Right You Are (If You Think You Are) – McLean, VA

Sometimes I write about an issue and then want to move on, but this can be difficult, especially if what’s written involves the various and shifting agendas of politicians around the world. So a few words are warranted regarding comments I made about US-China relations in last week’s issue (see “Until It Melts” 22 March, 2006).

Politics are extremely important when it comes to investment decisions. Economies around the world are political in nature, and the short-term thinking of decision makers often creates huge economic problems that eventually lead to major economic drawbacks.

Make no mistake, US politicians aren’t alone in this game. Every politician around the world is in the same game. The only problem now is that the US doesn’t–for the first time in the past sixty years–hold all the cards. At the same time, though, politicians have the power to create problems that can be difficult to fix once they appear. Does the name Reed Smoot ring a bell?

Currently, the US is the world’s biggest and most agile economy, even as it requires the rest of the world to finance its needs. There are many arguments as to why this is so and why it isn’t a problem, but that’s a discussion for another issue.

The fact is that for this arrangement to continue, all parties need to see its benefits. Unfortunately, this isn’t happening. But let’s look at a couple charts that demonstrate the US’ precarious position.

Notice in the chart below that in the second quarter of 2004, the deficit was 5.7 percent. At the end of 2005, the US current account deficit was 7 percent of gross domestic product (GDP). A big increase, by any measure, in a short period of time.

Current Account

In dollar terms, that’s $900 billion per year and $225 million in the last quarter of 2005 alone, as the chart below depicts.

Current Account Dollars

China’s (and India’s, for that matter) rise as a new and important economic power in the global economy and its desire for a bigger piece of the pie has surprised many people. Yet the efforts by some representatives to diminish the issue as one that can be solved with protectionist measures borders on the naïve, if not ignorant.

For an economy that has a legitimate chance of becoming a consumption powerhouse in the next ten years, China receives little respect. At the same time an assortment of US Senate committees continue to compete on who will issue the most incomprehensible statement regarding China.

The latest comes from the leaders of the Senate committee that oversees trade. The proposal imposes new penalties on countries that have a “currency imbalance” with the US. I must admit a complete lack of knowledge as to what a “currency imbalance” is and how these new measures will fix it.

I’ve gone into a little more detail than initially intended for two reasons. First, I want to emphasize the fact that if proposals of this sort become a reality, the global economy will experience a shock–no one knows how severe–that will negatively affect the markets and our investments. Second, it’s important that investors see beyond the smoke, otherwise you’ll lose sight of the big investment trends unfolding around the world.


Returning to the markets, the Federal Reserve raised rates once more, as expected, and indicated it might continue to tighten monetary policy. The continued tightening wasn’t expected, apparently, as the markets reacted negatively.

The market action after the Fed’s announcement was reminiscent of comments from the former chairman of the Fed during a banking conference in Germany on Nov. 19, 2004. In response to a question, Alan Greenspan said, “Rising interest rates have been advertised for so long and in so many places that anyone who has not appropriately hedged this position by now obviously is desirous of losing money.”

That said, it’s becoming increasingly obvious that the majority of investors aren’t certain as to what will be the final outcome of the Fed’s moves and the probable 2007 slowdown of the US economy. The debate between deflationists and inflationists remains animated.

I anticipate a deflationary outcome (i.e., a deleveraging of the consumer), and the only hedge able to cover both is gold.

Gold has been the object of ardor and the target of scorn throughout the centuries, but has never been refused as means of payment. The reason is that gold has no substitutes.

And given the demand for gold we’ve seen during the past three years (from central bank buying to new gold exchanges and liberalization of trade around the world), gold has become the world’s fourth currency. In today’s world of massive deficit spending and financial imbalances, expect demand for gold to continue to increase.

We first recommended gold as a hedge three years ago and the metal remains the ultimate bulwark; gold will rise much higher, easily surpassing previous highs by the end of the decade.

I’ve included an interesting chart below depicting the oil price of gold (i.e., how many barrels of oil are needed to buy an ounce of gold). You can see that the bull market in gold is still in its fist stages: The yellow metal is still more than 70 percent below its 1986 high and 50 percent below its long-term average.

Gold For Oil
Bloomberg, SRI

I’m initiating a gold position as a permanent hedge, the second such position (the other is in bonds; see “Hedge Your Bets,”). Buy gold bullion; if storage is a problem, the streetTRACKS Gold Trust (NYSE: GLD) is a suitable substitute.

