Invest in Oz

The All Ords/Gold Ratio

2009-08-27T16:32:00.013+10:00

A couple of posts back I detailed the relationship between the Dow Jones Industrial Average and gold. Historically, exchanging gold for stocks when the valuation has been less than five then exchanging stock for gold at a later point has been a highly profitable strategy. In this post, I want to explore whether a similar relationship exists for gold and the All Ordinaries Index.

The Australian dollar has a long history as a 'gold dollar'. Australia is among the top gold producers in the world, along with South Africa and the US. More recently, China has grown into a significant producer. However, in terms of the value of gold as a proportion of the overall economy, gold production is much more important for Australia (and South Africa) than it is in China or the US (a $10 billion gold mining industry in a nation with a population of 20 million is going to be 15 times more economically important than a $10 billion gold mining industry in a country with 300 million people).

This reliance on gold means a couple of things. When the value of gold goes up, it will create demand for Australian dollars both due to investment in mining, and to purchase the gold produced from our mines. Second, when the value of gold declines, the Australian dollar goes down as there is less demand for dollars to invest, and less dollars are needed to buy the same amount of gold. The net result (in theory) is that the price of gold denominated in Australian dollars is less volatile than gold denominated in other currencies. For example, if gold costs US$500 an ounce one Australian dollar buys 50 US cents, gold will be worth AU$1000. If the price of gold increases to US$700, this will increase demand for Australian dollars, and one Australian dollar may now buy 60 US cents, so gold will be worth $1166 an ounce. In US dollar terms, gold has gone up by 40%, while in Australian dollars it has risen only 17%. Similarly, if gold falls from US$700 to $500, demand for Australian dollars falls and may now only buy 50 US cents once again. In US dollar terms, the price of gold has fallen 28%, while in Australian dollar terms it has fallen only 14%.

That theory, with some exceptions, generally does hold true. Generally a weak Australian dollar equals a weak gold price, and vice versa. The moderating affect of the currency on gold price should also, naturally, extend to the relationship between stock markets and gold price. The All Ords:Gold ratio should be much less volatile than the Dow:Gold ratio because the price of gold itself is less volatile in Australia than in the United States.

Now for the chart:

The red line in the chart represents the Dow:gold ratio that I detailed in an earlier post. The blue line represents the All Ords:gold ratio. As predicted above, the All Ords is much less volatile than the Dow. Despite having near equal values in the early 1930s, the Dow:gold ratio peaked at 27 in the 60s, while the All Ords:gold managed just 13. Similarly, the two ratios had near equal values in the early 1980s; while the Dow:gold went on to went a peak of nearly 40, the All Ords:gold managed less than 7.

The moderating affect of such an important gold industry may play a role in this, but I dont think it gives us the whole picture. There are some other factors at play that may explain the differences. The first is fiscal policy. The US authorities are generally more eager to flood markets with cheap credit than in Australia. More excess money equals bigger bubbles, and, inevitably, bigger bubble bursts. The second factor relates specifically to the 1999 bubble. This was the 'tech bubble'. Im sure most of you can remember the short-lived craze of paying incredible prices for stocks like Amazon in the belief that they may one day make some money. The assets became massively overvalued, and eventually the bubble burst. Australia did not have a tech bubble: we lacked the communications infrastructure at the time to really develop one. I can recall paying $8 an hour for a 14.4k dialup connection in the late 90s - hardly the bleeding edge of a brave new technological world even back then. In hindsight, we dodged a bullet.

So what does this mean for investing? A couple of things. First, if you want to chase stock:gold bubbles, you are better off looking to the United States than Australia. If you are intent on applying this to the Australian market, buying at a All Ords:gold ratio of 2.5 and selling somewhere around 6 would have been a fairly successful way of going about it. You might be able to get in lower than that working on daily data (remember that the data in the charts is only end of year data) I eyeballed a some daily gold and all ords prices a while back and it seems to get down to about 2.2 earlier this year.

