Friday, October 5, 2012

Off Topic: A Letter To A Friend

A friend emailed me yesterday regarding the state of financial markets. He happens not to be a client of my fund, but nevertheless the advice and effort I give to him and his family is one similar to that of my clients too. I've attended university with his two older brothers, who happen to be very, very close friends of mine, but they do not share interest in the investment world as much as he does. His father has given him the responsibility of investing the family's capital, as they own a large consumer staples business in the Asia Pacific region and are very well off. The gentleman emailed me regarding stock prices, Australian real estate prices and Precious Metals. Today's post is a "one-off" where I will copy and paste a letter to a friend regarding investment advice. For obvious reasons, certain private parts, family discussions, names, greetings, side chat and other sensitive information has been removed / edited for the sake of privacy. Enjoy!

When it comes to advice for the financial markets, there is a reason why the majority of people in this business lose money consistently, while only a handful are successful and make a profit on a consistent basis. These clowns come on TV channels like Bloomberg and CNBC and they all sound the same. I think I always say this to you, but I'll repeat it again: when it comes to financial advice, the best thing to do is to do your own research and run your own investments. It is basic advice, but it is very, very important. That way you lose your own money if you make mistakes, or if you do your homework and have a little luck, you make your own profits. Listening to financial "gurus / bloggers / experts / traders" who think they know everything, for the majority of time is a complete waste, and this includes me too. 

I can be just as wrong as the common man on the street. As a matter of fact, because I spend a large amount of time in front of the computer reading, researching and studying all of this "stuff", the common man on the street probably knows a lot more about the economy than I do. I am talking about the common man that runs a business and isn't brainwashed by all these financial reports we read daily. That is because visiting local restaurants and night clubs, or just asking various taxi drivers how business is going can tell you a lot more than government statistics - which are all phoney anyway. And on that note, I can give you advice on what I see in the market place today and what I am doing with my money, but in the end I am no better than you or anyone else, so read as much as you can from as many people as you can and in the end, always think clearly by yourself. 

On the stock market...

So when it comes to stock prices I can tell you my view: every man and his dog is optimistic, positive, strongly invested and quite complacent. That to me is a cocktail of trouble! Let me explain...

Source: Short Side Of Long

Investors today are positive about corporate profits and earnings moving even higher than right now. They are also positive about corporate margins expanding even further (see the first chart above). But... let me tell you that earnings are already at record highs and so are corporate margins. No one ever got rich buying stocks when profit margins were at or close to all time highs. Notice that all the best investment opportunities and major market bottoms occurred when margins collapsed, like in 1974, 1982, 2002 and 2009 etc etc. When margins are depressed and earnings have collapsed due to a recession, stocks offer a great entry point and you get to catch the whole recovery. When you hear a lot of opinions regarding how positive fundamental picture is because "profits are at record highs" - that type of a parrot talk can usually be heard from all financial advisors and "gurus / experts" on TV near the peak of the stock market. Look at the chart above and see how profit margins peaked during the 2006/07 period. Now focus on the chart below:
Source: JP Morgan / Barry Ritholtz

Notice that from 2002 to 2007, the US Stock marked gained 100% and it did it during a huge credit boom, housing boom, Chinese boom, commodity boom and manufacturing boom. In 2006 and 2007, the world was in tip top shape and every analyst would have told you that things will continue into the blue skies… almost forever. And that was precisely when the market peaked out, just as the profit margins started to decline. Fast forward to today and the market has now gained 113% in even less time, rising even more rapidly and yet profit margins are at all time record high. That means, it is not probable that they will go even higher and most likely will do the opposite and mean revert downwards. Remember in capitalism, profit margins always mean revert. Currently, the market is driven by central bank's printing money and stimulating financial assets. This has forced a lot of speculation into the market, and yet constantly market participants argue that "there is a lot of cash on the sidelines" and that "funds are underinvested". Let me tell you that the market doesn't gain 113% in three years because everyone is underinvested and there is cash on the sidelines. How the hell did it get there, all by itself?
Source: Short Side Of Long

Furthermore, the majority of investors are now optimistic on stocks and have "made some profits" (as you yourself said in the email) after an almost vertical rally in recent months. But away from the short term, what really surprises me today is the way the majority are strongly invested, quite complacent and not worried about anything. Notice that the US stock market has rallied over 110% in the space of three and half years from its lows in March 2009. The time to be an optimist has long passed. It was wise to be one back in late 2008 and early 2009, when profit margins and earnings collapsed. Back than, retail investors as well as "mum and pop" investors held large amount of cash on the sideline due to fear (chart above shows cash levels reached over 40% of the portfolio on average). 

