Author Archive

  • Gold Crashes
    , September 23rd, 2011 at 5:31 pm

    On September 6th, the spot price of gold hit an intra-day high of $1,920.94 per ounce. Today, gold crashed over $100 per ounce. This was the third-largest daily percentage loss of the last 20 years.

    Gold slumped more than 6 percent at one point — its biggest slide since the financial crisis in 2008 — to hit early-August lows as this week’s losses accelerated. The sell off came even as stock and oil markets stabilized after Thursday’s rout.

    Adding to Thursday’s losses, gold is down almost 9 percent over the last two days, while silver has lost nearly 25 percent. In the case of gold particularly, it was the third-sharpest daily loss in the past 20 years.

    “I’m sure talk of hedge fund liquidation is helping to pressure things, though there’s no confirmation of any single fund selling,” said Jonathan Jossen, an independent COMEX trader.

    Despite its steep losses this week, gold remained up 16 percent year-to-date, thanks to gains from earlier months. But silver turned negative, with the spot price down almost 1 percent for the year.

    By 2:45 p.m. EDT, the spot price of bullion was down 5.5 percent at $1,641 an ounce, after falling to a session low under $1,628. The move was more than 5 standard deviations beyond the normal one-day change. At $127 an ounce, the intraday move was the biggest on record in dollar terms.

  • P/E Ratio Hits 22-Year Low
    , September 23rd, 2011 at 11:23 am

    Thanks to the recent plunge in stocks, the P/E Ratio for the S&P 500 fell to 12.05 based on yesterday’s close. That’s the lowest reading since April 17, 1989.

    Here’s a look at the S&P 500 (black line, left scale) along with its earnings (gold line, right scale). The two lines are scaled at a ratio of 16-to-1.

  • CWS Market Review – September 23, 2011
    , September 23rd, 2011 at 8:33 am

    One day after the Federal Reserve announced “Operation Twist,” the stock market got absolutely slammed. The Dow was dinged for 391 points on Thursday and this comes on top of a 283-point haircut we took on Wednesday, most of which came after the Fed’s announcement.

    In the last two days, the S&P 500 has shed 6%. The index closed Thursday’s trading session at 1,129.56 which is the lowest close in a month. We even hit an intra-day low of 1,114.22 which was below the recent closing low of August 8th (1,119.46). However, we haven’t pierced the intra-day low of 1,101.54 from August 9th. At least, not yet. The $VIX, also known as the Fear Index, shot up more than 10% on Thursday to close at 41.35 which is a one-month high.

    So what’s going on?

    In this issue of CWS Market Review, I’ll give you the low-down on the Fed’s plans and why the market reacted so negatively. Plus, I’ll update you on two very good earnings reports from our Buy List standouts, Oracle ($ORCL) and Bed Bath & Beyond ($BBBY). More importantly, I’ll highlight some outstanding high-yielding stocks that will help us weather the storm.

    First, let’s take a closer look at Bernanke’s new plan to get the economy off the mat. At 2:23 pm on Wednesday, the Federal Reserve released its policy statement from this week’s meeting. In it, the Fed said it’s going to replace $400 billion of short-term debt in its portfolio with long-term Treasury debt.

    The idea is to push long-term interest rates down with the hope of spurring more borrowing. Ideally, this will also help get the housing market going again. As I explained in the CWS Market Review from two weeks ago, economic recoveries are often led by the housing sector. The problem this time around is that housing is still flat on its back.

    Bernanke & Co essentially downgraded the entire U.S. economy. The Fed aims to sell roughly three-fourths of the amount of short-term debt it holds. Investors concluded that if the Fed is going into long-term bonds, well…they might as well ride that wave. So they dumped stocks and crowded into Treasuries. By “crowded,” I mean a massive buying panic.

    On Thursday, the yield on the 30-year Treasury plunged to 2.78%. That’s a drop of roughly 50 basis points from Wednesday afternoon. To put that in context, the Long-Term Bond ETF ($TLT) jumped from $114 to $123 in the same time period. (Remember that these are bonds. They’re supposed to be boring and stable.)

    As dramatic as the 30-year bond’s drop was, the 10-year plunged to its lowest yield ever. On Thursday, the yield hit 1.72%. That’s a drop of 150 basis points since July 1st. We’re through the looking glass here, people.

