"Blame It on Iraq" Market WrapUp by Jim Puplava

John Q may not know or care much about what happens in Venezuela or the Middle East. What he does care about is what he has to pay for gas at the pump. Nationwide that cost has gone up 11 cents a gallon over the past two weeks. Here in the People’s Republic of California, the price has risen $0.16 a gallon and for premium unleaded the cost is even more. The high price of energy can be attributed to four factors:

The strike in Venezuela sharply reduced crude shipments to the US, which relies on Venezuela for much of its foreign importation of oil. Fears over a disruption of oil flow due to war or a possible terrorist attack against the US or world energy infrastructure has added another premium to the price of energy. Regular winter demand for heating oil and natural gas due to cold winter temperatures has added another element to the cost of rising energy prices. These obvious factors have caused the price of energy to rise. Geopolitics is the greatest unknown element in the whole energy equation. How do you predict a terrorist attack or the outcome of war? The possibilities and various scenarios that would flow from the result of either or both events are too difficult to define with certainty.

There is one other element which is measurable and perhaps more indicative of future energy trends. It is the production decline curves of western producing oil and gas wells and the rate of new discoveries. On an annual basis we are discovering only one barrel of new oil for every four barrels of oil that we consume. Chances are that the gasoline in your automobile came from an oil well discovered more than 25 years ago. The simple fact is that we aren’t replacing the oil and natural gas we are consuming. Unlike the last crisis in the 1970s, which was geopolitically motivated, this crisis will be worse since we have not only geopolitical concerns, but also supply concerns as well. Already in this new century we are experiencing our second energy crisis in less than three years. We simply don’t have the supplies. At the same time, demand for energy continues to grow each year here in the US and especially in Asia. Demand is continuing to outstrip supply. Outside the Middle East, there simply aren’t any large known oil reserves outside Canada’s tar sands, so each time there is a potential disruption in supply due to a strike, a blocked port, a war or severe weather, the price of energy skyrockets.

What we are witnessing to some extent is the coming end of the petroleum age. The experts, and by this I mean the petroleum geologists, have warned as far back as the days of King Hubbert of the eventual decline of fossil fuels. This is what the industrial world now faces with each new crisis. Demand is outstripping supply and from this point forward, it is only going to get worse. By the middle of this decade and certainly by 2010, higher prices for all forms of energy are going to be a permanent feature of the economic landscape. The sooner we face up to this reality the better off we will be. Steps need to be taken now to avoid economic hardships later of declining energy reserves, especially in western countries. For the remainder of the oil age, the oil and natural gas reserves in the Middle East will take on even more significance.

The first two decades of this new century will be filled with wars for natural resources globally. The resources of water, oil, natural gas and even food will become scarcer and in short supply as population growth outstrips resource supply. The evidence in this trend can be seen in water shortages in the Middle East and US, to shortages of food in Asia, and a general dependency of the world on Middle Eastern oil. This is one reason why I believe we are going to see a new bull market in raw materials regardless of whether it is an inflationary or deflationary storm that hits world financial markets and economies. The growing demand and shrinking supplies of natural resources is independent of monetary storms. The monetary storm will only heighten this imbalance as money moves out of paper assets and heads for the safety of tangible resources, especially silver and gold.

Diplomacy Hits Metals
Speaking of silver and gold, the price of both precious metals fell today as it appears that the war in Iraq has been delayed by efforts by the French and Russians to circumvent adherence to UN resolution 1441. Both Russia and France have much to loose in a war against Iraq. Both countries have large trade and oil agreements with Saddam. In the case of Russia, lower oil prices as a result of the flow of Iraqi oil would harm Russia’s economy, which has benefited from higher oil prices. France has lucrative oil contracts to develop Iraqi oil fields. The latest peace plan by Russia and France to put thousands of UN peacekeepers in Iraq would do nothing to solve the issue of Saddam’s WMD. Their presence in the region could offer Saddam the prospect to gain valuable hostages.

Meanwhile, it has become apparent that France and Germany don’t speak for all of Europe as the Netherlands released control of Patriot Missiles for the defense of Turkey. France and Germany have snuffed Turkey in delaying Turkey’s admission into the EU. The latest moves by France and Germany risk alienating Turkey away from Europe and forcing the country to pursue an alternative political course.

