Drachmas, Dramas and Destruction Amidst the Summer Doldrums

The summer doldrums are finally here. This is newsworthy, in part because most of the summer has been marred by intense market jitters and volatility, and in part because it's taken an olympic effort to force market participants into finally enjoying summer. As we enjoy the final hedonistic days of IOC sponsored entertainment, here's a brief recap of the volatile usual suspects who're currently off stage.

First, there's the seemingly unending uncertainty over whether there'll be a new Greek Drachma. Despite strong indications that Greece is about to fire up their own printing presses (non-compliance with bail out terms, contracting economy, etc), the odds are that they'll stay in the union. If Greece "fails", market participants will increase their bets on "who's next", which will lead to Euro zone bailouts becoming increasingly more expensive (let's face it, even the ECB acting as a backstop is a bailout), and at some point this would be universally acknowledged as unsustainable. Once accepted, this would lead to the effective end of the Euro zone, the end of German exports to the Euro area, and a drastic decrease in German sales further afield - this will prove vastly more costly to Germany than a federalization of all Euro countries' debt issues; in fact, federalism will strongly support German industry (through a combination of a competitive global currency, and a large supportive "home market"). Recent German economic data strongly supports this view, but, of course, political interpretation could deviate. But, after the doldrums, the odds are for more barely-face-saving covert federal underwriting of the currency, unless... Unless Greek leftists manage to convince their electorate that the Euro is only a tool and extension of an imperialist pax-Germanica engineered to funnel all riches back to the fatherland, and that freedom, while not free, can only be bought by being a sovereign capable of printing.

On other stages other dramas are being rehersed. There's the US election (which, again, is earning its reputation as the "best entertainment money can buy" - provided you like a nice tragedy), the CHF is busy crippling segments of Switzerlands' non-diversified economy (while all banks continue to suffer and taxation initiatives continue to erode Swizerlands safe haven status), China desperately tries to both promote and control growth while giving the appearance of addressing issues of income inequality and access/corruption (recent high profile efforts would, in the parlance of the theater, surely be considered farcical), resource economies continue as two-speed economies (despite recent price pressures), and finally there's a moribund Japanese economy - escaping criticism only because no one has the energy left to criticize it.

For the most part people are optimists. US politicians continue to promise solutions. Chinese living in big cities will happily inform you that if you look straight up you can sometimes see that the sky is blue. Safe havens and resource economies (sometimes one and the same) while losing diversification and undermining their future prospects are universally envied. And, Japan's ever increasing debt burden is priced by the markets as sustainable. The obvious argument is, of course, that none of this is sustainable and we'll soon witness wealth destruction on a massive global scale. Frankly, there are too many scenarios to analyze, and, in some cases too little good quality data, so opinions proliferate while facts remain hard to find, but here's a takeaway:

The US 30 year bond, yields close to 2.8%, but if the US economy falters (more than it's already done), and if yields approach Japan's then the present value of the long bond will increase by around 25%. Odds are this won't happen, the USA is not Japan, but if Greek's decide on sovereignty then the long bond will destroy the market value of all in its path. So, in a low volatility environment, while the sheeple are captivated by the Olympic spectacle, it may be the right time to “cheaply” hedge some bets, and, feeling inspired by the gymnasts, perform some straddles – one thing is certain, volatility will be back.

Gold

Gold.  The utility of this precious metal rests on its ability to be a concentrated form of wealth. Its immutable nature gives it a permanent shine – not just now, but throughout human history. Unlike silver and platinum, whose fortunes wax and wane with their industrial applications, gold's value is independent of its utility. Unlike precious gems, which can be subjectively graded and valued, gold is a commodity – capable of being perfectly standardized and objectively valued at a myriad of transparent, liquid, and interconnected global markets. Gold is the preeminent sign of wealth all over the world. Gold, hoarded in government vaults, underwrites geopolitical power and imparts a sense of tangible value to currencies.

Adopting a contrarian perspective on the long term role of gold is futile. To argue that humanity will leave gold behind and focus on new Apple products as the ultimate sign of wealth is nonsense – the current crop of the spendthrift ultra-wealthy will be encasing their new high-tech gadgets in bejeweled gold cases, and spinning gold taps to brush their teeth, while ordinary mortals will continue to aspire to own a gold trinket or two. The combination of an increasing global population and affluence will continue to drive the demand for gold as a display of status and wealth, while economic uncertainties will guarantee its place in diversified investment portfolios.

Gold is proclaimed as the panacea for a wide array of troubles. In politically uncertain times, gold is a perfect hedge. Its high density and value means it can be easily transported and stored, which is good news both for desert nomads and central banks, and it's widely acknowledged that in an inflationary environment, gold is a hedge. This last decade, “gold bugs” have been well rewarded for their appreciation of the noble metal. During an extended period of falling interest rates, decreasing dividends, and equity markets struggling to regain lost ground, gold has more than doubled in value. As a “doomsday” investment it has shown greater resilience than reserve currencies and government bonds, and we are still waiting for it to take its starring role as the lead inflation fighter.

Now, let's have a look at price action. From a technical perspective, gold has obviously been in a multiyear bull trend, notable price action includes very strong performance during the last half of 2007 continuing into 2008, followed by a sell off combined with high volatility for the rest of 2008.  2009 marked the beginning of another leg in the bull rally, with gold prices going parabolic in August 2011 before a “blow off” top later that month, followed by a false continuation in September. Since topping gold has remained volatile, and, while its trading channel remains hard to define, it is narrowing. If the current consolidation in gold continues and gold conforms to a “standard” breakout from a lower volatility environment, then gold should be set for its next directional move towards the end of this summer.

Despite gold's recent price corrections, it remains in a major secular bull trend. Major areas of support have been breached and the trend is questioned – the first area has been breached (around 1600 – corresponding to around today's level of 155+ on the above ETF, NYSE:GLD), the second area of support is around 1300 (which, with GLD ETF costs will probably equate to close to 130, as opposed to 125). While it's possible to directly trade off these areas of support, the lowest risk strategy is probably to sell puts targeting these supports – incidentally, December GLD 150 contracts are trading at prices offering a sound entry and a 3.6% holding period return, or about 9% annualized.  This would never amount to a serious leveraged gold play, but as an "exposure to gold", or perhaps even as a commodity exposure this, or similar trades, deserve allocation.

In closing, some time ago, back in March (when I first thought that we were seeing a constructive consolidation price pattern begin to form) I had a conversation with a long time "gold bug" about miners' expense ratios.  I confessed that I could not understand how gold could trade at more than twice its "cost" (many miners report costs of just a little more than USD700).  The economic argument is simple: supply will ramp up until equilibrium is reached; lower grades will be exploited, higher fees will be paid etc etc.  While I knew that this equation was subject to externalities, such as government regulations, and political risks, to name just a few, it's still hard to accept gold's "premium".  To help overcome aversion to overpaying for gold (ignoring its historical roles as outlined above), the two major considerations are:

1. While miners are claiming low productions costs, supply remains inflexible due to the sector's inability to access capital (basically, investor trust was all but destroyed in the multi decade secular bear market that preceded the current bull market).  It's also natural to conclude that today's capital markets present huge barriers to entry for any speculative capital intensive company.

2. Most mining operations exist in politically challenging environments.  Whether it's a threat of nationalization, or simply permit risks; gold mining is a high risk venture and demands a big risk premium.

Establishing a long position in gold today implies that you're buying into these arguments (an adverse capital market, and risks galore - both political and environmental).