    I should point out that this recent action is slightly different from the fear trade that I’ve talked about before. The difference is that gold fell on Wednesday and it got hit hard yesterday which is a reflection that real short-term interest rates may rise from the Blutarsky levels they’re at right now. I doubt they’ll go very high, but the Fed is by far the largest player in the T-bill market.

    As you might expect, the major losers on Thursday were the cyclical stocks. The Morgan Stanley Cyclical Index (^CYC) dropped 5.22% on Thursday to close at 762.10. Two months ago, the index was at 1,071.84. Both the Energy Sector ETF ($XLE) and Materials Sector ETF ($XLB) lost more than 5.6% on Thursday while defensive areas like Consumer Staples ($XLP) and Healthcare ($XLV) lost “only” 1.90% and 2.02% respectively. (That’s exactly why we call them defensive.)

    The folks at Bespoke Investment Group point out that more than half of the stocks in the S&P 500 now yield more than the 10-year Treasury bond.

    Some analysts on Wall Street are saying that Operation Twist is a really covert bailout of the big banks. I’m not cynical enough to say that’s the Fed intent, but it will certainly help the banks offload their holdings on Treasury bonds. But I’m doubtful that Operation Twist will spur more mortgage lending or even get people to refinance. Mortgage rates are already at 60-year lows. I don’t see how a few more basis points will help out troubled homeowners.

    To be perfectly frank, I think this whole episode shows how limited the Fed’s powers really are. (At the Fed’s website, they included an FAQ on Operation Twist). David Kelly of JPMorgan Funds said, “Ben Bernanke is at least trying to do the right thing. He just doesn’t know what the right thing is.” Ouch!

    Still, some of the big banks like Goldman Sachs ($GS) and Morgan Stanley ($MS) plunged to multi-year lows. Bank of America ($BAC) closed at $6.06 on Thursday; Warren Buffett’s warrants have a strike price of $7.14. Our Buy List mega-bank, JPMorgan Chase ($JPM), fell below $30 per share and it now yields 3.42%. JPM is still, by far, the healthiest of the major banks.

    I honestly don’t see how Operation Twist will boost the economy, but I’m still not in the Double Dip camp. I think the most likely scenario is that the economy will bounce along at a 1% to 2% growth rate: not enough to get the labor market going but not slow enough to be an official recession.

    As rough as this week was for the stock market, I’m happy to say that we had two very good earnings report from our Buy List. After the close on Tuesday, Oracle ($ORCL) reported earnings of 48 cents per share which was two cents better than Wall Street’s forecast.

    I was actually expecting even more from Oracle. My mistake was that I didn’t foresee how weak their hardware business would be. Despite my over-optimism, the market reacted positively to the earnings report. On Wednesday, the shares got as high as $30.96. (Bear in mind that they were under $25 just one month ago.) The stock only broke down once the rest of the market did.

    Oracle continues to be a very profitable company. Over the past 12 months, Oracle’s cash flow is up 46%. Wall Street was mostly upbeat on the earnings report. For their fiscal second-quarter, which ends in November, Oracle forecasts earnings of 56 – 58 cents per share. That’s a surprisingly narrow range. The Q2 from last year came in at 51 cents per share and that was a very strong quarter; Oracle cautioned investors that the comparisons are much tougher. I continue to rate Oracle a strong buy up to $30 per share.

    While I was overly-optimistic on Oracle, I wasn’t optimistic enough on Bed Bath & Beyond ($BBBY). On Wednesday, the company reported fantastic second-quarter earnings of 93 cents per share. That was nine cents more than Wall Street was expecting.

    This comes on top of a blow-out earnings report last quarter. BBBY also raised their full-year guidance for the second time this year. Originally, the company told us to expect earnings to grow by 10% – 15% for this year. Then after the big earnings report in June, they raised that forecast to 15% – 20%. Now they’ve bumped that up to 22% – 25%. That translates to full-year earnings of $3.74 – $3.84 per share. In business, good news often leads to good news. Businesses aren’t like ball players who have an “off night” or a “hot hand.” If there’s something good going on, it will tend to last.

    At one point on Thursday, BBBY was one of only two stocks in the S&P 500 to be higher for the day. Thanks to Bed Bath & Beyond’s strong earnings and higher guidance, I’m raising my buy price to $60 per share. This is a very solid company.

