Dalton, Greiner, Hartman, Maher & Co., LLC

We’ve read three pieces over the past week discussing asset market bubbles, specifically referencing commodity prices. Evidently, the Fed is so interested in asset bubbles that the Chairman has commissioned three of his former Princeton colleagues to analyze previous bubbles, presumably to influence how the Fed deals with future episodes.

The Fed and, specifically, Chairman Greenspan have been the target of recent criticism in regards to their asymmetric approach to asset market bubbles. (It viewed its role as one dimensional.) The previous Fed administration’s policy was to turn a head during the evolution of asset bubbles. Instead, monetary authorities believed that it was their job to clean up the mess after the bubble imploded by reflating the system. The critics argue – rightfully in our opinion – that the reflation leads to a subsequent asset bubble and could eventually lead to a rise in the general inflation rate.

Recent speeches by Fed governors (Stern and Geithner) have expressed concerns regarding the Greenspan Fed’s decision not to target evolving asset bubbles. Stern opined, “I am reviewing this conclusion in the wake of this fallout from the decline in house prices and from the earlier collapse in technology stocks. . . It was neither easy nor costless to deal with the aftermath of unsustainably high asset prices”. That message is pretty clear. The rise and fall of two asset market bubbles over the past 15 years – technology stocks and residential real estate – and the Fed’s role in perpetuating their upside are being seriously questioned within the institution.

There is a strong probability that commodities are in an advanced stage of a bull market which could ultimately reach bubble proportions. However, even bubbles rarely proceed without an interruption which can be quite painful for those long the asset. We think we’ve likely entered one of those corrective periods for commodities.

You wouldn’t conclude that by watching oil prices. They hit a new high at $126+ per barrel on May 16^{th
,} and $133 on the 21^st. Even bearish news only seems to impact quotes for a day or two.

Not surprisingly, bullish sentiment is rampant. A recent ISI survey of institutional investors revealed that 41% of the 250 participants expected prices to continue rising this year while 10% believed they will exceed $150 by year end. Only 30% thought that oil prices would drop below $100 and only 4% felt they would crash below $80.

Chart I

The bulls argue that the erosion in the demand for oil in the U.S. (it’s actually down year-over-year) and other developed countries has been more than offset by the insatiable appetite for energy products by China, India and other emerging economies. We don’t think that the supply/demand dynamics have changed a whit while energy prices have gone up this last 50%. Instead, it’s pretty clear to us that most , if not all, of this recent rise in prices has been driven by speculators. Crude oil trading activity is up 50% over the past year and over 5 times in the past five.

A popular thesis among commodity and emerging market bulls is that the emerging economies have “decoupled” from those of the larger developed countries. These advocates point to the surging domestic demand in the emerging economies as well as the strong export markets among them, particularly in Asia. So, they expect little slowdown in those economies which will in turn, keep stroking the demand for all of these commodities. We don’t buy it. A lot of the exported and imported products in those economies end up being re-exported to developing countries. And Chinese exports account for fully 60% of its GDP. In addition, private consumption expenditures in the U.S., Europe, Japan and the U.S. dwarf those in China and India combined. And the developed world has been filling a larger and larger proportion of its consumption demand with imports from the emerging countries. Logic would suggest that the developing world cannot remain immune from a slowdown in the other ¾ of the global economy. In fact, there is a plethora of evidence to the contrary as the negative news mounts daily.

Oil demand has been highly correlated with global economic activity. And the global economic indicators are signaling a further slowing in business activity. It’s only a matter of time, in our opinion, that speculators will become wary of a continuation of the strong fundamentals that have been largely responsible for the surge in the demand for oil and its attendant surge in prices. When it breaks, it won’t be pretty.

But there’s little sign of fear among oil speculators. To that end, Congress has taken note of it. Recently it passed a resolution to cease further additions to the Strategic Petroleum Reserve. Moreover, that body is attempting to persuade the administration to actually release reserves from the SPR in an attempt to reverse the spike in oil prices. In addition, there is serious thought to raising margin requirements on oil futures contracts, perhaps to 100%. Currently, any given buyer of oil contracts is limited to a maximum number on any given exchange. Now there is consideration to limit the number of contracts combined for all exchanges. While we’re not advocates of heavy handed government intervention into markets, we can’t ignore the reality of this legislative and administrative intent.

