Happy Days

fire in the middle of the city during night time

Our resolve can wear down a lot after a couple of months of being hammered in the market. Choppy action for months can be harder than a steady grind down. You get your hopes up that the sector is decoupling from the general market just to get the rug pulled out from under you. 

It is hard to see that equity prices go towards, or below, prices the equities were at a year ago. Getting closer, or below, your entry price is even worse. When you are up by a lot you are playing with the house money. It does not give that much consolation that commodity stocks are performing a lot better than the overvalued tech stocks or the other overvalued sectors. The only thing that matters is that we do not lose money. If you give it all back, you get angry at yourself that you did not take some of it off the table. 

Still, keeping things in perspective is very important. Yes, a recession, or a several year long depression is a possibility. In that case a lot of wealth will be wiped out in the world, but we will still need food and energy to survive. I do not believe that uranium and other essential commodities will fall as much as many of the speculative options out there. (We do however see the uranium sector has outsized beta to the up- and downside again and again). If they do, I believe they will bounce quicker. Why? Because they are essential for our way of living. Most of the speculative cryptocurrencies and tech companies (with unproven business models) can not proclaim the same place in the Maslow hierarchy. Well funded companies with great management in a sector essential for the world energy supply will survive. Compared to other investments many commodities have few to no substitutes, and many of them also have very inelastic price demand. Demand can go down a certain amount during a recession, but if the commodity already is in a major supply deficit, there is a bigger margin of safety  compared to other investments. You still have to pick the right companies. (Picking the wrong one, who has to do a capital raise at the worst possible time, can be the difference between bad and spectacular returns). 

With hindsight on the last couple of years, I would maybe have been a little less aggressive and been more patient with putting on my positions. Lobo Tiggre, the Independent Speculator, is someone I want to emulate more. The markets have time and again given us great buying opportunities. I am however not changing my overall strategy. As with diets or fitness programs, the best strategy is the one you are able to follow. What helps a lot for me is having a job with a cash flow coming in every month. I have diversified some of my new funds into the oil sector, but I am still buying uranium. If we continue lower, I will have some money ready to take advantage of it.

Getting on the offensive

MGM Studios, Inc.

One of my older posts “The Big Commodity Short” has been shared this week. I think that most of it is still on point. If I could have made one change for my own part, I might have invested more in the oil and gas sector that has been on a tear the last year. Still, I think that I also may have dodged a bullet. The cheapest and most undervalued oil and gas equities were in Russia. When I wrote this piece we knew that rising commodity prices would lead to higher prices on other products. That this again would put pressure on the central bank banks to curb runaway prices was a given.The question is still if the central banks will continue to increase rates and cause a major recession.

One should not be in the situation where you doubt the thesis every time the market is going down. The markets do not move up or down in a straight line. I see proof almost every week that the thesis is unfolding:

On Thursday June 16th Borja (@piterloskot82) reported that CGN (China General Nuclear) and CGNPC (China General Nuclear Power Corporation) have entered into a new sales framework agreement for three years between 2023 and 2025 for 3.12 million pounds per year. The interesting part was that 40% of the contract was fixed at $61.78/lb multiplied by an inflation multiplier, but the majority (60%) of the contract was linked to the spot price:

CGN

I have two takeaways from this contract: The first one is that the fixed part of the contract is way higher than the spot price at the moment ($61.78/lb versus $46.98/lb). The second part is that CGN has the majority of the contract linked to the spot price at the future delivery date. CGN would not have 60% linked to the spot price if they did not think it would be a lot higher than $61.78 during the contract period 2023-2025.

We also got the news that Global Atomic has received a Letter of Intent from a major North American utility to produce 2.1 million pounds of uranium from 2025 to 2030. Utilities are looking for pounds outside the major producers with developers to diversify supply. (Previously we have seen companies like Encore Energy contracting pounds for delivery in 2023). We did not see a lot of this before 2021. Focusing on just the general markets and the spot price of uranium going down (while SPUT is getting stink bids filled) becomes very myopic with this backdrop.

The challenge now is to get on the offensive. When looking back at the time we are now five years in the future, what do you think will be the best decision you can make today? Do you believe this is a buying opportunity or should we abandon ship and wait for better times? I am looking for more cash to deploy more steadily, but I will try to be a bit patient the next couple of months.

