Commodities - The Long And Short Of It.

Commodity price performance has been a wild ride in 2008.

The record of price movement is outlined in the table and chart below. For each commodity, the table details year-to-date (YTD) %-age change, drop from 52-week high, and start of year to the 52-week high.

Oil has had the roughest ride falling 62% YTD, 75% from its 52-week high, and preceded by a rise of 53% to its 52-week high. This was followed by Copper, Platinum, and Natural Gas, which had a meteoric rise to its 52-week high of 83%.

Most of the commodities, save Gold, have behaved in kind, thanks to the long-only commodity indices like GSCI which enabled investors of all kinds to invest naked in long-only baskets of commodities. They all went up together, and they all came down together. Platinum and Silver, the other two precious metals dropped along with other commodities, while Gold resumed its dual status as favoured currency and store of value during periods of turmoil.

Commodities are indeed more volatile than stocks. When, and if, we see the return of expansionary and/or inflationary (or worse, hyper-inflationary) conditions, however, these will be a key asset class to allocate to. With all of the printing presses at the Fed whirring right now, some would say its inevitable.

The facts are that during this period in time, the only asset group to have its fundamentals unimpaired is commodities:

• Farmers can’t even get loans for fertilizer now.
• The supply of things is going to be in even worse shape coming out of this.
• Oil is crushed; it is below the cost of production in many places. It is below the cost of alternate sources of energy, so oil is going to make a huge comeback when it does go through the roof.
• The IEA recently came out with a study showing that the worlds reserves of oil are declining at the rate of 7% per year. You can do the arithmetic, the supply of everything is going down; oil and everything else; we’re going to have serious supply problems before too much longer. In 15 years there isn’t going to be any oil left unless somebody discovers a lot of oil quickly in accessible areas, and the price of energy has to go climb again.
• The fundamentals for General Motors are impaired, the fundamentals for Bank of America are impaired.
• The fundamentals for Zinc are improving, the fundamentals for cotton are improved.

Commodities will be the place to be if and when we come out of this crisis, but even if we don’t come out of it.

• In the 1970’s the economies were bad, but commodities went through the roof.
• In the 1930’s commodities were a much better place to be than stocks, because there was no supply.
• Gold will probably go much higher.

Platinum is more industrial, and certainly tied closely to the Auto industry; hen its time to buy Automobiles again, Platinum will be a spectacular play.

There are shortages, and then demand will suddenly come racing back, and there won’t be any inventories left; this is how economies have always evolved.

Where Do I Put My $200 Million Windfall?

Tomorrow's Europe-wide lottery offers a tax-free, lump-sum jackpot worth about $200 million. When I hand over my winning ticket, though, I will face a dilemma: Where do I stash my luck-gotten gains?

Burning through the first few million won't be a problem. I'll turn up for work on Monday morning with a case of champagne and get roaring drunk at my desk before someone calls security and kicks me out of the office. I'll limousine home, snooze for a few hours to sober up, and then hit the phones. "Hello, NetJets Inc.? I'd like to open an account, please. Oh, and once the funds clear, book me on a Dassault Falcon 7X to Aspen.''

Once I've bought the ski lodge, ordered an Aston Martin DBS sports car and selected my Sunseeker triple-decked yacht, bought the latest fashions from Versace and Chanel though, I have to find a home for my winnings. In these troubled times, there are few, if any, true havens.
I can't put my money in a bank. Deposit insurance programs are underfunded, overstressed and woefully inadequate given the size of my needs. Even with a smaller stash, do I really want to risk finding myself in a line of creditors when the authorities decide to let another institution follow Lehman Brothers Holdings Inc. over the cliff?

Banks still won't lend to each other, which is why the one-month money-market rate for US dollars is at 3.43 percent, its highest level since January. Why would I risk putting my money into an account, rather than under my mattress?

Defensively Dull

I'm sure Goldman Sachs Group Inc. and Morgan Stanley would welcome me with open arms, now that they have seen the error of their racy investment-banking ways and dulled down to become deposit takers. Nevertheless, I'm learning the lesson of recent years. Whatever Wall Street is selling, I'm not buying, no matter what Warren Buffett does.

The regulators, meantime, clearly don't want me to invest in financial markets. They have banned short selling in the stocks of such paragons of economic virtue as credit-rating company Moody's Corp. and hedge fund GLG Partners Inc. They look poised to regulate the credit-derivatives market out of existence.

Pretty soon, it will be illegal to buy anything that is rising in price -- oil and other commodities spring to mind -- and it will be forbidden to sell anything losing value. Why would I walk onto a playing field where the goalposts move arbitrarily and the rules are in flux? The mattress option is looking more and more attractive.

Negative Yields

Maybe I should blow my wad on U.S. Treasury bills, even if I end up investing at negative yields that mean I'm paying for the privilege of lending to the government. Do I really want to be in dollars, though, when China and other foreign holders of Treasuries look ready to dump the greenback, and the rating companies should be reviewing the U.S. government's AAA grade?

