Was last Tuesday’s 350-point rally the beginning of the end of the bear market or just a false “bear trap?” And a related question: “Did oil bottom at $33 and will it get re-tested?” Let’s see what we know.
Some things we know
Sometimes the objective observable facts can yield fairly clear conclusions. Usually that’s not the case. Usually you can use the available facts to make a decent argument in either direction. But sometimes the facts seem fairly clear.
For example, there should have been clarity about being at a turning point in 1982 - I think it was in September. We knew that interest rates were at historical highs, put there deliberately to try to strangle inflation out of the economy. High rates were strangling the economy as well as inflation. Then Paul Volker - the man who determined the direction of interest rates - actually told us in a magazine interview that interest rates were not going to go any higher, that the interest rate squeeze was over. So we could pretty well know that interest rates were going to head down. Falling interest rates are nearly always good for equities, and at that point nothing would have helped the economy as much as lower interest rates. So by the Fall of 1982 there were very good reasons to anticipate a strong, sustained upward movement in stocks.
Now we know interest rates are low. Short rates are almost zero. Even long rates are assuming only about 1% inflation, about as low as a healthy economy could go. So if we think that eventually the global economy will recover and become healthy again then clearly interest rates can only rise somewhat. If we think as some do that the huge cash injections and deficits being run by the U.S. government will eventually cause inflation, then rates could rise a great deal. If foreigners start to refuse to buy more U.S. debt as the Chinese hinted they might consider last week, then interest rates could go much higher. Rising rates are not generally good for stocks. In fact they are a heavy wind in the face of equities.
Here’s what else I think we can know with a fair degree of certainty:
- Financial stocks have been in panic mode partly because of a silly “mark to market” rule that makes no sense when there is no market to mark to for huge quantities of bazaar derivative-based securities; thus this rule has caused everyone to mistrust the banks and probably to underestimate the real value of their assets. That problem seems like it’s about to go away. Let’s pray.
- Speculators have been able to short down the stocks of companies with any whiff of unknowable risk in part because the “uptick rule” was abolished by the S.E.C. in 2007. The uptick rule is about to be re-established, so that problem is about to go away too.
- Banks are making healthy interest rate spreads on their loans.
These three facts are very bullish for financial stocks, which were selling at historically oversold prices. They’ve jumped but still seem cheap. I remember when Viacom sold for $2 per share in 1974. Eventually it got up to about $50. Could Citibank (C) be in a similar position today? I wonder what Citi’s global brand franchise and presence just by itself is worth.
On the other hand we also know that
- the economy is in the toilet and there is likely to be more pain for some time to come,
- consumer spending is unlikely to become robust for many years to come because people have lost a lot of their asset base and the appetite to resume their borrow-to-spend consumption habit,
- there is a lot more manufacturing and retailing capacity in the U.S. than the economy will need for many years to come, so capital spending is likely to be restrained for a long time,
- some major loan categories such as commercial real estate, car loans, and credit card loans still have a lot of write-downs to come,
- Eastern Europe is in worse shape than the U.S. and could cause financial strains for the Euro countries that could exacerbate global economic weakness. Some developing countries are in even worse shape.
The sum of all the above “facts” leads me to two conclusions:
1. We are likely to see more of a “relief rally” as it becomes increasingly clear that the government has finally unlocked the banking sector so that it can start to function more like normal. That success will reflect more optimism on the broader economy. A relief rally could extend for months and could bring the market back to Dow 10,000.
2. But a sustained long term bull market - lasting for years - is unlikely because stocks will be fighting a headwind of inflation concerns, higher interest rates, and sluggish fundamentals of demand - both consumer and capital spending. More important (or maybe the same thing), corporate earnings will be fighting the same headwinds for a long time.
So my guess - and I cannot exaggerate the humility and reluctance with which I offer this guess - is that after some kind of rally, we will enter into a period of general trendlessness, what is called “a stock-picker’s market.” That’s when stock averages fluctuate without direction. In such a market some individual stocks do well based on the ability of the company to succeed in a weak economy. Here is where Peter Lynch’s old concept of investing in companies you know and have confidence in should pay off.
What about energy investments?
The broad categories of energy investing are
- alternative and renewable energy
- natural gas
I don’t follow coal and I pay little attention to solar, wind, geothermal and other alternatives because the stocks tend to have speculative technology risks and rich pricing. I think SQM, a quasi-alternative energy play, is attractive now that it’s price has come down into the mid-20’s because it has an established cash flow in several good commodities (including iodine) and is a leader in lithium, which could see an explosion in demand from next-generation cars.
Natural gas is in a long term over-supply situation because of the vast discoveries of non-standard sources like shale. Natural gas could see a pop because $4 is too low to sustain production. The price could bounce dramatically based on very low rig counts, as some analysts now believe. But there is no reason to think that longer term natural gas in North America will sell much above $6 for very many years unless some national policy is adopted to promote its use to power cars and/or trucks. So I don’t own companies heavily tied to natural gas, other than some gas pipeline companies that offer attractive yields and Devon, which is an exceptionally well run company and a potential acquisition target.
