first majestic silver

The Winds of Change -- Depression 2009/10

I know that you are all getting confused, being bombarded from all sides by people a lot more eloquent, better writers and with much bigger reputations than me. The best advice I can give you is: Go back and check their records; see what they were saying last week, last month and last year. Your decision should then be easy

DISTORTED INFORMATION: There is not much point of rehashing what you are now reading in the news (history) papers and hearing in the media, except perhaps to remind you that you read it all here first, as early as two years ago. Wall St and the Media are just now waking up to the fact that the sub-prime Debacle is spreading to all forms of credit and that the write-offs by the financial institutions are really only just beginning (stay short the Financials) as one by one, yesterday’s superstars, such as Starbucks and the Financials, bite the dust. Why am I telling you the obvious? Only to reaffirm what I have always preached; that you must look at today’s headlines as being history and not news. Rather than extrapolating the past into the future, you must read between the lines and using the laws of economics try to figure what the effects of today’s events will have on the future; always taking into account that Trees Don’t Grow To The Skies. Look for today’s high fliers such as AAPL, RIMM and GOOG to top out and lead the QQQ to a breakdown to new lows.

Past is Prologue, History Repeats: Mainly because most people do not study the past and even if they did, it is all too often distorted by the politically correct historians and reporters. But most of all, history is distorted just as the news is distorted because nobody seems to understand how economics works. The best example was last letters discussions on OIL and how it is priced. It is also why we can’t seem to find solutions to Social Security and Medicare, when all it would take is a relatively simple application of free market principles. The only problem is that there does not seem to be anyone of prominence who understands these principles: Certainly not McCain or Obama!

Discussions about the price of oil are in the news every day, but my observation is that for the most part, these discussions serve only to confuse the public more. Most popular are the conspiracy theories, blaming the high prices on shadowy behind-the-scenes manipulators and the price gouging oil companies. These theories have one purpose, which is to keep the public stirred up and in the dark. Most people don't understand the futures market at all. I am by no means an expert, but I have gleaned enough information recently that I think I can enlighten some of my readers. Futures markets exist primarily to serve the producers and consumers of commodities who use futures contracts to hedge future prices of a given commodity. The producer wants to lock in a price that will ensure he covers his costs and makes a good profit. The consumer wants the same thing, and the object of both is to facilitate their business planning by being able to lock in their price so that they can guarantee delivery in the future at a set price. Those evil speculators are actually necessary participants in the market who serve the purpose of market makers, and they take risks to do it.

While fundamentals play an important role in futures prices, human emotions are also a big part of the mix. Occasionally, like now, irrationality rules the day and a price bubble forms. The easiest way to tell that a bubble exists is to check the monthly-based chart for a parabolic formation: This is where prices move higher in an accelerating curve that eventually becomes vertical. If you look at a chart for oil, you can see that this is the case today, which is a sure sign that prices are no longer connected to reality. You will also notice that just eighteen months ago, oil was at $50/bbl. Now it is nearly three times that price. Have fundamentals changed so radically during that time? Of course not. The same kind of irrationally is at work in the oil market as we had during the housing bubble and DOT.COM bubble in 2000. I can't even guess how high oil prices will go, but eventually there will be a TRIGGER of some sort and prices will CRASH dropping oil back to reality. Beware for a time, the sharpness of the eventual crash will drop prices below its equilibrium level. For me, the most obvious TRIGGER will be when Congress finally listens to the demands of the people and lifts the ban on domestic drilling. While that doesn't sound likely now, there is nothing more powerful than an angry public during an election year.

Bottom Line: Current high oil prices cannot and will not be sustained. Bubbles eventually burst, destroying all the stupid logic that is justifying the rising prices. I believe that when, not if, Congress lifts the drilling ban, oil prices will drop almost as fast as they rose by about 30% to 50%. By next month at the latest, you will see when they report oil usage, Supply/ Demand theory at work. Why else would oil companies be selling off?

COMMERCIAL REAL ESTATE

The social harmony reflected in the speculative fury and swarming show of flamboyance surrounding [Manhattan] real estate make it the perfect place for a classic Bubble Blow-Up which will also showcase my calls for the Real Estate Debacle to spread to Commercial Real Estate. Developers, who a year ago, would have killed for the chance to bid for even a building let alone a project are now backing away completely, to the extent of abandoning major projects in New York and elsewhere as the economy slows and lenders back away completely from financing real estate projects. New York City, with buyers coming from all over the world, is the last to feel the pain. The 180 degree swing in the Big Apple’s real estate market is highlighted by the sudden setback in the development of the rail yards and is a huge public embarrassment for everyone involved, including the developer but especially the authorities, who were counting on the money for their capital budgets. And let’s not forget the Bloomberg Administration, which had made the transformation of this once-industrial West Side eyesore into a show piece and a monument to himself. The momentum actually stalled months ago as plans for the expansion of the nearby Javits Convention Center collapsed and a “key element” of the West Side development, the extension of the No. 7 subway line, did not get off the ground. The real problems will begin to show themselves when the prices of existing real estate start to break down as the financial community retrenches jobs and big paychecks disappear.

