Return Of The Gold Standard
- Major US asset classes (stocks, bonds) offer a lot of principal risk for very little in return.
- Not too late to catch the train to Europe on the Currency Hedged platform.
- Wide international support for the Asian Infrastructure Investment Bank paves the way for the return of the Gold Standard.
Gold Bug: "Hey guys, did you hear Yellen wants to raise interest rates? The economy is doing well and you can put your money in stock or bonds, yields are gonna be higher. Nobody is gonna want to invest in gold anymore. I'll be ruined, ruined. "
Stock Bug: "Yeah, I've heard - I don't live under a rock like you, you know. But no, she can't do that. I am paying 20 times earnings already, CAPE is second highest in history and if the interest rate goes up, I have to adjust my Discounted Cash Flow model. Companies are gonna have to make way more money to justify their prices and frankly I have no idea how they are gonna do that. We are already at full employment and the rest of the world is a mess. I'll be ruined, ruined. "
Bond Bug: "Oh, no she can't do that. Nobody is going to want my bonds anymore. I was making stock-market like gains for so many years without the risk - he, he, ain't that clever! ... but, but, who's gonna want my 10-year now when the 2-year is giving you more yield? I'll be ruined, ruined."
Gold Bug: "... and I thought I had problems! Is there anybody that doesn't hate Yellen now?
It's St. Patty's - let's drink to that!"
And therein lies the rub. The entire investment world is against Janet Yellen now. Fear and loathing on Wall Street has never been greater. Future prospects for capital appreciation and yield in all US-based investment classes have never looked bleaker. It takes a Fed chair with a very strong spine to stand against the entire investment community and do the right thing - prick the bubble dead in its tracks and provide a fair opportunity for the next generation of buyers. Volker is in a class all by himself in the Fed Chair Hall of Fame - the slayer of the inflation dragon. Greenspan as much as he is reviled, kept the interest rates between 4-6% for the vast majority of his tenure and at least tried to tame the housing bubble by aggressively raising interest rates in the end. Bernanke was all beard and no spine... sorry, all style and no substance. He levied QE3 right in the middle of the upturn of the economic cycle; he piggy-backed the natural capacity of the economy to recover in order to justify a flawed economic theory. A flawed economic theory that has now failed to restart economic growth in Japan and will fail in Europe. What will Yellen do and how will we remember her?
Let's not forget, asset inflation is still inflation. Owners buy assets, they don't rent. We don't have an index for cost of ownership like the CPI, but if we did I guarantee you it would've never been higher.
Becoming an owner has never been more expensive. Upward mobility in America has never been more difficult. The Fed's policies have lead us there and they are the ones that have to correct this imbalance. All we need are normal interest rates, which in my book means bringing the 2-year treasury rate in line with the CPI (as flawed a measure as that is). The return on your risk free savings should match the rate of inflation thereby ensuring the purchasing power of the money is preserved.
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At present, we have a monetary policy which overtly reduces the purchasing power of our money by 2% a year and essentially acts as a covert wealth tax. I am not sure who authorized the Fed to implement a wealth tax, but if I could vote on a wealth tax, I would vote it down and I am sure most of America will as well.
It is time for Yellen to blaze her own path and lead the financial world to a better, more normal place. That will be difficult and hard and unseemly and will entail a couple of market corrections along the way. As much as our investment bugs worry, at least they have money to worry about and an abundance of financial intelligence. The proverbial widows and orphans out there who don't have the skill and know-how to protect themselves financially are being slowly robbed in plain sight of whatever little savings they have. This is not a policy an official appointed by the President and confirmed by the Senate should be implementing (not to mention an official with liberal inclinations).
It is still amazing to me that in a country like the US which is so suspicious of wealth transfer policies, the Fed managed to orchestrate one of the greatest wealth transfer schemes from labor to capital in modern history. It's not like corporations had a difficult time getting return on capital already. Yellen will have to normalize rates because it's right and like Kennedy said - because it's hard and not easy.
Fear and Loathing on Wall Street
If we look at the major US asset classes right now, the dividend yield on the S&P 500 at 1.87% and the interest on the 10-year treasury at 1.93% are in a virtual tie (again until 2012 an unprecedented market condition). Both are at historically low levels:
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The S&P 500 (NYSEARCA:SPY) is definitely looking expensive and toppy trading at 20x trailing PE as company earnings are starting to post year over year declines. For Q4 in 2014, the S&P 500 GAAP earnings came in at $22.81 per share a full 25% miss from the original expectations of $30.6 per share for the quarter and a straight 13% year on year decline vs. Q4 of 2013 (if you remember that was the first time the polar vortex was used to justify economic underperformance).
