II. PRECIOUS METALS
Huge rally, is it sustainable?
III. MARKET ACTION
Reflexive Bounce Seems Likely
IV. MONSOON REGION
V. SUMMARY OF INVESTMENT THEMES
- As if on cue, as soon as the U.S. stock market got within range of its 2014 and 2015 highs it began trending lower. In my opinion, the swiftness of the rally from the February lows through the mid-April highs made it more likely that at least a pause if not a correction would occur. It seems that may be unfolding now.
- Foreign stock and bond markets in general seem to be correcting at the exact same time. Most stock markets seem to be moving in tandem over the past six months.
- The U.S. dollar has now corrected to the lower end of its channel and briefly breached its lower level in early May before bouncing back up. This correction started around Thanksgiving and has worked off the overbought nature of the dollar. In fact, many of those who spoke of a higher dollar in early winter have left and are now talking about how much lower it could go. This could be setting the dollar up for its next rally.
- Not coincidentally, gold and silver are having their best run since 2013 as gold hovers around $1,300 oz. Gold has rallied 25% this year from a low of $1045.40 in December to a high of $1,306 May 1st. Silver has done even better, rising 32.6% from its December low of $13.62 to $18.06. Mining companies have done even better. The HUI gold miners’ index has rallied 138% in five months!
- Bonds have rallied as questions about how many times the Federal Reserve will raise rates this year have subsided. Now the question is if rates will rise at all in 2016!
- Finally the question on many investors’ minds is how a Trump, Clinton or Sanders presidency affects the markets in the short and long-term? I wish I had the answer. Shorter term, this election cycle seems to be injecting more uncertainty and markets hate uncertainty. Fortunately, uncertainty creates opportunity.
II. How did the precious metals market awaken from its three year slumber?
The precious metals seem to have begun a new cyclical bull market and the fundamentals are lining up for a potential multi-year move. From July of 2002 through the end of 2015 (before the recent rally), the U.S. dollar had lost 80% of its purchasing power versus gold! The U.S. National Debt level in 2002 was $6.2 trillion. It is now tripled to nearly $19.27 trillion. Presumed Republican Nominee Donald Trump was recently quoted by CNN as saying, “This is the United States Government. First of all, you never have to default because you print the money.” Many deride Mr. Trump for his outlandish comments, but this has been the prevailing attitude since we left the gold standard in the 1970s. Many presidents since the 1970s have pushed for more borrowing. Debt can be a wonderful thing if it is used for productive purposes, such as new plants and equipment, rehabilitation of aging infrastructure and other projects that could make an entity run smoother or faster. However, it can be an albatross if it is squandered on unproductive or short-sighted endeavors. This isn’t meant to be a political argument one way or the other, just pointing out that policies of larger debt levels have taken hold over the past 40 years and look set to continue globally at least a few more years.
My expectation is that any further slowing of the U.S. economy under either presumed presidential candidate would be met with additional stimulus via Federal Reserve quantiative easing or large fiscal spending plans to put people “back to work” via infrastructure upgrades. That costs money that the government doesn’t have, so of course it would be borrowed. While I do think that could be a very good use of funds, it is borrowed money nonetheless adding to our indebtedness.
For centuries gold and silver have been used as a store of wealth and both have provided citizens diversification in times of inflation and deflation by generally keeping purchasing power at least constant if not increasing it. That ability alone, could make the precious metals attractive if the Federal Reserve is not able to “escape” from their low, no and negative interest rate environment.
Last year, the hatred of the precious metals as a barbarous relic, and the mining companies as uninvestable was the prevailing narrative. Pierre Lassonde, chairman of Franco Nevada and board member of New Gold, is often considered one of the gold market’s greatest investors. At that time, he was interviewed in Grant’s Interest Rate Observer and described the current investment sentiment as “It’s the worst I’ve ever seen in 30 years… I’ve never seen gold equities trading at such a low valuation in 30 years.” Often it is only when something becomes so widely despised, feared, or dreaded, that an investor get the opportunity to buy it at a wide discount. The more out of favor it is the greater the discount. The greater the discount, the greater the potential return.
