Monthly Archives: July 2013

Could Gold’s trend suggest we are headed for another recession?

Gold is currently in an eight month down trend.  So what are the possibilities that gold’s downtrend could suggest?

A first notion could be that gold simply became overvalued starting after July of 2010 which is roughly the last time it was trading at the value it currently trades for today (July 16th, 2013).  After July 2010 the value of gold took about a year to peak at a price about 58% higher. Then it wavered near those highs for about  year, before dropping to, in this scenario, become more realistically valued as the price declined back over the last eight months.

Helping the drastic rise and fall could be the popularity of Gold Exchange Traded Funds (ie GLD, GTU, CEF, etc).  Gold ETFs have made it easier for the masses to purchase gold, so when market mob decides its in season, a lot of money can quickly surge into Gold and inflate the value (at least on virtual paper – but the difference between paper gold and physical gold is a subject for another article).  When the mob decides to exit, a lot of money can quickly leave, causing the value of gold to decline.

Another way to look at the current 8 month down trend could be that gold stayed reasonably valued as the Federal Reserve’s quantitative easing programs have devalued the dollar, thus making gold worth more.  Then Gold’s decline could indicate that though we are continually given data to suggest that the economy is doing well, the economy is really not very healthy, quantitative easing is becoming less and less effective, and gold is therefore secretly leading the charge into a recession or possibly even a depression where everything, including gold, becomes highly deflationary.

I know, you say… “Gold is a defensive commodity.  When people the world predicts a recession or depression, money is moved into gold and therefore the price of gold rises”.   I would agree with you, stating that yes, when a recession or depression is predicted, money is moved into gold and the price of gold rises.  But the world is not predicting a recession or depression and in a depression, everything loses value, including gold.  During a recession, what would cause gold to rise, would be the Federal Reserve “printing” even more money in an attempt to stimulate the economy and therefore gold would become the defensive place for money to flow into, due to fears of inflation and devaluing of the dollar.

Or, golds current decline could mean that everything that is happening in our economy is going well.  The reports we get on the economy are truthful and accurate.  Businesses are doing better and better, people are able to find jobs, unemployment is going down, etc.  Possibly the Federal Reserve’s quantitative easing programs are working wonderfully and stimulating the economy while not causing inflation and that is reflected in the current price of gold.

I don’t necessarily believe that gold is predicting a recession, but I am willing to accept that it is a possibility.  We’ve all heard the anecdote that Federal stimulus is like crack to the economy –  We are being loaded with a great feeling, but it takes more and more of the stimulus drug to keep the economy high.  We could be at a point where the current amount of continuing stimulus QE3 (currently 85 billion per month) isn’t enough to keep the economy high.  It needs even more stimulus to stave off the recession and following depression that would come without it.

Personally I think the future of gold’s price has some dependence on the regime in place.  Currently the democrats are in control and are very liberal in their spending.  Sure we have all these sequestration cuts, but if you look closely enough, most of the cuts are in the future, so who knows if they’ll really happen.  Its funny that when Enron did the same thing, it was illegal and the house of cards ending up falling down.  Luckily our government is more powerful than a single company.  If the republicans take over in the next presidential election and decide to halt a lot of the spending, I think we’ll see some drastic action in gold.

Do I really know where gold is going or what it is predicting?  Not really. I don’t believe to that in-tune with the market.  But I am a contrarian investor, and gold is currently down nearly 35% from its peak.  With its continual decline, it looks like it could be reasonably priced, and likely tending towards undervalued.

This undervalued pricing in gold, has a drastic effect on the mining sector and the miners are trading at very low prices relative to their peaks.

I have been buying and I believe it is a great time to start purchasing down in a proprietary pyramid fashion that I’ve developed over my years of successful investing, and I’ll discuss what that means and give deeper reasoning why I believe its time to purchase the mining sector in another article.

