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Interest Rates and Commodity Cycles- What Makes a Bubble?

Commodities / Resources Investing Jun 09, 2008 - 12:35 PM GMT

By: David_Petch

Commodities Best Financial Markets Analysis ArticleLarry Moe and Curly formed one of the most successful comedy trios in history, who rightfully so, went with the stage name The Three Stooges . Their routine was based on physical slapstick comedy applied to numerous stories and awkward situations. Their bumbling stupidity and lack of focus on any given situation made for entertaining comedy clips that spanned several decades of the 20th century. An example of their fine comedic routines can be seen in this clip titled Carpenters . To view an infinite supply of "The Three Stooges", simply enter this into the search bar on www.youtube.com and be prepared to be entertained for hours.


Speaking about being entertained, enter Larry Kudlow. John Browne of EuroPacific Capital was recently part of a debate in which Kudlow, along with two bullish cheerleaders, were trying to tear at the fabric of his bearish case. Browne is British, extremely knowledgeable and extremely polite...too polite to be dealing with the antics of Kudlow and Company. If you have not noticed, by the title of the article, a picture of "Larry" Kudlow was collated with images of Moe and Curly...now all we have to do is search for modern day representations of Moe and Curly on the Wall Street Entertainment. The problem is there are numerous candidates to add a "Moe" and "Curly" in forming a modern day trio, except they all perform monologue financial comedy shows.

I have only tuned into watch Kudlow and Company once in a blue moon to get a perspective of how far off the mainstream media is at understanding where we are in the commodity cycle. My conclusion is that they are still in the denial stage and have not even entered into the opposition or tentative acceptance yet...these psychological hurdles must be leaped over first before we enter slavish acceptance, which represents the blow-off phase. So, this commodity bull market may last far longer than any of us are lending credit. Further points mentioned within this article are related to the slapstick routine that Kudlow and his crew present which lack merit and substance.

Interest Rate and Commodity Cycles

Long-term interest rate cycles last for decades. According to my work on the 10-Year US Treasury Index, the pattern that started from the top of the 1980 top is "just" in the process of completing the long-term corrective pattern. Longer-term interest rates are about to enter a long-term trend, leaving the cheap rates of the past in the rear view mirror...something that Kudlow et al fail to realize.

Interest rates generally rise slowly as economy gains strength after a bottom is put in place after a significant bear market has terminated (remember bear markets go out with a whine, not a growl). A change in trend for a strong period of economic growth must be confirmed by numerous factors such as a confirmed economic bottom, real estate bottom, lack of a currency crisis, favourable demographic profiles in nations one seeks to invest in etc.

Stock markets have an inverse relationship to gold...the 1980-1999 period was in a bull market across the broad market indices while most commodities were in a severe bear market. For nearly 20 years, commodity prices were extremely low, which caused a lack of exploration and resource development for increasing reserves in the ground (oil, gold, silver, coal, cobalt etc.). Lack of exploration caused many of these companies to high grade the resources they had, leaving only the chaff.

Since 2000, commodity prices have risen substantially, but so have the expenses associated with exploration, development and maintenance of infrastructure not to mention the fact that labour and labour shortages have also gone up hand in hand. The price of mining one ounce of gold has been recently stated to cost $700-800/ounce at present, leaving only $80-100/ounce profit, which represents around 10-11% profit...this is a minimum for any sort of business trying to make a profit. Anyone who does not look at the net profit gold mines of present and thinks gold stocks are overvalued are examining these companies incorrectly. Rising inflationary pressures have forced costs up across the board so commodity prices must rise in order for companies extracting raw commodities to meet their associated costs or they close shop, plain and simple.

What Makes a Bubble?

Generally, bubbles occur when there is an excess supply of a given commodity or item in the market. Gold, oil and silver production are far from bringing additional supplies onto the market. The ability to explore for new resources and extract them is directly linked to the amount of available energy. Since we are in the era of Peak Oil, this automatically suggests that supplies will be limited in the future due to the availability of energy for extracting resources. For anyone not familiar with the concept of Peak Oil, I suggest everyone pay a visit to Matt Simmons web site, as he is by far the foremost global expert on Peak Oil.

