Monthly Archives: August 2011

At what point do we stop wondering what the crystal ball will show next?  Lately, every time I turn on the TV, the newscaster is announcing a new prediction for our economic future.  Sometimes two channels are simultaneously reporting completely different forecasts.  At this rate, how can one put faith in any of these hypotheses?  Will we eventually tire of these predictions (which are really nothing more than educated guesses) or will we just give up and roll with the punches?

Our favorite Irish economist Charlie Fell explores our "Prediction Addiction" in his latest blogpost.  Read the full article here.

 

Prediction Addiction

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Human beings are hard-wired to detect patterns and identify causal relationships amidst the constant stream of new information.  This behaviour can be traced to our ancestral past on the African savannah many millennia ago, where the ability to shape expectations from small samples of data, enabled our hunter-gatherer ancestors to successfully forage for edible fruits and seeds, stalk prey, avoid predators, find shelter, and seek mates. 

Scott Huettel, a neuroeconomist at Duke University, explains that, “The brain forms expectations about patterns because events in nature often do follow regular patterns:  When lightning flashes, thunder follows.  By rapidly identifying these regularities, the brain … can expect a reward even before it is delivered.

The ability to anticipate outcomes from regular patterns undoubtedly helped our ancestors to flourish but, Huettel warns that, “in our modern world, many events don’t follow the natural physical laws that our brains evolved to interpret.” The human brain is designed to conserve scarce neural resources, and so much so, that it requires only a single confirmation to anticipate a recurring pattern.  Huettel notes that as a result, “The patterns our modern brains identify are often illusory…

Pattern recognition and subsequent tactical buy or sell decisions are part and parcel of active investment management.  Investors however, often place too much emphasis on the recent past when forming expectations about the future – top-down analysts make tactical calls based on recent economic data, while technical analysts divine the future on historical patterns in stock prices.

Investors’ ‘prediction addiction,’ as the behaviour has been called by the financial columnist, Jason Zweig, is particularly relevant today.  Economists are busy shaving their economic growth forecasts for both this calendar year and next, following a string of disappointing data that fell well short of expectations.  Meanwhile, technical analysts are arguing for a reduction in equity allocations, given price action in the major stock market averages that confirms a change in the underlying trend.

Recession fears are afoot and investors are in need of guidance that will preserve capital and/or yield profits amid the uncertainty.  Indeed, anticipating turning points in the business cycle and, adjusting asset allocation accordingly, is central to successful top-down investing.

Unfortunately, economists have a patchy forecasting record at best, having failed to anticipate every one of the last five recessions.  Indeed, the monthly publication, Blue Chip Economic Indicators, noted in July 1990 that, “the year-ago consensus forecast of a soft landing in 1990 remains intact” – the economic expansion peaked that very month!

More than a decade later in March 2001, fewer than five per cent of economists anticipated that there would be a recession that year, even though a downturn was set to begin just days later.  More recently during the spring of 2008, the calls for a soft landing were almost deafening, despite the fact that the deepest recession since the 1930s was already underway.

Perhaps the study of historical price patterns performs better.  After all, stock price data is not reported with a lag and, unlike economic data, is not subject to revisions that continue several quarters after the fact.  As William Hamilton, the fourth editor of the Wall Street Journal wrote in his 1922 classic, ‘The Stock Market Barometer’ – “The market represents everything everybody knows, hopes, believes, anticipates, with all that knowledge sifted down to ... the bloodless verdict of the market place.”

The study of historical price patterns suggests that a further decline in the major market averages may lie in wait.  The 18 per cent fall in stock prices from their recent peak late-April, resulted in a bearish ‘Death Cross’ signal on August 12, as the stock market’s 50-day moving average of closing prices dropped below its 200-day moving average.

The ‘Death Cross’ is considered by technical analysts to be a portent of future weakness, but is the signal’s presumed ability to anticipate turning points and enhance investment performance supported by the historical record?  To find out, the ‘Death Cross’ and its converse, the ‘Golden Cross’, are employed as tactical sell and buy signals respectively, for a simple long/short strategy and, the investment results – excluding dividends – are compared with those generated from a straightforward buy-and-hold strategy.

