Interest Rate Jump is a Crack in the Facade

The interest rate on 10 year US Treasuries is currently trading at 2.85%.  This is a jump from 2.58% just one week ago.  An increase of 27 basis points (bps) may not see like much.  But if you purchased a $100,000 10 year US Treasury bond with a yield of 2.85% instead of 2.58% you would receive about $3,400 more interest payments over the next 10 years.  http://stream.marketwatch.com/story/markets/SS-4-4/SS-4-35951/

As of July 2013 the US has $11.9 trillion of debt held by the public and $4.8T held by intra-governmental agencies, such as the Social Security Administration.  The average interest rate on the publicly held debt is 1.9%, which is about $225 billion annually.  This weeks increase in interest rates of 27 basis points would increase the interest on the national debt by about $32 billion for a full year.  The US government cannot balance its budget as it is.  Increasing interest rates make the dream of a balanced budget even more fantastical.  http://www.treasurydirect.gov/govt/reports/pd/feddebt/feddebt_july13.pdf

Interest rates typically serve as an early warning system for economic trouble.  Rates serve as the canary in a coal mine.  However, as I wrote in a post about a week ago the canary has been suppressed further than a NSA whistle blower.  Purchases of US debt by the US Federal Reserve Bank have kept rates low.  As of August 14 the US Federal Reserve Bank owns over $1.9T of US Treasuries.  The Fed also has $1.4T of mortgage backed securities that are guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae.  And, the Fed has a few more assets it bought to help save the financial system and the economy which bring the its total assets to $3.6T.  http://www.federalreserve.gov/Releases/h41/Current/  Certainly, interest rates would have been higher if the Fed had not purchased $1.9M of Treasuries.  

Any chirp from the early warning system must be closely scrutinized since it is coming from behind a thick curtain of suppression.  The Fed will continue to acquire more and more US debt in a do or die effort to keep interest rates low.  At some point the global financial system will not let the US print more and more money by buying its own debt and the scheme will fracture with a sudden snap.  No bending before breaking.  If rates continue to climb next week, it will show that the Fed has become impotent.  Fear will over take greed.  

Keep your powder dry!  When the bond market fractures it will drag equities with it.  Speculators will sell quality stocks in order to raise cash and meet margin calls.  I have cash ready to take advantage of this eventuality.  What else would I do with cash?  Loan it to the US government for 10 years at 2.58%? No way!  One of the best investments I ever made was Coca-Cola (KO).  I purchased KO for about $23/share in 2008 during the market crash and sold it 3 years later for about $33/share.  That is a gain of about 50% in less than 3 years plus about 5% dividend yield during that time.  An impressive gain on a very solid, low risk investment.  

US Equities are Over Valued. I am standing by.

The US stock market is over valued.

1) Stock prices relative to earnings are above long-term averages
http://www.zerohedge.com/news/2013-07-29/faith-hope-and-pe-multiple-expansion

2) A historically large portion of the money currently invested in the stock market is borrowed.  Margin debt on the NYSE is near an all time high.  "The exuberant mood comes as margin debt on Wall Street hovers near $377bn, just below its all-time high and well above peaks before the dotcom crash and the Lehman crisis.  By Ambrose Evans-Pritchard, The Telegraph
http://www.telegraph.co.uk/finance/economics/10240740/Investors-euphoric-as-US-margin-debt-reaches-danger-levels.html


3) The US Federal Reserve's POMO operation has been propping up the stock market.  Since January 2009 the US Fed has purchased over $5B of stocks during each of 159 weeks.  Most of the gain in the S&P since January 2009 were during these same weeks.
From Zerohedge, "between January 2009 and April 2013, on days in which the Fed POMO was more than $5 billion, the stock market rose a total of 570 points, on days in which the POMO was less than $5 billion, the cumulative stock market gain was "only" 141 points, and when there was no POMO, the S&P gained... -51 points".
http://www.zerohedge.com/news/2013-08-13/us-treasury-finally-admits-truth-its-all-pomo-and-no-one-dares-fight-fed

The US Fed's POMO operation is confusing because of the jargon and its audacity.  Simply put the US government has been purchasing stocks.  But, how can that be?  I thought the US was in debt?  The US is borrowing more money to finance these stock purchases.  I suspect that these borrowings do not add to the US reported net debt, because stocks are included as an asset that offsets debt when calculating net debt.  If the stocks gain value they would decrease the US net debt.

