Fund Performance and Asset Price Inflation: The Dawn of a New Era

Dear Readers,

There is a major battle between the bulls and the bears. No matter how you look at it, both sides have very valid arguments for their existence.

When everyone was screaming doom and gloom at the beginning of 2012, I called for the S&P to rise to 1500 before the year was over. While we’re still not quite there yet, we’re awfully close: The S&P 500 finished up 7.10 points at 1,466.47 on Friday, its highest close since December 2007.

I am not here to tell you I was right, when so many experts were wrong. I am not here to tell you again that the Equedia Select Portfolio has outperformed the top hedge funds, mutual funds, and every benchmark index last year.

I am here to tell you why the market has performed the way it has, so that you can use it to your advantage. And the answer is very simple…

Asset Price Inflation

Inflated asset prices create optimism. The more something is worth, the wealthier and happier we feel. It doesn’t matter if our worth is all relative to our purchasing power; the more money we make, the better we feel. It’s all about perception.

That is why the Fed and central banks around the world are uncontrollably injecting more currency into the world than man has ever known. They want to make people feel good. And what better way to do that than to inflate the price of assets?

Asset price inflation is an economic phenomenon denoting a rise in price of assets, as opposed to ordinary goods and services. Typical assets are financial instruments such as bonds, shares, and their derivatives, as well as real estate and other capital goods.

The Fed’s goal isn’t to raise the price of food or energy, or other consumer goods; their goal is to raise the price of assets. Of course, their actions have other unintended consequences (see America’s Gold Wiped Out.)

Remember a few weeks ago when I explained what happens to the price of money, or interest rate, when money is printed? In short, interest rate drops. This leads to lower bond-yields, which in turn should alter how investors value equities relative to the fixed-income market. When long-term bond yields can’t keep up with inflation, and thus is losing value, fixed-income investors have to eventually rebalance their asset mix towards equities in order to maintain their current allocation (see The Dramatic Drop).

By incentivizing fund flows into the equity market, stocks rise. This boosts wealth and should make consumers, who now feel richer, spend more.

That’s why a few years ago, I told my readers not to worry about the stock market; especially if they’re worried about inflation.

The Age of Central Banks

With the stock market now nearing the 2007 highs, I would say the Fed’s plan has worked. I am not saying there won’t be any consequences, but the trillion dollar injections have thus far led the markets to more than a double since the lows of early 2009.

If you looked only to the stock market as our economic gauge, then the Fed has done a pretty good job thus far.

While the dynamics of the capital markets are much different than they were in 2008, the stock charts are showing that 2008 was just a minor blip in the market…for now.

Our history has been written by unforgettable economic events; from the Great Depression to the Nixon Shock, from the Tech Bubble to the Housing Bubble. This is the dawn of a new era: The Age of Central Banks.

Fund Performance

According to Goldman’s David Kostin, 2012 was a strong year for stock returns but a poor year for managers:

Nearly two-thirds of US equity mutual funds lagged their benchmarks. Their analysis of $1.3 trillion in US equity mutual fund assets reveals that 65% of large-cap core, 51% of large-cap growth, 80% of large-cap value, and 67% of small-cap mutual funds underperformed their respective benchmarks including the S&P 500, the Russell 1000 Growth, Russell 1000 Value, and Russell 2000.

As I mentioned last week, hedge funds also underperformed.

How is it possible that during a bull market year, so many experts got it wrong?

Because experts are trained to analyze economic data, balance sheets and so on. They’re not trained to predict political decisions nor predict computer algorithms.

We are in an era of manipulation. That is why so many experts got it wrong. They’re not reading between the lines, they’re simply reading.

The artificial inflating of asset prices above levels justified by sluggish fundamentals, have triggered the world into believing things are great. And the fact the Fed is continuing to show an aggressive “all-in” approach is good news for all types of markets.

But remember, there is a limit to how far and how long prices can deviate from fundamentals. This is particularly the case when central banks, acting without the support of other government entities, do not have enough tools to ensure strong and sustainable economic outcomes; there just isn’t a proven theory on how this can be achieved through central bank intervention.

There are plenty of books on how to trade using technical charting, value investing, and so on. Perhaps there should be a book on how to trade manipulation.

As I mentioned last week, there is a lot to be bullish about.

Technically, the markets look great. Low interest rates continue to push more individuals out of cash and bonds and into more risky investments, fuelling the market higher. We also have an additional and artificial $85 billion per month of liquidity being injected on an on-going basis until fundamentals get better.

But as I also mentioned last week, not everything is pretty.

