The Way Things Are: Some Thoughts on Market Movements:

The recent events in Libya apart from being gory and repulsive have provided American equities with an excuse to sell off. The past couple of days have witnessed a much needed sell off, and just as one was beginning to question the sanity behind the more or less straight line rally over the past two months (barring slight hiccups during the Egypt crisis), the fates have once again conspired to provide markets with a pseudo legitimate reason to sell off. There are a few people who dare to short the American equity markets these days. The VIX volatility index is finally up more than 20% after having flat-lined for the past few months at low levels indicating extreme confidence in the bull run. This is of course a healthy sign for equities which will eventually make their way higher. But what is amusing to me is that it took the beginnings of a revolt in the largest African oil producing nation to get investors to take their bear claws out.

Analysts are panicking about oil prices being too high to sustain the global recovery. This is comical to me, because a few months back, almost everybody was confident of a ramp up in oil prices, and WTI crude touched $92, without producing any overt discomfort amongst equity investors. Now that WTI is catching up with Brent, people are churning out articles about how harmful it is for equities and economies in general that oil prices are so high. Where was this concern two months ago? $100 which is seen as the inflection point for WTI crude oil is within gunning distance as I type this. There is no way of course that the global economic recovery is going to go anywhere with oil prices at such levels. I feel that there is going to be a significant amount of options volatility at these levels, and it is going to be interesting to see when the Libya situation diffuses, what keeps prices so high. With another spate Chinese monetary tightening last week, all indicators point towards a slight cooling off in Chinese demand for commodities like oil, which may lead to more sustainable prices by May. If not, the developing/emerging world is going to suffer more than anyone else.

I cannot begin to count how many times something like this has happened to the markets. They are certainly not efficient, but as soon as there is a hint of a guiding light, they do follow in the direction the charts indicate they are supposed to go. What is interesting to me is that while monitoring simultaneous market movements I find that equity indices and currencies reach extremely stubborn market levels together, and move in unison from those key levels. It almost seems like somebody is orchestrating perfect harmonious movements, because it really gets to the point where it seems too obvious to be true. I start questioning my own analysis at such points because things seem perfectly synchronised. I am sure the fact that 95% of futures are traded on computer screens, and the whole trading community has access to pretty much the same charts and key levels has something to do with this.

It certainly cannot be termed as destined market movements, since nothing is certain but the likelihood of the uncertain. However, in terms of raw probabilities, more often than not, the prevailing investor sentiment has much more to do with where the markets are, than any piece or data released at any point. A few weeks back when the unemployment data for the US came out, I was amazed that the market rallied on bad headline numbers. People found all sorts of justification for the rally, including the fact that America much like Europe saw a harsh winter, so people did not turn up to claim benefits etc. Another argument propagated by market pundits right after the rally was that the unemployment rate had fallen to 9%, and this was reason to rejoice. The irony of all this analysis that was churned out to justify the rally was the fact that within a week from the time of the rally, economists started talking about the natural rate of unemployment having gone up in the US. All that really mattered to the markets was that the bad headline numbers were not a good enough reason for a correction when the prevailing investor sentiment was overly bullish even in the overbought conditions.

Of course most analysts believe that the markets are always right, so it is better to give investors a bit of ‘forgetting the actual market reaction’ time before publishing the truth. Historically speaking, American unemployment has been at a structural rate around five and a half percent. Lately, economists have been stating that this might have gone up to seven percent, and in my opinion this is true. Just in order to sustain population growth, America needs to create 125,000-150,000 jobs every month, which it has consistently been falling short of.  It is not true however that the fall in unemployment rate that has been occurring since December has only to do with the weather. It is more related to people dropping out of the search for jobs, and running out of benefits to claim. Last year, the Nobel prize for economics was given to a couple of gentlemen who have done extensive research on search frictions, and it is ironic that search frictions are not understood at all by analysts who make tall claims about the recovery in the American jobs sector. This is definitely a jobless recovery and this is the ‘new normal’.

All That Glitters is Not Gold:

There are more than a few arguments being floated around backing the explosion of silver prices in the coming years. Looking at it from both fundamental and technical viewpoints, I am more than confident that silver prices are bound to rise steadily. The good thing is that with all the mystique surrounding gold, investors tend to ignore silver and its value as an alternative to Fiat currency. I am certain though that this will not last long, and people need to wake up and buy silver before they end up chasing the rally like they have with gold.

