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The Growing Appeal of Gold

    February 03, 2012

Shareholder ReportThe latest installment of our Shareholder Report has just been released and this issue is filled with interesting facts and observations about global markets our investment team gathered as we traveled the world searching for opportunities. As you can see from the cover image, gold’s growing appeal to a rising middle class of citizens in China and Asia is significantly reshaping the gold market as we know it.

The region has long carried an emotional attachment to gold. In fact, gold was one of China’s earliest forms of currency way back in 1091 B.C. With rising average incomes and wealth levels leading a new of age of prosperity in China, citizens are snatching up gold at an unbelievable rate. According to the Beijing Municipal Commission of Commerce, sales of precious metals jumped nearly 50 percent from the same time last year during China’s week-long New Year’s holiday in January.

This type of momentum is a catalyst for gold prices to remain strong in 2012.

This is one aspect of the American Dream Trade I discuss in my letter for the Report. There’s also an informative Q&A with China analyst Xian Liang who talks about the dramatic transformation his hometown of Shanghai has undergone over the past 20 years.

Check out the Shareholder Report page to view the full contents of the report. If you would like to request your own copy, send your name and address to editor@usfunds.com.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor.

 

From Dogs to Darlings

    February 02, 2012

As the saying goes, “every dog has its day” and global markets appear to have followed this historical trend lately as last year’s dogs became the darlings of January. Notably, small-caps, copper and junior resources stocks have climbed recently, indicating that momentum has shifted.

Take a look at the small-cap Russell 2000 Index which was decimated in July, days before the 50-day moving average fell below the 200-day moving average. I discussed how traders buy or sell off of these short-term and long-term moving averages when I wrote about the “golden cross” a few weeks ago.

This year is off to such a great start that if small caps continue this momentum, we should see the 50-day moving average for the Russell 2000 cross above the 200-day soon. This would likely drive new investor interest in this space.

Copper also took a few major blows last year, first in July and then in September as a result of the carry trade. To gain a yield advantage, large investors use the carry trade to advantageously borrow in yen (because interest rates are low), convert it to a stronger currency and invest in higher-return, higher-risk assets, specifically commodities and dividend-paying emerging markets stocks.

When the yen began to strengthen against the dollar in August and again in October, Japan intervened to weaken its currency. The yen quickly reversed, causing the higher-return assets to decline.

As our commodities table shows, copper was among the worst-performing commodities that we track, declining more than 20 percent last year. This lagging performance came despite supply/demand fundamentals that argued for higher prices.

We expected copper to eventually revert to its long-term mean and it only took a few positive drivers to drive prices higher. One of these drivers was the JP Morgan Global Manufacturing Purchasing Managers’ Index crossing above the three-month moving average, which occurred at the end of December. Ninety percent of the time, when this has happened, copper was positive over the next three months, with a median return of 10 percent over the following three months.

Additional drivers that have provided the impetus for higher prices include a significant increase in money supply, interest rate cuts around the world, and central banks dropping their reserve rate for banks.

Look for this trend to continue.

Also Read:

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor.

The Russell 2000 Index® is a U.S. equity index measuring the performance of the 2,000 smallest companies in the Russell 3000®, a widely recognized small-cap index. The Purchasing Manager’s Index is an indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.

 

What Milestone Will China Achieve Next?

    February 01, 2012

The Economist put together a comprehensive dateline, charting which year China overtook or will overtake the U.S., using 21 indicators of consumption, GDP or spending.

It summarizes the significant milestones reached over the last decade or so, reminding us how far China has come. One significant milestone marking the road of economic growth began when China became the largest consumer of steel, then shortly after, copper and energy, as the government focused on its massive buildout of infrastructure projects to support expected urbanization growth and rising incomes.

By 2001, China was buying more mobile phones than the U.S. as Chinese consumers spent rising discretionary income on the latest technology. Spending in mobile computing has also continued, as China also has the largest number of Internet users, the biggest personal-computer market and the largest smartphone market.

