Tag Archives: commodities

On Gold, Guns, Bread and Cadillacs…

Well, maybe not guns.  This isn’t that kind of post.  But I am going to talk about gold briefly.  One of the more interesting ways to think about the value of gold is its value in purchasing household items.  Because back in earlier times that was exactly how you paid for things.  Gold is money, after all.  Indeed, in the book “Hedgehogging” Barton Biggs refers to gold in such a manner:

The Old Testament recounts how, in 600 B.C., one ounce of gold bought 350 loaves of bread.  As of today, one ounce will still buy 350 loaves of bread in the United States.

Barton Biggs: Hedgehogging

In my area of the country in North Carolina, one ounce of gold will get you 446 loaves of bread.  So when measured in those terms, we’re overvalued even after the action we’ve seen over the past few months:

Today I heard it referred to in another way: gold vis-a-vis Cadillacs.  So first, I have to present to you the definitive video clip on Cadillacs…

And now back to the gold/Caddy ratio.  I stumbled across this post (hat tip: @hedgefundinvest and @FinanceTrends) that looked at the fact that in 1971 with gold pegged at $35 an ounce you needed about 11 pounds of gold to buy a ’71 Eldorado.  Take away the peg and it would’ve been much less gold (at $103 an ounce you need about 5 pounds).

Now?  You can get 2 Cadillac XLR-Vs for the same 11 pounds if you’re taking the $35 per ounce as your starting point.  If you used 5 pounds, well you’re out of luck because you won’t have enough based on Friday’s close at $1193.50.  So the starting point you choose is important.

But as for the overvaluation or lack thereof currently?  At these levels it may still be overbought even though we’ve seen a pretty sharp pullback from $1,250.  But I’d be wary about how much more of a decline we see here because volume has been higher even on up days and the revolt against central banks isn’t over by any stretch.

So in my mind, we’re in for more volatility not less.

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Commented on “The Reformed Broker”

The Reformed Broker has a good post out today on investing and essentially, where do we go from here.  I left him a comment there but I also wanted to post it here as well.

Josh,

First, a good article. And I think for the consensus point of view, it strikes a chord. That frame of reference you’re using is one that presupposes an inflationary environment. It’s natural for us to presume it because inflation is all most of us have ever seen or experienced.

But allow me to offer a different one. In a deflationary environment, your focus isn’t on increasing asset valuation, but preventing decreases in their values. Here, cash is the best defense not because it will gain the most, but because it will lose the least.

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by professorpinch
on The Reformed Broker using DISQUS.

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Commented on “Distressed Volatility”

Who’s the bidder? I suspect homebuilders in anticipation of having several months worth of extra work. The tax credit expires in the next week and I think it’s a rush to buy resources. In short, I think it’s a “hope & pray” trade.

Also, the timing of the credit expiration needs to be considered. It comes right at the start of peak homebuilding and home purchasing season. It’s timed to give the maximum lift, hoping that people will *believe* housing is in fact, better.

Let’s just say I’m skeptical…

Originally posted as a comment
by professorpinch
on Distressed Volatility using DISQUS.

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What if the Next Shoe to Drop is Oil?

File this under “buses you don’t see coming.” I’ve been giving the Dubai/UAE situtation some thought, trying to map out scenarios and possible second and third order effects. So far, I’ve been thinking mostly of the credit problems, but in an effort to keep an open mind about the relationships between asset classes and their risks, I’ve been trying to piece together an entirely different scenario… and I think I’ve got it.

Looking at the newsflow out of the Persian Gulf region, things don’t seem all that cheery on the Arabian peninsula. The folks at the Financial Times and FT Alphaville have been talking a lot about the problems with investments by Dubai/UAE (nothing new, but read this and this), and now Kuwait. Apparently, Kuwait has been guilty of the using the same tragic investment strategy as Dubai: real estate, private equity, and stocks.

Funny, but I’ve heard that before… I think it was in Larry McDonald’s book, where he talked about how much risk the company was taking. How much risk they were oblivious to…

But let’s get back on point. To talk about scenarios we need some data, some plausible linkages between the data, add in the current situation and the options available to respond, and voila you have a scenario.