My lottery win tomorrow, however personally enriching, will be dwarfed by the largess the U.S. government is lavishing on Wall Street. "$700 billion,'' says U.S. Treasury Secretary Henry Paulson "$1 trillion,'' says Barclays Capital. "$2 trillion,'' says Tom Sowanick, the chief investment officer for $22 billion in assets at Clearbrook Financial LLC in Princeton, New Jersey.
Sowanick added together $700 billion for rescuing Fannie Mae and Freddie Mac, the $29 billion Bear Stearns Cos. backstop, the $85 billion loan to American International Group Inc., the $700 billion Paulson plan, $500 billion to the Federal Deposit Insurance Corp., plus sundry other new obligations.

Cover-Up

If Sowanick is correct, the U.S. taxpayer will be on the hook for quadruple the amount that banks around the world have written off so far. That makes the U.S. seem like a place to avoid for a lottery winner seeking security in securities.

Paulson's aptly named Troubled Asset Relief Program, a tarp being the sheet you spread over the junk in the garage to hide it from critical, prying eyes, has a twist. While the Treasury won't buy your damaged collateralized-debt obligations directly, there is a way to offload your toxic CDOs -- provided they have defaulted and you can break them into their constituent parts.

Standard & Poor's reckons about $240 billion of the $450 billion of subprime CDOs it rated has suffered an event of default, according to a research note published this week by Royal Bank of Scotland Group Plc. "When a deal is in EOD, the controlling investor can choose to liquidate,'' the note says. "The Fed plan makes liquidation potentially the best option, as then the Fed bid can be hit for the underlying bonds.''

There's a spoof e-mail doing the rounds, aping those Nigerian banking-scam letters. "I am Ministry of the Treasury of Republic of America,'' it says. "My country has had crisis that causes need for large transfer of funds of $700 billion. If you would assist me in this matter it would be most profitable for you. After you send me bank account details, I will reply with detailed information about safeguards to protect the funds.''

I think I'm going to need a bigger mattress.

Put Away The Shovel

Put away that shovel. Mining stocks are getting hurt as investors anticipate a profit squeeze between rising investment costs and falling commodities prices.

The DJ Basic Resources STOXX index, which includes some of the world's main metals companies, including BHP Billiton and Rio Tinto, is down 26% in the past three months. That has left commodities companies trading at historically low multiples of expected earnings, suggesting either the shares are undervalued or investors believe miners' run of profit growth can't continue.

The latter looks most likely.

Even if commodities prices don't fall further, rising costs could be enough to squeeze profit margins and slow earnings growth -- even if the volumes shipped by the biggest companies continue to rise.

The latest interim results from BHP, run by Marius Kloppers, showed signs of the pressure. Operating margins were two percentage points lower at its Escondida copper mine in Chile compared with last year, and BHP saw deterioration of nine percentage points at its Olympic Dam copper and uranium mine in Australia.

Rival Rio Tinto, facing a takeover bid by BHP, also demonstrates how cost pressures are affecting capital investment. Inflation alone accounted for about half of the increase in its capital spending from 2003 through 2006, according to Lehman Brothers. Since then, Rio Tinto is likely to have found it is getting even less from its capital-expenditure dollars. Its capital spending was $5 billion in 2007, up 25% from 2006.

The rising cost of fuel, transport and equipment as well as hiring and retaining engineers explain the squeeze on miners' margins in some areas.

Miners can't expect higher commodities prices to come to the rescue, either, as consumption slows. Sector consolidation ought to offer safety from a price war or overinvestment. But this strategy, born during the boom, has yet to be tested in a downturn. Forcing more price rises on weakened customers looks unsustainable.

Goldman Sachs reckons half the world economy is in or facing recession. Even China might not spend so heavily on infrastructure in the short term. Some see a post-Olympics slowdown, if not a pause, resulting in the reduction of metal inventories.

With investors able to invest directly in commodities through exchange-traded funds and other vehicles, they don't have to dig into mining companies themselves to retain long-term exposure to metals. Mining stocks now trade on an average of around seven times bullish 2009 earnings estimates, compared with more than 12 times forward earnings at points in the recent past.

The sector looks cheap. But given the potential margin squeeze, only deceptively so.

Those Who Hesitated Have Lost Even More

A year into the credit crunch, banks should have learned a lesson: It pays to be first.

The small number of financial firms that acted early to repair balance sheets must be glad they bit the bullet when they did. It was easier and cheaper to raise equity capital in the early phases of the crisis. In January, when Citigroup raised $12.5 billion from selling convertible preferred shares, its stock was just shy of $25. At Monday's closing price of $17.61, shareholders would potentially face far heavier dilution.

Firms jettisoning troubled mortgage assets today would likely get worse prices than at any time in the crisis. Bonds backed by Alt-A mortgages and jumbo prime mortgages are trading at record lows, according to Credit Suisse, while subprime loans are only slightly above their mid-July trough.

E*Trade Financial looks lucky to have unloaded $3 billion of toxic mortgage assets to hedge fund Citadel in November. Market participants were aghast at the $800 million Citadel paid, because it implied a hefty 75% write-down. But a fire-sale discount today could be even larger.

Admittedly, firms that were quick to take bold steps did so because they had to. Others should have taken the cue from their sicker brethren. In fact, in today's markets, even hitting the wall first could end up being an advantage. Bear Stearns's shareholders should now feel lucky they got $10 a share, as should debt investors who were made whole.

