Revolutions, Cycles, and Migrations

"The secret of all victory lies in the organization of the nonobvious."
— Marcus Aurelius

"The one really rousing thing about human history is that, whether or no the proceedings go right, at any rate, the prophecies always go wrong. The promises are never fulfilled and the threats are never fulfilled. Even when good things do happen, they are never the good things that were guaranteed. And even when bad things happen, they are never the bad things that were inevitable. You may be quite certain that, if an old pessimist says the country is going to the dogs, it will go to any other animals except the dogs; if it be to the dromedaries or even the dragons…It was as if one weather prophet confidently predicted blazing sunshine and the other was equally certain of blinding fog; and they were both buried in a beautiful snowstorm and lay, fortunately dead, under a clear and starry sky."
— G.K. Chesterton, The Illustrated London News, April 17, 1926


The Little Yellow Book of Capitalism

The world moves in cycles. Sometimes they’re violent. Sometimes they’re peaceful. But they’re always natural. It’s true for politics as well as money.

Lord Rees Mogg got in touch early this week with his latest analysis of political cycles. They’re taking the world to the left. His piece hit my e-mail inbox a few days after Dr. Faber sent an analysis on economic cycles, especially commodities.

They’re both pretty timely. With commodities taking such a beating in the last few weeks, now is a good time to step back and see where we are in the larger cycle of things. Dr. Faber does a bang-up job of that. And while nothing can be completely reassuring (because no forecast can be completely right, except maybe that the sun will come up tomorrow), his analysis confirms that the commodity cycle has only just begun. It’s going to be a long one, and for patient investors, immensely profitable.

That doesn’t mean it’s without risk. But maybe your biggest risk right now is mistaking short-term noise for a long-term trend. For example, did you see today’s news that Russian Steel maker SeverStal is merging with Arcelor to create the world’s largest steel producer? Arcelor had been the target of a takeover bid by India’s Mittal Steel.

It isn’t the first time SeverStal has won a bidding war for real assets — the kind that produce capital and future income, the kind so very different from, say, mortgage lender Fannie Mae. In fact, the SeverStal bid caused me to flip back to Pages 117-18 of The Bull Hunter , where I found this passage:

"The Russians and the Chinese — our former communist competitors — aren’t racing out to buy Google. They’re buying real assets all over the globe, even right here in America. These capital assets will help them compete globally. They’ll also produce new income. The jobs have already moved. But some of the most important industrial machines and factories haven’t. So foreign investors are showing up in America [and all around the globe] to buy those too. It’s a perfectly sensible strategy, if you’re genuinely interested in long-term real economic growth…

"By now, the point should be shockingly clear. Foreign governments, foreign corporations, and wealthy investors are using financial assets to acquire real assets. The shift out of paper and into stuff is on…What can you do as an investor?"

The rest of The Bull Hunter proceeds to answer just that question. Names are named. And the whole idea of the Money Migration — the transfer of wealth from the West to the East — is spelled out in easy terms. That’s why some of my friends have privately called The Bull Hunter the "Little Yellow Book of Capitalism."

I’m not sure how I feel being compared to Mao. Not too good, to be honest. But you can judge for yourself if they’re right. The Bull Hunter is out in paperback today. At just under $10, I’ve spent more on bad beer. In my humble opinion, it is a bargain. And more importantly, with volatility on the uptake and some of the great financial events of our time playing out over the summer, it’s a useful guide for all investors. You can find it on or at your local bookstore.

(Greg’s Note: you can obtain the newly-released paperback edition of The Bull Hunter here.)

And in the meantime, here is more big-picture analysis from Lord Rees-Mogg and Dr. Faber. Have a great Memorial Day weekend.

A Turn to the Left, by Lord William Rees-Mogg

There are long-term political cycles as well as economic ones. At some periods, such as the Second World War, the challenges of history seem to sweep away a whole generation of weak statesmen and bring forward figures who are capable of overcoming great difficulties. Men like Daladier and Chamberlain are replaced by those like de Gaulle and Churchill. Equally, there are periods of weakness, when the leaders seem to lose control of events.

