The Federal Government Cannot Afford Higher Interest Rates on its Debt

Lately we have spent a lot of time reading, researching, and writing about the realities of what Rob Arnott calls the 3D Hurricane: Debt, Deficits, and Demographics. The reason we are doing so is that it is informative of the likely future path of monetary and fiscal policy– and such policies are likely to continue to play an important role in capital market returns going forward.

In our July 2013 Strategy Letter, we observed

While the Fed has been successful in lowering interest rates throughout the yield curve over the past 4 years, the national debt has grown to such a degree that the government can no longer afford to pay the average interest rate it paid as recently as 1999.  If the average interest rate on the national debt were at its median since 1966, annual interest on the existing debt would amount to $1.15 trillion, or 39% of current tax receipts—and this is before demographic aging really hits.

government cant afford higher rates

 

For all practical purposes, the Fed is no longer in charge of monetary policy.  It cannot raise interest rates, because in addition to weakening a still weak economy, the increase in interest expense on the national debt would be tremendous.  And at this point, the Fed likely cannot reduce its QE purchases by much, or at all.  As we’ve seen over the past few months, even a hint that the Fed may reduce purchases in the future has been enough to spark a modest rout in the bond market, and this has raised interest rates for newly issued Treasury debt, municipal debt and corporate debt.  It has also raised 30-year fixed mortgage rates from 3.51% in May to 4.51% in July, and this is likely at least part of the reason housing starts fell to a 1-year low in June.

If the Fed were to actually follow through and taper its QE purchases, or stop them altogether, the recent trend higher in interest rates would likely continue.  While it is a possible course of action, this recent end-of-QE “trial balloon” has shown the Fed, and everyone else, just how fragile the bond market already is.  And as we move on down the path of population aging, and its accompanying trend of increasing structural deficits in the years ahead, bond market fragility will likely only increase with time.

In our next update which should be out later this week, we compare the experience of bond investors in the 1940s to the 1970s and show how the likely future path of persistently low rates despite the specter of inflation will lead to greater real losses just as it did in the 1940s. After all, financial repression is all about reducing the real burden of debt, and handing bond investors real losses is one of the most effective ways to that.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions. Any links to Amazon.com may result in compensation to the author via the Amazon Associates program.

Prepare for the 1-2 Punch of Declining Earnings and Multiple Contraction

The market today is counting on continued earnings growth driven in large part by ongoing quantitative easing without inflationary consequences. In a recent strategy letter, we show that the market’s expectation for future earnings growth is overly optimistic based on the fact that earnings are currently more than 40% above the long-term trend and mean-reversion and history suggests that real earnings are likely to decline over the next 5 years.

 

source: Sitka Pacific Capital Management, LLC

source: Sitka Pacific Capital Management, LLC, R. Shiller

Furthermore, we show how these anticipated low levels of earnings growth over the next 5 years are typically accompanied by much lower valuations.

This 1-2 punch of declining real earnings and declining valuations are likely to lead to real inflation adjusted losses to owners of stocks while benefiting owners of real assets.

Featured in the letter:

  • Stock Market Valuations Rise and Fall with Real Earnings Growth (or Lack Thereof)
  • When the Long Term Arrives in the Short Term: Treasury Yields
  • There are Only a Few Good (Real) Investment Options During a Large Monetary Expansion

 

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions. Any links to Amazon.com may result in compensation to the author via the Amazon Associates program.

Where Are the Bears? Evidence vs. Anecdotes in Assessing Market Sentiment Over a Full Market Cycle

Imagine the stock market as a national park with just three kinds of animals: bulls, bears, and pigs. The saying “bulls make money, bears make money, pigs get slaughtered” conveys the idea that one can be bullish or bearish and be successful depending on the market environment, whereas greedy pigs are almost always set up for catastrophe.

Over the course of secular market cycles, the number of “animals in the park” varies greatly. Near secular market peaks such as those found in the U.S. in 1929, 1965, and 2000– there tends to not only be a lot of animals in the park, but they tend to mostly be bulls, with a healthy pig population, most of whom have falsely conceived of themselves as bulls. The bears are in the park; after all, most of them are converted bulls who have come to believe the ride is over, but they are simply on the sidelines, or in hibernation, waiting patiently for better opportunities. Conversely, near secular market bottoms, such as 1920, 1942, and 1982, not only are there not very many bulls, and practically no pigs, there just aren’t many animals left in the park period. During true secular stock market bottoms, there just aren’t many interested parties around any more. It is not fear or greed which dominates, but total indifference. I guess that’s why nobody hears the bell go off.

Howard Marks off the mark?

I believe Howard Marks is one of the most successful investors around today and I always appreciate his clear-sighted and clearly written memos. I’m sure he would agree however, that his views are not infallible and I believe now is one of those times where he is missing the mark. In a March 13, 2013 memo titled The Outlook for Equities, Mr. Marks revisits his “three stages of bull and bear markets” to assess where the U.S. stock market stands in the behavioral continuum from bull to bear market. This type of analysis is essential as accurately assessing sentiment gives one insight into the relative eagerness of buyers and sellers– and which camp is likely to have a more dominant influence on prices going forward:

“the study of market history only makes us better investors if it teaches us how to assess conditions as they are, rather than in retrospect. (…) a year ago, it was my feeling that equities were in the first stage of a bull market. Experience had been so bad for so long– and the level of dinsinterest was so high– that only a few investors thought equities could ever catch on again. No one should say the likelihood of improvement is entirely unrecognized today, as would have to be the case for this to still be stage one. I think the existence of improvement is generally accepted, but that acceptance is neither extremely widespread nor terribly overdone. Thus I’d say we’re somewhere in the first half of stage two. (…) when attitudes are moderate and allocations are low, like I feel is currently the case with equities, there’s little likelihood of investing being a big mistake.”

Howard Marks is hardly the only one suggesting that skepticism is high, Barry Ritholz discusses in Exuberance? Euphoria? Hardly . . . the idea that “since 2009, this continues to the most hated rally in market history. Until that changes, I suspect it has farther to run.”

The fact is that apart from some data on pension fund allocations, which I’ll discuss below, anecdotes that skepticism is high, expectations and participation are low, cash remains on the sidelines and the like, are only anecdotes. Not only are they anecdotes that market bulls like to share with one another (don’t worry, us bears have our own anecdotes that help get us fired up too) but they can be uniformly refuted with quantifiable evidence about actual positioning of traders and money managers as well as sentiment surveys.

What Howard Marks, Barry Ritholz, and other very smart, experienced, and observant investors are missing is a structural or secular shift in what bull and bear market attitudes look like. When there is not only a cyclical continuum between fear and greed, but a secular continuum between indifference and prevalence, one must look at past long-term cycles both domestically and in foreign countries, to help truly “assess conditions as they are.”

Different, but similar

Of course, the bulls are right that sentiment today is not the same as it was at other market tops over the last 13 years. Day trading is no longer a national past-time, cocktail party conversations rarely center around hot stocks,  and there are not many 27 year old sub-prime mortgage traders driving Lamborghinis. However, that is no argument that we’ll ever get to that kind of sentiment before stocks top out again.  In fact, if we continue on down the line of this long-term bear market, the one thing we can expect is each successive peak coming with less exuberance than the prior one, until there is very little exuberance or interest at all, even when the market does rise.  With that said, the currently quantifiable sentiment measures are certainly lop-sided enough to produce a major top concurrent with what John Hussman calls “over-bullish” conditions.

Mutual fund cash as a % of assets is near the all time low of 3.5% and at similar levels as 2007, 2000, and 1972 which saw subsequent declines of 46%, 43%, and 56%. Conversely, major market lows of 1974, 1982, and 1990 all saw mutual fund cash levels over 10%. The Wall Street Journal reported that number of bond funds which own stocks has climbed to 352 up 25% in the last year and the highest number in 18 years.

The net commercial hedger position in all stock index futures combined (inversely plotted) is now at a record dollar value of $55 billion net short. This means that speculators hold a record net long position valued at $55 billion, about the level of late 2006/2007.

source: www.sentimentrader.com

source: www.sentimentrader.com

The total amount of margin debt at NYSE member firms is back to near-record levels, reaching or exceeding peaks last seen in 2000 and  2007.

margin debt nyse 96-may 13

 

The correlation of long-short equity “hedge” funds monthly performance has risen to 0.9, meaning they are mostly betting on a market advance.

hf long spx ms may 2013

Additionally, various surveys of manager and advisor positions are showing elevated levels of bullishness. The National Association of Active Investment Managers sentiment survey, which asks investment managers whether they are long or short, hit a levered long position of 104% for the first time ever earlier this year and is just off that mark now.

