Even great secular bull markets involve crashes and violent price moves down. The crash of 1987 occurred within one of the greatest financial asset bull markets in history. Gold suffered a horrible cyclical bear market in 1973/1974 in its epic run from $35 to $800.

I think that there is a tremendous amount of financially driven money influencing commodity markets at present. ECRI tracks two commodity indexes – one of those that have exchange listed futures and another that do not. Those that have futures trading are up 100% as a basket year over year. Those that do not have futures trading are up just 10%.

This is reflective of the emergence of what I would call the “dumb” smart money flowing in to the “asset class” in the last 3 years. Many pension funds and endowments are now trying to replicate what Yale was doing 5-10 years ago – obviously very late to the game. They have been buying commodity index products to gain exposure. These indexes are dominated by energy – crude oil being the largest component by far.

The ag commodities and precious metals are much smaller portions of these indexes. I would expect them to get caught up as they were today in the initial stages of a commodities crash/cyclical correction, but eventually they should diverge.

I believe the long term fundamentals for ag commodities are excellent. The demographic forces in Asia and other emerging markets are powerful as their increased standards of living bring with them higher demand for protein in their diets. Stupid policies like ethanol just add gasoline to the fire. There is surely some financial buying/exposure in the space, but ag commodities are infamous for purging hot money in spectacular fashion and I suspect this period will be the same. Sugar is still at a very low inflation adjusted level…..and is down 20% in 11 days!

So in summary, I think today ushered in the beginning of what may be a vicious unwind of the “global growth” trade. Ag and gold is likely to suffer in the short/intermediate term but I believe they will diverge (particularly gold stocks) at some point. I/we have a significant position in the EEV to hedge our exposure in gold and ag which we reduced to what we’d call “core” positions last week due to our fear that they could get caught up in an unwind. Personally, I think the emerging markets are likely to lead the next downturn in the bear market – assuming that is what we are in of course.

I actually posted a response yesterday that appears to have been eaten by the web gremlins. I am not comfortable offering advice – simply not appropriate on David’s blog. I own some mutual funds and one junior miner.

I believe that consolidation will emerge once operating results improve. Notice that the bloodletting today in the sector has the metal down more than the major sector stock indexes. This is VERY positive in my opinion. The correction could surely last for a while and be quite deep, but I think the miners emerge as a great place to be if this is the beginning of the unwind of the global growth trade – i.e. commodities and emerging markets.

The Dean of Dracut

Many metals mining companies’ cost structures are comprised by 20% or more of energy. Obviously, energy prices have grown at a faster rate over the past several years compared to gold bullion prices. This has resulted in the higher cost producers, often junior miners, continuing to show poor operating results. Historically, major gold bull markets have ended with miners showing excellent operating results (i.e. earnings and free cash flow) and paying substantial dividends. The end stage of a great bull market often results in speculative mining companies that are in the exploratory phase going parabolic as speculators are attracted to good “stories”.

If gold prices begin to increase at a rate more rapid than oil, then the operating results of the miners should improve. Many gold bugs have largely abandoned the miners in favor of the GLD or physical metal because of the frustration of the poor operating results. I think the next phase in the bull market is likely to reverse this trend.

Finally, the sector is quite extended as is bullion. The stocks are quite reasonable compared to the metal, but a 5-10% drop in the metal is sure to drive a correction in the stocks should such a correction emerge. I think it will be interesting to see when/if the stocks can hang in relative to the metal in such a correction. For example, if gold drops 10% and the XAU and HUI “only” drop 10%, then I would take that as a sign that the stocks are so cheap relative to the metal that they will take a leadership role during the next uptrend….assuming there is another uptrend of course!

I don’t think the Fed can right the ship. I don’t think that the Feds can either, without imposing a new type of socialism on us all.

I am absolutely sick and tired of people suggesting that there is something the Fed can or should do to address this absolute mess we are in. The Fed is a ridiculously failed institution – just as almost every other institution that has been created out of crisis is or has been. It is laughable that so many are just now coming to this realization due to the current crisis. So many were derided as perma-bears for identifying the massive imbalances that have been building for 20 years.

