Shock to the System

2008 has been an incredible year for commodities. While this drastic shift in focus to our finite global resources may seem immediate to the vast majority of Earth’s inhabitants, it’s actually been coming for a very long time.

Many of us out there who have been involved in commodities trading and analysis have been warning, watching and waiting for the last two-three decades. So it comes as little shock to us that we are in this “crisis” now.

One of my favorite writers and lecturers (and Byron’s, too) is James Howard Kunstler. The Long Emergency is the title of one of Kunstler’s books, as well as one of his catchphrases, and, boy, is it dead on.

This commodities frenzy, and the related dash by nations to snatch up and secure all sorts of resources, has been a long time coming. It certainly didn’t happen overnight. I can safely say that for the vast majority of my career, commodities have been the poor red-headed stepchildren of the investment world. Two decades ago, when I walked onto the trading floor of the New York Cotton Exchange at the old World Trade Center, the climate was very different from today’s.

Back then, most “mainstream” investment houses looked at the commodity markets as a subculture. Commodities were, basically, another branch of Las Vegas, just without the free buffets, dancing girls and booze. Actually, maybe some of that stuff was available on a daily basis, but it was a lot different then.

I compare it to how Times Square was back in the 1970s and early ’80s. If you ever visited the Big Apple back then, you know that Times Square was the worst of all things. It was a seedy, grimy, crime center filled with many colorful characters. Let’s just say Times Square was not a place tourists went, unless, of course, they were sex tourists.

Beneath it all, though, was an unpolished gem. The same is true with the resources market.

Fast-forward to today.

Imagine you’re Rip Van Winkle and you go to sleep on 42nd Street back in, say, 1975 (let’s call you “Rip Van Wino”). You wake up in 2008 and see all the porno houses gone, bars shut down, strip clubs a distant memory… and then, suddenly, you are escorted to a homeless shelter because of New York policies on street people near 42nd Street…

Welcome to the new world.

In some ways, this is true of the commodity markets, too. When I got involved with commodities in 1988, the exchanges were the low men on the totem pole. The members held all the exchanges privately, and none were traded on the stock exchange. It was a secretive world, and the only way to get a job on the floor was to know somebody. I got my job because my best friend’s brothers owned seats on the floor and gave me a job as a clerk.

Everyone on the trading floor was either related to or knew someone in the biz; it was a very incestuous market. The basic reason was that there was so much money to be made in the market nobody wanted outsiders coming in. It was a shortsighted approach, but it was the rule of law down there. The problem was that the markets stayed small and took only a small percentage of the global investment pie.

As the early 1990s set in, commodities, basically, fell and/or stayed stagnant for much of the decade, except for during the occasional war, such as we had in 1990 and 1991 (oil went wild when Saddam Hussein invaded Kuwait).

The general public focused on stocks and still pooh-poohed commodities. Nobody talked about corn or soybeans at any cocktail parties I went to in 1991. Now it’s different. I must get 15 calls a week inviting me to speak about corn and soybeans at events or on TV. It’s been a paradigm shift from 1989 to 2009.

Question: If a bubble pops on Wall Street and all the traders are in the Hamptons, does it make a sound?

The most common question I have gotten on a weekly basis for the last 18 months is “When will the bubble pop?”

My answer is pretty standard: “There is no bubble!”

I am not usually invited back to those cocktail parties, as it scares the guests. The truth is we are not in a bubble. We are in an upward correction propelled by years of denial, stupidity, underinvestment and neglect. The blame falls squarely on several parties.

Wall Street is guilty for not embracing the commodity markets earlier. Wall Street should have allowed commodity prices to reflect the true nature of pent-up demand by making those markets available to its clients. Instead, Wall Street discounted commodities as some form of gambling.

The commodities exchanges and traders are also to blame for not making their markets more transparent, and for also projecting an image of secrecy and mystery.

And both Byron and I could tell you stories about the underinvestment in basic production over the past couple of decades. Really, what were people thinking? That prices were low, and would stay low forever? Did it ever occur to anyone that all those babies born in the 1970s and 1980s might some day grow up and want food, energy and manufactured goods?

No, this is not a bubble. It’s a coming of age, a big, hard reality check that has been decades in the making. I have seen more activity by Wall Street in the resource markets in the last three years than in the previous 17. And I do not expect that it will ever go back to the way it was. I also don’t expect to see 42nd Street filled with porno and hookers again, either.

Change is often hard to accept. $140 oil, $1,000 gold, $8 corn… this is all the new reality. None of these new price trends are a figment of some rogue speculator’s imagination or the products of evil activity. This is a wake-up call that our growing world is hungry for the limited resources it still has.

The most important thing to remember is that markets, even parabolic bull markets, always correct. Those corrections can be painful if one is overextended or married to one side of the market – in this case, the bull market.

So ride the wave of change, of course. Be flexible, buy on the corrections, sell for profits on the overdone rallies and vice versa. Go short when clear tops have been made (although I grant it can be hard to determine the exact top).

There is no trail of breadcrumbs to follow on Wall Street, but that’s why you have Byron and me to help guide you. As long as grains don’t go up too much more, we should be able to supply you with a good trail to follow for many years to come, whether commodities are in rally mode or consolidation.

Best wishes for profitable investing,

Kevin Kerr
for The Daily Reckoning
July 16, 2008

Kevin Kerr is the editor of two highly successful and acclaimed financial advisory newsletters, Resource Trader Alert and Outstanding Investments. A veteran commodities trader, Kevin uses his irreplaceable experience to advise his readers on a variety of commodities investments on a daily basis. Widely considered one of the nation’s top commodities gurus, Kevin’s expert opinions are routinely featured in the country’s premier media outlets.

