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Gold, inflation and decrease in the value of currency

The recent run up in gold prices to above 500 U.S Dollars has caused a stir in the financial markets. Is the run up an indicator of stronger inflation in the coming year or is this a trend because of the strong growth in the emerging markets and transfer of petro dollars to Russia and middle east?

Let us consider the first question - i.e., of inflation. Inflation is already running at multi year highs - the U.S I bond currently yields 6.83%. Many companies are expected to pass on the increased costs to the consumers next year - Kimberly Clark has said that the tissue prices will be upped by 6% starting in January 06 as noted in the link below.

http://www.shareholder.com/visitors/print_release.cfm?ReleaseID=179120

However, the above price increases are already factored into the gold prices and the run up in November is the one that is posing the question - "is the runup in gold price a harbinger of greater inflation and stagflation?". Economist wrote an article which basically debunked the theory of gold prices being the harginger of more inflation. The economist article compares and is able to correlate the increase in price of precious metals price to that of gold.
http://www.economist.com/opinion/displaystory.cfm?story_id=5246636

One of the reasons being touted for the increase in the price of gold is the gold ETFs GLD and IAU. Both these ETFs have low expense ratios and it is easy for investors to buy and sell gold like stocks through these ETFs. One doesnt have to go through the normal time consuming and expensive procedure to procure, secure and sell the precious metal. Investors have ploughed in about four billion dollars into these ETFs increasing the demand for gold bullion. The recent article in gold.org supports this theory.

http://www.gold.org/pr_archive/pdf/GDTQ305PressreleaseFINAL.pdf

The other reason for the strong demand for gold is the increase of wealth in emerging markets. As an example, in India the economy has been growing at a very fast clip ( 7-8% ) and is expected to keep growing that way for some years to come. The salaries have been growing even faster at the rate of 13-14% a year. This has resulted in a boom in all sorts of markets starting from the stock market to the use of consumer products such as cars. The trend is similar in other markets such as China, Russia and Brazil.

The only conundrum for this theory is that the stock prices of gold mining companies havent kept pace with the price of gold. The gold mining stocks GG, ABX, NEM and PDG havent kept pace with the price of gold. It is easy to conjecture that if the price of gold is to increase, the price of the gold mining stocks should also increase. The only reason this wouldnt happen is if the demand for gold is primarily from emerging markets. The currencies in emerging market countries are not freely convertible and it is not possible for individuals to buy the gold mining stocks. After all, gold is the real thing when compared to gold stocks.

The International Monetary Fund (IMF) has published its forecast for next year's global growth at 4.2%. The IMF forecast can be read here. http://www.nytimes.com/reuters/business/business-economy-imf.html

Even though economic forecasting is a bit like fortune telling and it doesnt account for unexpected events such as terrorist attacks, natural disasters; there is significant momentum in the current cycle and it is unlikely that the U.S economic growth will slow down significantly in 2006. As I have published in the earlier blog on S&P 500, it is likely that the SP500 will do fine next year.

We are seeing a global increase in wealth that is making more money chase the same goods. The demand from emerging markets will keep increasing. This has already shown itself in the increased demand for oil. Real estate is dearer all around the world now than was the case a few years back. The growth and demand from emerging markets will keep increasing.What is more likely is the growflation scenario - where we see growth and some inflation. It isnt going to matter what currency you own, everything is likely become dearer in the next couple of years. It is also likely that an average person's net worth will also increase significantly if the above scenario holds good.

Investing in India

The Indian economy is growing at a brisk pace in the 7-8% range. Though not in the same league as China in terms of growth rate, some consider India as having better prospects than China in the long term. The main reason for the optimism towards India is the presence of a democratic government for fifty+ years. The situation in China is unpredictable and political uncertainty is not good for investing public. The faking/intellectual property theft problem that exists in China doesnt exist to the same extent in India and it is easier for western companies to set up subsidiaries in India. The legal system is similar to that of Britain/U.S and companies have recourse to a system that is independent of the government.

