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FRED
12-29-06, 08:04 PM
Gold spot market closes 23% higher from the beginning of January '06
December 29, 2006 (Bullionvault)

Only in finance do the losers get to write history. The government then prints their memoirs in the statute books, while a new volume of folly and greed is begun.

Witness Barnard's Act of 1734. It sought "to prevent the infamous practice of stock-jobbing" that had peaked and exploded with the South Sea Bubble of 1720. Investors had long since fled Change Alley, however, and gone back to trading government bonds instead.

Come 1934, and the Securities Exchange Act tried to protect US investors from the Great Crash of five years before. It guaranteed liquidity to investors who were already broke. And in 2002, Sarbannes-Oxley set new standards for US corporate accounting, stock options and boardroom ethics.

Enron and Worldcom could never happen again, not least because they had already happened. But the US government started fighting the last war regardless, banning cavalry charges and fixed bayonets as the arms race went nuclear.

By the time Ebbers and Lay were trying to raise bail, Wall Street and the City had already moved on, massing asset-backed bonds and deploying collateralized debt obligations. Production of interest-rate swaps went into over-drive, and crack squads of investment bankers began planning leveraged buy-out deals to make Iwo Jiwa look like a picnic.

AntiSpin: Our sponsor/writer is doing a fine job making the case why we picked them up as a sponsor in the first place.

Up quietly more than the louder stock indexes this year, gold has another great year. Shhhhhhhhh! Don't tell anyone. More cheap gold for the rest of us. More...

Let's call it "Quantum Finance" for now, with a nod and a wink to Quantum Physics of course. No doubt the historians will come up with a better name in good time. But the financial science is just as complex as theoretical physics, based on the fact that "energy is not continuous but comes in small and discrete units," as one definition puts it. "The movement of these particles is inherently random. It is physically impossible to know both the position and the momentum of a particle at the same time...[and] the atomic world is nothing like the world we live in."

Just like today's financial markets, in other words – a random, unknowable and unreal world of atom-sized yields.*

Quantum Finance – the science of making money appear out of nowhere – is too complex for all but the very brightest young guns to grasp. Yet it underpins the entire financial universe today. The very fabric of money, mortgages and markets has come to rely on concepts and con-tricks not even the sales desks can follow. And Quantum Finance in its higher forms remains unregulated of course, which is just as it should be. For by the time the SEC and FSA get round to hiring the PhDs they need to make sense of the mess, the smart money will have already moved on, selling out as their Lear Jets get cleared for take-off.

What about the dumb money, you may wonder. Well, if you can't spot the patsy, then it must be you. And only two questions sit between us and the next raft of "last war" regulations today: Where will the bubble explode, and what should private investors do for a helmet?

First up, the bubble – or bubbles...

"The number of [corporate] defaults will rise even in the absence of an economic downturn or interest rate increases," said Wilbur L.Ross, the 'King of Bankruptcy' to a conference in London late last month. Chairman of W.L.Ross & Co. in New York, he says default rates will rise to around 7% of all companies in 2007. The rate is just 1% now.

"There will be some tragedies," Ross warned the conference by videolink. "When you pay higher multiples, you have less margin of error." The average leverage in European corporate deals today stands at 8.2 times EBITDA. In 2001 it was just 5.2 times.

Fitch Ratings say there's also trouble ahead in emerging markets. "With the carry trade fuelled by ample global liquidity and record financial market flows to emerging markets," it said this week, "big shifts in interest rate expectations and a further weakening of the US dollar would test those emerging markets with fragile policy credibility and large external and fiscal financing needs."

But perhaps the AAA-rated bond market will implode first. Bill Gross, head of Pimco, says we've reached a peak in making money from nowhere. Leverage on complex bond trades simply cannot get any higher, he believes, citing "a new derivative credit product retailed to institutional buyers under the sticker known as a CPDO or 'constant proportion debt obligation'."

"These multibillion-dollar instruments lever investment grade indices up to 15 times the amount invested," says Gross, "and offer or have offered a spread of 200 basis points over LIBOR with a AAA rating. Hard to pass up I suppose...

"But this AAA rating is subject to numerous (more numerous than usual) subjective assumptions," he goes on. "Increasing multiples of leverage beyond 15x near current yield spreads cannot maintain either a AAA rating and/or the 200 basis points in yield spread that have made this derivative so attractive...The increasing use of leverage, in other words, at least as applied to this particular area, appears to have run out of its magical ability to increase returns."

