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Financial Sense Newshour

The BIG Picture Transcription

April 8, 2006

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Bottom of the 9th or Extra Inning

[music: Take me out to the ballgame]

JOHN: Well, Jim, take me out to the ballgame – we shall look, are we at the bottom of the ninth or are we going to an extra inning here? The Fed has raised rates how many times? And what's going to go forward?

JIM: Well, we've had 15 consecutive rate hikes and it's widely expected on May 10th the Fed will go for the 16th time, taking the Federal Funds rate to 5%. There's a lot of question right now, John, OK, what do they do afterwards? And if we take a look at there's about 74 economists and investment banking firms that have been polled and surveyed by Bloomberg, and here's what the experts think: the median Federal Funds rate for the 1st quarter was 4 ¾ that's just about where we ended up – close to that; in the 2nd quarter the median Federal Funds rate is 5%; and the median Federal Funds rate remains at 5% for the 3rd quarter, for the 4th quarter; and then the 1st quarter of 2007, it drops from 5% down to 4 ¾.

The average for the 1st quarter was 4.71, with the high estimate at 5%, and the low at 4 ¾. When we get to the 2nd quarter, the high estimate is 5 ¼, meaning that the Fed would raise in June, and the low estimate is 4 ½. We get to the 3rd quarter, and the high estimate is 5 ½, which means by the time that the Fed got to August, they would have raised both in June and in August. The low estimate for the 3rd quarter is 4 ½, and by the time we get to the end of the 4th quarter the high estimate is 5 ¾, and the low is 4 ¼.

President Bush: These millions of new jobs are evidence of an economic resurgence, that is strong, broad and benefiting all Americans. Real after tax income has grown by more than 8% per person since I've taken office. That means on average Americans have an income that is $2,100 higher this year than it was in 2001, after adjusting for inflation.

Now, here's the problem, the Fed is standing on the edge of a precipice. We know for example the employment numbers that came out on Friday are overstated because of the birth death model. You will find that from February to May, you have these seasonal increases in employment, and then what happens in January they kind of remove some of the bogus numbers and tone it down. So, if you recall, in January, when the jobs numbers were negative that's because the Bureau of Labor Statistics was making an adjustment. So, we probably have an overstated unemployment rate. We have an overstated jobs picture because there are a lot of people that aren't being counted. For example, when your unemployment benefits run out, you fall off the unemployment list, they no longer count you. They think theoretically you’ve gone out and gotten a new job.

We also know that GDP is overstated due to the understatement of the inflation numbers, because they take the gross dollars of GDP, they back out the inflation to get real at real GDP. Well, if you can use a lower inflation number to deflate the real or the nominal GDP numbers then you get a higher growth rate for the economy. So, we know the economic numbers are distorted, we know the economy is weaker than reported, we know the jobless rate is higher than reported, and we also know that the inflation rate is higher than reported.

So, the Fed is at a point right now where we know they wanted to deflate the real estate bubble, but they didn't want to crush it. But John, unlike the stock market, where if the stock market falls a couple hundred points or we have a big sell off in the stock market, the Fed can go into the market the futures pit, you see these – I call them flag pole rallies – miracles, and they can go in the futures and put a floor underneath the market and just prop it up through the Plunge Protection Committee. You can't do that with real estate. If you have a variable rate mortgage and it just got reset from 3 ½ to 5 ½, and you can't afford to make your payments and you have to ditch your house, and enough of this happens, people start selling their houses, or they start filing for bankruptcy, or mortgage foreclosures. The Fed can't as easily go into the market, and just say “OK, let's intervene in the market.” They can lower interest rates but by then the real estate market may not be responding. For example, in the 91 recession where real estate headed the downturn in the economy, what happened is even though the Fed lowered interest rates 24 times, it would take another 5 or 6 years before the real estate market recovered, and we also had the savings and loan crisis that followed. [5: 44]

JOHN: Well, this is seemingly a sort of a delicate operation, because then what is really apparent that they want to do is they want to back off on the economy a bit to deflate the real estate bubble but not crush it down, but there is not a lot of of wiggle room in here to do it. It's like trying to make a fine tuned adjustment with a coarse instrument.

JIM: Yeah, we've talked about this on the program in the past. It's not like the Fed is sitting in front of this control panel and they have these digital gauges and they say “OK, we're going give this one a little crank and take it 10 degrees to the right, and we're going take this one 10 degrees to the left, and voila, we'll be at the perfect temperature for the economy.”

It doesn't work that way. As many people know, a lot of of times the rate hikes, there's a lag effect that is 3 to 6 months behind, so you don't really know when you're making these course adjustments as the Fed is doing what's going happen in the future. What we do know is they've been attempting to slow down the real estate bubble, deflate and take some of the air out, and you know what, we're getting mounting evidence that they're succeeding at that. The only problem is: do they push it too far? [6:58]

JOHN: Well, if you just look around you can see some evidences of this: real estate, mortgage applications are down; the supply of new homes is up, over 6 months – remember we've had this building frenzy in a lot of parts of the country right now. There's evidence it's beginning to slow right now. I don't know if that’s in the folk consciousness of this market, but there's evidence that that's what's happening.

JIM: Oh, absolutely. I mean if you look at some graphs and I'm getting ready to write a piece next week for Captain's Log, we've been gathering some information especially on the real estate market, but mortgage applications are way, way down. Because new home sales have slowed down what you have now is the supply of new homes that are hanging on the market; we’re up to a six month supply in existing new homes; median homes home prices are starting to come down; home builder surveys are starting to come down; and a sharp increase in adjustable mortgages that will experience a sharp increase in payments for homeowners. We have about $1 trillion of adjustable rate mortgages that are going to get reset here in the next 12 months. So, that means the people who own these homes, or these mortgages, are going to have their payments go up. That's going to take away purchasing power.

Here in California for example, we have gasoline prices up over where they were last September right after Katrina and Rita. We have rising gasoline prices, rising food prices, so the cost of living is going up. And the second thing that is now starting to roll over is we have mounting evidence that retail sales are now starting to rollover. Basically, we’ve got sort of a bifurcated market right now: you have wealthy individuals, so the Tiffany's, the Nordstrom’s are doing rather well, and then on the other side you have the Walmart shopper. And I think you're going to see more and more people have to cut back on expenses. I mean if your gasoline bill goes up $15 a week, if your food bill goes up $15 a week, if your utility bill goes up $15 a month, you're going to have to cut somewhere, and eventually that's what's going to happen. It's going to cut into consumption which will translate into lower retail sales. And as retail sales slump you're going to see retailers begin to slash, put things on sale, maybe not order as much from manufacturers, so the whole thing starts getting backfilled, and the next thing you know you have a slowdown. [9:25]

JOHN: OK. But if we have this sharp yield curve, people who are in ARMs right now – adjustable rate mortgages – aren’t they trying to roll that out and getting into something permanent before this thing hits?

JIM: Sure, my friend the mortgage broker, that's a lot of of his business right now. A lot of people know that their adjustable rate mortgages are going to be due to reset here in the next 12 months and because of an inverted yield curve there hasn't been much of a spread between what the reset rates are going to be, and what fixed rates are. So a lot of people that have built up equity who have the means are opting for that option. But you have a lot of people, a lot of marginal buyers that have come in who just aren’t in that position. Maybe they've built up some equity but even going to a higher rate is going to be a real pinch for them.

I think I've told the story of my realtor who listed a house after a couple got their adjustable rate mortgage reset. Their monthly mortgage payment went up $700. They couldn't afford to make that so they put their house on the market.

The problem that we have now with the long bond kicking in and it looks like it's going to go over to maybe 5 ¼, 5. 3, then you're going to to start seeing the long term end of the market start to tilt up, and when we start getting to 7% fixed rate mortgages, that's just simply going to kill the housing market. And if the Fed isn't careful here, what you could see happen, in other words if they push to 5 ¼, 5 ½, you could have a full blown financial crisis; unless they just gun the markets with helicopter money, which is maybe something they always had in mind, because as many people are aware of they just got rid of reporting M3, and we've got M3 growth rates which were last clocked at about an 8.7% annual increase. Who knows what they are now? [11:14]

JOHN: Yes, hopefully, somebody will be reporting that anyway regardless of whether or not the Fed reports it. One of the other things is we've been going around these cycles so to speak, we've had a huge amount of debt piled into the economy as well.