Why do I still own gold and silver?

white and gray bird on the bag of brown and black pig swimming on the beach during daytime

The majority of my articles are about uranium. My second biggest position is, even if I do not write a lot about it, in physical precious metals and the miners. Owning precious metals after August 2020 has been frustrating to say the least. Why do I still hold these positions when they are underperforming?

To defend an allocation to the physical gold and silver positions, we have to understand that all investments are not for maximizing the upside. Our allocation to physical should be considered more of an insurance. Something you only want for protection against a negative event like a currency devaluation. (The situation in Venezuela comes to mind). Investments in the miners are more for speculation and participating in the upside.

Inflation protection

Many people own precious metals as a hedge against inflation. In that environment, veteran investors will be quick to tell you that investments in energy and other commodities perform even better than precious metals. (A good reason to hold uranium, oil and other commodities).

The other benefit you get by owning precious metals is for diversification, and that it still performs in a deflationary environment. Let us compare the S&P 500 to the performance of gold during the financial crisis of 2008.

Gold during the 2008 Financial Crisis

During the 2008 financial crisis the stock market fell by more than 50% after the housing bubble popped.

From the top og $1549 in October 2007 it took about 16 months before the S&P 500 bottomed out at $735 in February 2009, down 52,5% from the 2007 top. From there, it would take another 49 months before the S&P 500 got back to break even in March 2013. In total, the S&P 500 spent more than 5 years underwater before it managed to get back above its 2007 highs.

The price of gold during the same time told a completely different story. From the S&P 500 top in October 2007, to the bottom in February 2007, gold went up 27%. By the time the S&P 500 was back at break even in March 2013, gold had gone up by more than 120%.

This is not an example to show how much you could have made if you rode the gold bull market perfectly. This is how part of your portfolio could have performed (not inflation adjusted) during the time of the financial crisis if you were diversified into physical gold. Owning an asset that protects you like this can make a big difference if you want to protect your wealth.

Caveat – Gold stocks are still stocks

It is important to emphasize that physical gold performed well as a hedge, not gold mining stocks. The gold stocks performed very similarly to the general stock market, they just fell even more. (On the positive side, they bottomed out and got back to break even earlier than the general market). Gold stocks were not a good hedge during the financial crisis.

What I am doing

Markets do not move when we want them to. I have a position in physical gold and silver for protection, and in the miners for upside. (I look to add to this, and to my cash position in 2022). Many talk about scaling out of some of their commodity positions, and into gold and silver miners later. I do not know if the market will be there for them when that time comes. I therefore have some exposure to gold and silver at all times. 

My portfolio is a mix of physical and Sprott’s gold or silver trusts. In addition I own some miners. For miners the big ETFs are where most of the funds have gone. I also have some select companies who have jockeys with a track record for making money for their shareholders. (Rick Rule has mentioned some of these jockeys in earlier interviews). Like everything else, you can get these companies at reasonable valuations if you buy them during weakness in the market.

Conspiracy Theories

Flat Earth

Conspiracy theories have a long and exciting history. Throughout history we have seen conspiracies to take over land, acquire power, wealth and influence by many. We also have theories about whether many of the events back in time are in fact as history says. We often call this conspiracy theories. 

There is actually an anecdote about the term “conspiracy theory”. It is only in recent decades that the term has been given the somewhat derogatory term it has today. It is therefore only fitting that there is even a conspiracy theory about the origin of the term “conspiracy theory”. The conspiracy theory claims that the CIA invented this term in 1967. They did this to disqualify anyone who questioned the official version of the assassination of John F. Kennedy, and anyone who doubted that Lee Harvey Oswald had acted alone. The extreme version of the theory is that they invented the whole concept of “conspiracy theory”, while the more moderate version is that the CIA made propaganda that gave negative associations to the term. 

My favorite conspiracy theory is about director Stanley Kubrick and Moon Landing. The theory is that the film “The Shining” is the director’s admission that he actually directed the moon landing in 1969, and that the United States never went to the moon. (Or at least did not go to the moon in 1969). Since Kubrick had made “2001 a Space Odyssey” in 1968, he was the perfect candidate for the job. The United States could not see itself beaten by the Soviet Union in the space race under any circumstances. The Shining is therefore according to conspiracy theorists, full of hints that Kubrick was the director behind the moon landing. A documentary has even been made about this. «Room 237», which addresses this and several conspiracy theories about the film.

