The Retail Gold Rush

Gold bullion is at record highs, and is set to rocket still higher. At least, this is the official sentiment of The London Bullion Market Association. But with prices already at record highs, is this the time to buy gold or the time to sell it?



There are two reasons commonly given to buy gold now. The first is that gold is a store of value. That is, although inflation eats away at the value of currencies, gold has a value that cannot be taken away. The second reason is that uncertainty drives gold prices higher, and today’s markets are certainly uncertain.

Gold is indeed a store of value, a currency, a component of jewelry and electronics, and more. The problem is that gold – like other commodities - usually keeps up with inflation and the business cycle but does not exceed it. In the past 3 years, however, gold has exceeded inflation greatly. Fear and speculation are the drivers of gold prices now.

Earlier this year, we saw the advent of gold-to-go machines. These vending machines hold a quote for 10 minutes, then scan the market and recalculate so the customer is always getting an up to date (but marked up) price. In Europe, these machines can be found in airports, hotels, and even supermarkets. For me, the gold-to-go machine marked the entry of retail “stupid money” into the market - money that arrives too late and stays too long.

If gold vending machines weren’t enough, consider the rise of solid or yellow gold miniatures. A few years ago, gold miniatures were an exclusive novelty. These days, the windows of high-end Chinese jewelry stores are loaded with solid gold rabbits, dragons, boars, oxen, and popular cartoon characters. The miniatures are popular with Chinese, since they offer a way to store wealth for posterity while simultaneously flaunting it.

The final sign of the gold peak is the de-hedging process of the gold producers themselves. In order to reduce income fluctuations caused by changing gold prices, most gold producers partially hedge their gold using futures or options. For example, companies buy futures that go up in value when gold goes down, and that go down in value when gold goes up. By hedging with futures, companies will not benefit as much from rising prices, but they will also not get stung by falling prices (arguably more important for profitable companies).

This year, many major gold producers have greatly reduced or even stopped hedging in the expectation of forever-rising prices. Barrick Gold, AngloGold Ashanti, Gold Fields and other companies have reduced their gold hedging by millions of ounces.

So, is gold going to drop? Should you short it?

At this point, there is still widespread fear all over the world, and this is partially justified by a worldwide housing bubble and precarious economies. Shorting gold at this point is probably not justified. However, neither is jumping on the bandwagon.

Gold prices are high – really high. Both as an investment and as a novelty, gold is more popular now than it has been in a very long time. I would refrain from buying. If you already own gold, consider selling some.

If you believe the world's currencies are being debased and you need to protect yourself, buy producers of commodities that have uses beyond merely a store of value - such as oil, uranium, lithium, and copper.

Buying something at the peak of its popularity is not always a stupid financial move, but statistics are against you.

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"My dear girl, there are some things that just aren't done, such as drinking Dom Perignon '53 above the temperature of 38 degrees Fahrenheit."

Sean Connery as James Bond, GoldFinger, 1964

Rare Earth Metals – China’s Trump Card?

Historical enemies Japan and China are at it again, this time about a disputed territory in the Diaoyu islands (known as the Senkaku islands in Japan).

On Sept 7th, two Japanese coast guard ships collided with a Chinese fishing vessel (or perhaps spy ship, since fishing vessels are used as spy ships by many nations). The Chinese captain (agent?) is now incarcerated in Japan, and Chinese officials are demanding his release.

There are many uninhabited "islands" in the oceans East of Japan, some of which are no more than lumps of rock a few inches above sea level, surrounded by concrete and tetrapods so they don’t wash away. The islands are important, of course, because whoever owns them can claim the surrounding mineral rights. At least, this is the presumption, despite a UN convention that “rocks that cannot sustain human or economic life of their own shall have no exclusive economic zone…”

What is interesting about this most recent incident is that China may be playing the “rare earth metals trump card" to end the conflict.

Rare earth metals are used in batteries, wind turbines, lasers, cell phones and other high-tech devices. In this latest diplomatic incident, China's customs clearance of rare earth metals into Japan has been “delayed.” China of course denies that they have implemented a trade ban.

Since China produces the vast majority of the world’s rare earth metals (more than 97% by some estimates), rare earth could become a handy negotiating tool for China in the future.

There is no doubt that rare earth metals - and therefore rare earth mining - will be an important area for investors to watch in the years to come.
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See also:

Govt Probing China's Rare Earth Trade Embargo

China will never waiver on issue of sovereignty: experts

Chinese people's willingness to travel to Japan drops amid diplomatic dispute

China denies tightening rare earth trade

Mabuchi worried about China fallout
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“Life is really simple, but we insist on making it complicated.”

Confucius
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Thank you, Frost Report Readers!

Last Wednesday marked the 10,000th unique visitor to the pages of The Frost Report.

