Kevin Armstrong’s Strategy Thoughts

November 2012

Confidence, Expectations and Markets!

Introduction

Over the last month markets have broadly meandered sideways and in so doing they have continued to deliver the ‘frustration’ that I discussed at length three months ago. Bulls on both bonds and equities have had both some good days and some bad days, and the same has been true for bears, but on balance there has been no resolution as to whether the action of the last few months has been the cresting of a bear market rally or an extension of a now fairly aged cyclical bull market in equities. Or the end of a very long term, secular, bull market in bonds. Amid such frustrating periods the most important thing an investor must do is avoid becoming frustrated. This may sound like a statement of the obvious, however, it is very easy to get swept up or down in whatever may have occurred over the last few hours or days. As the action of the last few months has illustrated, this is unlikely to prove rewarding. None of these frustrating movements have caused me to alter my outlook for asset markets and therefore my very cautious strategy has not changed. I worry about returns across virtually all asset classes and so continue to focus upon capital preservation. Having said that I do consider the recent action of commodity prices to be of some concern and I also worry about the apparent comfort that is being taken as a result of improving consumer confidence surveys.

In this month’s edition of Strategy Thoughts I explore both of these themes and conclude that there are likely some important cyclical and potentially secular messages in both of them. I also review the outlooks for gold and inflation (or deflation), not from an economic standpoint but from an ‘expectational’ one.

I have often ridiculed the efforts of investors to build an investment strategy and outlook based upon economic forecasts. This isn’t because I don’t believe anyone can forecast the economy, some analysts do have a decent track record, rather it is because determining what even a perfectly correct forecast will mean for investment assets is the real art. Markets throughout history have both risen and fallen apparently as a result of similar, or even identical, economic outcomes. The reason for this is expectations, and they are notoriously difficult to measure but ultimately they are what drive markets. A 4% GDP number may be seen as outstanding if expectations were for 3%, but equally it would be a disaster if 5% or more were expected. Still investors strive to construct an economic scenario upon which to base their investment strategy. This is because as human beings we hate uncertainty and so take comfort in a seemingly sensibly argued economic rationale, generally that comfort is misplaced, especially as the more comforting rationales tend to be the most widely held (we are herding animals) and therefore must already be reflected in the market. Another challenge is that expectations are constantly changing, often, and understandably, as a result of movements in the market about which those expectations are held.

Confidence surveys obviously attempt to divine where expectations are, this aim is admirable, but by the time they come out that ‘snapshot’ is frequently weeks out of date. Markets will already have reflected these changes. However, whilst broad consumer confidence surveys may only tell us what the markets already knew some weeks prior, surveys of CEO confidence may be of more value, but more on that later. First I want to look at gold and then some glimmers of hope, from an expectational standpoint, that the secular bear market that began more than twelve years ago, may be closer to its end than its beginning and possibly its middle.

Gold

In order to gain a useful perspective on the gold market it is important to take a long term view and it is also important to understand just what drives the price of gold. It obviously is not valuation, gold doesn’t pay any dividend or coupon and it doesn’t earn anything on a per share basis, it also is not inflation, contrary to popular belief borne out of the inflationary seventies, gold has risen through both inflationary and deflationary periods throughout history. And it is also clear that interest rates are not gold’s primary driver, the argument has been that the lower rates are then the less one is giving up to own gold and so its price should rise. This is a nice neat rationalisation, it seems to make sense, and yet over the last year, while it has become increasingly clear that the US Federal Reserve is going to keep cash rates at effectively zero for a longer and longer period, the price of gold has moved sideways to down. The price of gold is a perfect example of a market that simply reflects expectations, with no seemingly sensible valuation or economic rationalisations to get in the way it has to be levels of expectations, and their changes, that drive the price. This is why it is important to take a long term view of expectations for gold.

Ten and a half years ago, in a newsletter for The National Bank of New Zealand, I discussed the fact that a successful investor over the prior sixty years only had to make a handful of smart and bold investment decisions; own US shares from 1942 to 1966, commodities from 1967 through to 1980, Japanese shares for the decade of the eighties and then technology shares for the nineties. I concluded this section of the article with:

Financial assets generally have enjoyed massive price inflation over the last twenty years; it is therefore possible that once again real assets may start outperforming the still widely embraced financial assets.

