In the run-up to the 2004 presidential election, John Kerry spoke of the “Two Americas.”  While most campaign rhetoric is meaningless mantra intended to rally voters, Senator Kerry may have stumbled on to a profound observation.  There may or may not be two Americas today, but given the trends in education there soon will be.  We often use demographer Philip Longman’s quote that demographics are the future that has already been written.  In this case, demographic and educational trends have created two very different futures for America’s youth.  In a twist of irony, the Wall Street Journal ran two unrelated articles on October 21.
 
The first article, by Ron Alsop, is an adaptation of his 2008 book The Trophy Kids Grow Up: How the Millennial Generation is Shaking Up the Workplace. We generally refer to the children of the Baby Boomers as the“Echo Boomers” or as “Generation Y,” though the term “Millennials” certainly fits the bill equally well.
 
As the children of the self-indulgent Baby Boomers, the Millennials know a thing or two about “me-centered” narcissism and already appear to be outdoing their parents.  The Boomers raised their children to believe that, contrary to the laws of mathematics, everyone is “above average.”  This is perhaps best epitomized in little league sports where every kid, win or lose, gets a trophy.  As Mr. Alsop writes,
 
"Although members of other generations were considered somewhat spoiled in their youth, Millennials feel an unusually strong sense of entitlement.…More than 85% of hiring managers and human-resource executives said they feel that Millennials have a stronger sense of entitlement than older workers, according to a survey by CareerBuilder.com. The generation's greatest expectations: higher pay (74% of respondents); flexible work schedules (61%); a promotion within a year (56%); and more vacation or personal time (50%)…."

Where do such feelings come from? Blame it on doting parents, teachers and coaches. Millennials are truly "trophy kids," the pride and joy of their parents. The Millennials were lavishly praised and often received trophies when they excelled, and sometimes when they didn't, to avoid damaging their self-esteem…. This generation was treated so delicately that many schoolteachers stopped grading papers and tests in harsh-looking red ink.

Of course, the Millennials aren’t all bad.  They may be overly sensitive and woefully unprepared for the rough and tumble professional world, but this is also arguably the most competitive generation in history.  Millennials scratched and clawed with the best of them in order to get into America’s elite universities, and there certainly wasn’t a consolation trophy for failing to gain admission.  Particularly among parents on the higher end of the socio-economic ladder, these were the kids who had to balance their schoolwork with increasingly cutthroat sports and music competitions and even youth charity events.  They are also the most technology-savvy generation in history, even if most of this knowledge has thus far been wasted on Facebook and YouTube.
 
In his insightful book The Empty Cradle, Philip Longman identified a “chicken or egg” circular argument that explains why the Millennials ended up the way they did.  In a world with shrinking birthrates and with increasing returns on education, parents feel compelled to give each child as much attention and training as humanly possible.  But at the same time, the shear amount of time and money needed to make your child competitive makes it unfeasible to have more than one or two children.  The fewer children we have, the more we depend on the ones we do have to become successful.  If the higher-achieving among the Millennials have developed a sense of entitlement, it might be because they know that we need them more than they need us!
 
The Millennials may be largely unsuitable for the confines of corporate America, but then, so were Bill Gates and Steve Jobs, and these two rebellious Baby Boomers gave us Microsoft and Apple, respectively.  As this generation comes of age, we could indeed be looking at a new era of entrepreneurial energy and innovation.
 

Meanwhile, on the same day the Journal reported on the professional debut of “trophy” Millennials, there was a second article about this generation, written by Gary Fields.  At first glance, it’s hard to believe the two articles are describing the same generation.  As Mr. Fields writes in “The High School Dropout's Economic Ripple Effect,”
 

As the financial meltdown and economic slump hold the national spotlight, another potential crisis is on the horizon: a persistently high dropout rate that educators and mayors across the country say increases the threat to the country's strength and prosperity.

According to one study, only half of the high school students in the nation's 50 largest cities are graduating in four years, with a figure as low as 25% in Detroit. And while concern over dropouts isn't new, the problem now has officials outside of public education worried enough to get directly involved.

