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The Daily Reckoning | Monday, April 26, 2010 What a stronger yuan means for the Chinese consumer...and your wallet, The best basket to own when the Fed begins to tighten, Plus, Bill Bonner with more tales from the Argentine frontier and much, much more... Investing in Commodities A Hedge Against Rising Interest Rates Eric Fry Reporting from Laguna Beach, California... The Wall Street Journal says its time to load up on commodities. The price charts seem to agree. "Portfolios that add commodities after the Federal Reserve tightens the discount rate, perform better than portfolios that don't," observes Journal writer, Carolyn Cui. The Fed raised the discount rate in February and seems likely to continue raising rates. Therefore, says Cui, investors should be increasing their commodity exposure. She bases her observation on a new study to be published in the Journal of Investing. The authors of the study researched data from December 1970 through August 2007. Cui explains the process: "The researchers added a basket of commodity futures tracking the S&P GSCI Commodity Index to five types of stock portfolios: value, small-cap, momentum, growth and large-cap. The commodities added to the returns of all five equity styles during periods when the Fed tightens the discount rate." Interestingly, most commodity prices bottomed out in mid-February, which is exactly when the Federal Reserve hiked the discount rate to 0.75% - the first increase in the discount rate in more than three and a half years. From its February lows to the present, the CRB Index of commodity prices is up 8%. The CRB's advance is not just an "oil thing." Most commodities are advancing, including the long-slumbering agriculture complex. Several price indices are validating these recent inflationary signals coming from the commodity markets. The Producer Price Index is up 6% year over year; import prices are up 11.4%, and the ISM's Prices Paid Index has more than doubled during the last 12 months. Perhaps these price trends are inspiring the Fed to begin "tightening" - i.e. raising interest rates. Whatever the Fed's exact motive, it has begun to raise rates...and that's enough of a reason to begin buying commodities, according to the study Cui cites. "The strategy is pretty simple to follow and doesn't require much trading," says Cui. "During the 37 years the study covered, the Fed changed the discount rate 113 times, but only 18 of those moves represented directional changes - meaning investors would need to get in and out of commodities only 18 times. "So how can investors take advantage of the latest Fed rate-tightening cycle?" Cui asks. "First, they must decide how much money they want to devote to commodities. The study modeled allocations of 5%, 10% and 15%, and found that the 15% dose produced the best results. "Next," she says, "investors need to decide what to buy... There are commodity mutual funds and exchange-traded funds like the iShares S&P GSCI Commodity Indexed Trust. Investors also can make more-targeted bets with single-commodity funds: The SPDR Gold Shares tracks gold prices by holding physical bullion; US Commodity Funds LLC runs a suite of ETFs tracking prices of crude oil, natural gas and gasoline." A basket of commodities is probably the best approach for the long-term investor. Below, please find the latest commentary from Peter Schiff, president of Euro Pacific Capital and author of How an Economy Grows and Why It Crashes. The Daily Reckoning Presents To Peg or Not to Peg? PeterSchiff When a 10-ton elephant plods through a village of grass huts, the big question on everyone's mind is: which way is he going to turn next? With China, that fundamental question translates to guessing when Beijing will make changes to the value of the yuan. These decisions will determine the overall direction of the global economy, and will set the path that everyone must follow. Unfortunately, no Americans, even those who travel hat-in-hand to China, have a seat at the table where these decisions are being made. At the risk of beating a dead horse, let me reiterate my central thesis with respect to currency valuation: just as it is always better to be rich than to be poor, it is always better to have a strong currency than a weak one. Although this simple maxim puts me into conflict with much of the economic establishment, I hold its truth to be...well...self-evident. While I attended an economic conference last week in Shanghai, I found it notable - but not surprising - that two former Secretaries of the Treasury, John Snow and Hank Paulson, as well as current Treasury Secretary Tim Geither, and former President George W. Bush were then in the country at the same time. The fact that so many key American power brokers were in China simultaneously was no coincidence. In an overly indebted world, the $2.5 trillion that China holds in foreign reserves is acting as a center of economic gravity, inexorably pulling all market participants into its orbit. The effect of current Chinese currency policy (which, despite Beijing's protests to the contrary, is manipulation pure and simple) is to make the US dollar more valuable and the yuan less valuable. As a result, the benefits of manipulation accrue to Americans, not the Chinese. We get pay raises; they get pay cuts. Americans use their stronger dollars to buy products they would otherwise not have been able to afford. On the flip side, the Chinese people do without products that they otherwise would have been able to afford had