Week 43: A Poseidon Adventure

Summary:

The Greek saga continues. We now have a potential referendum where the Greek people will decide their own fate. A Eurozone exit is a definite possibility. The fact that the euro isn't plunging here says a lot about the world's reserve currency, the USD. The euro and the Eurozone is going to look a whole lot different in 12 months time. The crisis is accelerating. German, French and US bond markets are rallying again as investors flee to safety, while equity markets are also holding their own in anticipation of more monetary stimulus, which I think is just around the corner. Something's gotta give.

The model portfolio returned +2.7% last week. Equities gained +3.1%, bonds fell -0.2% and gold in euro terms added +4.3%. There is no change to the 60% equities / 20% bonds / 20% gold split. In October, the model portfolio returned +3.6% compared to +4.6% for the Aon Hewitt Managed Fund Index. Equities gained +6.3%, bonds fell -2.9% and gold in euro terms gained +2.0%. YTD through end-October, the model portfolio has returned +0.7% compared to -5.0% for the Aon Hewitt Managed Fund Index. Equities returned -6.6%, bonds rallied +2.2% and gold in euro terms gained +16.5%.

DJIA	11,955	Dollar Index	$76.15	CRB Index	319.85
DJTA	4,893	CAD/EUR	1.3865	Gold	$1,715
DJUA	450	USD/EUR	1.3855	Silver	$34.30
NDX	2,684	JPY/EUR	108.35	Copper	$3.63
S&P 500	1,253	JPY/USD	78.15	Oil WTI	$93.10
ISEQ	2,729	USD/GBP	1.6085	Natural Gas	$3.93
FTSE	5,544	10 Yr. Tsy.	129.05	Soybeans	$12.25
Nikkei	8,988	30 Yr. Tsy.	139.05	Corn	$6.60

Equities:

We live in interesting times. The Greek god Poseidon, protector of all waters, wouldn't have allowed it on his watch. Greece is hurtling towards debt default and the abyss. Meanwhile, their heavily under pressure Greek Prime Minister has pulled a political master stroke. He has negotiated the best possible deal he could for his people, namely a 50% haircut on Greek debt and a debt/GDP target of 120% by 2020, and then called a referendum to let the Greeks decide for themselves whether they want to stay in the Eurozone and accept the severe austerity measures or something possibly worse. Papandreou will probably resign but at least won't go down in history as the guy who sold out his country.

The choice is stark for the Greek people: option (a) is a decade of austerity, chasing a moving target of deficit and debt reductions to try and restore fiscal stability; or option (b) is an inevitable Eurozone exit and return to the drachma. With option (a), pensioners will in all likelihood get at least a 50% reduction in their pension, the retirement age will rise substantially, taxes will go up for the working population, government spending will go down and unemployment will remain high. With option (b), folks will get paid in funny money that will immediately devalue by 50-70%. Your €50,000 pension will turn into a 50,000 drachma pension and you will be one heck of a lot poorer. Anyone relying on the State will become significantly poorer.

We should watch with keen interest how this plays out. In Ireland, our debt/GDP will approach 110% this year and, despite the nearly €4 billion of planned budget cuts for 2012, we will still spend over €10 billion more than we take in taxes next year. By 2015, our debt/GDP will approach a Greek-like 140% and we still won't have a balanced budget because GDP growth will continue to be anaemic as we continue to try to close the budget gap. Last week, the government cut its GDP growth forecast for 2012 from 2.5% to sub 2%. We will be lucky if we grow by 1% in 2012. Unbelievably, government numbers include 4%+ GDP growth from 2013 onwards. It would be funny if it weren't so tragic.

Enough of the negativity I hear you say. There is one other solution that is potentially a lot less painful (in the short-term anyway). The ECB could just print money and inflate away a portion of Eurozone debts over time, the Eurobond solution. Jurgen Stark the hard-nosed German Bundesbanker has sensed this coming and resigned from the ECB in September. This followed initial steps by the ECB to intervene in the Euro sovereign debt markets, buying up peripheral country government bonds in a vain effort to keep a lid on bond yields; the first step on a slippery slope to debt monetisation. I think we will follow this path, reluctantly at first and then with enthusiasm. It is what central bankers do and a money-printing solution is politically appealing. Got gold?

Speaking of which, I want to talk a little (more) this week about the precious metals sector. I hope some of you have protected yourself from what is coming by investing somewhat in gold. If so, great. If not, $1,700/oz is a bargain. What are you waiting for? We are still early in this bull market. How early? Well, here is an updated chart comparing the current "gold bubble" with three past bubbles. This gold bubble began in 2001 at $250/oz. We have not yet entered the speculative phase, which, I think, will start once gold trades (and remains) above $2,000, which could happen in the next 6 months. Previous bubbles begin to accelerate higher once they reach approximately 6-7 times their initial price at the beginning of each prior bull market.

