In the Shadows of the Commodity Bubble - A Normal Correction Doesn't Seem Possible

Mar. 9.11 | About: Materials Select (XLB)

I refer you to Kyle Bass' letter, and I paraphrase and elaborate on his theme. There is an immense problem with bubbles beyond the emerging market/commodity inflation blowback and fallout. When they burst we will experience yet another maladjusted capital and banking crisis. And this one will be on top of the unresolved prior bubble bust. Therefore, I fear any relief that comes from a commodity down draft will expose the latest gaming to a costly hard landing. Meanwhile, the longer this bubble persists, the worse the eventual outcome.

Although this bubble has a speculative hoarding component to it, the maladjusted price signals also launch expensive development projects that create oversupply relative to the real economy. Because a portion of the demand for the projects is financial and speculative and is not coming from the real economy, an excess supply of capacity and output is created. Another part of the demand is stimulus related, a dynamic that is unsustainable in a world of badly stressed government treasuries.

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The bubble will burst when investors come to doubt that real demand for commodities is sustainable. In my game theory, that will happen when they smell the coffee on China's export sector rout [see here]. Once prices break, many development projects will be abandoned. The lenders, companies and investors involved will suffer huge losses. Ultimately, XLB is a great short.

Further, the cost of completing projects rises because of the general inflationary blow-back, making them difficult to complete. The end result is a repeat of the subprime crisis and leads to a plethora of half completed expensive commodity and developing market projects as witnessed in the real estate bubble in the last cycle.

Much of the speculative and business activity gets funded by the shadow banking sector, which is as unregulated and concentrated as ever. This is because the current regulation is focused on the banking sector, which in turn is focused on the last bubble; the new bubble is formed by cheap money flowing into shadow banking off balance sheet activities.

This has been in overdrive, with commodities and emerging markets being the principal sponge of all the cheap money. A bunch of players are all in. Money manager allocation is now extreme: equity surges to a record overweight of 67%; commodities are also at a record overweight of 28%. Index funds hold two billion bushels of corn, or 60 million tons versus total global stocks of 145 million tons.

I think some too big to fail banks have literally tried to corner commodity markets, and in their greed have created unsustainable dangerous bubble prices. This one will be hard to explain during the next round of dynamite strapped weekend emergency meetings, especially dealing with an already bankrupt government. That will be a come to Jesus moment, and I'd love to be a fly on the wall.

Once again, leverage is being applied, a fact that should not be overlooked. The real economy desperately needs a commodity sell off, but once one develops, we will see a separate banking and speculator crisis. The danger in the market now is that they need to stay in this crazy negative blow-back inflationary mode, or bust. A normal correction doesn't strike me as even possible.

Disclosure: I am short XLB.