BUY the SRS which is the best way for us little guys to short Commercial Real Estate. SRS also has options if you want to increase your leverage.

PRIVATE EQUITY

The very latest headlines from the private equity sector mark the beginning of the end for private equity. Here again, I was a little early when I first warned about the end of the private equity mania and the debacle to follow in late 2006 – early 2007. But one of the things I pointed out was that, while private equity was the type of activity that tends to extend a long advance, it would end up being particularly onerous to companies that employ it because it will end up saddling firms with burdensome debts at a time when cash is getting extremely hard to come by. Instead of reducing their exposure to debt, companies and individuals were leveraging themselves to the maximum. Buyers were financing their deals where 70% to 110% of the purchase price is bank debt and corporations have also significantly increased their use of debt financing not only for acquisitions, but to repurchase their own stock at all time highs. How dumb can you get? There was a fundamental shift in companies’ attitudes towards debt as shareholders have put more and more pressure on them to perform (stock price wise). So, a mountain of debt created by the upward surge of mergers and acquisitions, which is now dead in the water, is just now starting to drag down many a balance sheet. The last chapter in the private equity saga will show the full extent of the burden created by these deals and will become very visible as the Recession sets in and companies find it harder and harder to generate sufficient cash flow to meet even their interest expenses.

THE ECONOMY

Can you believe that the majority of analysts are still arguing about how much GDP growth will slow in the 2nd half of 2008? Instead of ignoring the seasonally adjusted and out-dated government statistics and realizing that we have been in Recession since the 4th Q of 2007, they should start discussing what should and could be done in order to ameliorate the Recession from turning into a Depression. I stand by my forecasts RECESSION 2008 - DEPRESSION 2009. Ok I will relent, the Depression might not start until 2010. After all, it takes time for the foolhardy legislation that will be coming out of Congress to be implemented. There will be no stopping the massive shift to the LEFT over the next 4 years or more. It’s America’s turn to learn its economic lessons as the rest of the world moves toward capitalism, we are moving further LEFT.. Socialism does not work

THE STOCK MARKET

The stock market is the product of Free Market Capitalism and while the Media and the public have not noticed the shift to the left, the Market has as the bullish breakout has failed and prices are headed for a retest of the March lows. We are now definitely in a secular BEAR MARKET. From now on, Bear Market rules apply! What that means is that Comparisons of Overbought/Oversold numbers such as Put/Call ratios, P/E ratios etc. must now be compared to pre 1990 numbers and especially not to numbers during the height of Bull Markets. (SDS represents Double Short the S&P, DXD is Double Short the DJII, QID is Double Short Nasdaq and IOW is Double Short the Russell 2000)

GOLD

Gold and metals, generally due to the long lead times and high costs it takes to get new mines into production, have very long Bull & Bear cycles that typically last 15 to 20 years each. We are now seven to nine years into the current Bull cycle. Depending on when the Bull Market for Gold started (1999 or 2001), we are in either in the first, third or the second half and most volatile part of the Bull cycle. If you take into account inflation, then the equivalent to the Jan. 1980 high price of $850 is now over 2,300 and rising fast, as the rate of inflation accelerates. The situation also holds true for all the other precious metals such as silver, platinum and palladium and all other commodities (both hard and soft), whose prices have been breaking out to all time record highs

There are other factors besides cycles that really make a difference to Gold such as its counter cyclicality to the US dollar. Gold also has the best and most consistent record as a store of value for more than 5,000 years and it is especially valuable during times of geopolitical stress and inflation.

Central banks around the world are worried about both inflation and the systemic Credit Stress not to mention some huge time bombs like $100+ (t)rillion worth of Derivatives that are still overhanging the world’s financial systems. Should there be a major failure because of the tremendous leverages involved, this could easily ignite a chain reaction similar to the sub-prime debacle that could bring down the entire world’s financial system. Overall, even during the best of times, Gold is a excellent diversifier with above average returns over very long periods of time and should be part of every diversified portfolio, if for no other reason than for insurance purposes. Do you realize that over the last 7 years, Gold has consistently been the #1 performer and yet I have never heard any Mutual Fund expert ever recommend buying a Gold Fund. As mater of fact, I just heard 3 out of the 5 people on CNBC’s “Smart Money” say that they hate Gold. What’s there to hate? Gold is the only thing that has kept up with inflation over the last 5000 years. How is that for a track record? It’s a lot better than their track record, No wonder they hate Gold!