The article reports that mayors in Houston and other Texas cities have resorted to going door to door to the homes of dropouts, essentially begging them to come back. In perhaps a bit of gallows humor, Mr. Fields continues:

Marguerite Kondracke, president and CEO of America's Promise,…calls the dropouts "our next class of nonperforming assets." She says that each year dropouts represent $320 billion in lost lifetime earning potential….

With other studies also showing increases in the number of students who aren't graduating, public officials are concerned those numbers will mean rising costs for social programs and prisons, as well as lost tax revenue because of the reduced earnings potential of dropouts.

Alas, it appears that Senator Kerry was correct about there being two Americas.  At the upper end of the social scale, we have a generation of highly educated, independent-thinking 20-somethings who, while spoiled, still have the world at their fingertips.  At the other end of this same generation, we have millions of children who do not finish high school.  In a world with higher returns than ever to education and lower returns to manual labor, this means a future level of income inequality unseen in America in generations.

 

Hello Coupons

The Boomer Bust

References

“I also admit confusion. In my 36 years as a professional investor I have not seen a period like this. Investors are afraid, journalists are morose, and the same old stories keep replaying endlessly. That's not normal. In the world I've known most of my life, old stories quickly lose their power over capital markets and get replaced by new surprises. That which everyone fixates on gets priced into the stock market quickly and can't drag on. But here, 19 months after we first started hearing about subprime mortgages, housing woes and weak financials, the stories moving stocks are little changed.”
 

The quote above is from Ken Fisher’s Forbes column from September 1, 2008, just before one of the most volatile market weeks in our lifetimes.  Nearly two years since the onset of the crisis, we just witnessed the bankruptcy of one venerable Wall Street firm—Lehman Brothers—and the distressed sale of another—Merrill Lynch, within six months of the failure of Bear Stearns, which was itself the biggest US corporate failure since the Enron debacle!

Meanwhile, consumers have gone into bunker mode, eschewing their credit cards and leaving the malls and restaurants empty. 

Though we’ve been surprised by how quickly everything has come to pass, this is exactly what HS Dent has been forecasting for two decades.  The Great Boom ushered in by the Baby Boomers has finally run its course and has met its end in a spectacular bust.

The key point we want to make now is that this bust is fundamentally different from those that have preceded it, including the most recent dotcom bust of 2000-2002.  Stocks may rally in the short-term, especially if the government plan to handle the bad debts as they did after the 1990s Savings and Loan debacle come to fruition as planned.  But unlike the 1990s, we do not think that this will ultimately “fix” the problems facing the country, nor will it put an end to what we believe is a secular bear market.  We use Japan as a case in point.

Throughout the 1990s and early 2000s, the storyline stayed constant: bad debts, impaired balance sheets, distressed consumers, and a strong aversion to risky assets continually sent the Japanese Nikkei lower.  True, in the wake of the stock market and property bubbles, the financial system was wrecked and the economy was haunted by the specter of bad debts that had to be written off.  However, in 1990s Japan—and today in America—something more fundamental happened.  The breakdown in the financial system reduced the ability of the Japanese to consume.  But long after these effects should have passed, aging demographics reduced their willingness to consume.  The shock effect of the stock market and housing bubbles were the tipping point that caused the change in societal mindset from a country of spenders to a country of savers. 

Officially, we may or may not be in recession (2nd quarter GDP was revised upwards), but it’s important to appreciate the context.  For a country used to 4% real GDP growth, growth of only 1-2% is a significant letdown.  It may not technically be a “recession,” but the effect is the same, at least in the minds of the people who matter most—the American consumers responsible for 70% of our annual economic output!

Stocks are likely to rally from their current depressed levels, as the immediate sense of panic subsides. Referring to a Benjamin Graham value model the domestic market is undervalued by 51%! There should be a rally from these prices, but make no mistake, we now believe that, at best, we are looking at a bear market rally within the context of a longer-term secular bear market.
 

