Dr. Stephen Leeb on Commodities and Inflation - Is He a Genius or Alarmist?
June 17, 2009 Larry Bellehumeur
I just finished reading a book called "Game Over" by Dr. Stephen Leeb, and I am not sure what to make of it. The basis of the book, at least how I have read it, is that there is going to be a pressing demand for resources (Oil, Natural Gas and all sorts of Mining products) that will push the price of these products to points that will force inflation-like conditions as there were in the 1970's (if not much worse).
His theory goes further on to say that unlike the 1970s (where most of the demand for oil was caused by Political conditions), this spike in prices is one that is more of a permanent nature, as the spike is more due to a lack of supply caused by a scarcity of the materials and/or the ability to extract the materials at a rate to meet the demand.
Because of this expected spike in Commodity prices, and the lack of choices available to the US Fed to control inflation (as it cannot risk further damage to the Housing market with the rise of Interest rates, nor can the US "Debt-ridden" consumer tolerate a spike in rates on their personal debt), Leeb contends that the Fed would rather tolerate High inflation (or maybe even Hyper-Inflation) rather than risk the chance of deflation.
Now, I will say that Dr. Leeb is much more of an alarmist than I ever would be, as he further goes onto to talk about how this may lead to the decline of civilization as we know it. However, he does bring up some interesting points. If his thesis were to come to pass (or even a slight variation of it), it would significantly change the way that most investors would need to think about their portfolio. Below I have listed some of his theories from the book. I have provided my opinion on them, and how Leeb and/or I suggest that you may utilize this theory in your investment strategies.
Leeb Theory #1
The World is running short on many key resources and will face critical shortages within 15 years.
Now, to be fair, Leeb isn't the only person out there suggesting that we are running low on key Resources. It is interesting that he has actually put a timeline for when we can expect to run dangerously low on some key Commodities.
Assuming that the rest of the world were to use the following resources at half of the rate (per Capita) that the US uses them today, the following are Leeb's estimates as to the current years of reserves:
Antimony - 13 Years
Chromium - 40 Years
Iridium - 4 Years
Lead - 8 Years
Nickel - 57 Years
Platinum - 42 Years
Silver - 9 Years
Uranium - 19 Years
Now, it would take a lot of development in the Developing world for them to approach even half of the Per Capita Consumption Rate that the US does today. However, even with a few more years added onto these totals, it is not unreasonable to assume that we may see serious shortages in key resources such as Silver, Uranium and Iridium before 2025.
Ways to play this theory:
Personally, I have started to watch BHP Billiton (BHP) a lot closer. They are a strong producer of several key Base Metals, as well as Iron Ore, Aluminum, and Coal. Their extra exposure to Oil and Diamonds are not a bad bonus, either. If the world economy starts to recover in 2010, BHP should do quite well. I would look for an entry point (for the US ADR) of between $47 to $50, as a good spot for a long-term hold.
Leeb Theory #2
The inevitable spike in Resource prices will cause Inflationary pressures unlike anything most of us have seen in our lifetimes
Leeb claimed that this would happen in his book earlier in this decade, "The Oil Factor". Did we have incredible inflationary pressure over the past few years when Oil exceeded $100/barrel, as he predicted? Well, it depends on who you ask. If you use the Government's normal way of measuring inflation [CPI], the answer would be that we had slightly higher than normal inflation over the past few years.
However, when you factor in Food and Energy (the two factors that are likely to see higher inflationary pressures with the rise in the price of Oil, and are not counted in CPI), one can't doubt that we did see some relatively strong Inflationary pressures. However, it would be a stretch to call them extreme. The same can be said for rising prices in other commodities from Food to Copper.
This doesn't mean that Leeb's Theory is incorrect. If we were to be running short on all of the commodities in the manner that he states in Point #1, then it wouldn't be hard to imagine 20+% annual inflation within the next decade. This is further exasperated by how the Fed has been reacting as of late. The incredible amount of dollars that has been printed on the "Bernanke/Geitner Printing Press" in 2008/09 will likely lead to a higher level on its own. If we were to see such rising commodity prices as Leeb predicts, I fear that his theory may be bang on the money. This problem is further worsened by the amount of debt that is held by Consumers in the US, who could not afford to have an Interest-Rate Induced Recession to control Inflation, as per the Volcker years.
