Saddling up with Death

–If Dr. Marc Faber is right, and the whole financial system we live in is basically doomed, then how advisable is it to keep acquiring financial investments like stocks and bonds? This is the question we began this week of reckoning with. It’s a pretty important one. And to be honest, the answer is very much up in the air.

–The case your editor made in the special edition of the Markets and Money over the weekend is simple:

The major global economic powers have been engaged in a contest of competitive currency devaluations. The result is the gradual dilution of the purchasing power of paper money, reflected in the rising prices of tangible goods (commodities)….The currency war is starting to produce geopolitical casualties.

–The point went a bit further. The more powerful geopolitical factors become in markets, the better it should generally be for tangible assets. It follows (we claim) that the owners and producers of tangible assets would start to command a premium in the share market too. That’s the general idea.

–The idea is attractive because it’s supported by inflationist policies of the world’s central banks. These policies are designed to keep cheap credit flowing into the financial system to keep financial asset prices higher and help banks (and whole countries) stay solvent. But that’s not all.

–It just so happens these policies have undermined faith in paper money and led to politically destabilising inflation (without growth!).  This inflation has hit first and hardest in those countries most vulnerable to higher food and energy prices. Hence the bull market in popular revolution.

–And so here we are wondering whether you can really profit from the Great Arab Revolt. Are energy and commodity stocks good hedges against inflation? And will shares resist the downward pressure on asset prices if quantitative easing prices fail?

–None of these are really new questions. It’s just that the last few weeks have made these questions more urgent. The answers will start to be revealed. And of course, there are going to be winners and losers. If you haven’t given these questions much thought, now would be a good time.

–The default and usually reliable position is to invest along the primary trend in the market.  In normal times, tomorrow is pretty much like yesterday and the improvements in life are incremental. For investors, that means that if you get your asset allocation right, and then pick a few proxies within the winning asset class, your investment strategy doesn’t have to be complicated.

–A simple version of that advice is this: buy stocks when they’re in a bull market. On that subject, Vale, the world’s largest iron ore producer, reckons the bull market in iron ore is going to last another three or four years. Vale’s marketing chief Jose Carlos Martins says that for this year, “I do not see a big change in the fundamentals.” That means more demand from China and high ore prices.

–“For sure, more iron ore will come into production—not only from Vale but from iron producers, but not an extent that could change the fundamental market situation,” he’s quoted as saying in today’s Australian Financial Review.  “We see every year China steel production growing. For this year, what they talk about is five per cent growth. And five per cent growth, only in China, will demand more than 50 million tonnes of iron ore.”

–The current spot iron ore price is already at record levels. If you believe the arguments made by David Gruen in this paper over at the RBA site, then the re-emergence of China and India into the global economy means that a “structural change” in Australia’s economy. And what is that change?

–Well, in his latest issue of the Australian Small-Cap Investigator, Kris Sayce argues that the Chinese demand for ore has, in effect, created a new class of companies in the ore industry that simply couldn’t exist without this structural change. It’s the same industry with a new breed of competitors thriving in a newly created ecosystem of opportunity, so to speak.

–These companies are not what you’d call classic “disruptive technology companies.” They don’t even really fit in with the “creative destruction” metaphor that describes how new start ups displace static incumbents. But Kris argues they still have the basic characteristic you’re looking for in a growth stock: the ability to capture quick profits and share price gains in a brand new market.

–Iron ore is not a brand new market, of course. But lower-quality ore deposits with shorter mine lives are not the kind of projects that would be worth pursuing in a normal commodity cycle. There are plenty of high-grade, economic, and large resources in the Pilbara. And most of them are locked up by a handful of companies you may already own (like BHP and Rio Tinto).

–Kris has argued, then, that small-cap investors can benefit from the tangible asset boom by punting on companies that have small production targets, but are riding along in the slipstream of an epic bull market in iron ore. That is one way of taking a position on global events that comes down to buying Aussie shares.

