Commodity Boom? You Ain't Seen Nothing Yet!

In America we have become accustomed to quick fixes to address the consequences of our mistakes and painless remedies to cure our afflictions. The trouble is many times we are merely focusing on the symptom and not the core concern and the problem re-emerges far greater than before. As we reach the end of the era of "Renegade Finance" I fear that the attempted cure and palliative measures will be even worse than the disease. You see the disease is leverage and this period of transitional de-leveraging is going to be more economically painful (both financially and psychologically) than anything we have experienced in our lives. The pain is unavoidable. The tragedy is that it is going to be so much worse because we are misdiagnosing the problem and exacerbating the real problem with fiscal and monetary policy measures already in the pipeline with even more to come.

You basically have two camps on opposite ends of the political-economic spectrum battling to "fix' the problem, both of which incorrectly identify the problem and offer harmful solutions, though well-intentioned they may be. Coming from the political left we have the philosophy of Keynesian market tinkering and interventionism followed by the Democrats. They typically favor policies which focus on consumption and pin the recent market failures on tax policies which favor the rich and on regulatory policies which are too lax and lead to abuse and excess of the securitization of debt, derivatives and other nefarious banking activities. George Soros yesterday joined company with the view espoused by Charles Morris in his recently released book "The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash," that the Reagan-Thatcher era of deregulation and lower taxes spawned the financial mess in which we now find ourselves. Coming from the political right are the supply-side monetarists who attribute our economic woes to a falling dollar and who call for even lower tax rates in order to spur further investment and draw more foreign capital. These are the Republicans who are clearly on the defensive with a Republican in the White House presiding over the current credit market debacle and looming recession. They are relenting on policies which will bring much more regulation and oversight to the financial services industry. Of the two groups, the latter is the one more stunned and somewhat disillusioned over credit meltdown and economic contraction we are now experiencing.

This brings me to why I believe that the "cure" could be worse than the "disease." The Bush Administration's new policies-fiscal, regulatory, and monetary (ostensibly independent but usually supportive of the Administration) are in fact designed to pre-empt the Democratically-controlled Congress whose solutions would go even further to stimulate consumption, broaden regulatory reform and enact legislation to change real estate law. The Democrats are on offense and the Republicans are on defense. The disheveled Republicans are trying to figure out what went wrong with their free-market philosophy. The Democrats receive even worse marks for thinking that their meddlesome policies to rein in the so-called excesses of the Regan era is what the system needs. The Gordian knot of this entire financial fiasco rests entirely with the Federal Reserve and our current fiat currency regime.

The Democrats' prescription for increased consumption and fiscal policies that will require even more money creation are precisely what landed us here in the first place. The Republicans falsely think that they are pursuing free market policies. They are not and this is the source of their dismay.  They do not understand that not allowing the market to set the interest rate negates the positive effects of all other free market policies. Whenever you have a group of people (the Federal Reserve) in charge of setting an interest rate and supply of money that runs counter to what the free market would have otherwise allowed, you have a system bound for failure. Interest rates have been chronically too low and money supply has been increasing at a fevered-pitch. 

We have had one asset bubble after another as a result of the total abandonment of any ties to the international gold standard and the Bretton Woods Agreement. Is it any wonder all of these bubbles have occurred only since 1971? You can link to my article "Debt, Demographics & Debasement are Destiny" for a further explanation on this topic. Isn't it clear that one day we will no longer be able to add more money and credit to the system. We have had one major bubble per decade since 1971, each bubble bigger than the last and requiring even more money creation than the prior bubble.  We have become addicted to ultra-expansionary monetary policies, credit growth and dependence on asset inflation, all of which were believed to be necessary to correct the problems associated with the last bubble. Need I remind you what the definition of insanity is?

The results of the polices being hurled upon us is going to be much higher inflation...Inflation which is going to make the costs of necessities of everyday life sky rocket at a time when American consumers will least be able to afford it.  A declining job market, failing economy, and de-leveraging credit market which makes credit even harder to come by will result, as Curtis Hessler writes in his April 2008 "Professional Timing Newsletter in the following:

Many expenses like fuel, food, medicine, education, taxes, and insurance will continue to march higher. These increases will mostly be a matter of rising commodity costs that are passed on to the consumer. There is nothing anyone can do about the price of depleting supplies of crude oil. However, discretionary spending will come under fire, and competition for that money will be intense.

