Lately, the stock market has been grabbing most of the headlines for its surprisingly strong performance since last March. But commodity prices have been surging as well. Favorable macro-economic trends are powering both markets.

The S&P 500 Index is up more than 50% from its March lows. Meanwhile, the CRB Index of commodity prices recently broke above the 280 level making new yearly highs - about a 40% advance from the lows of last year.

Therefore, no matter what America's grim economic data may be saying, the stock market and the commodity markets both agree that some sort of recovery is underway.

I how no opinion about where stock prices are headed next, but I feel fairly confident that commodity prices will continue trending higher over the coming years. That said, many commodity markets have already posted such large gains during the last few months that some investors may be skittish about climbing aboard.

I understand this fear, but investors must remember that commodities are not homogenous. Even though many of them have soared this year, some commodities have advanced very little. Corn is one of the notable laggards...and I think it has some catching up to do.

My recent research travels took me to the West Coast to revisit acquaintances made during the July National Chicken Marketing convention. (Yeah, that's what I do for fun!)

My big takeaway from this chicken confab was that most of the presenters and professionals in attendance believed that $3.00 corn was way too cheap and that corn prices would begin moving higher. I trust these guys. After all, it's their business to know the cost inputs from the egg to the bird on your plate. But their bullish outlook for corn was a minority opinion at the time.

Back in mid-summer, when this convention took place, the corn crop looked likely to make it through the summer months in great shape, with no threats in sight to disrupt high yields. Consequently, corn prices were languishing near multi-year lows.

But as it turns out, the "chicken crowd" was right to believe that corn prices were too cheap. And the corn price charts from last summer confirmed the strong potential for even higher prices. Though my view on trading weighs heavily on technical analysis, I learned long ago not to ignore important fundamental information. At the lowly price of $3.00 a bushel, the upside potential for corn seemed much greater than the downside risk.

That's why I urged the subscribers of my Resource Trader Alert (RTA) to enter a bullish trade on corn. Over at RTA we use options to directly play commodities themselves - options help limit our risks, while still providing ample opportunity to profit.

I recommended a six-month-long option play on corn, designed to benefit from any strong up-move in corn prices. The specific trade I recommended cost just a little more than $1,100 to initiate. I was looking for corn to move to $4.00 a bushel by then end of this year. But as it turned out, we hit that target in late October, which caused the value of the corn trade I recommended to more than double.

That's just how quickly the commodity options can move - a 25% rally in corn prices caused the recommended corn options to double. By using options we were able to maximize our profit potential and substantially limit our risk.

The reality of fundamental trading on things like weather, planting intentions, yields, exports or crop disease is that the information does not flow freely to everyone at the same time. The farmers, seed salesmen and grain elevator operators use their legal inside information in the market before others. Often, price charts reflect this "insider knowledge."

In other words, a price chart can provide an early indication that a market is about move into a bullish mode, even before any broadly disseminated public information would confirm the rising prices. Therefore, when you combine technical analysis with the informed insights of industry insiders, you can shift the odds of success greatly in your favor.

After a brief correction, corn is on the rise again and trading just above $4.00 a bushel. I'm staying with this friendly trend for now.

Regards,

Alan Knuckman
for The Daily Reckoning Australia

• Corn Prices on the Rebound
• Wheat Prices Look Set for a Move Up
• The Aussie Dollar as a Measure of Global Risk Appetite
• Nervous Investors ‘Short’ the Market By Buying Commodities
• Macmahon Holdings Limited (ASX:MAH) Near a 52 Week High

That's fantastic! Just 18 more months before we can put all of this behind us. Why didn't they aim to overcome the crisis a year ago? Oh well. Better late than never.

Of course, it is possible the leaders of the APEC nations have no idea what to do, and certainly don't agree on how to manage their currencies. The Journal reports that everyone is badgering the Americans and the Chinese to quit their cozy currency arrangement. America has effectively devalued the dollar with low interest rates, and the Chinese have matched the devaluation because of the semi-formal currency peg.

The results is a global race to the bottom, otherwise known as competitive currency devaluation. Exporting nations must mimic the Fed and keep rates low (or sell their own currencies and buy dollars) to stay competitive. It suits China and America for different reasons.

America's weak dollar hasn't exactly helped exports like everyone expected. In fact, the trade deficit widened last month on a weaker dollar, mostly due to huge oil imports. But as long as U.S. interest rates are kept low, the housing market will not implode. The weak dollar suits the Fed.

And a weak Yuan suits the Chinese for now. They remain the world's low cost producers. And their goods get even cheaper when the Yuan declines with the dollar. More market share is good for Chinese producers. But it doesn't make any other exporters trying to compete in manufactured or consumer goods very happy. About the only people, or metal, made happy by the current state of affairs is gold.

The weekend edition of the Australian Financial Review has gold on the cover, incidentally. You can see a picture of it a few paragraphs down. Underneath the giant golden letters it reads, "Why you shouldn't laugh about gold hitting $US2000 an oz." But if anyone's laughing, it's a nervous laughter.

Why? Well, the fact that the gold made the cover of the AFR confirmed our view that it was an excellent month to research uranium stocks. That's just what Diggers and Drillers editor Alex Cowie did. He published his first report as the full-time editor of Diggers and Drillers on Friday. It was on uranium, including one specific recommendation.

We talked with Alex about whether to write about gold this month or uranium. Trouble is, he'd already written about gold in October. We've been getting a lot of questions here at the DR about gold. The gold price is making new highs in U.S. dollars ($1,123.40 in the futures market last week), but hasn't carried over into Aussie dollar.

The strong Aussie dollar has capped the Aussie gold price for now. You can read what Alex has to say about it here. The short version, though, is that Aussie investors looking for leverage to higher gold prices ought to look at producers who incur cash production costs in U.S. dollars. This keeps costs under control, but ought to benefit share prices (all things being equal) if gold continues to make new highs.

November 2009	Winter 2006
Source: The Australian Financial Review	Source: Diggers and Drillers

By the way, a report predicting $2,000 gold was the very first letter we mailed when we began our financial publishing business in 2006. The prediction seemed a bit crazy back then. And truth be told, the report bombed. That is, very few readers took us up on the offer to subscribe to Diggers and Drillers and see what else we had to say about gold stocks and the resource industry.

And to be fair, the prediction hasn't come true...yet. Most Aussie gold stocks have lagged the move in bullion prices. And some people still think that gold itself as a genuine asset class is a crazy idea.

The author of the AFR's piece, Robert Guy, is grudging in his recognition of gold's recent performance: "Often dismissed as cranks and conspiracy theorists, true believers may have found vindication in gold's record-breaking run, which has underscored the migration of the mainstream to the long-held world view of these fringe dwellers."

And then he can't help himself. "Gold bugs' dystopian vision of debased currencies, enfeebled banks, debt-burdened governments resorting to the printing press, coupled with the menacing spectre of inflation, presents a worrying analogue to reality," he adds.

An 'analogue to reality'? Last we checked, all those things Guy mentions weren't just prophetic visions. They ARE reality. The real vision - in the sense of a something that appears in fevered recesses of the mind but has no existence in the physical world - is that government-led efforts to revive the economy by taking on more debt have actually worked and that everything is getting better and better.

But then, the idea that investors who buy gold are crazed believers is a convenient way of dismissing monetary history. Close your eyes and pretend everything is all right!

To understand the investment benefits of gold, you don't have to "believe" in gold in the way that, say, you have to believe in the Virgin birth or the resurrection to call yourself a Christian. You just have to understand how gold has always been part of a sound money system and how it promotes responsible government and personal liberty. It is not an act of faith. It's a rational conclusion.

Further, gold's physical attributes - durability, divisibility, transportability, relatively scarcity, and its sameness in all places - make it such a useful medium of exchange. To the extent that those qualities make for really useful money, gold does have an inherent value. Gold is very good money, which is why it's being remonetised after years in the Keynesian wilderness.

But we've written so much about gold in the past you are probably sick to death of it. So we'll conclude with two points. A sovereign debt crisis is brewing because Western Welfare states refuse to live within their means and are increasing public sector debt. This makes their currencies dangerous to own and their bonds subject to default. At the very least, most paper currencies face major devaluations.

The second point is that gold bullion is not a panacea for the problem of fiat currencies. It's a good start. But if you think the monetary world will somehow muddle through, then gold stocks give you leverage to a higher gold price. As eye-catching as gold's recent gains have been, we reckon most investors haven't begun to stock up and gold.

