Catching the Bid

Stocks are catching the bid again, trading higher. The S&P 500 has topped 1500, a level not seen since 2007. The Dow has also recovered from its lows to pre-meltdown levels, above 14,000. Stock traders shrugged off fiscal cliff fears, to extend the rally into the new year. Small investors are now joining the professional buyers, who have viewed stocks as undervalued assets for over a year. They are cashing in their bonds and emptying the mattresses to put money into stocks. What has propelled US equity markets? The answer may surprise you.

We’ll we know the presidential election has not pushed the stock market higher. To the contrary, stocks tumbled when the president was re-elected. Stocks had rallied with pre-election hopes of a new, pro-growth occupant in the Oval Office. But alas, that hope vanished when the final votes were tallied. The president could have won over traders by announcing a change in his economic policy to start his second term, but he didn’t, and his plan has consequences. More on that later.

So if the president’s economic policy did not stimulate the current rally, what did? The answer lies in a fundamental principle of free-market economics (and everyday life), namely, substitution. In his 1978 text Microeconomic Theory, Nicholson defines substitute goods as “those goods which, as a result of changed conditions, may replace each other in use (or consumption).” Investors treat risk-free yield as a desirable economic good. The world gold standard risk-free instrument has been the US Treasury bond, or note. Buyers of AAA-rated 10-year Treasury notes would typically collect 4% annual interest with virtually no risk of default. In contrast, equities as an asset class typically return 7%, commensurate with higher risk.

Companies could go bankrupt, products could fall out of favor, or stock prices could fall for any number of reasons. Throughout history, investors searching for yield have committed capital both to stocks and bonds, overweighting their portfolios in one or the other asset class according to their risk profile and investment objective.

But that time-tested strategy not longer holds. That’s because the Federal Reserve has changed the game. In his reverent adherence to Keynesian stimuli, Chairman Bernanke has taken away risk –free yield (or pushed it out to 30 year maturities), by instituting his Zero Interest Rate Policy (ZIRP). This massive credit intervention flattens the yield curve and drives real returns on medium term Treasury instruments (and CD’s) into negative territory. Investors naturally seek other instruments. They look for substitute goods. Many select high-yield dividend stocks, not for their equity value, but for their dividend income. When the buyers come in, stock prices rise.

Many investors have been holding cash since the great financial meltdown. They have lost capital while they held because the Dollar has lost purchasing power since then (and will continue to lose value). This too, is a result of the Federal Reserve’s massive credit intervention. Big Ben loves to print money. But we know that Gresham’s Law still holds. The Fed debases and devalues the currency each month by printing more money out of thin air in its $1 Trillion/ year Quantitative Easing program.

That’s not all QE is doing. QE is pumping up stocks with hot air. The Fed’s ultra-easy money regime keeps margin rates low, which spurs stocks, and also keeps borrowing rates low for corporate capital investment. Because of investor substitution, incoming stock buyers benefit from low margin rates. But companies are not rushing to but capital equipment at low interest rates. Instead, companies are sitting on roughly $2 Trillion in cash here, and keeping another $2 Trillion offshore and out of reach of Federal taxes. Some companies can think of nothing better to do with their cash than buy back shares. Stock buybacks tend to push stock prices higher (less stock outstanding, higher P/E for the same earnings), but they are a tremendous waste of capital. Excess corporate cash should rightly go to shareholder dividends or expansion.

In general, US companies are not expanding. They certainly are not hiring. No amount of Federal Reserve QE will force them to do either. Simply put, the Fed cannot create aggregate demand. This is heresy, of course, to the Chairman and the president’s economic team. But the reason that the president’s entire economic team has deserted him is because their Keynesian policies have utterly failed. TARP was a failure. The GM bailout was illegal. The $800 Billion Stimulus Package failed. Cash of Clunkers failed. Mortgage modification failed. The Payroll tax holiday failed. GDP is hovering at low levels, and dipped into negative territory last quarter. Unemployment has not declined since 2009, despite the administration’s spin. It remains stubbornly at 14% (U-6 measure), a level not seen since the 1930’s. We simply cannot print money, tax, spend and regulate our way to prosperity.

So should investors join the buying spree in stocks?Well, the speculator and the aggressive investor may find some gains in equities now. We have been realizing good profits each week in our Model Aggressive Portfolio (MAP), where we focus on near term trade (weekly) setups in stocks, options and futures. In MAP, we have been focused on stocks since November 2011 and our recommendations have made money each week. But the market holds risks for more conservative investors that enter at these levels. That’s because earnings, the mother’s milk of stocks, are beginning to top out for many large cap companies. We are seeing companies meet or beat 4^th quarter earnings expectations and miss revenue expectations. Revenue growth is essential to earnings growth. Many companies are guiding analysts lower going forward. These companies are reflecting lower global demand and the realities of continued recession in Europe, a slowdown in China and slowing demand in the US.

Slowing, low demand in the US won’t be reversed by raising taxes. But raising taxes yet again is exactly what the president intends to do. What is puzzling about the president’s tax obsession is history shows cutting taxes stimulates the economy. The economy jumps when consumers have more discretionary income to spend. What’s more, the Federal government gets more revenue when marginal tax rates are reduced. This happened as a result of the Kennedy tax cuts, the Reagan tax cuts, the Clinton tax cuts and the Bush tax cuts. Reducing federal regulation also stimulates the economy, as we saw most prominently in the Reagan years, the longest period of prosperity and economic growth in our time.

The technical indicators are signaling stocks are reaching major resistance. For the S&P 500 index (SPX), a good measure of the broad equity market, prices has climbed to just over 1500, a key resistance level. Price action of the SPX has formed a bullish inverted head-and-shoulders pattern on the daily charts with a neckline at 1458. The measured move on a bullish breakout above the neckline is 105, which brings a target level of 1563. The SPX made its breakout of the bullish pattern on January 10^th, and has been climbing steadily since. Yesterday, the SPX closed at 1522.29.

