will have to face the prospect of doing the heavy lifting in the context of global imbalances.

In this context, the important point to take home is that while intra-G3 currency moves may seem to suggest otherwise, rebalancing can never occur along this axis. This means that rebalancing must be narrated in relation to big emerging markets where the counterpart to dollar weakness has to come in the form of a basket of economies such as Brazil, India, China, Indonesia, Turkey etc. However, these economies are not happily assuming this role either and if they are not outright fixing their currency to the whims of the USD (and thus the Fed’s quantitative easing), they are busy contemplating how to slap on capital controls to control the flood of money coming in as a result of cheap funding opportunities in USD and/or JPY.

In short, they don’t  want the appreciation either and thus on we go into a market environment driven by the search for yield and where any signs that an economy may be able to sustainably offer a higher yield than elsewhere will trigger currency appreciation proxied by capital inflows to high yielding currencies funded by borrowing in low yielding currencies (carry trades).

The structural and theoretical factors that underpin such currency movements are important to emphasize even if they are, by now, an integral part of currency traders’ vocabulary. In a theoretical sense we are talking about the non-existence of the uncovered interest rate parity which has come to be known as so-called carry trade fundamentals.  These fundamentals as it were simply specify the well-known correlation between low yielding currencies and risky assets as well as market volatility. Concretely, this is the tendency for low yielding currencies to appreciate in conjunction with a fall in risky assets and increases in market volatility. Low yielders which traditionally have counted the CHF and the JPY have consequently been known to react on risk sentiment in the market where periods of low risk aversion saw these currencies used as funding currencies in carry trades that would subsequently unwind during periods of above average volatility. With respect to the market this means that above and beyond safe haven flows towards the G3 in periods of drama, interest differentials matter especially so, expectations of future interest differentials. Moreover, empirical evidence suggests (see e.g. Vistesen (2009)[1]) that periods in which the difference between low volatility and high volatility periods are large and significant, will also be the periods in which carry trade fundamentals are strongest (even if cross-asset correlations are always subject to notable time variation).

Beyond the concrete mechanics of the carry trade, this market feature also raises some fundamental questions about the effectiveness and transmission of global monetary policy Vistesen (2009) and Hugh (2009). To see this, consider first the question of where all the liquidity provided by the BOJ, the ECB and the Fed is actually going. Surely, the aim with such aggressive policies is to mend the domestic economies, but in a world where emerging economies continue to move along at +5% growth rates[2] low policy rates in the G3 act as a hugh sheet anchor for carry trading activity.

The flip side to this is then the receiving economies where, much to the chagrin of many central bankers, raising rates to quell the inflation that must come on the back of hot money inflows only serves to worsen the problem. Thus, and with a number of central banks stuck near the zero bound, raising rates only intensifies the pressure. This has been abundantly clear in economies such as Brazil, India, New Zealand, Australia, and most importantly in the CEE where many economies actually de-pegged back in 2008 with respect to the Euro because it was believed that the carry flows would lead to nominal appreciation that would choke off inflation. It initially did, but as risk aversion increased the CEE currencies plummeted.

This then is my view of global capital markets where the globalization of monetary policy drives carry trades to effectively weaken the control with which economies can deploy monetary policy to e.g. fight asset bubbles. It is important to keep this in mind in the points that follow.

The G3 in 2009 – A Recovery in the Works?

Even if economic activity in the first half of 2009 was heavily affected by the economic turmoil, the second half has seen the bulk of the developed world race back towards positive growth rates and thus, according to many, a recovery. Moreover, and in stark contrast to the complete seizure of credit markets and wholesale lending market that marked the height of the financial crisis in H02-2008, 2009 was the year, starting in Q2, that volatility and interbank rates declined to more soothing levels and where risky assets returned to their former buoyancy.

The question is whether this situation will continue into 2010 which seems to be a precondition for the hopes of a sustained V-shaped recovery. Additionally currency markets will take much of their direction from this too since the extent to which carry trades continue to fly will depend a lot on the effect and speed of ”normalization” by part of G3 central banks.