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The future prospects for corporate earnings this year don't look very encouraging either.
Banks and corporations still have to report the full extent of the damages resulting from the strength of the US dollar and the low energy prices. Loans written against oil revenues at $70 per barrel and above will have to be written down, energy producers will have to lower revenue and earnings estimates, tech corporations with major operations overseas will have to knock out 20-30% of their overseas earnings.
While some of these earnings expectations have been lowered, we know full well that the analysts on Wall Street will wait until the very last moment to drop the bad news. Look at the earnings expectations for this quarter. Expectations stayed unchanged even as the moves in the US dollar and the oil prices became an avalanche instead of a temporary market blip.
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Whatever the analysts say they are expecting now, you have to be prepared for at least a 20% haircut in earnings once the day of reckoning comes. As I discussed in a prior article, earnings miss expectations 80% of the time by an average of 18%. The first quarter earnings will be coming soon and the full extent of the damage will be become quite apparent.
Faced with the prospects of rising interest rates, what is an investor to do as the major US-based asset classes look tapped out and presently offer a lot of principal risk for very little in return?
Well, all we have to do is look at the major ETF leader board this year:
Europe, Currency Hedged
Apart from sounding like a drink James Bond would order in Monaco, Europe in a currency hedged form (NYSEARCA:HEDJ) is the place to be right now. This is a play on the long-term strong dollar theme I outlined in my article The Return of King Dollar nearly two years ago, long before it was fashionable. While we can debate the success of QE as an economic program, QE has two undeniable effects - it inflates asset values and devalues the currency. We have seen this script play out in the US and in Japan and it shouldn't take too much convincing. With the Euro dropping over 25% from its 52 week high, Super Mario has given large, very competitive, world class European corporations like Adidas, BMW, Airbus, etc., essentially a free 25% markup on their earnings. Their goods will become more competitive in the key markets of US and China (don't forget China monetary policy is pegged to the US dollar and as the dollar strengthens so does the yuan) increasing their revenues and competitive footprint. I am not an expert in picking individual companies in Europe nor am I a currency hedging expert, but if you want to participate in this, it makes sense to hire a financial advisor to implement this strategy for you. Or you can just buy HEDJ on any dips. You can also consider dabbling in European real estate via RWX or IFEU, but again any involvement has to be in currency hedged form. These ETFs are not currency hedged so you will have to do that yourself (or your advisor).
It is important to understand that you have not missed the train here. The divergence in monetary policy between the US and Europe will continue for at least the next 2 years. The Euro is far from its nadir. I foresee the Euro hitting at least $0.80 per dollar as the US normalizes its interest rate policy over the next two years. The American economy is in much better shape than Europe and will continue to be as the US slowly starts walking the path towards improving its outdated tax system.
The fair value of the US Dollar Index is at least 120 (presently hovering around 100). In addition, any political turmoil in Greece, Spain or Italy will put forward the prospect of at least Greece leaving the EMU. It is important to understand that just all investors in the US hate Janet Yellen, so does the population of Europe hate the euro. The Germans hate it because they have to carry the debts and outrageous pension schemes of the weaker European countries and the southern countries hate it because, well they can't inflate their way out of a jam. The euro has very weak political support and continued economic deterioration will give more and more power to the nationalist, socialist and separatist movements. Should Greece leave the EMU, the euro will have to be marked down further in order to reflect the loss of Greece's GDP as a backing for the currency. In an event such as this, do not be surprised to see the euro at $0.60 on the dollar.
Return of the Gold Standard
Obviously, if you want to be super lazy about it, you can just save your money in a savings account and sleep well at night as the US dollar (NYSEARCA:UUP) has been running circles around the S&P500 and long-term treasuries (NYSEARCA:TLT) for the past 6 months. Then take those savings and go on a trip to Italy and enjoy the scenery. But I digress. There are some major developments occurring in the world of international finance that will provide us with the next major investment theme for the next 2-3 years....
Yes, gold! This week brought some major news across the newswire:
For those not aware of this development, China is in the process of setting up the Asian Infrastructure Investment Bank (AIIB), a major World Bank and IMF competitor in the lender-of-last-resort business. Unhappy with its voting rights in the IMF and World Bank, China is striking on its own and setting up an institution in which it will be the dominant player.
