When I first started to point out some of the supply/demand imbalances and how the relentless injection of money into the system could produce higher agricultural prices down the road, prices were depressed. Now the fundamentals seem to be playing out and we have seen a major advance over the last year or so.

In my opinion any weakness into March should be another great opportunity for investment.

Daily Wealth newsletter reports that the “U.S. Crop Stock Forecasts Deepen Fears of Food Crisis” read a recent Financial Times headline. The U.S. government cut its estimate for key crops. This came only a week after the U.N. warned that the world faces “food price shock.” Corn and soybean prices jumped and now sit at 30-month highs. Inventories are very tight. Corn is up 94% since June.

And the world worries about a repeat of 2008, when food riots erupted in poor countries around the world. (We are already seeing this)

This is no real mystery when one considers the following:

1- Population increases around the globe
2- Decreases in the ratio of arable land mass (land that can be farmed)
3- Potential inflation from the root cause of excessive money printing
4- Gains in crop yields are slowing creating tighter and tighter supplies
5- Shifting diets in emerging countries due to income growth

So, it’s not just about the supply and demand issues, it’s also about major shifts in what’s going on in the world today.

The Daily Wealth report goes on to say “Food prices will have to rise: There is no way around this. We are all going to pay more for food. Wells Fargo predicts U.S. retail food prices will rise about 4% this year. Some things will go up much more. Pork and beef could rise more than 10%.

Emerging markets are vulnerable: This follows from the above. It doesn’t really faze the typical American to have to pay 4% more at the grocery store. Food is still such a small part of the typical American’s budget. I think Michael Pollan in The Omnivore’s Dilemma points out that the U.S. spends 9% of its income on food, which is among the lowest percentage of any people anywhere at any time in history.

The same is not true in India or China or many emerging markets. In China, people spend 50% of every incremental dollar on food. And in India, it’s more like 70%. So the rising price of food is felt more keenly in these markets.

The price of food is rising faster in emerging markets too. In India, food prices are up 18% and at there highest level in a year. China has the same problem. Prices rose 5% in November alone. All around the world, emerging markets have a big problem with rising food prices. Indonesia’s president is trying to get people to grow their own chili peppers. And the South Korean government recently released emergency stores of cabbage, pork, mackerel, radish, and other staples. I could go on and on.”

So, the moral of the story is, on any weakness I believe a position in agriculture would be a very smart move for the long term, both as a hedge against future inflation and as a way to build net worth. Please read these previous posts for more research on the subject:

Previous Post on Grains 1

Previous Post on Grains 2

Previous Post on Grains 3

Previous Post on Grains 4

Previous Post on Grains 5

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Global governments have gathered debt so massive that there is now concern whether it can be paid back at all without major disruptions for these countries, the U.S. included.  It’s easy to imagine that the value of currencies will be inflated down so dramatically that it presents a major opportunity for owning REAL THINGS that will become more valuable over time.

We have arable land issues and poor water conditions for growing, potential inflationary pressures and potential shortages that could fuel higher prices for quite some time to come. Of all the commodities that I can think of nothing is more valuable than food, especially in an inflationary environment, and particularly if there are demand driven shortages.

In a previous “Viewpoints” post, the foods were drifting in consolidation but lately prices are beginning to confirm the fundamental backdrop. Since the summer corn has appreciated by 47%, soybeans 30% and wheat 43%. There have also been major rallies in cotton and sugar.

I was reading an interesting article at DailyWealth.com on the subject and thought I would share some of the more salient points.

“In 2009, U.S. farmers grew 39% of the world’s corn – 307.4 million metric tons. The crop was worth $48 billion. Our corn exports totaled $8.7 billion. Here are some of the interesting excerpts.

“Most harvested corn in the U.S. is used to feed livestock – 43% of 2009 production. Almost as much (41%) was used for food, consumer, and industrial products (toothpaste, adhesives, cosmetics, starches, sweeteners, oils, beverages, industrial alcohol, fuel ethanol, etc.). The remainder was exported. The U.S. sent most of its corn to Japan, Mexico, and South Korea.”

“The second-largest corn grower, China, produced 165.9 million metric tons, or half the U.S. production. The European Union was a distant third, harvesting 62.7 million metric tons. Brazil checked in fourth, at 51 million metric tons.”

“In 2009, a severe drought in China killed millions of bushels of corn. Stockpiles dwindled to alarming levels as the government sold corn to keep the price from rocketing higher. Into 2010, the situation hasn’t improved. The Chinese have become net importers of corn for the first time in 16 years. Experts predict China will require 6 million to 8 million metric tons of corn this year.”

