More on the Gold Model
Posted by Eddy Elfenbein on October 7th, 2010 at 12:20 pm

I want to thank everyone who has responded to my post yesterday on gold. One of the things I heard most often was a desire to see a longer-term chart. Fortunately, Jake at EconomPicData has taken the model and made a very long-term chart.

The Onion: Something About Tax Cuts Or Earnings Or Money Or Something In Recent Economic News
Posted by Eddy Elfenbein on October 7th, 2010 at 11:59 am

The Onion has the story:

WASHINGTON—Some sort of tax cut or earnings or money or something was reported in economic news this week in further evidence that a lot of financial- related things have been going on lately.

According to numerous articles and economics segments from major media outlets, experts on banks and such have become increasingly concerned over a new extension or rates or a proposal or compromise that could signal fewer investments, and dollars, and so on.

The experts confirmed that the stimulus has played a role.

“This is a clear sign of a changing cycle,” some top guy at one of the big banks in New York said of purchasing power parity or possibly rate of return during a recent interview on CNN. “Which isn’t to say that a sustained drop in wages couldn’t still occur, even if the interest paid on reserves is lowered.”

“In short, it’s possible but not probable that growth could outpace our initial expectations,” added the banking guy, who went on to say other money things, too. “It depends on investor sentiment.”

The man, who also apparently mentioned the Nasdaq, the Dow, and the Japan one at some point or another, talked for a really long time about credit or reductions or possibly all these figures, which somehow relate to China.

Greece was also involved.

An analyst from Citigroup or Citibank announced on Monday that the Federal Reserve System is doing too much, while the Fed has failed to accomplish its goals to increase inflation or interest, which are different things. In addition, he was critical of the Fed’s efforts to regulate the Bernanke.

“There might be a light at the end of the tunnel, but right now the markets are still struggling,” the man who was wearing a blue suit and red tie said about some special money tunnel. “At this point, though, it’s too early to say.”

The head Treasury person, whose name sounds like Guyver or Meisner, appeared on every major network this week, either to assure Americans that everything was better or was going to get better or was never going to get better. Some other guy argued that it has never been that good. During interviews, the Treasury guy was observed on several occasions smiling or wincing.

According to a recent issue of The Wall Street Journal, there are currently a bunch of columns filled with a wide variety of numbers, letters, and symbols.

Geithner—that is the Treasury guy’s name.

Another expert, Lawrence Kudlow, who hosts the CNBC program The Kudlow Report, was upbeat over the amount of points available in the industrial average or pleased with where the percentages were at.

“It’s simple, actually, because the current dividend yield is equivalent to the most recent full-year dividend divided by the current share price,” Kudlow said really quickly. “And that’s basically the situation we’re in now, for better or worse.”

Paul Krugman, New York Times columnist and 2008 winner of the Nobel Prize for something in one of those economics categories, acknowledged in an editorial this week that the SEC must work closely with the stock market, Wall Street, and the New York Stock Exchange to maintain the bulls, bears, and opening bells. Krugman also said something could spur lending or trading or budgetary measures.

Although it has not been totally determined whether Krugman agrees with leading experts on assets or retail sales data or other fiscal things, reliable sources have confirmed that he has a beard.

Time or Newsweek recently published a cover story on the recession or the government debt or incomes or GDP or something similar to that, but kind of focused on how it’s the fault of the rich, the middle class, and the poor.

In addition, mutual funds, probably.

Dow Flirts with 11,000. Gets Number. Never Calls.
Posted by Eddy Elfenbein on October 7th, 2010 at 9:59 am

Good morning! The stock market is up again today on news that jobless claims fell. By the way, I shouldn’t say that’s the reason. I hate when the financial media lists the reasons why the market rises or falls. It’s more proper to say that the market is up and there’s news that jobless claims fell by 11,000 last week to 445,000.

The report on jobless claims comes out each Thursday and I think it’s one of the least important economic reports. Make no mistake, the big news will be tomorrow’s jobs report. Economists expect that the unemployment rate climbed to 9.7% last month from 9.6% in August.

