Author: Colin Twiggs

Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters. Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis. Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events. He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.
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Thoughts on Israel

We express our sympathy for the people of Israel who have suffered a brutal attack from HAMAS and its backers.

An act of such barbarity is bound to evoke a response and lead to further escalation of violence in the region. But that seems to be the intention.

Martin Indyk, former US Ambassador to Israel (1995-1997 and 2000-2001) and special envoy under President Obama for Israeli-Palestinian negotiations (2013-2014), was asked why this occurred now, after progress seemed to be made on an Israel-Palestine settlement:

I think you have to consider the context at this moment. The Arab world is coming to terms with Israel. Saudi Arabia is talking about normalizing relations with Israel. As part of that potential deal, the United States is pressing Israel to make concessions to the Palestinian Authority—Hamas’s enemy. So this was an opportunity for Hamas and its Iranian backers to disrupt the whole process, which I think in retrospect was deeply threatening to both of them. I don’t think that Hamas follows dictation from Iran, but I do think they act in coordination, and they had a common interest in disrupting the progress that was underway and that was gaining a lot of support among Arab populations. The idea was to embarrass those Arab leaders who have made peace with Israel, or who might do so, and to prove that Hamas and Iran are the ones who are able to inflict military defeat on Israel.

There are talks going on regarding a peace deal between Israel and Saudi Arabia, and conversations about U.S. security guarantees for Saudi Arabia. In all likelihood, a primary motivation for Hamas and Iran was a desire to disrupt that deal, because it threatened to isolate them. And this was a very good way to destroy its prospects, at least in the near term. Once the Palestinian issue returns to front and center, and Arabs around the Middle East are watching American weapons in Israeli hands killing large numbers of Palestinians, that will ignite a very strong reaction….

….And in terms of escalation, the party to watch most closely is Hezbollah. If the Palestinian death toll rises, Hezbollah will be tempted to join the fray. They have 150,000 rockets they can rain down on Israel’s main cities, and that will lead to an all-out war not just in Gaza but in Lebanon, too. And everybody would get dragged in that situation. (Foreign Affairs)

Conclusion

The aim of the attack was to provoke a violent retaliation which would disrupt an Arab-Israeli peace accord.
Starting another war would play into the perpetrator’s hands.
Netanyahu prides himself on being cautious. Now is the time to show restraint, bolster Israel’s defenses and continue to pursue peace in the region — which would sideline HAMAS and its Iranian backers.

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Copper breaks support while crude gets hammered

Copper broke support at $7900/tonne, signaling a primary decline with a target of its 2022 low at $7000. The primary down-trend warns of a global economic contraction.

Copper

The bear signal has yet to be confirmed by the broader-based Dow Jones Industrial Metals Index ($BIM) which is testing primary support at 155.

DJ Industrial Metals Index ($BIM)

Crude oil

Crude fell sharply this week, after a 3-month rally.

Nymex Light Crude

The fall was spurred by an early build of gasoline stocks ahead of winter, raising concerns of declining demand.

Gasoline inventories added a substantial 6.5 million barrels for the week to September 29, compared with a build of 1 million barrels for the previous week. Gasoline inventories are now 1% above the five-year average for this time of year….. production averaged 8.8 million barrels daily last week, which compared with 9.1 million barrels daily for the prior week. (oilprice.com)

Gasoline Stocks

Crude inventories have stabilized after a sharp decline during the release of strategic petroleum reserves (SPR).

EIA Crude Inventory

Releases from the SPR stopped in July — which coincides with the start of the recent crude rally. It will be interesting to see next week if a dip in this week’s SPR contributed to weak crude prices.

Strategic Petroleum Reserves (SPR)

Stocks & Bonds

The 10-year Treasury yield recovered to 4.78% on Friday.

10-Year Treasury Yield

Rising yields are driven by:

  • a large fiscal deficit of close to $2T;
  • commercial banks reducing Treasury holdings; and
  • the Bank of Japan allowing a limited rise in bond yields which could cause an outflow from USTs.

Bank of Japan - YCC

The S&P 500 rallied on the back of a strong labor report.

S&P 500

The S&P 500 Equal-Weighted Index test of primary support at 5600 is, however, likely to continue.

S&P 500 Equal-Weighted Index

Expect another Russell 2000 small caps ETF (IWM) test of primary support at 170 as well.

Russell 2000 Small Caps ETF (IWM)

Labor Market

The BLS report for September, with job gains of 336K, reflects a robust economy and strong labor market.

