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Today's Market WrapUp 04.16.2008 Mon Tue Wed Thu Fri Puplava Archive
Last week’s WrapUp provoked a lot of responses from both the commodity bulls and bears. I had hoped to get ahead of the likely bear comments by addressing several of the arguments that they would likely claim but ran out of time and space as last week’s article was already fairly long. However, I did address one reader’s comments by e-mail and will be using that e-mail exchange as a follow-up to last week’s article to present a more in-depth analysis of the commodity bull market versus bubble debate. The comments made by the reader are presented below with my original responses as well as additional material. Dear _____, First off let me thank you for taking the time to share your thoughts, and particularly so as they are contrary to my own. The smartest investors are those who keep an open mind and listen to both sides of a story, which is why I appreciate you sending your thoughts from the opposing side. One of the things I had hoped to write about was what the commodity bulls should be looking for in terms of warning signs of a bubble as the party will not go on forever, but run out of time and space. However, I would like to address some of the points you made.
My response to your statement is I am not amazed at all. The industrialization of major nations brings about demand for all types of resources for building their infrastructure from copper, lead, zinc, iron ore, oil, as well as food demand when diets improve. We’ve seen these periods before, but more importantly, the major driving force is not only demand but currency debasement that results in inflation/disinflation cycles. These alternating periods of inflation and disinflation typically last 20 years, though with bumps along the way. Secular inflation and disinflationary periods are associated with nearly all commodities rising in inflationary periods and nearly all falling in disinflationary periods. Were you amazed that virtually all commodity prices fell from 1980-2000? That period was the other side of the price appreciation coin that most forget. These secular trends in commodities are the historical norm, not aberrations. This can be seen clearly when looking at just a few categories from the producer price index (PPI) over roughly the last 100 years. As seen below, these six categories all show directional similarity during secular inflationary and deflationary/disinflationary periods. Figure
1 There are several causes for these secular periods of inflation and deflation. Two developments associated with secular periods of inflation are warfare, which puts a strain on resources that often leads to shortages, as well loose monetary policy relative to GDP. Though both warfare and loose monetary policy can be separate events, they often go hand in hand as governments increase national debt levels to finance wars. These links are shown in the following two figures with the first showing the link between monetary policy and inflation. As seen below, the secular periods of inflation and disinflation were associated with loose monetary policy during the inflationary period (1960-1980) and a tightening of monetary policy during the disinflationary period (1980-1995). The second figure below shows the secular inflationary trends over the last 100 years that are associated with major wars with the newest inflationary trend being characterized by the industrialization of China and India as well as the Iraq War. Figure
2 Figure
3 As Mark Twain said, “History doesn’t repeat itself, but it does rhyme.” This can be seen with the secular periods of inflation and deflation/disinflation below, with inflationary periods lasting from 20-22 years in length with deflationary/disinflationary periods typically lasting 10 years with the most recent episode characterized by a protracted trough that elongated the cycle to 21 years before inflation picked up. As you can see, there is a certain long term rhythm-like breathing of inflation and deflation as the economy undergoes booms and busts. Figure
4 Like the PPI figure shown above, the CPI figure below illustrates how secular inflationary periods are characterized by periods of warfare that put a strain on the resource sector. The CPI figure below shows nearly 200 years of historical data of secular trends in inflation that shows warfare either exacerbates secular periods of inflation that are already underway (Second Seminole War, American Civil War, WWI), or can actually be a catalyst in igniting a secular inflationary trend (WW II, Vietnam War). Figure
5 As shown in the PPI figure, there is a rhythm-like pattern in secular trends of inflation and deflation, with secular trends in inflation lasting between 15 to 20 years with deflationary periods lasting between 10 to 15 years. Looking back over the last 200 years of history shows that the cumulative annual rate of inflation has run about 1.41% with the positive upward trend in inflation shown below. Figure
6 Figure
7 As the figures illustrate above, the fact the commodities move in tandem both up and down is not surprising as the overall inflationary/deflationary climate tends to dominate the price direction of commodities in concert. So history clearly shows that IT IS NOT DIFFERENT THIS TIME as commodities are simply following the historical script.
