Dr. Stephen Leeb's Instablog

All Roads Lead To Commodities

Wed, 11 Nov 2009 11:40:37 -0500

Three seemingly disparate news items last week strongly suggest that the investment world is bifurcating into commodity and non-commodity investments – or if you will long-term winners and long-term losers.

First, India's central bank announced that it had bought 200 tons of gold from the International Monetary Fund. That's half of the total amount the IMF had planned on selling. For a relatively small central bank to buy that much in one fell swoop is a big deal. It promotes gold from the status of a “barbaric relic” to that of an alternative reserve currency. Moreover, it leaves China – and other Central Banks – with egg on their face.

If India does not buy the rest (and they have not ruled that out) it is almost certain other Central Banks, Sovereign Wealth funds, all those who are underinvested in precious metals to join a prospective scramble for gold et al. that far exceeds what the IMF is willing to sell. No wonder. Money supply in so-called non-inflationary countries have climbed 15 fold in the past generation or so while the total value of all above-ground gold has only doubled.

But we are not just bullish on precious metals. The second announcement was Warren Buffett's biggest investment of his career...

BUFFETT'S BET ON AMERICA (READ COMMODITIES)

Ten years ago, if someone had suggested Warren Buffett would pour nearly $26 billion into a capital-intensive company in the middle of a recession almost everyone on Wall Street would have laughed out loud.

Yet that's exactly what he did last week when he purchased Burlington Northern railway outright. In fact, it is the biggest purchase Buffett has ever made.

We have to confess we made an error. Some time ago, we discussed Buffett's interest in Burlington and described it as a company leveraged to commodity prices.

When we recently did a search for companies that, over the past ten years, had annual returns of 10% or more, Burlington made the list. However, because its returns were so outsized, we dismissed it as an anomaly. Turns out those returns may not have been anomalous.

According to his own words, Buffett's intent was to place a bet on America. Maybe so. But he's not betting on the U.S. stock market. He's betting on commodities.

Burlington Northern is leveraged to commodities in several ways. Commodities are its primary cargo. It also benefits from higher oil prices because railways use fuel more efficiently than trucks. Plus, if we compare Burlington's stock to the performance of the stock market and overall commodity prices, it clearly tracks commodities far more closely. As our chart indicates, BNI is a leveraged bet on commodities – and at least in terms of stock performance is completely divorced from broad market averages.

Last week's third important news item was the rise in unemployment to 10.2%. Even more striking is that the underemployed rate (which includes those who have only found part-time work or given up looking for work) now account for 17% of the population. That's 1/6 of all the people in America who can't get a job.

Why is high unemployment good news for commodities? Because it means that unlike 2008 the Fed will not be able to check the inflation that higher commodity prices engender. Keep in mind high commodity prices whether oil or copper are both inflationary and deflationary. Circa 2008, if you try to fight inflation you risk deflation. On the other hand, if you fight deflation by stimulus and more monetary easing, commodity prices go higher still. This potential vicious circle is likely one reason precious metals are rising in synch with other commodities.

Put all these announcements together, and the conclusions are pretty clear...

THE AGE OF COMMODITIES IS AT HAND

The investment world from now on will be increasingly dominated by commodities – both industrial and precious. The signs are all around. Gold hit another new high this morning at over $1,100 an ounce. Oil is about 150% above its lows. And while some like to argue that this is the result of speculation, the same certainly can't be said for iron ore, which has been on a similar bull run these past ten years. Iron prices are negotiated between producers (Australia and Brazil) and users (most notably China), with no element of speculation. Why would oil or any other surging commodity be any different?

The authoritative IEA will soon lower its expected growth in demand for oil. This is not a positive for it simply says we can only consume what we have – and in terms of oil it is much less than the world has been led to believe. And this is still another reason to believe that worldwide growth will be ever high commodity prices.

For the foreseeable future the real money will be made by either direct investment in commodities or investments that are leveraged to commodities. Buffett, for instance, bought a railroad rather than a silver mine. If you want to enjoy high returns, you want either indirect or direct investments in commodities.

One way to do this is to invest in resource-rich countries as well as particular commodities through the vehicle of exchange-traded funds (ETFs): for example, GLD for gold, SLV for silver, EWZ for Brazil, EWC for Canada, EWA for Australia, and FXI for China.

