1. WILKINS CAPITAL MANAGEMENT
April-May 2009
Abstract:
The financial markets have continued the rally that began in Oct. 2008 for gold
mining shares and March 2009 for U.S. equities. This essay discusses why the
current rally is underway and the structural and fundamental problems with this
rally while highlighting some indicators that can be used to pin-point the peak of
the current rally and to allow readers to shift their investments from risky to safe
assets (which will again be the asset class of choice from 2010-2011). I will also
discuss some ‘misunderstandings’ the mainstream press has about the markets
and the current stock market rally.
The Rally:
Prices of all financial assets have been increasing. This is due to a number of
factors, the most important of which is the massive increase in liquidity brought
about by Central Bank interest rate policy and Government increasing the money
supply and deficit spending.
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2. WILKINS CAPITAL MANAGEMENT
April-May 2009
Now that money supply growth has resumed, prices will resume their up-trend.
This will affect all assets, although it will likely benefit assets that have a structural
limit to their production levels, such as commodities and gold.
The best performing asset class will be gold and (gold mining shares in particular.)
This is due to the inability to increase gold supply in the face of higher prices and
the fact that the price of gold has fewer economic inputs than other commodities. In
other words, the price of gold will directly reflect the increase in money supply,
while other commodities will increase based on a combination of increased money
supply and economic growth. Because gold does not require economic growth to
increase in value, it has performed better than other commodities and this will allow
for continued share price increases (and profit increases) for producers of gold.
The Fundamental Problem:
The problem with the current rally is the fundamental and structural inefficiencies
that originally caused the economic collapse are being exacerbated by the current
government response. Instead of allowing the bad debts and inefficient (stupid)
investments to go bankrupt and get cleared from the market place,
1. The government has taken numerous bad loans onto their balance sheet (from
the banks) preserving the semblance of our banking sector, while delaying the
recognition of losses and delaying the day in which we hit bottom in our loss write
offs. This will lead to greater distortions in the market place going forward.
2. The government has attempted to make up for a lack of U.S. borrowing by
expanding Government borrowing & spending. Unfortunately the government is not
as efficient at deploying capital as the private sector and this will eventually cause
MORE busted investments going forward.
In effect the private capital markets have told the government it is a bad time to
invest and in response the government has TAKEN capital from the private sector
and invested the money anyway, AND paid their bureaucratic buddies a
management fee to boot. This is why I believe we have NOT seen the bottom in the
U.S. equity markets and I believe things will get much worse before they get better.
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3. WILKINS CAPITAL MANAGEMENT
April-May 2009
3. The result of increased Government borrowing will be higher long-term interest
rates and higher inflation down the line. This will further harm long-term business
growth and will result in a declining premium to be paid for equities.
If you can get 8% risk free bonds from the Gov’t, why purchase equity which can
default and only pays a dividend of 4%? This is the question people will be asking
themselves going into 2010 and the answer will be to buy bonds and sell equity.
Only when equity trades at a significant discount to risk-free bonds that people will
find true long-term value in holding stocks. This won’t happen for YEARS.
As long as the fundamental problems exist, we have to believe we are in a bear-
market rally and not seeing the beginning of a true long-running bull market.
4. Higher taxes are bad for business. The current administration has proposed a
number of tax hikes which I will not detail here. Needless to say, higher taxes will
contribute to less growth and protracted stagnation in our economic development.
Knowing we are in a bear-market rally allows us to keep an eye out for certain
indicators that the rally is ending. This will allow us to beat other market participants
to the punch and to sell our stocks just as the mainstream media convinces the public
that we are ‘finally coming out of the dark’ and ‘a new bull market is beginning’.
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4. WILKINS CAPITAL MANAGEMENT
April-May 2009
The Indicators:
I will be looking at a handful of indicators to point to a trend change in the end of
2009 and the beginning of 2010 (note: not all markets will simultaneously peak, gold
will likely peak first, equities second and energy last.)
VIX and VXO (implied volatility of options) will be a critical tool to pinpoint
optimal selling opportunities. As the public belief is a sustainable rally becomes
greater, it will be reflected by VIX and VXO moving below 20.