Today everybody is an optimist, even the bears are slightly invested, but the stock market rally of 110% plus has largely discounted the majority of good news such as record profits and record profit margins. Today, these same investors hold very small amounts of cash on the sideline due to greed, herding and being over exposed (chart above shows cash levels are now at 18% of the portfolio on average). You will notice that whenever cash levels drop, stocks tend to correct almost always. At the same time, when retail investors sell stocks and raise cash… now that is when it is the best time to invest. That is when you will see me excited. As I always say, you are either a contrarian or a casualty. Warren Buffet could tell you a thing or two regarding the sentiment and the chart above: "Attempt to be fearful when others are greedy and to be greedy only when others are fearful" ~ Warren Buffet

On the Precious Metals...

So the question is, if the stock market is not a good place to invest right now, could Gold or Silver present opportunities? Last time we talked, I told you that I wasn't doing anything. The reason for that has not changed. Europe is still a mess and Greece or even Spain is heading towards a default of some type that will shock the system similar to 2008. I know that almost everyone doesn't hold that opinion anymore, but I still do. I also didn't do anything because I remain fully invested in Precious Metals, including Silver. That means I rather not buy extra than is necessary and overexpose myself. Nevertheless, Silver has rallied from $26 to $35 from the middle of August towards the end of September, which is an impressive 35%. So since I am fully invested in this asset and the majority of my clients money is held there, my fund is up rather handsomely for the year (so far). 
Source: Deutsche Bank

Obviously, if Silver falls so will my performance. As wise men say, good times never last forever, so I understand that the recent rally has been a too far, too quick type of a move and could correct slightly in the coming weeks and months. But, regardless of what happens in a few months from here, I believe Gold and Silver will go much much higher in the next few years and I remain a long term investor in this asset class. During a bull market or a boom, the best thing to do is to exercise patience. Besides, when I look at an average portfolio of an investment fund, I notice that stocks are commonly about 37%, bonds are even higher at 49% (bond bubble anyone?), money markets (aka cash levels) are currently at 9% - which I already stated is extremely and dangerously low for an overbought stock market, and finally Gold is only at 1% of exposure. This makes me think that Gold is not in a bubble as investors are still largely under-exposed to this asset class. When I hear constant chatter on Bloomberg and CNBC from these so called "gurus" on how funds now hold 10% or 20% of their money in Gold, that is when I will become worried… and if and when Gold prices go high rapidly, I will most likely sell out. That is because, almost everybody will be super-bullish at that point.
Source: Merrill Lynch / Ann Bartels Technicals

Regarding your question about technicals of Gold, an investment friend in the Merrill Lynch technical team, who sends me regular newsletters regarding asset price movements, also talks about the resistance of $1,800 for Gold and how the price will rally once it "breaks" above that level. They also talk about Gold moving towards $3,000 in the next several quarters or years, according to their chart. I don't really know what to tell you in the short term. Short term market movements are like gambling and probability. It could go up, but it might not. It seems to be that a lot of investors are focused on these "technical levels" anticipating a breakout… the same levels you discussed in your email. In my experience, I've learned that it is not wise to focus on things that everyone else focuses on, because usually markets surprise and do something completely different. And it has also come to my attention, that in the near term, investors are too optimistic about Gold and Silver.
Source: Short Side Of Long

The retail crowd seems to have positioned for this breakout and a lot of speculation and hot money has flown into Gold recently. The chart above shows physical holdings in the major ETF trading product have exploded, so take note that whenever a majority rush into something, it is never wise to buy and the same goes for Gold. I'm also fortunate to read a few newsletters from various investment banks and also individual traders. Technical guys who run these "shorter term" publications are all anticipating a breakout above $1,800 and are decently positioned for it.

I am not saying Gold cannot move higher, all I am saying is that personally I would not buy right here right now. I'd rather wait for a pullback or wait for a setup where the retail investors sell Gold so I can "buy when others are fearful" as Mr Buffett himself wisely stated. You see, Gold has good fundamentals and reasons to why it is rising (unlike the stock market). As central banks print money, maybe even more investors will rush in and Gold might not even pullback. After all, my long term view is that Gold will go much higher. So while I am not selling my Precious Metals due to a good long term outlook, I am also refraining from buying today and tomorrow, due to the short term "froth and heat" in the market.

