Friday, May 16, 2008

Tipping Point

I wanted to write all of you because something has been troubling me. As I have gotten deeper and deeper into my understanding of economics, I have become disturbed to the point of throwing out some projections for your consideration. First, I need everyone to know that I'm leaving politics, wars and bias out of this discussion. I have considered many improbable events and believe these factors are irrelevant to my conservative projections. Second, This post is long, and fairly dry, but very important. If you don't have time to read and consider it now, I would encourage you to come back later. Third, I'm gonna need everyone to put on their tinfoil hats, but please keep an open mind because I'm citing sources. Ok, here we go.

Tipping Point
I believe that we as a country, perhaps as a civilization have reached or will soon reach some drastic tipping point. Perhaps a crisis, perhaps and hopefully just a culture shift. I simply can't and won't begin to guess the exact timing or nature of this "unknown unknown." To begin slowly, it seems to me that life for some cultures is growing more difficult despite technological and economic advances. In a "modern" world this trend is puzzling at least. For instance the Life Expectancy Drops for Some U.S. Women for the first time since the Spanish Flu (1918). I am now worried the United States will soon become one of the cultures facing difficulties.

Some of you may remember last summer when I remarked that individuals who were stretched to pay their mortgage should walk away. Sounded crazy huh? Now home values are down 30% on average, and up 80-90% in some areas like Ohio and Michigan. The media has even named the "walking away" phenomenon "jingle mail." Still sound crazy? Secondly if you ever visit my MySpace page you may have seen my investment widgets. Among a group of 50,000 investors, my two accounts have been consistently ranked in the top 2 and top 20 percentiles. I'm mentioning this because I base my investing on the projections I am about to share with you, and have easily beat the masses and the indices doing so. However, I'm not talking to you to convince you to think like me, or tell you how to make a million. I'm writing because I care and want everyone to understand and form their own opinions regarding these exceptional circumstances. In general I don't share many of my economic opinions, even within the financial communities of which I'm a member. One reason is because they sound nuts, but the future often is. Second, if people start believing me in droves, I will make less money. Hopefully I have your attention.

An Economic Event
Fundamentally, I believe the United States is on the verge of a major economic event. Perhaps a crash, almost certainly an extended contraction.

Notice I said "fundamentally and believe." I am basing my OPINION on FACT. Second, I am also betting on it. I have financial holdings that would increase in value with a collapse of the American economy. I continue, interpret my message as you will.

Demand, Demand, Demand
I feel that the United States (and many others) have severely underestimated the future demand for specific resources. Some may think that I am misunderstanding population growth rates, or alternatives, or technological advances. The fact is that those alternatives and advancements do not yet exist or do not yet exist in an economical form. Despite my lack of belief I would welcome either one. Unfortunately, I worry many Americas are once again looking for another "quick fix" as it applies to both food and energy.

(Notice I am making some assumptions; 1. current food and energy demand trends will continue upwards 2. No "breakthrough" (quick fix) technological advances. I'm doubtful regarding the prospects of Americans or Chinese curbing their consumption rates - unless costs rise significantly. However, that is the point I am making; costs will most likely rise sharply and quickly. I'm also doubtful of a quick fix energy solution since I believe in capitalism, economic efficiency and the laws of thermodynamics, but haven't seen much in the way of progress.)

India & China's Unseen Dietary Effect
Recently I read an article; India finds U.S. at Fault in Food Cost in the New York Times. What you must first know is that the Chinese and Indian populations outnumber the U.S. population by 7:1. However, what was most surprising was the global consumption comparison graphic. Basically the graphic shows how much more the United States consumes per person as compared to India and China. In terms of Chicken and Beef; 3:1. Corn 10:1. Milk 2:1. What this means is that China and India have a LONG way to go to catch up to the gluttonous consumption rates of the United States. Furthermore, their populations are substantial, intelligent, industrious and determined to achieve our standard of living. Alternatively, it would seem that if grain production does not substantially increase, someone (the U.S.?) must cut back or everyone will pay the increased cost that comes with increased demand.

