Sector Alert: Bernanke Is Making It Rain How you can profit from Russia’s cash and reserves surplus By Christian DeHaemer, Editor, BreakAway Investor A few years ago, professional football player Adam “Pacman” Jones threw 81,000 dollar bills off the balcony and onto the floor of a strip club in Las Vegas. The urban dictionary defines this act, popular in rap videos, as “making it rain.” A mêlée broke out when Jones wanted his money back. Shots were fired and everyone had a bad day. Jones said the rain was just for effect, not for keeping. Perhaps he changed his mind halfway through. No Free Lunch This reminds me of the current state of affairs at the Treasury, the Federal Reserve, Congress, the Pentagon and the White House. This government is spending money at the fantastic rate of $1 billion per minute. One of the core ideas here at Taipan Publishing Group is that the massive increase in the global money supply will spark high, double-digit inflation by the end of this year. Most economists will tell you that high rates of inflation are caused by an excessive growth of the money supply, too many dollars chasing too few goods — and that’s just what we will have once the production contraction and the dollar supply pass each other in the night. M2 Is Off and Running According to the Federal Reserve, money supply (M2) is growing at more than a 10% annual clip. M1 is growing at a 23% over the last six months. M1 is basically currency and travelers checks; M2 adds savings accounts and money market accounts. M3, which included things like derivatives, stopped being reported a few years ago. Both of these numbers are much higher than the Fed’s previously stated high water mark of 5%. And they don’t take into account Obama’s budget of $3.93 trillion for this year, and $3.55 trillion for next. Let’s not forget the TARP and TALF bailout programs that haven’t even been made public, much less added into the official numbers. And there’s a war on… and something about full medical coverage for all… The truth as reported by the Federal Reserve Bank of St. Louis is that the total currency and bank reserves, or the “monetary base,” more than doubled from 2008 to 2009. In the past three months it’s gone up 50%. This type of money expansion has never happened before in the U.S. And it is worrisome to say the least. Fast Cash The Fed is printing money to overcome the lack of credit. Money doesn’t expand in a vacuum. It is affected by the rate at which it turns over, or velocity. It is also affected by the real value of production, or what economists call output. In other words, you can find the real value of cash by multiplying money supply by its velocity, divided by output. (M*V)/Q = P — where Q is output and P is prices. The question is what factor will win. We know money supply is expanding and velocity and output (down 8.7% in Q4) are slowing down — as proven by savings rates increasing, factories shutting down and productivity falling 0.4% in Q4. Rain Falls Over the past six months, the velocity of money in terms of lending has hit a brick wall, leading to deflation in housing, food and oil. However, this will not last forever. All of that money has to go somewhere. Buyouts are picking up, including a $41.1 billion buyout of Schering-Plough (SGP:NYSE) by Merck (MRK:NYSE). Friends tell me they are refinancing under 5%. Mortgage brokers are hiring again, and corporate lending is picking up. The steep drop in velocity is reversing. Growth will return as companies buy up their competitors at a discount. This increase in velocity will spark a resurgence of inflation. When this happens, the safe haven of the U.S. dollar will be exposed as a sham. Assets priced in U.S. dollars like gold, oil and other hard assets will spike both as a true safe haven against inflation and due to the teeter-totter effect of the real assets/dollar relationship. The Russians Are Coming Given that argument, I want to invest in non-U.S. based hard assets. When I’m looking for a new investment during times when major currencies are changing trends I look for two things: pricing power parity and basic economic numbers. Pricing power parity shows you which currency is undervalued. The Economist has a Big Mac Index that shows which of the top 20 industrialized countries has the most undervalued currency. Russia, Reborn Since oil started falling and the dollar started going up, the Russian stock market has been killed. This was the fastest drop of any index. Russia’s fortunes are heavily tied to hydrocarbon and minerals. When the commodity boom went to