Gold Stock to Gold Price Ratio

One of the blogs I follow, World of Wallstreet, in his post Obvious (But Original) Thought About The Gold Stock To Price Of Gold Ratio, showed the graph below, hypothesizing that since stock indices have declined 40%, the fact that the gold stock:gold price ratio is down 40% doesn't mean that they're undervalued. He points to the ratio's September 2000 trough (0.15) as evidence that they may decline further.

It's a good thought, certainly suggesting that in the short term this "reversion to mean" may not pan out the way some people are hoping. That said, I'd like to see a longer term chart - it looks to me like the early end of this chart was also up around the .5 range, and that dropped right up until September 2000. That is - the $HUI:$GOLD trough coincides perfectly with the TSX peak during the tech boom. While the NASDAQ isn't as perfect of an inverse correlation, as it was already off its March 2000 peak, its catastrophic decline also significantly accelerated in September.

The ratio then rose through the recession that followed the tech crash. This suggests to me that the ratio's decline was due to money moving into trendy tech stocks, not an overall stock market decline.

My guess - stocks are leveraged against their underlying resource price, since they have a production cost that's more or less fixed. The fact that they're trailing the recent precious metal recovery suggests that investors are concerned that precious metals may once again decline.

Also, I'd point out that while some of the decline in indices is panic selling, some of it reflects reduced profit from individual companies. But a gold miner's profit is entirely related to the price he gets for gold, so at a minimum their decline relative to the gold price should be lower than the decline of the whole index.

I've never professed to be an expert at this. And I've certainly lost a fair bit of money making bad calls on where things are going. But it still seems to me that precious metals - whether producer stock or bullion - should hold up until financial volatility dies down.

Where to live: Renting vs Owning

I recently read this article on Smart Money, making the argument that renting a home, and using money saved each year to invest in stocks, was a smarter financial decision than owning a home. He brushes off pro-ownership arguments as clever uses of emotional language "throwing money away," "pride of ownership," and so on, claiming that stripped of emotional considerations, it's actually homeowners that are throwing money away.

His argument basically boils down to stocks having a real return of 7% annually over the long term while houses only match inflation. Factoring in that homeowners have maintenance costs that significantly offset the rent saved by owning, this makes renting the superior financial decision.

This clearly flies in the face of conventional wisdom, and reading his argument, I was unconvinced. So I've spent the last couple of days thinking on it and trying to determine the fallacy in the argument - I was pretty sure it had something to do with the way he threw away inflation - and I think I've nailed it down.

The experiment
So I ran my own analysis using his numbers, but this time adding inflation back into the mix. My world works like this:
- Average annual inflation: 3%
- Average annual stock returns: 10% (7% real return)
- Increase in house prices and rents: 3% (0% real return)
- Each year the homeowner must lay out 2% of the current value of his home in upkeep costs and property taxes.
- annual rent paid is 5% of the current house value
- A 4.3%, 25-year mortgage interest rate (ING Direct's current 5 year fixed rate)
- Any money saved in a given year will be put into the same stock investments regardless of which party saves it
- $1000 in closing costs for purchasing the house.

I looked at the 40 and 50 year time horizons, figuring that these represent the years around retirement, when you are most likely to be interested in your equity.

Results:
Okay, so using these numbers, it turns out that the renter will indeed finish richer. Interestingly, though, the homeowner will have more equity during years 2-6. If homes generate even a modest 1% real return, this homeowner advantage lasts to year 19.

But, I tried some tweaking of my admittedly simple model. Here's some situations where the homeowner will be wealthier than the renter:
- High inflation. If inflation is equal to the real return on stocks, (7% in my model), the homeowner has an advantage up until year 39. 1% more than stocks' real return, and the advantage lasts the full 50 years that I'm looking at.
- Rent is more than 5% of purchase price. If rent is 6.6% of purchase price, the 50 year mark is in the owner's favour. This represents a 15:1 ratio between rent price and purchase price. I consider this to be the most likely situation, since the 5% used in the article is kind of a bait and switch - he uses long term averages for the maintenance cost relative to purchase price, but only the rent to purchase price achieved during a market peak.

