zGi-BULL BEAR MARKETS

Gold prices were softer at the close of trade this week with the precious metal off by 0.37% in New York on Friday to close at $1575. The losses come despite a near 2.5% rally early in the week that took bullion briefly above the $1600 threshold before pulling back sharply. Sequestration concerns, which had dominated the headlines this week on newswires and financial reports, had little impact on broader markets with investors taking it in stride as equity markets closed the week higher across the board. Gold remains in a precarious position here with prices continuing to test long-standing trendline support dating back to the July 2011 lows and while our broader bias remains weighted to the downside, we will hold off on establishing new positions until the March opening range plays out.

The Humphrey Hawkins testimony this week took center stage as Federal Reserve Chairman Ben Bernanke addressed congress on Tuesday and Wednesday. Bernanke defended the central bank’s policy stance arguing that the benefits of quantitative easing currently outweigh the costs. Still the chairman did sound an improved outlook for the region amid the resilience in private sector consumption along with the rebound in housing while noting that interest rates will rise over time as the economy gets on a more sustainable path. On the heels of the recent rhetoric being disseminated by FOMC members, we may see a growing number of Fed officials start to discuss a tentative exit strategy over the coming month Bernanke stating that the central bank has the ‘tools necessary to tighten monetary policy when the time comes to do so.’ As such, gold advances are likely to remain limited as inflation expectations remain ‘stable’ and expectations for cessation of QE start to gather pace.

Looking ahead to next week, investors will be closely eyeing the Fed’s Beige Book on Wednesday for an updated assessment of the Fed’s twelve districts. With housing, consumer confidence, and ISM manufacturing data all topping estimates this week, the report could further fuel positive sentiment in broader equity markets which have posted an impressive rally since the start of 2013 trade. Beyond the slew of interest rate decision from the RBA, ECB, BoE, BoC and BOJ on tap for next week, the highly anticipated February non-farm payrolls report will be paramount as we head into the close of the first full week of March trade. Consensus estimates are calling for a print of 160K, up from 157K a month earlier with the unemployment rate widely expected to hold at 7.9%. Again here it’s important to take note of changes in the labor pool as discouraged workers returning to the workforce may put upward pressure on the headline unemployment rate. With the data flow out of the US continuing to suggest that the recovery is accelerating, gold prices remain at risk with prices likely to range as we head into Friday’s crucial print.

From a technical standpoint, gold has remained within the confines of a well-defined descending channel formation with prices settling the week just above the key confluence of channel support and long-standing trendline support dating back to the July 2011 lows at $1571. Although the broader directional bias remains weighted to the downside, we will maintain a neutral bias in the near-term pending a rally back into key resistance at $1626 or a break below critical support in the range between $1550-$1555. A break below key support at $1550 puts us back on track with such a scenario eying subsequent targets at the May 2012 lows at $1527 and $1483. Interim resistance now stands with the 1.382% extension at $1585 with a breach above this mark eyeing subsequent ceilings at the 23.6% retracement from the October decline at $1611 and the key 61.8% retracement from the rally off the December 2011 lows at $1626. Only a weekly close above the 100% extension at $1631 would invalidate our broader bias.

Rally We Can Believe In?

- 8 February 2013

Despite recent strength in equities, capital preservation remains the name of the game for many investors...

IN 2012, despite slowing growth, deepening sovereign debt problems and lackluster earnings, equity markets advanced strongly. In 2012, the MSCI All-Country World Index of equities increased 16.9% in 2012, including dividends, writes Satyajit Das for Dan Denning's Daily Reckoning Australia.

Twenty-three out of 24 benchmark indexes in developed markets increased. The US S&P 500 Index climbed 13%, the highest increase since 2009. European markets rallied, with Greece, Germany and Denmark increasing almost 30%. Only Spain's IBEX 35 fell, and only by a modest 5%. Despite its embalmed economy, Japan's Nikkei 225 Stock Average rose 23% in the largest rally since 2005.

