RSSCoal and Gold are Your Two Best Bets
By Kurt Kasun | July 15, 2008 | 1:45 PM | 4 Comments
Left to its own devices, the free market would clean up the current mess we find ourselves in relatively short order. Of course, in a free market we would have never grown to a position where total debt is 300% of GDP, the current account (trade) deficit exceeds 6%, and our unfunded liabilities (Social Security, Medicare, etc.) is of an amount we can never hope to pay out ($59 trillion and growing). The clean up would be painful because we would finally be paying the bill for a generation of gross excess. Agonizing is it would be, what the government has in store for us will be much worse.
Bob Hoye of Institutional Investors nails it writing, "The problem that won't go away is that the pitch by the central planners that risk had been eliminated prompted the greatest experiment in leverage in history. Actually this has been a multi-generational accumulation of reckless investment and central banking habits. The consequence, as we concluded last July was that "The credit markets are in the greatest train wreck in history."
Next month we will celebrate the 37th anniversary of totally abandoning the international gold standard. It has been quite a party ever since. Leverage permitted the greatest era of excess in the history of the world. Through money creation and new leveraged securitized toys to for Wall Streeters to play with, consumers and our government were allowed to go on a debt-induced spending spree that future Americans will paying for generations to come. This problem is bigger than subprime as many are coming to quickly realize.
A sharp and painful deflationary purging of the excess is what is called for. But for those who understand the "government to the rescue" culture which has evolved over the past century, we can expect a government response which brings the nation to the brink of bankruptcy. The numbers are just too big. A few years ago when I was working on my graduate thesis Barry Bannister, working at Legg Mason at the time, was kind enough to send me a few reports he had recently completed. I share with you the following two charts:
source: Barry Bannister
Over the past few weeks we endured another breath-taking deflationary scare. As indicated in the first chart, after the debt build in the 1920s, we suffered a deflationary depression in its aftermath. Will we suffer the same fate this go around? If you are caught leaning the wrong way in the "inflation vs. deflation" trade, you could be wiped out in short order. But President Bush, Secretary Paulson, and Fed Chairman Bernanke's coordinated policy response to ill-fated Freddie Mac and Fannie Mae (government equity purchase on the table) is there any question that the debt "will" warrant an inflationary response? Portfolios should make necessary adjustments in order to prepare.
The economists at the institutions that most influence world economic policies are Keynesians. I had a lengthy discussion last weekend with an economist at the IMF who is thoroughly convinced that a drop in aggregate demand will result in taking away of inflationary pressures as the world economy slows. Because they really do not fear inflation further convinces me that it is going to increase much higher than the mainstream is forecasting.
I don't think we are going to see Weimer-type hyperinflation like that experienced in Germany in the 1930s, however. During the course of that event, stock markets soared higher along with everything else. More recently, Zimbabwe's stock market was the top performer last year, but after accounting for inflation, the gains are almost worthless. I think we here in the US are going to experience a gradual decline in the asset classes which saw the biggest gains (stocks, housing, and other luxury items) and an increase in price in the items which are the necessities for everyday living and survival (food staples, fuel, basic materials). Regarding the former take a look at the chart below:
source: thechartstore.com
We did in fact violate the 1974 uptrend line I advised watching in my commentary. This strongly suggests that we will at least test the trendline that dates back to 1885, taking us down to around 6000 on the DJIA. If the Dow/Gold ratio returns back to 1 (one ounce of gold buys one share of the Dow) that takes gold up to $6000/oz. Does that seem absurd? Just like $150/barrel oil might have seemed outrageous at the beginning of the decade. On that point, we see Gold/Oil ratio at an historical low around 6.5:1. The historical average is closer to 10:1 and can run upwards of 16:1. This is very gold bullish. Note that the Dow/Gold and Gold/Oil ratios are pointing to higher gold prices but this does not nessarily indicate that we have an imminent event to trade on. We should, however, be very confident that long/short trades on these two ratios will pay off quite handsomely over time.
Another kicker for gold could be its increased stature as a safehaven investment. US bonds blinked on Friday in the wake of the crisis developing over the Fannie Mae and Freddie Mac. Longer term yields actually significantly backed up during the equity market selloff while gold moved much higher, seemingly capturing much of the money which would have otherwise fled into Treasuries. This bears further monitoring and is not yet the trend. Also notheworthy, though, is the fact that while the US stock market indices have plunged to two year lows, taking out their former March and January lows, yields on the 10-yr and 30-yr treasuries did not.