India also has a robust, well established stock market. The Bombay Stock Exchange located in Dalal Street was established in 1875 and is the oldest stock market in Asia. There are about 3500 stocks listed in the Bombay Stock Exchange. The overall market cap of the Indian Stock Exchange is estimated to be around 260 billion in 2005. The BSE is one of the worlds top five stock exchanges in terms of the number of transactions. Given the low liquidity of the overall market compared to the U.S stock market, the Indian stock market was susceptible for market manipulations. The S.E.C in the U.S has played a good role in playing the role of regulator and establishing market/trading rules. The absence of such an agency in India led to the market manipulation in the early nineties ( Harshad Mehta scandal ) and the later Ketan Parekh scandal. The Securities and Exchange Board of India ( SEBI ) was established in 1988 and was made an autonomous body in 1992 by the government of India after the Harshad Mehta scandal. The SEBI plays a watchdog and overseer of the market similar to S.E.C.

Given the continued economic growth in India and the expected growth in capitalization, liquidity in the Indian Stock market, how should an investor based in the U.S invest in the Indian market? Although the establishment of SEBI has put in place some rules in place, many stocks are still subject to manipulation. Given this, what are the best ways to invest in India?

Some Indian companies are listed in the U.S market ( NYSE and NASDAQ ) and are available in dollar denominated securities, typically at a premium. The companies listed in NYSE and NASDAQ are:

INFY - Infosys Technologies. INFY trades for about $58 in the Indian market and it trades for about $74 in the U.S market, a premium of about 25%.
SIFY - Sify Limited trading for $7
REDF - Rediff.com for $17.70
WIT - Wipro Limited trading for $11
HDB - HDFC Bank Limited trading for $50
IBN - ICICI Bank Lmtd trading for $25
VSL - Videsh Sanchar Nigam Limited for $15
MTL - Mahanagar Telephone Nigam Limited for $6.35
RDY - Doctor Reddy's Labs for $21
TTM - Tata Motors Limited trades for $12

One can buy these stocks directly or go through some mutual funds. The ones that invest exclusively in Indian mutual funds are IIF, IFN, ETGIX and MINDX.

ETGIX is a newly started fund in 2005 and has an expense ratio of 2.77%.
MINDX has a lower expense ratio that ETGIX with an expense ratio of 2%. There is a penalty of 2% for redemptions before ninety days.
IIF Morgan Stanley India Investment fund has an expense ratio of 1.5% and has the morningstar 5 star rating.
IFN India Fund Inc has an expense ratio of 1.6% and morning star 4 star rating.

One can also get exposure to Indian market through the ETF EEM ( emerging market index fund ) which invests roughly about 5% of its assets in India.

S&P 500 - rally into the end of 2005 and early 2006?

So far this year, the S&P 500 return has been lackluster compared to other major stock indices around the world. Some of the major indices around the world have recorded solid growth.

Nikkei 225 index has gone up by 33% for the year mainly on the renewed growth in Japan and the surge in exports. The Hangseng index has gone up by 7.5%. The commodity heavy Australian stock market has gone up by 20%. The Canadian index has gone up by 21%. The emerging markets have also been doing well. The gains exclude dividends.

In comparison the S&P 500 has gone up by 4.74% till date including dividends. Excluding the dividends, the gain has been a miniscule 3.1%. What is the reason for the lowly performance and how do the prospects look moving forward?

As the money magazine points out, the S&P 500 earnings have done well this year. http://money.cnn.com/2005/11/04/markets/2006earnings/ .

The earnings are expected to go up 15% this year - this is above expectations set last year. The earnings arent expected to drop much next year either - it is expected to be in the 10-12% range. There are other articles that point to a bull run in 2006. One such article is quoted in investor insight web site

World Trade, US Trade Balance, the dollar and stock/bond investing

The tables published by the WTO - ( http://www.wto.org ) - detail the leading exporters and importers in the world in 2004. The list is interesting and the top few nations in each category is noted below:

Exporters:

1. Germany - came in at #1 with $912 billion in exports with a growth of 20% year over year.
2. US - came in at #2 at 818 billion in exports with 13% growth year over year.
3. China at 593 billion in exports with 35% growth.

Importers:

1. United States at 1525 billion dollars registering 17% growth year over year.
2. Germany with 719 billion dollars registering 19% growth year over year.
3. China at 561 billion dollars showing 36% growth.