As we move through the final wave of Boomer driven spending, the global dynamics for investment portfolios change drastically. Consumer spending will come from non-US sources. Emerging markets will become more significant drivers as thoroughly explained in the book "When Markets Collide" and confirmed by continuing research into demographic spending patterns. Domestically weighted asset allocation models will dash the hopes of many retiree-wanabees.

Still Think Deflation is Impossible?

“Toyota plans to raise price of cars in Japan for the first time in 16 years.”

Financial Times, August 26, 2008

In recent news, inflation is a recurring scare.  As the headline above indicates, Toyota, one of the most efficient car manufacturers in the world, is being forced to raise prices in the home market.  Disturbingly to inflation hawks, it is not increased consumer demand or enhanced quality that is driving the price hike, but the rising cost of steel and other materials.

Our preoccupation is not with Toyota’s price increase, which will likely be a modest 2-3 percent, but by the fact that the company had flat prices in Japan for 16 years during a period when auto prices were rising virtually everywhere else in the world.  To put things in perspective, the last time Toyota raised prices in Japan, President Bush was the owner of the Texas Rangers baseball franchise and President Clinton was still the relatively unknown governor of Arkansas. 

Rising food and stubbornly high oil and gas prices will likely continue to grab the media’s attention for the next several months.  But let us look at the medium-to-long-term picture:

Home prices in America are falling and still show little evidence of stabilizing. Rising prices, high debt levels, and less access to new credit have already started to crimp consumer spending. Banks, hedge funds, and other financial companies are “deleveraging,” which means that they are selling assets and raising new funds to pay back their existing debts. So despite Federal Reserve attempts to “print money,” credit is being retired as fast as it can be created. 

Angry voters are nudging their representatives to “do something” about the biofuel subsidies and speculation that have combined to send food prices sharply higher. Finally, and perhaps most importantly, Baby Boomers are beginning to save for retirement, taking money that would ordinarily be spent in the economy out of circulation.

Do any of these trends make inflation seem likely? Prices are indeed likely to rise for the next few months as the commodity bubble slowly deflates.  But longer term, we see a long period ahead of stagnant or even falling prices.  As the example of Toyota in Japan proves, deflation is real. We expect it to occur in late 09 or early 2010.

The unfolding pension crisis in state and local pensions is, again, making the headlines.  The bear market of the past nine months has sent virtually all stock indices sharply lower.  It should come as no surprise that this has ravaged the asset values of state and local public pensions.

Writing for the Financial Times (“US public pension funds' returns slip 4%,” July 21, 2008), Deborah Brewster notes:

     "US public pension funds have had their worst returns in six years, losing an average of more than 4 per cent in the year  to June 30, that puts them under even greater pressure to meet their growing liabilities.

     "The average plan's funded status has declined by close to 5 per cent during the year, taking it well below 100 per cent to be only 96 per cent funded, according to BNY Mellon.

     "Until now funding had been improving, after five years of positive returns….

     "This year's loss is close to the loss of 4.8 per cent in 2001, which was the worst for pension funds in the 11 years from 1997."

With approximately 60% of all pension assets in equities, the funding status and fiscal health of the country’s pensions are directly tied to the performance of the stock market.  As we have been warning for the past several years, pension managers are simply not prepared for the possibility of a long-term bear market. 

Standard financial planning warns against the danger of taking large portfolio drawdowns when stocks are falling.  Doing so eats away at your capital and prevents you from fully enjoying the benefits of a rebound.  It can also cause your assets to become depleted much faster, thus causing you to run out of money in retirement. 

Pensions, unlike people, are presumed to have an infinite life, so they cannot “run out of money” in retirement, per se.  They can, however, become grossly underfunded when the value of their assets plunge during a multi-year bear market.   The assets shrink, but the liabilities remain.  Even worse, Brewster notes that “Even as pension fund returns shrink and liabilities widen, some state governments are giving their state employees higher pension benefits, further increasing the pressure on the funds and ensuring even greater liabilities.”

