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The Gold Bubble

April 19, 2011 1:46 pm in Global Economy // View Comments

In my opinion gold (and silver) is the next big bubble to burst!

Take a look at this chart which illustrates the price of an ounce of gold over the past 20 years:

Historical Gold Price Chart - 20 Years

20 Year US Dollar Gold Price (courtesy goldprice.org)

The meteoric rise in the price of Gold over the past three to four years is clear.  Indeed the price of Gold between about 1980 and the early 2000s averaged around US$350 per ounce.

The price now is just under $1500 per ounce.  Why?

As with most of our discussions about pricing being determined by ‘supply and demand’ – the demand for Gold is very high and this has been driving up the price.  My argument (and the argument of many others), however, is that the logic underpinning the demand for Gold is seriously flawed.

The demand for Gold is primarily driven by fear.  Fear about the state of the world economy, increasing inflationary pressures, the large fiscal deficit in the United States etc etc.  These fears are perfectly rational, but the conclusion that investing in Gold as a consequence of that fear is irrational.

People aren’t investing in Gold because the Gold is needed by industry, or to produce goods, or even because they like looking at it.  If miners were to stop producing gold today, current stockpiles would last at least 10 years.  Massive stock piles of Gold are sitting in bank vaults around the world because people believe that owning that Gold will provide financial security.

Why should Gold provide financial security?  This thinking is seriously outdated, and yearns back to a time when these prescious metals were indeed synonymous with ‘money’.  Up until 1971 the value of money was directly linked to gold (known as the ‘gold standard’), but those times are no more, and there is no fundamental justification for the current demand for Gold, i.e. the current price is not linked to any true ‘value’ of Gold.

In some ways this is reminiscent of the ‘.com’ bubble where companies were given ridiculously high ‘valuations’ because of the number of ‘eyeballs’ a particular website received… completely irrational, and completely unrelated to any fundamental ‘value’.

This is clearly a bubble.  It’s inevitable that this will unravel and that the Gold price will tumble, it’s just  question of how rapidly.

So what’s this ‘raising the debt ceiling’ all about?

April 11, 2011 2:28 pm in US Economy // View Comments

The USA has an unusual system of having a legal limit on the amount of public debt it is allowed to run up.  That limit is currently set at $14.3 Trillion.

It is anticipated that some time in May this ceiling will be reached.

It will take a majority vote of the United States congress to increase the debt ceiling.

Some have argued that increasing this ‘debt ceiling’ is an approval to allow the US government to continue to spend recklessly, and therefore it should not be approved.  But what would the consequences be of not increasing this limit?

In practice, if the ceiling is not increased, the US government will not be able to meet its financial obligations including contractual obligations associated with its current debts.  So it would actually result in the United States defaulting on its debt – and it would be the first time in history that the US has defaulted on its debt.

What happens when a country defaults on its debt?  The people lending money to that country get spooked, and charge more interest for its current and future debt.  So the outcome of not raising the debt ceiling would actually result in the fiscal or budget situation in the United States getting worse, not better.

So while those arguing for aggressive cuts to the United States governments spending may have a very good point.  Not raising the debt ceiling is the wrong way to pursue this objective.

Troubling Times for Europe

April 10, 2011 3:18 am in Global Economy // View Comments

The bail out of Portugal this week brings the number of European countries ‘bailed out’ by other Euro-zone countries to three.

The reasons for these bail outs and the causes are complex, but at the heart of this issue are three key problems:

  1. The Euro-zone is made up of a number of economically diverse countries, and most importantly some of the countries are much more productive (have higher ‘productivity‘) than others.  For example, Greece and Portugal have much lower productivity than say Germany.
  2. All Euro-zone countries are locked into a single currency – the Euro.  If Portugal for example was not part of the Euro-zone, rather than have to be bailed out, it could allow its currency to depreciate (reduce in value) which would make re-financing of its debt much easier.
  3. Many countries including these troubled European countries have run up high levels of public debt, and the cost of this debt, particularly in the aftermath of the Global Financial Crisis, has increased significantly.  The low economic growth and poor productivity in these countries has meant that banks will not lend more money to these countries, and as they are running out of money it has been left to the European Central bank (which is supported by the governments of all of the Euro-Zone countries) to ‘bail out’ these poorer performing economies.

So where to from here?

