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Economy 2008, part III: Precious metals still strong

Matt Stiles
0 Comments| July 7, 2008

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This is the third of a multi-part series from Matt Stiles. Catch up with parts I and II, A look back and World equity markets, before diving in to today’s article.

It is a rare treat when commentators take the effort to go through past picks and predictions to see what they got right – or wrong – and then let their readers know. The courage to own up to mistakes and celebrate wins is the hallmark of a trustworthy market watcher.

Please enjoy part III of Matt Stiles’ analysis below, “Precious metals still strong,” and stay tuned for more in the coming days.

Precious metals still strong

The big issue now on the minds of most people worldwide is the skyrocketing price of energy and food. I hear people in Vancouver whining on a day to day basis of how high gasoline prices are (at last sight $1.484/litre). If these people weren't my dear friends, I'd be inclined to whack them upside the head with some perspective. Total food costs for a large portion of the world population range from 40-80% of its already meager income. The price of many basic foods like rice, maize, wheat and corn have risen as much as 100%. Do the math. This puts that large portion of the world on the brink of starvation. It is with this heavy dose of perspective that we should all be viewing this minor inconvenience (an average of a 6-12% increase on OUR cost of living).

In part IV of my December series “Themes for 2008,” I stated:

I am wary of what the perception of an economic slowdown will have on the industrial commodities. I understand that real demand will be minimally affected by a potential worldwide slowdown, and there is relatively little new sources of supply coming on to the market like there was preceding other commodity bear markets. But perception is stronger than reality, so the possibility of large price declines remains a possibility in energy and industrial metals. It is not something that would lead me to short the market, but is enough to prevent me from taking large long positions.”

It appears that international buyers and sellers of commodities are indeed turning their eyes away from demand fundamentals, and increasingly focusing on supply. In this case, reality trumped perception. The uncertainty of supply has far outweighed possible demand destruction from a slowdown in the BRIC economies. In other words: “Peak Oil” is here. This is still a phenomenon that is apparently new to market pundits and politicians who seem to have no idea as to why prices are rising.

The first scapegoat was, of course, the evil speculators, driving up prices for their own personal gain. If this is true, then answer me this: If these speculators are paying such an exorbitant price for commodities, why aren't the producers of said commodities selling forward their production? There are three possible answers to this question. 1) They don't have the supplies they say they do, and therefore CAN'T sell them forward. 2) They have the supplies, but know the costs of extracting it will continue to grow, and so will prices – therefore they wait. 3) It's all a giant conspiracy between the Saudis, Russians, Texans, Venezuelans and their capitalist enemies (the speculators). Only two of the above possibilities are legitimate. If you need help identifying them, please click “back” on your browser window, for you are a lost cause.

I'm sure most readers have seen enough charts of oil's parabolic rise to make them puke, so let's look at something else. For many westerners without a Chevy Tahoe or Ford F350, the majority of energy costs come from natural gas. It is, unfortunately, also a luxury that we will one day have to do without. Our reserves of gas are dwindling and costs of extraction are increasing.

Click to see full-sized chart

When prices of natural gas nosedived in 2006 after the Amaranth hedge fund blow-up, I made an educated bet that prices would rise above $9 (via call options) in the hurricane season of 2007. I and a few other people I respect lost on this bet. But the price of natural gas is now approaching its all-time highs and we are still months away from the thick of hurricane season 2008. If something does cause supply interruptions, I would not be surprised to see the Henry Hub trade above $25 or even $30 per btu. (Note: I am not making the same bet this year.)

I am the last person you will likely hear say “it's different this time.” This phrase has usually been accompanied by numerous other asset bubbles over time – and to great loss. But all these other instances have revolved around asset markets that are not static in supply. Our main sources for raw materials are static to a large extent. And our sources for raw materials that are economically viable for extraction are absolutely static. Sure we can drill the arctic and we can mine the ocean floor. But at what cost? The term “bubble” has been applied to oil as early as $80. No other bubble in history has been termed as such until it has already burst. The very fact that oil rising is a negative for politicians and their minions in the media is enough to make me skeptical of this term.