Other central banks are also investing their governments money in equities.
http://www.zerohedge.com/news/2013-04-25/central-banks-join-herd-openly-buying-stocks-record-amounts

Some day the governments will no longer be able or willing to invest in equities, which will depress the markets.  

The market may not decline just because it is over valued today.  It may even appreciate for several years.  How many years did internet stocks appreciate before crashing in 2000?  It is tough to stay on the sidelines "while everyone else repeats history".  A lot of money can be made joining the irrational exuberance.  And, it can be lost very quickly, so be careful.  

Two Major Gold Miners Maintain Production Plans for 2013 Despite Drop in Gold Prices

Goldcorp (GG) and Newmont (NEM) recently reported Q2 financial results and outlook for the rest of 2013.  Surprisingly and contrary to some headlines both miners are maintaining production volume and all-in-sustaining cash cost guidance for 2013.  GG and NEM are not shutting mines or significantly cutting capital spending to generate more free cash flow.  Lower by-product (silver, copper, lead, and zinc) prices are being offset by favorable yields and mix compared to their guidance at the beginning of this year.

As a long time Goldcorp shareowner my concern was peaked by a Citibank analysis shown by Zerohedge.  http://www.zerohedge.com/news/2013-07-07/citi-no-gold-company-will-generate-free-cash-flow-current-gold-prices  The analysis implies that Goldcorp and Newmont will not generate free cash flow if gold is below about $1,600 per ounce.  There is much more to the story.

GG and NEM are forecasting an All-in Sustaining Cash Cost per gold ounce of $1,050 and $1,150 respectively for 2013.  Their forecasts assume today's commodity prices for by-products, such as silver, copper, lead, and zinc.  All-in Sustaining Cash Cost includes by-product credits and sustaining capital expenditures and excludes depreciation and expansionary and project capital.  These miners could generate free cash flow if they depleted their current reserves and did not spend on new projects.  Of course this is a poor long-term strategy, but one they could pursue if necessary until gold prices recovered.

GG and NEM have strong balance sheets and financing.  GG completed a $1.5B financing in March 2013.  So they can afford to keep investing in new projects.  Never the less, both have revised their capital spending plans.  Each are reducing their $2B+ capital plans for 2013 by only $200M.  

In Q2 each company wrote-off about $2B of value in inventory (leach pads), in the ground (reserves), and Property, Plant and Mine Developments because of the recent drop in gold prices.  NEM, for example used a long term gold price assumption of $1,400 which impaired the book value of their Property, Plant and Mine Developments by $1.5B.  Presumable, if/when the price of gold increases the companies could write up these assets and recognize a gain.  But, I doubt that accounting rules permit what goes down to go back up again in all these cases.

GG and NEM could generate cash with gold below $1,600 per ounce if necessary.  Fortunately, for them it is not necessary and they plan to continue investing in growth projects thereby doubling down their bets on rising gold prices.  GG and NEW stock prices traded up on Friday by 2.1% and 1.5% respectively, while gold was flat.

Also, note that GG and NEW do not nor do they plan to hedge revenue (e.g. gold).  During the gold price smack-down in April and May some alleged that gold miners' hedging activity was contributing to the price decline.  Not from either of these major miners.

All-in sustaining cash cost is a tricky metric.  It is not GAAP.  Many members of the World Gold Council have adopted this industry metric over the last several quarters.  Goldcorp management explained that GG's all-in sustaining cash cost will be much lower in the second half of 2013 due lower sustaining capital requirements than in Q1 and Q2.  The definition of sustaining must be a bit fuzzy.  So best to use this as a guideline and view it over time.

Kinross, Barrick, and Yamana report Q2 earning on August 1st.

http://www.thestar.com/business/2013/07/25/miners_pull_back_on_project_amid_weak_commodity_prices.html
http://business.financialpost.com/2013/07/25/goldcorp-q2-earnings-penasquito-writedown/

Citibank Analysis of Gold Miners' cost of production. All are >$1,300/ounce.

Zerohedge summarizes a Citibank analysis of 20 top gold miners.  The analysis shows that all 20 have an 'all in cost are over $1,300 per ounce.  And Citibank claims that no miner will generate free cash flow at current spot metal prices.

http://www.zerohedge.com/news/2013-07-07/citi-no-gold-company-will-generate-free-cash-flow-current-gold-prices

GoldCorp (GG) is one of my key holdings.  Reading from the chart in Citibank's analysis GG's all in cash cost of production is about $1,550 per ounce.  That's odd.  GG's 10Q report for 1Q13 shows that GG's sustaining cash cost of production is $1,135.  I suspect that the difference lies in 'sustaining cash cost' versus 'all in cost'.  All in cost include capital for new projects and expanding production and I suspect that it includes depreciation expenses as well.  Sustaining cash cost of production, which is not a GAAP metric which most gold miners started reporting this year is cash cost only, no depreciation and only sustaining capital.  Presumably, if GG can cut all exploratory capital they will generate free cash flow if gold sales are above $1,135 per ounce.  

