Soft Commodity Archives

Presidential Cycles and Australia

This week, there will be no newsletter as we are on the road in Australia.

What does Australia and year three of the US Presidential cycle have to do with each other? Usually, there would not be much of a connection.

But this year, there is a connection.

To over simplify, we are in year three of the cycle, the time when an incumbent President has to make sure the economy is as stimulated as possible so that the voters will give him another four years in the White House. As a result, it is often a good year to invest in risk assets like equities.

In this cycle, growth is coming from government spending and monetary expansion. And, while the Republicans may still get to repeat their temporary government shutdown routine (maybe they can avoid the political backlash this time), the expansionary policies at the FED are harder to stop.

That means we will continue to see inflationary money creation in the world’s reserve currency. And, since the money cannot all be put to work in the US economy, it will continue to fuel asset and commodity price growth around the globe.

How does that money get around the globe and into local economies? Primarily through Central Banks’ efforts to keep currencies from moving up against the US dollar, the FED’s accommodative policy is being exported to countries (like China) where inflationary expectations have already taken hold.

Australia is one of the places where these pressures will become most evident. As a major producer of agricultural and industrial commodities, it is a secondary beneficiary of the FED’s inflation creating policies. Not only has China’s boom created strong demand for iron ore, coal and other resources, it has also sent a wave of investment capital towards the continent sized country. This has ignited a surge in M&A activity as well as frothy real estate markets. The Reserve Bank of Australia has moved short rates about as high as politically possible (mortgages are mostly floating rate) so the next thing to go is the currency which has just crossed the 1.05 mark (FXA). If the Aussie dollar continues towards 1.10 and 1.20 as local investors expect, that’s a strong signal that one’s investments need to be well placed for an inflationary environment.

This week, for example, the base metal ETF (DBB) nudged the S&P 500 ETF (SPY) out of the top 3 in the Seeking Alpha ETF Portfolio. The main aim of the Fund King System is to track major investment flows to keep one’s money deployed in the most promising corners of one’s investment universe. Right now, it looks like major investors are positioning even more towards the inflation trade,

A Shiny Example

SLV has had a nice run since breaking north of $30 in the middle of February. That is not news but a checkable fact. For those investors who noticed that SLV was at the top of their rankings since July 12th of last year (when SLV closed at $17.62), it was a good opportunity to make money in a relatively non-correlated asset class. The only time it got sticky was at the beginning of this year when the price corrected.

The reason that we bring this up is not to brag. While SLV has done well, other investments that have made it into the top rankings have fared less well. The point is that most of those investments were eventually replaced by new market movers while SLV has hung in at the top of the lists despite the 10% correction that we saw in January. While we may have worried in these posts that the rerating between Gold and Silver may have run most of its course, the System kept pointing out that there was strong momentum behind the asset and that there were not that many more promising assets out there at the weekly measurement points.

My only slight regret…not swapping GLD for SLV a few weeks back when I was adjusting my Seeking Alpha ETF Portfolio. I would have looked very clever. But, in calmer moments, I realize that the regret and the emotion behind that regret is precisely why one should use an unemotional system to help execute one’s investment plan.

So, should you buy SLV now? Well, that all depends. Does it make sense as part of your universe? And, if it does, ask why? Make sure that you are not adding at this point because of past performance. Make sure that it is in there because you think other investors are worried about the US dollar or you think there is a chance that the Biomedical uses of silver are poised to go through the roof. In short, remember to separate the Asset Selection process from the Asset Trading process. And what happens when something better comes along in your universe? That’s easy, switch.

A Tarnished Example

Now that PIMCO has finally gotten it through to folks that, yes, they really are not keen on US Government paper (no link…too many choices), let’s look at how two bellwethers fared in the Fund King System.

TLT (which tracks 20 year plus US Treasuries) has been at or near the bottom of the US Sector ETF Universe since the beginning of November 2010. And less long term TLH (tracking 10-20 year Treasuries) has joined the bottom of the pile in another ETF portfolio since the end of November.

So, whether you were in the “Don’t Fight the Fed” or “Hyperinflation Around the Corner” camp, the Fund King System told you to steer clear of the asset class for the last three months. Even the FED could not buy up enough long dated Treasuries to keep TLT from dropping 10% over the period. Mr. Gross, the head of PIMCO noted in his newsletter that the FED has been buying as much as 70% of the newly issued Treasuries of late.