One speculative stock we like (if you can call a company with a £12 billion market cap speculative) is Eurasian Natural Resources (EURNF.PK). The company is located in Kazakhstan, which is extremely rich in resources (including iron ore) and only a train ride from China. In fact, we would not be surprised to see China make a bid for the company, especially with India getting out of the iron ore export business.

Sleeping With The Jaguars

Mon, 05 Oct 2009 16:12:45 -0400

The end of last week brought two important announcements, both of which are relevant to our investments, though not terribly cheerful.

The first of these is the latest report on employment from the Bureau of Labor Statistics. It could not have been worse. The horrific details included a larger than expected decline in employment, both in terms of payroll data and household surveys. Unemployment is nearly 10%, if you don't include people who are underemployed or who have stopped looking for work. (If you do include them, the rate could be closer to 17%.)

You may recall that, back towards the middle of this year, everyone was talking about positive second derivatives. This is a nifty bit of calculus/desperation that claimed that, while things were getting worse, they weren't getting worse as quickly.

Unfortunately, Friday's employment report was clearly a negative second derivative. Not only were the numbers worse than expected, they were worse than the previous month's. Whatever forward momentum the economy has, if any, seems to be much less than previously thought.

Oddly, the market did not sell off very much in response to this news. It seems the driving force behind stock prices today is not fundamentals so much as liquidity. So long as that remains true, overvaluations notwithstanding, we cannot accurately call a top.

Our long standing view remains the same, however. The downside risk today dwarfs any upside potential. Sure, prices could rise a little more, but we feel it's only prudent to take a cautious approach over the near term.

As for the other piece of news, you'd think the IOC must have read last week's update...

IN THE SHADOW OF BRAZIL

On Friday we had the announcement that the 2016 Olympics would take place in Rio de Janeiro, Brazil, rather than Chicago. This decision came despite President Obama's last minute plea to the International Olympic Committee.

The Olympics have evolved into serious business since their revival in the 19^th century. A host nation must spend enormous amounts of money to create suitable facilities for the games, in return for which it receives a tremendous economic boost to its economy that persists for many years after the actual event. Certainly, the U.S. economy could have used the help. But then, the Brazilians probably feel they've been poor for too long themselves.

We should note that Brazil's victory comes at the expense of not only the U.S. but also Spain and Japan, two other developed nations. It perfectly symbolizes the passing of the baton from the developed world to the developing world that we discussed in last week's update.

Of course, there's a lot to celebrate in the land of the Jaguar these days. This year, Brazil's economy will likely post positive growth, followed by a 5% gain in GDP in 2010. These are much better results than the U.S. economy can hope to see for some time, a further sign that the developing world may soon surpass the West. When that happens, will Latin America still be “the U.S.'s sphere of influence,” or will we find ourselves sleeping next to a newly invigorated Jaguar? But that's still a way down the road.

As for how to make money during this transition...

COLD WINTERS FOR THE DOLLAR SPELL GOOD TIMES FOR ENERGY

One other recent event worth noting is the G20/G7 meeting. In their public statements, this group has shown a certain reluctance to say that the decline in the U.S. dollar has been overdone. In other words, don't count on them supporting the dollar going forward.

Loss of dollar support is certainly positive news for gold.

A declining dollar will also be positive for oil. But there is something else in the wings that could dramatically accelerate an already sure uptrend in energy prices. We are talking about global warming or the lack thereof. Global warming has become a well entrenched ideology among scientists. Increasingly, however, the consensus view states that the next 10 to 20 years could actually be a cooler period within a long-term warming trend. We could see colder winters and lower average worldwide temperatures during this time. But according to the scientific community, a generation of colder temperatures is not reason to turn up the thermostats.

We have always had trouble with zealots whether they be Scientologists or ivory tower ideologues. And global warming is no exception. A few experiences and recent articles make me especially skeptical.

In the summer of 2008 I attended a conference hosted by Accenture in Rio. Sitting next to me for a good part of this event was the head of the National Oceanic and Atmospheric Administration. This man was a Naval Admiral and a Harvard Ph.D. in applied math. He struck me as a soft-spoken, level-headed, plain-speaking man – certainly not someone inclined towards hyperbole. In addition, as his assistant informed me, he was very thick-skinned.

