Have we just witnessed the start of a crash or a healthy correction? As the world's stock markets, commodity prices and property continued to climb higher last month, Warren Buffett, the legendary US investor, said at Berkshire Hathaway's annual meeting that 'like most trends, at the beginning it's driven by fundamentals [but] at some point speculation takes over.'
A prime example of speculators getting onto the bandwagon was the rally in the gold price from $600/oz to over $700/oz in just over three weeks. The background fundamentals became more supportive over the period: US foreign policy was unravelling, the spectre of inflation was raising its ugly head, oil prices were firm and the dollar was falling. But the speed and scale of bullion's rise suggests a prominent helping hand from speculators.
The problem about speculative excess is that you do not have a clue when precisely the music will stop. The important matter for investors, looking for longer-term rewards with more certainty, is where do we go from here?
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In the last few weeks we have seen a shake-out in financial assets generally. Commodities, where recent speculative excess has been greatest, have been hit hardest. This has a knock-on effect on mining and energy stocks, which in turn have driven stock indices down.
But there is something bigger going on.
When market participants see other investors liquidating their positions, they panic, do the same and ask questions later. This is why markets tend to fall faster than they rise. There's no such thing as an upward crash. The best explanation for the recent market upheavals is that investors have, en masse, switched to becoming more risk averse.
Is this change in mood justified? The proximate catalyst for the slump in share prices starting Wednesday last week was the disappointing US inflation numbers. Investors have been on a knife-edge in recent weeks, worrying that the Fed may overreact to economic data. Mr Bernanke makes less opaque utterances than his predecessor, and that transparency hasn't helped. So worse-than-expected inflation numbers provoked a sell- off in growth assets like commodities and equities, based on the view that the Fed will tighten US rates too much in the face of these figures.
But Mr Market has in effect overreacted on behalf of the Fed, and done Bernanke's work for him. Lower stock prices and lower commodity prices give the Fed less reason to tighten! Meanwhile, it follows that any benign economic data could spark a relief rally. In other words equity and commodity markets have just endured a healthy correction.
Indeed, there is little proof that the recent rally in commodity prices is finished. The current commodity bull run dates back to late 1999 when gold and oil bounced off their 25-year lows. Its origins lie in a slow and inadequate supply response to a surge in Asian demand. In recent months the commodity markets have overreacted to this powerful idea, and the ensuing falls have acted as a reality check for commodity investors.
Markets do not go up in a straight line, however persuasive the fundamentals. But as long as demand continues to outstrip supply, the recent falls in commodity prices do not signal the end of the bull run.
Commodity cycles are inherently much longer than most participants imagine. It takes seven to 10 years to bring on a new oilfield, and five to seven years to get a copper mine up and running. Higher commodity prices now are the price we must pay for not investing in production infrastructure 20 years ago.
The supply response is also hampered by declining oil reserves in the North Sea and Gulf of Mexico, plus the current rage for nationalising energy resources amongst Latin American politicians. Moreover, tighter environmental regulations and tougher obligations on mining companies to provide social programmes for the local populations have added to the planning time for new resource projects.
There are also shortages of equipment in the mining sector. Chip Goodyear, Chief Executive of BHP Billiton, told analysts earlier this year that miners had to wait up to 18 months for the giant tyres used on earth moving equipment. Skilled manpower is also in short supply. Workers are mindful of their improved bargaining power and there has been an increase in strikes among mine workers.
All these factors continue to hamper the supply response in commodity markets. They will help underpin firmer prices in the long-term. Nor are we on the threshold of a severe shake-out, as was experienced in 1987. Some pundits cite eerie similarities between now and then.
The run-up to 'Black Monday' was characterised by concerns about the widening US trade deficit, a falling dollar, fears of rising inflation and uncertainties surrounding the new Fed Chairman, Alan Greenspan. But as Mark Twain put it 'History does not repeat itself, it rhymes.'
The capitalist world now is very different from that in 1987. There has been a 25% jump in the global labour force since 1990, as ex-communist states have become part of the market economy. It follows that the balance of power is shifting decisively in favour of the corporate sector and away from labour. Meanwhile, the emergence of low cost centres has slashed the prices of manufactured goods, while the spread of technology has enabled companies to run their enterprises more effectively.
Accordingly profits as a proportion of GDP are historically high. But there is no reason why it shouldn't be higher. Our world of brisk growth, lower manufacturing costs and low real rates is a more benign environment for equities than in 1987.
The FTSE 100 index and the FT-All Share are now more or less back where they started the year. Yet the P/E ratio of the blue chip index has fallen from 14 to 12 since then. This undemanding rating, together with low borrowing costs and the return of fear amongst investors, presents a buying opportunity for the shrewd rather than foolhardy investor.
In my last essay (Why UK interest rates will rise) I identified three persuasive trends in economic life: the emergence of the uber rich with money to burn in their pockets, the dramatic rise in personal indebtedness and company insolvencies and the boom in commodity prices. Despite the correction in commodity prices, these trends are still in place.
By Brian Durrant of The Fleet Street Letter
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