If I miss the move, then I miss the move… no big deal. There is always another opportunity and that is one thing I've learned in this game. Another chance is just around the corner. Same goes for Silver, as Silver follows Gold rather closely, but just with larger downswings and larger upswings. If I had to buy one of the two, I'd rather buy Silver because it is cheaper on a historical basis. Silver is still 30% below its all time peak of $50, while Gold is very close to new all time highs. That makes me think that Silver has some catching up to do. Therefore, holding both with the longer term view is still fine in my opinion.

On the Economy and Australian real estate...

Finally, read my recent blog post, which argues that we are now on the edge of a global rescission (link here). When I look at Asia, it has been the powerhouse of the recent recovery out of the 2008 recession. However, their export volume is now declining, which signals to me that their customers - which are US and Europe - are showing signs of a slowdown and weak demand.
Source: Merrill Lynch

This has also been true when we look at global economic barometers like Crude Oil or the price of Copper, both of which are struggling. Let us not forget that marginal demand for these industrial commodities comes from the Asian expansion and growth. Greece barely consumes Copper or Oil, so when the price declines it is because something is not well with China, even though those clowns on TV constantly keep saying Eurozone this and Eurozone that, blaming a small tiny economy like Greece for the world's problems.

Source: Bloomberg

I got a Standard Chartered research note the other day, which covers Chinese Copper inventories in various ports near the South / East side of the country. There is idle stockpiles of copper everywhere and it keeps building up. This is a sign that economic activity is very low and slow in certain areas, because Copper is used in almost all building processes, as you probably know yourself. As all prices move on the premise of demand and supply, whenever demand decreases and supply increases, that tends to be the mortal enemy of future price action. When activity slows and the economy stalls, inventories build up and prices decline. Iron Ore inventories at Chinese ports are also through the roof too.

The Iron Ore fundamentals of demand and supply are even worse as prices have crashed recently. As you know well, Iron Ore is a main component of steel making and Australia's main export commodity. At the same time, China is the biggest producer of steel in the world, and therefore Australia's No 1 customer.

The Australian trade balance has now turned into a deficit as the mining boom slows further. That means, Australia is once again importing more goods and services than it is exporting. This weakens capital as it slowly leaves the country and it could most likely weaken the currency too. The slowdown will surely affect the economy. I also happen to think that government revenues will now fall, which could mean higher taxes for us, as the government will need to raise more money elsewhere. All in all, it does not signal great things ahead for the overvalued and overhyped Australian housing bubble.

You might already know that I am rather negative on this asset class and a hold a friendly bet over drinks and dinner, with a close family friend, who's family owns and manages a large private commercial and residential property trust in Australia in excess of $100 million dollars. He believes that Australia real estate prices will move sideways and do not have large downside risks. I hope for the sake of everyone in Australia that he is right. Furthermore, I am also quite aware that certain "experts" out of local investment banks, are now talking about how a mining boom end, signals a housing boom re-start (link here). 
Source: Trading Economics / Short Side Of Long

I personally do not think so and quite honestly, I think such thinking is slightly nuts (as in crazy). Australia has not had a recession for 21 years, while normal business cycles tend to last between 5 to 8 years. As we all should know, recessions are common reoccurrence for the economy to clean itself out and remove excesses. It just makes me think that excesses that have been built into the Australian economy are rather large these days, because it has not been cleaned out for 21 years, just the same way as a normal residence or a home would be rather dirty if it has not been cleaned out for 21 years, as well.

I am quite convinced that once a recession occurs, Australia real estate could drop more than 20% from peak to trough. The level of mortgage debt Australians hold is now much larger than in 2006 when the US housing market turned south. And let me tell you that soon enough, our unemployment rate will also start to rise. So the question is, will this debt be serviceable? Since I believe we are in for a mean reverting outcome, just like US profit margins, it is only a matter of time until the "the lucky country" takes a turn for the worse. Finally, I found this quite amusing and something that usually gets published at the top of economic growth:
Source: Amazon Books
"There's no better place to be during economic turbulence than Australia. Brilliant in a bust, we've learnt to use our brains in a boom. Despite a lingering inability to acknowledge our achievements at home, the rest of the world asks: how did we get it right?"