Gold, Housing and the Yield Curve
by John Mauldin
February 17, 2007
An Impressive Bull Run in Gold What the Yield Curve Tells Us GDP is AWOL That "Shocking" Housing Data A Family Road Trip
An Impressive Bull Run in Gold
One of the more frustrating things about being an analyst is to make a call and
then wait for what may be a long time before the market decides to approve of
your intuitive foresight ... or brutally punish your hubris. But it comes with
the territory, so if you have been doing this long enough, you eventually
develop some emotional calluses as well as a certain quantum of humility. Some
of the more dangerous characters in this business are those who refuse to
acknowledge they can be wrong and demand the market confirm their superior
wisdom. A good investment or great market call is evidence of their genius, but
if something negative happens, it is simply bad luck or an intransigent market.
Those who ride a bull need to realize that it is easy to get thrown off. Risk
controls are the mantra of the better players in the investment game.
I find the better analysts that I meet have a very refined sense of their
potential for being wrong at any given time. In fact, the better they are, the
more humility they seem to exhibit. They may pound the table when espousing
their point of view, and argue with great and laudable vigor; but they
constantly keep an open mind, looking to learn and grow with each missed call.
Thus, when you do make a call and the market decides to confirm your wisdom
fairly quickly, it is an easy thing to remember. It also is a reminder that luck
is a sometimes good thing. I became bearish on the dollar and thus bullish on
gold in early 2002. And it has been an impressive bull run.
Most of my bullishness about gold has been admittedly centered in my still
long-term bearish posture on the US dollar. And in the beginning of the run,
that was the correct position. But of late, gold has been in a bull market
across the board. My good friend and South African partner Prieur du Plessis
sent me the following graph and table, following a discussion on gold. While we
are familiar with the rise in gold in terms of the dollar, it is instructive to
look at how it has done in other major currencies (the euro, pound, yen and
Swiss franc):
For the last three years, gold has been in a bigger bull run in terms of yen
than in any other major currency, making new recent highs. And look at the
following table, which shows the percentage increase for gold in terms of nine
different currencies over the last two years:
Gold is at $668.50 and is having trouble busting through $670. There are
persistent rumors that there is a major seller at this level. Dennis Gartman (no
gold bug he, but he is currently bullish on the barbarous relic) writes this
morning:
"Moving on to gold, we note that the resistance between $668-670 has proven
formidable indeed, for gold has effectively traded within that range for the
half day prior to writing yesterday's TGL and for the past full day. Once again,
we've no idea who it is that is selling spot gold at $670, but it is someone of
very real consequence and with very material selling to be accomplished. Once
again, it may be a government, it may be a hedge fund, it may be miners hedging
forward production because of bank agreements made on a project or two or
three... it may be a combination of the above, or it may simply be very large
'specs' wishing to take profits on old long positions or wishing to get
materially short.
"All we care about is that it is someone or something that has thus far
successfully stopped gold from advancing, and with the week's end upon us, we
shall not be at all surprised to see that seller remain successful in keeping
gold from moving through his offers. Next week, however, the 'game' shall be
played with a bit more enthusiasm, and the seller... whoever or whatever 'he'
might be... shall have a far more difficult time keeping gold in check."
As I have said many times, gold is a neutral "currency." It is the one currency
that cannot be printed by a reserve bank, and thus, is a long-term hedge against
monetary deterioration. Gartman gives us a very wise quote from James Burton,
Chief Executive of the Gold Council, and one with which I totally agree. When
queried about whether a return to a gold standard is possible in the foreseeable
future, he answered:
"No - the gold standard was appropriate to the second half of the 19th century,
but circumstances are now different. But this does not mean that gold no longer
has a monetary role. It remains an important reserve asset for central banks
since it is the only reserve asset that is no one's liability. It is thus a
defense against unknown contingencies. It is a long-term inflation hedge and
also a proven dollar hedge while it has good diversification properties for a
central bank's reserve asset portfolio."
I would expect to see more developing central banks put some of their reserves
into gold over time, as the developed world sells some of their gold. I would
also not be surprised to see another bubble in gold develop at some point, as
there is something about the metal that seems to alter mental reality when it
starts to run. I hope not, for a bubble and the following aftermath would do a
great deal of damage.