And not surprisingly, it has picked up the support of major US allies Britain, Germany, France and Italy and possibly Australia and Japan enlisting in the coming days. The US has made a lot of international enemies over the past few years as it has overplayed its hand in using economic sanctions against geopolitical enemies.
While Iran and Russia are the most obvious examples of economies that have suffered the wrath of US imposed sanctions, the US has also used the fact that the US dollar is used in international trade to expand its territorial jurisdiction and has levied fines on companies in France and elsewhere that didn't comply with the sanctions. The most recent example is the US imposing a $9 billion fine on French bank BNP Paribas for involvement in Sudan, Cuba and Iran, even though France is not at odds with those countries itself.
This overreach has reduced international acceptance of the US dollar as a trading vehicle.
Saudi Arabia wants to divorce itself from the Petro dollar, obviously Iran and Russia and China want to divorce themselves from the US dollar, but so is Europe. Because the US is using the dollar an economic weapon, pretty soon it won't have it as a weapon in its arsenal.
Everybody else is now working on neutering this advantage. This leaves the US standing alone and unable to stem the tide of dissent. The days of the US dollar as the premier international reserve currency are numbered. Harry Dexter White, the architect of the US dollar standard, must be spinning in his grave.
So why does that matter to gold?
The competition between the IMF/World Bank and the AIIB will weaken the dollar status as a reserve currency, and in the fight between the dollar, the euro and the yuan, there will be only 2 winners - gold (NYSEARCA:GLD) and possibly bitcoin (Pending:COIN) - limited issue currency commodities with supranational acceptance and no "promise to pay" constraints; in other words, they don't depend on the solvency of a specific government to carry inherent value. A combination of both will facilitate international trade in the future.
The Gold Standard established at the Bretton Woods conference in 1944 will return in a new form.
Gold is also particularly attractive here because after a 3 year bear market, it is now trading very close to cost of production. The latest estimates by Hebba Investments and their series of "What It Really Costs To Mine Gold" peg the production cost between $1150-$1250 for most major miners.
Gold miners (NYSEARCA:GDX) have been cutting production for quite some time and their share prices have been pummeled to historic lows.
In addition, China and its state banks can now become a participant on the London bullion market as changes are being implemented to the fixing process:
"This month the physical gold market will undergo radical change when the four London fixing banks hand over the twice-daily fix to the International Commodity Exchange's trading platform on 20th March.
From 1st April the Financial Conduct Authority will extend its powers from regulating the participants to regulating the fix as well. This will transfer price control away from the bullion banks allowing direct access to the fixing process for all direct participants and sponsored clients.
From this flow two important consequences. Firstly, the London market is changing from an unregulated to a partially regulated market, reducing room for price manipulation. And secondly, the major Chinese state-owned banks, assuming they register as direct participants, have the opportunity to dominate the London physical market without having to deal through one of the current fixing banks. No announcement has been made yet as to who the direct participants will be, but it is a racing certainty China will be represented."The official Chinese gold reserves are pegged at about 1,000 tonnes as last reported in 2009.
Based on official figures from the Shanghai Gold Exchange, China has imported at least 8,459 tonnes of gold since 2008. So China's undeclared holdings are far higher, probably in excess of 8,000 tonnes which will make it the holder of the largest or second largest gold hoard in the world. When China announces its gold holdings, this will severely undermine the US dollar as an international medium of exchange. While the US dollar is still the best currency in the world and while there is no doubt in my mind that the US dollar trade-weighted index will continue its uninterrupted march towards 120, I think gold will also rise against the dollar far above the $1900 price achieved in 2011.
Just like with my US dollar forecast, I can't be specific on timing because timing is tough to achieve when it involves such complex political and economic institutions and the approval of many different constituencies. However, the stage is being set for substantial gold appreciation in the coming years.
One the main drivers for the new gold demand will be from investors seeking protection from geopolitical uncertainty and extreme currency volatility. While there still may be some downside over the next year or two, it's is very unlikely gold will fall below $1000-1100 for a significant amount of time due to cost of production constraints. It is possible that we have seen the final lows in gold during the Swiss referendum last year.
An astute investor will start accumulating silver (NYSEARCA:SLV) and gold both in physical and paper form and consult an expert on gold mining companies with good prospects. Or they can just buy gold miners and junior gold miners (NYSEARCA:GDXJ) ETFs or their 3x leveraged counterparts NUGT and JNUG. I would caution against passive accumulation of the leveraged ETFs as the swings in the ETFs make them lose significant value over time. I would recommend the leveraged ETFs to the swing traders and the regular ETFs to those with a long term buy-and-hold approach.