Ways to play this Theory: See Theory #4
Leeb Theory #3
Traditional "Defensive" Investments will offer bad (if not Negative) returns in this upcoming Inflationary environment.
In his book, Leeb re-states the common phrase of "History rarely repeats itself". Since this is likely true, it is impossible to know for sure which investments will be the optimal ones for any upcoming inflationary period, since the causes of the inflation are different than those from the late 70's, as an example. However, the period from 1970 to 1979 does allow us to at least see how traditional Defensive investments held up during the last major bout of inflation.
According to Leeb's research, here is how the following investments fared (in Real Returns) during the period of 1970 (at the High) to 1979 (Low):
Beverages -13%
Cosmetics -45.6%
Staples Retail-34%
As you can see, many of the commonly-held theories on what will perform well during downtimes do not appear to apply during times of high inflation. The reason is that although these companies may offer a service/product that people need for everyday life, and they also may be able to pass on many of the escalating costs onto their customers, they tend to be High P/E stocks to start with. Inflation tends to have the effect of lowering down P/E ratios.
The Question then becomes.....are there any Defensive stocks that will perform well during Inflationary times? The two types of Companies that comes to mind for me are those companies who have fixed prices that are linked inflation and those companies who hold a lot of "Hard Assets" as part of their Portfolio.
For the first part, Utilities and/or Pipelines should hold up fairly well during these times, at least in my opinion. First, these companies have fixed contracts that often allow them to raise their rates based on the Level of inflation (on a negative note, however, the inflation rate that they can raise rates is generally linked to the CPI, which can often not reflect the true inflation rate, but it is at least better than nothing).
The second important point is that while these companies often carry a lot of debt for their infrastructure, the rising inflation actually helps to reduce the "Real Cost" of that debt, allowing them to pay it off faster. On the negative side, many of these offer the Interest rates a little, the yields for these companies will seem a little less appealing to some investors.
As for companies with Hard Assets, two types of companies come to mind. The first is Pipelines/Utilities, where they often own a significant amount of Hard Assets. If the debt for these assets becomes less in Real Terms (due to rising inflation), but the value of the same assets manages to keep up with Inflation, this could be a "Gold Mine". The 2nd group that comes to mind are the REITs, since Real Estate Values has often kept up with Inflation. However, history does not always repeat itself, so it is hard to say if it will this time.
My Personal recommendations to Play this Theory:
- TransCanada (TRP) and Enbridge (ENB) can help with both the Utilities and Pipeline side. As well, Kinder Morgan (KMP) is a good play if you want exposure to primarily Pipelines.
- On the Pure Utility side, I personally like FPL Group (FPL), as they are not only a strong player in the Utility space, but they are also a rising player in the Wind space, which should see some rise over the next few years
- On the Real Estate side, for most people, my recommendation is "Own your home". Since this would likely make up a large percentage of one's total Investments, most people do not need to make any extra investments in this space. If you're not in this position, I would look at REITs that have a low Debt ratio and focus mostly on Industrial / Commercial markets. The reason why I would go after this space is that I suspect that we will see a run on Infrastructure Needs over the next few years, making this a better focus than on Office space.....
Leeb Theory #4
Gold is your best investment, followed by investments in: Oil Services Stocks, Oil Producers, Base Metals Miners, Gold Producers, "Solution Companies", TIPS and Defence Stocks
I can see the rationale behind holding Gold as a primary defense against Inflation. My only fear about owning Gold is for the other reason that most investor chose to own Gold, namely as a "Safe Haven" in a time of crisis. If we are indeed about to hit Peak Oil / Period of Hyper-Inflation, that sounds like a likely time to turn to a Safe Haven like Gold. Problem is......weren't we just in a similar time, with the possible Collapse of the Financial System? If Gold is supposed to be universally considered to be a Safe Haven, then I am curious as to why Gold is not $1500 an ounce now? Nevertheless, the average investor should hold some gold in their portfolio at all times.
As for the Commodity Producers (Oil Producers, Oil Services companies and Miners), Leeb's theory behind this one is to own the producers of the products that are causing all of the Inflation, as the price of their respective commodity is likely to rise as fast (or faster) than the rate of Inflation. This is likely a good theory, and one that I subscribe to.
