Portfolio Update - 03/31/07
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Dear Clients,
On Friday, The Dow Jones Index closed the quarter in negative territory – the first down quarter for the Dow since 2Q 2005. Despite the market’s recent sideways action, this is still the second longest stretch that the equity markets have been through without a 10% correction. Prior to the 3%+ drop on 2/27/07, it was the longest stretch the market had gone without a 2% intraday correction.
Here is how my performance measured up to the averages for the first quarter of 2007.
Core Portfolio (0.4)%
Focus Portfolio (2.3%)
S&P (VFINX) 0.2%
NASDAQ (QQQQ) 0.5%
Benchmark 1.2%
While my strategy continues to lag the major indexes by a small margin, a few very positive events took place over the last quarter that has solidified my faith in the direction I’m taking with your accounts. As you know, I’ve heavily weighted your portfolio towards Gold and Silver with a smaller allocation to other commodity sectors. Three specific trends have emerged that have increased my confidence in Gold and Silver. In this update, I’m going to focus on our Precious Metals positions as they will largely dictate how your account will perform over the next 6-12 months.
Three Bullish Trends for Gold and Silver
1. Fundamentals: Gold/Oil and Gold/CRB Index Ratio
2. Gold/Equity (non)correlation
3. Trend in Silver to Gold Leverage
1. Fundamentals:
The fundamental case for Precious Metals is improving daily. The Gold-to-Oil ratio is at the extreme low end of its historical range at around 10. The Gold-to-Oil ratio has ranged from 10 to 40 over the last 3 decades.
But I’d also like to examine the relationship between other commodity prices and Gold.
In the 70’s, the CRB index saw two substantial moves. In 1973 and 1978, the CRB index jumped over 100% and 70%, respectively. In those same periods, Gold jumped over 400% and almost 350%, respectively.
The CRB Index is up over 100% since the beginning of 2002 and up nearly 50% since the beginning of 2004. While Gold is up 140% since 2002 and 63% since 2004, history suggests that Gold still has plenty of room to appreciate. As long as the CRB index continues to climb, Gold will be a winner.
Weakness in the $US is also going to push up the prices for precious metals. Last month, the $US hit fresh cyclical lows against the Euro and Australian$. It is close to its low compared to the British Pound and Swiss Franc. The only currency it is holding up against is the Yen. At 82.92, the US$ index is approaching its all time low of 80.39. If and when it breaks through that support level, we could see substantial depreciation in our currency.
2. Precious Metals/Equity (non)correlation
The single most frustrating phenomenon in the markets over the last couple of months has been the uncharacteristically high correlation between Precious Metals and Equities. Historically, Gold & Silver have maintained a negative correlation against equities. However, since the summer of 2004, when France rejected the EU constitution, Gold has been joined at the hip of equities – including the steep sell-offs last May and this February (Silver was a bit late to the game but has caught up recently). This is obviously worrisome for somebody like myself who is bearish on equities.
However, in the latter half of March, precious metals seemingly became unhinged from equities. While two weeks certainly doesn’t establish a solidified trend, it is encouraging.
3. Silver/Gold leverage:
In my last couple updates, I’ve explained why I was favoring Silver over Gold. One of the reasons for being overweight in Silver is that it Silver is essentially leveraged Gold - meaning that if Gold goes up in price, silver should go up even more.
Since my last update, I’ve discovered a Precious Metal analyst named Roland Watson. I read a lot of his research and gained a greater insight into the relationship between these two metals. He has created an indicator that has successfully identified downturns in precious metals. His indicator is incredibly simple. It is based on the amount of leverage that silver provides over Gold. When the amount of leverage reaches 1.8x, it has historically signaled an ensuing sell-off in the metals.
Therefore, while we want silver to provide some leverage over Gold, according to Mr. Watson, too much leverage means the run is almost over. The good news for us is that the amount of leverage that silver provides over Gold has been gradually diminishing since both metals pulled back last summer. Exhibit E illustrates this trend. This is bullish for precious metals. Ideally, silver will still provide leverage over Gold but in a limited fashion. Once silver is beating Gold by a 1.8:1 margin (80% leverage) it will be time for us to start pairing back our position. This has occurred before every Gold and silver peak since the government legalized owning Gold in ’74.
Precious Metals Commentary Conclusion:
1. Be patient with Gold and Silver. Silver is particularly volatile and tends to have sharp corrections as it did in March (which is why my portfolio performance is flat for the year). Precious metals are an inflation hedge so as the economy slows, the market may discount the metals assuming that inflation will slow as well. However, once the rally in precious metals is re-established, I believe that they will provide incredible returns to your portfolio.
2. If I’m wrong about the long-term outlook for precious metals, I should be able to insulate you from any serious losses by keeping a close eye on the CRB index and the Silver/Gold Leverage.
