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MACRO
MUSINGS:
Time to Buy Gold
Stocks
by Justice Litle
Editor, Consilient
Investor
August 15, 2007
Make
new friends but keep the old.
One is silver and the other gold.
- unknown
Introducing
Quant's Law
GODWIN'S LAW -- more a
theory than a law -- speaks to the inevitable half-life of debate on the
internet. Per Wikipedia, Godwin's Law states the following:
As an online
discussion grows longer, the probability of a comparison involving Nazis
or Hitler approaches one.
The natural corollary
to Godwin's Law is that, as soon as Hitler or the Nazis pop up, the
debate is effectively over. Whoever resorts to the cliché first is the
automatic loser, being clearly void of anything more intelligent to say.
In that spirit -- and
in light of the latest Wall Street disaster -- we propose the following
"Quant's Law."
Whenever a
quantitative fund manager makes reference to a "100 year storm (or
flood)," a "10,000 year event," or an "X standard
deviation occurrence," where X is any double-digit number, the
probability of devastating financial loss approaches one.
Corollary to Quant's
Law: In the financial markets,"10,000 year events"
generally occur every 5 to 7 years.
The inspiration for
Quant's Law comes from David Viniar, Chief Financial Officer of Goldman
Sachs. In reference to the spectacular multi-billion-dollar meltdown of
two quant-driven Goldman funds, Mr. Viniar made apologetic reference to
"25 standard deviation moves, several days in a row."
Twenty-five standard
devations, hmm. How to put such a wild statistic in perspective?
Well, considering it
only takes three standard deviations to cover 99.7% of the bell
curve, we unscientifically estimate the likelihood of a twenty-five
standard deviation move to be on par with Britney Spears getting elected
President of the United States.
Hit me baby one more
time.
Too big for
their britches
The most remarkable
thing about these quant funds (ignorance of history aside) is their
seeming lack of acquaintance with basic market realities. One would
think that rocket scientists (actual rocket scientists!) would have at
least passing acquaintance with the laws of physics; specifically, the
physics of what happens when everyone piles into the same handful of
trades.
One would think so, but
apparently not.
Rick Bookstaber,
seasoned risk manager, accomplished quant, and author of a timely book
called A
Demon of Our Own Design, thinks the problem ultimately comes down to
size. These guys simply let their positions get so big, and so
correlated, there was no one left on the other side. Bookstaber writes:
...in
aggregate these quant funds may be operating beyond the capacity of the
markets... right now that is pretty much true by definition, since it
seems they can't get out of each other's way while they try to
liquidate. But even during less crisis-prone times, the money employed
by these strategies might be more than the market can absorb.
Again we say, hmm.
Shouldn't a minor factor like "how much the market can absorb"
be an integral part of any black box management strategy? Shouldn't the
impact of one's own market footprint be taken into account, especially
when staggering leverage is employed?
In a latticework piece
titled The
Principle of Ever Changing Cycles, we wrote about how the zero-sum
nature of markets resembles the parimutuel structure of the race track.
The "Principle" itself was taken from a half-century old book,
long out of print, called "The Secrets of Professional Turf
Betting" by Robert Bacon.
The flailing quants
(and their investors) would have done well to absorb Bacon's dog-eared
wisdom. Taking huge risks in pursuit of vanishingly small returns rarely
makes sense; it shouldn't take a supercomputer to figure that out. The
old lesson, underscored once again, can perhaps be stated thusly: If
you look around and see everyone doing the same thing you are -- and
doing it in huge size no less -- then SOMETHING IS PROBABLY WRONG.
Time to buy
gold stocks
Moving on from the
quants and their crowded house... let us now enter a nearly deserted
house. We refer here to those few crazy, or contrarian enough, to like
gold stocks at current levels.
The title says it
bluntly. We think it is time to buy gold stocks, and will here present
our basic top down argument as to why. But first, two caveats:
-
We're talking established producers. There are
fortunes to be made in the junior gold stocks, no doubt, but picking
juniors is not a top-down business; it's a rock-kicking business, in
which detailed knowledge of management teams and exploration sites is
key. Our argument here is macro in nature, and applies more to the
"seniors" with proven reserves.
-
This is an investing call, not a trading call. Gold
stocks aren't necessarily about to turn on a dime. They could be yet
lower a week from now, or even a month from now. Still, we feel gold
stocks could put in a triple or quadruple from current levels -- over
the course of months to years -- and it isn't clear when the move will
begin in earnest. Given that it could be sooner rather than later, we
think it's time to buy.
Cash to the
rescue?