So you see, the resulting policies' inflationary effects are akin to pouring salt in the wounds of struggling US consumers. I am in complete agreement with John Williams of Shadowstats.com when he writes:

The U.S. Treasury and Federal Reserve are effectively broadcasting that they will accept any cost - in terms of creation and loss of regulatory integrity - in order to save the domestic financial system. The alternatives -an imploded financial system, chaos in the citizen's daily living, collapse in normal business activity, social and political upheaval - are unthinkable to the powers that be. Unfortunately, their cures will be just as destructive, if not more so in the slightly long term. The government is only buying some time which has been traditional practice. Yet the current actions taken to stabilize the financial system have stet a course for [worse] inflation, which will eventually feed upon the U.S. government's long-term insolvency.

In a Pimco research paper titled "Renegade Economics: The Bretton Woods II Fiction," the authors warned us back in September of 2007 that "The world economy is on the threshold of significant upheaval because of the substantial structural change in the global financial architecture, now popularly known as "Bretton Woods II." Bretton Woods II is the informal de facto currency world that emerged in the world of fiat currencies after the collapse of formal Bretton Woods (I) Agreement. It is of note that Pimco is considered a leader in the world of fixed-income and they choose their words carefully. The authors succinctly sum up the risky environment we have created for ourselves, one that "artificially distorts risk premiums and encourages destabilizing financial practices such as the so-called "yen carry trade,"warning:

The hallmark of the pure paper standard is the indefinite postponement of
international payments imbalances, all the more so when its major violator possesses
sufficient military "currency" to prevent its creditors from punishing it for ongoing
profligacy. Under the gold standard, a deficit country, if it persisted in its deficit,
would eventually run out of gold. UnderBretton Woods II, a deficit country, if it is
the U.S., can keep right on printing money, especially if its creditors on the other side
are equally determined to perpetuate poor economic policies that enable them to
avoid the obligations otherwise imposed on them by an externally imposed and
neutral system such as the gold standard. The gold standard prohibited consuming
more than the stock of gold in the Treasury and since it was beyond the control of any
one nation, it made serial abuse of the system virtually impossible.
If BWII is indeed an offspring of Bretton Woods I, then, it can best be described as a
bastard child.

While this may be Waterloo for the Leveraged Fed-Financial-Industrial Complex and the US Stock Market, the fallout from de-leveraging and a government war on deflation (get your Whip Deflation Now! button) will result in even more inflationary policies from our government.  The prices of essential goods and services will be sent higher and the asset prices of homes and stocks will descend lower. The more the government intervenes, the more inflation we have, and the worse it is for consumers causing the government to want to intervene more.

This is looking to play out exactly opposite of how the last Great Depression of the 1930s did. We had tight monetary and fiscal polices before everything crashed before.  The US was the world's largest creditor nation and we were still tied to gold standard until FDR severed the tie in 1933. We had decade of debt deflation and depression as a result. But we are so much smarter now. Determined not to let this happen again, the Fed and the government are stirring fears of another deflationary depression and lining up inflationary and wrong-headed consumption-based stimulative package(s). And because the rest of the world will debase their currency to remain economically competitive we are on the cusp of the world's first hyper-inflationary event. Up until now a debate on whether we are returning to the stagflation that the U.S. experienced in the 1970s has largely focused on the "stag" or anemic growth part of the phenomenon. I think that within the next 12 months, we will be focusing on the "flation" aspect. We no longer have the gold standard to discipline/prevent us from printing too much money.  Instead of being the world's largest creditor nation, we are now the world's largest debtor nation.  It is evident to me that the handwriting is beginning to show up on the hyper-inflationary wall.

Protect and Prosper

Up to now I have been laying the fundamental groundwork for to buttress a more technically-based investment case I am about to make. While our politicians and government officials are leading the mainstream masses over an inflationary cliff a select few will benefit enormously, sadly to the cost to the majority. Despite what you might have heard or read in the popular financial media over the last couple of weeks (see the cover article of the most recent Barron's cover story explaining away the commodities boom as a speculative bubble), the transition of hard assets outperforming paper assets is about to accelerate. Since 2000 it is clear that hard assets have performed much better on a relative basis. Up until very recently both asset classes yielded positive returns since the bear market for stocks ended in 2002 (though hard assets performed much better). As a surge in inflation beckons, I expect that returns for paper assets and U.S. treasuries to again yield negative returns. The money that does not evaporate in those asset classes will pour into commodities and hard assets.

