Why Gold Won't Protect You From Inflation: What History Tells Us

Gold is a major investment for a lot of individual and institutional investors, and that everyone should be paying attention to gold right now because its price volatility can teach us all something about how fast markets can fall apart.

The combined market value of all stocks and bonds around the world is about $90 trillion whereas the mined value of all gold has a value of roughly $8 trillion. Of the $8 trillion however, only about $2 trillion is owned by investors (both institutional and retail). Given this, and given that the supply of gold (rate at which it is mined) is mostly unresponsive to the spot price (see my blog here for more details), it's hard to say that the price of gold is being decimated by an excess supply (vs. historical levels of supply).

Investor perceptions about the value of gold differ sharply though. For example, Warren Buffett famously believes that the recent run up in gold prices is comparable to the Dutch Tulip Bubble, the Dotcom Bubble, and the Housing Bubble. As he explained in a recent letter to Berkshire Hathaway (BRK.B) shareholders:

What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As "bandwagon" investors join any party, they create their own truth - for a while." Berkshire Hathaway 2011 Shareholder Letter, p. 18.


On the other side (at least as of 2011 and a Barron's interview at the time), you have Ray Dalio the founder of the world's largest hedge fund.

Gold is a very under-owned asset, even though gold has become much more popular. If you ask any central bank, any sovereign wealth fund, any individual what percentage of their portfolio is in gold in relationship to financial assets, you'll find it to be a very small percentage. It's an imprudently small percentage, particularly at a time when we're losing a currency regime. - Interview with Barron's, 2011



Gold has been seen as a viable alternative to stocks for more than a decade now, in part because for at least 20 years, gold has basically kept up with the stock market in terms of price appreciation. The fact that a gold bar is a non-productive asset, and that firms are supposed to grow in size and profitability, lead the comparability of returns between the two groups to be as much an indictment of stocks as an endorsement of gold. For example, from December 1999 to mid-2012, gold returned an average of 15.4% annually vs. 1.5% for stocks and 6.4% for US bonds.

Given the stellar performance by gold over the last two decades up until a couple of months ago, it is worth asking if these last two decades have been an aberration for gold, or if they are the norm. That is - will gold's price come back? Now of course, history is no guarantee of the future, but it is the most reliable guide we have.

Gold is often cited as a hedge against inflation, but in truth, its price seems to reflect much more than just that. For example, the following chart shows the ratio of the price of gold to the Consumer Price Index [CPI] for the US over time. If gold's price were truly just a function of inflation, then this ratio should be roughly constant on average overtime. As the graph below shows, it's not.

This hypothesis of gold's price being essentially a demand driven story is backed up by the final graph below which shows that gold output has not changed much since early 2000, even while the price of gold has skyrocketed.

Overall the conclusion from this evidence is that gold's price does not appear to be a reflection of inflation. Thus, while it is likely that eventually inflation will increase in the future, this may not actually help the price of gold much. This makes lowering, or at least restraining growth in, mining costs for companies like Barrick (ABX), Yamana (AUY), Newmont (NEM), and Goldcorp (GC) all the more important to the future of these companies. This does not necessarily mean that gold is a bad investment, or that these companies are a bad investment, however, as I will explain in my next article.

Finally, it's not at all clear that gold's price volatility is a product of inflation, fiat currency, or any recent phenomenon. Instead, as the graphs show, gold's price has simply started to rise very quickly in the last 80 years as Americans have become richer and had more money to invest. Essentially, it appears that the price of gold could be a demand-driven story.

Similarly, if we look simply at the real return on gold, the nominal return on gold, and the CPI, we see the same thing - gold's price is NOT driven by inflation or even actual future inflation or recent past inflation

Australian Dollar Higher as RBA Hold Rates, Less Dovish

The Australian Dollar rallied close to 0.5 per cent against the U.S. Dollar as the #RBA decided to hold rates as expected and released a somewhat more optimistic statement.

The #RBA, in their April meeting decided it was prudent to leave the official cash rate unchanged at 3.0 per cent. In their statement, the Bank noted that downside risks in terms of global growth appeared to be reduced with the United States experiencing moderate expansion. Growth in China - Australia’s largest two way trading partner - was also seen to have stabilized at a reasonable pace with domestic growth close to trend over 2012.

After relatively soft retail data being printed in January and February of 2013, the #RBA reported that moderate growth in private consumption spending is occurring with dwelling investments slowly picking up. In their March statement, the Reserve Bank stated that easing carried out through 2011 was still yet to take effect, however indicators as of April were suggesting that the easing steps are having an expansionary effect on the Australian economy.