The crown proof most people use is that the character Danny is wearing a sweater with the motif “Apollo 11” on it.

If this conspiracy theory had been true, I would have found it very amusing. I am therefore sad to say that I have seen several documentaries, analyses, and behind-the-scenes footage that unfortunately disprove this theory. Kubrick always used strong symbolism in his films and they can be interpreted in several ways according to what you are looking for. In The Shining it was the costume designer for the film who found the sweater with Apollo 11 as the motif for the character Danny. The costume designer said that she chose the sweater because it looked like it was homemade, and that the family in the film did not have a lot of money. Kubrick had no influence on this other than approving the choice she made. 

There are also conspiracy theories that are supported by traditional media. Everything that had to do with suspecting the Wuhan lab was behind the virus was off limits for over a year. The media said it was a conspiracy theory. You would get suspended off Youtube if you got to close with your accusations. Now, the media have suddenly turned and say the lab could have been behind the leaked virus. The bat (and the other explanations) the media gave instead can be seen as a conspiracy theory from them. The media tried to lump everyone who saw the lab leak as a probable explanation together with the flat earthers. 

The reason I am giving all these examples is just to encourage you to be more open. Conspiracy theories do not have to be invented by people in their basement with a tin foil hat over their heads. As an investor you will have to look past the headlines, or go beyond what the crowd is doing if you want outsized returns. It is important to be critical of everything you see and read.

Precious Metals

All this preamble for saying that I am open to the possibility that the gold and silver paper markets are manipulated. (What I do not want to speculate on is how far up this conspiracy goes).

What I am comfortable in saying is that paper short sellers are able to manipulate the paper price. They usually sell down hard during the low activity hours of the day when there are few buyers are around. The amount of paper contracts they are selling are several times the real volume exchanged in a year of the physical metal. One would expect higher volumes in a futures market, but I wonder if this was the intention when they started selling the futures contracts.

We experienced a massive demand for silver this Winter/Spring with the Silversqueeze. We saw massive amounts of people who took physical delivery. There were shortages at dealers, premiums were high, but the paper price was “tamped down” because of massive paper selling.

It has been very interesting to observe this. I have never been exposed to a market where the product is sold out, and the price is going down. This is not what I have learned about supply and demand in Economics class. For me this smells like bad fish.

I am following a lot of people for more information on the subject:

Sprott Money with Eric Sprott and Craig @TFMetals Hemke

GoldSilver with Michael Maloney @mike_maloney and Jeff Clark @TheGoldAdvisor

Arcadia Economics and Chris Marcus @ArcadiaEconomic

David Morgan

Wall Street Silver

@natefishpa behind renaissancemen.org

These are just at the top of my head, and there are several others to check out. Most of these have been called tin foil hat conspiracy theorists. In this case, I think it is more a badge of honour than an insult. I can be wrong about this, but it does not hurt to seek out independent information. Both that support, and undermines your hypothesis.

Common myths about gold

gold bars

If you bring up gold in casual conversation with people you can get a lot of reactions. You have some who love it as jewelry and want more of it. You have people who give it away for special occasions like weddings. You have gold bugs that talk about a financial collapse, and you have most of academia and the world of finance that call it a pet rock.

Gold has many opponents in the world of finance and academia. I therefore want to present the most common arguments against gold mentioned by James Rickards in the book “The New Case for Gold” (2016). Dispelling the most common myths about gold is just a small part of the book. I have mentioned James Rickards in a lot of my posts lately and I think more people should read his works. I recommend you start with The New Case for Gold if you want to get into his writing. If you like what you are reading you can start on his quartet of books on money with “Currency Wars” (2011). It is well worth your time if you want to know what the possible strategy of the central banks might be. You might say that his predictions are very dramatic, but we have seen very many strange things come to pass over the last year.

