2009: Go for Gold! Beware the US Treasury Bubble

``The world is lurching through a serious monetary disorder. The proximate cause is the collapse of the housing bubble and the subprime-credit crisis, but the ultimate cause is the inherently unstable monetary system foisted upon us by a banking cartel. Central bankers are called upon to act as lenders of last resort, but in their efforts to inflate their way out of the credit collapse, they risk igniting a hyperinflationary bonfire that will destroy the world's major fiat currencies. Gold was money once, and could become so again.”- Robert Blumen, Is Gold Money?

Except for Ghana (up 60%), Tunisia (up 10.6%) and Ecuador, which escaped the wrath of a global financial meltdown, all of the stock market benchmarks were in the red for 2008.

Nonetheless the other asset outperformers had been the US dollar and US treasuries both of which benefited from the forcible liquidation and served as the “safehaven” amidst the present deflationary scare, see figure 2.

Figure 2: Bespoke Invest: Gainers and Losers

According to Bespoke Invest, ``While it has been a horrible year for stocks (S&P 500 down 39%), it's been much worse for oil, which as we all know was up nearly 50% for the year back in July. While most asset classes are down big, the US Dollar has risen 6%, and Treasuries have skyrocketed. As shown, the 10-Year Treasury Note is up a whopping 21% this year, prompting the majority of market participants to call it the next bubble.”

This chart excludes another winner though, gold which racked up 4.95% in 2008 based in US dollar terms.

Yet, gold didn’t just gain against the US dollar. It likewise gained against most of the major currencies except for the Japanese Yen and Chinese Yuan see figure 3.

Figure 3: courtesy of James Turk of goldmoney.com: EIGHT years in a row

Why our fancy with gold?

Why our fancy with gold?

While we can cite growing demand supply imbalances amidst the present turmoil, our focus is on how global central bankers have been dealing with the present crisis.

Again while major global central banks have been force feeding the banking system with record amounts of money which is basically being eaten up by the losses of the highly financial leveraged system, eventually the seemingly endless tsunami of money being fed will overwhelm such losses. Of course, all this could take time but that would be in the assumption that we can time the markets. Nonetheless, the obvious effect will be risks of HIGHER inflation if not HYPERINFLATION. And inflation’s reappearance could be dramatic.

In addition, not all of the global economy has been ravaged by debt deflation. Economies in Asia for instance have been less leveraged or less affected, yet global governments including Asia and Emerging Markets have been adopting the same policies of currency debauchment. Stimulus programs that can’t be paid for by taxes or borrowed from taxpayers domestically or internationally will have to be met by the central banks’ printing or digital presses. Basically this implies inflation.

Again in the US, government fiscal deficits won’t only be about recapitalization and support of the financial industry but also about plugging of the shortfalls in tax revenues.

Figure 4: Nelson Rockefeller Institute: Deteriorating Tax Environment

The Nelson Rockefeller Institute projects tax collections “likely heading into negative territory for the first time since the last recession in 2002”.

So the amount exposed yet by the US government is likely to be a downpayment among other possible future installments.

Again all these sums up to a potential massive spillage of unsterilized money being churned out by global central banks and governments which the entire economic system will have to absorb.

Moneyness of Paper Money

Moreover, in a world where central banks are working to devalue their currencies overtime, any other currencies aren’t likely to assume the role of safehaven again because of implicit political interests.

Remember, paper currencies are basically IOUs issued and stamped by governments as “legal tender” and backed by nothing but FAITH in the issuer. Because paper money is an IOU, it bears counterparty risks.

Where money as a medium of exchange requires these characteristics: durability, divisibility, scarcity, portability, uniformity and acceptability, unlimited issuance of paper money essentially diminishes the moneyness quality of paper currencies. As we cited earlier given the massive and full scale deployment of the printing press globally, such the raises the risk of a potential of disintegration of the present financial architecture.

The chafing the characteristics of the moneyness of paper money, the gradual erosion faith over its LEGAL TENDER status, global currencies in a race to the bottom, potential upheaval of the monetary structure or the plain universality of economic law where the growth of supply of money is greater than economic output simply collectively means a loss of purchasing power of paper money against gold (and other real assets).

At best, gold, which bears no counterparty risks and functions as no one else’s liability, will be your insurance against the vast stealth tax employed by global governments. At worst, gold will regain its monetary luster or play a renewed role in reshaping the next global monetary regime (worst because of the unfathomable distress that the world will possibly undergo first before rediscovering gold’s importance).

This is why signs of shortages in physical gold has been offsetting the huge short positions taken by a few government controlled big banks (see Influencing Gold and Silver Markets, Backwardations Imply Higher Gold and Silver Prices), which is in my suspicion have been attempts to manipulate gold prices as to refrain from exposing the inflationary effects of their actions. Unfortunately, markets are larger than government can permanently control where manipulation can only influence price signals over a limited period.

Debt Over Issuance Over Limited Capital Equals Treasury Bubble

Finally, it is obvious that in a world where losses have been mounting and where institutions have been seeking refuge in governments, that capital is in an apparent shortage. Yet, expected material slowdown of world trade and a projected global economic deterioration implies an erosion of economic output, and perhaps a reduction of real savings, especially as governments work to redistribute residual capital.

Nonetheless as global governments attempt to reinflate the global economy, this translates to an ocean of issuance of debt instruments which would effectively compete with the diminishing supply of “savings-based” capital. This means that the panic driven boom in US treasuries seems more and more like time bomb waiting to implode that could bring about the next crisis to US treasuries holders.

