View: Vale, Commodity Bull

If you were with us yesterday, you'll know we left off with a question. That question is how to rationally respond to an irrational world. Specifically, you have to figure out whether Europe's geopolitical nervous breakdown requires any investment action. But let's be even more specific today.

What is the rational response of an investor who has come to understand that the greatest commodity boom in Australian history is over? It may be premature to give the resources bull market its last rites. In fact, it probably makes better sense to see the commodity market in evolutionary terms. It's maturing from a market led by iron ore and steel to one led by...other commodities. More on them shortly.

But for now, it would be hard to argue with the idea that all the easy money has been made from the China story. China's era of 8% GDP growth driven by fixed-asset investment is over. The huge surge in demand for iron ore and coal - coming off a supply/capacity deficit to begin with - drove earnings for BHP and Rio Tinto, and thus the whole Aussie market, for ten years. Take a look at the chart below and you'll see what we mean.

Source: StockCharts

The start date for the chart is arbitrary. We picked ten years as a sample period. It captures the bottom in stocks in 2003 and the full extent of the rally in commodity related stocks. The blue line is the All Ordinaries. The black line is the Dow Jones Industrials. Both indices are measured in local currency terms. So what does it tell you?

Australia's moment in the sun was big and bright, and peaked in 2007. The Dow has been less spectacular. But since August of last year - really since Greece became a thorn in every investor's side - the air has gone out of 'risk' assets. The flow of money back into US assets has allowed the Dow to catch up.

Imagine having a whole commodity boom and not making any money! Yet if Europe's debt crisis and China's lower growth continue to do a one-two on commodity prices, it's quite possible Aussie stocks will give back all of their gains from the last ten years...by the end of this year. You wouldn't even need a test of the 2009 lows to see that happen.

Could that really happen? Well, yes. The market is dominated by two forces. One force is deleveraging by businesses and households. People pay down debt and consume less. This leads eventually to lower stock prices.

Countering this force is central bank balance sheet expansion and other gimmicks. These tricks pump liquidity into financial markets and lead to occasional rallies in speculative assets. These rallies keep investors in the game. Meanwhile, moments of clarity about how hopeless Europe's situation is send stocks lower.

Not even Facebook can save us now! That was supposed to be a 'feel good' event for investors. But investors aren't feeling it at all. And good for them! Fool me once, shame on you. But sucker me into buying Facebook shares, shame on me!

Anyone who thinks the Facebook IPO has failed has misunderstood the purpose of the IPO. The IPO does not exist to channel much-needed capital from investors to a company. It exists so that wealth can be transferred from the buying public to insiders and investment banks. It's a simple transaction once you understand what the real goal is.

Those who got Facebook shares at the pre-IPO price of $38 would have been laughing all the way to the bank yesterday - and that's even after the shares fell another 11% on Monday. Maybe that sounds cynical. Or maybe investors are catching on to what the US stock market has become - a way of mining equity investors for their hard-earned cash.

That kind of cynicism is not helpful if you're trying to figure out what to do for the next ten years though, so we'll lay aside the snark and focus on the future. As Lenin once asked, what is to be done?

Part of 'situational awareness' is knowing where you are in history. It's useful to know that we're still in the deflating stages of a grand credit bubble. Central banks are fighting an anti-deflationary rear-guard battle against falling asset prices. They are armed with an infinite supply of digital money.

But the political will to fight a war in which the banking sector (and the bankers) are to be saved at the expense of the currency and the country...that will is flagging. We reckon there will be another attempt to rally the troops. It will come in the form of 'Eurobonds' jointly guaranteed by all of Europe.

Europe will take its collectivist social experiment to its logical conclusion. It will create a fiscal union, or at least a debt union. In the debt union, all government borrowing will be guaranteed by all of Europe. It will be the final attempt to create an economy where everyone lives at everyone else's expense.

It probably won't work. But somebody should try it. It will involve the creation of new bonds and probably vast new sums of money. It could even begin with the Greek election producing an expected outcome: a coalition of centrist parties that accepts the demands of the 'troika' and keeps Greece in the euro...for now. What might follow is a collective sigh of relief...and a big rally in shares.

Or the whole thing could come flying apart at the seams, which seems increasingly likely to us. But this is the end-game for the fiat money, fractional reserve-based Welfare State. All options are on the table to keep the scheme going, to borrow a diplomatic phrase. This is a war over the power to control and print money. No expense will be spared to keep the system going longer.

Tomorrow, we'll look at our favourite indicator for impending financial doom. It can help you decide when to buy or sell stocks. And it can tell you what else goes up when everything else goes down. Until then...

Regards,

Dan Denning for The Daily Reckoning Australia

From the Archives...

The Physical Gold Market - From the Weak to the Strong2012-05-18 - Greg Canavan

Why JP Morgan is Playing the Same Old Rigged Game 2012-05-17 - Eric Fry

Why Greece Can't Afford to Stay in the Euro2012-05-16 - Dan Denning

A Big Oops at JP Morgan!2012-05-15 - Dan Amoss

Preparing For China's Growth Slowdown With The 'Energy Hub' Portfolio2012-04-14 - Dan Denning

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