Today, shareholders might get nothing. The Fed is open to the idea of structuring investment-bank bailouts so that shareholders get wiped out completely, according to a speech Friday by Chairman Ben Bernanke. And debt holders might also have to take losses.

It isn't too late to act.

The Greatest Transfer Of Wealth In History

No, this discussion is not about oil.

The credit crisis really puts the free in free market. The freest market is supposed to be the United States, and the evidence in favour of that argument is mounting. It's just not what you think. Free, in this case, means a free ride for a select group of people. Wall Street never looked so good, or bad, depending on your perspective.

From early 2004 until mid-2007, the big Wall Street investment banks made $250-billion (U.S.) in profits. (That's Bank of America, Citigroup, JPMorgan, Morgan Stanley, Goldman Sachs, Lehman Brothers and Merrill Lynch.) During the past year, they've written off $107-billion. Keep in mind as we follow the money that if you include smaller dealers and commercial banks, the profit number swells and the writeoffs are even bigger.

As fate would have it, the writedowns, mostly garbage subprime loans, equal almost perfectly the amount of money Washington will dole out in stimulus cheques to get the economy going again. The House of Representatives Speaker said last year that the stimulus package would create 500,000 jobs. She got the number more or less right, but it was actually a loss of jobs.
Meanwhile, recent figures show that of the money that's been mailed and spent, only a 10th has gone to new spending.

The rest of it has been consumed by inflation (that is, because prices have gone up, even if consumers take their money to the mall, they're not helping the economy much).
Inflation is partly a product of easy money or low interest rates.

Why does the Federal Reserve keep interest rates low? To stimulate the economy, which is being ravaged by the housing recession. The housing recession, meanwhile, was fuelled by Wall Street's greed and recklessness, aided and abetted by the easy money and the fraudulence of builders, appraisers and mortgage brokers.

Back to Wall Street to start connecting the dots. According to the New York State Comptroller's Office, the big banks paid $33.2-billion in bonuses in 2007, down only slightly from 2006, an even more splendid year for subprime origination. During the past four years, bonuses closed in on $100-billion, not far off the writeoffs and the stimulus package.

Back to Washington, whose coffers are bare, meaning that $107-billion is borrowed money. Borrowed from whom? Savers, mostly foreign. Borrowed by whom? The taxpayer of course. So in effect, the stimulus package is simply a matter of the cash-strapped, highly indebted U.S. consumer borrowing to spend (or pay debts) to save the economy. Not good.

It's pretty clear what's happening. Ultimately, the people are borrowing to pay Wall Street bonuses. After all, these handsome rewards are based on the earnings of the banks, but they're not real earnings, since the assets that produced them are subsequently written off. The bubble that created these bogus earnings was inflated with the help of low money costs and lax supervision of financial firms.

The bursting bubble is roughing up the economy so badly that the government has to borrow to stimulate spending, which it fails to do. It might also have to borrow $25-billion to bail out government-sponsored mortgage insurers, including Fannie Mae. And since the government is really just the people who are getting hurt by the slowing economy, with no bonuses to comfort them, is this not the greatest transfer of wealth in history?

And we haven't touched on other largesse the people have extended Wall Street, such as the loan guarantees that helped JPMorgan buy Bear Stearns.

Karl Marx has nothing on these people. But Groucho might.

And you can argue that some of the losses are marked to market and might be reversed and that some of the bonuses were paid to people who had nothing to do with subprime. Probably true, but hair-splitting I say.

As individuals, we can learn a lot from these lessons -- especially what not to do.

INFLATION - The Next Crisis

One thing we find truly amazing about the markets is that they’re much more than just investments. Markets provide a way of peeking into the future, if you understand what they’re trying to tell you.

These lessons are ongoing but it’s fascinating and like a giant puzzle.

MARKETS TELL THE STORY

Sometimes the messages are pretty subtle. But other times they’re major, signaling massive economic, political or geopolitical shifts.

Most interesting is that the markets lead. So it’s important to recognize that whatever a market is telling you, it’s not going to be obvious when that market gives the signal. The message will become obvious later.

Let’s take gold as an example. It started moving up in a major bull market in 2001, and it’s been rising strongly and consistently ever since. Gold always leads inflation, so it was telling us that inflation was eventually going to head higher. That didn’t happen for quite a while, but now it’s another story. Plus, gold’s been telling us much more…

INFLATION ON THE AGENDA

I’ve been writing about inflation for a long time and why we thought it was coming back in a big way. As the years passed, the evidence became more overwhelming.

But most people haven’t been paying much attention. Aside from concerns about high oil and food prices, there are plenty of other things that are more worrisome.

In the U.S., for instance, consumer confidence fell to a nearly 30 year low and a recent poll showed that 81% feel that the U.S. is on the wrong track. This is primarily due to the war, the slowing economy and the housing situation.

And while these conditions remain serious, along with a slew of other concerns, like the heavy debt load, soaring foreclosures and so on, it’s important to recognize that this is the current situation. It’s not what’s coming.

What’s coming is higher inflation and it could prove to be more serious than most people think, at least based on what we’re now seeing.

NOW IT’S HERE...

