All That Glitters

Gold has become front-page investment news lately and I think it’s time to shed some light on the shiny metal that has no industrial purpose. We do have exposure to gold in our portfolios through the ETF SPDR Gold Trust (GLD). We have been holding gold since late 2007 and have recently reduced this exposure a bit. This is not a comment on our view but rather a rational decision based on correlation and reality. Gold over the long haul has a low or negative return (depending on how you measure it and if you adjust for inflation). Although many consider gold a hedge against pretty much everything, including currency devaluations, political and social unrest, and inflation, I believe this conventional view is flawed. Statistics do not prove that gold is a very good hedge. Actually, stock indices seem to outperform gold and outperform inflation (of course with greater volatility). On an inflation-adjusted basis, gold is still 50% below its all-time high set almost three decades ago while stocks, even after two 50% declines in that period, are up around 1000%.

In fact, it seems uncertain why gold should rise during inflationary times other than demand from other investors. For example, gold is up 33.5% YTD but inflation is down 2%. If gold prices are predicting future inflation then so should bonds, which should sell-off during periods of inflation, and TIPS, which move on inflation expectations. However, both are greatly unchanged from year ago levels and are down from earlier this year.

What is driving gold these days is something I call “investment demand for gold.” This phenomenon changed fair value for stocks in the 80s when anyone with a 401(k) or IRA needed to buy stocks regardless of the price. With the advent of easier ways to hold and own gold, portfolios are being reallocated to include gold in their asset mix. This is creating a new source of demand. Whether investors determine 5% or 25% is the appropriate portfolio holding is unclear. But until those portfolio shifts are completed gold will be supported. Once this shift has completed, gold should move less in line with stocks and more on diversification and correlation principals if not on inflation fears, political unrest and currency devaluations. Signs are on the horizon that this day is closer than you might think.

Buy Dollars Wear Diamonds?

We recently added UUP to the portfolio which give some long exposure to the U.S. dollar. The response was immediate from clients who were concerned about the “free fall” the dollar was experiencing and the negative press the dollar garnishes daily and the impact on the state of the American economy. I don’t see it that way and a further review of the facts looks very different than investor perceptions. Truth be told, I don’t know where the dollar is going any more then I know where stocks are going or, for that matter, any of our positions. What I do know is that each position collectively has a greater probability of going up than down at the current stage in the economic cycle. While any one position can be wrong we look at the portfolio as a whole, with the objective of making more money than we start with. What we have demonstrated, by rigorous analysis, is that the overall portfolio is positively sloped. It has high probability of being worth more in the near future with an appropriate level of risk. If I knew where any one position was going with greater certainty, then I would put only that position on and nothing else.

As for the dollar, I think it is misunderstood. I don’t believe the carry trade actually exists. Who would sell the dollar and buy currencies that have a positive carry of around 2% annually when the currency can move more than 2% against you in a day? It doesn’t seem reasonable. Furthermore, the current correlation to equities is not sustainable and in fact doesn’t even make sense that the stock market should go up when the dollar goes down. We are a net importing country. We buy more from other nations than they do from us. That means a weaker dollar makes it more expensive for us to buy foreign goods. While I know that it also makes it cheaper for other countries to buy our goods, the fact is that the net effect should be a negative. The dollar moves more on trade and investment flows than interest rate differentials. At least in the long run.