I

John Maynard Keynes said that “Gold is a barbarous relic”

(Gold belongs to the past)

First of all, Maynard Keynes never said this about gold. Keynes said “the gold standard is a barbarous relic” (Monetary Reform, 1924). He referred to the gold standard in Britain between 1922 and 1939. Britain, like many other countries, had abandoned the gold standard in 1914 to pursue an expansionary monetary policy during the First World War. When Churchill was Minister of Finance after the war, he tried to take the country back to the gold standard they had before the war again in 1925. The mistake he made was that he did this at the same gold price as they had before the war, even though the country now had a higher money supply. This resulted in deflation and a prolonged depression in the country long before the crash of 1929 in the United States. Had Churchill instead gone in for a higher gold price, much of this could probably have been avoided. In any case, it is a big difference to criticize a gold standard and not gold directly.

II

There is not enough gold in the world to cover world trade

This is perhaps the most common myth about gold, but this myth is incorrect. It is correct that there is a limited amount of gold in the world. Considering the amount of money in the world, at today’s gold price, it is not enough to cover today’s needs. What most people ignore is that even though the amount of gold is almost fixed, the price of gold is not. If the price of gold is higher, gold will be able to cover the money supply, whether it is M0, M1 or M2.

You also do not need to have 100% coverage of the money supply with gold. In 2016, for example, the United States, the Eurozone and China could go for a gold standard with 40% coverage in gold at $10,000 per ounce with the M1 money supply. If gold were also to cover M2, the gold price would be $50,000 per ounce. None of these prices are impossible. (For anyone talking about Bitcoin taking over as a means of payment and going to $100,000 or $1,000,000, this does not sound like an extreme option).

Explanation of money supply:

  • M0: The basic amount of money. Money originating from the central bank. Banks’ deposits with the central bank and cash in circulation.
  • M1: the narrow concept of money supply. Money immediately available for use. Transaction accounts and cash in circulation.
  • M2: the broad concept of money supply or public liquidity. M1 + other bank deposits including bank certificates and money market funds.

III

Supplies of recovered gold are not growing fast enough to cover world growth

Then the question is first which target figure should we use to measure growth. Average GDP growth between 2009 and 2014 has been 2.9%, Population growth has been 1.2% in the same period. Gold has increased by 1.6%. The question may be whether GDP should be a good measure of growth or could population growth be a more correct measure. The money supply growth from the Fed during the period during the period has been 22.5%. Which of these four numbers stands out the most?

IV

Gold was the cause of the Great Depression of the 1930s

This is not true. It was monetary policy in the 1920s that made it possible for a bubble to develop as it did. Many say that the Great Depression in America in the 1930s lasted so long due to experimental policies by politicians that resulted in great insecurity among companies and wealthy individuals. Due to fears of changes in the tax system or regulations, a great deal of capital was put on the sidelines during this period. The amount of money was never limited by the supply of gold during this period in the United States. Many, on the other hand, hung on to the money supply in the United States since the depression in the United Kingdom (from point I) was precisely due to this.

It is true that Churchill, by trying to return to the gold standard, which Britain had abandoned during the war, started the depression on the British Isles (from point 1). However, this depression did not spread much outside the United Kingdom. It took several years before the crash in the US in 1929. Several countries had a boom until then. On the other hand, the Depression spread from the United States to the rest of the world when the bubble burst in 1929 and lasted until World War II.

V

Gold has no return

This argument is completely true, but it is not an argument against gold. That’s an argument in gold’s favor. Gold should not have an interest, gold has no risk whatsoever. Gold is money. Bank deposits and cash are in a currency. There is a form of “inflation risk” on this currency, so there is a reason why we want to receive interest on this money. In addition, there is a risk that the bank might go bankrupt and not repay the money. These are two of the reasons why you should demand interest for having money in the bank. (In addition, the bank lends the deposits for mortgages on which they make money).

Furthermore, there are currently countries that issue loans with negative interest rates. In addition, several private banks in the world have only negative interest rates for those who make deposits. This means that you pay in more than what you get taken out of the bank. In this case, I prefer gold, which is a safer alternative for me to retain purchasing power and which does not have a negative interest rate.

