November 16, 2009

 

Short-Term Key: Negative

Long-Term Key: -58 (Neutral)

 

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Inside this week's update...

 

***** Why a weak dollar can't fix the trade imbalance.

***** Why the approach of Peak Gold implies Peak Everything.

***** What China sees that the U.S. refuses to.

***** Your best investments for 2010.

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Today, the U.S. Dollar Index dropped below 75 for the first time since last summer. Its inability to find a bottom has been in the news much lately, though it has not surprised us or other expert dollar watchers, including Warren Buffett.

Part of the dollar's problem is that the U.S. trade balance remains stuck in the red. We had hoped the recession would have curbed American consumption of goods imported from overseas, but that has not happened.

Economics 101 tells us that the solution to the trade balance would be for the dollar to continue its downward trend. However, the dollar has been falling for most of this year (and indeed most of this decade). So why haven't we seen more improvement?

The answer tells us a lot about where we should be investing these days...

 

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THE GOOD NEWS IS WE HAVE LOTS OF ALUMINUM. THE BAD NEWS IS...

 

A weaker dollar normally causes two key things to happen. First, it discourages imports. Obviously, if the dollar loses value relative to other currencies, imported goods become more expensive. In the case of consumer products, that should encourage people to buy American-made items, since products stamped “Made in China” won't be as noticeably cheap.

However, it turns out that the value of our imports hasn't been declining, it's been rising. In fact, it's up nearly 30% since its low at the start of 2009.

The second thing a weak dollar should lead to is higher exports, since it makes American-made products more affordable to people in other countries. Exports have gone up this year, which is good. However, exports have not gone up nearly as much as imports – hence trade balance that in the past few months has gone from bad to worse.

So what's going on?

Well, since the turn of the millennium, the price of oil and virtually every other commodity we need to run our economy has increased. By now, you must know the story with oil. U.S. production has been falling since the early 1970s, and we are now importing and consuming more than we produce ourselves. The same is true for copper, lead, platinum, zinc, and uranium. More than half our supply of these metals comes from overseas. In fact, the only critical industrial metal we have plenty of is aluminum. Moreover, the percentage of these metals that we need to import has been increasing since at least the late 1990’s. (Unfortunately, aluminum requires a lot of energy to produce.)

Raw material prices explain why the value of our imports remains high. We can't really cut back on our consumption of raw materials. Even if they become more expensive (whether due to a weaker dollar or scarcer supply), we have to keep buying. If you're dying of thirst, you'll gladly pay any price for the only glass of water in town.

Of course, part of the problem is our own complacency. Our ancestors who settled America found themselves living in a land of bountiful resources. In the past two centuries, we've come to take that bounty for granted. Now that we've exceeded the limits of what we have, we have been slow to adjust.

Let's take silver, for example. If we are to free ourselves from dependency on foreign oil, we will need to build an alternative energy infrastructure. Silver will be a key component of that. It has the highest thermal conductivity, which makes it an important component of solar panels. The same is true for copper, a critical component of the electrical grid.

The question is ... do rising prices for imported silver and copper reflect a fundamental scarcity of these metals (as it does in the case of oil)? We think so.

For example, we recently noticed an article in the Financial Times titled, “Peak Gold.” Gold, unlike industrial metals, is not critical to our economy. It may be a great investment in a world where currency prices are falling, but the world could probably get along without more gold. However, the possibility of a permanent peak in gold production implies that a permanent peak in many other raw materials is also at hand.

Let's be clear. Peak Gold would be a state where the cost of mining gold increases faster than gold prices, to the point where mining gold will no longer be profitable.

Admittedly, higher gold prices may encourage gold production to pick up a little next year. Some otherwise unprofitable projects will suddenly become worthwhile endeavors. However, if other minerals used in gold production, such as copper, oil, iron, etc. start rising as quickly as gold has been, then the cost of producing gold will make it uneconomical. Gold production could then plateau and start to decline.

What's more, a steep rise in all commodity prices could become self-feeding as it would start becoming prohibitively expensive to produce anything. All metals would suffer scarcities.

We've discussed the possibility of Peak Iron in a recent update, but we see very little discussion in the media about Peak Copper, Peak Silver, or Peak any other vital commodity. Yet Peak Silver may be closer than Peak Gold. According to the U.S. Geological Survey, the ratio of annual silver production to silver reserves that can be economically produced is only 1:10. In other words, each year we produce 10% of the silver that can be produced. In less than a decade, we could see big shortages.

In the case of copper, the ratio is a little more generous, but not much, especially if copper consumption rises 4-5% a year.

Bottom line: we're close to peak production in many commodities, and this will make it nearly impossible to ever reduce the trade deficit. The dollar could therefore remain in a permanent decline. True, we could try to increase our exports – but what would we export? We've done a great job exporting services, but that has its limits.

Nonetheless, as investors, the path is clear... 

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INVESTING IN THE AGE OF PEAK EVERYTHING

 

Clearly, commodity scarcity will create a new world in which classic economic laws may not work the same way. Sadly, the U.S. doesn't recognize the change and is not doing enough to replace vital commodities.

China, on the other hand, does recognize the danger. The nation is taking steps to build an infrastructure that will support alternative energies. Of course, that project will consume a good portion of the already scarce commodities, which will add to rising prices. But it will help China come out ahead of other nations.

In these conditions, our investment advice remains the same. Beyond issues such as weak banks, consumer debt, and monetary policy, the real issue is the growing shortage of commodities.

Gold, silver, and other precious metals will probably outshine everything else over the next few years. But as industrial metals grow more scarce, they too will be extremely profitable. The only caveat is that economic downturns, such as in 2008, will cause a temporary downturn in industrial commodities as well.

For 2010, we expect to see inflation, as the Federal Reserve has no incentive to check growth. That may not be good for stock prices, but it should be good for commodities.