Buy, Sell or Hold? Relax and Don't Panic

 

By Frank Holmes
CEO and Chief Investment Officer
U.S. Global Investors

There’s an old contrarian investing maxim from Baron Rothschild that says “the time to buy is when there’s blood in the streets, even if the blood is your own.” The idea is that the best investors strategize when others panic, allowing them to buy stocks on “sale.” The legend of Warren Buffett was built on this philosophy during the market turmoil of the mid-1970s.

There was more “blood in the streets” Monday as the world continued to digest S&P’s downgrade of U.S. debt, the two-week market selloff, and the likelihood the U.S. economy could possibly slide back into recession. These concerns, combined with continued political/economic struggles in the eurozone from socialist policies, have created a potent concoction of fear across global markets and sent volatility skyrocketing Monday to its highest level since the May 2010 “Flash Crash.” While many investors are running for the exits, others have chosen to ride the wave of volatility or buy depressed shares.

The S&P 500 Index has fallen 15 percent since July. This has happened only fives times since 1960: The 1987 Crash, the Asian financial crisis in 1998 and twice in 2008, according to research from Desjardins. In each of these instances, markets gained an average 9 percent the following month.

The CBOE Volatility Index (VIX) rose more than 46 percent to break the key 40 level, signaling an extreme event. In general, any time the VIX rises above 30 indicates conditions are volatile. Above 40, it’s clear the only thing at a premium in this market is fear.

The S&P 500 isn’t the only investment that’s been experiencing extremes. A flood of safe-haven buying this week sent gold prices up more than $80 an ounce (about 5 percent) to $1,746.73 at market close Friday. Gold prices are up over 43 percent for the past year and roughly 11 percent the past 30 days. The increase over the past month is roughly equal to gold’s normal volatility over an entire year and is a short-term risk for a minor correction in a secular bull market.

Meanwhile, oil (along with oil-related equities) has been bludgeoned down to price levels not seen in a year—off almost 25 percent from April 2011 highs. Other commodities such as copper, wheat and cotton have also taken sizable haircuts over the past two weeks.

Such market turmoil creates a real challenge for investors who are in it for the long haul. Investors must control their emotional response and remain on the lookout for opportunities. Equity performance and fear-driven volatility carry a strong inverse correlation. This chart shows sharp spikes in the VIX trigger an autonomic selloff in the S&P 500. However, these selloffs have historically resulted in strong rebounds, thus providing an opportunity for clever investors who like to buy their summer clothes during a winter sale and their winter clothes during the summer.

Before Monday, the VIX closed above the 40 level five times since 1995, and in all but one occurrence the market was at higher levels just three months later. The exception is 2008, when the VIX passed 40 on its way to 90 and remained elevated for months during the worst financial crisis since the Great Depression.

You can see from the table that the market has rebounded roughly 6 percent on average over the three-month period after hitting the 40 mark. Short-term reactions are more mixed. The market has swung 11 percent in either direction during the next month of trading and the average gain is only 80 basis points.

For the purposes of this exercise, the analysis is based on weekly data from August 8, 1995 through August 8, 2011. There were stretches of time, such as in 2008, when the VIX remained above 40, but we’re only counting the initial breach.

With this in mind, investors must remember there are some good opportunities out there and we’re working relentlessly to find them. Some of the best are in great American companies, whose balance sheets are the envy of Washington, with many carrying dividend yields above the 10-year Treasury bond. Currently, the 2.18 percent yield for the S&P 500 is the highest level since July 2009, Desjardins says.

A similar phenomenon took place following banking crises in France, Sweden and the U.S. during the 1990s. Without the ability to tap banks for additional capital, companies moved to large positive cash-flow positions and self-financed their growth, according to GaveKal research. These strong capital structures provided the foundation for the market’s bull run during the back half of the decade.

This opportunity has largely been ignored as investors have fled like lemmings to the “safety” of cash, government bonds and money market funds. These investments “afford zero prospects for capital gains and only microscopic income,” says Murray Pollitt from Pollitt & Co.

This mad dash for cash is driven by fear and investor desperation to preserve their money rather than make any. Naysayers have been flippantly labeling gold a bubble since it reached $500 an ounce, but have turned a blind eye to the unprecedented amount of “money pouring into government bits of paper” that is the “biggest bubble of all time,” says Pollitt.