I have often stated that once the miners turned higher, the move could be explosive…and that is exactly what has happened so far. In my opinion, the reason is that when the price of gold rises, most of the increased revenues from selling gold go straight to the mining companies’ earnings. When gold declines, the opposite happens. As gold moved lower from 2013-2015, the managements of mining companies took all kinds of steps to cut costs and streamline their businesses. They limited exploration, they laid off workers, the renegotiated contracts and divested underperforming businesses. The result were ultra-lean companies, whose earnings could explode when gold prices made the turn. That was my primary reason as to why the potential in those that survived could be so large.
As seen in the chart below, the Philadelphia Gold and Silver Index has rallied 144% off its lows to the recent highs. It is now correcting and working off an overbought level. Currently off 11% from its high, my target is for a 22.7% total correction in the mining index that may set the stage for the next rally. We are already half way through this correction in my opinion.
One of the many metrics I look it is the Gold/XAU ratio. It is a ratio of gold and silver mining stocks to the price of gold. As I am sure you know, mining companies are many more times volatile than the underlying price of gold and silver so they can wildly shoot above or below fair value. Here is a chart of the ratio going back through time. As you can see, at the turn of this year, gold mining stocks as compared to the price of gold were as cheap as they have ever been.
From 1984 when the index was created through 2008 before the financial crisis, the average ratio was 3.5X to 4X. During the crisis it exploded to 12X, meaning mining stocks were 3X cheaper compared to the price of gold than before the financial crisis. After both gold and mining stocks accelerated higher from 2008 -2011, that valuation closed to 6X. Since that point, the ratio got worse and worse for mining companies before peaking at 28X this winter. The recent rally in mining stocks has closed that gap back to 14.57X which is still above the valuation during the peak of the financial crisis.
Just to move back to pre-financial crisis levels, this mining index would have to rise another 150% without gold increasing at all. For those that think they missed the move, I don’t believe you have. While nothing moves in a straight line, and there will assuredly be volatility, I believe we are only in the first inning of the next move and it could be explosive. If you would like to discuss exposure to this industry, as always please reach out. It is important to note that precious metals companies may experience heightened volatility in times of stress. Due diligence should be done as not all companies in this industry are created equally. I believe the high quality companies, with significant assets, and proven management should be very successful as the bull market resumes.
The past two years have been tough on anyone investing in the sector. Those who regularly added to their positions during the 2014 and 2015 sell-off were greeted with even further weakness. It is not uncommon to have questioned the strategy of buying a cheap asset that kept getting cheaper. But, for those who did, the rewards so far have been quite impressive. The pressure of holding onto or adding to declining positions even if you believe in the positions can become overwhelming. As I am sure you know, much of investing is emotional. There are ways to attempt to reduce one’s emotional impact on their decision making but that is very hard to accomplish. Everyone knows that buying low and selling high is one of the keys of successful investing, yet it is also one of the hardest things to do. Often, perserverance can lead to great success. This may be another lesson that buying industries that are on sale has the potential to lead to more positive outcomes. In my opinion, we are setting the stage for the second act of this secular bull market in precious metals.
How much of your portfolio should be allocated to this asset class? That of course depends upon your personal financial situation, risk tolerance and time horizon. Billionaire investor Paul Singer advised having gold as 10% of one’s portfolio. Last year, Ray Dalio, the founder of the largest hedge fund on earth, Bridgewater Associates said, “If you don’t own gold…there’s no sensible reason other than you don’t know history or you don’t know the eocnomics of it.” In early May at the Ira Sohn investment conference, legendary investor Stan Druckenmiller told attendees” The conference wants a specific recommendation from me. Gold remains our largest currency allocation.”