While the easy money in gold has been made, the big money has yet to be made.

All that said, we think Alex's timing on uranium is good. Turning to your attention to those asset classes that no one wants to touch is hard to do. For one, you have to be conscious that what everyone is talking about is either fully priced or over-priced. Secondly, it takes some courage to step into a market that everyone hates, or finds so uninteresting that it's not worth the time.

Granted, uranium does not exactly constitute a hated asset. But it hasn't been in the limelight lately, has it? There was a small story in this weekend's Australian, though. Energy Resources Australia's CEO Rob Atkinson says the pieces are in place for a uranium shortage down the track.

He cited three factors. First, the GFC cut off the capital for new mine development. This happened with oil and gold, too, both of which were facing production peaks anyway. But in the uranium industry, you've had major interruptions of mine supply from two sources that were expected to be a lot more productive, BHP's Olympic Dam and Cameco's Cigar Lake mine.

On the demand side is the resurgence in the world's fleet of nuclear reactors, which use uranium as fuel. Of course nuclear power remains controversial in some places (like Australia) even as it figures prominently as part of the energy portfolio in other places (like China and India).

No matter how you "feel" about it, it's pretty likely that nuclear will emerge as the clear winner as an alternative to hydrocarbons. Who knows what kind of madness the world's leaders will agree to. The idea that the world can give up burning coal and still maintain a comfortable standard of living is belly-laughable.

But even if next month's climate change summit in Copenhagen fails to produce a breakthrough (and it already looks like that may be the case), uranium should come out of the summit...er...glowing. And don't get us started on that summit. We've heard the interviews and read the articles. It does indeed look like a massive power grab. But that is a subject for another day.

As an investment issue, uranium stocks present better value right now than some other commodity stocks. One reason is that prices in the spot uranium market have trended between US$40 and US$50 all year. They soared to US$140 along with oil in 2007, but have since fallen, stabilised, and consolidated.

In other words, uranium is one of the assets to resist the rising tide of global liquidity. That doesn't mean it's coiled like a spring and will inevitably rise. But there are some good reasons to take a closer look at it now. And Alex pointed out an important fact in his November article: future uranium producers will have to produce above a certain number of pounds per year for at least ten years in order to enter into agreements with the utility companies that buy uranium for fuel.

That means that not just any explorer or developer is going to win the uranium sweepstakes if prices begin to rise in the spot market. And, of course, if global GDP and industrial production again collapse because of a second credit crisis, demand for electricity - including future projections - will go down. Maybe the world will build fewer nuclear reactors than planned, needing less uranium than expected.

Dan Denning
for The Daily Reckoning Australia

• AUD Price of Gold a Measure of Gold’s Strength Against Other Currencies
• Good Month for Aussie Stocks, While U.S. Stocks Fell to Close the Quarter
• Uranium: A Carbon-friendly Substitute for Coal
• Thorium as a Nuclear Fuel
• Uranium and Gold Exploration Spending Both Down in Last Year

The burden of today's Daily Reckoning, then, is to remind these nattering nabobs of negativism that gold is not anyone else's debt. It is not anyone else's liability. It cannot be created with a few keystrokes. And for thousands of years, millions of people from all walks of life have been happy to use it as money because of its unique features (divisibility, durability, scarcity, difficulty in counterfeiting).

Gold is a commodity. But its price is not driven exclusively by the Indian jewellery market or investment demand. As a tangible commodity, gold has some of the aforementioned qualities that make it a fantastic medium of exchange.

And for people who trot out the canard that you can't buy a Big Mac with gold coins, what do you think goldsmith's notes were? They were receipts that indicated gold ownership and your ability to pay a debt. You could exchange goldsmith's notes as payment for goods and services because the paper claim was backed by a real asset. Goldsmith's notes were the precursor to bank notes. Same type of system, but with real money.

Is this all just some nostalgia for a financial system that no longer exists? Does gold have a real role to play in the future financial system? Of course it does! Gold is a threat to the fiat money peddlers from the warfare/welfare State because it exacts a heavy price for deficit spending and money creation. The expansion of credit or deficit spending is always possible in a fiat money system and thus placates voters with false prosperity borrowed from the future.

The rise in the gold price is telling us that markets are increasingly suspicious of the government-backed money and its ultimate affect on the real economy. Or, as guest essayist Greg Canavan says, " Gold is saying that the crisis is not over, that it is in fact getting worse. We are seeing Gresham's Law in action, as bad money pushes out the good. Gold is being swept off the market by millions of individuals who know that without fail governments always ruin the value of their paper money."

The only real - albeit shallow - criticism of the gold story is that it's primarily a U.S. dollar story. For Aussie investors, a collapsing greenback doesn't equate to a higher Aussie-dollar gold price. We would say, though, that this is a short-sighted appreciation of what gold is saying about the modern money system.

The modern money system is built on credit, debt, and government money backed by nothing. To believe that does not mean you'd covert all your assets to bullion, or all your shares to gold stocks. But it IS to believe that the architects of this system are criminals who effectively steal your wealth through inflation and control of the money supply.

If you have confidence in that system, you're a sucker. And if you don't hedge against its collapse, you're unprepared. After the last two years, is it so farfetched to believe that the foundations of financial capitalism - based on unsound money as they are - are weak by design and will fail in a world of increasing complexity and interconnectedness?

If you don't think it could happen, you haven't been living on Planet Earth. Either that or you're in a business where you want everyone to go back to doing what they were doing pre-Lehman collapse because it's good for your business. If that's the case, it's fine. But it's foolish to ignore 5,000 years of monetary history.

Yesterday we wrote about what happens when a complex network of trade and commerce begins to shrink as credit is withdrawn from the global system. Another side effect of the Lehman collapse is a bear market in trust. Trade, once free flowing and robust, becomes politicised. Trading partners begin to bicker.

Take Barack Obama's decision to slap a large import tariff on tyres made in China. It will probably just drive up the cost of cheap tires of middle-income Americans. But it makes America's unions happy, and Obama needs them to push through his health care agenda. China has responded with warnings about possible tariffs on U.S. poultry and auto parts exports.

It's probably not in neither country's economic interests to get in a trade war. But it reflects the ambiguity and hypocrisy of trade practices by both countries. There is no such thing as free trade. China subsidises production with cheap labour and produces at below production cost for some goods and services. America is happy to lose those manufacturing jobs if American shoppers get lower prices and have access to credit to make up for falling real wages.

But that whole strange relationship that has driven global growth for the last ten years has reached its use-by date. We're not sure what's going to replace it. But both parties are guilty of being currency manipulators and subsidisers. Formerly, their interests were aligned. Now, it's not so clear.

And finally a note from JL in Queensland about networks, nodes, and certain monetary commodities.

"Just my two cents worth. The difference between a node in a computer network vs. a node in the financial/economic system is that the node in the network can be self sustaining (provided that it's plugged in to electricity), whereas, most of the nodes in the financial/economic system are NOT self sustaining.

"The ONLY financial/economic node that would be self-sustaining and immune from ALL shocks (i.e. Exhibit the financial equivalent of homeostasis) is one that is 100% backed by a financial asset which is no one's liability. I'll leave you to guess what THAT financial asset may be.

Dan Denning
for The Daily Reckoning Australia

• Important Financial Anniversary: Collapse of Lehman Brothers
• Will Synchronized Rate Cuts Solve International Financial System Problems?
• Fed Willing to Print Money to Buy More Bonds to Keep U.S. Interest Low
• Is China Trying to Back its Currency With Metal?
• US Dollar As Reserve Currency Not Working Very Well

Well just a day after highlighting the size and scope of the Gorgon LNG project in Western Australia, we have news that it really is a big deal. It is so big, in fact, that Martin Ferguson, the Federal Minister for Energy and Resources, said Australia is emerging as an "energy superpower."

Shazzam!

Ferguson was in Beijing last night to sign a deal sending $50 billion worth of Gorgon gas to China over the next twenty years. Exxon Mobil will sell the gas to PetroChina and the Australian government will siphon off as much as $40 billion in tax and royalty revenues over the life of the project.

China gets energy. Exxon gets profit. Australia gets jobs and revenue. Investors get a whole new industry to play with.