Turns out he had testified before a Congressional committee on the subject of global warming. His frank answer to the Chairman was that there was not enough evidence to conclude global warming is taking place. The Admiral took a lot of verbal disrespect for expressing such an unpopular view, but his expertise in weather patterns cannot be denied. Nor could the lack of expertise by the Senator who lambasted him.

In light of the data suggesting we may experience a cooler period, I find myself more respectful of the Admiral's view.

I was also struck by a recent article in the August 2009 issue of Science in which scientists found it nearly impossible to incorporate the effect of the sun into climate models. Variability and system feedbacks seem to have a bigger influence on temperatures than the sun's radiation, even though we clearly get most of our heat from the sun.

Well, being unable to determine the sun's role in a climate model is a bit like excluding the role of rainfall from agriculture.

Our point is that we cannot assume the global warming theory is complete and proven. All we know is that we are likely to experience some colder winters in the years ahead, and they will in turn affect the demand for energy.

Colder weather will certainly up the demand for natural gas, oil, and coal, which will in turn drive up the prices of these commodities.

Energy prices are correcting at the moment, as they usually do between the driving season and the heating season. However, if we have a cold winter, we can expect gas and oil prices will be bid up substantially within the next 2-3 months. If people start to realize that cooler winters are a long-term scenario, energy prices may receive a long-term bid as well.

Once again, this bodes well for Brazil, a country which is a net energy exporter. It will impact other developing countries which will be consuming commodities hand over fist. And it will affect the U.S., where year-over-year energy prices show a positive gain despite the recent correction. By the start of next year, energy prices could easily be up 100% y-o-y. In the past, such a high rate of change has always signaled trouble for the stock market and the economy. If it happens this time, in the context of high unemployment, the impact could be worse.

Clearly, you should own energy stocks such as Schlumberger (SLB), the leading oil service company, Transocean (RIG), the leading deepwater driller, and others in our portfolio. The entire energy patch could see extraordinary gains in the years ahead – the result of a long-term trend that could force Al Gore to return his Nobel Prize.

The developing world takes over

Tue, 29 Sep 2009 12:07:49 -0400

A couple of economic statistics released last week suggest the economy may be growing more slowly than expected/hoped/prayed. These included a slowdown in housing and weaker durable goods orders (now that the cash for clunkers program has ended).

However, the biggest event was the G20 meeting in Pittsburgh, in which it was decided that the annual summit of the G8 (an organization of the world's top 8 developed economies) will now be replaced by a meeting of the G20 – a group that includes many of the developing and resource-rich nations I've been bullish on. This passing of the baton signals an important change in the world.

The days of U.S. hegemony have ended. Political power is shifting from Europe, Japan, and the U.S. to Asia, South America, and other developing nations, in recognition that economic power has gone the same way. In terms of goods produced, Chindia's economy has surpassed that of the U.S. The economy of the entire developing world now equals the entire developed world. And given the huge population of the developing world, we must conclude its growth potential far exceeds ours. If we ever get back on top again, it won't be for a very long time.

We've talked before about what this change implies. The developing world's voracious appetite for commodities promises to act as a tax on the developing world – pushing up prices to new heights and choking growth. Oil and some commodities may have corrected recently, but even another 10%-20% decline will only be a buying opportunity. As long as worldwide growth remains positive, commodities will be in a long-term bull market.

What's more, this change will have a more subtle but important impact on stock market returns...

MOVE OVER ENGLAND AND ROME!

THE U.S. TAKES A SEAT ON THE “FORMER CENTERS OF THE WORLD” BENCH

If you've been told you can expect to make 10-12% a year from an index fund, think again. The stats don't back up such creative spin.

People who talk about the long-term average return on stocks generally rely on some 83 years worth of data. A few people trace market history back as far as 1804, but it's not clear whether stats from back then are reliable enough or standardized enough to base conclusions on.

Nonetheless, whether you start from 1804 or 1926, all the data on long-term stock market performance is based on the U.S. Moreover, they cover a time when the U.S. went from being a developing nation to king of the developed world.