Overpowering: Years in which China overtakes the US

Looking into the next decade, The Economist also plots an estimation of when China’s GDP will be larger than that of the U.S. Using the assumptions of an average real GDP growth of 7.75 percent in China and 2.5 percent in America, inflation averaging 4 percent and 1.5 percent in China and the U.S., respectively, and yuan appreciation of 3 percent per year, China stands to be the largest economy by 2018.

However, if China grows faster with all the other factors remaining the same, the country’s GDP could be larger than the U.S.’s GDP by 2017. The magazine lets you change these assumptions for yourself so you can see when China will be the world’s largest economy. Go there now.

By clicking the link above, you will be directed to a third-party website. U.S. Global Investors does not endorse all information supplied by this website and is not responsible for its content.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor.

 

Heart of China Bull Beats Strong

    January 30, 2012

My debate last week with Gordon Chang on China’s future at the Vancouver Resource Investment Conference was a stimulating, intellectual exercise. A healthy market needs a compromise between the bid and ask, and a discussion between people who strongly disagree is a great way to promote critical thinking.

Critical thinking is vital to our investment process as a means to ensure that we question assumptions. One way our portfolio management team practices a critical-thinking process is through a weekly S.W.O.T. (Strengths-Weaknesses-Opportunities-Threats) analysis of key factors influencing global markets. By hammering out the positives and negatives, we can paint an accurate picture of the realities we face. The S.W.O.T. model allows us to avoid pitfalls by weighing the evidence.

Lack of critical thinking sometimes leads to bubbles, such as the one taking place in the parabolic rise in the number of articles foretelling China will experience a “hard landing.” Last fall, more than 1,000 articles questioned the possibility of a “China crash,” according to data from BCA Research. This is twice as high as the number in 2004, when fear articles reached 500. Gordon’s bearish pronouncements only added to the extreme negativity groupthink surrounding China’s economy.

Number of Articles Discussing the Potential of China's 'Hard Landing'

Investment strategist Keith Fitz-Gerald, a long-time friend of mine, wrote an excellent article comparing today’s doomsday sentiment of China to the naysayers who forecasted the demise of the U.S. during the market bottom of March 2009.

Throughout the past century, U.S. stocks went through many secular bear markets. Keith points to the 1929–1932 period when the Dow Jones Industrial Average declined by nearly 90 percent, along with pointing out the Dow’s loss of more than 52 percent from 1937 to 1942. Also, beginning in 1901, 1906, 1916 and 1973, there were four “40+ percent declines,” says Keith.

Americans have also endured two world wars, the Great Depression, presidential assassinations and the deadliest terrorist attack ever seen on U.S. soil. What’s important for investors to remember was that each significant market decline presented a “great buying opportunity” with U.S. stocks rising double-, or in some cases, triple-digits, writes Keith.

And, over the past 100 years, the Dow gained an outstanding 24,000 percent.

So despite setbacks including inflation, Tiananmen Square protests, the Asian financial crisis of 1997, and the SARS scare, over the last 30 years, China’s average annual real GDP has grown 10 percent.

With rising incomes and increasing urbanization, we believe China is pursuing the American Dream, and the government has shown great determination to build the necessary infrastructure along with a robust urban labor market. On a purchasing power parity basis, China’s share of world GDP has risen significantly, from around 3 percent in 1985 to a current world share of nearly 16 percent.

China Share of World GDP Increased Substatially

Yet, China is only in the middle of its supercycle with several stages to come. Supercycles, or what we call S-curves, are long, continuous waves of boom and bust inherent in human history. While the overall trend is up, periods of volatility are an intrinsic part of this supergrowth. Not every down period is a sign of demise—even a broken clock is right twice a day. It’s the wise active manager who learns to manage expectations by understanding the difference between short-term corrections and secular long-term bear markets.

While “risks certainly cannot be taken lightly,” BCA Research believes that the risk of a China crash is “exaggerated.” For example, bears often point to “shadow” banking practices to support their case.

