Storm Watch Update
RUNNING OUT OF TIME AND BULLETS
by Jim Puplava
www.financialsense.com
November 16, 2001

The chamber is near empty the bullets have been spent and their aim has missed the target. In eleven months the Fed has cut interest rates ten times, three half-point cuts since September 11^th. The Fed Open Market Committee will meet in Washington next month on December 11^th where another interest rate cut is expected. Another bullet will be fired, but will it reach its mark? In what is turning out to be one of the most aggressive rate-easing cycles in US history, the Fed is flooding the financial system with cheap and abundant credit. The results so far have been a surge in the unemployment rate from 4.2 percent in January to 5.4 percent and the worst monthly job cuts since World War II. (Source: Money/CNN)

Industrial output has fallen for 12 months in a row, the longest streak since World War II. Investment in business equipment and software has plunged 8.3% this year, falling eight straight months in a row. This has been accompanying by the worst profit deluge in a decade for the technology industry. Profits for the third quarter for America’s largest corporations were down by 72 percent from a year ago. They fell from $109.24 billion in 3Q 2000 to $30.56 billion in 3Q 2001. Companies have had to face rising costs; while prices for products and services have fallen. The drop in profits has cut a swath across all sectors ranging from semiconductors to financial services.

The economy now appears to be heading for recession after logging in its first quarter of negative economic growth in close to a decade. (Recessions are defined as two consecutive quarters of negative economic growth.) The economy looks like it is heading in that direction and the Fed is powerless to stop it. On a global basis, central banks in Europe and Asia are following the Fed. Interest rates are coming down in Europe and are likely to head even lower. In Japan they are at close to ground zero. In the U.S., it appears that we are heading in the same direction as Japan.

Real interest rates (current interest rates minus the inflation rate) are now negative; while nominal interest rates are at a forty-year record low. Record low mortgage rates are still propping up the real estate market and allowing consumers and corporations to refinance their debt. The Mortgage Bankers Association has reported that its index of mortgage applications set a record in the week ending November 9^th. Refinancing activity is accounting for 78.4% of all mortgage activity.

               Yes, but . . .

This trend may not last long. Mortgage rates are still below last year's levels, but they have recently turned higher. The slowdown in housing is easing, but it still remains high as consumers take advantage of low rates to trade up or buy new homes. Demand is still strong as a result of abundant and cheap credit, but this easing cycle isn’t going as planned.

Although short-term rates have fallen, long-term rates have remained stubbornly high. As the chart of the Treasury yield curve indicates, the curve has steepened from where it was a year ago. It took intervention by the Treasury in eliminating the sale of 30-year bonds to drive interest rates below 5 percent. By eliminating the sale of long-term bonds, the Treasury created a supply imbalance between the demand for longer-dated maturities by pension funds and insurers and the supply offered in the market. This forced investors to bid up the price of long-term debt issues as their supply is cut. This intervention is also what drove down longer-term rates over the last few weeks. It forced a reversal of interest rate hedges and bets that contributed to the rally in Treasuries. It is also forcing bond-market players to lower their safety targets by buying into the corporate debt market at a time that interest rate coverage is declining due to falling profits. Some are even going reluctantly into the junk bond market betting on a revival in profits next year.

Bond Investors Are Skittish for A Reason

All of this is creating uncertainty for the bond market, making the bond market just as volatile as the stock market. Long-term interest rates are determined by bond investors. Bond investors are sophisticated investors. They are the vigilantes of the interest rate market. Whenever they sense the danger of inflation, they begin to demand higher interest rates to compensate for the loss in purchasing power. Now we have a situation where the saving class is getting a negative return on their investment when you subtract the inflation rate from the interest rate offered on fixed income investments. This may be one reason that interest rates have started to head up again with the 30-year bond yield back up over five percent. The bond market senses danger. Bond investors have to be cognizant of the money supply. It is the growth in the money supply aggregates that are signaling trouble ahead for the bond markets. Webster’s defines inflation as an increase in the amount of money and credit in relation to the supply of goods and services.