The problem is one of momentum. For if leveraging cannot increase, then it's apt to shrink back, rather than stick. And the most likely cause of leverage recoiling, if all previous bubbles are a guide, will come with a bang, not a whimper.

Then there's the asset-backed bond market, most especially mortgage-backed securities (MBS). This draws the heavy-gun shelling away from Manhattan and onto consumers – first in the way their home loans are funded, and then in the investments made by their pension and insurance fund managers. It brings Quantum Finance right into your home!

The United States had $6.2 trillion in these mortgage-backed securities (MBS) at last count, nearly a quarter of the entire US bond market and 50% larger than the US government's own Treasury debt issue. Appetite amongst professional investors in Europe is so great, Sampo and ABN both flooded their MBS into the market in the very same week last year. Britain is late to the party, but it got $9.4bn from one lender last month, plus another $15bn from HSBC, the world's third largest bank.

And why ever not? Selling a bond backed by mortgage debt means the banks can lend that much money again, doubling their assets per Dollar of deposits. In Britain alone, this little scheme helped the major banks lend nearly $1 trillion more than they took in from savers between 2002 and 2005. Money from nowhere means money for nothing, and the banks have always loved that!

But "mortgage-related debt differs from most other categories of debt," notes a 2003 paper for the US Federal Reserve, "in that it is subject to the risk of prepayment." You might think the risk of early repayment hardly worth fretting about. Not compared with, say, the risk of never getting your money back at all. But when interest rates slip, homeowners refinance. So the MBS backed by the first loan now gets repaid...and that leaves MBS buyers holding cash instead of income.

What's a pension fund manager to do in the scramble for yield? Buy bonds of course, preferably long-dated Treasuries...thus pushing all bond prices higher...sending bond yields lower...and causing more mortgage re-fi that then repays more MBS!

"The market rallies, mortgages prepay, and all of a sudden people have to buy," says one MBS strategist. "It can turn into something that snowballs and causes the [bond] market to rally for a significant period of time."

The MBS market seeps into the wider financial universe via another leaky pipe, too. "When mortgages, or other debt instruments, are chopped up for securitisation," explains John Dizard in the Financial Times, "the more risky slices may go to high yield mutual funds and people who think they're sophisticated investors. The 'residual risk', 'first loss' or 'equity' slices go either to hedge funds or are retained by the dealers or banks who package the securitisations."

These dealers and banks don't use the Treasury market to offset the prepayment risk of MBS bonds, says Dizard. They go instead to the market for interest-rate swaps, where they can exchange one stream of income for another stream of yield, tweaking their earnings without selling their assets. As of June, interest-rate swaps – in nominal outstanding value – were worth $65 trillion.

"It's big, invisible plumbing," says Dizard, "like water mains, of little interest most of the time until there's a gurgling and nothing comes out of the pipe."

A gulp of air glugged out of the pipe at the start of this month. On Dec.7, the day that sub-prime US mortgage lender Ownit went bust, the spread on 10-year interest-rate swaps in the Dollar jumped 2.5 basis points. That might not sound like a lot, but it's five times the market's standard deviation. "A five standard deviation move in the Dow Jones Industrial Average would be a decline of 350 points," Dizard points out, "or a 40-point drop in the S&P500. That would have got your attention."

Remember, the interest-rate swaps market is worth 5 times the United States' annual economy. And maybe those cheap swaps between bankers – their little-seen deals that pump credit from the mortgage market into the bond market into the profits of banks, insurance managers and hedge funds – are about to get pricey.

"Ownit may have been the canary in the coalmine," says one MBS fund manager. Hell, he's so worried, he's switched to buying AAA-rated debt from Fannie Mae – which finally filed its 10k accounts for 2004 only this month – and the other government-backed agencies in the crumbling US mortgage market.

The money's got to go somewhere, remember. Professional investors abhor cash. But "there are not enough quality assets to go round, so people are buying up the rubbish, closing their eyes to the risk and hoping that nothing will go wrong," as Anthony Hilton put it in the London Evening Standard, also on Dec.7 for some reason.