I went on to raise some possibilities as to what might work in the decade ahead:

Commodities and precious metals have been amongst the most depressed assets since their bubble burst in 1980 and have long ago slipped off most serious investor’s radar screens. A marked change from twenty five years ago when they formed a part of any balanced portfolio. Prices in real, inflation adjusted terms for most commodities have plunged over the last twenty years even as demand for many of these products has grown. Eventually increased demand for any product in the absence of growing supply should result in price increases. With a growing world population, and a decreased focus on financial assets, resources and commodities generally may be the “previously depressed” asset that is next set to grow in price.

This assessment was largely based upon the fact that at the time no one wanted to invest in ‘real assets’ and gold in particular was seen as anything but precious. I pointed this out with this closing remark:

Most central banks around the world have been reducing their holdings of gold as reserves, this has undoubtedly had a depressing effect upon gold’s already depressed price. The price of gold has been bouncing along a little above $250 for a few years now having fallen from its high of $850 in 1980 and from an investors perspective has been largely unloved. It is interesting that over the last few months the price has begun to pick up at the same time as the world’s two fastest growing economies, Russia and China, have been buying gold for their reserves. The primary reason for their purchases has been their desire for diversification away from the very extended US dollar.

That was over a decade ago, how things have changed since. The dollar is anything but extended (on the upside) now and everyone it seems ‘knows’ the seemingly sensible reasons to own gold. This was highlighted in a recent CNBC article

"I think gold is going to go up against all currencies…central banks around the world are being too loose," Schiff said, arguing that the Dollar Index (Exchange:.DXY) "is going to be cut in half at a minimum. If we don’t change our policies, the dollar index could go much lower." On Wednesday, gold sank to a seven week low near $1,700 an ounce, only weeks after setting an 11-month high just shy of $1,800. "One day we’re going to look back at $1,700 with nostalgia," Schiff said. "People are going to be shocked at how inexpensive gold was when it could be snapped up for such a bargain price." (Emphasis added).

I think we can look back to the early 2000’s and be shocked at how ‘inexpensive’ gold was then, at least compared to current prices, but I believe it is more likely that gold is far closer to a peak than a trough and last year’s high may turn out to have been that peak. Certainly it has spawned an enormous industry in gold investment vehicles that barely existed ten years ago and is now spawning extravagant book titles.

A Wall Street Journal blog on 24^th October was headlined:

Gold: Do We Hear ’36,000′?

The blog went on to describe a soon to be released book;$10,000 Gold: Why Gold’s Inevitable Rise Is the Investor’s Safe Haven, by Canadian gold manager Nick Barisheff. The book forecasts that gold will hit $10,000 ‘before too long’.

The blog then went on to point out that similar extravagant claims have been made for other asset classes in the not too distant past.

“The resemblance may be purely coincidental, but the advance publicity for the book reminds us of what happened back in 1999, when a series of popular books forecasting sky-high stock prices came out one after another.”

The authors and publishers vied to outdo each other’s titles like drunken sophomores at a college football game yelling “We’re No. 1!” and “No, we are!” The low bid was Dow 36,000 by Kevin A. Hassett and James K. Glassman. Then there was David Elias’ Dow 40,000. Finally came Charles W. Kadlec’s Dow 100,000.

If history were to echo perhaps we have to wait for books proclaiming $50,000 or even $100,000 gold before calling a peak but perhaps such excess won’t take too long, in the equity market those titles came out in rapid succession towards the end of 1999. When Dow 36,000 came out in October 1999 it was forecasting that a market that had already quadrupled over the prior decade was going to quadruple again. Gold $10,000 is forecasting that a market that has risen six fold over the last decade is going to rise another six fold. Obviously anything could happen, but extravagant book titles tend to come out because they will sell, and what sells tends to reflect a comfortable consensus. They therefore reflect expectations that are already in the market. This certainly was the case with Dow 36,000.

