Author: Mark Dow

Before I start, I want to send wishes and prayers to Boston and my many friends there. I went to graduate school in the area, and my wife and I lived seven years at 780 Boylston Street, on the same block as today’s fateful blast. There are no words…

There’s another preliminary point I want to make. It is my view that gold is a deeply flawed investment vehicle that will hurt a lot of retail investors, investors who have listened to the predatory promoters with business models designed to stuff these investors with their products. I very much sympathize with those who have lost and will lose money due to this bad investment. It happens; we all get things wrong–sometimes dramatically. I can only hope the retail trapped longs have a risk management exit strategy and that they don’t override it.

Where I have no sympathy whatsoever is with the charlatans and hucksters. For them I can only wish pain. It’s too bad too many of them have already taken out enough fees and commissions in this gold bubble to set themselves up for life. But they are not going to get any of my sympathy when their businesses crumble, just as Countrywide, New Century and the like crumbled after their bubble popped.

So, with that, where are we now?

Up until last Friday we saw a steady and somewhat orderly decline. Tourist macro with the big positions (Einhorn, Loeb, Klarman, Paulsen, etc..) and commodity funds getting redemptions were the sellers. On the other side, retail investors continued to buy.

I stole the chart below from J.C. Parets’ write up of the MTA 2013 Symposium (h/t Josh Brown). It shows the retail buying as the professionals began to sell. The total ETF gold holdings continued to climb higher as gold prices went sideways. Even a tourist technical analyst like me knows what that means. I also know first-hand that mutual funds have been seeing inflows into gold funds as recently as last week.

 

All this ended on Friday, when, as I read the psychology and price patterns, we entered the acceleration phase of the decline. Nothing shakes emotions like speed. Those who thought last week they were seeing a buying opportunity suddenly froze: neither buying nor selling. And pros are not going to initiate shorts here. So, all that leaves us with is a handful of intrepid true believers and short coverers on the bid side, versus forced sellers on the offer–either because risk management is forcing them to do so or the margin clerk is. Either way, no one is selling down here because they want to.

I do expect that once the forced sellers at this level are spent, we will see a bounce. I think this starts tonight or tomorrow. Once the bounce plays out it would be a good time, IMO, for trapped longs to exit and those who share my thesis to re-establish shorts.

I think the Great Unwind of the over-accumulation of “real assets”—especially precious metals—has a long, long way to play out. Remember, this was only the first day that retail even had a chance to sell since they stopped buying last week, whereas the accumulation was years in the making.

Let me trot out a couple of charts. I did these charts on Saturday, in the hope of writing something sooner, but today’s price action has only strengthened the case.

Here’s a 10-year chart of the GLD. It looks like a massive top. The hope that it was forming a basing wedge or whatever was dashed by the price action on Friday. This chart looks like the top is in and it could fall a long, long way.

 

Some of you might be tempted to suggest that this “consolidation” doesn’t look much different than the one you can see in 2008 (above the lavender arc). For argument’s sake, let’s pretend they are similar.

In 2008, gold fell from the blue line down to the support represented by the red line. The red line is the base from which gold broke out in 2007, and hence, support. If a similar consolidation were to happen today, gold would fall back to the base from which it broke out in 2009—the blue line. That level is 100 on the GLD and about 1000 on gold futures. This would not be a comfortable consolidation to try and ride out from here.

But 2012-13 is not 2008. Back then, we were in crisis mode, with no clear bottom to our economy in sight. Inflation emerged as a big fear once the Fed started expanding its balance sheet aggressively in late 2008.

Today, we are on the back side of all that. The economy continues its anemic recovery. Inflation is really only a worry for the tin foil hat crowd. Joblessness is still very high, but it is grinding the right direction and household balance sheets have come a long way. The financial position of our financial and corporate sector is far, far better. In short, there are still fears, but they are fewer and less life threatening. This, plus the positioning and the fresh shift in psychology, will make it hard for gold to find a durable bottom anytime soon.

Again, here’s a clean chart of gold futures going back 14 years. Even my friends who are ideologically predisposed in favor of gold said this chart is a massive top.

 

Good luck.

Remember this post back in January? It said, inter alia, to watch the spread between the yield on the US 10yr note and the 2yr. It suggested something good was happening (US healing) and that we should all take note.

