Gold Stocks May Signal Shift

Note: The bottom in the S&P 500 (point E / red line) is not shown above - it occurs in late 2002.

The three charts below show the 2008 rally in gold stocks off the October lows. While the general stock market made lower lows in late November 2008, gold stocks made a higher low which is positive. Last week, the blue downward sloping trend line from the July 2008 highs was broken, which is also positive. The Gold Miners ETF (GDX) closed Friday at $28.67. We may consider taking some positions if GDX can break $33.60. If GDX cannot rise above $33.60, we will remain patient and protect principal. A continued rally in gold stocks would signal concerns about future price inflation.

Just as the U.S. dollar reversed in July of 2001, at some point in the current bear market we can expect the government's expansion of the money supply to catch up with the dollar. The moves off the recent highs in 2008 are thus far muted, but warrant our attention. The GM, Ford, and Chrysler bailout could be the straw that breaks the dollar's back.

TIPs, Treasury inflation-protected securities, are bonds that adjust their payments in an effort to keep up with published inflation. A sustained move off the bottom in TIPS would signal a shift away from concerns about deflation and towards inflation. Once they can find their footing, TIPs should offer an attractive risk-reward profile.

Stocks lagged inflation-friendly assets in terms of finding a bottom in the 2000-2002 bear market as shown in the first chart above. The charts below compare the 2002 bear market bottom to the lows made in November 2008. My primary concern about the current stock rally is the lack of sustained volume, which is compared at points a (2008 volume) and a1 (2002 volume) below. As we covered in our last update (Fundamentals, Valuations, and Technical Trends), I am also concerned about the lack of industry group leadership in the U.S. stock market.

Concerns Will Shift From Deflation to Inflation

Reasons to consider high-grade corporate bonds:

LQD is an exchange traded fund (ETF) that owns a diversified collection of investment grade (a.k.a. high-grade) bonds. LQD is paying approximately 5.8%. Bonds in the portfolio include those from Abbott Labs, IBM, Johnson & Johnson, Pepsico, UPS, and Wal-Mart.

Why have we been buying short-maturity CDs in recent months yielding between 2-3% when you can get some corporate bonds that pay between 10-20%?

• Default and economic risk
  
• The Fed may lower interest rates to nearly zero, which means new CDs and money markets will soon pay almost nothing. Locking in some higher (yet still low) rates of return will help us avoid declining CD and money market yields in the coming months.

The Fed is almost certain to lower interest rates on Tuesday of this week (12/16/09). The cuts will put the Fed's benchmark rate between 0.25% and 0.50%. CD rates will fall first, then money markets. Fortunately, we still have numerous CDs on the books paying between 4-5%. During the last radical cutting cycle by the Fed, the Schwab Money Market Fund hit a low yield of 0.35% in April of 2004.

Demand for government Treasury bonds was so high at last week's auctions investors were willing to accept a 0%, or even negative, return. There are two primary reasons for this: (1) fear and legitimate concern over the economic outlook, and (2) large institutions have limited options in terms of finding safe places for cash. As individual investors, we can use FDIC insured CDs (1-12 months) to get a positive return and safety of principal. A large institution will exceed FDIC limits rapidly, which makes even 0% Treasuries attractive in uncertain times. When fear levels start to decline and credit markets show even some moderate improvement, we can expect to see a rush out of Treasury bonds. Yields will rise and prices will fall rapidly. For now, we must respect the negative signals about the economic outlook a 0% Treasury is sending.

Due to rapidly declining rates of return, CD and money market investors will soon be looking for alternatives. Since Treasury bonds are in a mini bubble and pay low rates of return, the next logical step may be for investors to look at high-grade corporate bonds. High-grade bonds are issued by more stable and better capitalized companies.

While yields on bonds from less stable and more debt laden companies looks very appealing, the risk to our principal remains high. High Yield Bonds did not stop losing money until October of 2002 in the last economic downturn. Stocks also bottomed in October of 2002. Therefore, unless you think stocks have found a bottom, you should continue to be very careful chasing yield of any kind. As we covered in our last update (Fundamentals, Valuations, and Technical Trends), problems in housing are expected to continue for some time, which continues to lessen the appeal of stocks and commodities.

High-grade corporate bonds fared much better than high-yield bonds in the 2000-2002 bear market (as you would expect). The performance of high-grades in 2008 is not as encouraging (see below). What is somewhat encouraging is that high-grade corporate bonds have made some higher highs, and higher lows since they reversed in early October 2008.

Dan Fuss, a respected and successful bond fund manager, recently said, "I have never seen an opportunity, relative or absolute, as good as this to buy in the investment-grade bond market." Opportunities do exist, but we also must respect the risks which remain. With the economy weakening, we will continue to see default rates on all bonds rise. As a result, I prefer to use a diversified and easily liquidated approach, like an exchange-traded fund (ETF). Buying bonds from one company paying 10% sounds good, but if the company defaults, you could lose 100% of your principal. Even experienced bond experts have had trouble identifying default risk in this environment. They have been wrong about the credit worthiness of several companies since the credit markets began to become unstable. Buying an individual bond also carries liquidity risk, especially in times of crisis or panic. Selling a bond is much different than selling a stock. Bonds must be placed out for bid. In a weak market, while you are rapidly losing principal, you may not get a bid. Your bond may just sit there with no offers. With a diversified ETF, like LQD which trades over 800,000 shares per day, we can use stop-loss orders to determine in advance where we want to get out and protect principal. I think it is too early in the cycle to be buying individual bonds - too many unknowns about balance sheets, the economy, and liquidity.

I think the proper strategy is to remain skeptical, but to put a plan in place that allows us to take a 7-8% stake in high-grade corporate bonds if the market can begin to close a recent gap made during rapid price declines in September and October 2008. As shown in the chart below, a more aggressive entry would have us buy LQD if it can hit $95.17. A more conservative entry would be to enter if LQD can hit $102.78. For some clients, it may be best to buy some at $95.17 and then add some more if it can hit $102.78. At $95.17, we would be getting an annual dividend of roughly 5.70%. At $102.78, our yield would still be near 5.28%. The difference lies in the potential to gain 7.99% in share price appreciation between $95.17 and $102.78. The risk of being wrong and having LQD resume its downtrend is lower at $102.78. If LQD cannot continue to advance, we will remain patient and protect principal.

Plans for Both Principal Protection and Purchasing Power Protection

Chris Ciovacco
Ciovacco Capital Management

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