History is filled with cycles and each asset class carries its own DNA of volatility. Those who are highly leveraged or those forced to sell in order to raise capital are experiencing the most pain right now. Investors not in those two camps must remember that the markets are cyclical, just like the tide, which comes in and out each day, and the moon, which cycles every 29 days.

We expect gold to continue its pullback in the short-term as prices have become overextended. However, the long-term story remains firmly in place. HSBC says “If history is any judge, the decade-long gold rally will not end until sovereign risks—inside and out of the U.S.—recede.” The yield spreads for the majority of PIIGS (Portugal, Italy, Ireland, Greece, Spain) are well above historical norms, signaling the market has little confidence their sovereign debt issues will be solved any time soon.

Gold also measures out at relatively low levels when compared to other measures of economic growth/wealth over the past several decades. The chart on the left from Deutsche Bank compares gold prices relative to the S&P 500. Even though gold has appreciated against equities over the past decade, it is significantly cheaper than it was during previous bull runs in the 1930s and 1970s. Assuming no change in the S&P 500, gold prices would have to appreciate to $6,400 an ounce in order to reach the peak levels of the 1980s, according to Deutsche Bank.

Gold also has room to run before reaching a new high relative to G7 per capita incomes. Since 1970, an average consumer in one of the G7 countries (Canada, France, Germany, Italy, Japan, the U.K. and the U.S.) has been able to buy 69 ounces of gold with their annual income. Current G7 incomes would purchase only 26 ounces if gold prices averaged $1,550 an ounce. In order to reach lows set in the 1970s, gold prices would have to rise to $2,410 an ounce.

This week, HSBC said gold can rise to $1,850 an ounce this year and average $1,625 an ounce in 2012. One area that could directly benefit from gold prices maintaining such historically high levels is gold equities. The share prices for miners have lagged bullion significantly this year, pushing the gold-to-XAU ratio to the second-lowest level in nearly 30 years in June. Gold stocks also have a history of performing well when the U.S. economy hits a bump in the road. Depression-era babies might remember gold stocks’ strong performance during the 1930s.

This lag sets the stage for a possible strong rally in gold equities relative to bullion once mean reversion to historical levels kicks in, just like it has done time and time again. Desjardins notes that one current catalyst for a rebound in gold stocks is increased profitability from rising gold prices and decreased input costs due to oil’s 28 percent decline off of 2011 highs.

In addition, many quality gold companies are “paying investors to wait” by increasing dividend yield rates above those of money funds. This creates a cash incentive to hold shares of the company and allows investors to participate in rising earnings.

A key question for the global economy is: Who will lead a recovery in global markets? Where will growth come from?

With trillions of dollars in debt acting as a ball-and-chain for much of Europe, the U.S. and the rest of the developed world must detoxify their balance sheets before hitting the ground running. On the other hand, emerging market economies carry low levels of debt and operate like a cash business, making them the final frontier for strong economic growth.

A key reason is emerging market governments have the long-term policies in place to facilitate growth of their economies. GaveKal points out it’s unlikely we’ll get a second dose of large stimulus like we did in 2008-2009 because of inflationary pressures, but that magnitude of assistance isn’t needed. Because China and other emerging market governments focused their stimulus on job creation and infrastructure development, their roads to economic growth have already been paved.

This will allow them to flex their economic muscles during short-term instability and insulate them from the turmoil. This is why we think emerging markets will continue to shine for many years to come.

Take China’s $300+ billion commitment to construct a nationwide high speed rail network, for example. The project is already paid for and will invigorate consumption across all sectors of the economy by connecting 700 million people across 250 cities. The recent accident was a terrible tragedy but the country is not going to abandon its plans. Rather, China will learn from the setback and push forward with better safety standards.

While the investment herd rushes into CDs and other “zero” yielding investments, nimble-minded investors can use these cycles to seize current opportunities and position portfolios for when the bull market tide returns.

What are you or your clients doing? Buying, Selling or Holding? Let us know at editor@usfunds.com.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor.