The rate cut hold was largely expected by markets, however the less dovish statement saw investors regain confidence in the commodity based currency causing it to rally against most of its major counterparts.

Housing price update

Yesterday's release of the January Case Shiller Home Price Index confirms what we have known for most of the past year: home prices have been rising, following the bursting of the housing "bubble." The housing market is emerging from its worst calamity ever.

This chart compares the Case Shiller home price index to the one compiled by the folks at Radar Logic. Case Shiller is seasonally adjusted, but the Radar Logic series is not. Nevertheless, the two have been tracking each other nicely. Case Shiller reports that home prices have increased 8% over the past year, while the Radar Logic series shows a 12% increase. Split the difference: it's a safe bet that home prices have risen about 10% on average in the past year.

The housing "bubble" was caused by excessive demand, fueled by artificially cheap credit, which caused prices to rise to unsustainable levels and housing construction to create a significant excess inventory of homes. It took six years of sharply reduced new home construction and an approximately 40% decline in real home prices to "fix" this mess. Supply and demand for housing have come back into balance, though we are seeing signs that housing may now be in relative short supply, which is why prices are once again rising.

As home prices have fallen, rents have increased, with the result that prices and rents are now back to a more reasonable relationship. It's taken six years, but market forces have brought things back into balance.

Is GBP A Currency Crisis Waiting To Happen?

The idea that the UK is facing the possibility of a full-blown currency crisis has gathered increasing momentum since the start of the year, as #GBP has continued to battle with the #JPY for the dubious distinction of being the world's worst performing major currency (for the record, the #JPY has once again pulled ahead in this race to the bottom). Speaking in Amsterdam last week, the Dutch finance minister, and president of the Euro Group, Jeroen Dijsselbloem warned "England is vulnerable…a new sterling crisis could happen again."

 Before we get into whether such speculation is justified, or merely hyperbolic European schadenfreude, it is useful to first define exactly what a currency crisis is. Traditionally, a currency crisis is associated with fixed exchange rate regimes (such as the last UK currency crisis in 1992, when #GBP was a member of the ERM), and occurs when speculators determine that the peg is unsustainable (normally because it overvalues the currency).

 However, a currency peg is not a prerequisite for a currency crisis, which may be defined as a "dramatic change in the country's nominal exchange rate" (Temin, 2013). As #GBP (FXB) has no formal peg, a currency crisis could perhaps be linked instead to its 'fair value', as measured by purchasing power parity. Currently, using the OECD methodology for calculating purchasing power parity, GBP/USD (GBB) should currently be trading at about $1.47 on a 'fair value' basis (interestingly, despite the recent poor performance of #GBP, it still trades at a premium to the #USD; against the #EUR it looks about 10% undervalued).

 As such, if we use the #USD as our benchmark, it would perhaps make sense to view any #GBP depreciation of 25% or so below 'fair value' as a #GBP 'crisis'; this would imply a GBPUSD spot rate of about $1.10. Such a level may seem implausible, but we have been there before, during the currency crisis of the mid '80s, GBP/USD hit a low of $1.03 (it had been trading as high as $2.40 less than 5 years previously).

 So what could trigger a #GBP crisis that could see such a significant currency devaluation? Traditionally, there are two (related) factors that can trigger a currency crisis: 1) an unstable external debt position; or 2) a declining level of national competitiveness (often resulting in a large and / or persistent current account deficit). I would also be inclined to add a third factor, in light of the current economic environment: the excessive use of unconventional monetary policy (i.e. quantitative easing) to stimulate the domestic economy. The bad news for the UK is that all three risk factors represent red flags for #GBP.

 As we have pointed out numerous times, the UK has a serious debt problem. In fact, when it comes to external debt (i.e. the amount of debt provided by foreigners), the UK is in a league of its own, even when compared to other currency crisis candidates, such as the JPY. This puts #GBP at risk, as a capital flight out of #GBP could be triggered if foreign investors lose confidence in the UK.

However, when looked at on a net basis (i.e. when foreign assets, as well as liabilities, are considered) things begin to a look a little better. The UK's net liability position is 'only' 15% of #GDP, which is very much in line with the European average - although much worse than the UK's 'high point', reached in 1986, when the UK actually had a net foreign asset position of 22% of #GDP (amazing what a persistent current account deficit will do to your solvency!).