Certain commodities should also continue to gain. As the rise in the price of tangible assets takes on more of a "world fiat currency value decline" nature and less attributed to its world growth/higher demand characteristics, I expect the precious metals to outperform most, if not all commodities. Some of the other lagging commodities will also play catch up, particularly some of the "softs". Grains also have yet to hit their blowoff tops.
Mohamed El-Erian, Co-CEO and Co-CIO of Pimco and author the recently released book, When Markets Collide, made an excellent point while co-hosting CNBC's Squawk Box last week when he made the point that many commodities will only decline after the rallies exhaust themselves. He went on to say that they will first experience a period of "reverse elasticities," meaning that demand will still be strongly influenced by price, but that it will have the opposite effect which it normally does. Opposite in that at some point during the rally, buyers buy even more at current prices as they expect prices to rise even higher in the future (fear of contango in the commodity world) and suppliers are willing to supply less due to having expectations of receiving even higher prices in the future. You can see how this can lead to prices spiraling out of control.
This is consistent with the final exhaustive commodity rally I have been forecasting for the end of the decade and first wrote about in my commentary. Most commodity bulls see a relatively linear rise in commodity prices continuing for another decade or so. El-Erian's point on reverse elasticities and history tell us a final explosive rally is more likely in store. Such a multi-commodity superspike will likely lead to a world wide recession. This will present the buying opportunity of a lifetime for emerging market equites. Right now we have the still have the buying opportunity of a lifetime for certain commodities. Gold is my favorite, but what else?
I think that, for reasons I discussed in my commentary, finding ways to invest in actual commodites might present greater risk-adjusted returns than the investing in the companies that mine, grow, or produce the commodities. Outside of precious metals, I think that investments in coal companies present some the best remaining commodity opportunities. Coal miners are the exception to simply investing in the the commodities themselves. Their operational leverge is extremely strong in the current pricing environment. I outline the virtues of coal investments in my commentary. I would also like share a another Barry Bannister chart that shows the counter-market nature of the price of coal:
source: Barry Bannister
Along with gold, coal tends to go up when the market goes down. Coal stocks have moved up five and six-fold over the last year. This has been due to infrastructure bottlenecks and increased demand for fuel (thermal coal) for power generation and for steel making (metallurgical coal). Though coal stocks have corrected substanially over the last week or so we still have many non-believers. Fund managers in an April 28 Barron's interview capture much of the negative sector sentiment stating that "We are negative on the coal stocks and the coal industry in general. It's a dirty fuel that has been growing less than 2% annually here in the U.S. and somewhat faster abroad. Coal has one main use on the planet now, and that's to boil water to create steam to generate electricity. There is going to be growing political pressure to reduce coal usage. We think improvements in solar technology over the next decade will dramatically reduce the growth of coal demand."
Who knows what will happen over the next decade? The DJIA might drop to 3000 and rise to 30000 between now and then. I tend to make investments based on the next two years where I have a little more visibility. But if we sustain the worldwide economic collapse that I envision at the end of the decade, then citizens around the world will be demanding the cheapest heat and electricity available -possible climate concerns in the future be damned! And I can guarantee that the Europeans will be at the jumping off the global warming ship faster than anyone-some things never change. No other fuel will be able to compete with coal over the short term for base load power generation. I am more bullish on the prospects for thermal coal than met coal, given my forecast for a severe economic downturn. Most of the infrastructure bottlenecks will not be removed until we are well into economic decline in the early part of the next decade. The chief economist at the IEA, Fatih Bairol, continues to try to inject a dose of reality into the situation by stating that coal will be leading the world in electricity and power generation for the next 25 years.
Declining home values, stock portfolios, wealth and incomes coupled with higher costs and a deleveraging society where credit is tougher to come by will finally prick the American consumption bubble. This and sharply higher commodity prices will eventually drag down China and other emerging markets. Coal and gold have a record of rising in such periods while stock markets decline.
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Comments (4) | Related Topics » The Market | Commodities | Economy | Precious Metals | Coal
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