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Why I now invest in Exchange Traded Funds (ETFs) over individual stocks

Before I was married, I would invest in individual stocks.  Individual stocks are inherently more riskier than something like an ETF, not only because individual stocks are more vulnerable to larger swings, but there’s always the likelyhood that the individual company could go out of business, causing you to lose your entire investment.

It takes a lot of time to research and individual stock.  Beyond higher level macro picture of evaluating the economy and indivdual sectors, you need to spend time looking at intricate details like the company’s target market, finances, outlook, and management.  Failure to spend time to accurately look at and understand any of the major components that makes a company successful will leave you vulnerable to investing in a company that may go out of business.

Even if you do your diligence, then you are still vulnerable to the illegal espionage that can take a company down.  Management could be mis-reporting or there could be embezzlement.

No matter how well you research a company something could go wrong.  When I was single and didn’t have any dependents, I was more willing to take these risks by investing more of my investment money in individual companies.

Now that I am married and starting a family, both my time and risk tolerance have decreased.  I no longer have the time to obsessively bury myself in balance sheets and research various companies intricate details.  I also can’t risk the possibility of investing a significant portion of my portfolio in an individual company and having the company go out of business.

I now invest primarily in ETFs (Exchange Traded Funds), and I have become more sector focused.  I look for sectors that are getting beaten up for one reason or another.  I look more at the macro picture and have cut out the extra time it takes to investigating the intricate details of a particular company.

ETFs are funds, so there is virtually no chance of losing your entire investment.  Things may get rough and the value may diminish.  A few of the companies within the fund may go out of business, but since each individual company only represent a small portion of the ETF portfolio, the loss of that business won’t erase your investment.    Also, due to the law of averages, in really bad times, a couple companies within the ETF may go out of business, but likely that business will be picked up by other companies within the ETF and those respective stocks will gain in value (especially when the sector picks up), which will mitigate the damage done to your portfolio by the loss of the weaker companies.

I like ETFs over mutual funds because they don’t have “load” fees and usually have lower “expense” costs.  Most ETFs I invest in have an “Expense Ratio” around 0.5%.  Mutual funds tend to have higher management fees of around 1-3%.

When you purchase a mutual fund, the higher expenses go towards paying the fund manger, administrative fees, and advertising fees.  I don’t like paying for a fund manager because there’s so many fund mangers out there that the chance of purchasing a fund that actually does have an exceptional manager that’s worth the fees the person is getting paid is minimal.  To me, mutual funds are for the ignorant.  You are paying someone to sell you something and make you feel good about your investment, though its really no better than lesser managed fund that simply tries to represent a market segment, as mosts ETFs do.

 

 

I am a contrairian investor

I have pretty much always been a contrarian investor, meaning that I invest against the crowd.  I believe that commodities tend to get extremely over-valued and under-valued, and I don’t like to purchase any investment for more than its worth.

As you can read in my “about” page, I currently invest in ETF funds that tend to mimic sectors of the market which I believe are undervalued by the market.  I used to invest in individual company stocks, but now that I’m starting a family I have adjusted my risk tolerance accordingly.

For the most part, this “undervalued” usually translates, in simple terms, to a a stock or ETF that is trending down in price.  I believe the market to be extremely and obtusely emotional and that it tends to over-extend its trend in pricing on various commodities and therefore their respective sectors.

I also believe that, thanks to online self-investing platforms (i.e. Ameritrade, Etrade, Scottrade, etc.), that the amount of investors that have the ability to easily “short” sell a stock, and are doing so, is growing rapidly.  These  growing number of “day traders” act to help exaggerate already overly pronounced swings to the down side that create prices on commodities that are extremely undervalued.  I tend to purchase these discounted commodities.

It is very difficult to be a contrarian investor, for as you are purchasing against the short term market trend, you will have that sinking “wrong” feeling for some time, with the commodity continuing to fall after you’ve invested.  I understand and live with this, because I don’t believe anyone can call the bottom in a stock or sector on an accurate and regular basis.  Thus, I use a proprietary technique that I’ve developed over my years of investing where I start to purchase when I believe the stock/sector is already extremely undervalued.  Then I continue to purchasing in larger and larger quantities as the investment becomes more and more discounted.