In this context, it is paramount to distinguish between between transitory and structural factors where the former seem to be the main drivers of the upbeat sentiment and recent pickup in economic activity. The main point is that with a very opaque economic outlook, markets may err strongly on the timing and actual moves by central bank as well as on the outlook itself. This is, in part, a natural function of the fact that central bank themselves are not certain of how to play the situation going into 2010.

Personally, I am skeptical when it comes to the idea of a sustained recovery. In particular, it is important to emphasize that while the global economy, in relation to the Lehman fallout, may have dodged the initial bullet that would have led to a catastrophe and an immediate cascade of company and sovereign defaults, the structural setup has not changed much. Events in Dubai, the ongoing difficulties in Spain, Eastern Europe and most recently the jitters of the Greek sovereign debt are all timely reminders that perhaps, the real crisis which policy makers will be unable to avert lies ahead of us and not behind us.

Moving on to major currencies, the big story with respect to G3 flows in 2009 was without a doubt the ongoing weakness of the USD versus the Euro and JPY that gathered pace as the recovery took hold and especially as financial markets normalized with risky assets shooting for the moon.

In 2009 and using the average daily value between Jan 2008 and dec 2009 as index 100, the USD consequently weakened some 8.3% against the Euro and 3.4% against the JPY. One thing however is the relative measures of weakness and quite another is the levels observed. Consequently, a EUR/USD at +1.45 and a USD/JPY fluctuating in the 80s are levels where policy makers in Europe and Japan start to grow weary. Consider consequently the ECB’s continuing ”commitment” to the US authorities’ commitment to a strong dollar policy and the outright hints of intervention by part of the Japanese MOF and the BOJ and you get an impression of the kind of small but important skirmishes in an intra G3 context.

As ever, holding Old Maid is fiercely combated.

The G3 story of 2009 also highlights the big change observed with respect to the role as global carry trade funder. Thus and while the BOJ has been running  ZIRP/QE for the better part of the 21st century and thus also seemed secure as the global carry trade funder, something changed this time around. Consequently, we had the BOE, to a lesser extent the ECB, and most importantly the Fed who have all been forced committing to very low levels of interest rates in order to fight off deflation and to support the restoration of a financial system that has been mortally wounded during the evolving crisis. Especially the Fed’s frontloaded and aggressive policy response seems to have pushed the tables around in a G3 context. Thus, as risky assets began to fly in 2009 and volatility retraced to pre-crisis levels, it was the US economy that benefitted, so to speak, from a weak USD  to become the main funder of global carry trade flows and not the JPY much to the dissatisfaction, no doubt, of Japan who could no longer rely on continuing weak JPY to boost exports as the global economy left the intensive ward.

Going back to the idea of a global game of cards, we can then say 2009 saw the Euro and Japan jointly holding Old Maid relative to the US and the question then is; will this prevail into 2010?

G3 FX Themes for 2010 – Buy the Old Maid

The immediate answer to the question  above has to be no. After having scanned a vast array of 2010 predictions and analysis from the hands of some of the finest research shops I am convinced that the market believes that the USD will claw back some of its lost ground vis-a-vis the Euro and JPY in 2010.

Generally, the major theme for G3 FX markets in 2010 will be central bank policy and specifically the ease and speed with which unconventional monetary policies are withdrawn as well as the lag with which nominal interest rates follow. So far, the three big central banks are assuming their usual roles with the ECB rolling out a rather hawkish discourse on the removal of wholesale bank financing through its Enhanced Credit Support, over to the Fed promising low interest rates well into 2010 and only gradually speaking of removing QE and finally on to the BOJ who actually re-entered QE at an emergency meeting in the beginning of December and where we can expect the current rock bottom interest rate level to remain for as a far as the eye can see.

This sequential line-up is not consistent with the levels of the G3 crosses moving into 2010 and thus it would seem a sound call to expect the USD to take back some of its loss, most notably vis-à-vis the JPY which looks set to become, yet again, the funding currency of choice.

