Silver

There is a queer divergence between silver and gold.  While gold is within 30% of its all-time high, silver just bounced off $8.66 an ounce – down from $20.73 in May.  At the same time, physical silver seems to be difficult to come across.  Here in the United States, banks have ceased to broker it.  There have been reports from people who bought silver certificates that they are unable to redeem them for silver.  Additionally, there seems to be a shortage of retail silver (and platinum) in general.  A few people other than me have noticed.

So – why is silver priced below $10 while there is apparently a mass shortage?  There are two possibilities.  First is that there is some big supply which everyone but me knows about that hasn’t been released yet.  The second — and more probable — is that some big players are pushing the price down using derivatives and hoarding the physical commodity.  This wouldn’t be the first time the silver market has been cornered.

The secondary argument for silver is that it will gain from a flight to safety in either a highly inflationary or deflationary scenario.  As central banks around the world create more and more money in an attempt to reflate the credit markets, this will cause money to chase the best priced and soundest assets – silver will go up in price.  If it implodes, precious metals will be used as a safe haven for wealth and value.

Last Week’s Bloodbath

This month is not shaping up very well.  End-of-year selling is combining with deleveraging (Bill Cara points out that the short selling ban seems to have been timed in order to allow Goldman Sachs to deleverage to fit deposit bank regulations) with a healthy dose of sheer panic.  If it ended today, this October would be the 5th worst month on record for the Dow Jones Industrial Average since 1928.

The Bad & The Ugly

Let’s also face it:  large portions of this sector just simply aren’t ready to come up yet.  I reiterate that we’re fundamentally undervalued on a long term (6-18 months) period, but earnings are not going to support much higher valuations if they continue to come in like they have.  What to pay attention to:

Tuesday:  Pepsico, Intel, Johnson & Jonhson

Wednesday: Abbot Labs, AMR, Delta Air, JPMorgan, Coca-Cola, Wells Fargo

Thursday: AMD, BBT, Capital One, Continental Air, Google, Merrill Lynch, Nokia, United Tech

Friday: Honeywell

Additionally, there are a pile of smaller cap financial companies which could certainly set the table if they come in bad.

The Good

We’re so damned oversold, and there is so much damned money — most especially foreign — on the sidelines.  We’re due for a bounce.

Let’s not forget that the complexion of the market changes as the economy does.  Every 5-20 years, the market goes through a tectonic shift as the money invested in companies whose models are no longer as profitable shifts into companies who are.  Due to the fact that our business cycles are exaggerated by lending leverage and monetary supply inflation, they’ve both created new profit centres (from the risk arbitrage the investment banks make on mortgage debt out to the dozens of cottage industries created by the housing boom) and increased the speed at which our economy digests them.  The shift into technology was one such move which happened chiefly in the mid to late 90s.  The investment bank model rose out of the massive monetary supply inflation while the stock market was taking a beating in 01-02.  This same driving force turned the market into one dominated by raw material and energy costs in 2005 through 2007.

Now, we face a fundamentally different market – one that likely doesn’t reward leverage or debt risk.  The total market value of the stock market is likely to bounce around a lot from here without a whole lot of solid gains or losses.  New companies will replace their more poorly run counter-parts in indices.  Economic darwinism will cut the fat away, and allow capital to seek the best stewarts.  After this process is complete (which certainly takes time – months and maybe years), we can move on.

At the same time, there are many individual stocks which have had the snot beat out of them — and they are not going to stay at bargain values.  The Russell 2000 Value Index advancing by 4.67% while the rest of the market was mixed and down is an indication of where capital will find its best stewarts:   the companies whose earnings are the steadiest, come at the largest discount and with the lowest debt.

Note:  I am having some problems with WordPress’ post editor.

A Study of Market Recoveries

Fg. 1: Unemployment Rates, Non-farm Payroll Change m/m and the Dow: 1948-2008

The stock market is driven by the availability of capital coupled with stocks being the most attractive investment vehicle.  The American stock market has also benefited from foreign capital in-flows due to its having both the largest companies in the world and massive liquidity.  More recently, the procedes of foreign owned American consumer, corporate and government debt has also been re-invested through American investment banks.