What does it mean?

There is nothing wrong with SLV , TLT or TLH in absolute terms. Each of these ETFs represents claims on perfectly good assets. The deep meaning to take away from these two examples is that it does not pay to fight the trends. If investors (on balance) are shifting money out of US Treasuries and into hard assets like Silver, there is little point in trying to stand in the way. At some point, the tides of money will change directions and other asset classes will get swept up or down. When interest rates rise a couple hundred basis points, Bill Gross and his PIMCO colleagues will be back on the bid side. Why? Because they are in the business to make money; and money is made by buying low and selling high.

An interesting read

Supporters of Ron Paul can sometimes be a prickly bunch. But, they occasionally come up with very thought provoking concepts.

I like a good bash so when I came across an article entitled: “How to End the Federal Reserve System” by Gary North, I was prepared for a rehash of the old arguments about an evil cabal on Jekyll Island in 1910. But the real strength of the article comes about halfway through when Mr. North analyzes the demise of a government agency which had also been granted monopoly powers: the US Postal Service. He draws some interesting parallels about what technology could do to the Federal Reserve System long before Ron Paul and his supporters in Congress are able to rescind the Fed’s legal mandate.

Basically, the ability to move into other currencies with a few well place computer key strokes or even to develop new mediums of exchange means that even an institution as powerful and influential as the Federal Reserve is not immune from obsolescence.

Part of the appeal of ETFs like GLD and SLV is that they are theoretically redeemable into a fixed amount of Gold and Silver respectively. While pitched as a new idea, the concept of convertibility into precious metals was once the cornerstone of the US dollar’s value (and most other currencies before that). In an interconnected world that can work with services like PayPal, it’s probably only a matter of time before someone reinvents a multinational global fractional banking and payment system backed by gold, silver or some other store of value. If it is tied into Visa, Mastercard and American Express, one need not worry about carrying about sacks of heavy metal to the grocery store. Just as email eclipsed the first class letter (something that was unthinkable as recently as 20 years ago), there is a risk of a new currency system taking the premier spot occupied by the US dollar today.

Just because the risk exists, however, does not mean it will come to pass. The biggest difference between the US Post Office and the Federal Reserve is that the latter is a privately owned, profit seeking entity. Long before we are all paid in PayPal credits or Googles, the Federal Reserve (which is owned by and represents the largest US banks) will feel compelled to take steps to shore up the value of the US dollar. That more than anything else will lead to a change in policy that will likely see higher interest rates in the not too distant future.

While you are pondering your long term investment strategy, make sure to include a plan for higher interest rates.

What happens to Japan now?

The earthquake and tsunami that hit Japan on Friday will impact the country and the economy in ways that are hard to foresee at the moment. Despite the shocking video and photos, however, the natural disasters are unlikely to have a significant long term impact on the economy. As long as the authorities can keep the nuclear fallout to a minimum, the biggest issue will be reconstruction and who will buy the fresh batch of JGBs. That points to another force for higher than near zero interest rates in the world’s #3 economy.

From an investors’ point of view, the Nikkei 225 was the best of a weak bunch (Asia has lagged since November of last year) in our universe of 11 Asian indices as of Friday’s rankings. The earthquake and tsunami do not significantly change the long term public finance fundamentals of the country and most of the familiar exporting names have transferred significant portions of their manufacturing base to locations around the world in the last few decades.

Should you buy? If your universe is only Asian Equities: then perhaps. But, if you are looking at a broader range of asset classes, there are quite a few commodity based ones that look more attractive. As Japan is import dependent for almost all of its commodity needs, there are better places to invest your money.

System Numbers Flattening

As we pan across our portfolios, we notice a definite lowering of the numbers that the System is throwing out in the rankings. The last time this happened was in April/May of 2010 and it definitely foreshadowed a weak stretch for assets at the higher range of the risk spectrum. The numbers remained flat through the summer and started to recover in September of 2010, which coincided with a strengthening of sentiment that carried through until recently.

But what about all the reports of bullishness?

There have been a number of recent articles in all the right papers which have pointed to a general bullish sentiment in the market. These reports are couched in caveats but generally reveal that asset allocators are overweighting equities and bonds and underweighting cash. But the market is not all one way; there are still magazines to sell and as we approach the second anniversary of this strange bull market, we get think pieces like this in Barron’s. Unfortunately, the thinking is not terribly original or prescient.

