If you have $100, and $50 of that is borrowed, you own a net of $50. If you have $100 and by inflating the currency that $100 can only buy what $50 used to buy (is worth half as much)... you in effect also have a net of $50.
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If you own commodity futures, commodity stocks, gold or silver, foreign currency, or Cash as denominated in US dollars, then this post may be of interest to you. Put in different terms, this post has relevance to everyone... unless say, you are a robot on Mars. And even then...
This Labor Day edition of the 'Rose' is organized like this:
I. Overview
II. Inflation, the US dollar, Government policy, and why we are in this mess
III. Schiff and Rogers on the dollar
III. The potential role of hedge funds in all of this mess. Hint... it isn't small
IV. Summary, putting the pieces together, and closing comments
I. Overview
A number of very smart individuals have claimed that the US is on the cusp the greatest economic crisis since the Great Depression. My take is simple: I don't know if it will be that bad but I do believe that a serious recession is close to a foregone conclusion and that economically things are likely, as Lily Tomlin said, to get a lot worse before they get worse. In March (actually earlier but it was posted here in March) I wrote a post, titled In a Picture and a Word: Why this Market is So Dangerous. In there I described the reasons why I was very cautious about being long the market for most stocks. I have referred to this post many times on the 'Rose' because I believe it does a very good job of rationally putting the circumstances we confront into perspective.
I am a big picture kind of person and always have been. The top to bottom kind of approach that I use is what helped me excel as a biochemistry tutor back in my undergrad days at UCLA. It has also helped me in my investing decisions. Hopefully the explanation of my approach, as chronicled in the 'Rose' , has, or can in the future, help you as well.
The questions that have persisted in my mind since I first started to understand the state of this economy are simple: What can we do to protect ourselves economically now that we still have time and, if possible, how can we gain from the situation that lies at hand? These questions inspired me to look into the soft and hard commodities, the dollar, foreign currencies and more, and to ultimately seek some preliminary answers. The rest of this post looks at what I have found so far. Please note that this is still the beginning of an intellectual pursuit on my part. There is much more to come down the road. However, I hope that this provides a nice start, or, if not a start, a nice follow up, to the post mentioned above.
II. Inflation, the Keynesian approach, and why we are in this mess.
We all know that inflation occurs. A dollar buys less today than it did ten years ago and even less then it did 50 years ago. Many of us accept this as just one of the natural world's key tenets. We need air to breathe, water to drink, and more money now then we did in the past to buy the same goods. Don't ask why... just accept...
The truth is, however, that inflation is usually made by man. More specifically, it is made by the Federal Reserve. The video below, by a person I do not recognize but who knows what he is talking about overall here, describes how the silver in a pre-1964 quarter could buy close to about as much gas now as it could then... while a quarter itself buys almost nothing.
The point is that the real currency is not USD or any other currency but is gold and silver. Some people do not understand it in these terms... but really paper money is the secondary currency to items that never lose value. When gold goes up in terms of USD it mostly is due to inflation in the dollar rather than the change in the value of gold. It's like the Earth and the Sun: we live on the Earth so we view the Sun from the perspective of the Earth... but really the Earth revolves around the Sun and not vice-versa. Along these lines, the dollar revolves around fixed assets like precious metals, not the other way around.
When the Federal Reserve inflates the dollar (by lowering interest rates) it makes the purchasing power of the dollar decline. Why would the Reserve want to do this? What are they thinking? This delves into the very roots of what has lead to the economic weakening of the United States of America. It all harkens back to the Great Depression.