The M & Ms Have Me Worried

As these charts indicate, the money supply and credit in the system have gone parabolic. The M-3 aggregates and MZM are expanding at an annual 20% rate of growth. Inflating the supply of money at this rate carries consequences. You simply can’t create money of this magnitude without affecting other elements of the financial system. The Fed and Government Sponsored Entities (GSEs) may expand the supply of money and credit in the system, but they don’t always control where it goes. During the 70’s when the Fed was printing money, consumers and investors put that money into hard assets and real goods. This drove the price of those goods up because there was more money than supply. During the 90’s the supply of money went into financial assets and then into real estate subsequently driving up their price.

The Fed and the U.S. Treasury's recent action in their attempt to artificially control the price of money by making it abundantly available at a lower cost has ominous long-term consequences. It has over-stimulated the real estate market by creating excess demand that has inflated its cost. In the process, the Fed has created the second asset bubble after the stock market. Falling interest rates and rising stock market prices contributed to the tech bubble by over stimulating demand and production above what was needed by the economy. The consequences are most evident in the glut in technology inventories, falling prices, disappearing profits, and plunging stock prices.

The same thing has happened to real estate. Record low interest rates have over-stimulated demand for real estate, causing demand for housing to soar. Now the commercial real estate market has started to soften along with home building. Default rates are up along with record bankruptcies. Lower rates have caused many consumers to overspend and borrow. Now that the economy has softened and job losses have mounted, debt burdens have strained budgets and as a consequence debt defaults are rising.

Savers Stuck in Safe Havens & Investors Looking to Jump Ship

The other danger of artificially-controlled interest rates is that low rates of returns for savers make investing less profitable. As the above graph of negative real interest rates indicates, it is no longer attractive for savers to invest. Why lend money when you earn a negative return? This eventually leads savers and investors to logically seek alternative investments. The hope in Washington and on Wall Street is that savers and investors will have no choice but to return to the stock market given the low returns offered by money market funds, T-bills, and bonds. However, the stock market is grossly overvalued with few areas of opportunity. There is an even greater problem when it comes to stocks. Investors have lost a lot of money in the stock market. This year will be the second year in a row that investors have lost capital. A lot of retirement savings have gone up in smoke over the last 20 months.

Where to Nest Your Eggs?
If the market doesn’t turn around soon, much of the money still sitting in mutual funds will be heading for the exit gates. In a recent survey of investors, close to half of those surveyed said they will be looking at alternatives if their funds are down at the end of the year. That process may now be unfolding. The Investment Company Institute reports that $35.6 billion flew out of stock funds during the third quarter and money market mutual funds are at a record high of $2.309 trillion. The only thing the stock market has been able to do is to rally briefly. It has become a day trader's market with institutions joining day traders with short, impulsive moves in and out of stocks. There are no firm convictions and despite the fanfare over earnings, they are turning out to be nothing more than fluff. With stocks losing money, real interest rates negative, and nominal rates at 40-year lows, the financial industry offers few alternatives for savers and investors. The financial community is ill-prepared to deal with the challenges of today’s changing investment market. You can throw out the allocation models. They aren’t working. We have arrived at a situation similar to what investors faced in the late 60’s and 70’s when financial assets performed poorly. During that period, investors looked elsewhere. The place to be was hard assets or “things”. It was a decade of rising inflation and declining financial markets that were replaced by the rise in the price of commodities. (See Century Chart)

THE NEXT "BIG" THING

All of the above brings into question, what will be the next “big thing”? Where will the money flow and what will do well during a period of explosive monetary inflation? As pointed out earlier, the Fed is flooding the markets with money. It now becomes a question of where that hive of money will land next. Historically, periods of negative real returns in interest rates and monetary reflation have sparked the greatest rallies in the price of gold. The 1970’s were a good example of what happened when the Fed embarked on the same course it is pursuing today. When the money supply increases at a rate above the economy's ability to build goods or supply services, the results have been inflation. The chances for a reemergence of inflation are great. The fact that much of America’s spending binge has been supported by foreign capital through our mounting trade deficits creates a problem for the dollar and interest rates. This impacts both the bond and currency markets. When the country runs a trade and investment deficit with the rest of the world foreigners take our money in exchange for the goods they sell us. To our benefit, that money has been recycled back into our stock and bond markets.

