Sound far-fetched? Actually, it’s already started.

Let’s start by looking at what’s happening to food prices. Corn prices are up 44% in the past year. Soybeans are up 22%; wheat is up 23%. Even sugar is up 24%. It’s pretty clear something is going on here.

Because of those rising commodity costs, food companies are jacking up their prices to cope. As a result, expect to pay more for Big Macs, boxes of cereal and baking mixes, to name just a few things.

Two heavyweights have already weighed in. McDonald’s said it would raise prices in the U.S. for the first time in more than a year. General Mills, which makes Cheerios and Wheaties, said it will raise its prices for cereal and baking goods.

There are many more examples, but these two firms are bellwethers. More will follow in their footsteps. As they raise prices, inflation, as we commonly speak of it, will be here.

You won’t see it in the consumer price index, a popular inflation index — not at first. It currently bumps along at about 2%. But you should know that the government doctors up the CPI like a pitcher putting scuff marks on the ball to make it behave unnaturally. The government has made many adjustments to how it calculates the CPI over the years. All of the adjustments aim to make the CPI lower. Economist John Williams tracks the unadjusted CPI. According to him, it’s running at 8.5% already.

It’s not just food commodities that are rising. If they were the only things going up, we might just say something unique is happening in the agricultural markets.

But the prices of many commodities are surging. Metal prices are also up. Copper, for example, is up 27% in the last 12 months. The prices of gold and silver are up 26% and 32%, respectively.

Clearly, something greater is at work here for all these commodities to be rising so swiftly together. The truth is we’ve seen this movie before.

I recently attended Grant’s Fall Conference, held at the great old Plaza Hotel in New York. Marble and bronze decorate its halls and chambers. Amid the old-world splendor of the belle époque, Frank Byrd, the founder of Fielder Research, delivered a persuasive presentation arguing that what we are going through is a lot like the 1970s.

Unemployment was rising. And the CPI was actually coming down. Capital utilization was low, meaning there was a lot of slack in the economy. “Just before the great inflation,” Byrd told us, “things looked more deflationary than inflationary.

In the autumn of 1971 — on the eve of the greatest inflation in America in the 20th century — most people didn’t expect inflation at all. But three years later, the CPI hit 12%. The food CPI hit 20% in 1973. Are we setting up for another bout of 1970s style inflation? Byrd says absolutely.

There were five signposts in the 1970s that also exist today, Byrd maintains. In the 1960s, America began to pile up trade deficits. It consumed more than it produced. By 1971, foreigners started to cash in those dollars they accumulated, which forced the U.S. dollar off convertibility to gold at fixed prices and led to inflation at home. An eerily similar scenario could unfold today.

Secondly, money supply grew faster than the economy. The printing presses were running, in other words, to finance the government’s fiscal deficits. We’ve got that too.

Third, commodity prices went up. Oil increased fourfold, for instance.

Fourth, the government stepped in with price controls and ham-fisted regulations. We have a big government today, too. As Byrd points out, transfer payments — such as Social Security — make up nearly 20% of Americans’ disposable income today. Meaning, we’ve propped up consumption like never before.

Finally, bottlenecks and shortages emerged in the 1970s — think gas lines. We’ve seen that sporadically with the food crisis and oil spike in 2008.

Byrd goes further. And this is where his presentation introduces a novel element.

The environment of the 1970s discouraged investment, Byrd said, as inflation forced up interest rates, raising the cost of capital. You can see it in the falling dollar amounts companies invested during that period.

The last 30 years have been very different. Interest rates have been falling… and investment has been rising. A chart of the 10-year Treasury yield shows you all you need to know. It’s been an era of cheap money getting cheaper. As Byrd said, “No chart better defines the past 30 years: A long secular trend of declining interest rates and a declining cost of capital. No one under the age of 53 has experienced a world with a rising cost of capital.”

Keep in mind that investment trends often unfold slowly. And often, things happen exactly the way people least expect them to. Think about it: On the eve of the 1970s, the greatest inflation wave of the 20th century in America, investors were accepting Treasury yields of 4%. The bond market didn’t anticipate the great inflation, and it doesn’t today with the 10-year rate even lower, at 2.38%.

“Prices are liars,” John Burbank, the bearded manager of Passport Capital likes to say. Prices today don’t tell you about prices tomorrow. That is certainly true in the bond market.

Since high inflation is not widely discounted in the market, the effect it will have on certain investment could be big. This leads Byrd to say: “I believe being on the right side of the inflation question could be the single most important investment decision of the coming decade.”

It may well be. And certain investments do better than others in this kind of environment.