Essentially, the Japanese economy is not only highly dependent on exports to grow, it is also reeling under the yoke of a +2% deflation rate which means that the MOF will likely bully the BOJ into drastic measures in terms of buying government bonds as well as potential intervention. In a context where the US economy moves into whatever form of trend growth it may be able to generate and with the employment situation potentially improving into the first half of 2010, the Fed may have to change discourse and even the slightest hint from Bernanke that the Fed’s stance is about to change should favor the USD.

The EUR/USD also looks as a good sell, but the timing should be different according to e.g. Societe Generale who sees the EUR/USD gunning for 1.60 in H01 2010. Underpinning this view is a continued rally in risky assets and a cautious Fed relative to the ECB. So far the ECB is indeed looking more hawkish than the Fed which means that the EUR/USD may continue to enjoy support, but in my opinion this only goes to the unwinding of unconventional measurses. On the last ECB meeting it was worth noting the extent to which Trichet voiced the utmost sensitivity with respect to the economic outlook. In short, talk is preciously cheap in this context and the underlying economic fundamentals  strongly favor the US not so much because the US will now power ahead, but because major risks loom in Europe with the focus in particular on the fallout from Spain and Greece as well as the ongoing and unresolved mess in big parts of Eastern Europe. It will be very interesting to see whether the ECB maintains the discourse of ”normalization” which will have to entail a view on nominal interest rates sooner or later. Personally, I am very uncertain that we will see the ECB raising rates before the Fed since it would entail an unduly appreciation of the Euro not consistent with fundamentals.

In summary and mixing the market professionals’ call (e.g. Societe Générale) with my own I would emphasize the following;

• In an G3 context, 2010 clearly holds the potential for Dollar strength, but timing and intensity is going to differ. Most major research houses see the USD/JPY as a strong candidate for a correction that could move the pair back in the 100s. I concur. Whatever speed the US economy will have in 2010, Japan will be the laggard and the BOJ will be dragged kicking and screaming into a full out battery of QE measures.

• In my book the EUR/USD looks way too high even in the 1.40s. However, we have seen before that this pair may continue to rally so it is worth treating this one with care. Societe Générale sees dollar weakness sustained (except versus the JPY) well into 2010 and thus the EUR/USD continuing to drift upwards. I only conditionally agree. Especially I would emphasize the fact that the risks to the Euro, by far, out match those to the USD at the current juncture. In this way, I am less sanguine when it comes to the continuation of the ”recovery” and thus the rally in risky assets.

• Buy the Old Maid. If the rally in risky assets continue into 2010 and beyond, the Euro will be holding the Old Maid amongst the G3. If the recovery is stopped in its tracks it is very likely that it will be from an event conjured in Europe making the USD holder of Old Maid. The former looks the most plausible scenario at this point in time with the notable qualifier that the USD should strenghten against the JPY. In this way, the Old Maid will shift hands from the JPY to the Euro and potentially the USD with the outlook for the EUR/USD not easy to call.

[2] And dragging commodity economies with them (e.g. Australian, New Zealand, Norway etc).



Related posts:

1. Quantifying Eurozone Imbalances and the Internal Devaluation of Greece and Spain
2. The Burden of Rebalancing
3. Global Growth Forecasts – Seeing is Believing?

FIRST ROUND

With gold trading around $995 on 9 September 2009 in Gold Party Barely Started I wrote, “This puts $1,300 gold and $25 silver within range without greatly exceeding previous trading norms”.

Slightly later on 9 October 2009 with gold below $1,050 I was interviewed on BNN:

BNN HOST: You said the credit crisis has not been calmed but intensified. Why? … So as we get more and more concerned with the top of that pyramid, the derivatives play, you are talking about $1,300 bullion. How do you get to that figure?

TRACE: $1,300 bullion comes from looking at the 200 day moving averages and where gold has consolidated and where it goes based on the usual uplegs.  It looks like we are following the same thing that happened in 2004 with the rise in 2005, the consolidation in 2006, which went to the rise in 2007, and the consolidation in 2008, and it looks that it will lead to a similar rise in 2009 and 2010 which will take gold to $1,300 which should be a little bit above its 200 day moving average. But in the same trading ranges as we saw in 2005 and 2007.