One important thing to remember about all this is that it is all about exchanging one class of assets for another when one is cheap relative to the other. It doesnt necessarily correlate with the highest values of either asset in dollar terms. For example, in the chart above, the All Ords:gold most recently peaked in 1999, when the All Ords was around 3100. The All Ords didnt reach its dollar peak until 2007, at around 6700. However, in between the gold price had risen, and risen faster than the All Ordinaries. So if you had of exchanged stocks for gold in 1999, you would have bought more gold than if you had done the same in 2007, despite the All Ords more than doubling in dollar terms. If you can exchange one class of assets for another at an optimum time, and both these assets appreciate in the long term, you are going to end up a lot better off than if you merely held one or both of these assets all the time.

Bretton-Woods

2009-08-26T12:54:00.010+10:00

Just a quick additional to my last post. In my last post I described how some of the valuation differences between the two assets were the result of stock market bubbles, and alluded valuation differences arising from currency manipulation.

If you want to understand what happened during the 'currency manipulation bubble', I suggest reading the preface to this piece by Murray Rothbard, where he explains the mechanics and failure of the Breton-Woods system. I havent had a chance to read the entire piece yet, but Murray makes a very bold and chilling prediction:

"the financial press is filled with stories that the FDIC might well become bankrupt without a further infusion of taxpayer funds. Whereas the “safe” level of FDIC reserves to the deposits it “insures” is alleged to be 1.5 percent, the ratio is now sinking to approximately 0.2 percent, and this is held to be cause for concern.

The important point here is a basic change that has occurred in the psychology of the market and of the public. In contrast to the naive and unquestioning faith of yesteryear, everyone now realizes at least the possibility of collapse of the FDIC. At some point in the possibly near future, perhaps in the next recession and the next spate of bad bank loans, it might dawn upon the public that 1.5 percent is not very safe either, and that no such level can guard against the irresistible holocaust of the bank run. At that point, ignoring the usual mendacious assurances and soothing-syrup of the Establishment, the commercial banks might be plunged into their ultimate crisis. The United States authorities would then be faced with two stark choices. One would be to allow the entire banking system to collapse, along with virtually all the deposits and depositors in that system. Since, given the mind-set of American politicians, and their evident philosophy of “too big to fail,” it is certain that they would be forced to embrace the second alternative: massive, hyper-inflationary printing of enough cash to pay off all the bank liabilities. The redeposit of such cash in the banking system would bring about an immediate runaway inflation and a massive flight from the dollar."

Now bear in mind that this was written in 1991. We have seen a crisis in the banking sector bought about by exactly the bad loans Murray describes. We have seen the failure of government-backed insurers to deal with this. We have seen a massive government intervention to stave off the problem, paid for by printing new money, trillions of dollars. We are yet to see the hyperinflation and flight from the dollar, but I believe that it is coming.

The DOW/Gold Ratio

2009-08-22T18:11:00.003+10:00

A popular long-term analysis in the United States is examining the relationship between gold and the Dow Jones Industrial Average. There is a lot of information out there on if you google Dow/Gold ratio, so I wont go into it in too much detail (I could talk for days on this). Below is a chart of the relationship since 1896:

In 1915 it would buy one ‘Dow’, you would need about five ounces of gold (Dow=99, Gold=$20.67). In 1928, you would need 14 ounces of gold to buy one Dow (Dow=300, Gold=$20.67). In 1999, you’d need about 40 ounces of gold to buy one Dow (Dow=11500, Gold=$290). From the chart, it is clear that there are times when gold is cheap relative to the Dow, and other times when the Dow is cheap relative to gold.

In broad terms, the Dow:Gold ratio is most often somewhere around five. This was the case from 1986-1925, and again from 1931-1951. Occasionally, the Dow becomes much more valuable relative to gold, and then returns to five or less. Im not going to go all the way into the reasons for this, it isn’t vital right now. Suffice to say that I believe that it is due to central banks and governments manipulating the currency and creating excessive credit, giving us the ‘bubble’ cycle.

The first great break above a ratio of 5 is in the 1920’s. This was the bubble that gave us the great depression. The next break, and by far the longest lasting, occurred in the aftermath of WW2. Here the US government and the Federal Reserve simply printed too much paper money. At the time, the gold price was regulated at $35 an ounce (and for every $35 in circulation there was meant to be an ounce of gold in Fort Knox, which makes printing money out of thin air fraud on a massive scale!!!). As more money came into circulation, this inflated prices, including stock prices. Given that gold could not move in line with this inflation, the Dow/Gold ratio rose dramatically.