In Dow 36,000 James Glassman and Kevin Hassett recommended that all investors should have 80% of their investment assets in the equity market and it seems Glassman followed his own advice and in his own words his 80/20 portfolio got ‘hammered’. Chastened by this experience earlier last year Glassman released ‘Safety Net: The Strategy for De-Risking Your Investments in a Time of Turbulence’. In Safety Net Glassman is recommending a far more cautious and balanced approach, a 50% equities and 50% bond portfolio, not quite but close to the opposite end of the spectrum to where he was twelve years ago. Clearly Safety Net would have been a brilliant book to publish in late 1999, its advice would have been timely and extremely valuable to anyone that read it and would have ensured that so much of the pain that has been suffered over the intervening twelve years would have been avoided. But Safety Net would never have been published in those heady days of the late nineties, when everyone was going to be rich, because no one wanted to hear such a down beat outlook. What the public wanted, and so were given, were new racy high tech internet funds and books on how the sky was the limit. That was where expectations were then, and with such lofty expectations it is now obvious that disappointment was inevitable.

Now it seems, after twelve years of investment purgatory, expectations have travelled some distance back along the long term optimism / pessimism scale. Eventually, when the current secular bear market ends, ‘Never Again’ will be published, ‘why investment is the last thing anyone should do with their hard earned savings’ and maybe even Mr Glassman will oblige, and it will reflect expectations that have travelled all the way to the opposite extreme of Dow 36,000. We are not there yet, however, the fact that long term expectations have moved as far as they have is encouraging, at least from a very long term perspective.

In the meantime it should be enough to learn to avoid whatever books are hitting the best seller lists with extravagant forecasts, whether it is how to get rich in property, internet stocks or gold. These forecasts are far more a reflection of what has already worked, and a reflection of where collective expectations already are, than where future returns will be found.

To his credit Glassman has outlined why he was wrong about Dow 36,000:

“The world has changed since 1999. U.S. economic standing is now declining, and we have to account for risks not only to commerce but to the global order. In theory, historical averages show that stocks are a good buy if you can hang on through the miserable periods. But most investors find that excruciatingly difficult to do—a fact that I never fully appreciated in my 30 years of writing about investing. Fear, or simply a need for cash, triumphs, and people sell before stocks bounce back. I’ve gotten tired of telling investors to buckle up and hang on. Instead, I am urging them to adopt a more cautious strategy than the conventional financial wisdom—or "Dow 36,000"—would dictate.”

Expectations and emotions, or aggregate mood, are what drive markets over multiple time frames, not valuations and not economics.

Confidence

Consumer confidence numbers are one of the myriad of indicators that economists attempt to forecast, the thinking being that rising or falling results in these confidence surveys will give some guidance as to what the economy will do. On the back of that supposed ‘heads up’ on what the economy will do investors build investment strategies. The important question this raises is does confidence lead the market, and the answer unfortunately is that it does not; in fact given the delays in getting the results of these surveys out it actually lags the market a little. The results of confidence surveys do tell investors where markets are, that is whether they are rising or falling or in a bull or bear market, but that isn’t very valuable really as the market already provides the answer to that question!

A little over three years ago I wrote a Thoughts and Observations piece titled ‘Consumer Confidence – Cause or Effect?’ In it I wrote:

As well as the long term (secular) swings in valuation and confidence coinciding it is interesting to note that so too do many of the shorter term (cyclical) swings. This was particularly obvious during the long broad consolidation that the market went through from the mid 1960’s through to the early eighties. Each subsequent low point in the market occurred on sequentially lower confidence levels and at lower valuations; a similar pattern was seen at each successive peak. The important point is not that the market is driving consumer confidence or vice versa, rather that they both, virtually simultaneously, reflect a broader deep seated optimism or pessimism. Looking for changes in consumer confidence to provide some hint as to what markets might do is probably futile, just as believing that movements in the market affect confidence, they don’t. Both are driven by and reflective of basic levels of social mood, and its swings from pessimism to euphoria and back.