If you look at the dollar from a longer-term perspective things look a bit different. One year ago the dollar index was at 79.35 (the end of Q3 2008) and the NASDAQ was at 1584. Today the dollar is at 76.80 and the NASDAQ is it 1720 (as of Q3 2009). So the dollar fluctuated down about 3% while the NASDAQ rallied over 8%. I am not sure what the big concern is here. Adding a long dollar position to the portfolio reduced the volatility and drawdown of the portfolio with limited impact on the returns. In fact, when the markets were in a free-fall during Q1 2009 the long dollar offset much of that loss allowing the portfolio to withstand that drop and to participate in the rally with less risk. If we take a look at a longer time-horizon, such as from the two years when the S&P made its high in September 2007, we see even further the downside protection benefits of a long dollar position, as the dollar index was about 80.5 at that point and the S&P was above 1500. The dollar has fallen only about 5% since then and the S&P has dropped almost 30%. So I find it hard to connect the dots of a weaker dollar impacting the markets. Since inflation is one of the main culprits of a currency’s value, interest rates need to be raised to offset the impact of inflation. The core inflation indices are down over the past twelve months so that doesn’t pose an immediate problem. The bulgering debt burden appears to have some in the currency world concerned but demand for U.S. treasuries remains high and rates remain low which would not be the case if debt burden was hampering the credit markets. In the end it’s all about growth and I expect U.S. growth to exceed that of its trading partners. This should support a bottom for the dollar and eventually lead to a stronger dollar. And don’t worry as that can occur with a rising stock market, but it can also occur with a declining stock market. That is what makes this position so attractive.

Is the Recession Over?

Once again unemployment Friday released new information for me to review and, like the groundhog, try to make the prediction of how much more winter, I mean recession, we have left. As you know we at Astor focus rigorously on the employment numbers as we believe they speak volumes on the condition of the US economy at large as well as specific individual sectors.

It was this data that alerted us to be defensive as early as December 2007 and indicated that a slowdown was in the offering for 2008, and it will be this data that will signal the all-clear to be aggressive in high beta stocks. Of course there are those who will try to get ahead of the curve, forecast the recovery, and invest early, but it is unclear how they do this, and the more intriguing question is how they expect investors to forecast and time a possible expansion if they were not successful in getting out at any point during the recession. For my money, and that of our clients, we prefer to be highly confident that the recovery is underway and that a major decline is highly unlikely before we make our move. This has proven us well over the past nine years as we have been able to participate in most, if not all, of the upside with little fear of major losses, while also playing defense during major economic and market downturns. This approach has helped us avoid sharp losses twice this decade. So while the market might go up further from here, it is hard to be more then 50% certain it will go up as the current data doesn’t suggest anything more than that the economy is getting worse at a slower rate. Now if you want to read this as the beginning sign of an up-trend I am okay with that but history shows that the markets can decline significantly (10% or more) with economic statistics as they are currently, even if it is not as bad as it was a few months ago. This is not a condition where I would recommend aggressive positions. Although, there are some bright spots and we hold positions in sectors like technology, utilities and health care while we are defensive in major markets tied to the economic growth such as financials, energy and large cap.

So what are the numbers saying? Well, the economy is still losing jobs, hundreds of thousands per month at that. However, the payroll number was not as bad as expected and, believe it or not, the number was not boosted by government payrolls (which actually lost 7,000 jobs). Further good news was that the payroll numbers for last month and the month before were revised up (we didn’t lose as many jobs as we thought) and that is very encouraging.

However, job growth is only one part of the equation and output or economic growth (as measured by GDP) is the other. It still appears the economy will have contracted in the 2nd quarter. That will be four in a row and I have never seen that; so we are off the charts in looking for a bounce-back from negative growth.

Let’s add it all up. We are still losing jobs each month and each quarter, GDP is negative for the unprecedented fourth quarter in a row. The S&P, which has been down for six consecutive quarters, is finally going to have an up quarter, and that is the only real positive sign that is not just a better negative. But, remember, the S&P is still down year-over-year.