Here’s the chart today:

 

It doesn’t look so good for risk taking. It doesn’t mean the world will end, or that you have to join the Policy Bears in the bunker, but it means you have to protect yourself.

It also means I have to be careful with my precious metal shorts.

What we are seeing in the commodity complex is the drip, drip, drip of orderly liquidation. Commodity funds are losing assets and/or being shut down. Tourists who ventured into commodities to protect against macro fears that didn’t materialize have started to sell. And the sell-side commodity hype machine is now behind us. This is why commodities have stayed so oversold for so long with high negative sentiment readings, yet still go down pretty much every day.

When performance is dragging, less experienced traders often lock in profits on their winners and double down on laggards. The pros, however, prune their losers, and pros are the big holders of commodities. Hence, the drip, drip, drip. (NB: liquidations usually start with drip, drip, drip and end with flush.)

How far does the unwind have to go? These things are always hard to say with precision. But what we do know is that the commodity unwind should be a function of the size of the build-up—plus a reverse-bubble psychological dynamic once the selling gets going. Rapid rate of change influences emotion much more than level.

Since I believe the buildup was significant, with a good portion of it predating QE, I expect the unwind to be large and sustained. But, ultimately, every investor/trader has to come to his/her own determination of how big the unwind will be.

Do you think the US has put crisis behind it? This is really the only question you have to consider when you look at the above chart of gold since 2000.

What we have been seeing is that silver and gold are developing an increasingly negative correlation with the S&P. And it is in the precious metals where most of the tourist dollars reside. So hedging your equity longs with silver and gold—though it has worked very well for the past few months—will become more painful to hold onto in countertrend days, and possibly brutal in a selloff (both your longs and shorts may well move against you). It you have a cast-iron stomach, you should be fine. The reality is, however, that most of us don’t—and hanging on to a winning trend is the single hardest skill to learn in investing. A better hedge will help you do that.

Enter copper. During the speculative run on commodities, there was a lot of broad allocation to the asset class as well. This means copper (and to a lesser extent oil) will correlate in part to precious metals, and in part to the S&P, since, as an industrial metal it is more sensitive to growth. The bottom line: copper right now makes for a better macro hedge than silver or gold.

The point of this is that if you have been suffering from being underinvested and you are looking for a way to add stock risk to your book, a really solid way to do it that minimizes the risk of being the goat in two months’ time is to buy the stock you like based on your process, and hedge the beta out by shorting copper. It sensitivity to growth should make it go down on down equity days, but on up days it should lag—or even outright decline—based on the drip, drip, drip of the commodity unwind.

Here’s the chart of copper of the same time horizon, FWIW:

Apple and GDX, the ETF for gold mining stocks have very little in common–or so it would seem. One is a major technology stock, the other, a leveraged play on precious metals. Apple has tangible value, which at some price point will matter; Precious metals have whatever value we assign to them–the ultimate greater fool trade.

But the chart below shows a striking similarity. Both have been highly correlated to the downside in an overall up market.

Why? A tale of two bubbles. Both were the objects of excessive enthusiasm. This enthusiasm is now unwinding. My guess is that AAPL is close to finding a bottom. Precious metals–where there is no tangible anchor–look set to go much, much further.

The other interesting observation is the evolution of the rolling correlation between AAPL and the SPX. One thing to watch for is this correlation picking back up–implying the idiosyncratic component of the AAPL unwind is mostly behind us.

This was originally written for a blog over at the CFR. The framework is still useful today, IMO. At least you can compare it to how things have kind of turned out. Here is the link to the original.

The Dollar: It’s an Overhang, not a Hangover

By Mark Dow 
July 6, 2009

Few things are more confounding to economists and traders as forecasting currencies. However, as I have come to realize, the approach each group takes is very different. Economists are never wrong, only early; traders are often wrong, but never in doubt. Economists look at interest rate differentials, growth differentials, current account positions, and other fundamental factors. It doesn’t always help much, but it is a defensible place to start. Traders, on the other hand, cognizant or not, focus not on the fundamentals, but on the “fundamental story”. These stories typically emerge to fit recent price action and are then coupled with what economists refer to as stylized facts. Unlike facts, stylized facts are not stubborn things. Some stories turn out to be true, others false, but whether they are true or not the most powerful ones share two characteristics: they are easy to explain and intuitively appealing. And once a good story takes root it can be very difficult to dislodge it—irrespective of how untrue it may be.

