January 26, 2010

A Leading Indicator Says Gold to Go Up

The best leading indicator for gold is not the many TV and radio ads that talk about “gold’s behavior in bad times”, that it “has never been worth zero”, or “the currency of last resort”.

If dollars become totally worthless and the economy is in chaos as the gold salesmen imply, a better currency will probably be canned goods and bullets.  But I don’t think that is even a remote possibility.

Gold prices have a very strong relationship to real interest rates.  The term “real” means minus the inflation rate.  Simply put, Treasury bond rates, less inflation.

Whenever the inflation rate is above interest rates, real rates are negative and gold tends to take off.

For much of last year inflation was negative (called deflation, really), so even with the absurdly low rates on CDs, money markets and T-bills, those rates were higher than inflation so they did not make real interest rates go negative.

My Inflation and Tax Outlook for 2010 in the November 17, 2009 Money Matters (You can see the article at http://hepburncapital.com/newsletter/37112-inflation-and-tax-outlook-for-2010.html) warned my readers that inflation was getting ready to take off.  When that article was written inflation measured by the Consumer Price Index, was -1.3, a negative.  Today, only two months later, the CPI is reported to be 2.7%.

With higher inflation and the low, low interest rates, “real rates” have now turned negative.

I expect next month’s CPI report to put inflation at over 4%, enough to set off alarm bells. With interest rates next to zero, this means that real rates will be negative by almost 4%.

The last time we saw this high level of real rates was in the late 1970s when gold soared.

What makes this work is that gold buyers do not get any interest on the gold they buy.  Higher real interest rates on competing investments make gold look less attractive when compared on the basis of interest being paid.

When real rates become negative, the disadvantage of buying gold – not getting paid anything while you hold it – goes away because many savings vehicles don’t pay anything either, so more folks are likely to buy gold in that environment.

Until interest rates are raised high enough to provide better opportunities for investing elsewhere, the investment environment should continue to be favorable for gold and investors in other hard commodities.

How long can this favorable environment last?  I don’t really know for sure, but Richard Russell of the Dow Theory Letters mentioned that in just the next two years $10 trillion of debt must be refinanced by the US government, banks world wide and commercial real estate borrowers.

This mind boggling impending demand for investor dollars is very likely to drive up the price of those dollars.  And the price of dollars is the interest paid to use them.

So the party for gold will be over at some point, probably within the next couple of years, but until then, gold ought to have the wind at its back.

Back in the Office Again.

The weather in Mexico was wonderful, and I even discovered a very effective diet.  I call it the Tomorrow Diet, but it is not what you think.  I just remind myself that there will be more food tomorrow and I don’t have to eat everything in front of me.  It works, too.  I came home wearing the same size clothes as I left in.

Hear Will Hepburn Speak

Want a Free File Cabinet?

Hepburn Capital is retiring a light beige file 4-drawer cabinet (letter sized) in good condition.  If you have a use for such a cabinet, come on over and pick it up.  First come, first served.  And it is free to friends of Hepburn Capital.

Riddle:

Q: I went into the woods and got it. I sat down to seek it. I brought it home with me because I couldn’t find it. What is it?

A: A splinter

How’s the market doing?

The stock market had been giving off mixed signals until last week which saw the worst 3 days since the bear market ended last March.  While scary, such large 3-day drops have not been good predictors of major trend changes over the past 80+ years according to Jason Goepfert of SentimentTrader.com.

Lots of reasons for the decline have been bandied about including earnings reports, while good, were improving due to cost cutting, not improving sales.  

Inflation has also been mentioned as “the” cause of the decline, however there are conflicting signals in that regard, including still-falling interest rates on Treasury bonds which argues against inflation being the culprit at this time.

I think the real reason is the election results from Massachusetts.  The market does not care which party is in power, but what it really does not like is the uncertainty that comes with change.  And the election signals that there will be significant change coming to Washington.  

Investors positioned to take advantage of the proposed health care bill which appeared to be a certainty just a few weeks ago are now scrambling to protect their investments.

My guess is that this, too, will pass and the uptrend will resume until the inflation bogey-man jumps out and really scares everyone.

What we were saying back then.

From the January 31, 2008 article entitled Up, Up and Away:  “What had the Fed so on edge is the steadily increasing scope of the defaulting debt problems. For months now, there has been much talk of “sub-prime” loan losses, but the problems just keep spreading from there. As I said a few weeks ago, “there is never just one cockroach.”

As the Bear Stearns and Lehman Brothers collapses, just a few months later, were to prove, my cockroach theory was a good one to follow back then.

And from the same newsletter:  
“In my readings I have seen some very serious suggestions that several of the largest banks (and not just in the US), of the “too big to be allowed to fail” size, have negative net worth. Technically they are broke . . .
“I think there is quickly rising risk that taxpayer money is going to have to be spent on shoring up some of these big banks”, which, of course, turned out to be the understatement of the year.

It can be fun, in a ghoulish kind of way, to watch history unfold before our eyes.

What’s Going On In Your Portfolio?

The timing of our gold purchase a few weeks ago in our Careful Growth* and Balanced* accounts was not good as gold sold off this past week along with the stock market, but due to the analysis mentioned earlier in this newsletter I am being patient with it as I expect time to be on our side with this set of investments.

Our other stock holdings were pared back when I sold our telecom stock funds from the cruise boat somewhere off the coast of Baja, California.  Our 10% holding in semiconductor stock funds is our only direct stock market exposure right now.  The balance of our holdings include a floating rate loan fund, rising dollar fund, and a big chunk of our faithful high yield bond funds.

Flexible Income* accounts are still fully invested in high yield bond funds which have declined between 1% and 1.5% from their peak while the S&P 500 Index** has declined 5.08% from its peak.  Despite the flagging performance, high yields have not delivered a sell signal, so I am being patient with them, too.

Twice this past year we came within a whisker of triggering sell signals only to have high yields turn around and give us a few more strong months.

Successful investors have discipline and this is one of those times we should let the system work.

Our Spotlight Strategy

The Careful Growth model* ended 2009 with a profit of 7.89% after taking very low risk most of the year.  Its ten year total return has been 49.20% (after all fees have been deducted), an annualized rate of 4.92%.  Compared to the stock market average represented by the S&P 500’s** loss of 9.28% (-.92% annualized) over the same ten years, I feel pretty good about that.

Knowing when to sell and sit on the sidelines is what makes the difference.

Here are the details:

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*    The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed.   Activity in client accounts may be different from that in the model in amount of each investment, specific timing of trades, and actual security used, which may vary from account to account.  Not all trades are profitable.  It should not be assumed that current or future holdings will be profitable.   A list of all trades in these accounts for the past 12 months will be provided upon written request.

**  The S&P 500 and Nasdaq Indexes are unmanaged lists of stocks considered representative of the broad stock market.  Investors cannot invest directly in the S&P 500 Index.

This newsletter may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted. Information in this newsletter may be derived from sources deemed to be reliable; however we cannot guarantee its accuracy.  Please discuss any legal or tax matters with your advisors in those areas.  Neither the information presented nor any opinions expressed herein constitute a solicitation for the purchase or sale of any security.