Looking for Clues in a World that Appears Clueless – Oct 21, 2011

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

1. Looking for Clues in a World that Appears Clueless: The markets gyrate up or down from day to day, even hour to hour, depending on the expected outcome in Europe. This is a market that, like the G-20 today, is characterized by leaderless confusion.

What can we expect in the coming weeks and months? Are there any indicators we see that help us anticipate the end of 2011 – or perhaps the events that will unfold in 2012? Let’s look at several market specific variables and search for relevant clues.

What is the German Bund telling us? Like our Treasury market here in the U.S., the German bond market is a litmus test for concerns within the eurozone (ironically, red is the color for acidic conditions). It is the benchmark within Europe for less risky assets (we don’t agree that anything can be a “risk free” benchmark, as the US Treasury market is often described).

The depth of the German bond market (in liquidity terms), its relative balance-sheet strength, and the monetary and fiscal responsibility of the country, all argue for it being used as a reference point for credit quality. Decisions made in coming days and weeks may tarnish that reputation and standing.

There has been a move into German bonds this year (just as there has been in our Treasury market) on concerns over sovereign default and European bank solvency. This has created positive returns of over 7%, as investors have favored the credibility of the German Central bank and the underlying economic strength of that country to other sovereigns on the continent.

Heading into the weekend, we see these gains reversing, as the debt markets anticipate a massive bailout announcement in days. The number assumed is $1.3 trillion. (Remember the willingness of the Chinese to spend nearly that amount to stimulate domestic growth, in an economy a fraction the size of Europe.) While 1.3 trillion is a large number, we should remember the fundamental flaw of creating new debt structures to handle the old. More is not an enduring solution, just a quick fix.

By Friday’s close, the equity markets in Europe were saying, “A big check will be written,” while the German bund price acknowledged the same message as it sold off. One of these judgments, German bonds, is sober indeed, the other reflective of a market excited by the prospects of easy money and loose lending. The German bondholder sees the implications of an increased bailout commitment as a direct burden to taxpayers, while the equity markets, like an alcoholic sniffing a freshly opened bottle, approved. The question remains, will it be a check big enough to impress the markets? In our opinion, the larger the check, the more time you can buy before you deal with an even worse monetary mess.

2. The Constant, Losing Fight Against Reality: We would remind you that while liquidity is mood-altering, its impact is fleeting. The larger concern we have is not the hour-by-hour gyrations in the marketplace, but the ever-growing concentration of risks in sovereign governments who classically have made adjustments to their liabilities (just like the ones they are taking responsibility for now) via the currency markets – translation: devaluation. This further translates to added pressure for savers and investors in pursuit of a positive real rate of return.

Should the bailout figure disappoint, equities and every asset that rises with the tide of liquidity (precious metals included) will drop. We would remind you, however, that the short-term move in tandem of equities and the metals market is not an enduring correlation; it defies the non-correlation of the last 100 years.

There are many issues that drive the gold market and transcend the fleeting relationship between the two assets. In the short run, both asset classes have benefited from liquidity measures by the various global central banks. All boats rise with the tide, but the boats with holes in them do still eventually sink. While we are checking for holes in the precious metals markets, no water is coming in at present.

More importantly, as government liquidity raises the bar for what constitutes a real rate of return (what you make after inflation and after taxes – also to rise, no doubt) the need to own gold among individual investors rises even more. Larry Summers explained this relationship with accuracy in his essay, “Gibson’s paradox and the Summers Barsky Thesis.” We believe this is the calm before the storm, and metals should be acquired in a range between 1550 and 1650.

As Germany and France launch themselves into the monetary unknown (if that is in fact what the German bund is signaling), we see a compounding of monetary madness, and with time a compounding of inflationary effects, both within Europe and around the world. Credit concerns are likely to spread further in Europe, as German bond investors acknowledge the risk of taking on the shared weight of one, or even two, trillion dollars in shady obligations. France is likely to lose AAA status, followed by further downgrades for Italy, Spain, Portugal, and Ireland. All primary trends will reassert themselves after the dust settles from this bailout or that.

We continue to search for clues and infer what we can from them. There is no leadership in the equity markets, which seem spent on past promises of easy fixes and more money to come. Resources for each bailout project are increasingly limited, though the numbers continue to escalate, creating an unhealthy competition between governmental and non-governmental borrowers.

Patience is growing thin in the investment markets, with the towel ready to be thrown in if expectations of growth and accommodation are not met. Thus, we find politicians and central bankers living on a knife’s edge, trying not to disappoint while fighting the major trends of deleveraging and monetary inflation.

Best regards,

David McAlvany
President and CEO