Hot Money, Hot Commodities and the US Dollar Carry Trade Part 2

In the last part of the article I discussed the reason why the collapse of the US dollar is all but inevitable, but the US economy itself will be strong enough to survive. Let me say it again, collapse of the US dollar does not equal to collapse of the US economy. If the dollar becomes worthless, Microsoft (MSFT) or Intel can sell their hardware or software products for gold or coins. They can still manage to make a profit, because the world still want their products.

How do investors protect themselves during a currency collapse?

First, the majority of investors and the majority of average American people will be wiped out financially. That is a FACT of mathematical statistics when a country's currency collapses. Majority of people will be wiped out, but a selective few in the minority will be able to rip huge profit from the crisis. If you want to protect yourself, you can not be with the majority. You must be with the minority group of people. Do NOT let other people do the thinking for you.

So are you listening to the most popular economic analyst or the most popular financial TV host? If you do, you are in danger because you are together with the biggest group of fools! You find safety when you are forced to jump from a big boat to a small boat, not the other way around. Just ask Titanic survivors how they survived. They jumped onto very small boats instead of wait for something bigger than Titanic to come to their resque. Safe havens must necessarily be small and can not accomodate too many people.

Commodities are the only safe haven. As Jim Rogers said, commodities are the only asset class with fundamentals impaired, but improved. But there are lots of myths in the commodity investments. Even Jim Rogers himself had also spreaded some incorrect myths regarding commodities investment. Most people do not know how to invest in commodities because they have not even once laid their fingers on any physical commodity. The only thing they have ever touches is a computer keyboard and mouse. A computer and a brokage account is all you need to invest in commodities, right? Wrong!

The door for commodities investment is extremely narrow. Let me tell you a small story. I am a big fan of tellurium investment and hoard actual physical tellurium. The price low of tellurium a few years ago was about $10 per pound, recent high was about $140 per pound. I predicted tellurium price could go to multiples of gold price once phase change memory goes into wide application. Almost every one laughed at me. Some, a few, did take me up seriously but they ask me NOT where to buy the physical tellurium, but rather, where to buy paper future contracts of tellurium, or what mining stock they can buy. When they hear that these two investment instruments do not exist for palladium, they left with disappointment. Most market traders do not know what to do with physical asset. They would rather prefer the convenience of pushing a computer button to instantly buy and sell something. Till this day, I think there are far fewer tellurium investors than people who understand Einstein's Relativity.

I believe that pure computer trading is the wrong way to invest in commodities. To invest in commodities you HAVE to get your hands dirty and lay your hands on the physical things. Let me explain using the example of the United States Natural Gas (UNG) fund.

Recent dismay performance of UNG gave me pause to think about how to invest in commodities. Natural gas spot price recovered from the low of about $1.84 to now nearly $5, almost a triple, but the share price of UNG still struggles around $10. Why is UNG not tracking the price of the natural gas itself? The simple answer is it's killed by contango. But there is a deeper reason.

UNG does not hold the physical natural gas. Instead they hold futures contracts. In theory, when natural gas price goes up, the asset value of these futures contract also go up. But in reality such methodology is flawed. You are holding future contracts that you never intend to take delivery. So near the expiration of the future contracts, you are forced to sell them, at any low price. Mean while you must buy the next month's future contracts, at whatever high price they are offered. As a result, in each round of the roll-over, UNG loses positions and loses money.

More over, the more investors are interested in UNG, the worse a situation UNG finds itself in. (Remember, the bigger crowd is always the loser!!!) During each roll-over, UNG could be purchasing more future contracts than producers have products available to write those contracts, hence it bids up price on the buying end. Then it turn around to sell the future contracts to industry consumers, it has more to sell than the industry consumers can buy, hence it pushes the price down on the selling end. How could you not lose money? It's like two mechants compete with each other. They bid the price up purchasing produces from the same farm, and then cut each other's throat to sell to customers at super low prices. Both lose.

Since UNG purchases future contracts that it never intend to take delivery, conceiveably on the other end of trade could be some one who write future contracts that he never intended to deliver, as he does not have the product to deliver. As no delivery is ever demanded, such paper future contracts can be created out of thing air in unlimited quantity to "meet" investment demand. Basically one side provides empty promises of supply, the other side provides false demand that never materializes. This is nothing but a zero sum game. One party's loss is exactly the other party's gain.

Therefore it is flawed to believe that trading future contracts is investing in cmmodities. It is NOT. Future contracts are derivatives with which the two sides gamble against each other. The commodity may be bullish, but you have a 50/50 chance to beat your counter party to win.

If you are interested in commodity investment, do NOT buy paper derivatives, whose supply is unlimited. Buy the physical thing, which is limited, and take delivery.

