Gold/Silver/Commodity ETFs – A Bubble?
06-29-11 – The period of 2011–2013 (and 2011–2018/2019) remains my primary focus, when many cycles – years, decades and/or centuries in the making – reach fruition. Corresponding events could include the bursting of various bubbles…
The Ultimate Shell Game
**In the 1920’s – in the mania that was the US Stock bull market – one explanation for the early advance was that there was a shortage of securities for speculators to purchase. Not to worry, investors ‘across the Pond’ had an answer to the problem…
‘The Investment Trust’
Of course, something named ‘Investment Trust’ must be the height of integrity and stability. Why else would it have such a solid-sounding name? Who wouldn’t trust a Trust?? Scottish & English investors had been investing with/in Investment Trusts for the previous 30-40 years.
And, for a time, the Investment Trust was the answer to alleviate the perceived scarcity of available shares. In many respects, these Trusts were similar to today’s Mutual Funds and/or Hedge Funds. In fact, many speculators made a fortune in these vehicles – from 1921 all the way into 1929.
At the height of the speculative mania, the Chairman of the Democratic National Committee – John J. Raskob – devised a scheme that would allow almost anyone to become filthy rich in no time at all. He introduced this ‘amazing’ concept in the Summer of 1929 (what timing!). It involved a subsidized, debt-based ability for those that could not afford stock to be able to afford stock.
In many ways, the arguments he made sound remarkably similar to those of the late-1990’s and early-2000’s made by similar Democratic Statesmen in support of innovative mortgage loans that would allow almost anyone to buy a house that they otherwise could not afford (and one they could not afford to maintain, either).
In the 1920’s, this unabashed speculative euphoria was not isolated to a single political party. It was widespread. As these Investment Trusts grew and issued their own stock, other Investment Trusts were developed that solely invested in the shares of Investment Trusts.
So, you could own shares in an actual company. Or, you could own shares in a first-level Investment Trust that owned shares in an actual company. Or, you could own shares in a second-level Investment Trust that owned shares in a first-level Investment Trust that owned shares in an actual company.
Why invest directly when you can pay multiple premiums to support multiple levels of ‘middle-men’ and associated fees, interest, etc.?!?
The beauty of leverage reached never-before seen heights in the late-1920’s. One quote from a related book** sums it up best:
“In 1929 the discovery of the wonders of the geometric series struck Wall Street with a force comparable to the invention of the wheel. There was a rush to sponsor investment trusts which would sponsor investment trusts which would, in turn, sponsor investment trusts. The miracle of leverage, moreover, made this a relatively costless operation to the ultimate man behind all of the trusts.
Having launched one trust and retained a share of the common stock, the capital gains from leverage made it relatively easy to swing a second and larger one which enhanced the gains and made possible a third and still bigger trust.”
It was a never-ending ladder – or inverse pyramid – of shell corporations that were developed for only one purpose: creating shares (as opposed to an actual product) for speculators to purchase.
**The Great Crash 1929 by John Kenneth Galbraith – ©1954: Chapter III – In Goldman, Sachs We Trust.
The Thing That Hath Been…
In theory – and in a bull market – these ‘trusts’ were a justifiable idea, given the escalating prices of common shares and the resulting exclusion (of the common man) this created.
I have no doubt that in the 1920’s, the justifications sounded sincere, solid and secure. They were a ‘no-lose’ proposition and you would have to be insane not to throw caution to the wind and blindly jump on board.
Why would the fact that these ‘companies’ had no earnings, no tangible product and no real profits – other than the profits derived from the ‘greater fool’ scenario – be any reason to doubt the stability of these ingenious products?
Come to think of it, why would the fact that dozens – or even hundreds – of internet companies had no earnings, no tangible product and no real profits stop speculators from pouring their live savings and retirement hopes into them.
The 1990’s were another perfect example of history repeating itself… but with a twist.
The funny thing is that this cycle – that took 70 years to repeat – is still unfolding. The internet stock debacle of the 1990’s was only one facet of a multi-faceted shell game that has been playing out the past 20 years.
