Deja Vu for the Precious Metals

Deja Vu for the Precious Metals

The precious metals sector has been through quite a rollercoaster ride since we last talked about it back in May of last year. At the time of that post http://kiwiblackers.blogspot.co.nz/2013/05/a-dead-cat-bounce.html , gold had crashed through important support levels around $1530 and plunged as low as $1321 before staging a weak rally. The question at that time was whether or not gold had bottomed and would continue to rally or would the bounce soon peter out to be followed by more weakness. In that post I clearly outlined the reasons why I felt that the rally was a 'dead cat bounce' and that gold and silver still had a long way to fall before reaching a true bottom, I also mentioned a price projection in gold showing a downside target of $1070.

Subsequently both the metals resumed their descent, reaching new lows in July last year of $1179 in gold and $18.17 in silver, after which they again rallied before falling to test these levels of support once again in December. At this point the support levels held, forming a 'double bottom' chart pattern, reinforcing that level of support and allowing the metals to once again stage a rally. 

We can see this double bottom illustrated in the chart below.

 In this chart we can also see the rally that carried prices up to a high of $1392 in gold before topping out and suffering a sharp correction over the last couple of weeks.

So here we are again with the metals at a point of indecision-  Will they recover, resume their rally and finally end the correction that has been ongoing since mid 2011, or will they once again crash through these support levels and carry on to new lows?

To find the answers lets take another look at some of the factors that influenced our decision the last time around, our answers then and how it currently looks.

• At a genuine low we should expect the rebound to be strong with good volume as buyers return to the market and chase the price higher. Whilst this could still occur, thus far the recovery off the lows has been relatively weak with low volume. 

This time around the volume was once again unremarkable, and certainly not the surge in volume that would suggest a sustainable rally.

• As was discussed in 'Gold Revisited' the move through the long-term support level in gold has triggered a downside price objective of $1070 and whilst this might not eventuate, it is far from a positive development.  

This downside target still exists and has not been altered by the bounce from the double bottom, in fact it would need a rally up to around $1800 to invalidate the signal. Although we must remember that these targets are not always reached, it is still a bearish sign.

• On a price move as violent as we witnessed I would have expected the 'commercials' to have aggressively covered their short positions, but the latest COT data below shows that although they have bought back some of their 'shorts' it has hardly been dramatic, suggesting to me that they expect another bite at that cherry.  

 Lets look at the current Gold COT picture below.
 
 

You will recall that the red bars signify the net long/short position of the commercials, who for want of a better description we can think of as the professionals, the people that know what they are doing. We can see that the commercials did reduce their short positions substantially, reaching there lowest in July and December, the two periods during which the double bottom occurred, what a coincidence! However, since those December lows their short positions have expanded rapidly, and recently reached there biggest levels in almost a year. This does not paint a pretty picture for the bulls.

If we look at the Silver COT chart for confirmation, the situation is even more pronounced.

• Lastly, we are entering the weakest period of the year for precious metals. Traditionally gold prices enjoy three bullish periods within the calender year driven by demand for physical gold, the first of which is the buying induced by the Chinese New Year celebrations around January/February. The second period is around August/September when Asian farmers harvest their crops and invest the profits into physical gold, and lastly the Indian marriage season that lasts from September through to November which creates the biggest demand spike of all, as gold is a hugely important part of most Indian wedding ceremonies in its form as a dowry. This May to July timeframe is absent of any drivers of physical demand so we often witness weakness in the precious metals during this period.

This seasonal affect still holds true although it can be over-ridden to an extent by other more powerful factors in some years, but absent of something abnormal we should expect the precious metals to under-perform through this May to July timeframe.

All of these factors seem to point towards further weakness in the precious metals, however we should also expect this bearish outlook to be mirrored in the  outlook for the share prices of companies in the sector. A good proxy for the sector is the Market Vectors Gold Mining Index or GDX, so let's have a look at a point and figure chart to see if it gives us a target price.

 This seems to confirm the bearish outlook and gives us a downside target of $19.62, almost a 20% drop from current levels.

When we combine these factors it looks increasingly unlikely that we have seen a sustainable bottom in the precious metals, and as a consequence I still expect that $1170 price target in gold to be reached in due course. 

When and if it is, expect it to be accompanied by a chorus of calls declaring the end of gold and silver as an investment, experts suggesting the next stop is $600 in gold, and investors throwing in the towel swearing they will never touch the shares or metals again. This will be the anecdotal evidence we need to tell us the end of the correction is finally here, and the beginning of the rally that will take the precious metals back to their old highs and beyond has arrived.

The Sands of Time

The Sands of Time

Back in 1987, three physicists called Per Bak, Chao Tang and Kurt Weisenfeld wrote a computer program to simulate what happens when  grains of sand are repeatedly dropped onto a table top. They developed it to try to solve the problem as to why sometimes the dropping of one small grain of sand on a pile will cause no effect, sometimes it will create a small avalanche, and sometimes there will be a catastrophic collapse. After much dropping of sand they concluded that there was no pattern to the outcome, sometimes it was negligible, sometimes total collapse ensued, it appeared totally random.