Chicago Board Options Exchange (CBOE) Volatility Index (VIX) shows the market's expectation of 30-day volatility. The Dow Jones Industrial Average is a price-weighted average of 30 blue chip stocks that are generally leaders in their industry. The S&P 500 Stock Index is a widely recognized capitalization-weighted index of 500 common stock prices in U.S. companies. The Philadelphia Stock Exchange Gold and Silver Index (XAU) is a capitalization-weighted index that includes the leading companies involved in the mining of gold and silver.

 

Index Summary

• The major market indices were lower this week. The Dow Jones Industrial Average lost 1.53 percent. The S&P 500 Stock Index decreased 1.72 percent, while the Nasdaq Composite fell 0.96 percent.
• Barra Growth outperformed Barra Value as Barra Value finished 2.60 percent lower while Barra Growth decreased 0.91 percent. The Russell 2000 closed the week with a loss of 2.40 percent.
• The Hang Seng Composite Index finished lower by 6.06 percent, Taiwan fell 2.75 percent, and the KOSPI declined 7.74 percent.
• The 10-year Treasury bond yield closed 30 basis points lower at 2.26 percent.

 

Domestic Equity Market

 

The domestic stock market was volatile this week with the S&P 500 Index losing 1.72 percent. The figure below shows the performance of each sector in the index for the week. One sector managed a small increase, and the other nine sectors declined. The best-performing sector for the week was materials which increased 0.23 percent. Other top-three sectors were healthcare and technology. Financials was the worst performer, down 5 percent. Other bottom-three performers were energy and telecom services.

Within the materials sector, the best-performing stock was CF Industries Holdings, which rose 14.69 percent. Other top-five performers were Newmont Mining, Monsanto, Sigma-Aldrich, and Praxair.

Strengths

• The fertilizers & agricultural chemicals group was the best-performing group for the week, up 6 percent, led by CF Industries Holdings. The U.S. Department of Agriculture lowered its U.S. corn and soybean production forecasts sharply this week. This news was supportive of agricultural product prices and fertilizer equities.
• Three of the top-ten outperforming groups were real estate investment trusts (REITs). Residential, retail, and office REITs rose between 3 percent and 6 percent. At least two brokerage firms published reports pointing out that the spread between the dividend yield on REITs and the yield on the 10-year U.S. Treasury note is above the historical average spread, implying that REITs are attractive.
• The broadcasting group outperformed, gaining 5 percent. All three of the group members (CBS, Discovery Communications, and Scripps Networks Interactive) reported earnings the prior week which exceeded the consensus analysts’ estimates.

Weaknesses

• The education services group underperformed, losing 10 percent, led down by Devry. The for-profit educational firm warned that new student enrollment is lagging due to the economy, new government regulations regarding higher education, and an industry-wide reversion toward historical levels of enrollment after several years of exceptional enrollment growth.
• Several financial-related groups (regional banks, investment banking & brokerage, thrifts & mortgage finance, real estate services, and other diversified financial services) underperformed, falling from 8 percent to 11 percent.
• The construction materials group lost 10 percent, led down by its single member, Vulcan Materials. A major brokerage firm reiterated its “sell” rating on the stock, citing macro concerns and the uncertain impact of government spending on infrastructure continuing to weigh heavily on the stock.

Opportunities

• There may be an opportunity for gain in merger and acquisition (M&A) transactions in 2011. Corporate liquidity is high, thereby providing the means to pursue acquisitions.

Threats

• A mid-cycle slowdown in the domestic economy would be negative for stocks.
• An escalation in concerns over sovereign debt obligations in Europe would be negative for stocks.

 

The Economy and Bond Market

 

Treasury bond yields fell sharply for the second week in a row as U.S. debt was downgraded by Standard & Poor’s (S&P), European banks were beset with rumors that additional capital would be needed and the Fed stated that short-term interest rates would be unchanged for the next two years. Financial markets were extremely volatile this week, primarily driven by rapidly escalating fears surrounding Europe’s never-ending debt crisis and building concerns that a recession could not be ruled out.

In an interesting twist, the U.S. downgrade appears to have sent investors into Treasuries, sending yields much lower as investors were concerned additional sovereign downgrades would soon follow.