Let's begin with a
quick recap of current events.
In the past few days,
we've heard a lot about central banks making emergency injections of
liquidity into the markets. For example, Bloomberg reports:
The
ECB, the Fed and other central banks injected $154 billion into money
markets on Aug. 9 and $135.7 billion on Aug. 10 amid fears that U.S.
subprime mortgage losses will curtail lending.
...Central
banks in South Korea, the Philippines, Singapore, Indonesia, India and
Malaysia have said they are prepared to add cash to their systems if
required to prevent a squeeze on credit...
The
International Monetary Fund said last week that ``prompt action'' by
central banks to add cash to the banking system should help avert a
crisis in credit markets.
"Prompt
action" won't save the day of course. It may ease the pain
temporarily, but that's about it. Show us someone who thinks a modest
injection can fix things, and we'll show you someone who swore things
would never get this bad in the first place.
Inflation still
looms...
Keep in mind that the
global central banks, so ready and willing to avert this crisis with
cash, were up until recently dealing with inflationary pressures... the
result of having too much cash on the books.
Chinese inflation has
accelerated to "the highest rate in more than 10 years," Bloomberg
reports. Australia's central bank has raised inflation forecasts to
"the top of its target range." Official inflation numbers for
oil exporters in the Gulf ran as high as 11.8 percent last year. (Who
knows what the real numbers are.) Russia's inflation is three times that
of any other G8 country. In Europe, Ireland is sweating. (As for the
likes of Venezuela and Iran, don't ask.) And food prices are rising
everywhere, though government statistics deny it; the cost of milk, for
example, just hit record highs in the United States. The beat goes on.
In brief, this pressure
can be traced to two phenomena: the vendor finance arrangement and the
petrodollar pump. The vendor finance arrangement is shorthand for the
"Bretton Woods II" setup in which the United States sent
mountains of dollars to Asian exporters, exchanging paper for
"stuff." The Asian exporters, in turn, extended credit in
pursuit of local job creation.
The petrodollar pump is
a related version of the same, in which oil exporters took paper dollars
for barrels of crude, and then pumped those dollars back into US assets.
In this manner, huge
quantities of money were recycled back through equities and treasury
bonds (fueling the party we just lived through). Those dollars also
exerted slow-building inflationary pressure on the local economies
piling them up. A country taking in truckloads of greenbacks has to
print up currency of its own, you see, as exporters deposit dollars in
the local bank and swap them for yuan, rubles, dinar, etcetera. The only
alternative to printing is letting the home currency rise... which no
one wanted to do for fear of slowing down exports.
...As subprime
goes global
So thanks to their
taste for mercantilist job creation and paper currency accumulation, the
world's central banks are in a tough spot. They have to wrestle with
inflationary pressures in the teeth of a global credit crunch.
And don't assume the
subprime problem is contained to the United States, by the way.
According to some accounts, other countries could have even more serious
issues of the same flavor.
The South China
Morning Post quotes Yi Xianrong, an academic with the Chinese
Academy of Social Sciences, as saying "The quality of housing loans
[in China] are much worse than the subprime loans in the United
States." From his perch in London, Bloomberg columnist Matthew Lynn
adds that "not only does the U.K. face its own subprime crisis, it
could be far worse than in the U.S." And we have seen in recent
days how truly international the debacle has become, with banks in
Germany and hedge funds in Australia getting whacked.
This all feels like the
tip of a credit-contraction iceberg as bleeding creditors turtle up. US
banks now "refuse to accept subprime collateral," the Financial
Times reports; meanwhile the New York Times notes that
high-end real estate properties aren't selling -- even when someone
wants to buy -- because even the worthiest of borrowers are having
trouble securing loans.
Keep it Coming
The point of the above
is not to predict disaster for equities or the onset of global
depression. There is still a lot of money sloshing around. As we wrote a
few weeks ago, in Make
Way for the Sovereigns, Sovereign Wealth Funds by themselves have
the heft (and the cash) to put a floor under the markets if they choose
to do so.
Whether Sovereign
Wealth Funds step up or not, though, we suspect the liquidity will have
to keep coming; financial interventions can be long, drawn out affairs.
As trend follower John Henry has observed, the Fed does not just
"raise" and "lower" interest rates willy nilly. The
tendency is to lower, lower, lower (repeat a few more times)... and
then, when the tide turns, to raise, raise, raise and so on.
The global central bank
pattern for the foreseeable future -- months stretching into years
perhaps -- could be inject, inject, inject as gunshy creditors and
wounded borrowers demand medication.