"This is the case whether they are buying 20-year bonds issued by the current Iraqi government, sub-prime mortgages on slum property in Baltimore or a parcel of 130% mortgages issued to unemployed people in Wigan," Hilton went on. "The world's financial markets have forgotten the meaning of risk."

Not even Quantum Finance will stop the markets rediscovering risk in 2007, we guess. Cheap money could only ever get cheaper in this bubble, just as in all other bubbles. Higher rates would unwind the leverage, yet the leverage has now gone as high as it can with Dollar rates at just 5.25%. And the search for yield, when it blows up, will become a scramble for settlement...a rush into anything offering simple ownership over complexity, real value instead of gearing.

If that sounds a little like gold to you, you might be advised to pick up some more around $635 today. Only BullionVault operates a 24/7 gold market that will be open between today and Tuesday, Jan 2nd.

Happy New Year!

* The phrase Quantum Finance already exists, by the way, thanks to a paper of 2002, which looks like a spoof, and a book of 2004...which looks all too real...published by Cambridge University Press with the subtitle "Path integrals and Hamiltonians for options and interest rates". If that means anything to you, and you're reading this, you might want to fire up the Lear Jet before the gold market opens on January 2nd (http://www.bullionvault.com/from/itulip).

DemonD
12-30-06, 07:09 PM
Eric, I remember on the interview you did for the Canadian business news, you had talked about Euro-based securities along with gold as a viable investment option. While gold closed up 23%, here are the final tallies from the vanguard international index funds:

International Growth Inv YTD Returns
VWIGX $23.86 $0.03 0.13% 25.92%

International Value Fund
VTRIX $40.34 $0.08 0.20% 27.37%


Also, while there definitely has been a boom in LBO's and M&A's, retail investors holding funds such as these made out very well. The end of the year distribution for VTRIX yielded 9.94%, while the distribution for VWIGX was 10.88%. And this of course is the yield at the end of the year, not counting whatever your effective yield would be had you bought the funds at lower prices.

Looking over the other vanguard funds, gold's 23% appreciation beat the YTD returns of all vanguard domestic stock funds with the exception of the Precious Metals fund (34.30%), and the REIT Index fund (35.07%).

These numbers continue to back up my own personal investing philosophy, in saying that you are definitely right, and have been right, and will continue to be right in terms of the markets going forward, but that the best way to continue investing is through stocks and stock funds. Granted I have a very high risk tolerance, but that is my want, and imagine how high that vanguard PM fund will go if gold ends up another 23% next year. And yes, I do believe the distributions were aberrations for 06 due to all the crazy M&A activity, but my core investing philosophy is based around compounding (dividends, interest payments), and owning physical gold will not compound to accumulate more gold. On top of that is the fact that I personally believe that my investment money is better suited to buying stock in the human capital of a company when it comes to PM's; who is better at increasing my wealth with PM's, me, who has no expertise with PM's, or a company (or group of companies) with experienced executives and professionals who beat the return on physical gold by over 10% last year? For me, that choice is easy. It's not me. Maybe the majority of people who read and contribute to itulip are learned, experienced, and wise in how to invest in commodities. If that were the case, I'd be more likely to buy an ETF from you who knows how to do that, than to take the responsibility by myself. Not to mention the previous post that I had asked earlier in the year about historic stock prices from the 70's and 80's, where the worst performing mining company gave you a return of 300%, while others were well over 1000%.

To conclude, I will reduce my exposure to certain segments of the stock market next year, but I will likely increase my exposure to PM-based companies. That, and I still don't understand most of the charts that are put up on here. (The one I did understand is the one that's most scary - the reserves of banks versus outstanding debt issuances. Very scary indeed, and makes me believe Mr. Ross is not using hyperbole in terms of how bad things will get.)

I sincerely hope that my contributions here have been useful, and that my criticisms have been constructive over this past year. I've learned a lot from itulip, and am looking forward to a profitable (or at least wealth-neutral) 2007.

-DemonD, hoping that the RE market crashes as fast as it can so he can afford to buy a friggin house already.