“The Chinese corn crunch reminds the world of the food shortages of 2006-2008. Average global prices for wheat, corn, and soybeans spiked more than 100%. Rice prices surged more than 200%.”

This chart of the Power Shares Agriculture Fund (DBA) shows the sharp rise in agricultural commodity prices from 2007 to 2008…

“This price rise resulted from changing diets in developing countries and the U.S.’s move to use corn as a fuel source (ethanol). From 2006 to 2008, total global grain consumption increased 3% per year, up from 2% per year from 2000 to 2006. People were eating more meat. You need seven pounds of feed grain to produce one pound of beef.”

“Increasing affluence leads to a desire for greater luxury in everything, including food. Developing and developed countries are now competing for what they want to eat. And that means prices are going up again. ”

“The U.S. produced $31 billion worth of soybeans in 2009. It’s our largest agricultural export. Total exports in 2009 exceeded $16 billion, setting a record.”

“The U.S. produced almost one-third of the world’s soybeans in 2009 (91.4 million metric tons). Brazil and Argentina combined for 50% more of the globe’s production. China produced 7%, and India produced 4%.”

“Soybeans are also used for animal feed. They have twice as much protein content as any other major vegetable or grain. Their protein also makes up many common meat and dairy substitutes, including soymilk and tofu. Soybean oil is used for food and industrial applications.”

“China has overtaken the U.S. as the leader consuming 45 million metric tons of soybeans compared with the U.S.’s 51 million metric tons. Last year, China consumed at least 60 million metric tons. The U.S. consumed less than 50 million metric tons.”

“Unfortunately for China, its domestic production can’t begin to satisfy its growing soybean consumption. In 2009, the Chinese imported more than 45 million metric tons of soybeans. Almost half came from the United States. Chinese producers harvested a little more than 15 million metric tons on their own.”

“The China National Grain and Oils Information Center is projecting total Chinese imports for 2010 will total 60 million metric tons. That would be a 33% increase over 2009. The U.S. will likely supply half of this. This demand is already driving soybean prices back toward their record 2008 levels of $16 per bushel…”

“The combination of increasing global demand coupled with the Fed’s quantitative easing makes a huge move higher in these commodities (and funds like the DBA) likely. Prices could soar high enough to trigger a global crisis.”

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Markets have a tendency to continue their trend even after the fundamentals fail to support the continued advance. This is the definition of a bubble- a market running solely on speculation of higher prices. On the other hand you will see times where the market does not react to fresh fundamentals and in fact can begin heading the other way.

I think there is a very good possibility that the bond market is in camp number two here, ignoring good fundamental news for a continued advance. The inability to make new highs on the announcement of QE2 and the fact that the 10-year Treasury bond auction had the strongest demand in at least 16 years, is disturbing for the bull case.

In addition another warning sign is that the public feels more comfortable owning corporate paper as opposed to AAA U.S. Government paper. Mike Larson of Money and Markets pointed out months ago that “The relative behavior of different types of bonds — and the credit default swaps that reference them — tells you everything you need to know about who is really in good shape, and who isn’t. And right now, the trading action proves the U.S. is guilty of running a profligate, debt-ridden operation, one that’s in worse shape than some American corporations”

He noted where Berkshire Hathaway notes due in February 2012 dropped to 0.89 percent, 3.5 basis points below comparable-maturity Treasuries, in mid-March. Berkshire is officially rated AA+ by Standard & Poor’s, one notch below AAA. He also shows where Proctor and Gamble paper, rated AA-, due August 2012 notes, slipped to 1.12 percent, beating Treasuries by 6 basis points. Finally Johnson and Johnson’s August 2012 notes yielded only 3 basis points less than Treasuries. Unlike the other companies, it is rated AAA.

Also bothersome was when the  “U.S. Comptroller of the Currency (OCC) reported that America’s largest banks now hold $172.5 TRILLION in derivatives that are directly linked to interest rates, the most of all time. That’s over THIRTEEN times the amount they hold in credit derivatives — a primary cause of the 2008-2009 debt crisis.” said Martin Weiss of Weiss Management.

Another extreme development was seen recently when on Oct. 25, the U.S. Treasury auctioned $10 billion in treasury inflation protected securities, or TIPS, at a negative yield. In other words, it seemed that bidders were prepared to pay the U.S. government to own its debt.

Finally we have seen where the Thomson Reuters/Jefferies CRB index — a closely watched barometer of commodity prices — which has climbed to two-year highs recently, with some commodities exploding in price. See Related Post

So here we are, close to 60 years after the 1950 bottom in rates (around current levels) and 30 years after the 1980 peak at 15%. We have retraced the entire cycle from 1950. I’m not sure exactly what that means, but I do know that 30 years puts us in a rather mature trend, and more importantly we don’t have much further to ease rates where it makes any sense to take on the risk.

