July 2, 2010

Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

1. A Tale of Two Boats

Does anyone care about the Baltic Dry Index (BDI)? For many people, freight rates are only a consideration when sending Christmas boxes to relatives or paying shipping for an eBay order. Consequently, bulk commodity shipping rates rank fairly low on the general public’s list of interesting facts or vital statistics.

But the BDI measures the average cost of moving dry bulk cargoes (raw commodities) along 26 shipping routes. It is considered a leading economic indicator. This average cost cratered in 2008 by 94% as world trade came to a grinding halt. It then reversed course and went on a six-month up-trend, signaling a possible recovery in trade. But all that has changed – the index has now been down 25 days in a row. China had been replenishing stocks of basic commodities, which nudged shipping upward, but that process has again come to a grinding halt.

If you want to argue for a recovery in the global economy, there is a missing piece of data you should consider: the HARPEX. The HARPEX is also a shipping index, but it is not for the raw materials that go into manufactured products. This shipping index measures the container freight carrying finished commercial products heading to the stores for retail purchase. Here’s the missing link: The HARPEX fell, just like the BDI, but it never recovered. Retail sales remain anemic in the U.S. and Europe. Imports from Asia show that the commodity purchases made over the last six months have not been put into finished products or exported from the region.

Should a build-up of basic commodities in China concern us? Is this a sign of a subtle shift toward internal consumption? Or perhaps these are strategic purchases for the next “five year plan” (the 12th such plan by the Chinese authorities). And could such a plan include an attempt to purchase major commodity producers in an environment of lower commodity demand – lower demand artificially created by pre-purchasing the commodity needs for the next 12-18 months?

This is the curious “Tale of Two Boats,” – one going to Asia laden with commodities; the other coming to the U.S. and Europe, with no cargo to speak of.

2. European Banks: Less Bankrupt than Anticipated

European banks lent 131.9 billion euros to troubled banks on Thursday in contrast to analysts’ expectations of 200 billion euros. It was concluded that since the handout was less than expected, things were less bad than suspected in the European community. In response, gold fell to a five-week low and the euro rallied sharply against the U.S. dollar. We would remind investors that, once a going concern is bankrupt – which is the point at which debt service cannot be supported by ones profit margins – one cannot eliminate the problem with another loan.

We suspect that gold was already toppy, and, combined with the high expectation that it should correct (as in 2008), it was easy to manipulate lower. The 50-day average was met in no time flat as buyers stepped aside – for the moment. By the next morning, hedge fund managers and other large speculators were bidding the metal back up again, increasing long positions to ever-higher levels.

It’s interesting: Why would buyers be so bold as to buy the very next morning after a sharp drop? Could it be the failed debt auctions by the ECB (40% undersubscribed)? Could it be the poor ISM manufacturing data (56.2 versus 59) or the poor non-farm payroll (-125K) here in the U.S.? Commodity prices and U.S. consumer confidence are also in decline. We have also begun to witness some weakness in our own Treasury market, even as stocks fall – probably an early warning sign that the market realizes our own credit concerns as our economy weakens.

We could go on.

To sum it all up, investors are left with very few places to run. As a result, we suspect near term corrections for gold will not be as deep as the consensus anticipates.

3. Q: Am I Over-allocated to the Metals?

A: There is always a limit to how much of any one thing you should have in your portfolio. In this environment, if one looks at the charts, there isn’t much among the other asset classes that has performed as well as the metals in recent years. This is, in our opinion, due to gold’s non-economic characteristics.

As the economy finds its equilibrium state, which we believe is much lower than its current level, most other commodities and productive assets will struggle. Gold will eventually become a substitute for the currency (and the assets it represents) that caused all the trouble in the first place. This is because gold is, and always has been, real money. Therefore, in the category of “how much?,” it becomes a matter of personal preference and financial comfort.

Have a great 4th-of-July weekend!

David Burgess
VP Investment Management

David McAlvany
President and CEO