Strengths

• Retail sales for July rose 0.5 percent and got the third quarter off to a reasonably strong start.
• Initial jobless claims hit a four-month low, signaling stability in the job market.
• Foreclosure filings fell to the lowest level in nearly four years.

Weaknesses

• S&P downgraded the U.S. credit rating to AA+. Related agencies, such as Fannie Mae and Freddie Mac, were also downgraded.
• The University of Michigan Survey of Consumer Confidence dropped sharply, hitting the lowest level since May 1980.
• Global economic data remains generally weak. For example, Chinese industrial production was weaker than expected and Indian car sales fell 15.8 percent in July.

Opportunities

• With the economy weak and concerns brewing about an additional financial crisis, the Fed will remain accommodative for some time and bonds appear well supported in the current environment.

Threats

• There is a crisis of confidence in world leaders at the moment and the potential for another financial crisis is rising.

 

Gold Market

 

For the week, spot gold closed at $1,746.95, up $83.15 per ounce, or 5.0 percent for the week. Gold equities, as measured by the Philadelphia Gold & Silver Index, rose 5.4 percent. The U.S. Trade-Weighted Dollar Index was essentially unchanged for the week.

 

Strengths

• As reported on Mineweb, precious metals analyst David Morgan anticipates that silver could reach $65 to $75 an ounce. He attributes the main demand for silver coming from the East, where silver demand is growing for both industry and as an investment.
• Year-to-date, demand for silver in China and India is up 30 percent. Silver demand in China and India has increased sharply in recent years as more investors use silver as a store of value. About 70 percent of China’s silver demand comes from the industrial sectors. Albanian Minerals President and CEO Sahit Muja said, “Silver demand in China and India is set to rise 40 percent in 2012.”
• Reuters reported that gold available in exchange for cash has been drying up as prices are rising even higher. In Mexico City, it has been noted that fewer customers have been coming into the shops that buy bullion from local residents. The success of the cash-for-gold industry over the past three years has left fewer and fewer people with any “old gold.” For those who did cash out in 2008, they missed a three-year bullion boom in which prices doubled.

Weaknesses

• On Thursday, exchange operator CME Group raised margin requirements on gold futures by 22 percent, to $5,500 per contract from $4,500 per contract, which is the first time gold margins have been raised since November 15, 2010. Following this announcement, we saw gold settle to $1,764 per ounce.
• Rising margin requirements put a damper on gold prices on Friday, too, with prices slipping another $17.
• Overall, the gold stocks held up pretty well with the pullback in bullion prices.

Opportunities

• Eric Sprott believes gold has been the metal of the past decade, while silver is the metal of the decade to come. He says there is a large imbalance between demand and supply and that the metal is set for a major re-rating which will, in turn, bring the gold-to-silver ratio down to much lower levels.
• BlackRock’s investment strategist, James Holt, has said that the group will use profits from gold and bond investments to shop for bargains among the falling global equity markets. He stated that the firm will be seeking to put its resources into asset classes that are getting cheaper and cheaper, namely equities. BlackRock, one of the world’s largest money managers, holds 5 percent of its $83 billion global allocation fund in gold equities and gold exchange traded funds (ETFs). This could have a substantial positive effect on the gold equity market.
• Goldman Sachs and JP Morgan raised their gold price forecasts for the year, expecting the commodity to continue its surge as the sovereign debt issues in the U.S. and Europe intensify. JP Morgan now expects spot gold to soar to $2,500 an ounce by year end.
• Investors have been flocking to seek refuge in bullion amid economic concerns triggered by a downgrade of the U.S. debt.

Threats

• The last time we saw increased margin requirements for silver, just over three months ago, we saw silver fall from close to $50 an ounce back to below $34. Depending on market response, this scenario could be a possibility for gold as well, although there was much more leverage in the silver space compared to gold.
• The Ecuadorian President Rafael Correa has said that his government is demanding that mineral companies pay an 8 percent in mining royalties before “starting to extract the mineral.” His main driver behind this new policy is to assure that mining operations are “environmentally friendly and socially responsible,” with residents of the cities, parishes and communities near mining projects being the primary beneficiaries. Royalties to the extent of 8 percent have never been seen before and can make a project potentially uneconomic.
• Resource nationalism is one of Ernst & Young’s main concerns in its list of top ten risks facing the mining sector. As many governments struggle with budget deficits, the continuing boom in commodity prices has made the mining and metals sector an easy target as a source for increased revenue.

