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Don’t shun commodities!

March 27, 2007

CRB Spot Index overlaid on Dow Jones Industrial Index

>>Commodities are in a secular uptrend likely to last another 10-15 years. The DowGold Ratio chart affirms this fact as does the chart above showing the long term historical performance of the CRB Spot Index* plotted against the Dow Jones Industrial Index.

>>Viewed down the diagonal line in the chart above, the performance of the CRB Spot Index and the Dow Jones Industrial Index has been antithetical to an uncanny degree.

 >> Given that western equities are in secular downtrend, there is every reason to believe, based on this unique historical relationship, that commodities are likely to continue trending upwards for a number of years yet.

>> The unique relationship between US equities and commodities makes them a great asset class for diversification purposes and lends themselves to a buy and hold ideology using a suitable commodity fund or well diversified portfolios of commodities.

>>The economic growth stories of India, China, Russia, etc all add credence to this view. Given that commodity infrastructure takes time to build, demand is likely to outstrip supply in the short term leading to higher prices.

 >>But don’t go in blindly: remember, there will be cyclical vacillations within this secular uptrend that will test your nerves  – as we are currently enduring. We never go up in a straight line.

Commodities undergoing a cyclical correction

CRB Index is currently in the cyclical bear phase of the secular uptrend – don’t lose faith!

>>Trading the cycles by participating in the bull phases of the cycle and avoiding the bear part increases the chance of profitability. Within the class of commodities some will be more appealing than others – especially the more liquid commodities (Copper, Oil, Gold, etc). Choose those commodities that appeal to you – both on a risk and return level.

>>Certain commodities(especially the more liquid ones traded by hedge funds) are more prone to unsustainable parabolic rises – owing to speculative activity as more and more traders and speculators catch onto the “hype”. Parabolic rises, while fun on the ride up often end in tears on the way down. This is only normal, as prices fall to more “fundamental values” to readjust to the long term story.

Copper has also exhibited parabolic rises

 Copper has exhibited bouts of parabolic price** rises fueled by speculative price action

Gold prices parabolic indicating speculative activity

Gold has also exhibited parbolic price rises** over the period 2005-2006, explaining why it has been very volatile since, attempting to adjust to more normal levels.

>>Investors needs to be cautious of such activity which, unfortunately, results in high volatility especially if adopting a “buying and hold” strategy for commodities.

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*The CRB Spot Index is a bellweather for Commodities and more information on this can be found from the creators

** Parabolic rises are easily identifiable by their charcteristic rocket-like rises. They can also be identified by calculating the deviation of the price action from some mean value – in the chart of gold and copper above, the deviation from the 200D MA has been calculated and the results compared to the long run history. It is observable that during parabolic rises, the deviation of price from its 200D MA surpases two standard deviaitons – a truly rare event(statistically!)

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Dow Jones all time new highs – don’t be fooled

March 9, 2007

S&P 500 Historical Chart illustrating secular trends

>> This chart took me quite some time to piece together* but I feel it was time well spent to make an important point: we are trapped in a period dubbed a secular bear market** in American (and Western Equities) – likely to last another 15 to 20 years; refer to the Dow Gold Ratio chart

>>So how exactly can this be true given that the Dow Jones is making all time new highs and the S&P500 is edging ever closer to its 2000 high?

>> Referring to the chart above, we observe that US equities (measured using the S&P 500 barometer) have had the tendency of either trending upwards for extended periods or remaining in a trading range lasting several years. The earlier phenomenon, referred to as a secular uptrend in equities was keenly observable over the periods 1921-1929,1949-1966 and 1982-2000, whereas the latter occurence coined a secular downtrend(or bearmarket) – a period in which US equities have either fallen in price or oscillated in a trading range – was evident over the years 1900 – 1921,1929-1949 and 1966-1982

>> Also observable in this chart is the fact that secular uptrends in US equities have been demarcated by periods of rising P/Es §, otherwise known as valuation expansions and secular downtrend(secular bearmarket) phases have been defined by periods of valuation contractions (falling P/Es).