The historical record shows that before the most recent ‘Death Cross,’ there had been 63 tactical signals since the summer of 1949 – 32 buy and 31 sell signals – which, gives weight to the late Paul Samuelson’s criticism in 1966, that ‘The stock market has predicted nine out of the last five recessions.

The buy and sell signals resulted in 33 winning trades and 30 losing trades, which is not much better than a coin toss.  More importantly, the price return generated by the long/short strategy saw an initial $10,000 investment compound to $537,000 over the period, as against $775,000 for the buy-and-hold strategy.

The historical evidence suggests that the ‘Death Cross’ adds no value to the investment process.  However, a more complete examination of its credentials reveals that it subtracts from investment performance during secular bull markets, which are characterised by powerful up-trends with only the briefest of interruptions; it adds to performance during secular bear markets, which are characterised by a protracted sideways pattern that is punctuated by violent downward price swings.

The bearish indicator provided ample warning to investors of impending danger, close to a market top in both the autumn of 2000 and the winter of 2007.  Has the ‘Death Cross’ sounded an early warning bell once again?  Time will tell.

 

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

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When you think of the foreign currency market, what do you think of? Perhaps world economies exchanging money from one currency to another. Maybe large institutions making decisions that affect millions of stockholders or account owners.

But did you think about you you’re invested in the world currency market even if the scenarios above are not in your control?

The reality is that we’re all invested in the currency market in one way or another. The money in your pocket and your checking account gives you exposure to the value of your domestic currency (dollars, euros, pounds, yen, etc.). Granted, when it comes to money that you are likely to be spending in the short term on goods and services priced in the same currency it’s not really much exposure. But, for your bigger assets and holdings, it can be a different story.

Let’s take something like your retirement savings or pension plan. You will spend that in the future, potentially at a time when the value of the currency is lower. We’re not just talking about inflation here (though that’s a legitimate concern). We’re also talking about the currency’s value in terms of the currencies of its major trade partners.

That value influences the cost of the goods you buy which are imported from abroad, not to mention the cost of those trips around the globe you have in mind for your golden years, and that villa in the south of France you’re hoping to purchase.

The currency market also impacts you in other ways. The earnings of companies in your investment portfolio have exchange rate exposures in many cases. These come in two forms. One is exchange rate conversion of overseas income. The other is the impact exchange rates can have on the attractiveness of the company’s products abroad, and the costs of foreign goods and services it consumes.

For that matter, if you work for a multinational company, or one that does business abroad, your very livelihood could have exposure to the currency market. It’s become an increasingly large part of the world in which we live, work, and invest today.

It’s also one you can take advantage of in your investing plans.

The foreign exchange (Forex) market is a 24-hour per day, five day per week market (and even weekends in some cases) where people come together to swap currencies. If you’ve ever traveled abroad you have participated in the Forex market by exchanging your home currency for that of your destination.

So, is investing in Forex the right investment strategy for you? Consider the following:

-       With $4 trillion in daily trades, it’s the world’s largest market

-       It’s not as risky as they say: the volatility of currency exchange rates is markedly lower than most other markets

-       Analysis and trading is tricky but there are many programs where you can have the transactions made by expert traders in their own accounts automatically duplicated in yours.

Just like investing in any other market or asset class, you should consider educating yourself before you dive in. That’s why we’ve put together a primer called “The Smarties’ Guide to Alternative Investing in the Foreign Exchange Market” which gives you just enough information about the Forex market, how it works and how you can participate as an investor. Smart investors can find it here.  Happy investing.

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

I came across a poll being run by the folks at BabyPips today. The question is "Do you usually trade using hedging, i.e. making the opposite trade of the one that is currently open?" When I checked on the results this morning it showed that 29% of respondents responded that they do indeed use this sort of "hedging" (though I couldn't see the actual vote count). This strikes me as a very high number, considering there is no economic benefit to this activity, and it can actually cost the trader money in the form of additional spread and carry costs. Maybe it's a function of BabyPips being largely a newer trader oriented forum.

In retail forex, "hedging" has long been a hot-button subject. When the NFA ruled that US brokers could no longer use that type of accounting ("hedging" in this fashion is nothing more than a method of accounting), it created something of a firestorm among traders. My No More "Hedging" for Forex Traders post at the time remains by far the most commented one on my blog, with strong views expressed on both sides.