When the above situation occurs, thereby restricting supply, coupled with real negative interest rates similar to what occurred in the 1970's, it represents a turning point where longer-term interest rates will eventually begin to move up, dragging the price of gold much higher.

Markets control longer-term interest rates, no matter what meddling governments may try to do in the short-term. Once inflation really begins to dig its heels in later this year and through all of 2009, lenders will realize the associated risk with lending, inflationary pressures etc. This will cause them to demand a higher interest rate associated with loans in order to compensate for overall risk.

Banks with laddered loan portfolios from rates on lower rungs to higher rungs will require higher rates going forward to offset lower yielding loans and cover operational costs. This will force people to live within their means and automatically removes all components of the economy that depend on credit. Since the US GDP is represented by 72% of consumers, the overall economy is going to be hit hard. This will make the fiat paper regime less attractive and will drive anyone with money into hard assets i.e. gold and silver.

Breakdown in Logic, Manufacturing Base and the Economy

Kudlow fails to realize the above, particularly that gold is money, a commodity, and a hedge against inflation. In the 1979-1980 time frame when interest rates went to 15-20%, the US had large quantities of gold and silver, a large manufacturing base, favourable demographics, and was not so energy dependent. So the economy could absorb the large hike in interest rates. Fast forward to the present and none of the above is true anymore. Back then, higher interest rates popped gold because the USD was still a suitable replacement for gold. At present, the USD pattern is terrible and higher interest rates in the US no longer carries any tangible weight to cause an investment shift from gold. This translates into the death of the USD. So not only will rising interest rates be good for gold this cycle (driving the flight to tangible assets), it will force more people out of the dollar as it reaches a tipping point into anything that has value.

Another one of Kudlow's poor market assessments is how a perceived bull market is developing in the broad market indices (DOW, NASDAQ, S&P 500 Index). Price the S&P 500 Index using the USD Index, the Euro, or Canadian dollar, and although the present nominal value is near the 2000 high, in real terms it's actually no where near the former high. This is a form of illusion...that being the purchasing power of the S&P. Notice how Figure 1 illustrates the S&P 500 Index nominally expressed, while Figure 2 shows the S&P priced relative to the USD Index...quite a different perspective on how things look when the proper light is cast on the situation. The S&P in real value terms against the USD index is down around 22%. Just imagine how lower this value could go should the USD declined to 58-60 by July 2009.

Figure 1

Figure 2

Browne mentioned that the US economy is based upon consumers making up 72% of the GDP, followed by Kudlow quickly changing gears to focus on how well the US manufacturing sector is doing. Kudlow failed to account for the severe erosion of the US-based manufacturing sector from post WWII until present and the fact that credit expansion facilitated the extended bull market in part by consumers taking on more debt.

Now that the credit cycle has imploded, the 72% consumer-based economy is under pressure based on the reliance of credit for transactions. There is no way that the remaining 28% of the non-consumer economy (manufacturing, small percentage government) can carry the US through a period of time without some form of a market slowdown occurring (recession, depression or some form in between). Peak Oil will create regionalized economies that will cause a return of limited manufacturing capacity, but these changes can take decades to implement. The amount of growth is dependent upon the amount of available energy, so it is safe to assume future economic growth from today's perspective will be significantly smaller than today...if inflation persists, the economic output will be lower, but appear similar in nominal terms much like the differences noted in Figures 1 and 2 (i.e. lower degree of purchasing power). Also, Kudlow failed to realize how energy dependent the US is and how they are already at the point of saying "Uncle".

One funny point of the interview with Browne was seeing Kudlow "squeal" with delight noting that oil and gold were down for 1-2 days in a row. Oil shot up from $85 to a high of $137, before declining sharply to $122/barrel and shooting up to $138.change/barrel on Friday. Nothing moves as the crow flies , so the above volatility should come as no surprise to those that realize a bull market is a "Wall of Worry". One thing not mentioned on the show is that oil is likely set to touch or surpass $150/barrel this year. And eventually this will trigger a move in gold well above $1500/ounce by the end of 2009.