“Stories” that drive the dollar abound. They are usually easy to explain and intuitively appealing. Most of them turn out to be wrong. Excessively low interest rates in 2003, the Fed “printing money” today, large current account deficits, increasing budget deficits, Chinese concerns, all of these are given ample airtime. In short, the core story we have been hearing is that the dollar is now suffering a hangover from the fiscal, monetary and external account binge it has been on in recent years.

How well does this hangover story hold up? Not well.

First, dollar weakness has not been as dramatic as the story that has accompanied it. The only big decline came in 2007 (red arrow in the chart below) when the world was in massive risk seeking mode, loading up on carry, reaching for yield, constructing CDOs and CDO-squareds, and using the dollar as a funding currency. Much of this decline was unwound over the past year as the world began to deleverage. In fact, the dollar is right about at the same level as it was when Lehman went bankrupt.

Second, much of the story centers on the Fed’s expansion of base money. This is wrong on many counts. To begin with, the Fed is not printing as much as you might be led to think from listening to financial commentators on TV. Base money (here) has been flat lining since early this year (total liabilities are in the leftmost column). Moreover, the money multiplier has continued to decline, as credit is destroyed and the private sector delevers. (I think many commentators end up confusing base money with the broader money supply, but there is no need to get into this now). In addition, when the expansion of base money was truly rapid, from September to December of last year, the dollar was getting stronger. Why? Because that’s when the demand for dollars was strongest. Memories of Econ 101 and quotes from Milton Friedman have encouraged an excessive focus on the supply of money, when the real driver has been the sharp changes in demand. As funding pressures in the financial system eased, the dollar started to decline again. It is not a coincidence that the DXY (dollar index) made a high in early March when the S&P made its lows. Lastly, there is an article in this week’s Economist, pointing out how the ECB has been as expansionary as the Fed, but have been lower profile about it. But I haven’t heard any talk about the debasing of the Euro. In sum, sexy though the story might be, I don’t think the “Fed-is-printing-money-like-Zimbabwe” theme is really driving anything but the psycology of a few.

What about the current account deficit? No one home there either. As soon as the deleveraging accelerated, the US current account took a sharp turn northward. In the chart below I use the trade balance, which comes out monthly, as a proxy to capture the rate of change.

Ultimately, the current account story is much more a credit story than an FX story, in my view. And it is fixing itself without much help from the exchange rate. In fact, as you can see above, the increase in the trade deficit coincided pretty well and pretty monotonically with the great credit bubble in the US. So it shouldn’t surprise us that the decline in credit reverses it. (This also has implications for the need for foreign purchases of Treasuries, which has been cited as another concern.)

Fine. If these stories are wrong, does that mean I am bullish the dollar? The answer is no.

The dollar has an overhang problem.

For the past 60 years the dollar has been the only game in town. It was the lubricant for financial and trade globalization, the undisputed store of value in the international monetary system and the primary medium of exchange/unit of account for commerce. The world held more dollars, and the world transacted more often in dollars. Demand outside the U.S. for dollars grew rapidly for many, many years. For monetary balance inside the U.S. to be maintained, the Fed had to provide these dollars; otherwise interest rates at home would have been much higher.

Fast forward to today. The world has undergone a radical transformation. Abstracting from the current global recession, most countries across the world are in much better economic shape than was the case 15 years ago, and their currencies are more stable and increasingly more freely convertible. People trust their own currencies more, as well as the currencies of other countries. Dollar holders — central banks, sovereign wealth funds, international corporations and individuals alike — realize they have accumulated too many dollars over the years. Holding such a high percentage of one’s precautionary balances in dollars no longer makes sense in today’s world. Not because the dollar is bad per se, but because there are so many opportunities to diversify safely.