This all doesn’t add up to my definition of an expansion. It is a correction in a bear market where the odds are equal that the market can go up from here as down from here and I just don’t like those odds. During expansions and bull markets the odds greatly favor that the market will go up from current levels. The market becomes what I call positively sloped. I love expansions as it takes the guesswork out of investing. Just pick any day to buy and the odds greatly favor higher prices in the future. That is not what we have today. I am not saying that the markets can’t go up or that the end of the recession is not near, what I am saying is that once we can identify the expansion and bull market the risk/reward will be more compelling and the opportunities greater. When that will happen is anyone’s guess, as is whether the markets will be at higher levels than they are now once that occurs. Maybe or even probably yes they will, but really, who cares? It will be lower than when the recession and contraction began and there will be plenty of time and opportunity to make money during the next expansion, so why take on additional risk? The good news is that the entire market will not turn on a dime and that many sectors will turn before the entire economy. In fact, some have already entered a new bull market. This will give a portfolio like ours the ability to participate in the early stages of an expansion without the added risk and volatility of the uncertainty. When the economy started to contract and we became defensive it was late 2007/early 2008. There were many rallies and some economic indicators that looked to be improving but the reality was that the trend was down. While we didn’t know where the top of the market was, we did know that the odds favored lower prices in the future and we were comfortable being defensive at that time. And now, over a year and half later, it’s hard to remember where the price was at the exact start of the contraction. Most likely, a year and half after the next expansion it will be equally as hard to remember where exactly we got aggressive on the buy side, as it will most probably be from lower levels.

So follow the data and invest according to the direction of the economic trend that you can identify today and you won’t be disappointed.

Is the worst already behind us?

Unemployment Friday was an important day at Astor last week, just as it is every month. We review these numbers and aggregate them with other economic data at to get a fresh perspective on what the economy is doing. So what do we see now? Is the worst behind us?

Equities have rallied 30%+ since the lows of March on prospects of a recovery, and that sure feels good. Commodity prices have rallied 22% on the same prospects. However, it is interesting to note that the market is trading at about the same level as late December/early January. The market is still down a good 35% from 2007 levels, and that is after a significant rally the past two months. The US economy has lost over 2 million jobs this year alone and GDP contracted for the highly unusual 3rd quarter in a row. (That has only happened twice before…ever.) Banks appear to still need to raise capital, and while credit spreads have eased, interest rates have moved higher, which will make borrowing more of a challenge, and of great interest is the lack of increase in M levels even after tremendous government stimulus. If they still calculated M3 it would have contracted for the year. The commercial real estate market appears to be another looming problem as firms are unable to restructure debt covenants while losing tenants, and may be a land mine in waiting.

Here is how we see it. That extreme 25% drop in the market this year tells me something. It tells me the amount one needs to pay (the premium if you will) to get cash now. With liquidity virtually gone and credit non existent the only place left to get immediate cash (in two days) was the stock market. With the fear (unfounded I might add) of nationalization of financial related companies, there was nowhere else to turn for cash but to sell stocks. It was true fear and panic. The recovery from those lows has nothing to do with an economic recovery. This has been just a reversion back to where we were before the panic. The only difference is the actual economic statistics have deteriorated since the beginning of the year. Since it is very difficult to equate any current level of the stock market with the current economy, I’d rather just identify the direction of the market and the direction of the economy, and only make a move when it changes.

While the pace of deterioration has slowed recently, this does not mean growth has resumed. The market declines earlier this year reflected poor fundamentals as well as a panic of liquidity. I believe the lows are in. To make "new lows" something new will need to happen and we are watching for that. But that is not enough to say we are heading back to a bull market and economic expansion. It will most likely be a bit of a consolidation from levels somewhere around here plus or minus 10% (more likely minus). I think this is about it for the broad markets.

Time to Change

To that point, we firmly believe the current bounce is an opportunity to rebalance portfolios. For example, when the tech bubble peaked and declined some 70% in 2000-2003, it had a wonderful rally afterwards, but it never fully recovered. The losers did not become the winners during the next expansion. Many companies at the root of the collapse never recovered. That will happen again this time as well.

If you are not utilizing an active management strategy in your portfolio to manage risk and volatility, you must consider this now and stop leaving your portfolio to chance. While it is obviously too late to protect your portfolio against the massive declines of the past 18 months, this rally has created a real opportunity to re-adjust your investment approach.