 However, even when looking at the net position, there are some ominous warning signs for GBP. Notably, whilst almost all of the UK's foreign assets are denominated in foreign currencies, about 2/3rds of the liabilities are in #GBP. Whilst this is good news from a solvency point of view ( a country it is much less likely to default on liabilities denominated in the domestic currency as it can just print more), it provides a strong incentive for the UK to devalue the pound. In fact, the #GBP devaluation in 2008 resulted in an improvement in the UK's international investment position of approximately 34% of GDP!

It is also worth noting that while the UK holds a strong position in direct investments (net assets of +27% of GDP), it has a relatively weak position in portfolio investments (net liabilities of -38% of GDP). This is important when assessing the likelihood of a currency crisis, as portfolio investments are much more mobile (i.e. 'hot money') and susceptible to capital flight.

The second risk factor when assessing the probability of a currency crisis for the UK relates to productivity. A lack of domestic productivity can be a catalyst for a currency crisis for two reasons:

1) It leads to a current account deficit, placing direct pressure on the currency; and

2) It provides an incentive to devalue the currency to improve productivity.

Again, the signs are worrying for the UK on both counts. The UK has run a current account deficit (i.e. it imports more than its exports) since the early 1980's (which is one reason why its robust net asset position in 1986 has now become a net liability position, as highlighted above). Not only is this current account deficit position persistent, but it is deteriorating (it is now back to the highest level it has seen since the last current crisis in the early 1990s; about 3% of GDP).

 In addition, UK productivity continues to lag that of other industrialized countries. As of 2011, UK productivity was 21% lower than the average of the rest of the G7, on an output per worker basis! The reason for this under-performance is not entirely clear (indeed, the 'productivity puzzle' has been one of the most widely debated economic issues in the UK since the financial crisis). However, this productivity gap does represent a clear and present danger to #GBP, as the government and the Bank of England will be continually tempted to devalue the currency as means to reduce this gap. As the Sunday Times' Economics editor David Smith wrote last week: "I am no longer sure monetary policy is safe in (the Bank of England's) hands…short of erecting a sign on the front of the Bank saying "Sell Sterling" it could barely do more to signal its desire for a lower pound."

 The third factor which threatens the integrity of the pound is current UK monetary policy, and the stated intention to, in the words of Chancellor Osborne, combine "fiscal conservatism and monetary activism" to resolve the country's economic woes. Regardless of whether or not this strategy is the right one for the country, what is clear is that this can be a lethal combination for the currency. Current government policy is, in effect, shorthand for debt monetization and currency debasement. Rather than borrow money to stimulate the economy, the government will simply print it instead. As a result, the extent of money-printing by the Bank of England currently dwarfs even that of Bernanke's Fed (QE represents 26% of #GDP in the UK, versus a comparatively conservative 14% of #GDP in the US).

As such, we cannot disagree with Mr Jijsselbloem. The risk factors are clearly in place for a sterling crisis: 1) a large external debt position, with foreign currency assets and domestic currency liabilities; 2) uncompetitive domestic economy; and 3) large scale unconventional monetary easing. Whether these factors actually lead to a sterling crisis in the coming months in less certain; it is unlikely that the UK government would like to see a disorderly currency depreciation (and the risk of initiating one may curtail their money-printing ambitions), and other currencies, notably the USD and the JPY, face problems of their own. However, it is important to at least consider the possibility of a sterling crisis manifesting itself in the coming months; it's not like it hasn't happened before.

Gold Stocks Approaching a Crossroads

Recently, the Erste Group published a 120 page report covering precious metals. The report contains an absolute treasure of analysis, figures and charts concerning gold and the gold stocks. I have selected a few of the charts which help us explain the current status of the gold stocks. Essentially, there is a huge divergence between financial performance and valuations. Ultimately, the performance of the shares over the coming months will answer the question as to the resolution of that divergence.

We often hear how difficult of a time some mining companies are having. Although that is true, the reality is present conditions for gold miners have never been better. Rising costs are a problem but margins for the large unhedged producers are at bull market highs (and likely all-time highs).

The rising margins explain the consistent increase in cash flow and net income (with a few bumps) as the chart below depicts. Cash flow and net income for 2012 will also reach a bull market high.

Given the high margins, cash flow growth and record earnings why are the stocks struggling and trading well off their highs? A major and often forgotten explanation is the current low valuations. Several months ago, the price to cash flow valuation of senior producers was equivalent to valuation lows seen in 2000 and 2008. No chart better illustrates valuations then this one from BMO Capital Markets.

Now let’s examine the current technicals and draw a comparison between today’s bull market and the bull market from 1960 to 1980. Below we plot the current bull market in the HUI (red) and the Barron’s Gold Mining Index (BGMI). There are some differences but also some similarities. Note that the level 170 was key support and resistance for the BGMI for nearly five years. Once the Bgmi broke 170, it was headed much higher.