The last source of capital availability is monetary inflation.  Monetary inflation, however, will not raise the real value of any kind of security – stocks, gold or bonds.  In many case, particularly bonds, this actually leads to wealth destruction.  Gold is also destructive of producticity:  the total value of gold takes production away from the economy in the cost to mine it, transport it, hold it and secure it.  It certainly has been a vessel to retain wealth, but this is not an investment strategy – it’s a wealth presevation and storage facility at best.

Fg. 2: Unemployment rates peaking 4 months and 10% later in 1949

A Story of Recovery

The most directional of economic data is likely the unemployment rate.  Figure 1 shows the unemployment rate on the bottom half in red.  The unemployment rate is erratic, highly directional, and an immediate (monthly) statistic exposing the contraction and expansion of the economy in very real human terms.  When the economy is contracting, it is very difficult for new business to grow.  A recovery in unemployment rates is almost always preceded by market action.

Fg. 3: Unemployment rates peaking 6 months before the massive 1958/I 1959 bull market

It’s also important to note that the market dynamics weighs information differently depending on the context.

Conversely, the market tends to be overly optimistic at tops.

To address whether the valuations of US companies are attractive enough to invest in, we must look at the P/E ratio to see how expensive stocks are relative to their earnings.  What that number will be is currently up in the air:  we’ve just entered earnings season, and we’re going to find out how bad it really is out there.  This is combined with the October end-of-fiscal-year effect – we’re in for some more volatility to be sure.

Top-Down Analysis For The End of the Year

The top US banks are not overly leveraged — especially considering their European counterparts.  This fellow here has listed the top banks by assets governed in the USA and Europe and their leverage ratio.  I have no idea how the Europe is going to get out of their mess.  750B should be more than enough stablise the lending markets.  It wouldn’t even come close to allowing European banks to safely deleverage.  They’d better hope that train stays on track.

What it will do is help restore profitability in the financial sector – particularly in the Mortgage Investment, Investment Brokerage, Credit Services, and especially Regional Banks and Money Center Banks.

To put this in perspective, there are roughly $10.461 trillion dollars in consolidated assets held in major banks (assets governed of more than $300 million).  The top 5 banks hold half of that.

Up to date (Jun 30/08) debt/equity ratios:

JPMorgan Chase    -    9:1

Bank of America   -    9:1

Citibank               -    13:1

Wachovia             -    53:1

Wells Fargo          -    4:1

The plan of action is quite clear:  these big banks need to be kept profitable to maintain their shareholder equity and absorb the weaker banks with the help of the government.  Were these institutions to fail, The Great Depression would look like a cakewalk.  They make up for more than 5 trillion in deposits – roughly 1/3rd of the entire size of the US money supply.  Are we rewarding bad management?  No.  JPMorgan Chase, Bank of America, Citi and Wells Fargo are now put in the position of being able to save the rest of the lenders with their conservatism and some money supply inflation.  The key here is to do as much to stablise the credit markets and restore confidence as possible while having the print the least number of dollars.  Printing too many will result in a currency flight – but it won’t be to Euros (they’re going to have to print at a rate 3x ours), but probably rather hard assets.  Since hard assets (precious metals) are entirely productively useless, that would slow the economy down even more.

With profit margins on that 5 trillion managed only being around 34 billion, the 700B could be used to take the leverage ratio of the top 5 banks down to just over 5:1.  Over the course of a year, that would double their current profit, and the S&P 500 would gain roughly 20% from this action alone.  Hopefully this would grease the wheels and allow businesses to borrow and compete as usual.

I consequently think that the worst case 12-month return from this point is 20%.  I don’t think that this is a long-term solution in any stretch of the imagination – but it’s actually not our side of the Atlantic that’s really the problem when you compare our paltry 17:1 asset weighted average leverage to their 32:1.  The net result will be even larger EU sponsored packages which will allow their lower leverage banks to merge with more dangerously levered ones, and as a consequence, I suspect that the US economy is going to be quite a bit more competitive than the EU zone for the next 2-5 years.

Long a pair of ES contracts at 1143 and 1120 for the long haul.  I suspect the S&P 500 will particularly stand to benefit from the large exposure to large capitalised bank stocks which will see part of the “bail-out” go directly on their balance sheets.