A Seismic Shift in the Commodity Market
(March 2, 2008)
Dear Subscribers and Readers,
I hope all of you enjoyed our review of the CFA LA Annual Forecast Dinner last Wednesday evening. While the number of insights was not as many as that of last year's, what little we got was very insightful, especially in the context of the current downturn in housing as well as the “long boom” in the Chinese economy. In the meantime, I hope none of our subscribers is suffering from “whiplash” from last week's volatility in the U.S. stock market. While Friday was no doubt brutal, subscribers should note that our 100% long position in our DJIA Timing System is still collectively “in the black” as of Friday's close.
Let us now review our 7 most recent signals in our DJIA Timing System:
1st signal entered: 50% long position on September 7, 2006 at 11,385;
2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;
3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.
4th signal entered: 50% short position on October 4, 2007 at 13,956;
5th signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.
6th signal entered: 50% long position on January 9, 2008 at 12,630, giving us a loss of 363.61 points as of Friday at the close.
7th signal entered: Additional 50% long position on January 22, 2008 at 11,715, giving us a gain of 551.39 points as of Friday at the close.
I want to begin this commentary by briefly discussing the state of the U.S. capitalist system. It is not often that I need to write a commentary to defend the “60-year old cycle” of our post World War II capitalist structure – but given the many emails I have received over the last few weeks asserting that we are now seeing the end of the capitalist system as we know it, I find it worthwhile now to illustrate my thoughts on this matter – and I hope you will too.
Joseph Schumpeter – one of the most influential economists in the 20th century, a leading authoritative voice on capitalism, and the coiner of the term “creative destruction” – argued, in his seminal work “The Theory of Economic Development,” that entrepreneurs should be the main focus under the system of modern capitalism. In Schumpeter's time, this phenomenon was routinely ignored since it was impossible to “model” acts of entrepreneurship (and its irregular interruptions on the economy, whole industries and large businesses) in conventional econometric models. Given this model, the notion of a “steady state” and the idea of“equilibrium” in classical economics become obsolete. The fundamental nature of entrepreneurship results in innovation and the creation of new markets. With respect to the latter, Schumpeter notes that producers must take on the role to build demand – and that, given the proper initiative, human wants are not only inherently large, but also limitless. In other words, the foundation of capitalism depends on entrepreneurs to satisfy the wants of consumers that the entrepreneurs themselves have managed to convince consumers as needs.
Schumpeter stated the following five types of innovation as acts of entrepreneurialship. This was set forth in 1911 – long before they became popular or “conventional wisdom”:
- The introduction of a new good – that is one with which consumers are not yet familiar – or of a new quality of a good.
- The introduction of a new method of production, that is one not yet tested by experience in the branch of manufacture concerned.
- The opening of a new market, that is a market into which the particular branch of manufacture of the country in question has not previously entered, whether or not this market has existed before.
- The conquest of a new source of supply of raw materials or half-manufactured goods, again irrespective of whether this source already exists or whether it has first to be created.
- The carrying out of the new organization of any industry, like the creation of a monopoly position (for example through trustification) or the breaking up of a monopoly position.
Schumpeter then goes out of his way to emphasize the importance of new entrepreneurs and new companies in making new innovations that interrupt the status quo – this idea is what led to the coining of the now-popular term “creative destruction.” Moreover, he argues “the entrepreneur is never the risk bearer. The one who gives credit comes to grief if the undertaking fails … the direct economic responsibility of failure never falls on him [the entrepreneur].” In other words, Schumpeter was clarifying the role of capital in a modern capitalist system. Furthermore, he emphasizes that capitalism inevitably relies heavily on credit, that is, wealth that are based on future expectations and not yet accumulated. Here now, I want to quote the three essential paragraphs in Dr. Thomas McCraw's (Professor of Business History Emertius, Harvard Business School, and past winner of the Pulitzer Prize) latest work on Schumpeter, “Prophet of Innovation: Joseph Schumpeter and Creative Destruction”:
“The headquarters of the capitalist system,” says Schumpeter, is the money market – the place where credit is allocated. Investors clustered in money centers such as New York, London, and Berlin (and, today, also Tokyo, Shanghai, Silicon Valley, and other places) decide on which entrepreneurial projects deserve financial backing and which do not. “All kinds of credit requirements come to this market; all kinds of economic projects are first brought into relation with one another, and contend for their realization in it.”
