Sector Rotation: An Alternate Goldbug Scenario

By Kurt Kasun | November 14, 2007 | 4:05 PM | 2 Comments

Sector Rotation: An Alternate Goldbug Scenario

I don't think that I can remember a more tumultuous three-week trading period than the one we just experienced. My portfolio designed exclusively to take advantage of two major trends-the decline of the US Dollar and the rise of the rest of the world (mainly BRICs and emerging markets)-was alternating between the agony and ecstasy of investing in these high-performing groups on a daily basis as my personal "Daily Performance and Sentiment" chart below indicates.

 

Notwithstanding November 12^th's white knuckle one-day 13% plunge, my portfolio performance remains north of 20% since I began tracking on September 1. I live for beta. Sharpe, Sortino, and Treynor ratios are not in my vocabulary. In case you think I am overly bold I must reveal that I sold half of my portfolio that day, exiting margin and ending the day wondering what was next. I have only two rules to guide my investments:

1. Don't try to be a hero (always live to fight another day)
2. There are no other rules

During the last few days leading up to and including Monday of this week, it was difficult to discern what was happening (other than the fact that the monstrous gains I had accumulated since Sep were quickly vanishing). Turning to the charts, I think we might finally arrived at some clarity. November 12 might turn out to be the "washout" day. It appears that we just went through (survived if you are long) a three-month retest of the mid-August market drop. The CBOE Volatility Index (VIX--a measure of fear as much as a measure of volatility) peaked on August 16 at 37.50 when the S&P 500 bottomed out at 1370.60. Monday's VIX topped out at 31.09 and the S&P 500 1438.50 as the charts below indicate:

 

From a technical perspective, the lower high in the VIX and higher low in the S&P 500 is very bullish. There can be no guarantee that the November 12^th VIX and S&P levels will hold. In order to confirm I would like to see a close on the S&P 500 index above 1510. A failed attempt for stocks to rally above the 1500-resistance level would force me to reconsider my bullish prognosis.

The term "bullish" requires clarification. I am not bullish on the US economy or US equity markets. I rather, think that the US popular equity indices will limp along and register comparatively paltry gains (especially in comparison to the rest of the world's stock markets and taking into account currency conversions against a dropping dollar) over the next year to 18 months. The economy will do even worse. While globalization and the accompanying commodity super-cycle will continue to be the multi-year megatrends that will trump all others, I think we could now be entering the serious downturn that many were expecting in the 2009-2010 timeframe. Holders of this prediction are expecting to first go through a period of stratospheric, internet-like gains in the commodities and emerging market equities before the bottom falls out and the world collapses, rocketing the price of gold to the moon.

An equally, if not more likely scenario, is that we witness a cooling off of some the sub-sectors/countries that have been undergoing parabolic gains and some of the lagging sectors emerge as the new leaders during a period of prolonged economic uncertainty as the housing market woes in the US persist and US consumers begin the painful process of weaning themselves off of their credit-induced consumption binge. The virtuous cycle of securitization, cheap financing, consumption, and economic growth and symbiotic relationship between the "financial" and "real" economies are quickly reversing. Both booms (real and financial) were based on leverage, and the ability to leverage is being expunged.

As a result my expectations/assumptions are:

1. US Government core inflation indicators remain contained.
2. Instead of a 6-12 month recession, the US economy enters a 3-year period of 0-2% GDP annual growth.
3. The Fed lowers Fund rates to 3.0% by the end of next year.
4. Housing shows no signs of bottoming for at least two years.
5. The leverage phase for the US consumer is over-consumer spending declines-sectors reliant on US discretionary spending over this period significantly under-perform.

Based on the above and assuming the world's central banks maintain ultra-expansionary monetary policies, I think that gold and silver's time to shine could be right in front of us. I think that the biggest threat during this period will be global monetary disorder. Expectations and mass psychology are on the brink of major change/inversion. Fears of hyper-inflation or deflation will mount. Expecting prices of assets (principally real estate) to deflate and prices of heretofore contained goods and services to inlfate (if this were to occur) would likely be disruptive to the economy and financial markets. I think that gold and silver will be among the top performing asset classes during this period of uncertainty. But I expect BRIC/emerging markets, industrial metals, and infrastructure sectors to resume their leadership position once again sometime over the next 18-24 months.

This scenario, though painful and scary, avoids the Armageddon prediction with gold shooting above $5000/oz. While I don't totally discount the apocalyptic outcomes, I just think that, barring some Archduke Ferdinand-type event, the momentum behind the forces of globalization, urbanization, and industrialization are too strong to be overcome other than cyclical hiccups along the way.

Some are pointing to resource constraints (primarily-peak oil which I am a proponent of) as a major restraining factor where the global growth story hits a wall. I think that we be innovative and resourceful enough to surmount these substantial hurdles once we a forced into realistic solutions...which brings me to my new sector/sub-sector allocation model. While I am most bullish on precious metals, the next sector I am most bullish on is energy. While this would comes as little shock, what might a little more surprising is my hyper-bullish position in coal. To put it quite simply, if the period of anemic economic growth sets in as outlined above, then I expect concerns over carbon emissions and global warming to take a backseat to affordability anxieties of consumers struggling to balance their check books. While the price of oil has tripled, the price of coal is only up 71% over the same period. The prices of fossil fuels are as follows: oil is $12.51/mBTU; natural gas is $6.91/mBTU; and coal is $1.98. You can expect to see more coal-fired plant construction and coal-to-liquids (CTL which is an alternative to diesel or gasoline fuel) projects being announced during this period of economic hardship. This is the topic for another commentary, but it is suffice to say I strongly concur with Dresdner Kleinwort's report titled, "Clean Coal - the New Black."

In addition to coal and the precious metals, I expect the diversified miners to modestly out-perform other sub-sectors-for their coal and precious metals assets, if for nothing else. They should also keep a bid under them as sector consolidation continues and a fear of "peak resources" persists. I have scaled back a little in my three infrastructure sub-sectors-heavy equipment, engineering and construction, and shippers-but with expectations of $30 trillion to be spent on worldwide infrastructure by 2032, they should also continue to move higher. Emerging markets have been also scaled back as most of them are in desperate need of a correction. Regarding energy, I will probably add to the oil sub-sector (currently no holdings) as the move in these names remains extended. Uranium and natural gas maintain small weightings. The price of uranium ore appears to be putting in bottom for the former and the relative valuation of the latter compared to oil remains compelling.

Lastly, I will note that my confidence in the immediate prospects for coal and precious metals are underpinned by the two facts: One, they are two groups which were in extended periods and consolidation and just began to rally after the August bottom, and two, they both were among the last to fall during the markets period of November market weakness. I will continue to rely on technical and sentiment indicators to confirm or reject this investment strategy.

coal? i like ur resource plays but isnt the world awash in coal? Submitted by jsjgold on Wed, 2007/11/14 - 10:36pm » reply |