Shells, Shells, Everywhere…
Then, there were all those loans that were basically an empty shell. As they were packaged together (shell of shells) and sold to other ’investors’, the process matured. And, then, the inevitable explosion. And, there were the individual shells run by guys with names like Bernie.
One could argue that mutual funds & hedge funds are similar to the first level investment trusts of the 1920’s. These funds serve a valid purpose.
Then there are funds of funds. And, these too have a valid purpose… although they are increasing the precarious nature of this type of vehicle. As long as everything is going the right direction and at the right pace, no problem.
However, if history is going to again repeat itself… I would be looking for another twist.
The Destructive Duo…
It could be argued that there are two problems with these various forms of ‘shells’. One is they are not really a direct investment, but rather an investment in an investment.
The other problem is the leverage created by these vehicles. It is like an individual (as there were many in the past decade) who keeps refinancing their home – as the perceived value increases – and using the new-found wealth (equity) to indulge various desires.
When one has leveraged onself ‘to the hilt’, one cannot afford even the slightest glitch in the financial ‘plan’. A normal financial hiccup (unexpected expense or slight drop in income) is suddenly magnified exponentially… and the ultimate results are devastating.
The Newest Shell…
I cannot help but notice another type of shell… or trust… or fund… and wonder if/when it could reach a crescendo. And, it is one in which the leverage is already high to begin with. And, it is one that has grown exponentially with the roaring bull market of the past decade.
…And, it is related to the focus of this letter every month: Commodity futures and…
Corresponding to the 11-Year Sunspot Cycle – that coincides with booms & busts – ETFs were first introduced in 1989, with Index Participation Shares. This US version of ETFs was quickly shut down (but the clock had started ticking), so the Canadians developed a version in 1990. This ultimately led to the creation of SPDRs in 1993.
The 1990’s saw the first phase culminate with the introduction of the QQQs in 1999 (just as the Nasdaq 100 and the Tech Bubble were preparing to burst… so what else is new?).
In 2000, 11 years after the first ETF & in another parallel to Sunspot Cycles, these funds entered a new – and accelerated – phase with the introduction of iShares. Just as Sunspots shift polarity during each cycle, ETFs also ‘shifted gears’.
This second phase of ETFs was the one that coincided with the bull market in commodities. And, it is the phase that included the introduction and proliferation of Commodity ETFs. These ETFs began by owning the physical commodity (a tangible asset) but then moved on to owning futures (like a trust owning nothing but shares).
Now, don’t get me wrong. I am not bad-mouthing futures… or even Commodity ETFs. My living has been made in the futures arena for most of the past 30 years. But, that does not blind me from seeing an eerie parallel to these other highly-leveraged ‘events’ in speculative history.
Futures contracts are already highly-leveraged, often at a 20/1 (or greater) ratio. So, any miscalculations are exacerbated 20-fold. Now, add another level of leverage and you have the makings of a very precarious house of cards.
As long as everything is moving along smooth – and at a steady pace that nurtures proper liquidity – no problem. But, what if adverse market action occurs?
What if the commodity bull market – of 1999/2001 into 2011 – takes a ‘shell-lacking’ & experiences a serious correction?
And, what happens if this is not an orderly correction? (How many are orderly???)
A chunk of this commodity bull market has been driven by a diving Dollar. What happens if the Dollar experiences a 1-2 year rebound, as is appearing probable?
…There are dozens of possible fundamental events that could trigger a sell-off in commodities. Currently, many commodities are at the crescendo of the ‘Perfect Storm’ of bullish events (weak Dollar, Chinese demand, drought & flooding, etc.).
What happens if anything remotely related to ‘the norm’ returns?… And the price of commodities abruptly return to Earth. Or, is that no longer possible? IT
[Please refer to July 2011 INSIIDE Track for additional observations on a soon-to-be bursting bubble in commodities, directly linked – by the 40-Year Cycle – to events of 1971.]
NOTE: See related analysis – in Gold & Silver – at: