Despite the current, volatile environment, though, the expert team at Casey Research maintain their core prediction: that a highly inflationary cycle is not far off. While we, along with several external experts, continuously review our assumptions and conclusions and encourage dissenting opinions and analysis to avoid biased conclusions, so far we keep returning to our views about what’s coming. That said, the hardest thing to predict is not what will happen, but when.

The way I see it, the swift, far-reaching and mostly ill-conceived reactions from most of the world’s governments under the leadership of two apprentice sorcerers (Bernanke and Paulson) have until now resulted in a widespread run for an exit to nowhere, a deep credit freeze, and total and indiscriminate mistrust in the market and all of its players.

The fact remains that in the last year, many principles that have long been rooted in the success of capitalism have been thrown out of the window.

• First, market players discovered that the longest-lasting asset bubble in recent history was made possible by poor regulations (as opposed to lack thereof), greed, and the misunderstood and misrepresented risks of credit derivatives.
• Second, we found out the real meaning of “too big to fail.” If a business is large enough and has enough clout, it doesn’t matter how poorly managed it has been, it will be bailed out at the expense of taxpayers (us) and investors (us again).
• Third, we found that the rating systems the financial markets had been relying on have been misleading investors and failing to identify some of the riskiest asset classes. As a result, investors and all other economic agents are left with no means of evaluating risk as they conduct business, hence the credit freeze and rush to cash.
• Fourth, to add to the confusion, the U.S. Fed and Treasury, followed by many other central banks, have been altering the rules of the game by the minute (buying toxic waste at face value, bailing out certain financial institutions but not others, becoming shareholders of several behemoths in the banking and insurance industry, and trumping all accepted rules of creditors’ and stakeholders’ priority, prohibiting the shorting of certain classes of assets on a moment’s notice).
• Last but not least, the U.S. presidency, weakened by almost eight years of mismanagement, has continued to show total lack of leadership. It has empowered a couple of technocrats to run the country’s finances without leadership until a new administration gets in and, hopefully quickly, figures out what to do. To make matters worse, the EU has shown its ugliest face and demonstrated a fact we all truly knew but didn’t want to recognize until recently — that economic unity and coordination is easy in good times but almost impossible when the going gets tough.

No wonder economic actors are wreaking havoc as they race for shelter.

Add to this the fact that all natural resources have been hammered by the combination of a credit freeze and lower real and anticipated demand from most industrial nations.

Finally, junior exploration stocks – being very thinly traded and rightfully considered to be in a higher risk class — have been hammered twice as hard as the rest of the markets (hence the performance of the TSX-V, which has lost 76% in the last year and 30% in the past 30 days alone). The fact that many hedge funds had to unwind large positions in such a small market certainly did not help values.

What does this mean for investors in this market?

We all have suffered significant losses in our portfolios, and although our choices may have reduced some of the downside, quality companies have been hit almost as hard as fly-by-night juniors with no future.

Several of our companies are trading at or below cash value and get no goodwill for the significant assets and outstanding management teams they have assembled.

Although there is no way to tell when we will hit a bottom in these markets, we believe that once tax-loss selling season is over and reality settles in, we will see the beginning of a slow recovery process for the best of the juniors. Investors who have the ability to stay the course and are invested in the highest-quality juniors will recover from their losses and benefit from what will eventually be another bull market in commodities.

Precious metals and agriculture, followed by certain segments of the energy sector, will lead the way to widespread price increases across the range of commodities. While we can’t predict the exact timing of this run, the fundamentals are in place once the world economies take a turn for the better or at least stabilize somewhat.

Here is why:

• The current crisis is taking tremendous amounts of needed capacity off the supply pipeline. Whether it be energy, base metals, or agricultural goods, projects to bring online expensive oilfields and alternative fuel sources are being shelved and will take years to get back on track. Mines are closing and projects are being canceled, thereby removing much of the supply; the credit squeeze is cutting down on agricultural investment, and working capital constraints will dramatically limit supply.
• The world’s demographics are not changing, nor are the aspirations of a hard-working, fast-growing middle class in emerging economies. The changes that drove commodity markets up for the last few years are long lasting and real.
• Peak Oil and peak-everything. There is limited supply for many commodities, and although there are alternatives (curbing consumption and finding alternative sources of energy), it takes large investments to do so. In current markets, many of these investments are going to be put aside until the next crisis/shortage hits – at which point we will have years of a commodities bull run before an equilibrium is reached.
• We anticipate that China, Russia, and India will take advantage of low commodity prices to secure very large, long-term supply commitments while the Western world licks its wounds and tries to recover. By the time we do, an even larger portion of the world’s available resources may no longer be available on the markets, for example oil and gas.In the last edition of Casey Energy Opportunities, Marin Katusa pondered how the U.S. is going to replace the supply of uranium when the HEU program with Russia is set to expire in 2013. The answer is that the U.S. will struggle to replace 40% of its needs, and this will benefit a handful of U.S. suppliers with proven reserves. Currently shares of these companies, which have the cash to develop resources or are already producing with positive cash flows, are incredibly cheap – a win-win situation. Eventually similar opportunities will come from copper and strategic metals.
• We can expect the world to continue to be a very unstable place, where regional conflicts can quickly spread and spin out of control, with obvious impact on the smooth supply of key commodities (Gulf region, Nigeria, former Soviet republics, to name a few). In fact, a widespread financial crisis could precipitate those events as conflicts are often linked to economic hardship.
• The unprecedented deficits, a wave of bailouts, and growth in the money creation by central banks in the Western world will eventually lead to massive inflation. In the U.S. alone, the monetary supply has increased by 50% since early September. This will unequivocally reverse the current short-term deflationary pressures and lead to a steep devaluation of the dollar and other major currencies. At that point, precious metals and all tangible assets are poised for a strong recovery.