Bonds of all types returned around 5.7% on average. Safe haven buying and demand for yield increased, fuelling demand for bonds. Ever lower interest rates and risk margins did nothing to discourage buying.

Despite continued debasement of currencies through central bank quantitative easing, the S&P GSCI Total Return Index of 24 commodities rose 0.1%.

Highlighting the perversity, even debt of beleaguered European nations was in demand. Astute investors doubled their money on Greek bonds, in a surreal bet on an economically dead nation incapable of paying backs its debt.

In Chinese, 'Shi' is the art of understanding matter in flux. To preserve capital and the purchasing power of their money in these dysfunctional times, investors will need to understand the financial flux and negotiate its complicated cross currents.

Investors could easily delude themselves into thinking that 'happy days' have returned. But there has been a marked shift in the investment climate. Investment outcomes are now heavily dependent on government and central bank policy decisions.

The rally in the Euro and European bonds and stocks following the European Central Bank's announcement that it would purchase unlimited quantities of peripheral country debt demonstrated the risk of misreading policy.

Major central banks dominate markets. Their collective balance sheets have increased from around US$6 trillion before the crisis to more than US$18 trillion, an unprecedented 30% of global gross domestic product.

Government and central bank strategy is targeted at growth and creating inflation using non-conventional monetary policies, quantitative easing and specific inflation targets. High nominal growth would make existing debt levels more sustainable. Inflation would help reduce debt in real terms. But the strategy may not work.

While central banks are providing ample liquidity, the effects on credit creation, income, economic activity and inflation are complex and unstable. The velocity of money or the rate of circulation has slowed.

Banks are not using the reserves created and money provided to increase lending, reflecting a lack of demand for credit by stretched households and businesses with over capacity. The reduction in velocity offsets the effect of increased money flows and limits the pressure on prices.

Uncertainty about the effectiveness of policy complicates investment choices.

If policy makers succeed in restoring growth with modest inflation, then equities may prove the best investment. If the policies result in high or hyperinflation (such as that experienced in Weimar Germany or Zimbabwe), then real commodities and precious metals such as gold may be the best investment to protect against the erosion of the value of paper money.

If the policies prove ineffective, then a period of Japan-like stagnation may result. In such an environment bonds or other fixed income instruments will be the favored investment.

In recent times on a number of occasions, equities, bonds, commodities and gold have rallied simultaneously reflecting investor confusion.

For investments denominated in foreign currencies, the effect of loose monetary policies on currency values is an increasingly important influence on investment returns.

US Federal Reserve policies are designed to devalue the currency to reduce the value of outstanding US Dollar government debt held by foreign investors and also improve export competitiveness.

With all developed countries competing to weaken their currencies, the impact of foreign exchange fluctuations on investments – directly or indirectly through their effect on company earnings – is unpredictable.

Given the scale of the problems, governments have resorted to 'financial repression'. Governments are implementing a range of policies to channel funds to official institutions to liquidate debt. These include explicit or implicit control of interest rates, which are negative after adjustment for inflation.

This helps governments decrease debt servicing costs and reduce the real value of their debt. Investment and borrowing restrictions, to create captive domestic markets for government debt, via reserve requirement or explicit investment constraint, may be implemented. Free movement of funds internationally may be restricted via capital controls.

Changes in taxes, as government seek to garner revenue, will also affect returns.

There will be increased interference in financial markets, as governments intervene, overriding normal market mechanisms. Prohibitions on short selling, bond purchases and currency intervention are examples.

For investors, imitation may be the best investment strategy. As Pimco's Chief Investment Officer Bill Gross has repeated frequently during the crisis, the firm buys whatever the central banks are buying.

It is like the scene from When Harry Met Sally when a woman, having watched Meg Ryan fake an orgasm in Katz's Delicatessen, tells the waiter: 'I'll have whatever she's having'. But predicting policy actions is difficult.

Investment theory may not provide succor in this environment.

