Market Musings Blog

We don’t pay much attention to gold, believing that the price of the metal depends more on what someone is willing to pay for it as opposed to some intrinsic value. However, the near crash in its price has caught our eye lately. Why is gold dropping in price? We think:

• The stage was set months ago, as gold prices flattened and drifted down. With stocks and bonds booming, and the need for income and yield acute, it’s hard to justify holding an asset that requires storage and insurance, and pays no dividend. Yes, we know not everyone holds gold that way, but someone has to hold it that way, and those owners represent a huge part of the gold market. Probably more than one holder has shifted towards financial assets lately. 
• Cyprus is heading towards a sale of some of its gold reserves in order to self-fund its bailout. Portugal, lurching again towards a crisis, has a veritable boatload of gold, and might elect or be forced to do the same. The prospect of this kind of supply coming onto a market that has been weak for months is causing an acceleration of the decline.
• Today’s price action was brutal, and it coincides with slower growth reported by China. Inflation worry-warts can see the writing on the wall: we are about to shift from obsessing about rising prices to obsessing about falling prices and weaker economies. Even though currencies are being mistreated in a race to devalue, there’s little inflation as a result. What role, then, for gold?
• Gold’s price is echoing some serious deterioration in other metals and oil. With China slowing, commodities are in for a rough go for a while.

We have no idea where the ounce price will stop, but we’d be willing to bet it’s lower than today’s price. 

Those of a certain age will remember the words of this title as a commercial by a company that manufactured audio cassettes. The point was, the tape recording was so real it could not be distinguished from a live performance. That’s how we feel about the market these days. It looks like the real thing, but perhaps it is not. Certainly the media is worried that we’re about to crash at any moment, as are many investors. And woe to the investor who is still sitting on the fence about buying stocks. What to do? How to tell, if it’s real – or not?

We believe that valuation is the most enduring “tell” for market returns. Sentiment can interfere with valuation, as we saw in 2000-2002 and in 2008-2009. But in the end, buying assets cheaply will insure a decent return eventually. Currently, valuation is reasonable – not high but not particularly low either. This, combined with the Fed’s activities and improvements on the margin in the deficit, the jobs picture, and growth prospects provides the impetus for further appreciation. No doubt interruptions like a North Korean nuclear test or some other catastrophe will supply a reason for volatility – it’s the nature of markets to shift from rationality to sentiment. But in general we’d say this bull market is live, not Memorex. 

This year about $85 billion of cuts to the discretionary portion of the US budget will be implemented, at least under current law which, as we know, could change. Dire consequences have been forecast. Could these forecasts come true?

First of all, we’ve spent a couple hours with the Congressional Budget Office papers on this topic, as well as other writings, trying to understand one thing: are these really cuts or do they merely slow the rate of growth of spending? As best as we can tell, these will be real cuts, such that the federal government will spend less on many things in 2013 versus what was spent in 2012. However, Social Security, Medicaid, federal interest payments, and several other programs are exempt from the cuts. There will be only a modest cut to Medicare reimbursement rates. So while a part of the budget will be reduced, another large part will keep growing. 

The amount of the cuts in 2013 – at $85 billion – is around 0.5% of the overall US economy, and that’s overstated, because it is based on the US GDP in 2011, and the economy grew in 2012. 

Will this mean a hit to the economy – a recession, job losses, an uptick in the unemployment rate? Not likely. The size of the cuts is minuscule relative to our economy and the cuts are lagged, with the full effect unfolding over months rather than immediately. For evidence that informs our opinion, we looked to state budget cuts from 2009 through fiscal year 2013. In fiscal 2009, states had to cover budget gaps of $110 billion – that’s for one single year. In 2010, it was a huge $191 billion gap; the following years the gaps were $130 billion, $107 billion and for this year, $55 billion. Yet despite this drag, the economy began growing in 2010, posting 3% for the year. An $85 billion cut from the federal government will be less than any of those single years, except 2013, and our economy is healthier now. In out years, as the sequestration continues, we expect state and local hiring to pick up, taking up some or all of the slack from the federal level austerity. In fact, we are particularly lucky in that the synchrony of these events is allowing for slower deficit spending – something that is crucial to the future health of America’s economy.

As we expected, the Dow finally broke through the upper end of a long term trading range and is making new highs. Now that we’re here, worry abounds. Even analysts who expected new highs in 2013 are calling for a pullback. We take this as a good sign, meaning the rally can continue for a while. Day after day of a rising market is an unreasonable expectation, but certainly a market that works higher without drama is possible given the cautious sentiment. Except for Tuesday last week, daily moves in the Dow have been less than 100 points as opposed to the huge unsustainable leaps that are associated with extreme volatility. We also like the market’s breadth: every type of company is having its day in the sun. All told, the Dow is up over 9% so far this year. No doubt there will be bumps along the road – we’re not going to have a +60% year.

Meanwhile, bond interest rates are rising, but for the best possible reason: the economy looks better, inch by inch. Notably, history shows that stock market returns are excellent during times of slow, steady economic growth because that kind of environment is less prone to bubbles and distortions. 

All in all, we like it!