What happened to Gold and Silver between 1980 and 2000 ?

Although Gold's role as a hedge against inflation has been unparalleled for over 5000 years, it was challenged in the West and referred to as a “Barbarous Relic” during those 20 years where it seemed that Gold was no longer working. What was being overlooked is that in both Europe and North America, inflation had been brought under control and Gold was no longer needed as an inflation hedge. Plus the fact that, like all wild Bull Markets, it temporarily overshot its real value. And when they fall, they also overshoot on the way to the bottom. In other countries where inflation remained out of control and the value of their currencies deteriorated, Gold was doing its job perfectly well. With the markets now increasingly concerned about inflationary pressure and with the world’s printing of Fiat money running full blast and completely out of control, Gold has once more come back into prominence. While inflation is not (yet) at the levels of the early 1980s (in the first quarter of 1980, inflation in the United States was 14%), inflationary expectations combined with geopolitical risk and with a very questionable growth outlook have all served to reinforce Gold's defensive qualities.

What About Gold’s high price, will that not affect Demand?

Higher prices might affect jewelry demand negatively, but only in the very short term. Gold has always been considered what in Economics is called a “Superior Good”. Similar to a Rolex watch, the more it costs, the more people want it, especially once everyone is convinced its going higher and when buying gold jewelry is considered an investment. In the developing countries such as India and China, we see hundreds of millions of people being able to buy luxury goods and jewelry for the first time ever. The net effect on demand will be explosive. Investment demand is growing fast and is not at all affected by the higher prices: It’s actually the opposite. There is some kind of paradigm shift going on in the financial world towards real assets and away from inflated paper assets. Overall, we will see very strong demand from jewelry, the industrial and investment sides for years to come. As for China, figures from the World Gold Council showed sales of gold jewelry in China hit a record high of 302.2 tons in 2007, up 34 percent over the previous year. China has now overtaken the United States to become the world's second largest buyer of gold jewelry after India. But behind the remarkable growth lies a deep Chinese traditional appreciation of the precious metal as a hedge against social and economic risks. Thus far, Chinese consumers are not deterred by rising prices. Especially since inflation in China is already in double digits. Rather, they increasingly view Gold as not only a means to protect wealth, but also as an efficient and attractive part of their investment portfolio. The World Gold Council said investment demand for Gold at the retail level amounted to 23.9 tons in 2007, a rise of 60 percent compared with 2006. There is a lot of new wealth being created and because of the strong economic growth and an appreciating Yuan vs. US dollar, it makes Gold and other commodities traded in US dollars cheaper for the Chinese. This is also valid for all other countries with appreciating currencies vs. the US dollar.

What about central banks and the IMF selling Gold, to drive down prices.

They tried that in 1979, when they (the bankers) had a lot more Gold back then, than they do now, especially in relation to the world’s total supply of Gold. They could not do it then and they won’t be able to do it now. Back in 1979, every time they halted trading to auction off 4 or 8 million ounces, Gold opened $40 higher. Gold is a relatively thinly traded market. With the huge pools of money floating around in oil producing State Funds and Reserves in China and Japan, can you just imagine the bidding war that would develop if they had a chance to invest $25 or $50 billion in one shot, without affecting prices very much. Just imagine China, which has over a $ 1.5 trillion of reserves with less than 2% in Gold – while countries such as Germany holds over 60%, France over 55%, Switzerland over 40% or the USA over 75% in Gold. Let’s play a numbers game: If China (1.2%), India (4.1%), Japan (1.8%) and Russia (3.0%) decided to extend their Gold holdings to a still very conservative 10% of their overall monetary reserves, they would have to buy over 10,000 tons of Gold which is more than 5 years of current worldwide Gold production. Or more than 25 times the IMF’S 400 tons. I say, Bring On the Sales! Any temporary dip on the announcement of any coming sales would be a GOLDEN OPPORTUNITY (pun intended) to buy.

Hedge Funds

From time to time, there is also some large speculative momentum driven by hedge funds. But more importantly is the realization that Gold has again become its own asset class. Most of them are momentum players; just wait and see what happens when Gold once again breaks out and those deep pocketed players jump into a comparably small, thinly traded market. Quite a few Hedge Funds are already active in Gold futures and their participation has gone from less than 20 tons of Gold 5 years ago, to where it is over 800 tons today. If you look at the Commitments of Trades Reporty, you will see that long positions in futures held by large speculators are near all time highs. Some may take this as a contrarian indicator, but so far the positions remain high and are going higher.