Governments bonds are no longer risk free safe havens. The risk of default or loss of purchasing power either through devaluation of currency or diminution of purchasing power is prominent. As Jim Grant of Grant's Weekly Interest Rate Observer observed, government bonds now offer 'return free risk'.

Risk premiums are frequently negative as investors flock to safe assets or the latest bestest investment – US and German bonds, high yield corporate bonds or high dividend stocks.

Diversification to mitigate risk is difficult as correlation between different investment assets has increased and become volatile. The fundamental risk of domestic shares, international shares and property has frequently behaved similarly in the current economic environment. Even returns on cash are positively correlated to risky assets as interest rates have fallen in the recession.

Investors have assumed policy measures have reduced tail risk, the chance of large and frequent increases and decreases in prices. In fact, the opposite may be true. Attempts to suppress volatility, without addressing fundamental problems, increases the risk of major market breakdown in the future.

Investors may now need to consider comedian Will Rogers' advice: 'I'm more concerned about the return of my money than the return on my money'. Capital preservation will be the key to survival. This favors debt over equity or other risky assets, even though the safety of government debt is increasingly in question. It also favors defensive stocks or hard assets, like commodities.

Increasingly investment approaches focus on matching future cash flows, irrespective of whether it is a known future liability or retirement income needs. Products such as annuities targeted at retirees or specific saving plans that provide a guaranteed lump sum are growing in popularity.

Investment income (dividends or interest) may be the major source of return. Capital gains will be more difficult as the period of consistent stellar rises in price may be less likely in the future.

In bull markets, investment approaches focus on capital gains, income and capital return in that order. The current environment requires re-prioritization of those objectives.

Investors have increasingly embraced non-traditional investment. There has been strong interest in gold and other precious metals. Gold prices have risen strongly, although remaining below their 1980 peak in real terms.

Hedge funds and private equity funds continue to attract money, despite variable performance. The attraction is a focus on absolute return and greater investment flexibility. Despite well documented problems, structured products, where investors assuming credit risk or fluctuations in interest rates, currencies or equity prices in return for a higher interest rate, are making a comeback, driven by low interest rates.

Disillusioned with financial assets, the ultra-rich are focusing on scarcity – farmland, prime real estate in world cities with desirable properties and collectibles (fine arts, rare cars). Even wine has emerged as an asset class, giving a new meaning to the term 'liquidity'.

A key element is capturing volatility to take advantage of large price fluctuations – the unexpected melt ups and melt downs. This can be done by purchasing out-of-the money options which provide the investor unlimited gains from tail risk for a known fee.

Alternatively, volatility can be captured by allocating a portion of investment capital to either stocks which benefits in periods of 'irrational exuberance' (typically growth stocks) or 'irrational pessimism' (defensive stocks).

High levels of cash allow investors to capture volatility, taking advantage of sharp falls in value. Warren Buffett's Berkshire Hathaway maintained high levels of cash running into the crisis – around US$20 billion.

This liquid reserve was expensive to maintain as interest rates were close to zero. But it allowed Buffett to make lucrative and very high yielding strategic investments in Goldman Sachs, GE and (more recently) Bank of America.

'Independent' financial advisors and tipsters tell clients that decent returns can be still earned during periods of great uncertainty. They have successful proven investment spells and incantations that they can provide for the requisite fee and emoluments.

Unfortunately, few personal investors and even professional investment managers have the required knowledge, resources or skills. As one fund manager stated with disarming honesty, 'We are being paid to lose money.'

Probably the best that investors can hope to do is to avoid common pitfalls. Successful investors often succumb to what theologian Reinhold Niebuhr termed the 'most grievous temptations to self-adulation'. Success is always 10% skill and 90% luck, but it is unwise to try it without the quotient of skill. Hubris has resulted in a greater loss of wealth than market crashes.

Adjusting return expectations to more modest levels is essential. As Samuel Loyd, an Englishman who made his fortune in finance and was considered an authority on money and banking in his time, observed, 'No warning can save a people determined to grow suddenly rich.'
Article from Gold Bullion Vault