With the exception of uranium, I am not so hopeful on energy industry for this year. If you don’t sell them this round, there may be one more chance after some 1 or 2 weeks of the current short-term corrections. After that, energy stocks will probably drop along the general market, with bigger percentage of course.

The inventory picture for crude oil is simply terrible. Too many speculators have been playing the contango in the commodity futures market. What has been happening is that short-term price dropped too fast, while the longer term prices held up much better. A contango (higher future prices than current prices) in the futures market encourages traders to take current delivery, store it, and sell the futures at the same time. What resulted is basically additional (false) current demands that cushion the oil producers, at the expense of increase in future supplies from the release of inventory.

When inventory increases, it simply means that oil producers are not cutting production fast enough to match the fall in demand. That doesn’t bode well at all for the future prices.

I maintain my position that we will probably see something like a double-top formation in the general stock markets, with a second top forming at about June 15, plus or minus 1 week. After the second top falls off from the support trend line, the “sell in May, and go away” will reassert its power.

If you believe in Bible, what kind of investment choices should you make? One of the most mysterious chapters in Bible is the Revelation which predicts the end time. The most interesting part I would have to say are the seven seals. When I first read them, some were kind of clear, indicating wars and plagues. Some were not so clear at all, like the third seal (Revelation 6:6):
“A measure of wheat for a penny; and three measures of barley for a penny; and see thou hurt not the oil and the wine.” (King James Version)

My first reaction was what does that mean?? A penny? I learned much later what the penny means in Bible. Some versions use a shilling or (the Roman) denarius which is essentially a silver coin about the size of a dime, or about the wage of one day work (Matthew:20:2) at the time when Bible was written. In the New International Version, this is what it states for the same Revelation passage:
“A quart of wheat for a day’s wages, and three quarts of barley for a day’s wages, and do not damage the oil and the wine!”

Once you understand the units, it is more clear. First of all, silver which was the monetary unit was worth much more in ancient time, compared to our modern time. If we use an hourly (federal) minimum wage of US$6.55, and 8 hours a day, that will be $52.4, or about 3.75 one-ounce (28.35 gram) silver coins (at US$14) or about 23.5 denarius (4.5 gram of silver content). We are earning 24X in silver than ancient workers. So either it means that silver is vastly undervalued, or our wages are so much better valued than ancient workers. I’m guessing it’s probably somewhere in between, especially silver is no longer used as monetary units.

Secondly, the other part is that the wage of one entire day can only buy you very little amount of wheat or barley, barely enough to satisfy one man’s hunger. It is obvious that it means at the minimum that there is a great food inflation, if not inflation in general. However, it’s basically impossible to only have food inflation. Food is the most essential commodity. Food inflation will drive all other inflations.

As I contemplate what Bible means for the current global economic pictures, it is also important to note that United States is a predominantly Christian country. I think those scenarios if it comes unfolding could apply to US more than other countries through a US dollar depreciation.

We are obviously not through the current phase of economic deflation possibly until 2012. However, the next phase of great inflation is probably just around the corner. Keep the goal in sight.

Volatility is taking over the markets in all ways. Huge down and huge up. In less than a month, commodity complex has corrected significantly, while financial stocks have rebounded “strongly”.

(Click to see enlarged charts)

Since I’ve unloaded most of the energy stocks back in January (missing the entire run-up), I have been quite low on energy holdings. I picked up some natural gas stocks this week given that the price has dropped to the 40-weeks moving average.

There are many names that one can buy, APA, XTO, and CHK, not in any particular order. For a more conservative investor, one can also buy many of the Canadian energy trusts such as ERF, HTE, PWE, and PGH, which didn’t go up as much. And energy ETFs such as XLE, OIH, UNG, and USO, should be a very good way to participate too.

On the other hand, I don’t think the decline in commodities is over. The Elliot wave 3 should be over, and it will take some time for wave 4 to finish its consolidation. I do expect that commodities will probably trade in a range, either flat or slightly down.

If you are an investor, it should be a good time to restock at the low points. If you are a trader, you can probably trade this range for sometime, probably several months, or maybe even into next year.

Regardless, it is very evident that we have a synchronized global slowdown, signalled by emerging stock markets and commodity markets, as I have always believed back in January. In such a slowdown, most stocks will be down. I think the theme going forward will be first recession, and then stagflation.

Baltic Exchange Dry Index indicates the shipping rates around the globe. The actual data is not free and hard to look up. Here is the only place from investmenttools that I can to have any historical charts:

In conjunction with CRB index making new high, the “decoupling” theory of the global economy from US economy seems to be temporarily in play.

This has certainly not gone unnoticed by the shipping stocks NAT which were previously recommended here. NAT has gone from mid-20 to almost 40 now since March of 2008. I have recommended selling NAT back in Dec 2007 or early Jan 2008. My reasoning was that I did not subscribe to decoupling theory. However, whether decoupling theory is true or not, there seems to be an abundance of capital around the globe to bet on continual strength in emerging markets and its related bets.

Certainly, I have been more than amazed. But all the related charts seemed to indicate such. For now, I concede my defeat. However, it will be very interesting to see how things will look in the emerging markets when oil prices go above $200. As Mish have said in his blog, high energy price is actually deflationary (for non-energy related prices), only because you have less to spend on non-energy items.

It certainly looks like the commodity boom will continue for another while. If crude oil has a short term correction, I will definitely be a buyer. If not, I may have to slowly edge back into this market.

I missed out quite big on the recent waves of the hot energy sectors, due to my belief in the global synchronized slowdown. Energy sectors however are still in play (so far).

There are many sub-sectors in the energy. First it was coal, with FDG, PBT. Then it was natural gas, with CHK, APA. Then it was the rebirth of solar energy, with FSLR, SPWR. Most of these names have risen by at least 20% to 100%. And partly, thanks to the high crude oil price, the energy wave seems to be continuing.

Yes, to my surprise, crude oil price has not corrected much if at all. However, the calls from pundits for a significant commodity top, continue to worry me.

If I would have to invest now in the energy sector, I would probably invest in nuclear sector, with CCJ and DNN in mind, both of which I have already owned.

However, if crude oil does correct by more than 10%, expect these volatile stocks to go down even more.

The spot/future commodity markets in general may be making a major top. However, if the thesis of peak oil is correct, pretty much all of the above sub-sectors should give you very good return.

I look forward to a short-term bottom in the energy market to come. But I have been waiting for too long, just like waiting for the general stock markets to tank from last May to last October. Well, it did tank, but the grueling four months wore out my patience completely, and at the end, I gave up my short/hedge positions. Such is the tricky nature of the market.

I would recommend buying nuclear energy stocks for the long term. And if they correct 10% or more from here, I would load them up.

UNG and USO are the commodity ETFs created for people to invest in natural gas and crude oil. I thought after the debacle of under-performance of USO versus the spot market in 2006, UNG will at least wise up. Unfortunately, that is just not the case. It’s almost like a money-plundering business against retail investors, for participating in commodity markets via ETF. They just DON’T work.

I invested in UNG last July in 2007. At that time, the ratio chart of UNG versus $NATGAS was at about 6.25. Now, natural gas has been up significantly, but my ROI is barely some 2% gain. The UNG/$NATGAS ratio is now down at about 4.8, which is about 23% dropped, or money “stolen” from retail investors.

After under-perform by some 20% in USO in 2006, USO continues to under-perform by 7% in 2007. Since inception on April 12 2006, USO has under-performed by about 24%. Now the same story is repeating again in UNG, which started out on April 18, 2007. The tracking errors via futures market by the two fund managers are just too big in a timespan of 1 or 2 years.

I’m going to try out actual commodity futures market myself, instead of investing thru these stock ETFs. I plan to sell out UNG around this price, because I don’t believe in these ETFs anymore. Yeah, I’m going to roll-over the contracts myself if I have to, so that I don’t get hit by contango. In fact, I don’t plan to do any roll-over since I can simply buy the very far dated contracts instead.

Best luck.

Frugal at My 1st Million At 33 .com

First of all, let me say that I’m glad to be back to 1stmillionat33 after a long absence. I had some hardware issues which took a long time to resolve with HP. I’m glad that they are now behind me and I’m back to blogging full force.

