Friday, June 28, 2013

Gold Prices: Look Out Below

I haven't written about gold for some time, but its precipitous fall in price recently merits a mention.

When I last visited the subject in April 2013, gold had already moved sharply lower from the $1,875 per oz. that it reached in September 2011.  However, as the chart above clearly indicates, we continue to ratchet lower.

Here's what I wrote in April:

Although I believe I understand the gold bugs' position, I still believe that gold comes up short as a long-term asset class for most investors.

Gold has no practical uses, for one - its value lies solely in the eye of the beholder.  You can't take your gold bar to the grocery store, or to buy real estate, unless the seller is willing to accept it as payment.  Gold offers investors no dividends, so other than the psychic pleasure that one might derive from caressing a gold bar there is little appeal.

Stocks of viable companies, on the other hand, at least give investors the hope of increasing their wealth as companies grow.  I don't know what the world will look like in 10 years, but odds are pretty high that the world's economies will continue to grow, as they have done for the past few centuries.

So how low could gold prices go?

Today's "Alphaville" blog in the Financial Times carries a mention of some research done by Campbell Harvey of Duke University.  Professor Harvey's work suggests that gold remains overvalued, and that fair value for gold will be found around $800, or another -33% lower.

Here's an excerpt:

But on the subject of gold bottoms, some bottom talk is more compelling than others. Campbell Harvey, from Duke University, for example, has been arguing for a while that in real terms the gold price has been overvalued for some time.

So, on the basis that gold really is the inflation hedge some people think it is, its value should currently more about the … $800 mark

And here's the link to Harvey's paper:

In short, it would seem that it is too early to say that gold has reached any sort of near-term bottom.

Thursday, June 27, 2013

More Thoughts On Fed Policy

Graph of 10-Year Treasury Constant Maturity Rate
Although interest rates have retraced some of the rise that occurred earlier this week, most commentators and observers think that rates are only going to move in one direction: higher.

Individual investors are listening to the financial press, and are leaving the bond market in record numbers:

U.S.-listed bond mutual funds and exchange-traded funds saw record monthly redemptions of $61.7 billion through June 24 amid signs the country’s central bank may scale back its unprecedented stimulus. 

The redemptions surpassed the previous monthly record of $41.8 billion, set in October 2008, according to an e-mailed statement by TrimTabs Investment Research in Sausalito, California. Investors withdrew $52.8 billion from bond mutual funds and $8.9 billion from ETFs during the period, said Richard Stern, a spokesman for TrimTabs.

 However, a number of economists are wondering how the Fed reached the decision that the economy was strong enough to start withdrawing its support.

Writing in yesterday's London Times, for example, Ambrose Evans-Pritchard was almost apoplectic in his anger towards the Fed.  Here's an excerpt:

The entire pivot by the Federal Open Market Committee is mystifying, almost amateurish, and risks repeating the errors made by the Bank of Japan a decade ago, and perhaps repeating a mini-1937 when the Fed lost its nerve and tipped the US economy into a second leg of the Great Depression. "It’s all about tighter policy," was the lonely lament by St Louis Fed chief James Bullard.

Evans-Pritchard notes that there is very little economic data to justify the Fed's apparent change of heart.  Instead, he argues, that the move is largely based on politics, and pressure from other sources such as the Bank for International Settlements (BIS) and the German government:

But if the Fed has erred again this time, it can't hold a candle to the Bank for International Settlements (BIS). This club of central bankers - now entirely in thrall to the Bundesbank, and the liquidationist doctrines of the Chicago Fed circa 1931 - demanded a halt to QE this week, as well as rate rises, yet more fiscal tightening, and an even faster pace of credit deleveraging for good measure...

One thing is certain, if such a nihilist cocktail of BIS contraction were imposed on the world in its current condition, it would kill recovery altogether, throw millions more out of work, and probably extinguish a few democracies along the way.

I am not an economist, but after reviewing some basic economic charts I can see some of the reasons for the ire of Evans-Pritchard, among others.

For example, while it is true that since 2008 the Fed has massively inflated the money stock of the United States, it is also true that the money velocity has also dropped dramatically.

It is hard to see any inflationary pressures in a period of deleveraging.

FRED Graph

 There are no inflationary pressures evident:

 FRED Graph

And employment is still below 2008 levels:

FRED Graph

As my earlier post on the Fed's actions stated:  I sure hope they know what they're doing.

Wednesday, June 26, 2013

Life is Better on the (Tech) Edge

I had the chance to catch up with Bernstein's IT analyst Toni Sacconaghi yesterday.

Toni has been following the IT space for almost 14 years for Bernstein, and is one of the best on the Street.  His universe of coverage is relatively small - only six names - but they include technology bellwethers like Apple, EMC and IBM.

Large cap tech names mostly trade at very low multiples.  Based on Toni's estimates, all of the tech names he follows are trading at discounts to the S&P 500:

Apple                9.5x
 Dell                 12.0x
 EMC                11.7x
HP                     6.5x
IBM                  11.2x
Lexmark              8.3x

S&P 500          13.5x

So the obvious question:  Should portfolios be loading up on these stocks?

The answer is not as plain as you might expect.

