I wanted to provide a counterpoint to some recent articles posted on Investorgeeks that have suggested commodities are not a good place to invest.  More specifically, that the commodities boom is a high risk area of investing and potentially a giant bubble.

I have a different opinion.  I personally feel that investing in commodities is the only way to ensure in the coming years that your portfolio is not decimated by hyper inflation.

The Present State of the US Economy

Before we discuss this further, we need to do a quick summary of the present state of the US (world) economy:

1.  Ben Bernanke is printing money as fast as he is able.  As a result, M3 money supply is expanding at close to 20% per year.  Inflation, literally an expansion in the money supply, is running at close to 14% per year, as calculated using a basket of goods with no hedonics and weighting adjustments.  Clearly, we have managed to export some inflation.  However, I believe that is rapidly coming to an end due to the loss of confidence in the US economy and the pummeling the US dollar is taking.

2.  A flight to quality is depressing bond yields, with real yields that are NEGATIVE, even according to the government’s own crooked CPI.  Bond fund managers are calling for bailouts (at the expense of the US taxpayer).  Low yields were supposedly a result of petrodollar recycling and the yen carry trade.  The strengthening yen and diversification away from the USA suggests this binge is now over.

3.  The Fed is now willing to take the rubbish paper sitting on the books of large financial institutions and give them “liquidity” in return.  In effect, the Fed is buying these bonds for their face value, even though they know many are drastically overvalued if not worthless.  The US taxpayer is again left holding the bag.

4.  If we examine the Federal Government, we see overspending that is funded by thin air money creation (the Treasury floats some bonds and the Fed buys them with freshly created money).

5.  The Fed continues to lower the cost of money, slashing rates in attempt to create a positive carry trade for the banks.  Wall Street banks, and now brokerages, can borrow as much as necessary to bail themselves out.  This insidious practice is most detrimental to Mom and Pop investors who are unable to utilize the freshly created money until well after it has passed through the hands of the financial sector.  With the money supply increasing at 20% a year, it is the rare average Joe who is experiencing an increase in salary to compensate for their decreased purchasing power.  In fact, given the weak economy and the layoffs in the real estate and financial sectors with the consumer discretionary sector to follow, it is likely that wages will stagnate until the public wakes up to hyperinflation.

All of these actions are achieving two things:

1.  the death of US dollar; and

2.  a rise in the price of everything tangible (aka commodities).

This is very bad news for the US consumer.  Gold and oil have both appreciated a huge amount when priced in US dollars.  However, to the rest of the world, the price increases are partially offset by currency appreciation and perceived wealth due to inflated housing markets.

In effect, the standard of living of the average US consumer is DECREASING relative to the rest of the world.  For the past century, US consumers have helped themselves to a supersized portion of the world’s goods and services.  This was justified as the US was an industrial powerhouse.  Today, most production has been outsourced, leaving the US to sell services.  Ask yourself this – how many people do you know who are selling services compared to making products?  How many of those making products work for the auto industry?  What value do you think someone in the European Union places on an US accountant, lawyer or real estate agent?  More than a Chinese built toaster?  Less than a South Korean built plasma tv?

The falling dollar and high rate of inflation act as a tax on the US consumer.  As we all know, a tax increase slows the economy – decreasing consumption (Keynesian economics) or savings and investment (Austrian economics), depending on your world view.  We have seen the economy falling off the rails for months now.

While commodity prices have increased, firms have attempted to slow the rise in prices to maintain consumer demand.  As their margins narrow, expect to see a decrease in corporate profits.  We have already seen this with refinery crack spreads and food prices.

As a result, the full inflationary effect of all the “liquidity” trickling down from Wall Street to Main Street has not yet been seen.  All of these factors point to a sorry state for the US economy, and the world economy by extension.  “Stagflation” is here again.

Why Commodities?

Now that we have placed things into perspective, why should you invest in commodities?

Firstly, and most importantly, you cannot create commodities out of thin air.  Unlike the money supply, commodities require an investment of physical effort to create.  Imagine the entire GDP consisted of a single apple and the money supply was $10.  It is easy to work out that the apple would sell for $10.  Now imagine the Fed takes a piece of paper, writes $100 on it and marks it as official legal tender.  An investment bank would now purchase that apple for $100 and sell you a sliver for your $10.  We are at that point right now.  You have a decision to make – which would you rather own?  The apple or the $10?