JIM: Since the year 2000 the US economy has been adding between $2 and $2 ½ trillion of debt every single year. So, since the year 2000 we've added between $10 and $12 trillion of debt, that is a lot of debt even by American standards. So, if you have interest rates go up by 1% or 2% on that additional $10 to 12 trillion worth of additional debt you're talking about real money, and some real pain that's going to be inflicted on not only consumers but a lot of of businesses as well.

Another factor that we have is the derivatives market has just exploded over the last 5 or 6 years, and you also have a big carry trade market where people have borrowed whether they’re borrowing in the European market or the Japanese market and they’re obviously investing for a higher yield that could be US Treasuries, it could be junk bonds, or emerging market debt. So, if they push rates too far, 5 ¼, 5 ½, they very well run the risk they could push the economy over the cliff. [12:35]

JOHN: What would be the ripple effect of that if they did? How would it manifest?

JIM: I think you would have another crisis similar to what we had in 1991 with the S&L crisis. Obviously you would see a large increase in bankruptcies of the marginal buyers in the home market, and you're starting to see it right now; [you would see large increases in] foreclosures; a lot of the weak, intermediate lenders will start to go under – if they start to go under you could have a full blown financial crisis on your hands. And even some of the big banks could get in trouble because if you look at bank portfolios today, over 60% of bank portfolios are geared to the mortgage market.

So the banks are very heavily invested in the real estate market, especially with consumers, because most corporations aren’t doing as much business with banks. If you're a large corporation you tap the commercial paper market, or the debt security market where you can get a lot of better rates than you could borrowing from a bank. So what banks did in the 90s is they really went after the consumer loan business – credit card business. And now of course in this new century they've gone after the mortgage business.

So you’ve got a very precarious situation here. We did a story a couple of weeks ago walking the line, boy they’re walking the line, they’re at the edge of the cliff right now. [13:54]

JOHN: Is there anything that's deja vuish about this, have we seen this pattern before? Well, you know what the central banks are doing is we've abandoned the quantity theory of money, where central banks are saying, “hey, it doesn't matter how much we print, that's no longer inflation.” We call inflation rising prices when its true meaning is an increase in the supply of money. So what you have right now globally is rising interest rates, central banks are raising interest rates beginning here with the Fed, the Bank of England, the central banks of Canada and New Zealand, Japan to follow, the European central bank, they’re raising interest rates at the same time they’re flooding, literally flooding, the markets with money and credit. And as I pointed out last week that was one of the discoveries when I wrote the Day after Tomorrow: there is no shortage of money even today there is plenty of money around. You can get SBA loans to buy office buildings at 6 ½ interest rates; you can get boat loans at 6 ½; all kinds of different loan programs whether you want a short term fixed, variable rate – the negative amortization loans, they've kind of clamped down on those – but there are still plenty of loan programs that you can get qualified for. So, there's still plenty of lending that's taking place in the economy, and that's because money is plentiful. Unlike the Volcker Fed which cut the supply of money, the Greenspan Fed and I suspect looking at the M3 graphs from the last time we were able to monitor them, and also the repo market which is going bonkers. I'll have to have Mike Bolser back on the program because he tracks the repo market which is one means of the Fed injecting money into the banking system. But yes, we're actually flooding the markets with money, so they maybe talking “hey, we're fighting inflation,” but they’re goosing the economy and the financial markets with gazillions of dollars. [15:50]

JOHN: Yeah, but there's some indicators that are flying out there, look at what gold did week, the mainline talkies are all busy looking in the rear view mirror again, saying, “What, did you know there is a market in gold?” Commodities are flying, energy is up there, you’ve got to do something about that.

JIM: Yeah, I think what they’re trying to do, they would love to stop at 5%. In order to do that I maintain they need to get the gold and energy markets and commodities markets down. They’re having a little difficulty with gold and energy, but they've been taking part of the commodity complex down. They also need to get the market cooled down, you can't have the financial markets saying “hey, we're at the ninth inning, it's party time, let's break out the champagne and get another bubble going.” So I think what the Fed is doing is playing a game of chicken with the financial markets. They need to keep the financial markets fooled and on edge, they need to create some uncertainty right now because they want to take some of the froth out of the market. They've taken the froth out of the housing market, that is obvious, and there is a lot of evidence to that as we pointed out earlier. They’re taking some of the froth out of consumption with retail sales starting to slow down. So they need to take some of the froth out of the market the financial markets whether it's commodities, gold. If commodities keep going up, if the markets rise and in other words the financial markets call the Fed's bluff saying “aha, we think you're going to go on hold after the next one,” what they could do is force the Fed to overshoot, then the Fed will have to say “OK, we're going to have to show them we mean business.”

Then they'll raise interest rates and then if they do that we will have a full blown financial crisis on our hands, at a time when the Fed is being led by very inexperienced officials. Bernanke is basically an academic. A lot of the new people on the Fed FOMC committee, a lot of these people are inexperienced, and if they get into that kind of situation they’re going to have to rent Goodyear Blimps and the US Air Force to literally bomb the economic with funny money. Just take a look at the money supply growth in 2001, and 2002, when the Fed was fighting a stock market crash, and they were also fighting economic recession: one trillion dollars of new money creation I guarantee you, the one trillion will be nothing in terms of what they'll have to print and flood the markets with this next go around. So as we pointed out earlier we're really walking a fine line. [18:16]

JOHN: I can't believe that the Fed doesn’t realize where we're standing about this, they have to know somewhat about the risks that they’re doing. This is not flying blind is what I'm saying.

JIM: This week they just released the Fed Open Market minutes – they release them about 5 years later – from the May 2000 meeting. At that time the Fed knew that when it was raising interest rates they were creating a lot of uncertainity, and there was a big risk that if they kept on raising it would put a lot of more people out of work and it certainly did that; it would threaten the stock market, they certainly did that – the NASDAQ lost 75; we lost 3 million manufacturing jobs. And there was a quote from the May Fed meeting 2005, and it basically went like this:

When we've attempted to apply the brakes in past expansions we generally ended up skidding into a ditch, Mr. Prell said at the May 2000 meeting. Mr. Prell also said that in the current cycle there would seem to be a risk of a particularly large decline in the market, given that, by many conventional metrics we experienced a speculative bubble of extraordinary proportions.

He is now a private consultant. So the Fed knows they are walking a very fine line here because you’ve got to remember this is the gang that can't shoot straight. [19:44]

JOHN: But they have no choice.

JIM: Well, they know they’re creating tons of money, but they’re trying to have their cake and eat it too. They’re trying to say “we're going to print a gazillion dollars and we don't want there to be any inflation, or we don't want any speculation in the market.” It just does not work that way.

So if you take a look at every rate raising cycle, the only time we ever got close to anything like a soft landing was in 1994 when they raised the Federal Funds rate – I think they doubled it one year from 3 to 6 – and we got the Mexican peso crisis, Orange County went bankrupt, we had a blow up in derivatives, and that was what we called a soft landing. But when they tried it in previous cycles all the way back the last 50 years, usually you have a major financial accident and crisis: major bankruptcies in the banking system, company bankruptcies – Penn Central.

Just think back to the 70s when they were doing this, and also in the 80s. And then think back recently to the year 2000 – all through to the year 2000 when they were telling people: “Oh, the economy is strong, we're optimistic, growth should maintain at a level.” Well, guess what? The following year we were in a recession, and by the end of 2002 or Oct of 2002, the NASDAQ had lost 75 of its value.

So, if you're looking at the Fed to predict, these guys are like the lookout at Pearl Harbor, these guys aren’t going to tell you. They have to give this optimistic talk: “Oh, yeah, we're raising rates and we think the economy can handle this.” Internally they're probably saying, “holy cow, if we keep doing this, we're on the edge of a cliff, we may push this thing” like that last Fed Governor quoted “they may push us into a ditch.” [21:16]

JOHN: That could be an interesting experience.

JIM: Oh yeah, that should be fun.

JOHN: Jim, we have a new sponsor this week and when we come back we'll go to emails.

