The Real Bull Market
By James J Puplava CFP, September 22, 2003
Coffee prices are up this year and so is the price of wheat, sugar, lead, copper, oil, natural gas, platinum, gold and silver. Since hitting a bottom in the summer of 2001, commodity prices in general have done nothing but head north. We are starting to see prices for raw materials that haven't been seen in years--if not decades. Investors aren't sure whether this is a temporary cyclical upturn or the beginning of a real bull market. I am of the opinion that this new bull market in commodities is the "real thing." It is being driven by two crosscurrents; a migration out of paper and a migration of economic power from the west to the east.
Source: Financial Times
There have been five bull markets in commodities over the last century. The last one ended in 1981. Since that time, the price of most commodities have fallen or remained listless for the last two decades. When a new bull market begins, there are very few who believe in it. Throughout the beginning stages of the bull market in equities there were few who embraced its arrival. It did not gain wide acceptance from the general public until it was in its final stages beginning in 1995. From August of 1982 until January of 1995, the investment public remained out of stocks preferring the safety of fixed income investments such as bonds and certificates of deposit. Stocks were considered too risky of an investment until their price had risen sufficiently enough by 1995 to become acceptable. The public embraces change reluctantly preferring to hold on to the status quo. This is no more evident then what has transpired this year. Once again individual investors are going overboard in their desire to overpay for the privilege of owning paper assets. Investors have returned to technology stocks in the hopes that the past will come alive again. The public buys; while insiders sell. This is what market experts refer to as "distribution." If insiders are selling their stocks at record levels, they need buyers who are willing to take their shares and pay up for the privilege. John Q. is performing his role admirably as the buyer of last resort, overbuying and overpaying as is his custom.
If the public is hungry for stocks again, what is the smart money buying? Judging from the movement in commodity prices over the last few years, they are moving into hard assets in a big way. Gold and silver top the list, but their buying does not stop there. Commodity prices in general are on the move from metals to soft goods, grains and energy. Just about everything is up this year, but very few investors have noticed. That is how bull markets begin. They begin quietly when nobody is paying attention. The smart money moves in first and accumulates its position. Eventually the trend catches on at the institutional level. Once institutions catch on, the next leg of the bull market is set to begin. It is when the public catches on that a bull market enters into its final stages. At the moment the public doesn't even know that commodities exist as an asset class. The public is still chasing technology stocks as insiders unload all of their shares. As sheep are led to the slaughter, the public is about to get fleeced again. All John Q. really understands about commodities is that his grocery, heating and gas bills keep going up each month. John Q. has not made the connection between his rising monthly bills and rising commodity prices.
The cable channels are telling John Q. to buy stocks, especially technology shares where there is record insider selling, so he is buying with billions going into mutual funds each week. As far as investing in commodities, it isn't even on John Q.'s radar screen. The cable channels very seldom talk about investing in commodities and only then to disparage them. In the financial world and especially the financial press rising commodity prices are an anomaly. The financial press treats their rise as a freak accident as a result of falling equity prices. It hasn't even dawned on them that a new bull market has begun. It is amusing to hear chatter coming from the financial press that gold and silver equity shares are in a bubble; while they ignore the real bubble in paper assets.
Institutional Interest is Mounting
Meanwhile, the chatter in institutional circles is that commodities are emerging as a real asset class for institutional investors. They are becoming a major new investment theme and the investment houses are moving to capitalize on it. The World Gold Council will soon launch its closed end gold fund, first in London then in the U.S. Goldman Sachs now includes a commodity component in its asset allocation and other Wall Street firms are picking up on the trend. The newest entrant to the commodity business is the rising interest by pension funds. Pension funds tend to be long-term investors unlike the hot money that dominates hedge funds. The European pension funds have moved into the area and U.S. pension funds are sure to follow, especially as prices continue to rise.
The naysayers believe the recent move in commodities is nothing more than another speculative bubble. Anytime you see rising prices, especially if the rise has been spectacular, there are always Doubting Thomases. The phenomenal rise in gold and silver equity shares reflects investment scarcity more than it does a bubble. There just isn't that many gold and silver mining shares to accommodate all of the investment demand. So when demand rises, prices rise parabolically. There is a lot of money floating around as a result of America's burgeoning trade deficits and Fed-created liquidity. While paper money is in ample supply, the supply of tangible investments isn't. The market value of all the world's gold and silver mining companies is closer to $100 billion. The annual market for silver is only around $3.5 billion and for gold it is around $25 billion. This is a drop in the bucket when compared to the trillions sloshing around in the world's paper markets. With this much paper money floating around the globe, anything it wants to move into will rise exponentially, especially commodities where there is not enough supply to handle industrial demand and investment demand at the same time. This is just the first stage of the new bull market. In terms of past commodity bull markets, this is going to be the big one.