 Next they decided to look at the sand pile from above and show the degree of steepness of the faces by colouring flatter, more stable areas green and steeper more unstable faces red. As the test continued and more grains of sand were dropped, more of the face became red. Starting with small independent areas of red, slowly but surely the area of red increased and linked together forming a matrix over the surface of the pile. Up to this point the dropping of one small grain of sand could only affect small areas of the pile, but once the matrix was complete it had the potential to cause a total collapse. Scientists refer to this situation as a critical state, the point at which there is an opportunity for significant change.

Once this discovery was made, its influence was recognised in a whole range of seemingly random events from ecological disasters to earthquakes, and epidemics to traffic jams.

We also see this slow development of a critical state develop in financial markets.  As markets rally over a long time period they often climb a ‘wall of worry’, meaning that despite an increasing stream of market negative news-flow, investors continue to disregard or put a ‘positive spin’ on things and drive the market higher. At times investor’s ability to ignore reality is a sight to behold, as one by one the positive arguments for the market fall away to be replaced by negatives, they increasingly cling to the remaining bullish arguments until we finally arrive back at that sand-pile, and its critical state. At this point the market has reached an incredibly unstable condition, and any piece of seemingly innocuous bad news can be the grain of sand that causes the market to crash.

Another area where we are currently witnessing this phenomenon is in the increasing civil unrest occurring around the world. Over the last few months we have seen problems occurring in South America, the Middle East, Spain, Turkey, Thailand, Malaysia and most recently Ukraine. In all of these countries the people are rising up to protest at declining living standards, low economic growth, increasing taxation and rampant corruption. These problems have been developing for many years, laying the foundations for the crises we are seeing now. Like the financial ‘wall of worry’, the problems gradually intensify but change can’t happen until the time is right and we reach the critical state, then one more event occurs that breaks the camels back and the civil uprising begins. That is what we are seeing play out around the globe, and as the months roll on we will see it spread like an epidemic.

As I have discussed in previous posts, the financial implications of this will be the increasing flow of money to the last safe haven, the US dollar. Far more concerning will be the human cost as this cycle plays out, and its predictability doesn’t make it any easier to witness.

It’s clear to see that the phenomenon of the critical state is all around us and seems to permeate all aspects of our lives. But whilst its effects can be immensely damaging, knowledge of its existence and prevalence gives us all at least a chance to occasionally see it coming and avoid its outcome.

Cycling around the South Island of New Zealand

I am a trustee of a New Zealand based charity called The Shortbread Trust. Based in Nelson, we work to help people in developing countries by fundraising to build water wells to provide clean drinking water in Nepal, funding micro finance projects to give a helping hand to farmers in Africa, and buying Shelter-boxes to send to disaster zones. We take no administration fee and guarantee that 100% of donations go to the cause. Please see http://www.theshortbreadtrust.com/ for more information.

Currently our Chairman is preparing to cycle around the South Island of New Zealand towing a Shelter-box to raise awareness and as a fundraiser, see https://www.facebook.com/theshortbreadtrust for the full story.

If you like what we do, please consider making a donation.

Getting In Touch With Our Inner Spock

Getting In Touch With Our Inner Spock

As investors we all like to believe that we are smarter, shrewder and much more in tune with what’s happening in the world than the next guy. Our investment decisions are based on facts, a good understanding of the big picture and a clear grasp as to the reasons why our investments will out perform both the market and our contemporaries.

At least that is what we tell ourselves – unfortunately the reality is quite different.
 
 As a general rule, the average investor has a very poor grasp of the current or future investment drivers, has no clear understanding of why they make the investment choices they do (other than it's what everyone else appears to be doing!), and as a result consistently under-performs the market.

The cause of this phenomenon is rooted in the way our brains handle decision making. From extensive research it appears that we have two systems in the brain, the first we can call the X-system and we can think of this as our emotional approach to decision making (the Dr McCoy system for those Star Trek fans). The second we can call the C-system and is a logical, methodical approach to problem solving (the Spock system). It seems that the X-system is our default setting with all decisions being made in this ‘quick and dirty’ manner for the sake of expediency, and in the majority of circumstances this system serves us well. But in situations where we need to be more thorough and thoughtful about our decision making we have to actually engage the C-system to override the default X-system, and this is where we can encounter problems, especially in the world of financial investment.