 

Energy and Natural Resources Market

 

 

 

Strengths

• Despite this week’s late pullbacks in gold and equities, our Global Resources Fund outperformed for the week. The fund has also taken on a defensive position, focusing on the food and agriculture sectors, which have historically shown positive performance during uncertain times.
• Global sovereign uncertainty has caused investors to seek refuge in bullion, driving the price of the precious metal to new highs.
• Fertilizers, natural gas and chemicals were among the top half of the better-performing sectors this past week. The fund was able to make positive gains from exposure to these sectors.
• Oil rose on Friday, paring this week’s decline, and reversed losses as European equities and the U.S. stock-index futures climbed.
• Silver-buying in China and India is set to rise 40 percent in 2012. Industrial demand is the main driver coupled with the devaluation of the dollar. Economic problems, political tensions, inflation and exchange rates are additional factors contributing to rising silver prices. Silver demand in both countries has increased sharply in recent years as more investors use silver as a store of value.

Weaknesses

• Oil tanker stocks and the construction material and steel sectors were among the bottom-half performers this past week. These sectors continue to perform badly relative to other resources.
• Industrial metals suffered sharp liquidation on commodity trading advisor (CTA) and hedge fund selling. If the market repeats the 2010 second-quarter correction of 17 percent, this will indicate that copper could fall to $8,150.00 per ton.
• This week saw a couple of mergers and acquisitions fall apart. Among these, Coal India’s $1 billion plan to acquire Indonesia’s Golden Energy unraveled due to government approval complications and unfeasible numbers. Negotiations between Peabody and Arcelor, who are both biding for Macarthur Coal for a total of $5.2 billion, have been reported as turning hostile.
• Lackluster results in terms of South Africa’s output for the month of June were published. Gold output fell 5.7 percent in volume terms while mineral production fell 0.7 percent. Production of non-gold minerals was flat compared to last year.

Opportunities

• China’s July auto sales were up 6.7 percent. Year to date, total sales of commercial and passenger cars rose 2.2 percent.
• Analysts at Macquarie believe that a combination of factors, led by Chinese demand, offer fundamental support for steel at current price levels. With steel being a benchmark of economic development, the recent concerns over economic growth and sovereign turmoil have made many concerned about the near-term future for prices. They say it is unlikely to worsen and may well hold up better than more championed peers.
• On August 11, the USDA cut its U.S. corn and soybean production forecasts sharply, on lower acreage and yields. With weather disappointing during both the U.S. planting and growing season, prices will need to rally further to adjust demand down to the lower available supplies. This suggests that agricultural prices will continue to hold up relatively well in a slowing economic environment.
• Vale South Africa Exploration, a subsidiary of Vale Inco, the second-largest metal mining company in the world, acquired an industrial mining exploration license in Ethiopia last week.
• Canaccord stated that the projected tight supply-demand environment "should underpin investor confidence that copper prices of $6,600 and above are now simply normal.” Outlook for copper prices looks robust going forward because of tight supply as medium-term demand is higher than projected capacity.

Threats

• Concern over Namibia’s mining tax plans continue to surface. The Namibian government’s proposals for additional taxes on mining could shake the foundations of the country’s industry, according to industry players in the southern African state. Windhoek analysts estimate that the impact of the new taxes on mine profits could be as much as 15 percent.
• Continuing European sovereign turmoil may continue to negatively affect commodities.

 

Emerging Markets

 