Needless to say, this sort of "hedging" will not be among the risk management subjects I will be discussing in Wednesday's webinar. Instead, the focus will be on understanding volatility in the markets so one can be better prepared both for the risks implied and the opportunities it presents.

As a little bit of a taste, take a look at this chart.

What you see here is a comparison of daily volatility between the S&P 500 and the USD Index. The plots show the percent change for each market for each day, expressed as a positive figure (so a -1.5% would be plotted as +1.5%). As we can see, the stock market has moved around quite a bit more than the dollar has since the beginning of July, a time which encompasses things like the US debt ceiling debate and continued European sovereign credit issues. There may be a couple of sessions where the dollar was more volatile, but mostly the stock market moved markedly more than the currency index. That means on a strictly price volatility basis, the USD Index is quite a bit less risky than stocks. This is something investors looking for opportunities to diversify need to know.

If you've ever watched the 70's sitcom, The Odd Couple, you know that Oscar and Felix had their issues. Oscar, the disheveled, divorced, sportwriter, was the more socially-ept, carefree and witty character, while Felix was uptight, neurotic and of "the sky-is-falling" mentality. The two very different characters combined for a unique type of relationship: in the face of adversity they were somehow able to learn from each other and create opportunity.

The volatility we've seen in the markets over the past few months is what I'm coining: The Finance Odd Couple. On one hand, we have the Dow plunging 500 points in one day, countries in economic ruin and the U.S. credit rating experiencing the first downgrade in history. On the other hand, you have emerging economies rising, bullish analyst opinions on the US Dollar and opportunities to find the silver-lining in the market's volatility.

Because I am a glass-half-full kind of girl, I much prefer to see opportunity where everyone else sees doom and gloom. Case in point - the hot topic of this month's webinar called The Volatility Myth: Uncovering Opportunities in Turbulent Markets. John Forman, senior foreign exchange analyst, has some pretty interesting data to share with us on where the opportunities are for traders and investors alike. John has pulled this data together just for us and we want to share it with you. Wondering how volatile the markets really are? Curious as to where the opportunities lie? Want to ask some questions of your own?

I'll be hosting this month's webinar this coming Wednesday, August 24th at 12pm New York Time. Attendance is free and, by attending, we'll send you an exclusive copy of our nifty new eBook The Smarties' Guide to Alternative Investing in the Foreign Exchange Market. So, bring your questions, your opinions and your friends and join us for what promises to be an informative discussion and unique learning experience you can apply directly to your trading and investing. Register here.

See you at the webinar!

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Charlie Fell may be Irish, but he draws upon our very own Massachusetts history to explain the misfortune that has fallen upon Wall St.--witchcraft!  Well, not exactly, but he does use historical data to explain why a double-dip recession may not be in the cards.  Let's hope this bad spell ends before the situation gets even scarier!  Read his full blog-post here.

 

 

A Double-Dip is Not Reflected in Stock Prices

On this day in 1692, John Proctor along with fours others, including the Reverend George Burroughs, were executed by hanging at Gallows Hill in the village of Salem, Massachusetts, having being pronounced guilty of witchcraft and sentenced to death two weeks previously.  More than three centuries later and, the ‘black arts’ are clearly being practiced on Wall Street, as a coven of investment soothsayers has consulted their Ouija boards, amid the extreme volatility on financial markets, and divined that stock prices have already discounted the dreaded double-dip recession.

The diehard bulls on Wall Street stand accused of misplaced optimism that appears to be based on wishful thinking rather than hard facts.  The notion that an economic downturn is already reflected in stock prices at current levels is simply not supported by the historical evidence.

There have been nine recession-induced declines in the major stock market averages since the mid-1950s.  The mean and median drop in stock prices across these bearish episodes was 32 per cent and 28 per cent respectively, as compared with the 18 per cent fall from the recent cyclical high registered in late-April.

Furthermore, stock prices bottomed early last week on valuations – based on cyclically-adjusted earnings – that are several multiple points above the average recorded at the trough of previous recession-induced declines.  For current valuations to contract to the typical price/earnings multiple seen at previous cycle lows, the major indices would have to fall by a further 17 to 31 per cent, based on operating and reported numbers respectively.