I would like to thank all those who have visited my site, and all those who took the time to email me with their feedback and ideas (marketsandfinance AT gmail.com).

I try to reach strong conclusions only after studying all the facts (never predetermined), and point out prevailing illogical bias whenever possible. I am suspicious of any news article that gives opinions without revealing the facts that formed them. And, as every good investor should, I regularly try to prove myself wrong.
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To date, the top five all-time favorite articles for The Frost Report are:

Spin City

Chinese Real Estate - Trip Report

Stocks I Like – Citigroup

The World Housing Bubble

The US Economy - Headed in the Right Direction?
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Thanks again for your readership, and cheers to more insight in the future!

E. Frost,
The Frost Report

Mad About Taxes

The media and the public are divided and angry.

Some people, such as billionaire Warren Buffett, say that tax increases for the rich are “fair,” since the rich currently pay less tax than the poor. For others, any increase in taxes for the wealthy is an example of socialist government, and a disincentive for hard work.

The expiration of the Bush tax cuts has been called “the wrong move at the wrong time.” This expiration, combined with Obama’s proposed tax increases for those earning more than $200,000 per year has been dubbed the “small business killer.” Should we be worried?

When I worked as a lender, a consistent thing I noticed about small business owners is that they claim to have almost no income. A man could own a successful business, drive a Mercedes and take annual vacations to France, yet according to his company's financial statements be making $20,000 a year. This was normal.

For lenders, the financial statements of small business owners can be frustrating. Owners typically often write off so much (to avoid taxes) that it becomes difficult to approve their loans.

“Just show a little more income next year,” lenders often tell business owners.
“But then I will have to pay income tax," the owners counter. "You know I make lots of money. Can’t you just approve it?”

The proposed tax changes would raise taxes for individuals earning $200,000 per year, or families earning $250,000 per year, with lower taxes for those earning less: this is hardly a small business killer. A small business owner that shows an income of $200,000 per year would, in all likelihood, be earning at least 3 times that much - and there are simply not many small businesses pulling in that level of income.

Then there is the debate about lowering taxes for the middle class. Many members of the middle class themselves are opposed. Personally, I find this hilarious. One of my favorite things about the GOP is that they have actually convinced people earning less than $200K a year that tax cuts for the rich are good for the economy, but tax cuts for themselves are unnecessary. I love it! Gullibility knows no limits.

From an economic standpoint, lowering taxes for the nation’s middle class makes sense. The middle class tends to live “paycheck to paycheck,” spending almost everything they earn. Any decrease in taxes (increase in money to spend) would go directly into the local economy. High-income earners, on the other hand, tend to save more, or spend their money overseas. In terms of boosting the economy, a tax decrease for low- and medium-income earners gives far more bang for the buck.

Being that the US has a record deficit, somebody’s taxes need to increase. Increasing taxes for corporations is a bad idea, since unemployment is still far too high and corporations are the nations largest employers. Tax increases for the middle class is also a bad idea, since their spending levels (which constitute most of the US economy) are already low. The wealthy are the best choice for tax increases, because their personal spending levels will be least affected.

Tax cuts for the rich after the economy is rolling smoothly again – sure, why not? Everyone believes in the American dream. Everyone believes that someday, they too will earn more than $200,000 per year. And, they want to make sure tax levels are low when they get there.
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“In 1790, the nation which had fought a revolution against taxation without representation discovered that some of its citizens weren't much happier about taxation with representation.”

President Lyndon B Johnson

The Failure of Incubator Bank

Incubator Bank of Japan, which specializes in loans to small and medium-size enterprises, filed for bankruptcy last Friday. With it, the assumed infallibility of the Japanese bank failed as well – a profound moment.

In Japan, corporations typically partner with a bank from inception, and never change. The loyalty of companies to their banks, and vice versa, is therefore extremely high. Traditionally, this meant that a bank would give loans to its corporate partners, even when it was clear that these companies were on the brink (or over the brink) of insolvency: this was considered "dedication."

The failure of Incubator Bank is profound because the bank was actually allowed to fail. The Deposit Insurance Corporation of Japan - which protects customer deposits up to 10 million yen - was instituted way back in 1971, yet this is the first time is has ever been used.

Though Incubator Bank is relatively small, large Japanese banks will recognize this as the warning shot that it is. The Government will not allow a long recession of zombie companies - barely alive - to occur again.

The Japanese financial system is coming of age, and the “modern zaibatsu” (interconnected business-banking conglomerates), are no longer untouchable. The failure of a Japanese bank is a sign that the system has become more mature, confident, and responsible. Japan Inc. has been warned.
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"Always strive to stay one step ahead. Standing still is retrogressive."

