Trader’s Narrative

Market strategists have drawn a line and taken sides: is gold in a bubble? Jim Rogers and Nouriel Roubini had a verbal smack down via respective media interviews with the former manager of the Quantum Fund being the believer he’s always been in the power of commodities while the prophet of doom and gloom used the “b” word to describe the precious metal.

Now another pair of strategists have taken sides - although not as personal as Rogers and Roubini. Dennis Gartman, believes not only that gold is in a bubble, but that it should be obvious to everyone. But that doesn’t mean he’s necessarily climbing off the trend:

Meanwhile, David Rosenberg featured this chart to argue not only is gold not in a bubble, it is actually “cheap”:

Leaving aside the obvious arithmetic (instead of logarithmic) scale, comparing the S&P 500 index to the price of gold is a non sequitur. This is due to the incessant rise of the equity index, with that itself due to the survival bias built into the constituents that make up the S&P 500 index. And don’t forget a dash of inflation which pumps up stock prices and therefore, stock indexes. So a ratio of gold to equity prices will for the most part look like a ski hill - and be as meaningful.

I’m also puzzled why Rosenberg is so bullish on gold since he has been one of the prescient strategists who has beaten the deflation drum the loudest.

Market Measure of Forward Inflation
Other than the CPI figures from the US government sources, there is a market determined inflation measure. It is the implicit inflation as per the Treasury Inflation Protected Securities (TIPS). The TIPS data that I showed back in 2008 is no longer published by the Fed. Thankfully, Bloomberg disseminates a metric based on the nominal forward 5 years minus US inflation-linked bonds forward 5 years. So basically, this is the average inflation that the bond market expects from 2010 to 2015:

Source: Bloomberg

In the final days of last year, inflation expectations were the lowest in a very long time, fallin to just 0.41%. Earlier this month they reached 2.89% but today’s forward inflation expectation was still a muted 2.68%. Clearly, the bond vigilantes are not signaling a runaway inflation debacle in the near term future for the US.

So can it be that gold is in an honest to goodness bubble?

Gold Sentiment
Here are two measures of sentiment for the precious metal. The recent survey of Bloomberg terminal users on their conviction for gold found a remarkable 94% to be bullish.

That is a new record high since the survey started in 2004. Unfortunately, Bloomberg’s survey hasn’t been very good as a contrarian indicator. But it has rarely been above 90%. The closest it has gotten to this level was at the start of the year in January 2009 when it reached 91% bullish. Back then, gold was $900/oz. While there is a short history, the sheer lopsidedness of the recent consensus makes it noteworthy.

Courtesy of Elliott Wave, we get another measure of gold sentiment:

The Daily Sentiment Index (trade-futures.com) has been at, or above 90 percent gold bulls since November 3, a string of 10 straight days. The only other comparable streak of optimism over the past 22 years of data is leading up to the December 2, 2004 gold high when the DSI was at, or above 90 percent for 20 consecutive days. At that time, prices made a high at $458.70, declined over 10 percent, and did not exceed the December 2004 high again for the next 10 months. But during this entire 20 day stretch, optimism never reached the single day extreme that today did, with fully 97 percent of traders optimistic on gold’s future prospects. This time, we expect a larger decline, one that lasts longer too.

If we step back from the day to day movements of the stock market and take a very wide perspective, we notice some overarching cycles at play. One of these is the 18 year stock market. Some, like Art Cashin in the video below, express it as a 17.6 year cycle but in reality this is not a precise determination. The 18 year cycle is more an average than an accurate, regularly repeating cycle:

Since stock prices are supposed to be random, it is odd to find such an orderly pattern. Why equity prices follow this rhythm may not be so befuddling if we consider commodity prices as their counter balance. For example, zooming in, we can see the period from 1980’s to the present for the Reuters/Jeffries CRB Index, the most popular proxy for the commodity markets:

While the equity markets went on a generational bull market from the 1980’s to their top in 2000, the commodities markets were in a painful and protracted bear market. This wasn’t just a coincidence. Over the long term, equities and commodities are on a teeter totter: when one is up, the other down; when one wins, the other loses. Of course this relationship isn’t evident until you step back from the short term fluctuations.

The rationale for this is simple. The price of physical goods are expenses for corporations as they are the raw materials to produce things. When the costs increase, profits decrease. This trend continues until it reaches an inflection point where it can not continue. Profits decrease and a retrenchment takes place. Demand decreases for raw materials and their prices fall.

Then this trend continues until investments in the acquirement and production of raw materials is ignored. Mines take billions of dollars to develop and can take decades to ramp up production. Oil reserves likewise are expensive to find and exploit. As the current supplies are depleted, the prices of physical goods rises. It continues to rise until it reaches a tipping point when investment in the sector once again is lucrative. And the wheel turns again.

I was introduced to this cycle when I read Hot Commodities by Jim Rogers. This is a great introductory book to the commodities markets by the way. I highly recommend it.

