Coming off the heels of one of the worst performing quarters in recent memory, global financial markets let out a collective sigh of relief after the Fed engineered the Bear Stearns bailout. Stockmarkets worldwide rebounded sharply off their lows, and short term bottoms have been secured for now. Even though world economic performance has diverged pronouncedly over the last few quarters, stockmarket decoupling remains illusive. In fact, the region with the strongest growth momentum-Asia, had the worst market performance in the 1st quarter.
Although we believe factors continue to point to a worsening long term trend in corporate earnings and market valuations, outlook has improved in the short term. Markets are likely to buy time and move in sideways trading ranges over the next few months. While fundamentals do not support a positive outlook for the stockmarkets, stocks tend to hold up in environments of rising inflation. We are also looking for confirmation of decoupling in market performance worldwide as underlying fundamentals exert themselves. At which time, we will look to increase our exposure to emerging markets in Asia, Africa and the Middle East.
Contrary to some arguments that the US market valuation is low, and despite the fact that it has corrected sharply from the high, the current US market P/E multiple, based on trailing earnings, is at a historically overvalued territory of nearly 21 times. S&P 500 earnings are projected to drop to 55.15 by 2Q 08, as compared to the peak earnings of 84.92 in 3Q 07. Real earnings are collapsing fast in spite of Wall Street’s unrealistically optimistic projections for operating earnings to remain more robust.
All commodity prices have corrected sharply after the Fed aggressively cut interest rates and successfully engineered the Bear Stearns bailout. I will summarize below the likely reasons for these sharp corrections.
The Confluences of Factors Behind the Corrections of Commodities
* Commodities have risen sharply since last summer when the credit crisis started to gather storm, and have further accelerated since the end of 2007. This points to the fact that increasing amount of speculative capital had entered the space, capitalizing on momentum and short term gains. It is also reasonable to assume that not an insignificant percentage of this inflow came from hedge funds. This clearly created mini short term bubbles in most of the commodity prices.
* Bear Stearns is apparently the clearing broker for many commodity trading hedge funds. Bear’s demise could have forced some of these funds to deleverage and sell assets.
* Sentiment, at least in the short term, has turned more positive with the Fed’s bailout of a non bank. At this point, the consensus is for a v shaped short and sharp recession followed by an equally sharp recovery. Hedging assets such as commodities are sold, and shorts in financial stocks are covered.
* USD’s surprising strength in the face of the Fed’s aggressive interest rate cut signifies market expectation of a US recovery and dollar shorts are covered. Commodities, and especially precious metals, represent the opposite side of a seesaw against USD, and as USD strengthened, commodities weakened.
Financial markets are flashing conflicting signals with regard to growth and inflation. On the one hand, recent corrections in the price of commodities and energy point to expectation of weakening demand as economic growth worldwide slows. On the other hand, sharply steepening yield curve and USD rebound point to expectations of growth recovery.
However, one thing is certain. Western central banks will do whatever it takes to prevent a financial system collapse, and sharply increasing monetary inflation is one of the unwelcome byproducts of these bailouts. This kind of monetary inflation is highly likely to feed into general price inflation. As commodity prices are based in US dollars, and many emerging economies have pegged or semi pegged currencies to the US dollar, the US monetary policy has an overwhelming impact on global inflation. Thus the aggressive easing pursued by the US Federal Reserve will now put further upward pressure on global commodity prices. Already, there is a severe food crisis unfolding in many poor countries around the world. Globally, we are now pulled by the dichotomy of growing inflationary pressures in the emerging economies and gathering recessionary forces in the developed economies.
While history repeats itself, it rarely does it in exactly the same manner.With this in mind we can look back at the two periods of the depressionary 1930s and the stagflationary 1970s to show some parallels to the situations today. Both crises were a result of accelerated credit expansion which caused asset price inflation, and the 70s’ was further exacerbated by supply shocks of oil. The current debacle shows that bubbles created by excessive liquidity will eventually burst even in the face of no apparent policy tightening, unlike what preceded the 1929 crash. And although there is no supply shocks on the commodity front, tight supply demand balance exists in many commodities.
The Dow plunged some 89% in three years from its 1929 high and general prices deflated by some 10% per year for the following years. The price of gold was fixed at 20.67 USD (some 250 USD in today’s money) under the then prevailing gold standards. Gold was hoarded until President Roosevelt confiscated private gold holdings at the fixed price of 20.67 dollars before revaluing it to 35 USD (500 in today’s money) in 1933. As a proxy for mining stocks, Homestake Mining went from a low of $7 to a high of $36 in 1936. In the 1970’s stagflation, prices of gold went from $37.6 (around $200 in today’s money) at the end of 1970, to $641.2 (more than $1,500 in today’s money) at the end of 1980. Gold reached as high as $850 in late 1981 before Paul Volker’s policy to rein in inflation kicked in, and eventually heralded in the ensuing long term bear market which lasted some twenty years. Gold stocks also went up sharply, some more than 6 fold in the late 60s and 70s as other assets foundered.
Clearly, as everything else in our economic system, the price of gold is driven by the balance of supply and demand, but sentiment also plays a critical role in changing demand, as gold has little intrinsic value. Historically, gold held value in times of war, inflation (negative real interest rates) and financial crisis. The price of oil has been incredibly stable over the long run when measured in ounces of gold. This clearly shows that wildly fluctuating commodity prices are largely a monetary phenomenon. And while in the long run stockmarkets seem to have marched steadily upwards in nominal currency terms, they have also gyrated wildly when measured in ounces of gold. The ratio of Dow Jones Industrial Average and gold ran from a depressive low of 1 at the beginning of 1980s to a euphoric high of 43.7 at the peak of 2000 internet and new economic paradigm bubble. The difference between gold and equities is that gold is a store of value while equities grow in value. Interestingly, gold has out- performed Google, the brightest star of the information age, since late 2005. We have advocated gold holdings as a measure against monetary inflation and see no reason to change this stance now.
We also believe that the supply inelasticity of many commodities, and agricultural commodities in particular, make them more attractive investments vs stocks and real estates in the face of increasing demand as emerging economies become wealthier. The commodity space has always been characterized by intransparancy, high risk and insider bias, and shunned as a viable long term asset class traditionally. Nonetheless, there is evidence that some institutional investors have started to come around in their assessment and have started to increase the commodity exposure as part of their long term asset allocations. We believe the reward and risk profile still favors a meaningful exposure to this space.