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Peter Atwater: The Big "D" to Worry About Isn't Deflation. It's De-Financialization.


Markets that overreact on the way up overreact on the way down.

Money follows confidence. Always has. Always will.

Nowhere has that been more evident than in the changes to asset allocation pie charts over the past forty years. Portfolios that were once made up of 60% stocks and 40% bonds have become pies of a thousand slices. The number of asset classes has skyrocketed as investors looked for geographic diversification, inflation protection and ways to benefit from innovation and rapidly changing technology.

More recently, as opportunities in even these "non-traditional" asset classes appeared to have been harvested fully, investors expanded their horizons to include "frontier" markets, art, all forms of collectibles, commercial and corporate aircraft, trophy residential condominium properties, drug patents, and single-home rentals. If it could be financialized it was. Money had to go somewhere.

In 2011, as I reflected on the collapse of the housing market, I wrote about the impact of financialization on asset pricing, drawing on research from Robert Prechter, noting:

"...there is an entirely different pricing dynamic for assets purchased for their fundamental utility value versus assets purchased for their investment potential... When the price of a good or service rises, fewer people buy it, and when its price falls, more people buy it... In contrast, when the price of an investment rises, more people buy it, and when the price falls, fewer people buy it."

Over two generations, America watched as homes went from utility-priced post-War "shelters" to investment-priced financialized assets. At the very top, profit potential drove purchase decisions more than day-to-day living standards. We were flipping houses for profit rather than making houses our home. It was gains not garages that mattered.

Not surprisingly, with such extreme confidence, homeownership soared to record levels and there was seemingly unlimited credit to support home purchases. The whole food chain was in.

Money follows confidence.

But note what has happened to homeownership since the peak of the market.

Despite record low interest rates, better affordability and significant improvements in the labor market, ownership levels are plummeting.

Americans want to rent rather than own. Housing is rapidly returning to a utility-good - shelter - leaving residential real estate, the investment, in the dust.

What brought this to mind this week was a self-flagellating review of my comments on the commodities space over the past year. As someone who has been cast by many as bearish, it turns out that when it came to oil, ore and other commodities, I wasn't nearly negative enough. Sentiment that I thought was extremely negative became even more so.  Bad went to worse went to even worse. To use a word now seen frequently in the commodity space, prices were "obliterated."

In reflecting on what I missed, I realized that the answer was right in front of my face. I had seen this movie before. It was 2008 revisited. Just like housing then, commodities are now in the process of returning to their utility good roots. They are being de-financialized. Speculators and investors are exiting the markets. Money is following falling confidence out of the sector.

Right now the commodity-space narrative sounds like a mix of falling China demand, the end of a commodity super cycle and rising deflationary pressures of too much supply and too little demand. While all of these may be true, they are inadequate. Behind the scenes is a fundamental and profound shift in valuation methodology due to declining confidence.

Why this valuation change matters so much is that it suggests that we are still far from done. Speculators and investors are still circling the commodity space. While the knives have fallen sharply, there are still people out there willing to catch them. Hope remains that there will be a rebound in price.

What flies in the face of this renewed optimism is history. Once a utility-good-turned-investment bubble bursts, it always returns to a utility-good pricing scheme. Clearing prices are once again determined by fundamental supply and demand.

Now I realize that for commodities the notion of a speculator-less market seems ridiculous, but I am afraid that that is what is still ahead. Even worse, I expect that THE bottom will also be marked by far less "utility" demand than now exists accompanied by a saturating belief prolonged excess supply. "Peak oil" will be replaced by "Endless Oil."

We aren't there yet. Private equity firms and hedge funds titans like Carl Icahn and George Soros are just moving in to the commodity space. It is their exit that will be required.

To be clear, the renewed flow of speculative funds may trigger a bounce in commodity prices. Glencore's garage sale may have marked a major low just like the entry of private capital to the US housing market in the form of single family rentals also triggered a major bounce/bottom.

THE bottom, I am afraid, though, will be marked by hopelessness.

We aren't there in commodities and based on the chart above of US homeownership rates, I'd also offer that we aren't there in housing either. As I've said for some time, THE low will likely bring with it ownership rates that are between 50 and 55% -- something that we will see AFTER the home rental market implodes. Markets that overreact on the way up overreact on the way down.

But there are three other important points that I need to put out there.

First, the bounce in commodity prices is likely to be far shorter than the seven year "recovery" in housing that we have seen from 2009 to today. Not only will there be no public sector support for commodity providers but there is no "rental/rent-to-buy" re-financialization alternative either. Unlike 2008, policymakers can't stand up in front of voters and tell them that putting a floor on the price of gasoline and food is good, like they did with housing. Voters are commodity users not owners. In a world of weak wages and real wage deflation, the public policy pressure will be for lower not higher commodity prices. Given their voter bias, policymakers are only likely to make matters worse for owners.