When looking at this data, you must realize that the U.S. did not grow at the steady pace suggested by the long-term average. In the developing phase, growth was far more rapid. But as our economy matured, growth began to slow. Therefore, as an 83 or 205-year-old economy, the U.S. is unlikely to ever enjoy the pep and vitality it did in its youth. Nor will it likely become the fastest growing nation ever again, not when there are young whippersnappers like China and India running against us.

True, between 1970 and today, the growth rate of the U.S. exceeded that of the equally mature, developed nations (excluding Canada) by about 0.5% a year. We were the best of the old-timers.

However, during this period, average real returns from stocks were far less than in the 40 years before 1970 – despite the Great Depression of the 1930s. We had reached middle age and didn't realize it because the developing world was still in diapers. But the U.S. and the rest of the developed world were past their prime.

Now, it's not impossible that in the future the U.S. could regain some of its former influence. Kind of like a spry octogenarian who still has a few tricks up his sleeve. However, as we become a smaller piece of the global economy, we are losing status. With power shifting elsewhere, the U.S. will have to accept other nations' terms more often and dictate terms a little less. Consequently, our stock markets probably won't produce the same high returns everyone has been raised to expect.

Indeed, rather than plan on the long-term average returns continuing, we must recognize that real returns have been in a slow decline for 40 years (the late 1990s being just a bump in the road).

As investors, our path is clear...

DON'T BET ON GRANDAD

If we could give you one overriding piece of advice for the next few years, it is to avoid index funds or any other strategy that replicates the return on the S&P 500. We simply cannot see any scenario in which that would pay off well. Of course, there are many money managers who don't come close to beating the market, so an index fund might outperform the laggards. But if you want to get rich, you'll need to beat the S&P by a wide margin, and that means investing elsewhere.

We've said before that the economy seems destined to experience further bouts of either high inflation or deflation. It's hard to say for sure which. Curiously, whichever one you hope for depends a lot on your financial status.

If you're a financial institution, for instance, or simply very wealthy, you will probably hope for deflation. During the Great Depression of the 1930s, stocks, bonds, and T-bills all posted fairly decent returns. Certainly, they were more profitable than in the 1970s when inflation ruled. So if you're living off your financial assets, deflation will seem more appealing.

On the other hand, if you are struggling to raise a family in an economy where jobs are scarce, deflation is your worst enemy. Consequently, the majority of voters will find inflation more bearable, which is why we expect the government will err that way.

Yet, since we don't know for certain which of the two 'flations will result, we must find security in either event. Which brings us to the subject of gold.

Since 1971, gold bullion has returned an average of 9% a year – roughly equal to the long-term return on the international stock markets. In the more recent past, gold has outperformed every other major asset.

What makes gold's performance in the past four decades especially impressive is that it took place during periods of both inflation and deflation.

So gold is more than a hedge. It's an asset class of its own, and one that deserves a heavier weighting.

(An example of a hedge would be zero coupon bonds, which protect you even better than gold against a deflationary event.)

As for stocks, apart from avoiding index funds or any other overly diversified approach, we will steer you towards companies that can thrive in either inflation or deflation. We are looking now at companies which have dramatically outperformed over the last 10 years, produced strong double-digit returns, are sound enterprises, and retain the fundamental advantages they have enjoyed in the past. Since these companies thrived in both inflationary and deflationary periods, they have a better chance of thriving going forwards.

Some obvious examples of such companies are Apple (AAPL) and our recommended defence stocks. Stericycle (SRCL) has the advantages of being a deep franchise in the growing area of medical waste. Another curious success story is FPL, which is one of the few utilities to produce double-digit returns.

But whatever you invest in from now on, bear in mind that times have changed. You cannot depend on the past as a reliable guide to the future. Just like you wouldn't expect Muhammad Ali (now age 67) to win the heavyweight title again, don't expect the U.S. market to outperform the rest of the world. You must look at who's up and coming now.

