June 2011


Monthly Thoughts and Comments

Market and Economic Updates
June proved to be wild. The major indexes were down for the month and for the quarter and volatility continued to be rather dramatic. As an example, the S&P 500 was down 1.4% for the quarter, was down 7.2% from its high reached in on 4/29/11 to its low on 6/15/11 (47 days) and rebounded 3.3% in 15 days at the end of the month (chart 1). That should put to bed the question of whether the markets are being impacted by traders or investors. The NASDAQ experienced higher volatility but a similar trading pattern.
Greece continues to dominate the “news.” It looks like a deal to extend their debt from one to three years out to 30 is being accepted by most of EU banks. This is nothing more than a “soft default” and continued accounting manipulation. The banks get to continue to falsify their balance sheets, as does Greece. This is not over; the can has simply been kicked once again.
The economic news in the U.S. continued to slow through the rest of the quarter. The question is whether this is a just a temporary bump or a real slowdown. We believe it is both. The manufacturing/industrial area of the U.S. is slowly growing while the financial and consumer portion of the economy continue to lag. Jobs creation is still quite slow and inflation is eating into consumers’ pocketbooks.
China is facing rising inflation along with much of the Emerging Market. Brazil, Viet Nam, India are all fighting higher than expected inflation. Food and energy continue to be the major source of this inflation. China, which is more leveraged than just about any country has been raising rates, which is slowing bank loans. But that illiquidity is causing an economic slowdown and so now they are pumping liquidity back into the system. They are walking a tightrope in a hurricane.
Japan has reported some strong economic growth as they rebound from the devastating tsunami experienced in the first quarter. This could lead to higher commodities prices as rebuilding demand increases, it will depend on how much softness other countries experience at the same time.
Chart 1:  S&P 500 Index
Portfolio Updates
So we zigged when the markets zagged. Energy stocks as a group dropped 40% (unweighted) from the prior quarter and we have started buying. Commodities are down in general and we are starting to nibble on them again too. They may go down further, so we have added partial positions only.
In the energy sector, we have been focused on two areas: North American centric E&P and global energy services industry. Most recently we started buying the services companies. Oil has fallen from $114/barrel to $90/barrel, but oil production is not going up and even if there is a worldwide recession, demand will continue to rise over time. Energy producers have two risks: 1) replacing their oil or natural gas reserves, which most of the majors are unable to do; and 2) having their reserves nationalized.  Service companies, however, the companies that provide the rigs, and the drilling equipment, the logistics and the drilling expertise and the transportation and storage, they are still needed regardless of who owns the reserves.
We do own and are slowly adding to E&P (exploration and production) companies which: 1) are primarily based in the U.S. and Canada because that removes the nationalization risk; 2) are smaller in size and are able to increase their reserves; and 3) produce substantial cash flows and are able to pay attractive dividend yields.
Finally, we continue to like pipelines (transport gas and oil) as they typically have long-term contracts and are less impacted by changes in the commodity prices over the short run. These companies also tend to pay significant dividends as well.
Investment Focus: Gold
What is the attraction to gold? You can’t eat it and it is not used as an industrial metal; its primary commercial use is jewelry. You have to pay to store it and gold stocks historically have paid little or no dividends.  Oh, and by the way, it hasn’t performed particularly well in the past year either.  So why bother?
Gold is a hedge against fiat currencies. We have written numerous times about the financial issues brewing around the world. The common denominator is that many countries have figured out that when currencies aren’t backed with something of tangible value like gold, they could inflate it all they wanted by just printing more. So politicians could create more power for themselves by spending freely; for unlimited unemployment benefits, for overly generous health care and retirement plans for labor unions and for tax breaks targeted to companies that made generous campaign contributions. Money has been thrown around and everyone is told they can have everything they want. It is easy when you don’t have to balance a budget and you can create money from thin air.
But now the consequences are becoming apparent. When people finally realize that a currency isn’t worth the paper it is printed on, they no longer support that currency and all of a sudden the bill is due and payment is demanded. All of a sudden it is no longer feasible to give everybody everything they want. The problem, as Greeks can tell you, is that the population has come to believe they are entitled and you have riots for trying to right the boats, and riots if you don’t.  So when investors realize that much of the world’s wealth is built on fiat currencies and that when a few tumble, it could impact almost everyone and suddenly, gold becomes attractive because it is a store of value and is in limited supply.
There are different ways to invest in gold, and they each offer a different twist on hedges and therefore make sense at different times. The two primary ways to invest in gold are: 1) owning the physical metal (bullion); or 2) owning gold mining companies.
Bullion can be bought in multiple forms: 1) gold bars, gold coins or through ETFs which own bullion actually stored in a vault in equal amounts to the shares outstanding. Mining stocks can be purchased as individual shares traded on exchanges or through ETFs that own shares in multiple companies.
The advantage of owning the physical metal is that the price is based strictly on supply and demand. One doesn’t worry about increased expenses associated with running a business. The disadvantage is that bullion creates no cash flow and has a cost associated with assaying and housing the bullion safely.
Owning gold mining stocks do not have the physical limitations holding bullion does, however, the stocks are subject to the vagaries all companies are: of which the most important in the mining industry is energy costs. Thus, while gold has dropped in price in the past two months less than 4%, gold stocks are down between 15% and 50% (see chart 2).
While the two formats will generally follow each other over time, they can act very differently over short periods of time. More recently, with energy prices being so high, the stocks were seeing their margins falling faster than the value of their holdings was rising and thus the stocks have dropped considerably.
When fiat currencies are the biggest worry, logically, the metal itself becomes a more attractive as a hedge because it defends directly against the risk of owning a currency. Owning a stock is merely owning a currency. However, when stocks or the metal get too far out of balance with one another, opportunities arise. For instance, with gold stocks down so much, but gold itself flat, and with the price of energy having dropped rapidly recently from $114 to $90/barrel, then, assuming energy prices do not reverse quickly, the stocks should move up towards equilibrium with the metal because the margins for the companies will expand.
            Chart 2:  Gold vs Gold Stocks
In addition, if gold companies start to increase their dividends dramatically due to their increased cash flows, as beginning to happen, then the added yield will also help increase the values of the stocks.
As the stocks have come down, we are starting to add to our positions and use option strategies like covered call writing to add additional yield to the investments. Utilizing such strategies have converted stocks yielding 1% to yields closer to 5% – 8% over time.
If the metal starts to fall more (it has recently broken support and we would not be surprised if gold fell to around the 1420 level, then we will add more of the bullion in the form of ETFs as well.
Next Month: Earnings season is just starting. In the next month’s Thoughts and Comments, we will review Q2 earnings results.
If you have any questions, please contact us at info@harmonyam.com or ARosenfield@HarmonyAm.com
Alan E. Rosenfield
Managing Director

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