bust, all of the foreign money fled Russia, fast. This is because in the last bust Russia defaulted on some of its debt, and because speculators — including Russian banks — were shorting the ruble. The fact that it invaded Georgia didn’t help either. But history never repeats itself and this time, it’s different. Russia Has Cash Moody’s Investor Service said recently Russia won’t get a downgrade on its credit rating as the ruble has stabilized and the government isn’t taking on corporate debt obligations. Ruble Rises After falling 35% over the last six months, the ruble is up 2.8% since the end of January. This is key because it means that foreign investors are no longer fleeing the country. And Russia still has around $400 billion — the seventh largest foreign currency stockpile in the world. The U.S., by contrast, is going $3 trillion in the hole and counting. Not only does the country have cash, but the bad news is that its budget surplus is shrinking. That’s right, I said surplus. According to The Moscow Times, the government’s budget surplus shrank to 116.3 billion rubles ($3.3 billion) at the end of February from 359.8 billion rubles the previous month. This is expected to be Russia’s first budget deficit in 10 years. The U.S. has had one budget surplus in my lifetime, back in the later Clinton years — and that was jerry-rigged with duct tape and bailing wire. Russia Doesn’t Need to Borrow, Which Is the Opposite of the U.S. According to its top economic adviser, Russia has sufficient oil fund reserves to “live through this year without borrowing.” The government has no plans to sell bonds until the market improves and it switches to an expansion mode. The fact that the currency has stabilized means that as a non-Russian investor, I get a 35% discount on one of the world’s major energy producers — that’s in addition to the 70% discount on the equities. Things are changing. The cost of Russia’s largest export Urals crude is up 31% from its low in late December. Strong Defense The big story in Russia is that it blew through $300 billion in foreign currency reserves in an attempt to halt the slide of the ruble. Much like the defense of Stalingrad, it was messy and brutal but it would seem it worked. Reserves rose $2.4 billion to $384.3 billion in the week to Feb. 27. For the month, the decline was only $820 million. Low Inflation but Going Up Russia’s inflation rate stood at 0.3% between February 25 and March 2, the Federal State Statistics Service reported March 4. Meanwhile, inflation amounted to 4.2% for the year to date, compared to 3.7% for the same period of 2008. The government has projected that inflation in Russia could reach 14% in 2009, due to increased borrowing from reserve funds to cover the nation’s aforementioned budget deficit. Russia is also putting up $55 billion as part of a social bailout package and to cover some troubled banks. Dollar Drop The rising inflation and deteriorating balance sheet in the U.S. will inevitably cause the U.S. dollar to fall. This in turn will boost Russian stocks due to its oil and natural gas resources, which are priced in dollars. Most of the negative news is priced in. The major stock Russian exchange has bottomed and is up 27% in the last month. The fast money is coming back. In addition, Russian isn’t part of OPEC. OPEC is cutting petroleum output in an effort to boost the price of oil. Russia can and will sell as much as it can produce and benefit from OPEC’s cut in production. The simplest way to play the return of Mother Russia is to buy the Market Vectors Russia ETF (RSX). RSX tracks the DAXglobal Russia Index and you can buy it like you buy any other stock. The ETF’s major holdings are Gazprom Neft ADR, Gazprom OAO, Lukoil ADR, Mobile Telesys OJSC, NK Rosneft’ OAO, Rostelecom ADR, Sberbank Rossii OAO, Surgutneftegas OAO and Vimpel-Communications. In other words, the fund is heavily based on energy with a couple of telecoms thrown in. This fits our worldview for 2009-2010. It’s Priced for Armageddon These numbers represent past earnings, and so represent the past more than the future. This means that they are still pricing in 2008 numbers, when oil prices for the year averaged around $90. With Ben “Pacman” Bernanke making it rain in the U.S., the greenback’s days as the world’s safe haven will end. In anticipation of that, oil will climb back over $70 per barrel by the end of this year and the value numbers on Russian stocks will revert toward their mean and their share prices will soar. Consider Market Vectors Russia ETF (RSX) for your portfolio.