Relative Value

by Chris Sumner | June 28, 2009

�Measuring inflation today is difficult because what passes for money � unlimited paper currency � is itself so intermingled with credit as to make the two virtually indistinguishable.� ~ Reginald H. Howe [1]

Everybody knows you want to buy something of worth before the market recognizes the intrinsic value, right? Research from the �Graham & Dodd" School taught us to look for assets using fundamental analysis to best determine their intrinsic value. However, when determining intrinsic value we must define the market price of the subject asset in reference to a measurement. If the measurement or metric is elastic (or �flexible�) it requires added analysis to determine or formulate the true value of the asset. Today, global monetary inflation continues (increasing monetary aggregates) to exceed demand. To complicate matters, world fiat currencies are depreciating at different rates and vary in price relative to each other. The fundamentals for these fiat currencies are constantly changing and determining their values to each other may become more subjective. Markets are accepting the fact that world fiat currencies are no longer a constant long term store of value (money) by definition of the new fundamental trend in hard assets or anything equitable. In summary, a secular change has begun as demand for real assets has increased relative to fiat currencies or debt instruments.

Equity Markets Appreciating or Fiat Currencies Buying Less?

Many perceptive fundamental market strategists and technical analysts have noted all markets have been moving up worldwide when priced in multiple fiat currencies. Some have identified the synergistic movement of all markets once thought to historically move in opposite directions. An example of this would be that despite the increase of world wide stock indexes, the broad commodity indexes have also begun to rise after a twenty year secular bear market. Unlike the latter part of the 1960's into the 1980's, a time when the performance of many commodities exceeded worldwide stock markets (ex-Japan), today we are witnessing historical new highs in many larger capitalized stock and commodity markets in addition to many of the smaller emerging growth markets. These phenomena could be attributed to current worldwide monetary fundamentals (global currency debasement). The value investor must now question the nature of a markets appreciation (relative to multiple currencies or gold), its relative value and determination of safety. A fiat currency may be a safe haven for the trader with a shorter duration but the fundamentals and experiences of this new century has taught us there �is no way to protect savings from confiscation through inflation.� [2]

Global Equity Market Pessimism Continues To Build

Many critics in the past few years have correctly identified great leverage (debt) in today's economic system. We have been witnessing higher interest rates as a function of decreased demand relative to supply for fixed income debt securities (specifically in the US Treasury market). However, dire growth predictions and bearish scenarios for many world stock markets have generally failed to materialize (including new trends in many strategic commodities and faster growing foreign markets) when priced in many fiat currencies. One example would be the increased interest rates on 10 Year US Treasury bonds for the past 4 years has not slowed the appreciation of the Dow Jones Industrial Average or the S&P 500 when priced in US Dollars. Despite many incorrect projections in the past many analysts seem to be questioning the recent performance of stocks and many commodities in various world markets which do appear extremely overbought. Many technical and fundamental analyses have pointed to unsustainable world equity market appreciation, specifically China, and are projecting some type of correction. In summary, it seems as though we've come to another crossroad where investors are exposed to bullish and bearish sentiments creating confusion to what is the primary trend and where assets can seek safety.

Safety of Principal? Where to?

During times like these I find reading and reviewing dated economic reports and technical projections to be very helpful. I very much honor the commentary of many elder newsletter writers who have lived through many economic cycles and share strong founding principals in their analysis. These individuals often don't change their fundamental strategy from week to week. Changes are often very calculated and based upon hard data. When I compare such reports to more main stream research I generally find three different points of view:

General economic commentary focused on stocks and bonds. No signs of significant global currency debasement or debt/excess credit in the financial system. Some economic challenges are highlighted. General asset allocation models are usually recommended (diversification between stocks/bonds and limited international exposure).
The debt levels are historic in all areas of the economy. The economic fundamentals have become unsustainable. Expectations for lower stock markets could materialize. Many systemic risks are correctly identified. Commodities relying on economic growth could go down dramatically (specifically base metals). World fiat currencies are identified. The debt levels have created speculation in every asset class. �Bubbles� worldwide are identified through charts projected to be unsustainable. Limited duration bonds and cash (fiat currencies) are recommended with an allocation to precious metals bullion.
The debt levels are historic in all areas of the economy. The economic fundamentals have become unsustainable. Systemic risks are identified. World fiat currencies are debt instruments themselves and will not be a long term store of value. Own real assets as a store of value including resource stocks, water, farmland or precious metals equities and bullion.