That’s what I think the bond market is saying. You don’t have to have a bubble to have a market go down. Bubbles imply ownership is irrational and I don’t think owning bonds is irrational. I just think it is a terrible risk reward investment at these rates of return.

Here is the old “a picture is worth a thousand words”-The interest rate cycle from 1950 to the present, compliments of Money and Markets.

 
Claus Vogt of Money and Markets points out that, “the huge money inflow has bond mutual fund managers so excited. Bond fund monthly inflows are rivaling those of stock mutual funds during their record year of 2000. Unfortunately financial history is telling us that whenever a market is being discovered by the masses it’s in the final stages of a secular bull market. Second, the chart pattern for Treasury yields may very well turn out to be a major bottom formation — a huge double-bottom. The first was a panic low associated with the banking crisis of 2008. The second low is currently in the process of being formed. Speculating on a new round of what the Fed has named “quantitative easing,” that is buying Treasury bonds with newly created money, seems to be behind the strong down move in yields during the past months. This move looks like front running of the Fed. Buy the rumor sell the fact” may well be the credo of many astute buyers.

“Knowing that another buyer with very deep pockets and no loss aversion is coming in later, recent buyers have driven prices up, determined to dump their holdings to market participants like the Bernankes of the world. Therefore, I believe there is a real possibility the planned effects of QE2 have already taken place in anticipation of the Fed’s next policy step. And the monetary bureaucrats may be in for a nasty surprise. Third, there are obvious divergences in the behavior of different maturities. Up to five-year yields have declined below the December 2008 low, as shown in the following chart …
 

Source:www.decisionpoint.com

But longer maturities haven’t…. look at 10-year yields in the chart below …

Source:www.decisionpoint.com

Divergences between maturities like divergences in different stock indices are a warning of a possible trend change. The inability of all maturities to confirm is characteristic of the last stages of a bull or bear market. This is important because interest rates are probably the most important market. They affect every other important market we must deal with, and have a major impact on our everyday life. So I would prepare for higher rates, possibly sooner than we think, and definitely for much longer than we would care to see.

Traders and more speculative investors may want to stalk a short position on the current rally.  Look at the yields up to the five year maturities and compare them to the 10 year and the thirty year to see if they can all make yield lows on this rally. Also look at the 10 year and the thirty year to see if they confirm each other by both going to new yield lows. A failure to do so and a turn up in rates would signal that a rate bottom is already in place.
 
 
 

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Granted, there have been some great single stock performances over the last 12 months, but as a whole the S&P has grossly underperformed most commodities. The S&P for the 12 month look back is up 8.3%. Also worthwhile mentioning is that this brings us into territory where we are trading at 21.57 times earnings with a dividend yield of 1.87%. Although there is always room for more stock upside, this is not a “cheap” market as we are told daily on CNBC.  

Now, let’s look at some commodities for that same period. Palladium is up 73% and Cotton is up 55%. In fact 21 different commodities have outperformed the S&P, and 17 of them are up 0ver 20% for the 12 month period. Natural gas and cocoa are the only commodities that are tracked here that are down over the last 12 months.

I don’t know what fools the Government takes us for, but they want us to believe that there is no inflation. The most recent inflation numbers posted by Robert Schiller reflect inflation running at 1.4%.

I have a question. Can we really expect a new cotton shirt to be up only 1.4% when cotton has gone up 55% in the last year? Will I still pay the same for breakfast when Pork bellies and OJ rose over 25%, and coffee over 38%? Can I expect my grocery bills to go up only 1.4% when wheat and oats went up over 30% and corn is up over 45%, Cattle up over 19% and hogs up over 29%? I doubt it.

I don’t think there is much question that commodities have been the place to be over the last year, and my guess is that they will be the place to be for some time to come. I think that if we are truly in a recovery then commodity prices will reflect the recovery and lead the way out. On the other hand, if this is a false alarm recovery boosted by the government QE1 and potential QE2 aid, then you will want to own “real things” and not paper or fiat currency.

So, wake up and smell the coffee as they say.
 
 

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The American media is officially obsessed with sensational terminology when describing the financial markets these days. Nothing trends, it either explodes higher or melts down. We have “flash crashes”, a “new normal” and the frightening “double dip”. We also see bubbles about to burst everywhere.

I would like to know when we un-dipped in order to double dip. It seems to me very little has changed since we began this crisis. Regular folks still have a depressed house, a 401-k that’s cut in half or so, and less income if they have a job at all.