    Some other stocks on my Buy List that look particularly attractive right now (thanks to their high yields) include Abbott Labs ($ABT, yields 3.79%), AFLAC ($AFL, yields 3.75%), Johnson & Johnson ($JNJ, yields 3.68%), Reynolds American ($RAI, yields 5.85%), Sysco ($SYY, yields 4.00%) and Nicholas Financial ($NICK, yields 4.13%).

    That’s all for now. Be sure to keep checking the blog for daily updates. Next week is the final week of the third quarter. We’ll also get another revision to the second-quarter GDP report. I’ll have more market analysis for you in the next issue of CWS Market Review!

    – Eddy

  • Morning News: September 23, 2011
    , September 23rd, 2011 at 4:50 am

    G-20 Vows to Tackle ‘Renewed’ Global Risks

    ECB Ready to Act Next Month If Outlook Deteriorates

    Europe Mulls Increasing Rescue Fund Firepower

    Greece on Edge 24 Centuries After First Default

    European Stocks Pare Gains

    South Korea Regulator Says Some Banks That Flunked Stress Tests Now Sound

    Special Report: How to win business in Libya

    Crude Oil Rebounds More Than $1.00 Per Barrel

    Fed’s ‘Operation Twist’ Fails to Reassure

    Treasury Decline After G-20’s Pledge to Tackle Risks Damps Refuge Demand

    Whitman Will Stick to Apotheker’s HP Strategies

    Sany Roadshow on Course After $3.3 Billion Share Sale Delay

    In Rush to Assist Solyndra, U.S. Missed Warning Signs

    Old Saturn Plant Could Get a Second Chance

    Todd Sullivan: Temp Staffing & Total Employment & Recessions

    Stone Street: Is Our Tax System Fair? If Not, Why? — Veronique de Rugy

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  • The 2/10 Spread
    , September 22nd, 2011 at 3:52 pm

    I’m not exactly sure why, but the spread between the two- and ten-year Treasury bonds seems to have a very good track record of predicting recessions.

    Notice how the spread goes negative in the months before official recessions (the grey bars). That’s a track record that many economists would envy.

    The spread between the two and ten is still wide although it has narrowed over the past several weeks. Still, we’re a long way from the danger zone. That’s why I’m a Double Dip doubter. A recession, of course, will come along eventually, but this point combined with other data (like the ISM) tells me that a Double Dip recession is unlikely in the immediate future.

  • Cyclicals Plunge to a New Low
    , September 22nd, 2011 at 11:22 am

  • What Operation Twist Means for Gold
    , September 22nd, 2011 at 11:09 am

    In this post, I’m going to explain why I’m right and Larry Summers is wrong.

    On a point of economics.

    Last October, I unveiled my model for the price of gold (or as I like to think of it, a model for a model). I’m happy to see that the model has held up well since then. It’s one thing to predict the past, but it’s quite another thing for a model to hold up in your out-of-sample period.

    However, my gold model is more than just back-testing data. The key insight is that Gibson’s Paradox never went away. It still exists, just in a different form. I got this idea from a 1988 paper by Larry Summers and Robert Barsky, “Gibson’s Paradox and the Gold Standard.”

    Where I differ from Summers and Barsky is that I focused on short-term interest rates while they focused on long-term rates. Well, with Operation Twist we got a perfect test of who’s right.

    The Fed’s new plan is to sell short-term Treasury bills and buy long-term Treasury bonds. This means that long-rates will be pushed down and short-rates will be pushed up. If gold rises, then Barsky and Summers are right; if gold falls, then I’m right.

    Gold is down about $80 today to around $1,730 per ounce.

    I said in my original post that the price of gold is basically a political decision. The Fed can change the game anytime they want to. I can’t say whether this will lead to a long-term decline in gold. That will depend on inflation and interest rates. But for now, the gold market is clearly observing the short end of the yield curve.

    Here’s a look at my original post:

    One of the most controversial topics in investing is the price of gold. Eleven years ago, gold dropped as low as $252 per ounce. Since then, the yellow metal has risen more than five-fold, easily outpacing the major stock market indexes—and it seems to move higher every day.

    Some goldbugs say this is only the beginning and that gold will soon break $2,000, then $5,000 and then $10,000 per ounce.