Foreign investors now own over 40% of our Treasury market, over 20% of our stock market, and an equal or greater amount of our corporate bonds. They also own a sizable chunk of our real estate. If the rate of return from those investments turns negative as it now appears in the fixed income and stock markets, foreigners may seek better returns elsewhere. They can either withdraw from our financial markets, begin dumping dollars, or shift to alternatives like gold, silver, or real assets in exchange for their paper holdings. When that happens the jig is up for Washington and Wall Street. It is what happened during the 1970’s when investors, both domestic and foreign, no longer trusted the value of paper assets like stocks and bonds. Money simply went into things like gold, silver, oil, collectibles, real estate, foreign currencies or other tangible assets. It appears that we will see a resurgence of interest in tangibles.

The first evidence of this shift is the rise in precious metals stocks over the last 12 months when monetary re-flation began in earnest. Review the graph of the money supply, the graph of the S&P Gold Index, and the XAU for evidence. Individual gold stocks like Newmont Mining, Agnico-Eagle, and Franco-Nevada have done even better with 52 week and year-to-date returns of 50.48%/18.27%, 82.62%/55.5%, 75.10%/40.64% respectively. The price of gold and silver has valiantly tried to rally, but has been knocked down by bullion bank selling. Like the late 60’s and early 70’s, government has tried to control the price of gold. When you are inflating the money supply as the Fed is doing today, you hope to keep it quiet and not telegraph it openly. Gold is a barometer of monetary inflation. It signals when a monetary storm is approaching. When it rises, it spells trouble for financial assets, interest rates and the dollar. By inflating the supply of money, it has become necessary to hide its consequences, and therefore, the deliberate suppression of the price of gold.

Monetary Inflation is The Culprit
There has been growing evidence of monetary inflation for the last five years in the stock and bond markets. It has been masked by new paradigm theories that have served the purposes of the inflation-camp well. All of that money went into the stock market, inflating stock market returns far above the real earnings of companies. Instead of viewing inflated stock and real estate prices as inflationary, the rise in their respective prices was viewed in terms of a resilient American economy powered by super-productive, American corporations. We now know that just isn't so. The government has already revised GDP and productivity numbers much lower. As pointed out in my Storm Series and in A Penny Less ~ A Penny More, most of those profits have been inflated, overstated, and falsely reported. The real reason stock prices went up is attributable to a monetary phenomenon that was fed by hype coming from Washington, Wall Street, and the media. If we look at the way earnings are reported, it isn’t clear whether the media knows the difference between livestock or preferred stock. It certainly can’t be argued that no earnings, low earnings, artificial earnings, or great losses and sky high P/E multiples are the signs of intelligent investing. They resemble more of an asset bubble that was fed by an over-zealous monetary policy than anything else.

Shifting Seas in the Sands of Time
A rising gold stock market may be signaling a sea change ahead for the financial markets. It seems strange to most on Wall Street, Main Street, the media and even members of the mining community, that gold and silver, which have been running a supply deficit for over a decade, would suffer from such low prices. You do not find this phenomenon in any other commodity. If coffee, cocoa, corn, wheat or orange juice ran a supply deficit, would anybody question its rise? For that matter, those who farm it would simply cease to produce it and find other things to grow at better prices. This condition does not exist in the gold and silver markets. Both continue to run even greater supply deficits and the price continues to languish. It isn’t economically feasible to do this in the long run. When you can’t mine a mineral at a profit, two things will happen. If you continue to mine, you will run out of money and close down. Or, second, what can’t be done profitably is shut down. Both scenarios are happening to today's mining industry. Unprofitable mines are being shut down, abandoned, or sold off. Exploration is being scuttled and mining companies are either being taken over or are going out of business as the industry consolidates. All of this shrinks the supply of gold and silver; while the demand increases year after year.

What has led us to this condition is the artificial manipulation of the financial markets. When the Fed inflates the money supply, the inflation barometer seen in gold and silver prices is kept suppressed. The inflation numbers are also manipulated by constantly re-weighting or changing the components of the CPI and PPI index. Does anyone you know really believe that the rate of inflation is running between 2-3 percent a year?