Schumpeter goes on to argue that “in carrying out new combinations, ‘financing' as a special act” is critical to successful innovation. “By far the greater part of it does not come from thrift in the strict sense,” that is from abstaining from the consumption of part of one's regular income, but it consists of funds which are themselves the result of successful innovation and in which we shall later recognize entrepreneurial profit.” In other words, the financial basis of development comes not from penny-pinching but rather from new ventures. The important players in this process are entrepreneurs and investment bankers, who generate “new purchasing power out of nothing.” The investment banker is not just a middleman standing between savers and users of capital; he is instead “a producer” of money and credit, “the capitalist par excellence.”
Many times throughout his career, Schumpeter hammered home the necessity for credit and the function of banks in creating money. This fact of economic life – that banks create money – often seems questionable even to very intelligent people, and it was denied by some theorists well into the twentieth century. Schumpeter once told a group of Japanese economists that Keynes had said to him “there were not more than five people in the world who understood monetary theory,” adding that he, Schumpeter, assumed himself to be one of the five.”
In other words, the foundations of the modern capitalist system in the U.S. rest squarely on Wall Street, the venture capitalists in SoCal, and more recently, the thousands of hedge funds, private equity funds, and angel investors around the country. This is a major reason why the Federal Reserve, the European Central Bank, and the Bank of England are doing as much as they can to keep the “subprime virus” from spreading across the globe – and consequently, risk continued risk-aversion – and consequently, stifling not only general risk-taking, but financing of new ventures, general business expansion, and on a more immediate basis, the hiring of the new 2008 graduating class in mid-May. Another reason why the Fed is collapsing overnight rates and providing liquidity to illiquid borrowers (through holding private securities as collateral as opposed to only U.S. Treasuries) is that – first of all, there is no doubt in my mind that it still has sufficient power and leverage to arrest this latest decline (as I have covered in my previous commentaries. Note that I have also provided a counter-argument to George Soros' latest assertion that the latest crisis represents the end of the 60-year cycle of post WWII capitalism in our February 17th commentary.) – and second of all, in the modern capitalist, highly-leveraged system such as ours, there is no other choice but to provide as much liquidity as possible in addition to making the central bank as a lender of last resort. It is to be noted that even Joseph Schumpeter was relatively pessimistic on capitalism as a lasting economic system – however creative and innovative it is. While this argument is highly doubtful (as I mentioned to a friend this weekend, I firmly believe that capitalism, as we know it today, doesn't have any chance of ending until the Chinese and Indian secular story (two countries which encompass 40% of the world's under-banked and under-leveraged population) runs its course, which is at least 10 if not 20 years from now), this is one reason why Ben Bernanke –being a lifelong student of the Great Depression – was such a fitting choice for the Chairmanship of the Federal Reserve.
To put this all together, my current thoughts on the capitalist system have not changed from that of a month ago or a year ago. We are still very far away from the ultimate end of the capitalist system as we know it. As far as the “subprime virus” goes, we have talked about this to death since over a year ago. The ramifications – while not obvious at the time – were not unexpected. This is why we decided to sell our 100% long position in our DJIA Timing System back in May of last year. As the Federal Reserve chose to focus on inflation and “moral hazard” problems by not aggressively easing late last year, and with the Dow Industrials still near the 14,000 level in early October, we decided to go 50% short. It was not until the Fed made it clear that it will tackle the subprime problems head-on in early January that we chose to shift course, covering our 50% short position and going 50% long instead. We then followed it up with a 100% fully long position once the Fed confirmed it was going “for keeps” with a 75 basis point inter-meeting cut on the morning of January 22nd. The reasons were many – but the main ones were: 1) decent valuations in the U.S. stock market; 2) an undervalued U.S. Dollar, which provided tremendous valuations for foreigners in all kinds of asset classes denominated in the USD; 3) a banking system with a very well-capitalized overall balance sheet (ignore what the Comptroller of the Currency –who has never run a bank – has to say regarding upcoming banking failures) relative to past cycles, 4) a new-found willingness by the Fed to tackle the subprime virus and to arrest potential delevering in the financial sector, 5) a new-found cooperation with the European Central Bank, the Bank of England, the Bank of Japan, and the Bank of Canada, and 6) a general willingness by the Administration and Congress to move quickly on the U.S. economy, through one-time tax rebates, a raising of the GSE's caps and conforming limits, and a continued willingness to find new ways to arrest an economic decline going forward. With the tremendous build-up of capital “on the sidelines” over the last few weeks, and with the inevitable bailout of MBIA and Ambac, I am of the position that while there may be a retest of the January lows sometime over the next couple of weeks, chances are that the Dow Industrials and the S&P 500 have already bottomed and should mount a sustainable rally after the March 18, 2008 FOMC meeting, assuming the Fed cuts by 75 basis points at that meeting.