The Keynesian approach to finance
The Great Depression in the US, as most of us know, followed from the enormous credit crisis (leveraged stock buying) in the 1920s that eventually collapsed in 1929. The exuberant stock market incline gave people a false sense of wealth. They had a lot of money but the money was not real. People's perceived wealth was all built upon the assumption that the stock market would keep going up or, at least, would not come down. People thought they had more money, so they bought more real assets (real estate, jewelry, cars, etc.) and the prices went up. This was inflation. Goods kept costing more money and people 'had' more money. Such inflation, which was purely generated at hands of the market (as opposed to the Government), had to correct. When it did, as is often the case with the popping of bubbles, the correction overextended on the other side. Suddenly people had much less money then they did before. They could buy less and so prices went down. This was classic deflation. Because people could buy less businesses were not able to sell their products, went out of business, which caused people to lose their jobs, which in turn meant they could buy less and prices declined further, which spurred more job losses, and on and on. A dollar in 1934 was worth more, not less, than a dollar in 1928. Those that had a decent amount of money were rich. The problem is that very few had any money or were losing so much in business that they were soon not to have much money. Also, it was nearly impossible to borrow money because most people and businesses were afraid they would not be paid back. Their was a restriction in the supply of money. Without any money flowing through the country everything became locked up.
At the time, unlike today, the US government was quite wealthy. They had a fair amount of gold stashed away in their banks. They just let their gold sit there. In retrospect many argued that a different approach may have significantly shortened the Great Depression. If the US had lent out more gold, or printed more money, this may have once again started money flow through the economy. People would have money (or gold... which backed the dollar at the time), could buy things, which would in turn spur business, get people employed, give them more money, generate more business, give people more confidence to lend money, generate more buying power, spur business, etc. Grease the wheels a little, at least in principle, and the economy would be able to pick itself up.
The underlying phenomenon that occurred led to what has become the fabric of US policy... the Keynesian approach.
The key idea of Keynesian economics is that markets cannot simply be left to themselves. Over corrections are likely to occur. In such cases the government needs to step in to intervene, at least temporarily. Regardless of how you feel about this it is clear that there is a price to pay for using the Keynesian approach when it is not necessary. The disadvantage of inflating the dollar is that it makes it worth less... and eventually worthless. In certain cases, such as the Depression, I would agree that pumping money into the economy, at least until it starts to pick itself up again, may be a good idea. The problem is that the Keynesian approach has been adopted by the Fed as a general policy that is appropriate even in less than dire circumstances. The voting public loves to make money, loves to buy whatever they want, loves to feel rich. They do not like to be told that every boom requires a corrective bust. The business cycle is such that when things go too far in one direction the market corrects and there needs to be a period in which people get poorer, need to work harder, have to save more, etc. This is natural and healthy. Unfortunately, in the US, people don't want to hear this and politicians that tell America something to the effect of... we need to get poorer for a while, or we need to work harder or improve our educational system so that we work smarter, or that we need to drive less and do with less... don’t get elected! As such the Keynesian approach, in my opinion, has been used inappropriately. The only real way a person can become rich is to produce more than he or she consumes. When people obtain riches any other way the wealth is false and hence unsustainable.
In 1990s the United States became a richer nation due to the internet. The US produced a brilliant new product for the world to consume. Money flowed into American business and the workers did well because they were a part of real wealth creation. However, as we all know, a bubble formed and the riches went up too fast, too much, etc... There were a lot of 25 (and less) year-olds in San Francisco who were making $150,000 plus while working for businesses that were not generating any cash. This had to correct. There should have been a fairly substantial economic downturn in the US to flush this out of the system. Instead, under Greenspan, interest rates were lowered to almost nothing because, following the strict Keynesian approach, the way to dampen a recession is to artificially increase the money supply by inflating. This worked like a charm... and the recession lasted for less then a year. However, we have to ask ourselves, was this the kind of situation that required the drastic tactics that may have been necessary during the Great Depression? Or was this the abusive use of a tool that should only be employed in very specific circumstances?
The result of Greenspan's policy, in addition to lax Government regulation under the current administration, was to create an enormous, artificial, asset bubble that caused people to buy, consume, invest, etc. money that they didn't really have. By inflating the currency Greenspan made the dollar weaker, allowed shrewd individuals like Mozilo (Countrywide) to game the system, and had Americans buying products, often from Asia and the Middle East, that were way beyond their productive means. Make no mistake here: inflating the currency is just like borrowing money. If you have $100, and $50 of that is borrowed, you own a net of $50. If you have $100 and by inflating the currency that $100 can only buy what $50 used to buy (is worth half as much)... you in effect also have a net of $50.