Let me also wish everyone a belated Happy New Year even though the market started on a sour note. After all, money isn’t everything. Health and family count far more towards happiness – a truism reinforced for me during this past holiday season. That said, I remain optimistic, first and foremost, in my ability to navigate the economic waters to provide the best for me and my family. My overall perspective stays the same: I’m long gold and commodities and concerned with the economic prospects in the US due to an over emphasis on consumption. With that I’d like to talk about a long term technical indicator that has had uncanny accuracy in the past 15 years.

I learn about this long term indicator from an article on ContrarianInvestor (I’m a subscriber). I doubt they are the originator as moving average crossovers in general has been in use for a long time. The system looks at the relationship between the 17 and 43 week exponential moving averages (EMA) of the S&P 500 index. When the 17 week EMA is above the 43 week EMA, one should long the S&P, otherwise, one should short the S&P. The weekly EMAs are equivalent to the 85 and 215 day EMAs which I plotted using the new Yahoo charts below. I encourage you to play around with the time intervals for the averages. The signals are fairly “robust”, in the sense that buy/sell signals don’t change much given small variations in the intervals. For example, 85/200, 60/200, or even 60/170 give roughly the same thing.

Click to enlarge

The track record of this system is impressive: it correctly gave a buy signal in 1995, a sell signal in 2001 and a buy signal in 2003. One has to go back to 1991 to see a meaningful whiplash. If you go to a shorter interval, you’ll see that the two moving averages have been converging. Indeed, they crossed on Friday to give a fresh sell signal (using 85/215, shorter intervals would have generated the signal sooner)!

Again, I encourage you to play around with the time periods to see how well this system worked (or not worked) before. Although I haven’t done the exact calculation, it seems that this system would handily beat a buy-and-hold approach while having shallower drawdowns since 1950 which is how far the Yahoo data goes back to.

So what’s so magical about 17 and 43 weeks? I can hear you ask. Of course there’s some leeway in those two numbers, but I guess what you’re really asking is the philosophical basis for this system. There is none, or anything a priori that I can tell. This system is based on a long history of observed facts, which by the way, is identical to the reasoning behind statements like “in the long run, stocks go up by x% a year”.

Personally, I’m taking this sell signal very seriously even though I recognize that the market is very oversold and ripe for a bounce. On the other hand, my portfolio is set up to benefit from the on-going global growth story thus is susceptible to a global recession. While I still regard that as unlikely, I will most likely treat any significant bounces in the general market as opportunities to build up a hedge.

Yes, I know the markets are at new highs, and maybe I’m the last person who still hold the view that markets can still correct significantly (maybe by 10% to 15%).

Here are some recent articles that I gathered in no specific order. I suggest that you should read all of them. The markets are like a puzzle (and a moving/changing one). You must put all the pieces together, and attempt to decipher the whole view. I will not go into the details of these articles, but only make a brief comment on them.

1. Upcoming 4th quarter earnings & guidance from Todd Harrison. I consider Todd as one of the astute traders in the current credit crunch (based on his past articles). The 4th quarter guidance may become a point of realization where reality meets hype. Needless to say, I advise extreme caution.
2. Frank Barbera is indicating a potential top in crude oil, while Bob Hoye has gone out stating that the intermediate top in crude oil is/should be in already. Frank Barbera was a little more positive on crude. He believes a more sideways actions from crude due to falling of $US. In any case, what this entails for the the overall market is NOT good. Energy sector has been a leading sector in this bull market. But you can already see it faltering, especially the in the OIH chart (click on the chart, if you can’t see it clearly) which was definitely the leader in gain, but is NOT confirming the new highs in the markets. Furthermore, MACD is giving a sell signal.



3. Despite the above negatives, I am carefully bullsih on precious metals because $US doesn’t seem to be turning around yet. I subscribe to Clive Maund’s observations that PM markets may continue to stride forward due to fall in $US.
4. From the venerable trader Bill Cara’s recent posts, it appears that he is in agreement with my view on the global markets (1998 or 1970). Once in a while, it feels good that someone really well-respected has independently reached similar projections as you do.

So what is the KEY to all these markets, and what would be the TRIGGER of the coming actions? I believe that the TRIGGER can be the 4th quarter earning, a currency unpegging event by China or Petro-country, or another credit crunch event. But the real KEY to global markets lies in the exchange rate of US dollar. If you go back to the recent market panic on August 16th, you will see that market falls are associated with a dramatic rise in $US (to 82.13) and usually a rise in US bonds too. It is counter-intuitive, but it is very true. If the $US falls, US (and global) stock markets tend to rise, and vice versa. Such relationship is not always true, but during those periods that when it is true, the correlation is quite strong. My explanation is that during those times, US markets are definitely not making new high in foreign currency, which is a clear indication that the bull market is associated with US dollar devaluation/asset inflation. And when it goes to reverse gear, for some right or wrong reason, both $US and $US bonds serve as a false safe haven for global financial markets, and all markets (especially emerging markets) get hammered and/or repatriated back to US.

Have you noticed that something weird is happening in the currency markets this week (or last)? $US dollar index stopped falling and turned back up from about 77.6 level. BUT both commodity currencies: Canadian and Australian currencies are either at new highs or close to new highs. If you dig into the details of the turnaround, you will see that while Euro did retreat a little which helped, Japanese Yen did more of the heavy lifting. Apparently, there is some global cooperation going around to help lifting US dollar. However, this turn-around of $US dollar index is FALSE, and therefore, global markets are still making new highs.

If and when US dollar make another strong dead cat bounce, then WATCH OUT. Based on the timing of treasury bond markets however, it seems that this event will probably happen later rather than earlier. The 10 year bond yield is at 4.65%, and it’s truly in the optimal range for Goldilock economy. I think we are at the final stretch of a top, where bond yields are low so that it’s not breaking the backbone of the stock markets, and yet the expectation and sentiments of the stock markets are not turning yet from bullish to bearish. Maybe stock markets can stretch this run all the way into next year before a bigger correction.

In any case, when the lows come, I repeat again here, that the lows in ALL markets should be BOUGHT. I seriously believe that the coming US dollar devaluation is going to generate US domestic inflation and export so much asset inflation around the world that it will be a “Weimar Republic-style hyperinflationary equity blow-off”. Because this blow-off is global in nature, I think the monetary force will be spreaded thinner, and therefore it won’t feel like hyperinflationary (yeah, I tell you that people in China & Petro-countries ARE taking in all of our inflation). However, the best fireworks should be in foreign and precious metal markets, even though US stock markets will probably do pretty okay also in comparison to cash and bonds. The poor bears and deflationists will be crushed by Bernanke, even though they have been always right about the state of economy.

Make sure you get the sequence right. It’s going to be mild inflation, higher inflation, and almost like hyper-inflation, and then deflation/depression. Don’t miss out on the inflationary rocket going to the moon. And of course, since your capital gain is really simply going to compensate/compromise all the inflation, saving on your capital gain tax such as using retirement accounts or Roth IRA probably won’t be a bad idea. And for the last time for your benefits, let me repeat that please forget about using bonds for your retirement for the next 20 to 30 years.

At last, if Peak Oil is really correct and here, then make sure you switch onto the energy bandwagon when the deflation/depression make its early start.

It’s late so I’m not going to dwell too much on the sell-off today. I’ll try to be brief and to the point.

I expected earnings to take a hit in Q3 so the string of Q2 downside surprises was somewhat of a surprise for me. For now, I’m still treating this as a controlled descent even though I have always expected housing weakness to “spill over”. There is a tendency to think the market will keep falling after a big drop like today but things rarely move in a straight line. While I’m not a buy-and-holder, I’ll wait for a downtrend to be convincingly established before changing my long stance.

Precious metals

The XAU put/call ratio made a new high on Wednesday. I have discussed this ratio previously so I won’t belabor the background here. Let’s take a look at the three highest spikes, viz:

• 6/12/06 XAU put/call ratio = 6.7, 6/13/06 XAU intraday low = 119.11, 7/12/06 XAU intraday high = 150.70, a gain of 26.5%
• 6/26/07 XAU put/call ratio = 5.3, 6/27/07 XAU intraday low = 130.83, 7/20/07 XAU intraday high = 159.14, a gain of 21.6%
• 7/25/07 XAU put/call ratio = 7.3, 7/26/07 XAU intraday low = 144.50, …

To summarize, on the first two occasions, a significant bottom in XAU was made one day after and XAU gained 20+% within 1 month. What this most recent spike foretells remains to be seen.

Disclosure: I picked up some GDX calls today.