Another reason I know we are nowhere near bubble territory in the precious metals sector is that the mining stocks just haven't participated at all yet to any great extent. By way of illustration, here is a chart that measures the relationship between gold and the mining stocks. Historically, the miners are undervalued when gold reaches a multiple of 5.5 times the XAU (an ETF of gold and silver mining companies). Today, we are at 8.5 times the XAU. If gold reaches $2,000 and the gold:XAU ratio moves back down to 6 (still very undervalued), that would drive a 64% rally in XAU.

How about one of the major stocks in the mining sector, Newmont Mining, which can be bought for around $66/share today. The analyst community value the mining stocks at approximately two times NAV (net asset value). They calculate NAV using a long-term forecast for the gold price. Their average long-term forecast for gold is still unbelievably low at approximately $1,000. JP Morgan recently revised its long-term gold forecast up from $950/oz to $1.050/oz. That $100 increase in their forecast results in a price target increase in NEM of 45% from $55 to $80. If they increase their long-term target to $1,850, their NEM target goes to $200/share. Enough said. Gold is cheap. Miners are cheaper though that trend is slowly changing.

I think this bull market has the potential to be much greater than any of the prior ones. Gold bull markets rise on fear (equity bull markets rise on greed). If the euros or dollars in your pocket are being eroded by high inflation or if there is a real threat that the euro is going to dissolve, there will be a panic into the ultimate store of value, the ultimate inflation hedge. How many Irish pension schemes own gold or have a meaningful exposure to this sector? Some have invested with global equity managers that invest in this sector. BNYM Newton and Bedlam Asset Management come to mind. Some have invested in alternatives managers that hold bullion (Bridgewater). However, we are talking a tiny number of schemes and a very tiny percentage of assets. We should be introducing Irish pension schemes to what will be the biggest bull market of this decade.

Back to today's market…. From a technical perspective, we broke long-term support in August but have recently regained the upper hand. The primary trend remains upwards. Equity markets are preparing for inflationary times ahead. Despite the heightened volatility, I think the outlook for stocks in the short-term (November-March) remains positive. Stock markets are shrugging off the unending concerns involving peripheral country debts and possible Eurozone exits and instead are focusing on the massive additional central bank stimulus measures that are coming down the track. In fact, the Fed meets today and may give some hints of its plans for QE3 or additional debt monetisation. Stay tuned.

Bonds:

The current term structure of interest rates for the German, US and UK government bond markets are summarised in the following table.

Current Yields	German Bunds		U.S. Treasuries		U.K. Gilts
3-Month	0.34%		-0.01%		0.49%
2-Year	0.44%		0.24%		0.56%
5-Year	1.03%		0.93%		1.21%
10-Year	1.86%		2.04%		2.27%
30-Year	2.68%		3.07%		3.29%

The Aon Hewitt Asset Allocation Team currently maintains the following fair value yield estimates for 5, 10 and 30 year government bonds for the French, US and UK fixed income markets:

Fair Value Yields	German Bonds		U.S. Treasuries		U.K. Gilts
5-Year	4.30%		4.40%		5.30%
10-Year	4.40%		4.50%		5.30%
30-Year	4.40%		4.50%		5.30%

Government bond yields remain significantly below the fair value estimates of the Asset Allocation Team, particularly for 5 and 10-year government bonds, hence the continued bearish view on this particular asset class. Now, let's take a closer look at the trend in 10-year yields for Germany and the peripheral Eurozone debt markets. Just when you thought life was getting a little easier for Irish pension schemes, Greece spooks the markets and everyone piles back into German bunds. We are back at the multi-decade lows for bund yields, though it is a different story for some of the other Eurozone countries.

Italian government bond yields have breeched 6% and Berlusconi is under increasing strain. His government is close to collapse. In Ireland, we haven't issued 10-year bonds in a while so now we have to focus on 9-year bond yields as a measure of our sovereign risk. In Spain and Portugal, 10-year yields have hit 5.52% and 11.80% respectively. Meanwhile in the basket case, Greece, one-year yields are north of 200% and 10-year bonds yield nearly 25%. The market has chosen to ignore the fiscal and banking problems of France for now as yields there dropped below 3% once again. Who is going to be brave enough to recommend sovereign annuities in 1Q2012?

