Cue September

As if simply following the media script, markets finally pulled back again this week after relentless gains. Measuring the severity of the fall, last Friday we closed at 1,020 on the S&P, today we will wrap up near 1,010, marking a 1% reversal. Yikes! For the sake of metaphor, the stock market acts like a bobber on a rising tide of cash; each time bearish traders bite, the bobber descends. However, given the bears’ limited ability to set the hook, the bobber ascends to its natural location on the undulating cash. The point is, the news flow continues to keep the bears’ bite far too weak to pull this market down. The index has essentially flat-lined for the last month, making it susceptible to declines. Yet whenever these declines manifest they have been met with waves of cash and bullish news flow. This makes a difficult environment for short sellers (those who wager on declines). Pauses and pullbacks are merely pit-stops in the race toward higher levels and we welcome them. What’s perhaps most notable about this month-long period of digestion is how uncooperative stocks have been with the "pullback" paparazzi. Alas, the most interesting action this week came not from the stock market but from the metals markets as gold kissed $1,000 an ounce. This move created media excitement and journalists seem to get the most creative when it comes to reporting the mysterious drivers of gold prices. I will devote some attention to this topic as well as inventorying the week’s economic data, and then let you out of school early to enjoy your long weekend.

Economic Roll Call

The first week of a new month gives us the most useful economic data. This week the totality of the indicators show us that recovery continues. The Institute for Supply Management releases well regarded indicators on both manufacturing and service activities, and both releases this week surprised to the upside. Manufacturing activity in the US actually grew in August (first time in 19 months) while activity on the service sector shrank slightly (highest level in 11 months). Both of these reports indicate positive trends and significant improvements from trough levels reached in the 4^th quarter of 2008. Housing statistics continue their improvement as pending home sales advanced for the 6^th straight month and mortgage rates dropped, further encouraging buyer and re-finance behavior. Furthermore, housing prices increased in the second quarter compared with the first quarter, adding support to the notion that the market has stabilized if not turned. With corporate earnings rebounding, recoveries afoot in service and manufacturing industries and a rebound in the housing market, why isn’t employment rising? Because it lags! Today the unemployment rate in the US inched up to 9.7%, while employers shed 216,000 jobs last month. This continuous payroll elimination suppresses consumer activity, reflected in the anemic retail sales data we received this week. Jobs and consumer spending activity re-enforce each other and will join this party belatedly. Every economist and most professional traders know this, which is why the markets advanced today in the face of grim headlines. Rest easy when you read your Wall Street Journal tomorrow; the US economy will be adding jobs six months from now.

Choose Your Gold wisely

Unprecedented monetary and fiscal stimuli have stoked economies around the world. If too much money chasing too few goods defines inflation, then look out ahead. Legislators spending like drunken sailors and the decline of US fiscal credibility worldwide endanger the reserve status of the dollar. Our policies will surely frighten off the large buyers for US Treasuries, weakening the currency and inciting inflation. China will wage economic war on the US, stage a US debt buyer’s strike and watch the Greenback burn. These are the financial tabloid headlines of our day. Typically they accompany emails (that get forwarded to me) with links at the bottom to a gold broker. Gold climbed back toward $1,000 this week, so be prepared for gold bug emails. While we do favor the notion that the dollar will depreciate, there are several strategies to profit from that event, so let’s consider the relative merits of each. (All returns are YTD through 9/3/09.)

The Anarchy Trade:

Gold has no practical application other than adornment. Gold devotees primarily seek the metal out as a virtual bunker to protect capital from politics and central banking. The easiest way to get to gold directly is through the Gold ETF (GLD). Year to date returns? 11.18%.

The Mining Trade:

Gold miners derive their profits from a combination of fluctuations in gold prices and management acumen. Many miners hedge gold, which can be good or bad. The primary input cost for minors is oil, which can be good or bad. When management, input costs and gold prices all move favorably, mining stocks can add exponential movement to the underlying commodity. Clients of W&A have exposure to this trade through our holdings in the Nuveen Tradewinds Global Opportunities fund (up 35% year to date) and through Royce Value Services (up 30% year to date). The easiest way to own the gold miners is through the Gold Miners ETF (GDX). Year to date returns? 32%

The Priced-in-Dollars Trade:

Most natural resources clear the marketplace priced in dollars. These non-gold natural resources benefit from having practical application. Consider oil. A weaker dollar will drive oil prices higher, as will increasing oil demand. Therefore, a strengthening global recovery coupled with a weaker dollar adds significant propellant to oil prices – up 52% year to date. Broader energy baskets offer greater diversification while still representing the weak dollar, strong economy themes. The easiest way to own broad energy is through the Powershares DB Energy ETF (DBE). Year to date returns? 16%.

The Hard Currency Trade:

For the dollar to weaken, something has to strengthen. It’s a rule. Perhaps my favorite way to position for a weakening dollar is to locate countries whose currencies stand to benefit and identify attractive investment options there. Consider Brazil. Brazil has ample natural resources (see the Priced-in-Dollars Trade, above), improving management and input costs (see the Mining Trade, above) and has an improving sovereign fiscal position. Trifecta! Countries with similar fundamentals are known to have "hard currencies" that tend to trade inversely with the dollar. Here are some year to date currency movements for these nations versus the dollar: Brazilian Real +20%, Australian Dollar +15%, New Zealand Dollar + 13%, Norway Krone +13%, and the South African Rand + 19%. Why buy Exxon in the US (-13.5% this year) when you can buy Petroleo Brasileiro in Brazil (+66% this year). Clients of W&A have a good deal of exposure to this trade but most notably through our position in Janus Overseas (up 57% year to date). Other than constructing your own currency basket, the closest way to gain hard asset exposure is through the Van Eck Global Hard Assets fund (GHAAX). Year to date returns? 32%.

My point? Gold gets the headlines but there are smarter ways to play the theme. Right now elements of "The Mining Trade" and "The Hard Currency Trade" populate our portfolios; we also have a "Priced in Dollars" trade on deck if oil prices dip. "The Anarchy Trade" requires far too much mayhem for our tastes.

Enjoy your rest on Labor Day.

Remember: Performance is not an outcome, it's a discipline.