Regarding the hedged positions, I must reiterate that “permanent” hedge positions–currently gold and US Treasury bonds–are hedges specifically for the SRI Portfolio. Whether you buy into the other individual stock recommendations, be they long or sort, is left to your discretion.

If you shorted the BHP Billiton (NYSE: BHP) recommendation, you should be stopped out. As a reminder, in the March 8 issue I wrote:
A selloff in commodities is more likely than not. And given that no one knows at what level it will stop, although some people claim they do, investors should be prepared. Take profits off the table and reduce your exposure to mining stocks and the like. There will be better entry points ahead.

The more adventurous can also take a short position in one of the big mining stocks. One suggestion is BHP Billiton (NYSE: BHP). If the selling commences, it will suffer as much as any other, although it will fair better than the little mining stocks speculative money has been buying. If you short the BHP Billiton, place your stop at 37.75.

Metals should correct this year, but the timing for this recommendation, admittedly, was wrong.

In the same issue, I recommended a short on Brazil using the iShares MSCI Brazil Index Fund (NYSE: EWZ). That short is currently working. As I wrote then:

True, the market remains cheap on a valuation basis, but pullback would provide an opportunity for better buys. Investors who want to remain long in Brazil should set tight stops, especially if they’re trying to trade the market. Shorting is also an option, although you need to be careful, as the market can easily defy our rationale–just ask the poor souls who have been trying to short Google since its IPO days at around 100 all the way up to 475. Readers interested in shorting should use the iShares MSCI Brazil Index Fund (NYSE: EWZ) and place a stop at 44.

Brazil still looks like it wants to go down. For some extra hedging activity, continue shorting the iShares MSCI Brazil Index Fund.

Portfolio Talk

The Portfolio continues to build, as positions are initiated gradually. Many readers have asked about allocation suggestions; I’ll take this up next week. The plan is to offer allocation guidelines on an asset basis. As previously discussed, cash isn’t an option for the SRI Portfolio. Allocation recommendations will also be provided for specific stocks, sectors and countries.

For now, note that the Portfolio’s current allocation, for simplicity’s sake, is an equal amount of money in each stock.

Within the Portfolio, Japan and Singapore are the preferred countries, while Telecommunications is the favorite sector because of its defensive characteristics.

That oil prices continue to be high has surprised many people. Having written extensively on long-term trends regarding oil, especially as a contributing editor to Elliott Gue’s The Energy Strategist advisory, I’m not surprised by oil stocks recent lackluster performance.

The question now is whether the recent selloff in oil stocks is an opportunity to gain exposure to the sector. The consensus view is that the price of oil has peaked–since December, many commentators have been waiting for $40 oil. For now, the stocks will have a difficult time.

As an aside, SRI’s current working assumption is $50 oil. Stock valuations, especially for big oil, reflect the consensus view and, therefore, they trade at a big discount to the market at 10 times 2006 earnings.

Analysts expect oil prices to come down–the famous reversion to the mean argument–and, accordingly, recommend no oil exposure. Look at any correction as a breather in a structural bull market that should continue for another five years, if not longer.

For this year, expect oil companies’ earnings to surprise to the upside. Because of the the palpable pessimism and the fact that stocks should react positively, a big oil company will be added to the Portfolio.

Royal Dutch Shell (NYSE: RDS/A) has been through a lot since its glory days in the mid-1980s. It trades at a discount to the super major oil companies and to some of the smaller ones, too. The company has a price-to-earnings ratio of less than 8 times and a low price-to-cash-flow ratio of 6.5 times, while yielding 2.6 percent.

Many analysts admit that Shell is cheap, but view the stock as a value trap story. That’s because they consider management’s strategy too ill defined, not only at the operational level but the financial one as well. The latter is important because many investors are especially disappointed with management’s proposal of cash returns to investors.

It’s well known that if Shell is to regain some of its lost glory, then it has to be successful in its exploration and production efforts. The company hasn’t been good in that regard, especially with the previous management team. Give the company some time and re-evaluate later in the year. Buy Shell.


Finally, I offer a word on the political turmoil in Thailand, a market the SRI Portfolio may gain exposure to because of its low valuations and the potential for an upside surprise for the economy.

As far as the markets are concerned, Prime Minister Thaksin Shinawatra is the only credible choice. Thaksin will once again gain the support of the rural areas. Besides the potential boycott by the opposition (strange ideas on democracy) and other electorate technicalities, if Thaksin comes out strong once again (as he did in the last elections) the Thai market will rise.

Another important factor to bear in mind is that the 60th jubilee of the king’s accession to the throne will take place in June; political observers think the political situation must be resolved by then.

Stay tuned.