Pension funds and other institutional investors?

They actually are beginning to play a very important and ever increasing role in Gold and Commodities. Calpers, the largest US pension fund with around $240 billion in assets, recently decided to increase its commodity investments to 3% of its assets. That’s a 16-fold increase since it started to invest in commodities a little over a year ago. There are a lot of very powerful institutional investors entering the commodity sector and this trend has just started. This view is also confirmed by a survey conducted by Barclays Capital Mgmt. last December. About half of the 150 money managers surveyed intended to expand commodities to more than 10 percent of their total assets. When I forecasted a target range of $2,500 to $5,000 as early as two years ago, I was not just smoking gange.

What has happened to mining shares?

Since 2001, the AMEX Gold Bugs Index which was trading then at 35 is now trading at about 400. In other words, mining shares even after their recent sharp sell-off have outperformed metal prices and all other conventional asset by a wide margin. Don’t forget that for a producing mine, every $1 increase in the price of Gold goes straight to the bottom line and/or extends the life of the mine as lower grade ore becomes profitable to mine. (This is the reason why some mines report lower earnings in the face of rising Gold prices, as they mine the lowest grades first). In the last 6 to 9 months or so, this mechanism hasn’t worked because costs were rising rapidly and neutralized some of the higher revenues just as the price of Gold consolidated. Right now, the mining shares to Gold ratio is at or close to historically low levels and offers a tremendous buying opportunity. Many shares are sharply down because of the plethora of other investment vehicles such as ETF’s, Power ETFs options on ETFs as well as Futures and Options on Futures plus the fact of the sub prime aftershocks which lead to a sharp market sell-off, very high credit spreads and huge risk aversion towards all stocks. As an example, junior mining stocks are currently trading on average lower than when the bull market started in 2001. REMEMBER that old adage that states, “A Bull Market is never over until the Cats and Dogs have their day.” Right now, there are great buying opportunities in this sector. Fundamentals are strong, but shares are trading with discounts to their NPVs. Nobody can call exactly when the market will wake up, but rest assured it will wake up. Historically, moves in the junior mining sector are always very fast and furious with their biggest moves coinciding with the top in Gold as Greed overtakes Fear and caution is thrown to the winds. The good news is that with the way the juniors are acting, we are nowhere near the top of the Gold market.

COMMODITIES

After 20 years of being in the Dog House and its concomitant lack of investment in new mines, blended with the Government’s policies of paying Farmers not to farm (taking millions of acres out of production) and its less than brilliant mandate on Ethanol, Commodities have been rediscovered by investors. If all that was not enough, we have a resurging India, China, etc, with as much as 3 billion people, which not to long ago were living on a subsistence wage of $500/yr, suddenly making a decent wage while creating over 600,000 new millionaires, all of whom want to eat 3 squares a day. Combine all that with an environment in which we have negative real interest rates, inflation pressure and wildly overvalued stocks and real estate, supported by artificially low interest rates and lots of leverage - commodities had no place to go but up. As for Gold, Gold is not only a commodity, it is also money – in situations such as today investors, who beginning to recognize the overvaluation of all paper assets, are seeking protection against an overall paper asset meltdown and have no other choice but to buy Gold and Commodities.

The main drivers of higher metal prices

With low inventories in virtually all metals and growing demand and sluggish or even diminishing supply, Investors are just beginning to understand how severe the supply situation actually is. There is still only talk about a possible US recession, while nobody yet is willing to factor in a global economic slowdown. Demand will remain strong since this cycle has been activated because of structural changes in many developing countries. There are hundreds of millions of people entering the middle class. There are 10 million millionaires in the world today with 600,000 having joined this group in 2007. Entire cities, power plants and streets have to be built – those changes will transform these countries and until all these infrastructure projects – which are not being postponed because of higher copper prices etc., are achieved, demand will remain very strong. Unless there is a lot more supply coming online, prices will continue to rise. Supply is the problem. By way of example: South Africa has a major power shortage which probably cannot be solved before 2012–2015 at the earliest and was until recently the no. 2 Gold, Platinum and Palladium producer in the world. Prices have skyrocketed and will very likely be going much higher.

June 25, 2008

GOOD LUCK AND GOD BLESS

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Aubie Baltin CFA, CTA, CFP, PhD.

2078 Bonisle Circle

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The world’s gold supply increases by 2,600 tons per year versus the U.S. steel production of 11,000 tons per hour.
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