The Fed's commodity bubble

October 15, 2010: 11:33 AM ET

Everything from gold to rubber is reaching new highs. And that's just one of many landmines the stock market bulls are ignoring.

By Howard Penney, contributor

If Chuck Prince were in the game today, he would be dancing. In 2007, the former Citigroup CEO famously addressed a question about the bank's push into the booming mortgage market by saying: "As long as the music is playing, you've got to get up and dance. We're still dancing."

As we well know, that music eventually stopped and many of the revelers were crushed. But memories are short. Today, plenty of investors are dancing as the S&P 500 pushes higher, even while the already-elevated quantitative easing expectations continue to weigh on the dollar. It's just a matter of time before the music stops playing and the consequences of a debased currency are brought to bear on this economy.

There are many landmines scattered from New York to Beijing right now, and if the market lands on any one of them, the party will be over.

One major landmine is in Washington, DC: the Federal Reserve Board. The market has already begun to bake in expectations from a second round of quantitative easing, and an unlimited supply of money can dwarf the supply of some commodities. As a result, the Fed's policies are inciting increased speculative risk, thereby creating a commodity bubble.

Just how much of a bubble? Consider the following:

(1)  Gold trading at a record high

(2)   Tin trading at a record high

(3)   Cotton at a record high

(4)   Copper at a 27-month high

(5)   Rubber at a 27-month high

(6)   Soybean, Corn and Wheat all approaching 2008 record highs

Perhaps not surprisingly, then, inflation is becoming a problem across the globe. India, Australia and Canada all raised interest rates this year, and some voices in China are also calling for a move in rates to address inflation there.

Another landmine? Currency wars. The "exorbitant privilege" the United States holds as the world reserve currency holder is clearly being challenged by China, Russia, Germany and most importantly, by the markets. Too many people take it for granted that the dollar will always be king, but there are very sobering reasons to believe it won't.

First, it has not always been the world reserve currency. Second, economically buoyant rivals across the globe are calling for a new system. And instead of playing a hand to bringing us back to reality, our government is doing everything it can to keep the music going in the markets, only further irritating China and our other trade partners.

There are more landmines the bulls are hoping to dodge – in fact, the list appears endless: Stimulus tailwinds are now becoming headwinds; the deleveraged consumer; declining home prices and the foreclosure fiasco; bankrupt states and dry pension funds; currency wars; sovereign debt problems; slowing corporate earnings growth; unemployment; health care reform costs; consumer confidence and general economic uncertainty felt by corporations and individuals.

Of course, the bulls do have a few reasons to be hopeful that the music will continue. Gridlock from a Republican Congress could bode well for stocks. Corporate mergers and acquisitions have reached near pre-crisis levels, and the $1.6 trillion in cash on corporate balance sheets will eventually inject a new stimulus into the economy.

But a few positive signs won't go far enough to dodge the minefield completely. The crowd is screaming buy, but risk management is not about going with the crowd. Doing something – be it dancing or making an investment decision – is not a sound approach. It's better to be a wallflower while the DJ spins than to fall down with the dancers once the music stops.

Howard Penney is an analyst at Hedgeye, a research firm based in New Haven, Conn.

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Hedgeye

Hedgeye, a real-time investment research firm founded in 2008 by former Carlyle-Blue Wave portfolio manager Keith McCullough, operates as a virtual hedge fund. Staffed by research analysts from across Wall Street, Hedgeye offers fundamental, macro and sector analysis, present picks in a transparent way to its clients. It has built a stable of subscribers, which includes hedge funds and mutual funds, and recently launched a retail investor product.

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