Inflection Point (Part 2):
Financial Assets Give Way to Hard Assets
Recently, we outlined the case for why equity prices may be at an historical Inflection Point (https://markonomics101.com/2018/07/12/inflection-point-part-1-the-long-term-equity-valuation-cycle/). Both Price Earnings multiples (PEs) and Earnings themselves have very little apparent upside while being highly susceptible to a reversion to their long-run means. Such a reversion to the ultra-long run historical averages would equate to a massive 60% plunge in value.
While real estate has enjoyed yet another asset bubble, commodities or “hard assets”, which include metals, oil, building materials, and food products are either in nascent up trends or appear to be bottoming. Exporters of raw materials are strengthening while importers are feeling the effects of creeping inflation. The Oil Producing Exporting Countries (OPEC) once dominated the energy market. The high prices they helped to create, expedited the shale oil industry and fracking technologies in the United States and accomplished the unthinkable: Domestic Production, which had been in a massive decline, surged and suddenly put the US back on top as the world’s largest producer.
In the 1970’s, especially after the infamous Bretton Woods agreement, in which the US slammed shut the Gold Window and announced it would no longer honor a $35 per ounce Gold Price, the Dollar has been a fiat currency and has depreciated against Gold, Oil, and most other major world currencies. In fact, since Bretton Woods, the US Dollar has lost well in excess of 90% of its then purchasing power. Up until then, the loss had been more gradual and having been gold backed, the US Dollar stayed strong as the world’s reserve currency.
When the Dollar was no longer backed by gold, the metal soared from $35 per ounce in 1971 to $850 per ounce in 1980. Crude Oil had been near $3/barrel and quickly jumped to more than $30. Windfall profits tax prevented domestic suppliers from realizing inventory gains in the ground which kept drilling of new wells at a crawl. From the 9 Laws of Markonomics:(https://markonomics101.com/2018/07/08/the-9-laws-of-markonomics/), More Choice = More Prosperity. Not surprisingly, the battery of regulations, taxes, and restrictions did significant damage to the economy until the Oil Industry was deregulated in 1980.
The double digit budgetary growth from the Vietnam War time spending and the Great Society, plus wage price controls all conspired to create an almost out of control inflationary cycle, coupled with a recession.
That was then, but is it returning? Our analysis as outlined in “Can Anyone Win A Trade War” (https://markonomics101.com/2018/07/09/can-anyone-win-a-trade-war/), suggests categorically that the ramifications of restrictions on trade suggests the only possibility is some degree of economic contraction, combined with higher prices.
Trade wars must lead to HIGHER PRICES, FEWER Transactions, and therefore diminished growth. There can be no winners among warring parties.
But, there are potentials for winners in the markets. Those who recognize that the long run forces which have propelled equity and bond prices higher won’t and can’t last forever. Currents CAN and DO change. Easy money made, turns into easy money lost. Hard assets will appreciate smartly against financial assets.
Commodity prices are a key determinant of inflation and in turn, interest rates and PE multiples. Below, are some of the drivers of commodities.
Precious Metals, primarily Gold and Silver, have languished over a several year period and have made the perpetually BULLISH community look no better than “the boy who cried wolf”. Will that remain the case – nothing lasts forever.
Their charts are below:
GLD’s monthly chart gives every indication that Gold is in an extended bottoming pattern. While it has been stuck in a narrow range of 115 to 132, the building inflation pressure suggests the next move will be up. And, the long period of consolidation suggests the possibility of an extended and parabolic move. In fact, at current levels GLD is sitting on what is likely to be an excellent long run entry point.
There is more to commodities, naturally than precious metals. Crude Oil, whose benchmark is West Texas Intermediate (WTIC) has quietly doubled in less than a year. Oil, as economists note is “supply inelastic”. It takes substantially Higher prices to create a substantial jump in supply and quantity increases are not instant. Most of the increase is in the form of depletion of strategic reserves and other supplies. Actually, increasing production often takes either expedited drilling, expansion of pipelines throughput, uncapping uneconomic stripper wells, or a reduction in storage levels. New fields take years to develop. Long run, some of the pressure on price is alleviated through substitution, but its effects are anything but immediate.
Oil prices have been soaring for the last year, recently reaching $75 per Barrel after touching bottom at $30 in 2016 and, as of yet, is showing little sign of slowing down. Energy costs are key inputs into just about any manufactured item. As the percentage of oil production is more and more comprised of expensive and energy intensive shale, it is very influential in setting the price as it is a marginal and a highest cost source. In many areas, shale production has seen a rapid decline which can only be made up through additional drilling. Unlike conventional fields which produce for 30 years or more, shale wells hit their peak in 18 months and drop off rapidly thereafter. While shale has brought the United States back to producing 10 million barrels a day, it is both expensive and has ecological consequences which are not yet fully understood and accounted for.
Other commodities include base metals, building materials, livestock, and agricultural products. Taking all commodities into account, the best known basket of commodity prices is the Goldman Sachs Commodity Index, which trades as an ETF with the symbol GSG. The 5 year and 1 year charts are below:
The plummet of commodities through 2016 was a key factor in keeping inflation low, interest rates low, and profit margins of US Multi-National Corporations abnormally high. All of these long term trends have either reversed or are poised to reverse. For at least a decade, the effects of the Federal Reserve’s “Quantitative Easing” or QE has not shown up in the type of price inflation that had been feared. Since the advent of QE, (the tool employed by the Fed to dramatically increase both systemic liquidity and use the Balance Sheet expansion to avoid deflation) the so called “monetary velocity” pictured below
has experienced a huge drop. When monetary velocity falls, people do not engage in transactions as frequently and literally sit on cash. This is why the soaring liquidity ended up in FINANCIAL ASSETS where it could be parked rather than becoming part of the real economy. The anemic GDP from 2008 t0 2016 was largely the result of money just not flying around like it used to.
GDP is not only the aggregate of Mutually Beneficial Transactions (2nd Law of Markonomics) but also the amount of money, times how fast it circulates. If there is lots of money around and cheap credit, the impact on the Economy will be muted when people literally sit on it.
What happens when they start spending? INFLATION, HIGHER INTEREST RATES, HIGHER COMMODITY PRICES, and a much different world than many of us have gotten used to.
Part 3 of the Inflection Point series will tackle CRYPTOCURRENCIES. This sector will confound both proponents and detractors alike. How is this possible?
Check in to www.Markonomics101.com for our STUNNING analysis of this completely misunderstood sector.