I have been doing research on investments that will provide great inflation hedge… investments where profits will soar if inflation and interest rates pick up. And while there are a few opportunities I see in this space right now – most of them are too illiquid to talk about here (although I have just recommended one to my smaller group of Capital & Crisis readers). That said, I am working on some industry-wide ideas that I should be able to share with you shortly. Stay tuned…

Sincerely,
Chris Mayer
Penny Sleuth

November 10, 2010

“The Single Most Important Investment Decision of the Coming Decade” was originally featured in the Penny Sleuth.

I think it is coming. In fact, in many ways, it’s already here, just not yet widely recognized. The deflationists still hold sway in the bond market, where investors happily accept puny yields…

But there are ways that you can profit from this impending doom. Let’s discuss the types of companies that are safe from this certain fate…

The deflationists argue that the dollar will buy more tomorrow than it does today. It is inflation’s opposite. When most people talk about inflation and deflation, this is what they mean. This definition would pain the old economists who were more careful in their use of language.

Be that as it may, deflation today is an argument facing death by a thousand cuts. Every day, evidence rolls showing that the dollar is buying less. Today’s Wall Street Journal points to the whale in the aquarium. One headline reads, “From Cereal to Helicopters, Commodity Costs Exert Pressure.”

The article goes on to point out what is painfully obvious to anyone who follows commodities and companies. The cost of nearly everything is going up.

General Mills will boost the price of a quarter of its cereals to reflect rising prices for grains. Kraft is raising prices. Domino’s Pizza hasn’t said it will yet, but it did say the price of cheese is up 29% from a year ago. Profit margins are suffering in the meantime.

There is a long list of companies battling rising costs of the commodities. As the Journal notes:

“Corn is up 44%, milk is up 6.5%, hot rolled coil steel is up 4%, copper is up 29% and oil is up 14% from a year ago… Across Corporate America, more companies are wrestling with when and how much to raise prices as raw materials costs climb.”

Still, the Journal’s article had no discernible effect on the optimistic bondholders. (Or I should I write “bag holders”? For soon, they will be left holding the bag.) The bond market seemed bored and yields inched up just a touch today, such that the 10-year note pays a whopping 2.506%.

By the time the bond market says inflation is here, it will be too late — too late for bondholders.

In the meantime, the prices of gold and silver are up too. All of these things point to the obvious: The dollar is buying less.

Why? Let us the count the ways. There is the U.S. government bleeding red ink and heavily in debt. Both portend bad things ahead. How will they square the circle? The easiest — and the most politically expedient — way is to print more money.

There is the jawboning going between central banks of the world all trying to cheapen their currencies. The rationale is to stimulate exports, but don’t be fooled. The real effect of a cheapened currency is that your dollar will buy less.

There are kinds of fancy names for what the Fed is doing — “quantitative easing” comes to mind. But at bottom, they all mean the Fed will create more money.

More dollar printing simply dilutes the buying power of all dollars. And so we see today the beginnings of a fully fledged inflation. It can and will get much worse.

Don’t pay attention to that thing called the Consumer Price Index, or CPI. It is running at about 2%. It is an engineered figure and not to be trusted.

Nonetheless, on the basis of this suspect fluff, the Fed tells us inflation is under control. In fact, it is complaining that the inflation rate may be too low. Bernanke would have us believe the Fed can calibrate inflation within tolerances of 100 basis points. But it way overestimates its powers. Once the inflation train gets going, it will be very hard to slow down. One day, the Fed will wish inflation were only 2%.

In the meantime, what to do?

I think we do what we have always done. We try our best to invest intelligently. That includes investing in commodity companies that benefit from a higher inflation rate. Their selling prices will rise faster than their costs.

The price of commodities adjusts quickly to the falling dollar. Wages always lag that. Plus, there are fixed costs that adjust more slowly — such as leases, for example. So there will be a window for commodity companies to make some serious hay.

I’ll be watching this space closely for more specific examples in the near-term…

[Ed. Note: If you’re concerned about the ravages of inflation on your portfolio, a safe alternative is in TIPS ETFs. These inflation-protected Treasuries offer investors the safety of government-backed funds, but are adjusted to make up for inflation. A couple of interesting funds include the PIMCO 1-5 Year US TIPS Index Fund (NYSE: STPZ) and the iShares Barclays TIPS Bond Fund (NYSE: TIP).

Obviously the relative safety of these funds means that you’re forgoing some potential returns. To get the best of both worlds, I’d suggest you take a look at a few of Chris Mayer’s latest recommendations.]

Sincerely,
Chris Mayer
Penny Sleuth

October 29, 2010

How You Can Profit from the Impending Inflation… was originally featured in the Penny Sleuth.

In the spring of 1969, the Dow Jones industrial average stood at 969. By 1982, the Dow hit 1,071. That’s thirteen years of going nowhere. (We’ve had 10 years or so of going nowhere, though the ride between the poles has been anything but boring).

The problem is inflation makes that performance look better than it really was, like when a crooked judge makes a fight look close with a split decision even when the one fighter can barely walk to his corner and everybody in the building knows it was a rout.