Raw Materials and Tangibles

So where is this leading us? It is taking us to the next big thing, or what will become the next bubble -- raw materials or real things. Any asset which has greater demand than supply will ultimately rise. This is what happened to the price of gold and silver when it was finally forced free from government controls during the 1970’s. Gold and silver acted like coiled up springs when they were finally set free. It will be the same this time as well. This time however, its rise will be even more spectacular. Supply has diminished and we are running supply deficits in both gold and silver. This is without any monetary demand.  The market cap of the world’s gold and silver stocks has fallen to around $35 billion. There aren’t large deposits of either metal outside the gold deposits of central banks that could satisfy investor demand. Supply has shrunk as a result of industry consolidation and liquidation. The number of gold and silver equity stocks isn’t large enough to absorb even five percent of the money that is sitting in the equity markets. The only way this can be rectified is by higher prices -- higher prices for the physical metal and higher prices for unhedged mining stocks.

The New Thing in Newmont
There was a seminal event that happened this week with the takeover of Normandy Mining and Franco-Nevada by Newmont Mining. The result of this takeover when it is complete is that Newmont will emerge as one of the most powerful forces in the gold market. It will be number one in reserves and in production with 97 million ounces of gold reserves and annual gold production of eight million. It will have the largest market cap estimated to be $7-8 billion. It will be greatly leveraged to the price of gold since Newmont hedges very little of its gold, Franco-Nevada is unhedged and Normandy’s remaining hedges will be unwound. Newmont’s net debt to book value ratio will be reduced from 41% to 18%. The company will also enjoy Franco’s royalty stream of income. The company will own and operate 22 mines on five continents. The newly combined company will also control 60 million acres of land.

More importantly for the gold market, Newmont sees gold as money and could emerge as the new leader of the gold mining industry. Up until this point, the mining industry has been led by Barrick and Anglogold, known as notorious hedgers. The Barrick camp has sold years of gold production forward which has further served to reduce its price. The Barrick camp sees gold more as a commodity rather than as real money. They are behind a silly industry campaign to spend $200 million in advertising to bolster worldwide demand for jewelry in an effort to raise its price. Jewelry is a luxury and luxury items are the first to be eliminated from the budget in times of recession. The same thing could be accomplished by not selling gold short or hedging future production.

Another factor that bodes well for gold and silver is the money supply graphs illustrated earlier and the negative returns on savings. This means bond, currency, and stock market investors will be seeking alternatives to investing in paper assets. The spread between gold and silver lease rates and short term Treasury paper has also narrowed. This will put pressure on hedgers to cover their forward positions as the table below indicates.

Lease Rates as of November 16, 2001

It is my belief that with real interest returns now negative, stock investments hemorrhaging, and the dollar looking vulnerable, paper assets days are numbered. The collusion with which prices have been suppressed may also be coming to an end. There are simply too many brush fires to contain and too many holes in the dikes to plug. The financial markets and the financial industry are about to be turned upside down. The experience will not be pleasant. Investors are tired of negative real returns and will seek alternatives. When the masses wake up to the fact that they have been fooled, the exit gates won’t be wide enough.

Energy's Days Aren't Numbered

Energy, like precious metals, is controlled by the paper markets. Prices move up and down more on perception than fact. Rumors, innuendos and a misstatement of facts more often move the price of energy than actual fundamentals. There are three things about energy that are not presently understood. They are as follows:

1)   Oil is a political commodity.

2)   There are no huge stockpiles of oil in the West.

3)   Oil is a depleting asset.

The biggest fact that is misunderstood by investors and analysts is that oil is a product of politics. The difference between the price of producing oil and the price in the world markets is political. OPEC producers, especially Saudi Arabia and Kuwait, can produce oil for about a $1 a barrel. Non-OPEC producers in the western world find and produce oil at rates ranging between $6-$8 a barrel. At $10 a barrel, OPEC can still make money; while western producers would struggle to survive. OPEC would like to see rates go higher and so would western oil companies. Over the last few years, OPEC has been able to boost prices by controlling its supply.