    But the question is, “How can anyone reasonably calculate what the price of gold is?” For stocks, we have all sorts of ratios. Sure, those ratios can be off…but at least they’re something. With gold, we have nothing. After all, gold is just a rock (ok ok, an element).

    How the heck can we even begin to analyze gold’s value? There’s an old joke that the price of gold is understood by exactly two people in the entire world. They both work for the Bank of England and they disagree.

    In this post, I want to put forth a possible model for evaluating the price of gold. The purpose of the model isn’t to say where gold will go but to look at the underlying factors that drive gold. Let me caution that as with any model, this model has its flaws, but that doesn’t mean it isn’t useful.

    The key to understanding the gold market is to understand that it’s not really about gold at all. Instead, it’s about currencies, and in our case that means the dollar. Gold is really the anti-currency. It serves a valuable purpose in that it keeps all the other currencies honest (or exposes their dishonesty).

    This may sound odd but every currency has an interest rate tied to it. In essence, that interest rate is what the currency is all about. All those dollar bills in your wallet have an interest rate tied to them. The euro, the pound and the yen also all have interest rates tied to them.

    Before I get to my model, I want to take a step back for a moment and discuss a strange paradox in economics known as Gibson’s Paradox. This is one the most puzzling topics in economics. Gibson’s Paradox is the observation that interest rates tend to follow the general price level and not the rate of inflation. That’s very strange because it seems obvious that as inflation rises, interest rates ought to keep up. And as inflation falls back, rates should move back as well. But historically, that wasn’t the case.

    Instead, interest rates rose as prices rose, and rates only fell when there was deflation. This paradox has totally baffled economists for years. Yet it really does exist. John Maynard Keynes called it “one of the most completely established empirical facts in the whole field of quantitative economics.” Milton Friedman and Anna Schwartz said that “the Gibsonian Paradox remains an empirical phenomenon without a theoretical explanation.”

    Even many of today’s prominent economists have tried to tackle Gibson’s Paradox. In 1977, Robert Shiller and Jeremy Siegel wrote a paper on the topic. In 1988 Robert Barsky and none other than Larry Summers took on the paradox in their paper “Gibson’s Paradox and the Gold Standard,” and it’s this paper that I want to focus on. (By the way, in this paper the authors thank future econobloggers Greg Mankiw and Brad DeLong.)

    Summers and Barsky explain that the Gibson Paradox does indeed exist. They also say that it’s not connected with nominal interest rates but with real (meaning after-inflation) interest rates. The catch is that the paradox only works under a gold standard. Once the gold standard is gone, the Gibson Paradox fades away.

    It’s my hypothesis that Summers and Barsky are on to something and that we can use their insight to build a model for the price of gold. The key is that gold is tied to real interest rates. Where I differ from them is that I use real short-term interest rates whereas they focused on long-term rates.

    Here’s how it works. I’ve done some back-testing and found that the magic number is 2% (I’m dumbing this down for ease of explanation). Whenever the dollar’s real short-term interest rate is below 2%, gold rallies. Whenever the real short-term rate is above 2%, the price of gold falls. Gold holds steady at the equilibrium rate of 2%. It’s my contention that this was what the Gibson Paradox was all about since the price of gold was tied to the general price level.

    Now here’s the kicker: there’s a lot of volatility in this relationship. According to my backtest, for every one percentage point real rates differ from 2%, gold moves by eight times that amount per year. So if the real rates are at 1%, gold will move up at an 8% annualized rate. If real rates are at 0%, then gold will move up at a 16% rate (that’s been about the story for the past decade). Conversely, if the real rate jumps to 3%, then gold will drop at an 8% rate.

    Here’s what the model looks like against gold over the past two decades:

    The relationship isn’t perfect but it’s held up fairly well over the past 15 years or so. The same dynamic seems at work in the 15 years before that, but I think the ratios are different.

    In effect, gold acts like a highly-leveraged short position in U.S. Treasury bills and the breakeven point is 2% (or more precisely, a short on short-term TIPs).

    Let me make this clear that this is just a model and I’m not trying to explain 100% of gold’s movement. Gold is subject to a high degree of volatility and speculation. Geopolitical events, for example, can impact the price of gold. I would also imagine that at some point, gold could break a replacement price where it became so expensive that another commodity would replace its function in industry, and the price would suffer.