The economies of Greece, Portugal and Ireland are relatively small and so the Euro-Zone countries have been able to bail out these countries with relative ease.  BUT, these bail outs in and of themselves have not solved the underlying problems of poor economic performance in these countries, AND, if Spain (which has a larger economy than Greece, Portugal and Ireland put together) were to require a bail out (which is definite possibility) there could be significant implications for the Euro-Zone and indeed the global economy.

Nasdaq Rebalancing – What Does it Mean?

April 5, 2011 11:15 am in Stocks and Shares // View Comments

News today was that the ‘Nasdaq’ is “re-balancing” its ‘Nasdaq-100′ index to give more weight to Google, Intel, Microsoft and Oracle, but reduce the weight given to Apple stock.

What does this mean?  And why does it matter?

The Nasdaq is a stock market or a stock exchange that allows investors like you or I to purchase and sell stocks or shares in companies that have listed their shares with it for trading.

As with most major stock exchanges around the world, the Nasdaq stock exchange publishes an index which can be used by investors and the media to evaluate how a group of companies or a market as a whole is performing.   This is important because watching the share price of any one company is not a reliable way of evaluating how a market or a part of an economy is performing.  But an index, which is a weighted average of a number of stocks, can be monitored and can give much more useful information.

The Nasdaq stock exchange publishes a number of indices (indexes) but in the news today, the Nasdaq-100 was specifically discussed.  The Nasdaq-100 index is an index of the 100 largest non-financial companies listed on the Nasdaq exchange, and features a number of technology companies.

Some indices (indexes), are particularly important because they are used to guide the way fund managers (organisations or people that invest money on behalf of other people) allocate their investments.  For example, a particular fund manager might tell people investing in a retirement fund that the fund will be managed to achieve a return very similar to that of the ‘Nasdaq-100′ index.

So today the Nasdaq exchange announced that it would change the weighting of the Nasdaq-100 index to reduce the amount of weight given to Apple stock and increase the weightings of other companies such as Google and Microsoft so that the index as a whole more accurately reflects the relative value of these different companies.

One of the implications of this is that many fund managers around the world will have to sell Apple shares to bring their funds in line with the Nasdaq-100 index, and that will potentially cause Apple’s share price to fall.

What is Amortisation

March 17, 2011 12:49 pm in // View Comments

Before reading this quick reference about amortisation, please read the following posts:  Capital Expenses and Operating Expenses, and ‘Depreciation‘

Amortisation is an allocation of an expense over specified periods of time.

In financial accounting, amortisation is very similar to depreciation, except that it is typically applied to ‘intangible assets’ while depreciation is applied to ‘tangible or physical’ assets.

Intangible assets are assets that can’t be seen or touched – they’re not physical.  An examples of an ‘intangible asset’ is intellectual property.

Capital Expenses and Operating Expenses

March 17, 2011 12:31 pm in // View Comments

In business as well as in your own personal finances, it is important to have an understanding of the difference between ‘Capital Expenses’ and ‘Operating Expenses’.

Capital Expenses are typically once off investments or once off purchases of assets.  So an example of a capital expense for a typical person might be purchase of a house or a car.

For businesses, Capital Expenses might include purchases of machinery used to make things, or even purchase of a website.

Operating Expenses are generally costs that occur frequently during the day to day operations of a persons life, or a business.  For a person, an operating expense might be rent, or food costs, whereas for a business an operating expense might be employee salary costs or marketing costs.

In financial accounting, Capital Costs are treated differently to Operating Expenses.  In the Profit and Loss Statement, rather than include the full capital cost as one of the ‘expenses’, a portion of the capital cost is allocated as a ‘non-cash cost’ and is called ‘depreciation‘ or ‘amortisation’.

What is Depreciation

March 17, 2011 12:25 pm in // View Comments

Before reading this explanation of ‘Depreciation’, please read ‘Capital Expenses vs Operating Expenses‘.

To explain depreciation, think of a machine you might buy to help you make baskets to sell; lets say the machine costs $10,000 and you use this machine for 10 years before the machine will be too old, and you will have to buy a new one.  In accounting, we would say that this machine loses all of its value over 10 years or it depreciates by $1000 per year.  So in the Profit and Loss Statement you would show a non-cash or below the line cost called Depreciation and if it was over a 1 year period, the machine depreciation cost would be $1000.

So depreciation is the amount of value that a tangible asset has been deemed to decline over a specified period of time.

Some assets depreciate more quickly than others depending on how they are used, and how fast they deteriorate.

