This week the attention of most market participants will be on what action Congress takes in their sole week of session for the month of November. The most important item facing Congress is the looming expiration of the Bush tax cuts. Some progress is likely this week with both parties facing a backlash if no action is taken and all tax rates revert to higher levels. We believe this week will set the stage for Congress to pass a one or two-year extension of all the Bush tax cuts, but, as we noted last week, it is a close call.
The uncertainty over the fate of the tax cuts, along with faster-than expected inflation in China, stoking fears of a rate hike, and the ongoing debt problems in the eurozone, contributed to volatility last week. Stocks, as measured by the S&P 500, gave back 2.1% after gaining 3.6% in the prior week. Last week also saw two markets that have been immune to these considerations, demonstrate higher volatility:
- Gold prices fell 1.8% after gaining 2.5% the week before (according to Bloomberg data).
- Gold prices fell 1.8% after gaining 2.5% the week before (according to Bloomberg data).
The return of volatility to gold and emerging market stock prices has raised a question among some market participants: is the relentless climb pushing gold and emerging market stock prices into bubble territory? We do not think so. If they are bubbles, historically they still have a long way to inflate before they burst.
Gold prices have tracked the classic bubble pattern but have yet to enter the parabolic stage where the bursting of
the bubble and the ensuing sharp losses begin to become a risk. The investment bubbles of the past experienced far more inflation than what gold prices have experienced so far. The technology bubble of the 1990s (measured by the NASDAQ), the oil bubble of the late 1990s/early 2000s (measured by oil futures prices), and the housing bubble (measured by the S&P 500 Homebuilding Index) took 10 years and posted gains of about 1000% before they burst and quickly surrendered most of those gains.
What could push gold prices into historical bubble territory? While rising central bank demand, higher mining costs, and demand for gold as both a luxury and a savings vehicle from a rising middle class in China and India all help to support gold, the potential driver of a bubble would likely be driven by currency. Part of the rise in the price of gold is due to the decline in the value of the dollar. As the dollar goes down, the price of gold in dollars goes up. While gold has surged to an all time high over the past five months in dollar terms, gold denominated in euros remains below the levels reached five months ago. The move to record highs in the price of gold is more because we measure it in terms of a weakening US dollar. A sharp drop in the dollar would boost gold prices in dollar terms and may also result in upward
pressure on interest rates and slow economic, growth boosting demand for gold as a perceived safe haven. While we expect the Federal Reserve’s (Fed) program of stimulus will continue to weaken the dollar well into 2011, we do
not expect a sudden devaluation that would propel gold sharply higher.
Emerging markets suffered during the financial crisis of 2008-2009 when they experienced similar losses to developed markets. However, emerging market stocks have rebounded to prior peaks stoking fears of overvalued markets due for another sharp downturn. Emerging market stocks have not yet entered the parabolic stage where the. bursting of the bubble historically becomes a risk.
What could push emerging market stocks into historical bubble territory? A flood of money has been pouring out of slow-growing developed economies into rapidly growing emerging market economies. As a result, the currencies
of emerging market nations have been rising, elevating the risk of their exports, and becoming less competitive in world markets. As emerging market countries succumb to increasing pressure to reduce the strength of their currencies asset bubbles may inflate due to the excessive stimulus from domestic actions in addition to inflows from abroad.
While not in historical bubble territory, gold prices and emerging markets do have risks. For example, a contraction in growth in the emerging markets would weigh on both asset classes. And, importantly, if gold and emerging
market stocks continue to track the bubble pattern, they have reached the stage of the pattern where volatility picks up and sudden, sharp moves become more common as the bubbles inflate and risks build.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
High-Yield/Junk Bonds are not investment-grade securities, involve substantial risks, and generally should be part of the diversified portfolio of sophisticated investors.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.
Stock investing may involve risk including loss of principal.
Energy Sector: Companies whose businesses are dominated by either of the following activities: The construction or provision of oil rigs, drilling equipment and other energy-related service and equipment, including seismic data collection. The exploration, production, marketing, refining and/or transportation of oil and gas products, coal and consumable fuels.
Consumer Discretionary Sector: Companies that tend to be the most sensitive to economic cycles. Its manufacturing segment includes automotive, household durable goods, textiles and apparel, and leisure equipment. The service segment includes hotels, restaurants and other leisure facilities, media production and services, consumer retailing and services and education services.
Consumer Staples Sector: Companies whose businesses are less sensitive to economic cycles. It includes manufacturers and distributors of food, beverages and tobacco, and producers of non-durable household goods and personal products. It also includes food and drug retailing companies.
Health Care Sector: Companies are in two main industry groups—Health Care equipment and supplies or companies that provide health care-related services, including distributors of health care products, providers of basic health care services, and owners and operators of health care facilities and organizations. Companies primarily involved in the research, development, production, and marketing of pharmaceuticals and biotechnology products.
Financials Sector: Companies involved in activities such as banking, consumer finance, investment banking and brokerage, asset management, insurance and investment, and real estate, including REITs.
Industrials Sector: Companies whose businesses manufacture and distribute capital goods, including aerospace and defense, construction, engineering, and building products, electrical equipment, and industrial machinery. Provide commercial services and supplies, including printing, employment, environmental and office services. Provide transportation services, including airlines, couriers, marine, road and rail, and transportation infrastructure.
Manufacturing Sector: Companies engaged in chemical, mechanical, or physical transformation of materials, substances, or components into consumer or industrial goods.
Materials Sector: Companies that are engaged in a wide range of commodity-related manufacturing. Included in this sector are companies that manufacture chemicals, construction materials, glass, paper, forest products and related packaging products, metals, minerals and mining companies, including producers of steel.
Technology Software & Services Sector: Companies include those that primarily develop software in various fields such as the Internet, applications, systems and/or database management and companies that provide information technology consulting and services; technology hardware & Equipment, including manufacturers and distributors of communications equipment, computers and peripherals, electronic equipment and related instruments, and semiconductor equipment and products.
Telecommunications Services Sector: Companies that provide communications services primarily through a fixed line, cellular, wireless, high bandwidth, and/or fiber-optic cable network.
Utilities Sector: Companies considered electric, gas or water utilities, or companies that operate as independent producers and/or distributors of power.