No simple solutions to real life investing

Mon, 21 Sep 2009 17:15:29 -0400

At my annual medical exam last week, my physician told me something that blew me away. Twelve months ago, when I last saw him, he advised me to take selenium supplements. Selenium is a mineral which can be harmful in large doses. In fact, too much can cause side-effects such as hair loss, lethargy, etc. However, your body does need a small amount of selenium for healthy cell functioning. More to the point, many studies in the past suggested that selenium could inhibit the growth of prostate cancer cells. Consequently, physicians across the country have been telling men my age to take a little extra selenium. I followed my doctor's advice, and have been taking selenium for the past year, in addition to some other nutrients such as Vitamin E, which he also recommended.

Last week, after telling me I was in pretty good shape, my doctor told me to stop taking the selenium. Apparently, a new, very large study has been released in which thousands of men were given selenium and Vitamin E over a five and a half year period. The study found that neither of these supplements nor the combination of both reduced the incidence of cancer. In fact, the only thing taking these supplements may have done was give me an alternative explanation for why I lost a little hair and felt tired at times. (Until then I had just blamed the economy.)

Having a background in research, I decided to look up the studies myself to see why the new study produced such different results. Turns out we really can't blame doctors for having recommended these supplements in the past. The early studies certainly did look promising. The problem was that the old studies were done in vitro, meaning in test tubes, while the new study was performed in vivo, meaning with real life patients.

What happens in a living human body, unfortunately, can be a lot more complicated than what happens in a test tube. And while test tube studies can identify new relationships by looking at processes in isolation, those relationships don't always pan out in real life, where many other factors are involved.

So it is in the world of economics and investment...

WHY OIL DOES NOT MARCH TO ITS OWN DRUM

Economies, like living bodies, are highly complex. As investors, we have to be careful not to look at any one relationship in isolation and make it the be-all end-all. As much as possible, we much stay aware of the interplay between many different relationships and trends.

For instance, let's consider our old friend oil, which is always in the news these days. Today, so far, it's dipped under $70. In honesty, it could fall as low as $60 – temporarily – especially if worldwide growth is weaker than expected. Long-term, of course, I expect oil prices will go much higher. Nonetheless, you will often find oil industry experts extolling ways in which oil prices will stay low, despite rising worldwide demand.

The problem is that experts often overlook the fact that oil does not march to its own drum. One example that comes to mind is a recent article in Scientific American by a Vice President of Eni, a leading Italian oil company. The article makes the familiar case that new technology and conservation might help us stretch out the earth's oil supplies for the remainder of this century.

Like other writers, this VP looks at oil production in isolation. He ignores the interrelationships between oil and other commodities and the role emerging economies will play. Because it takes commodities to produce other commodities, oil is intertwined with a host of other industries in a complex array of relationships. Oil prices depend not just on the global supply and demand for energy, but on the fundamentals of water, copper, iron, nickel, etc. Not to mention emerging market growth, population growth, geopolitics, and other factors. Stress on any one of these factors increases stress on the others.

For instance, another article I came across recently points out that 1.3 billion people today – 4X the population of the U.S. - live on roughly $1.25 a day. Try telling them, from the comfort of your Chevrolet Equinox, that they must limit how much oil, potash, or any other essential commodity they can consume!

Truth is, those poor people are desperate for economic growth to improve their lives. And the only way they can have growth is to ramp up commodity consumption – adding infrastructure, building factories, and ramping up production of goods. You'd do the same in their shoes.

In fact, we really can't have worldwide growth without higher consumption of all commodities. From now on, you can expect to see prices of all commodities rise and fall (but mostly rise) in lockstep with each other.

Bottom line: stay invested in commodities if you want to benefit from global economic growth. Use dips, such as the one which may be shaping up in the commodity pits at the moment, to add to your positions in companies like Potash (POT), BHP Billiton (BHP), Schlumberger (SLB), and others in our portfolios.

And let's not forget...

THE NEXT GEOPOLITICAL TROUBLE SPOT?

We generally separate gold bullion from other commodities because gold functions as a currency more than a commodity. It's more of a savings vehicle than a raw material to be used up. Because the world is complex and risky today, it is all the more important to invest in the ultimate hedge against disaster, which is gold.

Gold makes even more sense when we consider what's currently taking place along the Saudi/Yemeni border. The popular press hasn't picked up on this yet, but it has serious implications.

