Monday, October 20, 2008


The markets are involved in an "economic recovery bounce". In other words, it does not matter if the economic recession is over or not, the things that were hit hard in recent months are enjoying a bounce. Sectors such as basic materials and energy are participating in the bounce, it is going to take a long time for traders to come to realize just how abundant the worlds supply of materials.

Prior to the 1990-91 real estate recession, copper stockpiles were virtually non existent. Stockpiles were listed at 500,000 tonnes but those were spread out at various sites, making it almost impossible to load up a full train without further production. The recession hit but the mines did not close down. Supplies were re-built. By 1994, copper stockpiles reached 6,000,000 tonnes; just in time, because a necessary ingredient of the 1990's economic boom was abundant industrial metals. By 1997, stockpiles were back down to 1,000,000 tonnes, but toward the end of the boom new mines opened and, wouldn't you know, during the economic slowdown of 2000, stockpiles reached 8,000,000 tonnes. When the events of 9-11-2001 caused further economic heartburn, stockpiles reached 10,000,000 tonnes. The swing in copper inventories from bottom to top was 20 fold.

Last year, there were almost no stockpiles of aluminum, zinc etc., but, during the economic cycle of the 1990's, zinc stockpiles rose from 500,000 tonnes to 12,500,000 tonnes and aluminum went from 100,000 tonnes to 2,600,000 tonnes. The swing in aluminum stockpiles was 26 times. so far. It will take years for auto makers to totally retool.

With the disappearance in the demand for copper, zinc, aluminum and other metals upon us, is the economic trade going to last? Not likely. The tea leaves that tell the future are always vague, but it is easy to understand that the demand for copper and other metals is highly cyclical. Copper traded for 50 cents per pound just a few years ago, during a time when more was being put into stockpiles than was being sold. Copper traded for $4 per pound last year. Copper traded last week for a little over $2 per pound. One set of copper users, car manufacturers, are selling cars at the lowest pace seen in 30 years. Car manufacturers are no longer outbidding one another for scarce copper. The price of copper is on its way to 50 cents or less.

Believers in peak oil, tend to believe that all resources are in short supply. They "buy" the theory that China and India will consume all the worlds resources. They believe in the impossible.

The stock market in China has fallen from 6,000 to 2,000 in less than a year! The Chinese market traded below 200 in 1991. I am not suggesting that the Chinese market is about to fall all the way back to 200. What I am saying is that the drop from 6,000 to 2,000 is a forecast of economic slowdown in China. So far, the rate of growth in China has fallen from 11.5% last year to 9.3% in the most recent quarter. If the EU is in recession, which it appears to be, then exports from China to the EU will slow.

I can't remember the ratios but one tonne of uranium replaces many tonnes of coal and one tonne of carbon nano-fibers replaces many tonnes of steel, the same way that one tonne of two by fours replace many tonnes of logs in a home. No one knows how many people our world can support but, so far, the number is many times larger than the forecasts of Mr. Gloom and Mr. Doom of ages past. China's policy of one child per family has been a tough pill for the Chinese people to swallow, but domestic population growth is negative in Japan and most of Europe. The age when children provided an economic benefit to the family are no more. In any event, our world history is of using resources more and more efficiently. The cost to produce and spend a copper penny is at least 1,000 times the costs to electronically produce and spend a penny.

The ""economic rebound trade" is part of our ongoing "see-saw trade". The weight of the energy, basic materials and capital goods can be held off for a short time but it will prove to be more than enough to push up the value of the consumer side of the see-saw. Please note that while consumer staples have been one of the beneficiaries of the confusion, consumer staples are not on the receiving end of this see saw. Consumer staples have held up very well as a part of the flight to quality (people have gotten off the see-saw to avoid the gyrations). The flight quality has included the flight to gold and t-bills. T-bills are being purchased to yield half a percent safe interest and gold is being purchased at $800 per ounce. The irony is that people are willing to accept almost "guaranteed" losses to avoid what they see as greater risk. They are avoiding risk at a time when the probabilities of upside risk are very high.

Back in the days of hard money, dollars were gold or silver or they were backed by gold or silver. The US Government was forced to constantly suffer runs on the bank. During strong economic times, there would be runs on silver. During strong economic times, as the value of industrial metals, such as silver, copper, zinc and aluminum sky rocketed, smart investors would bring gold to the bank and trade it for silver. No matter what the ratio set, the government soon found itself having to accept too much gold in exchange for all its silver or during hard times, the government ran out of gold when tonnes of silver were exchanged. In the late 1500's, Sir Thomas Gresham wrote down the rules about bad money driving out the good. This rule has become known as Gresham's law. In the past year, the value of industrial metals has collapsed. In particular, the price of industrial metals has collapsed relative to the price of gold.

Gold and industrial metals are now in a long downtrend. The decline in the value of industrial metals is part and parcel to a decline in inflation rates. Lower inflation rates produce higher real interest rates. The rational to hoard gold disappears during times when interest rates are higher than inflation rates. Thus, contrary to common beliefs, it is often the price of industrial metals that drags the price of gold up and down, not the other way around.