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JOHN: You don't suppose the guy that got took there was the governor of California, do you?

Emails and Q-Calls

Richard is in Petaluma, California:

If world price inflation is rising as a result of world wide currency inflation and given the us debt situation, and reliance on imports to maintain price stability, is there anything the United States could realistically do to stop the price inflation from contaminating US domestic markets?

JIM: Yes, stop printing money.

JOHN: That was too easy.

Hello, this is Aaron calling from Milwaukie, Wisconsin. I'm interested in your opinion of interest rates and the housing market. What would happen if Japan and China stopped funding our debts? Interest rates would go up but Ben Bernanke wants to reduce it down to zero. So what would happen to the housing market?

JIM: Well, I think you're seeing long term rates move up right now, that's what you're seeing with long term rates hitting 5%. I think as long term rates continue to head up, maybe to the 5 ¼, 5.3, that's really going to be tough on the housing market. You're going to start seeing the housing market roll over. In terms of China and Japan backing completely off, remember they can print money to buy our dollars, so it's to everybody's best interest to try to get an orderly decline in the dollar. Nobody at this point wants to see the dollar crash, because if we crash we're going to hurt them as well. And Japan's economy is just barely coming out of 15 years of real slow economic growth; Europe is just barely recovering, their economic is dependent heavily on exports, as is Japan and China right now. So it's not in everybody's best interests. So if the really started to come down I think you would see widespread foreign intervention. But right now rates are rising and the higher that they go, the worse off the housing market is going to be.

JOHN: interesting comment from Mark in Vancouver, British Colombia, he says:

April 1st, during a Financial Sense Newshour you repeated Jens Parsson's quote about inflation in The Dying of Money, I'd like to include one of my favorites from a German Renaissance man.

He's talking about Goethe

In Faust, Mephistopheles tells the emperor he is rich beyond his knowledge for the earth belongs to him, and it is filled with hidden treasures and deposits that can serve as collateral for an issue of paper money.

It sounds like the very same process.

It's also the promise that there is a free lunch, isn't it? But sooner or later, somebody has to pay for that lunch.

JIM: There is no such thing as a free lunch. Now, that's not to stop a politician from telling you they are going to give you one, but somebody pays. Most of the time we all end up paying.

Jim, small time new investor here trying to figure out if I should buy 1000 May 06 Google calls or Palladium. My question is what happened with Palladium between the year 2000 and now and what would actually be a better investment, Google or Palladium.

If I was to look at an investment right now my 2 favorite areas to invest in are energy and the gold market. And if you want the kind of leverage versus buying calls on Google you might want to buy junior mining companies because in my opinion junior mining companies (something I wrote many years ago called the Perfect Option) are like an option on the future price of gold, but unlike regular options that expire junior mining companies don't expire, so you don't have an end to that. So those are my 2 areas. If I had to look right now I would definitely continue to buy into the energy sector. Energy is still cheap in my opinion as is gold, given what has happened right now you’ve got junior mining companies selling at a 19% discount, even the major gold companies which were selling at 40% premiums have pulled back now, their premium is only about 19%. But energy companies and junior mining companies that's where I'd be going.

JOHN: From Ontario, Canada, Greg says:

I agree that the great inflation will come due to the reasons you stated. US monetary policy and trade deficits etc, I'm invested in and have done very well with precious metals. How will the upcoming great inflation affect other nations living in Canada? For example we have had trade and budget surpluses for many consecutive years. Canada has been paying down its debt as well, would all this doom and gloom be a detriment to countries as ours?

Yes, because we're going to annex Canada from the US.

JIM: I think some of the nations especially the natural resource nations are going to come out doing very well. I think Canada especially. I am very, very bullish on Canada because you're so blessed with so many natural resources whether it's metals, whether it's energy, whether it's forest products, even your agricultural base. There's so many things you have going for you right now. So I think the natural resource economies like Canada, New Zealand, Australia, Brazil, Argentina, some of the Latin American countries I think they are going to fare much better. I'm a little bit leery about some Latin American countries because Marxism is on the rise being led by Chavez, and we all know what happens with Marxism, a country is impoverished. [28:05]

JOHN: Jim, speaking of energy, let's go talk to Richard Loomis at World Energy.

Other Voices: Richard R. Loomis, President & CEO, World Energy Source

JIM: Well, gasoline prices are rising again and this time you can't blame Iraq or hurricanes. To talk about rising gas prices and ethanol, joining me on the program is Richard Loomis from World Energy.

Richard, on the way into work this morning, the gas station just raised premium prices to $3.09. We are now, at least where I live, we're above prices in terms of where they were when Katrina hit.

world energyRICHARD LOOMIS: It's interesting, yesterday, I filled up here in Texas, we're supposed to have lots of this stuff I think we were like $2.82 for premium. I think the national price right now is at $2.58, as of yesterday. So it's definitely rising, no doubt about it.

JIM: Let’s talk about what's causing it to rise. Now certainly, if we take a look at crude oil prices at $68.59, but we keep hearing from the financial press and the government that inventory levels have never been higher. So why the high gasoline prices?

RICHARD: Well, inventories are high, no doubt about it. But the industry itself has been talking about the quote-unquote 'bottleneck', and if you look at my last issue of World Energy. we've got a piece in there from [unrecognized] where they talk about how the supply is there but US refining capacity is constrained. And you know it's a constant theme now on the constraint, in that we can't produce enough. I was talking with Jeff Morriss of Alon, who's a refiner up in Dallas who is saying demand is still going up, and I haven't seen the demand figures from the last 2 months but we're headed into Summer, which is the driving period anyway. And if our demand increase has continued in the 1 to 2 to 3 percent level monthly, then we would actually not have the supply in place and your price is going to start to rise. I'll tell you this, if it continues to rise, we'll be back in front of Congress in no time. [30:06]

JIM: The thing that surprises me about all of this is at a time when we have supply constraints, and especially since we don't have the producing capacity here in the United States, we've made changes in terms of the sulfur contents of gasoline that went into effect in January. And then also in June we're making changes to gasoline in terms of sulfur content, and then we pass a law on ethanol. I wonder if we might talk about how that's creating some bottlenecks, and raising the price of gasoline.

RICHARD: Ethanol is interesting. I mean up until this point, the debate has always been is ethanol a good idea? And they've talked about how it's inefficient, you know, it costs more energy to make it than it does to use it. Well, that debate has gone now, it's mandated. And you look at this blending that's going on replacing the MTBE in gasoline, and you’ve got to provide the ethanol. We have 2 things going on here. We've got one company, ADM – Archer Daniels Midland – that has one quarter of our production capacity here in the United States. I think the next biggest one is a company called Bereson [ph.], and they've got about 230 million gallons in capacity. As soon as you mandate the use of ethanol as your blending additive, you create a real big problem . We only produce 4 ½ billion gallons a year of ethanol, but we use I think the number I saw for 2004 was 134 billion gallons of gasoline. You can do the math, it doesn't line up. And if E85 [demand] which is 85% ethanol – the blend that goes into mixed use cars – goes up, we can't supply the demand. Right now, we're importing the difference bringing it in from Brazil. And interestingly enough we're bringing it in from Jamaica and Costa Rica.

So you know you look at the demand line on ethanol and it's very interesting, and one of the things I noticed looking at the hurricanes when they came through last year the price of gasoline spiked, the demand on ethanol went up dramatically, and they went from a price of $1.60 to almost an equivalent price on gasoline, they were very close within about 10 cents of each other. And it happened much more quickly because we can't provide ethanol as fast as we can import refined gasoline. So we have an interesting thing there, if I was going to look at what companies I would be interested in right now, I would be looking for probably looking for companies that produce ethanol. I saw a release I think it was yesterday or the day before that Bill Gates was thinking of investing in ethanol, a company called Pacific Energy.

JIM: Yes, I think he owns a chunk of that company.

Richard, what about the MTBE liability? Like I know a couple of refiners like Valero are saying, “look, if you're not going to hold us harmless or give us liability protection for producers of MTBE – a rival oxygen fuel additive – you know what, if you aren’t going to give us protection from the tort attorneys, we're just going to shut it down.”