Also, let’s keep in mind that these people who are predicting the next big event are the same ones that were clueless when staring straight in the face of the real bubbles of the 2000 stock market top and the housing crisis.

In any event, in order to attract ratings and circulation something needs to happen for the media every day, even though in reality a crisis of this magnitude will take quite some time to unfold. According to them, we melted down, then recovered, and now are in jeopardy of melting down again. You could get dizzy, not to mention poor, if you don’t stay focused on reality. I wonder if there will be a triple dip.

The U.S. bond market is the “new bubble”, and although I personally would not buy bonds here, I certainly can see why they might continue to perform relative to stocks and real estate. It is not irrational.

If we continue to de-leverage, bonds will stay well bid for years, and even though low coupons are not exciting, there is still safety in a return of principal at maturity, and a positive real rate of return after inflation. As the Taipan Publishing Group points out “government bond yields were characterized as “rock-bottom” and “criminally low.” But those descriptions might have been too strong, as the chart below from Bespoke Investment Group shows.

“Looking back to 1962, ten-year yields in “real terms” — adjusted for core CPI — are not shockingly low. As you can see, in the 1970s, the real yield went sharply negative because reported inflation ate up the entire yield and then some.”

The media has also been quick to show us the “massive” inflow into bonds in the past year or so implying that there is overexposure. They also are implying that this is irrational behavior.

The reality is that U.S. investors don’t have nearly the exposure to bonds as they do stocks or real estate.  According to recent data from David Rosenberg, the American household has about 6% of their assets in bonds compared to 27% in real estate and 27% in stocks. The real exposure to the U.S household is in real estate and stocks. Combined, it represents over 50% of their assets.

On the other note, “The rationality of the message runs completely against the grain of how bubbles typically work. Consider two bubbles of recent vintage, the dot-com bubble and the housing bubble. In both cases, the message sent at the height of these bubbles was NOT rational. It was flat-out nutty. In the case of the dot com bubble, we were supposed to believe that fly-by-night companies with huge burn rates and zero earnings, founded by college kids and touted by sock puppets, were supposed to be worth triple-digit multiples on their way to dominating the world. In the case of the housing bubble, we were supposed to believe that home prices would never fall… that 50-year mortgages were the new thing” says the Taipan Publishing Group.

I think Felix Zuluf articulated the rational message of the bond market quite well in his latest commentary. “When an economy shows the weakest recovery on record despite one of the biggest monetary and fiscal stimuli on record, something is definitely different from previous cycles. In our view, it is debt deleveraging. So far, the US consumer and financial institutions have undertaken steps and decreased leverage to some degree but we are nowhere near the end of this process. At the very best, it will take another 2 years but most likely longer until that process is complete. In the meantime, household income growth or the lack thereof will become the decisive factor. At present, it does not look very encouraging as it is stagnant in most countries or anemic at best. Moreover, in the US, housing is an important balance sheet item for the average household and those prices continue to erode.”

As I said, I am not buying long bonds here but I can understand the message. I do think for safety reasons a position in short maturities still makes sense. Perhaps it’s a good time to tighten up maturities. I would also sell any long term bond funds as the return of principal does not exist there, and the fees will eventually eat up the low income distribution.

Everyone should be raising interest rates, they are too low worldwide,” Jim Rogers said in a phone interview from Singapore. “If the world economy gets better, that’s good for commodities demand. If the world economy does not get better, stocks are going to lose a lot as governments will print more money.”

So, perhaps interest rates are too low and a bond market top is in sight, who knows. Personally I agree with Jim Rogers that we are better advised to be long commodities and hard assets as opposed to paper assets such as stocks and bonds. On the other hand to have a position at the short end of the yield curve as a safe haven for future investment still makes sense.

I am sure of one thing. It always pays to maintain an “anything can happen” posture. It is only good planning to stay flexible and realize that several outcomes are possible. The most important thing is that our risk management strategy allows for the fact that we can be wrong yet live to fight another day.

Imagine that.
 
 

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If you can tell me something else where the fundamentals are so attractive…I’d be happy to put my money there, but I don’t know of any other place – JIM ROGERS ON AGRICULTURE
 

In my last post I talked a bit about the most recent developments in the agriculture market and how I thought it could be a great place to invest in the long term.

The case is really built on some basic facts that are practically impossible to change. First, in order to grow good crops we need good soil, water and the sun. Second, we need ample supplies to meet growing demand if we want to have stable prices.

But is that what’s going on? No.

The reality is that we have some problems with land, water and perhaps the sun. In addition it comes at a time where we are seeing the world’s population growing faster than food production.