Job Gains

Average hourly earnings growth slowed to 0.207% in September, or 2.5% annualized. Manufacturing wages reflect higher growth — 4.0% annualized — but that is a small slice of the economy compared to services.

Average Hourly Earnings

Average weekly hours worked — a leading indicator — remains stable at 34.4 hours/week.

Average Weekly Hours

Unemployment remained steady at 6.36 million, while job openings jumped in August, maintaining a sizable shortage.

Job Openings & Unemployment

Real GDP (blue) is expected to slow in Q3 to 1.5%, matching declining growth in aggregate weekly hours worked (purple).

Real GDP & Hours Worked

Dollar & Gold

The Dollar Index retraced to test new support at 106 but is unlikely to reverse course while Treasury yields are rising.

Dollar Index

Gold is testing primary support at $1800 per ounce, while Trend Index troughs below zero warn of selling pressure. Rising long-term Treasury yields and a strong Dollar are likely to weaken demand for Gold.

Spot Gold

Conclusion

Long-term Treasury yields are expected to rise, fueled by strong supply (fiscal deficits) and weak demand (from foreign investors and commercial banks). The outlook for rate cuts from the Fed is also fading as labor market remains tight.

The sharp drop in crude oil seems an overreaction when the labor market is strong and demand is likely to be robust. Further releases from the strategic petroleum reserve (SPR), a sharp fall in Chinese purchases, or an increase in supply (from Iran or Venezuela) seem unlikely at present.

Falling copper prices warn of a global economic contraction led by China, with Europe likely to follow. Confirmation by Dow Jones Industrial Metals Index ($BIM) breach of primary support at 155 would strengthen the bear signal.

Strong Treasury yields and a strong Dollar are likely to weaken demand for Gold unless there is increased instability, either geopolitical or financial.

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A tectonic shift hurts highly-leveraged sectors

The global economy is experiencing a tectonic shift — from a lack of demand (requiring stimulus) to a lack of supply (requiring suppression of demand).

The sharp rise in interest rates is just part of the adjustment to the new reality.

The rise in short-term rates did not have much impact on consumer spending. Personal Consumption is still above pre-pandemic levels relative to disposable personal income, while the savings rate has fallen to almost half of pre-pandemic levels.

Personal Consumption/Disposable Personal Income

High prices are the cure for high prices

The bond market and oil markets are now testing the assumption that the economy can cope with high interest rates and pull off a soft landing.

Two key prices — long-term interest rates and crude oil — are rising. This is likely to cause a strong contraction.

Mortgage rates (7.49% for 30-year) are at their highest level in more than 20 years.

30-Year Mortgage Rate

Corporate debt more than doubled relative to GDP since the 1980s, as corporations took advantage of cheap debt. When they roll over borrowings, they are now confronted with a sharp increase in debt servicing costs, forcing them to de-leverage.

Non-Financial Corporate Debt/GDP

Telecommunications Sector

The impact is clearly visible on sectors with high debt levels — like telecommunications, utilities, and real estate. The chart below compares performance of major telecommunications companies.

Telecommunications Sector

Only Orange (FNCTF), the French national carrier, has held its value since the start of 2022. Some, like Telstra (TLS) and Vodafone (VOD), succeeded in reducing debt by selling key assets (e.g. mobile phone towers) into a separate infrastructure trust. Spanish carrier Telefonica (TEFOF) has also done reasonably well, selling off some international interests. Many — notably Verizon (VZ), AT&T (T), Vodafone (VOD), and BT Group (BT) — have lost 40% of value in less than two years. Belgian carrier Proxima (BGAOF) gets the wooden spoon with a 60% loss.

Further adjustment will be necessary as the recent rise in long-term interest rates forces corporations to rein in capital expenditure and shed non-core assets in order to reduce debt exposure. That in turn impacts on equipment manufacturers like Ericsson (ERIC) and Nokia (NOK).

Ericsson (ERIC) and Nokia (NOK)

Conclusion

Rising long-term interest rates and crude oil prices are likely to cause a global economic contraction.

Sectors with high debt levels — like telecommunications, utilities, and real estate — will be forced to restructure due to rising interest rates. This is likely to have a domino effect on other sectors of the economy.

Acknowledgements

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Causes of inflation – a Monetarist perspective

20-minute summary by Prof. John Hearn

Cost-push inflation is a myth. Rising prices do not cause inflation unless you have more units of money to spend.

Demand-pull — caused by an expanding supply of money and its effect on aggregate demand — is only way you get inflation.

Managers of the money stock (central banks) are the cause.

If you only have £100 to spend and the price of gas goes up, you can still only spend £100. The relative prices of the basket of goods you purchase will adjust to find a new equilibrium.