The financial markets reacted favorably today after a little help in the futures pit. Efforts to rescue the market became apparent around 11:30 when another flagpole rally occurred. The word is that the war in Iraq has been delayed. This is pure balderdash. This weekend the Secretary of Defense Donald Rumsfeld activated The Civilian Reserve Air Fleet in an effort to expedite the US military’s capacity to transport forces to the region. The US and British military buildup continues to accelerate. The balance of power in the Middle East is about to change as the repercussions of war on world economies, the financial markets and political regimes reverberate in ways yet undetermined.

The markets ended up the day on the plus side, while the price of gold got hammered. The financial media has attributed gold’s recent rise due to political fears of an impending war with Iraq. However, the price of gold has been rising for the last two years on supply/demand fundamentals as well as market and monetary dis-equilibrium. Besides demand/supply imbalances, the dollar is no longer considered a safe haven as it once was in the 80’s and 90’s. In one sense, the media is correct about gold as a replacement for the dollar as a safe haven in times of trouble. As gold resumes its historical role as money, its price will rise, both from a fundamental point of view and as it transitions from its role as commodity.

Meanwhile, commercial hedgers, hedge funds and other major financial players have increased their short positions in gold and silver bullion as well as gold and silver equities. The latest Commitment of Traders report shows that large spec short positions increased by 3,295 contracts to 38,340 held short. Commercial Hedgers increased their short position in the latest week by 13,109 contracts to 162,286 held short. The only reduction in short positions as well as long positions occurred in small trader category. This may have more to do with the Exchange increasing margin requirements by 50 percent. Small traders aren’t as well capitalized as the major players. The increase in Exchange margin positions hurts the small players who are net long in gold and silver as opposed to the commercials. The Exchange’s decision to do this in my opinion was an attempt to stop another gold rally in its track.

The short position in silver has increased by 2,887 contracts to 87,790 in the commercial hedger category. The total short position in silver on the Comex is currently 99,410 contracts held short. That is equal to five times the amount of silver for delivery. This figure is even greater when you consider that not all silver held on the Comex is available for delivery. If only small traders would insist on taking delivery, we would see the greatest short squeeze in history. Total small trader long positions are greater than all of the silver available for delivery. They hold a great position of strength and don’t know it. Sun Tzu once wrote about studying your enemy’s weakness and then has the courage to exploit it. The greatest vulnerability in the precious metals markets is that the paper markets dominate the physical market and distort its intrinsic values. This is because paper is leveraged and can control the price of physical. This is another weakness that can be exploited by investors willing to go long. The large short position in paper is suppressing the price of gold and silver bullion and the price of gold and silver equities. Bullion is in short supply and so are gold and silver equities.

Many in the bullion community are whining over this situation, deeming it unfair. The big boys seem to be accorded special privileges and have used leveraged paper to control the price of precious metals. If you believe as I do that gold and silver are in a new bull market, use their weakness to your own advantage. Take advantage of their short positions in suppressing the price of silver and gold bullion and equity prices to go long. If you are buying bullion, whether it is silver or gold, take immediate delivery. Store it in a safe place but don’t leave it on the exchange. Leaving the bullion on the exchange removes the advantage afforded you. [See Let's Get Physical]

The same applies to buying high quality juniors and unhedged mining companies. There is a growing short position in precious metals equities that has given you another opportunity to buy if you missed out on the last rally. This is really a great time to be buying at subsidized prices made available to you due to the stupidity of the hedge fund and spec community. Remember if you are long bullion, start taking delivery. This holds especially true for silver. The silver short position is gigantic. The commercial and spec community have programmed their models for linear continuity. They believe the financial world is fluid and continuous. What they don’t realize is that we are now operating in a non-linear environment. Financial storms are building up force all around the globe. This is the kind of environment when rogue waves are most likely to surface and when one rogue wave is present others usually follow. In my opinion we are likely to see a series of ten-sigma events that should rock the financial markets. The financial models that have given the shorts such great comfort are based on linear continuity. The problem lies at the tail end of the bell shaped curve. We are moving from one period of discontinuity to the next in regular succession. The point here to understand is that financial models are predicting continuity when none actually exists. The truth is that non-linear events happen with much more frequency than generally admitted. It is this supposition that I believe is about to be tested. That is why you buy when the prices are down. That is why if you are long bullion, you should take immediate and safe delivery. I believe the greatest amount of damage to the financial markets is directly in front of us. The correct posture in this market is to be short paper and be long “things,” especially silver and gold.

