Monday, May 20, 2013

Why Gold is The Canary In The Coal Mine

According to Pimco's El-Erian, gold is similar to Apple and Facebook - its valuation became stretched and disconnected with the underlying fundamentals and therefore its price could no longer be justified. This is a process he calls "stable disequilibrium".

In the real world, we call that "common sense"...

There's another even more important reason why Gold, Apple and Facebook were the first assets to be exiled from the Central Bank lovefest - it's because they all had high valuation coupled with low or no yield.

In the case of gold, it has a cost of carry (aka. storage costs), so its yield is actually negative. In the case of Apple, only recently did it pay a small dividend. And Fadebook was an overpriced clusterfuck from the get-go. Coincidentally, this week is the one year anniversary of the FB IPO and the stock is still ~45% below its IPO day high.

As some of us have pointed out, the rockstars in this current bubble rally, are the highest yielding stocks - an inevitable consequence of zero interest rate policy. Unfortunately, the higher the price goes, the lower the earnings yield becomes. For stocks, the earnings yield is the inverse of the P/E ratio i.e. it's 'E' over 'P'. So if 'P' increases, then of course earnings as a ratio of price then declines. 

Let's check in with my favourite 100+ year-old "high yielding" stock, J&J. At this price level its P/E is an historically lofty 24 which implies an earnings yield of ~4% i.e. lower now than junk bonds. A year ago, J&J's earnings yield was 6%, so its yield has now fallen by a full 2%. Therefore, what we have learned is that money will flow into each asset/sector, until such time as the yield is reduced, and the asset becomes overvalued and then money flows out causing a "re-pricing" a la. gold and Apple:


In another dividend-driven disconnect - what happened to globally diversified electronics maker Emerson Electric after its abysmal earnings release on May 7th? To recap, they missed their earnings estimates and the stock tanked after hours. Management had this to say:
After a weaker-than-expected February and March, orders in April continued to trend downward, according to the company.
"Economies around the world are struggling for momentum," said Chairman and CEO David Farr. "Demand slowed in the second half of the quarter as overall global business confidence deteriorated. We do not see a catalyst to economic growth over the next six to nine months."
Where is the stock now, you ask?  At a new 52 week closing high thanks to its dividend, however tenuous:


So let's see - a slowing global economy, U.S. corporate profit margins at all time high, stock prices at all time highs and a corrupt finance industry and media with its head shoved up its own ass. What could go wrong?

Lastly, unfortunately for those people who have deluded themselves into believing that this artificially manipulated market can disconnect permanently from the underlying fundamentals, the penalty for being wrong will be more than they can afford.