Lelands Newsletter#27(Apr May09)


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Lelands Newsletter#27(Apr May09)

  1. 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. WILKINS CAPITAL MANAGEMENT 1
  2. 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. WILKINS CAPITAL MANAGEMENT 2
  3. 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’. WILKINS CAPITAL MANAGEMENT 3
  4. 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. WILKINS CAPITAL MANAGEMENT 4
  5. 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. WILKINS CAPITAL MANAGEMENT 5
  6. 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. WILKINS CAPITAL MANAGEMENT 6
  7. 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 Find this commentary interesting? You can subscribe to my stock trading update service for a quarterly fee of $150. I provide real-time updates of my buying and selling activities along with an overview of my investment portfolio and the reasons for my trading decisions. Find this commentary bothersome? Simply send an email to info@wilkinscapitalmanagement.com stating in the subject ‘REMOVE’ and you will be removed from my emailing list. Disclaimer: I am not a financial advisor. This email is not a solicitation to purchase or sell any 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 WILKINS CAPITAL MANAGEMENT 7