Mind you, this comes after the Gorgon consortium agreed to sell $25 billion worth of gas to India over the next 20 years as well. The deals are truly flowing. And there could be more. "As well as Gorgon and Woodside, there is the Sunrise project in the Timor Sea," Ferguson says. He's right. In fact, there are four major LNG zones in Australia.

Back in April we wrote this in a weekly update to Diggers and Drillers subscribers, "The other three major areas of LNG development are the Browse Basin (off the Kimberley Coast), Darwin (for LNG from the Timor Sea), and Gladstone in Queensland (the proposed terminal for export of coal-seam-methane projects in the Bowen and Surat basins). Under the Howard Government, Australia had as ambition the production of 60 million tonnes of LNG per year for export (mtpa). The current capacity of the four regions, according to industry analyst David Wood is more like 90mtpa. That would be more than half of current global production of 175mtpa."

Some of those regions are considered "conventional" LNG zones. Others, like the coal-seam-methane district in Queensland, are "unconventional." There are a few small firms operating there that Kris Sayce has been all over at the Australian Small Cap Investigator. Ferguson is excited about these too. "We also have an emerging industry on the east coast -- coal-seam methane. So we now have the opportunity, in my opinion, over the next 12 to 18 months, of getting investments of up to $100bn in the LNG sector."

With all that investment pouring into LNG production, and all those contracts pouring money into corporate and government coffers, you have to wonder what all the fuss about iron ore is over. In dollar terms anyway, it seems like less of a big deal. Aren't Australia and China getting along swimmingly?

For example, yesterday we learned that Andrew Forrest's Fortescue Metals Group will cut iron ore prices by 35% from last year's price in exchange for $7.2 billion in loans to fund expansion of its operations in the Pilbara. We should note that the price cut was negotiated with the China Iron and Steel Association (CISA) and that the loans will come from Chinese banks.

What gives? It's not likely that Fortescue's agreed price cut of 35% from last year's benchmark price (which is just two percent larger than what BHP and Rio have already agreed to with Japanese and Korean customers) is going to influence the negotiations between Rio Tinto and the CISA. But that seems to be the message behind the deal: you play nice with us and we'll loan money to you.

Fortescue has agreed to sell 20 million tonnes of ore over the next six months at the discounted price. Keep in mind that annual seaborne iron ore trade is closer to 400 million tonnes a year. It is a big deal. But not a huge deal, certainly not the sort of deal that would bring down the spot price of iron ore, which at over $110/tonne, is higher than the target benchmark price being sought by Chinese firms.

In any event, it looks to us like pricing power in the iron ore business is moving toward a new equilibrium. The annual price negotiations in which the ore producers are represented by one party (that can be squeezed by Chinese political machinations) and the steel makers are represented by another party (in this case, the CSIA, which seems to have made a meal of it) will be replaced.

But with what? BHP wants a benchmark index. China, seeking price certainty and the control a large customer expects to have, resists.

Whatever happens, we're beginning to think that energy exports will matter a lot more to Australian bottom lines than iron ore exports. Of course BHP and Rio are large diversified miners and employers. Troubled relations with China for to the two largest miners by market cap on the ASX are not good for investors.

But what is good for investors is the LNG boom. The big risk, as with any commodity, is that increased demand leads to over-supply. But that is not something we're worried about just yet. These projects take years to develop and secure permitting. Just in time LNG doesn't exist.

That means the firms with the biggest head start and the best prospective areas are going to be worth punting on. At least that's the idea anyway.

But while we're at it, let's report that at least one major investment bank is predicting a second commodity boom driven by a shortage of capital spending and resurgent demand. You always wonder if Goldman Sachs is just talking its own book because it's already made its bets in the sector. But for what it's worth, Goldman is predicting another commodity boom.

"We expect a commodity supply shortage in 2010," a company report proclaimed recently. "We have long emphasized that the commodity problem is, at heart, a supply shortage due to decades of suboptimal investment, which has been exacerbated over the past year by the sharp drop in prices and tight credit conditions. As the commodity markets rebound with the broader global economy we expect a redux of 2008 when severe supply constraints forced the rationing of demand through sharply higher prices to keep the markets balanced."

Goldman argues that the, " imbalances have actually worsened owing to the sharp drops in prices and tight credit conditions that have further impeded investment. In this context, it is important to emphasize that the commodity crisis is, at heart, a supply shortage. Although emerging market demand growth has been strong, the structural rise in prices that has been a key feature of commodity markets for the past several years would not have occurred if supply were sufficient. In reality, trend demand growth for many commodities has been slowing due to supply constraints that are restricting overall demand growth despite robust emerging market demand growth."

Goldman's note goes on to recommend a handful of blue-chip firms that will benefit from higher demand growth. Firms like Cairn India, Cameron (US), CNOOC (China), Hess (USA), Peterobras (Brazil), Suncor Energy (Candada), and more. For Aussie investors, there are a smaller number of energy blue chips and a larger number of excellent speculations.

Dan Denning
for The Daily Reckoning Australia

• The Iron Ore Pricing War Between China & Australia
• Buying Oil on Sale as U.S. Dollar Gets Weaker
• Rio Scraps Deal to Sell to Aluminium Corporation of China
• Giant Costco Opens in Melbourne!
• Bailout Deal Will Expand China’s Influence in U.S. Economy

Commonwealth Bank reported its full-year results to the ASX earlier this morning. The highlight (or lowlight) was that second-half profit fell by 16% to $4.72 billion compared to the previous six-month period. This happened despite a 19% surge in home lending to $257 billion and a smaller 6% growth in business loans to $135 billion.

Does it look like the bank is doubling down its bet on Aussie houses?

For the full year, if you exclude the $612 million after-tax profit on the acquisition of BankWest, CBA's net profit after tax was down 9%. Cash earnings fell by 7%. CBA also took a $2.94 billion impairment charge for bad loans. It took a loss on notes in failed day-care provider ABC Learning Centres and noted, "Home loan arrears over 90 days and personal lending arrears have increased on the prior year with deterioration in the second half."

Trade the banks if you'd like. In fact, that's what Gabriel says you ought to do - trade the trends. But buying and holding may be a bad strategy if bank earnings and cash flows remain so unpredictable. And we reckon they WILL remain unpredictable.

If we're right, households have just begun reducing their debt loads. It will take years for the leverage in the system to be wound down. If you're buying bank stocks you're assuming credit and debt growth will resume once this recession is over. That's a big assumption. And probably stupid.

By the way, CBA also said - presumably because cash earnings are down - that it's cutting its second half dividend by 25% to $1.15 per share. That puts the full-year dividend at $2.28 per share.

It's not shabby. But remember, you still have your capital at risk. And as Kris Sayce has shown in his debut issue of the Australian Wealth Gameplan, there are other businesses in Australia with strong and regular cash flows that also pay you regular dividend income - arguably with a lot less risk to your capital.

In case you think we're just bashing Aussie banks, we'd suggest that the profit outlook for U.S. banks sucks too. U.S. stocks fell overnight. One big reason why is that JP Morgan came out with a shiny new report that said losses at bond insurer MBIA may wipe out capital at the firm. MBIA's shares fell by 13%.

Wait! Haven't we seen this film before? Is it possible that the recovery in earnings everyone used to justify the recent rally was really just a bunch of second quarter cost cutting, and NOT a fundamental improvement in business conditions? Is it possible, as John Hussman suggests below, that the fundamentals that supported the previous bubble have vanished, making it more likely that corporate cash flows are headed lower for years to come?

Hold that thought. One of the factors that led to an increase in second quarter earnings was cost cutting. And officially, cost cutting - when it entails firing people - improves productivity. It does not, however, increase wealth.

There are two kinds of productivity. The first kind is where you produce more because you have new skills and you can do your job faster and better than before and produce something better. Your personal output rises and the aggregate output of the economy rises. That's the good kind of productivity. Everyone wins.

The other kind of productivity is where you end up doing the job of three people because two others have been fired. That is the bad kind of productivity. Your output rises. But your increased work load doesn't mean the economy is using resources more efficiently or producing more goods and services per person. You are also probably at least three times more miserable, stressed, and unhappy...having more than three martini lunches or whiskey breakfasts.

So what do you make of the fact that U.S. productivity grew by 6.4% in the second quarter according to the Bureau of Labour Statistics? It was definitely the second kind of productivity growth. Second quarter output actually fell by 1.7% according to the BLS. But total hours worked fell by 7.6%, raising the output per worker by the most since 2003.