Nomura Tokuanden
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American Economic Dictionary 2010

Knowing this list of terms will not help you make money in the stock market. It will, however, give you a few laughs at a cocktail party (or a few nods of agreement, depending on your crowd).
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Bankster – n. A banker, since bankers and gangsters have the same profession (stealing).

Bernanke Clown Confetti – n. Common stock certificates.

Big Casino (The) – n. The New York Stock Exchange.

Corporapists – n. Evil organizations (corporations) that no one can trust, despite the fact that most people who believe this belong to one.

Green Shoots – n. Any hint of economic recovery, no matter how small. Popularized by CNBC’s Larry Kudlow.

Helicopter Ben – n. Ben Bernanke, Chairman of the Federal Reserve Board. The nickname comes from a speech he gave in 2002, in which he referenced economist Milton Friedman's metaphor of a helicopter dropping money on the community as a way to rescue the economy.

Hummer – n. A heavy, unaffordable, and somewhat useless off-road vehicle. Also denotes buxom women who date only wealthy men (ie. “Watch out, she’s a hummer.”)

McGlobalization – n. The evil result of cultural export (ex. Hamburgers in France, or rap music at nightclubs in Mongolia).

Nuclear Banana Republic – n. The USA

Perceived Recession – n. An economic situation that makes life uncomfortable for an extended period of time. The technical definition of recession (two consecutive quarters of negative GDP) no longer applies, since by this definition the US is already out of recession.

Sheeple – n. Individuals who do not recognize that the world’s economy is under the control of big business/Jewish Zionists/communists/hedge funds/The Federal Reserve/ Literati/Right-Wing Christian Fundamentalists/The Freemasons, or any combination of the above.

Staycation – n. A vacation spent at home, since one can’t afford to go anywhere.

Toxic Waste – n. Income products composed of sub-prime loans. Named by the traders who sold them to unsuspecting clients.

Turbo-Tax Timmy – n. Timothy Geithner, United States Secretary of the Treasury. Named for an incident during his stint at the International Monetary Fund, where he blamed his late income tax filing on the popular tax preparation software “Turbo Tax."

Zero Interest - n. The basic rate of interest during the credit crisis. Also used to denote the lackadaisical attitude caused by the credit crisis (ie. "I'm not going to the party. Zero interest.")
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“Men can acquire knowledge, but not wisdom. Some of the greatest fools ever known were learned men.”

Spanish proverb

Pessimism is Wonderful

At dinner parties, coffee shops, classrooms and churches, the common voice of America is focused on the same two topics: recession & unemployment.

I have personally never seen a collective outlook so hopeless and dejected, where being positive about anything is seen as foolish. In short, the opportunity to invest in stocks continues to be wonderful.

I have written ad nauseum about the fact that times of great pessimism are the best times to buy stocks. But, since people find this so counter intuitive, here is the reason expressed in simple numbers…

Stock prices are determined by two major factors – company earnings and popularity. Times of pessimism tend to follow some great crisis that hurts company earnings and creates walls of worry.

Worry causes people to pay less for what earnings companies have, as reflected in a low price-to-earnings (P/E) ratio. During times of prosperity, the average P/E ratio of the market might be over 20. During times of deep pessimism, the average P/E of the market might be in the single digits. For the patient investor, the effects of company earnings and market P/E over the course of the business cycle is profound.

Say, for example, that during a recession, manufacturer General Electric's earnings are $1.00 per share at a P/E of 15, giving it a stock price of $15.00. After a few years, as the economy improves, GE’s income returns to $2.00 per share (the same level as before the recession, assuming that the company doesn't grow at all). At the same time, newly optimistic citizens begin buying stocks again, and stock prices rise to an average P/E of 20. This means that GE will now be priced at $2 x 20 or $40. Since one business cycle takes from between 3-7 years, in seven years or less you could make a return of 267% (from $15.00 to $40). The stock market rewards patience well.

At present, company earnings are low, P/E ratios are low, and negativity is high - the perfect formula for value investing.
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“The most common cause of low prices is pessimism - sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer.”

Warren Buffett
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Disclosure

Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.
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Throwing Away Money on Rent

“I want to buy my own place. I don’t want to ‘throw my money away’ on rent anymore.”

As a banker, I hear this sentiment often.

Amongst the reasons renters want to purchase their own place is because it annoys them to “give their money to a landlord” every month, allowing the landlord to get rich.

For most people, buying real estate is indeed a worthwhile and sensible economic decision, to say nothing of the pride of ownership and positive sense of responsibility that comes with owning a home. However, many renters have a twisted idea of how their finances will change once they purchase. To illustrate, I will use “Bob,” a typical renter.

In Bob’s marketplace, he pays $1000 per month for a 1-bedroom apartment with den, with hot water and cable TV included. He hates the idea of throwing away $1000 every month, so decides to purchase a condo in the same area.