The United Nations Food and Agriculture Organization said recently “that worldwide food production will have to rise by a staggering 70% by the middle of this century to satisfy demand growth and that “almost 400 million people will face famine unless food production is dramatically and urgently increased.”

That’s a lot of people in a very compromising position yet production has only increased about ½ of 1 % over the last 20 years to aid the situation. This certainly falls short of the United Nations forecast and in order to meet that forecast, production would have to rise threefold over the current levels. That could be tough.

If that’s not enough, see the chart below where stockpiles are already at record lows for wheat, rice, and coarse grains:

Also as I pointed out in a December post, arable farm land that is properly irrigated is in short supply in the countries that need it most. China used to be one of the largest exporters of soybeans, but now, China is the largest importer of soybeans. I would guess that the culprits here are increasing demand, deteriorating arable land mass and poor water supplies. China and India are well below the world’s average for water supplies yet these are the very countries where the populations are expected to grow the fastest.

Finally, the sun is entering a period where we are likely to see cooler temperatures, more droughts, and other less-than-ideal farming conditions. We’re just entering the low part of the sun spot cycle and this will mean lower crop yields and higher crop prices.

Andrew Mickey, the Chief Investment Strategist at Q1 Publishing pointed out that “Despite all the technological advancement, farming is still a very basic process. Crops still need soil, sun, and water. And one of those important factors is where the problem lies. The lack of quality soil can be offset, to a point, with fertilizer. And there’s also the modernization of the still fertile fields of Eastern Europe and Russia, which opens up a bunch of other issues.” This is why BHP is desperately trying to buy out Potash. They recognize just how profitable a large integrated fertilizer and related feed products company will be down the road.

Mickey also stated “As for water, modern irrigation systems can transport water much farther and distribute more efficiently. Granted, water tables are falling and there are other issues, but for now, there’s enough water in most key agriculture areas.” There may be enough water for now but what about the future. It seems to me the countries with the fastest population growth are the same ones with extremely low water supplies.

In any event, he makes a great point about something most of us don’t think about. What a big role the sun plays in crop production.

“The sun will turn out to be the problem. As we’ve been covering for a long time, the sun is entering the dormant period of the sunspot cycle. This means generally cooler temperatures, more droughts, and other less-than-ideal farming conditions. We’re just entering the low part of the sun spot cycle and this will mean lower crop yields and higher crop prices. The relationship of the sun spot cycle to agriculture is not some new-fangled theory though. In his book Financial Astrology, David William’s states, “In 1875, English economist William Stanley Jevons…announced a correlation in the fluctuations in the prices of wheat, barley, oats, beans, peas, vetches, and rye with [the] sunspot cycle.”

The chart below shows the history of sunspot cycles:

As Andrew so aptly sums up, “The combination of rising demand, low stockpiles, and falling production are creating the very real risk of an imminent “Agrastrophe.”

“Add in the upside potential of commodities and you’ve got a tremendous investment opportunity. There’s one other very important factor here though. If and when agriculture commodities start to run up, people will start stockpiling food. That will only exacerbate the supply/demand imbalance.”

“That’s what happened in late 2007 with the Asian rice riots and it’s still happening all around the world. There have been a total of 70 food riots in the past three years. That’s what makes a strong bull market in agriculture commodities different than others. When it does eventually peak, the run in agriculture will be driven by fear and greed. Those are two forces which by themselves are tremendously profitable for early investors, but are downright explosive when combined. The big run in agriculture is coming. It may not be this month or next month, but everything is in place. And, quite frankly, it’s tough to imagine a scenario where you won’t regret owning agriculture stocks in the next five years.”

And finally Jim Rogers had this to say on his blog August 19th, ”The fundamentals for agriculture have gotten better. The inventories are now at the lowest they’ve been in decades, not years. Sometime in the next few years, we’re going to have very serious shortages of food everywhere in the world and prices are going to go through the roof.”
 
 

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Back in mid December, I had posted a two part series on the agriculture sector. I tried to point out several developments that could lead to much higher prices down the road for the grains. The overhang of the de-leveraging that is going on in the global economy has kept prices in check, but it sure seems that things are changing. The grains have really taken off recently with wheat leading the charge.

I mentioned in the previous post that unlike some asset classes commodity prices can rise from increased demand over current supply, but they can also rise if supplies fall below stable demand. It is always interesting to see both in motion, where demand is increasing and supplies are diminishing. That’s what was happening last year during the price correction of 2008- 2009 and thus presented a good long term buying opportunity.

Now, with Russia’s (one of the world’s largest exporters of wheat) ban on exporting wheat, and the problems they have had with wild fires and droughts, we are looking at a more serious global supply disruption that could have a long lasting impact on global prices.

