Fishy business in the gold market

Contrarian Investor reports that gold is being loaned out at negative rates of interest, which he thinks is in order to help short the gold market. There's a manicured thumb on the scales, it seems.

Does asset inflation help support stock prices?

An anonymous comment on the preceding post has set me speculating further. The commentator says:

You are right, but I believe that this time around it will be equities, rather than commodities or real estate that will provide the hedge against coming inflation. Tobin's Q will prevail due to the juxtaposition of equity prices vs. the other two asset classes (which already had their surges) and the market's increasing valuation sophistication compared to the last time we saw hyperinflation in developed economies (i.e. the 1970s). So I've been buying stocks as an inflation hedge, despite the statistical evidence that this is foolish...

Wikipedia offers an explanation of Tobin's Q here. Essentially, Q is a measure of the relationship between the value of all a company's shares, and the value of the company's assets. If Q is greater than 1, there is some reason (real or imaginary) why the company has extra value to offer; if less than 1, a share investor could buy a company's underlying assets at a discount.

In 2006, Michael Alexander wrote a series of articles for Safe Haven, about stock cycles. Below, from the second in the series, is his graph for Q in several bear markets, including the one which he suggests began in 2000:

According to this, Q was already below 1 in 2006, and since the market is now back to about where it was a couple of years ago, that would suggest that shares are now fairly valued in relation to company assets.

But if history repeats itself, the current bear market has a long way to go, since the other three lasted 15 - 20 years. And in each of the previous cycles, Q slumped below 0.4.

Another complicating factor, thanks to the lending boom, is the real estate bubble. Steve Moyer is firmly of the opinion that real estate is very heavily overvalued, even now. So a collapse in that market would push Tobin's Q back up for many companies, a technical indication that share prices would have to drop steeply to get back to fair value (let alone overshoot to below Q=0.5).

In this context, it's worth noting that one of Mike Alexander's books, published in 2000, is titled "Stock Cycles: Why stocks won't beat money markets over the next twenty years".

Is inflation negatively correlated with real stock values?

I'm aware that I'm setting myself up to be laughed at by the quants, but I'm playing a hunch. The FTSE graphs I've done over the last couple of days suggested to me that periods of high inflation are bad news for stock prices, as well as for cash.

Obviously, this isn't exactly news - a quick Google leads me to this book by Alicia Haydock Munnell, where she says "The long-run negative correlation between stock prices and the rate of inflation has been confirmed in several statistical studies." Yet another academic study says "The bivariate results for the real stock returns-inflation pair weakly support a negative correlation in the 1970s and 1980s."

But what if we compare real stock prices with changes in the inflation rate? So I've done something childishly simple - perhaps childishly wrong, I await your correction:

First ("L2/J2"), I divided the FTSE index by the RPI index (end December figures in both cases); since the FTSE has grown in real terms by only about 1.6% p.a. since 1970, I think this should reduce some of the statistical noise - in effect, we have the inflation-adjusted value of the FTSE for each year end.

Then I looked at how much the RPI index had changed, year on year, expressed as a percentage.

Then I used Excel to calculate the correlation between the two sets of data. The figure (as you see at the bottom of the sheet) is (0.711). I may be mistaken but I think this shows that there is a strong negative correlation between changes in the inflation rate, and changes in the inflation-adjusted capital value of the FTSE.

(By contrast, the correlation between the annual percentage increase in RPI, and the annual percentage increase/decrease in the FTSE, is only 0.275576.)

FTSE stats from Wren Research, RPI from here and (for the latest 2 years) here.

Thinking about this, it would make sense: when inflation starts roaring away, investors will want better yields on stocks, so (as with bonds) the value of stocks needs to fall. The question is, how long does it take for the dividends to compensate for the capital loss, to someone who held the shares before the major inflationary period began?