Suddenly, there’s a lot of talk about inflation in official circles and that wasn’t the case before. But over the past couple of months, comments or inflation warnings were made by the Fed, the European Central Bank and the Bank of England. Government officials are speaking out, and so is the press. The International Monetary Fund was the most direct, warning that global inflation has re-emerged as a major threat to the world economy.

As I’ve often pointed out, inflation has been creeping back and it’s gaining momentum. In the past six months, for example, we’ve seen some huge double digit annualized jumps in U.S. wholesale prices, along with soaring money supply.

But what’s happening in other countries is even more interesting and it’s intensifying the global inflation concerns, which gold saw coming way back when.

Globalization boom...

As you know, many developing nations have been booming, thanks to globalization. This is taking place all over the world and this growth is much greater than in the developing countries.
It’s estimated that half of the world is leaving poverty behind as standards of living improve. That’s especially true of the BRIC countries, which are the emerging market leaders (Brazil, Russia, India and China). It’s also true of many Asian countries, as well as many of the Eastern European, Middle Eastern and Latin American countries.

As living standards improve, people in emerging nations are able to buy things they couldn’t afford before, like food and cars. This has greatly increased demand, and it’s put massive upward pressure on agricultural commodities and oil. It’s actually been the driving force behind the commodity boom.

Heating inflation

Over the years, I’ve taken quite a few trips to developing countries and we’ve seen grueling poverty up close. It’s a terrible situation and the fact that millions of people are escaping this lifestyle is a good thing, but like most things, there’s a price to pay. In this case, it’s inflation.

Inflation is picking up in most countries, for example, inflation is above 15% in many emerging countries like Vietnam, Latvia, Estonia, Pakistan and Egypt. It’s more than 10% in a lot of other countries and it’s a huge concern in Russia, China and India.

The bottom line is that inflation is at a 10 year high in emerging countries and The Economist says that two-thirds of the world’s population will probably suffer double-digit inflation rates this Summer. This is a huge deal and it explains why officials are concerned, but there’s more…

SOARING MONEY SUPPLY... GLOBALLY

Global monetary policy is now the loosest since the 1970s and money supply is growing almost three times faster in emerging countries than in the developed world. As you know, that’s the direct cause of inflation.

Plus, as The Economist points out, there are alarming similarities between emerging economies today and the rich world in the 1970s when the Great Inflation took off.

For example, in many emerging countries policymakers view the inflation rises as a short-term phenomenon and they’re taking superficial measures to deal with it.

So the causes are similar and the results will be the same for everyone, no matter where you live. As we’re already seeing, commodities, food, oil, building materials and so on… they’re all going up.

IN SUMMARY

It’s still to be seen how this will end. But so far, this inflation rise is coinciding almost perfectly with the commodity cycle. If this continues, and I believe that it will, then there’s a lot more inflation to come in the years ahead.

What’s currently happening also strongly favors the outlook for gold and the other commodities. It’s going to boost demand for gold as a safe haven during inflationary times and these ongoing developments are telling us to stay with commodities, gold and precious metals positions.

In fact, gold’s been telling us this all along. Now we’re starting to see why.

Sudden Slowdown or "What I Learned In The Dentist's Chair"

I was horizontal in the dentist’s chair yesterday when BBC’s World News reported a slowdown in the rate of growth in India. I had an hour of construction going on in my mouth to ponder on that before the good ole BBC news loop came round again, and I heard it repeated. The drill’s vibration was insufficient to thwart the bells ringing in my head.

The entire bull market in base and industrial metals is, according to many institutional investors and economic theologians, based on the fact of India and China’s unstoppable growth.

Admittedly, one quarter’s statistic indicating a deceleration in the rate of growth is hardly cause for alarm. However, should this pan out to be the first iteration of a change in the pattern we’ve grown accustomed (actually…more like addicted) to, we could be in for some serious trouble.

The world over, observers have been watching the ripple effect initiated by the real estate and credit bubble implosions comfortable in the knowledge that the Asian growth machine was proceeding seemingly unaffected by the carnage in London, New York and Berlin.

So if India is now to fall victim to higher capital, energy and raw material costs, is China right on its heels?

What is the greater implication for the United States and the rest of the G8 nations if this last bastion of economic fortitude is also to crumble?

According to the BBC (and yes I was taking notes while the dental crew was unleashing its own economic expansion in my yarp), “Growth is expected to continue to slow this year, but will remain higher than most other economies in the world.

"There will be deceleration this year coming from industry and high interest rates," said economist Saugata Bhattacharya, from the Mumbai-based Axis Bank.

"Industrial impulses will be curtailed. However, there will be a partial offsetting if agriculture and monsoons will be good," he said.

If agriculture and the monsoons are good?!

Isn’t this the nation where 17,500 farmers commit suicide in their fields each year precisely because agriculture and the monsoons are not good? That’s right. 17,500 farmers every year between 2003 and 2006 took their own lives standing in their fields because they owed, on average, US$1,000 or less. If I committed suicide every time I owed somebody a thousand dollars, it would be a most disagreeable movie version of Groundhog Day. At least 160,000 farmers have committed suicide since 1997, said K. Nagaraj of the Madras Institute of Development Studies.

