Indexology^® Blog

In honor of the upcoming 2014 Winter Olympics in Sochi, I thought it would be a good time to discuss gold, silver and bronze that are the metals in the Olympic medals. Since copper is the main metal in the bronze alloy, we’ll use copper as the index metal.

Let’s start with gold.  Recently, I had the privilege to discuss gold with Bluford Putnam, Managing Director and Chief Economist, of our partner, CME Group.  We talked about gold as a safe-haven, the central bank buying and the potential shutdown of miners – all which are factors that may cause gold to skyrocket or plummet.

In 2013 gold lost 28.3%, the most in a single year since 1981, when gold lost 32.8%.  Then, the recovery period for gold after the 1981 loss lasted 25 years. Also in 2013, central banks stopped buying gold and assets tracking gold ETPs fell by about 50%.  If history repeats itself, it may be a long recovery for gold but much depends on the fundamentals today.

Many investors who view gold as a safe haven, may be wondering if gold really is a safe haven. According to Blu, there will always be some investors that hold gold as a safe-haven but the central banks are the keepers of the money and hold gold. Although they started buying in the 1990-92 period, they stopped last spring since either they didn’t like the price action or they felt they had enough gold in their portfolio to be diversified. Given this, Blu feels the probability of disaster has really gone down, especially since many central bank actions have been put into place to prevent another storm. 

It seems a slowdown in central bank buying is clearly bearish for gold, but the relationship between monetary policy and gold is rather subtle.  According to Blu, if we start to see inflation but the Fed takes no action, that may be strong for the gold price since the Fed will be behind the curve. On the other hand, if the Fed takes early action and decides to move before inflation, they will be ahead of the curve and that is not good for gold. Blu stated that there is a much higher chance the Fed will be behind inflation but that inflation may not occur until 2015.

The last area of discussion between Blu and me centered around the impact of the gold price drop on gold miners. While some of the gold miners may have fallen into negative territory in 2013, some may not have been impacted since they may have hedged and locked-in an earlier, higher price. However, as the gold price approaches $1,200, Blu says that there might be some mine closures, but the reverse case of gold mining closures impacting the price of gold does not hold since when gold mines close the gold doesn’t disappear.  The much bigger influence in the price of gold is from the jewelry buying from China and India.

Now for the fun part, let’s compare the metals of the medals. Below is a picture of what the Sochi 2014 Medals look like:

To any Olympic athlete, gold is the goal; however, that may not be the case for an investor. Let’s take a look at the statistics to see how the metals stack up.  Below is a cumulative return chart of gold, silver and copper. Notice over the period that gold has the highest performance with a total of 593% followed by copper and then silver, gaining 452% and 283%.  

However, few look at returns without considering risk.  Over the time frame, risk as measured by annualized volatility was 47.6% for silver, 27.3% for gold and 26.3% for copper. Although silver had both the highest volatility and lowest cumulative return, it had the highest average monthly return, up 112 basis points. This is compared with only 73 bps for gold and 68 bps for copper in an average month. Further, in the average up month, silver had the highest gain of 8.9% versus only 6.0% for copper and 5.2% for gold. One might conclude taking the highest risk can pay off but looking at the downside counts as well. The reason gold had the highest cumulative return was since the average loss in a down month of -3.7% was smaller than for either copper’s or silver’s average monthly loss of -5.0% and -6.6%, respectively.  

One major difference between copper and both silver and gold is that copper is an industrial metal though gold and silver are precious metals. This makes copper more sensitive than gold to inflation.  Another key difference from the fact that copper is industrial is that the supply/demand model is dramatically different.  As Blu mentioned in the video, the gold is mined whether or not the miners shut down, but this is not the case for copper.  Copper supply has been stifled by declining ore grades, equipment failures and shortages, and labor disputes.  The impact can be observed and capitalized on by the roll return in the term structure of the futures curve.   See the chart below of historical backwardation and contango in copper, gold, and silver and notice the high backwardation at times for copper that are missing from gold and silver.

On average over the time period, copper’s premium or convenience yield was a positive 8 basis points per month, though gold and silver were abundant with average storage costs of 45 and 49 basis points, respectively.  See the table below for more details of premiums earned, represented by backwardation (positive roll return) and storage costs paid, represented by contango (negative roll return).

If we tally the count, and again using copper for bronze, the best medal is not as obvious to an investor as to an athlete. The bottom line is that gold is solid, silver has upside potential, and copper may be a winning hedge.

The New York-listed iShares Europe 350 ETF has more than doubled in size in the past six months; the front page of last Friday’s Financial Times reported that U.S. purchases of European equities have surged, while the Wall Street Journal noted yesterday that “Europe is back.”

European equities have underperformed U.S. equities by around 45% since the financial crisis. Despite having a good year in  2013, the S&P Europe 350 remains well below its pre-crisis levels; the S&P 500 spent much of late 2013 recording new highs.  So why would U.S. investors take an interest in European stocks?

One explanation is that while the Euro crisis of 2012 discouraged transatlantic investment, with better economic news it is natural to expect some returning investment from U.S. asset allocators. But valuations may also be playing an important role.

The comparatively small rise in European stock prices since 2009 has resulted  in much more attractive valuation levels than in the U.S., both at the security and Index level.  Dividend yield provides one example:

European equities look attractive on a risk-free rate comparison, too.  While the dividend yield for the S&P Europe 350 is well above the German 10 year rate of 1.6%, the dividend yield for the S&P 500 is below the current 10 year UST yield of 2.6%.

