Money for nothing

The headline on the story in the Sydney Morning Herald was much more provocative than the substance, but it stopped me and stirred me to have a think. The headline said, "Faber says gold price may reach $US6000". The story said, though,

MARC FABER, who told investors to bail out of US stocks a week before the 1987 Black Monday crash and began recommending commodities at the end of 2001, said gold might rise tenfold in the next 10 years.

"If the Dow Jones [index] goes up three times in the next 10 years, I think gold prices will go up by a minimum 10 times to something like $US6000 an ounce."

Well, that is a lot of IF and I'm inclined not to go there. Still, my thought process on reading the headline was not, "gee, gold is going up", but rather, "gee, the dollar is tanking and inflation is going through the roof". Visions of post WWI Weimar Republic played before my eyes, or Latin American just a few decades ago, where you had to run to the market with wheelbarrows full of cash before you needed another wheelbarrow full just to buy some bread.

There is just a little too much exuberance and not enough common risk aversion these days. The commodity markets are one reflection of it. Consider these remarks in stories over the last 24 hours.

Reuters, by Martin Hayes: "Although leading preciaous metals gold and silver wre still adrift of recent generational peaks, alalysts see these levels being surpassed, given the remorseless fund buying taking place. 'It is the funds - pure and simple - they are just buying precious and base (metals), and there is no real end-game in sight,' a trader said."

Reuters, April 25: "London Metal Exchange (LME) zinc ended at a new high and copper and nickel closed near their peaks on Tuesday on continued investment fund buying, and the market may run still higher, traders said. 'Traders with 25 years experience are wondering what is going on -- just pick a number from $9,000 to $20,000 for copper,' an LME trader said."

And the Australian Financial Review considers resource stocks at the height of their volatility. Stephen Wyatt reports (sub req'd):

Analysts and traders remain alert to further gyrations since only a week ago there was a short-lived spate of panic selling. Gold and silver were particularly hard hit, gold dropping below $US610 an ounce at one stage. Few analysts and traders would be surprised to see a further sharp downward correction at any time after the extraordinary rallies enjoyed by these markets.

Barclays Capital commodity analysts point out that the traded volumes in 23 of the largest UScommodity futures markets covering energy, base and precious metals, agriculture and livestock sectors, hit an historical high of 8.4million contracts in mid-April.

Open interest, the number of contracts open in the market, has been on an upward trend for the past 12months.

This is one of the greatest resources booms in Australia's history. And the boom has put commodities back onto the top shelf of the investment supermarket.

Analysts are gobsmacked at the massive price rises and are becoming increasingly nervous.

Citigroup commodities analyst Alan Heap warned that "these high values cannot be justified in terms of historical trends and the prevailing supply-demand fundamentals".

But like most analysts, he said a possible sell-off would be a technical sell-off rather than an end to this resources boom. Most analysts suspect that while commodities may be overextended now, they will remain strong because fundamentals are still very sound.

Getting back to the Mark Faber article,

The author of the newsletter The Gloom, Boom & Doom Report said gold wasn't expensive when "you compare its price to the quantity of money that has been printed in the last 10 to 15 years in the US and the world in general".

The outlook for gold depended on how much money Federal Reserve chairman Ben Bernanke "will print", Mr Faber said in an interview in Tokyo on Monday.

"As you know he has pronounced speeches about asset deflation," Mr Faber said, referring to Dr Bernanke. "He's concerned about real estate and stocks going down, so in the long run for sure he'll print money."

And this is a sure-fire recipe for inflation unless the CenBanks crank up interest rates, notwithstanding the apparent lack of "official" inflation, to begin to mop up all those freshly printed notes.

And while on the subject of the inflation we're not having whilst the Chinese and Indian labour forces are keeping a lid on Western labour costs, the Australian markets are snacking on new highs again today, without apparent threat or worry of any rate increases because inflation is a "no worries" issue here, too.

Earlier this week we had a report that the pipeline was full of inflation but the core rate was masking it and so it didn't offically exist, as the Herald reported.

Prices paid by businesses at the preliminary stages of production soared 1.6 per cent in the March quarter and 8.6 per cent over the year. But prices at the final stages of production rose just 0.8 per cent in the quarter and 3.8 per cent over the year.

The gap between price rises at the preliminary and final stages of production is now at its widest in more than five years.

Pressure is particularly acute in manufacturing, where input prices have risen 15 per cent over the past year, outpacing output price growth of 7.9 per cent.

Higher import prices for petrol contributed to inflation at each stage of the production process, but the spike in prices above $US70 a barrel for crude oil is not captured in the numbers.

Petrol price rises present a problem for the Reserve Bank because they add to inflationary risks while lowering consumer spending in the economy.

Analysts said the Reserve Bank would welcome the producer price news. "The Reserve Bank will greet the latest producer price data with a mighty sigh of relief," an economist at Commonwealth Securities, Andrew Mitchell, said.

The Reserve mentioned a pick-up in producer prices in its explanation for raising interest rates in March last year.

An interest rate strategist with Maquarie Bank, Rory Robertson, said the Reserve was more interested in general demand conditions in the economy than any pick-up in headline inflation.

Higher petrol prices are battering at the factory gate, but businesses appear reluctant to pass them on to consumers.

[The] measure of inflation at various points in the supply chain, released by the Bureau of Statistics yesterday, indicates businesses are squeezing margins to absorb rising fuel costs rather than putting up prices [which is damned sporting of them, I'd say].

And the CPI figures we got today elicited the same laisez faire market response. Although the headline rate was at the unexpectedly high top of the Reserve Bank's 3% comfort zone, the core rate (ignoring fuel and food as such volatile costs) was only 1.7%, proving that if you ignore the price rises in the economy, there is no inflation to worry about.

And just to underscore the complacency in the markets these days, John Mauldin passed along a report by James Montier, Director of Global Strategy at Dresdner Kleinwort Watterstein, in Mauldin's Outside the Box email this week. You should read the whole report, here. Here are some excerpts:

Investors seem to be displaying signs of pure fearlessness.
Our fear and greed index continues to remain at extreme risk-loving levels.

Further evidence of this enthusiasm for all things equity can be found by looking at the short interest ratio on the QQQQ (Nasdaq ETF).

This out performance of junk is not limited to the top few stocks. The chart below shows an equally weighted year-to-date performance by quality ranking. The worst stocks have had the best performance (C ranked stocks up an average 17% YTD) whilst the best quality stocks had the worst performance (A+ stocks up a mere 1.2% YTD)

A recent study by Standard and Poor's shows this is an unusual situation. In general, the highest rated quality stocks outperform the junk, and do so with lower risk.

The final worrying sign of a surge of interest in junk equity is provided by the volumes data on the OTC Bulletin Board (OTC BB). The OTC BB is a quotation service for OTC securities (i.e. those not listed on the Nasdaq or any of the national exchanges). It is to all intents and purposes, a market place for low quality stocks. Volumes have exploded in true mania style. At the time, 2000 looked like a huge surge in volumes; now it's barely a blip!

One final observation: this dash for trash is not limited to equities. As a recent Bloomberg report points out, "U.S. companies one step away from default are selling a record amount of bonds... Even CCC rated companies, considered in so-called technical default, meaning they asked investors to revise the terms of their (existing) debt, were able to sell bonds in the first quarter."