Fighting the cult of negativity, some realistic views on inflation
In my entire 25 months of participating in the markets, and in the CAPs blogs (and also yahoo message boards for specific stocks, although I participate alot less now than I used to on the YMBs, as I am not making many new stock picks) I have been overwhelmed by the negativity. In all of scope, consistency, and intensity it is remarkable.
I have read one book on investing, Dremans book from the 90s on contrarian investment strategies. In it he explains bear markets and market panics and explains that at bottoms nobody wants stocks, and every and any excuse is made why they are still expensive, while at tops or in bubbles any and every justification for why they are still cheap is paraded around grandly. By pure luck, I picked THE perfect book to buy for investing over these 25 months. That is, exactly, how it played out. His book also told and gave statistics on how in big crashes the stocks that crash the most will rebound the most, how the cheapest stocks outperform, and all of that. It all played out exactly as it has in the past, not really different at all. Remember that freaking p/e of the S&P chart that the bears loved to parade around as the market rallied in early 2009? Justifying that XL, with a price/book of about 0.1 based on todays book value, and a normalized p/e of about 1, was too expensive, you better sell it, right now, because the S&P would be fairly valued at 250. I can't even imagine how preposterous the justifications for the tech bubble valuations were.
Anyway, at times this resounding and infinitely energetic wall of negativity gets to me and I become incredibly irritable. I sit here at my computer imagining that my fellow CAPsters are sitting at home licking their lips, dreaming of a crash like tomorrow looks like, dreaming of seeing the misery in their neighbors eyes, drinking fine spirits as their precious metal holdings go up, and planning long and elaborate speeches to rub it in the face of everybody whose 401k dropped. Thats what really bothers me: the apparent reveling in the suffering of others.
Back then the negativity was about how all the banks were zombies and we were going to have a great depression, a deflationary crash, then it was how QE would cause runaway inflation, then back to deflation, now back to inflation and an amazing, internet-wide assault from hundreds of voices on how stupid Bernanke is and how he is to blame for everything. QE2 is causing food riots, unrest in the middle east, it and it alone - Bernanke, no, "The Bernanck" himself is causing all of this. There is no need to elaborate on how or why, or to think about other reasons why commodity prices may go up, or to even stop shouting at all. This is a cult, the goal is to chant. Sorry for the insulting tone, that is payback for making me aggravated on a regular basis for the last 2 years and for keeping probably thousands of people with kids to educate out of the biggest bull run of our lifetimes. Something for which I sort of think you'll never bother to even think about.
All I want to do in this post is offer some thoughts on why commodity prices may be going up that aren't QE2.
SPECULATORS AND CHINA, FOLKS
1. As part of Jim Chanos's short-china thesis, he has noted that every commodity company he talks to says that China is the marginal buyer. That has also repeatedly been noted in Alcoa and other earnings calls that I have participated in over the last couple of years. It has been a part of the "pro-commodity" thesis for the last 2 years as well. China is expanding, buying, therefore commodity demadn will stay up.
2. Again per Chanos's short-china thesis, China, the worlds 2nd largest economy, is now up to 70% of GDP being internal construction. That is 4x the peak for the US at the top of the bubble. That is a greater amount of construction than we ever had. It is massive, and it will consume enormous amounts of everything.
So maybe, just maybe, if actual user-demand is a part of the rise, Chinas enormous demand has something to do with it? I don't know.
3. Oil is probably actually now, or at least possibly, at a point where its demand/price interactions aren't so stretchy. Marginal increases in demand give larger increases in price.
4. All time record amounts of money are being speculated on commomdities. They are core parts of innumerable hedge funds and must be the trade-du-jour for retail investors, as the blogosphere is flat out full of discussion of them.
5. physically backed ETFs must now hold 10's of billions of dollars worth
6. this trend actually began well before any QE butwas massively interrupted by the crisis and worldwide recession.
7. As evidence for 4., that crisis saw innumerable hedge funds implode, many of which were heavily long commodities, and this exacerbated the swings in the prices.
8. Bearish people love shadowstats.com. Go there and look at his estimates of M3, the broadest (and most relevant, I would imagine) measure of money supply. Its been in decline for several years. The "printed money" has either A) not actually made its way into the economy or B) not actually replaced the money lost to deleveraging. THERE ARE LESS DOLLARS IN THE WORLD NOW THAN IN 2007.
People, from perch belly up to the bar, runaway massive speculation on commodities is a huge part of the price swings here. If this is not the case, I would love to hear why its not explained. Why does the fact that many times the actual user volume of futures trade every day not possibly explain a great deal of this? To counter, you would say that people are speculating with "funny money" from Bernanke. Its still the fanatical devotion to commodity buying in the speculative and investment world right now that is driving it. Bernanke didn't make them buy gold, copper, and oil with their funny money.
And, on a side note, I'm still waiting for my funny money check. I guess its coming pretty soon?
THE WHOLE CONCEPT OF COST-PUSH INFLATION IS A BIT OUT THERE. And beyond that, the entire idea of cost-push inflation seems fairly foolish. If bread and gasoline go up in price, how can that make clothes and televisions go up? Believe me, as a guy who has owned many businesses, if a business has the ability to force higher prices on its customres it does so with considerable haste.
The fact of the matter is that wages in the developed world have dropped over the last few years, reducing pricing power at companies, which is itself an anti-inflationary reality.
If a company can't pass on its costs, then rising commodity prices won't force massively rising inflation (except direclty in the commodity prices themselves) and they in fact create a deflationary force by reducing the amount of spare money that the average consumer has to spend.