Now, to come back to the Depression situation, let's see what the difference is between proper and improper use of Keynesian economics. If you are a business that has $100 and you know that by borrowing $50 you can use this extra $50 to build your business and eventually return more then you borrowed, then borrowing the $50 is a good idea. You pay back the $50 and come out ahead. This is the idea of inflating in the Great Depression: give the people enough money to get them back on their feet and they will be able to undo the financial lock-up and make more back than what they borrowed. In fact, many might argue that the Roosevelt Era New Deal projects involved this kind of approach. On the other hand, if people who can live with less than they have but are spoiled, borrow $50 in order to buy a bigger plasma TV made in China we have a very different circumstance. In this case they need to work harder or smarter instead of borrowing money that they just end up throwing away.
Unfortunately, because the US has been rich for so long, a consumer-based society, rather than a responsible producer-based society, has formed. This type of society may have been sustainable when America as a whole was rich and getting richer. However, this mechanism of doing things... of consuming and wanting more and more and saving/investing very little, does not work when the economics turn south. The government has encouraged the consumer-based approach by lowering interest rates ( = Americans borrowing) whenever the economy slowed down. In addition, because the US taxpayers do not like to pay taxes, and because the government has won votes by promising social programs to America, funding wars, buying foreign oil... etc that was never paid for, the US itself has become just like its citizens- a debt-laden, consumer orientated, dependent nation. The way out of this? Inflate the dollar.
It's just like the kids of the really really rich and successful. They get lazy and often don't do anything themselves. La Jolla, just outside of San Diego, is one of the richest towns in the world. I love to surf and I like San Diego in particular. I have been to La Jolla quite a bit. One thing I always joke about is that during the week the busiest time in La Jolla is always around 2:00 in the afternoon. That's the time that all the people in their 20s,30s, 40s, and 50s... the kind of people that are working EVERY WHERE ELSE, get up to eat breakfast...
When a country has become spoiled and dependent upon an infrastructure that works only as long as the country remains rich... the result can be serious trouble. I like to think in these terms for those SAT fanatics:
Stock is to Company as...
Currency is to Country
I'll let you draw your own conclusions...
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III. Schiff and Rogers on the dollar
Ok... that tells us why we are here. Now let's get into what we as Americans, or as foreigners (as I have mentioned most of my extended family lives in Western Europe) can do to protect ourselves and make the best of the circumstance we are in.
The knee-jerk reaction to a Keynesian Fed policy in times such as these would be to buy precious metals. Gold and silver have corrected down in price recently. Is this a tremendous buying opportunity? In order to have any chance of paying off the Government debt it is in the Fed's best interest to inflate the dollar. This makes the value of dollar, in terms of hard assets such as commodities, cheaper and hence easier to pay back. Additionally, the US now does face a potential Depression like crisis scenario. If the Fed were to significantly raise interest rates in order to salvage the dollar, or if the Fed refused to bail out companies like Bear Stearns that are connected through and through to almost every segment of the economy, it could be argued that an economic collapse, a run on the banks, and fear of lenders to lend at any interest rate, and other cascading deflationary events could ensue. I am not sure if this would happen but it is definitely a possibility. The idea here is that the Fed cannot deflate. without significantly affecting the economy in the short-term. It has it's hands tied: the only thing it can do is to inflate or do nothing, or face the consequences of a severe economic collapse. If you fundamentally believe that the Fed will only inflate further, then purchasing precious metals and commodities in general (like agriculture commodities), makes a lot sense.
The other element to consider here is the amount of garbage (SIVs and other home loan products) that are worth nothing and are sitting on Government books in exchange for Treasury Bills. The Fed did this to help prevent the deflationary collapse discussed. The problem is that this HAS to weaken the dollar. When you trade Billions or Trillions of dollars (treasuries) for garbage this makes the dollar weaker. It increases the supply of dollars (think of the garbage as printed money... since most of it will never be paid back unless the government forces the companies that borrowed to pay up and go bankrupt). So buy Gold and Silver?