This move up can also be seen in the Fibonacci extensions of the previous run up (June -Sept 2012) and pullback (Sept-Election swoon of November 2012). Since the November lows, price action has powered up to the 50% Fib (1448) at circle #1 on the chart below, then fell back to just above the 23.6% Fibo (1398 at circle #2), and quickly jumped past the 38.2% Fibo and surged right up to the 61.8 Fibo at 1472 (circle #3).After five days of consolidation at the 61.8 Fib, the SPX climbed steadily to the 78.6% Fibo at 1507 (circle #4) and appears to be headed higher still.

It is gratifying to see separate technical analyses in such lockstep agreement.

The speculator or aggressive investor that followed our Model Aggressive Portfolio (MAP) Recommendations has done very well with selected stocks, stock options and futures contracts over the last several months. Weekly returns have ranged from 30% to 77%. What choices are available to the conservative investor in today’s investment environment?

The answer certainly is not bonds, especially Treasurys. Treasury bonds yield negative real interest returns. Investment grade corporate bonds don’t offer much more for the added risk.

Conservative and prudent investors choose gold.

The case for choosing gold today is as strong as it has ever been. It can be made efficiently in the form of a parliamentary inquiry, so often used in my own sovereign state of New Hampshire’s General Court:

If you know, as I know, that stocks are full of Fed hot air, and the Fed has fenced off reasonable yields in fixed income instruments by intervening in the credit markets, and,

If you know, as I know, that corporate bonds offer yields only at a significant risk of default, and,

If you know, as I know, that the Federal Reserve is continuing to print money under its Quantitative Easing program, and has stated it will not stop until the unemployment rate is lower than 6.5%, and

If you know, as I know, that unlimited QE has no effect on the unemployment rate, and that

QE debases the currency and its purchasing power, and

If you know, as I know, that gold increases in value as the Dollar decreases in value, and that gold is recognized as the ultimate global currency,

Would you not agree with me that owning gold today will protect your wealth against the ravishing of fiat currency and tyrannical federal overreach?

That’s right. The answer for conservative investors is gold. In fact, aggressive investors should also own some gold to diversify their portfolios. Here’s why any investor should own gold now.

The great bull market for gold is continuing. The fundamentals are in force to push gold prices higher, and the technical analysis supports higher gold prices from here.

First, the fundamental case. It all boils down to central bank policy. The Fed, the ECB and BOJ are all maintaining accommodative monetary policies. That is, they will keep interest rates artificially low and continue to add liquidity by various forms of Quantitative Easing. QE itself debases the currency and drives commodity prices higher.Loss of confidence in the Dollar, the world’s reserve currency, is also reflected in the price of gold. Political instability in sensitive regions of the world affects the price of gold (and oil). We are seeing the war premium boosting oil prices as tensions rise over nuclear weapons development in Iran and North Korea. Even central banks are buying gold. That’s because unlike fiat currency, gold has intrinsic value. Gold is recognized as the ultimate global currency and store of value.

Second, the technical case.QE is weakening the Dollar. As the Dollar weakens the price of gold increases. The traditional inverse relationship between the Dollar and gold is present in today’s market. Global QE and US economic policy is keeping the Dollar weak. The weak Dollar supports higher commodity prices in general and higher gold prices in particular.

We can see this dynamic play out in the chart of gold vs Dollar below. Technical indicators on the daily and weekly basis charts are bearish for the Dollar. On the weekly basis charts, resistance is now 80.74 with support at 77.44. The Dollar is headed lower form here. A move down to the 78 level would command a gold price of 1800, a key resistance level.

What would cause the gold price to drop significantly?Well, if the Federal Reserve were to cease buying bonds (QE), the price of gold would drop. But Chairman Ben has reiterated his commitment to buying bonds at the rate of $85 Billion per month until unemployment is reduced to 6.5%. The January 2013 unemployment rate is 14.4% and the current regime has no pro-growth economic plan. The price of gold would drop if peace broke out in the Middle East and Iran, North Korea and China dismantled their nuclear weapons. Recent events in these tinderbox areas demonstrate there’s not much chance of that happening, particularly when the US is reducing its military strength to the point it can no longer fight in two theaters of operationat once. Gold would fall if real estate became a safe investment asset again. But it will take 10 years to work through the housing overhang of 5 million foreclosed properties that is weighing down home prices. And gold would fall, as it did in the Reagan years, if pro-growth tax reform, and a plan to balance the budget within ten years, which would include entitlement reform, were adopted now. As we saw in yesterday’s State of the Union address, the president is campaigning for higher taxes, more spending and more Federal regulation. No pro-growth agenda there.

So now is a good time to buy and hold gold. Buy gold to protect your wealth against the corrosive effect of ultra-easy monetary policy. Buy gold to maintain a store of value that is recognized universally. Buy gold to diversify your investment portfolio. Buy gold for peace of mind in uncertain times. Buy gold to secure yourself and your family.

Responsible citizens and prudent investors protect themselves and their wealth against the ambitions of over-reaching government authority and debasement of the currency by owning gold. Gold is honest money. Investors from around the world benefit from timely market analysis on gold and silver and portfolio recommendations contained in The Gold Speculator investment newsletter, which is based on the principles of free markets, private property, sound money and Austrian School economics.

The question for you to consider is how are you going to protect yourself from the vagaries of the fiat money and economic uncertainty?We publish The Gold Speculator to help people make better decisions about their money. Our Model Conservative Portfolio has outperformed the DJIA and the S&P 500 by more than 3:1 over the last several years.Follow @TheGoldSpec

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