The BBC's Karishma Vaswani in Mumbai said the rising cost of living had had a negative impact on consumer spending and the situation was likely to get worse before it got better.

India’s main growth slowdown occurred in the manufacturing sector. As it turns out, the same thing is happening in China. A Reuters story crossed the wire at 1:05 a.m. Eastern stating that "China's manufacturing sector slowed last month for the first time since January as export orders and domestic investment both weakened”.

And why should we be surprised?

China has essentially become the world’s manufacturer. If the G8 nations are in a pinch because the credit they’ve been “spending” for the last 10 years has in fact turned out to be play-dough, and the dismantling of the Betty Crocker Easy Bake credit oven has eliminated the clay ducats we’ve been using to acquire overpriced bricks and mortar, the obviously the world’s manufacturer is going to experience a reduction in demand, and by extension, Gross National Product.

Dare I say it? Is this the onset of global recession?

Do you ever feel like you’re on the Titanic, and you’re looking over the rail at the icebergs thinking, "Shouldn’t we be proceeding a little bit more cautiously?", while the men in uniform keep shouting, "Full speed ahead!"?

Alas, that is the world we live in. If our elected officials declare "Full Speed Ahead", then full speed ahead it is. Democracy’s Achilles heel, apparently.

So now what? Is it time to sell base metals, precious metals and all the juniors exploring for same? What about the big boys – the producers? As I said, this is the first news of diminished growth in China/India, and so a knee jerk reaction would be just that, at this point. But it’s a nervous eye watching the data today on my part.

If the Asian juggernaut has exhausted its momentum, all the gold, silver, oil and metals stocks in the world won’t feed a planet torn by food riots and civil warfare.

A Eulogy for Bear Stearns

Every crisis has it's unsung heroes. When the history books are written on The Great 2008 Credit Crunch, Bear Stearns shareholders - who today handed over their shares to JP Morgan for an Alexander Hamilton - will almost certainly have fulfilled that role. Investors everywhere owe them their gratitude.

The superheroes of the credit collapse have already been well eulogized. There's JP Morgan boss Jamie Dimon in his pin-striped cape swooping in to buy Bear and save the markets from mayhem, alongside Wonder Twins - New York Federal Reserve Bank chief Timothy Geithner and Treasury secretary Hank Paulson.

But the deal these Wall Street Super Friends structured to avoid Bear's spider web of counter-party relationships collapsing the global financial system would not have been possible without the sacrifice of the firm's equity holders, a third of whom included the company's own employees.

Their sacrifice served two purposes. By allowing JP Morgan to assume the 85-year-old firm - the alternative to a rushed bankruptcy and the liquidation of hundreds of billions of dollars of trades - financial Armageddon was arguably averted. Second, by getting no more than a tenner for a stock not long ago worth $170, Bear shareholders became sacrificial lambs for regulators intent on avoiding the nurturance of moral hazard.

So in addition to their $10, should we award Bear shareholders a Lucite plaque for their saviour status? The answer is no. Though they may deserve our thanks, they would have done a greater good by forcing Bear's hapless board, led by absentee chairman Jimmy Cayne, to better fulfil it's fiduciary obligations. Had they done so, the crisis - and the evaporation of Bear Stearns - might have been averted.

Crude Misconceptions

Just as the credit crunch seemed to be passing, at least in the US, another and much more ominous financial crisis has broken out.

The escalation of oil prices, which this week reached a previously unthinkable $US130 ($135) a barrel (with predictions of $US150 and $US200 soon to come), threatens to do far more damage to the world economy than the credit crunch.

Instead of just causing a brief recession, the oil and commodity boom threatens a prolonged period of global stagflation, the lethal combination of high inflation and economic stagnation last seen in the world economy in the 1970s and early '80s. This would be a disaster far more momentous than the repossession of a few million homes or collapse of a couple of banks.

Commodity inflation is far more lethal than a credit crunch for two reasons. It prevents central banks in advanced economies from cutting interest rates to keep their economies growing. Even worse, it encourages the governments of developing countries to turn their backs on global markets, resorting instead to price controls, trade restrictions and currency manipulations to protect their citizens from the rising costs of energy and food.

For both these reasons, the boom in oil and commodity prices - if it lasts much longer - could reverse the globalisation process that has delivered 20 years of almost uninterrupted growth to America and Europe and rescued billions of people from extreme poverty in China, India, Brazil and many other countries.

That is the bad news.

The good news is that the world is not as impotent as is often suggested in the face of this danger, since soaring commodity prices are not the ineluctable outcome of some fateful conjuncture of global economic forces, but rather the product of a typical financial boom-bust cycle, which could be deflated - especially with some help from sensible political action - as quickly as it built up.

The present commodity and oil boom shows all the classic symptoms of a financial bubble, such as Japan in the '80s, technology stocks in the '90s and, most recently, housing and mortgages in the US.

But surely, you will say, this commodity boom is different?

Surely it is driven by profound and lasting changes in global supply and demand: China's insatiable appetite for food and energy, geopolitical conflicts in the Middle East, the peaking of global oil reserves, droughts caused by global warming and so on?

All these fundamental points are perfectly valid, but they tell us nothing about whether the oil price will soon jump to $US200, stay at $US130 or fall back to $US60 next month.