For the rest of October we saw gold consolidate and prepare for the second round of this upleg.  The credit crisis intensified with CIT and Dubai.  Commercial real estate is still frozen and about $600B needs to be refinanced during 2010.  The spread between 2 and 10 year Treasuries has been getting omnious at highs not seen since the early 1980’s.

SECOND ROUND

On 28 October 2009 with gold trading at $1,031, the lowest price since the BNN interview, in Gold Party Intermission Nearly Over, I wrote:

While the probability for a profitable trade is not nearly as high as it would be should the price relative to the 200dma be significantly below the 200dma there is still room for the price to run as we enter winter.  The October intermission is likely coming to a close. …

The current correction and consolidation of gold appears to be within trend and expected based on the seasonality.  November is the strongest month and this recent correction on low volume is laying a strong foundation for a large move upwards.

Within 26 trading days gold for LBMA delivery was $1,218.75.

THIRD ROUND

Gold is currently trading at about $1,105 with a 50dma of $1,114.57 and a 200dma of $989.68 or a current price of 1.116x the 200dma.

There has been no substantive change to the quality of US Treasuries and the Federal Reserve is failing with quantitative easing.  The Greater Depression is still being intentionally exacerbated by the Obomba administration.  States are in even worse shape; so make sure you keep nothing in a safety deposit box or it may end up on Ebay.

One substantive change is that private ownership of gold now surpasses officially reported central bank holdings.  Big players like John Paulson with over $4B in gold investments is flanked by David Einhorn of Greenlight Capital and Paul T. Jones of Tudor Investments and the sheeplike investment community is beginning to change its attitude towards the Ancient Metal of Kings.  Freedom is good for business and private gold ownership is good for freedom.

As Ludwig von Mises wrote,

It is impossible to grasp the meaning of the idea of sound money if one does not realize that it was devised as an instrument for the protection of civil liberties against despotic inroads on the part of governments. Ideologically it belongs in the same class with political constitutions and bills of rights.

After seeing the record and the numbers I chuckle at some of the Establishment ‘financial professionals’.  For example, in January 2009 on my article ‘How the Treasury Bubble Will Burst and Why‘ at Seeking Alpha I received a comment from Alan Brochstein, CFA of AB Analytical Services and fellow Gold Standard Contributor who provides analytical services for hire. He said, “Trace, sorry, but this makes absolutely no sense…” This is not surprising considering his 8 Dec 2008 article ‘Own Gold? Time to Fold‘ where he stated, “Gold remains a sucker’s bet…”

Since Mr. Brochstein’s article gold has powered from $772 to $1,104.  But gold is not a portfolio asset; everything else is.  For those who perform mental calculations of value using gold as the numeraire the results are truly stunning and likely to lead the market entrepreneur to be shell-shocked.  It appears that following the advice of most of these ‘financial professionals’ peddling paper coupons was the real sucker’s bet.  Scoreboard.

CONCLUSION

Everything appears in place for the third round of gold’s upleg.  The previous two rounds have followed the same predictable pattern found during 2005 and 2007.  The fundamental reasons for owning gold have not changed.  Quantitative easing is failing as little colored tickets evaporate, federal budget deficits are ballooning, States are bankrupt, extremely respected money managers are moving into bullion, the world needs a new reserve currency and private ownership of gold is at record highs.

Sure, the third round of the upleg could not materialize for any number of reasons such as interest rates being raised, the mythical Cibola being discovered, etc.  As the upleg progresses the gold to silver ratio should probably close from the current 63.27 towards a more normal 50-55.  The better time to buy gold, silver or platinum was before the first or second rounds of this upleg.  But if the precious metals are absent from one’s portfolio then the second best time to buy them is now.  And by all means, avoid the GLD ETF despite the caterwauling of the prospectus challenged illiterate apologists as it is merely a paper ticket that struts around like the precious metal.