New high in Shanghai

Unbeknownest to many, Shanghai (SSEC) made a new high Wednesday night. Not too long ago just about everyone was worried about a Shanghai bust taking out the rest of the global markets. Well, I was never on that bandwagon. Recently, there has been an increase of IPO activity in China which is the chief mechanism by which mal-investments occur. However, my main argument was that time, or the persistence of price movements rather than its magnitude, contributes more to mass psychology in a bubble than anything else. Given that SSEC made a significant bottom in late 2005, this “bubble” is still in its early stage yet.

CAF (Morgan Stanley China A Share Fund) is the easiest way that I know to participate in the A shares market. It’s now sporting a 17% discount as US investors have been inundated with bubble talk. I currently have a small position in CAF in addition to some FXI.

“There’s a bull market somewhere”
So the saying goes. Today that somewhere is agricultural commodities (besides treasuries, that’s too obvious). On a Dow-down-300-pts day, they massively outperformed. Just check out DBA, POT, TNH, and of cause, this impressive break out by BG:

Best.

After USO for crude oil, there is another energy commodity ETF for natural gas. It’s UNG. Like most of other commodity ETF, it starts falling right after debut. And it has fallen big too, down about 30% from the height. Given the recent price history of natural gas, it could fall to $4 from the current $6 (price is for the futures market, rather than UNG itself). That’s another 33% potential drop. But for sure it cannot go down to zero, unless you don’t need to pay any natural gas bill.

The advantage of diversifying into pure commodity plays is that while commodity producers are influenced by all kinds of stock market related factors, commodity itself is less swung by the up and down of the stock markets. Rather it is determined by the economics of the supply and demand. The supposed un-correlation should serve a good complement to a portfolio reducing the overall volatility.

To invest in natural gas, one can invest in UNG directly, and/or natural gas companies such as XTO, CHK, BTU, etc. I already own CHK and BTU, but XTO has been a much better performer. I have always wanted to buy XTO, but when I occasionally do remember to check its stock price, the price has never seemed right to me.

As the demand for energy goes up, I expect rotation of rising prices among all energy sources. It’s really the relative economics of different energy that matters. If crude oil prices go up too high, people will shift to other energy sources whenever and wherever it’s viable to do so. There are plenty of choices such as natural gas, nuclear energy, coal, or any other alternative energy. One should asset-allocating for different energies components, and possibly rotate through different forms of energy investment.

At the price of $6 natural gas, and $74 crude oil, it may make sense to re-balance the stakes between natural gas and crude oil bets.

By the way, UNG like USO is an ETF that employ futures contract, and is subjected to price manipulation around expiration dates. Excessive cost in rolling over the contracts will eat into the performance of the ETF. USO is probably the best example in how your pocket can be emptied even when you’re right. The crude oil price is roughly the same around $72 to $75 in May 2006 and now. But some manipulators have managed to empty USO by 20% in a little bit more than 1 year timeframe from $70 down to $56. Now if that is not manipulation, I don’t know what that is. Is that a “random walk”? Shouldn’t the average of contango and backwardation be zero? I’m sure you’ve read the story on Amaranth’s 6 billion hedge fund blowup. But probably less people paid attention to who pocketed their money.

Anyway, for the above reason, I would definitely not put my money into USO or UNG for the long haul. But as a trading vehicle, it should be fine.

Mike Panzner (via the Big Picture) comments on the strength of the agricultural commodities:

Over the past nine months, the Reuters/Jeffries CRB index has essentially gone sideways, and five out of six of its sub-sectors haven’t really moved one way or the other. However, one group stands out: the agriculture sector, with a 33% gain relative to the CRB index.

I noted the break out in DBA (DB agricultural commodity ETF) two weeks ago. Unfortunately, it promptly rolled out of bed and managed to hold the 50 DMA only two days ago. I will continue to monitor this ETF as I’m long term upbeat on this sector. The fantastic volatility should present some interesting trading opportunities.

Now staying with the theme and just to show you a chart that blew my mind, here’s TNH (Terra Nitrogen Co. LP). It’s in the fertilizer business that is enjoying a boom from ethanol and a general lift in the price of agricultural products. Its limited partnership structure probably also attracted yield-seeking investors. I let it go at $75 and $85 and certainly am not recommending buying now. But if you’ve had it for a while, big hat tip to you!

Staying with the energy theme, today’s focus is the mid-tier uranium miner – Denison Mining. It trades in Toronto but is also accessible via pink sheets (Yahoo symbol: DML.TO/DMLCF.PK). I wrote Uranium: The Big Picture a while back when uranium oxide (U₃O₈, aka “yellow cake”) was priced at $42 a pound. Its price has since mushroomed to $95 a pound with almost no pull back along the way.

Cameco (CCJ) is the 800lb gorilla in this space. As mention briefly here, the flooding in its Cigar Lake mine opened doors for many smaller competitors. The current Denison Mines is the product of a merger between the old Denison (DEN.TO) and International Uranium (IUC.TO) which operates a uranium tailings (recycling) facility in Utah in addition to exploration properties in Canada and Mongolia. Denison’s star asset is its 22.5% stake in the McLean Lake production joint venture but it also has other mines at the construction stage, as well as equity stakes in several junior uranium companies. There is a lot more info in their Jan 2007 company presentation (Power Point).

Technically Denison seems to have just broken out of a consolidation triangle which is normally a good entry point.

For more on buying Canadian stocks via pink sheets, read here. The company is said to be preparing for an AMEX listing which should gather it many more fans.

Disclosure: I own this stock. As always, do your own due diligence before making any financial decisions.

Frugal, I finished my taxes last week. Ha!

My post on oil generated some nice comments, including this one from Mike:

it’s $3.50 per gallon at the pump here in San Jose. anyone figured out yet if their profits made in oil related investments actually get eroded in the high prices paid at the pump? sheesh….

While the question itself may be a little facetious, it serves well as a launching pad for two points I want to make. Oh, btw, I drive about 12k miles a year. At 24 mpg and $2.50/gal for regular around here, it’s just over $100 a month. Even if you assume my wife’s car consumes twice that, it’s still more than covered by the nice dividends from my CanRoys.

Sector allocation
The first point I want to bring up is on asset allocation. When one is trying to cover living expenses with capital gains or more commonly dividend income from one’s portfolio, it makes sense to have the sectors match. In the example I gave, dividends from the oil/gas sector covers our actual energy expenses. The same guideline can be applied to utilities, food, etc. Consequently, the sector allocation is determined by one’s actual expenses and dividend rates rather than the sector weighting in some index which is what one gets by buying an index fund. This is an excellent way to hedge the inflation as experienced by each individual.

Crude/gasoline price disparity
The second thing I want to point out is the faster appreciation of gasoline ($GASO) over crude ($WTIC) in the last couple month, which can be seen from the following two charts. Specifically, $GASO has seen 10 consecutive weeks of increases. Obviously, it means the consumer’s pocket book is being hit a lot harder than the headline oil price is suggesting.

A while back, I wrote Sweet and Sour on different grades of crude and petroleum products. It was a primer written by a layman for laymen, if you will. In it, I mentioned the 3-2-1 crack spread which is a very rough approximation of an oil refiner’s profit margin. Basically, 3 barrels of crude is assumed to produce 2 barrels of gasoline and 1 barrel of heating oil. Below is a chart of the crack spread along with crude prices courtesy of Chris Puplava from Financial Sense. Obviously, the refiners are minting money lately. It’s too bad I didn’t pay attention to the names that I mentioned myself. Tesoro (TSO) especially, has gone from $53 to $100 in 6 months.

Although I believe there is considerable political risk from a Democratic congress, I’m looking to increase exposure to refiners. Our energy needs depend on refining capacity as much as crude supply. As the supply of Arab light wanes (due to maturation of the Saudi Abqaiq and Berri fields), refiners geared towards processing heavier and sourer grades of crude will see their margins increase.

More about supply capacity
I cannot overemphasize the importance of refining capacity or petroleum extraction capacity in general. The Canadian oil sands which contain trillions of barrels of oil is being billed to be the savior of world’s energy problem. However, the mining and in situ extraction required are daunting tasks. The oil sand (bitumen) needs to be upgraded into a synthetic crude. The largest oil sands operator, Syncrude, has been expanding capacity in order to increase their production to 350,000 barrels per day (bpd) in 2007. According to this report (pdf, section 3.5) from the National Energy Board of Canada, even if all oil sand projects currently planned move forward, by 2010 total output will amount to little more than 3 MMbpd. Keep in mind that world energy needs are ~85 MMbpd currently and growth is projected to be 1.4-1.5 MMbpd for 2007-2008. Those number should put the promise of oil sands into perspective.