To see that these fundamentals are all irrelevant, we merely have to ask which of them has changed in the past nine months.

The answer is none.

The oil markets didn't suddenly discover China's oil demand nine months ago, so this cannot explain the doubling of prices since last August. In fact, China's insatiable demand growth has decelerated. In 2004 it was consuming an extra 0.9 million barrels a day; in 2007 it was consuming just an extra 0.3mbd. In the same period global demand growth has slowed from 3.6mbd to 0.7mbd. As a result, the increase in global demand growth is now well below last year's increase of 0.8mbd in non-OPEC production, according to ISI, a leading New York consulting group.

Why, then, are commodity prices still rising? The first point to note is that many no longer are. Rice, wheat and pork are 20 to 30 per cent cheaper than they were two months ago, when financial pundits identified Asian and African food riots as the first symptoms of a commodity super-cycle that would drive prices much higher. And the price of industrial commodities such as lead, zinc and nickel, supposedly in short supply a year ago, has now dropped by 40 to 60 per cent.

In fact, most major commodity indices would already be in a downtrend were it not for the dominance of oil.

But oil is the commodity that really matters, and surely the latest jump in prices proves that demand really does exceed supply? Not at all. In the late stages of financial bubbles, it is quite normal for prices to become completely detached from economic fundamentals. House prices in Florida and Spain kept rising even after property developers built far more homes than they could possibly sell.

The same thing happened in credit markets: mortgage securities kept rising even while banks created special purpose vehicles to acquire vast inventories of bonds for which there were no genuine buyers; and dozens of similar examples can be cited from the bubbles in internet stocks and Japan.

Similarly, the International Gold Council reported this week that gold demand for commercial uses and investment fell 17 per cent in January, just as the gold price surged through $US1000 for the first time.

Now consider the situation today in oil markets: the Gulf, according to ISI, is crammed with supertankers chartered by oil-producing governments to hold the inventories of oil they are pumping but cannot sell.

That physical oil is in excess supply at today's prices does not mean that producers are somehow cheating by storing their oil in tankers or keeping it in the ground. All it suggests is that there are few buyers for physical oil cargoes at today's prices, but there are plenty of buyers for pieces of paper linked to the price of oil next month and next year.

This situation is exactly analogous to the bubble in credit markets a year ago, when nobody wanted to buy sub-prime mortgage bonds but there was plenty of demand for financial derivatives that allowed investors to bet on the future value of these bonds.

In short, the standard economic assumption that supply and demand drive prices is only a starting point for understanding financial markets. In boom-bust cycles, the textbook theory is not just slightly inaccurate but totally wrong. This is the main argument made by George Soros in his fascinating book on the credit crunch, The New Paradigm for Financial Markets. In this book Soros explains how financial bubbles always start with some genuine economic transformation: the invention of the internet, the deregulation of credit or the rise of China as a commodity consumer.

He could have added The Netherlands' emergence as a financial centre triggering Tulipmania or Britain's global dominance as a naval power before the South Sea bubble of 1720. The trouble is that these initial perceptions of a new paradigm tell us nothing about how far financial prices will adjust in response: will Chinese demand drive oil prices to $50 or $100 or $1000?

Instead they can create a self-fulfilling momentum of rising prices and an inbuilt bias in the way that investors interpret the world. The resulting misconceptions drive market prices to a far from equilibrium position that bears almost no relation to the balance of underlying supply and demand.

The people who tell you that commodity prices today are driven by economic fundamentals are the same ones who said that house prices in Britain were rising because of land shortages. The amazing thing is that just months after losing hundreds of billions in the housing and mortgage bubbles, investors and governments across the world have reverted to the discredited fallacy that financial markets always reflect economic reality, instead of the boom-bust cycles and misconceptions that Soros's book vividly describes.

Banks - The Next Dot-Com Crash?

Accounting was invented by a Franciscan monk in the 15th century, but its First Rule - called "matching" - is still good today. It says that to compute true profit, you must match revenues with all costs that gave rise to these revenues. If you neglect even some costs, intentionally or otherwise, the resulting "profit" is incorrect, and may even be imaginary.

As an example, in the 1990s many tech companies wrote off cost of capital (mainly research and development) instead of amortizing it - and so did not include its portion in the price of the product. As a result they underpriced their gizmos, which, because of their low prices, then sold in large volume until the R&D "ran out" (became stale), and the companies had no money for new products. The products died, and the stocks melted.

When you sell below true cost, sooner or later you come to grief, whether you are a tech company, or a bank.

We already saw what happened when banks sold subprime mortgages below their real cost (which should have included the high risk of default): The imaginary "earnings" that banks booked over many years suddenly had to be wiped out in one year.

But what of bank loans to legitimate corporations? And what of derivatives - daisy-chain obligations to other banks or financial institutions? Are they priced any better? The answer is, most likely not. You see, most bank loans and derivatives today are based on a benchmark called Libor - the London interbank overnight rate. That's the cost of money that banks charge each other for overnight loans. Every morning, banks report the interbank rates they charged the previous night, then compute an average after tossing out the highest and the lowest rates. (This is done so no one bank can manipulate the average by reporting an extreme number.) Normally this works well. But recently, with the near meltdown of the financial system and the failure of Bear Stearns, banks have often been reluctant to lend to each other, even overnight. Because of this, the U.S. Federal Reserve Board had to lend to banks even against junky assets - subprime mortgages that may never be paid off in full - and the Bank of England even took over a failing bank. But banks still need to borrow from each other. Only now they do it at higher rates than they report, apparently.