Adjusted for inflation, or the weak dollar, the Dow was really more like 400. That makes it one of the worst stretches for the market since the 1930s.

The consumer price index, that flawed measure of inflation, doubled from 1960 to 1982. This is why a generation of people grew to believe that the best way to buy a house was to borrow all you could afford. And for a time, that looked brilliant. As Robert Sobel relates in a history of the period, a modest suburban home going for $30,000 in 1969 sold for $300,000 13 years later. With a lot of debt, your returns were much greater.

Of course, that kind of thinking eventually got us into a heap of trouble, as we now know.

But that period of time also had an effect on Corporate America’s balance sheets. When a company buys an asset, say a factory, it records its cost on its books. It will then depreciate this asset over time. So the value of the factory on its books will decline over time.

In a period of high inflation, its book value will be understated. The cost of a similar factory will be a lot higher in dollar terms, though the company will still show the old figure.

In other words, during periods of inflation, book values understate the true value of corporate assets. This happened in the 1960-82 period. Combine that with the stagnant market and you get many stocks trading for super cheap by 1982, when the great bull market began.

In fact, in July 1984, S&P reported that 30% of the stocks on the NYSE traded below net tangible book value. The old value mavens like Ben Graham would have had a field day.

What happened next, though, is what interests us especially. The low stock prices kicked off a takeover boom. The 1980s takeover mania was the busiest since the “age of Morgan at the turn of the century,” Sobel reports in his The Age of Giant Corporations. The 1980s was the age of the LBO, Barbarians at the Gate, Michael Milken and the corporate raider.

The oil industry also had its takeover boom. In fact, the outlines of the 1980s oil and gas industry look similar to today’s. In 1970s, there was a drilling boom as people thought that oil and gas prices would rise indefinitely. That collapsed and then you had oil and gas companies sitting on huge reserves they built up during the boom.

So in a time when it cost $15 a barrel to get oil out the ground, many oil companies traded for $5 a barrel in proven reserves. Getty Oil traded for $72 per share, with assets of $250 per share. Marathon’s stock went for $68, though each share had $210 in assets backing it up. And on and on it went.

Enter T. Boone Pickens. An Oklahoma-born geologist, Pickens was well aware of the value of these companies. He started going after them and making millions of dollars as bidding wars ensued. He lost several of these, but still cleared millions in profits.

There was a roll call of takeovers in the industry during this time — Shell bought Belridge Oil for $3.6 billion, DuPont bought Conoco for $7.4 billion and U.S. Steel took out Marathon for $6.5 billion. (Yes, U.S. Steel thought it would be smart to diversify). These were some of the bigger deals.

I won’t go too much into the history of this period, and perhaps I’ve already gone into too much detail. But I think something similar may be unfolding in today’s market.

We have the potential for high inflation thanks to the government’s monetary and fiscal stimulus. We also have a weak economy. In oil and gas, we have many companies trading cheaply in the wake of a drilling boom gone bust. What we need now is a T. Boone Pickens to shake things up.

Sincerely,
Chris Mayer

September 3, 2009

A New Age of Corporate Takeovers Could Soon Emerge was originally featured in the Penny Sleuth.

The interview was notable for two reasons – first, because interviews with the Chairman of the Fed were until now almost unheard of, and second, because Bernanke told 25 million viewers that we could see the recession end this year.

“We’ll see the recession coming to an end probably this year. We’ll see recovery beginning next year. And it will pick up steam over time,” he told Pelley.

But Bernanke was quick to qualify his projections: “We won’t be back to full employment. But we will see, I hope, the end of these declines that have been so strong in a last couple of quarters.”

Those are strong words for anyone who sits in Washington’s inner circle, but it’s important to remember that Bernanke hasn’t been a Washingtonian for long. And despite allegations that he’s been too generous with the financial industry, Wall Street is equally as foreign to him.

Bernanke spent the majority of his professional career as an academic, first as a professor at Stanford, NYU and MIT, then as the Chair of Princeton’s Economics Department.

During the interview, 60 Minutes stressed Bernanke’s small-town upbringing. They reminded America that Dr. Ben Bernanke, PhD grew up in the middle class in Dillion, South Carolina. And with no shortage of made-for-TV irony, the cameras met with Bernanke at his childhood home in Dillon, a rancher that’s in foreclosure because the current owners couldn’t make the payments.

But frills aside, what Bernanke said last Sunday night was important for investors to remember.

He pointed out that we’re not going to see any sort of an economic recovery until the financial system gets itself in order. While that doesn’t mean that the stock market has to make sense again, it does mean that our nation’s banks have to get their acts together before things get straightened out.

“The lesson of history is that you do not get a sustained economic recovery as long as the financial system is in crisis. We’ve seen some progress in the financial markets, absolutely. But until we get that stabilized and working normally, we’re not gonna see recovery. But we do have a plan,” he said.