Yemen is one of the world's poorest nations. For the past five weeks, rebels in the northern part of Yemen (which borders on Saudi Arabia) have been fighting government forces. In their struggle, the rebels are supported by al Qaeda, even though the rebels are Shia Moslems and al Qaeda are Sunnis. Apparently, the particular Shias and Sunnis in this campaign have decided they have a common target of destabilizing Saudi Arabia.

(Not surprising, rumors are floating around saying that Iran is also providing aid to the rebels. A weaker Saudi Arabia, with its oil reserves, would be an easier and more valuable takeover target for Iran than, say, Israel.)

We can't predict the future, but we can imagine the damage the world economy would suffer from an even less stable Middle East.

One final situation that concerns us is the lack of positive signs from the leading economic indicators. This morning's figures show another month of gains, but only in 60% of the indicators. No recession since the 1960s has ended without at least one month in which 100% of the indicators showed gains. The danger is that the market, which has been betting on a vibrant recovery, could be disappointed.

Because the headwinds today look stronger than the tailwinds, continue to hold zero coupon bonds, in addition to gold, for protection against a downturn in the market.

P.S. My doctor has now recommended I start taking Vitamin D, which the latest research suggests can protect against certain forms of cancer. Like the informed patient I try to be, I looked up the studies on Vitamin D (which were positive) and am now taking it. I'll try to keep you posted on whether this supplement proves truly beneficial over time.

Real Defensive Stocks

Mon, 14 Sep 2009 16:46:33 -0400

Readers often ask us why we continue to recommend investing in the defense industry. Actually, we hold three defense stocks in our Growth Portfolio: Northrop Grumman (NOC), Raytheon (RTN), and CACI International(CACI).

Admittedly, the defense industry depends on government contracts, and casual observers might wonder if these will soon start to shrink. Given the extraordinarily high deficits the government is running up these days – including massive sending on entitlement programs, healthcare, corporate bailouts, and economic stimulus - surely even the most profligate politician will be combing the budget looking for areas where some savings can be made. Defense would seem to be a prime candidate for cutbacks, especially since the war in Iraq looks past its peak. However, defense stocks have a lot more going for them than meets the eye! Here's why...

THE DECADE OF TURMOIL

As we keep pointing out, today's investment climate is both stranger and more precarious than the one most investors cut their teeth on. Look at the previous four decades and you'll see why.

In the 1980s and 1990s, when the baby boomer generation started investing, stocks ruled supreme. Those were the decades of low inflation and reliable growth. It was the climate which all the long-term, buy-hold-and-diversify investors see as the normal state of affairs.

However, we cannot forget that things were quite different in the 1970s. That period was marked by high inflation, with the result that the top performing assets were gold, oil, and other commodities.

So far the 2000s have proven to be even stranger than the 1970s. Instead of inflation or growth, the dominant theme has been deflation. Consequently, stocks have been trumped by gold and zero coupon bonds.

Our point is that the last 40 years disprove the theories of Roger Ibbotson, Jeremy Siegel, and the like who look at long-term averages for stocks, bonds, and cash and project steady returns along the historical mean. Those theories ignore the fact that markets are seldom “normal.” What good are long-term returns if in the short-term you get whacked?

We don't know for sure what comes next, but we doubt it will be a return to the golden age of late 20th century. Accepting that financial markets are volatile and undergo large swings in direction, it makes far better sense to hedge against the most likely risks at the moment, while you seek returns from the strongest trends currently unfolding.

Our two top hedges continue to be gold and zero coupon bonds. Zero coupons protect you from deflation. Gold protects you from most financial threats, including both deflation, inflation, and one other which people are now starting to discuss (here's where we get back to defense stocks)...

THE RISK THAT WON'T GO AWAY

The U.S. dollar has lost a lot of ground versus the euro recently, prompting nations around the world to start demanding something to replace the dollar – whether gold, new reserve currency a basket of currencies, drawing rights, etc. They'd like to hold something in their treasury that will retain value better. Yet, it will take more than just a rising euro to dethrone the dollar.

You see, the dollar holds supreme as the world's reserve currency for one main reason. Oil is priced in dollars. As long as that's true and oil remains the world's most important commodity, the dollar will play an important role on the global stage. The dollar will survive despite fears of inflation, deflation, or any other turbulence.