–The success of that strategy comes down, in part, to how quickly supply of key commodities can catch up with demand (assuming demand doesn’t fall a lot, which is a whole other debate). This gap between supply and demand varies from commodity to commodity. You have to look at it on a case by case basis. This is what Dr. Alex Cowie did last year when he recommended tin, copper, and potash companies. There’s plenty of evidence that it’s a great strategy.

–For example, resource investor and fund manager Eric Sprott reckons there is a massive shortage in silver. You can watch Sprott make the case here.  But the short version of the case is that Sprott reckons just seven large silver investors own close to 520 million ounces of silver. He concludes that investment demand for silver has been so strong that there’s very little non-mine supply sliver left for everyone else.

–A market that small—the silver market is only about $22 billion a year—with that big a gap between demand and supply is a market with enormous explosive potential.  That could mean explosion in the positive sense (much higher prices) or explosive in the negative sense (investors get blown up if silver prices fall dramatically, as they would if industrial demand fell in a global slowdown).

–Our colleague Greg Canavan, with his grounding in the principles of sound money, has argued that sliver (along with gold) is being remonetised into the world’s financial system. This means central banks are holding silver as a reserve asset. And it means more and more individual portfolios are including an exposure to precious metals, both shares and bullion.

–Silver is money, just as gold is money. They have the inherent benefit of being harder to produce than pieces of paper. Owning them is one way to preserve the value of your savings while the world’s complicated financial architecture falls apart.

–If you’re still not sure that gold is really money, ask yourself why Egypt has banned gold exports, according to the Middle East News Agency. It’s a capital control that prevents money from leaving the country in times of civil unrest. Get used to it. You’ll be seeing a lot more of it as the petro-dollar standard unravels.

–And speaking about petro dollars, what about oil and energy shares? Well, we wrote about them this weekend. The revolutions in North Africa and the Middle East almost certainly mean higher oil prices. But it also means renewed investment in unconventional energy projects. At the very least, countries will try to geographically diversify their long-term energy supplies.

–But the truth of the matter is the Middle East is home to the world’s largest, low-cost energy reserves. You can find energy in other places. It’s going to cost you, though. That could benefit Australia, with its coal, uranium, LNG, and other gas resources.

–Sinopec, one of China’s energy titans, is already on the case. Bloomberg reports that Sinopec and Conoco Phillips have both agreed to become part owners and customers of Origin Energy’s liquefied natural gas (LNG) project in Queensland. This, by the way, was also a story that Kris Sayce was way out ahead of, and for the same reasons (a new market ready to be exploited by agile first and second movers).

–Our own view, when it comes to the energy patch in Australia, is that all the low-hanging fruit has probably already been picked. When you see multi-nationals and oil majors splashing billions in cash, it means the smaller companies have already done a lot of the groundwork in establishing the viability of the business. It’s an easy way for larger companies to add to reserves without doing their own exploration.

–If you’re going to make money on tangible energy assets that haven’t yet been revauled, you’re going to have to either take a punt on much smaller exploration companies that have not been “de-risked” or do something else. We’ll get to the “something else” in a moment. But just remember, the “de-risking” of a project is littered with landmines that could blow up a share price (again in the negative way). You may get rewarded for your risk…just be sure you know what you’re getting into.

–As for the “something else,” look for other unconventional energy projects that are not LNG. There is a whole development model for one such industry that’s already established. It worked a treat in the States for increasing natural gas supply and driving up small companies hundreds of percent. That’s the story we told in the last issue of Australian Wealth Gameplan.

–That’s a brief and incomplete look at how some of the team here in St Kilda are using the share market to hedge against everyone else being doomed. Tomorrow, we’ll explore the doom more fully, including famine, pestilence, and war. And we’ll see if there’s really any way to ride with three of the four horsemen to higher profits, or if it’s a bad idea to saddle up with that gang at all. Until then….

Dan Denning
For Markets and Money Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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John McKay

As a reader of The Daily Reckoning of ten years’ standing, I commend the editorial staff on its efforts. I have yet to discover a better source of information, let alone another source of the TRUTH! The advice given in this publication and in Morning Morning is sound, unequalled in clarity and presented earnestly for the benefit of the reader and investor. I look forward to another year of expert guidance and information. Keep up the great work!

Yours sincerely,
John McKay

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