This will not occur overnight or all at once. The commodity correction which began three weeks ago could play out over the next couple of months. The money will begrudgingly begin rotating in soon, however. For now, the eternal optimists (typically the supply-side Republican types) are in all their glory as the US dollar firms, commodity prices drop, and US equities led by tech and financials rise.  Most of us (except for the extreme socialist Democrat types) want to hold on to the idea of a shining American exceptionalism and our glorious past. Such optimism that once served us well will turn out to be harmful greater investment community who think that they are investing in innovations that will create an even greater America. The American Dream is in severe need of a monetary cleansing and a restoration to honest money before such investments are prudent again. Those less ideologically-inclined might recognize their fallacy soon enough in the current inflationary environment and make the transition before they lose much of their wealth.

What is so amazing to me is that so few financial advisors have recognized the pattern of the rotation of hard and paper assets outperforming each other, a tend that tends to last 15-20 years. This has occurred without interruption since 1870 as Barry Bannister illustrates in the chart below:

CHART 1 (Courtesy Barry Bannister) U.S. Stock Market Relative to Commodities

Again, this reveals a bias against commodities as an asset class. Because this commodity bull market began around 2000-2001 most commodity bulls adhere to the 15-20 year up-cycle pattern, believing that we have at least another decade for this bull to play out.

Alternative View on the Commodity Cycle

I believe that the commodity cycle might not last the normal 15-20 years, but will rather "flame out" in spectacular fashion over the next couple of years. I base this alternative scenario on the following:

1)The previous three bubbles each lasted about a decade, with the rally having a final exhaustion phase in a year ending in "0" - 1980, 1990, 2000, 2010?

2)Physical demand for commodities will continue to rise against a backdrop of supply constraints

3)A torrent of new money created to offset the harmful economic effects of de-leveraging will be looking for an investment home

4)Commodities will become the safe-haven asset class where the flood of new liquidity will flow

5)Investment speculation will rise very sharply forcing prices to almost unimaginable high prices that will eventually cause rapid disorderly demand destruction, plunging the emerging markets into their first recession

The following charts support my view:

Chart 2: US Money Creation 1960-2005

Chart 3 (Courtesy TheChartStore.com): CRB Commodity Index Since 1956

Chart 4 (Courtesy TheChartStore.com): Nikkei 225 Index Since 1970

Chart 5 (Courtesy TheChartStore.com): Nasdaq Composite Index Since 1971

The first point I would like to make concerning the above charts is that I have used the US (M1, M2, and M3) as a proxy for the growth in worldwide money supply. It is evident that money supply began its real growth after Nixon closed the gold window in 1971. While the measure of money supply has grown roughly 20 times since 1970 economic growth has grown a fraction of that. The excess money has to flow somewhere. In the 1970s it largely flowed to commodities and hard assets. In the 1980s the Japanese Stock Market was the bubble of choice. The 1990s saw the spectacular rise of the Nasdaq outpace other groups. Each of these three bubbles was twice the size of the preceding one in terms of the peak return before the collapse. Again, note on the chart that the peak was achieved in a year ending in zero.

The commodity rally of the 1970s rose approximately 2.5 times (120-320). The Nikkei rally of the 1980s experienced a five-fold rally (8000-40000). And in the 1990's we witnessed the Nasdaq achieve a 10x return (500-5000). The rallies of the last two decades experienced significant corrections in "Year 8" just before the final "blow-off rally" which extended into the new decade.

If the pattern were to hold true to form, then the CRB index would be projected to rise 20 times, peaking at some point in 2010. Looking at Chart 1 and using a baseline of 200, this would take the CRB index up to 4000 or an 8-fold gain over the next two years. This might be a stretch, but not for some components of the index. Oil for example has already risen 10x to over $100/barrel. I do not think it unimaginable that gold would rally to $5000/oz-a 20-fold rise from the low around $250/oz. If you find my thesis impossible and $200 oil unfathomable I direct you to a recent Bloomberg article where none other than a Goldman Sachs analyst sees an "explosive commodity rallies" in the next couple of years with crude oil rising to $175 a barrel:

March 14 (Bloomberg) -- Commodities may have ``explosive rallies'' in the next couple of years, with crude oil rising to $175 a barrel, according to Goldman Sachs Group Inc. Political decisions on money flows, labor and technology are ``substantially constraining supply growth'' of commodities, Goldman analysts including Jeffrey Currie in London wrote in a report today. ``This will likely support the ongoing structural bull market in commodities until these policy-driven investment constraints are removed and/or demand is adjusted.'' Commodities are in their seventh year of gains as underinvestment in refineries, mines and land sent prices for oil, gold, platinum and wheat to records. More natural resources are controlled by political entities than at any time since the 17th century, according to the Goldman report.