The Fundamentals:

Every now and then in the world of investing, opportunities come along where the most profitable returns are provided by the safest assets to hold in the given economic cycle. The demand and supply of silver tell us that it is in fact one of those unique things to own, much like gold, when the prevailing economic environment dominated by inflation and instability fears dictates that it is both a safe and a lucrative investment. Unlike gold which is the first hedge for investors to run to; silver remains to be an afterthought. This is surely going to change, given that gold is already pretty expensive for small players (albeit it is not done with its bull run yet).

Silver supply has been lagging behind silver demand for a few years now. China, which used to be a net exporter of silver, has now become a net importer. Furthermore, the PBOC has expressed its interest in expanding its silver reserves. If this is not a bullish signal, I don’t know what is. The supply for silver has been declining steadily over the last 70 years, whereas the supply for gold has been rising. A major cause of the supply gap stems from the fact that a majority of silver that is found underground is found mostly, as a by-product during mining for other metals such as copper and lead. Therefore, the supply for silver cannot be ramped up very quickly even though it is not in short supply in nature.

The fastest growing area of the silver market is its use in industry, and analysts estimate that silver’s use in industry has gone from about 35% of entire production in silver to about 50% in recent times. Silver is used extensively in electrical devices, as it is a very good conductor of electricity. In fact, it is the best conductor of both electricity and heat amongst metals. There is zero wastage of electrical current when passed through silver, which is a property that makes it indispensible as a conductor. Here is something interesting on one of the applications for silver as a superconductor: http://www.gold-eagle.com/editorials_01/haynes111401.html. Silver is widely used in low technology and high technology manufacturing. Apart from all this, silver is of course widely used for coinage. The number of patents filed on silver, exceed those of most known metals, an indication that it is extremely useful to civilization for now.

The Technical:

Silver and gold prices have historically moved in tandem. Silver has traded at about one fifteenth to gold prices per ounce on an average. Currently, with gold around $1360 and silver around $30, silver is grossly undervalued at one forty fifth the price of gold per ounce. Economic cycles are all about mean reversion, and in the case of silver and gold, mean reversion dictates that silver catches up. Gold is certainly not going to have much of a downside in the coming 5 years, given that there is economic uncertainty as long as the developed world recovers on the crutches of easy money. If gold were to go to $1600, silver could easily go to at least $50 and still be trading at double the average ratio of gold to silver prices historically.

Silver is not waiting around for long. There has been heavy shorting of silver by big investment giants such as JP Morgan in an attempt to manipulate gold prices to keep the dollar stable. JP Morgan and its contemporaries are all front running open market operations for the Federal Reserve. JP Morgan has one of the biggest open short positions on silver. One does not need to be a conspiracy theory buff to believe that the US government and its Permanent Open Market Operators act hand in hand, looking after each other’s interests. That is the nature of capitalism, not cronyism or any other dirty word. However, the short positions on silver cannot hold off common investors for long. There has been a significant bull run on silver prices over the last year, and I truly believe in the very real upside potential this year as well.

The famous Dow Theory states that there are three primary phases in a bull market. The accumulation phase is when informed investor’s begin to participate in the market after observing facts that are not yet clear to the uninformed investor. This is the phase that silver will be in till it reaches $50 an ounce. After that, the accumulation phase will begin, whereby people will wake up and smell the coffee, and will participate in the trend up based on popularity and technical signals. This is the phase that gold is in right now. There is significant attention on the metal and prices have almost doubled since the global economic crisis began. The informed investor would have bought in to gold over two years back. The last phase is the excess phase, when the smart money starts to scale back its positions and selling off to people who are willing to buy an overbought market.

In Conclusion:

Silver, like any other commodity, cannot fall to a value of zero, unlike stocks which can. Brokers generally tend to advise investors to not have more than ten percent of their investments in things like silver and gold. Apart from the fact that this is just not the correct advice given the economic cycle we are in, brokers also cannot make any commissions off silver and gold. Two years ago, I had a discussion with a friend about my optimism about gold, and he retorted, what is the point of gold, you cannot eat it! This would surely not be his response now that we are in the second phase of the bull run in gold. Human beings tend to make decisions in a herd, so that they don’t have only themselves to blame when the outcome goes awry, and end up participating when everybody else is. This is not to say that geniuses do not act in this way; Newton’s example is the first one that comes to mind. He participated in the South Sea bubble, after seeing his friends get rich, and ended up joining as the bubble began to unwind and went broke. This is when he made his famous “I can calculate the motion of heavenly bodies but not the madness of people” quote. There is a still a slim chance of chasing gold and ending up cursing the madness of people, but not even that with silver.

