What if it's not a bubble? –
Bubbles past and present
March 31, 2008
If you haven't read Charles Mackay's 1841 classic "Extraordinary Popular Delusions and the Madness of Crowds", now's a good time. If it doesn't turn up at your local library between "Understanding Islam" and "Make a Killing on Forex", you can read it here for free:
http://www.econlib.org/library/mackay/macExContents.html
It's a fascinating history of the investor mob's favorite rallying cry: "This time it's really different!" Mackay details the development of the Dutch tulip mania, the South Seas trading bubble, and the disastrous "Mississippi Scheme" that bankrupted the French monarchy, plus a raft of lesser lunacies. It's a treat for anyone that enjoys scandal and history illuminated by psychological insights. If scandalous psyched-out history isn't your cup of tea, no matter. "Delusions" is worth the time just for the wild ride, like Chesterton's The Man Who Was Thursday, but with more anarchy and lawlessness.
Besides, no trader, investor or speculator should foray into the markets without knowing what a gullible fool he can be under the wrong circumstances. And that's what the book is really about: how unbelievably stupid human beings can be when greed clouds their thinking.
It's too bad Mackay isn't Shirley MacLaine, so he could come back in another life and update the book to include the Tech Wreck, the Real Estate Fever of 2002--2006 and the Derivative Disaster that's melting down at this very moment. Afterwards, he could stick around to document the Giant Gold and Commodities Bubble of 2008, and the subsequent crash.
Except...is that what's happening? Are we really experiencing a true "bubble" in commodities? Several years back, when "Easy Al" Greenspan was asked if a bubble was blowing up in U.S. real estate, he replied that, No, it wasn't. Besides, said the Fed chief, you can't identify a bubble until it bursts. But a few months later, Al grudgingly acknowledged that there might be the beginnings of a real estate fever in certain coastal markets, but it was quite limited and there was no danger of it getting out of hand. Finally, just before retiring, Greenspan admitted that there was a generalized speculative fever in real estate markets that displayed bubbly characteristics: Irrational Exuberance with a 30-year adjustable rate mortgage.
Have you got what it takes to be a bubble?
The term "bubble" gets thrown around pretty freely in investment circles. The way some people use it, it could mean The Next Hot Thing, or even sector rotation. But what constitutes a real, authentic, no-question-about-it investment bubble? When an investment, or class of investments, attracts so much attention and money that the price rises out of all proportion to its intrinsic utility or any reasonable estimate of future cash flows, I think we can call it a bubble. When tulip bulbs became so desirable in 1636 that a wealthy Dutchman traded a fine carriage and horses for a single bulb, and an especially rare variety sold for a price equal to seven years' wages for a workman, we can say that the price parted company with any sensible valuation metric.
Still, the Dutch Tulip Mania is so yesterday, and so Old World. No self-respecting hedge-fund manager would trade his house in the Hamptons for a flower bulb, hey? Let's bring the question into the 21st century. The Standard & Poor/Case-Shiller House Price Index reveals that U.S. home prices rose 74% from 2000 to 2006: Does that constitute a bubble? Hmmm, that's a bit different. Surely some of that price increase was rooted in monetary inflation, rather than just supply/demand issues or speculative excesses. We might back out the $DX's 18% decline and lop off another 6% for population growth, shift from renting to owning, and demand for 2nd homes all thrown together, and end up with an (admittedly arbitrary) increase of 50% for those six years.
At this point, I hear some of you sticklers saying, "Forget the U.S. Dollar Index! The buck certainly declined more than 18% during those years!" Well, whatever. Call it a 40% increase in home prices if you like. I'm nothing if not easygoing.
In any event, I have to say the real estate boom looked like a bubble and walked like a bubble, even if there wasn't a spectacular disconnect between price and utility value. You can call it an overheated market, and I'll call it a frothy excess; either way, it ended in disaster--for homebuyers, mortgage lenders and credit-derivative speculators. And especially for the Fed and the U.S. dollar.
The Real Stuff
So, let's talk commodities: Gold, silver, copper, oil, wheat and soybeans--are they in a bubble? Are prices rising out of all proportion to the intrinsic value of these items?
Many commentators have already proclaimed that commodities are certainly in a bubble, and the bubble is already bursting. In other words, we've seen the highs; it's all downhill from here, at least for another 18 to 20 years, until a new commodity cycle gets underway.