Alan Greenspan started yammering about productivity growth in 2003, when it looked like the U.S had leveraged the tech boom into a huge structural increase in productivity. The argument at the time was that computers and modern telecommunications had led to a huge surge in productivity.

The jury is still out on that. There are some industries that would simply not exist (or exist at the same level) without computers and the Internet (ours being one of them). But whether or not modern technology has made people more or less productive is an open question. Does Facebook make people more productive? Does Twitter?

It also depends on what kind of output you're talking about. If by productive you mean, "make more stuff" or you mean "generate more work." Information technology has generated huge volumes of work - information, trading, transactions - in the financial sector. But is the economy any wealthier for it? Has the capital stock of the nation increased?

Say's Law says that supply creates its own demand. What Jean Baptiste meant by that is that you create your own purchasing power and future demand by producing goods that you can sell. Those goods generate your income and that income becomes the source of your consumption. But in that old-fashioned way of thinking about things, all economic prosperity comes from producing things of value and selling them.

We live in the dying days of an era where people think wealth comes from consumption. Why else would the government encourage consumption without production via cash hand outs? It reckons this money will stimulate production by stimulating demand. But demand comes from people having money to spend to begin with. And they can only do this if the economy and the job market are geared toward producing wealth, not spending it.

Speaking of producing wealth, Chinese firms have been busy this week chasing Aussie real assets. State-controlled Yanzhou Coal has made a $3.5 billion bid for Felix Resources (ASX:FLX). This would be China's biggest Aussie acquisition to date. It values Felix at $18 per share, which is about 10% above the closing price before Felix went into a trading halt on the announcement.

And in today's Age, Barry Fitzgerald reports that Hebei Mining - the State-owned mining company of China's Hebei province - has taken a 14.9% stake in unlisted Western Australia uranium explorer Raisama. Raisama issued Hebei 4.5 million new shares and sold it 2.5 million existing shares at 25 cents a piece.

Raisama also said that, "''The Hebei provincial Government currently has plans to build at least three nuclear reactors and is selectively securing strategic interests in uranium exploration companies internationally that it believes have the best potential to meet the province's growing need for uranium."

Despite (or because of) all the controversy over the arrest of and bribery charges leveled at Rio Tinto iron ore executives in China, Chinese firms are still busy buying Aussie resource real estate. This is happening for a couple of reasons. China has heaps of U.S. dollars it gained in trade that it would like to get rid of before America inflates the value of them away. China also has long-term resource needs.

But since we've covered both those subjects before, let's address a different part of this equation: the valuation. Is China paying too much, too little, or just enough for its stake in Aussie resource firms?

Not all assets are created equal, we mentioned yesterday. For example, Commonwealth Bank's chief assets are its loans to customers and its deposits. But the deposits are callable by customers and the loans are only worth what they're worth if people can pay them back.

With resource companies, the main asset on the balance sheet is a mine, an ore body, or a lease or a permit to drill and/or explore a prospect. Sure, mining companies are capital intensive and this capital equipment shows up (in depreciating fashion) on the balance sheet, along with cash.

But the chief asset of any resource company is the resource it hopes to produce. Just what that asset is worth depends on a number of factors. One big factor is the quality and quantity of the resource. You want to know whether it's a reserve - a clearly defined asset with reasonable projections about how much can be produced economically, given today's commodity prices - or a resource (a less defined estimate of how much of a given commodity might be underground).

Other factors are the capital spending required to produce the asset (including mine constructing and ore processing, in some cases) and the operating expenditure. For example open pit mines are cheaper to build and operate than underground mines, and projects far away from infrastructure (rail, port, roads) have much higher operating costs. Labour and raw materials are also variable costs that tend to rise in a commodity boom, as we all found out in 2007.

The great variable in all this is the price of the underlying commodity itself. That changes based on both supply (other producers) and demand (economic growth, or the variables that drive individual commodity prices, including investment demand and speculation). In the traditional commodity cycle, high prices attract more producers and low prices drive out all but the lowest-cost producers with the lowest cost ore bodies.

Judging by this week's activity, Chinese firms are happy to take a stake in existing producers with clearly defined reserves and resources. But they're also happy to pony up the capital and fund explorers who have big hopes but no production and no clearly defined asset. So what does that tell you?

Maybe China is speculating on real assets the way Australians speculate on house prices and Americans speculate on stock prices. And what does THAT tell you?

For now, it tells us that Aussie assets - both equities and real assets in the ground - are in demand. Frankly it's all sounding bullish isn't it? Will Chinese demand for Australian resources diminish if the People's Bank of China tightens monetary policy to prevent bubbles in property and the share market? More on that subject tomorrow, including the dreaded Fibonacci retracement on the S&P 500.

Dan Denning
for The Daily Reckoning Australia

• Wesfarmers (ASX:WES) Increases Revenues But Not Earnings With Coles
• Banks or BHP?
• You Can Never Be Sure How Fabricated Income and Earnings Are These Days
• CRB Commodities Index Has Largest Decline in 50 Years
• Oil Was Down and the Banks Were Up

However, the question I find most interesting is whether gold is a real asset. One of the problems of investment is that there are two variables, reality and liquidity. Land or property are relatively illiquid, but are also real, in that they have a use which does not depend on their value in exchange. Gold is highly liquid, indeed it is more liquid than paper money. In extreme circumstances, paper money can lose all its value, when gold is still acceptable as payment. In 1940, when the French Army was defeated, many French people took to their automobiles to escape the advancing Germans. They found that petrol stations would not accept paper francs, but would sell their petrol in exchange for gold coins.

Gold also remains an acceptable currency in periods of high inflation, when paper money can lose all its value.

What does “reality” mean, when applied to an investment? Obviously we talk about “real estate” to describe the legal possession of property. I think that means property with a permanent character and at least a potential use. In the same way, the traditional theorists of the gold standard would say that gold was a real currency, because it has permanence and a potential non-monetary use.

I accept that reality in an asset is a relative factor. In an ideal world, we would all like to hold our financial needs in a currency with a high degree of permanence, strong alternative uses and high liquidity. We have to make do with currencies which fall short of perfect “reality”, and fall short of perfect liquidity as well. We make do with imperfect currencies because we have no choice.

Gold makes one think about these issues, but it makes one even more uneasy about electronic money. In book publishing, I am well aware of the library demand for archival books which can reasonably be expected to last for centuries, like the printed works of earlier centuries. We need also to have permanent money, which can be relied upon to survive, even it its value may decline over time. The historic value of gold has been astonishingly stable over centuries.

In an extreme example, one could be worried about the issue of money and about its preservation. Mr. Madoff has shown that fraud can reach the unbelievable level of $50 billion. Might there not be still larger frauds, so large as to achieve what the wartime German operation attempted, a complete take over of a targeted currency?

Cybercrime is already operating on a huge scale. Suppose that Al Qaeda, instead of attacking the twin towers, had attacked the electronic systems which record all the monetary holdings of New York. No lives might have been lost, but an electronic pulse might have erased one of the central counting houses of world finance. The world might have been ruined.

Is there not some element of this cybercatastrophe in the present world crisis. Reality may be a variable concept, with nothing 100 per cent real and hardly anything zero per cent. When I was born, in 1928, gold was money, and gold was over 90 per cent real. In 1970, when I was in my forties, money was paper, and even the convertibility into gold of the Bretton Woods Agreement was breaking up. Now money is a largely unidentifiable electronic pulse, itself vulnerable to attack by electronic means. Virtual money has very low reality, much lower than paper.

Surely this is a system which could be blown away because there is nothing in it to gain confidence. Even a return to paper money would raise the level of reality attached to world currencies. There is a problem of raising the reality level of all currencies – a problem which nineteenth century economists solved by convertibility to gold.

William Rees-Mogg
for The Daily Reckoning Australia

• David Ricardo’s Economic Theory is Sound Doctrine
• Gold is Money
• A Bull Market in Gold and Gold Alone
• Level 3 Assets Growing in All Five U.S. Investment Banks
• European Governments of the Eurozone are Separately Responsible for Their Euro-debt

The analysts were confident about valuations going forward, especially long term. Company execs swore their deals didn't need any money, while brokers and bankers alike had a gleam in their eye about the financing opportunities amid the debris - even a sense of urgency. One broker - my former business partner, actually - wondered whether the fundamentals for gold have ever been as bullish in our lives.