NAAIM may 2013 clipped

 

A similar message is conveyed by the Hulbert Newsletter Writers Stock Sentiment survey

Hulbert stocks sentiment

and the and Consensus Inc. % Bulls survey

Consensus Inc survey

Last, but not least, is the Barron’s Big Money survey, the cover of which featured a Bull on a pogo stick

Even so, the managers aren’t just bullish on U.S. stocks, but on equities generally. Some call it the TINA trade, for “there is no alternative” to stocks in a slow-growth, ultra-low interest rate world. Eighty-six percent of poll respondents are bullish on stocks for the next 12 months, and a whopping 94% like what they see for the next five years. Real estate has similar approval ratings.

As a reminder of what sort of indicator the cover of Barron’s featuring a bull might be, a picture courtesy of John Hussman is worth a thousand words.

source: www.hussmanfunds.com

source: www.hussmanfunds.com

In Barry Ritholz’s May 8th piece, Exuberance? Euphoria? Hardly . . . he writes

While I keep hearing some people claim there is an excess of giddiness, please excuse me for failing to see it. My frame of reference is the 1999-2000 top, and I certainly do not see anything remotely resembling that sort of sentiment…Remember the Dow 10,000 hats on CNBC? The insane expense accounts, lavish spending? The forecasts of Dow 36,000?

We’ll have to forgive Barry for missing the March 7, 2013 op-ed in Bloomberg, Market Record Shows How to Get to Dow 36,000 where the author of the now infamous 1999 book “Dow 36,000″ reminds us

From its low of 6,547 on March 9, 2009, the Dow has risen 117 percent. Another 117 percent in four years would put it at 31,022, just 16 percentage points shy of the magic number.

You can judge the author’s logic and credentials for yourself, but I can’t resist to mention that he is the Executive Director of the George W. Bush Institute, the standards for analytic rigor being what they are.

Yet despite all this quantifiable evidence that sentiment is well entrenched on the bullish end of the spectrum, something is clearly different. Individuals, the so called “mom and pop” investors just don’t seem to be participating, the “wealth effect” of rising asset prices does not seem to be driving economic growth, and overall interest in the finance market “game” just isn’t there. This is what Howard Marks, Barry Ritholz and others are seeing and if they are waiting for a return to the same prevalence of bullish sentiment, they will be waiting for a very long time.

http://www.zerohedge.com/news/2013-04-24/cnbc-viewership-plunges-eight-year-lows

http://www.zerohedge.com/news/2013-04-24/cnbc-viewership-plunges-eight-year-lows

 

Secular markets: from prevalence to indifference 

Secular market cycles are driven by many things including demographics and generational attitudes towards risk and investing. Stock market valuations, and thus stock market returns, are driven by the propensity to own equities. The propensity to own stocks is driven by a large share of folks in their peak earnings and savings years AND a favorable view of those folks towards the benefit of owning stocks. In other words, if a large share of the population has sufficient savings to invest and have mainly only experienced bull markets with above average returns, they will continue to invest incremental savings into stocks. Conversely, if a larger share is retiring and spending down their investment assets and/or are no longer enamored with the returns they have been receiving, they will continue to sell their stocks and move out of the market.

This is why there is a well documented relationship between market valuations (P/E ratio), and the ratio of 40 year old (savers and stock buyers) to 60 year olds (spenders and stock sellers), called the M/O ratio.

San Francisco Fed

It is instructive to look at how households and pension funds (in which households hold a significant portion of investment assets) allocate among stocks, bonds, and cash and how that allocation changes over time. I think most would agree that a very high allocation to stocks is a negative indicator of future returns as there are fewer incremental dollars to be allocated toward stocks and that low allocation to stocks represents an opportunity for future investment and returns.

Many investors and commentators point to the decline in stock allocations among US. pensions and households over the last 13 years as evidence that there remains a high degree of skepticism and money on the sidelines that will find its way into the market. One such chart, courtesy of Barry Ritholz, shows the asset allocation survey results from the American Association of Individual Investors which asks what percentage investors are allocating to stocks.

AAII chart 2013

www.ritholz.com

This chart shows the relative weighting to equities from the “historical average”– 1987  to date of 60%. What the chart does not show is that the “average” is always changing and in the case of the last 13 years, it is declining, just as it was rising during the 1990′s.  Thus, today’s roughly 63% allocation for these folks may actually represent an overweight to a new future average which could be quite lower. How much lower? Let’s look at some data from the OECD on household assets and pension fund allocations.

source: OECD; Sitka Pacific Capital Management, LLC

source: OECD; Sitka Pacific Capital Management, LLC

Direct ownership of U.S. equities represents approximately 32% of household assets. When we add mutual and pension funds (likely a blend of stocks and bonds around 50%), we get a total right around 50% of financial assets allocated to equities in one form or another. Compare this to 2000, when, according to the OECD, direct ownership of stocks alone accounted for 50.1% and the net allocation to equities was closer to 65%.

Contrast these levels of stock ownership with a country like Japan where total equity allocations are below 10%. Japan is real-time evidence of the power of a secular indifference to equities that spans a generation with a low propensity to own stocks. This is what a secular low for sentiment looks like.

Note the wide variation of asset allocation inside of pension funds around the globe. For example, according to the OECD, from 2001 to 2011, pension fund allocations to stocks fell in the U.S. from 54.6% to  48.1%, which may be a sign of the first leg of a secular bear market, whereas allocations in Japanese pension funds fell from over 27% to approximately 9%, surely the sign of a more advanced secular bear market driven by demographics and a two decade long response to a credit bubble .

pension funds asset allo by country 2011 OECD

An excellent report from the McKinsey Global Institute “The Emerging Equity Gap” highlights how asset allocation has trended over time in various countries. For example, at previous generational lows and subsequent secular bull markets in the U.S., allocations to stocks stood between 25% and 35%, a full 1/2 to 2/3 lower than the previous bull market peak. Similarly, Japanese household equity allocations have dropped over 2/3 from the peak in 1988, from 31% to under 10% today. So if history is any guide, we can expect a further move away from equities in the U.S., much greater than what we have seen so far.

Data from the Investment Company Institute (ICI) and others supports the view that what we are seeing is not simply a cyclically diminished appetite for equities, but a secular or structural one which will only be healed with passage of time and a restoration of value in the markets, as opposed to a continued rise which is what market bulls seem to be looking for. Ordinarily, and particularly during secular bull markets, there is a positive correlation between market returns and fund flows. That is why Howard Marks, among others, observes “a move upward can be powered by a switch from the fear of losing money to the fear of missing opportunity.” However, since 2009 in a rally that has produced triple digit returns, we have seen a  net cumulative outflow from equity funds.

net flow to equity funds and spx perf 98-12

The idea is supported by attitudes and actions of investors across generations as reported in a variety of recent articles:

  • among 401(k) participants in their fifties in 2001, 46% had more than 80 percent of their 401(k) accounts invested in equities As of 2011, only 25% of  401(k) participants in their fifties had more than 80 percent of their accounts invested in equities. (ICI)
  • in a survey of nearly 1,000 Gen Y investors with more than $100,000 worth of investible assets, 52% of the respondents agreed with the statement: “I will never feel comfortable investing in the stock market” vs 23% for all age groups, and collectively held a 33% allocation to cash, more than any other age group. (MFS Investment Management)
  • in a survey of approximately 600 higher education employees across Generation Y (ages 21-32), Generation X (ages 33-46) and Baby Boomers (ages 47-65), younger employees were found to be using the same asset allocation strategies as their older counterparts, with Gen Y using a similar asset mix (50% stock, 35% bond/annuity and 15% cash) as Gen X and Baby Boomers. (Fidelity)

Finally, in a study titled “Depression Babies: Do Marcroeconomic Experiences Affect Risk Taking,” Ulrike Malmendier and Stefan Nagel found that people who have experienced low stock-market returns throughout their lives are more pessimistic about future returns and subsequently less likely to invest in stocks. Given a shorter frame of reference to draw on, young people are especially prone to making decisions based on recent events. While the memory of past events fade over time and are replaced by new experiences, the researchers use periods lasting 20-50 years to find a correlation between past return experiences, future expectations, and stock market participation.