The U.S trade gap with the rest of the world widened to $66billion in September. Although the hurricanes are blamed for surge in imports and the reduction in exports - the trade deficit has been widening for quite some time. The trend is not showing any signs of abating any time soon. The trade balance with some key parterns can be found in the link http://www.census.gov/foreign-trade/balance/. The trade deficit with some key trading parternes looks like this.

Canada - $75 billion for the year
Mexico - $52 billion
China - $200 billion
Japan - $80 billion
India - $1o billion
France - $11 billion
United Kingdom - $10 billion
Russia - $11 billion

This year was the year the deficit was expected to stabilize and improve in the coming years. This looks unlikely given the 10-20% growth in deficit with key trading partners. The exports have also been growing at a good clip but are not keeping pace with imports. The surprise was the elevation of Germany as the top exporter in the world. China is expected to surpass both the U.S and Germany as the top trading nation in the world in the coming years.

What does this mean for the U.S dollar, the U.S economy and the world economy overall? The answers are far from clear. There are a couple of theories that predict the scenarios for the coming year.

First Scenario:

The trade deficit has to balance out or reduce over the long run. The current scenario can't continue on forever. This can happen in one of two ways - the U.S growth rate will be far lesser than the rest of the world - this will lead to more US exports and less US imports thus correcting the imbalance. The second scenario is one where the US currency gets devalued with other trading partners. This reduces the purchasing power of the dollar and increases the appeal for US made goods and services.

While it is is entirely possible for growth in the rest of the world to exceed that of the U.S - it is unlikely that the growth will come from former industrial powerhouses. The decline in population in Europe and Japan is the main reason for this - it is likely that the currently emerging countries - Chian, India, Brazil, Korea and South Africa will grow at a faster clip. Many of these countries have very low cost labor, so it is likely that they will be net exporters than importers in the near future.

The second scenario where the US currency gets devalued with the rest of the world also hasnt materialized. The interest rate differentials between Europe/Japan and US is the main reason for this. Chinese and Indian currencies cant be traded freely and aren't used as world's reserve currency. The emerging market countries cant afford to let their currencies appreciate signficantly against the dollar and risk losing jobs in their own country. For countries like China, it is ok to lose money than flame political riots at home.

Second Scenario:

The second theory says that there is a savings glut and that US is still the country of choice for foreign governments to park their trade surplus. The interest rates are good ( compared to the Euro or Yen ) and all the commodities, oil trade in dollar anyway. Given this huge stash of money chasing dollars and the reduced government deficits are causing long term treasury yields to be low. This poses the inverted yield conundrum where long term rates are the same or lower than the short term rates.

Given the non predictability of the US dollar movement, how should one be investing? How would it impact stocks and bonds? It is a difficult question to answer - in the short term it does seem as though the U.S interest rates will dictate the currency markets. With interest rates expected to reach 4.5% next year - it is likely the dollar will continue to gain against other currencies till early next year. After that, it is any ones guess on what will happen. Thus far this year, the iShares Japan Index Fund ( Ticker IWJ ) has appreciated by 10%. The German index fund EWG has gained only about 1%. In the Japanese and German case, the US dollar has appreciated. The returns would have been far greater if the dollar had declined in value. Consequently, the dollar strength has decreased the returns in other foreign investments.

Some are speculating that the dollar is headed down in FY06 - this includes the economist article http://www.economist.com/agenda/displaystory.cfm?story_id=5078354. Warren Buffett has decreased his exposure against the dollar this year given the strength of the dollar. However, the size of his bet is still substantial - to the tune of sixteen billion dollars. Next year is going to be an interesting year - if the predictions for dollar fall hold true, late this year/early next year might be a good opportunity to invest in Europe and Asia.

Berkshire Hathaway Rings in a strong third quarter

Bershire Hathaway, ticker BRKA for class A shares and BRKB for class B shares reported the third quarter earnings for FY05 yesterday yesterday, 11/04/2005. Berkshire quarterly report is different compared to many other companies - especially the high tech companies. There is no guidance for the next quarter, no proforma earnings, no smoothing of earnings and no one time charge that recurs every quarter. Things are laid out as they are.

Let us take a quick look at the financial results from this quarter.