How do I know? Because the BIS (Bank of International Settlements - a sort of central bank for central banks) said so. There is an apparent fudging going on, the BIS said, and the result is that Libor is likely higher than reported.

Why is this important? Well, Libor is the base rate on which almost any serious money being lent today is priced. A large industrial mortgage, say, may be priced at 2 per cent more than Libor, a corporate bond at an extra 1.5 per cent, and some derivatives at 3 per cent more.

Thus when Libor goes up, so does the cost of borrowing - as does the revenue of the banks, based on interest payments. But what if Libor goes down? Or even worse: What if Libor actually went up, but banks reported it as going down? What happens to true bank profits then?

Let's focus on the profit. Because what if banks, too ashamed to admit they have to borrow at high costs, understate these costs? What if they collectively, allegedly, start fudging Libor? Then, like dot-com companies that ignored cost of capital when they computed the cost of their gizmos and deluded themselves into thinking they were making money, banks, too, might be deluding themselves into thinking they are making money on Libor-based loans and derivatives, when in truth they are making much less, or perhaps even losing.

And if this is indeed the case - if the BIS is right and Libor is understated - then more bank writeoffs may be coming.

Just how much?

Well, here's a quick calculation: There are about $600-trillion (U.S.) in derivatives outstanding. The BIS thinks that Libor may be understated by about 0.3 per cent. Let's see now: 0.3 per cent of $600-trillion is about $1.8-trillion, or about 13 per cent of U.S. gross domestic product. This equals about four to five years of U.S. economic growth, or about twice the cost of subprime writeoffs to date. If Libor is repriced properly, surely there will be an impact.

Just how soon will this impact be felt? Perhaps not too far off. First, a BIS committee is now looking into the alleged fudging issue, so this may cause reported Libor to go up. But second, since it's unhealthy for North American loans to be based on European rates, something called NYibor has been suggested - the New York interbank overnight rate, an average based on overnight lending costs of North American banks. I suspect, however, that instead of alleviating the problem, this would only expose it: Once true overnight North American lending costs are shown, the base rate for all loans may go up, and more writeoffs may follow.

By that time the next leg of the bear market will very likely resume.

So continue to be wary of dicey financial stocks, stay liquid and bide your time. The real panic is probably yet to come.

Baiting The Dragon

Bear-baiting was a popular pastime in medieval England. A wild bear would be captured, brought to a public place and chained to a pole. A pack of dogs would then be let free to taunt and attack it. The bear would swipe back wildly, much to the amusement of the assembled throng. What the bear lacked in sophistication it made up for with brute force.

Today, the West is involved in a game of bear-baiting with China. China has been awarded the right to host the Olympic Games, about which it has worked itself into feverish excitement and so, correspondingly, the West is in the process of humiliating China, with the Tibet issue being the West's most effective stick. It is daring China to respond, knowing that China won't because it does not want to risk a boycott of the Games. China is like a tethered bear. Actually, more like a dragon, whose flames can reach much further than its claws.

Face is very important in Chinese culture and in the lead-up to the Games, the West is giving China no face at all. In the Western context, being publicly rebuked usually causes one to reflect on one's behaviour and wonder how one might improve. But humiliating China will simply make China angry. Protests aimed at the progression of the Olympic torch will not teach young Chinese in China that their Government is wrong on human rights. Instead, it is reinforcing their nationalism and hardening their attitudes against the West.

The Chinese don't see the pro-Tibet protests as well intentioned criticism. They regard them as a hypocritical denigration of China by a Western culture with a history of colonialism and genocide, which condones armed intervention in places like Iraq or Chechnya and practises waterboarding, while preaching about human rights.

Last week, protesters in China called for a boycott of local outlets of French retailer Carrefour after protesters in France upset the Olympic torch relay. They also accused it of financing the Dalai Lama.

Of course China scores badly on human rights. We all know that. China knows that. When China's human rights performance is compared with the West you see how far China has to go. But compare it with its recent past and you see how far China has come.

Partly, Western activists and governments want to punish China for the sins of its past such as the killings in and around Tiananmen Square in 1989. But it is arguable whether a Tiananmen-style crackdown is even possible today. It is certainly far less likely. One reason is because many of the problems that caused the student protests then have been fixed. Students chanted for democracy but few understood what that meant. What they really wanted was better student allowances and student accommodation. They have this now. And so much more.

The other part is a little bit darker. I believe it is a combination of fear and envy.

China today is far richer than it has ever been. Its economy is now about eight times bigger in real terms today than it was in 1989. Real income per head has grown by seven times. Let me ask you this: In real terms, are you eight times wealthier than you were 20 years ago? Has your income grown in real terms by sevenfold? The comparisons can be a bit unsettling.