One of the biggest elements of that plan is the “Bernanke Doctrine,” which Chairman Bernanke laid out right after he was sworn in as Fed Chairman back in 2002. In his seven-tiered plan, Bernanke emphasizes a systematic approach to avoiding deflation – one of the biggest concerns that we could face in a recession.

At present, the Bernanke Doctrine is in full effect, and as a result, we’re actually seeing modest inflation right now – up 0.4% in February according to Department of Labor numbers released today. Among other things, that small amount of inflation means that consumers aren’t being pressured by a lack of liquidity in the money supply.

If Bernanke has been this sharp so far on deflation, maybe his seemingly optimistic predictions aren’t so off-the-wall. After all, who has a better pulse on the economy than our nation’s chief economist?

As economic fundamentals begin to show themselves in the coming months, we’ll see if Ben’s hypothesis holds up.

Cheers,
Jonas Elmerraji

March 18, 2009

Berknanke’s Big Bet was originally featured in the Penny Sleuth.

That’s why the greatest inflation fighter in the world is under stress. Of course, we’re talking about gold. Gold is– and always has been– the safest place to put your cash. It has been traded as currency, stockpiled to backup paper money (think Fort Knox), and hedge spend-happy governments. Today, its hedging attribute is important.

Over the past few months, it’s become more and more difficult to buy physical gold. Even if you do locate it, what you actually pay is quite a bit more than its spot price.

In many cases, these buyers were willing to spend up to 25% more for gold than its value. That’s like your broker taking a quarter for every $1 share you buy.

So, if gold is too expensive, where can investors turn? Well, there’s always gold’s little brother…

Silver is not commonly thought of as an inflationary hedging tool. That is, until times get tough. And I don’t think you can find too many times tougher than right now.

Silver is often referred to as “the poor man’s gold”. We call it opportunity. You see, during the 1978-1980 precious metals rally, silver showed up late. Almost all of the large gains in silver came in the last few months.

We see the same events unfolding this time around. As we pointed out in the past, gold has always traded for about 16 times as much as silver, until the past few decades. Currently, the ratio sits around 71. When this number falls, silver booms.

Macroeconomics and ratios aside, there is one final reason we expect an enormous silver rally…

About 3 out of every 5 ounces of silver come from base metal mines. Roughly 28% of all silver comes from copper mines and another 32% comes from lead/zinc mines. Both of these sources are decreasing — and in some cases, completely shutting down — production due to the overall commodity market.

Only 10% of all silver comes from gold mines, which leaves just 30% of the total market to pure silver plays like Coeur d’Alene Mines Corp., Hecla Mining, and Pan American Silver. These serious cuts in production, gives us pure silver investors the inside track to cornering the silver market.

We are seeing a perfect storm brewing in the silver market. If you get in now, you might just beat the rush…

Sincerely,
Jim Nelson

March 17, 2009

How You Can Win with Silver was originally featured in the Penny Sleuth.

I explained it very simply. He likes to play this card game in which the players get different creatures and each of them has certain abilities. I explained to him how he valued certain cards highly because they are rare and hard to get. If the cards were easy to get and common, then they would be less valuable. This he understood.

So I told him that dollars work the same way. As the government prints more of them, they become less special. They buy less. We call this inflation.

Today, the Federal Reserve is laying the groundwork for massive inflation. “Over the past year,” Grant’s Interest Rate Observer notes, “the central bank’s balance sheet has grown by 133%. It was only yesterday when annual growth of 13% seemed aggressive, if not reckless, and certainly inflationary. Ten times that aggressive-if-not-reckless-and-certainly-inflationary rate of expansion is a fact that takes some getting used to.”

Over the last three months, Federal Reserve Bank credit is up 1,560%, reports Grant’s. It was only in September that the Fed’s balance sheet crossed $1 trillion for the first time. On Nov. 5, it scooted past $2 trillion. By year-end, says the president of the Federal Reserve Bank of Dallas, it could slide right on past $3 trillion. Our Federal Reserve seems hellbent on making Argentina look like Switzerland in terms of monetary restraint.

Why is this ballooning balance sheet inflationary? The Federal Reserve increases its assets by buying stuff — financial assets of banks and others. The Federal Reserve pays for these assets by creating money that did not exist before. That’s it. Simple as pie.

Of course, our government is not acting alone. Central banks across the globe are doing the same thing, if with somewhat lesser vigor, at the moment.

In any event, it means paper money will buy less. We may see nominal prices — for oil and gold and metals — continue to fall in the short term, but long term, I think we’re set up for some huge reflation in 2009.

Best Regards,
Chris Mayer
November 20, 2008

The Federal Reserve’s Reflation Infatuation was originally featured in the Penny Sleuth.