From a bearish point of view, we’ll have yet another debt ceiling debate fiasco, combined with potentially more negative news coming from China and/or Europe. Also, while earnings are projected to be higher in 2013, there is a big question of how this will be achieved; given that higher earnings in both 2011 and 2012 were as a result of a lot of cost-cutting (see The Next Fire Sale). Can these companies continue to cut costs? If so, at what expense? Lastly, the economy is still growing at a sluggish pace and unemployment still remains a major concern.

How this all plays out will be dictated a lot by government policy, none of which we can control or predict. In the meantime, should markets hold up, I believe more investors will participate in 2013 leading to a stronger retail market.

Conformity is part of human nature. Retail investors still like to chase and will invest more when things are moving up. With the stock market now up significantly over the last few years, perhaps now the retail market will participate.

That leads me to how we protect ourselves.

I’ve talked about owning farmland and other high-valued, rare assets in past letters. Unfortunately, most cannot afford, nor have the time capacity, to purchase such wealth protection assets.

So what can the regular Joe do?

Gold and Silver

It seems like the obvious answer, yet I still receive questions about this every day.

The upside fundamentals of gold and silver are all there. Its wealth preservation metrics cannot be matched by any manmade financial instrument. I’ve mentioned this in so many Letters over the past five years.

Gold has continually gone up in price for more than 13 years straight, and its value has been in an upward trend since the beginning of time. How many stocks can say that?

The retail investor will eventually get screwed by chasing the gains of the overall stock market. But that’s human nature; no one wants to be the first, and no one wants to be the last.

Eventually, the retail market will catch onto gold’s incredible rise. They will jump on the band wagon, as they do with all stocks and investments. The retail market, although easily spooked, is the strongest price-setter; bidding up things to ridiculous prices just to get a piece of the action. When the retail market participates, manipulation in the gold and silver market will be forced away and shorts in the sector will scramble to cover, sending prices even higher. I can’t say when this will occur, but I believe it will.

I purchased more physical silver this week when prices dipped below $30. There’s a lot of questions on buying bullion, bars, and coins; how to store it, where to buy it, how to insure it…

For me, much of the gold and silver I buy in the form of physical bullion, bars, or coins, I keep in a safe; away from manipulators, agencies, and the financial markets. How you insure it is up to you.

Don’t get me wrong, I still own gold and silver in the form of liquid financial instruments via stocks, ETF’s, and funds, but I keep a small portion of my physical gold and silver close by my side.

I also buy bullion for my son, as part of his future education plan. I am confident that silver will double its value in 10 years, so I buy silver bullion for him in addition to other education savings plans. And when I say a double in value, I mean a real double; not just a double based on inflation.

Let me show you what I mean, based on the US government’s CPI inflation calculator…

Silver vs. Dollar

Let’s say 10 years ago, a house costs $100,000.

In 2002, silver was just above $4 per ounce.

If you bought that house with silver ounces 10 years ago, it would cost you 25,000 ounces ($100,000/$4/oz = 25,000 oz).

If you wanted to buy that same house with today’s dollars, it would cost $164,092 — an increase of 64%. Simply put, it means you lost 39% of your purchasing power in 10 years, based on the CPI inflation calculator.

Silver is now trading around $30 per ounce, an increase of nearly 565% in the last 10 years.

Guess how many silver ounces it would take to buy that house now with today’s silver? Only 5470 ounces.

If you held your money in currency, you would have lost more than 39% of its value. To buy that same house with today’s dollars, you would need more money.

However, if you held silver, you would not only need less silver, but you will have enough silver to buy more than four houses, with lots of silver to spare.

It’s clear that if you saved the $100,000 and didn’t touch it for ten years, you would’ve lost a lot of money. If you bought silver instead, your 25,000 ounces of silver would now be worth $750,000 in today’s currency.

These numbers are real. And the data includes only the last 10 years. How much will silver, or gold, be worth 10 years from now when you consider that central banks are printing more money than ever, literally.

I am using silver as an example because everyone can afford it, but the same concept works with gold.

The math couldn’t be simpler. I can’t tell you what to do. But I can tell you what I am doing.

I just bought more physical silver.

Until next week,

Ivan Lo

Equedia Weekly

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Disclosure: I am long gold and silver through ETF’s and physical bullion, bars, and coins, as well as long both major and junior gold and silver companies. You can do the math. It’s your money to invest and we don’t share in your profits or your losses, so please take responsibility for doing your own due diligence. Remember, past performance is not indicative of future performance. Just because many of the companies in our previous Equedia Reports have done well, doesn’t mean they all will.

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