In the 1970s, the US government finally conceded that the relationship between gold and the US dollar couldn’t be sustained, the debasement of the currency was too complete to restore the currency. Gold became a regular commodity like any other, worth whatever anyone was willing to pay for it. Given that the price of gold had been held artificially low for such a long time, the price of gold soared, and the Dow/gold ratio collapsed.

The final peak we see is the tech bubble and its aftermath. The market became obsessed with the ‘new economy’ of the internet, and shunned gold, the barbarous relic. After the bubble burst in 1999, the ratio fell sharply and continues to fall. If history follows its usual trend, we have a way to go yet. The Dow/Gold ratio should go to five or below. Some are predicting it will be much, much lower than five. I believe that in the next decade or so the US will suffer a ‘dollar crisis’, where the international community loses faith altogether in the dollar and replaces it. If this happens, the US will collapse, and who knows how low the Dow/Gold ratio will go?

So much for history. From the Dow/Gold ratio we can learn a few things. First, it can be used to identify whether the US market is currently in a stock bubble. Second, it gives a measure of the cheapness/expense of gold independent of nominal dollar prices. Third, it provides generational opportunities to buy/sell gold and stocks. If you had sold gold and bought stocks when the Dow/Gold was three and exchanged stocks for gold sold them at even 15, you would be a very well off (if ancient) person by now. Judging by the chart, we are approaching the next generational opportunity to buy US stocks. In a few years to a decade, those holding gold will have an opportunity US stocks at once-in-a-generation prices. Pay attention, you’ll probably be quite old by the time you next stocks this cheap relative to gold.

It may well sound good (or horrific depending on your perspective) for the Americans, but what does it mean for us here in Australia? A few things, which I will explain in my next post.

Reminder Link

2009-08-18T14:49:00.003+10:00

This blog has been running for a while now, and the posts that describe the trading systems/ideas that are described here have fallen into the archives.

Here is a link to those posts:

All Ordinaries, Economic Growth and Inflation

AUD/JPY: A systematic relationship

and, of course,

Welcome and Disclaimer

End of July update

2009-08-11T12:07:00.004+10:00

Another two months have gone by (and didnt they fly!), so time for another update.

Over the last couple of months the market has staged a fairly strong recovery, and emerged fairly strongly from the -20% buy zone. We finished July at -14.5% from the market fair value. The market is still undervalued, but following the system that I outlined, we are now in a neutral hold zone. Chart below:

So where do we go from here? Long term, the market will grow in line with the economy. During that, there will be periodic swings of exuberance and pessimism that we can use to our advantage. More immediately, looking at the last thirty years of data in the chart above, once the market has climbed back above -20%, it has risen fairly dramatically, usually approaching the fair value within a couple of years. Whether this happens this time or we see a reversion to -20% or below remains to be seen. What is important to remember is that over the long term, we will see growth, the market will return to its fair value, and parts beyond.

Something to ponder: In November 2008 we first finished the month in the buy zone. Using the buying strategy outlined earlier, you would buy when the market finishes the month at or below -20%. In this instance you would have bought at 3389. At the end of July 2009, the market closed at 4250, a gain of about 25% plus dividends. Not bad money in my opinion.

End of May, 2009

2009-06-02T15:09:00.002+10:00

A couple more months have just fallen away, and it seems that a lot of market pessimism has gone with it. Obviously, this has all happened because I mentioned that things may stay subdued for some time last update.

All said and done, we havent recovered yet, and the market may go down again. We closed the month of May with the All Ords at 3888. This just nudges us out of the -20% 'buy zone', to -19.21%, which is the -20% - 50% 'hold zone'.

A word of caution though: while the historical data that I used to build this system is accurate, forward-looking predictions are just that, predictions. They are based on assumptions of economic growth and inflation that may change. Changes wont make much difference to the system, for example, 1% economic growth either way only moves the -20% line by 30-something points. The reason that Im telling you this is that there is a little ambiguity here, so if you want to buy at 3888 instead of 3777, it wont make much difference at the end of the day.