After the opening bell, Alcoa (AA) will be the first component of the Dow to report earnings. I really don’t have any opinions for or against Alcoa, but it will be interesting to see how the market reacts. Pepsi (PEP) cut the top end of its full-year EPS estimate due to poor currency exchange rates. Wall Street had been looking for up to $4.16 per share. Pepsi said it will be closer to $4.12 per share. The stock is down about 3% today.

The Buy List is trending higher this morning. AFLAC (AFL) broke $54 per share this morning. The stock is at its highest level since May. I’ve been very happy with this stock.

Ryan Fuhrmann at TheStreet listed the 5 most undervalued stocks in the S&P 500 and he included Eli Lilly (LLY):

Eli Lilly has severe top-line issues to deal with in the next few years, given nearly 60% of its drug sales are subject to patent expirations during the next seven years. However, this downside is more than reflected in the stock price and is a key reason I recently pegged the stock as big pharma’s most undervalued stock.(Read Big Pharma’s Most Undervalued Stock.) Better yet, management has committed to keeping the current dividend yield, which is about as high as you’ll find in the S&P 500 today. This should keep the stock as a dividend aristocrat for some time, and investors have a chance for big gains by picking up the shares.

The stock currently yields 5.3%.

Morning News: October 7, 2010
Posted by Eddy Elfenbein on October 7th, 2010 at 7:42 am

German August Industrial Production Jumps More Than Forecast

FOREX-Dollar Downtrend Gathers Pace; ECB in Focus

G-20’s `Mega-Trend’ Interventions Risk Protectionist Reprisals

Eurostar to Buy Siemens Trains in Bid to Counter Deutsche Bahn

F.T.C. Accuses Tax Relief Company of Empty Promises

Bank of England Holds Rates Steady

China, U.S. Square Off over Yuan

Asian Markets Down after Yen Hits New 15-Year-High

Shopping Malls Crack Down on Teenagers

The Bullhorn: Talking Cloud Stocks and Gold on CNNMoney

A Possible Model for the Price of Gold
Posted by Eddy Elfenbein on October 6th, 2010 at 8:15 am

One of the most controversial topics in investing is the price of gold. Eleven years ago, gold dropped as low as $252 per ounce. Since then, the yellow metal has risen more than five-fold, easily outpacing the major stock market indexes—and it seems to move higher every day.

Some goldbugs say this is only the beginning and that gold will soon break $2,000, then $5,000 and then $10,000 per ounce.

But the question is, “How can anyone reasonably calculate what the price of gold is?” For stocks, we have all sorts of ratios. Sure, those ratios can be off…but at least they’re something. With gold, we have nothing. After all, gold is just a rock (ok ok, an element).

How the heck can we even begin to analyze gold’s value? There’s an old joke that the price of gold is understood by exactly two people in the entire world. They both work for the Bank of England and they disagree.

In this post, I want to put forth a possible model for evaluating the price of gold. The purpose of the model isn’t to say where gold will go but to look at the underlying factors that drive gold. Let me caution that as with any model, this model has its flaws, but that doesn’t mean it isn’t useful.

The key to understanding the gold market is to understand that it’s not really about gold at all. Instead, it’s about currencies, and in our case that means the dollar. Gold is really the anti-currency. It serves a valuable purpose in that it keeps all the other currencies honest (or exposes their dishonesty).

This may sound odd but every currency has an interest rate tied to it. In essence, that interest rate is what the currency is all about. All those dollar bills in your wallet have an interest rate tied to them. The euro, the pound and the yen also all have interest rates tied to them.

Before I get to my model, I want to take a step back for a moment and discuss a strange paradox in economics known as Gibson’s Paradox. This is one the most puzzling topics in economics. Gibson’s Paradox is the observation that interest rates tend to follow the general price level and not the rate of inflation. That’s very strange because it seems obvious that as inflation rises, interest rates ought to keep up. And as inflation falls back, rates should move back as well. But historically, that wasn’t the case.

Instead, interest rates rose as prices rose, and rates only fell when there was deflation. This paradox has totally baffled economists for years. Yet it really does exist. John Maynard Keynes called it “one of the most completely established empirical facts in the whole field of quantitative economics.” Milton Friedman and Anna Schwartz said that “the Gibsonian Paradox remains an empirical phenomenon without a theoretical explanation.”