    Instead of explaining all of gold, my aim is to pinpoint the underlying factors that are strongly correlated with gold. The number and ratios I used (2% break-even and 8-to-1 ratio) seem to have the strongest correlation for recent history. How did I arrive at them? Simple trial and error. The true numbers may be off and I’ll leave the fine-tuning for someone else.

    In my view, there are a few key takeaways.

    The first and perhaps the most significant is that gold isn’t tied to inflation. It’s tied to low real rates which are often the by-product of inflation. Right now we have rising gold and low inflation. This isn’t a contradiction. (John Hempton wrote about this recently.)

    The second point is that when real rates are low, the price of gold can rise very, very rapidly.

    The third is that when real rates are high, gold can fall very, very quickly.

    Fourth, there’s no reason for there to be a relationship between equity prices and gold (like the Dow-to-gold ratio).

    Fifth, the TIPs yield curve indicates that low real rates may last for a few more years.

    The final point is that the price of gold is essentially political. If a central banker has the will to raise real rates as Volcker did 30 years ago, then the price of gold can be crushed.

    Technical note: If you want to see how the heck I got these numbers, please see this spreadsheet.

    Column A is the date.
    Column B is an index of real returns for T-bills I got from the latest Ibbotson Yearbook. It goes through the end of last year.
    Column C is a 2% trendline.
    Column D is adjusting B by C.
    Column E is inverting Column D since we’re shorting.
    Column F computes the monthly change the levered up 8-to-1.
    Column G is the Model with a starting price of $275 (in red).
    Column H is the price of gold. It goes up to last September.

  • Morning News: September 22, 2011
    , September 22nd, 2011 at 5:21 am

    Fed Outlook, China Rattle Investors

    Constraints on Central Banks Leave Markets Adrift

    Greece Cuts Wages, Pensions to Ensure Aid Payment

    Italian Yield Spread Rises to Euro-Era High

    Asia’s Millionaires Form Family Offices

    Canadian Dollar Slides To Near 2011 Lows On US Fed’s Operation Twist

    Crude Oil Down After Fed Meeting; Shrugs Off U.S. Data

    Fed Sees ‘Significant’ Risks as It Eases Policy

    United Technologies Agrees to Buy Goodrich for $16.5 Billion

    Ouster of Hewlett-Packard C.E.O. Is Expected

    Logitech Issues Third Profit Warning In Six Months

    BofA’s Drop Below Citi Credit Rating Foreseen: Chart of the Day

    U.A.W. Shelves Chrysler Talks and Turns to Ford

    Joyless Holiday Retail Forecast

    Jeff Miller: More Causal Confusion: The FOMC Decision and the Market Reaction

    Phil Pearlman: Network TV Fall Line Up All About Mathematics

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  • Investor Quiz
    , September 21st, 2011 at 11:39 pm

    Can you tell when the Fed’s announcement came out? Look real hard!

    The gold line is the S&P 500 and the black line is the Long-Term T-Bond ETF ($TLT).

  • Oracle’s Earnings Call
    , September 21st, 2011 at 5:15 pm

    Here’s the guidance portion from yesterday’s earnings call from Oracle ($ORCL), courtesy of Seeking Alpha:

    Now to the guidance. And as many of you remember, we had a great second quarter last year with New License up 21% on a non-GAAP basis and up 33% and GAAP EPS up 27%. So let me just say that again. New License was up 21%, non-GAAP EPS was up 33% and GAAP EPS was up 27%. So those are pretty tough comparisons, and we don’t expect much help from currency because at this point, it looks like only 1% stays where it is.

    New Software License revenue growth is expected to range from 6% to 16% in growth. Hardware Product revenue growth is expected to range from flat to negative 5%. However, we do expect gross margins and profitability of our overall Hardware business to improve during the quarter as we continue to move away from selling low-margin commodity servers and focus on selling engineered systems like Exadata, Exalogic and SPARC Solaris system.

    Total revenue growth on a non-GAAP basis is expected to range from 4% to 8%. On a GAAP basis, we expect total revenue growth of 5% to 9%. Non-GAAP EPS is expected to be somewhere between $0.56 and $0.58, up from $0.51 last year. GAAP EPS is expected to be $0.44 to $0.46. This guidance assumes a GAAP and non-GAAP tax rate of 27%. Of course, it may end up being different.