Stop and imagine for a minute what it is like to be a 35 year old saver. You became of aware of the market just as it was peaking (you may have even bought JDSU for $330/share from your dorm room in 2000 as I did) and have seen the ugly side of two bubbles, but fortunately have had very little savings to put into the markets. You have watched the value of your parents retirement portfolio stagnate and their U.S. stocks lose real purchasing power over the last 13 years as they push off the prospect of retirement. You have seen evidence of significant fraud and malfeasance as well as general greediness and ineptitude that accompanies every period of market excess. Add to that general mistrust, a lack of confidence in Wall Street bankers and those in Washington charged with overseeing them, a debt and deficit profile that reduces the prospect of receiving material support from social security, coupled with rapidly expanding income inequality benefiting the top 1%. Now that you’ve finally paid off that college debt, bought your first house, and have an expanding pool of savings, what are you going to do with it? Day trade the market and compete with high frequency traders? Hand it off to a financial services industry, that has hardly been the beacon of fiduciary duty, to compete for meager or non-existent returns after fees and taxes?

In summary, what we are seeing today is a “lower high” in the downward trending interest in stock market investing. Interest and sentiment likely peaked with bubble in 2000 and has experienced several cyclical lows and peaks over the last 13 years and will continue to make lower lows and lower highs until the secular bottom is finally in.

Bringing it all home: what a true market bottom looks like

At Sitka Pacific Capital Management we are often asked why we do not think the March 2009 low will prove to be the beginning of a new secular bull market in stocks lasting a decade or more. While the low around 666 on the S&P 500 could very well mark the nominal low in prices, we believe the stock market valuations will continue to decline as the challenges presented by demographics, deficit spending, and debt lead to higher inflation and much lower participation in the markets. Lower valuations, measured in a variety of ways, have accompanied every secular stock market bottom that we have studied both in the U.S. and abroad over the last 200 years and we expect this time to be no different.

A few signposts of a durable secular market bottom include generational disdain for stocks among tomorrow’s savers with a corresponding low allocation, a total lack of interest in the market, and valuations that reflect little hope for future value creation. These valuations have historically been below 10x normalized or cyclically adjusted P/Es, whether reported inflation and interest rates are high (as in early 1980s) or low (as in early 1940s) with stocks trading around book value, and cheap relative to real assets like gold and commodities. Some stock markets, like that of Japan, are much closer to this point, while others, like the U.S. are very far off indeed.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions. Any links to Amazon.com may result in compensation to the author via the Amazon Associates program.

Gold Miners- Back in the Abyss- An Update

Back on May 18th, 2012 I wrote a piece titled Jumping Into The Abyss: A Bull Case for Gold Mining Stocks. The miners had declined 40% from their August 2011 highs and for a variety of fundamental reasons like valuation and the relationship between mining costs and the price of gold and technical reasons, like sentiment, I felt the case to buy was compelling. The stocks subsequently rallied more than 30% over the following 4-5 months. In the 4-5 months since, the stocks have given back all of those gains and some more, leaving them down an additional 9% or so, with the majority of losses occurring in the last few days. All this has happened in the context of gold trading in a similar pattern, but with more modest gains and losses.

HUI Gold Bugs Index and Gold (GLD) 05/18/2012 to 02/20/2013
Source: finance.google.com

A reader emailed asking for a brief update so here it is.

It’s Darkest Before Dawn 

While I don’t think this is necessarily true in nature, it certainly seems to be in investing. As dark as things seemed for miners last spring and summer, the subsequent rally reminded investors that where there is value, there will eventually be returns. It is likely a sign of how short term focused this market is, that sentiment rapidly turned quite bullish on gold and mining stocks AFTER they rallied into the fall. Well, here we are again right back at extremes in sentiment.

This is true for gold itself among both the public

source: sentimentrader.com

and gold focused newsletter writers who are recommending a paltry 6.3% net long position and this way back when gold was $1,650/oz  (last week). I suspect this recommendation will have moved to a net short position by now, which would be in line with previous periods of extreme pessimism and near term gold weakness.

source: www.sentimentrader.com

The mining stocks have been even weaker than the metal itself. Not surprisingly, sentiment on the gold mining stocks is extremely negative, the only sector of the stock market with such a reading.

source: www.sentimentrader.com

 

Okay, so the miners, along with gold, have given back all their gains from last spring and sentiment is once again quite negative. Is that enough to support another rise from here? Will the next rise be any more sustainable than the last? To answer those questions, let’s quickly return to the fundamentals.

Fundamentals: Then vs. Now

Back in May 2012, I wrote

While buying mining stocks here could certainly look foolish in the near-term, NOT accumulating positions, or selling them for that matter, is likely to be the bigger mistake over the long term.

Gold mining stocks are attractive here for three primary reasons:

1. The sentiment on gold, and gold mining stock in particular, is at extreme bearish levels.

2. They are historically very cheap by a variety of relative and absolute measures of valuation.

3. The macro environment is likely to turn very supportive, thereby improving the fundamentals of the stocks, reversing the negative sentiment, and driving the valuations higher.

I believe we are more or less in the same place today, with valuations being even cheaper on some measures. On the macro environment front, I believe the markets are being fooled by the rhetoric out of the Fed, without looking at their current and likely future actions.

Valuation Matters

Gold mining stocks remain cheap by almost any objective measure.

One way to look at mining stocks is to compare them to the price of gold itself.

Here is an updated look at the HUI mining index relative to gold itself. It is hitting new lows.

Comparing miners to the price of gold itself, show miners are cheaper today than they have been in decades.

As I wrote in May, while the instructive, this measure doesn’t do you a lot of good if the price of gold is set to drop precipitously, an issue which I’ll address. Consider the case of 1980, when gold was experiencing an epic top and the mining stocks seemed to anticipate the lack of sustainability of the move, driving ratio of miners to gold to low levels. That said, the ratio has provided a pretty good clue to what future long-term returns will look like. Consider the following chart from John Hussman.

UPDATE John graciously emailed me an updated chart and the following observations:

divergences (between actual returns and previously estimated prospective returns) can be very informative. If you look at 2010, the prospective 3-year gain in the XAU was about 20%, but the actual 3-year return on the XAU has been about zero. That “undershoot” in actual XAU performance corresponds to the recent move in the Gold/XAU ratio to even higher levels, resulting in the extremely high prospective return that one would estimate at present.

source: John Hussman; www.hussmanfunds.com

I should note that John also warned that the most favorable conditions for miners tend to include periods where inflation is higher and 10 year bond yields are lower than 6 months prior and the economy is posting weak numbers, like PMI below 50. While we don’t have all these conditions in place today, it wouldn’t take much to get there.

The miners are also cheap on a variety of traditional metrics such as price to earnings and price to cash flow ratios. Today they are roughly similarly valued as they were in May as earnings and cash flow estimates have come down somewhat. Here are the updated charts.

Consider the trailing, current, and estimated ratios depicted for these three large mining companies. While one must be careful of future estimates of operating metrics and the consensus estimates are likely to be wrong in some way (please see my prior post, Run, Don’t Walk Away From Forward P/Es) when I see single digit P/E ratios and mid single digit price to cash flow ratios, I pay attention.

Of course, the true value of the mining stocks resides not simply in their ability to generate cash flow over the next few years, but in the intrinsic value of the resources that the companies can reasonably expect to extract. Even with long-term gold price estimates well below current prices, the stocks are trading cheap relative to their estimated Net Asset Value. The following chart shows the senior mining stocks price to estimated Net Asset Value courtesy of BofA Merrill Lynch.

source: BofA ML February 19, 2013 Report

 

Determining whether or not an investment is attractive requires understanding WHY something is mis-priced, as understanding market expectations is equally important as fundamentals.

In May 2012, market expectations for gold stocks seemed to relying on two key assumptions:

1. The price of gold will not go up significantly and may have a long-term average well below today’s price.

2. The costs for mining will continue to grow at a fast rate, negatively impacting margins and earnings growth.

Today, the market expectations for gold’s decline seem to be even stronger as investors consider the prospect of the end to the Fed’s accomodative policies. The expectations for costs and margins remains largely the same, despite qualitative signs that currently strong margins will be protected.

These are Mr. Market’s errors– and therein lies the opportunity for astute contrarian investors.

