Gold's Where the "Value" Is

By Graham Summers    Oct 14 2009 11:14AM www.gainspainscapital.com

140…

That’s the current P/E for the S&P 500 based on reported earnings (earnings that include write-downs). According to David Rosenberg of Gluskin Shef (and former Chief Economist of Merrill Lynch), no US market has ever been this expensive in history. The Tech Bubble, which by all accounts was an extraordinarily overpriced market traded around a P/E of 40 during its peak.

I realize not everyone likes to use reported earnings as a measure of value. After all, all those write-downs that are obliterating reported earnings are a one time event due to the worst credit collapse in 80+ years.

So let’s look at operating earnings (earnings without write-downs included). Today, the S&P 500 trades at a P/OE of 27.6. Put another way, assuming no earnings growth, if you bought the entire market at its current value today, it would take 30 years for you to break even on the deal.

Now, to be blunt, there are times when paying 30 times operating earnings for a business makes sense. If the business is a market leader worldwide, then the price is not too steep (this is roughly what Mars paid for Wrigley,  Proctor & Gamble paid for Gilette, etc). If you’re buying a brand that dominates your industry, paying 30 times operating earnings isn’t bad.

But paying 30 times operating earnings for the entire S&P 500... including businesses that are insolvent or bankrupt : AIG, Citigroup, Bank of America, etc? Sorry but I cannot imagine anyone in their right mind would be willing to pay that price.

And they’re not:

Last Friday, the market closed at its highest level for the year of 2009… on the lowest volume of the year. It’s been a hallmark of this rally that the higher it goes, the lower the volume. And when you consider that 70% of the market volume is High Frequency Trading Progams exchanging blocks of shares back and forth to collect a ¼ penny rebate, it’s clear that virtually NO ONE is buying the market at today’s levels.

After all, why would they?

David Rosenberg points out that typically when the US economy shifts from contraction to expansion (as some claim it is now) the stock market is usually price at a P/OE of 15 (roughly half its current levels). He also notes that there reason the P/OE is as high as 15 at these times is because earnings are extremely low due to economic hardships destorying profitability.

Indeed, with the exception of 2001, stocks have never been so rich after any recession in the last 55 years. Put another way, today’s S&P 500 is more expensive that at any point in the last half century when compared to the underlying economic conditions.

Bottomline: anyone going long right now is buying a very, very overpriced market. True, stocks could rally higher, but the market is already trading at what would easily qualify as bubble levels.

This is not surprising given the fact we have a bubble-crazed Fed Chairman hellbent on inflating stocks to the moon and destroying our currency so as not to repeat stock market performance of the Great Depression. He already helped manufacture two Bubbles in the last 10 years. Both of those ended horrifically.

Meanwhile, gold just broke its “neckline.”

If you’ll recall, in August ago I wrote about the massive inverse head and shoulders pattern gold had formed during the last three years. I presented the below chart to illustrate this:

At that time I wrote:

… gold has formed a long-term inverse head and shoulders formation (two smaller collapses book-ending a major collapse). Typically a head and shoulders predicts a massive collapse. However, when the head and shoulders is inverse, as is the case for gold today, this typically predicts a MAJOR leg up.

Indeed, any move above the “neckline” of 1,000 would forecast a MAJOR move up to $1,300 or so…

Well, last week, gold broke the neckline:

As you can see, gold’s recent rally took it above the critical point of upwards resistance. This indicates that the next leg up in the gold bull market has begun. The reason here is simple: investors have begun to realize that every central bank on the planet is hell bent on devaluing their currencies.

Interestingly, this new breakout corresponds perfectly with historic trends. As I wrote in August:

If we were to go by the historic pattern of the gold market in the ‘70s, gold should experience upwards resistance for 19 months after its first peak today. Gold’s recent peak was $1,014 in March ’08 (roughly 17 months ago).

If this bull market parallels the last one, then gold should renew its upward momentum in a very serious way starting in October 2009. And this next leg up should be a major one (the biggest gains came during the second rally in gold’s bull market in the ‘70s).

Well, here were are in October 2009, and gold is definitely making a major move upwards. To me, the reason here is simple: investors have begun to realize that every central bank on the planet is hell bent on devaluing their currencies.

Everyone and their mother believes the Fed’s actions are hurting the US dollar. But few people have taken noticed that the Europeans don’t want a strong euro, just as the Japanese don’t want a strong yen, just as the Swiss don’t want a strong franc.

Why?

None of these guys want their currencies to appreciate too far against the dollar because most if not ALL of them export to the US or trade products based in dollars. Having a strong currency against a weak dollar means increased production costs against a lower sales price.

This means LOWER profitability.

To combat this, countries are either aggressively printing money to stimulate their economies (China, Europe, the UK) or openly manipulating their currencies (Switzerland) in an effort to devalue their money against the dollar. Case in point, this latest breakout in gold happened WITHOUT the dollar falling to a new low:

As you can see, gold broke out dramatically this week. But the dollar failed to fall to a new low. This tells us that gold is beginning to decouple from the dollar and is soaring as investors the world over flee paper money in general. And of course, they’re piling into the one currency that CANNOT be devalued:

GOLD.

So where will the precious metal go from here? The above head and shoulders pattern forecasts a move to $1,300. But if we truly get gold mania (as we did in the late ‘70s) gold could rise 750%: that was how high gold rallied from August ’76 to January 1980 during the last gold bull market.

If gold were to rally 750% from its recent low ($700), that would put the precious metal at $5,250 per ounce!!!

I know, the idea of gold above $5,000 an ounce seems ridiculous to me too. But gold has produced these kinds of returns before. And with virtually every central bank on the planet printing money in an effort to stimulate their economies, it’s not hard to see how gold mania could push the precious metal to prices that seem outlandish today.

In light of this, I suggest having some exposure to the precious metal. Gold’s had a wild ride since 2000. But if this gold bull market continues to mirror that of the ‘70s (as it has so far), then we’re in for some real fireworks in the next couple of years.

Indeed, on that note, I’ve put together a FREE Special Report detailing an unusual means of playing the gold explosion. While most investors blindly pile into the gold ETF or buy gold bullion, this backdoor play allows you to buy the precious metal at an incredible $188 an ounce. If gold breaks above $1,000, the opportunity for triple digits gains is huge.

Swing by www.gainspainscapital.com /gold.html to pick up your FREE copy!!

Good Investing!

Graham Summers

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To that end, I’ve put together a FREE Special Report detailing an unusual means of playing the gold explosion. While most investors blindly pile into the gold ETF or buy gold bullion, this backdoor play allows you to buy the precious metal at an incredible $188 an ounce. If gold breaks above $1,200, the opportunity for triple digits gains is huge.

Swing by www.gainspainscapital.com /gold.html to pick up your FREE copy!!