Tough Sledding in the Markets and Economy

The jobs report came out this AM and it is not good, even very bad news. Job cuts of 533K were announced for November and October was revised up (down) to 320K from 240K; September was revised up to 403K from 284K. That is a lot of job loss the past 3 months, the worst since Q2 of 1980 when Paul Volcker shocked the economy into submission with 20% interest rates.

But those of us who follow the market daily are not too surprised by this bad employment "print". The stock market has been crashing anticipating very bad economic news, serving its function as oracle of the economy. And some of us (me) have seen job cuts at our own place of employment based on painful forecasts for 2009. So there is a very good chance the lousy numbers are already "baked in the cake" of the stock market. Today's (Friday's) early stock market action certainly suggests that, as the DJI is only off by 90 as I write now, but still well above the lows from mid November.

All of the economic slowness, global recession and the resultant strength of the dollar is just hammering energy, much to the displeasure of my portfolio. But at the same time, the government policy makers around the world appear prepared to "throw the kitchen sink" at the economy to get it going again. This will mean a recovery in 2009, maybe beginning as early as Q2. As soon as the world economies recover, the demand for energy will return and drive oil prices back up, though maybe not to $150 since the hedge funds have been hit hard and leveraged speculation in the near future is unlikely. But I think we could all live with $75-80 oil which more accurately reflected the rising demand and tight supply of early 2007. Prices in that range are economically sustainable and would create a stable environment for the Canroys.

I am swallowing hard and holding on to my energy shares, knowing that there will someday be an economic recovery and when it comes, there will also be some inflation to pay for all the money pumped into the economy. Higher economic demand accompanied by mild inflation will be a good environment for commodities and energy.

Here is more on oil:


$25 Oil Could Happen Before a Return to $100
December 05, 2008
By Matthew Hougan

http://seekingalpha.com/article/109393-25-oil-could-happen-before-a-return-to-100?source=article_lb_articles


Jim Wiandt says that oil will go to $100/barrel before it hits $25/barrel. I'm not so sure.

The reason I'm confident that the Dow Jones industrial average will top 10,000 before it hits 6,000 is that stocks are a leading indicator. They anticipate recoveries, typically turning upward 6-9 months before the economy as a whole. We are already one year into the recession, so I'm guessing we are getting close to the point where stocks will turn the corner. When you add in the fact that valuations and yields are the most attractive I've seen in my adult investing life, the outlook for equities is quite good.

Oil, on the other hand, reflects mostly immediate, near-term supply and demand. If the economy gets worse before it gets better, stocks might see the light at the end of the tunnel, but oil won't. It can't. Prices will keep falling as demand deteriorates in real time and the current supply glut gets worse.
Remember, oil is expensive to store. For the most part, it won't just sit around waiting to be used if there is a lack of demand. (Some can be stored, but not that much). It must be sold and used at whatever the current clearing price is.
And we have yet to see the magnitude of supply cutbacks in the oil market that we've seen in aluminum, copper and other commodities. The world is continuing to pump out millions and millions of barrels of oil.

Here are a few facts to consider:

• Oil has averaged a nominal price above $50/barrel in just three years in the history of the world: 2005 ($50.04/barrel), 2006 ($58.30/barrel) and 2007 ($64.20/barrel).
• On an inflation-adjusted basis, oil has averaged an annual price above $50/barrel for just 12 of the 62 years of the post-war era.
• The average inflation-adjusted price of oil in the post-war era is $33.65/barrel.
• Oil traded below $25/barrel as recently as 2002.
  

As the saying goes, "This time it's different" are the four most-expensive words in investing. So why not $25/barrel oil?

I was amazed during the recent oil price retreat how quick people were to say that $100/barrel was the "right" price for oil. $100/barrel is off the charts historically, and completely neglects both the supply and demand impacts that high oil prices have.

