VOLUME   1.13 1.
9 
Asset Recovery or Asset Bubble?
Talk of burgeoning asset price bubbles
has taken centre stage in the financial media.
Caught between modestly improving economic
data and fears of a liquidity-driven mania,
prices of stocks and commodities have been
increasingly volatile in recent weeks. Markets
from time to time have become skeptical that a
sustained period of growth will occur and
concerned that debt troubles will resurface.
The next phase of the recovery will
continue to see the Federal Reserve flooding
the system with liquidity in a marathon battle
against rising unemployment which, together
with elections, has always been the key to U.S.
economic policy. To date, there have been no
signals that would push the Fed to tighten
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VOLUME 
DECEMBER 4, 2009 
policy. Inflation is non-existent and long bond
yields are flat. The Fed has a green light.
Asset prices particularly in emerging
markets will get increasingly frothy as central
banks are forced to accommodate U.S.
monetary policy in order to limit currency
appreciation against the dollar. Protecting
themselves from the inevitable bubbles in
stocks and real estate will prove extremely
difficult without significant currency
appreciation.
Capital restrictions (such as Brazil’s
portfolio tax), raising reserve requirements and
other attempts to sterilize capital inflows have
rarely been successful when applied in the
past. Chart 1 shows the close correlation
between the change in U.S. dollar reserves held
 
 CHART 1

by the Chinese central bank, money supply and mother of all carry trades,” and forecast

the Shanghai stock index. It is the same story disaster. In our opinion, we are certainly in the

in Brazil, Indonesia, India and most other early stages of a bubble. Liquidity and capital

emerging markets and commodity producing flows have had a large impact on prices and

nations. Given that it is unlikely they will be most markets have gotten well ahead of the

willing to accept the steep currency fundamentals, although valuations are not

appreciation necessary to cool capital inflows, obviously yet in bubble territory.

emerging market asset prices will continue to

The principal risk in the current
be driven by U.S. monetary policy for the
environment is that international capital flows
foreseeable future.
could be extremely volatile. In the 1997 Asian

Does this mean that we are in a general Crisis, a correction turned into a full scale rout.

asset bubble? Opinions vary widely. Some A similar panic could easily develop in the

say 2009 has been just “a very good year.” current environment, causing the U.S. dollar

Others say that we have been experiencing “the carry trade to unwind with alacrity.

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 Although this may not be a bubble yet, U.S. and foreign financial institutions. How

we are certainly on track for one. Liquidity severe the damage would be is anyone’s guess

expansion will continue to drive the cycle for at this point.

the foreseeable future, creating risk of a violent

correction particularly in emerging markets,

A MURKY PICTURE OF A TENTATIVE
gold and other commodities.
RECOVERY
The Federal Reserve recognizes signs
The challenge with interpreting
of froth in foreign markets, but has made it
indicators for the U.S. economy is that fiscal
clear that it will not alter course well into 2010.
stimulus, bailouts and monetary policy have
The Fed will err on the side of excess liquidity
created a totally artificial picture. While it is
in order to deal with the more sensitive
true that we can expect these interventions to
problem of high unemployment. Furthermore,
continue through 2010, their impact has likely
letting banks and consumers rebuild their
peaked. Policy makers are becoming
tattered balance sheets through a broad
increasingly hemmed in politically and will
reflation of financial assets is in everyone’s
need to start demonstrating that they have a
short-term best interest.
credible plan to rein in deficits in order to keep
It is difficult to gauge how widespread
a handle on interest rates. With that proviso,
participation by the U.S. financial sector is in
we provide a look at some of the indicators we
this nascent speculative mania. However, it is
are following.
clear from the Dubai default that emerging
The U.S. economy officially returned to
markets are becoming increasingly vulnerable.
growth in the last quarter largely thanks to
If this turned into a panic sell-off, shockwaves
resilient retail sales. “Cash for clunkers” and
would trigger another round of losses at certain

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first time homebuyer subsidies had a large CHARTS 2-5

impact on these markets (charts 2 &3). Longer

term, the key problem facing the American

consumer is debt. Chart 4 shows the rise in

household debt, which began to increase much

faster than income in the late 1980’s. The

trend peaked in mid 2008 at close to 120%

debt to income ratio. If we assume that

household debt has been stretched to the

maximum, household deleveraging will be

prolonged as debt levels need to be brought

down to a manageable level.

What is unclear is how successful

policy makers will be in coaxing consumers

out to the malls while this process plays out.

Unemployment is now at 10%, but if we

include discouraged and under-employed

persons, the figure is 17.2%. Most

discouraging, structural unemployment is at its

highest level since the 1930’s: 35.6% of the

total unemployed have been out of work for at

least 6 months (Chart 5).

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 Existing house prices looked set to rise CHARTS 6-9

back from the lows of early 2009, but have

resumed the downward trend since June (Chart

6). The volume of existing sales has bounced

back to 2002-2003 levels, but new home sales

remain depressed, less than ¼ of the peak

(Chart 7). Few building permits are being

issued, indicating that no quick turnaround in

residential construction should be expected

(Chart 8).

