by Kevin Klombies, Senior Analyst

Wednesday, September 10, 2008

Chart Presentation: Bubble Trouble

Back in March Goldman Sachs published a report called ‘Revenge of the Old ‘Political’ Economy’ which set forth a bullish argument in favor of commodity prices. However, there was one line in this report that stuck with us so we are going to start things off today by quoting it.

“The strong biofuel-related demand for food crops has created an arbitrage between agriculture and oil markets, with sugar, corn, and motor gasoline prices converging on an energy-content basis.”

We have often argued that the dominant trend from 1999 forward has been relative strength for crude oil prices but to read that the trend had progressed to the point where food was now being priced on the basis of its energy content suggested to us that we had reached the stage of ‘absurd comparisons’. By this we mean that during the late stages of a ‘bubble’ relative prices move to such extremes that one always looks back and thinks that it should have been obvious. When the real estate value of Japan’s Imperial Gardens exceed the value of the state of Florida what was the message? When a start up opened for tradingas a multi-billion dollar company what was the message? When the market cap of Cisco exceeded that of General Electric and when fertilizer company Potash Corp. became Canada’s largest cap company… what was the message? To us the message was that prices had been driven to unsustainable levels.

In any event the chart below shows the ratio of equitiesto bonds (S&P 500 Index divided by the U.S. 30-year T-Bond futures) from 1987. The argument is that for the nine month period between the end of 1986 and the end of the third quarter in 1987 the value of equities relative tobonds drove relentlessly higher only to snap all the way back to the starting point as the equity markets ‘crashed’.

The argument that we have made on occasion in these pages is that the ratio of commodity prices toequity pricesfrom the start of last year’s fourth quarter through the end of June is very similar to the 1987 example. Since commodity prices were rising faster than equity prices trend or momentum-following money chased commodities. The stronger the ratio the more money the trade attracted. The problem was that once food prices had risen to their energy equivalent based on the premise that energy prices could only move higher… the unthinkable began to happen as energy prices turned lower. Now those long commodities as an ‘investment’ or long thestocks of commodity producers are finding out- quickly- what it feels like to be long the wrong side of an asset price bubble.