Thursday, March 27, 2008

How cheap are gold stocks relative to bullion?

My recent post entitled “A short term warning for US Dollar bears and commodity bulls” must have struck a nerve. I received a torrent of responses regarding gold, gold stocks and how the US economy was going down the tank.

In response, I analyzed the question of the relative value of gold stocks compared to gold bullion. The above chart shows the ratio of the PHLX Gold & Silver Index (XAU), which has a longer history than the popular Amex Gold Bugs Index (HUI), to gold bullion. Since the line is near the bottom of its historical range, it suggests that gold stocks are a bargain compared to gold.

A synthetic gold stock tells a different story: Rising production costs
Back in 2006 I wrote a research report (How to Watch for Signs that the Gold Correction is Ending, 15 March 2006; if you are interested in the full details email me and I will send it to you) detailing how to make a synthetic gold stock.

Conceptually a mine can be thought of as a series of call options on the underlying commodity, with the exercise price as the cost of production. If the commodity price falls below the cost of production, the mine operator has the option to either close or mothball the mine until prices improve. I created a synthetic gold stock by building a model based on these principles. Key features of the model are:

  • A series of eight deep-in-the-money call options on the price of gold, with terms of 1, 2, 3 … 8 years, which models a mine with an eight year life, a common estimate of long-lived gold mines;
  • An exercise price equal to cash production cost of $250, rising each year by the current inflation rate. ($250 appeared to be a common estimate of cash costs for existing gold stocks in 2006);
  • Equal amount of gold mined each year; and
  • The position is rolled forward once a year at a cost of 1.5%.

Of course, there are some important differences between the synthetic gold stock and the actual gold stocks themselves:

  • Gold miners have exploration upside and operational risk, which the synthetic gold stock does not;
  • Gold mining companies may hedge the gold price with forward sales and other derivatives;
  • Actual gold mines can somewhat manage the cost of production by high-grading when gold prices are low and mining a lower grade of ore when prices are high. The synthetic gold stock’s assumed cost is inflexible.

Production costs are rising
The synthetic tracked the actual index reasonably well until 2006 (which was, of course, the out of sample period) when the synthetic began vastly outperforming the actual index. Delving further into the model, I found that the price divergence was explained by rising production costs of shown by the actual gold miners. Recent analysis by David Galland of Casey Research confirms this trend of rising costs at major producers Barrick and Newmont.

So what’s the answer? Are gold stocks cheap or not?
Gold miners are experiencing higher costs than historical experience, which deflates the case that gold stocks are cheap compared to bullion because their margins are lower. However, higher costs can be explained either by companies mining a lower grade of ore in the current high price environment in order to preserve their reserves and asset value (which is bullish), or costs escalating out of control and squeezing bottom lines (which is bearish).

The truth probably lies somewhere in between the two explanations. Given the recent experience of NovaGold at Galore Creek, I would lean towards the latter as a more likely explanation of higher costs.

Here is a stupid question: rather than agonizing which is the correct explanation for rising production costs, why not just buy the synthetic? That way an investor can customize and control his desired risk profile and exposure to gold.

(Warning for individual investors - don't try this at home. The synthetic is a highly sophisticated instrument that even professionals can get wrong if implemented incorrectly.)

Tuesday, March 25, 2008

Have we quants been brainedwashed by Barra?

This is a line from Star Trek Next Generation when the Enterprise encounter the Borg and the Borg say something like:

We are the Borg, you will be assimilated – resistance is futile.

As a quant I feel like that sometimes when I encounter Barra and its software. The head of a prop desk once complained to me that everyone is using Barra and they were all getting the same solutions. So when the hedge that the software suggested turned sour, the effect was worse because it seemed that everyone else was rushing for the same exit at the same time.

There are also second order effects. Barra has taught us that the sources of equity risk are industry and common factor (style, size, etc.) and it has affected many quants' analytical frameworks. I was recently at a meeting of quantitative analysts when someone presented some equity analysis. There was general agreement was that the solution wasn’t very well-risk controlled as no self-respecting equity quant would compare two stocks (one in Autos, the other in Media) in the same sector against each other (Consumer Discretionary) as they would normalize for industry effects.

Have we been brainwashed to control risk by industry and common factor (and not much else), after being exposed to the Barra risk framework all this time or is this just another example of a crowded trade?

Comments welcome.

Wednesday, March 19, 2008

Smart funds still more defensive than the consensus

Was Tuesday's FOMC equity rally for real? Or should we take Wednesday's pullback as the real trend in the stock market?

A check in with the smart funds show that they are still more defensive than the consensus. Smart funds are showing a market beta that is lower than 1, or the market. By contrast the consensus funds' beta is at or slightly above 1.

There are very good technical reasons why this market should rally. It is extremely oversold and due for a bounce. However, smart funds don't seem to be convinced yet that this is THE BOTTOM. By this measure, rallies should be viewed as trading opportunities to sell into strength.

