Commodities, Inflation and the Fed

 | Dec 17, 2013 | 1:00 PM EST  | Comments
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I try to bounce around and talk about different things in this forum, but I really think something big is happening and we need to spend some time working on it.

The Fed began their program of quantitative easing back in 2008. It took people a while to even figure out what that was. Eventually they did. Eventually they figured out that the Fed was printing money to buy bonds. And people reasoned it out some more, and concluded that if there were more dollars in circulation, existing dollars would be worth less and gold would be worth more in dollar terms. That was pretty straightforward.

This was the kernel, the central idea of the inflation trade that dominated the investment landscape for the next three years. And it wasn't just confined to gold. All commodities -- base metals, ags, softs, energy -- went up simultaneously.

Before that, in the mid-2000s, commodities for the first time were being treated as an asset class, instead of idiosyncratic tradable units. If you recall, some of the banks made a huge business out of giving clients access to commodity indices via swaps, which were then hedged with futures. Prices of raw material inputs were going up everywhere, which started to upset some people. When people get upset, they complain to Congress about the effects that speculation were having on the commodity markets.

Nothing like that is happening today. Gold topped out in 2011 and the inflation that everyone was predicting in 2008 never happened. Instead, we experienced a mild disinflation. Now, central banks worldwide (most recently in Canada) are actually more worried about deflation rather than inflation. When central banks completely forget their primary purpose -- guarding against inflation -- it is probably right around the corner.

So it's been a two-year plus correction in gold, with a decline of almost 40%, and a decline of 60% in silver. But most people forget that gold had a 50% correction on the way to its highs in the early 1980s. I think it is still in a bull market. Many people disagree.

For those of you on Twitter, you probably are aware that there is a stridently vocal community of gold bears, people who retweet Paul Krugman columns and generally abuse gold bugs any chance they get. Bearish sentiment is at a fever pitch, and I suspect -- with no hard evidence -- that the fast money community is heavily short gold. It would make sense -- it has been the easiest trend to follow all year.

I'm not good at much, but I am good at determining when sentiment gets overheated, and besides the whole reason to be long gold in the first place -- that the Fed is printing money -- is still intact. Furthermore, it is highly likely that the Fed will lower IOER (interest on excess reserves), which has the potential to crank up money velocity and maybe create the inflation that never appeared in the first place. After all, MV=PQ, and even though Q has been going relentlessly higher, V has been going relentlessly lower, offsetting it.

I am very bullish on gold, and especially silver. I own SPDR Gold Shares Trust (GLD), iShares Silver Trust (SLV), Market Vectors Gold Miners ETF (GDX) and some physical gold and silver. I want to do some research on individual names that would be particularly levered to a return of the inflation trade. My conviction is very high. Also, for the first time in a while, I am growing more cautious on equities, and I reduced position sizes in a number of names Monday. Let's put it this way: the price of financial assets has grown all out of proportion to the price of real assets.

A journalist tweeted two days ago that "precious" should be struck from the phrase "precious metals." Lots of eye-rolling on that one. It's those kinds of statements that tell you that the turn is near.

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