Now from a fundamental point of view, every investor needs to ask: If I invest in something and I gain, WHO pays for my profit? You are not the FED so you can't create money out of thin air. If you make a profit, then some one or something must be paying you that profit. If you buy a stock and make money, it's because the business of the company generates revenue and income, or because another investor pays you more than your original cost. I invested in physical tellurium because I know some years down the line, First Solar (FSLR) or Intel (INTC) will pay me gold price to buy my tellurium hoard.

But who pays for your profit when you invest in a commodity? Do your fellow investors pay you? If so it sounds like a Ponzi scheme. It has to be industry users of the commodity that pays you the profit. The only way for you to get paid by industry users, is for you to participate in the supply and demand of the commodity, for you to become a physical demand and then a physical supply. That means the only sensible way of investing in commodities, is for you to take physical delivery, hold for long term, until the price is higher, then you sell to the industry users.

Once again, The door for commodities investment is extremely narrow. Most of supply and demand have been directly negotiated between industry suppliers and industry users, leaving you no opportunity to participate in the market. Natural gas is a good example. The opportunity to store natural gas is virtually non-existant for outsider investors. Any gain or loss is likely directly settles between industry suppliers and users, and that leaves investors out of the natural gas business and unable to rip profit from the price appreciation.

So if you think investing in commodities is as easy as pushing a computer button, and you do not have to deal with the huzzle of buying/selling, transporting and storing the actual physical stuff. Please pause and think again. WHO PAYS YOUR PROFIT if you are not taking all the huzzles?

For this reason I am inheritly suspicious about all sorts of commodity ETFs, like GLD and SLV. Particularly SLV. Read my previous Instablog regarding some red flags in the SLV fund. What troubles me is that these nice folks help you to take care of all the sweating and laboring to handle the physical stuff, and allow you comfortably making profit sitting in front of a computer. It just sounds too good to be true.

(to be continued...)

Full Disclosure: The author is long precious metal palladium and silver, hold big positions in palladium mines SWC and PAL, as well as SSRI and CDE. I hold shipping stocks like EXM, EGLE, TBSI, DRYS, and small positions in natural gas fund UNG. I short the US dollar by holding some long positions in margin brokage account.

Hot Money, Hot Commodities and the US Dollar Carry Trade Part 1

The collapse of the US dollar has passed the point of no return. An abrupt US currency collapse is now very possible. I hope we can see a gradual and orderly decline of the US dollar. But this best case scenario, as Peter Schiff hoped for, is now not likely. Peter Schiff still believes that there is still something that the FED or the US Government can do, to save the dollar. I disagree with him. Peter Schiff obviously does not understand how free market economy works, nor does Ron Paul, nor does Roubini. Jim Rogers is one of the few who understands and how free market capitalism works, and practices it by moving his family and assets to Asia. (President Obama: You still have two jobs to do: Buy the first lady an Iridium ring; and bring Jim Rogers home using Air Force One. That's all you need to have a strong family, a strong presidency and a strong nation. No kidding!)

This brings to me the Hot Money problem that China and other countries face. China has a gigantic foreign currency reserve that is composed mostly of US dollar assets, amid a looming prospect of ever falling dollar; China doesn't want to accumulate more dollars. But hot money keeps flowing in from the outside, smuggled in through Hong Kong, forcing China to print more RMB yuans to absorb the inflow of US dollars. China is not alone. Brazil recently slapped a 2% tax on foreign capital entering the nation's stock and exchange market. Australia is worried, too. Read how China's Commodity Carry Trade strategy of divesting the dollar: part 1 and part 2.

The Hot Money "problem" that China and the world worry about is actually free market principles working at their best. Basic Darwinism dictates that market capital will always go where it wants to go, not where the governments want it to go. Capital wants to get away from the soil that suffocates its growth, and move to fertile lands where it can thrive. Hot money flows out of the developed nations and into developing nations and nations with rich natural resources, because that's where opportunities of grow are.

Government interventions to stop the free flow of money are futile, fruitless and counter-productive; Government interventions to manipulate currencies and commodity prices are equally futile, fruitless, and counter-productive. Free market capitalism always works.

Recently Julian Robert thinks that the US faces Armageddon if the Chinese or Japanese stop buying the US debts, and that both countries maybe forced to sell US debts, due to domestic needs. He was right, except for the Norwegian part. The journalist asked: All the rich Norwegians have moved their money out of the country, so why do you invest there?

Good question! Capital money has its own mind. It wants to escape from hostile environments, and move to lands where it can grow and prosper. Rich Norwegians move their money out of the country because they are taxed to death. There are places where the taxation is less and the opportunity to grow is bigger. Again, government interventions are futile. China's effort to crack down on hot money inflow hardly made a dent. Equally futile was US government's tax cracking down on rich Americans who have foreign bank accounts. Such crack down is futile. If Americans want to move their money out of the country, there are plenty of ways to do it. Voting with feet is a more powerful than vote with a paper ballot. But if that's not enough, one could cast the ultimate vote with the US passport as the ballot ticket, at an overseas US consulate.

