The U.S. government is spending money they do not have. Last year the government borrowed 49 cents of every dollar they spent. A new entitlement for national health care has just been enacted on top of underfunded social security, medicare and medicaid mandates that will suck the lifeblood out of the economy. Over time it will become obvious, if it isn’t already, that tax revenues will not support the spending that is mandated.
To move past the politics of these actions, we only have to look to other developed countries to see they have the same problems. European countries have larger social programs that have been put in place over the last fifty years. The U.S. has now burrowed deeper into the social compact pile of rewarding the less fortunate and the lazy.
How do you invest like a contrarian with today’s global pressures on currencies, energy, and a very real fear of inflation? How do you put all the pieces of the puzzle together to anticipate where the next opportunity will be?
Since all the world’s developed economies are in the same boat, who can still float? The U.S. Who will get thrown overboard? Greece, Spain, Portugal and others in descending order, as bond vigilantes work their way down the food chain. We know this will happen, it already has started. We know the U.S. is in the same boat because, according to Bloomberg, the U.S. now pays a higher interest rate on two year notes than Berkshire Hathaway (BRK-A), Proctor and Gamble (NYSE:PG), Johnson and Johnson (NYSE:JNJ) and Lowe’s (NYSE:LOW). Bond vigilantes consider the credit risk of big box Lowes Home Improvement Centers less than the U.S. congress and Treasury. Of course, none of the private companies can print their own money to inflate their way out of debt.
Let us suppose that bond vigilantes move to the safest sovereign debt. They move to U.S. Treasuries. This holds interest rates down on U.S. debt compared to other countries. This buoys the value of the U.S. dollar verses other currencies.
There are two inputs in the pricing mechanism for global commodities, supply/demand and currency valuation. A stronger currency means lower commodity prices in that country. A strong dollar means lower commodity prices in U.S. dollars relative to other currencies regardless of supply/demand considerations.
We feel crude oil’s price is not justified at the present time. There is a premium in place for the expected economic recovery. When bad economic news scares this market, we could see the price of crude drop substantially. A small bubble appears to be building in crude that could be pierced by a lack of confidence in economic growth.
There is also a premium priced into crude oil directly tied to supply/demand. What is the likelihood of a supply disruption due to global terrorism or unrest in the Middle East? This premium can rise and fall quickly based on the daily news. We call this the “Ahmadinejad premium.’ Because of this ‘wild card’ we never short crude oil. If you must play here, only use put contracts so you know the exact amount of your potential loss when you open the trade.
If precious metals move inverse to fear of inflation and currency valuation, we can expect precious metals to move lower in U.S. dollars. We can also look at the historical relationship of oil vs. gold. How many barrels of oil does it take to buy one ounce of gold?
This chart of the price of gold divided by the price of crude oil tells us oil is cheap compared to gold. If oil is too expensive based on present demand and future economic projections, then gold has to be extraordinarily expensive.
This runs counter to popular thinking today, and that is called contrarian. Our recommendation, watch for any topping action and short GLD, SLV, AGQ, GDX and possibly TBT.
If we see a general market pullback that questions the economic recovery, bond vigilantes moving to U.S. debt and a stronger U.S. dollar; oil and gold could both fall precipitously. We think gold has farther to fall than oil and it does not involve the ‘Ahmadinejad premium.’
The success of today’s strategy will depend on timing your entry to one of the triggers mentioned. Again, look for a general market pullback because of news that involves the perception of a world-wide economic recovery, a stronger dollar and bond vigilantes favoring U.S. debt.
Disclosure: LONG TBT, GDX,BRK-B