Your point is spot on with “substitution” being one of the highest threats to strength in any one particular commodity. Whether it is competing agricultural products or energy products, when the price of one particular commodity rises significantly, demand destruction is seen as consumers and industries switch to lower priced alternatives (Ex: “As other staples soar, potatoes break new ground”). This then causes the price of the commodity to fall as inventories rise when demand shifts toward the use of cheaper substitutes. These substitutes then rise in price and you have rolling bull markets where various commodities rise when they become the chosen substitute for the previously higher priced commodity. We have seen this with corn and soybeans. The point is, agriculture products collectively rose because users just switched between one commodity to the next with there being no aggregate demand destruction (at least as of yet) as we are still in a secular inflationary environment characterized by foreign country industrialization. The lack of aggregate demand destruction can be seen in the CRB Foodstuffs Index below that is in one long continuous bull market that started at the turn of this decade. Figure
8
Two quick points to make are that price points can be incredibly misleading and bull markets tend to surprise to the upside. Just look at the huge moves in Cameco Corp. (CCJ) and Titanium Metals (TIE). Both corrected sharply only to skyrocket higher, with Cameco jumping to 1750% higher from the start and Titanium Metals up nearly 10,000% (previous period shaded red in longer term chart). Figure
9 Figure
10 Figure
11 Figure
12 We’ve seen huge moves in individual commodities as well that looked like bubble implosions that turned into nothing more than corrections and consolidations. For example, copper went parabolic in 2006, corrected sharply, but the supposed bursting bubble is turning into nothing more than a consolidation and looks quite possibly to be heading to new highs. Figure
13 Gold too had a sizeable advance in 2006, reaching more than $715/oz and then fell 22.5% or $160/oz in just a few months. The financial media called an end to the bull market in gold which was merely consolidating before reaching new highs. This is quite similar to the 1970s experience that saw gold correct 42% before heading higher with the correction posing more as a seventh-inning stretch then the bottom of the ninth. Figure
14 Figure
15 The point is that price alone is meaningless unless you have something to compare it to be able to have a multiple or some type of ratio. The stocks above, as well as the agriculture stocks you site need to be compared to earnings, sales, cash flow, or some other metric to determine if they have reached bubble status. Titanium Metals Corp. price multiples expanded to outrageous levels in 2006, which clearly was a bubble. Another example of price points and bubbles is housing. Housing prices alone are meaningless unless they can be compared to something else to tell you if there was a bubble, which is why I used the median home price to median income last week as an example to determine that housing was in a bubble. Looking at residential fixed investment as a share of total GDP showed that it had reached two standard deviations above the long-term average, a clear statistical extreme characteristic of a bubble. Like I said, price points (absolute numbers) are meaningless; its relative numbers that give you the big picture. Figure
16 Figure
17 So again, to determine if there is a bubble in commodities we look not at absolute numbers alone, but relative numbers, whether to something else or to historical norms. As was shown last week, comparing the energy sector’s weight to its historical past shows there is no investor driven bubble, not even close. The mania period in energy was seen late in the 1970s when energy’s weight in the S&P 500 nearly doubled from 15% to 30%. Energy’s weighting would have doubled from here to be close to its previous mania high, so according to the historical script, NO BUBBLE. Figure
18 In addition to historical comparisons, another way to measure what inning the commodity bull market might be in is by a relative comparison between hard assets and paper assets, again using relative numbers, not absolute numbers. Comparing the CRB Index relative to the 30 year government bond price shows the relative extreme the two reached at the height of the last commodity bubble in 1980. The ratio between the two reached a peak near 6.5 in 1980 and a low of 1.69 in 2001. With the current ratio at roughly 3.5, the CRB Index (commodities) would have to nearly double while bonds remained flat to reach its former relative high as we are still in a secular inflationary period. Figure
19 As stated last week, whenever commodities undergo a sprint northwards in price and then cool down, the media is quick to declare an end to the so-called “commodity bubble.” However, what is really going on is a secular bull market that frequently takes two steps forward and one back before reaccelerating. Secular bull markets are characterized by several bull markets that are longer and greater in magnitude than the bear market countertrend corrections. The converse is also true in secular bear markets where the bear markets are longer and greater in magnitude than the bull market countertrend rallies. These patterns are shown in the two secular markets in yields below. Figure
20 Figure
21 In summary, price alone is meaningless and devoid of substantial evidence of a bubble; it’s relative numbers that illustrate the evidence of a bubble. Moreover, it is far too easy to lose sight of the forest through the trees in terms of confusing a bear market correction as the bursting of a bubble when it is nothing more than a pause along the way for a secular trend to catch its breath.
To address this question, I would imply that there are many exceptions to the rule, and that while historical relationships can hold in the long run, there may be several short run examples of a deviation in trend. So, although the dollar may recover this year as foreign central banks lower interest rates, gold may not necessarily correct when the dollar rallies. An example of the dollar and gold moving in the same direction is the late 1970s experience. Gold saw its greatest advance in its last bull market during a sizable dollar rally and went parabolic. It wasn’t until inflation finally peaked that gold corrected. Figure
22 Figure
23 As inflation continues to remain elevated it is unlikely that gold will have peaked in this cycle. Moreover, deflationary forces have now turned into inflationary forces that will now add more fuel to the inflationary fire instead of cooling it. Imports from China were deflationary as a result of their cheap labor force, but no longer. The Chinese have allowed their currency to appreciate relative to the dollar to combat their own inflationary problem, making their goods more expensive to U.S. consumers. Thus, the outcome of a dollar rally on gold is uncertain, particularly so if inflation remains elevated. Figure
24 The final remark in the e-mail exchange is presented below and is a great exclamation point to end this WrapUp on commodities…
The only people who got burned in commodities and gold have been the traders through imperfect timing, not investors. This point is made clear when looking at the charts below that begin in the lower left corner and end in the upper right, which translates into bull market investing and long term capital gains, not losses. Figure
25 Figure
26 Figure
27 In conclusion, I have a question for all the commodity bears and bubble callers out there. Within the context of typical secular inflationary periods lasting from 15 to 20 years, and the current beginning roughly five to six years ago, what inning does it appear we are in? Closer to the first inning or ninth? Figure
28 Today’s Markets The markets rallied right out of the gate on yesterday’s after-market release from Intel Corp. who reported earnings of $0.29 per share, four cents higher than the consensus. Other earnings surprise on the day lifted the markets more than 2% despite a rally in oil prices that carried oil to nearly $115/barrel and gold up $15.60/oz to $944.30/oz as the dollar index sank 0.89%, falling to 71.38. The rally was broad based as all ten S&P 500 sectors were up on the day with the materials sector posting the day's strongest gains with a 4.96% advance led by Monsanto (7.22%) and Freeport-McMoran (7.32%), with the financial sector coming in second, up 3.30% on the day. The Dow Jones Industrial Average rose 256.80 points to close at 12619.27 (+2.08%), the S&P 500 gained 30.28 points to close at 1364.71 (+2.27%), and the NASDAQ rose 64.07 points to close at 2350.11 (+2.80%). Advancing issues represented 82% and 70% for the NYSE and NASDAQ respectively, reflecting a strong market advance. Chris Puplava Copyright © 2008 All rights reserved.
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