The Golden Ring
Adam Hamilton June 2, 2000 3049 Words
In the romantic days of feudal Europe, a mighty warrior class emerged the likes of which the world had never seen. With the seemingly innocuous invention of the stirrup, for the first time in history powerful men laden with body armor and bearing mighty weapons were able to maintain their balance while riding at a full gallop on monstrous war steeds. These knights were the bane of almost any foot soldier or light cavalry archer, and the heavy cavalry formed the contemporary equivalent of an armored division. Even with heavy armor and fearsome weapons, it took great courage to charge into the midst of hundreds of infantry trying to dismount the knights. While not making war, the knights held great chivalrous jousting contests to hone their skills and relax. These contests were popular events for lord and vassal alike, and drew great crowds. One of the events consisted of trying to lance the brass ring. A small ring was suspended at one end of the jousting field, and the contestant knights assembled on the opposite side. One by one, they would charge across the field at a full gallop, trying to line up the deadly tip of their lance to the seemingly impossible small target of the ring. While raging across the field, there were innumerable distractions, both external and internal, vying to break the necessary concentration of the warrior to achieve his goal. The crowds were cheering boisterously, the mighty movements of the stallion jarring the knight’s vision, and the tip of the lance dancing around as the knight fought to hold it steady. The internal distractions were even worse, including the fear of not performing well in front of other knights, the worry of humiliation in front of many fair maidens, and doubts as to whether the almost impossible task was achievable. The successful competitor had to thrust out the myriad of distractions and doubts, keep the faith, and concentrate without compromise on the target of the brass ring.
This week in the markets, contrarians faced a similar challenge to the knights of yore. While distractions swirled about, the task at hand, picking new undervalued investments before the crowd arrived, seemed quite daunting. The ridiculously overvalued US equity markets once again approached ludicrously overvalued levels, bubblevision declared inflation was dead and rate hikes finished, and the resolve of bears and contrarians was tested in the merciless crucible of the markets. How is a contrarian to survive this challenge? An unwavering focus on market fundamentals is the solution, keeping one’s sights firmly locked on the brass ring. Or, more appropriately for our times, the golden ring. Let’s take a brief look at the fundamentals in the markets this week and determine if the contrarian golden ring is still achievable.
On the most granular level, the fundamental symptom of any market bubble is simply overvalued assets. The idea of investing is so incredibly simple that even a child can grasp it. In order to make money in any market, one must buy low and sell high. In order to buy low, one has to find assets that are undervalued and have a high probability of seeking or exceeding their true value. The single greatest risk of investing is paying too much for any given investment.
With the unprecedented week in the NASDAQ, it would appear at first glance that value must have abounded there earlier in the week. Three of the four trading days saw top ten record gains, with Tuesday’s whopping 8% gain taking the pole position as the biggest daily percentage gain ever for the index and tying the largest point gain. Thursday and Friday saw similar massive upticks in the NASDAQ, with it closing up a spectacular 19% on the week. The beleaguered DJIA, while still in a boring 18-month old trading range, gained 4.8%, while the broad based S&P 500 leaped an amazing 7.1% on the week. Is the bull back? Or are the bears setting a wicked bear trap of epic proportions for the remaining bulls?
So how does the valuation of the US equity markets look? Was a bottom reached with bargain price levels abounding? Let’s take a look. For all of US equity market history, the average price earnings ratio of the markets has hovered around 12-14. If the P/E dropped to half those levels, the market was considered a bargain and a good buy. If the P/E more than doubled those levels, like in 1929, the equities were considered overvalued and a clear sell signal was evident. With the recent 40% “correction” in the NASDAQ and the large pullback of the DJIA how are the valuation levels looking at the moment? Let’s briefly examine ten widely held and extremely popular technology stocks, representing a massive $2 trillion in market capitalization. In the left columns, today’s price levels and multiples are listed, and the right columns show where each stock would be trading if it was valued near historical norms, at a P/E of 13.
Now it is important to point out all of the above equities are excellent companies, with great profits, fine management, and fantastic prospects for the future. The problem is simply the price. They have been bid way too high in the equity mania that has picked up steam in the last five years. As investors, especially for contrarians, the goal is to invest in assets that are depressed. With an average P/E ratio exceeding 83, do the above companies look like bargains at this valuation? The average loss if the companies were again valued at historically sound levels would be a catastrophic 81%. An investment in this basket of companies is incredibly risky by all historical standards. Financial markets always regress to their means over the long-term. The probability of these companies’ stocks dropping dramatically is orders of magnitude higher than a continuing rally, even after the recent havoc in the NASDAQ.