Astor Asset Management has specialized in this approach since 2001. We utilize the data the economy and market is giving us to tell us how and where to position our clients. We constantly assess the data and our analytical tools to stay ahead of curve. This approach has served us well over the decades as employment trends turned down in 2000 followed by a contraction and bear market and again in late 2007 early 2008. Our flagship L/S Balanced portfolio was down a mere 4.5% in 2008, and as of last Friday, was up over 4.5% for the year and making new profits for clients.

If you’re not using active management now for one reason or another, please click here to visit us online or call us at 800-899-8230. You owe it to yourself to investigate the benefits of a strategy like this to your financial situation. Let us talk you through it. You’ll be glad you did.

The Numbers

Everyone is throwing around the recent budget numbers as well as the total stimulus/bailout package amounts. These numbers are so big it reminds me of when I was a kid bragging about how many baskets I could make in a row in basketball. The conversation would start something like this: Boy 1, I can make 10 baskets in a row. Boy 2, oh yeah I can make 20. Boy 1, I can make 100. Boy 2, I could make a million. Boy 1 well I can make a billion. Boy 2, infinity! I win. Like the playground banter, the budget numbers have equally gotten out of touch with reality. Let me take this time to put some clarity in and shed some light on the numbers. First, millions and billions and trillions are very big numbers but let me put them into perspective. To count to a million would take 2 weeks, to count to a billion would take 35 years and a trillion would take you back to the caveman days.

Let’s look at some numbers. This is not a statement pro or con for or against the stimulus/bail out plan, as that is forth coming. This exercise below is just to put in some perspective.

• The total work force in the United States is about 150 million people. The number of employed is about 126 million.
• The total value of the stock market is about $9 trillion.
• The total value of housing market is about $15 trillion.
• Total GDP (amount of all goods and services) is $14 trillion.

Summing that up, 126 million people make $14 trillion dollars of stuff and own $24 trillion worth of housing and stocks.

Now let’s look at debt. The total government debt is $10 trillion and the total mortgage debt is about $9 trillion. Total debt (not including consumer, credit card debt) is about $19 trillion.

So looking at these numbers, it appears that total debt is $19 trillion (government plus mortgages not including consumer debt) total income is $14 trillion or about 135% total debt to income. That doesn’t sound that bad. Would you borrow $200k if your annual income was $150k?

Now the asset side. Total assets of stocks and houses is $25 trillion with total debt at $19 trillion. Not bad as debt to equity of 76%. Would you borrow $190k on a house worth $250k? Lastly, do you think the impact of borrowing another $1k if you already own $19k is a big deal? Well I guess the answer is it depends. It depends on your job, if your assets continue to grow and your income remains stable. Well that is something I do have an opinion about. Capitalism works! And it works IN SPITE of the plans and ideas coming out of Washington. This economy will grow again and we will get through this. And it won’t be because of any plan that comes from politicians. I just hope that doesn’t create too much of a drag. You see, the 125 million working Americans are waking up everyday going to work and trying to figure out a way to grow. To be more productive, make more money, and move the ball forward. And we will. And it will have nothing to do with the stimulus plan. Let’s just hope it doesn’t make it too much harder.

Now back to the numbers. If GDP gets back to growing at a 3% trend and assets appreciate at an 8% average in 14 years, the debt as a percentage of assets will be less than 15%, or could be paid off with just one month worth of income. The economy will grow, income levels will increase, and assets will appreciate. We will also have inflation which will make today’s debt worth less. I am not saying we can spend our way out of the recession, or that the current plan is the solution. I am just putting the numbers into perspective. Since the burden will fall on the 125 million Americans working (one way or another) and we will have to pay I thought I would shed some perspective on what the numbers look like. So let’s stop analyzing what the politicians are saying, turn off the TV and get to work. After all, we have an economy to save.

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Thanks for visiting The Bull Inside the Bear, Robert Stein's blog with up-to-date market commentary and updates on his new book, The Bull Inside the Bear: Finding New Investment Opportunities in Today's Fast-Changing Financial Markets, available online for pre-order at amazon.com. Click here to pre-order your copy today.