The above essay was excerpted from the latest issue of Oustanding Investment’s.

Oh dear reader! This morning, we are practically panting…

The world economy is slowing down. The global financial system is falling apart.

The whole situation is a mess…a disaster for investors…a catastrophe for homeowners…a Waterloo for the financial industry. But it is God’s gift to us.

What fun it is to read the paper! So much nonsense! So many clowns! Such drivel…such claptrap…everything is working out just as we expected.

We had to put down our copy of the Financial Times this morning. We were afraid of internal hemorrhage. Besides, our eyes were watering so much we could barely see…

First…there is Ben Bernanke on the cover, looking rather serious, as he appeared before the U.S. Congress yesterday. The poor man was expected to explain what was going on. What could he say, but that the economy was beset by “numerous difficulties?” He had to play the politician, in other words – the cunning dumbbell…avoiding at all costs saying anything useful or true. Of course, it is true enough to say that the economy faces troubles, but that description of it hides so many absurdities…and so many errors…and so many vanities and hallucinations.

Why didn’t he just come right out and explain that Americans have been living beyond their means…and now they’re being forced to cut back? That’s what yesterday’s retail sales figures showed – that consumer weren’t spending so much. What’s surprising about that? Nothing at all…we’ve been talking about it for months…even years.

But the news struck economists and financial reporters like a UFO sighting – they didn’t know what to make of it.

There’s also a photo of a long line in front of IndyMac’s door – waiting to get their money back. Mr. Bernanke might have also explained what was happening in the financial industry. Wall Street banks…Fannie Mae…Freddie Mac…IndyMac…Bear Stearns and the whole lot…made their money by peddling debt to people who already had too much. What did you think…that they could do that forever?

The headman at the Fed would have done us all a service, in our opinion, if he leveled with the nation.

“Look,” he might have said, “the prosperity we have enjoyed for the last few years has been largely an illusion; it was based on debt, leverage, and speculation. We all know you can’t get rich by spending more than you earn. And you can create real prosperity by borrowing money and spending it on consumer items. We’re now paying the price for those mistakes. Let’s just get it over with.”

Those words may or may not have been on call for him. He might have doodled something like that on the back of an envelope on the way to Capitol Hill. Maybe they came to him in a dream.

But when he got in front of the microphone, he realized that the truth is the last thing anyone wants to hear. He wisely avoided it, sticking with the stock phrases and standard wording of economic obfuscation.

Meanwhile, down the street, the U.S. president shifted from soporific twaddle to breathtaking imbecility.

“To the extent that we find weaknesses [in the financial system] we’ll move,” said the president of all the Americans, George W. Bush.

Mr. Bush has a weakness himself – for movement. He has presided over the most fidgety administration since Franklin Roosevelt. Not content to sit still, he spent more, borrowed more, and stirred up more dust than any previous administration. Now, he proposes a vast new expansion of the war against Free Enterprise.

Bailing out Bear Stearns, providing tax refund checks, and nationalizing Fannie and Freddie “signal a weakening of the administration’s ideological commitment to free-market principles,” says the Financial Times.

At this moment, we had to put down the paper. Where has the FT been? This administration has no commitment to any principles, as near as we can see. All it took was a terrorist attack in New York, and it threw over its entire conservative foreign policy in favor of reckless interventionism. And now we have a crisis in the financial industry. Of course, the big lenders, spenders and speculators are only getting what they deserve. Still, the Bush Administration is mounting an invasion.

We predict that it will have roughly the same results. Sweden, of all places, faced a major financial meltdown in 1991. The government hastened to intervene with a bailout. The cost – if translated to an American-scale economy – was more than $1 trillion. Mr. Bush’s intervention will cost that much – we predict. Or more.

*** Let’s check with our war correspondent.

As you recall, just when it looked as though inflation had the upper hand, the forces of deflation began a major counter-offensive. The artillery barrage began only a couple of weeks ago. Since then, the battle has shifted dramatically.

“The balance of economic forces is contractionary,” writes Martin Wolf in the Financial Times.

He notes that inflation is not completely whipped. On the very cover of the FT is the news that “inflation hits 16-year peak.” Also, gold rose strongly, which the dollar fell to a new all-time low against the euro. Still, the gods of financial war seem to have gone over to the deflation camp.

The banks are collapsing. The roof is caving in on housing. And yesterday, even the oil price slipped. It closed down $9 bucks.

So far, the black goo has confounded economists. The world economy is slowing down. People are cutting back on their use of energy. In the United States, families are taking vacations closer to home, for example.

Also, the Bernanke Fed was hinting strongly that it wouldn’t be lowering rates further – and might even be raising them. Under those conditions, the dollar was widely expected to go up…and the price of oil to go down.

It didn’t happen. And even now – with the price of oil dropping – you’d expect the dollar to go up and gold to go down. Nope. Didn’t happen. Speculators are wagering that the United States will soften up the dollar still further…they’re betting on more trouble, that is… They’re dumping oil, because it will inevitably and eventually respond to the drop in economic activity. But they’re buying gold, because they also want safety – from the dollar…from defaults…from bankruptcies…and from the claptrap solutions of public officials.

“If the ongoing deleveraging of the US economy weakened US consumption,” continues Wolf, “the economy might go into a deep recession. US fiscal deficits would then soar and long-term US interest rates might jump. This could make the debt dynamics of the US government look very unpleasant. A flight from the dollar and dollar bonds might even ensue.”

Until tomorrow,

Bill Bonner
The Daily Reckoning

P.S. There is one area of the market that’s not taking it on the chin right now – and that’s the commodities and natural resource sector. We realize many investors shy away from this area because it seems complicated – volatile, even.