Through our past letters we have turned more and more negative, we acknowledge. We’ll go through a quick summary of our thoughts since the beginning of the year:

We had been optimistic until March, hoping that the European Financial Stability Facility would be used to buy sovereign debt from EU peripherals in the secondary market. That alternative was dismissed and since then, the Euro zone has been following the path of typical currency crisis under convertibility.

In the meantime, emerging markets (creditor nations) have been fighting the inflation they consciously imported from the developed world, attacking the symptoms, rather than the root. The root was and is their monetary policies, which seek to prevent their respective currencies from appreciating (by buying FX reserves): The symptoms are higher balances in their respective banks, ready to fuel more consumption. They will continue the attack by limiting capital inflows in volume and in price (with taxes), increasing the banks reserve requirement ratios, capital or cost of funding.

In the US, we have and continue to witness a deterioration in the employment and activity indicators. Mainstream economists will point that this is in spite of the billions of fiscal debt being monetized, with QE1 and QE2. We, however, will say that this is occurring because of the billions of fiscal debt being monetized, with QE1 and QE2. Along this line of reasoning too, we wrote in our last letter: “…we see the relationship between cause and effect differently: We don’t see future higher oil prices driving energy stocks higher in the long term. On the contrary, because interventionism is destroying wealth, lowering asset valuations (i.e. stocks), production will be affected and the lower supply will push prices higher…”. We stand by this concept and today we show a chart (source: Bloomberg), which we fear may be signaling a nascent trend:

In the chart above, we compare the price of oil (orange) vs. the S&P TSX Energy index (white), for the period starting June 24th, 2011, the day after the International Energy Agency surprised the world with the announcement that 60MM barrels of oil would be released. The price of oil has outperformed the rise in value of energy stocks, 5.7% to 4.7%.  We fear this trend, which is characteristic of stagflation, may further develop, where it is better to buy the product than the means of production. Usually, the equity of the companies that produce commodities constitutes a leveraged way to bet on the price of such commodities: If we think the price oil will increase, we may buy energy stocks to earn a meaningful profit from that increase. If we think the price will decrease, we may short those energy stocks for the same reason. But under stagflation, that is no longer the case, particularly when the inflationary process spirals. We will be paying attention to this relationship.

Lastly, two weeks ago, we had warned that the price of gold would be challenged and that we preferred liquidity. We still believe gold will have a tough time going forward, but with the threat of Moody’s to downgrade Italian banks, the fear of risk contagion throughout the Eurozone began to spread (and was later confirmed with Portugal’s downgrade). Accordingly, during the sell-off on June 30th /July 1st, we had no choice but to get long of gold again. We will sit tight now.

Martin Sibileau