Of course, you might wonder why oil is priced in dollars, especially since the U.S. doesn't export oil. Right now, oil-rich nations lose money every time the dollar falls. Why don't they start demanding to be paid in their own currencies or a basket of currencies, or even gold? (If they were paid in gold, their income would have risen four-fold over the past ten years.)

The simple answer is that Saudi Arabia, the world's largest oil producer, insists on pricing oil in dollars. They will not risk damaging the U.S. by changing this policy. In fact, they seem reluctant to make any major decision without U.S. approval. (We've even heard that some Saudi planes won't fly without first receiving a clearance code from the U.S. authorities.) The U.S. essentially controls Saudi Arabia through its control of the kingdom's defense, and the Saudis need us.

For instance, we recently came across an article regarding trouble on the Yemen-Saudi border. Apparently, Yemeni Shias have launched a rebellion and hope to drag the minority Saudi Shias into the dispute. In this effort they are joined by al Qaeda (ironically, since al Qaeda are Sunnis). The story isn't getting much attention, possibly because security and sovereignty violations are all too common in the Middle East.
Nonetheless, the story highlights how much the Saudis depend on the U.S. for defense – and how much we need to protect Saudi Arabia. A disruption in Saudi oil production would be a disaster for the world economy.

Bottom line, the U.S. needs to keep the oil flowing, which means we need to defend Saudi Arabia at all costs. In turn, the Saudis will make sure the dollar remains the world's reserve currency. We should be glad of this, because it means we pay less for imported goods and materials.
However, it also means the U.S. must maintain an overwhelming defense capability. So you can count on defense manufacturers staying profitable for a very long time.

If we had to pick a favorite defense stock, it would be Raytheon, which depends less on high end programs and has a lot of advanced technology. CACI makes much of the software the Defense Dept. needs (you can't get a job there without ultra-high security clearance). That gives the company major franchise value.

You don't necessarily have to buy our top three defense stocks. Nor do you need to weight defense as strongly as gold or zero coupon bonds. But making defense a component of your portfolio will protect you against the real chance of economic and geopolitical turmoil.

The only safe investment in uncertain times

Tue, 08 Sep 2009 16:49:03 -0400

The big question remains: will we experience inflation or deflation in the months ahead? The good news for investors in gold is that it doesn't really matter. Precious metals will do well in either scenario.

True, we have seen gold move more or less in step with the market of late. But the yellow metal has taken bigger strides. Despite the recent rally, the 12-month return for the overall stock market is negative 17%. Whereas, shares in gold miners - as measured by the Philadelphia Gold & Silver Index (XAU) – have gained 35%. That's a 52% outperformance for gold stocks.

Today, gold broke through the psychologically significant $1,000 mark for the first time since February. We're not surprised by this move. And while gold may pull back a little in the near term, we have little doubt the metal of kings will seek much higher heights before too long. In fact, we have far more faith in gold today than we do in the stock market or the economy.

That's why we're recommending everyone own a stake in gold, including this gold fund which we expect will easily outperform the XAU in coming months...

SIDESTEP THE ECONOMY, BEAT THE MARKET

Within the gold arena, both bullion and the large miners offer potential gains and protection from both the 'flations. However, the strongest growth potential can be found among the small to mid-sized miners that are rapidly expanding their reserves. The easiest way to get diversified exposure to this group is through the closed-end fund, ASA.

We like ASA because its top holdings are not the usual suspects – the handful of large blue chip miners such as Barrick, Goldcorp, and Newmont, whose growth potential is limited. ASA does invest in these three, but underweights them in favor of faster growing companies like Randgold Resources (GOLD) and Newcrest Mining (NCMGY). ASA even includes one of our favorite junior miners, Nova Gold (NG), which is developing one of the largest gold deposits in the world (located in North America). Nova has partnered with Barrick on the project, which pretty much guarantees completion.

Nova shares once traded at around $20, before being trammeled last fall, and the stock carries some risk. But we believe it will eventually surpass its former high, and that the safest way to get a piece of the action is to buy ASA.

Returning to the question of inflation vs. deflation...

