WEST TEXAS TWO STEP—GOLD REMAINS THE WALLFLOWER

5/20/13

Today’s (i.e., Monday, 5/20/13’s, page C1) Wall Street Journal made much of the disparity of the performance of gold and West Texas Intermediate (“WTI”) crude oil.  By my calculations, as I write this, WTI is up 5.5% year to date while gold is down 17.5% and silver is down 12.2%.   As the Journal points out,

Skeptics say this mismatch may be a sign of trouble.

As one reads the article, one gleans that the experts must mean trouble for crude oil, as opposed to wider trouble for the markets, the economy, or Western civilization, which yours truly is always anticipating, but I digress.   People who follow these things point out that there is a mismatch between physical demand and investment demand for oil.  The former is still reflective of a sluggish economy, along with abundant supplies, while the former is being fueled by a thirst for, as the Journal puts it

higher returns than those shackled to rock-bottom interest rates.

The Journal may be right; who knows what goes on with various trading programs that react to what used to be considered miniscule moves of seemingly largely unrelated markets against each other?  

However…

The “out of bonds into crude oil futures” explanation doesn’t make much sense to old guys, like yours truly, who still embrace economic and financial fundamentals and have been trading long enough to know how perilous trading normally is. 

Two days ago (GOLD AND BONDS:   STRANGE BEDFELLOWS IN A YIELDLESS WORLD?, 5/18/13), I expostulated on my theory that the key to gold’s recent demise is not return but yield; i.e., gold may be getting hammered as part of wholesale desertion of low and no yield assets in favor of big dividend paying stocks, the risks of which are being downplayed or ignored.  If that theory is true, either gold has to trade up or crude oil has to trade down.   (Note that gold is up a little over 2% today and silver is up slightly more, but one day means nothing, at least to investors.) Investors can’t be fleeing no yield gold or low yield bonds in order to invest in no yield crude oil.  And it seems that if investors, or traders, more properly, are abandoning gold because it has no yield, they would also be abandoning crude oil.  Instead, they are bidding up crude oil, though 5.5% YTD only looks like a whopper return relative to the dismal performance of precious metals.

Again, I’ll leave the trading like a scalded dog to my younger and presumably wiser colleagues.  But it’s fun, and sometimes informative, to speculate on why commodities or markets are doing what they’re doing.   However, the only thing we can say for sure about crude oil is that there are big buyers, or a lot of little buyers, who like it for reasons we don’t know and can’t know.   We might also say, with only slightly less assurance, that any speculation as to their reasons is just that…speculation…and there is probably more going on than we know.

GOLD: YES, I’M SCARED…BUT I’M STAYING

4/15/13

As one who is long gold in a substantial, for me, way, of course I’m scared by what that ancient object of kingly desire has been doing of late and for the last several months.   At $1,371.60 the ounce as I write this, gold is down 18% for the year and is so far off its high (I saw and recorded an intra-day high of $1,911.20 on 9/6/11, but the reportage pegs the high lower.) that one with less experience than yours truly might despair (or rejoice, depending on one’s position) of ever seeing that Everestian peak again.

But what am I doing in response to my fears regarding gold?   Nothing.   I suspect, but can never know, that this would be perhaps the worst time to sell gold; getting in the middle of what looks like a margin call induced unwinding of large leveraged positions is never wise.  Further, the underlying reasons yours truly owns gold, the most salient of which is a total lack of faith in the world’s central bankers as a group (See only my latest post on this topic, 4/5/13’s “(BEN BERNAKE) CAN ‘CAUSE HE MIXES IT WITH LOVE AND MAKES THE WORLD TASTE GOOD…”), remain intact.

Of course, I, like anyone else, could be wrong; what we are seeing may be an indication of a worldwide deflation, in which case we, and I, would have far more to worry about than the value of our gold positions.   But, at least for now, I am thinking that a lot of people have thrown in the towel on gold and are taking what remain huge long term gains in the metal and its cousins, such as silver and platinum.   When I rebalance I will act accordingly; if this swoon continues, or even if the prices of precious metals stabilize, I will probably be adding to my gold and silver positions as a part of the normal rebalancing process, which is a few months off at the earliest.

I do want to point out something that I said in my last defense of my Treasury Inflation Protected Securities (“TIPS”) position on 2/2/13, YES, I’M STILL HOLDING ONTO MY TIPS, when I was going over, and dismissing, the alternatives to TIPS:

Mr. Arends suggests that those who are buying TIPS for inflation protection go into real estate and commodities.   I, and those I advise, have plenty of gold and silver exposure, primarily through the ETFs GLD and SLV.   But one has to understand that TIPs and, say, gold, display profoundly different risk profiles and therefore are not ready or obvious substitutions for each other.  (Emphasis mine)

Now readers are getting a vibrant and glaring example of what I was talking about; gold and TIPS have radically different risk profiles and, even though TIPS have sometimes been referred to as “paper gold,” gold and TIPS are not ready substitutes for each other.