The verdict of history is clear – the recent decline in stock prices and the resulting valuation multiples do not incorporate an economic downturn.  The historical evidence suggests that, given a recession-scenario, the S&P 500 could easily drop to 925 and, perhaps even further to below 775, as compared with a recent high of 1364.  In this regard, it is important to stress that the lesser of the two outcomes is more probable, should a downturn materialise, for a number of reasons.

First, a ‘true’ double-dip recession, where the level of real GDP during the up-cycle fails to exceed the previous business peak, has never before occurred in the post-WWII era.  The annual revision of the national income and product accounts, published by the Bureau of Economic Analysis (BEA) last month, revealed that the contraction in economic activity from the winter of 2007 to the summer of 2009 was greater than originally thought – at more than five per cent or half-way to a depression – while the subsequent recovery was not as robust as initially reported.

The lacklustre economic momentum since activity bottomed more than two years ago, means that slack in factor markets remains considerable – most notably in the market for labour.  The civilian unemployment rate has been north of 8 ½ per cent for 31 consecutive months – the longest stretch since the 1930s – and the current reading of 9.3 per cent is four percentage points above the average of the rate recorded at the previous nine business peaks.  Not surprisingly, real personal income, excluding transfer payments such as unemployment benefits, is still more than five per cent below the cycle peak, which suggests that households are decidedly short of firepower, even absent an economic downturn.

Second, the growth rate in nominal output – both year-on-year and quarter-on-quarter – has rarely been lower when the economy stood on the verge of recession.  The current pace of year-on-year growth is roughly half the typical level registered at previous business peaks, while the annual rate of quarter-on-quarter growth is more than two percentage points below its comparable number.

It cannot be stressed enough that a low growth rate in nominal output, combined with debt levels that are close to record highs relative to GDP, means that the economy is vulnerable to a vicious debt-deflation cycle, whereby demand-side constraints lead to falling nominal GDP, soaring unemployment and a catastrophic decline in corporate profits.

The household debt-to-GDP ratio has declined by more than eight percentage points from its peak to below ninety per cent, but the current figure remains high by historical standards, while declining tax revenues relative to GDP, combined with automatic stabilisers and various fiscal stimulus programmes, means that consumers’ deleveraging efforts have been more than offset by the increase in both federal and state debt-to-GDP ratios.  The bottom line is that the non-financial sector debt-to-GDP ratio has jumped from 226 per cent in 2007 to more than 245 per cent today.

Third, the prolonged ‘soft patch’ in the U.S. economy has already been transmitted to Europe.  Eurostat revealed earlier in the week that growth slowed to just 0.2 per cent in the euro-zone during the second quarter, as compared with the previous three-month period.

Should a recession in the U.S. materialise, the negative impact on the economic environment in Europe would surface relatively quickly via financial markets, and exacerbate the stress in sovereign debt markets that has already moved beyond the ‘soft’ periphery to Italy and Spain.  It is not unreasonable to argue that a full-blown recession in the euro-zone, at this juncture, would shut Italy out of the bond market, precipitate more than one sovereign default and a banking crisis that could bring an end to monetary union.

The notion that stock prices have already incorporated a double-dip recession is nothing less than bunkum.  The downside risk to stock prices from current levels, should the developed world succumb to recession, is material and cannot be dismissed out-of-hand, given that both governments and central banks lack the firepower to push the economy forward.  Tail-risk is high and caution is warranted.


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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Throughout the past few months, 200 of Massachusetts’ best and brightest technology companies have been competing for the prestigious Mass Tech Leadership Council awards.  Submissions were judged by a panel of Council trustees and local thought leaders who narrowed the contest down to 15 star-studded companies. We were totally psyched to learn that we made it to the finalist list!

Our fellow finalists could not be a more eclectic bunch of public and private companies. They have a wide array of products, ranging from Gemvara’s design-your-own jewelry to iWalk’s electronic limbs. The competition was stiff and we’re proud to be the only financial services tech company who made the cut.

On October 6th, all fifteen finalists will duel it out for the Product of the Year title at the Massachusetts Technology Awards Gala.  Throughout the cocktail reception, the CEO of each company will present their product and the winner will be judged by a live audience vote.   We’re counting on Currensee CEO, Dave Lemont, to dazzle the crowd and bring home our first Product of the Year Award!

