Market Comment

Sold on Gold

October 4, 2010

Sold on Gold


“After the printing press, the guillotine.”

                –French Revolution anecdote

Given the extent of the advance, 14% in four weeks, prices could come off well more, down to the vicinity of the 50MA in the chart below, and still be in a normal, healthy pullback.

There is the usual sense of disbelief regarding this advance, as with every rally since this bull market began in March ’09. Although we stopped paying attention to the popular sentiment indicators years ago, it is obvious that the individual investor, tarred and feathered from two serious bears in ten years, remains as pessimistic as any time since the ‘Thirties, arguably.

Our view on the economy is that the retail and consumer discretionary sectors would not be handily outperforming if the market did not expect a pickup in consumer spending, however mild, during H1 of ’11. This would appear to weaken the case for a double-dip, as well as deflation.

The move in gold is not surprising amid more money printing by the US Treasury. Ditto for the upward revaluation in base metals aluminum, copper, nickel, zinc, lead, and, especially, tin. It is not surprising that these all bottomed June 6, the day that the dollar peaked.

Silver, sometimes known as poor man’s gold, has finally begun to narrow the gap between it and gold. Perhaps overlooked is palladium, which, since July 1, has handily bested both silver and gold.

The term “bubble” seems to be used liberally these days. We believe gold has further to go before qualifying for bubble status. For starters, it is not close to its inflation-adjusted high in ’80. In addition, the extent of its rise cannot be confused with other bubbles, e.g. technology, or even the housing bubble. Also, it is not at that point where everyone has to own it. At some point, it is likely that the rise in gold and silver will appear to melt up.

We have been publicly positive on gold since Feb. 17, 2003, when we wrote “We believe gold remains attractive in diversified portfolios as a long-term hedge against a declining dollar, rising inflation, and geopolitical uncertainty, and in that order of importance.”

We have said before in these reports that the future rise in commodities –metals, energies, and agriculturals – has the potential to outdo even the technology bubble that fueled the greatest bull market since the ‘Thirties. The difference between the two is that, with technology, unlimited supply could be, and was, created in the form of new stock issued to the public. This sopped up the intense demand on the part of investors for anything Web-related. In December ’98, few Internet stocks existed for public consumption. The Street swiftly took care of that supply-demand imbalance by creating more supply via a raft of IPOs. And the bull ended in March ’00.

But with commodities, there is only so much hard stuff around. It can take years to put a new copper mine in operation, for example. As for the gold market, it is much smaller than most would think. In fact, there is surprisingly little in terms of reserves relative to the demand that potentially exists from central banks, Chinese and Indian consumers (a not insignificant lot), speculators, and institutions.

The greenback has fallen 6.5% in less than six weeks. Some believe that the more the dollar falls, the better off the US will be, as domestic manufacturers will be more competitive with their overseas rivals. To an extent, this is true. It is also true that a weaker dollar will likely diminish the chance of deflation, a major plus.

However, too much of a good thing is almost always bad. In this case, there would reach a point at which capital flight ensues, and dollar-denominated paper assets, such as Treasurys and most shares, would be pounded. The Fed would feel compelled to jack up rates to save the dollar, which by then would have lost its status as the world’s reserve currency, to be replaced by a basket of currencies or perhaps the renminbi.

The endgame in all of this: serious inflation.

Even if there is a stopover in deflation mode, which, given the behavior in shares appears to be a diminished risk, the massive amount of money creation that Mr. B would likely throw at the problem will lead to serious inflation, in our opinion.

All roads lead to inflation.

But before the whites of inflation’s eyes become visible, gold will have moved up appreciably from current levels, in our opinion. This due to the market being a discounting mechanism.

It is to be noted that the greenback presently is in its worst three-week decline in over 18 months. Any snapback rally may clearly be sharp enough to singe any Johnny-come-latelies to the gold party, perhaps more than just a little. We would only buy or add to gold positions on weakness, not strength.

Among the glamours, nearly all are extended from their most recent base, a victim of their own success.

Rackspace Hosting (RAX) is a favorite of ours in the intermediate-term by virtue of its fat earnings estimates of 50%/56%/45% for ’10/’11/’12, fairly high stability of earnings growth over the past three years, and membership in the No. 1 group, Internet-Network Solutions. We would note that, at present, the market is not focusing on companies’ 2010 earnings, but rather the outlook for ’11. This year is virtually a wrap; it is 75% done.