One can better view the current key pivot point from the chart below. The 52-55 range has been key support and resistance for GDX since late 2007. If and when GDX makes a weekly close above 55, you can bet that the prognosis will look quite bullish.

The market is at an interesting crossroads. Financial results have been strong but valuations are weak. The market believes earnings and cash flow will decline and has priced in that outcome to some degree. Ultimately, this will resolve itself in one of two ways. Producer margins can decline which would impact cash flows and profitability. That would eventually lead to lower share prices and GDX could threaten a break below 40. On the other hand, should margins increase then share prices will explode higher from a compounding effect. Rising margins will generate stronger cash flow and higher profits and the low valuations will rebound as sentiment would normalize. This is the fundamental case for the next major breakout in the gold shares.

 Given the technical damage from the recent selloff (which went a bit further than expected) one should not anticipate this crossroads to be resolved anytime soon. Think months rather than days or weeks. Ultimately, the shares will break 55 to the upside in 2013 thanks to the combination of a breakout in Gold combined with stable costs in 2013. 

#Christmas Rally Requires the SOX to Join In

The price action in the Phlx Semiconductor Index (SOX) is not looking good. Yet the SOX must rally for the Nasdaq to have a seasonal Christmas rally.

Large components are : INTC, AMD, MU, MRVL

We know that Intel has cut its guidance as .."the PC market is going into the toilet, and the global economy (ex-US) is plainly brutal". The performance of Intel (INTC) has been poor, therefore Intel needs to bounce to satisfy the need for a rally. They other question is can Apple Inc (AAPL) carry the NASDAQ all by itself? Watching and waiting.

The half cycle is when the cycle meets the zero line. When the half cycle is passed price action has little time to conform to the cycle dominance. If price action fails to conform then the cycle weakens.



Source: Readtheticker

Understanding Forex Margin and Leverage

What is Margin?

Using margin in Forex trading is a new concept for many traders, and one that is often misunderstood. Margin is a good faith deposit that a trader puts up for collateral to hold open a position. More often than not margin gets confused as a fee to a trader. It is actually not a transaction cost, but a portion of your account equity set aside and allocated as a margin deposit.
The advanced dealing rates window, found in the #FXCM Trading Station pictured below, will show you specifically how much margin is required to hold open one 10k position in a standard trading account. It is important to remember that this value represents one trading lot and that the amount of margin needed to hold open a position will ultimately be determined by trade size. As trade size increases your margin requirement will increase exponentially.

What is leverage?

Leverage is a byproduct of margin and allows an individual to control larger trade sizes. Traders will use this tool as a way to magnify their returns. It’s imperative to stress, that losses are also magnified when leverage is used. Therefore, it is important to understand that leverage needs to be controlled.

FXCM provides flexible leverage to its clients. You can trade with no leverage at all, or you can trade with a significant amount of leverage based off of your personal preferences. Let’s look at an example using effective leverage

Let’s assume a trader chooses to trade one mini lot of the USD/CAD. This trade would be the equivalent to controlling $10,000. Because the trade is 10 times larger than the equity in the trader’s account, the account is said to be leveraged 10 times or 10:1. Had the trader bought 20,000 units of the USD/CAD, which is equivalent to $20,000, their account would have been leveraged 20:1.

Effects of leverage

Using leverages can have extreme effects on your accounts if it is not used properly. Trading larger lot sizes through leverage can ratchet up your gains, but ultimately can lead to larger losses if a trade moves against you. Below we can see this concept in action by viewing a hypothetical trading scenario. Let’s assume both Trader A and Trader B have starting balances of $10,000. Trader A used his account to lever his account up to a 500,000 notional position using 50 to 1 leverage. Trader B traded a more conservative 5 to 1 leverage taking a notional position of 50,000. So what are the results on each traders balance after a 100 pip stop loss?

Trader A would have sustained a loss of $5,000, loosing near half their account balance on one position! Trader B on the other hand fared much better. Even though Trader B took a loss off 100 pips, the dollar value was cut to a loss of $500. Through leverage management Trader B can continue to trade and potentially take advantage of future winning moves. FXCM believes clients have a greater chance of long-term success when a conservative amount of leverage is used in their trading. Here is a recent study completed of thousands of FXCM accounts (“Traits of Successful Traders: How Much Capital Should I Trade Forex With?”). Keep this information in mind when looking to trade your next position and keepeffective leverage of 10 to 1 or less to maximize your trading.

---Written by Walker England, Trading Instructor