RICHARD: Well, I think in the last energy bill that was a big debate, and what the interesting lobby there I guess our litigators our legal lobby so to speak has been pushing hard on this. I mean it was a cash cow when this happened with asbestos. It was mandated for use, they put it in buildings, they decided it caused cancer, pulled it out of buildings, and then those that provided it became responsible. And if that were to occur again you know it would be a windfall for your class action lawsuits and all those kind of things. And our lobby has been working hard not to see that happen. There is still a question mark will it or won't it. But if I want to make a bet I would say if ethanol takes off if ethanol is successful then we will probably see more lawsuits on MTBE, primarily because the pressure to create it will be gone. [33:59]

JIM: It's surprising that Congress comes in and mandates something, and then they take it out of the law, and then they allow the lawyers to sue you for producing something they mandated. Somehow there seems to be a conflict of interest between the legal industry and Congress there.

RICHARD: Well, it's not just that. I mean, we've seen all kinds of very odd mixtures there, particularly with sanctions against countries. I remember when the 1998 sanctions were announced against Libya, and Conoco had to pull out of there. Now we're back and Conoco can't get their old properties. It didn't take us very long and we're right back where we started. So Congress has that circular nature, and in particular when it comes down to something as basic as natural resources, you know, oil and gas, these things are hard to produce, they require large amounts of capital, you’ve got a lot of money involved, and the industry has got pretty deep pockets. And I think this may be another way to redistribute that wealth. [34:56]

JIM: Deep pockets are very attractive to the tort attorneys because you know whether it's the drug industry or the tobacco industry, they have people at law firms that research industries for profitability, and then come up with junk science to sue them.

RICHARD: You’re not kidding on that one, it happens again and again. And I think if I look at our ethanol policy, I could almost say that that's a foreign policy, that what we're really doing is helping Brazil with its ethanol production. Their energy minister was saying that because of exports to the United States that they were looking at an increase of production of 3 to 4 times over where it is now. And their largest companies is a company called Grupo Cosan, it just went public and has seen a tremendous increase in share price. If you converted it to us dollars and IPO'd in US dollars in November it's up to 75 today. We've had a couple of pieces in World Energy from the Brazilian Energy Minister, but he's never talked about ethanol, it's kind of that very quiet part of the Brazilian economy. And their entire usage is up to 48%. So 48% of their cars run on ethanol. [36:03]

JIM: It's my understanding we have about 20% of our energy production still offline in the Gulf, we're in April now so we're what? About a month away from the next hurricane season. What happens if we get another Katrina or Rita through that area where the refineries are near Houston, Louisiana? Richard, are we going to be able to import the difference in finished products from overseas or from foreign producers? And will they be willing to make the different kinds of varieties and the Heinz 57 blends that the US requires?

RICHARD: Well, everything is available at a price. I think what we're really looking at and you can go to the geopolitics [which] fit in here very very well. The hurricanes took off enough production to be about equivalent to the amount of oil and gas or oil that we import from Venezuela, so about 1.4 million or somewhere in there. If we have another hurricane come in we're already 20 behind as you point out, this puts our global partners in a real position of power over the United States. It becomes a situation where if they will not increase production or give us more supply – not give us, but sell us – more supply we're in a real price spike. I think everybody has been genuinely surprised. I saw an interview with Secretary Bodman last week where he said that the $60 oil has not dampened our economy. He's right, but if you have $70 oil for a prolonged period of time, something has got to give. If you want to push it to $100 you add the politics of Iran and Venezuela together with a major hurricane coming through the gulf, then we're there.

I looked at the predictions for this Summer and I think it's between 4 and 5 category 3 hurricanes coming in to the Gulf and we probably will run through all of our name storms again. Interestingly enough, there are ways that we could balance this out, but for whatever reason we're not pursuing them. I've got an interesting piece in my upcoming World Energy on diesel fuel, and I know that we've covered that before but if you look at what happens with diesel you can make it with a diversified stock and we just went to an ultra low sulfur diesel, that standard comes up in June. If you compare that to say an ethanol, ethanol goes let's say about ¾ the distance of a gallon of gas, so 1 gallon of gasoline will take you 25% further, in other words, to say the same thing. Whereas a gallon of diesel will take you further than a gallon of gasoline. And the diesel can be made from coal, the diesel fuel can be made from natural gas, and the diesel fuel can also be made from oil. The difference being we don't have the vehicles to put it in, but they go on the market this Summer, and I think it will be very interesting to see how the consumers reacts to that. You can buy an ethanol mixed use car where you can put either one of these two items into it, or you can buy a diesel car and get 30 to 45 miles to the gallon, close to what a hybrid can get, and you'll pay an equivalent price to gasoline. [39:19]

JIM: What I don't understand is you go to other countries where they’re used to paying higher fuel prices because of taxation, and because they just don't have the ability to production it – they rely on imports – you see a lot more use of diesel vehicles. And I'm thinking Richard just off hand of European, their main form of transportation, they use a lot more diesel fuel than we do.

RICHARD: Again another interesting statistic there too: diesel accounts for about 48% of the vehicles in Europe. They had a 1% transportation fuel increase last year, now how could that be. Well, they can do that because their cars go 30% further than ours do because diesel fuel is more efficient, it's just a better mix. So as those cars get better, I mean conceivably if they continue to increase the volume of diesel cars, and they’re growing at about 2% a year now, they’re going to be neutral within 2 years. And again going forward, they’re going to see a fuel or a transportation cost decrease just by using a difference standard, just by using a different fuel. We could do the same thing here but unlike ethanol the use of diesel is not mandated, ethanol is. [40:34]

JIM: It just seems like politics are getting involved here and we're making a lot of bad decisions. If you don't have the ability to produce something that you mandate at the same time you're not going to give liability protection to those that produce something that you mandate, boy!, it just seems like we're setting ourselves up for a major energy crunch here.

RICHARD: All of that's true, Jim. But look what we just did on natural gas, I guess what was it 5 or 6 years ago we all decided we were going to do natural gas generation of power, and everything is going to be natural gas, and we're not going to build anymore nuclear plants, we're not going to build anymore coal plants, we're not going to build anything but natural gas. The head of Dow Chemical wrote in my magazine that it was the Marie Antoinette answer to energy: let them burn gas. No one took into consideration whether we had enough supply of natural gas. The only thing taken into consideration was that it was clean burning, that it was inexpensive at the time, and it should be good for the environment. Well, roll ahead to 2007, and what do we have? We have a natural gas price which I think today was around $7 and has been spiking up to 10, 12, 13 dollars not exactly the intended result, but it's a reoccurring pattern.

As consumers, if we can identify those patterns you can look at how do we diversify the fuel base. Dow has been moving plants and moving jobs out of the United States for the last 6 or 7 years, and headed to where natural gas is cheap just for this reason: they can't get the power and they can't get the stocks for their products at a low price. If I look at what is going to happen on the MTBE if they do get this legal class action suit going, and we do hold these people responsible for producing something we mandated, can the energy industry support it? At today's prices they probably can. We will not dampen our ability to produce oil and gas, and it will not dampen our ability to produce gasoline. What it will do is it will once again cut into these revenue streams and make it impossible for us to expand. Not that we can site a new refinery but try expanding one. Another advantage on the diesel fuel is we've had to go through a major renovation of our production of diesel fuel in that capacity in order to to create this low sulfur diesel fuel . So all of that equipment is new, and that means they can run at a higher rate, and can produce more, so our capacity is greater. [43:10]

JIM: Boy, it just seems to me Richard at a time when the United States is relying more and more on outside sources many of which are not friendly to the US, we are almost going backwards in our energy policy it's like the United States is becoming an energy banana republic.

RICHARD: I couldn’t agree more. And if you want to look at a lobbying adventure, somebody who does an excellent job, it's got to be ADM, because it doesn't make economic sense, but they got their idea passed through Congress, got it mandated, the laws are there, and we are going ethanol. And the American public seems to be very happy with this. Archer Daniels does not have the reputation of Exxon-Mobil, but they just became the Exxon-Mobil of ethanol. So, they've got it. I think they've got I think 1.07 billion gallons a year capacity powered on corn which is not our most efficient way of making ethanol. Like I say, they've got a ¼ of the supply. You can only make 330 gallons of ethanol for an acre of corn. The Brazilians can ramp up production faster because they can make 630 gallons from sugar per acre. And of course we’d like to think switchgrass could save it because it’s better, but nobody is doing it from switchgrass – a research facility has got it down to I think 1000, or 1150 gallons per acre on switchgrass – was it Oakridge? – but who's going to to compete with a juggernaut that's already got a ¼ of the nation's supply already developed on corn. [44:37]

JIM: I tell you Richard this is something to keep our eyes on, but hopefully as more people become aware of what's actually going on, perhaps when the price gets high enough, and painful enough we'll demand more appropriate solutions to our energy needs.

