For the S&P 500 to justify trading recently at 30 times earnings (twice its historical norms), analysts used the low interest environment and the US economic recovery as the rationalisation for high valuations. Now that interest rate increases in the US have become imminent, global stock markets have plunged. Why? Because:

• the level of debt in the US credit market is at historic levels
• interest rate increases may affect the housing market very negatively

As these are the props that sustained the US consumer, increase in rates can jeapordise the economic recovery, affecting the performance of equities. In addition, as rates rise, bond prices fall and bond portfolios will likely get decimated in the next few months.

Add to this the problems with Iraq, China’s attempt to cool off its economy and the surge in oil prices and things suddenly look much bleaker than just six weeks ago.

There are some analysts expressing concern about an impending stock market collapse! Mind you, there are always some analysts calling for a stock market collapse.

But there are genuine risks out there. According to Morgan Stanley’s chief economist “By digging in its heels and keeping the federal-funds rate negative in real terms, the Federal Reserve has now pushed America firmly into a multiple-bubble syndrome. This is shaping up to be a policy blunder of epic proportions.” So while the US economy shows real strength, there are deep structural problems underlying this growth.

Yogi Berra said, “I don’t not only don't know nothing, I don't even suspect nothing.” It’s far too dangerous an environment for you to have that attitude with your savings/investments…

So where do investors hide? Bonds are going to take losses as rates rise and stocks have far more downside risk than reward. The US $ is on a tear but with the budget and trade deficits at record levels and growing, it is defying the logic of supply and demand in the short run and is not likely to be sustainable. Asian equities perhaps, but as we can see from recent market activity, they are highly dependent on the state of the US economy and stock markets. Real estate and cash reign supreme, and alternate assets like commodities have performed very well.

Warren Buffett, the CEO of Berkshire Hathaway and the second richest American (over $ 40 billion in net worth) says he can’t see any value in the US market and has bet heavily against the US dollar, for the first time in his 40 plus year investing career.

Commodities should be part of the solution. You should seriously consider taking a part of your capital and investing it in this sector. I provided detailed reasons for this in earlier issues of this newsletter (First Issue/Second Issue).

But, should you invest in physical commodities (such as gold and silver) or invest in shares of mining companies or play the futures? What is the best risk-reward strategy?

This will, of course, vary for the individual investor. Future trading is complex and can generate substantial returns but at a high risk. You must know what you are doing or your capital can be wiped out in short order. This is something best left to the professionals, though I’m not sure anyone really knows what is going on with the derivatives market. Warren Buffett has called this $ 150 trillion market (80% of which is betting on interest rate spreads) a “weapon of mass destruction” and if it ever goes haywire, it may well take the global financial system with it.

Physical holding of precious metals is advisable as insurance. This should preferably be in bullion (bar) form as coins typically have a high premium built in over the value of the gold contained in the coin.

Jewelry, too, contains high making charges and so it is not ideal for purely investment purposes. It does have the advantage that it can be worn at social occasions while you wait for a global financial disaster to occur, but will your wife ever let you sell it...

What about equities of mining companies? Well, let’s assume you bought US $ 10,000 worth of physical gold on July 2, 2001, around the time that gold had begun to bottom out, at around $ 269 per ounce. You’d have bought about 37.2 ounces of gold.

Or you could have invested the same amount in the HUI, which is a weighted index listed on the American Stock Exchange (AMEX) and is made up of 15 of the largest mining companies in the world. Its value at that time was about 60.

Assume you just held the investment and then sold it on December 31, 2003. At the time, the price of gold was $ 416 and the index was at 255.

The value of your gold holdings would have risen from $ 10,000 to about $ 15,500, a total return over 2.5 years of 55%.

The value of your precious metals equities would have increased from $ 10,000 to about $ 42,500, a total return over 2.5 years of 325%.

What if you’d invested US $ 10,000 (equivalent to $ 15,600 Canadian dollars) in the shares of Wheaton River Mining, the first mining shares I bought when I returned to Canada, in October 2001. The price moved from Canadian $ 0.60 to $ 4.17 by the end of 2003. Your investment in Canadian $ would have increased almost 7 times (!) from $ 15, 600 to $ 108,700. As the US dollar had dropped in the meantime (giving you an additional foreign exchange gain), you’d have received an a total return in US $ terms of 595%.

While the Wheaton example is a singular one, you can see the power of investing in mining companies rather than the precious metal itself.

Why the difference? Because these companies are publicly listed on various stock exchanges, their shares trade at a multiple of present and future earnings.

Let’s take a very simple example to illustrate the point: If the price of gold climbs from $350 to $ 385, your holding of physical gold is up 10% in value. But, for a company mining gold, its revenues just went up 10% while all its costs remained essentially the same. That increase then goes straight to the bottom line.

So, let’s assume that a mining company has revenues of $ 10 million with a net profit of $ 1 million. With the increase in the price of gold, its revenue just increased to $ 11 million. As all costs are constant (it did not cost any more to produce or sell that gold), the $ 1 million becomes pure profit, increasing net profit to $ 2 million.

As earnings per share would have doubled, the price of its shares and therefore your investment in that company would have doubled as well.

So you can see a theoretical example of how a 10% increase in the price of gold can double the share value of a mining company. Add to that the speculative element of further anticipated rise in prices and mining discoveries, and you can see why multifold increases in equity values are possible.

Of course, in the real world, things change even in the short run. Costs do change in anticipation of growth, financings lead to dilution, etc. But the principle is true in general. The value of equities of resources companies increase faster than the value of the underlying commodity over a period of time (and vice versa when commodity prices fall!), and constitutes a different risk-reward trade-off to investing in the commodity itself.

In the period above, when gold prices soared, there were numerous companies that increased their share price many times their original value. So, if you believe that commodity prices are likely to increase, then you should be investing in Canadian resource companies. These would be producing and exploring for gold, silver, copper, oil and gas, nickel, platinum, diamonds and other resources.

Investing in commodities entails risks, as these are volatile in nature. In the coming months, though, I suspect they may well seem tame compared to what may happen with traditional mainstream asset classes, such are bonds, stocks and real estate.

How to invest in Canadian resource equities, where to do research and how I might be able to assist are topics for the next newsletter.