Check out our competition (and their blogs) below:

AisleBuyer- http://blog.aislebuyer.com/

Apperian- http://blog.apperian.com/

Digital Lumens- http://www.digitallumens.com/company/blog/

Gazelle- http://blog.gazelle.com/

Gemvara- http://blog.gemvara.com/

GrabCAD- http://blog.grabcad.com/

iWalk

KangoGift- http://blog.kangogift.com/

Myomo

Peer Transfer

SpaceClaim- http://www.myspaceclaim.com/blog/sc/default.aspx

Strohl Medical

TripAdvisor- http://tripadvisor.wordpress.com/

Vecna Technologies

If you’re interested in attending the event, visit the Mass TLC page here.  We’d love to have your support!

 

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

Just about every time someone in the news media talks about the forex market – unless they are specifically familiar with it – they seem to do so with some kind of descriptor phrase related to how risky and volatile it is. I've written before on the subject of comparing volatility across markets. I think, though, it's worth taking a look at recent market action and see how things stack up.

Take a look at this chart, which compares the daily % range of the S&P 500, the Dollar Index, 10yr Treasury Note yields, Gold, and Oil. It provides a good look at what's been going on in the markets since the beginning of July (though not including today's action – August 18, 2011).

What the chart plots is the daily price range for each market. It's expressed as the day range as a percentage of the day's mid point [(H-C)/((H+L)/2)].

The most striking feature of this chart is how volatile the 10yr Note yield has been. Now, this is looking at yields, not price, so probably overstates the volatility seen in those instruments somewhat, but still we would expect a fixed income market to be on the lower end of the volatility scale. The S&P downgrade of the US is clearly seen on the chart in the big spike, but we can see that yields were quite volatile even without taking that period into consideration.

It won't be much of a surprise to see Oil as the next most volatile market.

Take a look at what market is consistently at or very near the bottom every day, though. The pink line is the Dollar Index. That means the Index consistently has low daily prices ranges compared to the rest of the markets.

Just to confirm all of this, take a look at this second chart looking at daily changes rather than ranges.

This chart plots the absolute value of each day's change (open to close), meaning all values are plotted as positives. The pattern is pretty similar to the first chart. Rate volatility has been high, with the Oil market often not far behind, along with stocks. The USD Index, meanwhile, holds to the lower end of the range, very rarely venturing beyond a 1% change for a given day.

As I noted in my post last week, a lot of what’s going on in the markets right now is fundamentally driven. There is an element of the risk aversion pattern, but it’s not as simple as it was previously. As they always do, the markets are constantly shifting and changing. Gold is being driven by the massive amount of liquidity in the financial markets due to central bank activity (and/or the expectation thereof). Stocks and oil are reacting to retrenchment in the global economic situation. The currency markets have a lot of different influencing factors, not the least of which is the prospect of central bank intervention from Japan and Switzerland. And for now, at least, the dollar is not the singular safe haven in the currency markets, making it less prone to big swings than in the past.

These sorts of situations are the ones which tend to separate the trading wheat from the chaff. Those who can adapt to the new market conditions will survive and maybe even thrive. Those who cannot, will fall by the wayside, just like all those folks who developed trading strategies based on low volatility did when things changed in 2007.

From the aftermath of the debt ceiling crisis and the S&P downgrade to the release of the latest unemployment numbers, we’ve been busy counting the latest stories in the world currency markets. Check out our top picks of the week:

News on the S&P downgrade made headlines and many wonder what’s next for the U.S. economy. After a tumultuous week in the stock market, the CBOE Market Volatility Index rose 26 percent, marking a 29-month high. Some investors are stressing a need for new currencies and stock exchanges either in the form of a world economic system managed by the International Monetary Fund or cyber currencies. Meanwhile, gold futures soared due to the rating cut, reaching a record $1,697.70 an ounce. The U.S. Securities and Exchange Commission launched an investigation last week, asking Standard & Poor’s to provide information on employees who were informed of the downgrade decision before it was announced. Concern has once again risen for the European economic crisis as falling shares in French banks prompted finance and budget officials to search for new ways to trim public deficit. Employment numbers released last week show that U.S. unemployment benefits have dropped to a four-month low. These statistics have already impacted the currency markets; both the USD/JPY and USD/CHF have increased, which “releases the hot air” out of the franc and the yen. Japan continues to face problems with the rising yen, as the currency’s increase against the U.S. dollar leads to a cut in Japan’s export sales.