The problem with these approaches is that they either measure what people say (asset allocation intentions, bullish/bearish sentiment polls) or the way they think things should be (articles bemoaning the historically high CAPE, the Cyclically Adjusted Price Earnings ratio or why Gold should be trading at $5,000). They are not measuring what people are actually doing with their money.

Let’s think about how this works. If one owns equities (or property, or bonds, or gold bars), one is by definition bullish. But this is a lagging indicator because the actions surrounding the bullishness have been taken in the past and are unlikely to contribute to further upward price action in the short and medium term (unless the market has been cornered). So, after a run up, which by definition must mean a bunch of new investors have been bidding up prices and filling their portfolios with the asset-du-jour, one would hardly expect those avid collectors to “talk down” the price of their newly acquired assets. The trend can continue only with new money being attracted to the asset in question. That money can come from other asset classes, from the real economy via savings or, in the case of QE1 and QE2, from credits which materialize from FED activity on bank balance sheets. Once the new buying abates, the market pauses and often corrects.

While we make no claims that the Fund King System has any “crystal ball” properties, one of the things it will measure is the momentum of money as it flows into and between the various financial asset classes.

In this week’s survey, the assets still attracting investor favor are Energy, the US, Small Caps and Agriculture. Silver appears to have topped out after rushing to catch up to a more traditional valuation against Gold. It still ranks highly in some of the longer term portfolios but it has been dropping down with Gold on the shorter focused portfolios.

Our advice? It is time to watch the numbers a bit more closely than usual. We could be at the start of a larger correction in risk assets or it could just be a pause to see how some of the latest events turn out. The big issues are, in order of importance from an investment point of view, the level and sustainability of growth in the US, the risk of a slowdown in China induced by inflation fears and an ugly resolution to the Egyptian unrest which would upset the balance of power, peace and trade arrangements in the Middle East.

Inflation Sneaking In?

While trolling through the 24 hour news channels, one thing to watch out for is the quiet risk of inflation. The fact that the best looking assets are in the energy, agricultural and materials sectors leads one to conclude that there is more inflation running through the system than government statistics might suggest. There is no way to properly quantify how much inflation because the two most common measurements (Government Statistic and Personal Observation) are both flawed. The former is flawed because Governments collect and report the data which they use as a yardstick of successful governance. There is no question that the BLS has changed the rules over the past few decades to make the data as flattering as possible. The latter is flawed because our personal viewpoint is too narrow and we tend to focus on the things that are causing us the most anxiety. We tend to overlook those prices which are going down (unless it is our salary or house).

But how can we have inflation if growth is only in the 3-4% zone? Most of us have been schooled on the idea that inflation can only come about when the economy gets overheated (too much money chasing too few goods). When the economy is well below potential, there is little risk of inflation creeping in, right? That is the crux of the FED’s stimulative policy argument. But there is more than one way to create a bit of inflation. If we look at Zimbabwe, for example, its bout of hyperinflation did not come about from extremely robust economic growth. It came from printing up too many pieces of paper (too much money chasing too few goods).

One might be tempted to take comfort in the relatively low yields on long dated US Treasuries. But then again, one needs to look carefully at who is buying the paper. The FED is hardly going to demand an inflation premium on the US Treasuries it is buying with newly created money it created when one of its two mandates is to maintain price stability. I am not accusing anyone of “window dressing” but there is little incentive for the FED to haggle for the best price while it fills its shopping cart with long dated Treasuries.

Shadowstats Alternate Inflation MeasureShadowstats has an interesting take on inflation by taking the 1990 methodology and contrasting that with the current BLS methodology. There is no doubt that some spending patterns have changed since 1990 but it is interesting that the adjustments to the methodology have served to consistently show the US inflation picture in a flattering light.

Is China more expensive than Boston?

Eggs in HangzhouAn informal study picked up in this Wall Street Journal blog shows that a number of basic items in East China (Hangzhou, Zhejiang Province) are actually more expensive than the same items found in Boston. The study compares basic things like eggs, milk, beef, gasoline and apartments and finds that those aspiring to join the Chinese middle class are going to pay heavily for the privilege.

