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Kass: 15 Surprises for 2011

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10. The price of gold plummets by more than $250 an ounce in a four-week period in 2011 and is among the worst asset classes of the new year. The commodity experiences wild volatility in price (on five to 10 occasions, the price has a daily price change of at least $75), briefly trading under $1,050 an ounce during the year and ending the year between $1,100 and $1,200 an ounce.

By means of background, the price of gold has risen from about $250 an ounce 11 years ago to about $1,370 an ounce today -- compounding at more than a 16% rate annually. As a result, investing in gold has become de rigeur for hedge-hoggers and other institutional investors - and in due course gold has become a favored investment among individual investors.

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My surprise is that next year the price of gold has the potential to become the modern-day equivalent of Hans Christian Andersen's "The Emperor's New Clothes," a short tale about two weavers who promise an emperor a new suit of clothes that are invisible to those unfit for their positions, stupid or incompetent. When the emperor parades before his subjects in his new clothes, a child cries out, "But he isn't wearing anything at all!"

With a finite supply, gold has historically been viewed as a tangible asset that increases in value during uncertain (and inflationary) times. No wonder it has become such a desirable asset class following the Great Decession and credit crisis of 2008-09. Gold bugs remind the nonbelievers that for thousands of years, gold has been a store of value and, given the current state of the world's financial system, gold is the best house in a bad neighborhood of asset classes.

But gold, which may be the most crowded trade around, is viewed now as a commodity for all seasons -- during inflation, deflation, low or high economic growth.

There is a body of thought that maintains gold holds little value, that it is only a shiny metal with limited industrial value that throws off no income or cash flow (and, as such, its value cannot be determined or analyzed with any precision based on interest rates or any other measure). Those nonbelievers compare the dizzying price of gold to the unsustainable rise in comic book prices (and other collectibles) in the early 1990s, Internet stock prices in early 2000 or home prices in 2006-07.

Here is how Oaktree Management's Howard Marks draws a colorful parallel between gold and religion, over the past weekend in his always-thoughtful commentary on the markets:

 

My view is simple and starts with the observation that gold is a lot like religion. No one can prove that God exists ... or that God doesn't exist. The believer can't convince the atheist, and the atheist can't convince the believer. It's incredibly simple: either you believe in God or you don't. Well, that's exactly the way I think it is with gold. Either you're a believer or you're not.

What we do know is that gold is valued in an auction market based on the price where buyers ("the believers") and sellers ("the atheists") meet.

With an inability to gauge gold's intrinsic value, wide price swings remain possible. And wide price swings are what I expect in 2011.

There are numerous catalysts that can contribute to a surprising weakness in the price of gold in the upcoming year. But most likely, a large drop in the price of gold might simply be the result in a swing in sentiment that can be induced by a number of factors (or maybe even sentiment that the emperor (and gold investors/traders) aren't wearing anything at all!):

 

  • Investors might grow increasingly comfortable in a self-sustaining, inflation-free worldwide economic recovery.

     

  • Interest rates could ratchet higher, providing competition for non-income producing assets (like gold).

     

  • The world stock markets could surprise to the upside, reducing investors' interest in real assets (like gold).

     

  • The US government might (astonishingly) address the deficit.
In addition, there are numerous cautionary and anecdotal signs that are reminiscent of prior unsustainable asset class cycles or bubbles:

 

  1. Macro funds, like those managed by John Paulson, have outsized weightings in gold or even have established dedicated gold hedge funds.

     

  2. On Okeechobee Boulevard in West Palm Beach, Florida, hand-held placards that used to advertise condominiums and single-family homes for sale (during the housing bubble) have been replaced by hand-held signs advertising "We Buy Gold." On this well-populated street, gold exchange stores have replaced the omnipresent real estate and cell phone stores of the last speculative cycle. ("We Buy Gold," "Sell Your Unwanted Gold," "Get Cash Now For Your Gold" are names of a few of the retail outlets).

     

  3. Gold is even being dispensed in an ATM machine in the Town Center Mall in Boca Raton, Florida and at a hotel in Abu Dhabi.

     

  4. The company that dispenses the gold is PMX Communities, a Boca Raton-based company listed on the pink sheets. According to a recent release, the ATM gold dispensing machines now operate in 12 locations around the world.