What the Yield Curve Tells Us
The yield curve is the slope of the line between short-term and long-term
interest rates. In a normal world, you get more interest (yield) for
longer-dated maturities. But sometimes (rarely) the interest-rate world gets out
of sorts, and short-term rates become higher than long-term rates. The yield
curve is said to be inverted, as it is today - witness the graph from Bloomberg
below:
I have written at length about the various studies, first by Professor Harvey
Campbell of Duke and then later by New York Federal Reserve economists Mishkin
and Estrella, which show an inverted yield curve to be the best indicator of a
future recession. For those not familiar with the studies, you can go to my
December 30, 2005 e-letter to review:
http://www.investorsinsight.com/thoughts_va_print.aspx?EditionID=252
In short, the yield curve inverted significantly last fall; and if past
performance is indicative of future results, the studies suggest we should see a
recession as early as the late second quarter of this year, or more likely in
the third quarter. Note: we have never had an inverted yield curve as we
currently have without a recession following within about 4 quarters.
But a yield curve does not cause a recession. It simply tells us that something
wicked this way comes. Something is out of kilter in the economy. Looking back
at past recessions, it has been different things, so we can't look to history
with any sense of reliability to say, "This is it!"
So, when the yield curve gets inverted we must pay special attention. As we
examine the economic landscape today, what could bring about a recession or
serious slowdown? The service sector certainly seems to be in good shape.
Agricultural firms are getting record high prices. The financial sector, with
the notable exception of mortgage firms, is seeing ever higher profits. The
world seems awash with cash.
What could be the problem? As I have written for the past few months, I think
the culprit is going to be the housing market. Both as a result of a slowdown in
construction which will modestly increase unemployment, but more importantly as
a result of a decrease in the ability of the US consumer to borrow against their
home as home values go flat or fall and mortgage lenders have to tighten up the
credit standards. This is going to put a constraint on consumer spending, and
that is going to be enough to tip us into what I think is going to be a mild
recession.
Ken Fisher writes in this weeks Forbes that we have seen the bottom on the
housing market. "In the last six months housing stocks are up 24%, well ahead of
the market. If housing were destined to fall apart in 2007 these stocks wouldn't
be so strong now."
And maybe he's right, as the stocks are still relatively good values if they
meet their 2007-8 earnings projections. But the same argument could be made
about tech stocks in 1999. And the stock market was telling us in August of 2000
that the economy was getting ready to boom. The stock market does not always get
it right.
That being said, the data which has been coming out for the past few months has
not been kind to my predictions, but today we have new inputs which suggest that
maybe we are starting to see some cracks in the economy.
GDP is AWOL
Only a few weeks ago, we were told that the GDP for the fourth quarter was 3.4%,
which is rather robust. I must admit I was taken somewhat aback by that number,
as it did not square with the rest of what I was seeing. But you have to be
ready to admit you are wrong when you are. Only, we find the data is not as
robust as first thought.
The first estimate of GDP growth is done on a basis of estimates of inventory
and productivity, among other things. It turns out reducing inventories were the
basis of much of the growth estimate. Reducing inventories is not the same as
increased production. JP Morgan estimates GDP may have been overstated by as
much as 1%, and we will see that official number revised downward in the next
few months.
That "Shocking" Housing Data
This morning, while driving into the office, I was listening to CNBC. The
reporter was talking about the "shocking" housing starts number, which plunged
14.3%. As it happened, I was driving in with my daughter, and turned to her and
said, "There's nothing shocking about that number. It's what you would expect."
Well, maybe that's not quite the case. The lowest estimates were for about 6%
above what the actual number came in at (a 1.4 million starts pace, down from
1.6 million).
The number of homes under construction declined, the number of completions
declined, and the number of houses authorized but not yet started declined.
There is a simple explanation. Even with construction off more than 38% in the
past two quarters, inventories have only fallen by about 6% from a record high
in July of 573,000 homes.
Slower sales and cancellations of existing orders have caused the number of
unsold homes to pile up. The supply of homes at last year's sales rate averaged
6.4 months' worth, up from 4.4 months' worth in 2005 and 4 months in 2004. And
as the buying is slowing down, that inventory is rising. Sellers of previously
owned homes are lowering prices to drum up demand. The median price of a
previously owned, single- family home fell in 73 of 149 metropolitan areas in
the fourth quarter, a National Association of Realtors report showed yesterday.