As an aside, the plan of the US Federal Reserve to buy long dated bonds in an effort to close the arbitrage windows for banks could bring opportunities for foreign owners of US treasuries, where about 55% of privately held US treasury securities are foreigners (CRS Report for US Congress), to gracefully exit the bubble. It’s a wonder if China and Japan will do so. And it is amazing how complex the world is and full of unforeseen possibilities.

Eventually capital will be seeking a premium over the sea of debts which means higher interest rates for the world.

Relative Economic Growth, Lack of Access to Capital and Global Depression

``With greater wealth comes greater responsibility. This is inescapable. Wealth has a social function. If you own something, you must make decisions about how to use it. Consumers are always bidding for either ownership or the use of your assets. Ownership therefore has a price. If you do not respond to the offer, you are paying this price. You are paying the price in the form of forfeited opportunities. Whatever you do with the wealth, you could be doing something else with it. You cannot escape the responsibility of not doing something else with whatever you own.”-Professor Gary North, Honeymooner Politics

It can’t be an argument from the economic growth perspective too…

Figure 6: IMF: WEO Presentation: Economic growth decelerates Around the Globe

Even as global economic growth has moderated to 4 ½ in the first quarter of 2008 down from 5%, such growth clip is expected to decline further to 4.1% in 2008 and 3.9% in 2009, according to the IMF.

From the IMF’s World Economic Outlook update (emphasis mine),

``Growth for the United States in 2008 would moderate to 1.3 percent on an annual-average basis, an upward revision to reflect incoming data for the first half of the year. Nevertheless, the economy is projected to contract moderately during the second half of the year, as consumption would be dampened by rising oil and food prices and tight credit conditions, before starting to gradually recover in 2009. Growth projections for the euro area and Japan also show a slowdown in activity in the second half of 2008.

``Expansions in emerging and developing economies are also expected to lose steam. Growth in these economies is projected to ease to around 7 percent in 2008–09, from 8 percent in 2007. In China, growth is now projected to moderate from near 12 percent in 2007 to around 10 percent in 2008–09.”

In short, despite the moderating pace, the economic growth differentials are still tilted towards in favor of emerging market economies (see left pane in Figure 6).

Moreover, we can hardly buy the arguments from the deflationist proponents of a world depression or near depression see figure 7.

Figure 7: ADB: Asia’s Household Indebtedness

ADB’s data shows of the dearth of leverage or indebtedness of the household sector, which reinforces our supposition of the insufficient access to the banking system by a large segment of the Philippine economy. Similarly this represents both as a shortcoming and as an opportunity (huge growth area).

If the banking system, the main conduit for finance intermediation, has relatively low exposure, it explains why the Philippine capital market likewise lags the region or for most of the world.

It also gives credence to the outlook that a large section of the economy is levered to informal financing channels.

Basically Indonesia and the Philippines could be deemed as primeval cash based society. It also demonstrates why both countries have lagged in the aspects of developments simply because of the lack of access to capital and to paucity of sophistication to lever and recycle capital.

Figure 8: ADB: Public Sector and External Debt as % of GDP

External and Public sector Debt for most of Asia has likewise been materially improving. But the Philippines has the worst position among the peers but has likewise shown significant progress.

Of course past performance may not repeat in the future given the deteriorating conditions abroad, but given the composite framework of the Philippine economy or financials, we need to be substantially convinced of how a depression in the US will result to a depression in the Philippine economy or in Asia. We have discussed in details such linkages in ‘Is the Philippines Resilient Enough to Withstand A US Recession?’.

We also don’t share the view that advanced economies will RECOVER first given the so-called belated effects of an economic growth slowdown contagion to Asia or to emerging markets.

The reason is that the US or UK or countries presently scourged with the deleveraging process is a systemic impairment which will take a longer period for convalescence or for market clearing. Whereas Asia or emerging market’s bear market comes about from the trade and financial nexus with these economies and has not yet been a structural problem (YET).

As a reminder, from every cycle emerges a new market leader, e.g. in the US, the technology sector 1990s-2000 and financials and housing in 2003-2007 (today the energy sector appears to be at the helm) and it is likely that once a recovery phases there will likewise be a new market leader (perhaps the next bubble). And our likely candidate emanates from Asia or emerging markets.

To elaborate further, monetary inflation has been a process INTRINSIC to the fiat paper money/currency standard. Since the impact of inflation is always never equal, it gets to be absorbed in different points of the economy at different times.

For instance in 2003-2007, most of the inflationary actions by global monetary authorities got absorbed in the real estate sector backed by financial securities (structured finance, derivatives, mortgages backed securities, etc…).

Aside, the spillover from these actions led to global arbitrages which spurred a phenomenon of price values of stocks, emerging market debts and commodities.

But since the advent of the global credit crunch, much of the real estate financed securities have been deflating, thus, the inflation absorption has shifted towards hard assets. Hence, the accentuated surges in food, energy and commodity prices (which is why it gets political mileage). Now that commodity and oil prices are in a respite, our suspicion is that some asset classes are likely to takeover or benefit from these relative price adjustments or the rotating inflation.

Remember, these processes won’t come to a halt, especially under political imperatives to save the system or the poor or the society or the economy. There will always be some justifications (cloaked by technical jargons-or ‘intelligent nonsense’ as Black Swan savant Mr. Nassim Taleb would say) for such politically based actions.

Overall, if the popularly held inflation menace will be less of a threat to the global economy, aside from global markets having priced in MOST of the decline in economic growth aspects as reflected in the financial markets (markets indeed serve as great discounting mechanism) then it is likely that we should see the rotation of this inflationary assimilation into new conduits; let me guess-Asia.