     

  5. My spam emails normally consist of Viagra and "male enlargement" solicitations, but offer to buy gold have been on the rise over the last few months.
11. Among the most notable takeover deals in 2011, Microsoft launches a tender offer for Yahoo at $21.50 a share. With the company in play, News Corporation (NWS) follows with a competing and higher bid. The private equity community joins the fray. Microsoft (MSFT) ultimately prevails and pays $24 a share for Yahoo (YHOO).

Currently, Yahoo is universally viewed as a dysfunctional company, and few expect that Microsoft has an interest in the company. But a deal could be profitable and advantageous (more critical mass and immediate exposure to the rapidly growing Chinese market) to Microsoft:

  • Microsoft is hemorrhaging cash in its Internet operations (estimated $2.5 billion of losses in the last 12 months). Yahoo will immediately contribute $1.25 billion-plus of cash flow. (Applying a normal multiple, 6x to 9x creates $8.5 billion of value to Microsoft from Yahoo's current earnings before interest, taxes, depreciation and amortization).

     

  • Yahoo boasts net cash of $3.4 billion.

     

  • Yahoo's public holdings total $9.5 billion of value (AliBaba.com and Yahoo Japan).

     

  • Yahoo's private holdings total $6.0 billion.

  • Yahoo owns 40% of private AliBaba through two assets:
  1. A call option on Chinese search via Microsoft joint venture. Based on the value of Baidu, if Yahoo gets a 10% share of the $50 billion Chinese search market the value is $5 billion - the value to Yahoo is about $1 billion for each 10% of search share (40% of 50%).

     

  2. 40% of AliPay. This is the elephant in the room. Current AliPay payments are about two thirds of PayPal, but the company is growing much faster than PayPal and its market potential is far greater. PayPal is currently worth $18 billion -- making AliPay valued at $12 billion. Yahoo's 40% is worth $5 billion now but will easily be $10 billion in three years.

By means of background, on February 1, 2008, Microsoft offered $31 a share, or $45 billion, to acquire Yahoo in an unsolicited bid that included a combination of stock and cash. At that time, Yahoo!'s shares stood at $19 a share, and Microsoft was trading at $32 a share. (Today Microsoft trades at $27 a share, and Yahoo trades at $16 a share.)

Yahoo rejected the bid, claiming that it "substantially undervalued" the company and was not in the interest of its shareholders. In January 2009, Carol Bartz replaced Yahoo co-founder Jerry Yang, and six months later Microsoft and Yahoo entered into a search joint venture.

12. The Internet becomes the tactical nuke of the digital age. Cybercrime likely explodes exponentially as the Web is invaded by hackers. A specific target next year will be the NYSE, and I predict an attack that causes a week-long hiatus in trading and an abrupt slowdown in domestic business activity.

13. The SEC's insider trading case expands dramatically, reaching much further into the canyons of some of the largest hedge funds and mutual funds, and to several West Coast-based technology companies. This surprise is an extension of surprise No. 13 from last year's 20 Surprises for 2010:

Insider trading charges expand. The SEC alleges, in a broad-ranging sting, the existence of extensive exchange of information that goes well beyond Galleon's Silicon Valley executive connections. Several well-known long-only mutual funds are implicated in the sting, which reveals that they have consistently received privileged information from some of the largest public companies over the past decade.
The next SEC target is directed at some of the world's largest tech companies, including one of the leading manufacturers of flash memory cards, one of the largest contract manufacturers and a big producer of integrated circuits. A high-profile very senior executive in one of these companies is implicated and is forced out of his position.

With the depth of the investigations moving toward the center of some of the largest hedge and mutual funds, many of the more active traders are temporarily in "lockdown" mode as the hedge fund community's trading activity freezes up.

  • New York Stock Exchange volume and price volatility dries up (see surprise No. 4 on the sideways market).

     

  • Fox Business Network closes because of lack of interest.

     

  • CNBC reduces its live broadcasting schedule and resorts to paid programming before 6:00am and after 8:00pm.

     

  • Particularly hard-hit is Greenwich, Connecticut -- the home of many of the biggest hedge-hoggers who are alleged to have committed insider trading violations. The residential real estate market in Greenwich collapses.

14. There is a peaceful regime change in Iran.

15. China overplays it's economic hand by implementing multiple tightening and by its unwillingness to allow its currency to appreciate.

The region's GDP climbs by only 5% in 2011.

Doug Kass writes daily for RealMoney Silver, a premium bundle service from TheStreet.com. For a free trial to RealMoney Silver and exclusive access to Mr Kass's daily trading diary, please click here.

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