There are different techniques for calculating depreciation, the main ones are ‘straight line’ depreciation and ‘unit of production’ depreciation.  The example above of the Machine losing $1000 per year over 10 years is an example of ‘straight-line’ depreciation because the asset depreciates by the same amount each year.  The ‘Unit of Production’ method applies to assets that are used in the production of units.  For example, if we know a particular machine will be able to make 1,000,000 widgets over the course of its useful life, then to calculate the depreciation we would look at how many widgets were made in the specified period of time and allocate the cost accordingly.  The fast the widgets are produced – the more the depreciation and the fast the asset loses value.

Most physical or tangible assets that you or a business might buy will depreciate, or lose value over time, with ‘land’ being an important exception.

What is EBITDA?

March 17, 2011 11:33 am in // View Comments

EBITDA stands for Earnings Before Interest, Tax, Depreciation and Amortisation; pronounced ‘EeBitDaa’.  The word ‘Earnings’ in this definition basically means Profit – the surplus money generated by the business; the word ‘Before’ in Earnings Before Interest, Tax, Depreciation and Amortisation, just means ‘without including’, so EBITDA means ‘Earnings Without Including Interest, Tax, Depreciation and Amortisation’

In our explanation of EBIT we explained how in financial accounting we often want to exclude Interest and Tax from our analysis of a Profit & Loss statement.

Depreciation and Amortisation are other costs, called ‘non-cash costs’, that we may want to exclude from our consideration of the Profit and Loss statement because they are allocated costs from investments that were incurred at some time in the past.  Depreciation and Amortisation are more advanced financial concepts.  See the Quick Reference Post on Capital Expenses, as well as Depreciation and Amortisation for more details.

EBITDA is often considered a useful measure of financial performance because it shows the cash generated by a business and isn’t confused by accounting allocations, interest or tax.

What is an EBIT

March 16, 2011 1:52 pm in // View Comments

EBIT stands for Earnings Before Interest and Tax.

It is a specific term which is essentially the profit of a business before you take into consideration Interest and Tax.

Why would you want to focus on profit without considering Interest and Tax?  Well, often when using a Profit and Loss Statement, we are trying to evaluate how the business is performing, that is, are the people managing the business doing a good job?  Obviously interest, and tax has a bearing on how much money a business makes, but it usually doesn’t have much to do with how well the managers of the business are doing their job.  Interest is the money earned on interest sitting in the bank (which doesn’t require any significant management expertise), and Tax is set buy the government.  So because the performance of the managers of a business often doesn’t have much to do with Interest and Tax, it is useful to know what the business earning (or profit) are without consideration of Interest and Tax, and that’s what the business EBIT is.

Profit and Loss Statement

March 16, 2011 1:44 pm in // View Comments

The Profit and Loss Statement, (also known as an Income Statement or a ‘Statement of Financial Performance’) is the financial report most widely used to evaluate a businesses performance because it documents how much  surplus money, or money after expenses, a business is generating.

All Profit and Loss Statements have the same basic layout and structure:

Revenue (or Income)
List of Income Sources
Total Revenue

Expenses
List of Expenses
Total Expenses

Profit (or EBIT): which is equal to  Total Revenue – Total Expenses

A Profit and Loss Statement could equally be used for your personal finances, and people often construct a budget for their personal finances which is laid out in the same way as a Profit and Loss Statement.  Note that there is an important distinction between a budget and a Profit and Loss Statement – a budget is plan or prediction for future financial performance, while a Profit and Loss Statement is always looking back over some period of time to evaluate what actually happened.

A typical Profit and Loss Statement for a young person might look as follows:

Revenue or Income
My Salary (after                                        $35,000
Dividends from shares                                $1,500
Gift from parents                                            $500
Total Revenue                                       $37,000

Expenses
Rent                                                                  $10,000
Food                                                                 $6000
Health Insurance                                            $1000
Transport                                                        $4000
Entertainment / Going Out                         $4000
Extras                                                              $2000
Total Expenses                                        $36,000

Profit or Surplus Money                        $1,000

So this person is generating a surplus of $1,000 which could go into savings or an investment, or it could be used to buy something else.

An important question to ask when looking at a Profit and Loss statement is what time frame does it cover.  The ‘typical’ Profit and Loss Statement shown above doesn’t give any indication of whether or not the financial performance is good or not because no time frame is specifically shown.  This person could be generating $1000 profit a month, or year, or decade for all we know.  Without a time frame it doesn’t mean anything.

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