their government not transferred their purchasing power to us. The same effect is experienced with interest rates. In order to manipulate the dollar's value higher, the Chinese government has gobbled up more than $1 trillion of them. The Chinese then loan the dollars back to the US through purchases of government and mortgage- backed debt, which reduces the cost of servicing our massive liabilities. By the same token, if China were to stop manipulating the dollar higher, it would remove the props currently supporting our dysfunctional economy. American interest rates and consumer prices would soar, and our economy would suffer...perhaps dramatically so. Meanwhile, China would experience the opposite effect. Chinese consumer prices would fall, immediately raising living standards for average Chinese workers, whose higher real wages would finally allow them to fully enjoy the fruits of their labor. What strikes me as particularly dangerous is that no one, not even the Chinese, appear to understand these fundamental dynamics. All of the Shanghainese with whom I spoke last week were unaware that a stronger yuan would be in their own best interest. The way most people see it, a stronger currency is a bullet that China must be prepared to take in order to save the rest of the world from further pain. And so we watch the strange spectacle of China stubbornly resisting actions from which it would immediately and substantially benefit. In reality, an appreciating yuan is the bitter medicine Americans must swallow if our sick economy is ever to regain its health. (An allegorical explanation of this is contained in my new illustrated book, How an Economy Grows and Why it Crashes.) When Beijing finally comes to it senses, the transition will be unavoidably disruptive. For China, the long-term growth would far outweigh the short-term shock. America, however, would face a much less certain outcome. There is no question that, for Americans, the immediate effects would be very painful, with the gains only developing with time and prudent decision-making. Still, that does not mean we should resist the process. For the longer it is delayed, the more severe the pain and the longer the road back to prosperity. If you think China is important today, just wait a few years. For example, while the Chinese automobile market is now the largest in the world, 90% of Chinese car buyers pay cash. In contrast, only 15% of American car buyers do so. In other words, Chinese consumers can actually afford their cars, while most Americans cannot. Without huge car payments, Chinese consumers are in much better shape not only to trade up to newer cars in the future, but to purchase other products as well. This suggests huge future growth, not only in automobiles but also in other consumer products as well. This eruption of consumer demand, made possible by pent-up savings, is creating historic opportunities for investors. When the Chinese start using their wealth to expand their own economy rather than to subsidize ours, infrastructure may well be a primary beneficiary. Whenever the Chinese government decides to end the peg, the Chinese economy will benefit as a result. While as citizens we can hope that US leaders respond with the right policies to enable our economy to regain its former glory, as investors we should position ourselves to benefit from the more certain outcome. Peter Schiff for The Daily Reckoning Joel's Note: News just in is that we've secured Mr. Schiff as one of our guest speakers at this year's Agora Financial Investment Symposium, to be held in Vancouver between July 20-23. The theme for this year's conference is: Assault On Enterprise: How to Invest in the Age of Rising Taxes, Wall Street Crooks and Government Boondoggles. For a full, updated list of presenters and information on how you can join us, visit our webpage here. Alternatively, you can call: Opportunity Travel (formerly Agora Travel) at (800) 926-6575, or from outside the US (561) 243-6276. Peter Schiff is the president of Euro Pacific Capital and author of Crash Proof 2.0: How to Profit from the Economic Collapse. Bill Bonner The Devil in Goldman Sachs Bill Bonner Reckoning from Baltimore, Maryland... Poor Ol' Goldman... Just trying to do 'God's work'... And everybody treats it like the devil. The Washington Post yesterday carried a front-page headline, portraying the firm as though it was Satan himself: "Cheers at Goldman as housing market fell." Goldman executives were in a good mood for a good reason: they had bet against the mortgage market. Of course, that was the only reasonable thing to do. Anyone could see that the housing market was in a bubble. And everyone knew that the bubble would blow up sooner or later. Nobody knew better than Goldman because the firm helped create the bubble...selling those delicious, but teeth-rotting, mortgage-backed securities all over town. Goldman did the right thing. It bet against the mortgage market. Naturally, Goldman execs were happy when their bets began to pay off. But to hear the press tell the story, Goldman executives were like a devilish cabal...cackling about the fall of the mortgage market as if they were celebrating the sacking of Rome. "Sounds like we will make some serious money," said one exec in an email. Serious investors should pay no mind to the Goldman story. The Wall Street firm did the right thing - it helped separate the numbskulls from their money. And now, the numbskulls are moaning and the SEC is trying to salvage its reputation by prosecuting Goldman for betting the right