For the analysts and chart moguls who take that stance, I have a few words of kindly advice: You need to get out more. Instead of poring over mouldering charts from bygone eras, and chattering on about "historical ranges", why not step out of the cubicle and take a look at the here and now? For example, have you considered the effects of decades of inflation on commodity prices? Has it occurred to you that a $6 bushel of soybeans in 1988 is a very different item than a $6 bushel in 2008 dollars? If you chart most farm commodities in constant 1973 dollars, for example, the "bubble" simply disappears. Soybeans have risen by more than 50% in twelve months, but remain well below their median price for the last 40 years in inflation-adjusted terms. Furthermore, farming costs have soared. The cost of fertilizer has risen from $250/ton to over $1000 in many markets. Diesel fuel has more than tripled in recent years.
What about supply and demand? Severe drought has devastated crops in Australia and across Europe. As grain supplies around the world fall to perilous levels, food riots have led many governments to restrict food exports. The Economist reports that the United States and Kazakhstan are the only countries in the world still exporting wheat---but Kazakhstan just joined Argentina, Russia and Ukraine in placing heavy tariffs on grain exports. While China and Japan stockpile rice against supply risks, Cambodia, Indonesia and Thailand have banned rice sales or are considering restrictions.
In addition, the rush to biofuels has affected acreage allocations dramatically. Ethanol subsidies have induced farmers to shift vast tracts into corn, even as biodiesel spurs soybean demand and wheat silos stand empty. As a consequence, wheat and soybeans now occupy 10 million fewer acresthan they were allotted a decade ago.
"Something's happening here, and you don't know what it is, do you, Mr. Jones?"
Bob Dylan aside, just what is going on out there? If metals, energy and agricultural products are not the objects of an investment mania, then what on earth is going on? The Minnesota spring wheat contract vaulted from $5 to over $20 in a year's time. You don't call that a bubble? The gold price has quadrupled in less than a decade. Crude oil traded near $30 just a few years ago, but now sits solidly atop $100. And what's up with copper? We never gave copper a thought until 2004, when it suddenly jumped through $1 a pound. Then, while our horrified gaze was fixed on the spectacle of $110 oil, copper quietly climbed past $4 per lb.
Is this the result of hot-money speculations in the futures markets?
Or is it the blowback of frantic currency inflation by central bankers?
Is it caused by dwindling oil reserves, declining mine output and grain stocks at multi-decade lows?
Or maybe the booming new Asian middle class is funneling discretionary yuan, won, rupees and baht into all the stuff Westerners have enjoyed for decades, and driving up the component costs in the process?
Let me suggest answer (e): All of the above.
Commodity futures markets have stirred up an incendiary cocktail of inflation, speculation and roaring demand from developing nations for limited supplies of just about everything that people really want and need. I admit, it seems like what everyone wants is money, and more of it. But think again: If money was only good in poker games, how many people would get of bed each morning and slog off to work? Not yours truly, I can tell you.
So, can we talk?
Is $1000 gold really blown out of all proportion to gold's intrinsic worth? Does gold even have any "intrinsic" worth? You can't eat it, it pays no dividends, generates no revenues. What good is it? Well, it's money, or at least is used to be. And there's precious little of it on hand, unlike paper currency. And finding gold and getting it out of the ground is a nasty, difficult and dangerous business. That's why people who dislike work and have low ethical standards hardly ever become prospectors. It's too dusty and sweaty. Why not simply learn to run a press and become counterfeiters, like the Treasury Department and the Federal Reserve? Flexible hours, good pay, and you never have to leave the comfort of air conditioning---what's not to like? What, it's illegal? Well, that hasn't stopped the Fed from loaning money to Wall Street brokers at 2.5%, when they admit they can borrow money elsewhere. The Federal Reserve Act specifically prohibits the Fed from loaning money under these terms, but it's so...convenient.
Is crude oil insanely overpriced at $105 for a 42-gallon barrel? Well, there's a finite amount of it on hand, and the civilization we've cobbled together could not exist a single day without it. The major oil companies spend billions in a fruitless quest to replace dwindling reserves, while demand keeps ramping up. Every day, Shanghai puts 1000 new cars on the street, and the traffic in Calcutta--well, see for yourself: http://www.youtube.com/watch?v=Rbg0IfBG2gY
How about wheat, up from $3 a bushel to $11? U.S. wheat inventories are at a 59-year low, just when China and India have taken a shine to bread and pasta. Bad weather, bad planning, bad timing. So is wheat overpriced at $11? Maybe. Or maybe Mother Hubbard and the grain traders just noticed the pantry is alarmingly bare.