>> Like prices, P/Es are witnessed to oscillate like a pendulum – rarely settling at fair value and frequently swinging from extremes of overvaluation to undervaluation and back again over a number of years. Over the period 1966-1982, despite a 190% growth in earnings, P/Es contracted from a high of 25 to a low of roughly 28, coinciding with a secular bearmarket in US Equities at the time. In other words, it’s not enough for earning to be growing – the rating on those earnings must be growing as well, to realise a secular bullmarket in equities.

>> Another interesting fact to point out,based on this chart, is that despite the S&P 500 ending up at roughly the same point in 1980, than it started at in 1966, the index lost over 60% of it’s value to inflation over this period (see inflation adjusted chart)! The same trend is observable over the periods 1900- 1921 and 1929 – 1949. Secular bearmarkets simply do not provide sufficient protection to your capital from inflation.

>> A buy and hold strategy for US equities over these periods simply DOES NOT work, for this reason! In order to make money from equities over these period, active management (stock selection and trading the cycles becomes critical to success).

>>Now, coming back to the question we started off with :”How exactly can the Dow Jones(American Equities) be in a secular bearmarket given that it’s making all time new highs?”

>> The bubble in US equities in 2000 bolstered valuations to astronomical levels (observe how far valuations trended over this period above the overvalued level!) – a high of 45 in contrast to the historical mean of 17! Since then, US equity valuations have been in a period of contraction ( a simple 5 year moving average of historical PEs has been trending lower since the bubble peak in 2000) and are not likely to stop until they become very cheap – called a secular bearmarket! Also supporting this belief is the fact that despite the Dow Jones having surpassed the 2000 high (partly due to it’s orthodox construction), it is currently 10% below this value in inflation adjusted terms, whereas the S&P500 – a much more representative bellweather for corporate America, is currently 21% below it’s 2000 high! All these facts have portended to a secular bearmarket in US equities.

Dow & S&P inflation adjusted

Dow & S&P 500 inflation adjusted performance compared to original Dow & S&P 500

>> There are other facts that support this theory – such as the mass retirement of the baby boomers from some time in 2008 onwards, which is likely to put a strain the US economy and especially the health care sector. We won’t try to predict this ,we’ll just keep monitoring the charts.

>>Putting these facts together, what this means is:

  • We are likely to see the dow/S&P 500 continue trading in a range for several years to come, at times possibly testing the range but failing it.
  • Inflation adjusted, both indices are likely to continue falling – you are really losing capital!
  • A buy and hold strategy applied to US and Western Equities is destined to fail – active management is needed in the form of superior stock selection and trading the cycles within the range
  • On a buy and hold basis, US treasuries are likely to outperform US equities over this period.

>> So the next time you hear that the Dow has made a new all time high, just calm down before you jump through a hoola-hoop with your investment money.

Read the rest of this entry »

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Will the US housing market cause a recession?

March 7, 2007

US NAHB Traffic of Prospective buyers - a precursor for the S&P500 market?

>>A very interesting chart that illustrates an overlay of the US NAHB Traffic index*and the S&P 500 index, with the former lagged 15 months.

>>Historically, real estate downturns have had the tendency to lead the US economy into recessions and stock market slumps: In 1994, the bull market in stocks was portended by the NAHB index and in 1999, its decline starting in 1999 adumbrated the equity market wipeout the following year. Unsurprisingly, this index rebounded in November 2001 – approximately a year in advance of the stock market upswing that commenced in October 2002.

>>More worringly, in recent times – since July 2005, to be precise – the index has wiped out from a high of 55 in July 2005 to a low of 22 in September 2006; an incredible drop of 60%! According to the New York Times,  “The slump in home prices from the end of 2005 to the end of 2006 was the biggest year over year drop since the National Association of Realtors started keeping track in 1982.”

>>If historical correlations hold (the index has had an 84% correlation with the direction of the S&P 500 with a lag of 15 months from 1996-2006), then the US equity market could waterfall on the back of a weakened US economy. The fear is that this could occur this year!