Business activity appears to be

expanding at a healthy pace. The ISM

purchasing manager’s index1 is in positive

territory, but the non-manufacturing (service

sector) index turned negative (below 50) again

last month (Chart 9). Capacity utilization has

improved somewhat, but at 70.7% it remains at

an extremely low level (Chart 10). Producer

prices continue to show no sign of inflation

even at the crude materials level, despite the

rise in commodity spot prices (Chart 11).

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 Quantitative easing has yet to translate CHARTS 10 -12

into business credit expansion. It is impossible

to say that a depression would have occurred

without the unprecedented expansion of Fed

assets over the past 18 months; however it is

clear that the situation would have been much

worse without. Despite the increase in money

supply, business credit continues to shrink at a

rapid 20% annual rate. Typical of a balance

sheet recession, demand for credit is likely the

limiting factor rather than supply. Businesses

are unlikely to borrow heavily when excess

capacity abounds and the outlook is so

uncertain, and consumers are already

mortgaged to the hilt. The only type of credit

that is actually expanding is margin debt (Chart

14), raising questions about stock market risk.

Meanwhile, the banks are content to borrow at

zero rates and buy longer dated Treasuries at

close to 3½%.

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 To sum up, the few positive signals CHARTS 13 &14

coming from the U.S. economy are likely due

almost exclusively to stimulus. Fed policy has

yet to gain much traction domestically, and

low rates alone may not prove successful in

establishing sustainable growth. Restructuring

the U.S. economy is necessary and will take

time.

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INVESTMENT CONCLUSIONS translating into domestic consumer or business

credit expansion. It is true that U.S. monetary

The last nine months have been a
policy will likely spur asset price inflation in
remarkable period in that equities, gold and
emerging markets, but the lack of traction in
corporate bonds have all appreciated by double
the domestic economy means that slack will
digits. This has only occurred on two other
persist. Further, China is maintaining high
occasions in the last 50 years. Typically,
levels of investment in the manufacturing
equities perform best during periods of low and
sector, despite excess capacity. Given their
stable inflation, like the current environment.
refusal to allow the Rmb to appreciate, China
Gold (and other commodities) performs best
will continue to import inflation from the U.S.
during inflationary periods and when the dollar
There is no case for general consumer price
is weak, while government bonds tend to
inflation in the U.S. at this time.
outperform during periods of deflation and risk

aversion. The current, unusual dynamic where Regardless, momentum will likely

almost everything has gone up together cannot carry gold prices for a while longer. The gain

last forever. is up 38% year to date, and recent purchases by

some central banks have given retail investors

The link between the Fed’s
a confidence boost. Since the beginning of the
accumulation of assets and inflation is tenuous
bull market in gold in 2001, price action has
in the current environment. In most business
followed the 1968-1980 cycle closely (Chart
cycles, easy policy leads to credit expansion
15). During that 12 year period gold was up by
which eventually leads to pressure on prices
a factor of 20, indicating that gold could move
when business activity approaches maximum
higher if the mania continues to build.
capacity. The current environment diverges

from the typical cycle in that easy policy is not

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 Commodity prices have also been CHARTS 15 & 16

following a similar pattern to that of the 1971-

1980 period (Chart 16). However, unlike gold,

commodities have almost matched the price

increases of the 1970’s. It is worth noting that

in the 1970’s cycle, commodity price increases

preceded the big run-up in gold. Gold moved

in response to actual inflation and dollar

declines in the 70’s. Currently, gold is

appreciating purely on inflation expectations,

and is well ahead of dollar declines.

Surely, the large proportion of new

purchases of gold bought by retail investors

through ETFs, and the proliferation of shady

companies advertising on late night TV,

begging for any “unwanted” gold are both

clear signs we are in a mania.

In the absence of any evidence of

inflationary pressure, current gold prices are

vulnerable, particularly if the dollar were to

rally.

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 North American equities and corporate in 2010 when the “earnings phase” of the

bond spreads are still far from their best levels recovery gets going.

before the crash. As always, they have
responded well to plentiful liquidity. With the
House elections coming up next year, high
unemployment and no inflation, the tailwind
from monetary policy will remain in place.
However, valuations have become a bit
stretched and confirmation of improving
The U.S. dollar will remain under
pressure, but for the reasons we have continued
to state, the decline should remain orderly as
no one wants their currency to rise in a world
of deflation nor does anyone relish the chaos a
dollar collapse would trigger.

earnings is necessary for another big upleg in

equities. We expect financial results to be at

best ambiguous over the next couple quarters.

Until a pattern of improving earnings is clear, Tony & Rob Boeckh

December 4, 2009
expect equities to be range bound and volatile.
BoeckhInvestmentLetter.com
info@bccl.ca
If liquidity continues to drive equity
*All chart data from IHS/Global Insights, and
prices higher without clearly improving may not be reproduced without written
consent.
business conditions, be suspicious. As we

discussed above, the possibility of significant

correction in emerging markets and
commodities can’t be discounted. Continue to
1
The PMI index is based on five major
indicators: new orders, inventory levels, production,
supplier deliveries and the employment environment.

build liquidity on strength. There could be

some nasty surprises in the next few months

and there will likely be good opportunities later

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STOCKS

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COMMODITIES

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CURRENCIES

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INTEREST RATES

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