Phisix: Learning From the Lessons of Financial History

``Here’s the thing: When you get diversity breakdowns in markets, you get bubbles and crashes. When you get diversity breakdowns in societies, it’s ideologically similar. As Scott Page has shown, diversity (markets, ideas, ecologies) is a key to stability and growth.”-Josh Wolfe, Forbes Nanotech

In loving memory of my uncle Marciano U. Te (January 2, 1926-July 7, 2008)

``“The mistakes of a sanguine manager are far more to be dreaded than the theft of a dishonest manager," wrote Walter Bagehot. The best protection against excessively sanguine beliefs is the study of financial history, with its many examples of how easy it is to be plausible, but wrong, both as financial actors and as policy makers. Perhaps we need a required course in the recurring bubbles, busts, foibles and disasters of financial history for anyone to qualify as a government financial official. I have the same recommendation for management development in every financial firm.” Thus wrote veteran banker Alex Pollock, a resident fellow of the American Enterprise Institute, in advocating that the lessons from Financial History represents as the paramount guide into shaping of regulations-where history manifests of a slew of policy actions in reaction to market developments and their unintended backlashes-or for financial actors when divining portfolio strategies.

The most common problem we observe is that the public loves to adhere to simplified understanding of a complex problem, usually sourced from mainstream news, and apply nostrums as solutions. Whether it is the rice crisis, stratospheric oil or energy prices, or Phisix bear market it is basically all the same, we find a culprit, pin the blame on them without examining in depth why all these came about and worst, proffer solutions that are usually knee jerk responses bereft of historical morals which usually gets us mired into more trouble in the future.

Understanding the Phisix Bear Market

The Phisix, like most of the major equity benchmarks in the world including the US, is in a technical bear market, down by nearly 40% (37% to be exact based on Friday’s close). Since mainstream media is so fixated with oil and food, thus accordingly our market is likewise allegedly bogged by such issues.

We hardly hear any voice including from our so-called high profile experts in dealing with other pertinent issues: the continuing gridlock in the global credit market, the worsening economic slowdown in major developed worlds as a result of the deflating housing bubbles and attendant signs of contracting liquidity or monetary tightening in the global marketplace which has now become discriminate.

Of course, we do not share with depression advocates the view that the world is headed for Armageddon or that global financial “decoupling” is a fiction. As we mentioned, shrinking liquidity has made investment destinations become rather choosy or discriminate and our observation of Africa (see Recoupling and Inflation Doesn’t Explain Everything…) as benefiting from the present environment has been corroborated by the Economist magazine (emphasis ours),

``At the start of this year, some 15 sub-Saharan African countries had stockmarkets, listing some 500 companies with tradable shares and a combined market capitalisation–excluding relatively mighty South Africa's–of $100 billion, according to a report from Goldman Sachs, “Africa Rising”. Since then, these markets have mostly soared ever higher, even as shares everywhere else have plunged to earth. The best performing stockmarket among this impressive bunch is Ghana's, up by one-third so far this year.”

If this isn’t “decoupling” then I don’t know what this is suppose to represent.

Is it not a wonder why Africa seems immune to the same problem we or the world have been suffering from? Is it not the Philippines an “economically” better positioned compared to these states? So what’s the difference?

Honestly speaking, we don’t have an answer to everything although we do have some suspicions (prolonged years of underinvestment, prevailing commodity resource boom, probable portfolio rotations and China’s growing role in financing Africa’s infrastructure investments).

But there is one thing we can be sure of; if the premises cited by our financial experts do not seem to be applicable to African states, whom are supposedly in a far inferior position relative to us (based from the standpoint of economic statistics) or to most of our neighbors, then the likelihood is that the same conventional justifications used at our end stands from tenuous grounds.

Financial History And The Phases of Bear Markets

Figure 1: Phisix: History Shows 4 Bear Market Cycles

This brings us to financial history.

Financial markets are basically characterized by market trends borne out of the transitions of overinvestment-underinvestment cycles or commonly known as the Boom-Bust cycles.

Bear markets functioning as the other major market trend (other one being the Bullmarket) may constitute as either primary/structural/secular or secondary/cyclical/countertrend.

Primary-secular-structural bear market usually signifies the unwinding of previous excesses built up within the marketplace- as seen by massive overvaluation, speculative excesses (proliferation of margin trading) and “this time is different” euphoric attitudes- financed by too much debt or leverage in the banking system and or capital markets to the point of massive asset-liabilities mismatches which likewise reflects on major imbalances within an economy.

It may also represent fatalistic or defeatist government policies; remember the 5 cardinal sins-protectionism (nationalism, capital controls), regulatory overkill (high cost from added bureaucracy), monetary policy mistakes (bubble forming policies as negative real rates), excess taxation or war (political instability).

Overall, structural or secular bear markets reflect internal or endogenous adjustments as a result from these malinvestments or bungled policies.

On the other hand secondary-cyclical-countertrends are simply trends that correct temporarily against a major trend. Remember since no trend goes in a straight line major trends are likewise confronted with major corrections, and this could be triggered by many superficial factors.

The Phisix has not been a stranger to bear markets. In the past twenty two years we have seen four bear markets which equally reflect both cyclical and secular or structural (see figure 1) phases.

