Finding Underpriced Assets in a Monetary Crisis

Regardless of what side of the inflation/deflation debate you're on, one thing is certain: false forms of value are being destroyed and there is a "flight to safety" -- safe ways of preserving purchasing power. In our current environment, this has caused the US dollar to strengthen in the second half of 2008, and US government treasury bonds to rally as well.

So what does this mean for commodity prices? To answer this question, we will need to understand the origins of money.

The Origins of Money

Long, long ago, before the advent of paper money, people bartered goods. In other words, if you made shoes and I made pants, we might be able to work out a trade in which you would make a pair of shoes for me and I would make a pair of pants for you. In this way we would both be able to increase our wealth.

Of course, what if I wanted shoes but you did not need pants? We might then be able to have difficulty in making a trade. Unless, of course, you were able to accept my pants and trade them with someone else who wanted pants. And that is precisely what began to happen as economies developed. In such an environment, what became money was simply the most easily traded commodity. Such commodities typically had a few attributes:

1. Durability -- did not deterioriate over time, thus allowing wealth to be accumulated and an economy to be built on savings
2. Divisibility -- easily divided, thus enabling transactions of all sizes
3. Recognizability -- so that people could accept it as money with confidence
4. Portability -- so that people could take their money with them
5. Scarcity -- because too much of it would encourage speculation and making savings difficult

Many commodities were tried as money, though in the end, two stood out as clear winners: gold and silver. Thus you will sometimes find passionate gold and silver investors who say "gold is money."

What This Means If You Believe Deflation Is a Concern

If you view the crisis as deflationary in nature, the asset classes most appealing to you will be as follows (listed in order):

1. Real cash -- i.e. US dollars, euros, etc
2. Government issued bonds
3. Precious metals 4. commodities 5. consumer goods 6. real estate 7. financial goods (stocks, bonds, derivatives)

Deflationists argue the supply of paper, government-issued money in the economy is contracting, and thus it is not in danger of being devalued by excessive supply -- and so its purchasing value will increase as the market moves to find real stores of value.

What This Means If You Believe Inflation Is a Concern

If you believe inflation is a concern -- meaning that the government has excessively expanded the supply of paper money in the economy -- then the asset classes of choice will be as follows:

1. Precious metals
2. Commodities
3. Consumer goods
4. Real estate
5. Financial goods
6. Real cash
7. Government bonds

Of course, this would depend on how much inflation there is -- cash would higher on the list in the event if there is not much inflation. And with respect to financial goods, those correlated to healthy companies will be higher on the list.

How to Trade This

The easiest way of trading this is to trade asset classes against each other; for instance, if you're a deflationist, going long cash while shorting financials (which simply amounts to selling stocks and holding your money in a bank account). Conversely, you can look for potential arbitrage opportunities in which the market is not behaving as macroeconomics would posit that it does.

In our current times, for instance, commodities have fallen more than financial assets; the chart below shows the SPY against DBC (an ETF tracking an index of commodities). Commodities, represented by the blue and gray candles beneath the red and green candles, have fallen 16% more than the S&P over the past 200 trading days.

For this reason, many investment advisors are quite bullish on commodities, citing it as some of the best buying opportunities.

click to enlarge image

Of course, as the old saying goes, the market can stay irrational longer than you can stay solvent, so such strategies looking to take advantage of economic inconsistencies may benefit most if coupled with trend-following technical analysis.

Disclosure: Long gold and silver.

Comments

[H.J. Huneycutt:]

This is a great article. I now have something to reference every time someone says "gold has no value!" :)

Though, I'd argue that if inflation does hit, commodities might benefit more than precious metals. Precious metals are less volatile and hence, haven't been beaten down as much as other commodities. Meanwhile, precious metals do provide more safety than commodities (at least gold does --- I'd argue that silver is part industrial metal).

Jan 13 08:25 AM

[GMiki1:]

Oil is underpriced. I see on CNBC they say we're awash in oil because some companies are storing oil on tankers. However, they're doing that because the prices later in the year are slated to be much higher--am extreme contango. Depletion rates for oil are at 9.1 percent according to the International Energy Agency.

This week gold is shedding value due to the odd rebalancing of the commodity index funds. Next week? Gold could go up or even down (Jack Crooks et. al. say so). Are you in this for the long or short term. And in what forms? I see the gold and silver stocks are up today. Go figure.

Jan 13 11:29 AM

[Smarty_Pants:]

Informative article.

One potential difficultiy in playing SPY against DBC is that the pricing on the components of DBC (crude oil, heating oil, aluminum, gold, corn, and wheat) are in large part influenced by factors unrelated to changes in the monetary environment.

The price of wheat and corn can rise or fall based on changes in expectations regarding weather as can prices for heating oil or crude.

Just because both indices have fallen together over 'deflationary' concerns the past few months (there was also a bit of deleveraging going on in a scramble for cash), doesn't mean that they could decouple and move independently in the future. Bumper crops or fair weather could drive DBC lower at the same time SPY recovers, providing losses on both sides of a deflationary spread trade.

The correllation may be temporary. It's not a pure deflationary play.

Jan 13 11:42 AM

[Perki:]

Interesting article. I believe Gold became a standard because everyone agreed it was a standard -- which is the nature of any standard -- people agree or believe it is so.

Much like the American dollar has been a standard. Now really finance is all a faith-based exercise. I BELIEVE that my bank will return my money when I ask, I BELIEVE gold is a rock-solid-over-the-ag... standard of value. I BELIEVE the dollar is a safe-haven because the US Government is standing behind it, etc.

The issue we have now is that the things we have believed are safe are showing us otherwise by falling like a string of dominoes.

Gold is not immune from this questioning. Pants and shoes though, may have REAL lasting value. Well, as long as it is fashionable to wear them.

Jan 14 11:05 PM