If an individual retiree sees his or her 401(k) destroyed by a long-term bear market, they may have family or friends to ask for help, but where does a city or state go when the money runs out? 

The answer, unfortunately, is to you, the taxpayer.

Government sponsored pension plans have limited choices to solve funding problems related to future retiree pension payments.

Raising taxes will usually require voter approval. With retirees being the largest voting bloc, expect this ballot issue to fail.

Reducing pension payments involves breaking the employment and social contract with retirees. It happens in the private sector when companies use bankruptcy court to reorganize. Pension liabilities are transferred to the PBGC where benefit adjustments are made. Governmental entities have no similar process to get out of the responsibility for the benefit reductions, except to file for bankruptcy. The latter is the path followed by the City of Vallejo, California.

Who Shot GM?

In recent years, we have discussed with clients the slow-motion “death of pensions” that is occurring both in the private sector and the public arena.  On the private side, it is a subject that is worth attention even for those of us that do not have traditional pensions because we, as taxpayers, could end up bearing the burden of these plans if the providers go under. 
The traditional pension plan is slowly dying, and it is leaving the rest of us to pay its bills.  On the public side (cities, states, and public worker associations), the threat is worse; we have a direct responsibility for these plans.

In the case of private pensions, nowhere are the problems greater than in the auto industry.  Writing for the New York Times (“Siphoning GM’s Future,” July 10, 2008), Roger Lowenstein writes:

“General Motors once manufactured half the cars on the American road, but now it sells barely 2 in 10. Bankruptcy is not unthinkable for Detroit’s former king. The immediate cause of GM’s distress, of course, is the surging price of oil, which has put a chill on the sale of gas-guzzling sport utility vehicles and trucks. The company’s failure to invest early enough in hybrids is another culprit. Years of poor car design is another.

But none of GM’s management miscues was so damaging to its long-term fate as the rich pensions and health care that robbed General Motors of its financial flexibility and, ultimately, of its cash.”

One of the key points to keep in mind is that when these generous health and retirement plans came into place during the 1950s and 1960s, the US was in the midst of the greatest population boom in history.  It seems unlikely that anyone was looking forward 50-60 years and estimating that we would have a period of fewer children and greater automation, leading to fewer workers to support the retiring population.  This demographic shift is one of the major elements that are causing such pain at US companies as well as throughout the public sector.

This is the warning we have been issuing for several years now.  There are no easy “fixes” to the pension and healthcare crises.  For government plans like Social Security, Medicare, and the state and local pension and health plans, the solutions are 1) higher taxes, 2) a reduction of benefits, or 3) some combination of the two. 

For private plans such as that of General Motors, the choices are even less appealing.  In the event of bankruptcy and reorganization, which might actually be best for the company’s long-term competitiveness, the pension plans will fall into the lap of the Pension Benefit Guaranty Company – in other words, into your lap as a taxpayer.  We have evidence of this as the PBGC has assumed plans for United Airlines, Continental Airlines and others.

From the public’s perspective, the transfer of a pension benefit to the PBGC does not sound like a threatening change. After all, the FSLIC insured savings and loan depositors. The FDIC insures bank depositors. What’s the big deal?

The big deal for a company’s retirees is that the PBGC does not necessarily guaranty the anticipated pension income. It does become the administrator of the plan to guaranty the payment of benefits available from the plan’s current funding. In the case of United Airlines and Continental, the retiring employees experienced a 60% reduction in anticipated benefits.

As is true for 86% of the S&P-500 companies, pension plans are severely underfunded. All but three state pension systems are underfunded. If corporate profits or state tax collections wane, future funding of the liabilities may be difficult or impossible.

For GM, the United Auto Workers pension has nearly $100 billion in it. However, GM owes the plan another $65 billion. It must operate profitably for many years to generate the revenue to fund the obligation to the UAW pension plan. In this scenario, if benefits are not reduced, we taxpayers will be paying the difference.

If GM seeks creditor protection from the bankruptcy court, the UAW plan will go to the PBGC. GM retirees whose benefits are funded from the pension’s general accounts will likely experience a benefit reduction.

