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 16th
, and $133 on the 21st. 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

Source: ISI Group
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.
Chart II

Source: ISI Group
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.
Chart III
Will Oil Demand Weaken?

Source: BCA Research
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.
Chart IV
Inflation Expectations

Source: BCA Research
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 17th.
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.
Chart V
Credit Default Swaps

Source: BCA Research
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.
Chart VI

Source: UBS
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.

Source: Empirical Research Partners
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:
Chart VII
Commercial Bank Charge-Off Rates

Source: Empirical Research Partners
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.
Chart VIII
S&P 500 Financials

Source: Leuthold Group
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.
Chart IX
Banks Are Still Tightening

Source: BCA Research
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.
Chart X
Leuthold Regional Banks

Source: Leuthold Group
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.
Chart XI
Bank Dividend Yields

Source: Leuthold Group
Financials have begun to outperform the market since
the March 10th 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.
Best regards,

Timothy G. Dalton, Jr.
Chairman
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