But if the government borrows an extra £10 from the central bank, increasing the stock of money, prices will adjust to include the additional £10 spent by the government. The same basket of goods will now cost £110 and you have inflation.

That is why central banks hate monetarists. They would prefer you to believe that rising prices (cost-push) causes inflation.

Their deception is aided by the time lag between <>M and <>P of up to 2 years (<> = delta/change). From Milton Friedman’s Quantity Theory of Money: M * V = P * T (where M is money stock, V is velocity of money flow, P is prices and T is transactions)

Not all government borrowing is inflationary as it does not increase M unless debt is bought by the central bank.

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Nuclear or renewables?

Fossil fuels were the source of 83.7% of energy produced in the USA for the first half of 2023, compared to 7.8% for nuclear and 8.4% for renewables.

US Energy Sources

Take a closer look at renewables and 5.0% of the total comes from biomass — wood and biofuels like ethanol. Solar contributes 0.9% and wind 1.5%, for a total of only 2.4%.

US Energy Sources

The scale required to achieve a tenfold increase in wind and solar is hard to imagine. France, on the other hand, has already demonstrated what can be achieved with nuclear.

France: Nuclear

Uranium

Uranium prices are soaring, with the Sprott Physical Uranium Trust (SRUUF) climbing to a new high since its formation in 2021.

Sprott Physical Uranium Trust (SRUUF)

As John Quakes explained, on the social media site formerly known as Twitter, the shortage is caused by Rosatom buying uranium in Western markets due to sanctions restricting shipping insurance in Russia:

US Energy Sources: Renewables

Conclusion

Nuclear is the only viable option to replace fossil fuels for electricity generation. Renewables such as wind and solar may contribute but nuclear is the only option that can be implemented on such a scale.

Uranium prices are soaring and are likely to remain high for as long as Russia occupies part of Ukraine.

Acknowledgements

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Investing in Real Estate

In Monday’s update, we compared investing in stocks to investing in financial securities and concluded that stocks offer better long-term performance. Today, we use long-term data series for US and Australian real estate to evaluate their comparative performance.

US real estate data was sourced from Prof Robert Shiller, who created the Case-Shiller Index series. The chart below shows that US home prices from 1933 to 2023, a period of ninety years, appreciated to 69.5 times their original value.

Home Price Index

Adjusting for inflation, we get real appreciation of 2.9 times.

Again, CPI seems to understate inflation. Comparing the home price index to Gold, rather than CPI, provides a more accurate measure of appreciation in real terms. Gold appreciated 94.5 times over the same period, so the home price index actually lost value.

Calculation: 69.5/94.5 = 0.735 (i.e. a 26.5% loss of value)

Comparing data sources

A second source of home price data compares median prices, based on sales of existing homes, from 1953 to 2023. That shows growth of 22 times over the past seventy years, which is close to the Home Price Index appreciation of 21.25 over the same period.

Median Home Prices, Existing Homes

Australia

Australian housing data is harder to come by but we found an excellent source of long-term median house price data in the 2007 UNSW thesis of Dr Nigel David Stapledon. Using data from within the thesis, we were able to adjust nominal house prices to reflect constant quality (house values with no improvements) below.

Median Home Prices, Existing Homes, Constant Quality

Australian house prices appreciated 191.4 times between 1933 and 2006.

Unfortunately the data ends there, so we had to calculate a weighted average of median houses for 2007 to the present.

CoreLogic kindly provided us with values for their hedonic Home Value Index (for 5 Capital Cities) which also adjusts for quality:

Property Type	31/01/2007	31/07/2023
Houses		$399,182	$891,747

The gain of 2.23 is slightly higher than the 2.14 calculated from weighted average data for the 8 capital cities provided by the ABS.

Median Home Prices, Weighted Average of 8 Capital Cities

We opted for the higher figure from CoreLogic as likely to be more in line with the earlier Stapledon data. That gives a total nominal gain, adjusted for quality, of 426.8 for the ninety years from 1933 to 2023.

The price of Gold fines was fixed at £6-3/9 per troy ounce fine according to the Sydney Morning Herald on 2 January 1933, that converts to 12.375 Australian Dollars. Total gain for Gold in Australian Dollars over the past ninety years is therefore 232.9 times (A$2881.90/12.375).

We calculate the real gain for Australian house prices as 1.83 times over the past ninety years (426.8/232.9).

Conclusion

The US Home Price Index lost 26.5% in real terms, over the past ninety years (1933 – 2023), when compared to Gold.