VI

Gold has no intrinsic value

This is a statement from David Ricardo. If you are behind it, you are following in the footsteps of Marxism. Karl Marx used this argument in both the “Communist Manifesto” and “Das Kapital”. Both believe that value arises from capital and labor. The more work, the more value. Not a correct theory. For example; I can spend a long time drawing a picture with the best tools around me. Still, I’m not a good artist and this would result in a picture no one wants to buy. Carl Menger from the Austrian School rather suggests a subjective value. Based on the individual’s wishes and needs, the individual will suggest a value they will provide for a product or service. What the person is willing to pay determines value. Independent of capital and labor. Gold value will vary according to the need for people to have real value. In good times, the need for gold is low and correspondingly the value is low. In bad times, the need is higher and correspondingly the price goes up.

The Inflation King

Preserving or increasing my purchasing power has been a big reason why I am investing in commodities. At the moment there is no agreement on what the massive amounts of money printing will lead to. Will we have massive inflation or deflation (or will we have stagflation)? For this week I have focused on the Inflation King.

I love reading about historical figures like the Robber Barons: I’ve read about the Vanderbilts, Rockefellers, Carnegies, Mellons and Morgans. The topic of today is Hugo Stinnes, more famously known as the Inflation King, or “Inflationskönig” in the original German. Most of the information on Hugo Stinnes has been in German, and I did not know that much about this Tycoon before I read the book ”The New Depression” by James Rickards.

If you have grown up in the West and paid attention at school, you know that Germany in the 1920s suffered hyperinflation. This led to a devastating loss of purchasing power for the general population in the country. People lost all their savings they had in the bank, and they had to pay for products with more and more of their currency. There are pictures of people carrying cash in wheelbarrows and kids playing with their useless currency.

The hyperinflation was caused by massive money printing for paying reparations for the First World War from the Treaty of Versailles. The result of this devastating loss of purchasing power for the population. The depression that followed sowed the seed for what came to pass in the 1930s and 1940s.

The reichsmark became worthless. The exchange rate between it and the US dollar went from 208 to 1 in early 1921 to 4.2 trillion in late 1923.

Hugo Stinnes was born in 1870 and was from a prosperous German family who had interests in the coal mining industry. Later Hugo inherited the business, and expanded it by buying more mines and diversifying into shipping, buying cargo lines. He could then use his own vessels to transport the coal. (With John D. Rockefeller making a lot of money on transporting oil, it was probably not a bad idea to be in charge of your own transportation). He also expanded the shipping to include lumber and grains.

Hugo Stinnes

Prior to the Weimar hyperinflation, Stinnes borrowed vast sums of money in reichsmarks to make more purchases in the different sectors. (I have not found out if he was just a very big gambler, or if he had read up on the works from the Austrian School or similar). When the hyperinflation hit, the value of coal, steel and the price for shipping retained their value, while the reichsmarks fell in value. (Hugo Stinnes also had investments outside Germany where the currencies had not lost their value on the same scale).

Stinnes was able to repay his debts in worthless reichsmarks from his profits from his investment in commodity production and shipping. The price of the commodity, and the shipping of the products, went up while the debts stayed the same. Stinnes made so much money during the Weimar hyperinflation that his German nickname was ‘Inflationskönig’, which means ‘Inflation King’.

The reason why I bring up the example of Hugo Stinnes is that we have heard mostly about the middle classes being destroyed. If you are prepared you can take advantage of this instead of becoming a victim. Hyperinflation has happened in several places. Three examples are in Hungary, Venezuela and in Zimbabwe. There are cautionary tales throughout history which illustrate the consequences when too much money gets printed.

My takeaway

Writing this I have not run to the bank and borrowed as much as possible to do the same. (However, I did increase my mortgage a bit. I had already paid down a lot on it, and the mortgage is less than two times my yearly salary). I am also using most of my monthly salary to add to my commodity investments. With countries printing trillions of fiat currency with no end in sight, the value of the currencies will go down. The deflationary pressure we have experienced since the 1980 with products imported from low cost countries will not be enough. The price of labor might still be low, but the price of the commodities that go into the products will go up. For commodities we have no new supply coming online at today’s prices.

As for currency default, my home currency is one of the few in the world that is not printing itself into oblivion. I am more worried about the USD than the Norwegian Krone. I have most of my investments outside my home currency in CAD, USD and AUD. I do not expect hyperinflation but a steady devaluation of most currencies and the commodities going up or keeping their value.