For now, the EIA is forecasting a world surplus production of 2 MMbpd. So even if you think it’s not consistent with the forecast of inventory reduction, there is no need to rush and get your own 1,000 gal tank. I showed that chart on declining Saudi production in the last post. It is entirely possible that they were shutting down wells voluntarily to rest those fields. For now, I’m still expecting oil prices to decline following detente of the Iranian situation coupled with normal seasonality effects. The real test for Saudi production will come this summer when demand picks up again.

The last time we looked at the oil chart was in a post about CanRoys. At the time, there were plenty of oil bears on CNBC predicting $20-30 oil, but I was pretty sure that $50 was going to hold. Fast forward two months, oil’s back up to $63 a barrel. The talking heads would again have you believe that geopolitical tension is the sole cause while completely glossing over the fact that the rebound started long before this latest Iranian incident.

Personally I cringe every time I hear geopolitical events being used as an excuse for price increases, be it oil or gold or anything else. What’s usually left unsaid is that the prices invariably fall as such events subside. Except that quite often the prices don’t fall as much as they rise… While Iran may have contributed a couple of dollars to the oil price, there are greater forces at work. I’ll show a couple quick charts and links and leave you to make your own conclusions.

The first is Saudi oil output in the past five years. The data from four different sources were averaged to produce the black line. Over 2006, Saudi production declined from 9.4 MM bpd to just above 8.5 MM bpd. The full article can be found at the OilDrum.

The next chart is the Baker Hughes oil rig count for Saudi Arabia. The data is only up to early 2006. The rig count increased drastically in 2005, with no apparent corresponding increase in output. So it would seem that the new wells replaced declining production elsewhere, or Saudi Aramco embarked on a massive exploration program, or both. Oil price peaked in July 06, but other than a small supply bump in the middle of the year, Saudi production was a straight line down in 2006.

Click to enlarge

Was the reduction in Saudi oil output by choice or due to production limitations? I leave you to ponder that question. By the way, if you haven’t read Matt Simmons’ Twilight in the desert, now would be an excellent time.

Caveat: This is a look at the long term supply of crude oil, not a short term call to buy oil or oil stocks. As a matter of fact, I think oil will likely move down in the short term to form the right shoulder of an inverse H&S formation. If concerns about world economic growth emerge then $WTIC may retest the lows at $50. It would be a grand buying opportunity if were to happen.

Disclosure: I’m long oil stocks.

Yesterday I wrote a post titled “Caution is warranted” that I didn’t post here because of scheduling and that it contains a link that I know Frugal frowns upon. Since it was posted last night, it wouldn’t have made much a difference anyway.

Nothing I’m going to say is going to alleviate you losses, I don’t even pretend it will limit your future losses. But I do need to talk about specific actions I took today, if only because I have written about those positions in this blog.

- TCK Sold at a small loss as it dropped below the 50 dma. I expect there to be a concern over global economic activity such that base metal stocks will likely be under pressure.
- ITA Sold at a small gain as momentum indicators are rolling over.
- BG Sold at a gain. Same reason as ITA, but even more extended.
- NAT It was already oversold going into today. It dropped in the morning but was unscathed in the bigger carnage in the afternoon. Adding back the $1 dividend it would have been at the 200 dma. Hold
- CanRoys Oil did ok for most of the day. The energy sector had (some) relative strength and I’m a long term believer. Hold

I day-traded EWM and QQQQ and made a little pocket change. At one point, I wanted to short EEM but no shares were available, so I settled on EWM instead. Overall, I believe the sell-off in China was just a trigger for a market on very loose footing. The durable goods number this morning, for example, was awful. This could be as bad as last May and the potential to be worse since the most recent experience taught everyone to hold through the downturn. In addition to IAI and the home builders, I’ll be looking for more shorting opportunities in the days ahead.

Although I have been bearish on the economy, I made no concrete bets as top-calling is reserved for the very bright and the very dim. I’m still in the accumulation stage of my investment life and I couldn’t afford to sit the market out. Now that I believe a top has been established, it’s time to get serious about protecting my assets. I cannot sell the asset allocation accounts easily, so I’ll be looking to offset them with put options or inverse ETFs.

What about gold?

Spot gold fared well during regular Nymex hours. It clawed back from down $11 to close down only $2. However, once the thinly traded Access market started, it was a one way trip down south. It bottomed just below $660. Around 3pm when the Dow was down over 500 points and many PM stocks were down double digits I actually scooped up a couple of names. The fear was so palpable and the bottom so brief that I couldn’t click my mouse fast enough. Still, I’m not sure if I made the right decisions, I may just trade these shares for a quick bounce. At the end of the day I also picked up some GDX puts for protection just in case. Overall, my faith in gold/silver is unshaken. Although I’m quite aware of the short term dangers, the strength of the metals during regular Nymex hours gave me some confidence.

In conclusion, my message is that I don’t expect this to be a one-day event and concrete defensive steps need to be taken. Stay tuned and best of luck.

If you don’t know what is an inflation spiral, read this news about corn. A higher oil price creates demand for alternative energy. Demand for alternative energy creates ethanol demand. Ethanol demand creates higher price for corns. Higher price for corns creates bigger acreage of corns and less acreage for anything else. Therefore, you end up getting not only higher prices in corns, but also higher prices in wheat, soybeans. Since higher prices in corn result in higher costs for meat producers (chicken, hogs, cows), eventually higher prices of meat must come, not to mention a higher transporation cost for all foods (meat & vegetables) due to higher oil price.

Which stage are we at? Higher prices of corns are already here. Meat producers will need to eat up the higher costs temporarily. If you can be in sync with the wave of inflation, you can maximize your profit potential. The best bets on this inflation front I believe is in agricultural producers. The worst bets will be in the agricultural consumers (probably including ethanol producing plants).

Therefore, I suggest long in Archer-Daniels-Midland (ADM) which is one of the largest agricultural producer. Doubling up your bets to make it stock market neutral, you could also short meat producers from Yahoo’s list. Do watch out for possible acquisition due to low valuation in this meat industry. The industry was plagued by Avian Flu, and all kinds of animal diseases (Mad Cow, etc). I invested in GKIS once due to the recommendation from my newsletter Capital & Crisis, but sold out in less than 2 months because I don’t want to be the shareholder/owner of an animal killing machine (I am a 1/3-vegetarian, hopefully eating fully vegan food one day). GKIS was acquired by PPC at ~40% premium, so if you will be shorting, pay attention to valuation.

P.S. For disclosure purpose, I have an existing tiny long position (< 1%) in ADM. Please do your own due diligence because I may increase or decrease my position without notice. By the way, agricultural industry is not a like high-tech. An above-average return is not going to be up 100% or even 50% in a year. Please have a reasonable expectation.

Look at the following charts from stockcharts.com:

The first chart is the CRB, which was a more pronounced bull market in the USA. The bottom chart with $CRB divided by $USD (US dollar index) shows that commodity markets were ranged bound in the last two years priced in US dollar index (or a bucket of international currencies), and seem to have a bottom at about 3.30 for the last two years. Both charts have fallen under 200 days MA however. I believe determining whether the international commodity market has broken down is very important. If the commodity market priced internationally is not broken down, then it should be positive for BOTH stock and commodity markets towards 2009.

Obviously, using $USD index is still somewhat faulty since it doesn’t take the currency values of the major commodity consumers into account. The best chart would be constructed from all currencies, weighted by the amount of commodities that each country consumes. But this is the best that I can chart. You will need to combine both $CRB and $CRB:$USD in a weighted fashion to account for US contribution. Of course, China/India are still missing in the combined pictures. Here is the contribution for each currency in USD index.

The bull market in the past has been more pronounced priced in $US. But nevertheless, it has been a bull market in all currencies until the recent “breakdown”. Let’s see if $CRB:$USD will turn up in the next couple of months.

Look at the two charts below (click to see the details). The first one is the actual crude oil spot price. The second one is USO.

