THE stock market is enjoying the biggest boom we have seen for half a century. It beats the oil boom of the 1950s; the property boom of the early 1960s; the Poseidon boom of the early 1970s; the 1980s entrepreneurs' takeover boom that ended with the 1987 crash; and the dotcom boom of the late 1990s. But there are lessons in the end of those booms for Australians who have never experienced a crash. Some of the longer-term warning signs are appearing.
Booms occur when there is virtually unlimited cash available for lending and/or equity investment and that cash is ignited into an optimistic buying frenzy by an event or series of dramatic events.
Australia has boomed in 2005 and 2006 because we have again enjoyed the combination of a dramatic event and unlimited cash. The dramatic event was a huge rises in mineral prices caused by the Chinese driving their growth via capital works and export industries. Australia has been the best place to invest in that sort of China growth. Added to that, we have seen much better productivity among major companies.
The avalanche of money needed to spark a boom came via the superannuation funds and the willingness of banks to lend large sums secured on houses. In addition, there is an amazing $US4 trillion invested in global hedge funds, many of which are fuelling mineral prices by buying on the futures market.
The higher mineral prices in turn boost share prices. The previous booms all ended suddenly when there was an event (or series of events) that changed the optimistic scenario. Once the fall started, the selling became just as frenzied as the previous buying. I believe the seeds to end the current boom have been planted – it's a question of when they germinate.
But just as the end of the dotcom boom did not stop the internet, the end of the current boom will not reverse what is a long-term change in Australia's fortunes.
The 1950s oil boom was sparked by the discovery of oil at Rough Range in WA. It ended when it was found to be not as big as first thought. In the late 1950s and in 1960 the banks were conservative but the public, looking for better returns, lent vast sums to property developers like the Stanley Korman and Reid Murray groups, who used it for speculation, which did not produce the cash required to service the mountain of debt.
The late Harold Holt, then treasurer, collapsed the boom with a set of measures in 1960, including a threat to stop deductability of interest. When Poseidon hit nickel in August 1969, the ore body was open at both ends and looked like being a world-class find.
The boom ended when it was shown to be a modest deposit and that most of the other exploration companies that had boomed after the Poseidon strike had little prospect of success.
The 1980s saw overseas banks trying to enter Australia and Australian banks flooding the market with money to retain share. The entrepreneurs like Alan Bond, John Elliott and Robert Holmes a Court were able to borrow billions for takeovers. To stop that boom the Reserve Bank had to lift interest rates to around 17 per cent. Then came the global dotcom boom sparked by the coming internet revolution. It crashed because the speculation was way ahead of its time.
Whereas the dotcom boom was led from the US, this time the US market has been stagnant. The 2006 rise in the Australian market follows a long string of rises. This latest leg of the boom revolves around what the bulls see as a "perfect scenario" for our resource companies. And so cashed-up institutions are buying resource shares with their ears back, leading to big share price rises on the back of higher commodity prices.
The current "perfect scenario" being embraced by the market actually starts in the US where consumer demand has been strong over a long period. Although there is slackening, most current predictions are that it will remain high.
America has switched much of its manufacturing to Asia, so the US consumer remains a key driver of the export industries of Asia and in turn they drive commodity prices.
For over a decade Japan has slumbered but the world's second largest economy is awakening and growth is accelerating, albeit from a low base, and the market believes it will take up any slack left by a minor US slowdown.
Europe remains depressed but there are clear signs that its largest single economy, Germany, is quickening its growth rate.
Then there are the so-called BRIC countries, Brazil, Russia India and China, which continue to expand at a fast pace, though the biggest driver of resource demand, China, may be slowing.
Russia is going particularly well. Combine those forces and you have very strong demand for commodities led by iron ore, copper and zinc.
For the last three years analysts have forecast a downturn but with growth appearing in Japan and Europe, plus investment in the Middle East, many have embraced the boom.
Oil demand is also rising, especially as refining capacity restricts supply. The effect of strong physical demand is multiplied by the risk-taking of hedge funds, which have become major investors in mineral commodities – particularly oil and copper – via their futures purchasing.
In turn, that rekindles support for resource stocks. The metals and share markets are feeding on each other.
Anyone who has experienced previous booms and busts can see the danger. But experience shows that booms usually run much longer than expected and bust when you least expect it. Our share market boom will end when there is a significant fall in commodity prices.
At the core of global mineral demand are US consumers who have been spending more than their income because rising house prices have created extra wealth and confidence. They are borrowed to the hilt. Higher US house prices have defied the US Federal Reserve's short-term rate rises because most US home finance is long term and tied to the US long-term bond rate.
Until recent months US long-term bond rates actually fell, fuelling housing prices and therefore consumer demand. But the 10-year bond rate is now at 4.85 per cent, against the 3.8 per cent low point over the last 12 months.
That's effectively a 25 per cent rise in US housing interest rates in less than a year. In time it should dampen dwelling prices and curb consumer spending, especially as the Fed forecasts further interest rate rises to reduce inflation.
The bears say that later in the year any US slowdown will flow into demand for Chinese goods and in turn into demand for resources. The big question is whether higher demand from Japan and other parts of the world can offset any lower US consumer spending. The metal and share markets say it can. For Australian bulls, US short-term interest rates have almost reached the level of Australia – which is swinging funds out of the Australian dollar into the greenback. For Australian investors looking for protection against a falling Australian currency, resource stocks with most of their income in US dollars provide some safety, so adding a new dimension to the buying.
Companies like CSL, Brambles and perhaps James Hardie provide similar protection against a falling dollar. But the biggest danger to the boom is in China.
The new Chinese five-year economic plan was revealed at the World Economic Forum in January. It is very different to the last one. There is much less emphasis on coastal capital investment growth and more emphasis on health (including reduced pollution) and education, plus creating jobs in western China, which means more investment in farm production. While nuclear and hydro power investment will be important, China does not want more steel mills.
Not only will it slow growth from around 10 to 8 per cent, but the growth will be less commodity-driven. To help drive that process, credit control is being centralised, which is making it harder for high-risk new projects to get started and leading to over-capacity in the steel industry. In turn that is making China reluctant to allow the price of iron ore to rise. Coal has already slipped. But the share markets reckon that in the short term China will have no choice but to agree to higher prices.
Dr Carlo Caiani has just returned from China and says that later this year and in 2007 the measures introduced by the Chinese will slow demand. He forecasts big falls in commodity prices in 2007, outside uranium. Investors must be careful about assuming that the current ``perfect scenario'' will last through 2007.