DISCLOSURES:  Long physical gold, silver and platinum with no position the problematic SLV or GLD ETFs.

Join the forum discussion on this post - (1) Posts

Related posts:

1. Gold Party Intermission Nearly Over
2. Gold Rising As A Currency
3. Drooping Vietnam Dong Gets Devalued

The Australian newspaper reported over the weekend that the Perth Mint is not taking any more orders for gold until January. Our guess is that the Mint does not want to expose itself to higher future prices given that it does not have the inventory to meet the demand for bullion.

I sent the response below to them a couple of weeks ago, no response as yet:

Your guess that we do not want to be exposed to higher future prices is incorrect and is based on a misunderstanding of how the gold markets work. If we take an order and fix a metal price (it is also possible to take an order and agree to fix a price at the time the bullion is ready for delivery) then we immediately buy the raw gold that will be used to make the bars/coins for the client. There is therefore never any exposure the future prices. I discuss this is more detail in my blog on the value chain.

I really wish commentators would just call us up and ask us questions, rather than just guessing or making stuff up.

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Traditionally, Indian socialism has involved government control of all aspects of financial products or processes. As an example, government specified the time of day at which trading starts and the time of day where it stops. The RBI committee process on currency futures and interest rate futures specified that trading must start at 9 AM and stop at 5 PM.

In most areas of the Indian economy, goverment no longer controls the economy in such fashion. The government does not specify what time a shop opens or closes. There was a time when the Indian government did not permit the use of aluminium for making cans of soft drinks. A large fraction of such meddling in the economy has been dismantled (though not in finance).

A few weeks ago, SEBI came out with a liberalised policy: Exchanges could open anytime afer 9 AM and stop trading anytime before 5 PM. If NSE or BSE opt for longer hours, securities firms will face the decision about the time at which the shop opens for business and the time at which it closes. Staying open longer will involve somewhat higher costs and in return will yield somewhat higher revenues. Each shop will make its own decision about choosing a starting and a closing time.

What do we gain?

If Indian markets to be open from 9 AM to 9 PM, there are two benefits. First, consumers should have maximal choice on when they can achieve their trading needs. Recall that internationally, many grocery stores choose to stay open for 24 hours a day.

Second, in the late evening in India, the ADR market opens in the US, and it is important to link up the closing Indian prices to the opening US prices.

How will exchanges and their members cope?

If securities firms have to stay open for 12 hours a day, this will require process modification, including multiple shifts for certain employees.

These changes might seem burdensome. But similar changes have taken place before. With floor trading at the BSE, trading only lasted for two hours a day; but when NSE came along, trading moved up to 5.5 hours a day. Members doing commodity trading are already running to almost midnight.

Securities firms and exchanges will need to change their process design to achieve longer hours. If a securities firm has to trade from 9 to 9, this will require two shifts. The first shift will probably come to work at 8 AM, and stay till 3 PM, while a second shift will probably come to work at 3 PM and stay till 10 PM. Some firms will find that this does not make sense for them and they will choose to only keep their shop open for shorter hours.

The operation of securities markets in India is held back by infirmities of the payment system. A shift to longer trading hours will encounter frictions owing to problems with payments.

At first, clumsy solutions will be found because of problems of the payments system. But at the same time, when the industry demands more from the payments system, we set ourselves on the course for deeper surgery of the payments system. In this 21st century, we can and should have a payments system which processes 100,000 messages per second and runs for 24 hours a day. When the industry complains enough about the infirmities of what is in place, the existing payments system will be questioned, which could ultimately lead to improvements in the payments infrastructure.

A messy situation?

NSE and BSE have gone through a series of announcements. First, BSE said they would start at 9:45. Then NSE said they would start at 9 AM. Then both said they would think about this after the holidays.

These activities seem messy and confusing in the public eye. These tactical details are an inherent part of the market economy. When government control is withdrawn, and a license-permit raj is scaled down, we go from a tranquil and stable environment — the silence of a graveyard — to a dynamic environment where firms are thinking and reacting. This should be welcome.