OK, so tech stocks are overvalued. What else is new, you ask? Let’s take a look at ten excellent “traditional” companies, and see if their valuations have reached bargain levels. Once again this basket of leaders in American industry represents about $2 trillion in market capitalization, and all the stocks are very popular and widely held. Maybe the real equity bargains are to be found in more traditional blue-chip companies…
The average P/E ratio of this basket of superstars is an astonishing 46.5, and eight of these companies are members of the elite Dow 30, the bluest of blue chips! In order to approach historical valuation norms, 2/3 of the market capitalization of these companies would have to vaporize. Once again, these are fantastic companies that have simply been bid to unsustainable levels by enthusiastic mania “investors”. Interestingly enough, the market capitalization weighted average price earnings ratio of the DJIA weighed in at a bloated 39.5 at the close today. To trade at 13x earnings, the index would have to drop to an abysmal 3500.
So as contrarians, as we look at the market fundamental golden ring of valuation, what conclusions can we draw? Investing is a game of probabilities, and you need to ask yourself whether you believe the probability of these equities becoming “ten-bangers” and trading at 400 – 800x earnings or the probability of being literally decimated and trading at 4 – 8x earnings is higher. Will the inversely prophetic words “THIS TIME IT IS DIFFERENT” finally ring true for the first time in history? Have we reached a new utopian plateau of permanent growth and prosperity and tamed the human emotions of greed and fear?
The low volume ramp job of the big cap darlings this week made it much easier to maintain a contrarian outlook and keep focused on the golden ring. The young gunslingers who manage Other People’s Money in mutual funds typically are compensated based on the market value of their holdings at the end of each month, which helps explain this Tuesday and Wednesday’s action. In an auction market languishing with low volume, it is relatively easy to “paint the tape” by placing strategic bids on certain critical large cap stocks. Also, at the beginning of each month, a torrent of funds remitted by employers for the prior month’s 401(k) and other retirement plans withholding pours into mutual fund coffers, which is the most likely explanation for the continued rally into Friday. By the middle of next week, the flood of fresh money should dwindle and the equity markets will likely resume their downward trajectory. Intraday volatility on the NASDAQ continued to be extremely high this week, averaging 5.65% versus 5.66% last week. As the general average volatility trend climbs, the market bottom continues to gape beyond the horizon.
On the inflation and interest rate fundamentals front, the bulls trumpeted a very slight monthly increase in unemployment and a small climb in average wages as evidence the economy was slowing down. Both changes were so trivial, they are probably well within the range of statistical error. In addition, the folks who release the statistics invariably revise them a month later anyway, so it appears the bulls yet again put a great deal of faith on a flimsy premise. The slight rise in unemployment, viewed positively by bulls in their eternal proclamation of “No more rate hikes!”, may be due to the laying off of a myriad of temporary census workers who have mostly completed their job of counting every man, woman, child, dog, goat, and chicken in our great republic. The average hourly wages only increased by a penny, according to the Employment Report released today. One material limitation of these reports, however, is they are looking backwards in time and not anticipating future news. From other indicators, the wage inflation picture may not look so rosy. Various news reports continue to filter through the media indicating continuing wide upward pressure on wages, which won’t be viewed favorably by the hawks at the Fed. Knowledge workers continue to be difficult to find, and are still paid premium salaries. On the West Coast, janitors have been organizing strikes protesting the need for a living wage in their bubble-inspired highly inflationary tech economy. There have also been reports of teachers and nurses demanding higher wages. Don’t be misled by the hype, the trend of wage inflation is still climbing.
The unstoppable juggernaut of price inflation continued to rip meat from the hides of the bulls this week. Oil closed at $30.30, and has been hovering around the $30 per barrel mark for almost a month. These price levels are even more amazing considering the incredible propaganda and jawboning coming from the western governments and OPEC regarding anticipated production increases to keep the price of oil between $22 and $25 per barrel. I have seen reports, although I can’t verify their veracity, that indicate the large middle east oil producers are running at 90% of capacity and would have a tough time materially increasing production. Gasoline supplies in the States continue to dwindle, and higher fuel prices have vast and omnipresent effects as they ripple through the economy. Everything we consume, including tangible goods, disposable items, and foods, require energy to be produced and delivered to the point of ultimate consumption. Increases in energy prices cause price inflation everywhere in the economy, with almost no sectors escaping its encompassing curse. Many important products are petroleum based as well, including many plastics. To add insult to injury, the CRB commodity index remains at two year highs, representing a dozen and a half important commodities in the world economy. Monetary and price inflation is like Pandora’s Box. Once a country opens the box, it is virtually impossible to close, and the evils that spew forth from its depths may not be fully comprehended and respected by the populace for many years.
