July 13, 2011

Gold – Is it a Bubble?

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 9:23 PM by Robert Barone

Is the price of gold too high?  Too low?  Is it in bubble territory, ready to drop rapidly?  Think about what bubbles are – you know there is a bubble when everyone is trying to participate.  For example, during the dot.com bubble, my tennis pro was buying and selling options several times per day!  I knew we were in a bubble.  I even told him so.  And, during the housing bubble, all of the chatter at cocktail parties was about flipping houses as a side business.  I knew we were in a bubble (just didn’t know how frothy it really was!)  People say to me all of the time when I talk about gold: “I would love to own gold, but its price is just too high.”  Hmm!  Too high relative to what?

The price of gold certainly can be fickle.  After all, unlike other commodities that are essential inputs into some vital process (e.g. the production of energy or food), besides some very minor industrial applications, gold really has few practical uses (jewelry and art excepted).  There is nothing intrinsic in gold to give it value.  There is no cash dividend or earnings.  It goes up and down in value at the whims of investor demand.

Gold does have three characteristics that make it unique: 1) it is rare and hard to find (all the world’s gold is estimated to fit into two Olympic sized swimming pools); 2) it doesn’t change form – all of the gold ever mined is still with us as gold; 3) it cannot be “produced” via the combination of other materials.  Thus, its supply is well defined and increases very slowly and at great expense.  Thus, it is perfect as a medium of exchange or a store of value.

We all know what makes the demand for gold go up – distrust in fiat currencies, and government deficits resulting in paper money printing.  And that, of course, is why gold is rising in value today.  As long as that goes on, the price of gold will keep on rising. So, what could happen to make it fall in value?  I have listed several things below which could happen – I will let you be the judge of their likelihood:

  • The U.S. and the rest of the developed world (Europe) stop running fiscal deficits and stop printing money.  There is an immediate opportunity for this to begin in the U.S. if the GOP and Obama Administration can agree on significant spending cutbacks.  This means entitlement reform.
  • The U.S. economy magically finds its feet and its growth rate increases such that the unemployment rate begins to rapidly fall without additional monetary or fiscal stimulus.  Interest rates would be rising too.
  • As a subset of the above, housing prices find their bottom and begin to rise with home sales and new home construction picking up.
  • The dollar reverses is slide as the premier world reserve currency and becomes demanded because of its intrinsic strength, not just because it is better than all of the other bad alternative currencies (e.g., the Euro). (This requires fiscal and monetary discipline and a reduction in both public and private debt loads.)

As long as gold is viewed as the ultimate monetary unit, its value will increase (decrease) with the debasement (strength) of the fiat currencies.

Robert Barone, Ph.D.

July 13, 2011

Robert Barone is a Principal and an Investment Advisor Representative of Ancora West Advisors LLC, Reno, NV, a SEC Registered Investment Advisor.The mention of gold, commodities, or similar investments in this article should not be considered a recommendation to sell or purchase any commodity or similar investments mentioned.  Please consult an investment professional on how the purchase or sale of such investments can be implemented to meet your particular investment objective or goals.   Investments in gold, commodities, and/or similar investments are subject to risks.  It is important to obtain information about and understand these risks prior to investing.

 

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July 12, 2011

Italian Contagion

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 9:17 PM by Robert Barone

Just a couple of weeks ago, with the supposed “solution” to the Greek crisis, many market participants thought that the politicians had bought at least several months of relief from the European debt crisis.  But, just as the markets attacked the stocks of both Morgan Stanley and Goldman Sachs after the failure of Lehman, it should have been expected that the markets would go for the European Monetary Union’s (EMU) jugular, Italy.  And, it didn’t take long.

Too Big To Bail

Logically, Italy’s debt was always going to be the issue that determined the EMU’s fate.  That is because Italy’s sovereign debt outstanding is over €1.6 trillion (compared to €345 billion for Greece, and €150 billion for both Portugal and Ireland), its debt/GDP ratio is a punishing 120%, and its estimated annual funding needs will run at roughly €250 billion.  That annual funding need is larger than the other European PIGS (Portugal, Ireland, Greece and Spain) combined.  Because the remaining capacity of the ESFS (European Financial Stability Facility) is just €320 billion, it is not big enough to finance Italy’s borrowing needs for more than a year, much less deal with Ireland, Portugal and Spain.  Thus, Noruma Securities had dubbed Italy as “Too Big to Bail” (TBTB).  In the end, it would be up to Germany and France, the two biggest economic powers in the EMU, to save Italy, the third biggest economy.  That would require a commitment of more than €500 billion, or about 10% of their combined economies, a figure that is probably not politically doable.