These new developments come right in the face of the worlds’ population more than doubling since 1950 ( from about 2.5 billion to 6.7 billion and is expected to hit 9 billion by 2050), and the fact that most of this growth will occur in China and India the very places where it is most difficult to increase the production.

So, it only stands to reason that we will need more food.

The United Nations Food and Agriculture Organization (FAO) predicts that worldwide food production will “have to rise by a staggering 70 per cent by the middle of this century if food riots are not to become commonplace…Almost 400 million people will face famine unless food production is dramatically and urgently increased.”

“World agriculture production has increased a paltry 12% in the past two decades. That’s an annualized growth rate of 0.56% per year”, says Andrew Mickey at Istook Analyst.com. “That’s just not going to cut it. In order to meet the Food and Agriculture Organizations statement, agriculture production must grow by 70% in the next 30 years and would require an annualized growth rate of 1.6% – almost three times faster than the rate over the past 20 years.”

I guess over the longer term we can conclude that demand will out run the current production, and prices will rise, unless we increase supplies dramatically.

That doesn’t seem to be happening though (see chart below).

As I pointed out in the December post supplies are steadily decreasing. Stockpiles of grains have been falling since 2002 or so. In fact, wheat, rice and coarse grains are near record low supplies and surprising as it seems, prices have fallen along with supplies (until a few weeks ago).

Well, the Russia scare seems to have been the catalyst to wake the world up a bit. Traders are now wondering what this may mean for grain prices in the future. Right now we are in the midst of one of the strongest rallies in wheat since the late 1950’s. December wheat closed around 5.00 on June 1^st and is currently trading around 7.27.That is a 45% rise in a few months. Now, that’s quite a rally for a few months and might be overblown in the short run……. but it also might be a sign of what’s to come longer term.

So, what can world farmers due to increase supplies to meet the changing demand? What’s needed to get the job done?

Well two things for sure are arable land mass and good water supplies. The reality however is that water is a major problem in the very countries that are growing the fastest. India and China’s water supplies are disturbingly below the global average and the available arable land mass to increase production is low in China and non existent in India.

Thank goodness for Brazil who is rich in both water supplies and available land, but can they carry the rest of the world in increasing supplies to meet the future demand?

Stay tuned for part two of “Water Water Everywhere” when we will explore more of why we think investing in agriculture could be one of the best investments in the coming decade. Click here for part 2

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So where is long term value? Is it in the stock market…. or are we headed for the dreaded double dip recession or worse, a depression under the weight of deflation? Is it bonds…. or is this the calm before the inflation storm? Maybe it’s cash. Even though there is no yield, at least it’s safe. I think.

Honestly, I don’t know how the experts can be so sure of their opinions on the inflation/deflation debate. There seems to be forces on both sides of the argument that imply either or both could unfold. Not a very comforting thought, but there is clear cut evidence of the two forces at work. For example, when is the last time you saw Gold and Bonds go up together for any length of time? The deflationists lean on unemployment and the weak housing market while the inflationists talk of the massive easy monetary policy, and the trillions of dollars of spending by the current administration.

The Nobel Prize winning economist Paul Krugman recently said in the New York Times, that we are entering the Third Depression. Meanwhile, John Paulson the famous hedge fund manager has taken the opposite stance and positioned his money behind a huge bet on gold. Krugman says unemployment and housing continues to weigh on a recovery and will keep inflation at bay. He noted where May 2010 was the worst month for new home sales in America since records began in 1963. Paulson says there is “less than a 10%” chance of a double dip recession. The list of good thinkers goes on with Nouriel Roubini and Robert Precter behind deflation and Jim Rogers and Nassim Taleb backing the inflation horse. Who knows? I’m confused.

Sometimes when I’m confused I look at which investments are doing well to confirm which forecast is more likely to be accurate. This time that’s not working either. Deflationists who are short housing and long bonds over the last several years are doing well. So are the inflationists who own gold and some other commodities, yet stock investors are struggling.

The stock market has rallied somewhat in price from the lows but not really in value when looked at in terms of gold and not the dollar. The Dow divided by the price of one ounce of gold (the Dow / gold ratio) is currently 8.5 ounces of gold. In other words you can buy the Dow with 8.5 ounces of gold. In 1999 it took close to 45 ounces of gold to buy the Dow. So, when priced in gold, the US stock market has been in a severe bear market for the entire 21st century.

Gold on the other hand has been a great investment in the last several years but sometimes it’s hard to buy something that has gone up so much. Personally I believe gold is going higher in the long term but perhaps silver should be taken more seriously at this point. Silver might be a better investment for long term value when compared to gold, stocks or bonds.