It should be clear to most of us that the key to successful investing is precisely the kind of 'Spock' type thinking that the C-system delivers -  rational, logical, methodical and untroubled by human emotion. After all a good investment is a good investment irrespective of the emotion surrounding it. However you do not have to observe markets for too long to see that the majority of investors are anything but rational. It soon becomes clear that rational thought is the last thing on many investors minds as they chase the 'hot stocks' higher and sell the under performers down to ludicrous levels, and you would be wrong to suppose that this trait is only amongst the uninformed private investor. In my many years working for an Investment banking I witnessed some of the biggest funds on the planet acting like headless chickens, caught up in the emotional turmoil of the moment. The only difference being it wasn't their own money they were wasting!

 Now let’s take a little detour and take a short test:

1.     A bat and a ball together cost $1.10 in total. The bat costs a dollar more than the ball. How much does the ball cost?

2.     If it takes five minutes for five machines to make five widgets, how long would it take 100 machines to make 100 widgets?

3.     In a lake there is a patch of lily pads. Every day the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long will it take to cover half the lake?

Easy yes?  Designed by Shane Frederick of Yale and known as the Cognitive Reflection Task (CRT), these three simple questions show how effective we are at engaging our 'Spock' system to override our default 'McKoy' system. They are amazingly effective because each question offers a simple, obvious answer which is unfortunately wrong, and it is only by engaging 'Spock mode' that we will get them correct.

Let's have a look at each question and see how you got on.

The obvious answers were:

 Q1.   10c      Q2.    100 minutes     Q3      24 days

However the correct answers are:

Q1.     5c        Q2.      5 minutes       Q3      47 days

Don't feel too bad if you got one or all of them wrong. This test has been carried out on numerous groups of people and even with the best performing group (students from MIT), only 48% got all three questions correct.

This is quite staggering when you think about it. The fact that some of the smartest people on the planet can fail to answer three simple questions correctly, simply because they cannot override their emotional thinking process when required tells us an awful lot about why good long term investing can be so hard to achieve.

Still, now that you are aware of the problem, surely you can just force yourself into Spock mode and think rationally when the need arises? Well unfortunately it is not that easy. According to more research conducted into our ability to use willpower to force ourselves to comply, it seems that it acts similarly to a muscle in that it can become exhausted from overuse and we effectively run-out of reserves, returning to type.

So if we can't change our behaviour in spite of knowing how damaging it can be what can we do?

Fortunately there is an answer, and it is called 'having a system'

When many of the world's best investors are asked  about their success, a common theme often appears. They have a predetermined set of parameters that the investment must meet, they decide on a buying price which if achieved gives them the investment at the right valuation, they conduct  all their research 'in the cold light of day' away from the emotional pull of the markets, and finally, when the investment comes down to their predetermined price, they always buy it.

Now on paper this seems quite obvious, and indeed it is hardly rocket science. But anyone that has invested in financial markets will know just how hard it is to buy something that is going down. The sense of fear can be overwhelming and we rationalise our inaction away by convincing ourselves that we will be able to pick the bottom and have time to invest when the time is just right, except that picking the bottom is a rare event indeed and that more often than not investors miss out on the fleeting opportunity and end up seeing the price recover and having to pay more.
No matter how many times this happens to us, and we curse the missed opportunities and swear that the next time we will act, when the next time appears we are once again gripped with fear and the opportunity is lost. 
This is why having a system and sticking to it is the key. You are able to mentally delegate your decision making to 'the system' and free yourself from the emotional turmoil involved in making it, and as long as your investment parameters are robust you will benefit in the long run.

As human beings we are poorly equipped to cope in the modern world of financial investment, but we are smart enough to understand the reasons why and do something about it, and bar becoming Vulcan, having a system and sticking to it is the best we've got.

The Coming US Dollar Rally

The Coming US Dollar Rally

For the best part of the last 2500 years the world has had one national currency that has played a dominant, global role and acted as a ‘reserve’ currency. Starting with the silver drachma in ancient Athens, as the empire decayed and lost power the status of ‘holder of the reserve currency’ was passed onto the new dominant empire or country, firstly to the Roman Empire and then the Byzantine empire, the Arab world, then Florence, Venice, the Netherlands, Great Britain and finally since about 1914 the US dollar.

 Currently the US dollar is way out in front as the most dominant currency on the planet, making up 62% of all foreign exchange reserves held by the world’s Central Banks, and acting as the medium of exchange for the overwhelming majority of international transactions.

A number of factors have conspired to substantially weaken the dollar since its 2001 high, including the running of large trade deficits by the US government, the poor long term outlook for the US, and the impending ‘car-crash’ from its huge and expanding debt burden. This dollar weakness has led to much discussion as to whether it will be able to retain its status as the world’s reserve currency, or will a new currency or basket of currencies take over the role at some point.

Another factor stoking the debate is the ongoing impact of the US Federal Reserve’s quantitative easing (QE) policy on the value of the dollar. According to normal market theory this should lead to further dollar weakness, as whenever you print more of a particular currency the price of it should fall in comparison to other currencies. However, that presupposes a simplistic linear relationship, and what we have currently is anything but linear.