Supposedly, USO should track crude oil spot price. However, since USO does so via futures contract, it is subjected to contango (future price higher than immediate delivery price, which will be UNfavorable to rolling over the contract) or backwardation (future price lower than immediate delivery, which will be favorable to rolling over the contract). You would expect that rolling these contract over would not be such a big deal. But apparently, market manipulation near the futures expiration dates have made USO a costly investment. If you calculate the price gap between USO and crude oil spot, you will discover that from 2004 to March of 2006, the gap of USO – $WTIC is about $4 (ranges from $2.56 to $5.5, but mostly near $4). However, something happened in 2006. The peak in $WTIC was almost $80, while USO was just $74.6, going from being higher than $4 to being lower than $5. And the story doesn’t end there. The gap kept getting worse. On Jan 8th, the gap has grown to negative $8.

I checked the NAV from the home page of USO, just to make sure that what I’m seeing is not due to stock symbol trading at a discount to NAV.
From USO home page, the current NAV or net asset value was 47.70 on Jan 8th 2007.

Even when I factor the management fee / expense ratio of 0.50% for this recent underperforming 1 year, that will only take out $0.37 from USO if I use their peak price of $74 to calculate the fee.

How do you account for this difference of $12 going from +4 to -8 gap to $WTIC? That is a huge 24% loss (using $50) coming from nowhere. I believe that the answers probably lie in the technicalities of rolling the futures contracts. In general, if you don’t take physical delivery of your commodity, you are subjected to market manipulation near the expiration dates. And I think that is what had happened to USO. Obviously, the managers at USO had no choices but to simply rolling over their contracts whenever they see fit or being forced to do so. They don’t have tanks to store these crude oils. I supposed that their hands were forced. Actually, I recall reading an article on financialsense that talks about crude being down $2+ on the date of expiration, while the next closest contract is still some $2+ higher (can’t find it, but it was in Nov or Dec rollover). Usually it would be the most cost-effective to roll over contracts on the last day so that you don’t incur extra time costs. But in the case that I just mentioned, USO would take up an immediate $2 loss on such rollover.

Crude oil is definitely the most political and the more manipulated market. It goes to show you again that taking your gold & silver bars home is probably the best bets. Counting on that the shorts in gold/silver market don’t go bankrupt may be too big of an assumption. Actually, they probably won’t go bankrupt, since they’ve got Bernanke behind their back. They probably just won’t have gold & silver for you, even when the futures contract states that they are obligated to deliver you such.

Do NOT buy USO! Any commodity funds that you buy better be backed by actual physical commodities. Paying storage fee is far better than being at the mercy of market manipulators.

Today I’ll go a bit off the beaten path and venture a bit into the exciting world of, Canadian politics?!

Reuters reported on Dec. 14:

The chances of a quick election in Canada rose on Thursday when both the main opposition parties said they would not back the minority Conservative government in crucial votes early next year.

First, a little background on Canadian politics: Canada has a multi party, parliamentary system where the House of Commons holds much of the power. About one year ago, the Conservatives won a plurality (128/304) of seats in a general election and their leader, Stephen Harper, became the Prime Minister. Since the Conservatives are short of an absolute majority, they have what’s called a “minority government” which makes it difficult to pass legislation.

In December, the Liberals, the main opposition party, elected a new leader, Stéphane Dion. Dion wasted no time in voicing his opposition to the budget proposed by the government which led to the Reuters report above.

The investment angle (of course there is one) in all this again came from the Canadian Royalty Income Trusts (CANROYs). You’ll remember that a proposed change to tax the CANROYs by Finance Minister Flaherty resulted in a loss of ~$26B in the market cap of these trusts. The irate Canadian investors have dubbed it the “Halloween Massacre” base on the timing of the announcement.

The sad thing was that one of the promises by the Harper campaign was to leave the income trusts alone, not to mention that the Conservatives enjoyed wide support in the oil producing province of Alberta. It swept all 28 seats there on their way to victory.

So what if there is an early election? All politicians pander to voters when it’s crunch time and it’s no different in Canada. Retirees were badly hurt from this tax rule change and retirees vote if nothing else. So some relaxing of the rules seems likely. Ideas such as lengthening the waiting period form 4 years to 10 years, or providing a grandfather clause for existing oil/gas trusts have been floated around. Whatever actually happens, I think the worst news is out for CANROYs.

Of course the price of crude is a wild card. While I really enjoyed the gorgeous weather here in the Northeast last weekend, slackening demand and the prospect of a recession has really put a damper on energy prices. Crude (basis western Texas intermediate) has broken down a long term trend line and looking to test low 50’s in the near term. But crude is the most political commodity, I don’t think OPEC/Russia will standby to watch the price drop. I think Wall Street’s doubts in OPEC countries’ discipline to stick to production quotas were based on the previous cycles. Even if half of what Matt Simmons (of Twilight in the desert fame) says is true, we won’t see $40 oil again.

Here’s a small list of CANROYs. Many are poised to re-test the November reaction lows, some have already dropped below (of course, they’ve been paying dividends along the way). I’m steering my portfolio towards more dividend paying names this year, so I’ve been taking positions with the intention to hold. If the changing political winds in Canada provide something more immediate, all the better.

Click to enlarge

Two other blogs on this topic
Specious Argument: for the tax change
Senator Larry Campbell’s blog: check out the comments. Here’s a hint: retirees are not happy.

I’m thrilled of having James West to agree to be a regular guest writer on my site. For those who are not familiar with his work, he regularly watches and reports on the COT (Commitment of Trader) Reports at various futures/option exchange market. What is futures? Here is from investopedia:

A futures contract is a type of derivative instrument, or financial contract, in which two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. If you buy a futures contract, you are basically agreeing to buy something that a seller has not yet produced for a set price. But participating in the futures market does not necessarily mean that you will be responsible for receiving or delivering large inventories of physical commodities….

James’ articles regularly appear at financialsense.com. His reporting on COT is important to put together pieces of puzzles in the stock & various other markets. When you go to casino and play black-jack with dealers, assume that you can count dealers’ cards accurately, won’t you have a much higher long term success due to additional information on calculating the odds of having a bigger (or smaller) number card?

Likewise, it is the same with futures market. Most of the time, people only look at the stock market, stock options market, but forgetting that there is also a futures market. The major brokerage companies are the House in this case. And if you don’t look at the futures market, you are not counting all the cards (or even majority of the cards). Maybe by the outstanding open positions in the option market, you would conclude that market would more likely rise. But you may not be looking at the futures market, where more House money has been betted for a market fall.

By having James reporting on the COT data, I hope readers at 1stMillionAt33.com can be better informed of the futures market.

Let’s hope that James West will continue to make his articles available on an indefinite basis for everyone here. Please welcome James West, and be sure to visit his own site too.

Frugal

First of all, make sure you understand the title correctly. Investing against $US is in no way investing against US, nor is it unpatriotic. As I have talked many times in my blog, I expect a higher than normal inflation rate going forward compared to recent history and compared to other countries, most likely this will translate into a higher depreciation rate versus other currency, and rising prices of commodities. Warren Buffett has betted billions of dollars against $US in the foreign exchange market in his company Bershire Hathaway because he also believed that $US is vulnerable to depreciation due to heavy government debt overhang. Same for George Soros, and Bill Gates (Actually, some of their timing was not that ideal. I think they got screwed by all the central banks).

You could put some of your money in foreign currency, especially in a foreign country that you either travel to more frequently for personal or business reason. I don’t advise anyone to put too much cash in foreign currency in general. The reasons are that the amount of cash that you put in foreign currency will add to the amount of your idle non-investing cash. This amount of cash is also quite less usable to you since it is in foreign currency until you travel to the same foreign country. And unless you divert a significant amount of your asset to foreign cash, your overall portfolio cannot be protected against $US depreciation.

Despite all these, if you want to invest in foreign cash, you can do so very easily at www.everbank.com. This is one of the best international banking site that I’ve seen. Not only they offer certificate of deposit in foreign currency, but they also offer CD tied to a basket of commodity currencies (such as Australian/Canadian/South African dollars). The foreign exchange charge by them is a little expensive for my taste at 1.5%. It means that the moment you exchange your $US to foreign currency, you are already out of 1.5%. So unless you intend to leave those money in that currency for a very long term, and/or use them when you travel, it serves you no good to exchange your money just for a couple of years.

If you have an allocation for bond investment, I advise highly to allocate some money to foreign intermediate term bonds within your bond allocation. There is no easy way to tell how much you should allocate for each currency. Some of the currency that I like better for the long term are Euro, Japanese Yen, Chinese Renminbi, Canadian, Australian, and New Zealand dollars. My criteria for choosing a particular currency are a strong, expanding economy, and/or economy more based on production of commodity. European countries don’t grow that fast, but I would put some dollars in that economy since it (and maybe Yen) would probably be the first primary choice when $US falters.