Strengths

• China retail sales in July were up 17.2 percent year-over-year, and 1.26 percent month-over-month. Investors in Hong Kong and the Association of Southeast Asian Nations (ASEAN) stock markets have supported the stock price of consumer stables and luxury goods.
• China’s July industrial production was up 14 percent year-over-year, and 0.9 percent month-over-month, showing China is in a safe soft landing.
• China’s July exports were up 20.4 percent year-over-year, while imports were up 22.9 percent. July’s export numbers broke the monthly export record set in June. In spite of slowing growth in the U.S., Europe, and Japan, China export numbers show some hopeful signs that global trade is still resilient. From January to July, China’s total global trade surplus was $76.2 billion, but China runs a $29.5 billion trade deficit with Japan, and $12 billion with ASEAN countries.
• Korea’s central bank left its benchmark interest rate at 3.25 percent.
• China’s renminbi (RMB) rapidly appreciated during the week. The RMB, for the first time, closed at 6.3898 to the dollar. While a strong RMB is making Chinese consumers and corporations richer, it also helps other countries to sell more to China. Particularly in a world where there is a lack of growth, this will be able to help the U.S. and European countries with their economic recovery. A strong RMB is also positive for commodity producers, Chinese airlines, and Chinese tourism.
• China fixed asset investment grew 25.4 percent from January to July, showing robust activities.
• The Turkish Statistical Institute announced the industrial production indices for June 2011. The industrial production index increased 6.7 percent in June 2011, compared to the same month of 2010.
• Walmart, the world’s largest retailer, is said to be exploring a bid for Carrefour’s Brazil business to help bolster its scale in Latin America.

Weaknesses

• China’s July CPI was 6.5 percent, 0.01 percent higher than in June. Pork alone contributed 1.46 percent to the monthly number. Economists and analysts believe China’s inflation has peaked and expect CPI to come down slowly. This may not force the People’s Bank of China to further tighten the money supply by raising interest rates, but it won’t be enough to make the central bank ease the current policy. However, China’s National Development and Reform Commission (NRDC) said, after the inflation number was released, that China’s inflation is at an inflection point. It further said that China’s economy will be able to make a soft landing.
• China’s auto production and sales in July were up 1.26 percent and 2.18 percent year-over-year, respectively, but were down 6.69 percent and 11.19 percent month-over-month, respectively. Passenger car sales were one million units in the month, up 6.74 percent year-over-year, but down 8.78 percent from June.
• Hong Kong’s second quarter GDP grew 5.1 percent, less than the market estimate of 6 percent. Hong Kong residents are buying gold and houses to protect their wealth under the pressure of the dollar’s weakness.
• The combined outflows from all emerging market funds was $7.8 billion, with total outflows of $14 billion year-to-date. Country-wise, Russia saw the largest redemptions over the last 60 days.

Opportunities

• China tax revenue is increasing as a percentage of GDP and in absolute amount. Normally, higher tax income may not be a good thing for the economy, but this time is different. This huge revenue can provide the Chinese government with the means to handle the economy in case the global economy retreats into recession.
• Poland’s inflation rate unexpectedly fell in July on lower food prices, adding to arguments for the central bank to hold off on tightening monetary policy for the rest of the year.
• Finance ministers from across South America are discussing the creation of a fund to provide the region a safety net and ward off the effects of the global financial crisis, Brazilian Finance Minister Guido Mantega said. Officials are meeting in Buenos Aires to discuss creating a new stability fund or strengthening an existing mechanism, known as the Fondo Latinoamericano de Reservas. The $4 billion FLAR pools foreign currency reserves from five Andean nations plus Costa Rica and Uruguay to help member nations that run into balance of payment problems.

Threats

• Chinese premier Wen JiaBao asked the Ministry of Railway to lower the speed across all the high speed trains. China is now suspending approval for new rail projects. In addition, rumor has it in China that the government will reduce 20 percent of the affordable housing units planned for 2012. These events will affect the demand for building materials, such as steel and cements, and will be a headwind on the sector in the short term.
• Due to the U.S. government debt fiasco and European sovereign debt crisis, the probability for the world to go into a recession has increased. The market, therefore, is reasoning that the global economic environment may make the Chinese central bank think twice before implementing another rate increase, or not increase the rate at all. Should the PBOC go ahead and increase interest rates this month, the market likely will become volatile.
• Ukraine is keen to revise its Russian gas contract, looking for another $100 per cubic meter discount to Russian gas prices, which would bring Ukraine down to levels paid by Belarus. The discount would cost the Russian gas monopoly Gazprom $4 billion by JP Morgan estimates.
• Colombia is “very worried” about the possibility that the U.S. Federal Reserve will start a third round of asset purchases, known as quantitative easing, to boost the economy, Finance Minister Juan Carlos Echeverry said. He is worried that should the Federal Reserve do so, “It could bring another phase of the currency war.”

 

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