Recently, the commodities market is buffeted by events. It is much like a pool full of predator sharks trying to eat some of their own…whoever has proven to be weak. Some hedge funds have been nosing around, finding other hedge funds which are facing redemptions. Knowing that they will have to sell to raise cash for redemptions, the predatory funds are shorting the long positions and buying the short positions of the funds in danger…forcing them to liquidate at unfavorable prices.
In these cases, the forced liquidator fund’s loss turns into the predator fund’s gain. This is liquidation panic at its most primitive form. The current commodity market panic is a liquidation panic. This has led to a rally in the financials and a major decline in all classes of commodity stocks.
The argument against commodities is that global demand for commodities is going to shrink dramatically and stay down for many years. Most fund and money managers are located in Europe and North America, where they look around and see economic weakness, a battered banking system and many other problems…which they extrapolate that to the rest of the world. The argument continues that if the U.S. and Europe are weak, China, India, Singapore and all of emerging Asia will also be weak for a prolonged period of time. Their negative attitude is amplified when they see the countries of Eastern Europe infected with the same problems of the developed world. These managers believe if the economy goes bad in one developing country, such as Hungary other developing countries such as China will follow suit.
Firstly, we disagree that commodities will not be in demand for a long period of time. We also disagree with the notion or hypothesis that because things are bad in some former Eastern Bloc states (which happen to be running huge current account deficits) that they will also be bad in China and other emerging countries…which run big current account surpluses. To compare such disparate economic entities as Eastern European countries with China, India and other Asian developing countries is a huge mistake in our opinion.
China is our favorite potential market for investment, and we are itching to get invested as soon as the market starts to exhibit bottoming characteristics. We disagree that the Chinese economy will collapse, and we back that up with current economic statistics from China which continue to be strong. Many people doubt China’s future and the future of developing Asia as a whole, we are not among them.
We further think that much of the sell off in commodities is overdone. We are not brave enough to jump in to “catch a falling knife”, but we know that once a bottom forms for commodities and people realize that demand from Asia has not evaporated, many commodities will once again rise in value. We do agree however, that the market is (as always) primarily a psychological entity, and that the psychology of investors and traders can trump logic for long periods of time. This is one of those periods.
The negatives are on everyone’s mind. The negatives include fear of a meltdown in demand from Asia, forced liquidations and predator behavior in stock and commodity markets, fear of the new management of the U.S. economy after the presidential election, fear of a continuing de leveraging of the world banking system (which been going on for over a year), fear that no one knows how low all of the declines will go, and finally, fear that the entire bag of problems may prove insoluble and that a major depression will descend upon the world in the next year or so.
We continue to hold cash, but we also continue to watch China which has gotten reasonably priced in the last fourteen months as profits have risen and stock prices have fallen 65% as measured by the Shanghai Exchange index.
Agriculture related stocks have become attractive as demand for food remains strong, and new land will be put into production. This increases long term demand for inputs like fertilizers and farm chemicals.
If world economic hardship leads to military and political adversarial relationships, and the world awakens to the reality that those countries who have bailed out the world banking system (U.S., U.K. and European Union) have badly damaged their currencies to perform the bail out, then precious metals will once again be demanded as a hedge.
At some point, the freefall ends and these groups and others return to a rising trend. We continue to wait and watch, and although it sickens one to watch, it is encouraging to see the liquidation panic which often occurs near the later part of declines.
OUR CONCERNS FOR THE REMAINDER OF 2008 AND 2009
1. Diminished free trade
Economic hardship often creates populist political pressures worldwide. These populist appeals will grow in number. Some countries will implement anti-free trade and other nationalistic economic policies. These policies have shown themselves repeatedly to be at best unwise and at worst disastrous, but they have political appeal in times of hardship. In our opinion, the Smoot Hawley tariff bill in the U.S. was one of the major causes of the great depression of the 1930’s.
2. The continued credit crunch creates “zombie” banks.
The Fannie Mae and Freddie Mac nationalization was big at $5.4 trillion. It was actually just the bailout of one type of organization. It was much bigger, but not altogether dissimilar from the U.S. Government’s orchestrated takeover of Bear Stearns by J.P. Morgan.
We believe that the U.S. and European stock markets will begin to bottom when an actual overall plan, like the Resolution Trust Corp of the early 1990’s (but on a much bigger scale) is in place. It will have to restructure the financial institutions in the U.S. and probably much of Europe. Capital requirements for banks will remain the same, but investment banks will be required to have higher capital and will be regulated much like banks. The days of heavily leveraged bond bets by banks will have ended. It will take a lot work and a very large amount of money, and it will also probably require the support of many major governments, and the taxpayers of several countries will pay the bill.
3. If Mr. Obama is elected, he has said we can expect rising taxes, especially capital gains taxes.
Remember that the rise in capital gains taxes in 1986, combined with higher interest rates, is believed by many to have been the catalyst for the stock market crash of 1987. This is a serious potential negative for the U.S. and European stocks and economies.
4. More conflicts of interest like those at the Fannie Mae and at banks will be uncovered.
Financial institutions which speculated with the shareholders money (while engaging in at best borderline legal practices) will be uncovered, and the long-term effect will be a more conservative and slower growing capital market in the developed world. This is bearish for the U.S. dollar.
5. Russia continues to be an aggressive presence in the European area and the U.S. will become less of an aggressive presence in the Mid East.
Pakistan may also blow up and we may find that Russia and Iran are involved in intrigue in this area.
OPPORTUNITIES WE SEE FOR 2008 AND 2009
1. Asian growth continues.
The part of the world with the most opportunity for growth will continue to be Asia and not the parts of Asia that delude themselves, but rather the parts of Asia which meet challenges with decisive action. Brazil, China and possibly India continue to be big areas of opportunity.
2. Food, and the need for inputs to produce more food, continues to be a big area of opportunity.
This is tremendously bullish for fertilizer and other food related inputs.
3. A new opportunity to short the U.S. dollar will probably arise after the dollar rally runs its course.
Clearly, that will depend upon who is elected president, and what type of economic programs are implemented.
4. Political issues could bring support to Gold and Oil.
A military crisis in nuclear Pakistan and more problems in near-nuclear Iran may add to demand for gold and oil in 2009.
5. Real estate and mortgage bonds may become attractive in the coming months.
The ability to buy good real estate and good mortgage bonds at throw away prices, will surface in the later half of 2009. Real estate is regional and the timing of opportunities will differ from region to region.
Thanks for listening
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