Our Financial World: Adrift in Uncharted Waters

 |  Includes: DIA, SPY, USO, XLF
by: Chart M

A new year begins and that usually means new year resolutions and plans. But it's difficult to make plans in the financial world when one is adrift in uncharted waters, which is pretty much where we find ourselves today. Let's take a look at just two oddities we are faced with when trying to make investment decisions today:


Nope, not anymore. Government intervention from the Treasury, the Federal Reserve and the FDIC have left large footprints all over the financial markets. They started with the rescue of Bear Stearns (NYSE:BSC), followed by a semi-nationalization of Fannie Mae (FNM) and Freddie Mac (FRE), and then the decision not to rescue Lehman Brothers (OTC:LEHMQ).

After the Lehman failure, the government has been very busy rescuing and bailing out whomever they see fit. The result is that the taxpayer now owns stock in over 250 financial institutions and 3 automakers. The FDIC, which we think of as guaranteeing bank deposits, now also guarantees bonds from both financial intuitions (JP Morgan (NYSE:JPM), Goldman Sachs (NYSE:GS) Morgan Stanley (NYSE:MS)) and corporations (NYSE:GE).

Last week Chrysler received a government loan for $1.5 billion, in addition to the $4 billion they received earlier along with Ford (NYSE:F) and GM (NYSE:GM). And what did they do just hours after getting the nod on this $1.5 billion? They immediately offered interest free financing on new car purchases, thereby potentially perpetuating the original problem of offering suspect loans to people who can't afford them.

The breakup of the great global "financial supermarkets" is now under way with government help. The government has directly invested $45 billion in Citibank (NYSE:C) and is now backing $300 billion of Citi's real estate loans and securities. Bank of America (NYSE:BAC) just received additional "emergency" governmental support necessary to complete its purchase of Merrill Lynch (MER). The government will purchase an additional $20 billion of preferred stock (on top of an earlier $25 billion) and will guarantee a $118 billion pool of assets. The Fed is now purchasing Mortgage Backed Securities and Commercial Paper.

Having the government act in any market means that those markets are no longer trading off fundamentals, supply-and-demand, or even speculation. Instead, they are trading based on what the largest participant is doing. And since the government prints money as needed, as is evidenced by the growth in the Fed's balance sheet as well as the money supply, the government is the largest participant.


West Texas Intermediate Crude [WTIC] is the crude you see quoted on TV and in newspapers. For the past several weeks crude is trading with an unusually large contango. By way of background, the futures markets offer products with various expiration months in the "future." For West Texas crude, there are contracts offered monthly as far out as December 2017. Futures contracts trade in either backwardation, where later dated contracts trade for less than the current month contract, or in contango, where prices in succeeding delivery months are progressively higher than the nearest delivery month.

There are several things that affect backwardation and contango (interest rates, storage fees, insurance) but that is a discussion for another day. What is relevant as we begin 2009 is that for the past several weeks the front months have traded at a significant discount to future months. Front month WTIC (March) is trading at almost $43.00 while the contract 6 months out (September) is trading at $51.30. That means that the near term contract is trading at a 16% discount to the 6-month contract.

From a historical perspective, there have only been two instances since 1986 when the spread was greater than 15%. The first time was just before the Gulf war in 1989 and crude rallied 170% over the next 6 months. The second time was late 1998 when crude was trading in the high teens and was followed by a March 1999 article in the Economist that announced that "The price of oil has fallen by half in the past two years, to just over $10 a barrel. It may fall further…." Over the following 12 months crude jumped 160%.

There is yet another oddity in the oil markets, namely that WTIC has a very large divergence from Brent Crude (North Sea). West Texas Intermediate Crude typically trades at a premium to Brent Crude. Lately the pattern has reversed and now the WTIC discount to Brent is a staggering $10. In a normally functioning market, and also historically, speculators would arbitrage away any excess gains that could be had by playing the oil curve or the Brent spread.


The oil markets demonstrate some hard to explain divergences. On top of that, we have unprecedented government intervention. Be careful, stay informed and remember that these markets don't necessarily trade "as they normally do". One must be cognizant of these two very significant developments in the various asset markets and must be well-informed and well-prepared for the potential consequences of these oddities. Moreover, investors must re-assess potential risk / rewards in these difficult times.

Disclosure: No positions.