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-- Posted Sunday, 8 October 2006 | Digg This Article
Last week was a busy week on all fronts for market watchers. Metal prices fell hard early in the week but rallied sufficiently by mid-week to offset their losses and in the case of lead, zinc and aluminum, rallied well past their price levels of a few weeks ago. Gold, in spite of a late-week rally, is still off about 5% from the previous week’s price. The Dow Jones Industrial Index broke a new record high and bonds rallied alongside it, with the gains in longer-term bonds keeping pace with the gains in the stock market. I find that a bit unusual: short-term interest rates have been on hold for several months so the rise in longer term bonds is further inverting the yield curve, and an inverted yield curve usually forecasts economic trouble ahead. Along those lines I wasn’t surprised to see metals drop early in the week: weakening US economic growth means less demand for raw materials and hence lower base metals prices. I also expected to see the gold price fall in tandem with base metals as it had rallied with them from mid-2005 to May this year. What is surprising is the strength in US stocks. When a major stock index such as the Dow breaks a new record it means the outlook for the economy is good. Is it possible, therefore, that I am completely wrong worrying about slowing economic growth? Could high base metals prices and the rising stock market both be telling us that economic growth is fundamentally strong and here to stay? Bonds are rallying because bond investors are forecasting that the decline in economic growth will be sufficient to curb price inflation and therefore the Fed will not have to raise the overnight rate anytime soon and could, in fact, start cutting rates again. That puts bond investors diametrically opposite stock investors. Stocks should not be rallying if the forecast for economic growth is negative. We can reconcile the rise in bond prices with the rise in stock prices if we believe the US economy has found a perfect balance between economic growth and price stability, a position referred to as the Goldilocks economy, which is about as probable as finding Goldilocks herself in your own back yard. There is another way to correlate rising bond prices with rising stock prices. American companies issued a record $204 billion worth of bonds during the third quarter. Corporate bond issuances for the first three quarters of this year are already $677 billion, just a few billion shy of last year’s entire issuances of $689 billion, which was a record high. What are these companies doing with all that cash? Are they buying back shares? That would explain why stock prices are strong in spite of dire economic predictions. Six years ago when the stock market broke new record highs the dollar was also at record high levels as foreign capital poured into the US in search of financial assets. This time, however, the dollar barely budged. The rise in stock prices today does not appear to be driven by international demand for US equities. The rise in US equity prices makes no fundamental sense at all, and that probably means stock prices are going to become very volatile. Last time the stock market broke new ground there was euphoria on the Exchange floors and jubilation in the streets. This time, the response is far more muted. According to an article in the Wall Street Journal, floor traders were more concerned with layoffs than with celebrating record high stock prices. Americans are still refinancing their homes and converting home equity into cash, with $124 billion extracted through cash-out refinancings during the second quarter. That is down sharply from last year, but it is still a lot of money. A continuing decline in cash-out refinancings will negatively impact consumer spending and thus reduce US economic growth. Consumer spending accounts for 70% of US economic activity, and so it’s not something to be ignored. Ben Bernanke, the Chairman of Board of Governors of the Federal Reserve Bank, recently said there is limited evidence that the decline in the housing sector has spilled over into other parts of the economy. The housing market peaked a year ago and consumer spending and sentiment is still relatively strong. But while both he, and Mr. Donald Kohn, the Fed’s Vice Chairman, have downplayed the impact of the housing market on economic growth, Mr. Bernanke also said that he thought the decline in the housing sector could reduce US economic growth by a full percentage point during the second half of this year and into next year, from what it otherwise would have been, and Mr. Kohn admitted that the decline in housing construction and home sales has been more rapid and deeper than many economists predicted. For the time being it seems that the Fed is more concerned about inflation than weakness in the economy. Mr. Kohn said that while weaker economic growth is a concern, the risk of higher inflation is a greater concern at the moment. For his part, Mr. Bernanke said that price inflation is above the level the Fed would like it to be but added that the weakening economy could ease the pressure on price inflation. As you can tell by now, there is very little consensus about what is to come. Even though the Fed keeps talking about the risks of inflation the bond market is clearly predicting that the economy is going to weaken to such an extent that the Fed will have to cut interest rates. All this while the stock market is rallying. One thing I think we can all agree on is that there is a lot of confusion and uncertainty at the moment. During such times it is often useful to go back to basics, and I mean really basic stuff. The object of investing is to make money. That requires us to buy low and sell high. Right now US stocks are at record highs, long bonds are not quite at a record high but they are very high, and commodities are just slightly off their record highs. No buying candidates there. In markets like this you could either be bold or defensive. I prefer to be bold when others are not and right now there is an oversupply of boldness, so I’m defensive. The ultimate defensive position is cash. For some that means US dollars, or Canadian dollars, or euros, or yen. For me the ultimate form of cash is gold since I believe gold is money, with one big distinction: it is not a floating abstraction created by a bankrupt government supported only by legislation and the confidence of a brainwashed population. Gold is down more than 20% from