Success This Decade Points To Tangible Assets for Safety of Principal

The first point of view is obviously the general complacent view shared by the mass media and Wall Street. Point number two has generally been accepted by analysts expecting some type of severe economic contraction including deflation of many fiat currencies. The third point so far has proven to be more accurate as it’s identified fiat currencies, debt instruments themselves, as a long term problem (inflated supply continually increasing) in addition to other forms of debt (credit) in the world financial system (derivatives, mortgage securities, etc). The mentality of selling a precious metal because of economic weakness and buying a fiat currency has thus far proven to be inaccurate in the long run as we have witnessed new highs in gold and silver priced in many world currencies. As we can note from our experience so far this century, in addition to gold rising it appears many other commodities have risen much faster so precious metals may actually be �lagging� rather than �leading� the current market.

Paradigm Shift

Financial analysts who have solely lived in the United States (much less Wall Street) may see the world from a different perspective than international advisors. In addition to seeing the world differently, I believe we've come close to a time where people in a real business may experience many changes this century leading to a different perspective than the ever growing numbers of domestic or international asset managers. There is little doubt that many commentaries I've read from numerous analysts are less than honest. However, it’s possible that others in the financial asset world might really believe their projections despite the ever growing fundamentals pointing to greater imbalances in the relative amount of intangible securities to tangible assets. Could it be that the biggest bubble itself is the metric (fiat currencies) we're using to chart many markets today? What would we see if we priced a fiat currency (Y-Axis) in a given stock index over a period of time (X-Axis)? Would we come to the same conclusion that a stock market index is appreciating or we might conclude the possibility that the fiat currency is buying less of the stock index?

Numerous reports have shown �bubbles� in emerging market economies and base metals. A quick review of the Dow Jones Industrial Average over the past 100 years certainly looks like an aggressive chart. Is this a bubble? Are the Dow Jones companies growing in historic proportions or is it possible that the metric (the US fiat Dollar represented on the Y Axis) is depreciating relative to the Dow Jones Average?

Source: Wikipedia

Is it possible that the current acceleration of world currency debasement and credit has manifested itself into world markets? If this is the case it would seem to me the traditional forms of pricing and technical analysis may require some type of ratio analysis to determine the relative value of any index. I'm not suggesting the Dow Jones Industrial Stocks are in a bubble any more than other world markets. As a matter of fact some of these companies are now trading at much more reasonable multiples than they were 5 years ago. However, one look at the chart below and even the most novice stock investor should accept that much of the �appreciation� in all assets in the past 30 years could be greatly attributed to increased money supply.

Source: Economagic.com Time Series Page

Again, seeing the new market trends may require added metrics as the acceleration of fiat currencies worldwide are accelerating (if you believe this is solely a US Dollar phenomenon please see the estimated growth of other global fiat currencies on our site: Market Monitor). As a fundamental investor I still hold great respect for technical analysis. However, one look at the chart above should tell us the simple fact that a dollar today is obviously a greatly diluted instrument to what it was during the last bull market in commodities much less the last time inflation was a serious buzz word in the early 1980's. The creation of credit in our economic system is so prevalent today that one may soon need to use some type of ratio analysis to aid in the determination of what could really be considered �overbought� or �oversold.�

A very interesting book I've recently reviewed is John J. Murphy�s Intermarket Analysis. In the first chapter the book identified four financial markets � currencies, commodities, bonds and stocks. In a quick summary it highlighted some relationships which we have witnessed and may experience in the future:

A falling dollar is bullish for commodities; a rising dollar is bearish.
Commodities trend in the opposite direction as bond prices (same direction as interest rates).
Bond prices normally trend in the same direction as stock prices (therefore, rising interest rates are usually bad for stocks).
Duringa deflation (which is relatively rare), bond prices rise while stocks fall.