State Level Budget Problems Deepen
In other news today, the fiscal position of state governments continues to worsen. States from the west coast to the east coast and the heartland are suffering from budget imbalances as the fiscal crisis deepens. The unemployment rate continues to worsen at the state level. The federal government reported a lower employment rate last month but most states are reporting different results. As this Market Wrap was being written, Moody’s lowered the bond rating for the People’s Republic of California. Today’s downgrade follows similar downgrades in December by Fitch. The downgrade today reflects expectations the bumbling Davis Administration will not be able to close the fiscal gap. Moody’s said in its press statement that it expects budget deficits to extend well beyond 2004. California has become an inhospitable environment for business due to high taxes, a growing plethora of regulations, a high cost of living, and wacky environmental laws that drive up the price of housing and the cost of doing business in the state. Businesses are now leaving the state in droves. A recall movement has begun to recall the state’s governor on the basis of incompetence.

However, California isn’t the only state to find itself in this mess. Many states are cutting needed services while failing to trim bloated bureaucracies. At a time of strained household budgets, states are imposing additional taxes on working people. All forms of taxes are being considered from income taxes, sales taxes to property taxes. Some states like Arizona and California are exploring taxing the Internet. State governments are applying the wrong remedies at exactly the wrong time. Increased tax burdens on a heavily taxed and debt-laden consumer is the wrong. This is the kind of policy, when applied to a leveraged economy, could end up being the straw that broke the consumers back. This is the same kind of economic quackery that was applied during the Great Depression that turned from a recession to a depression. Politicians never learn from history, so like Santayana’s prediction, we are doomed to repeat history’s mistakes.

The markets rallied late in the day after another flagpole rally was engineered in the futures pit. The explanation given was that investors were relieved that Iraq stopped its objection to reconnaissance flights for weapons inspections. Investors dumped Treasuries and precious metals stocks and bullion and bought stocks. Another explanation would be that speculators dumped or shorted bullion and metals stocks. I believe it is foreigners that are dumping US Treasuries. As for all of the speculation in stocks, let’s just say it has become a professional game of speculation. With volume declining continuously since last July the stock market has become a game of professional speculation whereby hedge funds and mutual fund managers speculate in the market with no long-term convictions. It has become a trader’s game with very little worth investing in. Every move is a spec play and nothing more. This remains THE MOST OVERVALUED MARKET IN US STOCK MARKET HISTORY. Stock market capitalization is still above the average of market cap to GDP in the last century, which is higher than where the stock market was before the 1929 crash, the 1968 peak and the 1974 bear market.

Nonetheless, stock markets got a bit of a bounce over short-term euphoria on a delay in the coming war with Iraq. For Wall Street spec players the market’s dive and gold’s rise is all about Iraq. When you have three years of declining markets and bad market predictions, you need an excuse. The 2003 excuse is Iraq. The Iraq excuse follows corporate governance in 2002. In 2001, it was 9-11. In 2000, it was just a brief pause. This year’s official mantra is “Blame it on Iraq.” Even though markets rose in flagpole fashion, market breadth was weak with advancers beating out decliners by a 9-7 margin on the NYSE and by 17-14 on the Nasdaq. Volume was anemic continuing its trend of decline. This indicates there is no widespread support coming in for stocks from the investment public. This week Alan Greenspan testifies before Congress on the economy on Tuesday and Wednesday. I suspect the markets will experience a flagpole rally as they usually do when Alan addresses Congress. Look for a brief rally this week that should end shortly. There is no power behind these flagpoles. Today’s rally and the ones that should follow today are the product of the futures pit and nothing more.

Volume was weak at 1.22 billion shares on the NYSE and 1.18 billion on the Nasdaq. The VIX fell 1.10 to 37.70 and the VXN dropped .95 to 47.31.

Overseas Markets
European stocks fell amid concern an attack on Iraq would stunt economic growth in the region, cutting demand for products from companies such as Royal Philips Electronics NV, STMicroelectronics NV and Nokia Oyj. The Dow Jones Stoxx 50 Index dropped 0.4 percent to 2162.64. The index lost 3 percent last week as the U.S. called on the United Nations to enforce resolutions demanding Iraq give up weapons of mass destruction.

Japanese stocks rose for a third day in the slowest trading in a month. Canon Inc. led gains among computer-related exporters after the yen weakened against the dollar, raising optimism for their overseas sales. The Nikkei 225 Stock Average rose 0.4 percent to 8484.93. The Topix index added 0.4 percent to 842.69. Computer-related stocks were the second-biggest group gainer on the Topix after telephone shares.

CONTACT INFORMATION
James J. Puplava, CFP
PFS Group
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