The answer was unambiguous. The market has answered too.

Newmont and Freeport this week filed documents in conjunction with potential underwritings by J.P. Morgan and Citigroup, in the amounts of $1.2 billion and $750 million, respectively, totaling just under $2 billion. Kinross sold UBS about $400 million worth of stock last week. Lundin's Red Back also negotiated a bought deal worth about $150 million with a group of underwriters led by Cormark Securities and BMO last week. Earlier this month, Yamana closed a $135 million share offer and borrowed $200 million, while in December, Agnico-Eagle raised some $300 million from stock issuances after borrowing $300 million a few months earlier (in September). Where's the deflation?!

The money is coming into the gold sector. The Canadian National Post reported last week that gold miners are "raising cash with ease... many generalist funds have jumped onto the precious metals bandwagon."

Many juniors have also reported financings where needed. Some are turning them away. Share issues are just too dilutive down here, and any company that doesn't need money to survive 2009 is prudent to refuse.

Asked about the ability of miners to raise cash in this environment, the analysts at the podium at the Cambridge House investment conference in Vancouver all agreed there is always funding for assets that have sound economic fundamentals. They finance themselves. In fact, in my experience, it is often better to buy the shares of companies with good assets that need cash than companies with cash and no assets, even if the latter are trading at a discount to cash breakup, and even if funding is relatively scarce. Companies with a lot of cash can sometimes get lazy and put up their feet, or insiders waste it - or even steal it, if they lack integrity. Cash itself yields nothing. It's a depreciating good, as you know. It's one thing to buy a company at below cash breakup and then break it up and keep the extra cash. It is another thing to invest in a company at cash breakup or less. We invest to earn profits.

If you want to buy cash at a discount, buy a T-bill or term deposit. Or else, you're just sharing in potential losses due to debasement, negligence, debauchery or theft. That doesn't mean you should avoid the deals that have a lot of cash - just that's not what you're investing in. You are investing either in the underlying asset, which yields profit (i.e., more cash in the future) or management's abilities.

Ultimately, sound "assets" will hold their value better than idle cash in an inflationary environment.

It is obvious that through this crisis, despite some turbulence, gold prices have held up better than just about any other asset, commodity or currency (other than dollars and yen) we may imagine. From the point of view of a gold miner, this is a very good thing. Even better is that the price of oil, a significant cost input for miners, has fallen a lot relative to gold. This is bullish for margins. Also bullish for gold miners is that the slump may have freed up capital and labor for the development of gold assets, where previous scarcity drove up capex estimates so much that some projects had to be abandoned.

The combination of strong investment demand for gold and lower input costs makes gold stocks one of the only sectors poised for any growth in operating results (i.e., earnings and cash flows) in 2009.

On the other hand, the ratio of gold prices to many of the commodities, and the averages, is at more than a 10-year extreme, and it is not sustainable. As a matter of fact, I think it could be a drag on gold prices. Gold is the only commodity challenging the resistance point in its post-March 2008 downtrend.

It looks poised to break out, and the other commodities appear to be bottoming.

However, while the extremity lasts, it could cap gold prices.

My feeling is that the gold ratios (i.e., gold prices relative to other assets, commodities and currencies) are going to ebb in the short term while commodity prices catch up a little. I continue to think that this catch-up phase will include a rally in stock prices, and a general recovery in risk appetite, even if short-lived. While it lasts, it is likely to shave a few safe-haven points off gold. It hasn't started yet.

I'm not looking for new lows in gold on this... just some backfilling and consolidation while the other commodities and assets catch up some. This could happen over the next few months. Then look out.

Regardless, however, I expect gold shares to benefit from the general return of risk appetite too.

That is, but for some ebb and flow, I expect gold shares to do well whether gold goes up or not - so long as it doesn't go down too much. As long as it holds the $800-850 level, gold shares are a buy.

It is still a buyer's market. Many gold shares are still factoring in a gold price of less than $800. But don't be hasty.

Rather, be deliberate, which means don't waver from the plan or your conviction on dips. Buy them. Try not to buy on days when everyone else is, like today, but make sure you have a shopping list and just pick away at it when you get the dip.

Investors should always wade in (and out) of their positions, rather than jumping in and out - as ole Jesse Livermore used to do. They called him the "Boy Plunger." He made big on the way up and lost big on the way down. There are lots of folks like that on Wall Street. They're big gamblers. You could say the Fed made them. They don't care about the black swan, because they believe that should they lose, they will just win again tomorrow.

Keep in mind, though, you're not buying blue chips here. Small-cap miners (and options) are extremely volatile and risky.

Remember this is for 10-20% of your financial assets - whatever you can sleep at night with. Some people can sleep with more - some can't sleep anyway. I guess the analogy doesn't apply to insomniacs, but you get the gist.

Good trading,

Ed Bugos
for The Daily Reckoning

• Exhausted Gold Shares
• A Trader’s Market or an Investor’s Market?
• How to Trade Gold Shares
• Oil Prices Under $70
• Gold Demand Looks Bullish As Dust Settles

If, on the other hand, you want to know why oil prices could double this year, or how $52 trillion in total global debt will utterly suffocate central bank attempts to resuscitate bank lending, or Ben Bernanke's secret plan to turn trillions of dollars worth of toxic assets into shareholder equity, read on!

You're still with us? Good. Now, why are oil prices lying?

Prices communicate information. The NYMEX February oil contract fell over 5% today in New York trading to $34.40. This suggests oil is falling in value, at least in the short term. And maybe that's not totally a lie.

After all, the current oil price results from two factors. First, the absence of leverage from the oil futures market leaves prices reflecting immediate supply and demand. With inventories full, the market seems well supplied (so much so that OPEC is cutting production). Second, the reality that oil demand will be flat or slightly fall this year because of the worldwide financial pandemic.

Adequate supply plus stagnant demand equals $35 oil. So why is the December 2010 oil contract trading nearly 80% higher at $61.80? What could possibly happen between now and December 2010 that would cause oil to go up 80%?

Well, for one thing you might be in the early stages of an economic recovery by then. Demand would have recovered. Shares could be higher. Everything could be fine.

But we can think of at least three reasons why the current oil price is headed much higher this year (not in 2010). First, the lower oil price is actually going to lead to lower oil production later this year and next. Oil production is declining to begin with. But the crash in prices has put the kibosh on exploration and production.

Second, as Diggers and Drillers contributor Mike Graham explains in a January article on the subject, the clear trend within the oil market is that historical exporters are exporting less oil. There are several reasons for this, which Mike gets into in his story.

One is that oil exporters are hoarding it now and waiting for higher prices later. Another is that oil exporters are consuming more of their own production, leaving less for export. And still a third reason is that the world's largest oil exporters face declining production trends thanks to...you guessed it...Peak Oil.

Yes. Peak Oil has not gone away. It's been sent to the corner while the Credit Depression hogs the stage. But Goldman Sachs oil analyst Jeffrey Currie issued a report yesterday predicting a, "swift and violent rise" in oil prices in the second half of 2009.

Currie told a conference in London that, ""Thirty dollar oil reflects the same imbalances that got us to $147 oil. The problems haven't gone away. We still believe the day of reckoning is to come." What problems?

There are still major infrastructure bottlenecks in the global oil network. Currie says that despite the big fall off in demand, "This is not 1982-1983 all over again. The supply picture's radically different...the demand picture's radically different. The key difference is that today there are no large-scale next generation projects that are going to save the world. Commodity demand is exponentially higher than it was."

This brings us to the third reason oil prices should rise later this year: the oil trade is back on. Sure, credit may still be a scarce commodity. But if you judge traders by their actions, you can see the market is setting up for a big oil back draft. As evidence, Bloomberg reports that, "Morgan Stanley hired a super tanker to store crude oil in the Gulf of Mexico, joining Citigroup Inc. and Royal Dutch Shell Plc in trying to profit from higher prices later in the year, two shipbrokers said."

Our friend Dan Amoss back in America calls this the oil arbitrage trade, where supply is stockpiled offshore, and thus withheld from refiners, allowing existing gasoline inventories to be worked down. Then in six to twelve months time, when crude prices have moved higher, you simply park your ship at the terminal and cash in on the difference between what you paid six months ago (today) and the new market price.

