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Generational Dynamics Web Log for 23-Sep-06
Following the real estate bubble, the commodity bubble appears to be deflating

Web Log - September, 2006

Following the real estate bubble, the commodity bubble appears to be deflating

As real estate prices collapse, prices of oil, copper, sugar and other commodities reverse four years of record price increases.

Most mainstream economists are predicting slower economic growth in America, China and Japan, and many are predicting a recession. Slower economic growth means lower demand for basic materials, which is why investors are selling off commodities.

So far there's been only one major announced casualty: The hedge fund company Amaranth Advisors LLC, which had been managing $9.5 billion in investors funds just a month ago, has lost $6 billion.

The word "hedge fund" is a catch-all name for a variety of different kinds of investments that permit you to "bet" that something is going to happen or not happen. For example, if you're a sophisticated investor, you can find hedge funds that "bet" that the weather will be good, the weather will be bad, that gold prices will go up or that gold prices will go down.

Well, Amaranth bet billions of dollars that the price of natural gas would continue going up. With the collapse in commodity prices the last few weeks, the price of natural gas has gone down substantially, causing Amaranth to lose 65% of its investments -- and thus 65% of its clients' money. From this point on, the only people making money will be the lawyers.

Stephen Roach, chief economist at international investment firm Morgan Stanley, gives three reasons for the fall of commodity prices:

At long last, signs of cooling of China's economy. China's economy has been growing at an incredible 10% a year for twenty years, and the biggest reason for the rise in commodity prices in the last few years is that China has been sucking up huge amounts of basic materials -- oil, copper, iron ore and so forth -- to feed its factories.
Everyone knows that China has to have a recession sooner or later, and for five years the Chinese have been trying to slow down their economy, just enough to stablize it for a "soft landing," but not too much, which might cause a "hard landing." But the Chinese have repeatedly failed to find a way to cool down their economy -- until now. Finally, the economy seems to be cooling, which means that China will suck up smaller amounts of basic materials, reducing the demand for these materials, and so prices have been falling.

The collapse of the housing bubble. The housing market continues to collapse faster than expected, and this is affecting commodities in two ways. First, lots of basic materials go into new homes; for example, 46% of domestic copper goes to building construction. And second, consumers can no longer use refinancing to borrow money on their homes, and can purchase fewer manufactured goods. The collapse of the housing bubble is the main reason that almost all mainstream economists are predicting slower growth or a downturn this fall.

The transformation of the commodities market itself. This is the most unexpected of the reasons that Roach gives for the fall in commodity prices, and is based on the observation that more and more people are investing in commodity futures. (This is how you invest in commodities. For example, a "copper future" is a piece of paper that can be redeemed at a certain future date for actual copper.)
It used to be that no one except narrow specialists would ever buy commodity futures, which meant that commodity prices could be used as a predictor of future economic activity. But in the last few years, ordinary investors have treated the commodities market as simply another ordinary investment. Money has poured into commodities in the same way that it's poured into stocks, resulting in a sharp increase in commodity prices, and those prices can fall as they can for any other bubble.
This is a very interesting way of looking at it, and how a bubble feeds on itself. Investors went into commodities because they were priced low, and promised high returns. This pushed prices up and made commodities a bubble, and the rising prices only encourage investors to invest some more, in hopes of even higher returns. This cycle keeps repeating until there's a loss of confidence, and the bubble bursts. That's what's happening now.

There is another side to this. Some analysts claim that commodity prices are experiencing a "super-cycle," that the current brief troubles will past, and that prices will then continue to rise.

Merrill Lynch is promoting the "super-cycle" view. According to Merrill Lynch analyst David hall, commodities prices will strengthen in the next couple of months on a rebound in Chinese demand, especially in copper, fears of further strikes at mines and renewed demand as the northern hemisphere countries ended their summer holidays.

Andy Xie, Stephen Roach's associate at Morgan Stanley, argues very strongly that the commodities bubble is not about to burst.

"The commodity markets are currently experiencing an optical illusion," he says, and adds, "The talk of a collapse in metal prices is even more absurd, in my view."

He agrees that there's been a commodity bubble for four years, but says, "If the bubble were bursting, prices would fall below historical averages, i.e., metal prices could drop by 75% from current levels."