Richard, as we close why don't you tell people about World Energy, and tell them how they can find more information about it.

RICHARD: Well, World Energy is a quarterly magazine and it's entirely written by the CEOs, Presidents and Chairmen of the industry – these people we've been talking about. In any given issue we'll have 20 to 25 CEOs talking about what's going on. World Energy we've run in conjunction with a monthly magazine called World Energy Monthly Review, and in the monthly we address these kind of topics regularly, and in our upcoming issue we’re covering tax – of course, it’s April, time for tax. We also have World Energy television and you can find them all at the worldenergysource.com which is our website, and it's updated regularly. [45:36]

JIM: I know you ran an article last year about would we be facing higher gasoline prices. As a result you were addressing all these issues and here we are in April.

RICHARD: It certainly came right around didn't it. We were also looking to have very high diesel prices and demand and we've been running a lot on the ethanol issue.

JIM: Well, I tell you a very prescient call on your part, and I can't tell you enough, great publication, keep up the good work, and hope you'll come back and talk to us.

RICHARD: Well, thanks a lot Jim.

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Why Gold is Going Higher & What to Buy

JOHN: Well obviously one of those flag ship indicators as to how money is doing is gold, and gold is going up and let's face it, even today they were talking about “gosh, it's hit record highs.” And you know we talked about this long before it ever happened but here it is.

JIM: One of the reasons we're so bullish on gold and why we think it's going higher. I mean even this week the Financial Times quoted the president of Anglo Gold, Bobby Godsell, and he was saying that world gold production is due to stagnate over the next couple of years. And if we look at for example Anglo Gold's production has dropped from 6.2 million ounces, they’re projecting they will only produce 5.8 million ounces this year, so it has dropped 400,000; Newmont's gold production has dropped from 7.4 million ounces down to 6.2; you’ve seen Freeport McMoRan drop from 2.2 million oz down to 1 ½. So the gold industry is having great difficulty maintaining current production levels.

And the other thing despite all the dollars that we've spent on exploration there have not been any major gold deposits that have been discovered; and so it's another reason that the majors are having a hard time replacing their reserves. I mean a lot of the things that we talk for example in last week’s interview with Keith Barron of Aurelian, where Keith's been in the business 25 years, and you know there's been numerous, and numerous studies just like Matt Simmons' study of the world's major oil producing wells, there have been several key geologists – Ralph Bullis is one of them – and there just aren't a lot of elephants out there. And they are not finding elephants. And if you're somebody like a Newmont, you're producing 6 million ounces a year, how are you going to find 6 million ounces each year to replace.

And remember what we said last week, that it's taking anywhere from, you know you're lucky from the time you discover something and poke a hole in the ground, it's 10 years before you can bring that production online. Just for example, what? a couple of weeks ago Mexico announced a major oil discovery but they said it will be 10 years before we bring any of that into production. So, the next couple of years you're going to see stagnating production from not only major gold producing countries but the majors themselves, and it is unlikely that we're going to find something like a North Sea or a North Slope, or a Ghawar out there that is unknown.

The other thing that I think is even more interesting is the changing production profile in the gold business. In 1980 you had basically 4 countries in the world that were our main gold producers: South Africa was number one, you had Australia, the United States, and you had Canada. If you look at now where future gold production is going to come from, it's going to come from some very troubling and unstable places of the world: Russia; Mongolia – Mongolia just changed business contracts with several miners; the Congo; Venezuela – if you're a gold mining company, how comfortable would you feel going into Venezuela with a Hugo Chavez right now. So, future gold production is going to be coming from a lot of of very politically unstable very high risk areas of the globe. And that's one of the things that the majors are very cautious, and you can't blame them, you know, look what happened to the oil majors in the 60s and 70s where they had their oil properties expropriated by governments.

So, it's a very high risk world today and that's why with all these uncertainties don't expect gold production to really ramp up. At the same time, central banks are printing oceans of money and people are beginning to realize we have real monetary inflation in the world, and gold is rising against all the world's major currencies

JOHN: You know, Jim, as you describe this whole situation and we've talked about this before here on the show, there seems to be a relationship between peak oil and gold itself, in the fact that we may be approaching a situation I guess you could call this peak gold.

JIM: Yes, I think what you're seeing today is all the easy gold deposits have been found, what's left is in very politically unstable parts of the globe, or some areas that are going to be very hard to get to. We might be able to find gold in Antarctica but you know good luck in trying to get to it. And number 2, just imagine the harsh realities trying to mine it when you have freezing temperatures. The other thing too, the reality is the juniors have a better track record defining ore bodies than the majors do, which is one of the reasons we've been pounding the table that these late stage development juniors are going to become very attractive because: number one, they’re the ones that have found the gold deposits; they’re the ones chalking up the ounces; and these are companies that are even going to become very attractive for a takeover because they'll be able to turn a deposit into 200 to 300,000 ounces of annual production, and that's a major production profile. But also, even if they don't get taken out because of their valuations begin to rise more towards what they would be as producer, they could also go into production. [53:00]

JOHN: Well, it's obvious that you know you’ve been thumping on this subject for a long time, so you obviously believe gold is going higher, but the best place to be is what? To be in these juniors?

JIM: I would be in the late stage juniors and also junior producers because that's where I think the growth upside is going to be. The other thing though, the only caveat I probably would add is we're only buying in political stable areas of the world right now. Our 3 favorites places are Canada, Nevada, and Mexico. In fact, John, the Fraser Institute which does an annual survey of mining companies, and they sort of look at geopolitical risk, they just released their survey in March, and the best countries for geopolitical risk for mining: number one, and we're going to get to some states here because Nevada in the US is number one; number 2 is Chile; number 3 is Quebec, Canada; 4, is Mexico; 5 is Ontario, Canada; 6, is Western Australia; 7 is New South Wales, Australia; 8 is Alaska; 9 is the Northern Territory of Australia; and 10 is Brazil, with Argentina almost with the same kind of score. Those are the 10 safest areas of the globe right now to be mining because I mean just take a look at what happened to a lot of mining companies in Russia even oil companies where the Russian government you go and discover something and you know you build out the mine, or you build out an oil well, and then all of a sudden they change the terms of the contract.

There's no protection of contract rights and the real risk that you have here are permitting risk: because of environmental wacko you may not be able to get a permit to get a mine permitted, or you might be able to drill it but you won't be able to put a mine in because they won't give you the permit. Or you will have what we call moving the goal posts, where a government will say “OK, we want a 6% royalty on gold.” And all of a sudden they found out you discovered a major gold discovery, and they get greedy and then all of a sudden they say “we want 30%” Look what Chavez is doing down in Venezuela right now. You’ve got environmental risks “well, we want you to clean this up, no we want you to do this,” so they just keep moving, you think you have a deal then all of a sudden next week they change. [55:30]

JOHN: Yes, they change the rules of the game once the game is underway is what's happening.

JIM: Sure, and then you have security of your tenure. They might just decide you know what you have so much gold there and we're printing so much money we're going to basically nationalize you. And then the other thing you have with a lot of these countries is corruption. you know you’ve got widespread corruption with many governments in Latin America; you have it in Asia; you have it in a lot of these smaller countries where the gold is located: in the Congo; Venezuela; Mongolia. They’re just not politically secure and you have the corruption of officials. 56: 04

JOHN: And you either play the game or you don't play, that's the way it is in those countries.

JIM: Yeah, and the unfortunate thing when you're dealing with the government – their way of the highway.

JOHN: you know we've talked a lot of times speaking of the juniors by the way about what to look for in juniors is there anything we should either sort of review or add on to that for people considering this area.