Nonchalance

While there appears to be some concern in the financial markets about the European debt issues, the markets appear nonchalant about it.  The “contagion” so far appears to be limited to some of Europe’s banks and to the markets for PIIGS debt (Portugal, Ireland, Italy, Greece and Spain).   For example, the VIX for U.S. equities is barely off its lows.  Our belief is that this situation is much more serious than embodied in the current market reaction, and the “contagion” could easily spread worldwide:

  • A selloff in Italian bonds could put pressure on the Italian banking system (which holds 6.33% of Italy’s sovereign debt according to JPMorganChase), which could lead to fears of insolvency.  This, in turn could lead to bank runs and perhaps some failures.  But it surely would require government intervention (perhaps nationalization) and capital raises (if possible);
  • Any resulting bank bailouts would add more debt to an overburdened Europe, thus exacerbating an already critical debt situation;
  • But, the most dangerous “contagion” is most likely in the Credit Default Swap (CDS) arena which is extremely difficult to quantify because it remains unregulated.  As with Greece, any default runs the risk of triggering CDS payments.  And, it is not known if the CDS counterparties have sufficient capital to pay in the event of a default by Greece, much less Italy.  For all we know, there may be another AIG out there, or perhaps a CDS event may fatally wound a large systemic worldwide financial institution.

Our view is that this situation is much more dangerous than the markets have priced in.

Robert Barone, Ph.D.

Matt Marcewicz

July 12, 2011

Robert Barone is a Principal and an Investment Advisor Representative, and Matt Marcewicz is an Investment Advisor Representative of Ancora West Advisors LLC, Reno, NV, a SEC Registered Investment Advisor.Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

The mention of foreign currencies and foreign investments or similar investments in this article should not be considered recommendation to sell or purchase any security or similar investments mentioned.  An investment in the currencies and securities of foreign countries may be deemed to be speculative in nature.  Investments are subject to various investment, trading and foreign exchange risks including the risk of possible loss of principal.  It is important to obtain information about and understand these risks prior to investing. Consult an investment professional on how the purchase or sale of such investments may be implemented to meet your particular investment objective or goals.

A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A).  A copy of this Brochure may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

 

July 11, 2011

What’s Next for the Fed: Rock ‘N Roll!

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 9:11 PM by Robert Barone

On July 8, immediately after the dismal employment report, this is what the Wall Street Journal had to say:

After spending funds to fight the crisis, policy makers have few tools left to stimulate the economy.  Mr. Obama is focused on cutting the budget deficit, while the Federal Reserve, which sees unemployment at about 8.0% at the end of 2012, has already cut interest rates close to zero and is reluctant to purchase more government bonds now that inflation is rising. (Luca DiLeo, “Jobs Data Dim Recovery Hopes”)

In addition, in the last week of June, the U.S. 10 year Treasury Note’s interest cost rose 29 basis points from 2.91% (June 23rd) to 3.20% (July 1st).   At this writing, we cannot be sure if this move was in response to 1) the “temporary” respite of the Greek debt drama and a reversal of “flight to safety” trades, 2) a noticeable reduction in foreign demand for U.S. debt during the Treasury auctions of the week of June 27th, or 3) a combination of the two.  Indeed, during the June 27th week, QE2 was still active, so what happened to interest rates could just be a prelude of what will happen without additional Fed intervention.

In their 2010 working paper, “The future of public debt: prospects and implications” (Bank of International Settlements, March, 2010), authors Cecchetti, Mohanty and Zampoli conclude that since “Most of the projected deficits [for the world’s industrial economies] are structural rather than cyclical in nature … we can expect these deficits to persist even during the cyclical recovery”.  They ask: “When, in the absence of fiscal actions, will investors start demanding a much higher compensation for the risk of holding the increasingly large amounts of public debt that authorities are going to issue to finance their extravagant ways?”  They conclude that it is a question of “when”, not “if” markets put pressure on the cost of such debt, causing interest rates to rise.  Enter the Fed.

We saw the Fed liquefy the world in ’09 including non-member foreign banks over which they have little influence or authority.  And now we have learned that they secretly loaned huge amounts to the primary dealers in the aftermath of the financial crisis.  Then we saw them intervene again with the late August, 2010 announcement and subsequent June, 2011 completion of QE2.  During the latter intervention, the Fed essentially monetized much of the U.S. budget deficit.

Given the fact that the presidential election cycle has already begun, we strongly suspect that the weakening economy and upward pressure on interest rates due to oversupply will cause further Fed intervention, even if it isn’t called QE3.  At his post-Federal Open Market Committee (FOMC) press briefing, Bernanke indicated that if job growth falls below 80,000 per month, the Fed would likely intervene again.  (Job growth has now been below 80,000 for two consecutive months!)  So, “when” it comes (not “if”), what sort of intervention can we expect?

A look back at then Fed Governor Bernanke’s November 21, 2002 talk before the National Economists Club of Washington, D.C. entitled “Deflation: Making Sure ‘It’ Doesn’t Happen Here”, gives us some clues.  In that talk, he ostensibly outlined all of the tools available to the Fed if the overnight (Fed Funds) rate hit zero.  After all, at the time of the speech, deflation wasn’t expected in the foreseeable future, so he would have no reason not to outline all the tools he could think of.  I have outlined them below:

  • #1: Expand the scale of asset purchases;
  • #2: Expand the menu of assets the Fed buys.