The surge in commodity speculation has not escaped the Senate. That body is conducting hearings as we write. Recently, we heard Joe Lieberman describe the testimony on the subject as “fascinating”. He specifically referenced the huge spike in oil prices coincided with a paltry 1%-2% growth in global demand. Their conclusions were obvious. The price of black gold has taken on a life of its own, driven largely by speculators. What they decide to do about it and when is anyone’s guess. But this is an election year.

There are signs that certain commodity prices are correcting. Copper and several metal prices have dropped modestly, most likely reflecting the slowdown in global economic activity. Grain prices, particularly wheat and rice, are down sharply from their highs. Moreover, livestock producers are facing huge losses because of high grain prices. This will force them to liquidate herds and reduce the demand for grain. Finally, trading bands have been widened and margin requirements are being lifted on agricultural commodities. In the past, this has generally led to sharp corrections in grain prices.

A meaningful drop in commodity prices is likely a necessary condition, in our opinion, to change the leadership in the equity market. The globalization and commodity plays continue to absorb lots of capital. To reverse those flows, the speculative fervor must be broken. And given our argument on the previous few pages, we feel that there is a high probability that the process has begun.

Cooling commodity prices should at least temporarily reduce headline inflation later in the year. The spread between the 10-year Treasury bond yield and that of an inflation protected TIP of the same duration suggests that this is what investors expect.

Moderating inflation expectations combined with a break in the commodity cycle will likely redirect capital flows into the equities of the previous group of losers, mainly the financials and consumer discretionary stocks. But this won’t be enough to see meaningful moves in these stocks. There has to be tangible progress in the restoration of the global financial system to tempt investors to leap into yesterday’s laggards.

Most investors believe there’s a long way to go to achieve normalcy. Only 4% of the institutional investors in the above-mentioned ISI survey believe we’re in the “ninth inning” of the credit crisis. The vast majority, 84%, think we’re in the “middle innings”.

Much has happened since the Bear, Stearns transaction was announced on March 17^th. The Fed, Treasury and Congress have all gotten into the act with system rescue efforts. The reductions in the Fed Funds rate and the three auction facilities established by the Fed have probably been the most important initiatives in the gradual process of dislodging the credit log jam. The Fed has asked Congress to allow it to pay interest on bank reserves (most other developed central banks have that authority). It is likely to be legislated late in the year and will greatly facilitate the management of the Fed Funds rate. Importantly, our monetary authorities have shown a willingness to be creative in crafting solutions and will likely be put to the test again before normalcy is restored. To be sure, near term inflation concerns and criticisms of committing acts of “moral hazard” have taken a back seat to the credit crisis.

There are definite signs of tangible progress. The stock market has begun to emerge from its doldrums as the S&P 500 is up +11% from its March lows. Fixed income investors have moved out the risk curve a bit as spread products are now outperforming Treasuries.

Credit spreads have begun to recede after their huge spikes since last summer. Thirty-year mortgage, leveraged loan, commercial mortgages, Agencies, and investment grade bond spreads have all shrunk by 25-100 basis points. Also, even in the much maligned Credit Default Swap market, spreads have shrunk by 100 bps.

UBS has developed a proprietary measure of the appetite for risk-taking in global asset markets. It combines variables in the equity, fixed income and currency markets to construct its risk index. The index has recovered sharply since the extreme risk aversion days in mid-March, confirming the contraction of spreads across the fixed income market and the recovery in the equity market.

For sure, there’s more bad credit market news to come, and spreads will fluctuate. But we think we’ve seen the worst of it – enough so that the probability of a change in equity market leadership is pretty good.

The International Monetary Fund in an April report on the global financial situation estimated that full cycle credit losses would total almost $700 billion, with more than $400 billion absorbed by U.S. companies.

If this is at all accurate, it would mean that we’re about half way through the pain. That doesn’t seem unreasonable given the improvement in spreads, the recent robust levels of the debt capital markets and the spate of equity commitments in a wide range of deals and activities. In the last credit market crisis in the early `90’s, losses totaled about 3.6% of GDP. If the IMF estimates are at all in the ballpark, then losses incurred in this cycle would equate to about 3% of GDP. Painful, but not as bad as the last credit crisis. But no one knows. There are plenty of knowledgeable observers who think there’s a lot more pain to come. If that were not the case, then credit spreads would be back to normal levels. So, uncertainty and risk aversion, albeit somewhat moderated, reflect the consensus view.