Toll Brothers Inc., the largest US luxury home builder, reported a 33 percent
plunge in orders during the quarter ended Jan. 31. Ken Fisher has the company on
his buy list at 19 times what he calls depressed earnings. With today's
announcement it looks like earnings could get more depressed.
I think it is going to get worse as the sub-prime mortgage market starts to
cough homes that were sold the last two years back onto the market because of
foreclosures. Foreclosures are up five times in Denver, as an example.
Dave Seiders, chief economist at the National Association of Home Builders,
predicts that the cut in residential investment (construction) will shave one
percentage point from the economy's inflation-adjusted growth rate in the first
quarter, more than he was anticipating late last year.
But the real hit comes from the decrease in mortgage equity withdrawal. Let's
look again at the following graph. I know I have used it before, but it is at
the crux of my potential recession argument.
Mortgage Equity Withdrawal (MEW) accounted for over 2% of last year's GDP
growth. Take away that and 1% for construction, and we would have been close to
a recession.
Now MEWs are not going to disappear. This is the US consumer we are talking
about. They are committed to supporting world trade through increased borrowing.
No, the problem is going to be that MEWs are going to be harder and harder to
get, especially for sub-prime mortgages.
A decade ago sub-prime mortgages were a mere $35 billion. Today they are
one-fourth of all mortgages, about $665 billion. Somewhere in the neighborhood
of $1 trillion in adjustable-rate mortgages is eligible to be reset in the next
two years, sharply increasing payments and lowering the discretionary spending
ability of those homeowners.
But the real hit is going to be the inability of many to actually get loans. In
the same issue of Forbes where Fisher was telling us to buy home builders and
that the housing market is going to rebound, is a very interesting article about
the problems of sub-prime lenders. Here are some of the high (or maybe low)
lights.
Some 79% of the loans by FirstFed Financial were so-called stated income loans,
in which the borrower's income did not have to proven with W-2's, tax
statements, or payroll checks. The list of institutions with such problematic
loan policies is long. And the result is that there are going to be a lot of new
homeowners getting into financial difficulty. The Center for Responsible Lending
estimates that as many as 20% of the subprime mortgages made in the last two
years could go into foreclosure, or about 5% of the total homes sold. If just
half of those homes come back onto the market, it will cause home prices to
fall, limiting the ability of people to borrow, causing valuations to fall and a
reduction in MEWs.
Compound that with probable legislation sponsored by Democratic Congressman
Barney Frank and Senator Chris Dodd to tighten up lending standards and
disclosure rules, and you could see loans at the lower end of the market dry up.
And by the way, full disclosure requirements would be a very good thing.
The subprime mortgage market is going to be a scandal by the end of this year,
as these loans have been packaged and sold as investment-grade bonds by numerous
investment banks, mostly to European and Asian institutions. Some of these
Collateralized Debt Obligations, or CDOs, are going to default and there is
going to be a major wave of lawsuits.
So, will there be a recession? I still think so, and I think the culprit is
going to be the housing market, which is going to trigger a slowdown in consumer
spending, the first such slowdown since 1991. If Fisher is right and the housing
market is getting ready to take off, then I am going to be not just wrong, but
really wrong. We'll see.
A Family Road Trip
It is time to hit the send button. It is close to ten, and the poor editor and
tech support guy are waiting. And I have to get up quite early and drive to
Tulsa with some of my kids to watch my daughter cheer in her final home game.
These annual trips with the kids are actually fun, even though I am not much of
a fan of sitting in a car for long stretches. We'll have six of my seven in
Tulsa. We'll eat sushi and laugh a lot. Life is good.
One of my good friends, Dr. Gary North, distressingly lost his youngest son this
last week. I knew Caleb as a kid, as he was the age of my kids when we lived in
Tyler near Gary. I was particularly touched by the way Gary ended his letter
telling us about Caleb:
"Instead of sending an email of condolence to me, call your kids and tell them
you think they are terrific. Be specific as to why. It will help them work on
their good points. The older they are, the less you can do about their bad
points. Put your effort where it counts."
You can bet I will do just that this weekend. And it is good advice to all of
us. None of us knows the future.
I have adjusted much easier to the jet lag coming back from Africa than going. I
am back on Texas time. It has been a busy week, trying to catch up with office
issues, put in some writing and research time on my book, and a whole host of
things which seem to demand attention.
Have a great week, and get in touch with those you love.