A Vicious
Circle turns Virtuous
This is where the
enthusiasm for gold stocks comes in.
Up until now -- that
is, up until a few weeks ago -- upside for gold stocks was capped by at
least three negative perceptions.
--
Modest inflation expectations. Food and energy aside, the
general consensus of investors (until recently) was that inflation is
"contained." (Kind of like subprime was contained, eh?) This
belief was supported by the idea that low-wage competitors export
deflation along with low-priced goods, and that global economic growth
is robust enough to outpace monetary growth.
--
High and rising production costs. Mining companies were
simultaneously blessed and cursed by the developing world's insatiable
demand for raw materials; while accelerating demand led to higher metals
prices across the board, it also led to labor shortages, tire shortages,
transport bottlenecks, and killer production costs in general. The high
price of production was seen, correctly, as cutting sharply into gold
miner's profits.
--
Better alternatives in a rosy environment. When the sky is blue
and the sun is shining, who really needs gold anyway? An environment in
which everything is rosy, and inflation appears "contained,"
is not an environment supportive of gold stocks. Better to invest in
emerging markets, multinationals, and private equity takeover plays in
such times... anything linked to the cheery phrase "global economic
boom."
Now consider the
outlook ahead for gold stocks... particularly the possibility that all
three factors could soon be turned around.. Let's revisit each in
turn:
--
Rising inflation expectations. Seeing the worth of Wall
Street's assurances, does anyone trust the word "contained"
anymore? When various central banks are forced to continue injecting
liquidity into the system -- and when the Fed is finally forced to cut
rates -- the growing problem of inflation could reveal itself to all. (A
diving dollar could underscore this also.) The general best-case
scenario, we suspect, is one in which inflation rises quickly but not
too quickly. The worst case scenario is a deflationary downward
spiral... in which case "Helicopter Ben" earns his nickname,
and gold becomes the only stable proxy for cash.
--
Flatlining, or even declining, production costs. The high price
of crude oil is a function of supply and demand; more specifically, it
is a function of the "lack of slack" between daily global
supply and daily global demand. This means that oil is priced at the
margins; any increase or decrease in the amount of slack could have
powerful psychological effect. A short-term decline in demand, from the
United States or elsewhere, could open enough slack in the system for
the price of oil to fall. Oil will eventually just go back up again, of
course, as world demand always comes back around. But if the global
economy takes a breather, we could see temporarily lower energy prices
and lower base metal demand. This relief could lead to lower production
costs for gold miners -- fuel not so expensive, labor not so tight,
truck tires not so hard to find etcetera -- even as general inflation
expectations rise due to stimulus as noted above.
--
More focus on risk in an uncertain environment. In an uncertain
world with storm clouds on the horizon, gold takes on a new luster. If
investors express a desire to stay in equities but avoid financial
tomfoolery, they could well focus on the sectors and industries that are
"derivatives-free," featuring straight forward companies with
unleveraged balance sheets. Gold mining can be an ugly business, but
it's a solid one that the public (and institutionals) can understand.
Not Crowded
So that about sums it
up. Gold stocks previously looked unappealing in a world of high and
rising production costs, subdued inflation expectations, and wanton
disregard for risk. All those factors look set to shift.
If you pull up a chart
of your favorite gold stock right now, of course, you probably won't be
impressed... if anything the chart probably stinks.
That's a function of
being early, we suspect. Everyone is still gawking at the market
carnage, wondering how bad things are going to get. Few are thinking
about the next leg of the cycle, where the money is going to flow, and
so on. Starting with some partial gold positions -- and a full helping
of patience -- allows one to wait comfortably for the crowd to catch up.
Speaking of crowds and
carnage, one last word on those crazy quants. The recent meltdown saw
the phenomenon of good stocks going down even as bad stocks went up. The
WSJ reports:
The
stock market in the past few days has looked like it has gone haywire.
Shares that would have been expected to fall have risen, and shares that
might be considered safe have taken big hits.
Behind
the bizarre behavior: quantitative hedge funds. These funds rely on
computer models to pick which stocks to bet on and which to bet against.
They've been liquidating positions to raise cash. They sold stocks
they liked, forcing prices lower. For the stocks they sold short, the
opposite occurred; to exit from those positions, they were forced to buy.
The point? You can't
trust a crazy market, and charts don't always give the whole picture. If
more funds are forced to liquidate positions over the coming weeks,
there will be an even greater variety of bargains to be had. And,
paradoxically, the best opportunities could temporarily look like the
worst.
Profitably Yours,
Justice
© 2007 Justice Litle
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