E-piphany

The Initial Claims data this morning was a bit of a shock, coming in at 479k. The BLS said there were no special factors affecting the numbers, and explicitly said the auto-retooling distortions are probably no longer affecting the data. It’s only one week of a volatile series – and the day before Payrolls, at that – but if we get another couple of weeks like that it will begin to look like the second leg of the recession is starting earlier than expected. Equity index futures reacted negatively and the bond market opened lower while bonds rallied.

It probably had nothing to do with the day’s activity, but I also saw this headline. “Bankruptcy Filings Ticked Downward In Parts of South, But Rose 9 Percent Overall.” Despite all of the stimulus and the directed efforts to forestall filings, bankruptcies are up over the last year. They are highest in the places the real estate bubble was bubbliest, and lowest in the places where the bubble didn’t get as frothy. But overall, the fact that they are higher is sobering after so much stimulus.

Stocks eked out a moral victory but a small point loss (-0.1%), while 10y note yields fell to 2.91%. The VIX was basically unchanged; with Employment tomorrow it will likely fall again if stocks are near unchanged on Friday as the event risk passes.

That Employment report is shaping up to be fairly important. With the FOMC meeting in only a few days, it will be the last major piece of data the Committee will see. Recently, Chairman Bernanke (consciously or unconsciously) raised the importance of what is often a lagging indicator when he told Congress, “We are ready and we will act if the economy does not continue to improve, if we don’t see the kind of improvements in the labor market that we are hoping for and expecting.” Today’s Initial Claims data raises the bid even more, although as I said it is just one week.

Last month, Payrolls fell 125k, with private payrolls +83k. The Unemployment Rate unexpectedly dropped from 9.7% to 9.5%; most economists expect it to rise to 9.6% tomorrow although Daiwa and Deutsche both expect it to fall further to 9.3%. I am not sure why; it may be tactical. Last month, the ‘Rate declined mainly because the number of discouraged workers rose to a new cycle high, and as those people give up and drop out of the workforce they are not counted as unemployed. So the ‘Rate might fall if the economy is booming, or if the economy is really doing poorly. Maybe those economists want two chances to be right? For me, I’m with the consensus.

The consensus estimate for total payrolls tomorrow is for -65k, with private payrolls stronger at +90k. I am fascinated at the confidence in the continued strength of private payrolls, especially given the decline last month in average hours worked, combined with a relatively rare decline in the hourly earnings rate, and the surge in discouraged workers. Not that +90k is any great shakes, but…I’d be more worried about the first negative print since December. But all 54 of the economists surveyed expect a gain in private payrolls, from +20k to +150k. It seems more ripe for disappointment, to me.

A bad number may not necessarily be horrible for equities. I would think a decline led by selling from people who perceive bad growth as being bad for stocks might be met by buying from people who think quantitative easing Part Deux could be good for stocks. Still, given where the indices are, I don’t think I would fade a selloff.

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So – TIPS out to 5 years have a zero real yield. What this means, curiously, is that physical commodities are now competitive in terms of return with short TIPS. Over the long term, the real return on physical commodities is, by definition, zero (you had a pile of gold; you still have a pile of gold; ergo, your return in units of gold is zero). This is why I never advocate individual commodities as investments; commodity futures indices, on the other hand, have other sources of return: the return on collateral for the contracts, the risk premium, the rebalancing return, the convenience yield, and the phenomenon of expectational variance. That’s too much to go into here, but the point is that although I have never owned an ounce of gold (or silver, copper, nor a bushel of corn), I own GSG, which is an ETF (iShares) designed to track the S&P GSCI Commodity Index.

With TIPS’ real yield around zero, however, is gold now attractive? I don’t know that I would go so far as to say “attractive,” since a 0 real yield in the long run isn’t good and you can still beat that with long TIPS, but it may also diversify a portfolio since it won’t move very much like TIPS or other assets, and that will produce a small return from rebalancing over time.

The real question, though, is whether gold is in a bubble. If it is, then you won’t get a 0 real return over time; you’ll get a negative real return once the bubble unwinds (whenever that may be). But I think there’s a cogent argument that can be made that gold isn’t in a bubble at the moment.

Let’s compare the price of gold with the price of a couple of other real assets, so we can abstract from the whole question of whether gold is a good hedge against declining greenbacks. First, let’s look at a classic relationship: the number of barrels of oil you can buy with an ounce of gold. The chart below shows the front gold contract divided by spot oil prices.

Barrels of oil an ounce of gold will buy

With two volatile series, it isn’t a big surprise that the resulting series is volatile. But it seems “fair value” here is around 15-20. You can clearly see that gold looked cheap in the early 2000s – when no one had the courage to buy it! – and remained at a fairly cheap relationship to crude as both rallied up until 2008. Then crude collapsed, too far it seems; and they are now in a comfortable relationship to one another. Either they’re both rich, both cheap, or both about right.

The next picture is gold against stocks. The picture here is less clear. Gold was clearly too expensive relative to stocks in 1980; clearly too cheap in 2000; it is hard to say that the current level for gold is outrageously high.

The ratio of gold to the S&P 500 index

Finally, let’s look at gold versus the median sale price of an existing home. (The axis is 1000x the actual ratio of an ounce of gold to the price of a home, because the median home price series I am using was in thousands and I figured this was more readable anyway).

Gold/Median Existing Home Sales Prices (x 1000)

This picture is the least pleasant for gold. The long-term average looks like 4-5ish, and if you cut off the gold bubble three decades ago, it looks like gold is in uncharted territory. But I think this is the least instructive of the three. Crude is the most-similar asset: a hard commodity that trades on international exchanges. Stocks are less-similar; they pay dividends and represent heterogeneous corporate fortunes and valuations, but they are traded on international exchanges. Housing prices are least like gold. They are entirely local, and the housing stock completely changes character over time. I am not sure this last picture can tell us much about whether gold is currently overvalued or not, although it is a modest warning.

All in all, I think there are no real signs that gold is in a bubble at the moment. With real yields around zero out to the 5-year point, gold (probably through an ETF like GLD) is a defensible investment. Then again, my book also has a zero real return over time. So buy a pile of them, and sock them away in a vault with your gold. They’ll probably be worth something some day.

Just don’t let it go to your head, like in this classic episode of Gilligan’s Island!