I think the speculators entering the market today are completely missing this point. Weak social mood puts pressure on policymakers to lower commodity prices not to raise them.

Second, and related, far lower commodity prices will almost certainly mean social and political crises across emerging markets. Not only will this bring with it emerging markets sovereign and corporate defaults on steroids, but it will also challenge transnational corporations, too. Where companies touted the endless opportunities that existed in the BRICs and other emerging markets twenty years ago, they will flee the endless problems that now exist. Revenue declines will be meaningful and investment write-downs (both financial and capital) will pile up. The tentacles of commodity de-financialization will run far and wide.

One place that I expect de-financialization to wreak havoc is in the sovereign wealth fund space. Many of these buyers were the last to the table. Swamped with overflowing "petrodollars" they had to put their money to work no matter the price. Going forward, the de-financialization of commodities will reverse that cycle.

Finally, I expect that the de-financialization process is now going to accelerate across a much broader range of assets beginning with those which benefitted the most over the past seven years from the free flow of central bank liquidity.

Bubbles burst from the top backwards. Real estate, especially residential rental real estate and trophy commercial and residential real estate are going to be eviscerated. Prices on Billionaires Row are going to collapse as $100 million condos are suddenly valued as utility goods wanted by no one accompanied by seemingly endless supply. The same will hold true for other "billionaire" asset classes - art, private aircraft, collectibles, vacation properties etc. The billionaire bubble is bursting; and with it its closely aligned asset classes will be quickly de-financialized.

The other sector that is likely to face a sudden collapse from de-financialization is higher education. Like housing, it bounced from public policymakers' intervention at the bottom of the banking crisis.  Money followed public policymakers' confidence in the belief that a college education is a necessary investment for all.

A trillion dollars in student loans later, there are many more questions today than there in 2009 about the true value of education.
I continue to believe that the bursting of the for-profit college industry bubble was just the beginning of a much broader turndown for higher education. Soaring student debt and equity markets may have delayed the decline, but de-financialization will ultimately take hold. Based on the latest Perdue/Gallup poll, I think that moment is close.

While I will try to identify bullish opportunities in de-financializing asset classes I expect that those calls will be few and far between. As more and more asset classes de-financialize there is greater and greater risk of a market cascade in which falling asset values in one area trigger falling prices in another. We are seeing that already with commodity de-financialization, as it has roiled high yield credit markets, foreign exchange markets and global equity markets. Even worse, the collapse has triggered a "Where's Waldo?" phenomenon like we saw in 2008,where analysts and investors are trying to figure out how far the tentacles really reach. Investors are beginning to extrapolate risks. While I don't wish for it, the potential for a widespread price cascade here is extremely high as a result.

What is ahead will be described by economists and financial historians as a period of unprecedented deflation.  While true, they will miss the far more important point and the true cause: falling confidence triggering de-financialization resulting in a fundamental shift in asset valuation. It's a trifecta of pain.

As we move ahead the question you should be asking relative to all asset classes is, "What is the "investment's" true utility-value?"
That may seem like a ridiculous question today, but at THE bottom everyone will be asking it.

Peter Atwater's groundbreaking book "Moods and Markets" is now available on Amazon and Barnes & Noble.
"Peter Atwater brilliantly provides a framework for understanding both the socioeconomic hubris that led to the great credit bubble of the past decade and the dark social-psychological hangover that has resulted from its collapse. In so doing, he offers an invaluable guide to what promises to be a very difficult and turbulent period ahead as we experience what he calls the 'me, here, and now' behavioral tendencies of the post-crash world."  -Sherle R. Schwenninger, Director, Economic Growth Program, New America Foundation

Twitter: @Peter_Atwater

The information contained herein was prepared solely for the clients of Financial Insyghts LLC ("Financial Insyghts").  Any distribution beyond the intended recipient is strictly prohibited.
Financial Insyghts provides analysis of and commentary on how changes in confidence alter human decision making. Financial Insyghts is not registered as a securities broker-dealer or as an investment adviser either with the U.S. Securities and Exchange Commission or with any state securities regulatory authority. The material provided herein is for informational purposes only for the clients of Financial Insyghts. While specific companies may be referenced herein, no information is intended as securities brokerage, investment, tax, accounting or legal advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation or sponsorship of any company, security, or fund.
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Position in SH, GLD; Creditor of JPMorgan
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