Unfortunately this is such a complex issue that knee-jerk reactions just don't cut it. The argument could also be made that interest rates are already at 2%, that the Fed only has so much money with which to bail out companies and banks, and that the economic result of defusing the financial bubble is still just starting to be felt. As people lose their jobs and pay less taxes and less people can pay off their credit card bills (and default... and have less credit to spur the consumer driven economy) and baby boomers retire and require government Social Security and Medicare and on and on..... where will the government get the money to inflate... at what point can they no longer stop the deflationary collapse. After all, if you took the government out of the equation the US economy, as driven by American citizens with US dollars, would have to deflate. The natural correction for the inflation of the housing bubble is deflation. People have less money, prices drop, etc. In a deflationary situation the dollar strengthens (since no one has any) and gold/commodities drop in value when compared to the dollar. A deflationary situation is a terrible one in which to buy precious metals. That leads to the question: is the gold and silver trade over? The government has inflated as much as they can and now gold/silver are on their way back down?
I have held the question for a very long time as to what gold and silver are likely to do next. Since I didn't know I have looked to some very smart people that perhaps do. Peter Schiff, the president of Euro Pacific Capital, is someone that I respect. He has been a gold/silver bull for a long time and correctly predicted the housing bubble collapse and economic slowdown in the US as far back as 2005. He predicts that gold will likely be around $2,000 an ounce in the next year to two and is likely headed much higher then that going forward. Here is a video of him saying just that:
One of his interviewers had the same question I did: the current US crisis seems deflationary. How is that a bullish case for gold? His response is that the US will get poorer as the rest of the world (especially Asia) gets richer. That means that he expects the prices of goods and services that are restricted to the US (such as haircuts... etc.) to deflate but that goods that are purchased globally, (which I interpret as commodities, certain electronic goods, etc.) will continue to inflate in US dollars because the US dollar will get weaker. In fact, he expects that the currencies of countries that are major creditors rather then lenders will go up. This means that it will cost a Japanese or Chinese citizen less to than it does now to buy global goods even as it costs us more. Deflation for them. Inflation for us. If you have ever been to Mexico you know that you can often buy a burrito for almost nothing. When we go to Mexico we drive up the prices that locals have to pay even if we buy a burrito for only $1.00. They may pay the equivalent of only $.70 normally and now they have to pay $1.00. The same thing could happen here but in reverse. What if a $1,000 IPOD was cheap when looked at in Japanese currency? So Apple started selling all of their iPods for over $1,000... or just stopped selling the higher end iPods in the US altogether and started selling the shuffles only for $250 instead of $80 or whatever they charge now. Would that be deflationary from our perspective? In such a case the crappy US economy could deflate and prices would still inflate. That is a very scary scenario if it comes to pass and certainly makes the case for buying gold/silver and/or buying foreign currencies. Please note that Jim Rogers (Soros' former partner) has been saying for a long-time that he was getting rid of all of his US dollars. He was waiting for a rally in the dollar... now that he got it I assume he is out of dollars altogether.
Here is the video from Schiff regarding inflation and deflation and the dollar:
Jim Rogers on the dollar and on commodities: Video
III. The role of Hedge Funds/Speculators and the potential commodity collapse
If there is one thing that you need to learn about this market it is that you can almost never make a final decision without first asking: What role might the hedge funds/speculators have in all of this? Hedge funds and investment banks run this market. That is why we see perfect bounces off of the50 and 200 day moving averages, moves that fit almost too tightly into Bollinger Bands, and sell-offs and rebounds that often seem to happen irrespective of earnings. Enormously powerful computers go to work each and every day in the stock market.