I have mentioned in previous posts that unlike the majority of us that can choose to take our assets out of the financial markets when the need arises (by buying property, precious metals or some other tangible asset), the pool of money managed by the ‘professionals’ is simply too large to have that as an option. As a result they are locked into the game, constantly searching for the best relative investment in the best relative currency– in their world the least bad investment is the best investment!

When looking at the alternatives to the US dollar the list is quite short, there are only two that meet the criteria to serve as a truly global currency, the euro and the yen. Currently the eurozone is in total disarray, with its financial woes getting worse and no political will to address them. Money is being driven out of the region into US dollars in search of a safe haven, and the tensions are building to a flash point. Like a powder- keg finding a spark, the end game will be spectacular and result in a much lower euro, or no euro at all. In terms of Japan, they have committed to QE on steroids in an all out attempt to stimulate their economy into recovery, one of the major effects of which has been to trigger a collapse in the value of the yen, as yen denominated assets are sold and recycled into US dollars.

So although the long term outlook for the US dollar doesn’t look good, in the near term it still looks a whole lot better than the only other viable alternatives. Truly, in the land of the blind the one-eyed man is king!

While both of these ongoing events are creating a steady and increasing flow of money into US dollars, there is one other situation unfolding that will likely act as the catalyst to drive the dollar substantially higher. Over the last few years many countries and businesses alike have chosen to borrow in US dollars rather than their domestic currency due to its perceived safety and extremely low interest rates. As I explained in my last post http://kiwiblackers.blogspot.co.nz/2013/10/the-greatest-bubble-on-earth.html the era of low interest rates has come to an end, and as interest rates rise it will make the US dollar increasingly attractive relative to its competitors. Eventually these borrowers will be faced with increasing debt servicing costs and a debt that is increasing in value relative to their domestic currency, at this point there will be a scramble to buy dollars in order to pay back the debt, and when everyone heads for the exits at the same time it can get messy.

These two things combined - the current set-up in the US dollar and the impending increase in interest rates are what I believe sets the scene for a violent rally to occur over the next couple of years.

 Now lets turn our attention to the technical picture and see if it corroborates the fundamental outlook.

When trying to ascertain the US dollar’s relative strength or weakness we could just look at it compared to its cross rates with other currencies such as usd/euro, usd/yen, usd/gbp or usd/nzd. However, these only give us a picture of the relative dynamic between the two currencies not the market as a whole, although by looking at a number of crosses we would be able to discern if there is a general trend emerging. Fortunately there is a simpler way to gauge its performance using a basket of currencies called the US Dollar Index (USDX):

Investpedia explains the index thus:

‘Currently, this index is calculated by factoring in the exchange rates of six major world currencies: the euro, Japanese yen, Canadian dollar, British pound, Swedish krona and Swiss franc. This index started in 1973 with a base of 100 and is relative to this base. This means that a value of 120 would suggest that the U.S. dollar experienced a 20% increase in value over the time period.’  

Using the USDX gives us a great overview of the US dollar using only one chart, and below we can see how it has performed from 1999 to the present day.

Here we can see the collapse in the dollar from 2001 through to the 2008 low. Since then it has chopped around within a fairly large trading range, although since 2012 volatility has reduced and this is often a precursor  to a big move. Also the longer something has traded within a range, the more violent the move when the breakout finally occurs.

If this plays out as I think likely, it will create some major problems for the global eonomy:

• The increased volatility in foreign exchange markets will make it harder for corporates to transact business, especially impacting their ability to hedge their currency exposure.
• This US dollar squeeze will result in substantial losses for those that have US denominated loans.
• Importers will have to cope with rising prices as the dollar value increases, and this will in turn lead to imported inflation.
• Whilst weak local currencies might seem like good news to global exporters initially, a rising US dollar will likely stop any commodity boom in its tracks, and as already stated, the general disruption, undermining of confidence and increased volatility will all work to reduce global trade.

 

To conclude, I believe that any talk of the US dollar losing its reserve currency status is very premature, as the next few years will only cement its position as the undisputed number one currency in the world. However history does teach us that no matter how big and powerful an empire is, at some stage it will roll over into decline and the benefit of having the world’s reserve currency will be lost. 

That is a crisis for another day, let's hope we can cope with he one staring us in the face.

The Greatest Bubble on Earth

The Greatest Bubble on Earth

For the majority of investors the financial market of choice is the Stock Market, be it the Dow Jones Industrial Average, the FTSE 100 or the NZX50 there is an index of stocks near you that offers the opportunity to invest and get a return on your money. However although global stock markets are big, they are dwarfed by the scale of the market in global bonds.

 According to an August  2011 report by Mckinsey & Co the value of global stock markets were put at $54 trillion, by comparison global bond markets were valued at $157 trillion, almost three times the size. Of this $157 trillion the US debt market accounts for $37 trillion or about 24%, making it the single most important market when it comes to investment.