So first, let’s look at some data. I’m going to throw in a few charts I have that show the incomes of these government sponsored enterprises in Kuwait and the UAE:

Here’s a Y-o-Y chart of the same data from the UAE:

At the same time, oil/hydrocarbon exports have literally been fueling growth:

So while these GSEs are starting to rack up losses on their investments, dependence on oil exports has only gotten stronger.

All the while, the “cheap” credit they used to buy all of those assets is getting more and more expensive. So now if we think about the possible ramifications of asset deflation in the real estate, private equity & stock holdings these government-backed enterprises have, we arrive at some real stark choices really fast. There’s defaulting on the debt, liquidating the assets, extending and pretending, or selling oil.

Default prospects are rather fuzzy at the moment, since there is some debt that might be defaulted on while other debts will not be. Liquidating the assets? In this market? Extending and pretending won’t work in this case either because a number of the projects are unfinished and won’t cash flow as projected.

So that leaves us with the possibility of selling oil to pay off the debt. And these won’t be small bite-sized sales, but rather large oil sales to cover the debt that needs to be rolled/paid off. Next is the weekly chart of the nearby crude oil contract (hat tip: CME Group):

There’s no point in looking at a 15 minute chart, a release of oil reserves the size these two countries need to execute for debt payoffs would put a lot of supply in the market. And looking at the weekly chart, crude has been drifting higher. Price action is more like dawdling, actually, but after bouncing off of last year’s lows it has meandered higher. Based on this, I don’t think the market could easily absorb that kind of supply.

And as I alluded to in weeks past, a drop in oil prices would hurt some countries, just not the ones you’d think.

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Sovereign Credit Risk, Commodities Crashes, and Correlations in Under 140 Characters

Think talking about commodities and credit risk is hard? Try doing it in 140 characters or less. A friend of mine, Tim Backshall of Credit Derivatives Research, and I had the following discussion on Twitter. I’ll translate where necessary:

Here’s the document on Scribd he referred to:

Translation: a negative basis occurs when you have a divergence between a CDS spread and a bond spread. Normally these spreads should be around parity, probably a slight positive basis with bond spreads slightly tighter than CDS. But if it reverses, and you have a negative basis (CDS spread is tighter than the bond spread), you’re getting a trade where you get the yield on the cash bond and the CDS hedges the credit risk so you have a trade that is almost riskless. The following paper describes basis trades in depth:

At any rate, the doc Tim refers to shows the compression between both sets of countries. My instinctual response?

My explanation is simple: Brazil and Russia have sizable reliance on commodity exports and China is the largest gold producer. They have a large portion of the world’s population, and they’re not aging as rapidly as the Japanese and Western countries so they have a secular wind to their backs. But they still need people to buy what they produce and a collapse in commodities.

Tim’s response:

Mine follows:

Wasn’t thinking about China’s gold production.

Tim:

I gave him a response that’s unintuitive at first blush, but I’ll explain it:

CDS liquidity is a bit different than other instruments. The most liquid names are the ones where the credit/default risk is highest. So illiquidity here can be an indicator of strength.

The document being referred to:

Here’s a little tidbit from Tim about what this shows:

In an effort to show just how dramatic a shift there has been in risk in developed nations relative to emerging and less-developed nations, the chart compares SovX (an index of 15 Western European ‘developed’ Nations), EM (an index of 15 Emerging Market Nations), and CEEMEA (an index of 15 nations from Central and Eastern Europe, Middle East, and African Nations).

The SovX is mostly represented by the PIIGS (65%), and Venezuela, Turkey, Argentina and Brazil combine to account for more than 62% of the EM index. Turkey and Russia make up 49% of the CEEMEA index. When you add Hungary and Ukraine, you’ve essentially captured two-thirds of the risk.

But as Tim explains, there is something you have to be mindful of when you look at these indices:

It would appear that the CEEMEA and EM sovereign risk indices are threatened more by commodity price pressures than credit risk currently – and given the ‘relatively’ high price of oil/gas, their risk remains less of a concern than developed nations where the Ponzi appears to be in question.

A number of these countries are exporters of natural resources so they rely on price stability in commodities to make their economies grow. I say stability as opposed to rising prices because if we’ve seen it once, we’ve seen it a thousand times. Rising prices – and parabolic prices rises in particular – condition people to expect further increases which we all know can’t be sustained. The economy becomes intertwined through the use of debt so when prices fall, the ability to service the debt in the economy is called into question and prices of non-correlated assets all fall simultaneously. Can’t you tell I’ve had my coffee?