Concerning worldwide supply and demand for commodities while the U.S. is in a recession, a March 22nd article in The Economist titled "Commodities: A bit tarnished" observes:

Although the economic outlook for America is grim, most analysts assume that emerging markets will continue to grow relatively strongly. Meanwhile, global copper inventories amount to only two weeks' demand. Lead stocks are closer to one week's worth. Stocks of oil are also unusually low. So even small disruptions to supplies prompt dramatic reactions from the markets. Aluminum prices, for example, have risen in recent weeks because of a shortage of power in South Africa, which has reduced output from several smelters. Fears of a shortage of hydroelectric power in Chile are helping to buoy the price of copper.

The same article also addresses the extent to which the dollars' decline "seems to be fueling commodities' rise." Furthermore, they cite Merrill Lynch analyst Francisco Blanch who argues that:

The interest-rate cuts that have prompted the dollar to fall have produced a surge in liquidity in fast-growing emerging markets such as China and the Middle East. At the same time, governments in those countries try to insulate consumers from rising prices with subsidies and price controls. So demand for raw materials from such places continues to grow, despite high international prices. If Mr Blanch is right the Federal Reserve's latest cuts will only spur faster growth in demand in emerging markets, and so higher commodity prices. That, in turn, will increase America's oil-import bills, which will add to the current-account deficit and therefore heap further pressure on the dollar, setting a vicious cycle in motion.

Barron's Article: "Guess Who's Behind the Commodities Boom"

The answer to the question, according to Barron's is speculators. I think what we have just witnessed is the preamble to the real speculative bubble that is going to occur in commodity markets. Most investors have less than 5% of their assets in commodities. When their allocation reaches tech stock-level of early 2000 then we will know we have arrived at a bubble in its final stages. Moreover, Javier Blas, citing a Lehman Brothers research paper, in a Financial Times article titled "Industry Behind Metals Boom" counters the contention that commodities have risen due to fund flows, writing:

Prices of metals such as iron ore and cobalt that are bought and sold privately between producers and customers have risen faster than others such as copper that are traded on exchanges, says Lehman Brothers. The investment bank says this lends weight to the argument that supply and demand factors rather than just financial flows are behind the boom in prices. Its new index of non-exchange traded metals rose by 598 per cent from January 2002 to early this year. During the same time, an index of exchange traded metals rose 246 per cent. The diverging trend has gained pace in the past year with non-exchange traded metals rising 94 per cent and exchange traded metals gaining 26 per cent.

Regarding achieving an 8-fold increase in the CRB commodities index, several of the soft and grain commodity components have lagged the energy and metal components, but have recently shown signs of life and of possibly playing catch up. Looking at the chart below it is easy to see how the prices of corn, wheat, and soybeans would need to triple or quadruple just to reach their inflation adjusted highs. Because today's inflationary monetary policies are much more egregious and the worldwide demand story is so much larger than in the 1970s, it is easy to conclude that the gains in grains could be spectacular.
Chart 6 (Courtesy Marc Faber and Morgan Stanley): Wheat, Corn, Soybean Prices Deflated by U.S. PPI

 

Conclusion:
The majority of commodity bulls who believe that we have another decade for the commodity bull market to unfold may be correct and I would not totally discount this possibility. On the other hand, it is looking more and more that the economic interventionists in the U.S. are gaining the upper hand in policy making which portends a viscous and rapid inflationary cycle and a boom for commodities and hard assets. It is tragic that they could be causing the depression they are fighting so hard to prevent. As the unemployment rate ticks up from 4.8 to 4.9% (these figures are admittedly too low) you have the fourth-highest ranking Democrat in the House, Rahm Emanuel ,writing an editorial in the Wall Street Journal already calling for a "New New Deal." Left-Leaning media publications are presenting pictures food-stamp lines and of looming doom. The result of the policies in all of the hysteria, in what would be one of the saddest ironies in the economic history of the U.S., is that they might actually cause the depression they are trying to prevent. Many Congressional members are drafting a second stimulus package before the first one has even arrived and had time to work.

The result is more money, a lower dollar, higher inflation, lower asset prices, lower real estate prices, lower earnings, less hiring, and a calls for the government to do more which only serves to accelerate this viscous cycle. Protect yourself against this scenario by investing in hard assets.

I leave you with a quote from an essay titled "Gold and Economic Freedom" written in 1966 by Alan Greenspan before he himself became one of the statists he chides in the essay:

The abandonment of the gold standard made it possible for the welfare statists to use the banking system as a means to an unlimited expansion of credit...The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves. This is the shabby secret of the welfare statists' tirade against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this , one has no difficulty in understanding the statist's antagonism toward the gold standard.