With all the inflationary tendencies pressuring the market, the bulls believe only a single 25 basis point rate hike remains in the current tightening cycle. This hypothesis was one of the lynchpins of the incredible action we saw in the equity markets this week. Bubblevision spent most of the week trying to convince the retail investor that all is well in equity land, inflation was dying, and the rate hikes were nearing the end of their run. With the rallies and near record levels of consumer confidence reported, the retail investor must still believe the hype. That obscure little entity of heavyweight economists called the Organization for Economic Cooperation and Development, however, strongly disagrees with the bullish prognosticators on rate hikes. They put out a revised report this week indicating they believe that the US Fed will have to raise interest rates AT LEAST another 75 basis points by August to help stem the red tide of inflation washing over the American economy. In addition, the severely inverted yield curve indicates the bond market foresees some kind of economic trouble ahead. The next few months are bound to show the bulls are a bit premature in their announcements of unbridled equity appreciation, waning interest rate hikes, and no inflation. The ironclad negative influence on equities of the fundamentals of inflation and interest rate hikes are another golden ring that contrarians can focus on in order to drown out the incessant cacophony of the Wall Street hucksters.
In the currency markets this week, the dollar continued to slide against major world currencies, with the dollar index losing 1%. The slope of the trend appears to be sharpening in the southward trajectory. Even that bastard composite of fiat currencies, the Euro, gained significant ground against the dollar, reaching a 7 week high. The US desperately needs a strong dollar. We are spending a billion dollars more a day on foreign goods than we are selling, necessitating a billion a day in foreign investment to the US to float the yawning trade deficit. If the dollar weakens significantly, foreign capitalists will begin selling equities and then selling the dollar to repatriate their funds into other currencies. If this scenario starts in earnest, it is an extremely slippery slope and could spell major, major trouble for the US equity markets and dollar.
The arch nemesis of the dollar, gold, ended the week with a bang heard around the world. What a week for the “barbarous relic”! Check out this Friday chart, courtesy of the friendly metals gurus at www.kitco.com…
The metal leaped up on Friday, closing up over $9 an ounce, or 3.3%. Notice the extremely narrow trading range the metal had been stuck in the previous two days. Something strange was definitely disturbing the market, and it left a big foot print! The most ironic and satisfying part about the day for the gold zealots occurred when bubblevision had a few guests talking about the absence of inflation with “proof” being the tame gold price. At the very moment they were speaking, the gold price was leaping. It always pays to check the markets before one pontificates on them!
The internet goldbugs were all abuzz trying to explain the sudden rise in the ancient asset. A couple theories that caught my attention included dwindling stocks of the metal for delivery and the public release of the GATA report. Some very intelligent Gold-Eagle regulars who track the levels of gold available at the commodities trading exchanges are reporting shrinking stocks of the physical metal. This can be a cause of grave concern for market liquidity in commodities derivatives contracts. Holders of futures or options contracts have the right to demand delivery of physical gold rather than accepting a cash settlement on a derivative contract. With physical gold supplies at the exchanges apparently dwindling, an increase in the number of delivery intents could drive the commodities exchanges into technical insolvency or cause incredibly violent upwards movements in the physical gold market as shorts race to cover their positions to provide the physical gold to contractual counterparties. Another possibility for the price action is the public release of the Gold Anti-Trust Action Committee’s report on gold market manipulation they provided to Congress a few weeks ago. GATA has unearthed some incredible information, and I strongly recommend everyone takes the time to read (or at least skim) the 119 page report. It is the number one item on my reading list this weekend, and is located at www.gata.org/congress.pdf. You will need Adobe Acrobat Reader to view the report if you don’t already have it. It is a great piece of software, and is available for free download at www.adobe.com/products/acrobat/readermain.html.
So as a prudent investor how does one avoid the market turbulence and coming carnage? Buy low and sell high, anticipating the crowd like a true contrarian. When is the best time to buy a snowblower? In the winter after the first big blizzard when everyone is excited to own one? Of course not! The answer is in the summer when no one is thinking about snow. The geniuses of market history have not bought at the top, when popular opinion of an investment ran high. They made their purchases at the bottom, when the investment was vastly undervalued and under appreciated. They patiently waited as the perceptions of the rest of the world caught up with reality of the investment’s true value and then sold the investment at the height of its popularity for fantastic profits. As equities begin to fade from their zenith of popularity, the most unappreciated investment in the world is practically being given away. As a further inducement, this asset has been the most cherished investment throughout human history, with a great number of wars fought over it and innumerable kings and knights forsaking everything to seek it. It has also shined the brightest in times of the greatest uncertainty and turmoil. As you know, the investment is gold. Gold, at this moment in history, is the ultimate gold ring for a contrarian to focus on. Where is the probability of legendary gains the greatest? In equities vastly exceeding all norms of market valuations? Or in a timeless asset languishing at 20 year nominal lows? As the great bull market nears the inescapable barbecue of legend, gold will again shine like a supernova, awing the masses with its glory.
Keep your lance up, steel your mind from the market noise, and focus on the golden ring!
Adam Hamilton, CPA June 2, 2000