Speaking of TIPS…

First, they haven’t done all that poorly since my 2/2/13 post.  The 10 year TIP yield has gone down from a negative 57 basis points to a negative 73 basis points as I write this.  And the ETF TIP has gone up about a point to 122.   Yes, TIPS have underperformed conventional treasuries; the inflation assumption implied by the 10 year conventional and TIP yields has gone from 2.58% to 2.44%.  And stocks, again with a vastly different risk profile, have done far better.  But, on balance, if owning TIPS from the time I advised holding until now is the worst investment you ever make, you are indeed leading a charmed investment life.   If you’d held gold as an alternative to TIPS, you would have been licking your wounds.

Second, that TIPS are down slightly today while conventional treasuries are up, gold is down, and gold is getting pummeled lends credence to the deflationary argument.   But we are looking at one day’s trading, which is largely meaningless.  See, inter alia,  today’s other post, SO WHY HAS THE STOCK MARKET DONE SO WELL OF LATE?

YES, I’M STILL HOLDING ONTO MY TIPS

2/2/13

Occasionally, I will write purely financial pieces on Mighty Quinn on Politics and Money; this is one of those occasions.

In this weekend’s (i.e., 2/2/-2/3/13’s) Wall Street Journal (“Looking for Inflation Protection?   Take TIPS off Your List,” page B7), Brett Arends argues against holding Treasury Inflation Protected Securities (“TIPS”), which comprise an astronomical proportion of my portfolio and large proportions of the portfolios of those I informally advise.  Naturally, Mr. Arends’ comments merit a response, if only to clarify my thinking.

Mr. Arends’ main argument is that TIPS, with their negative real yield, are “a lock to lose money in real, inflation-adjusted terms.”   But this is not news to my readers; I’ve written extensively on this point at the now defunct Rant Finance:

1/8/13              TIPS:  STILL WARY, BUT STAYING, AFTER ALL THESE YEARS

10/3/12            WARY OF TIPS AT THESE LEVELS?  A LITTLE, BUT…I’M STAYING

7/19/12            10 YEAR TIPS AUCTIONED AT A RECORD LOW YIELD—NEGATIVE 63.7 BPS—WHAT, ME WORRY?

In the interest of space, only the most recent of these has been reproduced below.

While Mr. Arends reiterates my, and most people’s, primary objection to TIPS, he fails to

Answer a question I’ve asked in all the above posts:   What’s the alternative?  Yes, it seems crazy to hold an investment with a negative real yield, but, in an environment characterized by investments with negative real yields, TIPS make sense on a relative basis.

With the conventional ten year treasury yielding 2.01% and the ten year TIP yielding a negative -0.57%, if one holds ten year treasuries, one would be betting that inflation will average less than 2.58% over the next ten years.  I, for one, would take the other side of that bet all day.  If one were to hold cash at 0%, one would be betting that inflation will average less than 0.57% for the next ten years or that short rates will turn up quickly and decisively.  While I might consider taking the latter bet, would anyone care to take the former?

Mr. Arends did suggest going from long TIPS to shorter maturity TIPS (So how much can he really hate TIPS?  But I digress.)   This might be a good idea, primarily because TIP yields get less negative as one moves in the treasury curve (shortens maturities) and because short TIPS are less exposed to increases in real rates than long TIPS.   But to take one’s capital gains (As Mr. Arends points out, the February, 2040 TIP is up 40% in price since its issuance three years ago.) and pay the attendant taxes (even at the lower capital gains rate, as Mr. Arends also points out)  for such a small change in positioning seems a little silly.   And those of us who hold our TIPS in funds (the exchange traded fund (“ETF”) TIP or a TIP fund from a major mutual fund family) don’t have that option, though Vanguard has now come out with a short maturity TIP ETF, and I’m sure Vanguard isn’t alone.   Still, moving out of TIP into the short term TIP ETF involves a lot of taxes for not much of a change in one’s portfolio.

Mr. Arends suggests that those who are buying TIPS for inflation protection go into real estate and commodities.   I, and those I advise, have plenty of gold and silver exposure, primarily through the ETFs GLD and SLV.   But one has to understand that TIPs and, say, gold, display profoundly different risk profiles and therefore are not ready or obvious substitutions for each other.

