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The Trend Resumes

February 8, 2014

Bull vs. Bears

On Monday, financial markets around the world seemed to be losing their grip and news commentators were nervously calling for a variety of interesting near apocalyptic financial scenarios. Who can blame them? If you assumed that financial markets were based on fixed money supply, current stock valuations would surely be too elevated as dire economic conditions around the world today are simply not reflected in nominal values of assets globally.  By the end of the week, the fear had subsided somewhat(look at the VIX below) and to add confusion to many minds, the big move up that we witnessed in stock markets on Friday was due to the fact that the US employment numbers were awful(and would imply more future money printing). Why do the markets not reflect economic reality anymore?

vix

Readers of this blog know that ever since my first post, I have stated that we live in stagflationary times in which economic output sputters along while prices increase. While we can endlessly argue about the actual rate of inflation, it is clear that it exceeds the nominal rate of interest that can be earned in a bank account, currently about 0.1%. Bonds don’t fare much better and considering the global monetary base below, why would anyone in their right mind want to hold cash or bonds below their level of depreciation?

Global monetary base

When governments around the world issue more and more debt(bonds), the price of them should fall and this would be the case were it not for the global central banks printing money to purchase government debt. Needless to say, this policy will end at one point in the not so distant future and lead to grave losses for bond investors.

Real Assets

Real-Estate-or-stocks

A rational investor will come to the conclusion that the bond market is artificially propped up by central banks globally and cash is undesirable because it yields nothing while it loses purchasing power. Keep in mind that Mr. Bernanke printed lots of US$, Mr. Kuroda Japanese Yen and Mr. Draghi Euros, Mr. King Pounds… Nobody has printed houses or Pepsi Shares. Herein lies the attraction in real assets. While no asset is entirely detached from monetary and fiscal policy, real assets can only be devalued through taxation and economic conditions, not outright supply expansion as we see in cash and bonds. Therefore, I continue to see the stock market surfing wave 5 of the Elliot wave I wrote about a few articles ago(Surfing the Elliot Wave). Trends in general do not change without an accelerated spike both on the upside(greed) and on the downside(fear). So far, we have not witnessed the near vertical, enthusiastic push to the upside and while the economy looks weak, stock prices are likely to continue going up as more fresh money is pumped into financial assets, hence stagflation.

S&P500

Source

 

Gold

Pot of gold coins

I would like to point out that this is a wonderful time to purchase gold as an insurance product against any financial portfolio. It is currently trading at roughly the cost of production, historically speaking a great entry point because if the price drops, there will be less gold mined pushing up future prices. Should the financial markets ever get out of the central banks’ control you will find yourself clinging to the 5-10% gold hedge as your financial life boat. And in case utopia sets in and there is never another downturn in the future, you will still hold the same amount of ounces rather than pay insurance every year. Given that over time, all asset prices increase nominally, I would assume that gold will as well or otherwise it will not be mined anymore which would certainly boost the price.

Finally, I would like to add that if you consider buying gold, please buy the physical product. The gold market is very interesting as it exists in many different forms. If you choose to buy a gold certificate from a bank that entitles you to a certain amount of ounces, the gold is yours only in thought. After all, the central bank owns the physical metal, leases it to a bank and that bank then sells you the right to that gold. The problem with this mode of accounting is that the gold you think you own now has three owners: The central bank, the retail bank and you, the customer. If there ever were a financial panic, do you think you would be able to go to the bank and pick up your coins? “Probably not” would be my answer as we are used to having “bank holidays” when markets are in disarray. As for buying futures at an exchange and not taking delivery, keep in mind that the COMEX has only about 10% of gold in storage against its outstanding claims meaning that if customers actually took delivery, the COMEX could not comply and would have to settle in cash as its rules allow.

Conclusion 

Stagflation in conjunction with financial repression(negative real interest rates) is a monetary phenomenon that is widely misunderstood. As long as the global financial system chugs along and Mrs. Yellen does not crash the party by reversing QE, expect all real assets to rise in price as smart money attempts to avoid the loss of purchasing power through cash and bonds. Within the wide array of real assets, it takes due diligence to find the right mix of these assets. Good luck!

Yellen

 

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