Now replace “apple” in the last statement with “ounce of silver”.  One ounce of silver last year sold for ~$12.  Today is sells for over $20.  Has the ounce of silver changed?  No.  Has the value of paper money depreciated relative to the silver ounce?  Yes.  If you can purchase 10 loaves of bread with one ounce of silver now, you can bet that in 5 years time, in 10 years time, in 100 years time you are going to be able to purchase about the same quantity for your silver ounce, regardless of its face value in terms of “paper money”.  There will be fluctuations – in good times the value of silver will be lower, in bad times higher, but the inverse is true of almost every asset class.

Secondly, in most cases, “demand” for the commodity results in its destruction.  The apple is eaten.  Copper becomes part of the toaster and plasma tv mentioned above.

Thirdly, a difficulty in stockpiling (imagine how difficult it would be to store copper worth $1M compared to an electronic bank account) hinders manipulation in the commodity itself relative to the financial markets.  Very few individuals own the necessary warehouse space to store large volumes of any commodity, with the exception of the precious metals.  Doing so has costs with no yield.   It is true that markets can be manipulated through futures, but the majority of open positions are closed prior to settlement to avoid taking physical delivery (most futures dealers will do this for you automatically and do not allow physical delivery to occur).  Futures are generally available for every month, ensuring that markets are renewed repeatedly.  Attempts to “corner” the market in assets such as silver and copper have generally been disastrous.  Recently we saw such an attempt in natural gas that resulted in a hedge fund blow up and a depreciated price wiped away relatively quickly.

In short, the increase in copper from less than $1 to greater than $3 per pound is not due to manipulation, but rather supply and demand.

Lastly, the bull market is still young.  While a growing number of people talk about the commodity bull run, many are still invested in financial assets or real estate.  Each commodity normally has only a small number of companies in production.  Physical delivery of precious metals is rare.  A 25 year bear market has taught many individuals to stay clear.

Have you ever stopped to wonder why Cortez was so entranced by Aztec gold or why pieces of eight (silver coins) were a store of wealth for hundreds of years?

What and How to Invest?

In the event you are even slightly concerned about hyperinflation and want to protect your purchasing power, you should take action to ensure that around 5% of your wealth is stored in hard currency.

In short, take physical delivery of gold, silver, platinum or palladium.  As a secondary hedge, purchase some stocks who are early to mid stage producers.  Examples include Chesapeake (natural gas), CNOOC (oil), Pan American (silver) and Yamana (gold).

As another option, you can purchase the oil, natural gas, gold or silver ETFs, or invest in a broader basket of agricultural or industrial commodities.

Futures are risky and the use of leverage can blow up in your face.  However, there is no requirement for you to use the ~10 to 1 leverage.  If you had $10,000 to invest, you could purchase a contract for 100 barrels of oil for delivery in December of 2010, rather than ten contracts for 1,000 barrels.  That way you can hold through a 10 or 20% correction without forced liquidation.  If you want to take some extra risk, wait for a pull back (to say $90 a barrel) and buy two contracts.

Conclusion: Depression?

Lastly, and on a slight tangent, history shows that approximately every 100 years the world witnesses a depression.  This is normally the result of government intervention that pushes a recession over the cliff.  The last depression occurred in the 1930s.  The majority of the people who experienced the depression were so scarred, they hoarded food for the rest of their lives.  They hated debt and purchased precious metals to prepare for the next depression that never came.  Many maintained their own garden to have some control over their food supply.  Their children, the baby boomers, were less risk adverse but still heeded the lessons of their parents.  Their grandchildren, generation X and Y, have only a mild understanding of what a depression is and how bad things could become.

The world will face many challenges over the next decade – peak oil, peak natural gas, peak coal, record low supplies of foodstocks such as wheat and corn despite record production for the last decade, the retirement of many workers with the most experience and knowledge, and a population projected to increase by 50% by the end of the century.  I think it is prudent to prepare for the Black Swan that could be around the corner.

As always, good luck.

Phil

Disclaimer:  The author owns shares in all four stocks mentioned and silver and gold bullion.

This post is for entertainment purposes only. No part of this post should be construed to constitute investment advice. The author is not an investment professional and assumes no responsibility for any investment activities you undertake. Prior to undertaking any financial decisions, you should contact an investment professional.

Nice article Phil. You summed it up well, with the dollar losing its value with time and no longer being backed up by gold, commodities will become increasingly interesting to investors as investments but also as hedges against inflation. Precious metals may well become even more precious.

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