To put it another way, stock prices are now trading where they were in 1997. What's to say oil shouldn't be trading where it was in 2002?
The truth is, I have no idea where oil prices are headed. But I don't think it's a gimme that they're going back to $100/barrel. In fact, if you gave me 2-1 odds, I'd bet they hit $25/barrel first.

P.S.: One more thought about oil. Even if you strongly disagree with me and think crude oil is a screaming buy, please be careful before you buy a crude oil futures ETF like the US Oil Fund (NYSEArca: USO). Oil is in a violent contango. A fund like USO faces a 3% monthly headwind from contango right now, meaning oil prices must rise about 3% each month just to offset the losses from rolling contracts forward. Until that situation is reversed, investing in crude oil futures could be challenging... even if I'm wrong about crude oil prices.

After the Bottom, Then What?

Some day soon, maybe today, maybe in a month, the stock market will find its bottom. Some technicians are predicting 7500, which is the same as the market lows in July 2002 and March 2003. Those form a natural line of resistance for the DJI. Others, like Art Cashin, the CNBC old-timer floor trader, thinks it might be 7000. It is very unlikely the market would crash down to 5000 or 4000. That would require the economic depression scenario, since it will require much lower aggregate corporate earnings to drive stock prices that low. Most think a depression is possible only if the global bankers do not respond with aggressive money creation. So far, the central bankers have responded.

What will be the investment class that does best coming out of the market slump? If you think that all the liquification to unfreeze the financial markets comes with the price of much higher inflation, as I do, then the best place to be will be asset classes that benefit from inflation: hard assets / commodities.

Have you noticed how the global deflationary environment rewards currencies that are doing the most to reinflate their economies, like Japan and the USA? The dollar has soared the past two months from $1.60USD per 1 Euro, to $1.20USD to 1 Euro, a 25% move. The turnaround in Japan is even more dramatic. The yen is now trading at 92Y per $1USD while it was at 120Y per $1USD just a few months ago. The Euro has weakened against the Dollar and the Dollar against the Yen. The Euro has weakend by 40% to the Yen in just a few months. Amazing! And disruptive! How can Japanese export goods compete in Europe after such a currency move? The answer is, they can't. This is why the Japanese Nikkei stock index dropped to a 26 year low today.

This is all about the unwinding of the "Yen Carry Trade" where global investors borrowed the very cheap yen, with interest rates in Japan at only 0.5%, and loaned the same money in other countries at much higher rates, or used the funds to finance commodities futures transactions, which helped drive up commodity prices. With the trade now in full-speed reverse, all that borrowed money is flowing back to the Yen as traders and hedge funds sell their positions and repay their Yen borrowings. As they do so, they convert some / most of their Yen back to US dollars, which strengthens the dollar. Because they are preparing for fund redemptions, they put the funds in very short term, super safe US Treasury bills. This causes competition for Treasury bills causing the interest rates on those instruments to drop to ridiculous low levels of less than 0.25%.

Even the Canadian dollar has gotten into the game, and has gone from parity at $1C per $1USD to $0.78C to $1USD in just a couple months.

On this last point, it has made the performance of the Canroys and other Canadian stocks more dismal when converted to $USD. My Canroy stocks, like Pennwest, Pengrowth, Provident, Canadian National Resources and Daylight Energy, are all down 50% or more the past two months. So is DHG, the closed end high dividend fund that is heavily invested in Canroys. About 1/3 of this decline, though, is the exchange rate. The other 2/3 of the decline can be attributed to the decline in the price of oil, which itself is because of the unwinding of hedge and mutual fund positions. That is a temporary phenomena, so long as I don't have to sell. Since mine are (now) completely unlevered retirement funds, I can hang on till the environment changes. Most of the Emerging Market stocks (Brazil, Mexico, Russia, etc) share with Canada their reliance on commodities for their economy and currency strength. So, emerging markets will also benefit from a global change in sentiment.