The unfolding of these long-term trends serves as a tremendous reminder of the importance of financial planning. Having worked 30 years to find your pension benefit reduced from, let’s say $5,000 monthly to $2,000 monthly, will impact either your retirement date or your lifestyle.

Having worked your career anticipating an attractive monthly pension benefit implies other unintended consequences. Most likely, workers saved additional money to supplement retirement. Now, many are facing circumstances where the savings are insufficient. What had been expected to be for “extras” may not be enough for essentials.

As if this is not enough to deal with, GM will most likely discontinue its support of retiree health care benefits. GM is not in a position to transfer this liability to the workers as Goodyear Tire & rubber has done. As a post-retirement benefit, health care is not a lifetime contract like the pension plan. Health care is only an annual obligation. Retirees who do not have a contingency plan for their own health care expenses place their retirement security in peril.

Good financial planning incorporates many scenarios, including the ones we hope never happen.

When the canary quit singing, the coal miners knew toxic gases were high, and it was time to vacate. Today, in our world of high speed communication, the canary has awakened and begun to chirp. We should be paying attention.

Our canary is a quasi-governmental agency – the Securities Investor Protection Corporation, or SIPC. I found this hard to believe. However, SPIC is running radio and TV ads touting the amount of money that it has paid to investors. Presumably, that will make investors feel good in the midst of all the more disconcerting economic news.

THE ONLY REASON SIPC PAYS OUT ANY MONEY is due to the failure of a brokerage firm to remain financially viable and stay in business. As an insurer, you only have to pay when there are losses.

SIPC’s ads are a defacto announcement of brokerage firms failing. Apparently, the firms were not as large and noticeable as the collapse of Bear-Stearns because the failures did not receive attention in the national press. At this writing, there are fourteen brokerage firms being settled by SIPC.

SIPC guarantees investors’ funds held in brokerage accounts. The guaranty is limited to $100,000 of cash and a maximum of $500,000 of total value in securities and cash per account. Typically, brokerages buy additional insurance for excess coverage in the event of their default.

We do not know the details of the failures that have resulted in SIPC reimbursing investors for their loss of securities or cash. We do know recent history. The collapse of the savings and loan industry and settling of accounts by FSLIC took up to two years. We do know that major brokerage firms have collapsed in the past quarter century during the greatest bull market of the last 100 years.

Our concern is what lies ahead as the Boomer generation prepares for retirement. Boomers will reduce their consumer spending to focus on debt reduction and asset accumulation for retirement. The demographic change in our country will be much greater than the corresponding change in Japan during the 1990s. We expect a protracted bear market in US stocks beginning in 2009, or 2010, at the latest.

Since SIPC is already settling accounts on failed brokerage firms in a bull market environment, we are very concerned about what happens in a bear market. In a good market there are other firms willing to take over the trading of investor accounts as we recently witnessed with JP Morgan’s acquisition of Bear-Stearns. In a bear market, ready buyers may be more difficult to find since their financial conditions may be compromised.

The worst case scenario is that SIPC has to actually settle investor accounts in a failed brokerage firm. With the firm closed, SIPC must audit the accounts before delivering cash or securities. Will that take two weeks or two years? We do not know. However, it is the “government here to help you.” FSLIC had to go to Congress for a special appropriation (read that tax assessment on us) to pay off the depositors of the S&Ls. Everyone received their insured account balances, eventually.

Internally, we have been receiving invitations from brokerage firms to attend meetings explaining how financially secure they are and why our clients should not worry about keeping their accounts with the broker. Paraphrasing the Queen in Hamlet, “…the (firm) doth protest too much, methinks.”

Brokerage firms get into financial trouble and violate net capital requirements because of bad decisions, bad market bets or excessive leverage. Legally allowed to use client assets for collateral, brokerage firms are often very highly leveraged. I have seen more than one national firm collapse during my career. Remember EF Hutton? Lehman Brothers? Integrated Resources?