We can see from the chart of M3 that deflation, the decrease in credit or money supply, is extremely rare. So rare in fact the last one was in the 1930�s (please note a very interesting editorial from Michael Nystrom on this subject). A second point is we need to continually define what the US Dollar is falling relative to. The USDX is a currency index which may tell us the US Dollar is losing purchasing power via the Euro or Canadian Dollar, but if the other currencies are depreciated (inflated) the relative values of all currencies may continue to fall versus anything tangible. In addition, US Government inflation statistics have been altered to the point that they now successfully no longer reveal the bulk of the inflation in our system. There is no doubt we are entering a brave new world where what is perceived to be appreciating may actually be depreciating, and vice versa. Mr. Murphy�s book is a good example of this new way of thinking.

Global Fiat Currency Holders: Perceptions Changing?

Despite the fact that crude oil, natural gas, base metals or equitable shares of a stock are not universally accepted as a currency one can’thelp but wonder if individuals or institutions with different experiences than financial analysts are slowly considering other assets as a better relative store of value than fiat currencies. If � The Great Inflation� plays out as seems to be the case I believe we'll continue to see deflation when pricing assets in gold and silver, monetary metals inflating (increasing in supply) at lower rates than global world fiat currencies, and significant inflation when priced in world currencies. I'm not suggesting that assets held in money market or a fiat currency are or will be totally worthless. We know this not to be true as world fiat currencies are accepted for goods and services to date. However, using a currency for transactions is obviously a greatly different manner than considering it a store of value. Future countries, companies and individuals may consider alternative assets to retain purchasing power. Recent events this month suggest foreigners may be looking for other stores of value.

UAE Won't Rule Out Dropping Dollar Peg - By Dylan Bowman and Reuters - By Dylan Bowman
Reuters ArabianBusiness.com, Dubai
Sunday, June 24, 2007
China Eases Overseas Share Curbs - By Jamil Anderlini
Financial Times, London
Thursday, June 21, 2007
China's Chinalco to buy Peru Copper - By Laura Mandaro
MarketWatch.com
Monday, June 11, 2007
Syria to End Dollar Peg, 2nd Arab Country in 2 Weeks - By Zainab Fattah and Matthew Brown
Bloomberg.com
Monday, June 4, 2007

Innovators Capitalizing on Change

Innovative management of companies with direct experience in real assets or manufacturing may more clearly experience price inflation resulting from such monetary excesses. The former CEO of Goldcorp, Mr. Robert McEwen may have seen changes in the economy ahead of many analysts. Mr. McEwen�s experience gave him the courage to make a radical change:

believed the price of gold had bottomed and was set to go higher, which led to the idea of holding back production for higher prices. In 2001, Goldcorp held back five percent of production. In 2002, ten percent was withheld and I also went into the market and purchased some gold. We started holding back gold when the price was U.S. $270 an ounce. Today it's above U.S. $400. At the peak, we held more gold than the Bank of Canada, more gold than what was held by 50 of the 114 central banks that hold gold.

In 2004, Silver Standard Resources (SSRI) CEO Robert Quartermain announced that they had purchased almost 2 million ounces of physical silver, deploying approximately 20% of their corporate cash. It wasn�t long before the balance sheets of Goldcorp and Silver Standard Resources had greatly benefited from the actions of these two mining pioneers. I believe we may be entering a period where more innovative companies may see the same fundamentals and continue to move their operating capital towards assets which may retain a store of value better than fiat currencies. It would also not be surprising to see many of these companies in new emerging economies (Malaysia, Singapore, Vietnam, etc�) or in commodity rich regions such as Canada. These net producers of assets may see many things in the past few years as a result of their experiences in production. It is for this reason that despite the fact I remain relatively cautious on the price of many base metals like copper when priced in gold, I'm not sure the Copper bears will have their day when the price of Copper plummets well below the $1.50 a pound (an area where many financial analysis were calling to short the metal). Despite the fact many commodities may appear to be short term �overbought� I believe the fundamentals of the fiat currencies in existence today may be poor enough to create difficult challenges for manufacturers with excess inventory. This is in great contrast to a leveraged investment fund speculating on the price of an asset.