The Cyclical Phases (as measured by peak to trough)

Following EDSA I, the Phisix soared by TEN times before:

1. August 1987 to October 1988- the Phisix lost about 45% and consolidated for 13 months before recovering and resuming another attempt to the upside. The trigger for the bear market in 1987 – ex-Col. Honasan’s August 28^th Black Friday’s botched coup d'état against erstwhile President Cory Aquino.

2. November 1989 to October 1990- the Phisix lost about 62% in about 11 months before convalescing. The trigger for the bear market of 1989 -November 30^th Makati coup again by ex-Col. Honasan.

The aftermath to the last cyclical bear market saw the Phisix soar by over 5 times to its 1997 high of 3,447.

As you can see, political upheavals such as the past aborted coup attempts could serve as triggers to bear markets.

The Structural/Secular Phase (as measured by peak to trough)

Figure 2: IMF: Asia: A Perspective on the Subprime Crisis

Figure 2 from IMF’s Khor Hoe Ee and Kee Rui Xiong reveals of the similarity between today’s subprime debacle in the US and the 1997 Asian experience.

Abundant liquidity, massive capital inflows, overcapacity from overinvestments, loose credit standards, soaring assets fueled by leverage, inordinate foreign currency debts, conflicting interests from participants (agency problem) and moral hazard among others have been enumerated as main contributors to these pair of boom bust cycles.

In the Philippine financial markets, the angst from the fundamental adjustments of the 1997 crisis was mainly expressed via massive price revaluations as the sharp depreciation of the Peso, the collapse in real estate prices and the initial collapse of the Phisix.

Again what must be remembered was that even if the bubble popping contagion was seen from a regional perspective, the imbalances brought about by the above factors was seen in the construct of the domestic economy and in the local financial markets. In short, the bubble was internally generated as much as it reflected the region’s activities.

This leads us back to figure 1, the secular bear market of the Phisix…

3. February 1997 to October 1998-the Phisix lost 66% in about 20 months. But following the election of President Joseph Estrada, the cyclical Presidential honeymoon period led to the Phisix rebound of 120%. This could be interpreted as the cyclical bullmarket within the secular bear market.

4. July 1999 to November 2001- the Phisix lost 62% in about 28 months for the culmination of the secular bear market cycle. Oddly, the Phisix appear to trace the developments in the US markets or when the Nasdaq dot.com bubble imploded in 2000, for a huge chunk of this cycle.

From the above we learned that it is very important to distinguish between the basic compositions of market trends. Why? Because, the torment from a secular bear market relative to the cyclical bear market is far worse in terms of depth (longer duration for adjustments) and scale (larger degree of losses). Thus you can make your portfolio adjustments to reflect on the risks involved once you can categorize which part of the cycle we are into.

In general, the internal market configurations and domestic economic structural dynamics determine the adjustments reflected in the financial markets from which demarcates the cyclicality or secularity of a given trend.

Alternatively, this means that if today’s problems emanates from exogenous factors then unless it becomes severe enough to fundamentally alter the present economic and financial landscape, we should expect the present bear market to represent the cyclical nature of today’s underlying market trends.

No Bubble: A Reprise!

Have we been in a structural bubble? No, as we scrupulously argued in Phisix: No Bubble! Time for Greed Amidst Fear.

Figure 3: IMF: Improving Balance Sheets and No Property Bubble

Even IMF’s Khor Hoe Ee and Kee Rui Xiong argues in their piece that balance sheets of corporate debt levels have been markedly improving in Asia, aside from modest property appreciation seen relative to the advances in Europe and the US see figure 3.

But there are always exist some form of risks most likely coming from a contagion, quoting Mr. Khor and Mr. Kee (highlight mine),

``Even so, Asian policymakers must watch for remaining risks from the subprime crisis that could pose problems for Asia. These include what a Standard & Poor's report called a possible "triple whammy" on banks: more subprime-related losses, an adverse impact on Asian financial markets that affects banks, and an adverse impact on Asian economies that affects banks.

``But to date, such impacts seem muted. Asian banks are engaged in traditional bank lending and are not heavily exposed to the more sophisticated types of financial products that have hurt financial sectors in many industrial countries. However, a decline in the real economy as a result of economic declines in the United States and Europe could cause a significant deterioration in the quality of bank loans.”

Since the banking system has been the foremost conduit for the financing of most the Asian economies, all eyes should now focus on how banks will adjust to the ensuing downdraft in the economic growth of developed countries or from the junctures of rising “inflation”.

This I think is what the global financial market has thus far priced in, aside from the ongoing delevaraging process that has fomented the forcible selling of most liquid asset classes by institutions caught in the web of illiquidity stasis.

And if Asia is not a bubble then the likelihood is that the bear market arising from the present contagion conditions as mentioned above could be likewise be cyclical and temporary in nature. If our analysis is correct then we should see the rendition of the same patterns even amongst our neighbors.

Vietnam climbed about EIGHT times from late 2003 and has corrected 66% over the past 8 months. Today, the much ballyhooed “next China” seems to be healing (but needs further confirmation) and is up 20% from its most recent lows.

India likewise soared nearly FIVE times over the past four years and is down nearly 40% from the peak and could see still some selling pressures. Whereas China’s Shanghai index skyrocketed 4.5 times since only 2005 (or a bullmarket of about 2 years old!) and has surrendered 57% of those gains (based from its recent peak prices).

Meanwhile, our neighbor Indonesia has climbed about 4.5 times also since 2003 and has contracted by 32% during the first panic in August of 2007, but interestingly remains above this level. The JKSE is also presently above its April lows (-23% from peak) and is today down by about 20%.