German 10-Yr Yield at 1.77% DOWN from 2.11% last week

French 10-Yr Yield at 2.95% DOWN from 3.15% last week

Irish 9-Yr Yield at 8.26% UP from 8.15% last week

Italian 10-Yr Yield at 6.20% UP from 5.90% last week

Greek 10-Yr Yield at 24.65% UP from 24.05% last week

Spanish 10-Yr Yield at 5.52% UP from 5.45% last week

Portuguese 10-Yr Yield at 11.80% DOWN from 12.25% last week

Commodities:

Gold closed on Friday at $1,744/oz, up a very respectable +16.5% year-to-date in euro terms.

Public opinion on the commodities sector bottomed out last month and has begun to recover, but there is plenty of time left yet for prices to move higher. Likewise, following this modest bounce in the US dollar in the short-term as investors panic into perceived safe havens, there is plenty of scope for the USD to continue its decline, which is what I expect in the months ahead.

The model portfolio returned +2.7% last week. Equities gained +3.1%, bonds fell -0.2% and gold in euro terms added +4.3%. There is no change to the 60% equities / 20% bonds / 20% gold split. In October, the model portfolio returned +3.6% compared to +4.6% for the Aon Hewitt Managed Fund Index. Equities gained +6.3%, bonds fell -2.9% and gold in euro terms gained +2.0%. YTD through end-October, the model portfolio has returned +0.7% compared to -5.0% for the Aon Hewitt Managed Fund Index. Equities returned -6.6%, bonds rallied +2.2% and gold in euro terms gained +16.5%.

TOP TEN INVESTMENT IDEAS FOR 2011:

	Top 10 For 2011	28/01/2011	Comment
1	Long Gold	$1,337	Conservative inflation hedge
2	Long CEF.A	$18.95	ETF backed by 50% gold, 50% silver
3	Long NEM	$55.00	Miner leveraged to rising gold prices
4	Long EGD	$4.20	Mining services company that sells equipment to the sector without taking the exploration risk.
5	Long GDXJ	$34.60	Junior miners ETF – when gold hits bubble territory, GDXJ will best capture the mania that follows.
6	Short 30 Yr Treas.	$121.45*	28 year bond bull market over, with US 10-year yields troughing at 2.4%.
7	Long MSFT	$27.75	The cash machine of the technology sector; single-digit P/E with double-digit EPS growth.
8	Long CAD/ Short JPY	JPY 82.00	JPY must decline so Japan can regain competitiveness and reduce its massive debt burden (200% of GDP).
9	Long Sugar	$0.34/lb	Commodity play with strong supply/demand imbalance
10	Long Soybeans	$14.05/ bushel	Commodity play with strong supply/demand imbalance

YTD PERFORMANCE OF 2011 BEST IDEAS:

		28 January 2011	31 October 2011	2011 Return YTD
1	Long Gold	$1,337	$1,715	28.3%
2	Long CEF.A	CAD 18.95	CAD 22.55	19.0%
3	Long NEM	$55.00	$66.83	21.5%
4	Long EGD	$4.20	$3.80	-9.5%
5	Long GDXJ	$34.60	$31.10	-10.1%
6	Short 30-Year Treas.	$121.45	$139.05	-14.5%
7	Long MSFT	$27.75	$26.63	-4.0%
8	Long CAD/Short JPY	JPY 82.00	JPY 78.10	-4.8%
9	Long Sugar	$0.34	$0.26	-23.5%
10	Long Soybeans	$14.05	$12.30	-12.5%
2011 Top 10 Ideas Average Performance				-1.0%
AH Managed Fund Index				-5.0%
FTSE AW Dev. Index (Equity)				-6.6%

PERFORMANCE OF 2010 BEST IDEAS:

		01 January 2010	31 December 2010	2010 Return
1	Long Gold	$1,097	$1,421	29.5%
2	Long Silver	$16.88	$30.91	83.1%
3	Short 30-Year Treas.	$115.38	$122.10	-5.8%
4	Long NEM	$47.31	$61.43	29.8%
5	Long PAAS	$23.81	$41.20	73.0%
6	Long DVN	$73.50	$78.51	6.8%
7	Long CAD/EUR	CAD 1.5100	CAD 1.3356	11.5%
8	Long Nikkei	10,546	10,229	-3.0%
9	Long Sugar	$0.27/lb	$0.321/lb	18.9%
10	Long Soybeans	$10.54/bsl	$14.09/bsl	33.7%
2010 Top 10 Ideas Average Performance				27.8%
AH Managed Fund Index				12.0%
FTSE AW Dev. Index (Equity)				20.1%