If your portfolio is small, and cannot invest in individual bonds, I would suggest buying some un-hedged international bond fund, preferably having no US component in it. I found and invested in a low-fee bond like that BEGBX, but its returns are (and were) not great. The primary reasons are obviously that $US has been going quite strong against foreign currency these past 1 to 2 years, and that bonds in foreign currency usually pay less interest than US, especially Japanese bonds which has its interest rate at almost 0%. For that reason alone, I probably would not put too much money into Yen if at all. So please do set your expectation lower when you invest in foreign bonds, and understand your reasons for investing in them. You’re taking a position, not for a quick short term gain.

You can either buy diversified global stock funds or country-specific mutual funds or ETFs (such as EWJ for Japan, EWY for Korea, EWT for Taiwan, IFN for India, EWC for Canada, EWA for Australia, etc.) Diversifying in foreign countries may also help reducing your portfolio volatility, according to Modern Portfolio Theory (MPT). Personally, I would recommend buying ETF/mutual fund from Vanguard, and possibly fine-tune your allocation by adding EWJ, EWY, IFN, and maybe EWA/EWC (both of which are more tied to commodity markets if you are interested). How much you should allocate for each depends on your personal preference? In the long term however, this percentage may be the determining factor of how well your portfolio performs.

By commodity, I don’t mean physical commodity, but rather any investments that are related to commodity price. More specifically, they are natural resources and/or precious metals. I have two focused posts on how to invest in those two sectors. Please simply click on the hyperlinks. Assuming $US depreciates, investing in these two sectors will help retaining the purchasing power of your US dollars. The biggest advantage of investing in commodity-related investments is that it is the more direct way of maintaining your purchasing power (if deflation sets in, your money in this sector will shrink since the current price of commodity is less compared to the time you invested). However, commodity sector is the most volatile sectors of all. If you cannot take an annual swing of some 40+ %, you should control the volatility by sizing this portion to a small percentage until you can accept its overall volatility effect on your portfolio.

Since most of the people (if living in the US) will have the majority of assets in the US and/or dominated in $US, it simply makes good investing sense to have your asset diversified in different countries if not in different currency. Most financial advisors will advise you to at least have 10% to 20% stock/mutual fund holding in foreign stocks. Historically, such diversification reduces your overall portfolio volatility. For the following classes of assets: foreign cash, foreign bond, foreign stocks, and commodity-related investment, I recommend foreign stocks as the safer and better long term way to invest against $US for smaller investors. If your portfolio size is sufficiently large > $500K, I suggest to consider foreign bonds as part of your existing bond portfolio.

If one’s portfolio is big enough (>$300K), and has the tolerance for extreme volatility, one can put some 5% to 20% into commodity-related investments in natural resources and precious metal investments. At times, this may be the only saving grace for your portfolio when both domestic and foreign stocks are down. More and more, due to globalization of world economy, this is increasingly true. Stock markets around the world are quite synchronized. Investing just in foreign stocks most likely will not save you a heart attack in the short term (when all stocks fall) but only giving you a long term advantage.

In the two previous posts in this series (here and here), I discussed a basic allocation plan using stocks and bonds. The current article examines some alternative asset classes that may boost the return without much additional risk.

REITs
Real estate investment trusts are a very popular sector in the past five years along with the bubblicious housing market. REITs (and other income trusts, MLPs) can be thought of as straddling both stocks and bonds. They are ultra long maturity fixed income plays that also reflect the value of the underlying assets. You will not find them in the portfolios at Fund Advice, but they are included in many other plans including that of Index Fund Advisor. A typical allocation would be in the range of 5-10%. There are at least four ETFs of REITs (IYR, ICF, VNQ and RWR) as well as numerous mutual funds available. Current yields of the ETFs are 3-4%.

My thinking on REITs has been evolving. I have been wary of the housing bubble as I have written elsewhere; therefore, it was natural to be concerned about the value of the underlying real estate. On the other hand, REITs are not the same as residential housing, there are apartment/commercial/nursing home/forestry REITs that may be quite resilient. The price action certainly supports the latter view. The chart below compares IYR (iShares DJ Real Esteat Index ETF) with ^HGX (Philly housing index, mostly home builders). You can see that IYR has been steadily increasing with little volatility since 2003 even as the home builders peaked last summer and the apparent deflation of the housing bubble.

More information on REITs can be found here and here.

MLPs and CANROYs
Master Limited Partnerships (MLPs) are similar to REITs in that they do not pay income taxes, and their shares trade on the major stock exchanges just like regular stocks. However, REITs and MLPs are different in structure. Unlike REITs, which are a special type of corporation, MLPs are partnerships. MLPs get special tax treatment. An MLP does not incur income taxes. Its income is allocated among all partners in proportion to their ownership interest. To qualify for the tax benefit, 90 percent of an MLP’s income must come from activities in real estate, commodities, or natural resources such as mining, timber or energy production and related activities. However, MLPs may not be suitable for IRAs and other tax-sheltered accounts.

CANROYs stands for Canadian royalty trusts. More often than not they are oil/gas operators which ties into the commodity theme below. They grabbed dividend investors’ attention during 2003/2004 because many of their payouts were equating to 15% to 20% yields. Now, because so many investors are on to them, share prices have gone up, dropping yields for most to the 6% to 12% range.

Frugal has written on both topics:
Master Limited Partnership – Great Dividend Savers
List of High Yield Dividend Stocks (Up to 18.6%)
Royalty Trusts – Get Paid Royalties w/o Paying (Much) Taxes

Commodities
“Commodity” is a wide-ranging term encompassing hydrocarbon fuels (oil, gas, coal), metals (precious and base), soft goods (grains, sugar), etc. They tracked by at least three major indices: the Commodity Research Bureau (CRB) index, the DJ/AIG commodity index and the Goldman Sachs Commodity indices. All have shown tremendous appreciation since1999.

If you have been following my other articles, you would have known that I’m heavily over weighted in precious metals (PMs) and the energy complex. One attraction of PMs is their lack of correlation to either general equities or bonds according to this study by the highly regarded Ibbotson Associates. I have yet to write a big picture overview for the PM sector, but I urge readers to visit the PM related sites I have linked to in the side bar.

Anyone had to fill up gas in the last two years would understand my preoccupation with the energy sector. I subscribe to the “peak oil” theory which basically states that the world’s reserve of cheap oil has already/is going to run out soon. Again, this is a topic deserving of at least several posts of its own, and I won’t go into much details here.

Hot Commodities : How Anyone Can Invest Profitably in the World’s Best Market Jim Rogers was the best selling author of Adventure Capitalist and Investment Biker. He was also partner to Soros in the legendary Quantum fund. “Rogers also offers practical advice and information for beginners, including the best resources, how to read the commodities reports in the newspaper or on television, the various ways to open an account, information on index funds (such as Rogers’ own index fund that he started in 1998), mechanisms, terminology, and other vital details people must know before investing. Clearly written and entertaining.” — Amazon review

There are two ways to gain exposure to commodities: buy the commodities themselves, or buy stocks in the commodity producing (including exploration) companies. In the first category, the Pimco commodity real return strategy fund (PCRDX and family), the newly launched Deutsch Bank commodity index ETF (DBC) and the more recent iSharies GSCI trust (GSG) are convenient ways for participating through the commodity futures market. For PMs specifically, there are three index ETFs (GLD and IAU for gold, SLV for silver), and a close end fund (CEF, the Central Canada Fund) for both gold and silver. For crude oil, there is USO. Buying the actual commodity eschews individual company risks and may offer short term trading opportunities.

Stocks in the commodity producing (or exploration) companies are more volatile, usually carry some political and management risk, but also offer a healthy leverage to the underlying commodity as they come to be more and more valued on their secure reserves. There are many mutual funds and ETFs available in this area. For precious metals, ASA, GDX and GGN are traded on US exchanges; XGD is traded in Toronto. Gold mutual fund performances in various time periods can be viewed here.

I have spill the most ink in this section because in my view its lack of representation is the biggest weakness in Merriman’s portfolios. Currently, my own target allocation is 30% general domestic equities, 30% general international equities, 10% commodities and 30% bonds. In my actively managed accounts however, PM and energy shares are weighted much more heavily.