Effect of interest rate
My model wasn't well set up for dealing with changes in interest rates. Notably, I was kind of lazy about setting up the annual payments. Should I feel like revisiting this, version 2 will have better handling of interest rates.

Other factors
There's of course lots of other factors in here. Aside from the emotional decisions - stability, pride of ownership, etc - there's also some variables in terms of people's ability to manage their money. Most people, having made the decision to be lifelong renters, will not figure out what owning a place would have cost them, and then put whatever savings they have over than into an investment account. Most people will wind up increasing their standard of living instead, so some of my assumptions about growth on money saved each year don't translate well in the real world.

Even if stock markets continue to match historical long term averages - which is by no means certain - it's unlikely that average individual investors will exactly match this performance. While index funds make this easier, they have small but still material management fees that over the long term may kill the homeowner's advantage.

Uncertainty
I haven't independently researched the ratios used in the original article, and just accepted them as truth. Logically, I've having trouble with the idea that house prices and rents have both matched inflation, but the ratio between the two has more than doubled.

Conclusion:
The decision to buy or rent is not as clear cut as most Canadians believe. Deciding between the two, even if we stick purely to a financial calculation, requires making a lot of assumptions about how the world is going to behave in the future. The difference between the two can be significant in one model, but making a small change to one of the many variables involved, come out showing the exact opposite.

Myself, I'm still happy to own a home, and don't think I much want to sell in the near future. But this project has, I think, shown that I obsessed too much about home ownership, that delaying home ownership doesn't necessarily put you behind.

Odd Links

While I continue to have little investing news to update, I did have an odd convergence of interests today, when I discovered that one of my travel photos had been linked from an article about Jack Madoff.

Aside from that, I continue to sit on my stocks. Their value has dropped to the point that I can put them all into a TFSA, which I will be doing on Friday. FR has started to recover, so I'm again feeling optimistic about the future. WEE continues to lag behind, and has pretty much flattened around the 50 cent mark. I'm looking forward to the next financial report, as I think their revenue growth should help the stock price.

Where's the Bottom?

I've been absolutely pummelled in the past month. My currently holdings have all but collapsed. I'm frustrated, and confused, but I'm not prepared to sell, I guess, since I still think that the companies I own are solid, have a good base of cash to get through the credit crunch, and as a result, are massively undervalued. FR is being discussed by a few analysts as a prime takeover tarket, which would be a relief to me, as it means I should at least get my money back out of it. Overall, as far as I can tell, they're basically victims of a market wide selloff, and that's got me jittery.

I've been expecting a bottom for probably about 3 months, but things just keep getting worse. So there goes my instincts. It's possible that this could be the greatest crash since '29. I have scoffed at this idea for months, as overall things seem to be humming along in the real world - people still have jobs, still pay their bills - not like the 30s, when a quarter of the population was out of work, and those who were employed saw their incomes decline by 42%. But marketwise, things are getting to the point where I'm just a little panicky. I was reading recently that the Japanese exchange had PE ratios in the range of 2 during their crisis in the 90s...that's scary.

But maybe my panick is a good sign. I keep envisioning the emotional charts - where people get the most frustrated at their investments just as things start to turn around. But I'm not over hopeful anymore, I just keep waiting for the other shoe to drop, as it were.

Anyone out there more optimistic?

A Disappointing Update

I haven't blogged much lately. I've been somewhat depressed and embarassed by my current situation. My current holdings have declined by as much as 50% - currently sitting at 45% - from their book value. Add to that a screw up with my FNX puts - I could have made about $2000, instead I panicked and sold off at a $450 loss. Such is life.

Basically, for the first time since I started, my losses on currently holdings have outstripped my gains on closed positions. I haven't done the math yet - I'm a little scared to - but I figure it must be over $1000 net, which isn't insignificant to me. I've also had some financial interruptions elsewhere, meaning I've had to pull out some cash from my investment funds, making it an even bigger problem, because I'm not in a position to buy more at what I consider to be massively discounted prices.