Concerning the price of gold…

Back in May 2012, I argued

what appears to be completely absent from the market’s current assessment of gold and silver mining stocks is the likely actions by the Fed and other central banks in the coming months and years in response to lower trend growth in global GDP and the ongoing sovereign debt crisis. In a point made by colleague Brian McAuley in a series of recent client letters, the Fed and other central banks will likely print a lot of money in the coming years in response to slower economic growth and high government debt levels.

Sure enough, by September we got the latest installment of QE by the Fed, which is not so much an installment, but an open ended promise, currently slated at $85 billion worth of bond purchases a month,  and one I wrote extensively about in QE n+1 What The Fed Is Really Up To.  We have also seen a strong move towards expansionary policy at the Bank of Japan.

However it didn’t take long for enthusiasm for the gold-as-hedge-against-monetary-expansionism meme to dry up. In January, the Fed released it’s December minutes which highlighted several FOMC members concerns about the sustainability of current policies.

That bit of rhetoric seemed to cause a slide in the price of gold which has continued throughout the new year and was exasperated   by today’s release of the January minutes highlighting more worries that its current stimulus measures could result in instability in financial markets and may be difficult to remove in the future.

source: www.stockcharts.com

If gold weakness is in fact a result of this rhetoric, gold owners have nothing to worry about. The Fed is not about to execute on any sort of exit.

At Sitka Pacific we discussed this with clients in our Annual Letter which will become publicly available in a few months.

Anyone who is familiar with the basic math of the deficit and debt can see what would likely happen if the Fed stopped buying at this point, let alone started *selling* their holdings.  The more they buy as this decade rolls onward, the more they can’t sell without the government running into a funding crisis.  In fact, we are likely already beyond the point at which the Fed can’t even stop buying without creating a funding crisis.  We discussed this in our November 2012 Client Letter. And yet, they need to keep talking about exit strategies in order for the obvious to be a little less obvious, or perhaps to somehow satisfy the doubt deep down in the own consciences. It’s worth noting that there are even fewer hawkish consciences voting at the Fed in 2013 than there was in 2012.

 Beyond the forward looking assessment of the Fed’s ability to exit given structural deficits and the lack of political will to address them, there is always history. We could look at past instances of the Fed “exiting” or reducing the monetary base after past periods of “temporary” monetary expansion. We could do that sort of analysis if such a thing had ever happened. In fact, it never has.

There was no “exit” from the 1929–1945 monetary expansion. In fact, since 1918, there have been no significant, lasting declines in the monetary base.

Gold is one of the assets most sensitive to central bank  monetary expansion, and in this sense the price of gold is merely following the lead of the Fed and other major central banks. The growth in the monetary base is one way to look at gold from a value perspective, as it rises roughly in concert with the money supply, and the chart below shows the same rise in the monetary base, this time accompanied by the price of gold. After Nixon ended the convertibility of dollars and gold in 1971, the price of gold, then unchained from the official exchange rate, quickly caught up with the cumulative growth of the monetary base. And in fact, as most bull markets do, during the parabolic rise at the end, it probably overshot its value.

 

 Today, gold appears undervalued relative to the growth in the monetary base that has occurred up to now, and in light of the monetary expansion the Fed and other central banks are currently undertaking, gold appears more undervalued. The Fed’s current quantitative easing program probably won’t be curtailed until households stop deleveraging and the government can handle the rising interest expense on its expanding debt.

Yet, in the face of all this, many gold mining stocks are now selling at valuations that suggest the market has priced in a decline in the price of gold back to 2007 levels, before the Fed began expanding its balance sheet during the financial crisis. Many gold mining stocks are now selling near or below their book value, which is the market’s way of saying that these businesses won’t be able to add shareholder value in the coming years by mining gold and silver. If the price of gold were to decline below $700 or so, it would certainly be the case that most mining companies wouldn’t be able to profitably sell gold. Yet such a decline in gold is the main implied assumption being priced in by the market today, and this has sent valuations of gold mining stocks to their lowest levels since the current bull market began.

Concerning the price of everything else…

Back in May, I highlighted how much costs to mine an ounce of gold had increased and how how investors were extrapolating those rising costs. And while cash costs for 2012 appear to be coming in right at the levels forecasted back in May, analysts are using much higher forecasts for 2013 and 2014.  This despite subdued prices for both crude oil and copper, two decent proxies for mining company costs.

Qualitatively, mining company executives are getting religion regarding ambitious capex programs and are working to secure margins, focusing on profitability over production. We have seen several recent executive firings at major mining companies that show boards are serious about protecting shareholder value.

Bringing It All Home

I wrote back in May that

if mining stock prices are being held back by a negative view of the gold price and concern over input costs then the shares should rally if either one of these conditions is resolved favorably. The input costs for miners will decline if the economy weakens from here. The reversal in the price oil the last few weeks seems to be confirming this view. At the same time, it seems likely that evidence of further economic weakness, regardless of the origin, is going to be met with a policy response that will benefit gold.

We saw glimpses of that last fall causing mining shares to rally by 30%.

Today, investors will need to start watching what the Fed and other major central banks are actually doing, as opposed to saying, and with it will come a realization that gold is likely headed higher, not lower. One of the first places that realization should benefit is gold mining stocks.

As I wrote back in May, the timing of these events is highly uncertain, but not really that important. The incredibly cheap valuations for mining stocks coupled with the extreme bearish sentiment provides for a substantial margin of safety. Mining company stock prices look to be falling BACK into the abyss; I am there waiting for them with open arms.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions. Any links to Amazon.com may result in compensation to the author via the Amazon Associates program.

QE n+1 What The Fed Is Really Up To

As I survey the news stories and other analysis on the Fed’s recent announcement, most fall short of describing what the Fed is really up to. Here is a hint: it’s not really about employment. It’s not really about “price stability” or really about growth either.

The Fed is engaging in QEn+1 (open ended quantitative easing) because they are trying to keep a dying system alive. The Fed will commit all of its resources and use all of its privilege in this effort because it is the only system they know. Policy makers and the institutions they represent are literally fighting not just for their jobs, but for the survival of their worldview, their lives’ work, and their raison d’être.

In this context it is not surprising that they are resorting to what Sitka colleague Mish describes as Desperation Bazooka Tactics.

The System 

Since the creation of the Fed in 1913, the U.S. has embarked on a grand experiment. The system really started to take shape in the 1930s after the Government made private ownership of gold illegal and devalued the US dollar by 40%. Following the aftermath of WWII, the U.S. gained the Exorbitant Privilege of issuing ever increasing amounts of dollar denominated debt without regard to trade and current account deficits. Following Nixon’s fatal blow to any vestige of the gold standard, in what Jim Rickards calls the Second Currency War in the early 1970s, the growth in debt reached a whole new level.

source: research.stlouisfed.org

Prior to the 1970s, the Government sector was the predominant issuer of debt in the U.S. Following the move to an entirely fiat currency, consumers and businesses got in on the action. Between 1970 and 2008, Consumer debt as a percentage of GDP grew from just over 40% to just under 100%. The real action however, was in the financial sector. Financial sector debt grew from just 10% of GDP in 1970 to over 117% in 2008. This represented the tipping point in financial sector leverage which precipitated the credit crises and the great recession of 2007-2009.

Throughout the 1980s and 1990s, often referred to as “The Great Moderation,” it took ever increasing amounts of debt to fuel consumption, economic growth, and corporate profits. From 1975-1990, each $1 of GDP growth was accompanied by approximately 50 cents of debt. Throughout the 1990s and the first half of the 2000s, that relationship averaged closer to 1:1. For more on this, please see Mish’s post with data and analysis from Trim Tabs.

Any perceived or inevitable economic hiccups were met with ever increasingly accommodative monetary policy responses (Mexico 1994, Asian Currency Crises 1997, Russian default, LTCM 1998, Y2K 2000, Tech Media Telecom bubble burst 2001) as the greater systemic leverage increased the consequences of adverse market responses i.e. falling asset prices.

Central Bankers, emboldened by the perception of their success throughout the 80s and 90s, or perhaps because they have no other options, continue to double down on the policy that asset price declines are bad and should be avoided by lowering the cost of money to encourage investors and speculators to put capital to work. Commercial and investment banks have been happy to participate not only with their own capital, but by providing cheap leverage to others. In so doing, they have secured and ever growing share of GDP in both profits and compensation.

Financial Sector Profit Share of GDP

 

Source: http://baselinescenario.com; Bureau of Economic Analysis

The so-called ‘Greenspan Put’ has led to a mis-allocation of capital on a grand and global scale, most disastrously the housing and mortgage debt bubble from 2000-2006. In a system where the rewards for risk taking accrue to private individuals, but the risk of failure is socialized– borne by the Government at taxpayer expense– it is easy to see how poor decisions are routinely made.