Even many of today’s prominent economists have tried to tackle Gibson’s Paradox. In 1977, Robert Shiller and Jeremy Siegel wrote a paper on the topic. In 1988 Robert Barsky and none other than Larry Summers took on the paradox in their paper “Gibson’s Paradox and the Gold Standard,” and it’s this paper that I want to focus on. (By the way, in this paper the authors thank future econobloggers Greg Mankiw and Brad DeLong.)

Summers and Barsky explain that the Gibson Paradox does indeed exist. They also say that it’s not connected with nominal interest rates but with real (meaning after-inflation) interest rates. The catch is that the paradox only works under a gold standard. Once the gold standard is gone, the Gibson Paradox fades away.

It’s my hypothesis that Summers and Barsky are on to something and that we can use their insight to build a model for the price of gold. The key is that gold is tied to real interest rates. Where I differ from them is that I use real short-term interest rates whereas they focused on long-term rates.

Here’s how it works. I’ve done some back-testing and found that the magic number is 2% (I’m dumbing this down for ease of explanation). Whenever the dollar’s real short-term interest rate is below 2%, gold rallies. Whenever the real short-term rate is above 2%, the price of gold falls. Gold holds steady at the equilibrium rate of 2%. It’s my contention that this was what the Gibson Paradox was all about since the price of gold was tied to the general price level.

Now here’s the kicker: there’s a lot of volatility in this relationship. According to my backtest, for every one percentage point real rates differ from 2%, gold moves by eight times that amount per year. So if the real rates are at 1%, gold will move up at an 8% annualized rate. If real rates are at 0%, then gold will move up at a 16% rate (that’s been about the story for the past decade). Conversely, if the real rate jumps to 3%, then gold will drop at an 8% rate.

Here’s what the model looks like against gold over the past two decades:

The relationship isn’t perfect but it’s held up fairly well over the past 15 years or so. The same dynamic seems at work in the 15 years before that, but I think the ratios are different.

In effect, gold acts like a highly-leveraged short position in U.S. Treasury bills and the breakeven point is 2% (or more precisely, a short on short-term TIPs).

Let me make this clear that this is just a model and I’m not trying to explain 100% of gold’s movement. Gold is subject to a high degree of volatility and speculation. Geopolitical events, for example, can impact the price of gold. I would also imagine that at some point, gold could break a replacement price where it became so expensive that another commodity would replace its function in industry, and the price would suffer.

Instead of explaining all of gold, my aim is to pinpoint the underlying factors that are strongly correlated with gold. The number and ratios I used (2% break-even and 8-to-1 ratio) seem to have the strongest correlation for recent history. How did I arrive at them? Simple trial and error. The true numbers may be off and I’ll leave the fine-tuning for someone else.

In my view, there are a few key takeaways.

The first and perhaps the most significant is that gold isn’t tied to inflation. It’s tied to low real rates which are often the by-product of inflation. Right now we have rising gold and low inflation. This isn’t a contradiction. (John Hempton wrote about this recently.)

The second point is that when real rates are low, the price of gold can rise very, very rapidly.

The third is that when real rates are high, gold can fall very, very quickly.

Fourth, there’s no reason for there to be a relationship between equity prices and gold (like the Dow-to-gold ratio).

Fifth, the TIPs yield curve indicates that low real rates may last for a few more years.

The final point is that the price of gold is essentially political. If a central banker has the will to raise real rates as Volcker did 30 years ago, then the price of gold can be crushed.

Technical note: If you want to see how the heck I got these numbers, please see this spreadsheet.

Column A is the date.
Column B is an index of real returns for T-bills I got from the latest Ibbotson Yearbook. It goes through the end of last year.
Column C is a 2% trendline.
Column D is adjusting B by C.
Column E is inverting Column D since we’re shorting.
Column F computes the monthly change the levered up 8-to-1.
Column G is the Model with a starting price of $275 (in red).
Column H is the price of gold. It goes up to last September.