But I remain optimistic. Wavefront (TSX-V:WEE) recently made an announcement that they now have purchase agreements for 106 tools. Their break even point is estimated to be between 100 and 110 tools, so once the installations are done, they'll be pretty close. Their news release figures all 106 currently on tap should be installed before the end of the calendar year, making 2009 a big year for Wavefront.

First Majestic (TSX:FR) has declined along with the price of silver. Again, a company that is increasing production, and I figure that in the not too distant future, they should be on solid ground even at reduced prices, so it seems again to be a mistake to mark them down to the extent that they have. These two holdings - the only two I currently have - are very different. Wavefront has a patented technology, so they're able to set the price and it doesn't change, it's just a matter of making the sales, which they seem to be doing, albeit slowly. First Majestic produces a commodity, so has no problem making sales, but is at the mercy of the market for how much they can charge.

As a result, I've been unwilling to sell off at reduced prices, because I sure don't want to be sitting on my cash when the rebound comes. That was my mistake with FNX - I let my fear induced by current price movement to talk me out of my holdings, and as a result missed a big opportunity.

Investment Lessons from the Blackjack Table

Sometimes, I play blackjack. It's the only type of gambling that I've ever really been interested in, due to the surprisingly small house advantage - I don't have the skill to count cards, yet the odds are still not stacked too high against me. It occurs to me that there are a lot of similarities between blackjack and stock trading.

The main thing, I think, is that odds are in blackjack that at some point in the evening, you'll have more money than you started with. If you walk away from the table at that point, you've won - just not much. On the other hand, if you stick around waiting for the big payout, odds are good that you'll wind up behind, but there's that tantalizing chance that you'll walk away rich.

I sold my Timminco stock for a $400 profit, 9%. This is not the most I could have sold it for, and if TIM can deliver on their promise to make UMG-Si at $10-$15/kg, it could easily turn out that I missed out on $10 000. But, like blackjack, it's probably best with a wild swinging stock like this to walk away while I'm up. There's every possibility that they will be unable to deliver on their promises, in which case the company will only be worth a fraction of its current value.

I've found this to be true in my other speculative holdings. I have a great deal more confidence in the ability of FR and WEE to deliver on their promises...yet in both cases I've let slip chances to make a 10% profit and walk away, and in return, I'm currently sitting down 22% on the two.

So, maybe I'm a wimp...maybe I really don't have the balls of steel that it takes to make the big returns. On the other hand, maybe I'm that smart player who can consistently take small profits and run with them. After all, if I could consistently turn 10% on a trade in about a week, I could generate massive annual gains.

Anyway, for better or worse, TIM is closed, and I'm looking for the next one.

Update:
In the time it took me to write this post, TIM dropped from $16.30, where I sold it, to $15.00...within pennies of my buy point. Am I feeling happy right now? I think so.

Stress Much?

So my resource intensive portfolio has been melting down of late. FR is now down 23%, WEE down 34%. It's been a pretty nasty couple of weeks.

I keep toying with the idea of selling, but I just feel like these prices are insanely low for these companies, so I'm not prepared to do so. Maybe I'm crazy, but I still think that despite falloff in resource prices, they're still companies with a lot of growth potential. I'm particularly annoyed because these are companies which didn't benefit all that much from price runup, but seem to be taking the full brunt of the downturn in resources.

Anyway, still in them. Don't really want to sell when they're down...not while I'm still confident in their futures.

On another note, I opened a position in Timminco (TSX:TIM) today. TIM makes solar grade silicon, and was a star performer on the TSX last year. This year it had been performing well, but its second quarter earnings missed expectations, and led to a 25% drop in value. While that's cause for worry, I read the earnings information, and it seems like it it's not all that bad. I don't think it fundamentally changes the bright future for the company, which is what its stock price is largely based on. Pretty much the whole drop was in overnight trading, and today it held steady with high volume, so I don't think I'm the only one who smells a deal.