The commodities market, which influences the stock market and global economies as well (I would say that $5 gas can affect the economy), is even more affected by big institutions because there is more leverage and less regulation involved. Many people would argue that the huge run-up in commodity prices has been due to increase in global demand. To a certain extent this is certainly true. However, the dramatic price increases, and sell-offs, that we see clearly go beyond pure supply/demand economics. I have argued for months that the price of OIL has been largely manipulated on the London ICE. If true, we would expect similar occurrences in other commodities that are traded on international future exchanges. If it is true that investment banks, hedge funds, etc. have made a ton by driving commodity prices higher then they are worth then we should also expect a corrective downside that could be much more dramatic then most people, perhaps even people like Rogers and Schiff, have anticipated. Some argue that this situation is unique because the commodity demand is external from the US economy. However, even if you agree with this, if speculators have over inflated the prices in order to make substantial gains then these same speculators may look at historical patterns as mechanism for justifying their profit-taking. A profit-taking scenario of this magnitude may cascade upon itself and create fear, panic, and a dramatic pullback in commodity prices. Remember that oil was $140 a barrel only a few months ago. Do you really think that the demand has dropped that much in a few months?
Here are some very interesting videos. I especially recommend these for anyone that holds commodities or commodity stocks...
Why Commodity Prices are in the Process of Peaking
The Great Commodity Bubble and Hedge Fund Unwind
IV. Thoughts and Tying Things UP.
I was hoping to conclude this post by coming to some kind of a definitive answer about how we may gain here. A great conclusion would be: consider buying gold or consider shorting commodities or think about going short oil and long corn... etc. However, the issue at hand here has so many complexities that as I search further I only come up with more questions rather than with answers. This is still a very valuable piece, however. It does not provide an answer but it does offer insight into what to look for. It is interesting that Goldman Sachs called recently called for a return to high prices in oil but the markets have just not really moved much. The hurricane threats create slight spikes but as soon as the threats diminish the price of oil falls right back down. This paints a very bearish scenario for oil... and a bullish scenario for oil shorts such as DUG. What about mining companies? If de-leveraging of commodities by speculators is real then it would not be a great idea to be long miners. This is especially true if BRIC countries slow more then is currently forecast and if the rapid decline in the stock markets of China and India are accurate foretellers of the coming economy over there. On the other hand if Schiff turns out to be correct then putting some money into gold or silver coins or ETFs such as CEF and GLD, may be wise ideas right now. It's hard to say. However, there are a few closing points that may be of value
- Considering the competing influences a work here it is very important to gauge the commodities situation closely. If you have considerable commodities exposure and you start to see a significant move one way or the other this post may shine some light on what is going on and what to do next. I will continue to monitor the charts of UYM, SMN, DIG, DUG, and others to use technicals and trades as means of spotting potential trends. You may choose to do the same.
- It may not be a bad idea to hedge here. If Schiff is right and the dollar is going to weaken considerably it would be great to have some gold or silver right now. I am considering buying a little and seeing what happens. I may also buy CEF and short DIG or buy CEF and short UYM... and see what happens next and use the information learned and learn new information to make the best decisions
- Not all commodities are equal. My favorite commodity remains potash for a number of reasons. First, as far as I know, it is not traded on futures exchange and therefore is not subject to speculator price manipulation. Second, even in a slowing global economy, the potash supply/demand dynamics are way out of whack. Third, a country like China wants stability at all cost. They will do almost anything to make sure that their people receive the food they want. Once people realize how they can eat it is very difficult to put that demand back into a bottle. Metallurgic coal is probably my second favorite commodity (not including gold/silver which I am still deciding on). This high-grade coal is needed both for steel making and secondarily for energy. The supply/demand deficiency here means people can't stay warm in the worst-case scenario. That is also a big problem. I still like the potash story better and I do not own coal names but I like the names such as ANR better then most.
- Unless you really feel that you understand which way this thing is going (and if you do please comment) it may be wise not to be too overexposed on the long or short side of the commodities story until there is more clarity as to how much the slowdown in the US and Europe will spread to the rest of the world. As always of course I recommend that every person do what they think is best. In order to do that, without simply getting lucky, requires you to have a firm understanding of this complex issue.
"The Yellow Rose Street Beat" is for informational purposes only. It does not give investment advice.
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