Mexicans no longer have to keep as many dollars under the mattress. Brazilian companies no longer need to keep a war chest of dollars hidden in the Cayman Islands in order to ensure access to imported inputs. Sovereign wealth funds have realized that it is neither wise nor prudent to keep so much of its stock of wealth in one currency. Investment management firms are starting to offer more non-dollar share classes for their products. And Italians, Poles, and Turks — peoples closely linked in one way or another to the euro — are thinking less and less in dollars (it is amazing that they still do at all).

The transactional demand for dollars is also declining. This too puts downward pressure on the dollar. In countries like Brazil and India, hotel bills used to be presented in dollars. Not any more. Cabs in emerging economies used to prefer payment in dollars. Now it’s not worth the hassle. Many countries that historically quoted real estate prices in dollars are doing so less and less. Bilateral trade, on an ad hoc basis, is ever more frequently eschewing the dollar for other currencies.

With the demand for dollars structurally falling, the dollar should face headwinds until currency stockpiles have adjusted and a new equilibrium is found. With some 70 percent of dollars in circulation held outside of the US, unwinding this overhang may take a long time. This doesn’t mean we can’t have vicious countertrend rallies in the dollar. Every time risk aversion gets intense enough, the dollar tends to do exactly this. But it does suggest that you can expect the dollar to be undervalued relative to any intertemporal, goods market concept of its underlying value for quite some time.

Commodities as a group have been underperforming equities for about six months now. The correlation between the two groups has been grinding lower. Even more important, I think the underperformance of commodities—and by extension emerging markets—will persist for some time.

Hang on. If the backdrop is improving growth expectations and continued, if not increased, global central bank base money expansion, why have they underperformed and why should it continue? Here’s my answer.

Misunderstanding Monetary Policy

This is going to sound bad so I’m just going to say it: Most investors and commentators have a deeply flawed understanding of monetary policy. Very few have any direct experience in this complex issue area. Many equate printing money with the money supply. They think changes in base money drive currencies. Most haven’t internalized that the money supply in a modern monetary system is endogenous (i.e. created by banks and risk appetite, not the central bank).

It is for these reasons people feared inflation, higher Treasury yields and a collapse in the dollar in response to the Fed’s exceptional measures. Remember stagflation? Me neither. None of these things happened.

People are now catching on to this. The percentage of investors who now think the Fed balance sheet will provoke a new crisis or that the ONLY possible solution to the US debt is inflating it away has shrunk considerably. This reduces the demand for hard assets.

Pavlov’s Oil

Many may have forgotten by now that the first massive wave in commodities was in 2007-2008, back before we knew what QE was. The story then was China and the Emerging Markets were rapidly plugging into the grid, set to consume our finite reserves with their vertiginous growth trajectories.

Subsequent boomlets in commodity prices, the ones that came post-crisis, were linked mainly to monetary stimuli and the flight into hard assets.

Together, this imprinting led us to reach for emerging markets and commodities any time we had a risk-on phase. In this last phase people have again reached for commodities and emerging markets to express their bullishness, but I’m suggesting this time they are setting themselves up for disappointment.

The first reason is that the emerging markets have downshifted their rate of growth. Some even have their own processes of credit digestion to contend with. Moreover, before the downshift we feared EM could grow to the sky, leaving many of us guessing at how intense the competition for scarce resources would become. We now have a better handle on “how high is high”.

Second, we have been coming around to a better understanding of monetary policy. We now increasingly get that the effects of monetary policy will be largely psychological and transitory until the deleveraging process approaches completion. At least, I hope we do. Otherwise, the fall in commodity prices will be deeper and the pain trade will last longer.

These developments will, eventually, reprogram our reaction function. The days where we’d say, as someone else recently put it, “it’s going to be a risk-on day, let’s buy 200m AUD”, are likely to fade further and further into the recesses of our memories.

Beware the Hype Machine

When the sell-side makes “a thing” out of an asset class, there is usually considerable downside and unwind at some point ahead. The length and depth of the downside is typically a pretty clean function of the length and breadth of the hype. And in 2011 commodities became a thing.

Sell-side firms were sending team after team of analysts and strategists to explain exotic commodity trades, often to hedge fund managers who had no experience in them. Buy-side firms started to scramble to build their own teams and launch new strategies. John Paulson was still in hero mode and he was buying gold, thus giving cover to others’ hubris. And, of course, the gold ads on television were busy shifting into a higher gear. I could just close my eyes at night and hear the sound of central banks printing money.