On the other hand, our Phisix has trailed all of them up by only 280% from June 2003 to October 2007 and has touched the 40% threshold of losses just the other week.

Another, in a structural bear market practically all issues are supposedly headed for the gutters, but this isn’t the case today. In fact some issues have been trading within their 2007 highs: namely, Pilipino Telephone (PLTL), Petron Corp (PCOR) and Oriental Petroleum (OPM), or at near historical highs Manila Water (MWC), Philodrill (OV) and Semirara Corp (SCC).

Again these are empirical evidences that today’s bear market is cyclical in nature.

The point of this exercise is to show you the following:

1. Relativity of the performance of the previous upside and the present downturn matters. Market trends are generally determined by the longer term trends and are usually impeded by intermittent secondary or cyclical-counter trends.

2. Experts usually use existing headline information to account for present market actions but whose analysis can be shown NOT TO BE CONSISTENT with the broader market picture or if taken from a macro perspective. To quote self development author Robert Ringer, ``A false perception of reality leads to false premises, which in turn leads to false assumptions, which in turn leads to false conclusions, which, ultimately, leads to negative results…Which is why it’s incumbent upon you to become adept at distinguishing between reality and illusion. A false perception of reality — regardless of the cause — automatically leads to failure. An accurate perception of reality doesn’t guarantee success, but it’s an excellent first step in the right direction.”

3. Since people by nature are hurt by the prospects of pain more than the delight from future gains-this accounts for a cognitive bias called LOSS AVERSION- thus, losses tend to be fast and furious, even during cyclical markets due to the impulsive nature of investors.

4. If the recent losses signify cyclicality and not structural impairments then the gist of the losses appear to have been priced in for many of Asian markets (Barring any massive shocks from external channels, e.g. stock market crash in the US or UK). This is not to imply that they can’t go lower. What we mean is that the scale of losses will probably be much lesser from this point on or the degree of losses could be in the process of culminating.

5. The cyclicality, tendency to overshoot, false premises and relative performance combines to reinforce the likelihood of a faster than expected recovery.

6. Finally we are not in the practice of financial voodooism to suggest when exactly the turning point will be. From our perspective, using the lessons of the financial history, we should use the present crisis as an opportunity to grab worthwhile investment themes which are likely to be selective given the present character of heightened risk aversion.

To quote PIMCO’s co CEO Mohamed El-Erian (emphasis mine),

``Today's markets are particularly tricky as they provide the duality of both great opportunity and enormous risk. And in contrast to recent years, investors will not be able to appeal to a few macro themes; be they bullish ("the great moderation" and "goldilocks") or bearish ("debt exhaustion" and the collapse of structured finance). Instead of the phase of highly correlated market moves, up and then down, we will witness the gradual assertion of fundamental differentiation between market segments and for instruments in the capital structures…

``This volatile cocktail also speaks to the other side of the duality: the existence of big opportunities. The toxic mix is causing markets to throw the baby out with the bath water. There is now a littering of high quality assets whose prices are divorced from their underlying quality. Rather than reflect fundamentals that will eventually assert themselves, these valuations have fallen victim to the seemingly endless disruption in the financing of highly leveraged owners that have no choice but to continually dispose of assets in a disorderly fashion.”

If Oil Is A Bubble, Then It Is A Government Sponsored Bubble!

``The economic hardship, of which we had a taste in 1981 and 1982, will be much worse. That in itself is bad enough news, but historically, when a nation debauches its currency international trade breaks down — today 40 percent of international trade is carried out through barter — protectionist sentiments rise — as they have in Congress already — eliciting hostile feelings with our friends. Free-trade alliances break down, breeding strong feelings of nationalism — all conditions that traditionally lead to war; a likely scenario for the 1990s, unless our economic policies and attitudes regarding government are quickly changed.”- Congressman Ron Paul, The Economics of a Free Society

Are Oil and Commodities In A Bubble?

Oil prices dashed to a phenomenal record at $135 per barrel and many have screamed “BUBBLE”!

By definition a bubble means assets or securities priced far from its perceived “fundamentals” or irrationally and impulsively driven by excessive speculation.

The stated reasons for the commodity “bubble”: forced short covering from miscalculated bets, frenetic inventory accumulation by big oil consumers (e.g. airlines) or by nations- such as China use of diesel generation for rescue efforts and for stock piling ahead of the Olympics and worst, alleged collusion to manipulate oil prices such as evidences of government contracted oil tankers holding inventories at seas, rerouting of speculative trades from regulated markets to unregulated markets such as OTC and International Exchange (ICE) and massive jump of investments from pension funds and banks via “Indexed” Speculation.

Any markets always contain certain degrees of speculative element simply because of varying expectations and interests by market participants which are essentially reflected on prices. Some are there to hedge their produce, some are there to profit from short term/momentum trades or take advantage of arbitrage spreads, some are there to profit from long term investments and in cases of a bubble, most will be there simply to be a part of the crowd!

As for the supposed commodity bubble, as we noted previously, while there have been some signs of an emergent bubble, they seem far away from being a Bubble “bubble” as we know of.

Mainstream analysts continue to cavil as they did in early 2006. For us, this represents signs of denial. They think of the financials (with all its present hurdles) and the tech industry as still the vogue place to be and such represents as high quality investments, while the commodity industry has always been condemned and is still relegated to account of low grade cyclical driven speculation. They think past performance will produce the same distribution outcomes.

Under the framework of the psychological cycle operating under a boom-bust or bubble cycle, until the mainstream thinking capitulates, the commodity boom has an enormous room to run.