Economic freedom is an important aspect of the totality of freedom — just ask any ordinary Chinese. If human rights are measured in terms of not just the absence of tyranny but also the absence of poverty, then China's leadership has done more for human rights for a greater number of people than anyone in history. Contrast that with the number of so-called democratic countries whose people live in abject poverty and misery and fear for their lives everyday.

Media diversity has grown enormously. New laws are being drafted. Women, particularly, have benefited. They are at the forefront of the export revolution. Jobs in factories mean that no longer are they a husband away from poverty. No longer must they endure abusive marriages because they have no other means of support. Millions of women in China now earn a living in their own right. But much more must be done. The pragmatic approach would be to congratulate China on its spectacular progress and then point out ways for further progress.

Tibet is important but it should not be allowed to capture the human rights debate. For one, it is not obvious that human rights abuses are worse in Tibet than elsewhere in China. Is freedom of worship severely curtailed in Tibet? Not so, judging by the numbers of monks, and yet elsewhere in China, for example, Falun Gong has been all but wiped out. Human rights abuses are almost certainly worse among China's minority Uyghur population. Executions among the Uyghurs are believed to be higher than anywhere in China. But who cares? The Uyghurs are Muslims and aren't as quaint and non-threatening as Buddhists.

The Dalai Lama chose to flee Tibet. But other disenfranchised leaders choose to stay put. Aung San Suu Kyi is one example. While the Dalai Lama decamps from one Grand Hyatt to the next, Aung San Suu Kyi remains under house arrest in her dilapidated Rangoon house.

And who fled with the Dalai Lama? Certainly not ordinary Tibetans. The bulk of those who fled were members of the nobility and their wealthy sympathisers, those who had the most to lose from the advancing communists.

So do the remnants of the Tibetan aristocracy, who comprise the vocal part of the Tibetans in exile, really speak for ordinary Tibetans in Tibet? The truth is that two generations ago this feudal elite was oppressing Tibet's ordinary folk in the most appalling manner.

Their children have never lived in Tibet and many now have the same Hollywood fantasy rosy-eyed view of it that their Western supporters have. Perhaps their parents and grandparents when speaking of how wonderful life in the old country was for them, should also explain how that idyllic and elitist lifestyle was borne on the broken backs of their common people. Then again, maybe they have, and in comparison to the ordinary lives that they lead, much like the rest of us, the old privileges seem very appealing. To be an aristocrat once again--makes organizing a protest with misguided followers seem like a very small price to pay.

I don't think anyone in their right mind would want a country to turn back the clock 700 years and suffer those living conditions and hierarchical social structures -- nor would they tolerate the proposal to install a religious-based monarchy that by its own ideology would preclude democracy. Or would they?

What's Wrong With YOUR Mutual Funds' Performance?

Mutual funds are a hot commodity with individual investors and financial institutions. In fact, there are more mutual funds in existence than there are individual stocks -– that's almost 10,000 funds, for those of you taking notes. That amounts to more than $9 trillion invested in these things, just in North America alone.

With so much money riding on the success of mutual funds, how is it that 80% of them under-perform the stock market?

The answer is simple. A mutual fund is simply a collection of stocks and/or bonds. Mutual funds are financial intermediaries -- they are set up to receive your money and then make investments with the money. Most mutual funds are "actively managed," meaning the mutual fund shareholders, through a yearly fee, pay a mutual fund manager to actively buy and sell stocks or bonds within the fund. When you buy mutual fund shares, you are a shareholder -- an owner -- of that mutual fund, with voting rights in proportion to your ownership of the fund.

Though you would think that mutual funds provide benefits to shareholders by hiring "expert" stock pickers, the sad truth of the matter is that over time, the vast majority –- approximately 80% -- of mutual funds under-perform the average return of the stock market.

Why the underperformance? Are these MBAs in dapper suits the world's worst stock pickers or what? Did someone forget to carry a decimal? No and no.

Quite simply, the majority of mutual funds fall short because of the fees they charge you to be a shareholder. You pay for the privilege of active management. You pay for a fund's sales force, slick marketing, television ads, trading costs, and the fund manager's cloth-napkin business lunch and weekend cottage by the lake or the condo in Maui.

The costs of being in the average actively managed mutual fund over time are, put simply, very, very severe. The average actively managed stock mutual fund returns approximately 2% less per year to its shareholders than the stock market returns in general. That means that before your dollar even gets to the fund manager to invest, his company has already taken two cents off the top. And we won’t even speak about the poor performers.

Although 2% may not sound like that big of a deal when the market is returning roughly 20% per year as it did from 1995 through 1998, the standard returns for the stock market historically are closer to 10%.

Consider whether this is severe enough for you: over 50 years, a $10,000 investment will compound to $1,170,000 at 10% returns per year, but to only $470,000 at 8% per year. At 11% annual growth, $1 surrendered in year one is over $23 less for your retirement in thirty years. Add those dollars up, and you've handed over a lot of cash.

Most recently, the markets have had a lot of difficulty simply breaking even and with the subprime meltdown spreading its contagion globally, the extent and duration is still proving to be greater than anyone has envisioned.

An extended global market slowdown makes reducing costs during this period of static or negative returns even more important. Consider switching to funds with lower management expense ratios (MERs), such as index funds and exchange traded funds. These investments can be used to diversify and rebalance your investment holdings.