For a while, it seemed the world's food and energy problems were under control. Decades of technological advancements boosted output on the farm, in oil and gas fields and in mining and extraction techniques. Productivity gains have reached a plateau, but global demand keeps surging.
Sinister plots--right out in the open!
Now then, there's another element that we need to talk about and that's---manipulation. Whoa, wait, come back! We're not talking conspiracy theories here, we're just mentioning certain well-known and indisputable facts. Such as...
The gold price has been manipulated for many years. What am I talking about? I'm talking about the Emergency Banking Relief Act of 1933 & Presidential Executive Order 6102, which confiscated privately owned gold, fixing the price at $20.67 per ounce until the confiscation was completed, and then promptly raising it to $35. In the 1970's, private ownership of gold was legal again, but central banks continued to sell gold reserves to manage the gold price. Fed Chairman Alan Greenspan stated that "central bankers stand ready to sell gold in increasing quantities" to keep the gold price under control. If fixing and suppressing the price isn't manipulation, what is?
Furthermore, there is a very large and concentrated short position in gold held by a handful of deep-pocketed firms on the New York Mercantile Exchange. The position is so large as to be indicative of an attempt to cap the gold price, and has been maintained in the face of gold's current uptrend. Isn't there something just a little suspicious about that?
Which brings us to silver. For many years, the Silver User's Association insisted that there was no reason for the price of silver to rise, that in fact silver was so plentiful that it was considerably overpriced at $5 per ounce. "The stuff's just like dirt; it's dang near everywhere you step. Can't help tracking it into the house on a wet day."
What the SUA neglected to mention was that, according to the United States Geological Survey, about 4/5 of all the silver ever mined has been destroyed beyond economic recovery. Well, we still have huge stockpiles, right? Not any more. We had substantial stockpiles of silver 60 years ago, and those stockpiles have been almost completely exhausted. In fact, we're running a bit short of silver. More than 900 million ounces are consumed each year by industry, jewelers and flatware makers, plus investment demand. The world's mines produced only about 650 million ounces last year. The rest is drawn from dwindling stockpiles or recovered from used photographic film.
The fact is, there is less than half as much silver above ground than there is gold these days. Gold is too expensive to consume in the using, and we still have nearly all the gold that was ever taken out of the ground. But our silver is mostly gone, and silver is rarer than most people think. Despite the SUA's propaganda, silver occurs in the earth's crust at a rate of .07 parts per million. Gold is only 17 times more scarce, yet trades at a price 50 times higher. Is something funny going on there?
You might ask, what's so special about silver? Among other things, silver has the highest thermal and electrical conductivity of any element. It's extremely ductile and malleable. It also happens to be bactericidal. In fact, in some applications there is no substitute for silver. In short, silver is a very rare element with unique qualities.
Now, I am the very last person to suggest that the Silver User's Association might have indulged in a little self-serving misrepresentation. But there's another inconvenient truth to grapple with: Silver is the most manipulated commodity of all on the futures exchanges. The Commitment of Traders report shows a huge and concentrated short position in silver futures, some 400 million ounces comprising more than half of the world's annual production of silver, held by eight or fewer large firms on NYMEX. That position has persisted for many years despite silver's rise from $5 per oz. in 2003 to as high as $21 recently. The Commodity Futures Trading Commission acknowledges the giant short position but refuses to call it manipulative.
If you knew that most of the world's gasoline or wheat was controlled by a handful of unnamed and very wealthy entities, wouldn't you suspect that something a bit dodgy was going on? Well, so would I.
It all comes down to this
So, just maybe, there is another reason why some of our commodities are rising rapidly in price. The prices of gold and silver have been suppressed, held underwater for long periods by various parties with a self-interested ax to grind. Now that the world's consumers and money supplies have together grown to a tipping point, those price manipulations are becoming harder and harder to maintain. In fact, they look to be unraveling under the strain. Gold and silver are not overshooting reasonable price levels; in reality they are simply normalizing after a long period of artificial price suppression.
Maybe the surge in commodity prices is actually not a bubble at all, but a convergence of global factors that signal a new era, where the focus shifts away from paper assets to real, tangible things that people actually use and care about. After all, do vulture capitalists and hedge-fund traders really add substantial value to our world? Perhaps ordinary workers---growers, miners, and the engineers who facilitate their work--will eventually be viewed as more productive than money-shufflers. Wouldn't that be different?
I'd like to think that all the deference to, and worship of, investment bankers and IPO brokers is just another of those things Charles Mackay wrote about. You know, an extraordinary popular delusion--one that's coming to an end.
Gabriel Gray
This article was first published at www.grahamanalytics.com