Newsletter #117  11/28/2012

“Between a Rock and a Hard Place: Why the Fed is Struggling To Revive Our Economy... And How This Will Affect Your Investments!”

“Now that the Presidential election is over, it’s time to look to the future. Predicting the Fed’s actions is always vital for successful investing, and Obama’s re-election helps us to understand what the Fed is going to do.

“Also in this issue: will the US soon produce more oil than Saudi Arabia? Recent media reports say yes, but there’s more to the story than what they’re telling you. Here’s why we’re still planning to make lots of money from high oil prices!”

As President Obama prepares for four more years in the White House, what can we expect to see?

There are lots of unknowns ahead of us. What plans does Obama have for his second term? What will Obamacare do to our economy and our healthcare system? Can the “fiscal cliff” be fully avoided or not?

We won’t know the full answers to some of these for years. But there’s one thing that’s already clear...

The Federal Reserve’s ‘Stimulus Machine’ Will Continue

Mitt Romney, if he was elected, planned to fire Fed Chairman Bernanke. He also wanted to shut down the QE3 program, along with other things that the Fed was doing under Obama.

But Romney lost. So it’s safe to assume that the Fed will continue its present course.

The US economy is in a dangerous condition. Although it’s (barely) growing today, its recovery is extremely fragile. There are multiple ways that our economy could plunge back into deep recession at any time.

In last month’s issue, I described how Bernanke is trying to inflate financial assets, especially stocks. I also discussed how monetary inflation will probably continue much longer than most people expect.

This month, I’ll discuss why Bernanke feels that he must do this—why he’ll keep printing money while simultaneously trying to drive interest rates down even farther than they already are.

He’ll do all this even though he knows that money-printing is economically destructive. And he’ll do all this even though he knows that...

Today’s Low Interest Rates Are A Disaster

Interest rates are at historic lows. This is catastrophic for major sectors of our economy, especially those relying on bonds.

Bonds are among the safest investments. Unlike stocks or other assets, when a bond matures, you get your principal back.

As a result, many institutions must buy bonds, because they’re required to be conservative with their investments. There’s a long list of these institutions: pension funds, insurance companies, and many others.

But today’s rock-bottom rates means that bonds are paying peanuts today. Many have negative returns when inflation is considered. So these institutions are hemorrhaging.

The carnage isn’t limited to large institutions. Retirees, savers, and fixed-income investors are also suffering badly.

And the suffering is spreading. For example, many pension funds are getting lower returns on their assets, so they’re reducing payouts. Pensioners who earned benefits are in some cases only getting partial payments. And workers who haven’t even retired yet are being hit with larger required contributions to the pensions, to make up the deficits.

There’s also a tremendous danger growing for all those institutions which are buying bonds at today’s interest rates.

Bonds move inversely to interest rates. As rates go up, the value of existing bonds goes down (because better rates than theirs have become available).

So all those institutions which are being forced to invest in bonds today are buying time bombs. Once rates go back up, current bond buyers are going to get trampled.

Add it all up, and we see why low rates are a disaster for major sectors of our economy. But at the same time, for other sectors of our economy...

Higher Interest Rates Would Be a Disaster

Low rates are crucial to resuscitating our economy.

Fed Chairman Bernanke knows this. It’s one of the main motivations driving the Fed’s actions right now.

There are multiple reasons to keep rates at historic lows. Each of them would be compelling enough by itself. Combined, they leave Bernanke no choice but to drive rates as low as they can possibly go.

Low rates stimulate consumer demand. It’s far easier to buy high-ticket items like cars and houses when rates are low. And low credit-card rates mean that even moderately-priced goods enjoy higher demand.

Low rates also prop up the stock market. This is true for several reasons.

First, consumer demand is stimulated, as we just saw. This means businesses sell more goods and services.

Second, the cost of capital is low. This allows business owners to expand their capacity and invest in their businesses for less money.

Third, the above two items means that corporate earnings will be higher. And earnings are the scorecard for how well stocks are doing. Overall, earnings are the primary driver for stock valuations, and rates are one of the primary drivers for earnings.

Fourth, as a result of the above, stock valuation models are based on interest rates. This is especially true for the capital assets pricing model.

Every educated investor has been taught this model. It tells you to adjust your returns to the risk-free rate (i.e., Treasuries). Your return minus the riskiness of the investment needs to be greater than the risk-free rate.

When rates are as low as they are today, this model tells you that you’re an idiot to be in Treasuries.