DEFLATION – BUT ONLY IF THE GOVERNMENT NEGLECTS ITS DUTY

The Friday's employment numbers made a palpable argument for deflation. Despite today's massive stimulus efforts, U.S. unemployment reached 9.7%. If you count partially employed persons, the rate jumps to over 16%.

That's hardly the sign of a rapidly growing economy. In recent past recessions, unemployment did not get anywhere near double-digits by any measure. Obviously, we are seeing deflationary pressure at work.

Moreover, those who argue that unemployment has acted as a lagging indicator of growth in past recessions have missed the point. Unemployment under 7% can be a lagging indicator. But we cannot see one in six people unable to find work in this country in the same positive light.

We're concerned about the recent slowdown in M2 growth. M2 is the broadest measure of the money supply which the government dares publish today. Recently, the 3-month rate of M2 growth hit generation lows, while the 6-month rate is near zero. This is a clear sign that banks are afraid to lend and instead are hoarding their cash. Coinciding with consumers who are spending less and saving more, the lack of lending argues against economic growth.

We also feel dismay when we look at the bond market. In any kind of recovery, whether “V” or “U” shaped, bond yields should be rising. Yet they remain very low, contradicting the theory of “green shoots” and suggesting deflation could arise.

However, the case for deflation has one weakness. If the government wants to prevent deflation, it can. And it has every reason to do so.

Consider the recent “cash for clunkers” program. Rumor had it that many people in the administration expected this program to fail. Some of the President's advisers expected very few Americans would trade in their car to take advantage of it. Instead, it was a success, proving that no matter how badly a stock market crash affects the American consumer, he still can't resist the lure of free money.

As we near the election of 2010 and push comes to shove, the government will find it hard to resist launching similar programs that will boost consumer spending high enough to counteract the forces of deflation.

Given the choice, the government will always choose inflation over deflation as the lesser of two evils. We can see this bias reflected in the neglect of the U.S. dollar value. As the government stimulates the economy through deficit spending, nations around the world, including China, Brazil, Russia, and even agencies of the UN are losing faith in the dollar and calling for the creation of a new reserve currency. So far, the Fed has done little to counter this push.

Should the dollar actually be replaced, its value will drop substantially, resulting in higher prices for everything we import – an extremely inflationary event. Even if manufacturing started shifting back to the U.S. from China, we would have no way to protect ourselves from the rising global prices for oil, copper, and every other commodity. Higher commodity prices will act as a tax on the economy, requiring even higher stimulus spending to counteract. The dollar would continue to lose ground.

Of course, the Fed could elect to let the economy fall apart. The 1930s proved that might be good for the financial markets – which is the case for deflation – but it would be political suicide at the very least. Nonetheless, short bouts of deflation are quite possible, so you need to be prepared.

If you look at a chart comparing the performance of the S&P to gold and zero coupon bonds since the beginning of this decade, you'll find the 2000s were a great decade to own zero coupon bonds. Zeros doubled in value, while stock prices fell in both nominal and real terms.

Clearly, during this period the average investor feared deflation more than inflation. Zero coupon bonds did well because they offer protection against deflation.

However, you would have made even more money by investing in gold. No matter if inflation or deflation is the biggest threat, investors will turn to gold for safety. Gold thrives during uncertainty and financial turmoil. We've had plenty of that this decade, and we may get plenty more.

So even though gold may look pricey today at around $1,000, that price may seem dirt-cheap a few years from now. Of course, you should continue to own other investments, including our recommendations. But even if you only hold 10-15% of your savings in gold, you may be very well rewarded. It's the only investment that protects you from both the 'flations.

Slowly, the world will realize the days of American hegemony have passed. So have the days of growth without inflation. Now we have the days of turmoil in which the golden rule is “He who has the gold rules.”

Once again, almost any sound gold miner or bullion itself should do well, but we think ASA is the best bet for most investors.

Disclosure: Leeb Group, its officers, directors, shareholders, employees and affiliated entities and/or clients of such affiliated entities may currently maintain direct or indirect ownership positions in financial instruments (i.e., stocks, bonds, options, warrants, etc.) of companies or entities whose underlying exposure is in the companies mentioned in this article.