In other news, the carry trade strategy is kicking butt. The Australian dollar has appreciated rapidly, and the AUD/JPY is currently a whopping 78.5. This equates to a 131% gain since I bought Australian dollars for 59.3 at the start of this year. It seems to have run up a bit too quickly, so we'll probably see a retracement before long.

No charts this update, but if you are following this, you should know what Im talking about by now!

End of March update

2009-04-15T09:28:00.004+10:00

Its been a fairly subdued couple of months in the market. There appears to be early signs of a recovery, which is what would be expected after the All Ords drops below -20%. However, at the end of March this is the fifth month below -20%.

As you can see from the chart, in most instances when the market reaches -20% it rebounds quite rapidly, within a couple of months the market turns around and is back above the -20% buy zone. This is different. It is starting to resemble the 1981-1983 period, where the market stayed below -20% for 18 consequtive months, and plumbed much lower depths (lower than -30%) than usual.

Im sure that some out there are wondering whether the market will ever recover. We've certainly heard enough commentary about the 'end of capitalism' over the last year. People were thinking the same things in the early 1980s. But the market did recover in the 1980s, and it will undoubtedly do it again. We can now look back at the early 1980s as the great buying opportunity that it was. I believe that we find ourselves in much the same situation today.

AUD/JPY carry trading has firmly emerged from the sub-60 buy zone, currently sitting around 71. I now think that its unlikely that we will return to the buy zone any time soon, but be ready just in case. At the moment, my carry trading account is up 100%. Approximately 94% of this is unrealised capital gains, and the remainer balance and position interest.

In other news, Im hoping to get some more analysis up this month. I've applied my All Ords analysis to the Dow Jones. This has not been at all successful, which I think is due to the official US growth and inflation figures being an utter work of fiction. I may publish this anyway, just for interest. I'm also hoping to repeat the analysis with the FTSE and the Nikkei, so hopefully at least one of these will be up this month.

End of January update

2009-02-04T15:10:00.004+11:00

Another month down. The talking heads would have you believe that the world is coming to an end. Political glad-hands abound. Business as usual it seems.

Lets see what the real picture is:

ALL ORDS The all ords edged downwards for the month, dropping about 200 points. However, something more important seems to be happening: a band of resistance appears to be forming around 3300. This could signal a good buying opportunity.

In terms of where we are to the real value of the market, we are in a about the same place as the end of last month. We ended the month at 23.5%, which is in buy territory.
AUD/JPY

The AUD/JPY took a bit of a beating this month. We started around 64, went as high as 68 before diving back to 57 to close the month. Most of this movement seems to have been caused by the now-confirmed expectation that the RBA would cut rates again.

The good news is that AUD rates are still much higher than JPY. Also, we are back below 60 (we went close to 55 again a few days ago), so its a good time to open carry trades.

All Ordinaries: Comparative returns

2009-01-21T16:33:00.002+11:00

I'm just running a few numbers to show you all the long-term power of the All Ordinaries relationship I posted earlier.

Say there are two people start a regular savings plan in 1980. Each ends the month with $1000 to invest somewhere. The first person invests his money every month in an All Ords index fund regardless of market conditions. At 01/01/2009, he would have invested $349,000 and have $870,000 worth of shares, equal to an average annual return of 6.26%. Not too shabby at all.

The second person watches the market more closely. He only invests in the market when it ends the month at least 20% below it's fair value. When the market ends the month above 20% below the fair value, he puts his money in the bank and waits. If the market closes 50% above its fair value, he sells all his stocks. At 01/01/2009, he would have invested $349,000 and have $2,140,000 in shares, equal to an average annual return of 11.05%. Nothing to sneeze at there.

So:
Person 1: Invests $349k, Finishes with $870k
Person 2: Invests $349k, Finishes with $2,140k.

Of course, the past is no guarantee of future returns.

AUD/JPY reenters the buy zone

2009-01-15T08:02:00.003+11:00

Recent falls in the AUD/JPY has brought it back into the buy zone I defined in my last post.

We are currently sitting at 58.58. This is around the area where the AUD/JPY has found support recently and reversed its trend.

AUD/JPY: A systematic relationship

2009-01-09T12:11:00.018+11:00

Interest, Smith, Australia and Japan

When Adam Smith wrote about interest rates in The Wealth of Nations he made two important observations: First, the rate of interest on money in a nation is a proportion of the usual rate of profit. Second, the usual rate of profit is much higher in developing regions than heavily developed commercial nations.