JIM: We use a concept called forward ounces when we look at a junior and I think a lot of times people are looking at valuing a junior and they might say, OK, this is the companies market cap, they have this many ounces, you divide their ounces into their market cap, and say “ah, the company is too expensive.” But the one thing you have to understand with a junior, number one is they have no revenues, they go into the market, they raise equity money and then they take that money and they drill their properties so they going to take those drills and hopefully find more gold. So if you're in a late stage development company where they are doing exploration work where they are adding more ounces, you have to take a look at what it is that they are doing; and looking at for example their success rates how successful have they been in finding new gold deposits and adding ounces what are their finding costs. And then you need to look at companies that are cashed up, you can look at the drill program because most companies after they've gotten quite a few assays back from the lab they will release a drilling program, they’re saying “OK, here's what we're finding.”

So you can look at those drill programs, you read the results and in many ways you can extrapolate where those ounces will be. So, then you can compute the present price market cap based on for example where the company is going to be a year from now. I mean we're involved in a couple of companies that will probably add a million ounces in the next 12 months, and we take that into consideration in terms of our purchasing programs. So we're not just looking at the fact that they may have a million ounces, a million and a half, or two million ounces now, what we're looking at is if you're running 4 or 5 drills on the program and you have 3 or 4 new gold discoveries and you’ve got a very active drill program, we know you're going to have new resources coming down the road. And so you try to estimate based on what the company has delivered in the past, how successful they've been, what their finding costs are, and then you can do some sort of rough back of the envelope calculations. I mean it's never precise but you can get more precise when you start taking a look at drill results and do some calculations, and then say “hey, it looks like this company can add a million ounces, or half a million ounces, and based on their current market price this company is still cheap.”

JOHN: Jim, I take it so far at least you're bullish on juniors. Is there a point at which you bail out or change that position and do something else?

JIM: I think the next 3 to 5 years are the years to make some really good money in the gold market, and especially with the junior market. I would be accumulating positions because you know a lot of these juniors are making new discoveries, they’re adding ounces. We look for companies to add half a million to a million ounces a year, and especially if they've had a successful track record of doing that or large enough land package where you know they’re in a large prolific gold belt so you know there's going to be more gold discoveries. And also late stage so they can start taking it towards production or they are very close to a prefeasibility study so their ounces get into reserves which makes them a very attractive take over candidate. Also, it makes it much more likely you get a better picture that they could go into production and make a profit, but I think the next 3 to 5 years are going to be the best years in the junior mining business, and they've been great since 2001. But I think the next 3 to 5 years are going to be explosive.

Once gold gets past, oh, I would say 2000, and as we get to the end of the second phase of this bull market things are just going to get so goofy, and especially when we get to phase 3, and at that point you're going to see Maria Bartiromo at the futures pit, or you'll have a CNBC going bonkers with some gold IPO, and you might have just silly stuff where a company has gone public, they’re going to raise $100 million because they’re going to go discover the Lost Dutchman mine in Arizona, or something like that. And it'll be based on some pie in the sky type stuff very similar to what we saw in the stock market in the late 90s.

And remember from 1995 to the year 2000 that was the third phase of the equity bull market, that's where over 95% of the money came into the mutual fund market, that's when the tech phase, the internet phase it just got outright goofy. And at that point you are just going to want to sit back and just watch your net worth multiply and multiply and multiply because it will get so goofy, and at that point I just think you just run a real risk at that point I probably wouldn’t be doing the kind of investing that we're doing now where we try to base it as much as we can on knowledge and value. At that point it's just going to be goofy stuff, you'll see Cramer doing headstands on TV, your neighbor's going to be talking about the next gold IPO, it'll be the front cover, we'll have gold radio shows, there'll be a hundred difference gold sites. It's going to be nuts. That's the point you just sit back, relax and just watch it multiply and then as it multiplies every time it multiplies you take a little off the table, it multiplies again, you take a little off the table, and you just start cashing in. It's kind of like planting the seeds in the harvest and then you just watch the corn grow when at some point it'll be time to harvest it. [1:01: 57]

JOHN: Jim, let's pull this up to a conclusion here for this segment of the Big Picture. How would we sum up what we've been talking about?

JIM: I would say your best play given where the gold market is going, once again is late stage juniors. We've been buying when we got out of our majors in December but we've been steadily accumulating one junior at a time since December where we'll be taking our junior positions up to 65%. We're financing a couple of companies right now. I've found my next 2 Kimbers and they are being given away. So, I think the market over the next 3 to 5 years is going to be good for the junior mining market. We know for example that majors are not replacing their reserves, their production profile is shrinking. We know there are'nt large deposits out there, we know that a lot of the areas where future gold production is going to be coming from are very politically unstable areas of the world. So this universe is going to get more finite and finite, and I think the time now is to get into your positions, continue to accumulate those positions and wait patiently because gold is going higher. There is no doubt about that. [1:03:05

JOHN: Well, it's interesting I used to hike around Superstition Mountain Christmas morning in fact, that became a tradition, and never found that mine. That's why I'm doing this radio show, Jim.

JIM: And in phase 3 you may just want to go public and raise the money to do it.

Well, speaking of higher gold prices and funny money.

JOHN: Let's go over to Hong Kong and our next guest.

Other Voices: Puru Saxena, Editor, Money Matters

JIM: Well, you know we hear a lot today about tightening liquidity globally, central banks are raising interest rates but what's happening underneath the surface. In other words if liquidity is tightening why is money supply increasing? Joining us on Other voices this week is Puru Saxena, he joins us from Hong Kong.

Puru, I want to start out with one of your newsletters, The Wealth Illusion and you have some figures there on global money supply growth, why don't we start out by talking about that, because they’re talking about tightening liquidity , I sure in heck don't see it, do you?

puru saxenaPURU SAXENA: Thank you very much for having me on the program, Jim.

Absolutely not, I agree with you 100% I don't see any monetary tightening taking place. On the surface central banks continue to increase interest rates to try and please the public and to show the public that they are actively doing something but in reality the money supply is increasing at a scary pace. If you look at Australia the money supply growth year over year is 8%, Britain about 12%, Canada about 6.4%, Denmark is about 24%, and America and the Euro zone is 8% per annum. So where is the money supply tightening?

In fact I would argue that since the modern day central banking started in the us in 1913 when the Federal Reserve came into power, since then the US dollar has lost about 92 of its purchasing power due to inflation in other words monetary printing and an increase in the supply of money. And there is a lot of confusion these days when people say, inflation is low because the government's skewed figures say they 2 or 3 but in reality inflation has to be properly defined. inflation is the increase in the quantity of money, or money supply growth, not increases in prices. Prices only rise as a consequence of inflation. So, in other words, I would say that inflation is still rampant, it's up to you whether you want to see it or not. [1:05: 27]

JIM: What really surprises me, Puru, is that very intelligent people, I mean if you take a look at Wall Street you’ve got people who are Harvard educated, you have CFAs, and if we would have seen this kind of money creation in the late 70s when I got in the business, 8% money supply growth in M3 we would be looking at higher interest rates, you would be hearing the bond markets get hammered and everybody talking about inflation. Instead today we talk about disinflation, deflation and low interest rates, and tightening liquidity. It doesn't make sense to me.

PURU: Absolutely right, you know I'm also very, very surprised because if you look at very intelligent people and they are equating deflation to a fall in prices, and inflation to an increase in prices. That's absolutely incorrect because rising or falling prices are a consequence of inflation or deflation. If you look at Japan everyone is now convinced that Japan went through deflation, and that deflation is really a monster, and everyone should avoid deflation at all costs. But I would argue that Japan never really had any deflation because if you look at the money supply growth over the 80s, as well as the 90s, the money supply in Japan has continued to rise. For sure, it did not rise as quickly in Japan as in the US or some other countries, but what I would say is that Japan witnessed a milder rate of inflation, or money printing, not deflation. So, this deflation voodoo is just a voodoo. In reality, we have not witnessed deflation in any country since 1929 – the Great Depression . So I don't know what these people are talking about. [1:07:10]

JIM: You know what I think it is, Puru, and I've had some thoughts on this deflation argument on Japan, if the Japanese central bank is creating a lot of money through money supply growth, but if the population as a whole hoards its money, or saves it, they take this money out of circulation, or export it, doesn't that offset some of the money creation?