way. As usual, the pundits are on the story too - kicking the poor Goldman crew when they're down. And as usual, they are drawing all the wrong conclusions. Roger Lowenstein, in the New York Times: WHILE the Securities and Exchange Commission's allegations that Goldman Sachs defrauded clients is certainly big news, the case also raises a far broader issue that goes to the heart of how Wall Street has strayed from its intended mission. Wall Street's purpose, you will recall, is to raise money for industry: to finance steel mills and technology companies and, yes, even mortgages. But the collateralized debt obligations involved in the Goldman trades, like billions of dollars of similar trades sponsored by most every Wall Street firm, raised nothing for nobody. In essence, they were simply a side bet - like those in a casino - that allowed speculators to increase society's mortgage wager without financing a single house. The mortgage investment that is the focus of the S.E.C.'s civil lawsuit against Goldman, Abacus 2007-AC1, didn't contain any actual mortgage bonds. Rather, it was made up of credit default swaps that "referenced" such bonds. Thus the investors weren't truly "investing" - they were gambling on the success or failure of the bonds that actually did own mortgages. Some parties bet that the mortgage bonds would pay off; others (notably the hedge fund manager John Paulson) bet that they would fail. But no actual bonds - and no actual mortgages - were created or owned by the parties involved. Lowenstein's point is that Wall Street has lost its way. It is no longer providing a useful service. Instead, it has turned itself into a casino. So far, so good. But his solution? More regulation! Of course, the regulators were on the case the whole time. But, according to the news reports last week, while the biggest scams of all time were going on the SEC team was busy watching porn on its office computers! It missed Madoff. It missed Sanford. It missed the greatest bubble in financial history. More regulation? Forget it! ----------------------------------------------------------- And more thoughts... Life Goes On "The poor little girl saw her mother in the house, naked, with a man..." The adobe houses that people live in up in the mountains are not very big. Usually just one or two rooms. There are not many secrets in family life. "At least they could go outside, behind some bushes or something... You'd think this place is a paradise..." In many ways it is paradise. The valleys are green. The sky is blue. The sun is hot. There are no traffic jams. No drug dealers. No TV. No stone-hearted tax collectors. No stone head politicians. No crackpot economists. "But these children are not innocent...they've seen everything... Well, not the same things that kids in the city have seen...but they are not innocent. The problem here is that they don't have families... Not all of them, of course. But a lot of the girls just have babies. First with one man...then with another... And sometimes they start as young as 12 years old. They see their mothers...and then they do the same thing." We had invited the entire local school over for an outing. Two teachers - Olivia and Lilliane - along with their 23 students. Lilliane, a slim, attractive woman in her 40s, with black hair pulled back in a bun and bright read lips, was telling us about the problems they face: "I've been here for 26 years. We used to have twice as many students as we do now. But now the girls don't have as many children. They know how to avoid getting pregnant. But they still carry on... "And they're bolder and naughtier than they used to be. I woke up one night and found one older boy had snuck into the school and was in bed with one of the girls. We had to make a rule...no one gets to stay in the school after they are older than 12. But even that doesn't seem like enough. One night we found a boy of ten in bed with a girl of 11. They're just too young for that kind of thing. "Many of the children stay with us because they live too far up in the hills to go home at night. And some of them live so far away that they have to stay with us on the weekends too. We have 9 who stay with us on the weekends now. "But it's exhausting for us, because we have to keep an eye on them at night...we can't trust the children to behave themselves." When the children arrived, they filed into the house quietly, timidly. Many of them had never been in a real house before. "Have a seat...sit down," we told them. They sat down without a word. The house was silent. Our Spanish is not good enough to entertain a group of 23 children. In a flash of inspiration, we picked up the guitar and started singing the first song that occurred to us: "Your cheatin' heart...will tell on you...." The kids giggled. By the time we were finished the final verse, Elizabeth had brought in the pan casero (homemade, unleavened bread) with marmalade on it. They had brought their own cups, into which we poured mate cocido - a type of herb tea. The kids seemed satisfied. When they were finished, they went out into the courtyard. "Gimme five," said Calvert loudly, to a group of boys. "Up high...down low...uh oh...too slow." The boys laughed. One by one, they tried to slap Calvert's hand before he jerked it away. Then, Edward got out his soccer ball and the boys all played. As for the girls, we don't know what they were doing. But our Argentine friend, Maria, had gotten back to the house by then. She had been on a long ride on a short, uncomfortable mule. Maria plays the guitar and sings