In the insurance category, revenues went up by 6.2% compared to the year ago quarter. Finance products revenue increased by 7.1%. The cost and expenses went up 2.4 billion ( 14.6% increase ) compared to last year thus reducing the earnings per share compared to the prior year's quarter by about 48%. The main reason for this is the Hurricanes Katrina and Rita.

Cash flow from operating activities increases 12.35% for the first nine months of this year compared to the same period last year. Cash flow from investing activities showed a decline and this is a good sign - it shows more money is being put to work. Cash flow from financing activities went up for the first nine months of this year. Cash and equivalents increased by about 7% year over year - this would have been higher but for the additional six billion ploughed into investment activities.

Overall, the underlying businesses are performing very strongly for Berkshire. The investment of cash continues to be handled very well by Warren Buffett and Charlie Munger. All in all, a very solid quarter for Berkshire.

Motley fool published an article saying why Berkshire is a bargain. The link to that article is attached below. http://www.fool.com/news/commentary/2005/commentary05110206.htm?source=eptyholnk303100&logvisit=y&npu=y. This article is well written except for the future returns part. I think the range of future returns will vary somewhere in 6 - 9% range as opposed to the assumed annual compound rate of 13.8%. Even if you consider the mean of this range at 7.5% - it will end up with a healthy 181K in ten years which isnt bad for a class A share. A similar article is also carried out in Barrons that describes how book value evaluation at Berkshire is conservative. http://www.smartmoney.com/barrons/index.cfm?story=20050404

Morningstar http://news.morningstar.com/doc/article/0,,144207,00.html also did a good analysis of Berkshires equity position vs. the different businesses it owns. The break down of different assets by Q2 2005 looks as follows. 30.4% in cash, 16% in bonds, 29% public equities and 24% outright ownership of businesses. Per morningstar - the weight of publicly owned equities has declined from 51.3% to 29%.

Berkshire is also a good hedge against dollar going down given its investment in government bonds and the foreign currency bet. It is also fairly risk free compared to the other high fliers today such as Google, Microsoft or even WalMart. The management philosophy of this company is very well laid out and no other company can match the record of retaining top notch CEOs. In the era of slash and burn execs that get out with golden parachutes , this company is an anamoly.

Things are also looking up for Berkshire from the investment returns point of view. The short term yield for U.S treasuries has been inching up and is likely to hit 4.5% next year. This will boost the investment income. The negative headline risk quoted by one analyst is also abating. The insurance/re-insurance rates in hurricane affected areas is also expected to go up and recouped within the next year. The hurricane related losses can be looked as a one time charge. The business fundamentals are very strong and things are looking up for this stock in the next couple of quarters.

Hedging Against Inflation

With the recent increase in energy prices there is increased talk about inflation. What options are available for ordinary investors to hedge against inflation?

The best option to hedge against inflation is to stay employed - the salary is likely eventually keep pace with inflation. There is a contrary opinion though - if cheap labor (skilled/unskilled) is plentiful and easily available it is likely that the salary increase in the U.S wont keep pace with inflation and living standards will decline.

Besides this, there are several other options.

One can buy gold, no, it is not required to stow away the yellow metal in the locker or basement anymore. The gold ETF which trades by the moniker GLD is a good alternative with a low expense ratio of 0.4%. Gold has been up about 7% for the year easily outpacing both inflation and S&P 500 index.

Then there is real estate. Typically real estate is a even better hedge against inflation than gold. Since inhabitable real estate on earth is limited and cant be produced like gold, this is a better hedge. However, given the current sky high prices on land and housing properties - it may not be a good bet. One has to pay property taxes and then maintain the property ( land or house ). Land doesnt require insurance but house will need insurance.

The U.S government offers I bonds for individual investors which provide an interest rate of inflation + 1%. The interest rate for the next six months is 6.73%. The interest compounds monthly and can be held till maturity. The maturity period is thirty years. I bonds can be bought from the treasury directly ( http://www.savingsbonds.gov/indiv/indiv.htm ) or through some local banks that offer them.

Finally there is the stock market which has historically done better than inflation in recorded history. Given the many risks that exist in today's market to unanticipated natural and man made events - it makes sense to diversify into different asset classes.