Maybe the sales line that stocks are a long-term hedge against inflation, is only half-right: it'd pay even better (when inflation begins smouldering) to switch out of cash, bonds and stocks and into other stores of value (such as commodities and houses), and come back again when the inflationary fire looks as though it's been brought under control. Look at the real capital values of the Dow and FTSE in these graphs, and imagine you had stayed out for a decade or more, then jumped in with your portfolio in the early 80s, or mid 90s.

But speculators have already gotten into commodities, and (thanks to greedy banks and lax governments) houses are massively oversubscribed. Nevertheless, commodities may yet be a better long-term punt than the average investment at this stage, and there are those who will argue the case for good agricultural land. So maybe there's still an opportunity to get on the cruise ship, even if we've missed the speedboat?

It's so difficult when, as Marc Faber says, for the first time we're in a world-wide bubble. This nasty combination of monetary and fiscal crises has us running in all directions.

UPDATE

Yes, I've got my methodology wrong, as my brother has pointed out. So I'm back to the simpler, positive (real, but not so strong) correlation between percentage changes in the FTSE and the RPI: 0.275576. Interestingly, the correlation is very slightly better (about 0.285), if you look at the FTSE 12 months ahead of the RPI.

It's just that, visually, the inflation "mountain" of the 70s and early 80s seems to want to turn upside down and fill the inflation-adjusted "crater" of the FTSE in the same period. But at least there is a definite correlation, over the series as a whole from 1971-2007.

Long term inflation in the UK

The enemy

RPI figures from here and (for the latest 2 years) here. Rebased so Dec 1915 = 1.

Panic overstated?

40 years on from the Summer of Love. Here's a chart I made to show the capital value of the Dow at the end of each calendar year.

I used Yahoo! for Dow valuations (ex dividends); rebased them so that Dec 1967 = 100; and adjusted for cumulative inflation as per Inflation Data's calculator.

Theoretically, someone investing a sum in the Dow at the end of 1967 would have had to wait 28 years to see it return to its original (inflation-adjusted) value.

But over the whole 40 years, the averaged return is 2.175% per annum compounded, which is very close to the 2.2% p.a. real capital growth on the S&P 500 (1871-2006) illustrated in the previous post.

These long views suggest that the Dow's recent 12-year zoom is merely a kind of rebalancing. In this context, it's interesting to see that as of September 2007, the price-earnings ratio of the S&P 500 is not far off its average over the period since 1871. The fall in stock valuations since then should have brought the p/e ratio even closer to the norm.


By way of comparison, here below is the result of a similar exercise for the FTSE, though I have been unable to go back further than 1970. Again, it's the close at end December each year up to 2007, adjusted in this case for RPI. FTSE stats from Wren Research, RPI from here and (for the latest 2 years) here.

The overall shape looks fairly similar to that of the Dow over the same period. Average capital gain over 37 years is c. 1.6% p.a. compounded.

Dow & S&P500 adjusted for inflation - importance of dividends

Source: Safe Haven article on importance of dividends

Source: The Big Picture

... and the Dow Jones without dividends, measured against inflation:

Source: iTulip

Source: Fred's Intelligent Bear Site

Source: Chart of the Day

& the NYSE Index:

Source: Inflation Data

Foreign holdings of US Treasury Securities, Jan 2007 - Jan 2008

S&P 500 price-earnings ratio

Source: "Political Calculations" blog

UK M4 stats (click to enlarge)

Beakernomics: house prices

Beakernomics: world income

Globalization (latest in RED)

Don Boudreaux interviewed (by a colleague) on his liberal econ book "Globalization"

Recent newspage updates

From "The Big Picture" blog




Dumping of US treasuries imminent, starting with Korea, says Burnick

Don Boudreaux interviewed (by a colleague) on his liberal econ book "Globalization"

"Not until total debt comes down to a realistic number can a real recovery take place. If debt is to be destroyed to that magnitude the deflation will be monstrous."