its highs in May. With the gold price under $600 an ounce the metal is attractive once again, but don’t interpret that to mean the gold price could not fall further from here. In the short term the biggest risk to the gold price remains the fact that base metals prices are way too high and when they fall they could drag the gold price down even further. I would be ecstatic if the gold price fell further -- the lower the better. It doesn’t matter that my current positions would decline in price because the intrinsic value of the companies I own, and the gold I have, would not change, and the lower the prices fall the less I have to pay for the same intrinsic value. You panic and sell when prices fall only when you don’t know the intrinsic value of your investments. When you do know what your assets are worth it is easy to sell them when they are over-priced and easy to buy more when they are under-valued. Paul van Eeden Conferences: My next speaking engagement is in New York on October 19th, at a dinner organized by the Committee for Monetary Research and Education. If you are interested in attending, please contact Elizabeth Currier at cmre@bellsouth.net. Newsletter: If you enjoy reading these commentaries I suggest you go to my website at http://www.paulvaneeden.com/commentary.php and register to get them by email. Rest assured that I do not sell or rent any of my subscribers’ email addresses. Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com) or contact his publisher at (800) 528-0559 or (602) 252-4477. Disclaimer: This letter/article is not intended to meet your specific individual investment needs and it is not tailored to your personal financial situation. Nothing contained herein constitutes, is intended, or deemed to be -- either implied or otherwise -- investment advice. This letter/article reflects the personal views and opinions of Paul van Eeden and that is all it purports to be. While the information herein is believed to be accurate and reliable it is not guaranteed or implied to be so. The information herein may not be complete or correct; it is provided in good faith but without any legal responsibility or obligation to provide future updates. Neither Paul van Eeden, nor anyone else, accepts any responsibility, or assumes any liability, whatsoever, for any direct, indirect or consequential loss arising from the use of the information in this letter/article. The information contained herein is subject to change without notice, may become outdated and will not be updated. Paul van Eeden, entities that he controls, family, friends, employees, associates, and others may have positions in securities mentioned, or discussed, in this letter/article. While every attempt is made to avoid conflicts of interest, such conflicts do arise from time to time. Whenever a conflict of interest arises, every attempt is made to resolve such conflict in the best possible interest of all parties, but you should not assume that your interest would be placed ahead of anyone else’s interest in the event of a conflict of interest. No part of this letter/article may be reproduced, copied, emailed, faxed, or distributed (in any form) without the express written permission of Paul van Eeden. Everything contained herein is subject to international copyright protection.
-- Posted Sunday, 8 October 2006 | Digg This Article
Previous Articles by Paul van Eeden
Paul van Eeden is an independent investor, analyst and newsletter editor.
Born in South Africa, Paul graduated from university with a degree in chemistry and applied chemistry with additional credits in accounting, economics, business economics, philosophy, statistics, mathematics, biochemistry and physics.
Paul's first business was an African art distributorship, of which he acquired a 50% interest during his first year at university in 1985. He has experience, either as an owner, manager or director, in plastics manufacturing, food supplements and cosmetics distribution, advertising & marketing as well as the manufacturing and distribution of gas detection equipment.
Paul van Eeden left South Africa in 1994. He joined Yorkton Securities in Toronto as a stock broker in 1995 and moved to Global Resource Investments in Carlsbad, California in 1996. In November 2002, Paul decided to leave the brokerage industry and joined Doug Casey as co-editor of the International Speculator (www.internationalspeculator.com) newsletter.
His investment approach was shaped by the ideas of Benjamin Graham and David Dodd so Paul is always on the search for tangible value that can be bought at a reasonable price. That can usually be accomplished only during the trough of a market, which is currently not the case for general US equities.
Therefore Paul decided to focus on the natural resources sector, specifically gold. The period from 1996 to 2001 was a trying time - the bottom of the worst bear market in gold in twenty years - but, of course, it was also a time of opportunity.
At the San Francisco Gold Show in November 1998, Paul van Eeden introduced his original thesis that the gold price in US dollars is driven by the US dollar exchange rate, and that traditional commodity style analyses would not yield predictive results when applied to gold. He showed that a dollar-only view of the gold market is inadequate: understanding the gold price requires a global view, incorporating exchange rates across many currencies. This novel line of thinking is now ubiquitously accepted.
In 2003 Paul went further, showing that the price of gold in US dollars is tightly correlated to the expansion of US monetary aggregates (M3) and that an analysis of gold as money not only clarifies the gold price from 1971 to the present, it has other implications that are still unforeseen by most financial and commodity analysts today. One of these is that the gold price will soon exceed $1,000 an ounce. Another is that, aside from operational differences, not all gold mining companies will benefit equally from this increase in the gold price.
Paul van Eeden not only does his own research on the fundamental drivers behind the gold market, he also takes a hands-on approach to investment analysis: interviewing management, studying exploration projects and visiting mining operations. Whilst investing in mining and exploration companies is inherently risky, value is never far from his mind and features forcefully in his selection criteria.
Most of Paul's time, now, is devoted to finding investments for his own portfolio.
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