Conclusion

The S&P is a fluid index, which by definition means that poorly performing components can be removed and replaced with other stocks in different sectors that perform well. At present energy and gold stocks make up 7% and 0.5% of the S&P 500 Index, respectively. At the peak of the 1980 commodity bull market, energy and gold stocks constituted 25% and 17% of the S&P 500 Index, respectively. From this perspective, with the financial industry making up 30% of the S&P 500 Index only one conclusion can be drawn. Financials will contract as a percentage of the S&P as the commodity bull market matures, with energies and gold stocks making up much of the difference.

What happens to the value of the S&P 500 Index over the next 4-5 years because of this? Chances are it will remain buoyant, surprising many, possibly even hitting between 1400-1600 between 2011-2012, but that is based upon nominal value. If the S&P were to be examined as per Figure 2 (any other currency), it may have a purchasing power value of 700-800...maybe lower. The commodity bull market will help to keep the S&P 500 Index afloat for some time, but once the inflationary period reverts to deflation, no more tricks will be up any sleeves to keep things propped up...the magic hat will be empty. Once the commodity bull market ends around late 2011/early 2012, the stock market is likely to start a sharp decline not bottoming until some point in 2014-2016.

I could go on into further detail covering all of the logic errors present in Kudlow's argument, but you should be getting the point by now, which is the primary aim here today. Kudlow is the epitome of Wall Street slapstick financial humour, which is good for a laugh, but not to be taken seriously for preserving wealth. Continue accumulation of gold and silver bullion, energy stocks and precious metal stocks in politically secure areas of the world as a financial storm presently not seen by many will soon to hit the US coasts from all angles.

A major portion of the work I do is technically oriented, but I write 2-3 editorials per week often intertwined within the analysis . For further viewing of prior work, simply click on the Archive section of this site. I update the AMEX Gold BUGS Index, AMEX Oil Index, US Dollar Index, 10-Year US Treasury Index, S&P 500 Index as well as commentary on market-related issues and new technical analysis findings. We follow some 60 stocks, with a focus on core positions and stocks that actually make up our personal portfolio. As well, the keeper of the site, Captain Hook writes 3-4 articles per week discussing macro issues, ratio analysis of various markets and an in-depth study of put/call ratios and shorting candidates.

By David Petch

http://www.treasurechests.info

I generally try to write at least one editorial per week, although typically not as long as this one. At www.treasurechests.info , once per week (with updates if required), I track the Amex Gold BUGS Index, AMEX Oil Index, US Dollar Index, 10 Year US Treasury Index and the S&P 500 Index using various forms of technical analysis, including Elliott Wave. Captain Hook the site proprietor writes 2-3 articles per week on the “big picture” by tying in recent market action with numerous index ratios, money supply, COT positions etc. We also cover some 60 plus stocks in the precious metals, energy and base metals categories (with a focus on stocks around our provinces).

With the above being just one example of how we go about identifying value for investors, if this is the kind of analysis you are looking for we invite you to visit our site and discover more about how our service can further aid in achieving your financial goals. In this regard, whether it's top down macro-analysis designed to assist in opinion shaping and investment policy, or analysis on specific opportunities in the precious metals and energy sectors believed to possess exceptional value, like mindedly at Treasure Chests we in turn strive to provide the best value possible. So again, pay us a visit and discover why a small investment on your part could pay you handsome rewards in the not too distant future.

And of course if you have any questions, comments, or criticisms regarding the above, please feel free to drop us a line . We very much enjoy hearing from you on these items.

Disclaimer: The above is a matter of opinion and is not intended as investment advice. Information and analysis above are derived from sources and utilizing methods believed reliable, but we cannot accept responsibility for any trading losses you may incur as a result of this analysis. Comments within the text should not be construed as specific recommendations to buy or sell securities. Individuals should consult with their broker and personal financial advisors before engaging in any trading activities as we are not registered brokers or advisors. Certain statements included herein may constitute "forward-looking statements" with the meaning of certain securities legislative measures. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the above mentioned companies, and / or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Do your own due diligence.

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