I can only quote views like this for so long without commenting. This is truly moronic. Commodities prices have been falling for only a few weeks, and they've fallen 10-15% in that time. The fact that they haven't fallen 75% yet is no reason to conclude that they won't; the 1929 stock market crash didn't bottom out for four full years, for example.

When Xie says that "Commodity price decouples from demand," he means the same thing as the Roach's third reason, given above, but he draws the wrong conclusion.

"Until three years ago, Chinese demand was probably the driver of commodity prices," he says. "But the flood of financial investment in the commodity market in late 2003 changed the dynamic. The total amount of financial investment in the commodity market could be four times China’s total annual imports. The financial factor has overshadowed the China factor. China has become an excuse for money to flow into the market."

In other words, commodity prices haven't spiked because manufacturers are demanding them; they're spiking because investors have been pouring money into the commodity market.

Well Andy, that's exactly what a bubble is. And if investors can pour money into a market, they can pull it out.

And here's the dumbest remark of all: "The number of financial professionals in the commodity sector may have increased by 10 times in the past five years. As long as these numbers remain, commodity prices will remain high because they will have to talk up prices to keep their businesses functioning."

Xie is saying that a bubble can be prevented by talking. This is the nonsense that I criticized Ben Bernanke for before he became Fed Chairman.

His belief, as laid out in a speech he made on October 7, 2004, that the Fed strongly influences the stock and bond markets merely by publishing the Open Market Committee minutes earlier and more often. In other words, fundamentals aren't important; only jawboning is.

This kind of reasoning exposes the ridiculous direction that today's top "experts" in macroeconomics have gone. The treat the stock market or the commodities market as a pyramid scheme, where the price keeps going up as long as you can find a "greater fool" to purchase from you.

Today's stock market is at about Dow 11500. What should this value be? What's the "real" value of the stock market today? You can believe either of two things: That the "real" value of the stock market is whatever investors are willing to pay; or that the "real" value of the stock market depends on the values of the underlying companies.

If you believe that it's whatever investors will pay, then why not Dow 20000, or Dow 100000, or Dow 1 million? What difference does it make? And if it can be down Dow 20000, then it could also be Dow 2000 or Dow 1000. Investing in the stock market is just a crap shoot.

If you believe that the "real" value of the stock market depends on the value of the underlying companies, then there's no question what its value is: The stock market is worth Dow 4500-5000; it's overpriced by 200%, same as in 1929.

This same reasoning applies to commodities, only more so. Xie himself points out, "For example, pension funds are buying commodities. They are essentially buying items like copper to be warehoused for future sales to China at higher prices."

So here's what Xie is saying: Pension fund investors are spending money to warehouse overpriced copper that nobody needs, in the hope that China will buy it later at even higher prices. And this is one of the reasons that Xie gives why the bubble WON'T burst. Is he nuts?

Xie also gives one more interesting statistic: "In the past five years, the funds flow into commodities was possibly equal to three or four times China’s total annual demand for commodities. Financial demand has simply overwhelmed real demand in price determination."

What this means is that the commodities bubble is HUGE and that there must be a LOT of warehoused copper, hoping it will be sold to China later. At some point, some investor is going to say, "I need some money, so I'm going to sell off this copper at a lower price," and with so much copper warehoused, there will be round after round of this. That has to happen sometime. Oh wait, it's already started happening.

One of Xie's conclusions: "The current cycle resembles the boom-burst cycles of the nineteenth century. The difference now is that the financial system is very sophisticated in taking risks."

It's hard to know how to respond to such silliness. I guess the best response is the old saying: Pride goeth before the fall.

From the point of view of Generational Dynamics, the various bubbles, including the real estate bubble, the credit bubble, the commodities bubble, and China's entire economy, have been generated by the zero or near-zero interest rates earlier in this decade in America, Japan and China. Those bubbles are now coming undone, and corporate earnings in many sectors are being affected.

Generational Dynamics has been predicting since 2002 that we're entering a new 1930s style Great Depression, with a stock market crash most likely by the 2006-2007 time frame. This could happen next week, next month, next year or after that, but the collapse of these bubbles indicates that the time is probably sooner rather than later. (23-Sep-06) Permanent Link
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Generational Dynamics Web Log for 23-Sep-06 Following the real estate bubble, the commodity bubble appears to be deflating

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Generational Dynamics Web Log for 23-Sep-06
Following the real estate bubble, the commodity bubble appears to be deflating