Furthermore, the Great Moderation/Debt Binge required an almost unprecedented level of cooperation between Government and Corporate, predominantly Financial Corporate interests. From deregulation and/or back door anti-competitive legislation to large  Government contracts, the financial industry needs the support of policy makers. Nowhere is this much needed support more obvious than in the variety of “special” or “one-time” subsidies and bail-outs we’ve seen over the last half decade where the Government remains in the red by over $175 billion. However, as I’ll discuss below, the Fed’s interest rate policy and bond buying/money printing programs are the most important, if less obvious, handouts to the banking system.

As much as the financial industry needs the Government, it seems policy makers, especially elected officials, need the financial industry. For more on Federal Reserve employees’ roles with the industry it is charged with overseeing, see this Huffington Post report. Contributions from the FIRE sector have ballooned from roughly $62 million in 1990 to over $500 million in 2008. Below is the contributions from various interests to candidates and elections in the current cycle thus far. Importantly, none of this includes the insane amounts of money spent on lobbying. For example, according to opensecrets.org and the Center for Responsive Politics, the FIRE sector has spent over $5.1 BILLION on lobbying since 1998.

Source: opensecrets.org, data from Federal Election Commission as of 08/06/2012

It should also be noted that the “Great Moderation” was not great for everybody. Income inequality has steadily grown as our economy has become more dependent on debt. It is not surprising that the increased reliance on debt has resulted in a larger share of profits to those who control the system of financial intermediation. The Fed has and will continue to play a role in keeping this system in place.

 To summarize, the system, the status quo that the Fed is trying to protect is one in which assets are ever increasing in price, thereby allowing the banking system to have an ever growing capital and collateral base upon which to make ever increasing loans and extract an ever increasing share of GDP. This is the “virtuous cycle” that Fed is charged with sustaining. However, now that we’ve approached a limit to system-wide debt levels, the Fed and other Central Banks are focused on doing whatever it takes to keep the wheels on.

The End of an Era 

As Hyman Minsky argued and common sense suggests, there comes a point when you can not simply throw more good money after bad and expect ever increasing amounts of debt to solve a problem (asset bubbles and subsequent crashes) caused by too much debt. We reached that point in 2008. The private market deleveraging began in earnest in 2009.

In just 3-4 years, total non-Government debt  has fallen from a combined 295% of GDP to 255%. Normally, such a dramatic deleveraging would serve to lower the prices for all assets whose price is sensitive to the effects of the deleveraging. In this case, declining financial debt would have lowered prices for the assets loaned against (real estate, etc.) and held by (mortgage, corporate debt and loans, stocks, etc.) financial institutions as they sold assets to right-size their balance sheets at the same time declining consumer debt would have lowered overall demand for products often purchased on credit (pretty much everything in modern day America). These are the falling asset prices that the Fed is so desperately trying to prevent. This is the deflationary boogeyman.

In order to reflate our over-indebted economy, the Government picked up where the private sector left off. Total Government debt has increased by about 35% of GDP (a more than 50% increase in 4 years) helping to offset the decline in private sector debt of 40% of GDP.  The increased borrowing really took off with the variety of fiscal “stimulus” programs introduced after 2008. Thus we have seen very little system-wide deleveraging, only a partial burden shifting, from the private, mostly financial, sector to the Government. In my opinion, it is a little to soon to conclude that America is executing a “Beautiful Deleveraging” as Ray Dalio of Bridgewater suggests. The outcome of these episodes are measured in decades, not quarters.

Total Government Debt / GDP

As the credit crises took shape in 2008 and it became clear the Government would be issuing massive amounts of debt, the Fed quickly lowered rates to near zero. This helps to keep debt service for both current and new borrowers more manageable.

Nothing Left To See Here Folks

However, it quickly became clear that traditional policies such as lowering benchmark interest rates (no matter how obscenely low) would not do the trick.  With the worry (justifiable) that market participants may not want to buy ever increasing amounts of debt at every higher prices (lower yields), policy makers realized that they would have to step in where discerning, private investors may not wish  to be, especially with Government deficits quickly ballooning to over $1.3 trillion dollars, approaching 10% of GDP, and no plan to reduce it in sight.

Anybody want to lend to this guy?

Since 2008, however, the reflationary model that the Fed relies upon to “save the economy” has been broken. It now takes about $2.50 of debt to drive each $1 of economic growth. For more on this, please see Mish’s post with data and analysis from Trim Tabs. Furthermore, what Zero Interest Rate Policy, Quantitative Easing, Operation Twist, and the like have proven, is that monetary policy can no longer improve general economic conditions like employment. The Fed is pushing on a string.

For evidence that the employment picture is even grimmer than the stated 8.1% rate, please consider Mish’s work in Yes Virginia, It’s a Recession that details while without the dramatic and unprecedented decline in labor force participation (mostly people who have just given up on looking for work, many of whom are now claiming disability insurance), the unemployment rate would be closer to 11%.

Lance Roberts of Street Talk Live also explains in QE3 and Bernanke’s Folly that there is “no evidence that bond buying programs have any effect on fostering employment” and the remarkable rise of the number of Americans participating in Food Assistance and/or collecting Disability leaves little doubt that the working class is not benefiting at all from QE.

Wrong Direction: # of NEW entrants into Food Assistance and Disability programs

The evidence is clear that Quantitative Easing has done little to encourage robust enough economic growth to make a meaningful impact on employment. There is also little evidence that targeted programs like purchasing MBS are materially helping the housing market broadly.

The evidence is also clear, that QE, large scale asset purchases, and artificially low interest rates, help banks tremendously. And boy do they need it.

Net Interest Margin less charge offs and delinquencies

 Just as the private market deleveraging was taking hold, banks were experiencing a dramatic rise in delinquencies (green line above) and charge-offs (red line). With high financial system leverage, it doesn’t take too many losses to make many banks insolvent.

“Extend and Pretend” has become the mantra over the last few years as questionable corporate borrowers received new terms on their delinquent or maturing loans (after all, everybody knows  ”a rolling loan gains no loss”). Banks didn’t want to take the losses and the Fed enabled them to avoid doing so by relieving them of troubled assets and allowing them to borrow at artificially low rates. Quantitative Easing has had the desired (if not stated) effect of improving banks’ capital position and beginning to turn a desperate situation around. Bank net interest margins after delinquencies and charge-offs (the blue line) are on the mend.

But the improved capital position of the banks has not helped the overall economy or the employment situation.  Again, Lance Roberts:

The evidence is abundant that the only beneficiary of these balance sheet programs is Wall Street. As shown in the chart below the average level of excess reserves for banks was roughly $19 billion from 1984 to 2008. Since 2008 excess reserves held at banks has swelled to more than $1.5 trillion currently.

With the consumer weak, unemployment high, foreclosures and delinquencies still burdensome, and businesses constrained by lack of demand – there is little desire, or need, for credit.

Artificially suppressing interest rates has additional implications beyond enabling profligate Governments and corporations to borrow more. It also represents a tax on savers, robbing them of interest income and transferring that income to debtors in the form of borrowing costs near or below the rate of inflation. My conservative estimate is that ZIRP has now robbed money market fund savers/investors alone of approximately $200 billion in lost interest income since 2008. This is the purest form of financial repression.  This does not even include the lower interest income from other types of fixed income investments. Negative real interest rates have pushed savers/investors/speculators into high yield bonds allowing many low quality corporate issuers to remain in business and maintain high leverage. Surely the policy prescriptions preventing failure of businesses and slowing the process of competition and creative destruction will have a lasting impact on the robustness of our capitalist system.

 QEn+1

In a 2002 speech, “Deflation: Making Sure “It” Doesn’t Happen Here,” now-Federal Reserve Chairman Ben Bernanke gave a hypothetical policy prescription for declining asset prices: Print money, buy securities. It was from this speech that Chairman Bernanke got his nickname ”Helicopter Ben” for proposing Milton Friedman’s idea that Government could always drop money from a helicopter to stave off deflation. Here we are, ten years later, and he is putting that theory into action.

source: Steen Jakobsen, Saxo Bank

Courtesy of the first two quantitative easing programs, the Fed’s balance sheets exploded from a few percentage points of GDP to nearly 20% of GDP in just over 3 years.