There is a solution. Do not custody assets with your brokerage firm. Insist on using a trust company for custody and safe keeping. Your brokers will likely object due to the greater administrative task in placing trades. Tough!

Trust companies cannot use client assets as collateral for their borrowing purposes. The whole concept of trust custody is the separation and safe keeping of assets for another party.

Trust company financial regulations are much more stringent than required for brokerage firms. After all, trust companies do not have the task of creating new and enticing investments to attract your investment dollars. The trust companies’ responsibility is to guard your assets and account for everything that is due you, kept separate from others and their own accounts.

Tough markets have always resulted in brokerage firm failures. With an Economic Tsunami just ahead, expect more Bear-Stearns like events. They will probably be less visible and more slowly resolved. If you are caught in one, your account is frozen until a resolution is determined. No trading. No redemptions. No cash withdrawals. If you are on margin, you will get your loan called but be unable to sell your stocks for settlement. Be certain to have a back up line of credit equal to or greater than your margin limit.

Alternatively, move your accounts to a trust company. Your broker does have one to work with. You give up your ability to margin your assets. You may have to give up check writing against your investments (a different form of margin, but margin, nonetheless). You gain increased security and control of your assets through all market conditions. You remove an unnecessary risk from your personal finances. With that, you should have greater peace of mind.

Like all markets, the performance of housing is determined by only two things: supply and demand. In the late 1990s and early 2000s, demand was strong due to natural demographic trends and to a booming economy. Unfortunately, by 2004, the demographic trends driving natural demand had peaked, but the supply of new homes was still being ramped up to meet speculative demand. When it all came crashing down in 2006 and 2007, the market was left with a massive over-supply that we are still working off today, hence the decline in prices.

As HS Dent wrote in Demographics Trends in Real Estate and in the HS Dent Forecast, this supply glut is likely to last for more than a decade, particularly in the large “McMansion” segment so beloved by affluent Baby Boomers in their primes.

The good news is that the housing market is not a uniform block. There are different subsets, such as apartments, starter homes, trade-up homes, etc, and each has its own demand dynamics based on demographic trends.

Demand for starter homes by first-time Echo Boomer buyers is quietly gathering steam. The largest cohort of Echo Boomers will be graduating from high-school this year, meaning that the bulge of students currently crowding the universities will soon be moving on to the next stage of their lives: early career. These Echo Boomers will first create a surge in demand for apartments and then for starter homes as they begin to settle down and start families.

As Shawn Tully reports in his June 6, 2008 article on CNNMoney.com, this trend is already understood by America’s homebuilders:

"During the housing bubble, KB Home priced out first-time homebuyers by building bigger. Its new, more modest model provides a glimpse of what the return of the housing market may look like…

During the bubble, KB Home, like many other big builders, blew up its old-line business [of mass-produced tract homes] by going ritzy and building expensive houses. Now KB is among the first homebuilders to recognize the error of its ways, and it is returning to its roots as a purveyor of low-cost, smaller homes. In some cases KB is even using the same façades from the go-go years and then shrinking the house that lurks behind them to be half as deep - and about half as expensive…"

Of course, KB Homes was not in error by satisfying the demand for the largest, richest generation in history. The Baby Boomers wanted McMansions, and they got them. KB’s only error was believing that this trend would continue.

The McMansion market is dead for the foreseeable future, but this doesn’t mean that all home construction will cease in the coming years. Echoing HS Dent’s own commentary on the situation, Tully writes:

"When the real estate market comes back, it will not be with a sonic boom. It is likely to be subtle, below the public's radar. The revival will probably begin in the areas hit hardest by the bust: in Florida, Las Vegas, and the honeycombed tracts that flank the broad freeways east of Los Angeles known as the Inland Empire….

Why will housing come back? For a reason as solid as floor joists: The entry-level buyer…, the twenty something young professionals who rent until they get married or the first child arrives, and then reach for the American dream of homeownership…. "

When the housing market recovers, it will do so in a smaller, more affordable form, which is good for young Echo Boomers buying their first house. Unfortunately, it will do very little for the millions of existing homeowners who have seen the value of their McMansions fall precipitously.