Morning News: October 6, 2010
Posted by Eddy Elfenbein on October 6th, 2010 at 7:41 am

Bailout Loss Estimated at $29 Billion

EU Says Greek 2006-09 Debt, Deficit to be Revised Up

Goldman Sachs Says U.S. Economy May Be `Fairly Bad’

Bernanke Counters Fed Unity Doubt as Regional Chiefs Echo

Foreclosure Furor Rises; Many Call for a Freeze

IMF Warns Against Currency War

Costco Profit Rises, Beating Expectations

Central Banks Open Spigot

The Breadth is Excellent

The Buy List Soars
Posted by Eddy Elfenbein on October 5th, 2010 at 6:39 pm

I wanted to pass along a quick update today on the Buy List because we had an outstanding day. All told, the Buy List soared 2.13% which was better than 2.09% for the S&P 500.

That’s actually a lot better than it looks because our Buy List is designed to have a lower “beta” than the rest of the market, so it’s a surprise to see us beat the market on such a big day.

The other reason is that Nicholas Financial (NICK) ticked down to $9.19 per share right before the close. Even though NICK is a conservative company, it’s a very small-cap stock so it can get knocked around a lot on any given day. Bear in mind that just yesterday NICK reached a 52-week high of $9.60 per share.

I’m not saying I love NICK but it’s allowed to eat cookies in my bed.

Also, Joey Banks (JOSB) hit a new high and it’s up over 60% for us this year!

The Buy List is now +6.84% for the year compared with 4.09% for the S&P 500 (not including dividends). The Buy List is now at its highest close in nearly five months. So far, we’re up 11.29% in the second half of 2010.

Mid-day Update
Posted by Eddy Elfenbein on October 5th, 2010 at 1:01 pm

This is turning into a very good day! As of 12:59 pm, the Dow is holding onto its gains, currently +171 points and within 80 points of breaking 11,000. Woo! The S&P 500 is also having a very strong day, up 21 and closing in on 1,160. The Nasdaq is up 50. The 30-year Treasury is currently at 3.73%.

The stock market is holding on to its gains partly thanks to the Bank of Japan’s decision to cut its key interest rate to 0%. Also contributing to the good news is the Institute for Supply Management’s non-manufacturing ISM Index report which was released at 10 am today and featured a rise from 51.5% in August to 53.2% in September.

The higher market is helping our Buy List. Jos. A. Bank (JOSB) just reached an all-time high, breaking through $45. It’s now up 60% for us year-to-date. Moog (MOG-A) is having a very nice day. The shares are up about 6%.

Gold is very strong and it’s close to $1,340 an ounce.

The market is looking nervously at Friday’s jobs report. We’ll get a preview of the jobs report tomorrow at 8:15 when the ADP report comes out (ADP is a private payroll firm).

Whitney: Safer Banking Rules Will Hurt the Middle Class
Posted by Eddy Elfenbein on October 5th, 2010 at 10:23 am

The money part starts around 3:50.

Dow +103 on BOJ Move
Posted by Eddy Elfenbein on October 5th, 2010 at 10:06 am

The market is moving up this morning thanks to a decision by the Central Bank of Japan to weaken the yen. They’re using some of the same medicine we are: cutting rates to zero and buying back bonds. This will hopefully help Japanese exporters. Right now, all the major indexes are higher and 19 of the 20 stocks on our Buy List are up (NICK is unchanged).

Yesterday evening, Ben Bernanke gave more clues that the Fed is close to a second round of quantitative easing. The yield on the two-year note is still near a record low.

“The additional purchases — although we don’t have precise numbers for how big the effects are — I do think they have the ability to ease financial conditions,” Bernanke said yesterday at a forum with college students in Providence, Rhode Island. He said the first wave that ended in March was an “effective program.”

The Fed snapped up $300 billion of Treasuries last year, and said in August it would reinvest proceeds from maturing mortgage holdings into government debt. The central bank is scheduled today to buy Treasuries due from September 2016 to August 2020, and from March 2013 to August 2014 tomorrow.

Walgreen (WAG) had good news to report. The company said that same-store sales rose 0.4% and the stock was upgraded by Jefferies. There was also a report showing that office vacancies are now at 17.5% which is the highest level in 17 years.