Smith provided the examples of the as yet relatively undeveloped New World and the industrial and commerical nations of Europe, most importantly Holland. In the New World, the abundance of natural resources such as land, minerals and timber provided more opportunities for higher return on investment than Holland which largely relied on commerce and manufacturing. As a consequence, the demand for money in the New World to develop capital was much higher than the Old World. Hence, the higher demand resulted in a higher rate of interest.

This systematic difference between developing and industrialised nations still exists today. Perhaps the clearest example is the relationship between Australia and Japan. Australia is a relatively young nation that principally derives its income from primary products (e.g. food, minerals, and other bulk commodities). In contrast, Japan is a heavily industrialised nation that derives most of its revenue from manufacturing and commercial activity. Interest rates therefore should be lower in Japan and higher in Australia. This is exactly the relationship that can be seen from observing central bank interest rates over the last 20 years:

Some time ago I produced a similar chart for a longer time frame. Unfortunately, I cant seem to track down the original data at the moment, but I will update this when I find. Suffice to say that the interest rate differential has existed for a much longer period of time than shown in the chart, perhaps since WWII, perhaps even longer.

Exploiting the Relationship

So interest rates in Australia are higher than Japan. So what? Its rather meaningless unless we can exploit it. The best way to exploit it is to buy high interest Australian Dollars with low interest Japanese yen. For example, if you purchased $100,000 with 6,500,000 yen (65 yen to the dollar exchange rate) you could (at the moment) collect about 4.5% interest a year, instead of the virtual zero interest that the yen attracts. Interest-straved Japanese savers have been doing this for years, buying high-yield Australian, New-Zealand, US and European debt with their low-yielding yen savings. The Japanese call this Uridashi.

Good news for the Japanese, but its not really practical for most Australians. On the one hand, we can collect the interest the Japanese are chasing simply by having a term deposit, without having to resort to complex international loans. On the other, it isnt practical for most of us to borrow yen directly from Japanese banks to buy Australian debt.

The easiest way for most Australians to exploit the dollar/yen interest rate differential is through spot forex (foreign exhchange) trading. This offers additional advantages, as well as risks. The main advantage of forex trading is the capacity to leverage your positions, which is also the main risk. Most brokers will offer a leverage rate of between 20:1 and 100:1. The more leverage you employ, the higher your potential rewards, but the higher the risk. I'll use a maximum leverage of 50:1 for this example.

Most brokers will offer you a reasonable rate of interest on your account balance, lets say 4%. If you open an account and deposit money, you will collect 4% p.a. Lets further assume that the ask price (the price the broker will lend to you at) for the yen is 1%, the bid price (the amount that the broker will offer you in interest) for the dollar is 4%, and the Australian dollar buys 65 yen. This is a differential of 3%. Now, if we were to borrow enough yen to buy an amount of Australian dollars equal to the amount we deposited, we would collect 7% interest p.a. (4% account balance + 3% differential). However, if the dollar fell to 32 yen you would experience a margin call and lose most of your account balance. Buying double your account balance will yield 10% interest, and you would experience a margin call at 44 yen. Five times, 19% interest and a margin call at 55 yen. Ten times, 34% interest and a margin call at 60 yen. Even a leverage of 10:1 is stupidly dangerous, so I wont bother quoting any more figures.

Timing Entries and Exits

While the interest rate differential has been historically systematic, it does not follow that all times are equally good to enter the market (just like any other market). For example, if you had entered the market at even the modest leverage of 1.5:1 when the AUD/JPY was 100, you would have experienced a margin call in recent months. Even at a 1:1 leverage, unless you have nerves of steel you would have been close enough to a margin call to break a sweat.

So far Ive just been talking about interest. Another thing to consider is capital gains. For example, if you bought in at 65 and it rose to 100 at 1:1 margin this would be a capital gain of 54%. At 2:1, 108%, etc. Some people who use this strategy see the interest differential as the prize and the capital gain as a bonus, others the capital gain as the prize and the interest as a bonus. Some both.