PURU: I wouldn’t think so because what we've seen in Japan is that the central bank kept introducing liquidity into the system, and the Japanese started saving a lot of money, and as a result because nobody was really spending or investing money, asset prices came down quite considerably. I mean the Nikkei or Japanese stocks came down from 40,000 in 1990 to as little as 7 or 8,000 a couple of years ago; and also real estate prices came down 50 or 60%. So what happened is that the Japanese now were in a much better situation , I would argue that this fall in asset prices we’ve witnessed in Japan in the last 10 or 15 years has actually been very good for the Japanese consumers because things have become cheaper and the savings rate has been pretty high. So as a result the standard of living has become better, and the cost of living has also become better because things have become cheap. [1:08:27]

JIM: Well you know one of the things that central banks are afraid of is deflation, harkening back to what happened to the United States in the 1930s. I think the way we handled deflation is what made things as bad as they became. If you take a look at the situation that you describe going on in Japan, and Marc Faber has echoed that same thing, for the average person on the street in Japan things have become better over the last 10 years.

PURU: That's absolutely right. Deflation becomes a real monster for a society which is heavily, heavily in debt. For instance if you look at the US today, the total liabilities include the unfunded liabilities of the Social Security and Medicare; the figures come in at a whopping $46 trillion, and that is roughly 350% of GDP. So, during such a scenario, if you get deflation now, in other words a real contraction in the supply of money which causes the value of money to increase, then you're going to have real problems because to make it easier to service debt you need inflation. Let me explain, if for example your Grandmother borrowed $50,000, 50 years ago, at that point $50,000 would be a lot of money. But due to money creation which is also inflation, $50,000 today is not a lot of money, and it's easier to repay. So for a debt laden society you need a constant stream of inflation otherwise this debt becomes extremely hard to service. [1:09:58]

JIM: And we have I might add in the United States a lot of embedded inflation with the way we're running trade deficits, budget deficits and increasing the supply of money, but yet I'm still astounded by the fact that anybody living in the United States goes to a grocery store, puts gasoline in their car, pays for insurance premium, sends their kids to school, go sees a doctor or a dentist ,or pays their utility bills, even entertainment – goes to a movie theater, movie tickets are now $10 – how they can say there's no inflation?

PURU: I don't know, I think we have to ask the average American that question because the same thing in Hong Kong [is happening]: prices have gone up quite significantly. If you look at the cost of property, property prices have almost doubled anywhere in the world over the last 5 or 6 years due to this excess liquidity being pumped by the central banks. The M3 money growth in the US alone has increased by about 55 or 60% over the last six years or so. No wonder that the Federal Reserve has decided that M3 isn't worth printing anymore, or publishing any more. But if you look at the cost of living all over the world, Jim, you will realize it is becoming very, very expensive to live on this planet. And I think that is extremely dangerous for the majority of people who don't have the capital to ride assets and become more wealthy, and the poor are going to become even poorer, and the wealth gap is going to get wider and wider, because if you print money at 8 to 10 to 12% a year, the consequence of that is things become really expensive. You may try and hide this from the public by adjusting and seasonally adjusting and readjusting your inflation figures and CPI figures, but I would urge your listeners to go and follow the money supply growth rates around the world because that gives you a good indication of what inflation is, because money supply growth is inflation. [1:12:01]

JIM: I couldn’t agree with you more, Puru.

I want to change topics for a minute, since you're over in Hong Kong you have a closer eye on what's going on in China. Every time we see the price of oil rise – as we've seen today where you know oil looks like it's heading back up to $70 a barrel – we all hear about the Chinese slowdown in growth theory we get these stories out there. From your perspective, you and I were talking just before we went on the air, China is importing more oil.

PURU: That's absolutely right. I've been hearing about this for a long time oil rising prices is going to cause consumers to slowdown, and oil becoming expensive. But Jim, I'll tell you what, with the rates China and India are developing I don't think the Chinese and Indians are going to swap their new acquired cars for bicycles any time soon. I just don't see that happening. In fact if you look at the imports over the last couple of months, at the beginning of the year, Chinese imports of oil have gone up 34% in January and February of this year when compared to last year. China has imported 179 million barrels of oil over this period. Asian imports have also increased this year by about 15% year on year so rising prices don't necessarily mean that they’re going to hurt consumption because everyone needs oil, and as you mentioned several times on your show – I agree with you 100% - that the world's oil production peak is upon us and if you look at the per capita consumption rates in China and India, China only consumes about 1.8 barrels of oil per capita. India is not even that India consumes 8 barrels a year. If you compare that with some of the developed economies in Asia such as South Korea and Japan, these guys consume about 15 or 17 barrels a year. So, the divide is just so great and I don't see how oil prices are going to go to $30 or $40 a barrel. I think oil prices may even double or triple from these levels within the next 5 to 7 years. 1: 14: 01

JIM: Puru, I want to change the conversation, and move on to the commodity markets. We've seen gold prices more than double here since 2001, we've seen oil prices go up over 200%, we've seen – I don't care if you take any commodity lead, zinc, copper, silver – and they’re calling it a bubble. Where was it I read recently I think we're going to add another half a billion people on the planet in the next 10 years or less. So you’ve got population growth, and we're just in the beginning stages of the cycle. What happens when money starts fleeing the paper markets because people start waking up to 8% and 9% and 10% money creation growth rates in the money supply are inflationary.

PURU: Jim, I speak at a number of investment conferences and seminars and when I talk about commodities, before that I usually ask the audience whether anyone owns commodities, and these are extremely wealthy people in Asia, and I can assure you less than 5% of people present in the conferences actually raise their hands. I'm absolutely stunned when I hear that commodities are in a bubble, that commodities are expensive and then they’re going to go down, because if you look at the history of commodities, in 2001, commodities or raw materials which everyone uses in life, were the cheapest they had ever been in the history of capitalism when you adjusted for inflation.

If you look at some of the commodities today, for sure, oil has gone up 6 times, gold and silver have doubled, but if you also look at the recent history of bull markets over the last 3 or 4 decades you would realize that a doubling or a tripling of prices are absolutely nothing. In the 70s, sugar went up 45 times, oil went up 30 times, gold went up over 20 times, silver went up over 20 times. In the 80s when money started flowing into Japan the Nikkei went up 8 or 9 times, and in the 80s and 90s, when stocks were doing extremely well the NASDAQ went up 50 times and the Dow went up 14 times.

So, how can this be the end of the bull market or a commodities bubble when prices have only doubled or tripled and the public is still pretty much out of commodities? People don't even know how to own commodities, let alone profit from it. So I would argue that commodities are not in a bubble, we've only had a 5 year upswing. History has shown commodities bull markets have lasted a very long time because when demand increases it takes an awfully long time to increase the supply because unlike financial assets like stocks and bonds it takes real work and a lot of time and money and infrastructure to bring new supply online. So I think this boom is going to carry on for a very long time. [1:16: 50]

JIM: Well, Puru, I'm trying to find something we're going to disagree on. Well, listen, as we close why don't you tell people if they wanted to find more about what you do, Puru, how they could do so?

PURU: We are based in Hong Kong we are registered investment advisers. Our firm manages segregated accounts on behalf of high net worth individuals, family offices, and corporations and the region and around the world. I also publish a monthly report, Money Matters which is available from my website, and the website is www.purusaxena.com. Thank you very much, Jim, for having me on your show.

JIM: Well, I hope you'll come back and talk to us, and I just want to let our listeners know you also write pieces for our site, you can find him on our site as well. So, Puru once again top of the morning to you, and I hope you have a great day. Thanks for joining us.

PURU: Thank you very much for having me Jim, it was a pleasure.

Great Companies - Great Values

JOHN: Well, there are obviously great companies in which to invest, and knowing what those companies are and why. And this is an investment and not a speculation, I think that's an important distinction to make. And possibly the key to good investing is indeed understanding what's happening. Warren Buffet probably on of the greater investors of our day continues to astound people because just when you think he's gotten everything out of it that he possibly could, he finds something new to invest in, like PetroChina in energy. I know you surprised people, a number of people choked on their beers during the program when you were saying the Dow would reach new highs, and that certain tech stocks were looking good. This wasn't orthodox.

