• A Possible Model for the Price of Gold
    Posted by 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 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 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 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 on October 5th, 2010 at 10:23 am

    The money part starts around 3:50.

  • Dow +103 on BOJ Move
    Posted by 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.

  • Morning News: October, 5, 2010
    Posted by on October 5th, 2010 at 7:58 am

    Bank of Japan Cuts Rates to as Low as Zero Percent

    Rogue Trader at Société Générale Gets Jail Term

    China’s Snub of Yuan Pleas Fuels Doubts on Europe Growth

    Europe Services, Manufacturing Cool as Retail Sales Decline

    Stock Futures Rise on Bank of Japan Move, ISM Data Due

    Bernanke Says More Fed Asset Purchases Could Help

    Moody’s Warns it May Downgrade Ireland’s Debt

    Televisa to Buy Stake in Univision

    Flash Crash Magnet Syndrome

  • Citi Gave Back One-Third of Profits to Financial, Legal or Regulatory Costs
    Posted by on October 4th, 2010 at 2:47 pm

    Mike Mayo, an analyst at CLSA, raised his price target on Citigroup (C) from $3.50 to $4 and maintained his underperform rating. (Nope, I don’t get it either.) But this caught my eye.

    For every $3 of profit the last decade, Citi gave back a dollar because of regulatory, legal, financial or accounting losses, observes Mayo. That means Citi’s main problem is how not to “mess up,” in Mayo’s view.

    Sandler O’Neill notes that the Treasury’s stake in Citigroup — meaning the taxpayers — has fallen from 27% to 12%.

  • Abby Joseph Cohen: Stocks Are Still Atttractive
    Posted by on October 4th, 2010 at 12:56 pm

  • Beware Friday’s Jobs Report
    Posted by on October 4th, 2010 at 11:14 am

    This is the first full week of the fourth quarter. The big economic news will come on Friday with the September jobs report. This will also be the last jobs report before the election. The bad news is that the labor market is still in very rough shape. Wall Street expects that unemployment will tick up from 9.6% in August to 9.7% in September. This means that despite impressive growth in profits, it’s not trickling down to new jobs.

    Fed Chairman Ben Bernanke will speak later today and Wall Street will be paying even closer attention than usual. The reason is that the Fed is expected to announce another round of “quantitative easing” which is a fancy name for a money dump. Bernanke, of course, won’t say this explicitly. Instead, he’ll imply his actions under a blizzard of econo-speak. Any clue we can find will be a big deal. Personally, I don’t think a QE announcement will come until after the election. Bear in mind that the two-year Treasury just hit an all-time low of 0.375%. Ouch!

    The other big news for this week is the start of earnings season. Alcoa (AA) is set to report this Thursday. Wall Street expects to see Alcoa report earnings of six cents per share which is a big bust from the 28 cents per share they earned a year ago. Earnings season won’t kick into high gear for the rest of Wall Street until next week and the week after.

    Interestingly, Wall Street analysts are beginning to pare back some of their earnings estimates. It’s not big but it’s noticeable because the analyst community hasn’t done this in a long time. Almost continuously since the world exploded, analysts have raised and raised their forecasts. More than 70% of S&P 500 companies have topped Wall Street’s forecast for four-straight quarters. That’s the longest streak since 1993.

    Last month, Wall Street’s consensus earnings forecast for S&P 500 earnings for 2011 got as high as $96.16. Now it’s down to $95.17. Like I said, it’s not a major change but it’s the first move lower in a long time. I’d also point out that eight of the 22 worst days ever have come in October.

    Finally, here’s a look at how many Americans have been unemployed for 15 weeks or longer. This shows you how different this (former??) recession is from previous ones.