The world seems now to be going through one of these periods of decline, which are not always the fault of the statesmen concerned. It is possible for great statesmen to face a challenge not suited to their experience or talent. Churchill was a failure as chancellor of the Exchequer in the late 1920s. He went back onto the gold standard at too high a rate and made an overaggressive response to the industrial problems of postwar development.

At present, most of the governments of the Western nations are weak. We are particularly conscious of this in London, where Tony Blair is clinging onto power but has lost public confidence. The latest polling figures show the Conservatives, under their new leader, David Cameron, ahead at 38%, Labor at 34% and the Liberal Democrats at 20%. The next general election is expected in 2008, but could be postponed until 2009. The new home secretary, John Reid, is the tough guy of the Blair administration. He has delivered an extraordinary attack on his own department, accusing it of a systemic failure over prisons, immigration and information technology. His criticisms are justified, but I have never before heard a minister criticize his own department in such terms.

A similar situation exists in France, where the problems are worse. President Chirac now has virtually no chance of being re-elected in the election of 2007. His prime minister and chosen successor, M. de Villepin, is at 6% in the polls. The choice seems to be one between M. Nicolas Sarkozy and a charismatic woman leader of the left, Mme. Ségolène Royal. At present, it looks as though France will swing to the left next year.

In Italy, the swing to the left has already taken place. Romano Prodi narrowly defeated Silvio Berlusconi in the election. But the prospect for the Prodi government is alarming. Its majority is small and Italy’s economic problems are serious. Italy has had virtually no growth in the last year. In the larger European powers, Angela Merkel in Germany is the only head of government who is gaining support.

European governments are in trouble, but one always looks primarily to the United States. The next presidential election is not until November 2008, but the campaign has already started, if only for the party nominations. The front-runners for the Democrats are Hillary Clinton and Al Gore, who have both the name recognition and the fund-raising ability. Neither of them can be ruled out, though Hillary has many enemies and Al has the reputation of being a loser, though he won until the Supreme Court took it away from him.

For the United Sates, there are two issues: the economy and Iraq. The current downturns in the U.S. housing market and in global stock markets provide reasons for anxiety about the economy, particularly for the midterm congressional elections next November. Iraq has become an unpopular war.

Current polls suggest that the Democrats may be able to break through in November and win at least one of the houses of Congress. The advantage of incumbency and the large number of gerrymandered Republican seats provides some sort of a sea wall for the Republicans in the House of Representatives, but when sea walls break, the floods follow.

A Democratic majority in the House of Representatives, if one is elected, will attack President Bush. He may be impeached, like Clinton, or threatened with impeachment, like Nixon. He will certainly face a House inquiry of some kind. The Democrats have not forgiven the Republicans for their attack on Clinton, or for "stealing the White House." The attack on President Bush may or may not decide the presidential race in 2008. It would certainly disquiet and damage the president’s last two years in office.

Bonds, Stocks, Commodities, Real Estate, or Gold? By Dr. Marc Faber

I have great sympathy for the view that over the last 200 or so years, investments in commodities performed poorly when compared to cash flow-producing assets such as stocks and bonds. As I have shown in earlier reports, real raw industrial prices have been in a downtrend since the Napoleonic Wars (see the chart below). I also agree that, as the analysts at GaveKal suggest, "Every so often, we experience a massive break higher in commodity prices in which commodity indexes triple in less than three years," which is then followed by a period of poor performance.

Still, we need to ask ourselves why in the last 200 years commodities, adjusted for inflation, were in a continuous downtrend and whether it is possible that something might have changed in the last few years, which would suggest that this downtrend is about to give way to a sustained outperformance of commodities compared to the U.S. GDP deflator.

The other question is of a more near-term nature. Should commodities, having approximately trebled in price since 2001, be sold, or should we expect far more substantial price increases? I have to confess that I have little confidence that I can answer these questions satisfactorily.


Still, the following should be considered. In the 19th century, and for most of the 20th, industrialization was concentrated in a few countries, which for simplicity we shall call the Western industrialized world. The world’s economy was at the time characterized by an abundance of land, resources, and cheap labor (certainly in the colonies and later in the developing countries) and a relatively limited supply of manufactured goods.