Keith believes Beijing was “deliberately tapping on the brakes,” in 2009, when the central bank increased the reserve required ratio for commercial banks, effectively reducing the amount of money banks could loan. This resulted in a sharp decrease in the amount of credit available and significantly increased rates from 4.78 percent to 8.06 percent, according to BCA.

One negative consequence of China’s quantitative tightening was that it forced some private firms unable to gain loans from state-controlled banks to seek credit from “loan sharks at sometimes deathly high borrowing costs,” says BCA.

We sent our research analyst to his home country of China to find out how prevalent this problem was. The Shanghai-native Xian Liang joined an investigative tour led by research firm China International Capital Corporation (CICC) to the Zhejiang Province. His group had access to executives from banks, private lenders and local government agencies, many of which he found knowledgeable and shrewd.

During his research trip, he learned about an extensive survey done by Alibaba of 2,800 smaller and medium enterprises, which showed that half of the enterprises needed external financing, and the companies that currently borrow from banks—only 13 percent of Alibaba’s sample—faced pretty stringent risk management practices.

For example, one commercial bank that lends primarily to smaller companies checks the electric and water meters of the businesses to make sure they are actually using energy. They delve into the personal habits of the private entrepreneurs to gauge if the executives are creditworthy and financially sound, as it is believed that character has a lot to do with one’s willingness and ability to repay.

Overall, Xian understood the alleged systemic credit risks in the banking system to be manageable at this point. The government had been prudent to not only raise interest rates six times, but it also increased the reserve limit banks must set aside against loans.

BCA identified an additional unintended consequence of the tightening. Some banks tried to bypass tight regulatory controls so they could extend credit, leading to an “increase in off-balance-sheet activities,” according to BCA. This activity was recognized by the government, and the central bank has “increased its oversight of off-balance-sheet items.”

BCA says that in a way, “‘shadow’ banking activity can be viewed as an attempt by market participants to create more market-driven interest rates.”

In a report of Asian banks, CLSA Asia-Pacific Markets found that non-performing loans (NPL)—those assets not yet delinquent but that have fallen behind schedule—remain near a 12-year low in China, and the NPL-to-loan ratio is under 1 percent. This default rate is extremely low compared to the 1999–2002 timeframe, and it is believed that no large debt defaults are expected due to China’s ability to create liquidity.

China's Non Performing Loans Ratio Remains Near Historic Low

Keith Fitz-Gerald says the government has an abundance of liquidity. It has set aside $3.2 trillion in reserves, amounting to half of the country’s entire GDP. Keith says this could potentially be spent on recapitalizing its banking sector, with “plenty of money to spare.”

Besides the reserves, China has more fiscal and monetary firepower than several emerging markets. The Economist analyzed 27 emerging markets and ranked the country’s ability to ease monetary policy, taking into consideration inflation, excess credit, real interest rates, currency movements and current-account balances. Then it created a “fiscal-flexibility index” which included government debt and the budget deficit. A score of 100 means a country has no flexibility to ease policies; a score near zero means a greater ability to “let out the throttle.”

This chart “suggests that China, Indonesia and Saudi Arabia have the greatest capacity to use monetary and fiscal policies to support growth,” compared to other listed emerging markets, says The Economist.

China has room to ease fiscal and montetary policy

Many bearish articles that appeared last fall relied on generalities taken out of context. They offer anecdotes of ghost cities, empty shopping malls, robber barons, worker suicides and citizen protests as reasons the country as a whole is headed for a crash. These efforts to highlight China’s economic imperfections are akin to saying the U.S. is a poor nation because impoverished areas still exist. As analysts, it is our job to research and make a rational determination whether the facts are material or superfluous.

“China is merely going through the first uncomfortable growing pains of its adolescence,” Keith says, and he does not believe it’s the end of the world if China goes through a market correction. What he’ll be doing instead is investing.

As our team continuously weighs the evidence of China’s economy, I agree with my friend. Moments such as these offer buying opportunities for global investors.

We believe China is a buying opportunity.