There are two possible things to be concerned about when owning these companies during an Inflationary period. First, Inflation is unlikely to go straight up forever, as there will be inevitable times of low inflation or even deflation. So, it is unlikely that one would want to hold these stocks infinitely, but rather to trade them at signs that inflation may be cooling. The other thing to watch is to see if their rate of earnings / revenue growth is keeping pace with their costs, as many of their input costs (Materials, Energy, Skilled Labor and more) will also be rising at a fast pace. So, watch to see if the bottom line is increasing as fast as the top line.
As for the last two, TIPS is the easier one to explain. Having an investment that is designed to return slightly over the cost of inflation is a good thing during a period of Inflation. What is not a good thing is that it doesn't necessarily track the rate of the "true" inflation. The other concern is one of taxes, so these are best owned in your Tax-free accounts.
As for Defense stocks, Leeb claims that the US will have to spend an increasing amount to bolster their Military to allow them to replace a lot of older equipment, as well as to increase their strength to defend access to necessary future resources. I think this is a reasonable scenario and would subscribe to this theory
My Personal recommendations to play this Theory:
Gold (GLD)
Oil Producers (CNQ, SU, COP, DVN)
Oil Services (RIG, BHI, SLB, WFT)
Base Metal Miners (BHP, TCK.B)
Solution Companies (FLR, Veolia)
Gold Producers (G, ABX)
TIPS - TIP
Defence - Northrup Grumman (NOC)
Leeb Theory #5
One of the only companies that do not fall under the above list who will thrive will be Berkshire Hathaway
Leeb's theory has more to do with Berkshire's Re-Insurance business than with the stock picking prowess of Buffett. This is obvious, as while he praises Berkshire's Insurance businesses, Leeb also criticizes owning many of the very companies that make up a significant part of their Stock holdings (namely AXP and KO). Leeb's theory is that Berkshire's tremendous strength is their large position in the field of Reinsurance, which he refers to as a "rapidly growing Industry". With their strong Capital base (one that Leeb claims is 3x larger than its nearest competitor), he feels that this should ensure growth in the "Mid-Teen percent" area, even during times when other Insurers/Reinsurers are performing badly.
Leeb Theory #6
One would be wise to invest in the "BRAC" Countries (Brazil, Russia, Australia and Canada) as these are the 4 countries who have the most resources that they are able to export
This is a bit of a variation of the famous "BRIC" acronym which refers more to the top 4 emerging economies. What Leeb is getting at is that these countries will be in a position to export significant amounts of at least one of the key resources needed by the world. His advice is to invest in all aspects of these economies, but for slightly different reasons.
The "BR" part of the equation are more growth plays. While they will be exporting a significant amount of their resources (which you can invest in through ETF), you are also investing in the domestic growth that these two emerging economies are going to undergo. In the case of the "AC" countries, you are investing more in their export side of their economies as neither of these countries are likely to see the same growth rate as the first two. This helps to balance out the risk/reward equation.
In the case of Canada, you are getting the widest variety of resources (as they have dominant resources in Oil, Nat Gas, Potash, Diamonds, Uranium, Base Metals and Fresh Water), where as the other ones tend to have their resources more focuses on a couple of different commodities.
I do differ a bit from Leeb in one manner, in that he mentions owning an ETF for the Broad stock market for each individual country. While this may make some sense, you do have to be careful in that you may be owning significant parts of your portfolio in companies that will not do well in the upcoming Inflationary environment.
In the case of Canada, you would be owning up to 40% of the portfolio in Financial-related Stocks, many of which have significant presence in areas of the world that may not do well in the upcoming times. My preference would be to own stocks that are direct plays on the commodities themselves, plays on where the wealth of the commodities may be invested, and direct plays on the increased wealth of the economy (such as Retail companies/REITS that are specifically focused on those domestic markets)
Overall, as a small investor, I can only hope that Leeb's theories do not come true (I believe that he even states this in the book). The reality is that the book shows a long-term view on a problem that many investors/politicians may be too short-sighted to see. I would recommend it as a good read, even if you don't subscribe to his theories
Disclosure -- Long on TRP, GLD, RIG, BHI, SLB, WFT, TIP, BRK.B,
No Current Short Positions in any of the stocks mentioned.