Printing new money (stimulus) is far easier for governments than the alternative, which is a full-blown deflation, crashing markets and a subsequent depression. In a depression, prices of everything drops in value and the purchasing power of the currency actually goes up, which encourages savings and hoarding cash. Why buy a car today (if you have the money), when you can buy the car next year for less currency. The thing with inflation is that it hurts people that have been good savers the most.

Inflation is already here. I go by the definition that inflation is an increase of money supply. “Inflation is always and everywhere a monetary phenomenon.” Increasing prices, which we often call inflation, is a result of the inflation. The question is if we will see increasing prices on goods and services. For anyone who has seen the price of copper or lumber, or anything that is not included in the reported  CPI, the answer is yes. We get a decline of purchasing power of a given currency over time.

I do not care if you are a Tin Baron or Uranium-, Silver-, or Gold bug. We will all be inflation kings.

The Big Commodity Short

large bison

This Sunday I will give my thoughts about the coming supercycle in commodities and why I am bullish on almost all of them going forward.

Most people are aware that I am a Uranium Bug and that I have a good allocation to precious metals. I have also just recently made my first allocation to the oil business, but I have to admit that I am optimistic about the whole commodity sector. I have tried to give an explanation for this enthusiasm in the following paragraphs. 

Backdrop

Commodities are currently 50% cheaper than their lowest point the last 50 years if you compare them to the S&P 500. There are several reasons for this. The cyclical nature of commodities is that we go through boom and bust cycles. We have seen many of these over the decades. Still, the latest downturn has been exaggerated by a number of contributing factors:

A big factor is there is so much passive money waiting to chase the next big thing. We are looking back at 10 years where everyone has been piling into tech companies, weed and cryptocurrencies. Some people are maybe a bit agitated that these sectors have taken away money from commodities, but there is also a silver lining. Instead of having a better funded market, that might be in a supply and demand equilibrium, we are seeing great potential for outside returns on our investments.

I listened to a great interview with Mark Thompson on the podcast “Mining Stock Daily” in their “Tin Special”. He put into words what has been in the back of my mind about the commodities sector for a long time:

The median fund in the world’s allocation to commodities is zero, and most funds do not touch it. In the 80s and 90s, the risky part of people’s portfolios were either allocated to biotech or to commodities exploration. That part is now consumed by tech companies or bitcoin (and other cryptocurrencies) instead. We therefore have not had the needed allocation to commodities that you need to find new deposits. This has in turn affected the supply side. This underinvestment makes commodities very attractive after 10 years of underinvestment.

In the meantime commodities, which are essential for maintaining our living standards, have underperformed. The cost of producing the commodities is in many cases higher than what the companies make selling them. This has led to production cuts and supply being removed from the market. Prices have to increase a lot to incentivize production. However, this supply can’t be turned back on with a flip of a switch. Ramping up production takes time. The companies have to hire and train workers, permits have to be granted and CAPEX investments have to be made. 

The easiest example I can choose from here is uranium. The world is totally dependent on uranium for the 10% of energy production coming from nuclear power. If we want a snowball’s chance in hell of making the climate goals, we can not depend on windmills and solar panels alone. At today’s prices the cost of producing uranium is higher than what they get paid by utilities. For incentivising new supply the price of uranium has to go up. If not quoting Rick Rule: the lights go out. 

We have the same scenario with battery metals like lithium nickel and copper needed for electrification of the world. There are many other commodities that I have not mentioned, but safe to say I am bullish on most of them.

In the coming commodity super cycle we will see massive amounts of passive funds crowding into the different commodity sectors. Passive investing has increased by a lot the last 10 years, and this will hit the very small markets like a ton of bricks. This will have a bigger impact than most people can imagine. When 50% of the market is passive, it will be very different from the bull run in the early 2000s. Passive flows say: let’s buy what is going up no matter the price. Because of this you get big moves. I believe we will see new all time highs in most of the commodity sectors. Many of the sectors today are trading for a total value under the value of companies like Apple or Amazon. When passive funds see the outperformance of the different commodity sectors sustained over time, we will see a rotation away from growth/tech stocks. It is just a question of time. 

We are seeing some evidence for this already. Again, I will give some examples from the uranium sector, because it is the one I am following the closest. In Australia Paladin will be included on ASX 200 and 300 later this year. This means that there will be passive flows coming into the company and give the valuation of the company a tailwind. In Canada we have the same situation with Nexgen and Denison Mines will be added to the S&P/TSX Composite Index.