I’ve covered this topic often in recent weeks. Take a moment to read my other positive observations on China:

Past performance does not guarantee future results. All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. By clicking the link above, you will be directed to a third-party website. U.S. Global Investors does not endorse all information supplied by this website and is not responsible for its content.

The Dow Jones Industrial Average is a price-weighted average of 30 blue chip stocks that are generally leaders in their industry.

None of U.S. Global Investors Funds held any of the securities mentioned as of 12/31/11.

 

Junior Resources Companies Set to Outperform?

    January 27, 2012

In volatile markets, small stocks typically lag larger companies as investors flee what they perceive to be risk. However, this love affair with large-caps is generally short lived as investors return to the beaten-up small caps when the turmoil subsides. Historically, small-caps have outperformed their larger counterparts.

In 2011, junior miners were shunned, but Global Resources Fund (PSPFX) co-portfolio managers Evan Smith and Brian Hicks pointed out to me this week that we’re beginning to see signs of small-cap strength.

This chart compares the performance of the S&P TSX Venture Index (TSX), which holds a basket of junior resources stocks, to the returns of the Morgan Stanley Commodity Related Index (CRX). You can see that the junior stocks began to outperform around July 2010 and carried that momentum over a period of six months, reaching a high in March 2011. That’s when investor took a turn for the worse and volatility began picking up, sending the TSX tumbling compared to the CRX.

TSX vs CRX

The TSX versus the CRX measure hit a low on December 14, well below the historical average. In technical terms, the December 14 level was 1.37 standard deviations below the two-year mean. Small-caps have only received this level of punishment a little more than 10 percent of the time over the past two years.

Frequency of Spread Occurences

If we assume a reversion to the mean—which means these junior stocks would return to the two-year normal range—small-caps could outperform large caps by 20 percent. This bounce back could have a big impact on the Global Resources Fund because of its junior resources holdings.

Recent events have driven the outperformance of riskier investments—we’ve discussed two of the three recently. Emerging market countries including Brazil, India and China have switched from a tightening mode to an easing cycle, which generally has had a positive effect on the markets. For example, when China lowered its required reserve ratio, there was a record increase in M-2 money supply shortly after.

Also, the JPMorgan Global Manufacturing Purchasing Managers’ Index crossed above the three-month moving average. Going back to 1998, there have only been 20 times this event has occurred, and each time, it has been associated with higher prices for oil, copper, materials and energy.

In December, the European Central Bank began its Long Term Refinancing Operation (LTRO) program, offering banks three-year loans at a discount. LTRO has helped to reassure markets and boost equities.

From a technical perspective, the TSX is now above its 50-day moving average, which may be self-fulfilling and could help attract money flows to this area of the market.

Please consider carefully a fund’s investment objectives, risks, charges and expenses. For this and other important information, obtain a fund prospectus by visiting www.usfunds.com or by calling 1-800-US-FUNDS (1-800-873-8637). Read it carefully before investing. Distributed by U.S. Global Brokerage, Inc.

Foreign and emerging market investing involves special risks such as currency fluctuation and less public disclosure, as well as economic and political risk. Because the Global Resources Fund concentrates its investments in a specific industry, the fund may be subject to greater risks and fluctuations than a portfolio representing a broader range of industries.

The Morgan Stanley Commodity Related Index (CRX) is an equal-dollar weighted index of 20 stocks involved in commodity related industries such as energy, non-ferrous metals, agriculture, and forest products. The index was developed with a base value of 200 as of March 15, 1996. The S&P/TSX Venture Composite Index is a broad market indicator for the Canadian venture capital market. The index is market capitalization weighted and, at its inception, included 531 companies. A quarterly revision process is used to remove companies that comprise less than 0.05% of the weight of the index, and add companies whose weight, when included, will be greater than 0.05% of the index. The Purchasing Manager’s Index is an indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.

M2 Money Supply is a broad measure of money supply that includes M1 in addition to all time-related deposits, savings deposits, and non-institutional money-market funds.

Standard deviation is a measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is also known as historical volatility.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor.

 

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