When I was an expatriate in Shanghai in the 90’s, the cost of living for my family was 50% higher than that of Hong Kong but that was largely due to government imposed restrictions. Private housing was a brand new concept, expats were restricted to certain government controlled areas that charged outrageous rents and private car car ownership was almost unheard of (bicycles and buses were the main form of transportation around town). Beef and milk were frivolous luxuries and priced accordingly. A comparison of this sort 10-12 years ago would have been an apples-to-oranges type of undertaking.

But in the major cities of Eastern China (Zhejiang Province, Jiangsu Province and Shanghai municipality), owning a 100m (3600 sq ft) apartment, driving a nice car and buying more than rice and veggies for dinner have become the signposts of entry into the middle class for the young urban professional couple and their one child. The fact that these prices are both on the rise and that they constitute a much higher proportion of disposable income than in Boston is a serious political issue for China.

But Chinese officialdom is no better off than the hamster on its exercise wheel. Slowing the economy to control inflation imported from the US FED’s extremely accomodative policy (through a nearly fixed exchange rate) runs the risk of stalling the economy and sending tens of millions of urban workers to the unemployment lines. Keeping the hamster wheel going at present speed threatens a return to double digit inflation off a not so low base (as demonstrated in this article) which will eventually price China out of its traditional export based markets.

January Effect

As we cross the midway mark on January, the various portfolios that we run under the Fund King System are all pointing in the same general direction. Commodities (metals, softs and energy), and US sectors – tech, regional banks (acquisition targets) and small caps are all clustering around the top of the rankings.

Part of the reason is the stimulus package which came attached as a condition of continuing the Bush tax cuts beyond their expiration date. According to this article in Zerohedge, the payroll tax cut and the “Make Work Pay” tax credit will amount to 180 billion in stimulus this year. Add in the main premise of the article, that non-paying mortgages amount to a stealth stimulus, and much of this year’s expected GDP growth is coming from non-renewable sources. What is not stressed in the article is that the $1.4 trillion dollars in non-paying but not yet foreclosed mortgages amounts to 10% of US GDP. Some of that money will be recovered eventually when the foreclosed houses are sold but it is safe to say that in the meantime a big chunk of wealth is tied up in the process.

But if the US were the only economy to consider, commodities would be heading down rather than up. Commodities are rising because developing countries are importing the incredibly loose monetary policy of the US through linked exchange rates (or simply a desire to stay export competitive). Whether one thinks China is growing at 7% or 10% (and there is a range of opinion even within China’s government), a near zero percent accommodative monetary regime is not the correct policy response. A number of articles comparing today’s situation with the Asian Crisis of 1997-98 have started to connect the dots which is why there are so many warnings of overheating in China (ie. we have all seen this movie before and we know how it ends). The flooding in Australia may add further pressure to the inflation picture. Coking coal is a key ingredient in steel production and the flooding in Queensland has temporarily suspended production at mines which amounts to an estimated 40% of world supply.

Which of these trends has staying power? Small caps are famous for running out of steam as soon as February rolls around. Regional bank acquisitions might trundle on for longer because the industry is due for consolidation and the banks at the top of the feeding chain are not only TBTF (too big to fail) but enjoy preferred access to Central Bank funding. The jury is out on the tech surge. If cashed up corporations are ready to invest in productivity enhancements, there might be a sustainable trend. If the improvements are just part of the inventory restocking, then the sector will fall back next quarter. Only the upward pressure on commodity prices appears to have staying power for now. So, watch the System closely because we are likely to see leadership changes in the coming two or three months.

Seeking Alpha Portfolio

SA Portfolio RankingThis week is a good time to review what we have in the 20 ETF Universe and start to plan for any changes we might want to make at the three month mark which is coming up in three weeks.

The changes will center around correcting for my bias in favor of Emerging Markets and Asia, potentially removing SPY because it is too broadly based and adding at least one fixed income asset class.

A quick review of the performance of the portfolio: We are currently holding 250 shares of IXC (Global Energy), 550 shares of EWT (Taiwan MSCI), and 160 shares of EWW (Mexico Investible) plus $659.85 in cash. So far we have racked up $87.45 in commissions and $1,450.50 in short term capital losses. The portfolio was up 2.1% last week so we are still underwater in week 9 with a total loss of 1.86%. We started with $30k on November 15th and at Friday’s close, we are looking at $29,441.95.

As you can see from the ranking, there is no need for any switches this week.