Bob buys a $260,000 condo, using a down payment of $30,000 and a $230,000 mortgage. Bob’s monthly mortgage payment is $1234.69. He pays an additional $200 per month for condo maintenance fees and $100 for property taxes, for a total monthly payment of $1534.69. Bob is pleased with his decision. What Bob is not aware of is that he is actually “throwing away” more money now than he was prior to his purchase.

Bob’s first monthly payment will be $1534.69, of which $958.33 will be interest, $200 for maintenance fees and $100 for taxes, with only $276.36 going toward the principle. That is, Bob is now “throwing away” $1258.36 ($1534.69 – $276.36) - a full $258 more than before, not including the utilities and cable that he now has to pay for himself. Over time, more of Bob’s money will go toward the principle, but at the moment Bob is deeply in the red compared to his previous situation. Did Bob make a mistake?

In order to make a wise real estate investment decision, certain rules are best followed:

1) Don’t buy into a declining market (or an exceptionally “hot” market which could soon decline) unless you plan to stay in your home for several years. It is best to purchase when values during the previous 6 months have been roughly flat or rising. There is no point paying $276 toward the principle every month (like Bob), if the value of your property is dropping more than that.

2) Don’t purchase unless you intend to stay in a place for 3+ years, with 5 or more being optimal. During shorter periods of time market values can decline (see Rule 1), and fees (such as moving fees, agent commissions, taxes etc) will take a bite out of any potential profits.

3) Buy something well within your comfort zone. No more than 32% of your monthly pre-tax income should go toward mortgage payments and condo fees.

4) Make sure you have fallback funds. Too many people put all of their savings toward a purchase, leaving nothing for emergencies.

If Bob intends to stay in his property for 5 years or more, has funds set aside for emergencies, and has purchased in a flat or rising market, he has probably made a wise investment decision. Over the years, his monthly payments will remain the same while local rents rise, with more of his payment going toward the principle (and less toward interest) every month. And, he will see his property increase in value while he enjoys living there.

Real estate can be a great investment. Just make sure you do it right.
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“The only difference between a cult and a religion is the amount of real estate they own.”

Frank Zappa, musician

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Bob’s Mortgage

Principal = $230000
Interest Rate = 5%
Amortization Period = 30 Years
Bob’s monthly payment is $1234.69
First year mortgage amortization schedule (click to enlarge):

ETFMFs – Money Maker (but not for you)

Due to low fees and the ease of buying & selling, Exchange-Traded Funds (ETFs) have developed an excellent reputation amongst small investors. In fact, many people are cashing in their mutual funds to purchase ETFs through discount brokerages (such as E-Trade, TD Waterhouse etc.).

To compete, the mutual fund industry has retaliated with perhaps the most senseless investment product created in years – the Exchange-Traded Fund Mutual Fund.

Traditional Exchange-Traded Funds (ETFs) are similar to mutual funds. Each ETF is actually a “basket” of stocks, so by purchasing a single ETF you make a small investment in several companies. For example, if you buy stock symbol ZEO (A Canadian Oil and Gas Index Exchange-Traded Fund), you purchase a portfolio of common shares of Canadian oil and gas companies. ETFs are therefore a great way for the small investor to diversify.

There are 2 major things that make ETFs superior to mutual funds. 1) ETFs can be bought or sold at any point in the day, instantly, just like a stock. In contrast, mutual fund prices are determined only at the end of the day, and require 1-3 days for processing. 2) ETFs have lower management fees than mutual funds - sometimes much lower.

An Exchange-Traded Fund Mutual Fund (ETFMF) is basically a basket of ETFs, put together to form a mutual fund. That is, you take stocks from several companies and put them in a portfolio, then take several of these portfolios and put them in a portfolio, and the result is an “ETFMF.” With an ETFMF, you get all the disadvantages of a mutual fund with none of the benefits. You pay the high fees of a mutual fund, except now in multiple layers (since you pay the ETF fees, and then mutual fund fees on top). And, you cannot buy or sell them in the market like real ETFs, since they are actually mutual funds.

The reason ETFMFs were created, from what I can tell, is to satisfy naive customers who don’t really understand what an ETF is. Now, customers can ask a mutual fund salesperson, “Do you sell ETFs?” and the salesperson can answer “Yes.” Other than this, I see no benefit to them whatsoever.

If you want to buy a mutual fund that is similar to an ETF, buy an Index Mutual Fund, which is also a basket of companies and has low fees. If you want to buy an ETF, buy a real ETF. ETFMFs are a hybrid product that someone dreamed up in a back room, and have no place in your portfolio.
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“It’s likely that some don’t even know that these fees are being deducted from their funds or who they are ultimately compensating.”

SEC Chairman Mary Schapiro, regarding mutual fund fees.
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