miércoles, 23 de agosto de 2017

miércoles, agosto 23, 2017

Time For Gold And Silver Miners - Part 3

by: Paul Wong


- Rotation from growth to value is accelerating with gold/silver.

- Both gold/silver and miners deserve a place as value assets – gold/silver as cash equivalents and miners as stock holdings.

- Timing is reinforcing by recent events to be favorable for both the short and long term.
 
'Wealth is the accumulation of ownerships of various real and financial assets that ideally preserve or appreciate in values. Periodic partial rotations from financial to real assets to lock in profits have proven over history to be essentially smart before each onset of the modern 10-year cyclic crisis.' 
'Fiat currencies, all of which devalue at different rates in conjunction with times of money printing, are merely media of exchange to convert profits to one's wealth holdings in achieving the goal of accumulating ownerships.'
Thesis: Gold/silver and miners are good short- and long-term investments as global political and financial stresses increase.
 
Introduction
 
Collective Wisdom - The best answers are most often provided by sharing the collective wisdom of a group of knowledgeable people with different expertise for the common goal to benefit all.
 
Effectively, we are building an intelligent 'Ark of Higher Knowledge' together to prepare and prosper even with the coming financial storm. I have expanded this article to silver and silver miners which are following gold higher.
 
This article is an update of my August article, which can be found here. Gold/silver has advanced and the uptrend will likely continue.
 
At the highs of stock and bond markets, the smart moves are to rotate from growth to value, from financials to real assets, and gold is the ultimate real value asset.

The Case for Gold - a passionate pledge

Macro events are becoming more favorable to precious metals and miners, as shown in the updated table below:
 
The elevated conflicts globally in the past two weeks have enabled gold/silver to ascend.

Dollar Index

Investment is all about relativity, or locating relative value in this case. In our complex financial world, relativity permeates all asset classes to connect them. As such, mathematical tools that were developed, such as base comparison, correlation etc., can be used to track and sometimes forecast each asset class.
 
The performance of gold (GLD in the gold color) empirically is inversely correlated to the Dollar Index in the blue color (UUP) multiple by a factor of approximately 2 (as shown below).
 
As such, the dollar index alone has the most influence over the price of gold short term.
 
Dollar index is descending to the lowest level in the past 15 months. The fall reflects the problems internally with increasing budget deficits and record national debts in the form of treasury bonds. The economy appears to be fine but growth seems very limited.
 
Most likely, the dollar index will stay at or close to this level for the next few months until the debt ceiling debate is over in October.
 
Gold is trending up, from $1209 in July towards $1300. Seasonally, August to October are good months for gold.
 
 
 
To measure the true or real value of gold by multiplying it with the dollar index (UUP*GLD in the brown color shown below), the recent rise confirms that gold's up move is real by overcoming the weakness in the dollar. This is a good way to gauge the global confidence in gold, as it is traded internationally.
 
Looking at the last top for gold in May to July 2016, dollar index was at the same level or higher than today; gold conceivably can reach the same target of $1375 according to the dollar index. The last top was the result of anxiety about political uncertainties in Europe leading to Brexit. This time, there are even more uncertainties with higher stakes because of disagreements among the major countries. Each week, there is more escalation in rhetoric. The condition now is quite conducive for gold price to follow the up move and repeats the top of 2016. There is still plenty of room to move to the $1375 level again within three months.

As Alternate Money

 
 
The above illustration depicts the potential flow of cash equivalents to gold during times of increasing turmoil in the financial or stock market. The best example was the last crisis from 2007 to 2009, gold rose 50% while the stock market dropped 50%. Another note of the financial crisis was the performance of long duration treasury bond, it rose 30%. However, this time treasury bond may not offer the same safety net long term mostly because bondholders may demand higher interest rates due to much higher national debts. As such, gold may remain the lone choice to guard against chaos.

Inflation Protection

The chart below compares gold and other cash equivalents to the effects of various inflation rates of 0%, 2%,5% and 8% relative to the USD:
Holding dollar index constant and with ultra-low interest rates today, the returns are quite low -- except potentially for gold by assuming gold preserves value.
 