If a new bull market is gathering steam, higher prices will most likely induce others to begin buying. Supply is limited. According to Fred Hickey, mining companeis are forecasting an average 7% decline in production this year thanks to the aforementioned lack of investment in exploration. If history is any guide, and we are in a five wave rally upwards, we seem to be in the wave 2 correction at the moment. When complete, it could usher in the most powerful wave of this rally (wave 3 up). According to Agnico Eagle’s CEO, the next $200 rise in the price of gold, from $1300 to $1500 oz. is where you will really see the gain in corporate earnings. So far, in Q2, the average realized gold price in London is $1,250 oz. In a stock market where many areas are sporting declining earnings, this may well be a sector that sports positive earnings surprises.
III. MARKET ACTION
I think it makes sense to continue to update these charts as we move forward because they may help in the efficient deployment of hard earned savings in the coming year. I believe that markets don’t move in straight lines. Markets like life, are cyclical. Fortunately, one can use market action, sentiment levels and momentum to provide clues where we might be in a given market cycle. This chart of the S&P 500 shows key support and resistance levels of the stock market.
You will notice that by watching the top and the bottom indicators they may give you signals of the markets being overbought and oversold in the short term. This helps give an idea of where we are in the move.
It looks like to me that we may be in the beginning of a larger move lower, but for now, the support level of the 2015 and 2016 sell-offs has held. We seem to be in the latter stages of a bounce that pushed through resistance but has now become overbought. I will be watching to see if in the next correction if we can stay above that 2,000 level on the S&P 500.
Next is a three year chart of the S&P 500 going back to 2013.
You can see how the chart appears to be rolling over in a topping process. Each time the market reached oversold conditions it bounced back up. Further, each time it sold off it stopped at the 1,880 weekly closing level. At that 1,880 level the market would be 12% below its all-time high. A weekly break of this level would signal to me a more nasty bear market is unfolding and increased risk management may be necessary. Investors would be wise to use the bounce we are getting to make sure they are not too risky for their tolerance to withstand volatility.
And finally lets go back and look over the past twenty years.
In the past, this chart has been able to show deterioration in the markets prior to the market sustaining major losses. This long term chart’s sell signal is still in place despite the recent market bounce. If you are an investor that was able to hold through the previous downturns, didn’t panic and even added to your risk positions then you should be fine. But, if you are at all concerned I feel as though this bounce may be the last, best chance to re-position your portfolio if something worse is afoot.
IV. MONSOON REGION
In the developed world we take cellphones and what they do to make our lives easier for granted. We are about as close to 100% cell phone penetration in the U.S. as we will get. Even those in poverty are given phones by our government. Those that don’t have cell phones at this point do so for their own reasons. In China, cellphones have a 92% penetration rate. But, what about India? As seen below, in Oct. 2015, India crossed 1 billion cell phone users but currently only 74% of the population has a cellphone. I will go out on a limb and say that number will rise significantly in the next decade.
The Indian government remains committed to setting up digital infrastrucuture and promoting its use. According to KPMG and IAMAI, there were approximately 82 million 3G cellphone subscribers in India by the end of 2014. That number is currently 220 million according to Counterpoint Research and projected to reach 284 million by the end of next year.
India has the third biggest internet user base in the world and roughly 50% are mobile only! India recently passed the U.S. to become the second largest smartphone market in the world. The key to this story is that many in India are bypasssing a step that virtually all of us Americans took. We began accessing the internet from a desktop PC. Then many of us used laptops and finally mobile phones. As smartphones increased computer power, we now perform many functions on them previously reserved for PCs or laptops. Nowadays, there is very little that can’t be done on a high end smartphone.
Many in the Indian population are bypassing desktops and laptops all together. They are moving from no internet access to full acccess via their mobile smartphone and a world of information and commerce is becoming available.
There are a number of investment implications of this movement to be aware of. The first is the amount of data that will be passed through their network. Similar to how things are here. Very few understood a decade ago how much data would move over the internet. Remember, back then Blockbuster was still a large, profitable company. Now we consume content as much on phones and tablets as we do on PCs. I think Indian telecom companies as well as international ones serving that market will see data usage go through the roof in the next five years. According to the Times of India, Indian telecom companies have installed 200,000 cellphone towers in the past 15 months and every third minute a tower is being installed. “What has been done in the past fifteen months has not been done in past 20 years,” Kapil Sibal, advocate for telecom. The telecom and tower sector may stand to profit handsomely from this emerging trend.