A number of years ago I read a book by Jim Rogers called Hot Commodities. The most important fact I took away from this book was that the average length of commodity bull markets was 18 years. Jim has been bang on about commodities for many years now, so I respect him greatly. I also respect the ability of a worldwide cataclysmic financial meltdown to dilute the value of even supply-sensitive commodities for a number of years.

So, is it possible that this is the shortest commodity bull market of all time? Of course. Anything is possible. Is it possible that we are only halfway through a terrible rise in commodity prices that will destroy much of the world's population through starvation? Sadly, this is statistically more probable. But, as always, there is one area that outperforms others at any given time. So although crude oil and fertilizer may retrace their parabolic rise at some point, we can still play the bull market with “commodities” that have relatively underperformed.

Precious metals

I refuse to label myself as a “gold bug.” Were all tech investors “dot-bombers” in the mid 90s? Of course not. The term gold bug is used by those who proliferate paper currencies and see it in their interest that the general populace has no savings and therefore no wealth. Gold is the Achilles Heel to central bankers and their quest to impoverish us all and destroy our wealth (and therefore power) through gradual inflation.

It is for this reason that I have been correctly bullish on precious metals for many years. As my readers know, gold and silver are money. And when the financial system is on the fritz, money performs best. There is also a static supply of recoverable precious metals, and the cost of extracting it is extremely dependant on energy costs. A number of high profile gold mines have delayed production due to the increasing cost, and even my local bullion dealer says his supply of metal is already in jeopardy. Can a lid be kept on precious metals despite all this? I don't think so. The charts don't think so either:

click here for full-sized chart

click here for full-sized chart

As can be seen from the charts above, there is no reason to be bearish on precious metals from a technical perspective. The relationship of gold to the price of crude oil I find particularly interesting. Note the uniform nine-year intervals in the oversold conditions. This is a small data sample, but for that trendline to be broken to the downside, something very abnormal would need to occur.

On multiple occasions I have made my reasons for being bullish on precious metals very clear: The risks to the financial system we have enjoyed for all of our lifetimes are in serious jeopardy. And as this enormously leveraged system contracts, people will be liquidating their assets and looking for a place to store them. Faith in fiat currencies is at an all time low, so the relative safe haven of tangible assets like oil, gold and land will outperform until this deleveraging ends.

The common reasoning for gold rising is that inflation is rising, that the dollar is losing its value, and therefore people (er, speculators) are buying gold. That argument literally falls apart with the next chart I will show you, which is the ratio between the price of gold and the 10-year Treasury yield. What this chart is telling us is that the risk is of deflation and not inflation.

click here for full-sized chart

Every once in a while I hear the question asked, “What happened to the bond vigilantes?” This last chart tells us that instead of selling bonds, they're hoarding them. Those who have been betting on higher inflation numbers have had their heads handed to them on a silver (pun intended) platter. I don't have the exact data in front of me, but a rough glance tells me that even in the hyperinflationary scare of the late 70s/early 80s, gold way underperformed Treasury yields. Now they're outperforming. As I have mentioned before, gold performs best in times of deflation and hyperinflation, and worst during times of inflation and disinflation.

In my relatively short experience with the markets, one thing I have noticed is that bond and futures traders are far more sophisticated than equities traders (this logic can be extended to “analysts” and “economists”). Betting on inflation accelerating from here is likely a losing bet.

The Federal Reserve has set up numerous auction facilities, swap arrangements, and other measures that amount to doling out free “money” in the short term. None of this appears to be working. Credit destruction is unstoppable as collateral values continue their relentless decline. The emperor has no clothes. The Paul van Eedens of the world continue to harp on growth in M3 as a sign of looming hyperinflation, yet a closer look at credit markets suggest otherwise. What van Eeden is missing is that commercial banks are bringing off-balance-sheet assets back on to their balance sheets, and they show up as loans, and therefore more credit inflation. Mike Shedlock is far better than I at explaining such matters, so I urge my readers to read one of his latest entries detailing this point. You can find that here: https://globaleconomicanalysis.blogspot.com/2008/06/bank-credit-is-contracting.html

This ties in very well with my next installment that will focus on currencies.



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