This can clearly be seen in the chart of US consumer confidence. Since the secular bear market began Consumer Confidence has tracked the market, it certainly has not led the market. The long term, secular peak, in consumer confidence was recorded in February and again in June 2000, at about the same level as was seen at the onset of the prior secular bear market in the mid 1960’s. Confidence then fell through to April 2003 and bottomed, the market had bottomed several months earlier. Confidence then rose throughout the cyclical bull market finally peaking at a lower peak than the prior peak, in August 2007. It then collapsed, coincident with the market, to a record low level and eventually bottomed in March 2009, exactly when not only the US but virtually every market in the world bottomed. Confidence then rose from that depressed level and finally peaked in March 2011, around the time most world markets recorded their last cyclical peak.

The same pattern of confidence tracking the ebb and flow of cyclical bull and bear markets was seen through the last secular bear market from 1966 to 1982 and it is interesting to note that just as the price low for the market was seen at the depths of the 1974 cyclical bear market, not at the end of the secular bear market in 1982, so too was the confidence trough. Whilst cyclical peaks throughout that secular bear market were more or less at similar levels that was not the case in the confidence survey, each subsequent peak in confidence coincided with a cyclical peak in the market but at sequentially lower levels. The same pattern has been seen over the last twelve years. This means that the depths of the lows seen in confidence in early 2003 need not be revisited but it is equally unlikely that the highs of 2007 and 2000 will be seen until long after the current secular bear market ends.

Whilst consumer confidence may not tell us any more than ‘where we are’ there is one confidence survey that seems to give some insight as to ‘where things are going’, and that is the survey of the confidence of corporate chief executive officers.

What follows is the latest result of the CEO confidence survey from the Conference Board.

CEO Confidence Declines Again

04 Oct. 2012

The Conference Board Measure of CEO Confidence™, which fell in the second quarter, declined again in the third quarter. The Measure now reads 42, down from 47 in the previous quarter (a reading of more than 50 points reflects more positive than negative responses).

Says Lynn Franco, Director of Economic Indicators at The Conference Board: “This latest report reflects ongoing concern about the strength of the economy. CEOs’ assessment of current conditions remains weak and they have grown increasingly pessimistic about the short-term outlook. Sluggish growth and a persistent cloud of uncertainty have played a role in CEOs curtailing spending plans this year.”

CEOs’ assessment of current economic conditions has grown more pessimistic, with just 9 percent stating conditions have improved compared to six months ago, down from 17 percent last quarter. Chief executives are also more negative in assessing their own industries. Now, just 14 percent of business leaders say conditions have improved, compared with 22 percent in the second quarter.

CEOs’ optimism about the short-term outlook has also declined. Currently, less than 12 percent of business leaders expect economic conditions to improve over the next six months, down from 20 percent last quarter. Expectations for their own industries are also more pessimistic, with just 15 percent of CEOs anticipating an improvement in conditions in the months ahead, down from 25 percent in the second quarter.  

Clearly this outlook is materially bleaker than that of consumers and it has already been deteriorating for some time. Worryingly this is a remarkably similar picture to that evidenced by CEO confidence surveys in late 2007 and into early 2008. This was an excerpt from the Conference Board’s release in January 2008:

Business leaders’ confidence in the U.S. economy has dipped to the lowest level since late 2000.

The Conference Board Measure of CEO Confidence, which had declined to 44 in the third quarter of 2007, fell to 39 in the fourth quarter. The last time the measure fell below 40 was in the fourth quarter of 2000, when it dropped to 31. (A reading of more than 50 points reflects more positive than negative responses.)

Unfortunately little comfort should be taken from the relatively elevated levels of consumer confidence in the US; all it tells us is that the market should be close to its recovery high, which until a few weeks ago it was. The fact that CEO confidence has continued to decline, in a similar manner to the slide seen ahead of the GFC associated bear market, is of far greater concern.