This is extremely simple stuff. If gas goes up, heating bills go up, and needed food goes up, this creates less demand for new cars, restaurant tabs, new clothes, and other discretionaries, which in turn disables companies that make those from raising prices. It is also deflationary to itself as it increases the likelihood of a recession.
What it is is bearish for corporate profit margins. If the consumer has less money to spend, and if their input costs are rising, they get a bit of a squeeze.
Its bearish for wall street, eventually, but not actually bullish for broad widespread inflation.
THE "STAGFLATION" OF THE 70S IS NOT GOING TO GET REPEATED NOW, AND HERE IS WHY.
We don't have wage growth. In the 1970s (thanks to Tom Graff's blog from RealMoney Silver, which is my #1 favorite paid stock/market/blog service) we had 3 years with double digit inflation, 74, 79, and 80. In those 3 years CPI was 12.3, 13.3, and 12.5. Unit wage growth was 11.5, 12, 11.3. Right now unit wage growth is still negative and overall wage growth is far from great.
If wages aren't rising, and necessary commodity prices rise like crazy, where is all the money to support 10%/year increases in the cost of rent, housing, clothes, furniture, trampolines, liquor, and bar tabs going to come from?
Without wage growth a repeat of the 1970s just isn't in the cards.
SO WHAT IS IN THE CARDS?
Scenario one - endgame is a china slowdown. Imagine that the worlds current biggest consumer of many commodities, China (there is one heckuva lot more construction going on there than here, so we can't blame ourselves, and we can'nt one bit blame "The Bernanck" for actual user-demand), comes to a crash or significant slow-down from its currently unsustainable path of construction malinvestment: say Chanos is right, basically, eventually. ... That will reduce commodity demand AND PROBALBY MORE IMPORTANTLY that will take the wind out of the sails of commodity speculators, resulting in falling commodity prices.
If the rest of the world suffers greatly for this, via less exports to China or something else, that could lead to another worldwide economic slowdown or even recession which should further supress commodity prices and further discourage speculators from going all in on Copper with 10x leverage.
If the rest of the world doesn't suffer greatly for this, that may mark the onset of the next secular bull market, as only once the runaway rising of commodity prices comes to a halt will a new decade or two of growth and prosperity transpire. Its worked that way EVERY SINGLE TIME for 150 years. Fantastic paper by Barry Banister on that thats easily the most helpful tool I have ever seen in understanding the cycles of markets.
Scenario two - endgame is a commodity-inflation forced slowdown or recession. Lets be serious if we manage to speculate our way into another epic commodity bubble, gas at $4-5-6 bucks, heck, gas at 8 bucks. Bread is 5 bucks a loaf, milk is 5 bucks a gallon.
What happens? We have a recession, again, and so does half the world. People NEED gas and food and if those prices head upwards eternally they will STILL have to keep buying them, and that will lead to less and less demand for other things, which will lead to layoffs at manufacturing plants and restaurants and shopping malls and car lots. Thats deflationary, then we see commodity prices fall again.
Scenario three - commodities underperform equities for a time and speculators sell copper and buy some SPY. I don't know if thats goign to happen just yet, but it would be a better case. World growth is encouraged by falling commodity prices and the "wealth effect" and ... the endgame still sees commodity prices at best stabilize and at worst fall.
Scenario four - China is sustainable and it continues this level of construction forever or at least a really long time. This breaks into two seperate scenarios: in4a eventually speculative interest and the premium it is causing leaves the market and we stabilize at actual supply/demand. We now have to wait for demand from the rest of the world to catch up to drive prices still higher, etc. And 4b speculators are not increasing prices, but rather this is actual market demand, in which case prices still must eventually stabilize at China's demand levelplus a continued reduced level from the rest of the world, whose economies suffer the ill effects of the high commodity prices.
Bottom line: we have high unemployment and very low wage growth. If commodity prices continue to be run up forever this will almost certainly force, eventually, a recession, which will almost certainly result in commodity prices coming back down. If China stumbles as Chanos anticipates, this will almost certainly result in commodity prices coming back down.
The 70s had significant wage growth (wages, in fact, nearly doubled in that decade), right now we do not. That is an ENORMOUS difference, and drastically reduces or renders overwhelmingly unlikely the probability of 70s style stagflation. Indeed, continued commodity inflation seems to point to a path that would send commodity prices back down again.
And beyond that, to my point about the "cult of negativity" and their present contention that Ben Bernanke is the reason for all bad things, including the fact that they stubbed their toe yesterday and their neighbor has a nicer lawn... people, if someone is exporting inflation to the world right now its CHINA, they are the buyer. Beyond that we have really only ourselves and the speculators among us to blame, and those spending all their free cash buying commodities would, ahem, be the ones running up the prices.
I do realize you could argue that the speculators are buying because of Bernanke and QE, but this was already the worlds great obsession before QE and before the crisis. Commodities are the giant momentum trend, the thing heading to a bubble, just liek tech in 1997 or whatever. So everybody is piling on the bandwagon, left and right. We have an abnormal amount of investment cash going into commodities, this is causing higher prices.
From my perch, the vast majority of the likely scenarios lead to a cessation of rising commodity prices or drops, because if they keep rising too long we go back into recession, etc.
Flopflation, not stagflation, is the most likely outcome. Hyperinflation remains a wildly improbable outcome and essentially all of the discussion that predicts it is ... every bit as well thought out as that p/e chart of the S&P touted so long ago all over blogs everywhere by angry bears. HAHA!