The picture above is a comparison between QQQ (an ETF that includes 100 of the largest companies listed on the Nasdaq stock exchange) and URNM (the NORTH SHORE GLOBAL URANIUM MINING ETF). The last year URNM has a return of 222% compared to 63% for the QQQ.

I expect this to be a trend we will see continue over the next 5 years. After overperformance the funds will rotate out of their old favorite sectors and enter the commodities sector. A couple more quarters of outperformance and we should witness the metaphor about forcing the contents of Hoover Dam through a straw coming to fruition.

Second-order thinking

rocket launch liftoff long exposure

Today I will have a very short post about second-order thinking. A term made famous by Howard Marks from Oaktree Capital. I have applied some of his principles to my investment philosophy.

To explain second-order thinking, it is always good to use an example: Imagine that you have a company that is doing well in terms of profitability and the share price returns. One who uses first-order thinking reasons that this is positive and wants to buy shares in the company. Second-order thinking, on the other hand, can come to a different conclusion. The company is competently run and does well, but all investors already think so. The company might be overvalued and the stock overpriced. The second order conclusion may therefore be that it is best to sell.

When I started investing in stocks, it was mostly first-order thinking. I never thought I would buy shares in industries where most producers were losing money. First-order thinking says a company that is losing money will probably give a negative return, and maybe risk bankruptcy. This is quite simple and straightforward. If a company spends more money on producing something than they get paid, they lose money.

For investing in most industries, this is a good practice. I used this first-order thinking in 2011 and 2012 for my investments in banks. Banks were demanded to build a capital buffer to improve their solvency to be better prepared for a downturn in the future. The newspapers were at the time saying that the banks’ interest margins were unreasonably high, and the banks took too much from customers. I thought that instead of fighting against the banks, it would be easier to become a part-owner of them. I started buying shares in the banks that had better than normal profitability. The next few years this was a great investment. Several banks saw returns of over 100%. I would consider this first-order thinking, but no one said it has to be unprofitable to do the obvious.

Second order thinking

What I try to do more of today is second-order thinking. The person most responsible for this is Rick Rule, legendary investor and CEO of Sprott U.S. Holdings. (Now retired, I am looking forward to him saying what he really thinks about companies. He has said he can talk more freely about them in retirement). He has an expression that says: “The cure for high prices is high prices”, and “the cure for low prices is low prices”. This term applies especially to the commodities sector.

If we are in an industry that experiences high prices, it will attract more players. Think of the shale oil industry in the United States when oil prices were above $100 a barrel. With several offering the same product, the supply eventually became so high that there was a surplus of the product. This in turn led to falling prices. See below for the number of operating rigs in the USA and correspondingly for the fuel oil price:

Number of operating rigs in the US Baker Hughes

In 2014 oil production became so high, together with expectations of rising production, that the oil price dropped 50 %. It did not bottom out before the fall 2016. Leading to a long bear market in the oil market.

Brent Crude Oil Prices Makrotrends

Similarly with low prices for a product, you will eventually lose so much supply from the market that the price of the product has to increase to attract production. If not, no one will produce the product again. There are several industries that are completely dependent on raw materials to be able to produce their end products. Electricity, cars, or pharmaceuticals, all of them are dependent on commodities.

“The cure for low prices is truly low prices.” Prices can however stay low for several years. Excess supply has to be worked off. In addition, in most cases there needs to be a triggering factor that causes prices to start moving upwards. Often there is a perceived, abrupt shortage of the product. For example, suppliers may have production stoppages due to natural disasters, wars or a pandemic. If the buyers expect that they still can get the item product, they will not bid up the price. What makes raw materials special is that when the price goes up, the demand often goes up as well. This is contrary to what economists think is rational for market participants. The damage of running out of critical raw materials in production is far higher than paying higher prices for them. (Very often the price of the raw material is immaterial for the end product. Silver is in a lot of products. Very often it is in quantities that amount to a couple of dollars. If the price goes from $25 to $50 it does not affect the end product that much). 

In 2020 we had a great example of fear of running out of a product. You want to find similar opportunities in the commodity market.