>>Surprisingly, so far the US economy has remained resilient to a recession notwithstanding the slump in the housing sector. Normally, a weak housing market has meant a slowdown in the construction sector and a fall in construction materials. It is also not unexpected that construction-related employment should take a hit – especially considering that 30% of all jobs created since the end of the last recession in 2001(1.4 millin) have been in sectors related to the US housing market boom (according to an estimate by Capital Economics).

>> The ripple effect of the housing crash is often reduced consumer spending and increased unemployment. Over the past several years, the rising price of properties in the US has allowed consumers to support their consumption with cash flow derived from borrowing against their homes – an activity dubbed Mortgage Equity withdrawal . With house prices rising, this has been a key contributor to consumer wealth(U.S. homeowners pulled more than $450 billion in equity out of their homes in 2005), allowing consumers to treat their homes like ATM machines. With house prices falling now, consumption is likely to take a hit as the ATM machines go bust – or so goes the theory! Given that consumption constitutes 70% of GDP in the US, it’s only reasonable that a slowdown in consumption would precede a slowdown in GDP growth.

>> For now, there’s little hard evidence that the housing slowdown is dragging the US economy into a recession.  The economy grew at a sluggish 2.2 percent pace in the final quarter of last year, much slower than initially reported, battled by the weak housing market. With mounting concerns that mortgage lenders might be hurt by the increasing level of defaults and delinquencies especially in the sub-prime area , the fear is that each negative development is likely to fuels additional deterioration putting further pressure on the banks and sending the economy into a tailspin. We just hope it doesn’t get too ugly!

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*NAHB Traffic Index – Derived from a monthly survey that NAHB has been conducting for 20 years, the NAHB/Wells Fargo Housing Market Index (HMI) gauges builder perceptions of current single-family home sales and sales expectations for the next six months as either good, fair or poor. The survey also asks builders to rate traffic of prospective buyers as either high to very high, average or low to very low. Scores for each component are then used to calculate a seasonally adjusted index where any number over 50 indicates that more builders view sales conditions as good than poor.

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Dow Gold Ratio 1896 – 2006 showing secular trends in US equities and commodities

March 2, 2007

Historical Dow Gold Ratio

Dow Gold Ratio 1896 – 2006 showing secular trends in US equities and commodities

>>The Dow Gold ratio is a unique way of illustrating the fact that Western Equities have historically tended to trend over durations lasting generations.

>> It measures the number of ounces of gold it takes to purchase a unit of ‘the Dow,’ in essence replacing fiat currency(the dollar) with specie currency(gold).

>> A rising Dow/Gold ratio (1920-1928,1940-1965 and 1980-1999) has marked periods of secular uptrend in the Dow Jones Industrial Index i.e. periods in which US Equities have significantly outperformed physical commodities (gold, etc). A buy and hold strategy applied to US equities over this period has proven very successful.

>> A falling Dow/Gold ratio (1928-1934,1965-1980 and 1999-ongoing) has marked periods of secular downtrend in the Dow Jones Industrial Index i.e. periods in which US Equities have significantly underperformed physical commodities (gold, etc) and a buy and hold strategy applied to US Equities for secular periods has proven generally unsuccessful. Over these periods, active management and specific stock selection has been the way to add value.

>>Interestingly enough, despite the Dow Industrials making new all time highs in 2007, the long term trend of the Dow/Gold ratio remains unfaltered and gold continues to outperform the Dow(US Equities).

>>A simple extrapolation of the Dow/Gold ratio reveals that the secular downtrend in US Equities will end somewhere between 2015 and 2020.

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UK Equities Relative Strength Performance comparitive to UK Government Bonds

February 26, 2007

UK Equities relative to UK Government Bonds

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Investing using chart ideas

February 23, 2007

Welcome to simplycharts.wordpress.com

The idea of this blog is to give you simple charts to compliment your investment ideas. Please feel free to comment on these charts and give useful feedback.

Good luck!