To keep my sanity, I only put money into the market that I won’t need for at least 10 years.  My investments are future, long-term focused.  I am not a day-trader and I understand that I am purchasing something that is out of favor and may be for some time.  For me, this helps take a lot of the short term emotion out of worrying about the price as it drops.

My belief is that if I am pragmatic in my assessment of an undervalued sector and start purchasing at a point where I already think the sector is quite undervalued and it goes down far beyond that, I will be purchasing the majority of my allocated investment money into an extremely undervalued situation, and in the long run, I will receive outstanding returns.

Market sectors are very cyclical.  They go up and they go down.  One sector becomes the big rage, due to the appearance of the big current global or national situation.  Often the news drives a sector higher.  Since there’s only so much money, for the raging sector to go up in value, the money has to come from elsewhere, part of which is other sectors and those “out of favor” sectors become temporarily undervalued.  For me, this is the time to buy into those sectors as they are selling at a discount.

In the short term I tend to lose value as I build my investment into the sector, but long term I am almost always right.  I rarely sell a commodity for an overall loss, and on those few occasions that I have, I almost always regretted it as I ended up missing our on very good gains when the stock did finally take off towards the overly exaggerated “up side”.

When I follow my own investing techniques and don’t allow my self to deviate due to emotional responses, my worst case scenario is usually that I sold too soon, for not enough profit.

 

Why are the values of gold and silver mining stocks going so low?

With the price of gold taking over a 30% drop from its most recent peak in October of 2012 and nearly a 35% drop from its all time high in September of 2011, the precious metal mining sector has been absolutely crushed.

Specifically the large cap Market Vectors Gold Miners Index ETF fund (GDX) has dropped 58% and the small cap Market Vectors Junior Gold Miners ETF (GDXJ) has dropped 65% from their most recent peaks in September of 2012.  They are down substantially more from their all time peaks (65% and 80% respectively).

So why have the miners taken so much more drastic of a plunge than gold itself?  The following is a simplified analysis to help you get started understanding the answer.

Over the last hundred years (or so) we’ve removed all the easier to find gold from the near surface of the earth, and now miners have to do a lot more work, in more remote locations, while using bigger and more powerful equipment to get at harder to access deposits in the earth.  And that work and equipment costs more and more money.

If you add up all the expenses it takes for a company to pull as much gold as they can out of the ground in a year, then divide it by the total weight of that gold they extracted in that year, you get an average cost per weight that it takes for the company mine gold.

If that average price to mine gold is below the current price of gold, the miner obviously loses money when they sell their extracted gold.  If the price they can sell the gold for is greater than their average cost to pull it out of the ground, they obviously make money.

The kicker is that when the price of gold is bigger than than the cost to mine it, every extra amount that the selling price of gold goes up is pure extra profit.

Lets take an example.  Say it costs the mining company $1300/oz to extract the gold and get it ready to sell.  And, say the current price of gold is $1400/oz.  The miner profits $100/oz.

Now say that the cost to mine remains the same at $1300/oz, but the price of gold rises to $1500/oz.   Now the miner profits $200/oz.  So the miner’s profits doubled without them doing anything different.

A company who’s profits double, is (in simple terms) worth twice as much, or will have a 100% increase in value above its price before the profit change.  Whereas in the scenario above, gold only increased in value 7%.  So a 7% increase in gold price, caused a 100% increase in the value of the average company mining it.

From the example above, you should be able to see that relatively small changes in the price of gold can have significant impacts on the profits, and therefore, the trading prices of gold mining companies.

Currently, depending on what source you find and decide to believe, the price of gold is near or below what it costs for for an average mining company to mine it.  So the mining companies are, on average, losing money.