The reason that bond markets the world over fly beneath the radar of the majority of investors is mainly because they are more difficult to understand, but whilst it is certainly the case that you do need a greater depth of financial knowledge to navigate the world of bonds safely, you do not need to be a genius, a little bit of thought and application will do the trick. There is however an old saying that goes ‘There is only one difference between the people that work in bonds, and those that work in equities – it’s called a brain’, now having worked in equities for almost thirty years I have some issue with that statement, but I will admit that there is more than a grain of truth in it!

So why is the bond market so large in comparison to equities when it is clear that the majority of investors don’t understand it enough to invest in it? There are a couple of reasons, firstly because bonds are debt instruments they are the primary source of funding for governments and many corporates, with both of these entities prefering the certainty of borrowing at a fixed rate for a fixed duration. Because of the diversity of the issuing entities, their credit rating, the time till maturity of the bond and the interest rate available, the bond market overs a deep pool of liquidity to those investors looking for the benefit of a fixed rate of return. On the demand  side of the equation, although the majority of investors (mainly individuals) don't understand the market enough to invest in it directly, this group only controls a small part of the total pool of investment funds, the overwhelming majority of these funds are controlled by institutions like pension funds, insurance companies and financial institutions, and these organizations do understand how the market works (theoretically!).

These institutions purchase bonds for a whole host of reasons including preserving capital, earning a predictable return, ensuring they can meet future pension liabilities, to buffer themselves from the effects of stock market volatility, to act as a hedge against political uncertainty, and as a directional bet on falling inflation to name just a few. Often it is a more mundane reason, because the bigger the institution the fewer the options available to park its money (under the mattress is not an option), and the massive liquidity available in the bond market makes it an attractive option.

Since the 1980’s we have witnessed a huge secular bull market rally in global bonds, and with the inverse relationship between a bond price and its interest rate (see http://www.investopedia.com/university/bonds/bonds3.asp ), we have seen interest rates falling in this period from the high double digits down to the low single digits into the middle of last year. This huge rally is just part of a much larger repeating cycle of economic boom to bust and back again, first discovered by the Russian economist Nickolai Kondratiev and now known as the Kondratiev cycle. 

The cycle itself can be broken down into four distinct phases, often labelled spring, summer, autumn and winter. In the spring phase  credit flows into the productive areas of the economy, leading to a huge amount of economic activity bringing growth and prosperity (think 1950 – 1970), as the cycle wears on spring turns into summer and  this explosive growth plateaus,  leading to a reduction of investment opportunities  and as a result the credit heads towards other areas resulting in general rising prices, rising commodity prices and rising interest rates, and thereby setting the stage for the huge bond market rally to follow during the autumn period.  

It’s from this point of extremely bombed out bond prices (and the corresponding high interest rates) that our current bond market rally originated, and its that journey of falling interest rates over the last thirty years that has powered the numerous other asset price booms that have occurred over the same period.

Since the lows of 1981 the market has rallied consistently, resulting in one of the longest winning streaks in the history of investment. According to Merrill Lynch, long term bonds returned over 11% a year through to 2011, and that is spectacular by any investment benchmark.

Over the last few years this trend has been accentuated by the US Federal Reserve’s decision to skew the bond market with the use of QE, in order to keep interest rates low. Through the various manifestations of QE1,2 and 3, rates have been driven to multi decade lows in order to spur a sustainable recovery, but inspite of pumping billions of dollars into the system, it remains elusive.

 The chart below shows us the path of US interest rates since the mid 1950s.

 

Looking at this chart it is plain to see that rates can virtually go no lower, but when the tide turns, and it always does, it suggest they can potentially go much higher. 

We got a preview of how ugly that might look when the Fed announced back on 19th June that it would begin "tapering" some of its QE policies contingent upon continued positive economic data, and that it would scale back its bond purchases from $85 billion to $65 billion a month during the then upcoming September 2013 policy meeting. It also suggested that the bond buying program could wrap up by mid-2014 and laid out the path by which it would likely start raising rates. 

The effect was dramatic, with bonds plummeting and US interest rates jumping 0.80% in a few days (a 0.80% increase on a 1.70% interest rate is a big move in anyone's language), this reaction also bled out into equities with the Dow Jones dropping 659 points in the three days following the announcement. 

Scared by the markets reaction to someone taking away the 'juice', the Fed proceeded to reassure the financial markets until their 18th September  meeting, at which they announced they would be holding off from any tapering for the timebeing, triggering a short-lived relief rally in both equities and bonds.

This short episode, whilst slightly bizarre, has been informative as it has given us a taster of just how painful it will be when the bond market bubble finally pops. 