JIM: No, it wasn't orthodox but you know what we try to do at least when I came to my conclusion about where we were going on inflation and then also recognizing that inflation has two outlets to the real economy or the financial markets. If you really want to understand what happened in the late 80s and 90s in the markets you need to understand inflation, and paper assets – asset bubbles – were a form of monetary inflation, and that's where a lot of the wealth of money creation was going into.

But aside from that if you understand that we live in an area and time of great inflation, whether you're seeing it in asset bubbles or now in the real economy whether it's energy prices, food prices just take a look at what's happening to the cost of living in this country.

But, understanding that you're always try to apply a value perspective, and the one thing that we try to do is we try to find great companies. And it goes back to the old value style of investing. And you really want to find as Warren Buffet has done so often is find companies that have a durable competitive franchise and then buy it when you can do so cheaply. And John, if you look, there are two kinds of businesses that make great investments. Companies that have a great consumer or competitive franchise where they have high profit margins – obviously the higher the profit margin, the more profit for the company and investors.

Another great company may be a business that doesn't have a high profit margin but they have a high inventory turnover. So if they are turning over their inventory rapidly that's another great business where you can make it in quantity so to speak. And then what you need to do is learn how to identify these companies. In other words how do you determine if a company has a durable competitive franchise. Well, one way is you take a look at return on equity. Any company that is making 15% or more return on equity is a company that has a good competitive franchise, and especially if they've done that consistently. What you don't want to do is find a company that they make 15% return on equity or 30% return on equity one year, and then the next year it's down to 6% or 7%. So you want to look for consistency.

And then a second thing that you want to look for is a lot of of times you can get a high return on equity by just simply leveraging the balance sheet. for example, General Motors has had a high ROE but they've done it because they are so leveraged in debt. So the way you kind of throw out those kinds of companies is also do a comparative test and look at return on capital, and if the return on capital is right out there with ROE then you know you’ve got a good company.

And then I guess once you’ve found this company, then you have to know when to purchase it, and we tend to weigh more towards fundamentals on the purchase side. In other words we compute intrinsic values for companies, and we look for companies that are selling at discounts from their intrinsic values, somewhere in the neighborhood of 40 to 50%. So what we're doing is buying what Ben Graham talked about is a margin of safety. That doesn't mean that the stock price won't fluctuate, I mean in today's market that's just the nature of the beast. But what you're doing is if a company has a value of 100, and an intrinsic value of let's say $100, based on predictable cash flows and earnings, and predictable ROE, and a number of other factors – we look and calculate that on 3 different methods – but then if it has an intrinsic value of $100 and you can buy it for $50 then to me that adds a margin of safety and if the stock dips a little bit then you add to your positions. And right now believe it or not we are finding some great growth companies with 40% to 50% discounts which we'll use market pullbacks to load up and I think as Frank was talking about earlier in the expert's section in the 1st hour I think we're going to get a possibility of that 10% to 15% correction. So, I think there's going to be some great values that investors are going to be able to load up on: energy in our opinion is still cheap; alternative energy we've got a great alternative energy company that's going to be one of the largest powerhouses in the industry globally, and it's selling at a 40 discount from its intrinsic value.

We're finding great companies overseas in the water industry; drug companies as well; and maybe some surprising companies, we've done some quick trades in the technology sector, we've gotten out of some of our tech stocks, we've had some nice trades, we'll have a chance to go back and buy them again even cheaper. But I think John this is a great market to be investing in, because you have central banks that are literally flooding the markets with money. Just as this week we heard from Puru Saxena where he's talking about what global tightness: there isn't any. They've got money supply in the United States growing at probably 9%, you’ve got it growing at close to 9% in Europe, Australia, Japan, China. The central banks of the globe are inflating in unison right now, and that's why you’ve got gold rising against most major currencies. [1:24:16]

JOHN: So basically what you're saying is in an age of inflation there's really nothing cheap, well we might make some exceptions for energy, but what you're really hunting around for is something that I guess we could call reasonable given the atmosphere that we're in.

JIM: Sure, and I think that you can apply these principles to any investment market whether you're looking at commodity related companies, I mean we're finding junior mining companies for gold in the ground at 8 and $9 an oz at a time, when gold is almost 600. We're looking at buying future producers. We've got a base metal company that we've accumulated with that has the potential to rise almost 200% from where it is now, based on its growth rates, and you're seeing these sell offs in the market, people just dump these companies, and we're using that as a chance to pick up these companies.

You’ve got to keep an open mind and I think what happens is you can get into the very bearish case. Short sellers have lost a lot of money, and I think it's because they don't understand about intervention in the financial markets – those flag pole rallies that take place where the buyer comes into the futures pit, central banks inflating globally in unison. And you can read that picture of what the gold market is telling you. But take a look at what central banks are doing and this is the age that we live in, and so what you try to do is find things that are reasonable, find things when the prices are right, and invest in trends that you know are going to be profitable very long term.

I think two core areas are energy, base metals and precious metals. I think another core area is going to be alternative energy, water; I think drugs and to a certain extent, certain types of technology. This to me is I think is a long term trend that is going to be with us for several decades. [1:26:09]

JOHN: Yes, but you were saying this 5 years ago, Jim.

JIM: Well, the trouble was 5 years ago people thought I was nuts.

JOHN: I haven't changed my opinion of that by the way. You're not off the hook, you know .

JIM: OK. I guess 5 years ago we were buying energy stocks, I literally got calls from clients: “What the heck are you doing buying oil. What's Canadian oil sands? Why are we buying commodities.” This was in 2001, and 2002 we were buying gold and of course if you were listening to this program in the Summer of 2001, we started initially picking up some of our gold positions, and we owned some gold in the 90s. One of our largest holdings was Franco Nevada which eventually got taken off by Newmont but that was the only area that I felt safe owning at the time because the gold market wasn't doing well, so I wanted to be with a company that was at least making a lot of money. And the gold mining business through gold royalties which was at that time the only way to play the market, but yeah, I haven't changed, we still buy water, we're picking up more alternative energy, we're still in the energy sector, we've held on through thick and thin, we have a large position in that area; and we like drug stocks because we have an aging population in the United States, Japan, Europe, and most of the major industrialized countries. When you get older, people start taking more medications. money the margins r'n as high as they were in the 1980s, but you’ve got more unit sales. So, going back to what makes great companies: high profit margins, or high turnover with the drug companies you have both. [1:27:46]

JOHN: Well, Jim, next week we're going to have a shortened program because it is Easter Weekend and the markets are closed on Good Friday, which is April 14th. We will be doing a show, but it will be a little shortened. Who are we having on anyway?

JIM: Coming up next week, Peter Tertzakian, he's written a book on oil A Thousand Barrels a Second is the name of his book, the subtitle is “the coming oil breakpoint and the challenges facing an energy dependent market”, so we're going to have him on the program; and then also joining us from London, will be Russell Napier, he's written a book called Anatomy of the Bear and so we're going to have 2 special interviews coming up next week, and the Big Picture we won't have our regular guest experts in our first hour because the markets will be closed on Friday, John. So you and I will be doing our show on Thursday.

So, all of that, much more coming up. Also, just to give you a heads up later on in the month, Ike Iossif will join me for Ahead of the Trends; Dan Reingold will join us on the 29th Confessions of a Wall Street Analyst, you're not going to want to miss that; and the first week of Matt Simmons, Chairman of Simmons Intl and author of Twilight in the Desert and May 13th, Dr. Leonard Peikoff The Ominous Parallels. He was Ayn Rand’s successor. He's going to be joining us on the program in the month of May. So, some great stuff coming up, and May 6th we'll just be running the Simmons interview because I take off to sea, because all work and no sail makes Jim's forecasts fail. So time to go sailing again. But a lot of stuff coming up on the program.

In the meantime we'd like to thank you for joining us here on the Financial Sense Newshour, until you and I talk again have yourself a pleasant weekend.

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© 1997-2011 Financial Sense® All Rights Reserved.

The opinions of the contributors to Financial Sense® do not necessarily reflect those of Financial Sense, its staff, or its parent company.