too, only people don't laugh at her. She must have entertained the girls somehow. Maria was the last to come back from our outing. We had left the house early in the morning to ride up to see Dona Ileena - an old woman who lives high in the mountains. Her husband, Felix, fell down a few weeks ago and hit his head. He was taken down from their lodge and driven to a hospital a couple of hours away. That left Ileena alone. No one had seen her in several days; we thought we should pay her a visit. We don't know how Maria ended up on the mule. But she was a good sport about it. On the way back, she switched mounts with someone else, but then went back to the mule. The horses took up a steady trot for a couple of miles across the plain...up the valley...until they arrived at the pass. Then, they slowed to a walk to pick their way down the rocky road that led to the smaller valley below. It took 2 hours to reach the alfalfa fields. We dismounted for a few minutes, drank some water, tightened our saddle girth straps, and headed upstream. The river was dry at first. Then, a trickle of water appeared. We continued up the valley, making our way between thorn bushes, alamos trees, pampas grasses and the rock cliff wall on the side of the river. On the right, we passed two abandoned adobe houses. On the left, there were Indian ruins...the stone walls that once held small terraced fields. After another hour and a half, Gustavo, who was leading this expedition, pointed up to the right. "We have to go up there. That's where Ileena lives." It was not obvious how we were going to get up there. Gustavo didn't hesitate. He found a path through the thorn bushes...that turned into a path through the rocks. The horses strained to get up the hillside. It's amazing where they can go. Soon, they were on a green mesa, their riders still on their backs. The pasture looked over-grazed, but we saw only one horse, tied up near the house, and two cows lying under a tree. Our horses stepped over a low stone wall, another relic of the Indian days. The place was naturally fortified. Steep cliffs guarded the access on three sides. On the other, the mountain went up rather than down. Over on the edge of the cliff was an enclosure of sticks and logs, where a herd of goats was kept; the enclosure was not meant to keep them from getting out, but to keep the puma from getting in. It must have been moved there from in front of the house, where there was about three feet of goat manure, forming a large circle. The house was made of adobe, with a low, mud roof and a few openings to let out the smoke. Off to the side was another low building, also of adobe, probably used for tools and storage. No one came out. "Ileena..." Gustavo yelled, urging his horse closer to the house. Still, no sound came from the house. Then, a moment later, Ileena came out, dressed in a dirty, dusty, torn dress...a sweater, and a pair of cloth shoes, torn open at the toes. Her grey hair was pinned behind her head and her face was crossed by hundreds of wrinkles. She might have been 60...or 90...we couldn't tell. She smiled. We got down off our horses, and greeted her warmly with kisses and hugs. But we couldn't understand what she said. Gustavo had to translate. Then, when we were satisfied that all was well, we mounted up again for the long ride back. "The Indians never left here," Maria explained. "This place has probably been inhabited for 1,000 years. Nothing much has changed." This is not the first time we've met Ileena. She and Felix were often down in the valley when we visited. They always seemed to be in a good humor. Thin and spry, it looked like they would live forever. But now Felix is in a hospital with a head injury and no one is sure he'll ever be completely right again. Life goes on. The following day, life went on some more. We rode up to the old reservoir. Uphill and down. Over rocks and streams. Among ancient Indian ruins...and saddle sores. The old reservoir is still there. Perhaps it too dates from the time of the Inca or even before the Inca - the Diaguitas - or even some more ancient group. A long time ago, after the hunter gatherers began settling down to plant corn and potatoes, people figured out that if they were going to live in this valley they had to find a way to store and direct the little water they had. Life needs water. And there was not enough water falling from the sky to support much of anything. We examined the old reservoir and then gave up. There is no way to get machinery to it. And it is too big to dig out by hand. Riding back, we passed one of the adobe houses where "la gente" live. An old woman, short and fat, came running out. She had a handkerchief to her face, as though he had been crying. "Jorge... Jorge..." Jorge turned his horse around. He rode over to the old woman and spoke to her for a few minutes. Then, he rejoined our group... "She told me my father died... She heard it on the radio. He lives in Salta. But they make announcements on the radio for the people in the mountains to inform them of important events. "He was 85 years old...and sick... I'll confirm it when we get back to the house. (We have a satellite phone for emergencies). If it is true, I'll have to leave to go get the body..." Life goes on... Regards, Bill Bonner, for The Daily Reckoning ----------------------------------------------------------- Here at The Daily Reckoning, we value your questions and comments. If you would like to send us a few thoughts of your own, please address them to your managing editor at joel@dailyreckoning.com