11 March 2009

Inflation tide is just getting started

March 6, 2009

"Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone's guess, though one likely consequence is an onslaught of inflation."

— Berkshire Hathaway 2008 annual report

Last week was a very good week due to the signals given by the market. It was the first time in a long time that the price of oil increased (17%) at the same time that the S&P 500 declined due to more talk of the nationalization of US banks. The thirty year US Treasury Bond decreased bringing yields up to 3.72% from a low of 2.65% in December, leading me to wonder if global investors are waking up to the US’s ability to pay back these mounting liabilities? Lastly, the decline in the price of gold and gold stocks might be signaling some level of rotation within the inflation hedges.

These changes in trend are particularly important because I am convinced that the market is set-up for a very good rebound, as some of the reflationary efforts of the Fed should start to have some effect. If I am correct, within the next few weeks we should see signs of market strength and the beginning of a pretty good rally in the context of a bear market. If this is the case, it is very encouraging to see the oil sector leading the way. As Warren Buffet said to his shareholders “an onslaught of inflation” is rearing it’s head and the market is chasing the most undervalued inflation protection in the market, the energy sector.

I was also very encouraged by the actions taken by Chinese Officials during US Secretary Clinton’s recent visit to China. Her mission was to advise the Chinese on the importance of the value of their US$ and Treasury holdings, and that it was in their joint benefit not to sell them. However the Chinese signaled the importance of Energy Security for their own strategic benefit. On the day of her arrival they signed a deal with the Russians to buy oil at $73 a barrel for the next twenty years, in essence giving Gasprom a much needed $25 Billion lifeline, this was too bad for Citigroup who also needs it. Upon her departure they further announced that they are on the acquisition mode for global oil companies. This is in addition to the US$1.7 billion China Minmetals Corp bid for Rio Tinto, and the US$10 billion deal with Petrobras to help fund the development of Brazil’s massive oil reserves. The smart money is understanding the importance of Energy Security for the Chinese, who now sit with two trillion US dollars. It is impossible for the Chinese Government to attain it’s long term goals without Energy Security, and the current reality of global oil reserves makes it a given that control is essential. Furthermore, Abu Dhabi’s purchase of Nova Chemicals and Total’s purchase of UTS Energy are further confirmation that the world is waking up to the need to convert US dollars into real assets; this trend will only accelerate.

The move out of Treasury’s and gold was also very impressive because it is signaling early signs that the smart money is exiting the comfort zone of the safety trade. Many will begin to recognize that the market has currently corrected more than an expected recovery by year end warrants, and that some of the efforts of the Fed should start to take effect. Furthermore, the current negative environment has created an excessive number of short positions in the system that will soon need to be covered if the market starts to rise. Lastly I expect that due to the reflationary efforts of the Fed, next quarters economic numbers will show a deceleration of a worsening economy and give the bulls some much need it relief. Conditions are ripe for a good rally that could last anywhere from two months or longer. My opinion is that it will last much longer as the market is currently setup in a similar manner as 1928. Coming into 1928 the market had greatly declined led by the bad conditions of the banking sector due to their irrational exuberance with real estate. Furthermore, in a similar manner Hoover won the election in 1928 and entered office in March of 1929, and American’s where still reminiscent of the Roaring Twenties. By early 1929 the market started a wonderful ascent fuelled mostly by lax margin rules and cheap lending; this ascent climaxed in October of 1929. I think the current reflationary policies have asked much of American taxpayers without much reward. Therefore, it is very important for the new administration to encourage some level of hope by making people feel richer, the herd will believe it as it is to early for the final climax. Due to the decline in the housing marker this can only come from the stock market.

The flight out of the safety zone might also hurt gold stocks temporarily as we see some rotation out of gold. The relative undervaluation of oil producers versus gold producers merits much consideration by the rational investor, and many will recognize this trade. Furthermore, many who sought gold as safety will also consider locking in their gains and rotating some of their holdings to the overall market. If the market starts to strengthen during the next few weeks it will be the beginning of the reflationary efforts of the Fed. This is very likely since many investors still do not recognize the economic reality that awaits them and believe that the economy will begin to recover by year end. The smart money will recognize the importance of the fact that oil started this rally and the fact that it will be leading it. The next course of action will be to decide whether it is time to overweight the oil sector. I will be looking to re-enter gold after the market has taken traction, by then we should start to see the effects of supply destruction which will be the next fuel booster for the coming inflation.

Lastly I would like to mention that agriculture stocks have been gaining nicely since October 2008 with gains of about 35%. Investors who added the companies like Agrium or Potash Corp, or the Agribusiness ETFs Ceres or Claymore to their portfolios in October should continue to do well. Hopefully Agrium’s purchase of CF Industry goes through as it is very accretive for both companies. Furthermore the current drought in the Southern Hemisphere is catching up to North America where Governor Schwarzenegger is declaring water rationing for farmers in California, this will have serious implication for food prices. If you thought the food problems we had last summer had gone away think again, just this week the US Agriculture Department raised the alarm for higher food cost this summer.

It has been my contention since last fall that due to the level of money creation inflation is inevitable. I further speculated that the precious metals sector would take the lead in signaling the loss of purchasing power of currencies, followed by the agriculture sector, and then the oil sector. So far this course is playing out accordingly. It is important to understand that prior to a Tsunami the water recedes only to comeback with full force. My observations lead me to believe that the early tides of this massive inflationary Tsunami are coming in. The next period will be the last chance to inflation-proof your portfolio. If you do not yet believe in the inflation thesis raise cash during the next market bounce, otherwise reposition yourself to benefit from this paradigmatic transfer of wealth. My main investment thesis, inflation hedging, has not changed and I continue to recommend that clients have greater long term consideration in precious metals, agriculture, and energy. I would be very happy to discuss my conclusions and their implications for your net worth, please feel free to contact me.

I will doing the Market Call segment on Canada’s business channel BNN on Friday March 13th from 12:00 to 1:00 pm, feel free to call in.


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