The most recent announcement has the Fed purchasing $40 billion of Mortgage Backed Securities (MBS) every month in addition to current programs to purchase long-term treasuries amounting to another $45 billion/month. The announced purchases of bank assets by the Fed through the end of ’13 is expected to total $735 billion, which is an equivalent to half of banks’ current holdings of MBS, resulting in the total expansion of the Fed’s balance sheet since ’08 from $860 billion to $3.6 trillion. The Fed’s balance sheet will expand yet again, most likely towards 25% of GDP by the end of 2013, barring any additional unannounced activity and assuming continued economic growth.

More importantly, the open-ended nature of the policy,  is taking us into a new era of ‘whatever it takes’ to keep the current status quo alive.  Not only did the Fed say that the large scale asset purchases with newly printed money “would continue until the labor market improved significantly,” but

the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.

It is entirely clear that extreme monetary policy is not about improving the real economic variables that effect most Americans. It is not about employment, it is not about growth, it is not about price stability for consumers. The Fed has now said as much. Monetary policy is protecting the status quo of an overly indebted, overly financialized economy. Monetary policy is about picking winners like banks, their executives, and their co-symbiotic relationship with politicians regardless off the impact on the losers.

Who loses with QEn+1?

Savers. Those on a fixed income. Investors who await cheap asset prices to increase the probability of worthwhile returns. The increasingly poor and poorly-equipped working class who is dependent upon policy makers focused on the wrong things. Consumers who spend an ever increasing portion of their stagnant wages on food, gas, and energy.

Research by former Fed President William F. Ford suggests there is a significantly negative  impact on the very things the policy portends to aid, growth and jobs.

http://www.aier.org/article/2485-downside-monetary-easing

Globally, there are other losers too. Rising social and geopolitical uncertainty caused by rising commodity prices and growing income disparity goes hand in hand with the Fed’s efforts to blow life into a dying paradigm.

Bringing It All Home

A popular line of logic/analysis goes something like this: well, the Fed is going to print money and suppress interest rates, that is going to push the prices for all assets higher so buy stocks, gold, commodities, high yield debt, etc. Risk On! Cash and treasuries will be the only sure loser, the logic goes.

That is a dangerous speculation to make. It is not yet clear that the Fed is willing and/or politically able to print all the money it needs to expand the monetary base sufficiently to prevent nominal asset prices from falling. In previous debt deflationary episodes (for which we have data) such as the U.S. in the 1930s and Japan more recently, it has taken a combination of declining asset prices and expanding monetary bases (through currency debasement/money printing) to arrive at a more fully reserved (and solvent) banking system. This has typically looked like a 1:1 relationship between the monetary base and all outstanding bank loans. If the Fed wishes to prevent material declines in asset prices and nominal GDP it would have to expand the monetary base by expanding its balance sheet to something like $7 trillion! That would be the equivalent of 6 additional QE programs of the magnitude we’ve seen so far. That is what it would take to put enough cash into the banking system to directly or indirectly fund the fiscal deficits to keep GDP from contracting and price deflation from taking hold. I don’t think we know yet whether the Fed has the mandate or political will to trash the purchasing power of the dollar so unabashedly. And certainly the consequences for global trade and geo-political instability are great.

As an aside, a relatively harmless way to increase the monetary base would be for the Government to recognize gold as base money, a reserve asset apart from from currency. The Government could mark its 8,133 tonnes of gold to market, instead of at $42/oz which would put the current value just shy of $500 billion. Then allow the market to work and assign whatever price to gold it wishes with its new found understanding of gold role as monetary asset in Government policy. With a $7 trillion monetary base, even a ~20% role for gold as part of the monetary base (as it has now, marked to market), you are looking at gold around~$4,500/oz . No wonder gold goes up as a result of QE!

QE can affect nominal asset prices, but cannot prevent real losses from taking place and value being restored to markets so long as  we continue to operate in a mostly democratic, capitalistic and market-based system. Of course, there are risks that we move far away from these paradigms too, but that topic is for another day.

The Fed cannot eliminate the effects of debt deflation and deleveraging. They can only try and shift burdens. And try they will. There will be money printing. It may not be enough to prevent substantial asset price declines or it may be too much to prevent a total collapse in confidence in the dollar and unacceptable inflation. Either way, they will keep doing what they know how to do until they get the results they want or ‘die trying’.

Asset values will decline in real terms, whether you choose to look at inflation, gold, or some other measure of the purchasing power of the dollar. Whether that decline is fast or slow, depends on future installments of QEn+1.

The sell off in the S&P 500 priced in gold is set to resume

The best way to navigate this sort of environment is to hold substantial allocations to gold and related stocks and cash. I made the bull case for mining stocks in a recent post Jumping Into the Abyss. When considering stocks, one must be very selective or avoid them all together. At the same time, one should be weary of their fixed income investments and be on the look out for the potential for negative real returns or adverse changes to the perceived credit quality of the issuers.

Over the coming quarters and years we will begin to see how the process of additional deleveraging takes place. We will find out if significantly lower nominal prices will be available and thus the cash will come in handy. If the Fed really does make its way to infinity and beyond, then substantial allocations to gold, not without its own risk, will help protect future purchasing and investing power.

 

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions. Any links to Amazon.com may result in compensation to the author via the Amazon Associates program.

Jumping Into The Abyss: A Bull Case for Gold Mining Stocks

Gold mining stocks, as measured by the AMEX Gold Bugs Index (HUI), are down nearly 40% from their August 2011 high. Representative ETFs such as GDX and GDXJ as down similar amounts, if not more.  Mining company stock prices look to be falling into the abyss.

While buying mining stocks here could certainly look foolish in the near-term, NOT accumulating positions, or selling them for that matter, is likely to be the bigger mistake over the long term.

Gold mining stocks are attractive here for three primary reasons:

1. The sentiment on gold, and gold mining stock in particular, is at extreme bearish levels.

2. They are historically very cheap by a variety of relative and absolute measures of valuation.

3. The macro environment is likely to turn very supportive, thereby improving the fundamentals of the stocks, reversing the negative sentiment, and driving the valuations higher.

All That Glitters?

The price of gold, being a non-productive asset and all, has always been subject to the changing whimsy of investors/collectors/hedgers/speculators. Yet the extreme change from bullish to bearish sentiment over the last 6-9 months has been pretty incredible.

This is true when you consider the opinion of the public:

source: www.sentimentrader.com

Or the opinion of market professionals:

as of 04/17/12 source: http://www.kitco.com/ind/Holmes/20120417.html

 

And also true for the publishers of Gold-focused investment newsletters, who now recommend a net short -14.8% position in the anti-currency monetary unit:

source: www.sentimentrader.com

 

A corollary to poor sentiment on gold is the overwhelmingly bullish sentiment with respect to the US Dollar

source: www.sentimentrader.com

 

Of course, one does not have to be bearish on the dollar versus other paper currencies like Euro, Yen, Pound, Aussie or Canadian Dollar, etc. to be bullish on gold. Gold can just as easily strengthen (or weaken for that matter) against those other currencies more than it does against the dollar to have a scenario where both gold and the US trade weighted dollar move in the same direction.

The extreme pessimism is also visible in mining stocks, which do not necessarily trade congruently with the price of the metal on which their business relies (more on this below). Please consider the sector sentiment measurement, again from wwww.sentimentrader.com. As of March 28, 2012 the extreme pessimism for gold stocks stood out relative to the rest of the market:

source: www.sentimentrader.com

Since then, negative sentiment in other sectors has started to catch up with the mining stocks:

source: www.sentimentrader.com

What investors say is another matter from what they do. An investors have been pulling away from gold-related investments. This is true when one looks at the ETFs and ETNs that track gold, which the World Gold Council estimates saw a 58% DECLINE in the volume of gold purchased in 2011 despite rising prices and growing global demand for physical gold.  And it is also true for fund flows into mining stock related funds as evidenced by the Rydex data

source: DecisionPoint.com

Valuation Matters

Are gold mining stocks cheap? The answer is yes, by almost any objective measure. One way to look at mining stocks is to compare them to the price of gold itself.