Yes, we don’t deny that sharp movements of prices assets in one direction should equate to equally dramatic movements to the downside, but what concerns us is the long term trend because trying to time markets for us is a vanity play.

In May of 2005 The Cure Is Worse Than The Disease, we outlined our case for the bullmarket in oil…

``1. US Federal Reserve for expanding credit to an unprecedented scale and its negative real interest rate policy which fueled massive speculative positions globally,

``2. The excess printing of paper monies by the collective governments stoking an inflationary environment,

``3. The OPEC members for nationalizing their respective oil industries thereby misallocating capital investments that led to the present underinvestments,

``4. The Chinese government for adapting a market-based economy (from less than 100,000 cars in 1994 to over 2 million cars 2004),

``5. The US dollar-remimbi peg that accelerated an infrastructure and real estate boom thereby increasing demand for oil,

``6. The war on terror that has disrupted oil supplies,

``7. The Bush administration for the continually loading up the Strategic Petroleum Reserve, and…

``8. The lawyers and environmentalists for increased regulations on explorations and oil refinery requirements.

Have any of the above factors changed? Except for the recent suspension of the stockpiling of the US Strategic Petroleum Reserves, generally all of these fundamentals remain in place.

But we’d like to make some modifications if not additions; for the demand side it’s not only about China but of emerging markets (we are talking about India, Brazil, Russia, Southeast Asia and others representing about 80% of the world’s 6.6 billion population).

Most importantly, we missed one very important variable which ensures the longevity of the commodity cycle….PRICE CONTROLS.

Nonetheless, have oil prices risen enough to impact demand? We doubt so, simply because the market price of oil has not been reflected equally in different countries because of the varying extent of PRICE CONTROLS and if not tax structures encompassing the industry.

Politicization Of The “Oil Bubble”

The recent “bubble” perspective arises from mostly the arguments of the “DEMAND” side.

Just because investments in commodity indices (of which oil makes up a significant share) allegedly surged from $13 billion to $260 billion doesn’t imply that it is in a bubble. Not everything that attracts investments automatically equates to a bubble. Not everything that goes up is a bubble.

Media’s “framing” of information based on relative figures depicts of a bias. And this cognitive bias is known as the Contrast Principle where-we notice difference between things, not absolute measures (changing minds.org). In contrast, the market for derivatives exploded by 44% to $596 TRILLION (and not billions) or to over TEN times the global GDP, yet mainstream seems quiescent about such development. Derivatives are financial instruments or contracts based on the underlying assets such as foreign exchange, interest rates, equities, commodities, inflation indices or even weather predictions.

Why? Because commodity prices impact the real world. And in the real world, people’s lifestyles are affected by commodity price movements, thus have the tendency to be politicized.

And because people refuse to understand the underlying issues, instead they seek for emotionally satisfying terse explanations via melodramatic narratives as seen through heroes and villains. To quote Thomas Sowell ``Voters don't want to hear about impersonal things like supply and demand. They want to hear about how their political heroes will stop the villains from "gouging" them or "exploiting" them with high prices. Moral melodrama is where it's at, politically.”

Nonetheless, when measured relative to its exposure as financial derivatives, according to the Bank of International Settlements, commodities account for only 1.5% (26.5% growth year on year) of the outstanding derivatives in 2007 compared to interest rates 65% (34.83% growth year on year), foreign exchange 9.4% (39.65%), credit default swaps 9.7% (102%), equities 1.4% (13.6%) and others. So as a function of the derivatives markets in relative terms, we don’t see any signs of bubble like performances from commodities.

Yet, commodities cannot be qualified in the same way we evaluate stocks or housing assets, as Ms. Caroline Baum of Bloomberg rightly argues (highlight mine),

``With other asset classes, there are metrics that allow us to quantify the degree to which prices have strayed from their fundamental moorings. Stock prices have an historical relationship with underlying earnings. House prices don't stray too far from their ``earnings'' stream, or rental value.

``With commodities, no such quantifiable ratio exits. Instead, analysts point to verticality, or the rate of price increases in a short period of time; to the fact that open interest in futures contracts dwarfs actual supply; or to the sheer volume of trading.”

In other words, in the absence of any valid metrics to assess if commodities prices have meaningfully careened away from fundamentals, market price actions have been the principal criteria for labeling the activities of oil and commodity prices as a bubble. And market price actions do not tell the whole picture.

This leads us to politicization.

Some have argued to regulators to restrict or limit the participation and speculative positions of institutional investors (pension funds, hedge funds and etc.) into investing in oil and commodity space since they have accounted for a substantial increase in the market capitalization of commodity based index funds.

Backed by circumstantial evidence, the claim is that additional demand from institutional investors represents a form of “hoarding” in the futures market unduly driving up prices. Investors have been able to go around Commodity Futures Trading Commission (CFTC) market position limits on commodity acquisitions by swapping with investment banks, who in turn hedges the (total return) swap by buying futures contract. This loophole of allowing swap for hedges has paved way for the unlimited size positioning which concurrently drives up the market caps of commodity index funds.

But cash and futures market signify two distinct functions which essentially refutes such argument, according to the Economist (emphasis mine),

``Yet few bankers agree that speculation has much to do with price rises. For one thing, indexed funds do not actually buy any physical oil, since it is bulky and expensive to store. Instead they buy contracts for future delivery, a few months hence. When the delivery date approaches, they sell their contract to someone who actually needs the oil right away, and then invest the proceeds in more futures. So far from holding oil back from the market, they tend to be big sellers of oil for immediate delivery.