Finster
12-30-06, 09:27 PM
... These numbers continue to back up my own personal investing philosophy, in saying that you are definitely right, and have been right, and will continue to be right in terms of the markets going forward, but that the best way to continue investing is through stocks and stock funds. Granted I have a very high risk tolerance, but that is my want, and imagine how high that vanguard PM fund will go if gold ends up another 23% next year. And yes, I do believe the distributions were aberrations for 06 due to all the crazy M&A activity, but my core investing philosophy is based around compounding (dividends, interest payments), and owning physical gold will not compound to accumulate more gold. On top of that is the fact that I personally believe that my investment money is better suited to buying stock in the human capital of a company when it comes to PM's; who is better at increasing my wealth with PM's, me, who has no expertise with PM's, or a company (or group of companies) with experienced executives and professionals who beat the return on physical gold by over 10% last year? ... To conclude, I will reduce my exposure to certain segments of the stock market next year, but I will likely increase my exposure to PM-based companies...

A crucial thing to keep in mind here is that the performance you cite occured during not only a positive environment for PMs, but for stocks in general. In this kind of environment, stocks of companies that mine PMs are in large part beta plays. When the environment for equities is not so positive, mining company stocks can be real stinkers - outperforming the market to the down side.

PM mining company stock is not a form of PM - it's a form of stock. And the historical record shows that for the investor depending on the perfomance of PMs to bail him out when the going is bad in the stock market, PM mining company stock bails out on him.

Owning mining stock is not a bad idea, but it should not make up an undue proportion of one's stock allocation, and in no instance be regarded a substitute for ownership of actual physical PM.

The two charts below show what happened to PM mining stock in the crash of 1987 and the crash of 2002. The first is of Newmont Mining along with the S&P 500 in 1987, and the second of the Amex Gold Bugs index (HUI) in 2002.

In both cases, when equities crashed, mining stocks annihilated.

http://users.zoominternet.net/~fwuthering/Posts/NEMSPX87.png

http://users.zoominternet.net/~fwuthering/Posts/HUISPX02.png

DemonD
01-02-07, 10:47 PM
A crucial thing to keep in mind here is that the performance you cite occured during not only a positive environment for PMs, but for stocks in general. In this kind of environment, stocks of companies that mine PMs are in large part beta plays. When the environment for equities is not so positive, mining company stocks can be real stinkers - outperforming the market to the down side.

PM mining company stock is not a form of PM - it's a form of stock. And the historical record shows that for the investor depending on the perfomance of PMs to bail him out when the going is bad in the stock market, PM mining company stock bails out on him.

Owning mining stock is not a bad idea, but it should not make up an undue proportion of one's stock allocation, and in no instance be regarded a substitute for ownership of actual physical PM.

The two charts below show what happened to PM mining stock in the crash of 1987 and the crash of 2002. The first is of Newmont Mining along with the S&P 500 in 1987, and the second of the Amex Gold Bugs index (HUI) in 2002.

In both cases, when equities crashed, mining stocks annihilated.



I see 2 problems with your arguments Finster.

One is that you can use this to your advantage... when the market crashes, then go buy. In the first chart, it seems like Newmont basically tracked along with the market after the market went down. And gold wasn't exactly a great investment throughout the 1990's. If you assume gold will perform better, it's reasonable to predict gold mining will do better than it did before.

Second, in the second chart, your time frame sample is far too small. It seems like you cherry-picked a bad time frame. Let me do a quick search on 2000-2006 here...

Jan 3, 2000 - Open 74.03
The low point you cherry-picked was 35.31, this was the week of November 13, 2000. A substantial loss, however if you had stayed in the market, it would have gone back to 74 by the beginning of 2002. You would have been ahead of the market.
Dec. 29, 2006 - Close 338.24

That's a 4.5x return on investment, and that's without dividends reinvested if you were in a mining fund or stocks that paid distributions. Incidentally, gold rose from what was the low, about 270 to 639.50 as i'm looking at it right now, which is a 2.4x return from trough to now. Now imagine if you had bought gold bugs index at it's low... you'd be sitting on a 10x gain.

Further, the simple fact as I see it is that people who are trained to turn gold into note-exchanging currency are better at doing that then I am.

Now, if you think gold is going to go down, then obviously holding gold-mining stocks is not a good choice in any type of market environment. Let me see if I can find that old post from the general section... here it is.

http://www.nowandfutures.com/download/casey_gold_stocks_70s_80s_GStocks.gif

There are a whole slew of PM-related companies that shot up big time in value in what was basically a flat market in the late 1970's.