Instead of the futile crack down, the US government needs to exam itself in retrospect and ask why Americans are moving money to foreign soil, and what it can do to attract foreign money to come back to US soil. This is the key: When the money is leaving the US soil for foreign land, so are the job opportunities, so are our best investors, our best innovators and our best technical professionals, and so are our nation's future. So what do we have left? A dying US dollar and millions of jobless and hopeless hungry and angry people either sit at home waiting for the government to feed them, or else take to the street.

Peter Schiff believes that to save the dollar, all we need is the FED dramatically hike up the rate, stop money printing, and the US government massively cut spending and raise tax. The basic ideas are right. But if he believes those are realistic or possible, he really doesn't understand how free market works. What works is not what a government does, but rather what a government does NOT do. In China's history, every dynasty that prospered was only because the emperor taxed little and asserted little control of the society.

Great Chinese philosopher Lao Tzu said that governing a great nation is like cooking a small delicacy: You cook just enough so all the original flavors are preserved. If you over-cook then what comes out is anything but a delicacy. Sure America is a melting pot. But President Obama is cooking this melting pot way too hard that not only there is lots of capital spill over, but the melting pot itself is melting!!! Just ask the first lady how to cook!

Peter Schiff believes the FED can still dramatically hike up the rate and stop money printing, and the government can dramatically cut spending and hike tax, in order to save the US dollar. If it was that easy, if a government has the power to salvage its own currency, then why didn't Zimbabwe's President Mugabe do it? Did he not raise interest rate of Z$ dramatically? He has the money printer so he can afford to pay any high interest, right? Higher interest is meaningless if the principal itself, the value of one dollar drops even faster. The FED stops printing money? Who is going to buy our mountains of new issue US treasury bonds, if the FED doesn't print money out of thin air to buy our own debt?

How about the US government dramatically cut spending and hike up tax rate? You can't collect more tax from business that are not profitable, and hence has no tax to pay. Higher tax will force the profitable businesses to move to overseas, reducing, instead of increasing tax revenue. Cut spending? Which part do we cut? I think we should first cut the all the bailouts to the big banks and let them fail? But then do we want a nationwide bank runs and bank failures, and watch FDIC to go bankrupt? How about cut welfare and cut unemployment benefits. Then all the desperate people deprived of livelihoods probably will siege the White House, bringing their empty pots alone, banging and singing, until the resident has to get away on a helicopter.

Let's face reality, Mr. Peter Schiff. When you see the melting pot itself is melting and there's lots of boiling spill over, you are going to tell people that we can still have a great dinner if we do the right thing? NO! You should honestly tell the people that there is no more delicacy for dinner. The people HAVE to go to sleep with an empty stomach. What we can still do, is not to try save the delicacy, but to save the pot, so we can still cook a good meal tomorrow. Of course, Peter, you can not win votes by telling people they will be hungry. But that's the reality.

There is no salvation of the US dollar. But the US economy itself can survive and prosper. There are certain elements of the US economy, no, not the banks, not the Wall Street, but the real productive sections of the US economy, that will survive and prosper. American farmers will continue to produce food that the world needs. Intel (INTC), AMD and Microsoft (MSFT) will continue to produce computer hardware and software that the world needs. Catepillar (CAT) will continue to produce great construction machineries that China and the rest of the world wants. My most favorite mining company, Montana's Stillwater Mining Company (SWC), one of the world's only two primary palladium producers, will continue to produce palladium because the rest of the world still needs palladium, even though the bankrupt GM doesn't want to buy from SWC. Not to mention we have so many of America's world class science and technology products that the world needs from us. Not to mention our best treasure, the US constitution, one of the most beautiful constitution and the envy of the world's poor, tired, suppressed and desperate people.

Yes, the US dollar, a fiat currency, will collapse; No, the US economy itself will not collapse. A good historical precedence is hyperinflation Weimar Germany did not destroy Germany: It still had enough economic and military power to allow Hitler to launch World War Two.

Yes, the US Federal government is bankrupt, as is the FED; But No, the American nation, as well as individual states, will not go bankrupt. California will not go bankrupt. It has a constitution mandated balanced budget until recent years, and it is trying very hard to return to balanced budget, amid the difficult environment of tax revenue short fall and spending needs. It's heart breaking to see people start to talk about the possibility of session of individual states from the nation. But unless the federal government realize its own limit, and live within its limit, I think as we raise to the USSA we could well become the next USSR one day. The US government itself needs a bailout, not just the dollar.

I will discuss in the next part of this article how individual investors can protect themselves and make profit from the downfall of the dollar. Specifically I will talk about equities, commodities and US dollar carry trades, as well as how to use leverage to increase your gain.

Full Disclosure: The author is long precious metal palladium and silver, hold big positions in palladium mines SWC and PAL, as well as SSRI and CDE. I hold shipping stocks like EXM, EGLE, TBSI, DRYS, and natural gas fund UNG. I short the US dollar by holding some long positions in margin brokage account.