Ramblings of a Portfolio Manager or Every Rally Has a Golden Lining? We published no Ramblings last week as we took Labor Day off to roast a pig and to ruminate on the state of the capital markets. While cooking our tasty ruminant we found a number of things to chew upon but, in particular, we noted that the Calendar placed us solidly in September while the market indices showed us solidly in the black! What about the doomsayers’ daily history lesson regarding September’s evil legacy and it’s strong correlation to the omnipresent “too far, too fast” market indicator? And, if the market is truly going up on positive sentiment, why is Gold soaring, the dollar sinking and interest rates dropping? Are we are in economic Bizzaroland?
Actually, these seemingly contradictory moves in asset classes make sense and say a great deal about where the market sees the economy 6 months to a year out. Let’s start with Gold, as the move in this asset class is intertwined with the others. There are usually 3 reasons why investors like to hold Gold: 1. as an inflation hedge; 2. as a safe haven to hedge against the risk in other asset classes (like stocks and bonds) and 3. due to weakness in the US Dollar. Taking each in turn, Inflation: currently, most credible forecasts see tame inflation (deflation is off the table for now) over the next 6-12 months as the economy is expected to recover slowly, keeping wage growth in check, and these expectations have not been increased in the last month. This outlook is buttressed by the lack of movement in 10 year treasury inflation spreads and the still historically low velocity of money (meaning banks still aren’t lending). The lack of significant inflation outlook is also one reason why US interest rates have been coming down. Safe Haven: the volatility index, or VIX, a measure of fear in the stock market, has been trending down and is now at a one-year low—almost to pre-crisis levels—as are credit default spreads, suggesting that fear of shocks to other asset values is not significant. By the way, although it has been positive lately, the long-term correlation between Gold and stock prices is pretty much zero, debunking the pretty metal as a safe haven in a stock market storm. Weak dollar: Gold’s correlation to the US dollar is inverse and much stronger than its correlation with stock prices. The same holds true for Oil, which has also been climbing in price as of late. Weakness in the dollar, we believe, is behind the asset class paradox we have been seeing this month. The US Dollar has been taking it on the chin as of late as inflation fears remain muted and a huge supply of US debt is expected to hit the market. Lack of fear has also reduced the demand for US currency as a safe haven, driving down its price relative to other currencies. Of course, the Fed has signaled no expected increase in interest rates in the near future, thus dampening demand for the dollar.
So why are rates dropping and stocks rising? Rates, as we have discussed, are trending lower as inflation outlooks have been downsized and the Fed remains on hold. There is also a growing sense that Obama’s $Trillion Health Care package is on the ropes, suggesting smaller than originally expected future US borrowing. Stocks, on the other hand, are following simple Graham and Dodd fundamental analysis: lower rates increase the present value of earnings and dividend streams, thus making stocks more valuable In addition, a weak dollar means that US exports are more competitive in the global market, signaling greater future international demand and higher revenues for our multinationals. It’s no surprise, then, that industrials have been the best performers this month. In the absence of any negative information, thus, stocks are trending higher. Really, it is as simple as that.
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