So do we have any clues as to what might trigger it and when it will happen? On this point the Kondratiev cycle provides some guidance. When the credit fueled boom of autumn finally ends, it is replaced by the Kondratiev winter. During this period there is a credit crisis leading to a credit crunch and sharply rising interest rates, this squeezes the excesses (built up during the preceeding autumn phase) out of the system by bankruptcy and default until we are once again ready for the cycle to begin again (think 1930s depression -1950).

 In our current situation, most of the debt is held by sovereign states, meaning that it is the debt of countries that will come under the most pressure as investors increasingly come to realise that holding sovereign debt is no longer a safe investment. This is already starting to happen.

In terms of when will it start, the answer is it already has. We saw the lows in US interest rates back in mid 2012, since then they have been rising despite the best efforts of the Fed. I can already hear some people saying 'that's just an American problem, it won't happen here', unfortunately I don't share their optimism. Because of the long held belief that the US is the safest of safe havens, the US Treasury bond market is the benchmark against which all other investments are measured and as a result where US interest rates go, sooner or later so do our own. It will be impossible for any country to insulate itself from the effects of a collapsing US bond market, it is just an unpleasant flipside of globalization.

Currently the financial markets are wrestling with the potential fallout from a failure to resolve the US budget issue and the pending debt ceiling debacle. I think there will be a lot more politicking before we see a resolution (ie kick the can down the road!) and we will likely see global stockmarkets and the US dollar turn weaker before there is enough pressure on politicians to come to an agreement. Once this correction has run its course I believe we will see some dominant trends emerge. As the Kondratiev winter starts to bite, the bond bubble will finally burst, starting in the weakest economies first. Money will increasingly flow from these economies into the US looking for yield and a safe haven, unfortunately we now know that the old standby of the US bond market isn't as safe as it used to be, offers virtually no return on your money and is at the end of a thirty year rally, and as a consequence this money will go to the only game left in town, the stock market.

 This promises to be a very scary ride, the long US treasury bond trade is very crowded indeed (by definition it always is at bubble tops), and when everyone heads for the exits at the same time it will get messy. But this time, unlike stock market bubbles that are painful but not terminal, the effects will be far more profound and far-reaching, with the potential to impact all our lives no matter where we live.

The Bond markets have been a great ride for 30 years but now is the time to get off this particular gravy train.

Higher interest rates are coming to a town near you, protect yourself!

Let The Trend Be Your Friend

Let The Trend Be Your Friend

I have long argued that the rally in equity markets we have witnessed since the lows of 2008/9 is a cyclical bull market recovery within the context of a much larger and longer secular bear market. Meaning that although these cyclical bull rallies can be extremely powerful and rewarding for those along for the ride,when the rally ends they will once again roll over and head south as a cyclical bear market takes over. 

 This procession of cyclical bull followed by cyclical bear and back again forms a huge, long-term trading range where equities go virtually nowhere. This is illustrated in the chart below, showing the movement of the US S&P500 index throughout its previous secular bear market period and comparing it to today's (this chart is a bit 'busy' but the point to note is the sequence of large rallies followed by collapses during the 66 to 82 timeframe, denoted in red), and although this is only comparing the current and previous secular bear market periods, the same 'pattern' exists in all secular bears to a large extent.

        

However, although the markets may be meandering their way to nowhere, one very important thing is changing, and that is valuations. 

By definition, the end of a secular bull market is signified by extremely low dividend yields and extremely high valuations, these having occured as investors caught up in the euphoria have bought shares in search of capital gains, driving prices and valuations up and the corresponding yields down until they get to extremes. Although company dividends generally increase over time, prices have simply been pushed up faster than the capacity for earnings to keep pace.

It is at this point that markets roll over into both a short term cyclical bear that will take prices down, and a long term secular bear that will ultimately return valuations to 'cheap'.

This long term rollercoaster of cyclical bull to bear and back is what buys the time for earnings to catch up.

At the end of these secular bear markets, the combination of increased earnings and reduced prices make valuations 'cheap' once again, and the stage is set for a new secular bull market to take place. 
It was the absence of valuations at anything like 'cheap' levels at the 2008/9 lows that strongly suggests that the secular bear market  is ongoing and that what we are witnessing is a continuation, albeit a long one, of the cyclical bull rally from those lows, NOT an entirely new secular bull market.

Now whilst this sets the background picture, it does not helps us with trying to predict when this rally will end and be replaced by the next cyclical bear market. I have talked in previous posts about the nature of tops being a process not an event, and that it takes time for the rally to 'run out of steam' as sellers slowly overpower buyers, this often being reflected in a dome shaped appearance.
 


 I have also talked about the CBOE S&P 100 Volatility Index and its use as a contrarian guide to investor complacency as to the risk of a market collapse. The process being that the more the market rallies, the more bullish investors become and the less they desire downside protection in the form of 'put' options. This lack of demand for puts is reflected in the low levels of volatility, and at extremes can be a useful indicator of a pending sell-off in the markets.