Media Hysteria, including promoting the latest rally, and reminding readers of
numerous reasons why ‘it is different this time’ will be another valuable indication
of a top.
Volume spiking followed by a significant reduction in volume will be another sign
of a top. I will use the spike in volume to move out of stocks that are generally less
liquid. (Micro-Caps).
Valuations that are no-longer compelling will be a slightly less useful indicator.
While high valuations will be an indication not to buy, valuations can go from high
to higher and this will be a less useful tool to pinpoint the top.
Divergences in the markets, such as only the most large cap names in the sector
continuing to rally (while the rest are putting in lower highs), or multiple markets
having put in lower highs but market X continues to rally, will be a sign that market
X will be the next to peak.
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5. WILKINS CAPITAL MANAGEMENT
April-May 2009
The Misunderstanding:
The mainstream media has become used to the idea of bull markets being long-term
growth based upon consumer spending in the U.S., while bear markets are short-
term events caused by evil speculators that the public should ‘sit out’. This mindset
can be observed in many publications waiting for a ‘final low’ ‘towards the end of
2009’ before a ‘strong, sustainable rally’. This mindset can also be observed given
the fact that most analysts will consider a bull-market (i.e. the safe place to get into
the market) to be in effect after a 20% increase in prices. Similarly, if prices decline
by 20% usually it is considered time to get out of the market.
This way of talking about the markets completely ignores the fundamental changes
to economic development and Central Banking policy following the Asian Financial
Crisis of 1997 and the Nasdaq Bubble of 2000 (i.e. The U.S. entering a 15-20 year
bear-market). The details of these changes are too great to cover in this short essay,
however, I would like to point out a few examples that I believe are representative of
the mainstream investors mind-set. Hopefully I can discuss the ‘misunderstanding’
in greater detail at another time.
Ex. 1 The government knows what they are doing and can help
Ex. 2 Inflation isn’t a problem
Ex. 3 The media knows what they are talking about
Ex. 4 Buy and Hold is a reasonable investment strategy
Ex. 5 Bear markets are short-term events
Basically, if you understand that Ex. 1-5 are all NOT TRUE, then you have an
advantage. The false understanding of current events has helped created the deeply
oversold markets we observed earlier this year. As inflation skyrockets and growth
stagnates, the public will come to believe in owning gold and other commodity
related investments, as the demand for heat, transportation and a sound method of
saving wealth will continue to be in demand even if people aren’t buying new
houses, cars and flat screen televisions.
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6. WILKINS CAPITAL MANAGEMENT
April-May 2009
Note in the chart below the long-term trend change in long-term U.S. interest rates.
This multi-decade shift will be one of the most important factors to consider when
making investments over the years to come. Many investors believe we have
deflation and further interest rate declines in store, as the reality of higher interest
rates becomes more apparent, public investment money will flow to new places.
I will detail some places money will flow as a result of higher interest rates in future
essays. In the meantime, it is important to realize a long-term uptrend in interest
rates will have a dramatically negative effect on asset prices and growth throughout
the world, and to prepare for the implications of this long-term trend shift.
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7. WILKINS CAPITAL MANAGEMENT
April-May 2009
In conclusion:
You want to hold the gold and commodity stocks you bought in Oct-March.
If you don’t own any gold or commodity stocks, buy some on the next dip in price.
When VXO and VIX are hitting new lows, the media is gushing about gold, prices
are going parabolic and treasury yields are hitting multi-year extremes, it will be
time to shift your money to treasury bonds and short-positions.
In the meantime hold your positions.
If anyone has any questions, feel free to email me at lelandwilkins@myway.com
-Leland Wilkins
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securities. I recommend speaking with a financial advisor or other investment
professional before making any purchase or sale decisions. This report may include
information obtained from sources believed to be reliable and accurate as of the date of
this publication, but no independent verification has been made to ensure its accuracy or
completeness. Opinions expressed are subject to change without notice.
The graphs provided in my update were made available by thechartstore.com and copied
from Dr. Faber’s newsletter the gloomboomdoom report.
An Archive of my newsletters can be found at the following site:
www.wilkinscapitalmanagement.com
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