Ratios, gold, and reflation

For most people, thinking in terms of absolute returns is natural, thinking terms of relative returns to a benchmark has become acceptable, and thinking in terms of relative returns between asset classes is far off. At it’s simplest, by making an investment from cash holdings investors are making a relative consideration: the investment should outperform cash over the anticipated holding period. Sounds pretty straight forward.

In the past 5 to 10 years, charts showing the Dow vs. gold have been floating around. While it sounds simple, this basic premise is actually at the heart of investing and a focus for macro traders. Currency investors are used to thinking of investments as relative between pairs of currencies, or in complex strategies, relationships between multiple moving yet interrelated parts.

Why all the intro?

Recently, I’ve been speaking to a number of traders and investors about the inflation/deflation debate and it’s implications for investors in the future. One trader (H.T. Macro Man) in particular prompted me with a seemingly simple thought: it’s not whether you’re long or short – it’s WHAT you’re long and short, as massive rotations, rolling bubbles, and inflation/deflation get implemented across and within asset classes.

So today, I want to highlight a couple of the ratios we’ve started exploring with some of the implications:

Everyone knows that gold has been going up.

As it has, if we start looking at other assets priced in gold (I’ll use GLD as a proxy for our conversation) we start seeing some potentially undervalued opportunities.

(Source: The Big Picture)

It doesn’t mean the S&P is cheap, nor gold expensive, but the S&P priced in gold is certainly not as expensive as it was just a few short weeks ago.

But to continue our exploration…

Check out the agricultural sector (DBA used as proxy) priced in gold:

In 2005, Marc Faber discussed asset inflation vs consumer price inflation in his Gloom, Boom, and Doom Report and included a discussion of gold as an inflation hedge. The conclusion was that gold was a better hedge for deflation, perhaps as we’ve seen in the recent action, while agriculture was a better inflation hedge. Could the extension of this ratio signify the end of deflation and the beginning of inflationary pressure?

What about moving away from commodities and looking at some other relationship? As readers know, I’m not a big fan of the euro. Traditionally, bad political structures lead to significant underperformance over the long term. In that light, we have distrusted China, Russia, and the euro (the currency not all European firms). Last week we looked at putting money to work in Greece (while short the euro), which has turned out OK so far, with both NBG and OTE holding up nicely from our entry point. But what about the larger picture of the eurozone countries? I’m still pretty negative long term on the euro, but look at the relationship between EZU vs. SPY:

There is a good chance the relationship will get more extended before reverting, but it’s worth noting that at some point the eurozone countries will become a significantly undervalued relative to the S&P.

Lastly, Gartman brought up this relationship recently and it’s one a lot of traders I know have been looking at: euro/yen. While I’ve been focusing on the euro/usd, and anticipate that it will continue to weaken, euro/yen has broken down after having been in a relatively tight range:

What does it tell us? Money is coming out of the euro and going into yen. Risk is being taken off the table as carry trades are unwound and money is going back into funding currencies. This has obviously been a problem for both the US and Japan which are themselves trying to stimulate inflation. Japan has already announced additional quantitative easing, and the US is sure to follow…which leads us back to where we started…

Money will need to find a home in an environment of competitive devaluation, and while deflationary pressures have “won”, I believe that we are close to a turning point. I anticipate that it will translate into a challenging environment for bonds (increasing rates) and a potential opportunity for agricultural related investments (certainly relative to other asset classes, if not on a local currency basis). I’ll continue exploring implementation methods in the upcoming weeks, but I’ll certainly be looking at the ratios to find the undervalued assets.

Deadly discount rate

We’re reading more and more about research being done in low to negative real interest rate environments. For example, what discount rate should we use for valuations? All the PE deals being struck, what WACC are they using? Who’s financing it at a fixed rate? For that matter, how are the banks figuring out their spreads over LIBOR?

We often go back to the same set of books and principles, and I’m reminded of Ed Easterling’s book Unexpected Returns. We are moving from a period of price stability to instability. It doesn’t actually matter for valuations whether we move towards inflation or deflation – both will be bad for stocks. That being said, I’m heartened by the articles coming out that hopefully provide a reality check. Today, for example, in the Asia Times, David Goldman highlights why a low interest rate environment makes today’s valuations look exceedingly expensive.This article is a great start to trying to measure the sensitivity of stocks to changes in the interest rate – AT THESE RATES. That’s they key. These are still not normal times! Goldman describes a (crude, but effective for order of magnitude) model to measure equity duration (interest-rate sensitivity).

The recovery of the S&P 500 since its March 2009 lows reflects an anemic level of earnings as well as a very low discount rate. A rise in the short-term interest rate (in reality, in the whole yield curve) could take a very big bite out of equity prices. I don’t quite believe that a 2% risk free rate implies a drop in the S&P by half — this is a numerical example rather than a realistic model — but it does highlight the sensitivity to watch out for.

To read the full article (which you should), click here.

Naysayers will tell you a lot of things about imminent recoveries, low relative P/E’s, or forward P/E expectations. I’m still wary of valuations based on unrealistic circumstances and inputs.

Currencies and 1987

Remember the fateful day in 1987? Judging by the profile of most of our readers, probably not, but you may have read about it. So let’s review. Market gyrates. Currencies are exhibiting massive dislocations. Government officials step in (over a weekend) to talk one currency down. Globally, everyone believes that an Asian country will buy up the US (remember the movie Gung Ho?), that US manufacturing is done, and that US workers are fat and lazy. We have the largest housing crisis imaginable looming with the S&L crisis. Yikes! Sounds eerily similar. For those of you who looked into Boom Bust http://www.amazon.com/Boom-Bust-Prices-Banking-Depression/dp/085683243X/ref=sr_1_1?ie=UTF8&s=books&qid=1255459441&sr=8-1 the 18-20 year cycle with mid-cycle slumps should come as no surprise.

And so, while I’m not convinced by this rally in equities at all, I’m equally unconvinced by the decline of the dollar. There is a big disconnect between bonds holding up, declining dollar, rising gold, rising equities, and the macro picture (jobs, real estate, govn’t spending). Some market is sending the wrong signal…I just don’t know which one yet.

Cisco and Travelers replace GM and Citi in the Dow 30

OK. Not surprising. See my previous post on replacements of GM in the S&P 500.

http://www.marketwatch.com/story//travelers-replacing-citigroup-in-dow-industrials