So, if you ask me if I am still bullish on the resource sector, my answer yes, now more than ever. Juniors are juniors, and when things go wrong, they get beaten down. The strong ones with great teams and lots of cash will survive and prosper, the others will disappear. When commodities come back with a vengeance, there will be fewer companies, almost all with good projects… and those who are invested in these few companies will see a very sizeable appreciation of their capital as the broader public returns.

It’s very hard to be a contrarian investor, especially when all forces seem to be against you, but one thing the markets have taught me is that memory on the Street is unbelievably short, and they will come back.

Not only is the economy presently going haywire, there’s also still the boogeyman of Peak Oil looming on the horizon. While oil prices are at a low not seen for a while, it is all but certain that this sweet relief for motorists won’t last very long.

When oil prices come roaring back, the energy market will virtually explode… and,  if you are safely positioned in the right stocks by then, your bank account will too. Learn more about how being a contrarian investor can earn you a fortune – click here.

Source: Lost Principles

According to an Oppenheimer research note picked up by Dow Jones MarketWatch: “As more than 80% of corporate funding came from the capital markets during 2007, we can’t help but believe that such a massive extraction of liquidity from the market will have a profound impact on the U.S. economy. [...] As bank balance sheets show similar strain to brokers’ own balance sheets, there is little room in the system to ‘pick up the slack’ vis a vis corporate lending.”

Despite the doom and gloom, i-banks have rallied this week.

“Banks have a lot more things to worry about, however,” says John Stepek. “Even if the latest writedowns represent a beginning to the clear-out, we won’t see a return to the days of easy credit for a long, long time. Lehman Brothers’ rights issue was over-subscribed, but it’s not that surprising, given the terms on offer. The convertible preference shares pay a 7.25% dividend

“The problems in the financial world caused by the credit crisis are now firmly entrenched in the ‘real’ economy. Even in the days before credit derivatives became so widespread, a worsening economic environment was always bad news for banks. With so many other dodgy debt instruments linked to corporate defaults and credit card debt out there, we can expect to see more parcels of toxic debt revealing themselves as conditions worsen.”

The first true credit default swap was carried out as late as 1995, although various types of credit protection derivatives existed earlier. Its structure is similar to an ordinary interest rate or currency swap transaction, and the CDS market is covered by the International Swaps and Derivatives Association Inc.

Under a CDS, a bank originates loan to a company. A second bank (or other financial institution) can agree to cover the credit risk for the loan, by agreeing to make payment to originating bank if the company defaults on the original loan. The originating bank pays a small insurance premium to the second bank for assuming the risk of the loan.

Typically, payments under a CDS would only be triggered by the company’s failure to pay interest or principal on its debts due to bankruptcy or some other severe liquidity issue. But there are a host of intermediate or special cases that will doubtless provoke lawsuits when something goes wrong (CDS being a new market, it is by no means “recession-proof”).

Credit default swaps were sold to the world as hedging transactions. Investors were told that they were simply transfers of risk, so that banks that made loans could transfer credit risks to insurance companies, which did not make loans directly, or to foreign banks that could not easily make loans in the U.S. market.

And if an originating bank sells its loan exposure only once, and sells it to a financial firm of undoubtedly solid credit, the CDS does indeed act as a hedge for the originating bank; it transfers the company’s credit risk from the bank to the financial firm that bought its CDS.

But the product did not work as advertised.

Enter the Traders

Salesmen and traders took over, and expanded the volume far beyond what was required for hedging.

After all, bonuses depend on the volume of business. Therefore, bank traders sold the credit risk of a loan not just once, but as many as 10 times. And they sold it not to solid banks and insurance companies, but to three solid banks, one solid insurance company, three dodgy brokers and three hedge funds. Then the traders went out and sold other CDS products that were not even related to actual loans on the books, but to imaginary indices of credit quality in the “widget” industry.

The credit risk of the system was hugely multiplied.

Instead of one $10 million credit risk loan, there are now ten $10 million credit risks on just one loan.

• Three on solid banks – but will they stay solid?
• One on a solid insurance company – probably OK.
• Three on dodgy brokers – who knows?
• And three on hedge funds – probably not OK in a real downturn.

The total credit risk in the system has been increased from the original $10 million loan to somewhere between $160 million to 200 million, depending on whether the banks and insurance company are financially solid.

Of course, a lot of those credit risks offset each other, so that if the company that took the loan goes bust, the only risk to the bank that sold all those CDS is to the profits it expected to make. But since it probably hedged those positions against others, if the company does go bust, and dodgy brokers and hedge funds stop paying up, the total losses in the system from that company’s credit risk are likely to be a substantial multiple of the original $10 million loan.

But please don’t think I was exaggerating when I said as many as 10 credit default swaps got sold for each loan.

The U.S. commercial loan market is worth about $5 trillion, yet the volume of CDS outstanding is currently no less than $50 trillion. In other words, a huge number of traders, salesmen and quants have been making money off this product, without any real “hedging” rationale at all.

And it all worked fine while the volume of defaults remained low, which is why the market expanded from $2 trillion to $50 trillion between 2000 and 2007.