In other words, by keeping rates so low, Bernanke is driving investors out of Treasuries and into stocks. Again, the market benefits.

On the other hand, if rates went up, all these benefits would be reversed. The cost of capital would go up. Business owners couldn’t invest into their businesses. Consumer demand would shrink. Business profits would nosedive. Stock investors would flee back into bonds.

In other words, the economy would sink, businesses would go under, and stocks would get pounded.

Bernanke knows all this, of course. So he’s printing money at a furious clip to stimulate demand, to drive up asset prices (as I described last month), and to buy mortgage securities and keep rates as low as possible.

And as for the insurance companies, pension funds, fixed-income investors, retirees, and everybody else who’s getting bled out by rock-bottom rates... tough luck. They’re just collateral damage.

This point is worth repeating: if the American economy is to be kept alive, it’s crucial for rates to stay low. In fact, it’s so crucial that Bernanke is willing to blow up entire categories of investors and financial institutions to get it done.

Unfortunately for us, these investors and institutions might not be the only ones who get blown up, because...

Low Rates Aren’t Working

In past business cycles, whenever the Fed lowered rates, it stimulated the economy.

Today, rates are at ridiculously low levels (historically speaking). Despite this, our economy is barely holding its head above water.

This tells us that something is very wrong. The patient is very sick.

Obviously, we aren’t in an ordinary business cycle. This cycle kicked off with the bursting of the housing bubble—a financial nuclear bomb with far-reaching consequences.

A bubble isn’t necessarily a big deal. In fact, just in the last decade or so, we saw two major bubbles: one in tech stocks, then another in energy prices. Both of these burst and deflated with little economic impact (other than to the unfortunate investors who bought in at the top).

But housing was different. This was a leveraged bubble, in a fundamental sector of our economy. Leveraged no-doc loans were a disaster not only for the American economy, but also to everybody else in the world that bought the packaged loans from us.

And the housing crash that followed was incredibly destructive. This destroyed one of the fundamental items of faith in America—that owning your home was the most important part of building your wealth. Even though economic storms might occur, your home would always be a solid fortress. Even though other markets (stocks, bonds, etc.) might go up and down, your home would always be the foundation of your financial security.

The housing crash has devastated America both psychologically and financially. Despite rock-bottom interest rates, consumer demand has not revived.

Why? Because...

Most Americans are either scared or broke.

Boomers in particular have radically changed their mindset. They’re getting close to retirement, and they just got pounded in the crash of 2008. They aren’t going to spend like they used to.

As for younger generations, they don’t have the money to spend. The youngest in particular are learning to rent instead of buy, and to live very frugally overall.

In other words, we aren’t going back to the pre-2008 era.

This is the classic problem that Keynes called “animal spirits.” Even if people have money, they aren’t going to spend it if they’re scared.

Over time, fear turns into habit. And an ominous trend is developing in America overall: we’re starting to get a Depression mentality.

The 1930s Depression scarred Americans deeply. After it was over, people thought and acted very differently than they had before. Even many who were millionaires still lived like paupers.

The frightening thing about this way of thinking is that it can take up to a full generation to go away.

Some analysts speculated that a Romney victory in the election might have stimulated confidence. There’s such hatred of Obama in the business community and among investors that his loss alone might have spiked demand somewhat.

Realistically though, that would have been short-lived. The imbalances in our economy are too severe, and...

Sagging demand is only part of the problem.

Money supply is another.

The Fed has pumped the banking system full of cash. The banking system overall has about $1.6 trillion in excess reserves.

But banks aren’t lending it out—they’re sitting on it instead. This is taking a horrible toll on the economy. Low rates don’t do anybody any good, if no lending is actually taking place.

The Dodd-Frank Wall Street Reform and Consumer Protection Act gets a large part of the blame. This makes it far harder for banks to package up loans and sell them. Now they have to keep the loans on their books. As a result, they’ve tightened up lending and underwriting standards, along with other things.

The bottom line is that banks have tons of cash, but it’s not getting out into the economy. Again, this wasn’t a problem in previous business cycles. Again, the game has changed.

Meanwhile, over $2 trillion is sitting in corporate accounts overseas. This money isn’t circulating in the US either, for two reasons.

First of all, if the money were brought home, Washington would take a huge tax bite out of it.

Second, there’s no reason to bring the money home anyway. Since there’s little consumer demand, companies can’t justify investing the money here.