According to economist David Rosenberg, we are halfway through the current bear market. This estimate is in keeping with the 18 year cycle if we assume that the top was in early 2000. And the counter estimate is that we have the same period of time left in the commodities bull market. But something is amiss.

The CRB index crumbled 57% from its top in 2008. We haven’t seen such a decline before in a commodity bull market. Those are serious deflationary forces at play right now in the world economy. Which is why central banks are throwing everything and the kitchen sink at it to prevent it from spiraling out of control. Here is a free 60 page book from EWI about the dangers of deflation and how to position yourself both defensively and offensively to benefit.

Rosenberg continue to believe in a healthy commodity bull market but I’m not so sure. What we saw last year was not a normal bull market but a speculative bubble caused by lax regulations which allowed large institutions to run roughshod over everyone else and walk prices higher. The aftermath of bubbles is always ugly and unpredictable to some degree so I have my suspicions that the regular cycle was tampered with, in a sense, by this.

Art Cashin on the 17.6 Year Cycle:

Jim Rogers and Warren Buffett are on different sides of the recent government bailout. Rogers calls the US more communist than China, adding that the Fed bailout is “socialism for the rich“:

If the video doesn’t show up, you can see it here.

Buffett sees things differently: “I wouldn’t change anything in the plan myself,” adding in his own interview with CNBC. “It’s the best deal and the most sensible deal available now.”

More relevant links at news.tradersnarrative.com

In June when crude oil closed above $138, I featured the chart below, showing that adjusted for inflation crude oil was not only exhibiting classic bubble behavior, but that it dwarfed previous oil spikes:

The next day as Texas tea ramped up the most dollars in its trading history, I mentioned that even if we looked at crude oil priced in gold, it was expensive:

…which would imply that if this ratio has any significance, a top in oil is close at hand.

It took a few weeks until the top was put in oil at ~$148 in mid July. But as of now it is down approximately 27%

A quick glance at the chart shows previous resistance, now support, at the round number $100. When or if, oil continues to fall, it will provide relief for the economy. As for whether the spike up was manipulation, normal market dynamics, a bubble, etc. I’ll leave you to explore that for yourself.

You can find a lot of links about oil and the price of oil here.

What can possibly explain the behavior of the price of oil? The Senate committee has heard testimony from a variety of sources and a variety of viewpoints ranging from accusing the regulators to be tacit participants in market manipulation to “Peak Oil”.

This same sort of back and forth happens whenever we have bubbles forming. There are always those who argue that it is simply a speculative mania, and then there are the true “believers” who bring arguments and evidence why things have changed.

To show you how difficult it is to make any sense of this, consider that two very smart and very wealthy investors find themselves on opposite sides of the argument: George Soros believes there is a bubble, while his ex-partner, Jim Rogers, feels the opposite is true.

But it isn’t difficult to see why many believe that the price of oil no longer represents a true picture of the value of this commodity; after all, it has more than doubled within the span of less than two years:

Note that the chart above is using a logarithmic axis for price and even then you can see that the slope of the rise from 2007 to present is much steeper than that between 2002 - 2006. Here’s an even more long term chart of crude, this time adjusted for inflation:

Source: St. Louis Fed (FRED database)

Oil Shock
This chart clearly shows that the world economy is undergoing a severe “oil shock”. One that pales in comparison to ones which we’ve seen so far in either the Gulf War or the 1979 Iranian Revolution (or the 1973-4 oil embargo - not shown on chart). Which goes a long way in explaining why consumer sentiment is at multi-decade lows.

One of the defining characteristics of a mania is a parabolic chart: increasingly steep price curve within a shorter and shorter time frame. And clearly, that is what we are seeing. While there may be disagreements whether this is really a bubble, what most can not deny is that the rise we have seen so far is just unsustainable if projected into the future.

Perfect Storm
My gut feeling is that we are seeing a confluence of forces, among them, long only commodity funds, a weak dollar, negative real interest rates (which always increase commodity prices) and demand from an increasingly voracious industrial complex in China and India.

But the fact that the increase in price has come in such a short time and it has been so incredibly sharp tells me that it can not be simply explained by the usual market forces of demand and supply. Something else must be at work to drive the price of crude as high as it has done within such a short time span. But only time will reveal what exactly what that “something else” is.

If you doubt that bubbles can not form in “real assets” then you’ve probably overlooked a lot of examples from history: the Japanese real estate bubble, gold, silver, etc. And if you believe that market manipulation is impossible or the overworked imagination of conspiracy theorists, then I would remind you of the California electricity crisis in 2000.

Silver Lining
If the price of oil here truly represents real demand and supply the potential silver lining on such a cloud is that it will not only change people’s consumption habits, it will spur on the development of better alternative energy sources. This is what I don’t understand, if you are a dyed in the wool “peak oil” believer, why invest in a dying industry? why not invest in those companies which will rise up out of the ashes and propel us forward? or do the “peak oilers” believe we are going to regress technologically?

Or consider it another way, if you were to go back in time, would you try to corner the whale oil market? or invest in Texas oil fields?