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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.
Excerpted
from the 7/14/08 Global MegaTrends Portofolio's Newsletter:
To view the
full newsletter and gain access to Kurt's market-crushing Global MegaTrends
Portfolio, click here.
Kurt Kasun
www.greenfaucet.com
A
contributing writer to GreenFaucet.com, Kurt
Kasun writes a high-end investment timing service, GlobalMacro, which is
focused on identifying opportunities that produce returns in excess of market
with reasonable risk. He is strategically located in Washington, D.C.,
a key to maintaining contacts and relationships which help Kurt understand
global policy and economic factors as they emerge. His investment approach
has always been macro in nature largely due to his undergraduate studies at
the U.S. Military Academy
at West Point (B. S. National Security, Public Affairs, 1989) and his
graduate studies at George
Mason University
(M.A. International Commerce and Policy, 2006).
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