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Wednesday, September 29, 2010

King Cotton or King Dollar....

Is it just me or has anyone else noticed that the futures price of cotton is ramping up pretty dramatically. What do the cotton traders know that we don’t? Could it be a run on cotton in anticipation of the FED’s QE2? Of course I am making fun of the commodity rise and QE2 here. Most people believe that if we could stop the FED from printing\monetizing dollar bills that we could save tons of paper and hence the rainforests. What people don’t know is that the US Dollar bill is not actually made from paper, but instead it is a special cotton linen blend; which is why if you look closely you can see the fibers particularly the red and blue single fibers integrated in to the bill. I am guessing that to keep the public fooled the US Government uses preshrunk cotton, but I digress.

In all seriousness my wife and I were out to dinner this past Saturday with friends and I got in to a discussion about the Dollar. I like talking with my friend about economic issues and business as he has been a CFO for a variety of companies. He is also is Ivy League educated, so he is a pretty knowledgeable fellow with strong opinions. The conversation actually started off with the subject of the original TARP bailout and whether or not we were truly on the brink of financial Armageddon, which I believe was over blown by the media just like H1N1 and the anthrax scares etc… Would there have been problems due to the credit market freeze up, of course, but this simplistic view does not take in to account lines of credit and other means of funding that are on contract and would have been unaffected. We agreed to disagree and this is not the focus of this post, instead it was just a little color commentary.

So as we discussed the Dollar we talked about the concept of beggar thy neighbor where all currencies are debased against each other. At the moment all governments around the world are engaged in a game of devaluing their currency against everyone else’s in an effort to restart their economy. Presently, if your currency is weak it will drive exports; that is if you have a manufacturing sector that can export. My friend’s argument was that all will be well if the governments around the world keep devaluing currency against each others. Today all the currencies are what is called FIAT currencies, no it has nothing to do with the Italian car company, but instead it means that they are not backed by anything tangible such as gold or land.

In the land of FIAT currencies the US Dollar for the moment is considered the least toxic of the superfund sites. The problem is that this is a race to the bottom since you can only devalue to zero. Given the debt and problems of the economies and governments worldwide there appear to be few winners in this currency war. There have been many arguments showing pretty graphs demonstrating that the US’s situation is “less bad” then other countries such as Greece, however, all the graphs, charts and articles I have seen are misleading. They are misleading because they never include all the debt of the US, specifically I am talking about the unfunded or off balance sheet liabilities. An article was recently published quoting Larry Kotlikoff and the unfunded liabilities including social security, medicare , various wars and other items now totals in excess of $200 Trillion…..NO THAT IS NOT A MISPRINT IT IS TRILLION WITH A “T”.



So not only are we in a race to the bottom but a global confidence game as well, and this cannot end well. The implications for the Dollar are that it along with most currencies will end up in the dust bin of history like so many FIAT currencies before it. It is the devaluing of currency and loss of confidence in FIAT money that is boosting gold and silver prices worldwide, since all the currencies are devaluing against each other they all need to devalue against something and that something is precious metals. This group of metals are called precious because they are hard to come by unlike currency which these days can be created in massive quantities by a few keystrokes. The prior debt fueled boom and now the debt fueled recovery only serve to undermine the currencies and place a put under precious metals, since they are no ones liability and are not subject to random dilution. Instead the cure for the debt bust and now debt recovery is going to be more debt which sows the seeds of a massive inflation as more will need to be printed and monetized to keep the game going.

For the record I am not a gold bug nor do I recommend that you run out and buy 100% of your assets in precious metals bullion or stocks, but instead you should look for a pull back to add a percentage of your portfolio as insurance. Many of you are thinking that the metals have had quite the run and this is the peak, to that I say I have heard that argument going all the way back to $325 an ounce on gold and $5 on silver. As of this moment the public is asleep at the switch regarding the precious metals market, don’t believe me call up 10 of your friends and ask them if they have any precious metals related instruments. I would venture to guess that few if any have money in this area. You will know it is time to be cautious when your mail man, barber, taxi driver is chatting you up about how much they are making from their metals investments, just like the dot com mania. Unless the government meaningfully reforms its profligate ways and we allow the markets to actually function without intervention and continual debt and money printing the story for precious metals will not change.
Other cultures view precious metals differently than the West and the US in particular. Here in the US we have not experienced a significant negative monetary event in the economy since the 70’s, which will be viewed as small once the scale of the current mess is understood. As a result of a benign monetary environment the insurance value of precious metals have been derided and mocked by the Keynesians for decades. The main arguments against precious metals are that you can’t eat it, it does not pay interest and it relies on other people to value it and bid the price up. Last I checked there are thousands of financial instruments none of which you can eat, many of which pay no interest or dividend and all of which require other people to make a market in the security in other words bid up the price, yet they are recommended and promoted regularly.


The arguments don’t hold water, instead it is a smoke screen. The reality is that a piece of metal is no ones liability, there is no counterparty risk. The limiting factor of precious metals is why the monetarists despise them, because a system of currency bound by anything that cannot be easily printed restricts growth of government and also money supply; which ironically would aid the FED in its true job of price stability. The FED and monetarists have not complied with their own mandate for if they had a Dollar of today would not have the purchasing power of a nickel in 1913, instead a Dollar would be more constant. It can be argued that gold in particular is a constant and that the Dollar is the variable in terms of store of value. The bottom line is that I believe precious metals, while they may fluctuate in price since nothing goes up in a straight line, is going higher over the foreseeable future. As I have stressed in prior posts in today’s world return of capital is just as if not more important than return on capital. You will not get rich on bullion but you maintain your wealth. The precious metal stocks could potentially make you rich, but they are far riskier and should only be played once you have the necessary insurance.

Disclosure : Long Bullion, Gold and Silver Shares

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