There also a number of technical analysis indicators that are used to monitor the internal health of the market and the level of participation, but some of the most indepth statistical analysis has been done by Tim Woods of www.cyclesman.net.
Through Tim's research he has discovered that there are certain similarities that occur at almost all cyclical bull rally tops, including the low correlation of certain indices and the appearance of a large number of divergences between price and supporting technical indicators (these occur when price makes a new high or low, but the indicator does not, thereby failing to confirm the price move).

 According to his analysis, the pieces are not yet in place for the cyclical bear market to begin, and this along with my own analysis and the appearance of a large and growing trend in the US dollar means I am apt to agree.

Since the tribulations that started to occur in the Euro zone last year, money has been gradually flowing towards the US via the US dollar. This trickle was given a boost with the Cyprus 'bail-in' plan that made it clear to investors that their bank deposits were not safe, and become more sustained once Japan declared war by QE on its own currency in the name of rescueing its economy. These events have acted as a catalyst in driving money to the safest of havens, the US. 

It seems ironic that with all the issues that currently entangle it, and the attrocious state of its finances, the US can still be considered a safe haven, however in the land of the blind the one-eyed man is king, and the US will continue to benefit from this increasing flow of funds into the US dollar as the problems in both Japan and the Euro zone worsen over the next couple of years.

This promises to have major repercussions on financial markets as this flow of funds will have two main effects, firstly driving the US dollar substantially higher, and secondly act as a major support for US equities as these funds are put to work. This really could be the dominant theme over the next couple of years and could overpower everything else, driving  US equities much higher in spite of their being overextended already.
 
Now whilst I do not now believe we are currently close to the top, I do think we are close to a top. US equities do seem ready for a correction  which has the potential to take them down between 7-10%, but in the light of what I have just said, the difference now is that at that point there is the potential for getting into the market to take advantage of the rally that will take it to new highs.

Once this rally takes hold we will have to monitor it for signs that the end is near, because this could become the longest cyclical bull rally in history, and one other point that Tim Woods has discovered is that the longer and farther the rally continues, the more painful the resultant cyclical bear.

 To help with clarity here is a loose chronology of what I think will occur:

• Equity market correction taking markets down 10% ish, possibly caused by Fed comments re QE tapering or Euro stress over the upcoming German elections.
• Correction ends to be replaced with another rally driven by increasing flow of funds into US dollar.
• Rally takes equities to new highs as money flow becomes a flood, driven by collapsing Euro zone and Japanese Yen, this inspite of equities being over-extended by most benchmarks.
•  Soaring US dollar and collapsing Euro, Japanese Yen and many sovereign debt markets.
• Rally ends as the US becomes the last man standing, and the perception of it as a safe haven evaporates.
• Equity markets collapse in a cyclical bear market, taking equities down to 'cheap' valuations once again.

It promises to be a very wild ride in financial markets over the next couple of years, as the number and complexity of macro themes is unprecedented, the benign period of the 80's,90's and early 2000's is well and truly behind us.

                                                                                                                                                                              

NZ House Price Boom Rekindled

NZ House Price Boom Rekindled

After a couple of years of idling, NZ house prices are once again moving into top gear with REINZ's data showing the median New Zealand house price sale was $400,000 in March compared with $370,000 in March 2012, an annual increase of 8.1 per cent, whilst Auckland's median house price increased by 13.5 per cent, from $495,200 to $562,000 over the same period. These sorts of increase are a worry for both the Government and the Reserve Bank and are exactly what they were hoping to avoid, unfortunately they have both been long on talk and short on action, and without fundamental reform to address supply and demand side issues, this is one problem that will not go away.

I discussed the overvalued state of the housing market back in October 2012, in my post ‘ The New Zealand Property Market - The Bubble that Never Bursts', in it I outlined a number of the current problems, a few possible solutions and also illustrated that despite public perception, house prices can and do go down. However I also said that it would probably need the next global financial crisis to trigger the correction, because waiting for governments and central banks to do the job would likely be a long and painful experience. They are much better at talking a good game than implementing it, especially when it directly affects many of their supporters. For those of you that would like to catch up on that post you can find it here http://kiwiblackers.blogspot.co.nz/2012_10_01_archive.html

So let’s have a look at some of the issues currently affecting the housing market and see what we can discover.

 

1. Is this rally only a NZ phenomenon? 

 

No, a number of other countries are experience an uplift in their property markets, among them the US and the UK, however there are many other countries that are still seeing static or falling prices. It really is a very mixed bag seemingly dependent upon the economic situation in the respective country. But one very important point to note is that the countries that are now having the rally, also had the correction from the 2007 peaks, with both the US and the UK property markets falling by around 30% from their peak in real terms, once again making them attractive in valuation terms. By contrast, the most that NZ experienced was a 15% correction in real terms, nothing like the fall necessary to make them ‘cheap' once again. 