Such metrics are attracting attention, and not just from U.S. investors.  In the U.K., The Telegraph’s list of countries with the most attractive CAPE valuations is heavily biased towards European entries.  Other examples abound.

Note in both cases that the yield of the index (which is tilted in favour of larger companies) is higher than the average stock yield, suggesting that smaller-cap companies have not been the drivers of income.  That means that the risk profile can look attractive too: a dividend yield of 2.8% is available even when restricting attention only to those members of the Europe 350 that have increased dividends every year for the past 10 years*.

All other things equal, the Europe 350 would have to gain 50% in price to match U.S. dividend yields.  The stock markets are famed for their regular mockery of predictions, but to the degree that valuations are driving U.S. flows into Europe, such dynamics are likely to remain in place for some time.

As we all know by now, Ben Bernanke is gone. He was focused on not having a depression on his watch so he pulled out all kinds of never-before-tried policy tools. Consequently, Janet Yellen will have to cope with the unintended consequences of QE — namely big unrealized losses in the Fed’s bond portfolio. 

Recently, I had the privilege to sit down with Bluford Putnam, Managing Director and Chief Economist, of our partner, CME Group, to discuss how the Fed under Yellen will be different from Bernanke’s Fed.

Although Yellen is also a strong advocate for the traditional Fed culture, which balances inflation and employment goals, she is likely to move to a more “hawkish” position if inflation pressures were to rise unexpectedly, at least from her point of view. Given her specialty in the labor markets, she is likely to focus in much greater detail in all areas of the labor markets, not just headline unemployment but also duration of unemployment, turnover of jobs and part-time employment. She wants to see who got fired versus who left their job voluntarily since a voluntary move may reflect confidence to secure another job, possibly indicating greater market confidence.  By evaluating the numbers in greater depth than the prior Fed, Yellen will use her insight into the labor markets as the starting point to forecast inflation.  While she doesn’t want inflation more than anyone else, her way may be different of finding the indication.

Another key difference in the New Fed is the addition of the new Vice-Chair, Stanley Fischer. He is the former head of the Israeli Central Bank, a former MIT Professor (Bernanke studied under Fischer), and brings an international view that has been missing at the Fed since Robert Heller retired from the board 20 years ago.  The policy implications for the US dollar and other currencies and central banks may get some much needed attention that has been absent for decades.

When Bernanke adopted QE, he made the asset size of the Fed’s balance sheet huge so its importance to the economy and to politicians has increased dramatically.  Possibly as a result of that, the second confirmation vote in the Senate (2010) had more dissents than any previous vote.  That trend followed through to Yellen.  According to Putnam, The Fed Chair is going to be a very divisive appointment in Jan-2018 when Yellen terms is up.  On the way, as members of the Board of Governors leave their posts, each new appointment may face greater political scrutiny and polarization in the US Senate.

For more on the New Fed, my colleague, David Blitzer, also posted some of his New Fed insights earlier this year.

Someone asked me this last week: “What’s a normal or typical VIX level?”  That’s a good question.  Here is the answer: 20.2.

And 17.1.

And also 13.0.

Before I go into why it takes at least three numbers to answer this question, let me remind you that the history of the CBOE Volatility Index (VIX) looks like this:

Figuring out the normal VIX level is akin to figuring out how high Alaska, my home state, is above sea level.  A skilled topographer could determine an average for the whole state, but this statistic would be skewed by Mount McKinley and the other huge mountains in the Last Frontier.  But an average is still useful to know.  For VIX, the average daily closing value for the 10 years ending December 2013 was 20.2.

When people worry about outliers skewing the average, they often turn to the median.  This is the second number I introduced: 17.1.  If you were to order the 2,517 trading days over the last 10 years by their closing VIX value, 17.1 would be next to the 1,259^th observation, the middle one.

Finally, you may want to know the mode.  The closing VIX value that showed up most – after rounding to the nearest whole number – was the last number I introduced, 13, followed by 12 and other levels just higher than those (see chart below).  This surprised me.  I would’ve guessed higher.

To go back to the Alaska analogy, if you were to trek across that state, you would spend most of your time trudging through tundra, navigating lakes and rivers, and hiking small and medium sized mountains.  You would want to prepare mostly for this.  On rare occasions, though, you would come across a breathtaking mountain that would lodge itself in your memory and define your experience.

VIX works in a similar way.  Lots of the mundane, but then peaks you won’t soon forget.

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Related posts:
You’ve seen VIX. Now finally learn what it means
Turn VIX into information you can use
Where VIX comes from

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*By the way, the mean elevation of Alaska is 1,900 feet.  Mount McKinley is 20,320 feet.

Similar to fixed income securities, the U.S. Preferred Stock market has started 2014 with positive performance. The S&P U.S. Preferred Stock Index  (Total Return) ended January 2014 up 2.68% .  A good start given the S&P 500 Index (Total Return) was down 3.46%.  As a fixed income comparison the S&P/BGCantor U.S. Treasury Bond  7-10 Year  Index was up 2.98% for the month.

Looking back over a longer period the price return (excluding dividends) of the index declined 5.42% for the twelve months ending January 31^st.  The dividend yield of the S&P U.S. Preferred  Stock Index ended January at slightly over 6.9%.   The net result was a positive return of 1.23% during that twelve month period.  Simply put, the dividend income helped keep the returns in positive territory.

The 12 month total returns of both indices are charted below.

Over the five year period ending January 31, 2014, the S&P U.S. Preferred Stock Index had a five year annualized return of over 17.6% while the S&P 500 returned over 19.1%.  The five year total return values for both indices are charted below.