 

source: Sitka Pacific; Stockcharts.com

While the instructive, this measure doesn’t do you a lot of good if the price of gold is set to drop precipitously. Consider the case of 1980, when gold was experiencing an epic top and the mining stocks seemed to anticipate the lack of sustainability of the move, driving ratio of miners to gold to low levels. That said, the ratio has provided a pretty good clue to what future long-term returns will look like. Consider the following chart from John Hussman:

source: John Hussman, http://www.hussmanfunds.com/wmc/wmc111121.htm

However, the miners are also cheap on a variety of traditional metrics such as price to earnings and price to cash flow ratios. Consider the trailing, current, and estimated ratios depicted for these three large mining companies. While one must be careful of future estimates of operating metrics and the consensus estimates are likely to be wrong in some way (please see my prior post, Run, Don’t Walk Away From Forward P/Es) when I see single digit P/E ratios and mid single digit price to cash flow ratios, I pay attention.

Select Senior Mining Stocks Are Cheap

 

Of course, the true value of the mining stocks resides not simply in their ability to generate cash flow over the next few years, but in the intrinsic value of the resources that the companies can reasonably expect to extract. Even with long-term gold price estimates well below current prices, the stocks are trading cheap relative to their estimated Net Asset Value. The following chart shows the senior mining stocks price to estimated Net Asset Value courtesy of BofA Merrill Lynch.

Senior Mining Stocks: Price to NAV source: BofA ML

By many measures, Junior mining and exploration stocks are even cheaper. I know of several that trade for little more than the net cash on the balance sheet, despite strong evidence of proven and probable gold reserves. These companies will likely be acquired at some point. However, there are too many caveats to enumerate here, so I’ll leave further inquiry to the eager and opportunistic among you.

Determining whether or not an investment is attractive requires understanding WHY something is mispriced, as understanding market expectations is equally important as fundamentals.

Market expectations for gold stocks seem to relying on two key assumptions:

1. The price of gold will not go up significantly and may have a long-term average well below today’s price.

2. The costs for mining will continue to grow at a fast rate, negatively impacting margins and earnings growth.

These two conditions have certainly been in place over the last 6 months, a period which has seen mining stocks decline by approximately 25%. Mr. Market is once again extrapolating recent trends into the indefinite future which can be particularly dangerous at turning points. Anticipating a change in one or both of these two conditions may set the stage for a meaningful rally in mining stock shares.

Concerning the price of gold…

A review of research on gold and silver mining stocks reveals that analysts use long-term price forecasts for gold of around $1,200 when attempting to value the companies. Additionally, the sentiment data demonstrated above indicates that market participants hold little hope that the price of gold is set to rise from it’s current level of below $1,600/oz.

There have been numerous pressures on the price of gold, ranging from USD strength making gold more expensive to foreign buyers to strikes by gold merchants in India to a general liquidation mentality to the markets in the last few weeks.

However, what appears to be completely absent from the market’s current assessment of gold and silver mining stocks is the likely actions by the Fed and other central banks in the coming months and years in response to lower trend growth in global GDP and the ongoing sovereign debt crisis. In a point made by colleague Brian McAuley in a series of recent client letters, the Fed and other central banks will likely print a lot of money in the coming years in response to slower economic growth and high government debt levels. On a global scale, this money printing has continued almost without interruption since 2007, and over the past two years it has accelerated.  The balance sheets of the eight largest central banks tripled from 2007 through 2011, and during that time the price of gold and silver also tripled. Sitka Pacific colleague Mish, has provided a nice update here courtesy of Saxo Bank:

source: Saxo Bank via Mish's Global Economic Analysis

However, even with this dramatic central bank balance sheet expansion, economic growth remains slow and we have yet to deal with the eventual impact of our buildup in government debt.  That impact is just starting to be felt in Europe, and it has resulted in a stalled Eurozone economy and a dramatic expansion of the European Central Bank’s balance sheet to the tune of $1.3 Trillion which the ECB handed out to banks in late 2011 and early 2012 via LTROs.  The U.S. will likely face a similar set of circumstances at some point in the coming years, and when we consider the likely path of central bank balance sheets within the broader context of low growth and high debt, it seems very likely the expansion we’ve seen in recent years will only continue, supporting gold prices further. It is notable that even a breath of the potential for future easing which came from the FOMC’s April meeting notes were enough to stop gold’s slide and take metal prices higher the last few days.

Sitka Pacific CIO Brian McAuley writes that

with the current sell-off in miners, the market is factoring in no additional central bank activity in the coming years and a decline in gold and silver prices beyond the declines seen since last summer, to the point where many mining companies will become only marginally profitable.  While it is always possible gold and silver prices could decline in the short-term, especially if market conditions were to worsen dramatically before additional easing by the Fed, the current panic out of gold and silver mining stocks appears to be a substantial long-term opportunity in light of our economic circumstances.

Concerning the price of everything else…

Consider the year over year change in cash cost estimates for the 1st quarter of 2012 from the analysts at BofA. With costs “unexpectedly” rising so fast, it is no wonder so many holders rushed for the door!

source: BofA Merrill Lynch

So while miners are reporting record earnings and cash flows (when it costs you around $600 to produce something that you can sell for $1,600, life is pretty good) investors are disappointed the earnings are not currently growing anywhere near revenues. The list of things driving mining costs higher is daunting:

  • Energy prices, especially diesel
  • Mining equipment prices, driven by higher base metal prices among other things
  • Wages for relatively scarce mining-related labor (though SG&A appears fairly well contained)
  • Merger & Acquisition costs
  • Taxes, Environmental and Regulatory Costs, etc.
We are three years into an relatively weak cyclical recovery in the developed world that has so far failed to reach “escape velocity” and appears vulnerable once again. Furthermore, there is strong evidence that China, the marginal consumer of oil and other industrial commodities, is slowing dramatically.  What happens to these input prices if the global economy rolls over? Miner’s costs will fall, or at least stop growing.

Source: stockcharts.com -- lines represent average prices for each year

Please see  Mish’s post 12 Predictions by Michael Pettis on China; Non-Food Commodity Prices Will Collapse Over Next Three to Four Years; Nails in the Hard Landing Coffin?

Bringing It All Home

If mining stock prices are being held back by a negative view of the gold price and concern over input costs then the shares should rally if either one of these conditions is resolved favorably. The input costs for miners will decline if the economy weakens from here. The reversal in the price oil the last few weeks seems to be confirming this view. At the same time, it seems likely that evidence of further economic weakness, regardless of the origin, is going to be met with a policy response that will benefit gold.

There is strong historical evidence that mining stocks respond very favorably to environments where the economy is weakening, real interest rates are falling, and the stocks are priced inexpensively relative to the metal. As John Hussman illuminated way back in 1999

Not surprisingly, the combination of all of these is rare but extremely powerful. In the rare instances when 1) The rate of inflation has been higher than 6 months earlier, 2) Treasury bond yields have been lower than 6 months earlier, 3) the NAPM Purchasing Managers Index has been below 50, and 4) the Gold/XAU ratio has been above 4.0, the XAU has soared at an astounding rate of 123.63% annualized. In contrast, when none of these have been true, the XAU has plunged at -53.21% annualized. That’s a gaping difference

Since 1999, the combination of those factors has become increasingly less rare. So has overly accomodative monetary policy and money printing. Ditto for spectacular gains in mining company shares.

The timing of these events is highly uncertain, but not really that important. The incredibly cheap valuations for mining stocks coupled with the extreme bearish sentiment provides for a substantial margin of safety. Mining company stock prices look to be falling into the abyss; I am jumping in after them.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions. Any links to Amazon.com may result in compensation to the author via the Amazon Associates program.

The Quality Conundrum

We are witnessing the end of a remarkable and confounding era for stocks, best described by the “quality conundrum” investors faced for much of the last two years. During that time, the combined outperformance of low-quality stocks alongside  the underperformance of high-quality stocks,  was unprecedented in the last 30 years.

Now, we are embarking on an era where high-quality stocks will likely significantly outperform low-quality stocks, resolving this conundrum. Regardless of how you manage money for your clients, understanding this impending regime change will be critical to delivering superior performance.

The resolution of the quality conundrum will proceed independent of the overall market’s direction. This is important because the third, and perhaps final, painful decline of the current secular bear market remains ahead. Against that backdrop the renewed outperformance of high-quality stocks may begin as a flight to safety, but can continue as the seedlings of a new secular bull market, eventually driving market indexes higher. Attractive absolute valuations of many high-quality companies – those trading at single-digit P/E and cash-flow multiples, around tangible book value, and with respectable 3-6% dividend yields – will be the foundation for those eventual gains.

By reviewing the nature and magnitude of the quality conundrum investors have faced of late, we can begin to understand how it will resolve and how to take advantage of the looming shift.

