Melt Up Scenario? 1/19/12 gold settle: 1654.5

A week ago, in my last post, I discussed the bullish case for gold. We are now trading higher, having made overnight highs of over 1670 last night. Despite my correct bullishness over the last week or so, I felt very confident that we would see a sell off yesterday. That sell off never came. I was kind of bummed about the fact that we didn't sell off because I was so confident that we would. Calls were getting offered in the gold options, and had been for a couple of days even as we were going higher (This type of option action often portends a coming sell off). Volume was light, which makes everything mean less, but still I was disappointed. This morning I got the Credit Suisse daily note, and saw that they had raised their S&P target to 1400 for 2012. Sentiment has been strong, housing numbers improving, and then great jobless claims data came this morning. Seeing the S&P settle above 1300 for two straight days, I began to wonder if maybe this bull was just too strong to fight. For now, I think the answer is yes.

I went through my mental Rolodex and began to see if I could compare this market to any markets we have seen over the past couple of years. What this market reminds me of most is the beginning of 2010. At the time I was working at a wealth management firm, and we decided to buy LEN and KBH (homebuilders) on the close the day before one of them (I forget which one it was) was to report earnings. A good research call I had read argued that the tax refunds they were going to receive were so tremendous that their battered stock prices would have to rally. The day after we bought the stocks, are biggest regret was not buying more. Both were up about 10% after earnings. It was a favorable tax situation, not a positive outlook for home building that made these stocks pop. The bear case of course was all too easy. With tremendous inventory overhang in the housing market, how could you buy these stocks? It was obvious just how bad that market was, but it didn't mean that the stocks weren't buys.

Why is now similar? For one, I'm starting to hear these home builders, which were all but forgotten about for the last few years get some press again. Jamie Dimon has suggested we may be near a bottom in the housing market. Stocks like Bank of America (which have significant mortgage exposure) have popped since this new positive housing sentiment has come about. And all the while, stocks have been inching up slowly but consistently. While the equities did dip after these earnings initially came out, I believe they marked the beginning of the melt up that took us into the summer months. And for the past two days, we've actually seen some treasury selling. So for now, this rally looks like it has legs, even if they push slowly. We are more likely to move slowly to the upside. This is in part why implied volatility is getting smashed as we move higher. My visceral side sees what I believe to be a series of pathetic threads and excuses that hold Europe together, and wants to short the market to no end. But this is a known known to use the phrase. This is the wrong time to get short.

As a counter point, Katie Stockton was on CNBC today saying that market conditions are currently overbought. She believes a close above 1308 next Friday would confirm the move higher. Katie knows her stuff, so this number is probably worth paying attention to. I however, would feel comfortable being long (both equities and gold) and getting out of those longs if we are unable to hold these levels.

The Golden Rule (and its bullish)

On December 17th I posted a letter I wrote to the authors of a Barron's article on the Fiat Gold blog. At the time, I was focused on just how diametrically opposed the views were in just the first two articles of that week's paper. I pointed out that what was different between the two views was not whether Europe would recover (both believed there was no soft landing), but rather the method through which they would address the issues confronting them. Would it be a process of deleveraging and economic austerity, or a money printing fest with inflated money being used to pay down the excessive outstanding debt? At the time gold was not being viewed as a safe haven. On days where bad news hit and the stock market tanked, gold would tank too. The golden rule is that money printing should be bullish for gold, but "bad news" did not appear, like it has been in the past, to serve as an impetus for gold prices going higher. Over the past few weeks, we are starting to see a few things take place which are showing that the bull case for gold going forward is still in tact despite a 25+% retracement toward the end of last year.

Today, as has been the case at least three times now this year, Gold rallied as the US dollar rallied. Often, when the dollar is strong, gold will sell off because it becomes cheaper in dollar denominated terms. To see that gold can perform positively as it did today, despite this is encouraging. While the stock market has been trading higher, we saw gold futures trading up this morning while stock futures were lower. Gold began trading in lock step with equities before breaking down on our last move lower. To see it trading under different market conditions (up when the stock market is down, up despite a stronger dollar etc) shows that there is demand for gold independent of some obvious correlation.

Market observation aside, the fundamental case for bullish gold is that it thrives in an inflationary environment. Despite European talks of austerity, Pimco's Bill Gross talks about what is going on right beneath our noses, which is really quantitative easing at its heart. I should point out (and the letter is really worth the read http://www.pimco.com/EN/Insights/Pages/Towards-the-Paranormal-Jan-2012.aspx) that Gross is not saying that money printing will be the inevitable inflationary way out of Europe. He leaves room for the "fat left-tailed" scenario of delevering as a strong possibility and even says that "gold at $1550 seems pricey, but it has upward legs if QEs continue". Earlier in the paper he discusses the racket that is the Italian bond market. Italian banks are issuing government guaranteed paper, and taking the proceeds and investing them in Italian sovereign bonds. This is a nice way to prop up the banks and the government bonds, especially considering that banks are receiving approximately 7% on 10 year paper. Of course, the fact that even with this scam going on yields are as high as 7% is very disconcerting. I however, am focused on the fact that this is classic unadvertised quantitative easing taking place. The government is not buying their own bonds, but rather facilitating the purchase of its bonds by someone else. The end result is essentially the same. QEs are good for gold.