In order to make cash GG could also reduce production at their higher cost mines in addition to cutting capital for new projects.   Mine production cost varies widely.  Two of GG's biggest mines had negative cash cost in 2012 when including the value of the by-products (silver and copper).  And, a couple of GG's mines had gold cash cost over $800 per ounce.

Certainly many gold mines are unprofitable at current gold and silver and copper prices.  Over the last 5-10 years the cost of production for gold has increased almost as fast as the price.  Yet total production volume has remained flat.  Refer to some of my earlier posts for more statistics.  

The strong gold mining companies with low sustaining cash cost will survive the downturn in prices and emerge stronger as their competition folds.  The reduction in supply as high-cost mines are decommissioned, exploration slows, and new projects are moth balled should have quite an impact on gold and silver supply.  This reduction in supply would affect the price in a normal market.  The current markets are anything but normal.

Citibank's report suggests that GG will not be profitable while gold is below $1,550 per ounce.  No wonder valuations for the miners are getting hammered.  Time to brush off my own analysis of GG.  Hopefully, GG will present their own forecast for the rest of 2013 soon, perhaps with their Q2 results.  It will be very interesting to see how drastically GG is cutting back on capital for explorations and new projects. 

Hedge Funds up only 1.4% Year to Date while S&P 500 is up 12.6%

Who is making gains?

Seems that I have a lot of highly compensated company in grossly under performing the S&P 500 so far this year.  

The more interesting aspect of the hedgies performance is the other side of their trades.  Who has been making money?  It must be the central banks and their proxies the global, too big-to-fail banks.  Or are the central banks errand boys for the banks?

http://www.businessweek.com/news/2013-07-05/hedge-funds-post-biggest-declines-in-one-year-amid-market-rout

Most of the money hedge funds manage is for pension funds.  Pension funds for regular folks such as fire-fighters, teachers, employees of large companies, etc., etc.  The funds are under performing the S&P because the central banks continue to inflate the markets (stocks, bonds, real estate) with new created money.  This new money, created by the central banks adds to national debt which must be paid by higher taxes some day.  Therefore, right now your pension fund is likely losing money and you will be paying for it in the form of higher taxes.  Insult to injury.

3 Indicators that the Bull Market will not run much higher

This article http://www.hussmanfunds.com/wmc/wmc130318.htm about market conditions by John Hussman presents a couple strong indicators that the stock market is currently overvalued.

1) Currently, few investment advisors are bearish.  The percentage of investment advisors with bearish sentiment is now 18.8% of all advisors.  Historically, bearish advisor sentiment below 20% has portended significant market declines.  You read that right.  This is a contrarian indicator: when advisors are less bearish the market has declined.  This link explains the indicator: http://www.investorsintelligence.com/x/us_advisors_sentiment.html

2) Stocks are expensive compared to earnings.  The Shiller P/E is currently above 23X.  The Shiller P/E (Price to Earnings) is the total value of the S&P 500 divided by the 10-year average of inflation-adjusted earnings.  Historically, a Shiller P/E above 18X has indicated overvalued markets.

A chart of the Shiller P/E over time is here: http://www.multpl.com/shiller-pe/

The S&P P/E today based on trailing 12 months of earnings is 18X.  The historical median for this measure of P/E is 14.5X.  http://www.multpl.com/

3) Corporate profits after tax are 11% of GDP.  Historically, corporate profits average about 6% of GDP.  And, according to the Fed Reserve Bank of St Louis have never been above 10.5% until recently.  http://research.stlouisfed.org/fred2/graph/?g=cSh

This all make sense.  The S&P is up 10% year to date and all the analysts are jumping on board.  Stocks are expensive to earnings because investors are bidding up alternatives to paltry interest rates on bonds with easy money from the Fed.  Corporate profits are a larger portion of the GDP 'pie' because the government and household sectors are being squeezed.  So, the question is when.  When will markets and valuations revert to the mean?  When will extend and pretend end?  My guess is within 3 years from now.  And, it seems that the current bull market in equities has little room to run higher.