THE ASSET BUBBLE OF THE PAST DECADE WILL TRANSFORM ITSELF INTO THE ASSET COLLAPSE OF THE COMING DECADE (May 19, 2006): The key feature of the worldwide financial markets in the past fifteen years has been the complete reversal from extremely tight lending standards in the early 1990s, to the all-time record easy lending standards that exist today. For the first time in history, emerging-market citizens can borrow almost as much money as they would like, while in the U.S., virtually anyone can borrow a million dollars, especially if the loan is backed by a piece of residential property. As U.S. housing prices have modestly declined in the past several months, banks have relaxed their mortgage lending standards, rather than making them more stringent.
The effect of all of this borrowing has not been lost on the asset prices of virtually everything. Artwork of all kinds is at an all-time high, a substantial multiple of where it was just four years ago. Racehorses are selling at all-time peaks. Stamps, coins, and virtually all collectibles have seen astonishing gains just in the past few years. A Stradivarius violin sold for $3.5 million at Christie's a few days ago, the highest price ever paid for any musical instrument at auction. U.S. residential real estate prices, while modestly lower in most places than they were last summer, are still close to all-time record ratios to incomes and rents. Not surprisingly, multi-year highs were also experienced recently in most worldwide equity markets, with most emerging markets reaching all-time peaks within the past several months. Many of these bourses sported higher P/E ratios than the New York Stock Exchange for the first time in history. Investors have not only been clamoring for the equities of emerging markets, but also their currencies, which in several dozen countries hit all-time record peaks recently versus the U.S. dollar. Commodities, adjusted for inflation, reached their highest levels since the early 1980s.
To everything there is a season. The great worldwide asset bubble is now transitioning to a great worldwide asset collapse. Real estate has been dropping in the U.S. since the summer of 2005, by a modest percentage. QQQQ has made a pattern of several lower highs since January 11. An increasing number of emerging markets, such as Dubai, have seen a sharp decline from their January peaks. Several small-country currencies have collapsed, including the Icelandic krona. It is only a matter of time before virtually all other asset classes join in the downturn. Of course, there will be sharp rebounds along the way, to confuse the unwary. But, a decade from now, credit will probably be extremely difficult to obtain around the world, and most assets will be at their lowest real levels in more than two decades.
The persistent increase in asset valuations has led to a public anticipation of increased inflation. Just as deflation was all the rage five years ago, now inflation is the flavor of the year. The media is full of stories about why prices will accelerate higher. Popular theories have recently abounded about how the government is intentionally understating the official inflation figures. A week ago, yields on long-dated U.S. Treasuries reached their highest levels in four years, while sentiment toward U.S. Treasuries was its most bearish in more than six years. More money flowed into commodity funds in 2006 than in the previous two decades combined. Even Bill Gross, one of the few public champions of the thesis of falling interest rates, admitted publicly this week that he was "wrong" about his prediction of lower Treasury yields.
Back in the land of facts, which few people are interested in visiting at any time, the commitments for U.S. Treasury bonds recently showed an all-time record long commercial position. The respected ECRI survey of inflation has been showing progressively declining readings for several months. Worldwide physical buying of commodities has declined by the greatest percentage since the early 1980s. The exchange-traded fund TLT, consisting of Treasuries with between 20 and 30 years to maturity, has been making a pattern of higher lows for one week, thereby returning to its levels of late April, not even counting a large dividend paid at the beginning of the month. The U.S. dollar has also been completing an important bottoming pattern against most worldwide currencies, especially versus the currencies of commodity-producing nations such as Canada and Australia.
The media is almost never interested in facts which do not support recent market behavior. So the media tells you why the U.S. dollar will continue to decline, why long-term interest rates will continue to rise, why the bull market in commodities has just begun, why real estate prices cannot possibly fall significantly, and why the recent decline in U.S. equities will soon be reversed and lead to new all-time highs.
The past week has served as a reminder that the truth will eventually assert itself. HUI, the Amex Index of Unhedged Gold Mining Shares, plunged from a peak of 401.69 in the morning of Thursday, May 11, 2006 to an intraday low of 323.77 yesterday, a retreat of 19.4%. This is the greatest-ever one-week pullback for this index, and ranks among the sharpest short-term declines for gold mining shares ever recorded.
There is an important distinction between the behavior of commodities and the performance of other asset classes. Most assets have recently begun a decline which will probably continue for several years or more. Real estate worldwide may decline for a full decade, as probably will artwork, racehorses, and so on. Equities, which traditionally lead the economy, usually bottom several years before most assets, so they will probably make their deepest nominal lows in four or five years.
A useful parallel would be a comparison with 1987. In 1987, worldwide equities had been in a bull market for five years. They would continue in a bull market for another 12-1/2 years, but before that, they would undergo two sharp corrections in 1987 and in 1990. Commodities today are similar to U.S. equities in the summer of 1987. The long-term outlook is excellent, but the short term is going to be quite unpleasant for those on the long side.
Secular bull and bear markets in commodities usually last for an average of about two decades. Since the recent bull market began about five years ago, this leaves another fifteen years to go. However, given the recent incredible bullish outlook on commodities--such as Market Vane recording 97% of traders bullish on silver, and 96% bullish on copper--the behavior of almost all commodities over the next half year is likely to consist almost entirely of declines, with occasional sharp bounces. The early stages of bear markets in equities reliably coincide with declines in commodities, as was seen in previous equity bear markets that began in 1980, 1990, and 2000. Since most commodities have risen so sharply in the past half year, even a 40% pullback for many of them would not violate their long-term upward trends.
At this point, if you haven't fallen asleep, you're probably thinking: "The Canadian dollar will fall? How loony! Everyone knows that inflation is rising, so how can you state that it's not? Interest rates are obviously going higher, since I hear them say so every day on the radio. My broker told me last week to put some of my money in commodities, since they're going up. And if real estate prices have a little drop, they'll be at new all-time highs in another year or so."
It's never easy to go against a 97% consensus. But this is likely to be one of the most profitable times in history to do so, since the overvaluations in so many asset classes are at such rare and exaggerated extremes.
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