Commodity Investment Products Will Increase
Like any new bull market there are very few investment choices to choose from. Investors can invest in shares of mining companies or own the actual physical bullion. When it comes to other commodities such as soft goods, livestock and grains, the options are few. Investors can go into the futures markets or try to find commodity index funds. In this regard there are few choices other than futures or the companies that produce the commodities themselves. Yet, this is just the beginning of a new bull market. Over time as institutional interests increase, more choices will be available. I can still remember the early bull market in equities in the 1980s when the number of mutual funds occupied only a quarter of a page of The Wall Street Journal. Given time and further price increases, the financial business will respond with new products to accommodate investment demand. The World Gold Council's ETF is just the beginning. More avenues for investing in commodities will be forthcoming, especially as prices continue to rise.
Another way to play this new bull market in commodities is to invest in the companies that produce the stuff. At the moment investors are ignoring them whether it is integrated oil companies, natural gas producers, water companies or commodity distributors. The best part about this forgotten part of the equity market is that the shares of these companies are selling at low P/E multiples, low book values, and in most cases pay attractive dividends. This is a trend that should continue for a while longer until this latest bear market rally fades, folds, or crashes.
The "Big One"
As to why we are entering into a new prolonged bull market in hard assets I return to its two main driving forces: a transition out of paper assets and Asia's reawaking. As to the first trend which is paper asset depreciation, it is important to understand the words inflation and deflation. They are both consequences of monetary policy. There is a lot of confusion today when it comes to the meaning of the word deflation. Falling prices aren't deflation. Falling prices are the natural economic outcome to increased production. The ability to produce better and more widgets brings with it lower prices. It is the natural consequence of economic law. In this regard when there are more goods that can be produced at a lower price, the consumer and the world are better off. This is a good thing, not a bad thing as the left and socialist planners would have you believe. Lower prices as a result of more productive goods produced helps to offset lower wage growth. It is a natural consequence to lower wage growth and labor costs that help offset and balance the economic equation.
On the other hand, deflation as a result of monetary policy occurs only when the supply of money and credit contract within an economy. In this regard there is no evidence anywhere of this occurring. Look at the graphs below of M3. It is still expanding, not contracting. As long as the Fed or any other central bank for that matter has the ability to print money there will always be inflation somewhere within the economy. The three charts below of the U.S. money supply, trade deficit, and the dollar are all three related.
It is one of the driving factors behind the migration out of paper assets. The smart money is bailing out of paper because it knows that the value of paper is eroding with every new dollar that the Fed creates. Right now the Fed is big on printing money and expanding credit. When the Fed does this, it creates inflation. Inflation has and will always be a monetary phenomenon and its source will always be governments or their central banks.
No Longer an Economic Superpower
Today the markets got a reality check regarding the strong dollar policy of the U.S. It is becoming more apparent with the U.S. trade deficit expanding that a strong dollar policy, given America's debt position, is no longer a reality. America's trade deficits and budget deficits resemble and look more like a third world nation than it does a superpower. We are only a superpower when it comes to our military. Economically we have gone into decline. One of the foremost trademarks of an empire in decline is a debasement of its currency. That is what has been happening to the dollar since 2001. The next round of dollar depreciation has just begun as a result of this last weekend. This weekend's agreement between the G7 countries to let the dollar fall is one more quiver in the argument for a new bull market in commodities. The agreement from Dubai is being compared to the 1985 Plaza Accord, which sent the dollar tumbling against the yen and other currencies ultimately leading to the stock market crash of October of 1987.
What is important to understand is that the investment game is about to change. The G7 who have been unable to reach an accord or broad consensus on anything recently are finally in agreement. The agreement is to let the dollar fall. Traders believe that this latest agreement means that the Japanese (who have been big buyers of U.S. Treasury debt) will be scaling back their Treasury bond purchases. That will mean a lower dollar and higher interest rates. Without Asian central bank support, interest rates will be heading up unless the Fed starts monetizing the government's deficits. Monetizing the government debt in order to avoid another economic soft patch is something the Fed has already discussed. If need be, it will implement this policy if interest rates rise too rapidly or if the economy begins to weaken again. What is clear is that monetary and fiscal policy has not been enough to keep the economy going. Now currency debasement will be attempted in the hopes that a cheaper dollar will make imports more expensive and American goods more competitive.