Investment Mentality: Short Term or Long Term?

Formulating the real value will benefit from added analysis using ratios relative to other hard assets which can’tbe created ad infinitum. [3] Investors also need to determine their mentality (duration) and risk tolerance. Asset classes once considered to be speculative (bullion) may soon be seen as a form of money (store of value). Mr. John J. Murphy had accurately stated: �Intermarket work is market-driven. There is nothing theoretical about a profit and loss statement.� The future may require investors to see through corrections in asset prices in fiat currency and accumulate real value. Distribution of assets with intrinsic value may favor the groups with strong fundamentals who can use volatility to their advantage. I believe the innovative investors, investment managers and companies will continue to determine new ways to visualize future value. Assets like Crude Oil were trading significantly below their price today during the height of the high technology boom. Investors and management capitalized on this opportunity by accepting change. More opportunities lay ahead for those who accept change. As Mr. Robert McEwen promotes: �New Capital Is Not Scarce, People and Innovation Are.�

Investors need to consider other metrics than one fiat currency when determining value.
Real wealth consists of capital and tangible assets which can not be created out of nothing. Companies with good management in these industries may continue to outperform.
Fixed income debt (bonds) holders in this environment are losing purchasing power, with continued interest rate risk, credit risk and currency risk (or inflation risks). Real value may become increasingly difficult to define should the market accept currency risk.
Companies, larger institutions or individuals may soon choose to hold hard assets instead of currencies. This may create distortions in inventories and prices.
�Cash is King� - Significant increases in global currencies may create short term volatility in all asset prices, ultimately �scaring� investors away from real assets. Real monetary assets, gold and silver, are being accumulated by strong companies and developing nations.
�Cash is Trash� - Longer duration charts reveal longer term challenges when attaining capital preservation in fiat currencies versus �things.� No world currency is backed by anything tangible. [4]

Ratio Analysis

This week the Federal Reserve �Open Market Committee� is meeting for the fourth time this year. We are in a seasonally slow period for many hard assets (summer). There should be no surprise to see the downside actions in the gold and silver markets. As the Gold Antitrust Action Committee has displayed, these are �managed� markets. During times like these I like to review the �big picture� and relate it to our fundamental analysis of many asset classes and specific holdings.

An initial analysis starts with the value of US 10 Year Treasury Notes priced in US Dollars (Federal Reserve Notes) relative to gold. Stock market bears have been calling for higher rates to be the death of higher equity prices. This has not happened in the past 4 years. Despite higher interest rates on multiple forms of US Treasury debt, the effects of negative real interest rates can best be seen in the 10 Year US Treasury Note priced in Gold.

A quick review of the S&P 500 in US Dollars reveals a retest of the highs in 2000. Multiple technical analysts are calling for corrections as we meet resistance priced in fiat US Dollars. A second look at the S&P 500 priced in crude oil reveals an equity market which looks to have largely burst (take this into account when you see technical analysts bearish on multiple stock market indexes or commodities ex-crude oil).

Despite my bullishness on Malaysian Markets, you can see they are no longer nearly as inexpensive when priced in the S&P 500. Meanwhile we see the S&P 500 has continued to slide versus International Stocks.

The charts below indicate some of the growth in emerging markets is becoming recognized. The relative value in these markets to the S&P 500 is obviously not the same as 5 years ago.

The larger capitalized energy stocks are being recognized for their value. Many energy companies are still selling at very reasonable valuations but the chart should show the easy money has been made. On the other hand the Philadelphia Stock Exchange Gold & Silver Index (XAU) has also attracted capital, growing in size, yet its appreciation is nowhere near that of its hard asset counterparts. In the earlier part of the 1980's this index was selling at eight times it’s current price today when looking through the eyes of the S&P 500. Many investors and technical analysts remain bearish. This is a good contrarian indicator.

Despite the parabolic rise in copper, we see today's price is significantly less than it was relative to crude oil in the early 1990's. An ounce of gold is now selling at around 200 pounds of copper.