So when is a good time to buy? Below is a chart of the AUD/JPY since the dollar floated in 1984. The value of the yen declined precipitously in the mid to late 1980s due to structural changes associated with the float of the currency. This part of the chart can be ignored.

After the structural adjustments of the 1980s, the AUD/JPY has largley moved in a range from 55 to 110. The lowest point the dollar has fallen to is 54 yen, which occured in late 2000. Based on the chart, it seems sensible to purchase AUD/JPY positions at 60 or below and close these positions at 100.

Beyond the chart, there is one other factor that makes this a sensible strategy: interference from central banks. Japan is Australia's largest trading partner and as such Australia has a strong interest in the value of the dollar relative to the yen. Similarly, as an industrial nation, the Japanese have a strong interest in depressing the value of their currency to give their exports a competitive advantage. When the dollar falls too low, the Reverse Bank of Australia starts buying it to support its price. When the dollar gets too high, the RBA exchanges their dollars for foreign currency. Doubtless the Bank of Japan does the same thing. These factors act to constrain the AUD/JPY to the range observed above.

Summing up

The most important part of this strategy is to understand the risks, and determine the degree of risk you are willing to take. As for me personally, I currently have positions at about 5:1 leverage. My average purchase price was about 59. If I can close these positions out next time it gets to 100, this will be a 350% profit, plus at least 15% interest per year until then.

All Ordinaries, Economic Growth and Inflation

2009-01-07T17:06:00.011+11:00

All Ordinaries and Inflation

The All Ordinaries is a market index that measures the value of shares traded on the ASX. Similar indices are found elsewhere in the world, such as the Dow Jones Industrial Average and the Nikkei. One problem with indices is that they do not account for the effects of inflation, which complicates the interpretation of long-term trends. There are two main problems: first, inflation tends to underestimate historic price movements; second, it overestimates the real rate of market return.

The below figure shows both the nominal values for the All Ordinaries since 1980 and the same values adjusted for inflation into year 2000 dollars. In nominal terms, the All Ords has 546 to approximately 3500 at the end of 2008, equal to growth of around 6.5% per year. Once adjusted for inflation, 1482 points to 2750 at the end of 2008. This equates to real growth of around 2% per year since 1980.

Stock Markets and Economic Growth

The All Ordinaries contains a large number of companies that largely operate in Australia. While the performance of individual companies will vary substantially depending on a wide range of variables, overall the vagaries of individual companies will even out over the entire market. These companies largely operate in Australia; therefore any real growth in the All Ords must be derived from real (i.e. inflation adjusted) growth in the Australian economy. Long-term All Ordinaries growth cannot greatly exceed the rate growth in the broader Australian economy.

If markets behaved rationally, the All Ords would grow at the same rate as the Australian economy. However, markets do not always behave rationally, but suffer from periods of pessimism and exuberance. The below figure has two components: first, the inflation adjusted All Ords (blue line); second, a representation of the ‘fair value’ of the All Ords. The ‘fair value’ is calculated by multiplying value of the All Ordinaries from January 1 1980 by the reported rate of Australian economic growth for the year. Notwithstanding frequent deviations, the inflation-adjusted All Ords closely follows the values indicated by growth in the broader economy.

Market Timing

After a deviation, the inflation-adjusted All Ords tends to return to the ‘fair value’ indicated by economic growth. By measuring the distance of the All Ords from their fair value, market entry and exit opportunities can be identified. This can be done by measuring the distance of the All Ords from the fair value as a percent, as shown below:

Generally, in times of pessimism the market tends to fall to 20-30% below its fair value. In times of exuberance, the market rises 20-50% above its fair value. Over the last 28 years, purchasing when the index falls to 20% below its fair value and selling when the index exceeds the fair value by 50% would have proved a highly successful strategy, as show in the figure below:

Welcome and Disclaimer

2009-01-07T14:46:00.002+11:00

Welcome to my blog.

I've started this as a way to organise and share my thoughts and strategies on trading in various markets from an Australian perspective.

I make absolutely no guarantees or promises in this blog. All forward-looking statements are my personal opinion only, and is not investment advice. By using any information on this website you agree that you do so at your own risk, and do not hold the publisher or their agents accountable for any financial losses or distress you may suffer.