The graph of the trade deficit above illustrates the U.S. predicament. In the second quarter the U.S. current account deficit reached $138.7 billion. It is now growing at an annualized rate of $550 billion a year. When a country runs deficits this large its currency normally comes under pressure. The dollar has strengthened recently as a result of Asian central bank intervention. Asian central bank purchases of Treasury debt in the second quarter were almost as large as our current account deficit. These purchases were the main reason why the dollar rallied and why long-term interest rates remain this low. Foreign holdings of our Treasury debt are now at a record.
Countries such as China and Japan have been dumping yen to keep it from rising against the dollar. The IMF and the G7 countries are frightened by the size of the U.S. current account deficit and the threat it now poses to the world economy. The purpose of this weekend is get in front of a dollar crisis before it becomes unmanageable. It's either get in front of the problem now or face a bigger crisis later. The only problem with currency crises is that they tend to get bigger and go father than policy experts can control. The problem with the Plaza Accord in 1985 is that once the dollar started falling, it kept on falling, driving up interest rates and leading ultimately to the stock market crash of 1987.
The next leg of the dollar's decline could send gold and silver prices to levels that have not been seen in over a decade.
As the dollar falls and as other central banks weaken their currencies, we could find ourselves repeating the 1930s "beggar thy neighbor" policies as each country tries to outdo its neighbors in depreciating its currency. The debasement of currencies and especially the dollar is one of the main crosscurrents behind transition from paper to hard assets.
The other crosscurrent is Asia itself. Just as the last two centuries were dominated by the English and then the Americans, the new century will be dominated by Asia and more importantly China. China is emerging as the world's dominant manufacturing power just as India is emerging as a dominant power in services. The region's rapid advance is going to mean a higher standard of living and a greater demand for raw materials. This is another supporting factor in the new bull market in raw materials or hard assets.
Asia is also developing into the world's most important capital and banking region. It is the primary source of excess capital in the world. Asia's current account surplus stands in direct contrast to the U.S.'s account deficits. The region ran an account surplus of $246 billion last year. Asians are saving up to 37% of their GDP and are the greatest source of capital loans to the U.S. Moreover personal income growth in Asia is running at close to 9% per year. This means an improving standard of living, better diets and consumption of more commodities. Not all Asians may own cars, but if they all go out and buy motor scooters you're talking about all of the excess surplus of OPEC. China's manufacturing skills, its competitive low cost labor force and efficiency and its hard working populace are going to shift the balance of economic power from west to the east. At the same time it is going to shift the markets for raw materials. As China industrializes and as its standard of living increases, it will exert a demand influence over the price of commodities and act as a floor underneath their price. China and Asia will be the second fundamental pillar of support in this new bull market in commodities or "things" as I like to call them.
I have written on this subject on numerous occasions over the last three years beginning with my Storm Series in July of 2000. I won't belabor the subject here any longer other than to say that we are only in the beginning stages of this new bull market. Once again the fortunes in this decade are going to be made in the following four areas and they are all commodity related. They are as follows:
- Precious metals: silver first gold second
- Energy: natural gas first oil second
Back at the casino it was a losing day for the markets as traders digested the import of this weekend's G7 meeting. The major indexes suffered their worst losses in seven weeks as a result of the freefall in the dollar. The markets are now realizing that the biggest threat to the post-bubble economy is a sharp decline in the dollar. The dollar hit a three-year low against the Japanese yen. The greenback also fell sharply against other Asian currencies and the Euro. The fall in the dollar hit all major indexes across the globe beginning in Asia where the Nikkei fell 4.24 5 in today's trading. European stock indexes suffered through losses that ranged from 2.5-3.4%. Technology stocks and financial stocks were among the hardest hit by today's market decline. Financials fell over fears that without foreign intervention interest rates will start rising in the U.S. again.
The dollar's fall and the market's correction did not deter stock market bulls who saw a silver lining in today's dollar fall. A lower dollar will mean higher profits for U.S. international companies by increasing the value of their overseas sales. The currencies slide has added 3 percentage points to U.S. company profits this year.
Volume came in at 1.24 billion on the NYSE and 1.70 billion on the NASDAQ. Decliners beat out advancers decisively by a 23-9 margin on the Big Board and by 21-11 on the NASDAQ. The VIX rose .57 to close at 19.65 and the VXN fell 1.80 to 27.94.
Charts courtesy of: www.stockcharts.com
© 2003 James Puplava