To further the demand aspect; the grain requirement to feed animals to feed humans is approximately 10:1 as opposed to the grain required to just feed humans directly. So...if we do a little quick math...we can ignore the pre-existing populations...we multiply by 3X for the changes in diet...then multiply by 10X for the added animal grain requirement. By my fuzzy math, we now need 30X the grain we did. Furthermore, the world's grain reserves are at record low levels (as noted in December by the UN). Or perhaps you didn't notice the change in food prices (U.S. seeing worst food inflation in 17 years)?

Now, read this sentence, stop for a second, then close your eyes and think about what it takes to produce even 10X more grain. 10X more land, equipment, fuels, fertilizers. More resources that you can even fathom...because it is after 30X more than current production. This moves me to the third factor; fuels. Energy. How on earth will we power the machines to produce these crops and move them around?

Well, the USDA's take on how we will keep energy prices in check is this; "new oil discoveries, new technologies for finding and extracting oil, the ability to switch to non-oil energy sources, the ability to increase energy efficiency by substituting nonenergy inputs for energy, and continued expansion and improvement in renewable energy." ( What the hell does that mean? They mean it to say they are relying on certain factors. Unfortunately none of those factors exist. It is all based on hope.

Obviously almost all of our agriculture infrastructure is powered by petroleum. We cannot simply switch to hydrogen and solar powered combines. The technology doesn't exist in even a semi-economical form. Therefore, until I start seeing solar thrashers and tractors, I will continue to invest in the collapse of the dollar and the exponential rise of the almighty foreign barrel.

Furthermore, added crops to accommodate a dietary shift and animal demands, will require added fertilizer. Fertilizer production is already a primary source of natural gas demand. As a side note, I haven't really mentioned corn. The U.S. consumption rate of corn per person is about 10X (think corn syrup) the average, and corn is a very fertilizer-intensive crop.

Money, Inflation and distortions
We all talk about inflation as the given fact that prices go up. The reality is that inflation is an increase in money that causes prices to go up. Thereby using that definition, I have no qualms in stating that, barring a technological miracle, food and energy will never in your lifetime significantly drop in dollar pricing. How can I be so sure? The policies of the United States government have guaranteed it. You see...we've been overspending a bit and running a debt. While overspending can at times lead to economic progress, it has not in this case. We have continually borrowed money from communist china to purchase oil at lifetime high prices from fundamentalist countries that are generally not friendly to us. If our country does not use the borrowed funds to create genuine progress, even servicing our debt will become very burdensome. The only way to pay back what we owe will be to dramatically cut spending or create new money. Regardless, it will have the same net effect, economic contraction. We are running an international tab to pay our outrageous domestic bills. We are putting the rent on the credit card...get it? We are no longer financing prosperity...we are now financing poverty.

The United States has been able to finance this "progress" because of global faith in the US economy, and a world dependence on petrodollars. You see...the majority of oil is traded in the world must be traded in dollars. So as the world's (china's) addiction to oil has increased, they've needed more dollars to keep buying oil. At this point some will surely say...but aren't those dollars then being spent elsewhere and isn't that a good thing? Well, in party, they are being spent by oil producing countries to buy our infrastructure. This scenario leaves the United States with less resources to generate profit and you guessed it...more dollars. If this were to change, it could have a significant effect on the price of oil and the value of the dollar. Strangely though, the dollar has already started to fall in value, dramatically. Over the last year alone the dollar has lost about 10% of it's purchasing power. However, we still have to pay to service our debt. Our "minimum payment" if you will. That too will become harder and harder. Across the nation government revenues are starting to contract along with the spending of the America people.

Lastly, I believe that many within the government know that there is a serious issue. Consider for example two measures of the average price of consumer goods. First the CPI (Consumer Price Index) vs. the newer "core inflation" number. The CPI is a comprehensive measurement, while the "core" measurement ignores the "fluctuating" prices of food and energy. THEY JUST LEAVE OUT FOOD AND ENERGY when considering how much prices are rising. Before 2000 the federal reserve reports were based on CPI, they are now based on the "core" inflation number. Consider that last month that the Department of Energy announced energy prices jumped, while the Bureau of Labor Statistics (who is responsible for CPI) declared they fell. Have you seen anything about falling energy prices on the news or at the pump? Another example is the fact that the housing component of the CPI didn't jump along with the housing boom.