In many cases this will be a significant detriment for Boomers. Many Boomers have approached retirement with their real estate equity as a portion of their retirement capital. Since their track record with real estate prices has been consistently rising with intermitent disruption, the underlying assumption is that this softening of prices is temporary.

While real estate is always local, the high flying prices of recent years requires a resurgence of buyers who can afford and who need a McMansion. Few regions of our country are expected to see the necessary demographic growth to revive the pricing we experienced in 2006 and 2007. Boomers who planned on converting appreciated home equity to retirement income assets are loathe to face the reality of deferred retirement, lowered expectations and other consequences of insufficient dedicated retirement assets.

At time of writing, crude oil is hitting new highs daily. Having already reached the previously inconceivable level of $135 per barrel, some analysts now see $200 oil as a real possibility, as do we now as well. Meanwhile, bloody food riots have broken out across the globe as millions of people have effectively been pulled back below the poverty line due to soaring costs for basic necessities.

The commodity bubble is something that HS Dent has commented on extensively since 2006 when it became a critical factor again for the first time since the 1970s. Commodities go through typical boom and bust cycles every 29 – 30 years as our research has shown, and investor interest reaches extremes in the late stages of this cycle. But today, we see something truly extraordinary: the rise of long-only commodity indexing has created an enormous source of new demand from large institutional investors that has absorbed virtually all of the market’s liquidity. It is this new breed of broad commodity index funds that allocate blindly to all sectors – as well as the popular gold, oil, and other specialized ETFs – that have increasingly fueled this bubble as much as the industrialization of China and the developing world.

In testimony before the United States Senate in May, hedge fund manager Michael Masters offers perhaps the best commentary on the commodities bubble that we have seen to date. We have copied excerpts from his testimony below, and we highly recommend reading the full transcript though at least the first seven pages:

Excerpts from Michael Master’s testimony before the Senate Committee on Homeland Security and Government Affairs, May 20, 2008:

Commodities prices have increased more in the aggregate over the last five years than at any other time in U.S. history. We have seen commodity price spikes occur in the past as a result of supply crises, such as during the 1973 Arab Oil Embargo. But today, unlike previous episodes, supply is ample: there are no lines at the gas pump and there is plenty of food on the shelves…. [Emphasis Added]

What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets: Institutional Investors. Specifically, these are Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments and other Institutional Investors. Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant…. [Emphasis Added]

Index Speculator demand is distinctly different from Traditional Speculator demand; it arises purely from portfolio allocation decisions. When an Institutional Investor decides to allocate 2% to commodities futures, for example, they come to the market with a set amount of money. They are not concerned with the price per unit; they will buy as many futures contracts as they need, at whatever price is necessary, until all of their money has been “put to work.” Their insensitivity to price multiplies their impact on commodity markets…[and provides the perfect recipe for a bubble. Just as during the final stages of the tech boom, for these investors price and supply/demand does not matter – HS Dent].

There is a crucial distinction between Traditional Speculators and Index Speculators: Traditional Speculators provide liquidity by both buying and selling futures. Index Speculators buy futures and then roll their positions by buying calendar spreads. They never sell. Therefore, they consume liquidity and provide zero benefit to the futures markets…. [Emphasis Added]

In the early part of this decade, some institutional investors who suffered as a result of the severe equity bear market of 2000-2002, began to look to the commodity futures market as a potential new “asset class” suitable for institutional investment. [Emphasis Added] While the commodities markets have always had some speculators, never before had major investment institutions seriously considered the commodities futures markets as viable for larger scale investment programs. Commodities looked attractive because they have historically been “uncorrelated,” meaning they trade inversely to fixed income and equity portfolios. Mainline financial industry consultants, who advised large institutions on portfolio allocations, suggested for the first time that investors could “buy and hold” commodities futures, just like investors previously had done with stocks and bonds….