``That is important because it means that there is no hoarding, typically a prerequisite for a speculative bubble. Indeed, as discussed, America’s stocks and those of most other countries are at normal levels. If the indexed funds were indeed pushing the price of oil beyond the level justified by supply and demand, then they would be having trouble selling their futures contracts at such high prices before they matured. But there is no sign of that. In fact, until recently, oil for immediate delivery was more expensive than futures contracts.”

This is especially elaborate in the non-storable commodities (livestock and meats). The point is cash markets represents the actual balance of demand and supply and is unlikely to be subjected to massive speculations as alleged to be in contrast to houses or stocks.

Governments Controls The Supply Side Of The Oil Market

This brings us to the arguments vastly overlooked by Keynesian populists, the supply side.

Given today’s highly anticipated global economic slowdown, reduced economic activities should have translated to lower demand, thereby pulling down prices. Yet with oil prices having doubled over the past year, pricing signals should have dictated for more supplies, as shown in figure 1.

Figure 1 courtesy of US Global Investors: Oil Supplies remain Stagnant

But conventional supplies have hardly made a dent to the oil pricing market possibly due to the stagnant production by both OPEC (green line) and Non-OPEC (blue line) even amidst a global economic growth slowdown. With a slim spread between supply and demand, any drop in demand could easily be offset by an equivalent drop in supplies, and if supply falls faster than demand prices then prices will continue to rise!

And importantly, we must not forget that the supply side of the oil market is basically controlled (about 80% of reserves) by governments through national oil companies. Hence, the oil market is NOT a laissez faire or free market, but like rice or food markets, they account as political commodity market functioning under the auspices of nation states.

If oil is indeed in a “bubble” and government intends to pop the “bubble”, then common sense tell us that oil producing governments can simply deliver the coup de grace by offloading its “surplus” oil into the market! No amount of “speculative futures” can withstand the forces of actual supplies crammed into the markets. But has this happened? No.

If the oil markets have NOT been responding to the price signals, it is because the national oil companies, aside from governments themselves, have been responsible for the supply constraints and nobody else.

Underinvestments arising from misallocation of resources, geological restrictions emanating from environmental concerns, legal proscriptions to allow private and or foreign capital for domestic oil explorations and development of the industry (as in Mexico), nationalization of the oil industry (see Figure 2) and capital and technological inhibitions from national governments have all contributed to these imbalances.

Figure 2 Resource Investor/ Guriev, Sergei, Anton Kolotilin, and Konstantin Sonin: High Oil Prices lead to Expropriation or Resource Nationalism

Resource nationalism or nationalization or expropriation happens during high oil prices as the Resource Investor.com quotes Sergei Guriev, Anton Kolotilin, Konstantin Sonin’s paper (highlight mine),

``On the one hand, it seems natural that the higher the oil price, the more valuable the oil assets and the stronger the incentive to expropriate. On the other hand, given the costs of expropriation, it is not immediately clear why a government of an oil-producing country would respond to a positive oil price shock with expropriation rather than just with imposing higher taxes. Using taxes contingent on (observable and verifiable) oil prices, the government can preserve oil companies' incentives for investment in new fields and cost-reducing technologies. This straightforward solution, however, relies on the external enforcement of contracts, which is not the case: the government is both an enforcer and a contracting party. Therefore, this contract can only be self-enforced. As BP’s then-CEO recently said, “There is no such thing in the [Petroleum] E[xploration] & P[roduction] business as a contract that is not renegotiated” (Weiner and Click, 2007). The only protection for a private company is the government's desire to benefit from more efficient production in the future and checks and balances that assure that the government in office pursues the long-term national interest…We show that expropriations are indeed more likely to take place when oil price (controlling for its long-term trend) is high and in countries where political institutions are weak. The results hold for both measures of institutions that we use (constraints on the executive and the level of democracy from the Polity IV dataset). Most importantly, the results hold even if we control for country fixed effects; in other words, in a given country, expropriation is likelier in periods of weakened institutions.”

With due respect to Mssrs. Guriev et. al., the main difference between nationalization and higher taxes essentially boils down to control.

Private companies operating under high tax regime may use accounting ruses to go around taxes or resort to technical smuggling. In contrast, nationalization denotes of complete control over oil revenues.

Further, countries with politically weak institutions only underscore such dilemma. Companies can bribe their way out of taxes and unevenly distribute pelf to the bureaucracy. On the other hand, under nationalized industries bribes or corruption are most likely systemically organized.

Besides, the main incentive why countries engage in resource nationalism is almost entirely about politics. Oil companies can be a source of rewarding political affiliates or dispensing of political favors. Oil revenues can also be meant for expanding bureaucratic spending such as popular social welfare programs in order to preserve the incumbent’s grip on to power.

This is of course aside from what we mentioned earlier, accrued material personal benefits by those in power. Like cows, national governments find a way to milk these oil companies until they dry.

Besides, future development is only a catchword for vote generation applicable mostly during election seasons.

Governments Also Influence Demand Side Of The Oil Market

Governments have likewise been directly and indirectly responsible for pumping up demand.

This by inordinately expanding money and credit intermediation via a loose monetary, price caps and subsidies that has led to widespread smuggling across borders and expanded demand because of profit incentives through price arbitrage and “hoarding” and the amassing of strategic reserves by oil importing countries.

Figure 3: Whiskey and Gunpowder: Money Supply and Oil Prices

Chris Mayer of Whiskey and Gunpowder opines that US money supply and oil prices has an unusually powerful correlation as shown in Figure 3.