Mish: "Germany fears global meltdown"

Hutchinson: new financial system by 2013

Derivatives: Banking capital "insufficient to handle even one per cent of potential losses."

"Matt" on US M3, the money supply, inflation

California realtors report house prices collapsing (htp: Drudge Report, LA Times)

Skills shortgage hampering US job repatriation, says AT&T chief (htp: Drudge Report)

KPMG criticised for allegedly poor auditing of failed US mortgage firm (htp: Drudge Report)

2008 US durable goods report: semiconductors down sharply since New Year (htp: Karl Denninger)

Monty Guild: stock rally if mortgage bond market stabilises; invest in non-leveraged areas

USA - Economy (latest in RED)

Dumping of US treasuries imminent, starting with Korea, says Burnick

"Matt" on US M3, the money supply, inflation

California realtors report house prices collapsing (htp: Drudge Report, LA Times)

Skills shortgage hampering US job repatriation, says AT&T chief (htp: Drudge Report)

2008 US durable goods report: semiconductors down sharply since New Year (htp: Karl Denninger)

Brad Setser presentation (Sept 2006): "Chinese Financing of the United States"

"Naked Capitalism"blog: "China now buys a lot of US debt through London..."

In 2007, UK increased holding of US public debt by 224% to $300 bn, Japan reduced by $50 bn

Major sectors of US economy already in foreign hands

Sub-prime and Credit Crunch (latest in RED)

"IMF states that the UK is particularly exposed to the current crisis"

"Not until total debt comes down to a realistic number can a real recovery take place. If debt is to be destroyed to that magnitude the deflation will be monstrous."

Mish: "Germany fears global meltdown"

Hutchinson: new financial system by 2013

Derivatives: Banking capital "insufficient to handle even one per cent of potential losses."

California realtors report house prices collapsing (htp: Drudge Report, LA Times)

KPMG criticised for allegedly poor auditing of failed US mortgage firm (htp: Drudge Report)

More on the "sucker clause"
Denninger: JPM may have been forced to bid more for Bear Stearns by trick clause

Subprime explained using stickman cartoons (htp: Neatorama)

"Wat Tyler": UK GDP to fall 1.3%

Wagner: Goldman thinks recession means 30% house price drop, 39% mortgages in negative equity

Amerman: 2007 subprime a prelude to much bigger potential crisis

Denninger: house prices to fall 15% - 50%

China's need to expand territory (latest in RED)

Chinese strategic interest in Tibet, and also the Indian region of Arunachal Pradesh
Chinese incursions into Arunachal Pradesh (2007 story)

"China Watch" from Jane's Intelligence Review

Official Chinese government website (incl. environment & international issues)

China angling for territory swap with India

Russia's north-eastern border with China: future tensions?

"Maps published in China show Burma as part of Chinese territory"

Unsustainable exploitation of Tibet's natural resources by China

Lovelock: "China uninhabitable by 2040"
Dr William Gray disagrees, predicts cooling within next 10 years (audio)

Chinese agricultural production "could drop 10% by 2050" because of climate change

Climate change in Tibet threatening East Asia's water supply

Investment (latest in RED)

Susan Walker: hold T-notes, not gold or the Dow, in a recession

John Mauldin: p/e ratio a predictor of bull/bear markets; detailed guidance on investment principles

From "The Big Picture" blog

Monty Guild: stock rally if mortgage bond market stabilises; invest in non-leveraged areas

Faber: historically, volatility bad for investors - stay out, take your girl on holiday

Falling US dollar threatens yen "carry trade", could trigger investment crisis

Gold a haven in crisis, NOT a long-term inflation-adjusted investment

Henry To: Cash-to-equity ratio at 20-year high, US stock market "oversold"

Denninger: Deleveraging of hedge funds may hit equities, commodities

Inflation - UK (latest in RED)

UK M4 accelerated in past 5 years

Prof. Costas Milas: M4 money supply growth up to 10% p.a. not significantly inflationary

M4 expansion offset by declining velocity of money (see 2005 slide below) (plus UK M4 in £billions, below, right)

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BoE Bulletin (Q3 2007): "Interpreting Movements in Broad Money"

Intermission

The FTSE has just closed at 5,414.40, about 1,150 points down from a recent high (10 December 2007) of 6,565.40.