Furthermore, currently only 50% of Indians have a bank account according to the Reserve Bank of India. What is interesting is that the Indian people are moving from traditional branch banking, bypassing the desktop PC and going straight to mobile banking. In fact, many Indians first experience banking is not in a branch but on a smartphone. It took an American commercial to open my eyes to what was right in front of my face. It was a commercial in which a rural, Indian business was conducting transactions via a mobile smartphone. The business owner didn’t use a branch, yet was brought out of the barter system to the banking system by smartphone technology. According to Deepak Sherma, head of digital banking at Kotak Mahiurda Bank, 125 million Indians opened new bank accounts in the past six months. That is 10% of the population. If this trend continues, Indian banks could be another major beneficiary of this smartphone penetration.
While it seems more and more companies are struggling selling goods to the saturated developed world markets, the countries surrounding the Indian ocean seem to be major beneficiaries of developed market competition. Not just smartphones, but costs of many technologies are being driven down to more affordable levels. If you are looking for potential growth over the next decade I believe it is hard not to believe the story of the Monsoon Region!
V. INVESTMENT IDEAS
- Rather than trying to “beat the market”, focus on beating inflation and the rate on cash. Plan for safety and liquidity while seeking positive returns.
- Equity valuations are very rich but masked due to the distortion of the Treasury curve. Volatility is returning to the markets and I think long/short managers are best positioned to capture this volatility by owning companies with strong businesses, barriers to entry, and good valuations and selling short weaker companies with high debt loads that have risen sharply with the broad market rally. I think this strategy of hedged equity may have the potential to produce attractive risk-adjusted returns if and when investors begin to question the valuations of companies. Stock investing involves risk including loss of principal. No strategy ensures success or protects against a loss. Long positions may decline as short positions rise, thereby accelerating potential losses to the investor.
- (NEW) Monsoon country investments. Attempting to take advantage of demographic, educational and investment possibilities in the countries surrounding the old spice routes of the Indian Ocean
- In 2013, the Affordable Care Act began implementation. There will be many winners and losers in the healthcare industry as a result of the biggest change in the healthcare industry’s history. With the largest portion of the U.S. population entering their golden years, healthcare needs will become even more important. Long/short Healthcare seems to be a very attractive way to invest in a sector with lots of potential and lots of potential pitfalls. Investing in a specific sector involves additional risk and will be subject to greater volatility than investing more broadly.
- Supply problems remain high across the energy asset class. While there isn’t a current shortage of energy on the planet, it is taking more and more energy and capital to discover, drill, transport and refine it. Long term Demand should continue to grow globally, particularly in China, India, and other developing countries.
- Potential food shortages due to inclement weather and higher demand from the emerging Asian middle class could result in a boon to agricultural land and potash fertilizer companies. International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
- Tight supply and a depressed single family home market are combining to keep apartment buildings full while driving rents higher. The number of potential renters continues to expand as a large cohort or echo boomers enters the workforce. Rents have been increasing as the desire to remain mobile and inability to secure home financing keeps renting attractive. In addition, low supply of new rental units should allow this space to flourish. Apartment REITS typically offer dividends and potential appreciation opportunities. Investing in Real Estate Investment Trusts (REITs) involves special risks such as potential illiquidity and may not be suitable for all investors. There is no assurance that the investment objectives of this program will be attained. The payment of dividends is not guaranteed. Companies may reduce or eliminate the payment of dividends at any given time.
- Precious metals mining companies have been extremely beaten down over the past four years. Mining is an industry that spans hundreds of years. Companies that mine for commodities are often highly cyclical, meaning they have sustained moves both up and down. When investing in the mining space it is important to be a contrarian. Ideally, you would want to accumulate miners when sentiment is poor around them and sell them when sentiment is positive. Historically this has been a good strategy.
No strategy ensures success or protects against a loss.
Colin B. Exelby
Celestial Wealth Management
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