Monday, June 16, 2008
The two-year old commentary excerpted below was recently stumbled upon while doing weekly maintenance work for the companion investment website Iacono Research.
It was written back on May 21st, 2006 when oil traded at $70 a barrel, natural gas was at $6 per MBTU, gold fetched $650 per ounce, and silver sold for $12.50 per ounce.
The Next Year or SoThis was written just one week after the gold price had peaked at $725 per ounce in May of 2006 and many investors in precious metals were beginning to lose confidence.
This is a good time to talk about what looms on the horizon as the Summer of 2006 nears and the real estate chickens come home to roost. In this section I hope to give you my big picture view of the next year or so, what events might transpire, and what the investment posture is likely to be here. This week is evidence that the process that I'm about to describe has probably already begun.
Some of these views are included in the On Investing section of the website, but here I'll try to fill in a little detail as it relates to where we are, where we are going, and how this relates to positions in the model portfolio.
How We Got Here
Monetary policymakers in the U.S. are in a difficult position right now - rising "inflation" is becoming very noticeable and the tried and true remedy of higher interest rates and restrictive lending as a way to combat rising prices is wholly incompatible with continued growth in the housing market, based as it is on an increasing amount of credit and debt.
Housing has been the key driver of economic growth throughout the world in recent years as debt-fueled consumption brought the world economy out of what should have been a much deeper recession after the stock market bubble burst at the turn of the century. But, this was a very short-term solution to a very long-term problem.
The short-term solution was the creation of another bubble in response to the one that just burst, however, the long-term problems remain - most notably government commitments that it can't keep and the impact of global labor arbitrage on American living standards.
Today, all that money and credit that was generated during the housing boom years has worked its way back into rising consumer prices and energy costs, and we are faced with the same long-term problems mentioned above which have now only gotten worse. We probably would have been a lot better off in the long-run had there been a much deeper recession a few years ago, but the contemporary approach to monetary policy is to stimulate the economy in any way possible when economic weakness appears.
Now we are in the position where the cure for illness of "inflation" (higher interest rates) is likely to kill the patient (the economy). The big question is what will Ben Bernanke and the Federal Reserve do?
The Same Old Response to Economic Weakness
It is clear to me that the solution to upcoming economic weakness will be to somehow give the appearance of fighting inflation while at the same time massively stimulating the economy. The inflation statistics have been highly manipulated over the last twenty five years to make rising prices appear less than they really are, however, you can't really hide $3.50 gasoline or $5000 medical insurance premiums.
People are slowly beginning to realize that with the exception of inexpensive imported goods, prices in general are now rising, and in many cases they are rising rapidly.
Interest rates just can't be raised to 6, 8, or 10 percent or more to quell inflation with an American consumer so loaded with debt - interest rates at these higher levels will crush the housing market. So, when housing and the rest of the economy begin to substantially weaken in the months ahead, and with the threat of a big move downward in equities amid shaken investor confidence, the Federal Reserve and the Federal Government are likely to again take drastic measures to combat the decline by somehow creating more money and credit, cutting taxes, providing handouts - you name it.
That is what they do. More monetary stimulus is the solution to nearly every economic problem.
Ben Bernanke has vowed to never allow the The Great Depression to be repeated, and he should be taken at his word. Ignoring the roots of the problem (the credit expansion of the 1920s), modern central bankers view the failure of monetary policy during that period as a failure to create enough money and credit to stimulate the economy after the 1929 stock market crash.
Current monetary policy is based on classical Keynesian economics where credit expansion and government borrowing are used to combat economic weakness, however, as Keynes himself said, "In the long run, we're all dead". Many, including myself, believe that this was an implicit acknowledgement that at some point in time Keynesian economics would eventually fail to deliver.
That point in time may be close at hand, and the rest of the world may well realize it - this is what makes the next economic downturn different than any previous downturn, as best evidenced by the recent rise in the price of gold.
What Happens Next
The timing of events is of course uncertain. When will economic weakness arrive? What fate will the housing market succumb to? These are unknowable.
One thing that you can be sure of is that no one has a vested interest in the world economy falling apart. The central bankers and government leaders in the world will do what they have to do to in an attempt to avoid a crisis, and if a crisis does ensue, they will do whatever they have to do to restore confidence. With the mainstream financial news media ready and willing to help shape public opinion, they have a distinct advantage versus previous eras where panic spread amongst traders on the floors of stock exchanges.
It is for this reason that a worldwide crash in the near term is not deemed likely, and this is the reason why we want to remain almost completely invested at the moment. There will come a time in the years ahead when it will probably make sense to go to an all cash position or an all gold position, but that time is not believed to be near.
What is likely to happen when the next significant economic weakness is upon us is that the Fed will, at least privately, focus on saving the economy versus fighting inflation - they will continue to try to "talk" inflation down, but ultimately, their most powerful weapon against rising prices, restricting money and credit, will not be available to them.
So, the question is, where does all this new money go?
Unless there is some other new asset class that can be inflated, like stocks in the 1990s and real estate in recent years, much of this new money will likely go into commodities in general and precious metals in particular. The road will be bumpy, particularly the transition from economic weakness to the arrival of new stimulus - large declines and great volatility are likely to be experienced during this interval, as evidenced this past week, and there will be some fantastic buying opportunities for natural resource exploration companies.
But in the end, it is deemed best to stay almost fully invested for the long-term, knowing with a high degree of certainty what is coming - economic weakness, followed by huge monetary stimulus that will work its way into commodities and precious metals.
At some point in time years from now, a new world monetary order will be constructed, and the dollar will permanently lose its standing as the world's reserve currency. This is a sad thing to say, but unfortunately, there are no signs of any elected officials doing anything about the long-term financial problems in the U.S. - delivering the sort of pain to the populace required to address these problems is not something that politicians are wont to do for fear of losing the next election to an opponent who promises to make the improvements in a pain-free manner.
More likely than not, at some point a major worldwide financial crisis will ensue and the world economic order will change dramatically and permanently as a result. But, importantly, between now and that time, commodities will soar in U.S. Dollar terms due to supply/demand imbalances and as a flight to safety.
At the time, oil had been quietly hovering around $65 a barrel for about nine months since the 2005 hurricanes struck the Gulf Coast and the price of natural gas had fallen by more than 50 percent.
Naturally, most of the mainstream financial media was convinced that the "commodities bubble" had burst. As it turns out, that was one tough bubble.