(We have used the following rule of thumb since the ‘Nineties: Once a fiscal year is one-half over, the market begins to focus on the next fiscal year more than it does the current year. E.g. with companies on a December fiscal year, beginning in July (and certainly by August), we ignore the estimates for ’10 and focus on the ’11 estimate in percentage terms. We like RAX’ combination of high expected earnings growth and high stability of that expected growth: 50% to 56% to 45% is very smooth for a company growing at such a heady clip. Plus, its past three-year earnings stability is quite good. For technology companies, this is uncommon. Less important, but still worth noting, is its near-ideal market cap of $3.22B, liquid enough for institutions but not too big.)

RAX does not represent an attractive entry at present levels. It would take an 8.8% drop to bring it back to the top of its prior base, which is too extended for our comfort. Aggressive participants could consider taking a junior position (half of normal position size) with a looser stop on a clearing of the Sept. 28 high of 26.50. This would be quite aggressive, but would be less so with every day in which price goes sideways and stays below 26.50. If there is a stock in the current group of glamours that might get away with coming out above 26.50 – and then staying above it – it just might be RAX, but this is not a high-probability setup by any stretch. We would prefer to let price put in at least another five days which might take some of the attention away from the stock. Having said this, the character of most glamours with 50% estimates that initially come out of a long base (nine months, in this case) is a play-hard-to-get vibe. They do not make it easy to enter a position. Ironically, these are the ones that often turn out to be the biggest winners. What transpires with RAX over the next several sessions may be a function of the averages. If the averages continue higher without pulling back from here, it is likely RAX will move higher without pausing or pulling back much.

We expect Amazon.com (AMZN) to be a leader in any continuation of this move in the averages. This by virtue of its 38%/31% estimates for ’11/’12, its must-own status among institutions (big growth/mega capitalization), and its extreme accumulation. Though this is subject to change, at this moment, rather than enter on a pullback, we would prefer to buy the breakout.

Apple Computer (AAPL) is another that might lead, but we do not expect it to perform as well as AMZN, mainly due to its slower estimates (23%/17% for Sept ’10/’11). Neutral accumulation over the past 13 weeks is another, lesser reason. Both AMZN and AAPL went straight up and are entitled to pull back and digest recent rises.

Among the liquid precious metals, Allied Nevada (ANV), Silver Wheaton (SLW), Buenaventura (BVN), and Randgold Resources (GOLD) are the leaders, all extended.

Among commodities lately, the more esoteric, the better the performer. Silver and palladium are less followed and talked-about than gold, yet have performed better than the yellow metal. Tin is far less popular as an investment vehicle than copper or aluminum, yet tin has been the best performing base metal for months.

But the very best performers among all commodities have been the most esoteric, mysterious ones of all, titles that lie below the radar of at least 99.5% of all investors. More on this in a future report.

In summation, the averages are entitled to pull back more than just a little, in light of their beefy move off the late-August lows. Leadership, though quality, is nowhere near as ubiquitous as in the February-April advance. Very few, if any, glamours offer a high-probability entry for fresh-money buys.

Kevin Marder

Gil Morales & Company, LLC (“GMC”), 8033 Sunset Boulevard, Suite 830, Los Angeles, California, 90046. GMC is a Registered Investment Adviser. This information is issued solely for informational purposes and does not constitute an offer to sell or a solicitation of an offer to buy securities. Information contained herein is based on sources which we believe to be reliable but is not guaranteed by us as being accurate and does not purport to be a complete statement or summary of available data. Past performance is not a guarantee, nor is it necessarily indicative, of future results. Opinions expressed herein are statements of our judgment as of the publication date and are subject to change without notice. Entities including but not limited to GMC, its members, officers, directors, employees, customers, agents, and affiliates may have a position, long or short, in the securities referred to herein, and/or other related securities, and may increase or decrease such position or take a contra position. Additional information is available upon written request. This publication is for clients of Gil Morales & Company, LLC. Reproduction without written permission is strictly prohibited and will be prosecuted to the full extent of the law. ©2008-2018 Gil Morales & Company, LLC. All rights reserved.