My hypothesis is that this distortion is intentional. It allows for miscalculations in government pay, social security payments and of course political PR. Consider perhaps that the phony inflation rate also must also be kept low to inflate the returns on government bonds. If you knew the government was printing money at a faster rate than your bonds earnings could keep up, why would you buy bonds? Why would you help the government raise money while you lost it? That's right, you wouldn't. Nor would china or the rest of the world. Our ATM would become unplugged.

Consumer Spending.
In America, the customer is always right, always spending and makes up about 70% of our economy...yes, 70%. However, over a period of 6 years or so many Americans were conned into believing they could have the American dream with little work, no savings and no down payment. After all, we were "creating wealth," whatever the hell that means. However, after we count all the junk we bought from China...our homes weren't worth as much as we thought and we were just creating credit...much different than wealth.

Now...the "contained" credit bubble is busting and it all leads to decreased consumer demand (by volume. The consumer may buy more in dollars of items like fuels, but it's only to keep up, not an actual increase in demand). It started with banks not lending to each other, then to consumers, then to businesses and decreased M&A, cutting credit lines...hell the mortgage companies are now maintaining the houses they assured Americans they could afford! The banks are borrowing cash at record levels (from the fed now) and so are consumers (from their credit cards now) - months into this credit situation that is "closer to the end" says secretary Paulson. The FDIC is staffing up for bank failures. In California we've now broke 1,000 foreclosure auctions per day. Vallejo, CA (pop. 120,000) has decided to file for bankruptcy. Nationally there is currently a year of housing inventory. Vacancy levels are at or near historic highs ( - PDF). Many municipalities are having trouble meeting budgets with rising energy costs and shrinking tax receipts. Notable layoffs have been Yahoo 1,000 / Aloha 3500 / Eli Lilly 500 / ATA ~4500 / Lehman Brothers 1400 / Merrill 4000 / Bear Stearns, up to 10,000 / Citi, up to 24000 / Ford 2500 / GM 3500 / Even the pentagon is threatening layoffs (or posturing?). Again, to me...that spells decreased demand, decreased economic activity.

Lastly, you'll notice I didn't tie all of these factors together in a cascading if-this-then-maybe-this scenario. Each factor can stand independently and represents a major threat. Each individual example supports the underlying thesis. When combined, I think they represent a greater threat. A good question might be; which is the weakest link and which could cause the most fallout? I'll leave that to you.

Future Prospects
Unfortunately I can't include a "solutions" section. For starters the United States could stop overspending. However, there is little we can instantaneously do regarding global demand or the amount we owe.

What should you do? Well, that is up to you depending on your beliefs, your thesis. I also can't give you advice, only tell you what I'll be doing. I will be trying to secure my future among the uncertainty through profit. :) To be clear, I'm not forecasting red dawn, this isn't about wars or politics. I don't "think" supplies will be the issue. I just think cost to Americans will be. Regardless of whether the dollar falls or not; I believe commodities, natural resources, food, water, energy, metal and materials will stay in demand for quite some time. Owning an ETF (Exchange Traded Fund) that owns or profits from physical assets (commodities), which will hold their long-term international value, is imperative.

Then again...maybe it's just me, maybe this is how an economy is supposed to work or maybe it's just this silly hat. Either way, I'll be buying

GLD - gold commodity ETF
MXI - Global materials ETF
DBE - oil commodity ETF
KOL - coal ETF (assuming oil holds or continues to rise)
IXC - global energy ETF
(NOTE: Everything listed is a fund, not an individual company. The funds are either comprised of a portfolio of companies which is managed my a competing fund manager or are based on the actual price of an underlying commodity.)

I look forward to reading and publishing (if it's cool) your feedback. Affirmation is OK, but I'd really to be told why I'm full of it to understand if there is anything I'm not seeing.

Take Care


Anonymous Anonymous said...

One point to note, Indian beef consumption will remain low for religious reasons, but I agree an Indian and Chinese middle class pose a huge economic challenge to the worlds resources. Americans should plan on eating less meat and driving less.

11:12 AM  
Blogger Josh said...

That is a very good point that I was aware of...but I clumped together. Perhaps that was inappropriate, but they'll have to raise that calorie count somehow.

10:57 AM  

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