PS...Buy physical silver not ETFs.

The week of January 31st: The Anatomy of Denial:

The present American economic recovery is driven to a large extent by the surge in equities since November. There are no caves for any bears to take cover, and the bulls are having a field day. I am sceptical of how far the availability of cheap credit can go in sustaining this jobless recovery, and even more sceptical of the complete disregard for bad data. The American economy seems to have gone into complete denial mode, and that is by no means indicative of a healthy recovery. American unemployment has traditionally been high for a developed country, at an average of around 5.7% from 1948 to 2010, but the slow pace of job creation is surely going to pinch.

In December, about 103,000 jobs were created in the American economy (later revised to 1,21,000), which was a very disappointing number after the optimism that had already been priced into the S&P 500 by the time the Non-Farms data was released. The equity markets took the headline number in their stride and shifted focus to the drop in the unemployment rate from 9.8% to 9.4%. It was assumed that the headline numbers were heavily influenced by the holiday season in December.

On 4^th February, the first reading for Non Farm Payroll again had disappointing headline numbers. January saw the creation of a mere 36,000 jobs, while the unemployment rate again fell from 9.4% to 9%. The markets once again chose to focus on the unemployment rate falling rather than the lacklustre job creation in the private sector. The S&P 500 and Dow Jones Industrial Average finished the week at new multi year highs. Last week’s rally showed that fear of a contagion in the Middle East, and rising commodity prices have been priced in, and equities are not concerned about the ballooning deficit (even as 10 year treasury yield has climbed over 30 basis points last week to reach its highest levels since May 2010).

It is estimated that around 2,60,000 people have dropped out of the work force in America, and this has been a strong contributing factor to the fall in the unemployment rate. People are giving up looking for jobs, and people are running out of benefits to claim (unemployment benefits without extensions typically last for about 26 weeks). How can a shrinking labour force and disenchanted job seekers indicate a healthy recovery to the markets? This rally in stocks seems to be based on self fulfilling optimism, and a myopic view towards debt sustainability. In the words of the famous economist Joan Robinson “modern capitalism has no purpose except to keep the show going”.

In his recent State of the Union address, Barack Obama said a lot of things that were expected from him. He stressed on the need for America to innovate itself out of the crisis, and emphasised that America’s education system needs overhauling to become more competitive. This would have made Schumpeter happy but he forgot to mention that there are thousands of recent college graduates, who are either looking or have given up looking for jobs.  He also spent a large proportion of his talk on new spending measures while conveniently forgetting about the $1.5 trillion deficit that needs to be addressed soon.

The Federal Reserve has stated that unless the unemployment rate falls to 7%, the second stimulus programme will be pursued till June at the very least. Even at the current rate at which unemployment is dropping due to people leaving the workforce waiting for hiring conditions to improve, this number will not be reached. So the equity markets are secure in the knowledge that bond yields will not be allowed to go up significantly, and investors will keep pouring in their money into equities for lack of an alternative for investing their savings. The real test for the American economy and the so called recovery is going to be in June, when the stimulus runs out. For now markets are happy in the knowledge that the Fed is looking after its equity investors.

When the stimulus runs out, and America’s unemployment and debt problems rise to the surface of the average investor’s consciousness once again, it will be the real acid test for the Ben Bernanke and his colleagues. There is no doubt in my mind that there will be little hesitation on their part to announce another asset purchase programme if markets tumble significantly after the exhaustion of the current round of asset purchases. For now they must be hoping that the current aggressive policy will guide equities to a point from where even a significant fall would seem like a much needed correction to the markets. Keeping in mind that we are at almost double the levels in the S&P 500 from early 2009 to now, even a 200 point fall would seem like a minor correction in the longer term scheme of things.

Whether or not one believes in the invincibility of the Federal Reserve and the Greenback; it is certainly clear that the current situation is reminiscent of a ponzi scheme. The current economic climate is catering to a select few individuals in the economy. Consumer spending is up, but only for the top 30% of the population. Employment is not picking up, and the construction sector has seen a net decline in hiring over the last month. Debt is reaching 100% of GDP, currently standing at well over $13 trillion. Equities are soaring at elevated price to earnings ratios, and are affordable only to the well off. Tax cuts have been extended for the rich, and there is no talk of addressing deficit cutting through curbing entitlements. All this seems a bit too messy to justify an unabated rally, and neither Obama’s administration nor the Fed, seem in any mood to curb the enthusiasm amongst the well off. Delay is indeed the deadliest form of denial.