 

2. We already know about land supply constraint, the lack of houses being built and the cost of construction but is there anything else driving the rally?

 

•   Persistent low interest rates are having multiple effects:

   

  It conditions borrowers to cheap credit and skews their perception of the risk and probability of interest rate rises, so encouraging them to take on debt.

   

  It forces investors to seek out yield in riskier assets because they cannot earn enough from deposits, so boosting speculative investing in housing.

   

  By allowing those with a mortgage to continue to service their debt at artificially low interest rates rather than having to sell the asset, supply is taken out of the market and the correction process is delayed, this creates pent-up demand from first time buyers and forces them to over leverage. 

   

• Consumer confidence is at its highest since the 2008 GFC, and when people feel confident they spend money, and the more confident they feel the more likely they are to spend on big ticket items, and items don’t get much bigger than housing. (A side note is that consumer confidence can be used as a contrarian indicator, it is often at its peak just before the economy rolls over, and at its low just before the recovery begins). 

• Little to no changes in tax policy towards housing as an investment asset means that investors continue to see housing as the best game in town and are now re-entering the market, and as such will continue to compete with those trying to buy a home rather than an asset.

   

   And probably the most important aspect:

• In Auckland where the problems are most acute, there is clear evidence of extensive foreign buying of property. There are numerous stories of developers being outbid by mainly Asian investors for development land, with some people speculating that this is being used as a ticket into NZ because owning real estate increases immigration visa points. There are also many stories regarding young Asians able to buy properties by accessing large deposits out of Asia.

It is the combination of many factors over a considerable time period that has allowed the distortions in the housing market to develop, but it is the inflow of funds from offshore that are likely to really exacerbate the problem. The arguments that the critics of Asian buying are being racist, and that because this buying only makes up a small % of the total number of housing transactions it is not a problem, are completely missing the point.

 It is irrelevant whether the buying is from Asia, the US or Europe,the problem is not who is buying, but that the money is coming from an external source that is completely disconnected from the local market, which allows prices to be driven far above the levels that fundamentals are able to justify. It is also important to note that the price of any asset is set at the margin, which means that it is the buyer that pays the highest price for an asset that sets the price, it doesn't matter how far adrift the other potential buyers are, you only ever need one buyer to drive up the price. 

 

As an example consider a row of 20 identical houses in a street that are valued at $300000 each, there is only one house currently for sale and 2 buyers, one a local hoping to buy it for $300000, but able to pay up to $325000, and one from out of town that needs to buy a house that week and can pay whatever it takes. Unsurprisingly, the bidding is won by our 'out of towner' for $350000 and the effect is that all the other owners now have an expectation that their home is worth $350000 and will not sell for any less, forcing the buyers to pay the new asking price ($50000 above fair value) if they want to get into the market.  

 

In this example we see the effect that a solitary buyer has on price and perception, it should also then be clear that when that external buying is prolonged, major distortions will occur, and the greater the gap between price and fundamentals the more painful the correction when it happens.

 

So now we know what is driving the rally, how long is it likely to last?

 

The flippant answer is as long as there is fuel to drive it, meaning low interest rates, an ongoing flow of external capital and a lack of structural reform.  

 

Of these three, the least likely to occur is meaningful reform of all aspects of the housing market, the chances of a government led, co-ordinated overhaul of all the problem areas anytime in the near future are virtually nil.

 

Over the last couple of weeks global interest rates have risen as markets start to discount the reduction in direct US stimulus as recently indicated by the US Federal Reserve, and markets will remain vulnerable to any comments from the Fed about its $US85 billion in monthly bond purchases, which have driven bond prices up, kept interest rates at historic lows and helped drive the stock market's rally the last four years.

 

This is likely the start of what will be a long road to much higher interest rates as a new bear market develops in the Sovereign Debt market, and this will put severe strain on the housing market as debt servicing costs soar. You may like to review a previous post on the future for interest rates at http://kiwiblackers.blogspot.co.nz/2012_08_01_archive.html

Lastly, and the most difficult to predict is when the flow of overseas funding runs out. My best guess is that this will coincide with the next down-leg of the ongoing GFC, as this time it will likely impact Asia, Australia and therefore NZ to a far greater extent than in 2008, and I would expect to see global economies start to roll over within an 18 month timeframe.

To conclude, in spite of the ongoing over-valuation of NZ property, the conditions are currently ripe for further gains in the short to medium term, however it is crucial to understand that prices have disconnected from fundamentals and it is predominantly the combination of an ongoing supply of foreign money and cheap domestic credit that is levitating it. 

 

Once these drivers come to an end (and they always do!) it will be a long way down. Anyone choosing to invest now, especially in the Auckland area is buying into the 'greater fool' theory, namely they are relying on some greater fool to buy it off them at some point in the future!