In Barrons recent cover story (see Barrons article), roundtable members were once again interviewed about their thoughts on the economy, the markets, and select stocks. While there was varying opinion about the short-term outlook, many believe that the market has gotten ahead of itself, with some expressing longer-term concerns - even if the a short-term rally continues. As a hedge against the recent government spending spree and potential coming hyperinflation, some have stressed their continued interest in gold (one analysts with a $850/ounce entry point). The short-term stimulus / long-term worry perspective was articulated by Felix Zulauf, stating that:

"The U.S. economy will look a little better in the next two to three quarters, due to inventory restocking and fiscal stimulus. But the improvement won't continue after mid-2010, when the economy turns bumpy again."

Zulauf goes on to state that:

"The market undershot into March, and will probably overshoot in the first half of next year. The first rally is just about done. The market might climb into July, but it will correct in the fall, with stocks retracing maybe 50% of the recent advance. That will provide an opportunity to buy for a rally next spring or summer. That's the whole mini-bull market. Economic conditions won't support more than that."

Fred Hickey goes on to mention that while there are similarities to the 1930s, the current situation is different in that by adding liquidity, we may be recreating the very problem we were trying to solve. As mentioned by Hickey:

"The situation is reminiscent of the past 14 years, when the Fed primed the pump and created bubbles everywhere."

In a different Barrons article (see second article), Michael Darda, chief economist at MKM Partners, is more optimistic short and long-term, and expects the market to bottom this summer. As evidence, Darda points to the money base, measuring currency-in-circulation, bank reserves, and vault cash (see second Barrons article). The money base is now near a record high of around 2.9 times the stock market's value, a value that is slightly below a higher value in February (right before stocks took off), but below the average of 1.5 over the last 20 years. As Darda points out, the value was below 0.9 times as the stock market peaked in 2007. And while rising yields on the 10-year Treasuries have reduced refinancing, and threaten to lower home prices, Darda points out that what is important is the spread of the yield curve. The current slope is signaling strength, and not giving an inverted slope recession prediction.

But Darda does concede that while futures are pricing in a 50 bps increase in short-term rates by the end of the year, he expects unemployment levels and politics will keep the Fed from raising rates - in what could be a choice of risking a "repeat of the 1970s than a repeat of 1937-1938." This perspective of short-term moves followed by long-term concerns is in line with Arthur Laffer's recent higher inflation / higher interest rates op-ed piece in the WSJ (see previous post). In the article, Laffer highlighted that in:

"shorter time frames, the expansion of money the expansion of money can also result in higher stock prices, a weaker currency, and increases in commodity prices such as oil and gold."

Of course, over the long-term, such effects are much more negative, not only for the economy, but the market as well. Therefore, while good economist seem to vary somewhat on the short-term outlook of the economy and market (not unexpected), most agree that the longer-term consequences of the 2008 credit crisis and subsequent spending will provide a challenging environment at best going forward, especially long-term. As mentioned before (see previous post), plan accordingly.

There is an excellent opinion article in the Wall Street Journal today by Arthur Laffer (see WSJ article). In the article, Laffer discusses the increase in the monetary base, and how in the past 95% of the monetary base was composed of currency-in-circulation. Even with the recent unprecedented increase, cash-in-circulation has risen only 10%, now making up less than 50% of the monetary base, whereas bank reserves have increased nearly 20-fold. Granted, an increase in bank reserves was needed as a result of the liquidity issues of 2008 in order to make it possible for banks to begin lending again, but the balance has shifted too far. Laffer points out that banks will no doubt continue to make loans until they are once again reserved constrained. Currently, as banks make more loans and put more money into the system, the growth rate of M1 (currency in circulation, demand deposits, and travelers checks - see wikipedia article) is now around 15%. This of course will result in higher inflation and higher interest rates. As mentioned by Laffer,

"In shorter time frames, the expansion of money can also result in higher stock prices, a weaker currency, and increases in commodity prices such as oil and gold."

Does this market situation seem familiar? Unless the Fed acts to reduce the monetary base, which appears unlikely anytime soon given that there is no easy approach or outcome (see the Laffer article), it appears likely that the Fed will continue to lose control over rates (see previous post), and the markets will continue to tip towards inflation (see additional previous post). Plan accordingly.