If a company loses money for more than a short period of time, it is likely to go out of business.  A company that is likely going to go out of business is worth very little and nobody wants to buy it.

So with the price of gold going down, and the miners seemingly losing money, it appears as though miner stocks are not worth purchasing, and their trading prices have plummeted to those apparent levels.

Beyond the basic examples above, it is also helpful to know that pricing gets taken to extremes as the sum of people trading in the market make up a virtual mob that is actually quite emotional. When things are going in a certain direction, the mob becomes increasingly focused in that unilateral direction and pays less and less attention to the extremeness of the trend.

It starts with the basic economics of supply and demand. Because just about everyone is doing the same thing, there is usually not enough of whatever the mob is buying (supply) for the amount of people in the mob trying to buy it (demand).  Therefore the price of that thing goes up to balance the limited supply and growing demand.

In the opposite direction, as is happening with the miners, there is too much supply because everyone is selling, creating an oversupply, and the price therefore goes down.

On top of this, add in the effect that people psychologically see that a trend is happening and expect that it will go on forever and you get an extreme overall sentiment in the mob.  People see that everyone is doing something, and expect that because everyone is doing it that same thing it will go on forever.  So it becomes seemingly obvious that one should join the crowd.

We saw this with the housing bubble.  People bought houses because they prices were going up so drastically.  If you didn’t by a house “now”, you’d never be able to own one, because the prices just kept going up and up.  Loans were easy and cheap so people bought as much house as they could afford the payments on, expecting that if anything went wrong, they could just sell the house for a profit as everyone had heard about “those people” that bought a house and sold it a few months later for a 50% profit.  This caused prices to surge.

Of course the reverse also turned out to be true.  When the short term interest rates on those easy loans started adjusting up, people could no longer afford the payments on their homes and suddenly everyone started having to sell their houses.  With virtually everyone selling and nobody buying, the prices plummeted.  Many homeowners, even though they could afford their payments, walked away from their houses, because there was “no way it would ever get its value back”.

Bringing this thought pattern back to gold and the gold miners, we currently have a situation where the price of gold and the miners are going down.  So we have a trend that is snowballing downward.  The mob is becoming unilaterally focused on the downward trend.  People believe that because the price of gold is going down, it is going to continue going down forever, and therefore the miners are never going to be profitable again.  So more and more investors are joining in on selling and “cutting their losses”.  So the miners seem to have virtually no value and their stocks are trading at such a value.

Now… there’s one more effect I need to mention that adds to exponentially increase the already exponential effect of the mob mentality.  And that is the wonderful and exciting ability for market participants in the mob to “short” sell a stock.  This means that a company (stock) can be sold by a person that doesn’t even own it!

What?!!

Yes, that’s right! And you can even short sell gold!  Yes, there are ways to sell gold that you don’t even yet own!

As this article is already getting long, we can get into the details of “short” selling stock and gold in another article, but for now you just need to know that people try to profit on the downtrend of a stock or commodities price.  They “sell” a stock they don’t yet own, and if the price goes down, they can make money.

This (somewhat virtual) selling makes it look like the mob is more focused on selling than it really is. This amplification effect causes the a fore mentioned psychological reasons to sell to be exponentially stronger, as the situation looks like even more of the mob is aligned in one selling direction, causing the trend to look even more negative.  A trend develops and the psychological effect to join in and sell before the value becomes worthless sets in.

So the miners are currently really getting hit hard by all these effects and their prices have plummeted.

So is it time to invest in the mining sector?

I have been buying and I believe it is a great time to start purchasing down in a proprietary pyramid fashion that I’ve developed over my years of successful investing, and I’ll discuss what that means and give deeper reasoning why I believe its time to purchase the mining sector in another article.

Join my mailing list to be notified when it comes out!

UPDATE:  See my article on ETFs creating shares for short positions for yet another reason why miner ETF prices get overly extended on the down (and up) side.