More importantly, and over the longer-run, it now increasingly looks like that institutional investors – starting with public pension funds – are now shifting their commodity strategy from one of investing in long-only commodity funds into one of satisfying long-term energy needs by investing in infrastructure, though means such as private equity, venture capital, and private partnerships with public company. As I mentioned in our mid-week commentary, Russell Read, the Chief Investment Officer of CalPERS (which control approximately $250 billion of pension assets) penned a seminal article for the fourth-quarter CFA Conference Proceedings recently articulating their new strategy for investing in natural resources going forward. At this point, they are for the most part invested in long-only commodity funds for their natural resource allocation, but judging from this article, it is now clear that:
1) CalPERS is shifting their commodity strategy from a long-only commodity fund strategy into one of infrastructure;
2) CalPERS is going to invest in infrastructure mainly through private equity or in existing partnerships with public companies - such as pipelines, power plants, alternative energy, and so forth.
3) CalPERS will also not hesitate to hedge their downside risks in conjunction with these projects. e.g. if a biofuels plant isn't profitable unless oil is over $70 a barrel, then they would not hesitate shorting oil at $70 a barrel.
The bottom line is that CalPERS articulated a wholly different strategy to invest in commodities as opposed to their current strategy of long-only commodity funds. Not only will they most likely not invest any more funds in long-only commodity funds - especially with oil at $103 - but it is also clear that much of their future investments will be conducive to directly satisfying the increase global demand in commodities. In other words, their actions as articulated in this article will be deflationary for commodity prices (increasing supply, increasing competition through alternative energy sources, increased price pressure through hedging schemes, etc.) going forward. On a more immediate timeframe, much of the tail-wind from institutional funds into commodities will also decline as other pension funds follow CalPERS' strategy. In essence, Russell Read (along with his 190 staff members which include 33 CFA Charterholders, 41 MBAs, 3 PhDs, 6 JDs, and 10 CPAs) is taking the $90 to $100 price signal in crude oil prices as an indication of a long-term secular bull market in demand for energy. Once institutional investors and drilling and exploration companies recognize this secular bull market (as the late 1970s can attest to), the majority of the bull market in crude oil prices is already over – as BY DEFINITION, CalPERS and whatever partners it chooses to work with in the future – is now committed to performing two of the entrepreneurial acts (acts number 2 and 4) as stated above by Schumpeter – which would in turn not only be hugely profitable for CalPERS (versus blindly going long crude oil futures contracts at $100 a barrel), but will also be hugely deflationary for energy prices as new sources and methods of delivery of energy are found and implemented. Ladies and Gentlemen: This is a significant development in the commodity market. Five years from now, I believe folks will look back to this article and designate the penning of that article as a turning point not only for a boom in energy infrastructure, but more importantly for us, the beginning of a significant deflationary force in energy prices.
For those who continue to believe that the emerging “middle class” citizens of emerging markets will save the day (through greater consumption of energy, proteins, etc.), I have this to offer: Don't forget that after World War II, the emerging middle class of the US, Japan, Western Europe, Hong Kong, Singapore, Argentina, Brazil, etc., all demanded more metals, proteins, crude, etc, and yet commodity prices dropped anyway - through a combination of higher productivity, greater exploration technology, etc. While this “EM middle class thesis” may have been simple when crude was trading at $30 a barrel, it no longer is with crude trading at $100 a barrel. As I am typing this, some governments are already threatening to cut energy subsidies and “food riots” have already broken out in certain countries. On a more immediate timeframe, it looks like energy and food demand is decreasing, not increasing.
Turning to the domestic stock market, the amount of “cash on the sidelines” waiting to be invested has increased again from last week and is now very close to a record amount relative to U.S. market cap. This indicator – the ratio between US money market assets (both retail and institutional) and the market capitalization of the S&P 500 – had been particularly useful as a gauge of how oversold the US stock market really is – as well as how sustainable a current rally may be. I first got the idea of constructing this chart from Ned Davis Research – who had constructed a similar chart for a Barron's article in late 2006. Following is an update of that chart (monthly) showing the ratio between U.S. money market assets and the market capitalization of the S&P 500 from January 1981 to February 2008:
As of Friday at the close, the ratio between money market fund assets and the market cap of the S&P 500 rose to 26.71% - a level not seen since February 2003, and is now at a significantly higher level than where it was in October 1990 – the last time the U.S. stock market gave us a once-in-a-decade buying opportunity. While this indicator is usually not a great short-term timing indicator, it is to be noted that this reading is now extremely high on a historical basis and should be supportive for stock prices not only for over the next few years, but over the next few months as well. Even though the stock market can do anything over the short-run, my guess is that we have already seen the bottom in late January – which means that we will continue to remain 100% long in our DJIA Timing System for the time being, unless the Fed backs away from its current easing campaign, or if the MBIA/Ambac issues are not resolved as promptly as possible.