Doing more on moving away from central planning

SEBI needs to move forward on many fronts in terms of getting away from government control of product features. There is no reason to restrict exchanges to the zone from 9 to 5. Similarly, many other product features on the derivatives market need to be decontrolled: what underlyings to use, whether cash settlement or physical settlement, the expiry dates, the contract sizes, etc. Government control of these product features is as legitimate as government control over the design of a bicycle.

There is a difference between regulation and control. The role of government is to specify pollution standards for cars and to require seat belts or airbags. It is not to design cars.

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Christmas is fast approaching and I thought that instead of writing up my pendant to the flurry of 2010 market outlooks (it will come at some point over the Christmas), I would point you to a recent paper I read on leveraged buyouts and private equity industry. The paper is written by Steven N. Kaplan and Per Strömberg at the Institute for Financial Research in Stockholm and offers a nice overview of industry which has grown in importance since it was conceptualized in the roaring 1980s and spawned stories such as Wall Street as well as it was of course an integral part of the story of Milken and the junk bond market’s rapid ascend and subsequent fall from grace.

Normally, leveraged buyouts and private equity are not topics that fill the pages here at Alpha.Sources and I am not about to start a tradition. However, during my first year in grad school at Copenhagen Business School I co-authored a paper on the topic of leveraged buyouts and specifically how the spreads on Mezzanine debt is determined. So, I am a little bit predisposed to take an interest in this even if I am the only one out of the quintet working on the paper that has not yet joined the PE or M&A industry in some form or the other. I don’t plan to either although the section on fees and compensation suggest that I should clearly consider this a career path.

Messieurs Strömberg and Kaplan essentially present us with an overview article that knits together a nice picture of how scholarly financial research has investigated and dealt with the private equity industry LBOs drawing naturally heavily on the seminal work of Michael Jensen. The original contribution in the form of the empirical analysis is less ground breaking even if its conclusions are quite interesting as they support the idea that the LBO/PE industry is subject to notable boom and bust cycles often (and naturally) centered around the cost of debt relative to equity. Needless to say that the “Great Moderation” and the subsequent low interest rates it brought with it represented a major driver of the large amount of deals struck in an 2003/04 to 2007 context.

Private equity funds first emerged in the early 1980s. Nominal dollars committed each year to U.S. private equity funds have increased exponentially since then, from $0.2 billion in 1980 to over $200 billion in 2007. Given the large increase in firm market values over this period, it is more appropriate to measure committed capital as a percentage of the total value of the U.S. stock market. The deflated
series, presented in Figure 1, suggests that private equity commitments are cyclical. They increased in the 1980s, peaked in 1988, declined in the early 1990s, increased through the late 1990s, peaked in 1998, declined again in the early 2000s, and then began climbing in 2003. By 2006 and 2007, private equity commitments appeared extremely high by historical standards, exceeding 1 percent of the U.S. stock market’s value.

Clearly, 1% of the public market at its peak suggest that it remains a niche industry (and product), as the authors argue and as you will learn from reading up on private equity, it is an industry which has been the source of much inspiration in terms of especially corporate governance.

Having said this, private equity and LBOs ares still riddled with myths particularly concerning the potential downsides. I am not saying this because I unequivocally think that private equity (and especially LBOs) have no downsides, but because the discussion is often framed so as to make private equity and LBOs the prime example of the illness which is (Anglo-Saxon/Short term) capitalism.

Proponents of leveraged buyouts, like Jensen (1989), argue that private equity firms apply financial, governance, and operational engineering to their portfolio companies, and, in so doing, improve firm operations and create economic value. In contrast, some argue that private equity firms take advantage of tax breaks and superior information, but do not create any operational value. Moreover, critics sometimes argue that private equity activity is influenced by market timing (and market mispricing) between debt and equity markets. In this section, we consider the proponents’ views and the first set of criticisms about whether private equity creates operational value.