According to the CFTC and spot market participants, commodities futures prices are the benchmark for the prices of actual physical commodities, so when Index Speculators drive futures prices higher, the effects are felt immediately in spot prices and the real economy. So there is a direct link between commodities futures prices and the prices your constituents are paying for essential goods.... [Emphasis Added]

In the popular press the explanation given most often for rising oil prices is the increased demand for oil from China. According to the DOE, annual Chinese demand for petroleum has increased over the last five years from 1.88 billion barrels to 2.8 billion barrels, an increase of 920 million barrels. Over the same five-year period, Index Speculators’ demand for petroleum futures has increased by 848 million barrels. The increase in demand from Index Speculators is almost equal to the increase in demand from China! [Emphasis Added]

In fact, Index Speculators have now stockpiled, via the futures market, the equivalent of 1.1 billion barrels of petroleum, effectively adding eight times as much oil to their own stockpile as the United States has added to the Strategic Petroleum Reserve over the last five years. [Emphasis Added]

Let’s turn our attention to food prices, which have skyrocketed in the last six months. When asked to explain this dramatic increase, economists’ replies typically focus on the diversion of a significant portion of the U.S. corn crop to ethanol production. What they overlook is the fact that Institutional Investors have purchased over 2 billion bushels of corn futures in the last five years. Right now, Index Speculators have stockpiled enough corn futures to potentially fuel the entire United States ethanol industry at full capacity for a year. That’s equivalent to producing 5.3 billion gallons of ethanol, which would make America the world’s largest ethanol producer….

Furthermore, commodities futures markets are much smaller than the capital markets, so multi-billion-dollar allocations to commodities markets will have a far greater impact on prices. In 2004, the total value of futures contracts outstanding for all 25 index commodities amounted to only about $180 billion. Compare that with worldwide equity markets which totaled $44 trillion, or over 240 times bigger. [Emphasis Added] That year, Index Speculators poured $25 billion into these markets, an amount equivalent to 14% of the total market….

Index Speculators’ trading strategies amount to virtual hoarding via the commodities futures markets. Institutional Investors are buying up essential items that exist in limited quantities for the sole purpose of reaping speculative profits.

Think about it this way: If Wall Street concocted a scheme whereby investors bought large amounts of pharmaceutical drugs and medical devices in order to profit from the resulting increase in prices, making these essential items unaffordable to sick and dying people, society would be justly outraged. [Emphasis Added]

Why is there not outrage over the fact that Americans must pay drastically more to feed their families, fuel their cars, and heat their homes?

Index Speculators provide no benefit to the futures markets and they inflict a tremendous cost upon society. Individually, these participants are not acting with malicious intent; collectively, however, their impact reaches into the wallets of every American consumer.

Masters makes a very compelling argument that the recent surge in commodity prices is both substantially and increasingly the result of passive index investment, not real demand from consumers (which is also rising) and not even from traditional hedgers and speculators. Traditional speculators go both long and short and sometimes take physical possession in the end, thus providing liquidity to the real commercial users of the commodities and providing a useful service. The indexers do just the opposite. Rather than provide liquidity, they compete for it. And their insensitivity to price and supply/demand factors compounds the problem.

This has clearly fueled the commodity bubble, but it does not mean that we should expect an imminent crash. As Lord Keynes said and we have often repeated, markets can stay irrational longer than you can stay solvent. This level of speculation, greater than in the 1970s, almost guarantees that this bubble will become more parabolic in the next year or so and will create extremes that will ultimately force both a major correction in the US and global equity markets and a global downturn.

The next great depression and extended downturn ahead will be caused by a decline in demographic and technology cycles. But the trigger for the next great crash will likely be runaway commodity prices that accelerate the downturn.

The commodity bubble has already become the primary factor in the present short term correction starting in late May that is likely to continue into June. It will almost certainly become the most important trigger for the next great crash we have been predicting between mid to late 2009 and late 2010, in line with the peak in our 29 – 30-year Commodity Cycle. When this bull market in commodities finally cracks, look out below.