In 1980 Gold traded at $800 per ounce and silver at $50 per ounce. Today Gold is around $1200 per ounce and silver is around $17. This baffles me as much as the bonds and gold going up together for years.

In 1980 it took about 16 ounces of silver to buy an ounce of gold (The gold/silver ratio). Now it takes 70 ounces of silver to buy an ounce of gold. If the ratio were 16 today silver would be $75 per ounce, a far cry from $17. In fact, silver could go up three fold just to reach the 1980 high, and that’s not adjusted for inflation.

Now, that of course is 1980 prices. The historical range of recent years has been more like 45-50 which would still put silver around $25 per ounce up from the current $17 which is still close to 50% higher than current levels. In any event either gold is very expensive or silver is cheap against gold. I think it’s more likely that silver is undervalued and the ratio should close favoring silver. Here is a chart that shows how far silver is below its inflation-adjusted peak reached in 1980.

Also there seems to be major demand surfacing in the silver coin and silver ETF markets. Jeff Clarke of Casey’s Gold & Resource Report points out that even though silver has underperformed gold it has still been strong compared to other investments. “This price strength from the “poor man’s gold” has spilled over into tremendous investment demand – especially so for silver coins. The U.S. Mint sold more Silver Eagles in the first quarter of this year – just over nine million – than any prior quarter in its history. The Royal Canadian Mint produced 9.7 million silver maple leafs in 2009, also a record. Take a look at the jump in U.S. Mint coin sales since 2007: Silver bullion ETFs are growing, too, experiencing a five-fold increase in metal holdings since 2006.”

So considering the alternatives, perhaps we should buy silver on any weakness. It has a good chance to perform in either a deflationary scenario as a store of value or as a hedge against a falling dollar and inflation.

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“Everyone hates natural gas right now and rightfully so. It has been in an extended down move for a long time. On the other hand, it has fallen below the critical $4.00, which has triggered buying on previous occasions, lending an underlying support to further declines. We are approaching (or have arrived) at the “its déjà vu all over again,” buy zone.”

Today, natural gas has once again held in the “buy zone,” and rallied out to around the 4.80 zone (Basis August). This lends more credibility to a longer term bottom and perhaps a very important bottom considering what is going on fundamentally.

I have mentioned before where Natural gas is the “natural” alternative to some of our energy problems, especially when one considers the BP spill and its influence on future deep water drilling in America. Perhaps the BP blunder does not stop us from drilling, but I would think it will certainly slow it down dramatically. Look what happened to nuclear growth after the Three Mile Island incident. It virtually stopped dead.

Now, I don’t think drilling stops dead, I think NG will be taken more seriously for transportation energy, especially when one considers that natural gas burns cleaner than oil. In the power generation world, NG emits 60% less CO2 than coal to create the same amount of electricity. Gas also emits far less of other pollutants such as sulfur dioxide and mercury. 

In addition, America has an abundant supply of natural gas and it works with the existing electrical grid. This makes it the fuel of choice for electricity generators looking to build new capacity amid uncertainty over carbon and environmental regulation.  The boom in natural gas will require more pipelines, processing, and storage facilities which will be supported by government loan guarantees.

I also mentioned in the April post that some of the Majors are recognizing NG as a good investment for the future. For example, ExxonMobil invested in a $41 billion acquisition of XTO Energy at the end of last year. I thought that “this kind of commitment is a major bet on the future of natural gas and could set the stage for a raft of future acquisitions by energy majors in the next few years.”

“In 1970, we imported 24% of our oil. Today, it’s more than 65% and growing. We consume 25% of the world’s oil with 4% of the world’s population and if that’s not bad enough we depend on countries that hate us for two thirds of it. We send between $400 to $500 billion dollars a year to foreign nations, that we are in desperate need of right here”.

At the end of the day there are two major fuels that power our electrical grid. One is coal and natural gas is the other. Most power plants can switch the fuels it burns to generate electricity depending on price. Right now natural gas fuels around 23% of the electricity generation in the U.S. and Coal supplies 45%. (Nuclear, hydro, and alternative-fuel plants supply the rest.).

According to Platt’s, which tracks the coal industry, “power plants began to switch from coal to gas in 2009 when gas fell to less than $5.50 per MMBTU (million British thermal units). The government places tons of restrictions on burning coal (and more are on the way). Coal soot is full of harmful stuff – sulfur, nitrogen compounds, and metals (like mercury and lead). The EPA strictly limits these compounds. So power plants face three choices to limit that pollution – install an expensive filter to capture the pollutants before they leave the smoke stack, burn cleaner (but less efficient) coal, or use natural gas”.