The simplest concept is hardest to grasp because we are swayed to believe the alternative to truth about the magnitude of inflation. Of course, inflation is very real; as real as growth rate of money printing which is part of the definition of inflation.

The heart of the argument to seek the truth about inflation is to identify the best indicator or indicators. Taking gold as an inflation indicator, the average rise in gold price is averaging 7% compound annually for the past 20 or 50 years, including bear and bull runs that last 5 to 15 year each. Since gold is money, adopting long term average of 7% is a good way to determine true inflation. Some may say that gold is not a good indicator, but maybe there is no perfect one.
 
We may try other high inflation indicators such as rent or health cost, each of them will likely be imperfect. Money supply growth M2 averages approximately 7% for the past 10 years, which is one of the best way to gauge as inflation. From Shadowstats, applying pre-1982 methodology, inflation is running 7+% for the past ten years. By any measure, 7% inflation number seems to agree more with the increase of overall daily expense increase; 5% more than the official inflation number. There are huge consequences if inflation is higher, real returns on all assets will be much lower or negative.
 
Therefore, we need to focus on investments that have high returns to overcome the effect of the potential 7% real inflation.
 
Of all liquid asset of value preservation, gold may be the only one that can keep up with real inflation.
 
Short story on hyperinflation - I was in China a few years ago. I met an old professor who showed me a book of stamps from 1942 to 1949; during WW2 and before the Communist takeover. The price of the same stamp went up from 50 cents to 500 dollars. The only thing that came through my mind was, no wonder the Nationalist was defeated, not necessary militarily but economically by inflation.

Inflation and Oil Price

The past four months have been unusual that oil price declined and hit bottom from April to June, instead of rising at the beginning of driving season. Mostly, importing nations exerted their superior political and financial influences to flood the market as much as possible to keep the inventory from declining too fast. The result was oil price has been low through most of the driving season. Oil price started a slow and steady recovery since June.

Lately, global demands are healthy and the increase is 1.3 million barrels per day in 2017. The shale oil companies were announcing reductions in capital spending for the rest of the year; the cut back will slow down production increase. Supplies probably fell behind demands currently judging from the declining global inventories. With supply disruptions such as the deteriorating situation in Venezuela, outlook appears to be getting better for oil price to rise for the next two months.
 
If oil price heads up rapidly, global inflation will follow.

Interest Rates

Interest rate has been drifting down recently due to dollar weakness, with no immediate interest rate hike. All these factors will likely continue for the next few months. Lately, the Fed is wavering about quantitative tightening or rate normalization; dollar will stay weak for the next three months to provide the background for gold to move up. Keeping interest rate low is good for gold.

Huge Debt Buildup

 
The simple yet elegant figure illustrates the effect of interest rates on bond prices, with respect to falling and rising interest rates. The concept applies to all bonds by just changing the scales on the y axis, and shifting the time slightly on the x axis. Long duration bond peaked last year, junk bond appears to be peaking. Junking the junk will become fashionable again. The robust usage of the figure above makes visualizing the effect of rising interest rate and falling bond price easy.
 
Normalization of interest rates back to the higher levels will bring about losses to almost all bonds.
 
The following is a simple formula to evaluate real and nominal bond return. Taking the one-year performance of 7-10-year duration (IEF) treasury bond as an example, assuming 5% inflation:
Real Value (%) = 100 - Inflation + yield +/- gain/loss
 
Real Value (%) = 100 - 5 + 2 -5 = 92 (12 months loss 8% with inflation)
 
Nominal Value (%) = 100 - 0 + 2 - 5 = 97 (12 months loss 3% without inflation)
 
Losses on mid duration bonds, real and nominal, began to appear since 2016. Real positive returns, yield with inflation plus gains/losses, should be the reason for investing in bonds. For the past 35 years, increasingly gains in bond price surpassed yield as the main driver for bond investing until last year when interest rate hit zero, and rates started to rise. Gains in bond price became losses. The odds are the glory decades of bond investment are over globally. The example above shows that with interest rate on the way up after hitting the floor, chances are losses in bonds will spread and accelerate in the coming years.
 
