Sunday, December 7, 2014

Financial Markets: The Sound Of Popping Bubbles

(Drivebycuriosity) - Did you hear the sound of the popping bubbles? In the recent days simultaneously 2 huge speculation bubbles bursted, which both have been bloated for years: The oil price bubble and the China pessimism bubble.

1. Oil - The Mother Of All Bubbles

The oil price accelerated its collapse that has started this summer. Since June the price for Brent Crude dropped 38%. The high speed of the drop shows that a speculative bubble is popping.

In the recent years I had written frequently that oil is the "mother of all bubbles" (driveby) and the "greatest bubble of them all" (driveby). The oil price has been artificially elevated by banks, hedge funds and other speculators who have pumped a lot of money into the oil market (via financial instruments called futures). In the recent years they ignored that the US oil production was growing fast, thanks to the technological progress (fracking), and that the energy demand was constrained because of rising energy efficiency (cars and other machines need less energy) and a weak economy in Europe.

Instead the oil speculation focused on geopolitical risks. Many speculators had set huge bets that conflicts in and with Iran,  Russia, Iraq, Syria and other problem regions could lead to a severe disruption of the oil supply.

For more than 2 years the oil market resembled a hot air balloon: A steady flow of geopolitical news (Ukraine, Middle East) had been heating the speculation on upcoming supply problems and had been keeping the price of oil high like a balloon in the air.

But all the alleged geopolitical supply disruptions didn't happen so far - or were mild - so that over years the oil supply has been growing faster than the demand. This lead to a growing oil glut  which brought the bubble finally to burst. Saudi Arabia and other OPEC oil suppliers are now accepting lower oil prices (by keeping their production levels) to maintain their market shares.

2. China Pessimism Bubble

China’s stock market, represented by the Shanghai Composite index, has surged 21% in the last ten trading days and gained 40% year-to-date. The sudden outburst reminds of a spring coil. The Shanghai Composite has been artificial depressed over around 3 years thanks. China´s stocks were trapped in a pessimism trap.

Investors have been obsessed with the negative aspects in China and ignored the ongoing strength of the broad economy - the China pessimism bubble (driveby). For years China bears like New York Times correspondent Paul Krugman, perma-pessimist Nouriel Roubini and Jim Chanos, a hedge fund manager and short seller, have been banging the "China crash drum" . The notorious China crash callers claim that China is suffering from huge structural problems like too high debts and too huge investments into real estate which would cause a "hard landing" of the Chinese economy.

The China pessimism bubble popped because:

1. The predicted China crash didn´t happen so far. Instead China´s economy is experiencing an orderly retreat.

2. Recently China´s central bank cut her interest rates - the first reduction in 2 years (!) - and signaled further reductions.

3. The Chinese government is continuing reforms that started already last year to encourage economic growth and stimulate consumer spending (less-mao). Recently Beijing announced more reforms, including a liberation of stock trading between Hong Kong and mainland China, and announced more investments into airports, railways and other infrastructure.

4. China is benefitting from the oil price collapse. The country doesn`t have oil, nor natural gas and lacks most of the other important commodities (corn, wheat, iron). Now the Chinese have more money to spend for consumer goods, houses & services and Chinese companies, for instance railways, have less energy costs.

3. New Levels?

Even after the bubbles had popped oil is still expensive - it costs still around 3 times we had to pay in the 1990s - and China is still cheap. The Shanghai Composite is currently trading at 10 times expected 2015 earnings, compared with 15 for the MSCI world index, an average of developed markets (economist)

It seems reasonable to me  - as an educated guess - that oil prices & china stocks will be turbulent in the coming months, but I don´t expect that both markets jump back to old levels because the fundamental factors have changed (as described). Therefore I expect that oil stays significantly cheaper than in the recent 4 years and China will gain more in 2015.

Time will tell.

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