The apex came in the spring 2011, a month or two before the final parabolic burst in silver. The Morgan Stanley commodity specialist came in to visit with his 8-man team. When he recommended, as his best idea, a pairs trade “long rhodium and short molybdenum” (really, I’m not kidding), I knew that the time for shorting precious metals would be soon upon us.

The bottom line: the speculative demand for commodities is likely to become less robust over time, and the growth rate of emerging markets more modest and definable. We are in the midst of the process of pricing these factors in. And the good news is the decline in commodity prices need not presage a collapse in global growth if it is mostly a function of a slow unwind of past excesses and the market’s previous monetary miscalibration.

A friend of mine from London (a currency-oriented macro guy) with whom I regularly exchange ideas asked me my views this morning. I’ve posted my side of these exchanges before. Here’s the latest:

I think the story with gold/silver is the same one we’ve been discussing since May 2011. The fever peaked (with the parabolic silver spike), and now we realize that (1) monetary easing isn’t as powerful as the markets had been thinking and (2) all the “tail-risk reasons” for owning gold and silver are melting away. And it is still a crowded trade amongst the macro tourist crowd that hate US monetary policy, but, when you read what they write, clearly haven’t understood it (e.g. inflation, higher yields, US-is-Greece, pick your variant). Think Einhorn, Loeb, Paulsen, Dalio (though Dalio’s not a tourist), etc.

In short, the monetary tables are now turned: it’s not Bernanke who needs an exit strategy, it’s them.

The framework I finally got around to laying out in June last year goes through things factor by factor. It seems as relevant now as it was then—at least to me.

More broadly, I am bullish, structurally. Growth will be mediocre, with scope for upward surprise only in the US—and even this would be modest. Plus in the US we have to slog through a fair amount more of fiscal drag. Growth everywhere else is not great, and in Europe it’s downright terrible. There is not enough lipstick in the whole Sephora chain for the PIIGS, and I expect more downside surprises—both with respect to depth and duration, but at least the surprises should now be of a lesser magnitude.

We will likely have risk hiccups out of the Old World, but the end game there (re-memberfication of the euro—I know, not a word) will be further out in time and only after years of economic contraction bring radical political alternatives more solidly into the mainstream. For now these forces are still dancing around the fringes.

But, for the medium term, I think low-ish but steady global growth is good for equities. Notice below how the amplitude of the surprise index swings post-crisis has been contracting. Textbook disaster myopia. Bottom line: People will need to take risk. Multiples should expand. Dividends are still a draw. Cash hurts.

I have been long equities (admittedly a little slow in jumping back on after getting off end-December) and short gold and silver. I haven’t needed to trade much. I took down equity risk on Friday for the first time in a while. I don’t like what I see in the European indices of late and if gold and silver accelerate further to the downside (which is my base case) the old correlation to equities would likely come back, dragging equities down along with the shiny stuff.

The equity market is loaded enough with “late purchases” that it wouldn’t take a huge story to generate a shakeout. A hard fall in precious metals could catalyze such a story. What would that story be? It really doesn’t matter much; we market participants always reverse engineer something plausible whenever we see sharp price action.

I am holding core long positions, now partially hedged with European “stuff”—in addition to the precious metal shorts. I hope we get a selloff in the next month or so, so that I can increase equity exposure. I suspect I am not alone in this, which of course complicates my odds of being right. If the selloff in precious metals accelerates too much I will probably trim some futures and sell some puts against a good part of the rest. But sooner or later—who knows when?—we are going to get a whoosh-type selloff in precious metals for the reasons outlined in my framework, so it’s very unlikely that I would take my exposure to zero. In my dream sequence, I am hoping that the market will let me keep my long equities, short precious metals positioning for the bulk of this year if not longer.

Late in January I was worried about having been too cautious since end-December yet too late to the party to add risk. I posted some charts showing that the odds were decent that the shift afoot was structural in nature, unlike the stop and go markets of the past two years. These charts made me more confident to go with the flow. Here is an update of those charts. And, sadly for the Policy Bears, the song remains the same.

The 2s-10s steepener trend looks robust, not tired. A great sign for risk taking.