Since Tim was on a roll by now, I wasn’t going to dissuade from his research:

And now the document:

Do I really have to say anything about this?

Of course, I had a response. After all, I got a hat tip:

All of which points to a rally in the US Dollar, because of the negative correlation between commodities and the greenback. But there is another currency that could fill the role of a hedge currency, and in reality it should be a better hedge.

If only their government saw it that way too…

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Wordless Wednesday 01-06-10

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The *Real* Case for Commodities

This is very true. There is comfort in owning stuff, that as Dennis Gartman says, “would hurt if they were dropped on your foot.”

Oil, gold, corn, wheat—perhaps the most attractive thing about commodities is they seem so concrete. Investors know that a barrel of oil may be worth more or less at the end of the day, but it will never disappear. In an age when major financial institutions can go bust overnight, that holds a lot of appeal.

via The Case for Commodities – BusinessWeek.

But the premise that this is a move to hedge against inflation, in my mind is false. To me, there is something bigger going on here and it’s not just an inflation play.

To start, let’s discuss what these commodities are priced in: dollars.

Since most commodities are priced in U.S. dollars, 2010 may be a good year to invest in them. That’s because the Federal Reserve has kept interest rates close to zero and increased the money supply dramatically, a move some experts say will ultimately devalue the dollar and spark inflation. As the amount a dollar can purchase decreases, commodity prices rise in relative terms. “Inflation usually starts by the government printing too much money,” says Victor Sperandeo, a commodities trader and developer of a commodities index called the S&P Commodity Trends Indicator (S&P CTI). “Never in its history has the U.S. printed more money. When inflation becomes visible, we will start to see stocks slow down and commodities accelerate.”

The dollar is the world’s reserve currency, and it’s a fiat currency. Investopedia defines fiat money this way:

Currency that a government has declared to be legal tender, despite the fact that it has no intrinsic value and is not backed by reserves. Historically, most currencies were based on physical commodities such as gold or silver, but fiat money is based solely on faith.

The “faith” being spoken of is the faith that the currency is going to be worth something tomorrow. Most people just assume that this means higher prices and a loss of purchasing power. And there has certainly been a lot of that:

But there may be some other forces at work here, and we shouldn’t rule them out. As I mentioned in looking at the credit market, as Hank Paulson’s “repricing of risk” continues, Bill Gross’ “new normal” unfolds. The credit market’s view of the risk/return relationship has undergone a major change. What made sense from a risk/return perspective 3-5 years ago doesn’t make sense now. The volatility in price moves we see is an indicator of just how cautious everyone is: in a world where there’s little risk, people have very little incentive to change their habits and patterns. We left that world behind us sometime in ’07.

And looking at the Fed’s balance sheet, their risk/return perspective has undergone a shift as well:

Where the market’s risk/reward set-up has become more cautious, the Fed has become much less so. But there’s one teeny, tiny, problem:

Part of the Fed’s job is to manage the dollar. In my mind, that should be its only job, but the dual mandate they are under is frankly, asinine. Full employment and price stability? Who comes up with this stuff? Everyone knows the incentive in such a regime is to maximize employment because price stability involves administering discipline. It involves doing something that will make most politicians howl: saying “No.”

The chart shows the Fed has undergone a regime shift in how they manage the central bank, and by proxy, the dollar; the symbol for all fiat currencies. If there was extreme distrust of the Fed and the dollar, the risk wouldn’t be hyperinflation, it would be in going back to a barter system. Think of the benefits of a paper/fiat currency: easy to carry, easily exchanged with other fiat currencies, etc. The purpose of a currency is essentially to facilitate trade. In order for that to happen, you need belief that the paper will be worth something, and someone will protect its value.

But what if nobody believed anyone was willing to stand behind their currency, and protect its value? What do you use? You use commodities and you settle trades with an actual physical settlement, unless you introduce the use of credit and IOUs. But the abuse of credit brought us to this point and the pendulum has swung to being risk averse, so if credit/IOUs were extended, the terms would have to be tight, and physical settlement has to happen pretty quickly after a transaction.

So we don’t need to see hyperinflation or a big spike in inflation to take hold. We just have to be more skeptical, more cynical of our governments and central banks to protect our money’s value.

And that’s a bull market that has really strong, powerful legs to it.

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