So this mountain of cash is doing exactly zero to help the US economy. It does however present...

A Clear and Present Danger

Corporate cash plus excess bank reserves add up to almost $4 trillion.

Compare this to our entire national GDP of ‘only’ $15 trillion. This excess cash represents about one-fourth of our entire economy.

Right now, this cash is bottled up in the financial system. What happens though if something opens the floodgates?

Congress could do this overnight. All it would take is to loosen banking and lending standards, and proclaim a tax holiday for overseas cash that’s brought home in a certain period of time.

If Washington really wanted to “stimulate” the economy, something like this could be done. The danger is that it would be overdone, and all that money would pour in over a short period of time.

Imagine what would happen if $4 trillion flooded into our $15 trillion economy. “Hyperinflation” wouldn’t begin to describe it.

There’d be far too many dollars chasing far too few goods. Consumer prices would skyrocket, and they wouldn’t be the only things to do so. Speculators would rampage through commodity markets, equity markets, and every other market you can think of.

There’d be bubbles inflating and bursting everywhere.

That’s why I continue to urge my investor clients to own gold, even though inflation seems to be very low. First of all, inflation isn’t as low as we’re told, as I’ve discussed previously in GEA.

Second, inflation could ignite instantly throughout the United States. There’s enough cash around to do this—it’s just waiting to be released.

And with each passing month, the temptation grows for Washington to pull this kind of stunt, because...

We’re Stuck in a Deep, Deep Rut

As I said earlier, the US economy is very, very sick. It needs a serious jolt of adrenaline to get it moving again.

But how can this be done? We have a $15 trillion economy. It’s hard to move the needle on $15 trillion.

During the Presidential campaign, there were chest-pounding promises of “five percent economic growth” if only we would elect that particular candidate. Such promises were absolute rubbish.

The same is true for all the empty promises about lowering taxes. The vitality of the economy relies much more on interest rates than tax rates, and interest rates are already down to zero. And the needle still isn’t moving.

The correct way to get out of this mess involves raising taxes, slashing spending, slashing benefits programs, and waiting patiently for several years until all the imbalances work themselves out. But this is impossible politically.

That means we’re stuck in this rut until Washington gets the courage to do the right thing (which is unlikely), or does something foolhardy (which seems far more likely).

But even in the midst of this, there’s good news for us as investors. Let’s switch gears for a moment and discuss this question...

Has the US Solved Its Oil Crisis?

In GEA, we’ve made huge returns riding the oil bull. Is the party over?

According to the New York Times, the Wall Street Journal, and many other media outlets, the answer is yes.

You probably saw all the stories about how the US would be the world’s leading oil producer—larger even than Saudi Arabia—by 2017. A few years after that, we’ll supposedly be “all but self-sufficient” in our energy needs.

These stories were incomplete at best, and flat-out misleading at worst.

The story originates in a report by the IEA (International Energy Agency). This report is a Pollyanna analysis of US shale oil deposits and the bonanza of oil production that we’ll supposedly get from them.

The media’s level of excitement over this was not only unjustified, it was disappointing. The IEA has a long track record of failed predictions and overly optimistic forecasts for future energy production. Why the journalists are trusting the IEA now is a mystery.

Anyway, it’s true that the US has enormous deposits of shale oil and shale gas. But it’s not true that these deposits solve our energy problems.

Part of the confusion comes from the media’s tendency to lump together shale gas and shale oil. These are completely different energy sources, going to completely different markets.

Shale gas (along with natural gas from other sources) is in massive overabundance. The glut has driven prices down relentlessly. In this sense, shale gas has been a boon to the economy.

But shale oil is a completely different story. That’s why we need to discuss each separately.

Shale Gas: In a Bubble?

In 2012, natural gas prices hit lows last seen a decade ago. Supply is abundant, and shale gas gets much of the credit for this.

But a growing number of analysts are warning that the bonanza can’t last. For example, geological consultant Arthur Berman has been highly critical of the shale gas industry overall, pointing out that reckless overproduction has poisoned the well (no pun intended) by causing gas prices to collapse by more than 40 percent.

As a result, investors have lost hundreds of billions of dollars. Berman points out that investors won’t keep pumping money into things that don’t generate returns.

There are also many questions surrounding the long-term viability of many of the deposits. Fracking (hydraulic fracturing) allows much higher production per well, but it’s highly controversial. Lawsuits are raging about the severe environmental damage attributed to fracking, including the poisoning or outright draining of underground water aquifers.