Commodities

I have referred to economist A. Gary Shilling many times over the last couple of years and in particular I recommended his book ‘The Age of Deleveraging’. He recently made clear his outlook for commodities in no uncertain terms in one of John Mauldin’s ‘Outside the Box’ pieces:

“The weakness in commodity prices, starting in early 2011, no doubt has been anticipating both a hard landing in China and a global recession. In my view, the foundation of the decade-long commodity bubble is crumbling, and the unfolding of a hard landing in China and worldwide recession will depress commodity prices considerably, even from current levels, as disillusionment replaces investor enthusiasm.”

I have shared his views on commodities, albeit perhaps less stridently, for many months. In April of this year I wrote:

No changes were made to our outlook on currencies. We continue to view the low seen last year in the US dollar as potentially a long term bottom and that surprises going forward are more likely to be on the upside for the US currency. In commodities we anticipate further downside and see last year’s peak in the CRB index as an important cyclical peak.

The weakness in the CRB is particularly notable given the strength in oil and raises some questions as to the durability of oil’s bull market.

Since then oil has fallen by about 25% and commodities indices have moved on balance sideways and rolled over recently. This leaves the peak seen in April of last year as the high for many commodities, just as it was for many stock markets around the world, as I discussed last month, and it raises the question whether the widely feared central bank induced inflation is as big a threat as so many currently believe.  

Last week CNBC ran the following story;

Fed’s Lacker: Latest Stimulus Will Boost Inflation Friday, 26 Oct 2012

 

Over the last four years the inflation versus deflation debate has swung from one extreme to another several times and each time the fear of one or the other grew to such a crescendo that major headlines were being made. The fear proved to be misplaced and gradually a fear of the opposite outcome grew.

Even after markets rolled over in late 2007 and into 2008 the major fear was inflation:

Inflation fears and oil prices pinch markets, June 11, 2008 New York Times

 

Soaring corn price fuels food inflation fears, June 11, 2008 Times Online

 

But as markets continued to collapse that fear receded and the fear of outright deflation emerged:

First inflation, now it’s deflation fears, Nov 11, 2008 Reuters

JUST four months ago, soaring commodity costs were the biggest economic worry as the oil price raced to a record high. Now the buzzword is deflation, which is altering both the economic outlook and the way governments need to respond to the threat of a deep recession.

This reversal was seen in just a handful of months. Finally as markets bottomed and began to rally gradually the deflation fear fell away only to be replaced by the threat of inflation again:

IMF Warns on Inflation, Growth Risks, Feb 6,2011 WSJ

 

Inflation leaps to 8-month high, pressure on Bank, Jan 18, 2011 Reuters

 

Inflation rise sparks fears of long-term spike, Jan 17, 2011 The Australian

 

Bond Market Flashes Inflation Warning, Feb 7 2011 WSJ

Jump in U.S. Treasury yields signals market fear that Fed is behind the curve on prices

How to Profit From Inflation, Feb 5, 2011 WSJ WEEKEND INVESTOR

The Scourge of Rising Prices Hasn’t Hit Home Yet, but the Underlying Signs Point to Trouble Ahead. Here’s What You Should Do Now

These fears have continued to grow and the fear behind them has only been stoked by the same ‘QE to infinity’ that is inspiring the many gold bulls discussed earlier. Throughout this secular bear market, that is nearly thirteen years old now, I have consistently believed that deflation was a far bigger threat than the kind of inflation that so many of us lived through in the seventies and early eighties when gold had its last great bull market and blow off, this continues to be my view. It is worth repeating a comment that the octogenarian market commentator Richard Russell wrote during the spike in inflation fears four years ago:

In the investment business, it pays to be suspicious of the obvious. If it’s obvious, every dim-wit knows about it, and it seldom pays to follow what every dim-wit knows and is operating on. 

Example – Everybody know that inflation lies ahead. Again, be suspicious of what everybody knows. 

This is very sage advice, and not only about the prospects for inflation, it gets to the heart of what I have consistently maintained drives markets; expectations. It is when hopes are dashed and fears prove baseless that markets reverse, not when the news goes from good to bad or vice versa.

I said don’t believe in the Music Man!