The potential for plants to move from coal to natural gas can also be seen in the NG to Coal Ratio.

According to istockanalysyst.com, “The coal-to-gas ratio measures the price of each fuel per MMBTU. So when the ratio is 1, the amount of coal needed to generate one MMBTU costs the same as the amount of natural gas needed to generate one MMBTU. When the ratio is below 1, burning gas costs more than burning coal. When the ratio exceeds 1, coal is more expensive. Typically, gas is too expensive relative to coal to justify the switch. From 1993 to 2002, the ratio bounced between 0.3 and 0.8. From September 2002 to October 2008, it stayed below 0.5. Then, in late 2008, the price of coal began to rise just as the price of natural gas tanked. You can see the big spike in the ratio in the chart below.”

Even though we have backed off of the highs of last year we are relatively cheap to coal, something to keep an eye on. This evidence may not be enough to see NG prices rise sharply, but it certainly lends support to the price floor underneath.

Other signs of a bottom can also be seen in the dynamics between the oil and natural gas markets. Gas producers are now switching to oil exploration as the ratio of natural gas to oil prices is at a near high of 21 to 1. This is simple economics. Producers make way more money exploring for oil these days, and the shift to explore for oil instead of NG will be seen in the NG supplies in the future.

Natural gas giant Chesapeake Energy for instance has recently leased 700,000 acres in the Rocky Mountains to drill for oil. “The economics just compel you to look for oil rather than natural gas right now,” said Chesapeake CEO Aubrey McClendon. Also gas producer SandRidge Energy announced a $1.5 billion takeover of oil producer Arena Resources. SandRidge CEO Tom Ward recently told analysts at a major energy conference that producers can make “10 times more money” drilling for oil compared to natural gas.

So, keep your eye on the new developments in the NG market. Increased demand, Competitive pricing compared to oil and coal, a cleaner abundant alternative to oil and coal, and possible lower supplies due to less exploration may very well lead to a good investment.

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If you really think about it, the Euro is as much of an experiment as it is a currency. As I mentioned in my previous post, the Euro idea was that 16 different countries could join hands under one united monetary policy. The trick is to accomplish this under separate cultures, political structures, and economic climates. How’s that working out?

Anyone who looks at this situation like a human being and not an academic analyst realizes it’s a tough task.

The three amigos, Angela Merkel (Chancellor of Germany), Nicolas Sarkozy (President of France), and Jean-Claude Trichet (head of the European Central Bank) have engineered a $962 billion rescue package. Impressive as it sounds however, the rescue package still has major flies in the ointment, and essentially buys nothing more than time.

Europe is effectively borrowing huge sums from itself. The “PIGS” do not just have a debt problem; they have an economic growth problem, which means they must get more productive and export more. Spain and Portugal are still hemorrhaging and the 20% unemployment will sure put a cramp in any growth. This means a lower Euro if the economy wants to survive.

And why is no one talking about France? Italy owes France $511 Billion (20% of their GDP) on top of Ireland at $60 billion, Greece at $75 billion, Spain at $220 billion and Portugal at $45 billion. That’s a total of $911 billion (over 35% of their GDP) owed to them by questionable countries.

If things continue to deteriorate in Italy and Spain how can’t France suffer. Also, who does France owe and how much? It seems endless.

Ludwig Von Mises, the father of Austrian economics said “There is no means of avoiding the final collapse of a boom expansion brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

To add to the problem the ECB is losing credibility. Last week they said debt monetization (buying bonds) was not even under discussion. Then they did exactly that a few days later. If you change horses in mid stream investors might just get the impression that you’re not to be trusted. They may trust you even less when they realize the solution will be funneled through a “special purpose vehicle”, which is a way concealing questionable accounting by removing debt from the balance sheet and moving it elsewhere.

What is this, three-card monte?

Move it where you like, it’s still there, under one of those cards. Citicorp and Enron attempted to solve their problems through “special purpose vehicles” and look how well that worked out.

Now, finally I would like to take a moment to clear up all this confusion of exactly who owes who what.

Here is a breakdown of the “PIG” debt structure as of December 31^st, and expressed in Dollar terms.

Ireland, Spain, Portugal and Greece all owe Italy. Hold on though, because Italy owes all of them money too, plus Italy owes France, Germany and Great Brittan. I owe you, but you owe me less, but he owes me more than you. If I get him to pay me some, I can pay you some, if you can get the other guy to pay you some, so you can pay me some.

It reminds me of the great Abbott and Costello comedy skit “Who’s on First?”  (Click here to view video)
 

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