 

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

In his latest article, "Secular Trends In Gold", Irish Times columnist Charlie Fell examines what the skyrocketing price of gold means for investors.  Could it be a golden investment opportunity?  Read full article here.

 

Secular Trends in Gold PDF Print E-mail
On this day in 1982, the secular bear market that had weighed on stock returns since the late-1960s, reached bottom – with share prices almost 65 per cent below their secular peak in real terms and no higher than levels first reached way back in 1954.  As stock prices stumbled and erased years of upward progress over the course of the drawn-out bear market, gold rewarded disillusioned equity investors who sought its protection. 

Indeed, by the summer of 1982, gold’s purchasing power had jumped almost fourfold from the level that prevailed when the downtrend in the major stock market averages got underway fourteen years earlier – even though the high real interest rates required to fight runaway inflation, had terminated the secular bull in the precious metal two years previously.

Fast forward to today and the downgrade of U.S. government debt by Standard & Poor’s, alongside the escalating euro-zone sovereign debt crisis, confirms that the primary downtrend in Western stock markets that commenced more than a decade ago, is alive and well.  U.S. stock prices at current levels are almost 45 per cent below their secular peak in real terms, such that all capital gains since the spring of 1997 have been erased.

Meanwhile, gold continues to frustrate its critics, as the price of the precious metal edges ever higher and is up almost fivefold in real terms since the dot.com equity bubble began to deflate more than a decade ago.  Once again, the precious metal has served its owners well and proved to be an effective offset to lacklustre stock market returns, even though investors’ primary concern during the current secular bear has been the potential for demand-side deflation, and not the disturbingly, high inflation that precipitated the downtrend in stock prices during the 1970s.

Secular bear markets in stocks are characterised by a downtrend in the multiple that investors are willing to pay for one dollar of trend earnings, and are precipitated by movements away from price stability towards runaway inflation or demand-side deflation arising from the unravelling of unsustainable debt balances.  These are the same conditions in which the diversification properties of gold spring to the fore, as the accompanying economic uncertainty increases the precious metal’s allure.

Gold’s performance through the inflationary 1970s following President Nixon’s decision four decades ago, to suspend the precious metal’s convertibility into U.S. dollars for official holders, is well-known and has contributed to the universally-accepted premise that the yellow metal is an effective inflation hedge.  The conventional wisdom stands in sharp contrast to the late-Professor Roy Jastram’s conclusion in his 1977 classic, ‘The Golden Constant.

Professor Jastram analysed the behaviour of gold prices in the U.K. from 1560 to 1976 and in the U.S. from 1800 to 1976.  His work revealed that the precious metal proved to be an excellent store of value through the long sweep of history, but his analysis also showed that it was an ineffective inflation hedge over relatively shorter intervals, as its purchasing power declined during inflationary episodes.

The real value of gold for example, dropped by more than 20 per cent in the U.K. in each of the periods 1702-1723, 1752-1776 and 1793-1813, while it lost two-thirds of its purchasing power from 1897 to 1920.  This somewhat surprising result can be explained by the precious metal’s monetary role in the Gold Standard, and by definition, the purchasing power of money declines during inflationary episodes.

An update to Jastram’s work by Jill Leyland in 2009 reveals gold has served as an effective inflation hedge since the collapse of the Bretton Woods system of fixed exchange rates four decades ago, as individuals sought the protection of the precious metal during periods of rapidly rising prices.

Jastram’s study also showed that the purchasing power of gold tended to increase and often markedly, during deflationary episodes, which again can be explained by the precious metal’s close links to the monetary standard.  Since the precious metal only performed well under deflation when the Gold Standard was intact and has served as an effective store of value since the end of dollar convertibility, some commentators believe that it would perform poorly – should the developed world succumb to a destructive debt deflation.

The logic is wide of the mark.  Individuals scramble for liquidity and flee financial assets during deflations, but the deteriorating credit quality of currency issuers and the resulting loss of confidence, mean that gold is typically preferred to paper currency as a hoarding vehicle.  To quote former-Federal Reserve Chairman, Alan Greenspan – “Gold... is relevant wholly because of the historic and widespread perception of gold as an indicator of a flight from currency.” Thus, should the U.S. economy enter a recession or the euro-zone sovereign debt crisis continue to rage, the resulting deflationary pressures and loss of confidence in currency would, in all likelihood, result in a higher gold price.