But the gyrations have gone on for much longer. The FTSE bust UPwards through 5,438 on 29 October 1998, heading for nearly 7,000 by the end of 1999; popped and went through 5,417.60 in a DOWNwards direction on 29 August 2001; hit bottom (3,287) on 12 March 2003; rose back UP through 5,358.60 on 2 November 2005 - and here we are again.

Except we haven't factored-in inflation, so each later revisiting of the 5,400 level represents a further loss in real terms.

Meanwhile, let's take a look at what we might do to preserve what little wealth we have.

Residential property: costs about double its long term trend (3x income). But Mrs S isn't keen on a caravan, not even, as I suggested, "if we get a nice horse".

Stocks: the S&P's long-term trend p/e ratio is a little under 15, so to get back to that it should fall by 25 - 30%. Looks like we're partway there. Emerging markets have boomed, but as that sage Christopher Fildes said many years ago, the definition of an emerging market is that is is a market from which it may be difficult to emerge.

Bonds: a painful subject, with CDOs and the like. Hard to tell quality from rubbish at the moment, and if the credit contraction forces interest rates up, the capital value of bonds will have to fall to match the yield available on other kinds of loaned money.

Commodities: some markets such as gold are small enough to be manipulated by speculators (and sales from stock) - and much of the investment in them may be leveraged, which brings in extra uncertainty because the credit crunch could force sales to cover cash calls. Others, such as oil, may be affected by reduced demand in a recession. So commodities are not a no-brainer for the amateur investor. How many will know when they've reached the top of the price spike? Agriculture might be interesting, though, as I reported a while ago and as Jimmy Rogers says now, according to Contrarian Investor.

No wonder Marc Faber said last year that he saw bubbles everywhere. He has since gotten into gold, among other things, but he is a very smart, quick-moving trader. If I had any serious money, I'd rather use him (and others like him) than try to compete with him.

What else?

Some governments offer their own instruments for matching inflation - Index Linked Savings Certificates in the UK, TIPS in the USA, for example.

I suppose that if you expect food and fuel to rise in price, you might stock up - though a John Denver-type petrol store is probably unwise, if not illegal. And even tinned food, rice and dried pasta will only stay in good condition for so long.

And not everything is likely to go up. We look as though we're in for an odd combination of inflation and deflation. Houses, stocks, maybe bonds, maybe some commodities, may present buying opportunities sometime. And how about those consumer durables - the cars, computers etc you may want to renew or upgrade sometime? So cash really doesn't seem that bad to me, so long as you make sure you're maximising your rights under local depositor protection laws.

And then there's the bigger picture. Douglas Adams, author of The Hitchhiker's Guide To The Galaxy, observed of unhappiness: "Many solutions were suggested for this problem, but most of these were largely concerned with the movement of small green pieces of paper, which is odd because on the whole it wasn't the small green pieces of paper which were unhappy." My point is not that money is unimportant, but that it won't be enough to see ourselves all right - we still have to live with our neighbours. It's important to get the economy straightened-out, because when others are unhappy and insecure, we shan't be safe, either. Perhaps there's a selfish element in altruism.

It's pretty clear how things are now, and there's no need to keep the sirens going when you can see the fire. All I hope is that concerted, imaginative action will minimise the damage. A wilder hope is that we might reform the system - especially our rotten currencies and remote, self-centred politicians. I've learned much from joining in the debate, but don't think I have much more to contribute at this stage, so I think I'll be better off giving my ego a rest and reading you, instead.

My final guess, for now: it'll be time to get back into the swim in the Spring of 2010.