There is a big difference between identifying a problem and how one executes an investment strategy. Personally, I was a chicken little risk taker up until July of last year even as I had been calling for the financial apocalypse for a few years. The reality is that the WORLD has been in one big credit bubble. This is not just a US problem. Europe is in deep and the emerging markets have been the epicenter of a vendor-financing scheme not all that dis-similar to what pre-empted Cisco’s post-2000 collapse.

Country’s like China have traded the sovereignty of their currencies and monetary policies for political expediency – i.e. trying to employ the billions of entrants into the global labor force. Now, they are dealing with the natural result of price fixing. The inflation problems in the dollar peg nations is causing massive issues that are likely to get worse.

As I wrote on this blog 2 months ago, I targeted the EEV for purchase in the mid $70’s based on my belief that the January/February spike was a bear market rally and that the next phase of the bear market would transition downside leadership to the global growth market segments such as emerging markets that have performed so well over the past 6 years. I believe that the current ruckess over the Bear Stearns and US financial mess is causing people to miss the major shoes to fall next. Europe is likely heading or already in recession and its banking system is not much better than ours – plus they have a fragmented monetary regime. What would happen in the US presently if the Fed was dominated by Texans rather than Californians and there was a vigorous history of centuries of nationalism between the two? Well, the ECB is still dominated by the Bundesbank and Germany hasn’t experienced a housing bubble like Spain has. Will France and Germany bow to the pressures in Spain and Italy? Probably at some point, but it indicates that the Euro zone is also in jeopardy.

While the consumption class in the emerging world is certainly growing at a mighty rate, it remains a rounding error on the global stage. I simply don’t see how people believe that the emerging economies can withstand or even thrive during a Euro/Japan/US recessionary environment. Many point to commodity price strength to justify this belief. ECRI points out that their index of commodities that DO NOT have exchange listed futures contracts are up just 10% yoy versus the 100%+ of those commodities that do. This indicates that there is a massive financial move into commodities that is distorting price discovery…just another misallocation of capital in the long list of central bank induced miallocations. All of that printed money will head somewhere!

As for investing in this environment, I personally have still not heard/read one “value investor” address the issue of valuation in the broad market using normalized profit margins, book value or P/S. Jeremy Grantham stated last quarter that GMO’s long term fair value for the SPX was around 900 and they didn’t pull that number out of thin air.

All historical major economic debacles began with financial crisis that eventually bleed over into the “real” economy. This is a tremendous risk at present in my opinion. Those ignoring this risk are being reckless in my opinion. Certainly, markets are extremely extended on the downside at present, so anything can happen in the short term. However, I believe that anyone not doing some kind of hedging is ignoring the possibility of a “black swan” event. The global economy has reached a critical state and the deer has farted. Whether or not the avalanche turns into the “big one” is unknowable but given the financial sector debacle and global imbalances, the snow levels are at record depths and therefore I would argue that the risks of the “big one” are higher than they have been in decades.

At the risk of sounding like an alarmist at a point when the market is at a multi-year low, I’ll share what I am doing to combat things. I am long the Yen versus the Euro. I am long ag commodities but certainly not the ag stocks. I own some healthcare, which is the one major market sector that is trading around historical norms as far as profit margins go and very reasonably from a P/E and P/S basis. I still own a position in NLY which is certainly at risk but I believe can weather and thrive given the current financial mess. I am short the emerging markets and REIT’s. I’d like to be short the financials but fear that government bailouts could cause excruciating pain as a short seller. I doubt REIT bailouts are on the radar of the Feds at this point and they display many of the same problems as the general financial sector. The precious metals sector has certainly had a run, but it still shows no signs of excessive speculation. The junior minors continue to perform horribly as costs remain a problem. Should the financial buying in broad commodities reverse, gold is sure to be impacted at first, but I suspect the miners to emerge after the initial sell off and be an explosive investment as gold recovers and their energy costs plummet.

I apologize once again for taking up so much space – this is a selfish exercise for me to help clarify my own thinking and I welcome any criticisms/debate. I sincerely wish David and everyone else success in combating this environment.

As I told a 24 year old who works for me on Friday, read everything you can about the current environment, as it has not occurred in this country in almost 80 years and is likely to be a turning point in the history of this once great nation.