Flat Forecasts for Oil
Now that economies around the globe have weakened, the growth in oil demand has slowed down. In its latest estimates the IEA forecasts that world oil consumption will increase by only 120,000 barrels a day during the fourth quarter. Oil demand is expected to be flat over last year. However oil experts predict global consumption will grow by 1.5 million barrels a day annually over the next five years. That growth will be driven by emerging economies like India, China, and South America. The question is, where will all that oil come from? There is still plenty of oil to be found, but it is in difficult areas of the globe like Russia’s far eastern providence of Sakhalin. Sakhalin Island is 4,000 miles away from Moscow. The oil is located in a remote region that is dominated by a hostile climate making its extraction difficult. Other deposits of oil lie in deepwater regions off West Africa, in the Gulf of Mexico and in the Caspian. There is oil to be found, but it will be expensive. It will take higher oil prices before oil companies make the huge investment to deliver it to energy-hungry western consumers.

A Game of Chicken
So right now there is a game of chicken going on between OPEC and Russia as to who will flinch first. OPEC announced on Wednesday that they would cut production by another 1.5 million barrels a day on January 1^st. They want non-OPEC producers to cut production by 500,000 barrels a day. The next largest producer besides Saudi Arabia is Russia. At the moment, Russia isn’t going along. The Russians need higher oil prices as much as OPEC and Western producers do. Russia’s main source of revenues comes from oil and now, natural gas. For the first time in years, the Russians are paying their bills and Russia’s President Putin enjoys widespread popularity. Putin’s popularity comes from the country's economic rebound which has been helped by growing oil revenues to Russia’s treasury. Higher oil prices translate into bigger government budgets. Russia, which desperately needs all of its oil revenues, would rather have OPEC cut back production.

Who will flinch first? In the words of Saudi oil minister, Ali al-Naimi, “We will see who has the resolve… If the price really drops and stays down, you will see a lot of instability not only in the economy but also in the stock of companies and their ability to invest in future production.” So at the moment, the war of words continues. The Saudis did this once before to Russia in the 1980's. They started a price war that drove down the price of oil and decimated the Russian economy which took more than a decade to recover. Russia has diversified its energy base since then by exports of natural gas to Europe. So it isn't entirely dependent on oil revenues. But the Russian economy is much weaker now than back then. So is Saudi Arabia. A vicious price war can undo the Saudi monarchy just as easily as it can the Russian economy. At the moment, the House of Saud is betting it has stronger staying power. The monarchy should be aware that it has other threats -- bin Laden is one of them. Osama bin Laden and al Qaeda, along with the Taliban, could achieve strategic objectives by disrupting the flow of oil from OPEC's main producer: Saudi Arabia. By disrupting the flow of oil in the Gulf, they would drive up the price of oil in world markets and deliver another mortal blow to the U. S. economy.

Oil is All About Politics
This brings up another aspect of oil that is political. Most of the world’s oil reserves, about 75%, lie in the Persian Gulf and Caspian Sea. The region is very unstable politically. Anyone who reads a newspaper or watches the news is aware of the regional wars, rumors of war, and act of terrorism that plague these territories. Saudi Arabia, as the world’s largest oil producer, poses the single biggest supply threat. Terrorist attacks against its export terminals or pipelines would result in significant supply disruptions. Osama bin Laden and the rising tide of Islamic fundamentalism pose a serious threat to a major source of supply for western countries. One of al Qaeda’s goals is to topple the House of Saud.

Whether it is attacks against Saudi oil terminals, sinking ships in the Straits of Hormuz, or blowing up pipelines coming out of the Caspian, the region is vulnerable to supply disruptions. Even western oil giants like Exxon-Mobile, Royal Dutch, BP Amoco, and Chevron-Texaco do business in these unstable regions. They have substantial assets and are spending great sums of money in areas dominated by Islamic militants. Like it or not, the western world, and especially the U.S., are heavily dependent on Middle East oil. We are dependent now and will remain so well into the early decades of this new century.