It is normal for the oil futures to be in contango, where spot prices are lower than futures prices. What's less normal is the amount of oil being stockpiled offshore. "Frontline Ltd., the world's biggest owner of supertankers, said Jan. 14 about 80 million barrels of crude oil are being stored in tankers, the most in 20 years," Bloomberg ads.

We also suspect that oil as an inflation hedge will come back into vogue later this year, which might be adding to the appeal of buying today at bargain basement prices. What's more, you can never discount (although you can never fully quantify) the geopolitical aspect of oil prices. A good general rule of thumb is the more war there is in the Middle East, the more likely oil is to go higher.

So what should you do? That's the subject of the January issue of Diggers and Drillers. More on that after we publish it for subscribers first later this week.

Next is a massive topic we are reluctant to introduce today. But we have to. There is no other way around it. It begins with a question: how much air is left in the credit bubble?

Actually, the question comes via Howard Ruff and Steve Hochberg. Let's start with Hochberg.

He's the lead analyst at Elliott Wave International. Bob Prechter's folks have been forecasting for years that the collapse of the credit bubble would lead to a general and massive deflation, including much lower gold prices. In his latest analysis, courtesy of a DR Reader, Hochberg explains:

"The systemic build up of total market credit is so large, currently about $52 trillion, that its implosion will swamp the Fed's attempts to inflate. And as CTC [Conquer the Crash] discusses, the remaining dollars that are not extinguished through bankruptcy, restructuring and write-offs, will increase in value. The thirst for cash will be insatiable relative to all other assets.

"Initially, the Fed's attempt to inflate was akin to using a garden hose to refill Lake Mead after the Hoover Dam collapsed. Over the past five months the chart shows that the Fed has graduated to a fire hose. But creating just over $2 trillion in the face of a contracting pool of $52 trillion in total credit market debt is just not going to get the job done, and the only thing getting hosed right now is us."

" Eventually credit will contract to the point whereby the income generated from economic production will be able to sustain it and at that point, yes, the U.S. dollar should indeed collapse of the weight of all the Fed's machinations and gold should soar. But before the market arrives at that point, deflation must run its course. In our opinion, there is still a long way to go."

But how far? A lot depends on the composition of that $52 trillion in credit. It can't all just vanish can it? But how much of it is securitised by relatively stable assets? And how much of it could potentially melt away under the intense heat of deflation?

This is not an easy question to answer. But it begins with knowing what you're dealing with. Specifically, you have to know who owes how much, and who owns how much. Those are two different questions. Let's deal with the first one. And we promise we'll make this as painless as possible. If you want to review this data yourself, by the way, you can find it here.

Keep in mind this data deals just with the U.S. And keep in mind it is government data. But the general question is this: how much deflation is left in the credit bubble and who stands the most to lose from it?

The Fed breaks up the total credit market debt outstanding into three categories: Domestic Nonfinancial Sectors (households, farms, nonfinancial corporations, state and local governments, and the Federal government), Financial Sectors (commercial banking, REITs, broker dealers, savings institutions, Government sponsored enterprise, Agency and GSE pools, and issuers of asset backed securities), and finally, the rest of the world.

What we find is that $32.9 trillion in credit market debt outstanding, as of the third quarter in 2008, was owed by the domestic non-financial sector. That's 63% of the $52 trillion total. Households are on the hook for most of that, with $13.9 trillion owed (or 26% of all credit market debt outstanding). That would mostly be home mortgages we reckon.

Next within the financial sector are non-financial corporate businesses with $7 trillion, non-farm corporate businesses at $3.7 trillion, state and local governments at $2.2 trillion, and the United States Federal government at $5.5 trillion.

So what does it tell us? Well it tells us that if U.S. house prices continue to fall, there is a lot of room left to deflate in the credit bubble, at least several trillion dollars. It's not hard to see this happening, given the rise in foreclosures, the prospect of even less federal funding for refinancing of mortgages, and the sudden collapse of America's banking model.

But the lack of credit for refinancing and the looming wave of Alt-A recasts this year and next is, in some sense, already old news. What also keeps us up at night is the $16 trillion in credit owed by the financial sectors. How much of that is at risk to further deflation?

You can get an idea by looking at the L2 table on page 59 of the Flow of Funds report. There is $6 trillion in corporate bonds outstanding. Nearly $5 trillion in Agency and GSE-backed securitised mortgage pools are on the books, and another $3.1 trillion in GSE debt itself. This does not include $1 trillion in "other loans and advances" which may or may not include home equity lines of credit.

We're sure you get the picture by now. There is still at least $8 trillion housing related assets owed by the financial sector. That might be kind of tough to pay off, given the falling value of the assets which securitise that debt. So who stands the most to lose if households can't pay their mortgages, corporations default on their bonds, and housing-related assets held by financial corporations continue to fall?

The financial sector combined holds $37 trillion in credit market "assets." It owns $37 trillion in other people's promises to pay. Those promises, all $37 trillion of them, are on the books at face value. What's more, U.S.-chartered commercial banks (Citibank, Bank of America for example) own $8.2 trillion in credit market "assets." Life insurance companies own another $2.9 trillion. Money market mutual funds own $2.1 trillion in credit market assets, while mutual funds own $2.3 trillion.

Do you see what we're getting at? The institutions that have the most to lose from a fall in the value of their credit market "assets" also have large obligations to shareholders and pensioners. Those institutions are counting on those assets to meet their own future liabilities (which do not fluctuate in value). And households are relying on those assets to retire, or in some cases, to live month-to-month on a fixed income.

Someone is going to lose, somehow. Or everyone will.

Households win if the value of the credit they owe (their mortgage) is written down or managed lower by some new law. But investors counting on that asset (often the household itself through a pension or life insurance) don't win if the amount they are owed is arbitrarily reduced.

Either way, Prechter's group is probably right. There is more deflation ahead. A lot of it. And not just in housing.

The corporate bond market would be another place to look. Corporate defaults haven't begun to rise noticeably yet. But faced with a much slower economy and much higher borrowing costs, it's going to be tough for highly indebted firms to roll over their debt, much less take on anything new. Dividends are already being slashed here in Australia.

And where does the deflation of the $52 trillion credit bubble leave us? Well Howard Ruff reckons we get a period of serious deflation, punctuated by a period of hyperinflation. Over at Kitco, he writes that, "First, we will continue to plunge into a major deflation period which will be characterized as a 'recession,' and later in the year as a 'depression.' Deflation and inflation are always monetary phenomena."

"Second, deflation will evolve into a run-away-hyper-inflationary depression because of what government will do to try to prevent deflation, which is synonymous with depression and has overtones of the 1930s."

How will government accomplish that? More on it tomorrow. Meanwhile, and finally, some timely reader mail.

"why do your emails have to be so long winded.... they waffle on toooo [sic] much, one metaphore [sic] after another... can any one really be bothered in there busy lives readin [sic] over all that.... I actually find some of the factual input useful, but there isnt [sic] much of that... a friendly tip, cut your newsletters/emails by 80%, get to the point and lose the metaphores [sic] and long winded useless stories.... the genuine potential investors your trying to pull in wont [sic] be inpressed [sic] with such dragged out point of views...I am a member of a well known share forum, many think the same as I do... the dailyreckoning could do allot [sic] better, it has so much potential, yet your [sic] boring people..."

Zzzz. Huh? What's that? Oh yes, this free daily e-mail about world historic financial events is too long and won't impress interested investors.

First, a tip. Maybe you should spend more time on spelling and grammar. But that is beside the point.

Sure the Daily Reckoning can be long. And we're grateful that you invite us into your living room and office each day to hear what we read. We don't take your time for granted, which is why put time and effort into what we write. And some times it takes time and effort to unwind a complicated subject.

If we had more time, the DR would be shorter. And in fact, we'd like to launch a subscription-based DR later this year. It would be a shorter, more to-the-point version of the DR with action to take. But in the meantime, we don't have the time for a shorter DR! So you'll have to deal with the long one. Or watch television instead. Your choice, if you're still reading that is.

Dan Denning,
for The Daily Reckoning Australia

• What is the Oil Price Telling Us?
• Pemex and Mexican Peak Oil Equal Expensive Oil
• The Coming Oil Back Draft
• No Spike in Oil Price Following IEA “Third Oil Shock” Announcement
• Oil Prices Under $70

By the way, by new low, we mean could the indices take out the March 2003 lows? For example, in the week of March 10th, 2003, the All Ords settled at 2,716. It would a nearly 23% fall to there from today's trading level.