At the same time, growth and progress was concentrated among a very small part of the global economy — either in the Western industrialized countries or among a tiny part of the population (the elite) in developing countries. In addition, there were hardly any other sectors in the economy where productivity improvements were as high as in agriculture and mining.

These factors — abundance of land, labor, and resources, combined with huge productivity improvements and limited demand from the then still small industrialized world — may, at least partially, explain why commodity prices failed to match consumer price increases for much of the last 200 years. Remember that, in the first half of the 19th century, manufacturing was concentrated in England, with a tiny population, while the British Empire could draw on the supply of commodities from an enormous territory.

Then, in the second half of the 20th century, we experienced the socialist and communist ideologies, and in India policies of self-reliance and isolation. As a result, about half the world’s population remained largely absent as consumers of goods. (How many motorcycles and cars were there in the Soviet Union, China, India, and Vietnam 25 years ago?)

But while largely absent as consumers, people in these countries continued to produce raw materials and agricultural products. Therefore, I suspect that the removal of approximately half the world’s population as consumers through socialism and communism may have been an important factor in the poor long-term performance of commodities compared to the U.S. GDP deflator, and other assets such as equities.


Since the breakdown of communism and socialism, the world’s economic fundamentals seem to have changed very importantly. Initially, the impact of the end of socialism was muted. Production shifted to China, but as had been the case with production shifting from the West to Japan, South Korea, and Taiwan between 1960-1990, rising industrial production in former communist countries largely substituted for production in the West. But over time, in countries such as China, rising investments and industrial production boosted real per capita incomes considerably and made way for a tidal wave of new consumers. In turn, these additional new consumers lifted industrial production further, in order to satisfy not only the demand from their export markets, but their own needs as well.

Thus, industrial production and capital spending increased further. This led to additional income and employment gains, further domestic demand increases, and so on (multiplier effects). In short, as explained in earlier reports, the opening of China and of other countries has permanently shifted the demand curve for consumer goods and services (for example, transportation) to the right, and along with it the demand for industrial commodities and, notably, energy (see the chart above). Now, if all goes well in India (a big if, I concede), then the demand for goods, services, and, hence, commodities will continue to increase very substantially for another 10-20 years.

As can be seen from the chart, Indian oil consumption has just recently started to turn up. Should its demand now accelerate, as we believe it will do, it is very likely that China’s and India’s oil demand could double in the next eight years (see chart). (Note that demand from China and India for oil doubled in the last 10 years.)


There are a few more points to consider. For much of the last 200 years, developing countries, where many of the world’s natural resources are located, had trade and current account deficits with the industrialized world. These deficits were a constant drag on these countries’ ability to accumulate wealth. But now, through its current account deficit, the United States is shifting around $800 billion annually to the economically emerging world.

This represents a huge shift in wealth from the rich United States to the current account surplus countries. That this shift in wealth stimulates their economies and consumption, and along with these their own demand for commodities, should be clear. (Rising domestic energy demand in Indonesia amid falling production has turned the country into an oil net importer!)

Now, for most countries, a current account deficit the size of that of the United States would lead to some sort of crisis (for example, the Asian crisis of 1997) and then to a curbing of consumption. However, in the case of the United States, which is endowed with a reserve currency, trade and current account deficits are simply financed by "money printing." So at least for a while (but not forever), the shift in wealth to the emerging world won’t have a negative impact on America’s economy and consumption.

And at least for now, rising demand and wealth in the rest of the world won’t be offset by declining demand and shrinking wealth in the United States. On the contrary, the global imbalances arising from overconsumption in the United States have brought about a global economic expansion, which, while unsustainable in the long run, is nevertheless firing on all four cylinders at present. Simply put, the excess liquidity that the Fed has created — and that it is still creating, I might add — has led to a global and synchronized economic boom. (If money were tight, the asset markets wouldn’t rise.)

Supply Begets Demand

The following point regarding the demand for commodities is frequently overlooked. In the developed countries, commodities account for a very small part of the economy. As a result, price increases for oil and other commodities have a very minor impact on growth rates and on consumption. However, in the commodity-producing countries (in the Middle East, Africa, Russia, Latin America), commodity production is an important part of the economy. So when commodity prices rise, their economies are, as in the case of the Middle East, turbocharged. GDP per capita then soars and leads to a consumption and investment boom, which then increases these countries’ own demand for commodities.