What will cause this change? Reflation. Once the markets, and then the economy, bottom, and economic growth reappears here in the USA, but even more dramatically in the emerging markets, global demand will once again increase for all things commodity: energy, grain, metals, chemicals and gold. I do not believe that the global banking system is nimble enough to take all the liquidity back out of the market that has been put in to save the financial system, as fast as will be necessary to avoid inflation. I think inflation, maybe relatively high inflation of over 5%, is a certainty within 24 months. The pain to avoid inflation will politically be just too great, as it will require buying back the financial instruments issued to flood the economy with money. When central banks buy back financial instruments, they raise interest rates in the process and make capital more scarce. It will be hard to take actions that will hurt the economy almost as soon as it starts to get repaired.

So, if you can stomach the volatility, and if you are still invested today, then I guess you have proven you can, hang on to your energy and commodity stocks. If possible, buy more, or at least reinvest dividends to capture more stock at the current low prices. The next couple years will not be much fund. But eventually the sun will shine. And if the 1970s are any precedent, it will shine most brightly on asset classes that benefit from too many dollars chasing too few goods.

Bill Gross, the oft quoted chairman of PIMCO Advisors and global bond guru, agrees with this perspective. Today on CNBC he made took a similar position (I was just happy to be aligned with his perspective, certainly not the other way around). I have posted his appearance for your viewing pleasure (see right hand bar).

www.cnbc.com/id/15840232?video=906626482

Updating Jim Rogers' World View

It has been a while since I have checked in on Jim Rogers and his world view. He is the most traveled and convincing speaker / investor in global markets, and has become decidely anti-American, even though he hales from Alabama. He recently moved his family to Singapore to get closer to the locus of future world growth, Asia, and more specifically China. He also is fleeing the American dollar, which he considers to be doomed.

Jim Rogers first gained fame as the partner of George Soros managing the Quantum Fund in the 1970s. He did very well for himself garnering a net worth over $100M by 1980. Now, almost 30 years later, he has grown that to over $1B, according to news reports. Since the late 1990s, Rogers has been an outspoken bull on commodities. His self-designed commodity index has returned almost 500% over that time. Here is a chart of the index performance over the past 3 years (since trading began in 2005):

The "sell signal" is clear at about 37.50 on this chart. The Sell occurred on around July 20, which was very close to other commodity downturns (some of which did begin back in June). But observing this Sell would save quite a bit of future losses until commodities strengthen.

But what sets Jim Rogers apart more than his wealth, is his unique contrarian perspective on the world and investments therein (though, maybe a little less contratrian today, then in 2000 during his world tour of investment locales, with wife Paige). (see "Adventure Capitalist").

I am leary about commodities over the next 6 months to a year, as the world economy temporarily slows and the US dollar strengthens relative to other weakening economies (mostly Euroland). I recently sold almost all my commodity stocks, except for one mutual fund (VGPMX) and my Canroy stocks.

But, I agree with Jim Rogers' long term thesis that the balance of world economic power will shift to Asia over the coming 20 years and will be marked by a long running shortage of materials while enduring increasing demand. I will invest accordingly and keep an eye on the dollar to signal my move back to commodities and energy.

I found a couple recent stories on Jim Rogers and will provide a link to them so you can read up and learn what Rogers is up to:

The first is "Rogers Sill Bullish on Commodities" August 15, 2008 at the "Living off Dividend website: http://livingoffdividends.com/2008/08/15/rogers-still-bullish-on-commodities/

The second story is from Bloomberg News which I have repeated below:

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aLr71mSZqOLI

Avoid Dollar `At All Costs,' Investor Rogers Says (Update2)
By Zhang Shidong

June 30 (Bloomberg) -- Jim Rogers, who in April 2006 correctly predicted oil would reach $100 a barrel and gold $1,000 an ounce, said investors should steer clear of the dollar as the U.S. economy slows and favor commodities this year.

The dollar has slipped 7.7 percent against the euro and 5.9 percent versus the yen in 2008 as the Federal Reserve cut interest rates to stave off a U.S. recession. Oil prices have doubled in the past 12 months, while gold is up 44 percent.