Empirical Research Partners has done some excellent work on credit cycles. They point out that the book value of the financial system was about $300 billion at the onset of the early 1990’s credit crisis. Total losses came to a massive two-thirds of the sector’s book value. Today, the book value is $1.8 trillion, or six times the level 20 years ago. If the IMF is at all close to its aggregate loss estimate, total charge-offs in this cycle will be roughly 20-25% of book value. Once again painful, but nothing like the last cycle.

Empirical Research notes that in the previous credit cycle, financial stocks bottomed after 45% of the total losses had been realized:

So far, this financial stock cycle has tracked the S&L crisis meltdown almost step-for-step. Obviously, that doesn’t mean that it’s a foregone conclusion that financial stocks will match the V-shaped recovery of the previous cycle just because we might be through half of the pain.

Banks continue to be extremely cautious. Total loans grew at a very subdued 2% rate in April, and securities holdings dropped at a 10% annual rate. This in stark contrast to the 3.5% growth in total asset growth in the first quarter. Moreover, banks continue to tighten lending standards for all types of loans. Consequently, we wouldn’t be surprised if loan growth continued to be sluggish and perhaps even contract for a brief period until bankers can see light at the end of the foreclosure tunnel.

Banks are also raising capital. In fact, they’ve raised about $200 billion over the past few months. This is partly out of necessity to replace the capital extinguished by credit losses but also due to the not so gentle urging of the regulators. Equity infusions and dilution were part of the solution in the last credit crisis. Empirical Research notes that in each year between 1990 and 1992 about a fifth of the companies’ share count went up at least 5%, and financial stocks still outperformed the market. In 1992, 30% of financial companies increased their share count by at least 5%, and the sector beat the S&P 500 by +20 percentage points.

Financial stocks are now selling at one-half the price/book value of the S&P 500. Focusing on regional banks, the group’s price/book value has declined from its 2005 peak of 210% to 140% currently. The negative sentiment towards banks, not surprisingly, has reached extreme levels. This is usually a pretty good indicator of a washed out group ready to bounce. Bank insiders have become much more positive about their companies’ future (see second panel in Chart X). Strong insider buying has historically been a catalyst for subsequent outperformance for individual stocks and groups.

The collapse in bank share prices combined with few dividend cuts have pushed the yield on the Leuthold Regional Bank Index to a very generous 5.7%. Not withstanding the strong possibility of more dividend cuts, this is pretty compelling. Almost everything looks cheap against the overvalued 10-year Treasury bond. But bank stock yields are the most competitive that they’ve been in years against all kinds of fixed income alternatives.

Financials have begun to outperform the market since the March 10^th lows. Barely, but still outperforming. If we’re really about half way through the credit cycle and risk aversion continues to moderate, there’s more outperformance ahead. But a bigger pay day for the group awaits the correction in the globalization and commodity frenzy. We think it will happen.

We’d love to leave you on the happy note. But intellectual honesty prevents that. We are becoming increasingly worried about the growing possibility of a more serious rise in inflation once the next economic recovery takes hold. The current Fed easing policies and the still vast amount of excess savings in the emerging world and oil-rich nations virtually ensure the funding of the next asset bubble and the re-stimulation of the global economy. Once the monetary authorities begin injecting liquidity into the limping economy, those funds seek out the reflating asset. Rarely, do those investors flush with cash rush to buy up the casualties of the previous asset bubbles. In this case it’s residential real estate and those that have financed it. Instead, the odds strongly favor a return of investors’ love affair with globalization and commodity plays. Emerging markets, oil, metals, gold, agricultural commodities and the like should all be at the leading edge of the action. This won’t be good for inflation, interest rates and a wide swath of the equity market. A return to the stagflation of the `70’s? Could be. It would not be a lot of fun. But maybe we could avoid CCR, Three Dog Night and the hair styles.

There is a possibility this could be truncated. Probably not avoided, but truncated. If one were to take the recent Fed concerns regarding the evolution of asset bubbles seriously, we could see an end to the Greenspan model of benign neglect. Such a policy change wouldn’t be painless as the bubble was extinguished via the old fashioned way – tight money. Quite the contrary. But the pain would be far less than what would come if the bubble were allowed to run its course.