Quoting Mr. Mayer (emphasis mine), ``Since January 2001, you can explain the move in the price of oil largely as a function of increasing money supply. As the amount of money grows, the price of oil rises. In fact, almost 87% of the move in the price of oil can be explained by the increase in money supply.

``Basically, $100 per barrel oil is what we would expect to see, given this relationship between the oil price and money supply. Given that we are still in the midst of a credit crisis of sorts, it seems unlikely the Fed will tighten money in any way at all. That leaves a clear path for the price of oil and commodities to continue to rally in nominal terms.”

Since the US is presently engaged in a currency debasing policy as seen with its ongoing “nationalization” of mortgage related losses or whose financial sector have been undergoing a “liquidity” transfusion from the US Federal Reserve, such loose policies have been weighing enormously on the US dollar. The softening economy likewise has contributed to these dollar infirmities.

And since oil prices have been traded mostly in US dollars, the weakening of the US dollar has similarly accounted for a strong inverse correlation with oil prices. In short, a weak dollar-strong oil phenomenon as seen in figure 4.

Figure 4: Stock charts.com: US dollar Index, Euro and Oil

From the Sydney Morning Herald: ``The correlation coefficient between oil and the euro-dollar exchange rate has been 0.95 for the past year, indicating they have moved in the same direction 95% of the time. The correlation is calculated based on the price changes of oil and the currencies.”

This simply means that given the same rate of a near lockstep association, if the US dollar index (whose basket comprise over 50% weightings by the Euro) continues to weaken, oil prices will most likely continue with its advance or vice versa.

The blue vertical lines, in Figure 4, shows of some notable congruence (interim inflection points) in the prices activities of the US dollar and Oil or Euro.

In addition to US money supplies and the inverse correlation of the US dollar Index and Oil, we have long argued that the US policy of “reflation” are being transmitted to emerging countries via monetary pegs which results to even looser policies leading to a more intense “goods and services” inflation on a globalized scale, see Figure 5.

Figure 5: Economist: Negative Real Rates and A Boom in Global Money Supplies

We have always emphasized on the importance of interest rates because it determines the saving, spending and consumption patterns of individuals, industries or economies and thus shape economic growth, direction of asset domestic asset prices and “inflation” expectations. Meanwhile, the yield spread is one of the many major contributory factors that generate investor incentives or disincentives for allocating scarce resources.

The chart shows how the world has embarked on a loose monetary policy characterized by a booming money supply (right) mostly in emerging markets and negative real interest rates (left) as measured by short-term yields over nominal GDP growth, where the Economist notes ``So it is worrying that global monetary policy is now at its loosest since the 1970s: the average world real interest rate is negative.”

Loose monetary policies threaten economic growth by price instability or the acceleration of “goods and services” inflation. Again from the Economist (emphasis mine),

``Even if the Fed's interest rate suits the American economy, global interest rates are too low. In turn, the unwarranted stimulus to demand in emerging economies is further pushing up commodity prices; so too is speculative buying by investors seeking higher returns than from bond yields, which are still being depressed by the emerging economies' build-up of reserves. This stokes inflationary pressures in America and Europe and makes life difficult for rich-country central banks.

``Loose money in America and rigid exchange rates in emerging economies are a perilous mix. The longer emerging economies hold down their exchange rates, the greater the risk of rising global inflation. Admittedly, exchange-rate appreciation is not as simple a remedy for emerging economies as some claim: a rise in interest rates and the expectation of a further appreciation in the exchange rate could, perversely, exacerbate inflation by sucking in more capital; and setting the exchange rate free risks massive overvaluation. But with an economic serial killer on the loose, one way or another monetary policy will have to tighten and exchange rates rise.”

So those worried about the pockets of “deflation” in some parts of the world should likewise reckon with how in a global economy, the US Federal Reserve policies as the de facto international currency reserve, has diffused into the emerging markets and how these policies have affected the investing and consumption patterns which has been affecting commodity prices now spreading over to a more pronounced politically sensitive “goods and services” inflation.

Moreover, the investing pattern arising from the growth stories of commodity backed emerging countries have provided further backstop to commodity and commodity based investments.

Next we have price controls.

In an effort to control goods and prices inflation many countries have used price controls or subsidies to buy political stability. Price controls have created arbitrage opportunities within borders, escalating demand for oil to profit from spreads. Such arbitrage opportunities have prompted for incidences of fuel smuggling even within China or in parts of the Asian region and elsewhere.

I even read an account somewhere where some Hong Kong residents have been said to transit to nearby China in order to have their gas tank filled, since gas prices in China is said to be a third of the world market.

These price distorting schemes have helped in the expansion of outsized demand for fuel around the world which has led to elevated oil prices at these levels.

Since rising commodity prices affect the real economy, the clamor for political subsidies will continue to mount.

Commodity bears argue that emerging markets can’t afford such subsidies because it will impair their fiscal positions, thus by lifting subsidies demand will slow.

If political survival is at stake, it is highly questionable if the present set of leaders will undertake unpopular measures that would compromise their positions.

Besides, the other factors possibly influencing the demand supply imbalances in the oil market could due to geopolitical considerations, the structural decline of conventional global oil production (otherwise known as “peak-oil”) or as an unintended consequence from stringent regulations.

If it is also true that government tankers were reportedly kept at seas or seemed to have withheld inventories on the account of expectations for higher prices then it all also goes to show that governments themselves have been engaged in speculations over oil prices.

Needless to say, if oil is in a bubble, then it is obviously a government sponsored bubble!