This is not an exercise in fear mongering, by the way. For most of this week, we've been focussed on a scenario where an increase in the global money supply causes widespread consumer price inflation and at least some inflation in commodity prices. But we need to take a closer look at another possibility today-a staggering earnings depression in resource stocks.

And be warned, it is not pretty. The only good news is that there are at least two businesses we can think of that will do well in an otherwise abysmal situation. More on them further below.

Here is the problem in brief: we know that financial earnings will suck for the fourth quarter. While Aussie financials may be relatively better off than their U.S. and European counterparts, their ability to increase earnings (especially when they are so reluctant to loan to begin with) is suspect. Either way, with Bernanke talking about another effort to re-capitalise banks, it doesn't appear the supply of credit to the real economy is going to increase any time soon-at least not via traditional bank lending.

Next is the real economy. Last night we learned that industrial production in the Eurozone's 15-member bloc fell by 7.7% year-over-year. Couple this with falling industrial production data from China, Japan and North America and you have nearly irrefutable evidence that the first-half slowdown in the global economy is going to be a lot more severe than any of the official estimates by the likes of the IMF, the World Bank, and the Fed.

None of this is good for Aussie commodity demand. Even though commodity prices are already down by large amounts, we now have the possibility of an ugly earnings shock for Aussie resource producers in the first and second quarters of this year. Whether this is already priced into resource shares is a question we'll deal with in a moment.

But it would be wise to not underestimate the possibility of a massive, earnings-crushing double whammy for resources. First, is rapidly contracting global industrial production. This could lead to an unpleasant (and not priced-in) decline in Australia's export earnings. Financial earnings have already been decimated by the credit crisis. Now that the crisis is storming into the real economy, are resource earnings next?

According to the RBA, "Australia's export earnings make up around 20 per cent of total domestic income on average, and thus have a significant influence on economic activity." Two of the biggest contributors to those earnings over the last few years were coal and iron ore. Both saw huge increases in annual contract prices as pre-Olympic Chinese steel production soared.

But now the reverse is happening. The Chinese are working down stockpiles and inventories. And waiting. But waiting for what? They are not just waiting for a resumption in global growth, at which point they will resume production and demand for Aussie raw materials. No. They are waiting for March and April

March and April are the looming deadlines for the annual contract price negotiations for bulk commodities like coal and iron ore. Right now, spot prices are well under contract prices-a reversal from last year when Indian iron ore traded at a premium in the spot market to Australian contract ore. Indian spot ores traded as low as $65/tonne late last year. That's well below the $90/tonne price negotiated for 2008, and a lot further below the spot price of $200/tonne achieved earlier in 2008.

So what can you expect? Contract prices are going to come down, probably by as much as 40%. The steel producers could ask for an even bigger price cut, but that would ultimately affect the number of viable projects in the Aussie and Brazilian markets (and sow the seeds for a shortage and higher prices in 2010).

Before then, though, you can be sure the decline in contract prices is going to combine with a plunging global economy to punish Australian export earnings. Putting aside the effect this will have on national income (along with job losses to accommodate the lower demand for raw materials), you now have a situation where the earnings recession could lead the Aussie market could take out the 2003 lows.

Just to repeat: the proximate cause of a 22% decline from today's levels on the All Ords would be a brutal double smack down of much lower global industrial production in the real economy (lower resource demand) and a huge reduction in contract prices for Australia's two main export earners (coal and iron ore).

But what would all this mean for resource shares? That is the question. Well, as hard as it is to believe, we reckon it would lead to new lows. Despite their gut-wrenching falls from last year, there could be even worse ahead. Perhaps that is why today's Australian Financial Review leads with the story that "$60bn projects under threat."

The Fin reports that falling resource prices and the lack of access to credit could shelve $60 billion in new Aussie resource projects. And that's on top of the $11 billion in projects that have already been deferred or cancelled altogether. ABARE still reckons there are 85 advanced projects valued t $67 billion that will proceed. But what about the 347 less advanced projects, valued at $220 billion? Who is going to fund those in this climate?

And more important, what would be the best investment strategy in a situation where there is a final, blow-off contraction in the resource patch? Well, as a thought experiment, one way to avoid another massive fall in the ASX and All Ords is to simply liquidate everything now and keep your head low. Such a strategy acknowledges that the bottom of the cycle in commodities has not yet been reached, and that it is not prudent to hang on for grim death. Rallies would be sold.

However, that is not to say that the bottom of this cycle is going to leave you wandering in the equity desert for 20 years. Earlier this week, we published Dr. Marc Faber's analysis that commodities may be the one asset class for whom the current situation most resembles stocks in 1987-the big correction/crash was an interval in the cycle, not the end of it. What would that mean in this case?

It would mean that the real economic consequences of the credit crunch are going to accelerate in the first two quarters of this year, leading to much lower global trade, industrial production, and export earnings for Aussie producers. Already you see this with plunging freight rates. This economic slowdown, along with the seemingly inevitable contract prices for coal and iron in March of this year, mean a steep drop in Aussie resource stocks in the next four months.

And then?

It's important to remember that commodities are heaving perfectly naturally and cyclically at the moment. "We know that this is a perfect economic storm," says Mitch Hooke, the CEO of the Minerals Council of Australian in today's AFR. "There is going to be some wreckage, there is going to be some damage and there will be a drop in supply. But demand will come back and then outstrip supply, and when that happens there will be a rapid recovery in prices and then production."

He's right, of course. This is basic cyclical economics. Its how things worked in the first stage of the resource bull. The increase in prices and the availability of finance led to surge in publicly listed explorers. Mind you with the exception of the base metals, you did not see a huge increase in new commodity supply come from all these new explorers (that's important later).

But now, the cycle has reasserted itself on the downside. Boom gives way to liquidating bust in the commodity sector, where free market economics still functions (unlike in finance). Slower final demand and tighter credit are pushing non-producers and those resource companies without cash or lines of credit right to the wall. There's nowhere left to go for many of them except out of business or into the hands of larger acquirers.

This too, is part of the cycle. When small would-be miners with quality resource projects and ore bodies lack the financing to produce those ore bodies (and can't live off the production of another working mine) they don't survive, at least not without help from a larger, cashed-up producer. This has an obvious effect (and also represents an opportunity for investors). Supply of commodities and minerals falls as the small firms disappear and the big ones mothball capacity. "Pebbles" get scooped up.

But when will the cycle bottom? This year? Not that we're a big believe in equilibrium, but the fall in supply will eventually get more in line with current demand (which itself may fall for awhile). And so you get a consolidation and contraction for a few quarters. Equity prices would react to all this much sooner, of course.

But what is the general, long-term trend for commodity prices? If we accept Marc Faber's analysis last week, the commodity cycle is not dead. It is merely resting. After a 20-year bear market and a eight year bull market, the cycle must now work through effects of a credit contraction and slower global growth.

Some analysts, like those at UCI say that the long term is good, even if the short term could be very gad. "The secular trend remains upward due to tight supply/demand fundamentals. In medium term, focus will be on global slowdown, easing inflationary pressures, dollar recovery, monetary tightening - all bearish for commodities."

Mind you, even in such a bearish argument for commodities, you might find an exception in gold producers, although not the explorers. The junior gold explorers are fast, like everyone else, running out of finance. Our forecast? Gold production is going to fall this year at the same time gold prices rise.

We've focused so much on the demand side for gold as an inflation-hedge that it's easy to forget gold is a mining business. You have to find it and dig it up. It is hard to increase the mine supply of gold.

True, there are large above-ground hoards of gold held by central banks. But in terms of mine supply, you can probably expect lower production this year, meaning those gold producers without debt might make attractive investments, even in the first six months of this year-and especially if the gold price reacts to the increase in global money supply.

Another exception might be LNG. Our man Kris Sayce at the Australian Small Cap Investigator has been all over this story. In fact, his two LNG share tips from the last two months are each up over 100% already. Kris was able to spot the bull within the bear. LNG is rapidly emerging as a substitute for oil as a transportation fuel (see the Pickens Plan by U.S. billionaire T. Boone Pickens).

LNG is also an infant industry in Australia. But it's already attracting the interest of large foreign firms who want in on an energy source coveted by Asian economies like Korea, Japan, and of course, China. So even amidst the general bearishness in oil prices, a punter could find some nice little earners in the Aussie energy patch.