Case in point, the CEO of the best major bank remarked last week that he personally will not buy any long duration sovereign bond as long-term investment. The figure and formula above demonstrate his opinion vividly.

Market Overvaluation

Considering all the domestic and foreign news for the past three weeks, there is some nervousness in the market. Instead of glorifying FAANG, we are watching ICBM. International incident can be a trigger for this overvalue stock market to fall.
 
The Dollar Index UUP (in blue) is very weak for 8 months, as shown in the chart below. UUP*SPY (in gray), which is the real value of the stock market, has been declining since March. The downtrend means that the stock market might not be strong as it looks. As the stock market (SPY) (in orange) is forming a top, all the patterns together are worrisome. Judging from the declines small stocks and loss of breath in the market for the past 4 weeks, a correction may be under way already. A repeat of the August 2015 flash crash or correction is becoming more likely in the next 2 months.
 

Global Tension and Political Uncertainty

International conflicts appear to be heating up since last month. Instead of economic cooperation, major powers switched to confrontations in many areas. The increase domestic and foreign tensions are the main reason that gold is performing nicely and ready to continue the upward march towards another high.
 
Debt ceiling debate in September will soon be the main topic. Most likely, the heated bargaining will last till the very end, before an agreement will be compromised in late September.
 
Uncertainties will keep dollar low and aid gold during this period.

Gold Undervalued and Under-owned

At market tops, rotation from growth to value asset is a smart move. The current gold bull run is still young and the price is reasonably low considering the factors described; in comparing to other financial assets such as stocks and bonds which are vastly overvalued. Increase asset allocation to gold ahead of the crowd can prove to be prudent.

Supply and Demand

As measured in other currencies reflecting the 10% devaluation of the dollar since December, gold becomes quite cheap for European or Asian investors. The Germans have increase their gold purchase. Banks and central banks need to accumulate more gold to keep a higher percentage in the Tier 1 asset to prepare for the coming crisis. Demand from global investors are increasing in 2017.
 
Supplies are falling according to schedule since peaking in 2015. Reduction in capital expenditure for the past few years have kept production low. Reduction in scrap metal recycling this year also reduces supplies.
 
 
The above graph has been updated with the recent price of gold, and the devaluing scale of USD based on gold. Basic conditions for each bull and bear run are labeled. The long-term perspective of interplay between gold and USD reveals the true reason that we ought to have faith in valuing gold, as oppose to the dollar and other dollar based financial assets.

The anticipated current bull run's annual rate of increase can exceed 20%. The last bottom in the December 2015 reversal served as the bottom and the starting point for the next up leg toward 2020.
 
Gold Miners
 
Gold has been leading silver since the July 7 bottom. Silver was coming to live and responded strongly. Both gold and silver miners have been following gold's lead. If gold continues to move up and breaks $1300, the miners most likely will surpass the performance of gold in the coming months.
 
The reason being profitability above cost, as price increases above certain threshold, earnings will accelerate. During bull runs, investing in miners (GDX) is much more rewarding than gold GLD itself. The following chart shows the potential for gold miner's advance back to last year's high from the current low level.
 
 
By the same token, silver miners offer a larger potential if silver continues to move up towards the high of 2016 again.
 
 
 
The above charts are comparisons among dollar index, gold, silver and miners. The main point is if dollar index stays at the current level, political events around the world can move the prices of gold and silver to the July 2016 highs; the miners will likely respond accordingly to reach similar levels respectively.
 
Conclusión
'Choosing among cash equivalents, for sure that they devalue with inflation except gold which has some chances to appreciate with inflation.'
In describing the truth about gold amid all the fabricated noises around us. We better train ourselves to know the difference, otherwise we will get hurt financially.
 
With markets topping out while gold and miners advancing, it is time to rethink about asset allocations. A rational move these days is to increase the portion for gold to 10% or more of cash equivalents, and additional 10% or more of stock holdings in miners. The seasons of the ten-year investment cycle is changing, so gold accumulation during up move is the theme. Let us track along the uptrend together.

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