The S&P 500 appreciated 6.8 times over the past ninety years when measured against Gold, and 9.7 times compared to US real estate (Home Price Index).

Using Gold as the benchmark, we conclude that Australian real estate prices appreciated faster than US real estate over the past ninety years, growing 1.83 times in real terms, whereas the US depreciated to 0.735 of its original real value.

We suspect the difference is largely due to the substantial fall in US real estate values after the 2008 sub-prime crisis, whereas Australian home prices continued to grow. We expect that performance of the two will converge in the long-term.

Lastly, when measured against Gold, US stocks outperformed Australian real estate. The S&P 500 grew 3.7 times against Australian home prices, in real terms, over the past ninety years.

This does not mean that we should ignore real estate as an investment medium. But a portfolio concentrated in real estate, without diversification into stocks and precious metals, could underperform in the long-term.

Acknowledgements

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Why invest in stocks?

Some clients are understandably nervous about investing in stocks because of the volatility. Invest at the wrong time and you can experience a draw-down that takes years to recover. Many shy away, preferring the security of term deposits or the bricks and mortar of real estate investments.

The best argument for investing in stocks is two of the most enduring long-term trends in finance.

First, the secular down-trend in purchasing power of the Dollar.

Dollar Purchasing Power

Inflation has been eating away at investors’ capital for more than ninety years. Purchasing power of the Dollar declined from 794 in 1933 to 33 today — a loss of almost 96%. That means $24 today can only buy what one Dollar bought in 1933.

The second trend, by no coincidence, is the appreciation of real asset prices over the same time period.

The S&P 500 grew from 7.03 at the start of 1933 to 4546 in June 2023 — 649 times the original investment.

S&P 500 Index

Gold data is only available since 1959. In April 1933, President Franklin Roosevelt signed Executive Order 6102, forbidding “the hoarding of Gold Coin, Gold Bullion, and Gold Certificates” by US citizens. Americans were required to hand in their gold by May 1st in return for compensation at $20.67 per ounce. Since then, Gold has appreciated 94.5 times its 1933 exchange value in Dollar terms.

Spot Gold Prices

Over time, investing in real assets has protected investors’ capital from the ravages of inflation, while financial assets have for long periods failed to adequately compensate investors in real terms (after inflation). The chart below compares the yield on Moody’s Aaa corporate bonds to CPI inflation.

Moody's Aaa Corporate Bond Yield & CPI

Conclusion

Purchasing power of the Dollar depreciated by 24 times over the past ninety years due to inflation. Adjusting for inflation, the S&P 500 has grown to 27 times its original Dollar value in 1933, while Gold gained 3.9 times in real terms.

We would argue that the consumer price index understates inflation. Gold does not grow in value — it is constant in real terms.

If we take Gold as our benchmark of real value, then the S&P 500 has grown 6.8 times in real terms — a far more believable performance.

Stocks are a great hedge against inflation provided the investor can tolerate volatility in their portfolio. How to manage volatility will be the subject of discussion in a further update.

Acknowledgents

 

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Investing is a loser’s game

I’ve said this many times before but I think it bears repeating. Investing is a loser’s game, one that is won by making the fewest mistakes. There will be times, sometimes fleeting, when the payoff from being bold is so large you have to make the bet. But those moments, periods when sentiment becomes so extreme it can’t last, are rare. The rest of the time, investors are much better served by making only small changes to avoid large mistakes. ~ Joseph Calhoun III, Alhambra Investments

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Henry Fielding | The best advice ever written

By Henry Fielding, more than two centuries ago, in The History of Tom Jones, a Foundling (1749):

Wisdom, in short, whose lessons have been represented as so hard to learn by those who were never at her school, teaches us only to extend a simple maxim universally known and followed even in the lowest life, a little farther than that life carries it. And this is not to buy at too dear a price.

Now, whoever takes this maxim abroad with him into the grand market of the world, and constantly applies it to honors, to riches, to pleasures, and to every other commodity which that market affords, is, I will venture to affirm, a wise man; and must be so acknowledged in the worldly sense of the word: for he makes the best of bargains, since in reality he purchases everything at the price of a little trouble, and carries home all the goods I have mentioned, while he keeps his health, his innocence and his reputation, the common prices which are paid for them by others, entire and to himself.

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New RBA governor

New RBA Governor

The Treasurer has appointed Michele Bullock as Governor of the RBA for a seven-year term commencing 18 September 2023.

Michele Bullock was deputy governor under Phil Lowe, so a sensible move. Not a Labour Party stooge as the market feared.

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