EURAUD and EURCHF are signs of financial normalization. Don’t worry that AUD is considered a growth currency (more on this below), the bigger signal is that people are crawling out of their bunkers.

Mortgage rates (above) look set to go higher. Wait. Isn’t this bad for housing and therefore for the overall US recovery?

Answer: no, for two reasons. One, from a financial point of view it shows investors are moving out the risk spectrum. And two, price hasn’t been holding buyers back. Down payments, job security, and tighter lending standard have. Levels are still plenty low enough for solid borrowers who can make the down payment to buy.

If indeed this is the structural shift in risk taking that it appears to be, it will be more about normalizing financial risk appetite than a rapid acceleration in growth—either here in the US or globally. This means the reflexive reach for commodities and commodity proxies (e.g. AUD) that has accompanied every risk impulse for the past five years may come a cropper this time—particularly since we have seen behind the Great Monetary Curtain and realize the machine is being run by mortals (i.e. The broader money supply is endogenous, and is driven by risk appetite and not money printing).

The portfolio implication for the investor? Structurally long equities, hedged with structural commodity shorts.

Four charts tell a powerful story of where we are. They all say “It’s Structural this time”. Safe Haven Exodus.

Yes, I know a correction could happen at any time. I myself got caught out jumping off the train a little too early back in late December. But longer-term, if you do the impossible and look out over the news cycle, these four charts below tell us a structural shift in risk allocation is afoot. The Policy Bears, the Central Planning Truthers, are either getting tapped on the shoulder or rounded up to be executed. How fitting: Death by stocks.

I am not talking about short- and medium-term positions, the kinds that get picked up in sentiment surveys and overbought/oversold oscillators. I am referring to the structural hedges big, slower-to-move strategic investors have had on to protect against the next macro crash. These massive structural trades—and make no mistake, they are measured by the ‘yard’—appear to be in a fairly early phase of unwinding.

 

Above is the yield spread between the 2yr and 10yr UST yields, charted on a weekly basis back 5yrs. Moving higher is referred to as curve steepening, and is associated positively with growth expectations and risk taking. If you think about where this spread was in 2011 and how much better we feel about today’s economy and financial landscape, this spread could easily get back to well north of 200bps.

Another structural Safe Haven position has been to be short EURCHF. In size. Long CHF and short EUR. The reasoning is clear. Europe bad, Switzerland safe. I don’t think Europe is anywhere near out of the woods, but between the LTRO and the OMT, they have “merely” a growth problem now—or, at least for the next year or two. Rightly or wrongly, people are assigning a higher probability to Europe muddling through, causing the macro monsters to unwind the flight-to-Zurich trade.

 

A first cousin of the EURCHF position is short EURAUD. Again, the logic is clear. Europe has no growth prospects and risked imminent financial meltdown. AUD, on the other hand, lives where the growth is, with a commodity kicker/China play thrown in. It has also trended for a long time, suggesting that a lot of trend following CTAs and hedgies have been riding it. The chart here two, suggests this trade too is now in the early phases of getting unwound.

 

Lastly, a more exotic version of these Safe Haven positions is Short TRYZAR. This, too is unwinding. This trade is trickier because there are idiosyncratic moving parts in both countries, especially South Africa. But it does reflect global normalization from crisis mode coupled with modest growth. It also suggests, as do the 2s10s steepener and long EURAUD, that commodities will not bounce back as forcefully as they have in the past few years on bouts of risk appetite.

 

But I should finish by being clear about my views: Don’t confuse me with a growth bull. Both the developed and developing economies have “digestive” issues they need to grind through, and economic expectations have improved to the point that when fiscal drag in the US starts kicking harder there will be room for disappointment. But the incipient unwind of these positions is nonetheless a strong long-term positive. It tells us a broader investing audience is, in deed and not just in word, coming around to realizing the next financial calamity, the Lehman II, that lurking “Other shoe”, is just not on the horizon.

On December 16th I posted some trading views, in which I referenced the economic surprise index Citigroup publishes for the US. Here it is, from that date, below:

And here is the update from today:

Remember, a positive reading of the Index suggests that economic releases have been, on balance, beating consensus. So a lower positive number means less positive surprise. It doesn’t mean negative surprise until it crosses zero.

We’re approaching zero pretty fast.