One ‘expectation’ that I have been very dubious about has been that central banks can and will do ‘whatever it takes’.

Two months ago in the September edition of Strategy Thoughts I discussed at some length the concern I had that investors seemed to have absolute faith in the power of central bankers to prevent an investment market catastrophe. I was astounded that this faith was so strong despite the Global Financial Crisis, the worst economic and investment market collapse in seven decades, being less than a handful of years ago. I suppose one might try to argue that things would have been worse if not for central bankers but it seemed three months ago, and continues to now, that investors’ expectations over central bankers’ ‘power’ are far too optimistic. Last month Dallas Fed chairman Richard Fisher, who has been outspokenly critical of the ‘Bernanke doctrine’ commented in a speech:

 “It will come as no surprise to those who know me that I did not argue in favour of additional monetary accommodation during our meetings last week”.

“I have repeatedly made it clear, in internal Federal Open Market Committee deliberations and in public speeches, that I believe that with each program we undertake to venture further in that direction, we are sailing into uncharted waters. We are blessed at the Fed with sophisticated econometric models and superb analysts. We can easily conjure plausible stories as to what we will do when it comes to our next tack of eventually reversing course.”

“The truth, however, is that nobody on the committee, nor on our staffs at the board of governors and the 12 banks, really knows what is holding back the economy. Nobody really knows what will work to get the economy back on course.”

“And nobody –in fact no central bank anywhere on the planet – has the experience of successfully navigating a return home from the place in which we now find ourselves.”

“No central bank –not least the Federal Reserve – has ever been on this cruise before.”

As the slide down the ‘slope of hope’ continues this blind faith, or hope, will gradually, and at times rapidly, evaporate and be dashed. When the next cyclical, and possibly secular, buying opportunity arrives central bankers will likely be despised for the terrible job they have done rather than celebrated as being able to do ‘whatever it takes’.

Conclusions

Overall my views on most asset classes and markets have not changed since early last year. It was then that most equity markets rolled over and began sliding down their next cyclical bear market, their next slope of hope. Very few markets have rallied to higher highs on this most recent rally but the widely followed US market obviously has. Nonetheless I continue to believe that a cyclical bear market globally is continuing to unfold and that preservation of capital continues to be more important than chasing returns or yield, particularly in what is likely to continue to be an environment more characterised by deflation than inflation.

None of these conclusions are arrived at as a result of my economic outlook, I don’t start out with such an outlook, but obviously if my scenario for investment markets eventuates it is likely that more challenging times lie ahead rather than the continued, albeit weak, recovery that so many hope for. Markets are driven by people, their hopes and fears and expectations, and as such reflect aggregate social mood. The beauty of markets is that they reflect this virtually instantly, in real time. The same cannot be said either of confidence surveys or economic numbers, both of which suffer from substantial lags.

Final Comment

It has been commented that many of my remarks tend to be quite US centric, this is a fair observation but not one that I currently take as a criticism. The world does still look primarily to the US for leadership, and not just in the area of financial markets. This reliance upon the US for a lead on what may happen next, at least in the area of markets, was brought home today by the frequent comments on the TV and radio to the effect that with the US markets closed due to Hurricane Sandy it was difficult to know what other markets would do. It will certainly be interesting to see just what happens when markets open once more on Wednesday US time.

Kevin Armstrong

30^th October 2012

Disclaimer

The information presented in Kevin Armstrong’s Strategy Thoughts is provided for informational purposes only and is not to be considered as an offer or a solicitation to buy or sell particular securities. Information should not be interpreted as investment or personal investment advice or as an endorsement of individual securities. Always consult a financial adviser before making any investment decisions. The research herein does not have regard to specific investment objectives, financial situation and the particular needs of any specific individual who may read Kevin Armstrong’s Strategy Thoughts. The information is believed to be-but not guaranteed-to be accurate. Past performance is never a guarantee of future performance. Kevin Armstrong’s Strategy Thoughts nor its author accepts no responsibility for any losses or damages resulting from decisions made from or because of information within this publication. Investing and trading securities is always risky so you should do your own research before buying or selling securities.