Monday, March 17, 2008

A short term warning for US Dollar bears and commodity bulls

As the cacophony of voices calling for doom for the US Dollar (and conversely a rise in commodity prices) come to a crescendo (example here) and gold tops $1,000/oz. and oil tops $110/bbl, I would like to reiterate my word of short term warning for the Dollar bears and commodity bulls. Signs of a speculative blow-off are everywhere.

Sentiment is getting a little extreme for this trade to continue too much further in the short term. Recently Bob Moriarty of sounded a note of caution (italics are mine):

Nothing goes straight up and nothing goes straight down. As edifying as it is to see silver and gold go up almost every day, now and again all markets take a breather.

I run a gold site and it's considered heresy to suggest commodities correct but they do. Even the lowly dollar goes in the opposite direction on occasions.

Ten days later, he hedged his earlier comment and conceded the bullish case for gold based on an apocalyptic scenario for the US economy and Dollar:

It's a time for caution. We SHOULD have a violent correction in gold and silver and the dollar based on emotion and government intervention but we could see $3,000 gold in a week or the start of a living nightmare brought to you by the Gang of Fools in Washington. No one knows.
To me, that was the first sign of a speculative blow-off in the USD and commodities. The second sign: Both Energy and Gold stocks are at or near the top of their relative uptrend channels against the S&P 500. Can they go higher? Yes. However, the relative downside risk in the near term appears to outweigh the upside rewards.

The third sign of excessive bullishness: The Commitment of Traders chart from CFTC data of large speculators in gold show that they are in a crowded long position, which is contrarian bearish:

My inner trader says that we are in the final stages of a speculative blow-off in commodities and has the potential to correct violently. My inner investor agrees with the consensus view, however, that we are in a long multi-year decline of the US Dollar and multi-year rise for commodities.

Thursday, March 13, 2008

Hedge fund bodies floating to the surface

A followup to my posts on hedge fund problems here and here, I see that there are more news headlines such as Hedge funds on the brink as US Federal Reserve cash fails to ease crisis. This market is not likely to make a definitive bottom until some dead bodies (literally or figuratively) start to float to the surface. We are starting to see the bodies.

In the short term, however, there could be trouble. The Yen has strengthened against the US Dollar through the 100 level. As I mentioned before, this could portend a panic selloff.

Wall Street nursery rhymes

It's Friday. For your amusement I reproduce some of the traditional nursery rhymes adopted to a Wall Street theme that we used to recite and sing to our daughter:

The five little piggies
This little piggy put in a market order...
This little piggy put in a limit order...
This little piggy traded derivatives...
This little piggy traded cash [market]...
And this little piggy got caught insider trading and went
wee wee wee wee wee...
...all the way to Club Fed.

Old MacDonald
Old MacDonald had a farm,
On this farm he had an investment banker,
And a Strong Buy here and a Strong Buy there
Here a Buy there a Buy
Everywhere a Strong Buy!
Old MacDonald had a farm

Happy Friday!

Monday, March 10, 2008

An idiot's equity market neutral fund: More on Morningstar rankings

I received a lot of feedback on my original post about a month ago entitled An idiot's equity market neutral fund, where I used Morningstar rankings to pick a series of mutual funds in order to produce an alpha. Much of the criticism centered around the use of Morningstar rankings. Numerous studies have shown that relying on Morningstar rankings alone did not produce positive excess returns and that they formed inefficient portfolios (for examples see here, here, here and here).

The key to success of the synthetic equity market neutral strategy's forecast alpha seems to be the change made in 2002 when Morningstar normalizated fund ranks within style groups. This effect was documented by a new study (Morey & Gottesman 2006). In addition, I picked relatively low cost funds with expense ratios < 1%, which should reduce any "headwind" in the process of alpha production.

Friday, March 7, 2008

Hedge fund implode-o-meter

I discovered a neat site called the Hedge fund implode-o-meter, which lists hedge fund blowups. It also shows funds on an ailing list - check it out.

As US equities continue to perform poorly and hedge funds remain highly correlated with the S&P 500, the Implode-o-meter list is likely to grow.

Tuesday, March 4, 2008

Yen carry trade at a critical juncture

In the last few days much has been made about the Euro going through 1.50 against the US Dollar. I am more concerned about the systemic risks posed by the recent strength of the Japanese Yen as it may lead to a rush for the exits on the Yen carry trade.

The accompanying chart is an index (31 Dec 2000 = 100) of a equal weighted basket of high yielding currencies (New Zealand Dollar, Mexican Peso, Indonesian Rupiah, Turkish Lira and Hungarian Forint) against the Japanese Yen as an pedal-to-the-metal version of the Yen carry trade. The index hit all-time highs in the July 2007 but have fallen about 14% since then and is reaching a critical technical support.

Hedge funds and currency traders who put on such trades tend to be highly levered and they are not well capitalized enough to withstand large losses. In such instances everyone becomes a technician and chart reader. I am sure that there are many stop loss orders placed just below the support line. Should the Yen strengthen further against these high-yielding currencies and these stops are hit, it would be pandemonium as everyone rushes for the exits, leading to a highly disorderly re-pricing of risk by the markets .

If that happens, this risk-avoidance contagion could very likely spread to other markets. Watch out below!