This dependency is likely to lead to war beyond what is now occurring against al Qaeda in Afghanistan. A strike against Iraq and Saddam Hussein would have far reaching implications. It is enough to say that we are now at war in this region and that war is likely to spread beyond the borders of Afghanistan. In war, anything can happen, which is why the President has ordered that the U.S. Strategic Petroleum Reserves to be built up.

No Large Stockpiles
A second point that needs to be understood is that there are no large stockpiles outside the Strategic Petroleum Reserves that the U.S. and the West can rely on in the case of a supply disruption triggered by a political event. U.S. oil production has been in decline since the early 70’s. We now import close to 60% of our oil. That percentage is going to increase over this decade. With 4% of the world’s population, we consume 25% of the world’s oil and have only 3% of the world’s oil reserves. Most U.S. wells are small stripper wells that produce 2-3 barrels of oil a day. In contrast, Middle East wells are capable of producing 20,000 barrels or more a day. They not only produce more, but they can do so at a very low cost.

The same situation exists for natural gas. Just as the US is dependent on foreign oil, it is also dependent on imported gas from Canada. The U.S. gas industry has been unable to boost natural gas output despite significant investments over the last three years. Therefore we now rely on Canada to supply 16% of our natural gas needs. Although Canada is friendly and stable, its own productive capacity is peaking. Canada will unlikely provide a permanent fix for America’s voracious appetite for energy. Conservation will not do the trick either. The only solution is for higher oil and natural gas prices that drive more exploration and investment in alternative energy sources. Until that is done, the world of energy will remain uncertain, subject to supply disruptions and price shocks. Any way you look at it, the price of energy is going to go up during this decade. We will either experience higher prices through government price controls that create shortages, or war may disrupt supply leading to another oil shock similar to the 1970’s, or it may simply be supply dislocations created by the vagaries of market prices.

The market price for oil and the supply and demand forecasts made on energy bear little resemblance to actual production and consumption. It is essentially a problem of perception. If oil inventories go up one or two weeks in a row, or if gas inventories do the same, the assumption is made that there is a glut in energy. This is the assumption that is being made by today’s oil and natural gas prices. That assumption of ample supply could easily change to shortage with one cold weather snap or a terrorist bomb.

Going, Going, Gone
The final point to understand is that oil is a depleting asset. On a global basis, we consume close to 76 million barrels of oil a day. That is 76 million barrels of oil that isn’t being replaced by new discoveries. There is more oil to be discovered, but not at the rate with which it is now being consumed. The new oil discoveries outside the Middle East and the Caspian will be more expensive to find and produce. They won’t be found and produced without higher prices. Western oil and gas fields are in decline. That decline curve in production will accelerate during this decade at a time of rising global demand. This makes the West and especially the US more dependent on outside sources of oil that it may not be able to control.

Today's current market price of energy does not reflect reality. There are only three things that need to be understood. 1) Oil is a political commodity. The bulk of the world’s oil lies in very unstable regions of the world subject political upheaval, war and terrorism. 2) There are no large sources of oil or natural gas outside the Middle East, the Caspian and the South China Seas. There are no large stockpiles of inventory to be sold. All oil being produced is being consumed. It is not piling up in warehouses around the globe. 3) Finally, we are not replacing the oil and natural gas that we consume. Oil and gas are depleting assets. It is that simple. As an investor and consumer, what does that tell you about its future price?

This brings me back to the U.S. economy and financial markets. It is obvious everywhere you look, that central banks are flooding the markets with money. So far it hasn’t been able to rescue the economy or financial markets. Stock prices are still going down, global economies are still heading toward recession, and corporate profits are disappearing. The Fed has fired most of its bullets and they have missed their mark. Time may be running out for Mr. Greenspan and his fellow peers around the globe. The more time that elapses between each Fed rate cut and recovery, the greater the degree of disenchantment. If the economy and markets don’t bounce back, the risk is greater for the dollar. Confidence in paper is evaporating. The longer rates of return for savings and investment remain negative, the greater the chance that money being created so abundantly by the Fed will seek a new home. For Mr. Greenspan, the hourglass is running out of sand and there are only a few bullets left in the chamber. ~ JP

© 2001 James J. Puplava
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