Now perhaps these quantitative easing do take place, and for reasons you can read in the Gross piece, more money supply does not lead to inflation. We have learned post 2008 that easing the monetary supply does not ensure lending will take place, as Gross points out due in part to the flatness of the yield curve. If easy monetary policy fails, then maybe taking down leverage in the system will inevitably be the only way out. It is clear, however, that quantitative easing is covertly taking place already, and will run its course before we reach the point where it is determined ineffective. With a backdrop like that, and gold maintaining its long term uptrend as well as breaking above its 200 day moving average, the bull scenario is in full swing.

The China Problem

When you read a title like "The China problem" what are you first thoughts? Perhaps concerns about a slowing economy or whether the Chinese central bank is really going to continue to ease. Perhaps you think about whether housing is a bubble, or whether or not the Chinese lower labor cost advantage is really anything more than advanced looking communism that is bound to fail. All are reasonable concerns. But the China problem I am referring to is different, and it lies right here in New York. Only in this case, China is not actually the problem, in fact, it is the solution.

In a throw away line, as if its obvious, Reuters writes " Macau's gaming revenue easily trumps that of Las Vegas" (http://www.reuters.com/article/2012/01/03/uk-macau-revenue-idUSLNE80200620120103) While this might seem surprising to some, it probably is not to anyone who has spent significant amounts of time in casinos. That is because gambling plays a big role in Asian culture. To the Chinese, a particular year or moon might be lucky for gambling. Casinos in America are lined with Chinese players, and it is staggering to see just how many come from the buses in Chinatown, New York. These buses go to Pennsylvania as well as Connecticut casinos; bringing revenues one could only imagine (how much is probably rather difficult to get statistical data on). But one has to wonder, at a time when money is always tight in state and city budgets, how long it can be until New York starts getting a piece of the action?


While gambling is slowly being expanded in New York (at facilities like Aqueduct and Yonkers Raceway) we are still a long way from having a full blown casino. Poker is still not legal, and where gambling is legal, real live (as opposed to electronic) table games are not permitted. But the potential dollars that could be brought in and used to fund programs would probably blow anyone's mind. Keep in mind that the Chinatown economy in New York is almost exclusively cash. It is practically a self sustaining economy that need not put dollars into businesses outside their local street territory. As such, tracking the proper taxes owed by Chinatown residents must be a mere impossibility. But with New York state run casinos, the money from that otherwise underground economy would finally come to New York. And how hard of a political sell could this really be? New jobs anyone?

Chris Christie, the Jersey governor recently decided that he wants to legalize gambling across the state. This is a change from his previous position. While Christie is all about balancing budgets, one can understand why he previously didn't support the notion. Namely, New Jersey has Atlantic City. What will sadly come to be an even more depressed city in years to come, has no shot for survival in this environment. People from New York would rather drive an hour less each way and go to Pennsylvania for a day trip. The new casinos are taking away business that was once exclusively Atlantic City's. It is only a matter of time until AC can no longer stand on its own two feet. So, it appears Christie has chosen to get in front of getting those gambling customers from Northern Jersey and New York in his state, rather than in Pennsylvania.

The gambling movement has been picking up a lot of steam lately. There is money to be collected. New York is sitting on a gold mine (even as the gold mining stocks under-perform) right in its backyard. Let's see how long it takes until they tap into it.

Buried Treasure

As we opened up trading for 2012, commodities and stocks got off to a hot start. Encouragingly, we have been getting good economic data here in the USA, including today's better than expected ISM manufacturing index results. With today as the first day of the new year, and fresh capital to return to the markets, I think it is too early to draw conclusions about our direction. However, equities did move higher toward the end of 2011, and to see this follow through is a positive sign. But rather than break it all down, I would prefer to point out that this has not led to a sharp sell off in treasuries. While treasuries have not been rallying, they are staying remarkably well bid. Through the stock market rally of the last two weeks, the ten year has managed to stay below 2%. Whether or not you believe this pop we have had is a sign of risk on or not, it is important to note that demand is still strong from treasuries.....whether that is because the US government is buying them covertly....ehhh we'll probably never know.

On the same topic, I recently read that there is decreasing foreign demand for treasuries in a piece attached to a recent "Mineset" mailing (Mineset is a letter I receive from known gold expert, Jim Sinclair). In the letter, Sinclair attaches quotes from an article by Michael Mackenzie who points out that "Holdings of U.S. Treasuries by foreign central banks has fallen by a record amount over the past four weeks according to the latest Federal Reserve data." So while there is demand of late, it is no thanks to foreign banks.

Investment demand for US treasuries is complex. We cannot simply say that demand or lack there of is a sign of any grave danger or miraculous rally. It is important to note such allocation of capital however, because it can help us from getting too caught up in common assumptions. What's bullish for stocks may not be bearish for bonds and vice versa. Let's not see the treasuries rally big one day when the stock market is down and profess that it is because investors are "fleeing for safety". I mean who has ever heard reporters toss that baseless term around to simplify a story? Despite a positive US data backdrop and robust looking stock market, treasuries are still the toast of the capital allocation town.