The criticism against market timing and mispricing is difficult to sustain in my opinion. In short, mispricing and to some extent market timing refer to the idea that private equity and LBO activity take advantage of the relative price of debt (i.e. the interest rate) vs the price of equity and thus this is also in part what gives the industry its boom/bust nature. However, I have difficulties seeing how this can be a source of criticism as such. Also on the perennial question of employment and short termism the critiques fall short. Consequently, the evidence that private equity should be characterised by asset strippers who simply cut employment to increase productivity and employ ultra short term horizons is simply not there I think.

Also, many of the big ticket LBO deals who tend to get a lot of attention are also of public companies (utilities) where rather aggressive cost cutting is a natural part of the process. On the short term behavior, it is equally not borne out in the data except of course as a pure (and important) operational aspect in the sense that an increase in debt financing reduces free cash flow and thus forces companies to make plans on how they can continue servicing the debt (the free cash flow problem). But this is supposed to be good no?

Well, perhaps not all good and I would certainly not disregard the connection between a cyclical boom/bust industry driven by the cost and supply of debt and the fact that companies may be moved into a leverage ratio which is not optimal.

The mispricing theory implies that relatively more deals will be undertaken when debt markets are unusually favorable. Kaplan and Stein (1993) present evidence consistent with a role for overly favorable terms from high-yield bond investors in the 1980s buyout wave. The credit market turmoil in late 2007 and early 2008 suggests that overly favorable terms from debt investors may have helped fuel
the buyout wave from 2005 through mid-2007.”

(…)

”These patterns suggest that the debt used in a given leveraged buyout may be driven more by credit market conditions than by the relative benefits of leverage for the firm.”

But then again, the evidence on default rates does not suggest that LBOs are more likely to default although this may change radically once we get the data from 2007+ parsed by researchers.

The big issue in the context of the pros and cons of private equity and LBOs is really performance. Especially, it is important to distinguish between two performance measures. One is the extent to which private equity leads to higher value creation and a more efficient operational and governance structure at the level of the acquired company. And another is whether it leads to excess returns for the investors.

Without going too much into detail the existing evidence seems to support the claim that private equity (often in connection with LBOs) tend to increase firm value and efficiency whereas the question of returns is more fickle (my emphasis and ordering of quotes).

Overall, we interpret the empirical evidence as largely consistent with the existence of operating and productivity improvements after leveraged buyouts. Most of these results are based on leveraged buyouts completed before the latest private equity wave. Accordingly, the performance of leveraged buyouts completed in the latest private equity wave is clearly a desirable topic for future research

(…)

Given that so many leveraged buyouts occurred recently, it is not surprising that 54 percent of the 17,171 sample transactions (going back to 1970) had not yet been exited by November 2007. This
raises two important issues. First, any conclusions about the long-run economic impact of leveraged buyouts may be premature. Second, empirical analyses of the performance of leveraged buyouts will likely suffer from selection bias to the extent they only consider realized investments.

Could this mean that with a financial crisis lingering since 2007, the post mortem on a large part of yet to be exited will turn into sour grapes? I am inclined to think so although we need to factor in that the industry itself has grown more complex and diverse. Essentially, funds may have the opportunity to extent the period in which they manage their portfolio and thus increase result as a sole function of market timing or they may choose to offload to other private equity funds which is a fast growing exit strategy (in relative terms). However, most private equity funds are closed ended and thus the butcher’s bill will have to settled at some point with potential subpar returns to follow. However, let me be clear. Regardless of the return offered to the partners is an unequivocal force of good if the discipline and governance enforced by private equity ownership creates operational value through increased productivity and other efficiency gains.

Yet, it is in the context of private equity as a financial asset that I think the criticism (if any) should be levied. In particular it is very important to point out that the return from private equity that may potentially accrue to you and me as retail investors is zip, nada and nothing. We simply don’t have access to this and in this sense, the idea of private equity as a surpreme alternative to a public market is rather daft. Quite simply after the managers, partners and the pension fund has had its fees the retail investor in the bottom of the pile will enjoy none of the return created at the firm level. In fact, evidence seem to suggest that even the pension fund who enters as a limited parter may not even experience excess return over the market.

In any case, as you can see, it made me think a little bit. Over to you then …

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Source: Google Finance

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