Mr. Arends did not suggest common stocks, and especially big dividend payers, as an inflation hedge.   There would have would been some merit to this suggestion, but stocks, while providing a good inflation hedge in the long run don’t do so well in the short run when inflation starts to pick up.   Further, increasing one’s equity exposure because one no longer likes his or her TIP position seems to be making an asset allocation decision with too many other variables swirling around it.

Mr. Arends makes some good points and I thank him for causing me to reexamine my assumptions, but I will continue to hold my TIPS…and will let my readers, and those I advise, however informally, know quickly should I change my minds.

PROMISED 1/8/13 POST REPRODUCTION:

TIPS:  STILL WARY, BUT STAYING, AFTER ALL THESE YEARS

1/8/13

Treasury Inflation Protected Securities, or TIPS, have taken a beating over the last month or so.   The yield on the ten year TIP has increased from a record low negative 93 basis points (“bps”) on 12/6/12 to a negative 67 basis points as I write this.  The ETF TIP has fallen from a high of 123.30 on 12/6/12 to 121.07 as I write this.  As loyal readers know, I have been long TIPS in one form or another in a big (for me) way for a long time.   This investment has worked out very well for yours truly, so, naturally, I am nervous about it, as any prudent investor should be after a prolonged pleasant experience; complacency is dangerous in investing, as it is in most aspects of life.  So I have been watching TIPS closely and have curbed, but not abandoned, my enthusiasm for them.  See my 10/3/12 post, WARY OF TIPS AT THESE LEVELS?  A LITTLE, BUT…I’M STAYING.

The recent drop in TIPS is entirely attributable to the drop in treasuries in the wake of anticipated and actual “progress” in the fiscal cliff negotiations (See, inter alia, my 1/2/13 post at Rant Political, FISCAL CLIFF REVISITED for some thoughts on the so-called fiscal cliff.); note that the implied inflation rate in the 10 year TIP has increased, albeit by only 2 bps to 2.54%, since 12/6/12, indicating a very slight outperformance of the conventional 10 year by the 10 year TIP.   Therefore, a logical conclusion would be that if one really believes that the fiscal cliff deal was sufficiently salubrious for the economy and the market to justify the post January 2 rally in stocks, one should be abandoning both conventional treasuries and TIPS and doing so with enthusiasm.  

Yours truly, for one, is not yet ready to declare that the patchwork excuse for a deal that the eminences in Washington managed to barf out after their deadline has removed the obstacles the economy and the stock markets faced in seeking their true, and much higher, levels.  Indeed, the fiscal problems of the U.S. government are merely one range of mountains the world economy must surmount, and even those problems were not solved by this poor excuse for a deal.   While the rally could be justified for a trade, largely on the greater fool theory, which tends to work well in the world of short run trading, it is utterly baffling from an investment standpoint.   And if one believes the stock market rally has no legs, as the last few days seem to be indicating, it’s hard to think that treasuries and, by extension, TIPS, are in serious peril at this juncture.

However…

We are not dealing with conventional times or conventional markets.   The reason that the conventional ten year treasury is yielding 187 basis points, a yield still laughably paltry though way up from its low of 138 bps in July, is because the Fed is buying the lion’s share (about ¾) of treasury issuance.   If the Fed were to back off, conventional rates would increase, if not soar.  And if the Fed were to back off, it would, necessarily, stop creating the money it uses to monetize the debt (Let’s call a spade a spade.).   That would presumably tamp down inflation expectations, which would cause TIPS to underperform a poorly performing conventional treasury market as real rates increase and inflation expectations decrease.   This is a bad, if not a nightmare, scenario for TIPS.

So if one believes that the economy is improving sufficiently for the Fed to back off its aggressive bond purchasing programs, or the fiscal cliff deal impresses Obsequious Ben and His Merry Men to the point at which they no longer feel that their wise beneficence, and prodigious money creation, is necessary, then, yes, one should get out of TIPS with alacrity.   But yours truly believes neither that the economic roads have been made smooth nor that the fiscal cliff deal solves much of anything.   So I will continue to hold TIPS.  

Admittedly, part of my reason for being tenacious, or stubborn, on TIPS, as it was on 10/3/12, is that I can’t think of anywhere else to go with the money.  While that is not generally a good reason to hold anything (There is always cash at a few basis points.), my October 3 theory on the dearth of alternatives seems to have held; the stock market has been essentially flat since then.  And I suspect it continues to hold.   Stocks are scary in the wake of this rally and just about any scenario that would make cash attractive would make TIPS more attractive.  I have liked, and profited from, gold for the last several years, and I like it more after its recent defenestration, but to commit TIPS money to gold would be to move into an entirely different risk universe.

So, yes, I am staying with TIPS.