Both QE1 and QE2 used these tools.  In QE1, the Fed purchased non-traditional assets for its portfolio, including mortgage backed securities (MBS) and derivatives.  In both QE1 and QE2, the “scale” of asset purchases was dramatically increased.

  • #3: A commitment to holding the overnight rate at zero for some specified period.

This tool is currently in practice with the Fed’s “extended period” language in the Federal Open Market Committee (FOMC) minutes.

  • #4: Announcement of explicit ceilings on longer-maturity Treasury debt.

This isn’t new.  The Fed did this in the 1940s and a version of it again in the 1960s.  During a period of approximately 10 years ending with the Federal Reserve-Treasury Accord of 1951, the Fed “pegged” the long-term Treasury bond yield at 2.5%.  And, during the Kennedy Administration, the Fed sold T-bills and purchased an equal amount of longer dated T-Notes in order to reduce long-term rates.   Bernanke believes that the announced policy of pegging will cause arbitrageurs to keep yields near the announced peg, especially if the Fed intervenes several times to prove its commitment.

  • #5: Directly influencing the yields on privately issued securities.

“If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.”  Think GM, Chrysler, AIG.

  • #6: Purchase foreign government debt.

The Fed would do this, Bernanke explains, to influence the market for foreign exchange, i.e., to weaken the dollar.  He points to the dollar devaluation of 1933-34 as an “effective weapon against deflation”.  “The devaluation and the rapid increase in the money supply it permitted ended the U.S. deflation remarkably quickly … The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market.”  (While this is true, a mere two years later, after the withdrawal of government stimulus, a second severe recession began,  one that would last until the U.S. geared up for World War II.  And the 1937 slump in stocks was one of the largest on record.)

  • #7: Tax cuts accommodated by a program of open market purchases.

“A money-financed tax cut is essentially equivalent to Milton Friedman’s famous ‘helicopter drop’ of money”, he said in the speech.  (Hence his nickname – Helicopter Ben.)  The extension of the Bush tax cuts along with the reduction in the social security payroll tax is a recent example of this policy.

These 7 tools are non-traditional, and Bernanke admits that by using them, the Fed “will be operating in less familiar territory” and will “introduce uncertainty in the size and timing of the economy’s response to policy actions”.  Nevertheless, he says, “a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition … A central bank … retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is zero”.  Today, any objective economist will tell you that, despite all of the monetary and fiscal stimulus, aggregate demand and economic activity has been minimally impacted.  At the July post-FOMC press briefing, Bernanke admitted that he has no explanation as to why the economy has remained “soft”.  Nevertheless, as stated above, in an election cycle, the Fed would be expected to do “something”.

Of the 7 available tools, #1 appears to have been taken off the table, and #3 is presently employed.  Tools #5 and #7 have been used, and may be employed again.  #5 was heavily used in the financial crisis (GM, Chrysler, AIG), and #7 requires the cooperation of Congress (tax cuts).  The Fed said that it won’t reduce the size of its balance sheet in the near future, holding it steady like a rock, but will invest or roll any maturities or payoffs back into the market.  Hence, the Fed has already embarked upon a policy of what we will call Rock ‘N Roll.  As part of Rock ‘N Roll, we also expect the Fed to change the composition of its balance sheet to attempt to impact yields on private sector bonds (#5).

Conclusion

Over the past 2 years, Fed actions appear to have had little impact on aggregate demand.  In 2002, when he outlined these non-traditional tools, Bernanke said he had no idea of the magnitude of their effectiveness.  Today, however, we have a couple of years of historical data on which to judge.  Eric Swanson, an economist at the Fed of San Francisco, in a March, 2011 paper entitled “Let’s Twist Again: A High-Frequency Event-Study Analysis of Operation Twist and Its Implications for QE2” concluded that the impact of QE2 on the Treasury yield curve was a statistically significant, but moderate 15 basis points.  (That’s not much for $600 billion!)  In addition, Swanson says that the effects “diminish substantially as one moves away from Treasury securities and toward private credit instruments”.

Thus, despite their demonstrated impotence, we expect that the Fed will use tools #4 and #5 in an effort to lower longer-term Treasury rates and simultaneously attempt to reduce private sector rates.  The success of such moves is much in doubt, especially if their balance sheet is constrained.   Tool #6, and other policies to weaken the dollar, however, will continue to be the primary and most effective thrust of Fed policy.  That means inflation will continue to be fostered.

Robert Barone, Ph.D.

Joshua Barone

July 11, 2011

Robert Barone and Joshua Barone are Principals and an Investment Advisor Representatives of Ancora West Advisors LLC, Reno, NV, an SEC Registered Investment Advisor.Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A).  A copy of this Brochure may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.