The above statements are not meant to be an affront to Gibson's Paradox. The price of gold actually moves inversely to the real interest rate on the long term bond. This is perhaps the most important fundamental understanding that one needs to do well as an investor. The key point that is so frequently ignored is that rising short term rates are tools used by central bankers to ultimately lower long term rates. Commodities trade with short interest rates and inflation but a rise in short interest rates, inflation and commodities tends to ultimately push long rates down. It is counter intuitive but true that rising inflation proves to be a powerful force that ultimately drives bond rates down.

All of the above explains why the ratio chart of silver to gold provides better forecasts than the average economist. At the start of one of the worst bear markets of all time, from 1970 to 1982, silver was valued at 5.7% of the value of gold. By the time the market was ready to soar, in the fall of 1982, the price of silver was valued at only 1.75% of the value of gold. The ratio still had a long way to fall. By 1991, the ratio hit 1%. It was time to buy real assets, every thing from semiconductors to real estate. Prior to the big 2000 peak in tech stocks, the ratio had bounced all the way to 2.4% in 1998. It got back to the 1.2% range when it was time to buy stocks and real estate in 2002 and 2003. In 2006 and 2007, the ratio rose to 2.2% and 2.3%. It was time to avoid real estate in particular. Today, this ratio is back to 1.2%. Those who suggest that we are at the start of another great bear market are not paying attention to relative values.

Looking at the numbers from a different angle, we find that by 2002 it took 810 ounces of gold to buy the average house. Since then, the price of houses increased but the price of gold soared. Today, it only takes 300 ounces of gold to buy the average house. Which is cheap, houses or gold? The numbers for silver tell a similar story; it took 53,000 ounces of silver to buy the average house in 2004 but it takes only 15,000 ounces today. The relative cost of a house has fallen 72%! Today, the smart investor sells his gold and silver to buy real estate or stocks on the other end of the see-saw from capital goods, basic materials, energy and consumer staples.

Hank Paulson is taking plenty of time to let the Sword of Damocles hang over the heads of bankers. Bankers do not know their capital positions until after the government buys mortgage backed securities. This period of uncertainty is giving weak kneed investors ample opportunity to sell at low prices, and, how! The public has sold and sold stock mutual funds and bought gold and t-bills. Last year, there was 7 trillion dollars in US money market accounts, this year, with the Dow Jones down 40%, the public continues to sock away money in these funds. The buying opportunity of an age is upon us but the people are afraid.

The public continues to hold energy, capital goods and basic materials in their 401-K accounts. Thus, in the place where they continue to invest, on a regular monthly basis, they continue to buy the "wrong stuff". Again, the economic recovery trade in these sectors is only a bounce. These sectors had great runs, the prices are down enough to find support but not enough to make these sectors the place to invest for major profits. Industrial metal mines will continue to pump out ore at steady rates. For a few years, much of it will be added to stockpiles. Sales of existing homes picked up a bit last month, this does not mean that builders will rush out to build millions of new homes in 2009 or 2010; not in the USA, England, Australia or China. The car story is similar, customers are not going to rush out to buy the big SUV's sitting on lots all around the world. Lower gasoline prices will cause a rebound in the number of miles driven but for many years to come there will be a relative increase in miles driven in more fuel efficient cars and a relative decrease in miles driven to miles not driven. For example, those who own two cars will drive the more efficient one the most and more trips will be made by scooter.

Lower interest rates, lower fuel prices and lower commodity prices will put more money in the hands of consumers. The real price of manufactured goods is going to continue to fall. Retailers are going to enjoy a surge in consumer spending. There is an economic recovery in the works, but the current bounce in "old" sectors is only a bounce. The real value of homes is rising. Banks will soon begin to recognize a bounce in the value of mortgage backed paper. Bank stocks down 50% over two years are set to recover. The rotation to bank stocks is underway. Soon, there will be a nice surge in retailers and technology stocks will follow. For now, the best values are in the banking sector.

Oil supplies work differently than metal stockpiles in that much oil is left in storage under-ground. During the 1990's when oil was in abundant supply, drillers continued to operate their equipment, they continued to drill for oil. They spent most of their efforts finding new oil rather than developing fields where oil was known to exist. This is the reason that when demand soared by 20 million barrels per day, there were no shortages. The oil companies did a great job of developing existing wells. The price went from $1 per gallon to $4 but the free market pricing system maintained order. Eventually, the congress was forced to release restrictions on drilling. Over the next several years, drillers will once again drill when new oil is not immediately needed.

Cuba has reported the recent discovery of 20 Billion Barrels of Oil, in the Gulf of Mexico, adjacent to US waters! During the debate about allowing US off shore drilling, old US Geological numbers were often quoted. Tell me the truth, do you really believe there are only 18 Billion Barrels of Oil off the entire coast of the USA when Brazil has found 70 Billion Barrels, so far, and when Cuba has found 20 Billion Barrels, so far? We know that millions of barrels annually leak into the waters off the coast of California. Eventually, stupidity gets trumped by economics. We will eventually extract the oil from California waters rather than let it pollute our planet.

No matter if Obama or McCain is our next President, either will have to contend with a liberal congress. One that, so far, has been too stupid to collect oil that is ours. A congress that would rather pay friends to pollute than to allow resources to be used. The price that will be paid again will be pork money given to the friendliest of campaign donors. We are not about to run out of resources, we are about to run out of ways for government officials to pay off their friends.