LNG and precious metals are the promising exceptions to the bearish general trend of commodities. It's what our analysts are working on full time at the moment. And there may be others. But we thought it important to at least explore a scenario in which things get much worse for commodities. It's hard to believe that's possible.

However, we simply don't know-and no one does-how markets will react to increasingly large sums of money injected in the global banking system, or what direct Fed purchases of assets might to world's economy. In the long-term, as we've said before, the high saving emerging market nations are going to cease funding U.S. deficits and develop their own economies-focused more on domestic demand export growth.

That scenario-growth of consumption in the emerging world-is commodity intensive and favours Aussie producers. But getting to that that next stage in the global economy is easier said than done. Will it happen this year? Next year? In five years? Nobody knows.

Tomorrow, we'll return to the subjects of banks, the alchemy of turning debt into equity, and what it all means!

Dan Denning
for The Daily Reckoning Australia

• Australia & China: Already Partners in the Commodity Boom
• Dollar’s Demise Has Started a Chain Reaction in Currency and Commodity Markets
• Commodities Tell Us the World Won’t Stop Turning in a Financial Crisis
• Commodity Inflation Causes Consumers to Cut Back on Spending
• The Australian Resource Boom Isn’t Dead Yet

It might be too much to say Vancouver got its start with a bunch of alcoholics, but there's no denying that Jack Deighton, or 'Gassy Jack,' as he was known, had a hand in making the city.

As legend has it, Gassy Jack, a garrulous Yorkshire-born steamship operator, arrived in 1867 with a yellow dog, a First Nations wife and a barrel of whiskey. He solicited help from workers by telling them if they helped him build a tavern, he'd give them free drinks. So they did, and within 24 hours, the Globe Saloon was open for business, slaking the thirst of a rough frontier crowd of miners, trappers and loggers.

When a little village grew up around the saloon, Gastown was born.

This is where modern Vancouver began. Today, Gastown is the old section of the city. You can stroll down its cobblestone streets adorned with antique street lamps and stop off at one of the many bars and restaurants. You can see the old steam clock on Water Street, a local landmark. (But it's kind of a sham, because the steam clock is actually powered by electricity. It was also built in 1977, despite its antique look.) There are also some shops hocking the usual kitschy fare like faux totem poles and snow globes.

Salute the bronze statue of Gassy Jack, standing atop a whiskey barrel, in Maple Square. Then head over to my favorite microbrewery in the city, Steamworks, and order a Lions Gate Lager and a brick-oven pizza.

As you wipe the beer foam from your lips, you can think about the story of early wealth creation in Vancouver. Spanish explorers in search of the Northwest Passage arrived in the 18th century. You can still see their influence in street names such as Cordova, Cardero and Valdez. The British explorer Capt. James Cook also hit the west coast of Vancouver Island, looking for the Northwest Passage. Vancouver, though, gets its name from George Vancouver, who sailed the inlet in 1792.

Eventually, a number of early explorers, including Simon Fraser and Alexander MacKenzie, helped map the region's interior. In 1824, the Hudson Bay Co. began running fur trading posts out here. In 1858, prospectors found gold on the banks of the Fraser and Thompson rivers. The first sawmills along the Fraser River opened up in 1860. And there you have the triumvirate that drew adventurers and entrepreneurs from all over - furs, gold and timber. Into that swirl stepped Gassy Jack.

I like the city of Vancouver and enjoy going there every year for my publisher's big annual conference. This year's theme tackled investing in the age of scarcity. Perfectly appropriate for the market we find ourselves in.

Gassy Jack and all those early explorers, adventurers, prospectors, loggers and miners did their part to spice up the 19th century. As with most of the history of the Americas, fortunes bloomed as men beat paths to nature's riches. It was the basic stuff - metals, timber and other commodities - that made men rich. The voracious appetites fueled by the Industrial Revolution and rising urbanization created enormous demand for the natural storehouse of riches in the largely untapped Americas. If you were bold and talented (and lucky), you could strike out on some open valley or inviting hillside or promising riverbank - and dig or plant or pan your way to fame and fortune.

Despite all the advances and promises of the 21st century, we still need those basics. We've always needed them, but there is new urgency to the quest. The motor for that demand is a sort of second Industrial Revolution, in China and India, in particular. But it's a revolution that broadens out to many emerging markets. The analogy is not lost on certain investors.

Jeremy Grantham heads up GMO, a respected money manager. Grantham has been largely spot on in the big-picture sense of staying bearish on stocks for the last eight years or so. He is bullish long term on commodities. In his latest quarterly letter, Grantham makes some good points about the future of commodities and emerging markets.

His conclusion first: 'In the short term, slowing world economic growth combines with credit, currency and inflation problems to dominate the outlook and offer poor prospects for emerging markets and commodities. Longer term, the reverse is true, and they look like the assets to own.'

It is mostly the long term (looking out a couple of years) that interests me, although I obviously don't aim to step into any immediate problems if I can help it.

Longer-term backing for commodities demand comes from two sources, Grantham says:

'The first is that if enough people enter economic take-off at approximately the same time, as 2.3 billion Chinese and Indians have now done, then the pressure on resources might happen to increase marginal costs slightly faster than technology could offset them.'

This has already happened. It's why the price of oil, for example, is so much higher than historical averages. All that demand hits very quickly, but it takes time to bring new supply to market. In the interim, higher prices result.

This seems well-known already. Most investors realize that behind the commodities boom stands surging demand from countries such as China - former 'runts' now muscling in on the global dinner table.

The second reason is more interesting. Grantham believes that the global growth spurt has come at the expense of eating away at some hard-to-replace resources:

'Underground water resources that currently sustain some of our most productive land but, like a metronome, tick off a reduction of several feet each year; rain-fed waters that, although renewable, are finite and already so overused that previously valuable lakes retreat to sometimes disastrous local effects and river volumes, once seemingly limitless, are now fought over; subsoil, which took thousands of years to form, is depleted through casual use (in the Midwest, for every bushel of wheat produced, it is said that a bushel of subsoil is lost. Our farmers are in the mining business! Yes, the soil is incredibly deep, but it is still finite); high-grade mineral ores are fully developed, the very best are long gone and all are irreplaceable; previously fertile land has often been overgrazed and turned into desert.'

At Mayer's Special Situations, we've been on the water beat since this publication began in summer 2006. We've also watched the agricultural boom unfold, and we've picked up nice profits along the way. We are, in fact, still invested in these ideas.

Along with these ideas, oil, natural gas and base metals all have become more difficult and expensive to produce. Recently, we've had to sit through a pretty tough correction on the commodity names. Stocks in these sectors have sold off in a big way this summer, as I've noted. Based purely on fundamentals, though, these stocks haven't looked this cheap in years.

But short term, such drawdowns are common on the way to eventual higher prices. Grantham, too, says as much:

'The prices of commodities are likely to crack short term, but this will be just a tease. In the next decades, the prices of all future raw materials will be priced as just what they are: irreplaceable. Oil, for example, will never again be priced on the marginal cost of pumping a marginal barrel from some giant Saudi oil field, as has been the practice for most of the last 100 years of oil production. Real cost is always replacement cost, and oil, a precious feedstock for chemicals and fertilizers, simply cannot be replaced.'

I don't take as hard a plumb line as old Grantham does. I believe there is, even now, lots of room for innovation and replacement. Oil, for example, is replaceable in a broad sense. We can get energy from a broad array of sources. But it's not an easy or painless transition.

Slowing economic growth is the bigger issue. That's problematic for most commodities, short term. The market, though, is probably punishing the commodity companies too severely. That creates some interesting opportunities.

You can more easily pick up stocks trading for discounts to readily ascertainable net asset values now than anytime in the last five years, in my view. It doesn't mean making money in commodities is a lock or that it will be easy. Lots can go wrong with individual companies, and the drawdowns will probably be more than most investors can stomach. But longer term, looking out a few years, I think an investor will be happy with the portfolio assembled in the doubtful summer days of 2008.

Regards,

Chris Mayer

for The Daily Reckoning Australia

• Each Major Economic Trend Rises and Falls
• A Worst-Case Commodity Scenario
• Oil Prices Under $70
• Fall in Commodity Prices Will Reduce Inflationary Forces
• Commodity Inflation Causes Consumers to Cut Back on Spending