Fracking also shortens the lifespan of each well. Arthur Berman quotes statistics from the Eagle Ford shale deposit in South Texas (currently the most active play in the US), which show that annual decline rates average more than 42 percent.

At this rate, it will take hundreds of additional wells drilled each year just to maintain current levels of production. That’s about $10-12 billion of additional investment needed per year, in an industry where investors have been burned severely by a collapse of prices. Where will this money come from? Nowhere, is Berman’s answer.

So it’s quite possible that shale gas is in a reverse bubble, so to speak—that prices will snap back much higher than their current lows.

(In GEA, we generally prefer oil stocks to companies that specialize in gas production. However, we do watch this market closely. If good opportunities arise here, we’ll be sure to take advantage of them.)

We see then that the truth about America’s shale energy isn’t as rosy as the media stories claim. And that’s just for shale gas. When we get to shale oil, the situation is even worse.

Shale Oil: A Mirage?

Will shale oil really allow America to produce more crude than Saudi Arabia?

According to the recent media stories, yes. But according to many experts, no.

Part of the confusion arises because there are multiple types of shale oil. For example, the Bakken formation in North Dakota is conventional crude oil where the source rock happens to be shale. (Strictly speaking, this isn't shale oil—it's conventional oil that's found in oil-bearing shale.)

Conversely, true “shale oil” deposits are unconventional. They don’t really contain oil, just a mixture of organic chemicals called kerogen.

Let’s discuss the Bakken deposit first. There’s a tremendous amount of excitement surrounding this field, and here, the excitement is justified. The Bakken promises to be the largest oil field ever discovered in America, with tens of billions of barrels of recoverable oil.

However, as productive as the Bakken field is, there’s still a physical limit to how much oil can be extracted at a time. The Oil & Gas Journal predicts an ultimate limit of 1.5-2 mbpd (million barrels of oil per day).

That’s a lot of oil. But it's less than 20 percent of our 11.2 mbpd deficit, which we import from other nations.

It's also a future goal, not a current achievement. Even after years of frantic drilling in North Dakota, total Bakken production today is only about one-half mbpd.

So if we’re to be “all but self-sufficient” as the IEA report said, we need a tremendous amount of oil from other sources. And here’s where the analysis starts to go wrong.

Optimistic forecasts like the IEA’s include lots of shale oil that’s not actually oil in the usual sense. When most people think of oil, they think of pockets of liquid hydrocarbons trapped underground. To get it out, all you need to do is puncture a hole into the deposit, and start pumping.

But shale oil is completely different. The “oil” is actually kerogen: a mixture of organic compounds distributed thinly throughout the layers of rock. To get it out, you need to mine the rock, transport it to a processing facility, crush it, and heat the rubble.

The heating is necessary not only to melt the kerogen out of the rock, but also to decompose it into something resembling crude oil. This requires very high temperatures: up to 900-970 degrees Fahrenheit.

Even then, the liquid can’t be refined yet. You need to filter out the particulates, get rid of toxic contaminants like arsenic, and remove other impurities like iron, sulfur, and nitrogen.

Then you finally have something that can refined into conventional petroleum products.

Obviously, this process is far more expensive than just pumping crude out of the ground. It also requires a tremendous amount of energy.

And that’s the kicker. Many deposits of shale oil have a negative EROI (energy return on investment). It takes more energy to produce the oil than the oil itself contains.

This isn’t an issue of cost, it’s an issue of physics. It means that many shale oil deposits will never be viable, at least not until some radically new technology comes along.

Of course, there have been many attempts at increasing shale’s EROI. For example, one popular idea is to reduce processing by melting the kerogen in the ground before extracting it. But physics again becomes a problem—the steam that’s pumped into the ground causes the rock to expand, so the fractures and boreholes tend to squeeze shut and extraction becomes impossible. That forces you to start mining again, which is the whole thing you were trying to avoid.

So on the one hand, the US has a tremendous amount of shale oil, especially in the Bakken, and its production is increasing. On the other hand, the conventional shale oil is inadequate to meet demand, and many of the unconventional deposits are non-viable with current technology. And the Pollyanna predictions are ignoring this.

Which means that for now...

The Oil Bull Will Continue

We can expect oil prices to remain high for the next several years at least.