Gold’s diversification properties are not only apparent through a secular bear market in stocks, but also in the face of periodic crises that lead to substantial declines in equity values.  As Jill Leyland remarks, “Men and women have turned to gold in times of distress, whether, political, economic, or personal…”  Indeed, the verdict of history shows that gold has increased in value during each of the most savage downturns in stock prices of the past 50 years including 1973-74, 1987, 2000-2002, and 2007-2009.

Gold is the ultimate hedge against instability and uncertainty.  Given that a return to price stability is unlikely anytime soon, while tail-risk in the form of inflation or deflation is high, the environment is near-perfect for gold to shine.  The recent parabolic upward move however, suggests that it would not be advisable to initiate positions at current levels.  Nevertheless, far-sighted investors should raise strategic weightings on weakness.

 

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

1 Comment

There's no doubt that we've had some serious volatility over the last week or so thanks to the S&P downgrade of the US credit rating and the move by the FOMC to put a time frame on the "extended period" language that's long been in place regarding how long the zero interest rate policy would continue. Those two specific events, however, only served to accelerate the market's reaction to on-going issues, especially those around the European sovereign and banking sector issues. There's been a lot of talking about the comparison to 2008. Let's take a look at that.

Stocks
Clearly, equity prices have taken a tumble. The bars for the last two weeks in the S&P 500 are certainly large, at least by comparison to those from recent times. They are certainly akin to the types of ranges seen in 2008 during the worst of the selling, but the volatility measures aren't yet anywhere close to where they got three years back.

Notice on the chart below how N-ATR (Normalized Average True Range, which expresses average period ranges as a % of average price over the same time frame) has only just turned up. It hasn't yet reached even 5%, never mind getting anywhere close to the 2008 peak near 10%. Likewise, BWI (width of the Bollinger Bands as a % of the 20-period average) has only just turned up and has a long, long way to go to match those prior highs.

Oil & Gold
A look at the oil chart (continuous front-month contract futures) shows a very similar pattern. Volatility has upticked, but we're a long way from being anything like 2008. The same is true for gold, though there we can see that back in 2008 and 2009 the BWI peaks weren't quite as high on a relative basis as was N-ATR.

Treasury Market
Back in 2008 and into 2009 there was a lot of volatility in the Treasury market as the result of a massive flight to quality when investors thought the world was coming to an end. We can see the peaks in N-ATR and BWI during that period on the 10yr Treasury futures (continuous front month contract) chart below. As we've seen in stocks and commodities, though, while there's been an uptick of late in both volatility readings, in neither case are where at levels anything like where they were back during the financial crisis. Both measures are generally in line with their ranges for the last year or so.

The Dollar
How, what about the currency market? We barely see any change in volatility in the USD Index. Notice in the chart below how N-ATR is holding steady near 2%, which is a little above the mid-point of the range going back to 2007. It's basically holding to the range it's been in since late 2009. This is despite some pretty big swings in value. Meanwhile, BWI has actually continued declining toward the low end of its range of the last 4-5 years. That, by the way, gets me to start looking for some kind of new major trend move to develop before long (relatively speaking, since we're talking about the weekly time frame).

EUR/JPY
The EUR/JPY cross rate has been looked at as an indication or risk aversion in the global markets. It's a function of the carry trade on the JPY side as money tends to move in and out of the yen when market psychology changes. At the same time, the EUR is often the first currency sold when currency traders want to express risk aversion. As such, the cross is likely to see somewhat exacerbated volatility in nervous markets. As we can see from the chart below, though, while volatility has ticked up somewhat, both BWI and N-ATR remain well within recent ranges.

Conclusion
What I think this all basically tell us is that the equity markets are dealing with their own issues, some of which are clearly related to the global economic environment as indicated by the action in oil. The currency markets don't show near the same sort of market strain as we saw in 2008, and the Treasury market doesn't either, indicating that it's not the global financial system underpinning issues this time around. It's more about actual economic fundamentals this time around. We may see volatility in stocks stay somewhat elevated for a while (it tends to cycle like that), but I don't see much of a knock-on effect in the currency market.