Even while equities were rallying over the last few months, some well-known hedge funds were increasing their exposure to gold (see WSJ article). Some of those buying gold, gold futures, and shares of gold producing companies include Greenlight Capital, Paulson and Company, Eton Park Capital Management, and Blue Ridge Capital Holdings, among others. Yet, instead of providing a hedge against a market correction, the move appears to be motivated more by a worry of excess spending and borrowing by the government, resulting in an eventual spike in inflation, and rally in gold prices. While the recent market run has scared some away from the trade, many others are staying long, and even adding to positions, with current gold-related hedge fund investments coming in on average around 5 percent of assets. With gold still holding above $900 an ounce, there is some worry that a crowded trade will keep the shiny metal from moving much higher in the short-term. Nonetheless, for those with a longer investment horizon, there is still an expectation that the excessive printing of money will eventually cause the chickens to come home to roost, validating those who continue to stay long gold.

In a recently published research paper in the Journal of Applied Corporate Finance, Tim Adam (from the MIT Sloan School of Management) and Chitru Fernando (from the University of Oklahoma Michael F. Price College of Business) report in their research paper "Can Companies Use Hedging Programs to Profit from the Market? Evidence from Gold Producers" that during the 10 year period of 1989-1999, the gold derivatives market was characterized by a positive risk premium that resulted in short forward positions generating positive cash flows. The authors found that the gold mining companies that hedged their production during this time realized an average cash flow gain of $11 million, or $24 per ounce of hedged gold per year, compared on average to an annual net income of only $3.5 million without hedging. Of interest is that as a result of the positive risk premium that resulted from a positive spread between the forward price and the realized future spot price, short derivatives positions did not result in significant losses, even when the price of gold increased. In summary, hedging helped increase profits.

Also of interest in the article was the finding that there was also a significant level of volatility in corporate hedge ratios, implying that some managers were incorporating market timing into their hedging strategies (no surprise, as hedgers will sometimes begin to speculate). The authors found that attempts to time the market by "selective hedging" were futile and unprofitable, even causing the company to consistently lag the markets as they attempted with little success to successfully adjust their hedge ratios in response to expectations regarding market direction.

In summary, hedging helped profits, but the benefits were from hedging, and not from the risk managers ability to predict price moves as they set their hedge ratios. Therefore, one can expect, at least for the gold mining companies, that while earnings and profits may remain volatile, those investors holding longer-term investments should see higher returns from companies that successfully implement and execute a defined hedging program that do not try to engage in market timing. While it is difficult to know when any company that you are investing in begins to move from hedging to market timing, at least knowing that a company is hedging will give you the potential for higher returns as long as you can weather a few up or down moves that may temporarily reduce profit margins.

Money continues to flow into gold assets and gold ETFs (see Time Online article). The SPDR Gold Trust has expanded its holdings by 26 percent since the Lehman Brothers failure. South Africa has temporarily run out of krugerrands, and the US Mint has also temporarily suspended sales of American Buffalo bullion coins (American Eagle coins were already halted in August). Maybe this is a contrarian sign. The market action today certainly is promising.

Commodities have fallen into Bear Market territory, down 21 percent as measured by the S&P GSCI Index (see Bloomberg article). Amazing, the bear market defined 20 percent or more move down has occurred since the July 3rd highs for the index, just a little over a month ago. Specifically, gold is off 22 percent from its recent highs, silver is down 33 percent, platinum is down 36 percent, and crude oil has fallen 23 percent. The move is certainly what you would call a serious short-term correction, and starts to make you wonder when and if a snap-back is going to occur, even if the move is just temporary. Nonetheless, the weak reaction of crude oil to the recent military issues in Georgia certainly makes one suspect that crude oil wants to go down further. It will be interesting to see how this plays out. The $110 and $100 prices should be the next interesting decision points for crude.

At the same time gold prices fall below $900 (off 10% in a few weeks), Newmont Mining is reporting that it plans to spend nearly $250 million on exploration this year - and the increase is not just because gold is commanding a high price. Apparently there has been a shrinking number of gold finds above five million ounces, a key number to make a mine worth the trouble, or at least produce better margins. About 4 percent of reserves meet this benchmark. Apparently Newmont is depleting its reserves at 10 ounces a minute, but needs a replacement of 14 ounces a minute (I assume to keep up with supply and maintain reserve capacity). Currently, Newmont has about 86 million ounces of gold in reserve. In comparison, Barrick Gold Corp held about 124 million ounces in reserve, as of last year. Like other industries, commodity prices (i.e., energy), are increasing the cost of production.

Tickers: NEM, ABX