Bubbling over
Posted 01:18 p.m., May 5, 2008
It appears that the investment establishment has decided to declare the recent steep rise in commodities prices a “bubble.” Giving these rising prices this label is a way of saying that the climb in commodities prices is somehow “artificial,” caused by a mob of “speculators” who are driving prices higher on the futures markets with little or no correlation with the underlying economic realities of supply and demand. The mostly unspoken argument here is that supply is not as tight, and demand not as voracious, as current price levels would suggest.
A further implication that I haven’t seen addressed is this: If we are indeed seeing a classic bubble in commodities prices, then what we can expect to see at some point is what always follows a true bubble: a collapse, which in this case would mean deflation, and probably on a scale not seen since the early 1930s.
It might be helpful in assessing these notions to see what a classic bubble looks like, what a more “normal” uptrend looks like, and what the current picture in a major commodity – crude oil, in this case – looks like. By “looks like,” of course, I mean what the price charts look like.
Here’s the “normal” uptrend (and its ensuing correction):
The orange lines on this chart show how a technical stock analyst might analyze this index’s movements. Points A, B and C define a “trendline.” With three “touch points,” this particular trendline generally would be considered pretty well-established; a line based on just two touch points wouldn’t be considered very reliable for forecasting purposes. The upper trendline is simply a line that’s parallel to the bottom line, drawn from the next significant high following the low that serves as the starting point for the bottom line.
A digression: Burton Malkiel, in his classic statement of orthodox economics’ view of the stock market, “A Random Walk Down Wall Street,” heaps copious amounts of scorn on technical analysis, in particular on the use of trendlines. But the reason they actually make sense is simply that any line on a graph like this represents a certain growth rate. In the case of the chart above, the bottom line shows the overall rate of growth from point A to points B and C. The upper line shows the same growth rate but starting from the high point at D.
A parallel channel like the one shown gives us a picture of the overall parameters within which investors feel comfortable with the index’s price movements. At the high end (which you can see gets slightly above the upper line in a couple of spots), investors start to feel that the price is “too high,” while at the lower end, they may feel the price is a bargain; as a result, the price oscillates (irregularly, to be sure) between these boundaries.
In the case of the Nasdaq Bank Index, investors went from being pretty pessimistic in late 2002/early 2003 (points B and C) to pretty optimistic at the end of 2004 (the second peak above the upper trendline). From that point, the index wandered more or less sideways until late 2006, when it topped out near the midpoint of the trend channel. From there, it edged toward the lower line, and last June it decisively broke through the lower line, signaling that a “correction” is in progress.
As of Friday’s close, the decline in this index from the point of the trendline break amounted to 20 percent. That’s a five-year low and a pretty steep correction, but so far it all falls within a reasonable definition of “normal” market action. (The decline from the 1998 peak to the 2000 low, point A, was about 40 percent.)
Now, here’s an example of what a true bubble looks like:
Here we see a similarly well-established uptrend channel, but in June 2003 the data series breaks through the upper trendline as it kicks off a steep advance of a type some analysts refer to as a “hyperbolic” uptrend, perhaps the surest sign of a classic bubble. From May 2003, the month before the break, to the February 2006 peak, residential construction spending soared 52 percent.
From that peak, this indicator has fallen 36 percent and is slightly below the May 2003 level. One possible target for the bottom of this decline would be the last near-touch of the lower trendline before the bubble began, in January 2002; that would imply a total decline from the peak of about 45 percent, or a further 13 percent decline from the most recent data point reported for March. That would be relatively light punishment; the bursting of the stock market bubble of the 1920s was followed by a decline of about 90 percent that left the Dow Jones industrial average at a 30-year low.
So now let’s look at crude oil (note that this chart is on log scale, so the numbers on the vertical scale don’t indicate dollar values):
As is obvious, crude futures prices remain within a well-established, “normal”-looking trend channel dating back at least to 1998. I’ve added a couple of extra parallel lines to show where the “mid-channel” is for this series, as such a channel often defines support or resistance levels. I’ve also included a linear regression for the entire data sample (the light blue line), something orthodox economists might look at more favorably than the trend channel.
As you can see, the current price is in the upper half of the long-term channel but remains below the uppermost trendline. It’s also not terribly far above the linear regression, though that line has zero usefulness for forecasting purposes.
Supposing that crude oil futures might be due for a correction, here are some possible targets, assuming a rapid drop from the current level: to the upper mid-channel line: about $91-$92 a barrel, about a 20 percent decline from Friday’s close; to the lower mid-channel line, about $76-$77 a barrel, or about a 33 percent drop from the current level; and to the lowest trendline, about $50-$51 a barrel, about a 55 percent to 60 percent decline from Friday’s close. Even that decline would knock prices down only to roughly where they were in January 2007, or just a little over a year ago.
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