The energy stocks are now providing leverage to the price of crude oil after retesting 17.5 times a barrel during the past 5 years. You can see that despite higher crude oil prices in 2002 (from around $20 to $32), the American Stock Exchange Oil Index failed to provide leverage, moving from over 25 to 12 times crude oil. Investors who accumulated energy stocks during the past five years are being greatly rewarded. Today, the larger capitalized gold and silver stocks are again nearing historical lows. Market sentiment in this sector is naturally becoming increasingly bearish much like the energy stocks in the spring of 2003.

The Philadelphia Stock Exchange Gold & Silver Index (XAU) is retesting its historic low of ten times silver. Despite my bullishness in silver this chart clearly shows the market has yet to accept the gold and silver producers as stores of value relative to the price of silver. A closer look at the Philadelphia Stock Exchange Gold & Silver Index (XAU) reveals it has rallied 200% versus the S&P 500 from its low and appears to be consolidating after early 2006. Despite the increase in 2006 versus the S&P we see the gold stocks have failed to provide leverage versus gold and silver (again, this would account for the bearishness in this sector). While some see this as a non-confirmation investors seeking strong fundamentals have great opportunities to buy quality companies at discounts to their net asset value.

From a more recent perspective, it will be interesting to see how low the sentiment in mining stocks can go. You can see the sentiment in energy stocks dropped below 20% bulls (80% negativity towards the sector) two times last year (June and October). Despite a retest in January, indexes like the Philadelphia Oil Services Index moved some 50%. There are opportunities for innovative investors who do their homework�

Summary

The charts above are not a perfect science. Remember, the market capitalization of many of the indexes have changed. An example would be the relative increase in the size of the Philadelphia Stock Exchange Gold & Silver Index (XAU) may make it more accessible to institutional asset managers. This accounts for some of the bearish sentiment as analysts bearish on the short term movements of the S&P 500 see the possibility of these stocks being sold along with the general stock market.

Perceptions of value may be different. We know there is no shortage of credit being created in today's economy. An institutional Wall Street asset manager may see the world differently than a purchasing manager of a larger industrial manufacturer. Many faster growing emerging economies favor many forms of tangible wealth (monetary metals) over fiat currencies adding to demand. Investors in these countries may continue to accumulate based upon recent negative experiences within their currency (Russia, South America, Southeast Asia, etc). Many western analysts sill see fiat currencies and bonds (both debt based instruments) as safer havens than bullion or other hard assets. This mentality within the westernized financial industry should be expected given the twenty plus year bull market in paper assets.

Many companies within the mining sector are now selling at significant discounts to their net asset value. Fundamentals also point to continued value in the energy sector, including alternative energy and technologies in this arena. Faster growing markets are still of interest but the days of extremely low valuations are mostly gone. Some domestic stocks appear reasonable as valuations return to more reasonable levels (specifically versus many foreign markets). In addition, some domestic companies may benefit from a lower UD Dollar. Bonds present the greatest risk to principal given the fundamentals.

In the short term it’s impossible to know what will happen in world markets. Prior scandals like REFCO now seem to be distant memories as the recent mortgage crises have our attention. A book could be written regarding the many challenges facing global equity or real estate markets. There is reason to be concerned. Many analysts will continue to predict the correlation between the problems in paper assets (fixed income debt securities and derivatives) with the performance of many asset classes. Institutions may greatly benefit from the fear (investors remain in oversized fixed income assets while well capitalized funds accumulate many resources and companies benefiting from the new trends at discounts).

A disciplined investor can use periods of extreme pessimism to accumulate fundamentally sound assets. Smaller investment groups using discipline and fundamentals have a significant advantage over the mass psychology of crowds and investment funds trading on momentum (some using computer analog rhythms). Sound economic analysis (supply versus demand) provides the best platform to give the wise investor time to accumulate real wealth.

[1] Real Gold, Paper Gold and Fool�s Gold: The Pathology of Inflation, October 16^th, 1999
[2] Gold and Economic Freedom, The Objectivist, 1966, Allan Greenspan
[3] Wikipedia - Real Versus Nominal Value
[4] International Monetary Fund - IMF.org

Contact Information

Chris Sumner | Registered Representative, Puplava Securities, Inc. | California | Email