A conundrum among many

The market has a way of frustrating even the most patient investors. Value investors who correctly identified the expensive valuations of large-cap equities in the late 1990s spent several years watching those overvalued markets become even more so. Investors who correctly identified the nominal lows in stock prices in 1974 had to wait another seven years for their investments to begin compounding at meaningful real rates of return. In November 1979, investors who watched gold appreciate over 1,100% in less than 10 years – and were sure that, at $400/oz, its pricing was unmistakably speculative –  must have been shocked to see prices double once more to over $850/oz over the course of the next few months. As the eminently quotable John Maynard Keynes noted, the market can stay irrational longer than most investors can stay solvent. This, no doubt, is a lesson learned and relearned throughout history.

Fortunately, for those investors who aim to stay solvent and generate a meaningful return along the way, the occasional irrationality of market prices has a counter-force – mean reversion. This phenomenon is driven by valuation, which as James Montier points out, is the closest thing we have to a law of gravity in finance. . In the Seven Immutable Laws of Investing, he identifies valuation as the primary determinant of long-term returns, and countless academic studies back up that assertion.

Those focused on valuations were pleased to see stocks trading around 700 on the S&P 500 in March of 2009. At a normalized P/E of 13, the market was priced to deliver decent returns for the foreseeable future, approximately8-10% annualized. Investors of nearly all types, in nearly every risky asset class, saw tremendous value. Only those paralyzed by fear or a lack of liquid capital were unable to benefit from the cheapest market we had seen since the mid 1980s.

source: Sitka Pacific Capital Management

The joy of inexpensive markets faded rather quickly, however, as the S&P 500 rallied more than 40% over the subsequent six months and went on to appreciate by more than 75% from its March 2009 low by the end of 2010. In essence, the promise of 5-10 years of 8-10% annualized returns was compressed into just a handful of quarters.

Skeptics have observed that more than just fundamentals have been driving stock prices over the last few years. Whether it was crisis-induced fiscal and monetary policy, rampant global liquidity from expanding central bank balance sheets, or greed’s influence on “animal spirits” – something just didn’t feel right about the nature of the stock market’s rally from the March 2009 lows.

The Quality Conundrum and the Dash for Trash

During the market rout of late 2008 and early 2009, the market punished the stocks of the weakest companies the most. This made sense. We were not only in a recession, which meant declining revenues, but many companies had taken on a tremendous amount of debt over the previous 5-10 years and were vulnerable as a result. As Russell Napier of CLSA reminded us at the CFA annual conference, “equities are the fine sliver of hope between assets and liabilities.” The prospect for increased bankruptcy risk rightly drove prices of the stocks with the most financial and operating leverage down the most. High-quality stocks were outperforming their lower-quality brethren.

Once it became clear, however, that the Federal Reserve and the U.S. Government would be the lender of last resort, committed to a policy of extend-and-pretend to minimize the near-term pain of failed businesses, the dash for trash was on.

In 2010, Brian Smith, CFA, of Atlanta Capital Management, published The Third Dimension: An Investor’s Guide to Understanding the Impact of “Quality” on Portfolio Performance. The article makes a compelling case for the long-term, risk-adjusted return advantage of high-quality stocks, which Smith defined as those rated B+ or better by Standard and Poor’s.

 

source: Atlanta Capital Management

Unfortunately, similar to the excess returns that can be found with value stocks, the relative returns on these investments can be choppy – there can be long periods when low-quality stocks outperform. Witness the chart below, which shows the rolling 12-month returns for high- and low-quality stocks (in excess of the Russell 3000 broad stock index) from 1980 to 2009. As noted above, during 2008, high-quality stocks delivered over 4% excess returns versus the Russell 3000, while the lowest-quality stocks offered an excess loss of over -2%.

souce: Atlanta Capital Management

The outperformance of high-quality stocks, however, was short-lived. In 2009, the lowest-quality stocks outperformed the broad market by more than 15%, the largest margin in at least the last 30 years.

But that doesn’t even tell the whole story. Over the same period, the highest-quality stocks underperformed the broad market by nearly 9%, also among the largest such discrepancies in over 30 years. By the end of 2009, the spread between the excess returns of the highest-quality stocks and the lowest over the preceding 12 months, over -24%, was the most extreme it has been over the last 30 years, on par with the spread that existed when the market peaked in early 2000.

The Law of Gravity At Work

The extreme divergence between the returns of high-quality and low-quality stocks threw the relative valuations of the two groups out of whack. Normally, high-quality stocks get premium valuations relative to their low quality-counterparts. This makes both intuitive and theoretical sense, since high-quality stocks tend to have higher returns-on-equity and more stable earnings. As Brian Smith of Atlanta Capital showed, however, at the end of 2009 high-quality stocks actually traded at a 15% discount to low-quality stocks on current earnings and sported a dividend yield more than 60% higher.

The anomalous performance moderated some in 2010, but investors who focused on taking advantage of the mismatch continued to be frustrated. High-quality stocks lost over 4%, and low-quality stocks gained more than 6% in excess of the broad market.  The low-quality skew of the market was particularly evident in the rally sparked by the second round of Quantitative Easing in the fourth quarter of 2010.

source: Atlanta Capital Management; Sitka Pacific Capital Management

So far in 2011, we’ve seen a clarifying of the quality conundrum. Much in the same way the markets for risky assets have broadly reassessed the sustainability of stimulus-driven returns, the outperformance of low-quality stocks has reversed course. This reversal has been confirmed by a commensurate positive excess return to high-quality stocks. In the 12 months ending October 31st, high-quality stocks have generated nearly 1% excess returns, while low-quality stocks have lost over 2%, for a spread of over 3%. This trend likely grew stronger in November.

Agreeing to Agree. And Disagree.

It is difficult to say what exactly drives returns to high- or low-quality stocks over various time periods. Certainly valuation is important. At the peak of the market in 2000, larger, high-quality, “blue-chip” stocks carried excessive premium valuations – just as the “Nifty Fifty” did in the late 1960s. The laws of valuation ensured poor subsequent returns. What we label quality is also subject to error – many large-capitalization investment banks, commercial banks, insurance companies, and the like have all been inappropriately highly rated by S&P recently.

We can also measure quality in different ways. An analysis of factor returns, for example, shows that stocks that rank highly on certain quality factors, like earnings stability, inventory turnover, debt/assets, ROE and the like have generated meaningful long-term excess returns, though in varying amounts for different sectors.

Furthermore, it is difficult to generalize about the propensity for high- or low-quality stocks to outperform in up- or down-market environments, which gives market bulls and bears something on which to agree. During the secular bull market of the 1980s and 1990s, high-quality outperformance was the norm, with low-quality surges only appearing briefly, typically during speculative periods preceding the short corrections of the era. In contrast, during the secular bear market of the last 12 years or so, high-quality stocks have delivered excess returns only during market declines. Perhaps the sustainable and ongoing outperformance of high-quality stocks is a necessary marker of durable broad market gains.

This gives the long high-quality/ short low-quality trade an unusual and extraordinarily valuable distinction:  It can generate meaningful returns regardless of whether one expects a cyclical broad market decline or whether one expects that we are in the early stages of a multi-year bull market. As long as relative valuations for high-quality stocks remain attractive, the relative returns can be robust. Indeed, in GMO’s monthly forecast of 7-year asset class returns, U.S. high-quality stocks are priced to deliver 5.4% annualized real returns, which far exceeds the 1.8% forecast for the U.S. large-cap space and -0.4% forecast for the U.S. small-cap class.

source: Atlanta Capital Management; Sitka Pacific Capital Management

At Sitka Pacific, we currently favor global high-quality stocks with inexpensive valuations in the equity portion of our Absolute Return strategy, while hedging that exposure with positions that move against various broad market indexes. In our long/short equity strategy, Hedged Growth, we are further able to take advantage of expensive, low-quality stocks on the short side – leading to a more direct manifestation of this theme and an opportunity to generate meaningful returns in a variety of market environments.

Bringing It All Home

Understanding the returns to high- versus low-quality stocks is as important today as understanding the relationship between growth and value stocks. Whether you are picking stocks or evaluating outside managers, it is essential to understand the drivers of future returns. The quality conundrum has created tremendous opportunity, and some investors will capture these returns better than others. A flexible long/short approach, emphasizing high-quality stocks with low valuations, will generate meaningful positive returns – in a world in which such returns will continue to be hard to come by.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions. Any links to Amazon.com may result in compensation to the author via the Amazon Associates program.