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The Invisible Crash and a changing Canadian stock market

The boom in commodity prices is part of a rush to inflation, says this advisory, which also describes some significant changes on the TSX.

Commodities have been much on our mind lately. Yesterday we heard from one Canadian analyst who believes that Asian demand will more than offset an anticipated U.S. slowdown in maintaining the general health of commodity prices.

Today we visit an analyst with a slightly more sinister interpretation of high commodity prices. Supply and demand is doing its job, all right, we read in Ian McAvity’s Deliberations on World Markets. But there’s more to the story.

In a word: inflation. This advisory worries that in their efforts to avoid one type of market crash, the powers-that-be will bring about another type of crash, less obvious but just as deadly.

The advisory also tells us how the leadership of the Toronto Stock Exchange has passed from one sector to another, and why the Bank of Canada is liable to put forth every effort to keep the ever-muscular loonie under control.

But first, the spectre of a silent but deadly crash.

Inflationary depression

Perhaps the greatest danger ahead, according to Mr. McAvity, is the advent of an “Invisible Crash.” This phrase, coined by Mr. James Dines is his 1975 book of the same name, is roughly parallel to stagflation. That is, inflation combined with a stagnant economy. In this case, however, it refers specifically to the impact of inflation on the value of stock market securities.

When the book was written, stock markets were coming down from their highs at the beginning of the decade. And the paper losses suffered by investors were much greater than they at first supposed. The reason? The galloping inflation brought on by the global oil crisis that began in 1973.

The erosion in the purchasing power of the dollar meant that the value of assets had fallen much further in real terms than in face value. In short, without all the fanfare of 1929, stocks and other securities hadn’t simply corrected, they had “crashed.” They were in the midst of an “inflationary depression.”

It might be added that Mr. Dines was advocating an investment in gold shares (private ownership of gold was illegal in the U.S. until the end of 1974). Paper securities can always be rendered worthless, he warned, and in more ways than one.

Well, that was 33 years ago. But history does repeat itself, Mr. McAvity implies, and commodity prices may be right in the middle of the impending inflationary crisis.

Alice in Wonderland and the 80-year-old nun

“There has never been much doubt that in the face of financial crisis, political pressure in the G-7 economies will inevitably resort to expedient pain-deferral by throwing money at any problem,” says Mr. McAvity.

The editor likes to refer to the exotic new investment derivatives that have plagued the credit markets as “cockroaches” coming out of the woodwork. We keep hearing government proposals to “make it go away” by cutting interest rates or resorting to various government sponsored agencies to take on the problem, “so the Alice in Wonderland lifestyle of living beyond our means continues.”

This, of course, leads to hyperinflation.

“Central bankers preach against the evils of inflation all the while they facilitate it… like the used car salesman assuring every buyer that an 80-year-old nun only drove this lemon to church on her daily trip.”

While this may raise a few questions about the purchasing power of nuns, it’s time to see where commodities come into the picture.

In the hands of aggressive traders

Commodity prices are soaring for good and sufficient reasons, says Mr. McAvity. There are real pressures of supply and demand stemming from the industrial revolutions underway in Brazil, China, Russia, India and other emerging economies.

These in turn are exacerbated by under-investment in the natural resources sector and certain physical limitations. It’s harder to raise the capital necessary for new exploration and development and harder to get permits for new projects, partly due to environmental concerns.

“The picture is compounded,” adds the editor, “by a flood of liquidity in the hands of aggressive traders attracted by accelerating momentum as well as ‘investment demand’.” This demand is fuelled by studies claiming that commodities move independently of more conventional assets like stocks or bonds.

Loss of purchasing power

And there’s one more stimulant: the falling U.S. dollar. “A third factor is an eroding denominator, the dollar, backed only by a U.S. administration oblivious to its currency losing integrity,” says Mr. McAvity.

And it’s not just the dollar. Commodity price inflation is also outstripping the euro and the yen. The difference, according to the editor, is that Europeans, with a history of currency debasement, are sensitive to the problem, while the U.S. apparently doesn’t care.

So the strength of commodities does have a firm base in an expanding global economy. But the prices of raw materials are also rising on a disconcerting wave of inflation. That doesn’t mean commodities should be abandoned, in this editor’s view, simply that their rising values should be treated with prudence.

Mr. McAvity is insistent on one point. “Inflation is not just rising prices, it is the loss of purchasing power of a currency.” He illustrates with a chart on the progress of the Dow Jones Industrial Average from 1928 to the present. The editor demonstrates “the illusion of higher prices” by removing inflation from the equation and leaving a large gap between the apparent rise in value and the real rise in value.

“If they can avoid a more serious crash from the credit mess,” he concludes, “everything Washington is doing in reaction to the latest shocks suggests they hope to engineer a replay of The Invisible Crash.”

New leader on the TSX

There’s another commodity price to take into account, this time on the home front. “With the resurgent oil price leading the way, the leadership of the TSX has changed,” announces Mr. McAvity. “Financials have slipped to a 27.6% weighting from 32.6% a year ago, while Energy has become the dominant sector at 29.1%, up from 26.6%.”

To put it all in perspective, he returns to 2003, the early days of the bull market in commodities. At that time the Financial Index was worth more than energy and materials combined. Now it accounts for just 56 per cent of those two sectors combined.

This has all happened despite a fair amount of agitation in the energy industry over trust tax changes and royalty reviews. This helped bring the energy index down temporarily, but the relentless strength in the price of oil seems to be able to overcome these local worries, suggests the editor.

More cockroaches

As for the financial sector, Mr. McAvity is “a tad skeptical about the constant flow of media spin that, apart from the Canadian Imperial Bank of Commerce (TSX-CIBC) and Bank of Montreal (TSX-BMO), everyone else in the Canadian financial sector was too clever to get burned by the meltdown afflicting New York and every other financial centre.”

The fiasco over asset backed commercial paper (ABCP) hasn’t really been solved, he adds. More “cockroaches” are liable to see the light of day. With that in mind, the editor has taken a position in the leveraged bear exchange-traded fund on financials, Horizons BetaPro S&P/TSX Capped Financials Bear Plus ETF (TSX-HFD).

“For Canadians with huge taxable gains in long held Canadian banks, this may be a useful hedge vehicle to avoid precipitating a taxable event.”

Problems for Canadian exporters

Finally, Mr. McAvity judges the immediate future of the Canadian dollar in the face of a U.S. slowdown. True to his pessimism about the credit crunch, he suspects “a longer and deeper U.S. recession than currently expected by the pollsters.”

This will have a “magnified impact” this time around because Canadian branch plants of U.S firms have seen labour costs soar with what amounts to a 70 per cent surge in the value of the Canadian dollar over the past five years.

He discounts much of the Hillary Clinton-Barak Obama NAFTA debate in the Democratic primaries as hot air. But he admits to some concern about the possiblity of a protectionist policy under a President Obama (apparently discounting a Republican victory). That is, more trouble for Canadian exporters.

Adding up all these problems and potential problems for Canadian exporters, Mr. McAvity concludes that the Bank of Canada will keep on acting aggressively to prevent any sharp rises in the value of the loonie.

In this part of the country, the only invisible crashes lately have been vehicles disappearing into snowbanks. Let’s hope we don’t have to look forward to the other kind of invisible crash, the one that makes more dollars disappear into fewer returns.