Tag Archives: Commodity

Currency devaluation’s effect on the markets and the importance of diversification

With commodities rallying across the board this year (most are up between 20% and 100%), copper is at an all-time high, palladium at a 10-year high, oil near its two-year highs, and the Treasuries falling, traders are obviously look for real assets.

The realest assets are commodities, but behind those are shares in companies that produce real goods and earn real profits. We tend to look at those profits in Dollar terms, but they really aren’t. A company making a 10% margin is making a 10% margin in the goods it sells, not in Dollars. In other words, a company could sell 90% of its goods to breakeven and hold the other 10% of the goods produced as profit instead of converting it into Dollars. Or that extra 10% could be converted into gold, silver, or whatever it wants, as long as it has a place to store the profits. Therefore, as long as a company continues to sell, the devaluation of currencies should affect it less than non-performing assets, such as Treasuries which will get hit by rising interest rates and inflation.

Actually, stocks tend to do well during periods of inflation, as long as the economy does well too. If a company’s costs rise, it simply passes along all or most of that to its customers. So if costs rise 10%, a company raises its selling price by the same amount to maintain its margin. As long as all countries experience the same inflation, there will little effect on the company. If we are seeing a worldwide currency devaluation, as I believe, stocks should rise as long as the economy holds up. Of course, commodities will likely do best, but stocks won’t be far behind. They’ll continue to earn a real rate of return of 4% to 7% or so. Bonds though will get double hit by rising interest rates and devaluation. Buying a bond yielding 4% today will yield a negative return if inflation exceeds that amount. And rising interest rates will reduce the Present Value of the bond too.

I would add a major caveat to all this: there is a chance of a major economic decline. With government’s deep in debt and many cutting back, the economy could suffer. Whether we see sub-par growth for the next generation or a double-dip recession remains to be seen. But if this economic decline occurs, stocks will get hit, of course. Commodities will also fall. Industrial commodities, such as copper and oil, may do even worse than stocks while precious metals will hold up better, but they too are likely to decline as they did during the 2008 market crash.

I’m not an economic adviser, but I always recommend diversification. Unless you have a lot of time to spend analyzing the market and become very good at it, chances are you won’t be able to “beat the market.” In fact, even the experts have a hard doing so and, statistically speaking, it has not been proven that anybody can beat the market (those that appear to do so may just be black swans). So own some stocks, some bonds, some commodities, and hold some cash. How much in each depends on your age and risk tolerance. You will not make a killing by diversifying, but in this political and economic environment, protecting your money is paramount. And with the future so uncertain, diversification is the only way to be sure your wealth won’t disappear in a market crash or rally, if governments go bankrupt or become solvent, or if the economy strengthens or weakens. No single investment will perform well in all the possible situations. Remember gold’s decline in 2008 or the larger decline from 1981 to 1998. Cash could be eaten up by inflation. Treasuries by rising interest rates. Stocks by an economic decline. But it is very unlikely that all four will decline together.

For example, learn more about Harry Browne’s Permanent Portfolio. I don’t necessarily recommend his portfolio as is. Much depends on your age and risk tolerance and ability to purchase these funds/instruments. But it certainly gives you a clearer picture of the importance of diversification.

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Dollar holding steady, so why are commodity prices way up? And where’s the inflation?

The US Dollar Index is up three percent this year. On the surface, it appears as if we have not experienced a Dollar devaluation this year. But that is not so. Looking at the US Dollar Index or the Dollar against other currencies gives you a false sense of what is happening. The Dollar is being devalued, but so it the Euro, Yen, and most other currencies. All currencies are falling together, but that means they aren’t changing against each other.

How is the Dollar doing against other things, like commodities. Most people look at gold and silver as a currency substitute. Adam Smith looked at wheat prices to measure the value of one’s labor. In today’s global economy, oil may be even more important. So how are the metals, oil, and agriculture doing compared to the Dollar?

Gold is up 28 percent so far this year. Silver is up 79 percent. Platinum is up 19 percent. Palladium is up 92 percent. Copper is up 29 percent.
Crude oil is up 12 percent. Wheat is up 91 percent. Corn is up 56 percent. Soybeans are up 32 percent. Cotton is up 97 percent. Sugar is up 40 percent.

No matter how you measure it, commodity prices are up. Another way of looking at it: the Dollar buys less of each of the above items. Inflation or Dollar devaluation. Whatever you call it, it is happening right now.

So why aren’t we feeling the effects of this falling wage rate or, from the other perspective, this inflation? In fact, we are to a small degree. Just ask anybody around you about their financial situation. Times are tough. But why aren’t we feeling it to the extent the statistics imply? Simply because raw materials make up just a small percentage of the total cost of the things we buy. Personal income, whether it be wages, benefits, capital gains, or corporate profits flowing to individuals, makes up 86 percent of GDP. Raw materials is somewhere around 10 percent of GDP. So it should come as no surprise that rising commodity prices have not, for the most part, not found their way into the CPI statistics. In fact, I’d guess that rising health-care costs have been a bigger contributor to inflation than commodities. On the other hand, falling housing prices are keeping inflation in check.

But what if commodity prices not risen so much? What if the Dollar had not been devalued? In that case, we would either see rising wages or deflation. One is seen as good and the other evil, but they are really the same thing. Either we’d earn more and be able to buy more good with our earnings or we’d have the same wages but lower prices would allow us to buy more with our earnings. Just look at how much we’ve benefited from deflation in the technology area. Don’t we all wish other goods would fall in price as well?

While we have inflation in some areas, such as commodities and health care, we have deflation in other areas, such as housing. Even though the Dollar is being devalued in comparison to non-currency money like gold and silver, it is holding steady against other currencies that are devaluing at similar rates. But we’d be much better off if the United States didn’t devalue: we’d benefit from rising wages or falling prices, either of which would enable us to buy more goods. But the government fears deflation, not for our sakes, but for its own. Deflation makes the real value of the government debt rise. Inflation though makes the real value of that debt smaller, enabling the government to hide its incompetence, that is until interest rates rise. If the government doesn’t right its ship soon, inflation or deflation will become a secondary issues. Interest rates will rise and the government won’t be able to hide its debt and deficit with inflation.