Can these technological challenges be overcome? I certainly hope so. Plentiful oil would be a tremendous boon to the American economy. The opposite is also true—if we don’t fix our shortage of affordable oil soon, we’ll be in deep doo-doo.

But we can’t make our investing decisions based on “maybe someday"—we need to make our decisions on what’s happening right now. And right now, there’s a lot of blind optimism in the media and other places about our energy outlook, and its impact on our economy.

And that brings us back to our primary topic this month—the US economy.

The Clock is Ticking

Over the years, I’ve done several studies on recessions and growth cycles. Most cycles last 3-5 years.

In our current cycle, we’re in an economic recovery and growth phase (though not by much). It started in 2009. That means we’re going into the fourth year of growth.

The growth phase of a cycle is like running a long race. You start strong, then you get tired and weaker over time.

Normally, at the end of a cycle, the numbers are harder to beat. You start to get imbalances, and the Fed has to raise rates. Rates usually get raised too high, and this starts a recession.

But we’re not in a normal cycle. Despite being in year four, we’re barely growing.

We’re also struggling with high energy prices. As we just saw, these aren’t going away any time soon. Gasoline at $3-$4 is a real ball-and-chain that our economy has to drag around.

That’s why I think there’s a good chance that this cycle will get extended. If inflation remains low, the Fed will avoid raising rates. This would be extremely unusual, but it’s possible.

And if this happens, it will make investing very challenging. The longer a cycle goes, the more unpredictable the markets become.

That’s why I pulled most of our GEA portfolio out of the market last year. We made about 100 percent in two years, so it was time to take our “riding the trend” profits off the table and start trading.

So let’s recap the environment we’re in. The Fed is driving rates down as low as possible, to keep the economy alive. Meanwhile, Bernanke is running the printing presses 24/7, cranking out $40 billion per month in new dollars.

As if this weren’t enough of a threat, there’s $4 trillion sitting on the sidelines in corporate accounts and banking reserves. If the owners of that money decide to set it loose, we’ll see oceans of money pouring into the financial sector, among other places.

Meanwhile, the IEA is promoting pie-in-the-sky stories about the US being the new Saudi Arabia, because we happen to have a lot of greasy rocks within our borders. This is deluding investors about our oil problems, but reality will reassert itself soon.

High oil prices will be a strong headwind for our economy. They will force Fed officials to crank up the stimulus machine even higher than they otherwise would.

So here are the steps I recommend you take:

• Think twice before investing in bonds or other rate-dependent securities today. You’ll get spanked hard once rates go back up. And you can get far better returns with good stocks anyway.
• Make sure your portfolio has a strong foundation of gold. Inflation is low today, but could become a monster in very short order. A mountain of money that’s over one-quarter of our entire GDP, if set loose in our economy, could have catastrophic results. We hope this won’t happen, but don’t bet your financial future on it. Gold is the best protection against this and other forms of inflation.
• Keep on top of my email Updates. Some of my recommendations will be shorter-term than they’ve been in the past, and we’ll probably be using a more varied combination of option trades. As this phase of the economic cycle gets more and more distorted, we need to stay nimble.
• Consider my Gold & Energy Options Trader service. It’s designed for emotional extremes in the market, which are all but guaranteed today. It’s also designed to make short-term trades (the current average is about three weeks)—which will protect you from shifts in the market. That’s perfect for today’s environment.

This month alone (which isn’t even over yet), GEOT readers have received recommendations for three trades, for combined gains of 96.71 percent:

• 6.64 percent gain on SPY calls in 4 days
• 63.75 percent gain on a GLD call spread in 4 days
• 26.32 percent gain on USO calls in 5 days

And November’s results aren’t unusual...

Gold & Energy Options Trader is up 373% just since August 16, with average gains of 31% on each trade.

In order to be a successful trader, you need a system that gives you confidence and makes you feel successful.

For most traders, that’s a low risk, high probability strategy that wins more than it loses.

That’s exactly what I've found in my GEOT method.

In the last five years, GEOT made 192 trade recommendations: 151 were winners, and only 41 have been losers or broke even.

That’s a 78.6% win rate.

My average trade delivers about 21% every 20 trading days.

When you add it up, if you followed every one of my recommendations over the last five years, you could have turned a small $10,000 initial investment into $421,019, or a $50,000 trading account into $2,105,095 in just 60 months (before commissions and fees).

Even if you caught only half of my trades, you’d still generate over 100 times the returns of the S&P over the last five years.

I reveal how it works in this video:

Click here to watch the video