Avoid the dollar "at all costs", said Rogers, chairman of Rogers Holdings, in a speech in Shanghai today. "The best investments in 2008 are commodities and natural resources. Agricultural prices have much higher to go over the next decade. We have a shortage of everything, including seeds.''

Oil and metal prices in New York have surged as a slumping U.S. currency made them cheaper for non-dollar investors to buy as a hedge against inflation in a slowing global economy. The dollar has stabilized in recent weeks, with currency volatility falling by the most since 1999 this quarter.

The comments from Rogers, 65, come two days after he told investors at a conference in Nanjing not to "give up" on Chinese shares, which have made China the world's second worst performers this year. Rogers, who first started buying Chinese stocks in 1999, said he hadn't sold any of his holdings.

Commodity Bull

Investors failed to take heed today, as the benchmark CSI 300 Index extended an eight-month slump amid expectation government measures to slow inflation will hurt corporate profits. The gauge is down 53 percent from its Oct. 16, 2007 record and has dropped 23 percent in June. That would be the index's worst month since it was introduced in April 2005.

Rising food and fuel costs have helped to drive China's consumer prices to their highest in almost 12 years, prompting the central bank to lift interest rates six times last year and order banks to set aside a record amount in reserve to curb loan growth.

Speculation that the People's Bank of China would raise borrowing costs for the first time this year dragged the CSI 300 down by 5.5 percent on June 27.
Rogers, who now lives in Singapore, is best known for being a commodity bull since 1999, before the market started to rally in 2002. His Rogers International Commodity Index has more than quadrupled since it started in 1998.

The price of wheat, rice and soybeans reached records this year after adverse weather curbed global output and reduced stockpiles amid rising demand.

"Not High Enough"

Rogers is anticipating further gains in crude oil, which reached an all-time high of $142.99 a barrel on June 27. Futures were recently at $142.74.

"Crude oil prices are not high enough to stop people from consuming more energy,'' the investor said. "The bull market will not go to an end until supply and demand come to a balance.''

His comments today echo the themes in his latest book "A Bull in China: Investing Profitably in the World's Greatest Market,'' in which he tells investors to get out of the dollar, teach their children Chinese and buy commodities.

Rogers said last October he planned to shift all his assets out of the dollar, which fell to a three-week low against the yen on June 27. He predicted last month that the U.S. currency's decline would pause in the second quarter because it was overdone.

To contact the reporter on this story: Zhang Shidong in Shanghai at szhang5@bloomberg.net.

Commodity Prices Peaking?

Regarding the commodity price discussion by Stephen Leeb in a recent newsletter, I think we can have it both ways, both the Barrons and WSJ positions. We are in the midst of a "short term" correction in commodity prices. Basically, the price increases got ahead of themselves at a time of weakening demand. The commodities markets are heavily influenced by speculative cash flows in today's market. It has become a favorite play ground of hedge funds and hot money. The size of the commodities markets is relatively small compared to the amount of funds available to chase those commodities, so the prices are easily moved around by speculative money flows. I agree with the 30% correction forecast by Barrons, and we are just about half way there on gold with the price in the upper 800s.

But I also agree with the WSJ article which makes the case for supply constraints as the "long term" problem for commodities pricing. New supplies of natural resources and ag products are hard to bring on line. Demand will not create instant new supply like it might for financial products or electronics, which are very easy to ramp up in terms of production (all financial products require is a paper and pen). New mines or oil wells require land acquisition, permitting, support infrastructure (roads, power, etc), labor in places where it may not be already available (Northern Canada), large capital funding, plant design and engineering, etc. And as the most accessible resources are tapped out, the remaining resources are in harder and harder to develop locations (mining seems to go with mountainous terrain for example).

So, I think we can consider both arguments and invest accordingly. If you like to trade short term, like me, the trade now is to be short the commodities. But if you are more of a buy and hold investor, then the proper trade is long. And the new lower prices make this a decent entry point for gold, copper, iron, etc. Ag commodities will also be a good buy if they pull back a bit more.