Municipal bonds, foreign bonds/currencies, income producing closed-end funds
I’m lumping all these together under the big umbrella as alternatives in the fixed income category. A great site to do research on them is ETFconnect.com.

For individuals in high tax brackets and whose bond allocation are in taxable accounts, municipal bonds offer superior return as the income is tax free at the federal and state (if bonds are from the state you reside in) level. There are closed-end funds that offer very respectable yields (5-6% with leverage).

The US$ has been trending downward since 2000, although the decline was interrupted since the beginning of 2005, longer term it would have to lose value (against gold and Asian currencies most probably) in order to pay for the Social Security and Medicare obligations. It won’t happen in a linear fashion or overnight, but diversification into foreigh bonds or currencies seems prudent and consistent with the basic tenets of asset allocation.

The Dollar Crisis: Causes, Consequences, Cures , Revised and Updated Posterity may remember The Dollar Crisis as a seminal book in the field of 21st century economics. Indeed, rarely has a book offered such a grim yet, well argued view of the current economic situation facing the world.”– Steven Irvine, FinanceAsia

“Duncan writes like a man who’s already seen tomorrow.” — James Grant, Grant’s Interest Rate Observer

One can purshase foreign bond mutual funds. I currently own OIBAX ( it has a front load). Some no load alternatives are PSAFX (has ~15% PM, my wife owns), BEGBX, PFBDX, PEMDX, LSGLX, etc. There are plenty of closed-end funds in this area, again the best bet is to do a search on ETFconnect.com. Yields of high single digit can be expected. On the currency side, Everbank offers foreign currency CD’s (single currency CD’s with a minimum of $10k, index CD’s from 20k) that are worth looking into.

Just to echo Frugal’s Oil market is close at bottom, I picked up some PDS, a Canadian oil/gas royalty trust yesterday.

According to Yahoo Finance, it’s yielding 11.7% based on yesterday’s close at $28.49 — much more appetizing after the recent fall as can be seen from the chart. My read of the chart also tells me that it made at least a short term bottom. The technical picture was only a secondary consideration since I purchased it for its income generating potential for my asset allocation account.

For obvious reasons, the above is not financial advice. Please do you own due diligence before purchasing any stock! Other similar stocks that you could consider are ERF, PVX, PWI, etc.

Have you heard the drop of a needle? No one speaks up anymore. While at the same time, the headlines are overtaken by commodity bears. In a way, sentiment-wise, this is a good thing for bull.

Such big reversal in the gold market happened before, but certainly it is not welcomed by any bulls. While I did expect the decline of crude oil (to $65, but not down to $62), I did not expect such a dramatic reversal in gold. In fact, the timing of such event is simply too suspicious. The entire week going towards the quadruple witching day experienced big selling pressure.

With the big loss of Amaranth hedge fund in the natural gas, things are really grim for commodity right now.

What is my own forecast now?

Gold/Silver: Change to Hold from Buy. Expecting another washout possibly with HUI down to 265, and spot gold down to 550 before a sustainable rally.

General market: Intermediate-term (4 to 5 months) Strong Buy. Adding short-term (~2 to 4 weeks) Sell. Long-term (6+ months) Sell (not so sure yet).

Oil: Change from Hold to possibly short-term Buy in maybe 1 to 3 weeks.

I think the commodity correction probably needs to be more extended, but maybe not much more downside. An extended sideway action of some 2 to 6 months may be in store. Put in simple layman’s term, you probably don’t need to rush in for any new cash. I do hope that a renewed bull in commodity will coincide with a renewed bear in stock market in about another 6 months.

I am still evaluating whether commodity market in general began its bear market descent in May. However, history shows that a “phase change” is never so short in duration. Certainly, commodity market cannot be called a bubble simply due to the participation rate. However, I do not reject the thesis from bears. One must be open-minded to all possibilities. If the bear market began, then it should be the time to liquidate instead of catching more falling knives.

Warren Buffet started investing in ConocoPhillips in the fourth quarter of 2005. But I beat Warren Buffet by fully 1 year on his purchase on this stock, or almost 32% gain (if I use $60 for end of 2005). Click on the image to see a bigger picture from my Scottrade account record.

I just saw the recommendation from DailyWealth again on this stock. It has a very good studies on COP. You can take a look. The article title is “Warren Buffet’s Favorite Energy Hedge Fund”.

Obviously, Warren Buffet is in this stock for the long term. So am I. I bought it in 2004, and just left it there. This year is a year of energy bull on hold, so there was not much return on COP this year. Next year, we shall see. It’s time for anyone who is not onboard to get onboard I believe. I don’t believe it’s too late. And Warren Buffet certainly believed that it’s not too late. But please do your due diligence before investing in anything.

P.S. Lots of readings & links for any of the readers today from PF carnival and My Digg of the Week, or links in this post. I won’t write more for today.

Gold & silver, or more often referred as precious metals (PM) in general, are one kind of commodity. Investing in pure physical commodity usually cannot be done as a long term investment. A commodity has no other value besides its intrinsic value. It will never increase in quantity nor quality as an investment or product, unlike stock, ownership in a company where the corporate earnings can potentially increase with time. So why am I investing in such stupid and “boring” investments?

My primary reason for investing in precious metal & its associated mining stocks is for the inflation protection from fiat currency expansion and its relative undervalue. Yes, gold is undervalued even at today’s price of about $630 per troy ounce. On an inflation-adjusted basis, gold needs to exceed $2090 in 2006 dollar to overcome its 1980 peak.

Comparing to price of crude oil, the price of gold is again undervalued relatively speaking. Oil has almost tripled while the price of gold only doubled since the recent low. Especially with a potential Peak Oil in the global oil production, when oil rises, gold inevitably will rise together.

Comparing to Dow Jones, the cycle of paper stocks seems to be over while the cycle of tangibles like gold has begun. In fact, if you reference to the chart 13 on pg.18 of “The Return of the Bear” by Martin Pring, the well-known technical analyst, you can see that the trend line of S&P 500 over gold has been solidly broken. No matter how you parse it, either gold goes up or stocks go down.

You can read more details on the arguments for investing in gold in this gold-eagle.com article by Eric Hommelberg. It has an excellent summary for investing in gold.

1. From CNN: Hedging a decline in $US using gold.
2. From USA Today: How to hedge against hyperinflation using gold.

P.S. I want to thank Eric Hommelberg at www.golddrivers.com for making all the figures available for this article. I myself is a subscriber to his golddrivers newsletter, and I can attest to the fact that a couple of his recommendations that have truly hit the jackpot (10X return). The volatility can be extreme (+1000% to -90%) for junior mining companies if bought at the wrong time. With the potential high returns, it is always accompanied with high risks. I will not recommended investing in junior minings for any beginning investors.

If you have never heard about peak oil, then you really should read about it in earnest, RIGHT NOW. Search on Google and read everything that you can about it. If it is real, which I think it is, it is going to change the way we live on Earth. It will be a paradigm shift.

Peak oil is a theory by Hubbert, a geologist at Shell. It’s also called the Hubbert’s peak. Essentially, it is based on empirical evidences that the production of oil (or any commodities) follows a Gaussian normal distribution or bell-shaped curve. And by all best estimates, the peak of this bell-shaped curve is from 2005 to 2010. In fact, some experts have declared that peak oil is behind us already. Hubbert gave two predictions in 1956, one of them dated that US oil production will peak around 1970s, and the peak turned out to be the year of 1970. US oil production has ever since gone into decline. However, at the time of Hubbert making such prediction, he was ridiculed widely for his opinions.

You may ask why a normal distribution curve. In fact, this curve is the most sensible curve out of all. In the theories of probabilities, there is a theorem called the Central Limit Theorem. It proves that any sum of MANY independent identically distributed random variables will approach the normal distribution when the number of variables approach very large. Although I never saw anyone tries to make a proof from the Central Limit Theorem to the oil production curve, intuitively I believe that both can borrow the same mathematical framework. One simply needs to treat every small or big oil field as an independent random event, and the final sum approach the normal distribution curve.

So here is a theory of peak oil that is based on empirical evidences and has been formerly shown to render correct prediction. In fact, not just oil, but many production of basic materials follow such curve. Many other people have tried to date the peak for global oil production. Some dates go as far as 2020. I do know for a fact that because of the technology advancement in secondary and tertiary extraction from the oil fields, most likely the peak can be postponed by a little somehow. But whatever extra production that you get now, you will be hit by the accelerated decline in production post-peak.

