Market Insight — Fundemental Resource Demand Is There

by BWK ~ February 7, 2008

Fundemental Resource Demand Is There…

Have you ever gone ice-skating on a pond after a couple weeks of freezing temperatures?

Sure, you know that the water down under is very cold. And you know that you could die of hypothermia in a matter of minutes if you fell in. But during a cold spell, the ice becomes thick and solid. So you tend to discount the risk of skating away from the shoreline.

But would you ice-skate on that pond after a week or so of warm weather? Your perception of the risk would change, right?

Good Times and Risk-taking

Something similar happens with investing. When times are good, investors collectively take on risk. The longer the good times last, the more debt people tend to accumulate. But it takes cash flow to pay the interest and carrying cost of that debt. Just like when you ice-skate on the pond in the frozen days of winter, it is easy to take on risk when times are good.

Is there such a thing as taking on too much risk? Well, let’s ask the question another way. Is there such a thing as skating on thin ice?

Eventually, investors — skating on thin ice — reach a point where their collective cash flow cannot pay off the interest and carrying costs of the total debt. The ice cracks and breaks, so to speak. Lenders call the loans. Many investors have to sell assets to raise cash. This leads to a collapse in asset values.

This kind of situation actually has a name. It’s called a “Minsky moment,” after the American economist Hyman Minsky (1919-1996). Minsky spent his formative years living through the Great Depression of the 1930s. Because of this, Minsky was a pessimist.

Over his long career, Minsky was very much a contrarian. Minsky argued that markets are inherently unstable. He wrote about how long stretches of good times encourage inefficient waves of raw speculation. The speculation almost always involves borrowed funds. Eventually, the banks call the loans. Asset prices collapse in the wake of widespread selling. The good times end in long stretches of hard times.

Fundamental Demand Is Still out There

We have seen some pretty serious movements in the world stock markets lately. And the housing markets in the U.S., and some other parts of the world, are also sinking. So the question is, are we living in a Minsky moment just now?

We might not know the answer to the question for a couple of years, after we can look back in perspective. But I think that we sure seem to be seeing small-scale versions of those Minsky moments.

A lot of people (individuals, businesses, banks, even governments) are way overextended — they have skated too far out over the thin ice. So these people are selling assets in a hurry. Thus, we see sharp movements in the prices for gold and oil, in particular.

Gold has moved as much as $40 in intraday trading, dropping like a stone and then halting abruptly at some support level.

And oil, too, has had days when it moved several dollars in one direction or another — on no real news based on supply or availability. But the oil price swings seem to end with a quick stop at some price level.

These abrupt movements indicate that there are holders out there who are unloading assets. This is probably in response to a need to raise cash in a hurry. Maybe the friendly banker just called with an unfriendly message. So the “sell” order goes out. But when the price of gold or oil falls sharply, someone else in the marketplace reacts by buying into the drop. Someone else is securing the asset.

What this tells me is that — at least for precious metals and energy — the fundamental demand is still out there. The price swings might be mini Minsky moments for some individual asset holder or another. But long term, the supply of precious metal and energy is constrained, due to geological and aboveground factors. What we are seeing is this: People with strong financial hands are taking assets away from others with weaker hands. And long term, I am bullish on the prices for precious metals and energy resources.