Let us now discuss the most recent action in the U.S. stock market via the Dow Theory. Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from January 2006 to the present:
For the week ending February 29, 2008, the Dow Industrials declined 114.63 points while the Dow Transports declined 130.01 points as oil prices continued to rise, and as the Delta-Northwest merger is now in doubt. For the third week in a row, the Dow Transports exhibited greater weakness than the Dow Industrials. However, given its role as a leading indicator of the broad market since October 2002, it is not foretelling inevitable weakness in the stock market just yet. For now, we will stay 100% long in our DJIA Timing System.
I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys. The latest four-week moving average of these sentiment indicators rose from last week's reading of -5.8% to -5.0% for the week ending February 29, 2008. Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:
Given this significant reversal in sentiment over the last two weeks, and given that it is bouncing from an extremely oversold level (most oversold since April 2003), there is a good chance that sentiment is reversing from its extremely pessimistic readings of late January to early February – which should be bullish for the stock market in the short-run. Given this and the impending “rescue” of the monoline insurers, I continue to be comfortable with a 100% long position in our DJIA Timing System, and will most likely not par back until/unless we see the stock market or these sentiment indicators get overbought again, or should the Fed back away from its aggressive easing campaign.
I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index. For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward. Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.
When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls. As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms. This makes the indicator a perfect contrarian indicator for the stock market, and it has had a great track record so far according to the following Wall Street Journal article. Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:
With the 20-day moving average of the ISE Sentiment Index declining to 95.0 and the 50-day moving average declining to 102.3 in the latest week, the ISE Sentiment Index is at its most oversold level since records have been kept – i.e. even more oversold than where they were at the October 2002 lows. Given the capitulation bottom that we saw on January 22nd, the immensely oversold conditions as confirmed by the NYSE ARMS Index and the new highs vs. new lows on the NASDAQ Composite, the impending rescue of the monoline insurers, the historically high crude oil inventories in the U.S., and the promise of more Fed easing, I believe we have already witnessed a bottom in both the Dow Industrials and the S&P 500. For now, we will stay with our 100% position in our DJIA Timing System, and will only scale back if the Fed backs away from its easing campaign or if the monoline rescue fails to go through.
Conclusion: As the capitalist system “goes to the brink,” there are folks – including George Soros – who are now calling for the inevitable end of the post World War II U.S. Capitalist system. While the U.S. capitalist system is undeniably on the brink, subscribers should remember that this is the nature of the capitalist system – and yet, the U.S. financial system and economy has always recovered from financial calamities that were more severe than the current one. Sure, there are always the “unknown unknowns” (the “daisy chains” of OTC derivatives is most frequently as cited as one reason, but given that 80% of all OTC derivative contracts are plain vanilla swaps, I wouldn't put too much weight on this “indicator) but given the strong capital adequacy ratios of U.S. commercial banks, the strong balance sheets of U.S. corporations, and the amount of capital sitting on the sidelines (including those from Asia, the GCC, and emerging markets in general – which were never available in such an abundant amount in past financial crises) I continue to hold the belief that the U.S. stock market will emerge from the current crisis without piercing the January 22nd intraday lows. Furthermore, as Joseph Schumpeter suggests – the five overriding acts of an entrepreneur can only be implemented with the access of credit – so there is now no doubt that the Fed will do everything in its power (both from an economic and political standpoint) to ease the current credit crisis as much as possible.
With respect to the commodity market – in particular natural resources, CalPERS has just articulated a wholly different investment strategy in this space – specifically shifting from its current strategy of investing in long-only commodity funds to that of one involving infrastructure that will directly be conducive to satisfy rising global natural resources demand going forward. In other words, CalPERS – through the recent price signals in the crude oil markets – is now recognizing the long-term viability of commodity demand over the next 10 to 20 years. While this recognition by itself is not a deflationary force (i.e. a contrarian indicator), CalPERS' response – by investing in energy infrastructure, including source of alternative energy and thus committing two of the five acts of entrepreneurship acts as specified by Schumpeter – is definitely a deflationary force for commodity prices in the future (but acts which will be hugely profitable for CalPERs and their partners). In the short-run, such a shift by CalPERS would at least remove a tail-wind behind higher commodity prices as less institutional money flow to long-only commodity funds. For now, we continue to be bullish on the U.S. stock market, given that the vast majority of our contrarian/sentiment indicators have hit multi-year lows, and given the Fed's accommodative stance and the immense amount of cash currently on the sidelines. While anything can happen in the short-run, we believe that there is a little downside in U.S. (and Japanese) equities at current levels. For long-term investors especially, the market continues to be a “buy.”
Henry To, CFA