Yes, Toni agrees that these stocks are cheap, but they might be for a reason.

Spending on technology has slowed dramatically from the pace of the last couple of decades.  Toni is predicting that spending on tech hardware will be only slightly ahead of the pace of 2012 - up +2%.  Compare to the high teens growth rates of the late 1990's, or high single digits just a few years ago, the tech space is a different world than it had been in the past.

The tech space has become somewhat bifurcated. There are the large stocks that Toni follows, which trade a low multiples suggesting that their best growth days are behind them.

Then there is the high flying, rapidly growing technology names whose business is growing at +50% to +100% per year. These would be names like LinkedIn (100x 2014 earnings estimates) or WorkDay (36x sales).  Investors are willing to pay up for these stocks since they represent the future - maybe.

There are, of course, a huge number of technology names that fall somewhere in between the big stalwarts and the high-fliers.  These still trade at a modest premium to the market, but have better growth rates as well.

Bernstein suggests a barbell approach to the technology sector, and has the data to back up their insights.

Historically, it seems, that the best way to invest in technology stocks is to invest on the edges, and ignore the middle. Bernstein advocates a portfolio combining stocks with the highest growth profiles (and loftiest valuation) and stocks with the slowest growth potential (and cheapest valuation), and ignoring the 60% of the tech stocks that do not fit either criteria.

Based on results going back to December 1977, a barbell approach combining highest + lowest valuation tech stocks has robustly outperformed a middle-of -the-road approach.

In other words, in tech land, living life on the edge(s) is the way to go.

Tuesday, June 25, 2013

The Pain of Selling


Well, I think the secret is if you have a lot of stocks, some will do mediocre, some will do okay, and if one of two of 'em go up big time, you produce a fabulous result. And I think that's the promise to some people. 
Investment legend Benjamin Graham taught his students at Columbia (which included a fellow named Warren Buffett) that a the proper way to judge the worth of security analysis is not whether subsequent market movements confirmed your work, but whether you got the facts right.  The market,  Graham felt, was simply too fickle.

I was reminded of Graham's words yesterday, when one of the stocks I own in many client portfolios cratered over the past couple of days.

I have long been a fan of Allergan.  The company is best known for its signature drug Botox, but it also sells a wide variety of specialty pharmaceuticals and medical devices.

I have seen management on a couple of occasions, and have listened to a number of well-respected analysts give their thoughts on the company's prospects.

Over the years that I have owned the stock, while I have at times been concerned about the increasing valuation that the market had been assigning to Allergan, I remained confident about both the company's prospects as well as its management to regard the position as one of my less-risky holdings.

That is, until it dropped -15% over the past couple of trading days.

Here's what top analyst (and occasional Random Glenings reader) Kelley Roche wrote about the company in an internal memo:

Allergan (AGN) is off almost 15% since Friday following the FDA's release of draft bioequivalence guidance for generics of Restasis (AGN’s market leading drug for dry eye). The potential for generic competition to Restasis has been a risk for AGN given the size of the drug (~14% of AGN’s revenue, 20-30% of AGN’s profit) and the May 2014 patent expiration, but the company and analysts thought a large, lengthy and challenging clinical study would likely be required to support a generic – and thus push out the life of Restasis. However….the draft guidance issued on Friday was an unexpected negative surprise, as it suggested two pathways to generic approval, including a pathway that would not include clinical studies for the generics (“in vitro”). If FDA’s six criteria are met, the agency stated it could support bioequivalence of a generic product. However, the draft guidance also notes that if this data is not equivalent, clinical studies would be required (best case for AGN). AGN has previously stated that it does not believe that the non-clinical route is sufficient to guarantee that a generic is equivalent to Restasis, and it is expected that AGN will challenge the FDA’s guidance during the 60 day comment period.

Why this is such a big problem for AGN: 1) A generic form of Restasis could enter the market much sooner than anyone thought. 2) AGN is known as a pretty good protector of its patents/products, so this is a big surprise. 3) This is the second execution setback over the past few months. 4) Valuation has always commanded a premium, but if AGN continues to falter like this the multiple could be at risk.    

I have to reiterate that the FDA’s release is DRAFT guidance, so this is not yet set in stone but of course the markets are assuming the worst. There have been a few downgrades and AGN is in the penalty box until it reports on 8/1. AGN’s dividend is tiny (.24% yield) and it hasn’t raised the dividend in 7 years. 

 In general, I sell a stock for one of three reasons:

  1. If my initial analysis was wrong;
  2. If there is better opportunity;
  3. If something has fundamentally changed at the company.
Clearly the fundamentals at Allergan have altered, as Kelley's note indicates.  And so, with great pain and reluctance, I sold the stock in client portfolios.

One final point:  When a stock has a waterfall decline such as Allergan experienced in the last couple of days, it is not unusual for the stock price to experience a small bounce in the next few days.  Thus, when a stock experiences a precipitous drop, there is always the temptation to wait for a few days, and hope to exit at better prices.

After doing this for more than 30 years, however, I have often found playing for a "dead cat" bounce to be more aggravating than it is worth.  Better to simply sell and move on, and look for the next opportunity.