January 28, 2011

Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

There are several oak paneled rooms that I would have enjoyed sitting in this week and last. Oh to be a fly on the wall, and listen to the intellectual banter; likely controversial, and perhaps inane. For one, the Fed released its communiqué from the last meeting, and of course our curiosity remains piqued as to how the State Department analyzes first Tunisia, and now Egypt. (The richer conversation might have been found amongst oil traders!)

1. From North Africa to North America: A Whirlwind Tour. It appears markets are not the only thing proving to be volatile – try North African politics, and someday perhaps North American, for all the same reasons. Egypt erupted like Tunisia with the public upset over political corruption (the new definition of “PC”), and the direct implications of rising food and energy prices to daily living. People are feeling the squeeze on the one hand, and seeing others (the political elite or at least politically connected in these countries) avoid it completely, and the response is in a word, volatile. Oil markets will be sensitive to regional contagion, like a wind storm taking the sands of discontent any and everywhere. Social unrest can take on a life of its own, something that the Sauds would prefer not to see.

Why bother insinuating a similarity between an almost hopeless continent and the strongest country in the World (Yes, the United States remains by all measures the strongest – even if only relatively so)? We see in the recent FOMC comments the kind of disconnect that leads to political volatility. It is a disconnect between policy makers, and those living with the results of those policies (there is a two tiered system, if you didn’t know that already). As we see it, that is quite similar to the dual realities often found in countries like Egypt, and Tunisia to name a few.

2. FOMC Communiqué: Disconnected. Comments from the Fed are telling, if nothing else of the thin air breathed by those with their heads so high in the clouds. On the one hand, the Fed acknowledges rising commodity prices, but then downplays inflation in the same breath saying, “Although commodity prices have risen [which is simply stating the obvious] longer term inflation expectations have remained stable, and measures of underlying inflation have been trending downward.” To which Goldman analysts observe curiously, “To us, the main surprise … is that the FOMC continued to characterize core inflation as trending downward despite an uptick in the December CPI.” It seems we are not alone in questioning the Fed’s dismissal of the facts.

So, the street experience of inflation is not at all consistent with the Fed’s assessment. Our point is that by the time the Fed catches up with reality, the folks in the street, demanding an increase in wages, price controls, and other subsidies from state and federal sources, will also be demanding someone’s head on a pike – not unlike Tunisia and Egypt. The question is whether the general public can be continually lied to over the real motives behind QE1 and QE2 – bailing out the banks. If the Fed acknowledges the Inflation issue, rates must necessarily rise, and the liquidity tap servicing banks would thus be turned off. This of course raises the question of how stable banks are, even with the trillions infused into the financial system.

3. Bank Earnings: How to Get from A to B. Let me digress to those institutions. In spite of access to record amounts of liquidity from the Fed, banks have turned in mixed earnings results this quarter. As we’ve taken another look at these results we find many of the major banking institutions boosting there profits by taking money already set aside for loan losses and adding those dollars to the bottom line – is that actual revenue? Not in our book. Imagine taking your children’s college savings and adding them to this year’s current income: You’d hardly call that an earnings increase!

Some bankers argue that this signals an improvement in outlook, as assets previously considered impaired are returning to full value allowing for a reduction in reserves and a reversal of earlier write downs by the institution. Fair enough we say, but why then can we not employ the FASB standards that mark those same assets to market? Why is it that banks insist on a free pass on pricing those assets to reflect something more than a modeled, or worse yet, make believe number? The truth: ABS/MBS and other loans on the books remain significantly impaired, and accounting gimmicks alone are allowing for the shift in capital from loan loss reserves to cash. Banks are not the best bet in our view, and the Feds actions defending its Zero interest rate policy support our conclusion that weakness in the sector is worse than many care to acknowledge.

4. Gold Volatility: Relishing the Downs and the Ups in the Market. Speaking of present tense weakness, and of a market that holds great promise this year and next, let’s discuss gold. In our January 7, 2011 missive we pointed out the welcome correction in gold and the prices at which we would be adding to positions. As you might guess from those comments, we are happier by the day! Volatility in any market signifies the struggle between differing opinions as to whether a market is and should go higher or lower. This week was entertaining.

By Friday, the Wall Street Journal offered a partial explanation for the weeks ups and downs, the swings being equally interesting if you like bungee jumping. Leverage was the story, with the reminder to all that you can be right on the trend, and wrong on the timing, which won’t hurt you unless you are leveraged. So, we are told a single trader took 10 million dollars and controlled a position equal to South Africa’s annual gold production, and when his fined tuned calculations got skewed, he got proverbially . . . well, you know, taken out of the market. As sizable trades where unwound, other traders jumped on board, not knowing what was causing the increase in liquidations. Reason returned by Friday.

The conclusion to this yo yo-esque experience is that the primary trend is critical to identify, and remain invested with. We have been and remain in a bull market in gold and silver. Secular trends are often interrupted by cyclical reversals. Remain with the trend, and you will find yourself rewarded. And please, avoid leverage. While it is sometimes attractive, it is always dangerous.

The present volatility in the gold market is welcome. The other forms of volatility discussed previously, we would prefer to avoid. However, the Fed will need to deal with reality sooner than later if it wishes to avoid general discontent – or, more severely, a North American version of the Twitter Revolution.

Have a great weekend.

David McAlvany
President and CEO

David Burgess
VP Investment Management