This is particularly true for resource-rich countries that have large populations and also explains why, in the 19th century, when agriculture was still the dominant sector in the U.S. economy, rising grain prices led to economic booms, while declining commodity prices were associated with crises. (In recent years, financial markets have begun to have a similar impact on economic activity as agriculture had in the 19th century: Rising stock markets = boom, falling stock markets = bust.)

In sum, we could argue that the emergence of a large number of new consumers in the world following the breakdown of communism; expansionary monetary policies in the United States, which have led to a rapidly growing current account deficit; the U.S. dollar’s position as a reserve currency, which enables the Fed to create an almost endless supply of dollars; and new demand from the commodity producers themselves have all led to a significant increase in the demand for raw materials.

I am not predicting here that from now on the demand for commodities will always outstrip the supply. In time, new technologies (in particular, in the field of nanotechnology), which will permit resources to be used more efficiently, and conservation will curtail demand for raw materials. But until the effects of these factors kick in, a tight balance between rising demand and existing supplies could remain in place for quite some time.

Other Factors to Consider in the Pricing of Commodities

As discussed in the past, commodity cycles (Kondratieff cycles) are of a long-term nature (see chart). From peak to peak or trough to trough, they last 45-60 years. Now, if we take the last commodities price peak as having occurred in real terms (adjusted for the CPI) in 1974 and in nominal terms in 1980, the down wave lasted until somewhere between 1998-2002. (In real terms, commodities bottomed out in 2002.)

So the down wave would have lasted between approximately 18-28 years, which would fit with the Kondratieff long wave cycle, in which the rising and the declining waves each last between 22-30 years. We are now in year 2006 — in other words, in real terms, we are only in the fourth year of the rising wave.


Based on previous long commodity cycles (lasting, as indicated, 22-30 years), it would therefore be most unusual for commodities to peak out now. And especially so considering the severe and long bear market in commodities we had since the 1970s, which brought down commodity prices in real terms by more than 80% (see chart). Once in a while in history, there are so-called price revolutions, such as those that occurred in the 16th, 18th, and 20th centuries.

During these price revolutions, commodity and consumer prices do rise for an extended period of time. Inflating prices are usually caused by expanding money supply combined with genuine shortages. As can be seen from the chart below, the enormous quantity of gold and silver that flowed from the Americas to Spain led to rapid price increases throughout Europe for most of the 16th century. An index of wheat, livestock, and wood in England rose from around 100 in 1500 to 788, 649, and 500, respectively, just past the end of the century.


I mention the 16th-century price revolution because of the similarities with today’s environment. In the 16th century, the economic sphere of the world was significantly enlarged as a result of the discovery voyages. Global liquidity expanded enormously as a result of the gold and silver shipments from the New World and borrowings by the Spanish Crown. In addition, global trade took off following the circumnavigation of the Cape of Good Hope by Vasco da Gama in 1498.

At the same time, commodity prices were very depressed. Today, the world’s economic sphere is vastly expanding. Around 3 billion people who lived under the socialist and communist ideologies are being integrated into the capitalistic system; the Federal Reserve and other central banks are increasing global liquidity by printing money; international trade in goods and services is growing strongly, thanks to new technologies (containers, Boeing 747 freight carriers, the Internet); and commodities have reached, in real terms, their lowest level in the history of capitalism.

So when I compare the 16th century to the current environment, I could envision a 21st-century price revolution that would drive commodity prices up for an extended period of time. I may add that when commodity markets become tight, excess liquidity has a particularly favorable impact on commodity prices compared to the prices of manufactured goods and wages. This is so because producers of commodities can reduce supplies (by producing less, producers can earn even more) and partly because investors and speculators begin to hoard commodities as a hedge against monetary depreciation (a flight into hard assets in order to hedge against inflation).

(Greg’s Note: here ends Dr. Faber’s excerpt.)

Regards — and until next time,
Dan Denning
May 27, 2006