Based on what is happening currently, I have reasons to believe that we are right at the peak of global oil production. You can read more about it in the book of by Matt Simmons, where he discussed his findings on the oil fields of Saudi Arabia. I heard from financialsense that Saudi Arabia has paid some 4X amount of money to obtain the oil digging rigs around the world, frantically trying to making up any amount of shortfall in their oil production.

What are the implications and ramifications of Peak Oil if it is true and we’re close to the peak (if not behind it)? At the time of the two most populated countries China and India coming to join the world as the new capitalists, improving their living standards, and therefore increasing dramatically their usage of oil and natural resources around the world, global oil demand has stepped on the acceralated pedal. Unfortunately, oil production appears to be almost at the peak. If you recall from the basic of economics, supply/demand curve, with dwindling supply and increasing demand, the only resolution for price is to go up. What’s even worse is that both the supply and demand are relatively inelastic. Supply cannot be increased without dramatically higher price; demand cannot be decreased with our current economic and transportation infrastructure. Relative inelasticity will simply worsen the crude oil price picture.

Here are some more books & websites on Peak Oil. If you have time & money, I suggest you try to read as much as you can about this topic. When I first visited Life After Oil Crash, I was really depressed about the bleak outlook. However, I was able to climb out quickly due to my religious belief and my general optimism. Just be aware not to sink too deep emotionally. But do reflect on all the facts. After all, even a physics professor David Goldstein at Caltech (top three, if not #1 university in science in the US) has subscribed to the theory of peak oil.

1. Life After Oil Crash
2. Peak Oil.com
3. Peak Oil blog
4. Peak Oil from Energy Bulletin
5. HubbertPeak.com

Unfortunately, the development of alternative energy sources and most importantly the infrastructures are so far behind that I doubt that if peak oil is upon us, mankind would be able to come out of the crisis without some serious economic and social upheavals.

P.S. Due to the lack of my time, I would really appreciate anyone who can write some very short summaries or comments on any links or books so that everyone can benefit from it. Thanks. By the way, I bought Hubbert’s Peak, and it has too much technical information for non-geologists. Personally, I would suggest trying Golstein, Simmon’s books.

Natural resources are commodity, meaning that there is no added value at all, besides its intrinsic value as being the material (such as metals or energy) or the commonly consumed products (such as pork, wheat, coffee).  Because there is often no added values, they are probably the least “fashionable” investment that you can find.  It’s whether you have it (holding companies), or you produce it (producer companies), or you explore for it (exploration companies), or you help to explore/extract/distribute it (service/distribution companies), or not.

The most direct way of investing in natural resources is to trade futures contracts in the COMEX or any other commodity market.  Commodities are highly seasonal, and didn’t trend up or down until recent years.  Investing in futures can give you a very big leverage power.  Even when you have carefully planned your leveraging strategy, the leverage in futures market can still sometimes hurt you.  At COMEX, they can change the margin requirement on your leveraged positions for the benefit of the big shorting players.  At such time, you will need to come up with additional cash capital to keep your existing positions.  Often, the result is a wholesale of liquidations by many longs, whether you choose to sell or not.  It’s hard to play a game, when the rules of the game can change against you, right in the middle of the rising fun.  Using leverage under such circumstances become even more dangerous and unmanageable.

Besides futures market, you can invest in the equity market.  If you invest in natural resource producer stocks, you get a little more leverage beyond holding the physical commodity.  The leverage comes in the following form: the natural resource companies have a cost basis of XXX dollars, and the market price for the commodity is at YYY dollars.  The gross profit for the natural resource company will be YYY – XXX dollars.  Assuming that when the market price for this physical commodity doubles to 2*YYY, the gross profit for company will not just double, but definitely more than double.  The only special case is when the cost basis XXX=0 (which is impossible), then the particular natural resource company will not give you any more leverage beyond the physical commodity.  Depending on the actual numbers, the profits can potentially go up very quickly.  When the profits go up, the companies when valuated on the basis of Price to Earning (P/E) ratio, will go up accordingly.

Understanding the gross profit equation is important to the understanding of investing in the natural resource companies.  The equation cannot be simpler, and yet it has a lot of information.  Here is the expanded examinations on how the price of natural resource interacts with the producer companies.  For the following discussion, I assume that one company produces the natural resource at $100, while the other higher cost basis company produces at $200.

1. Survival of the fittest: When the price of the natural resource is very low, the profits at the higher cost basis companies will be wiped out rather quickly.  At such time, only the low-cost companies can survive.  Supposed that the price for the natural resource is at $110, the higher cost company will be bleeding cash, while the lowest cost company makes a tiny profit of $10.
2. Leverage beyond physical commodity: But when the metal price goes from $110 to $220, the natural resource price itself doubled, while the profit at the lower cost company goes from $10 to $120, 12X increase, and the profit at the higher cost company goes from negative to $20.
3. Higher leverage at higher cost basis company: Let’s assume that price goes up again from $220 to $240, a mere increase of $20, the profit at the lower cost company goes from $120 to $140, a 16.7% increase, while the profit at the higher cost company goes from $20 to $40, a much bigger 100% increase.  At such time, it is actually better to invest in the higher cost company despite all the irony associated with it.

The second important thing about the gross profit equation is that normally the sale is priced in the international currency, while the cost is priced in the local currency where it is produced.  This trickiness is not apparent at all in the equation.  When the local currency is very strong, it will actually hurt the commodity producers.  Vice versa, it is also true.  A weak local currency is helpful for the commodity producers to compete at the international arena.

The last extremely important thing about investing in natural resource producing companies is that if the natural resource cannot be easily replenished, the reserve/resource base for the producers become very important.  When the reserve is depleted, the producers must find ways to replenish the reserves, or else the production cannot be sustained.  Natural resources that can be replenished easily are by planting trees (PCL, RYN) at the time of cutting, or any agricultural products.  Natural resources that cannot be replenished easily are oil, gas, any precious metals, or some industrial metals.  There are two different types of measurements for the in-the-ground natural resources: reserves and resources.  Reserves are the recoverable resources at the current market pricing structure.  Definition of Resources is more loose.  Some resource estimates don’t give any consideration to the cost of extracting the natural resources out-of-ground.  That can be very dangerous for investing, because it is possible that those natural resources are as good as nothing, due to the high extraction cost involved.  Amount of reserve to the amount of annual production is an important ratio to consider.  It essentially indicates how long the producer company can operate before running empty.  The consideration in reserves brings out another needed class of natural resource companies: exploration.

Exploration companies are companies that set out to discover places on Earth that have the particular type of natural resource in interest.  These companies are speculative in nature.  But if they succeed in discovering a natural resource base, it is like hitting a home run.  The return can be splendid.  However, because you cannot know beforehand that who will make the discovery and who will not find it, oftentimes, it is highly advisable to either put very minimum amount of your portfolio in this class of investment, or that if you have more money, you should diversify among many more companies than usual, and in each company, you should place a smaller amount than usual too.  But bottomline is still the collective performance of all of your bets in this class.  Obviously, if you leave it to the law of probability, you won’t do too good.  To get an above average performance in this class of investment, you will need a lot of research which often is not available or financially impractical for retail investors.  Still, the return of 10X to even 50X for a home run is sometimes too good to completely take a pass.

The last class of companies are service/distribution companies for the natural resources.  This type of companies perform related services in respect to the particular type of natural resources.  The service/distribution companies depend much less on the up & down of the underlying commodity prices, but more on the volume of the commodity being distributed, or the related services performed.  Their performance usually correlate less to the price of commodity.  Some natural resource service industries may actually inversely correlate to the rise of price of commodity, because as the price goes up, the volume goes down, and therefore, service revenues on those volume actually go down.  But more often than not, stocks in service/distribution companies in natural resources often go up in sympathy with the natural resources.  With a rising total revenue of natural resources, there is often more rooms for profits made along the way.

Here is some holding ETFs that you can consider investing for natural resources: IAU (0.4% expense) & GLD (0.3% expense) for gold, SLV (0.5% expense) for silver, USO (0.85% expense) for crude oil, DBC (1.3% expense) for general commodity, XLB (0.25% expense) for stocks in basic materials.  Here are some mutual funds that I found using Yahoo finance search.  I sorted the list using expense ratio which is very important for the long term performance.  Many top performers in the list probably track more closely to XLE (energy spider, 0.25% expense) and OIH (oil service holder) and are not really natural resources in all kinds but more like a narrowly focused energy mutual fund (VGENX, etc).