Oil is the interesting energy commodity, in my opinion, as it has been for the past few years because of the large and increasing decline rates for existing fields. Oil is interesting from two viewpoints - as a supply-and-demand matter and as a currency hedge. On both scores there is reason to feel that the bullish forces are gathering again and may have their way over the course of the next few years. I think the potential rewards from being long oil and oil stocks are starting to become very interesting.
Oil - the fundamental case
I recently posted an analysis of oil supply/demand scenarios through 2015. While I encourage readers to consider the entire piece, the bottom line of my analysis is that high and rising declines in production from existing oil fields (including especially offshore fields) will - in a few years - overwhelm the recent past and near future reduction in global oil demand. Even if the eventual recovery of the global economy doesn’t cause oil demand to rise substantially from the present much reduced levels, within a few years declines in existing fields will cause another supply shortage. I think we’ll start to see much lower spare capacity around 2011.
However, in the short term oil prices could stay low or even decline from the current $40 -$45 area since the world is in an an extreme and growing over-supply situation at present in terms of spare capacity. I’ve estimated that spare capacity will be just under 6 mb/d by the end of 2009. For comparison, spare capacity was 2 mb/d when oil was over $125.
Continuing declines in global economic activity could exacerbate the over-supply. For example, it was recently reported that Chinese exports were down 25+% in February. The Chinese have been importing substantial amounts of oil to fill their strategic reserves, no doubt adding meaningful amounts of demand, but now they have little more storage capacity left. Also, institutions that estimate demand are lowering their predictions consistently, as the IEA and the EIA did recently. OECD economies will be getting weaker for the next 6 - 12 months in all likelihood. So it seems likely that a significant over-supply condition will pertain for roughly another two years.
The oil price might re-test its prior lows, given the over-supply condition, or the price could begin to creep up with a recovering stock market. But I doubt there will be a sustained rally in the price of oil for a year or more. OPEC’s bet is that restricting immediate supplies will increase price. But restricting supplies also increases spare capacity. If prices rise in the face of a lot of spare capacity, it could be hard to enforce supply restrictions on greedy OPEC members.
On the other hand $40/barrel is too low a price to support some current production for very much longer or to encourage new production. Higher cost oil such as deep offshore and oil sands production face some potential shut-downs at $40 oil. Perhaps more important EOR (Enhanced Oil Recovery) efforts like gas or chemical injection or thermal recovery that have been so effective in recent years at stemming decline rates have little incentive at $40 oil. So the next year or two may see a supply contraction that could lift oil prices somewhat.
Three forces are acting or may act to support the oil price. One is OPEC, of course, and another is possible speculative buying of oil in regard to future inflation and/or potential devaluations in global currencies, about which more below. OPEC has had limited success in keeping oil off the market, thanks mainly to the Saudis. The Saudis are trying hard to get all members to comply better, putting out signals that they will not cut further until all OPEC members comply with their quotas.
A third potential upward influence on oil , a wild card, is the possibility of renewed global military tensions that could threaten oil supplies or supply routes. Military tensions seem to be increasing. One simply has to name the countries to make the point: North Korea, Pakistan, Iran, Palestine, Venezuela, Mexico. Such tensions could rise to the point of becoming a reason for speculators to be long oil.
All in all, it would not surprise me to see gradually increasing oil prices through 12/2010. An oil price in the $70 - $90 range would represent an equilibrium in supply and demand that would reflect the marginal cost of producing more expensive oil. That equilibrium could come about over the next 12 - 24 months as the decline in existing oil field production reduces the amount of global spare capacity thus raising prices to motivate producers to maximize production again.
The really interesting and significant result of my analysis (assuming it is correct) is that by 2012 there will be an oil shortage condition once again, as existed in 2008, which means oil could be selling at over $100 again by some point in 2012. By the end of 2013 I have calculated that oil should be in a serious shortage condition, thus requiring much higher prices in order to destroy demand.
If I’m right about a coming oil shortage, several investment conclusions seem warranted. First, oil stocks should perform decently in the short term and over the next 18 months or so. Some have the potential to do quite well this year even if the price only gets into the $55 - $65 area. Second, long term oil calls look very attractive (I have started to buy some). Third, oil stocks may have even more stellar appreciation in 2011 and 2012 if a trend toward shortages, as I predict, is seen in reduced (even if ample) levels of spare capacity. Fourth, if we return to a condition of oil shortages in four or five years from now, the global economy - which is likely to be growing at that point but still in a weakened condition - might be crippled once again. That outlook is an additional reason that I do not anticipate a long sustained bull market in stocks going forward.
Inflation prospects and oil
The other interesting investment aspect of oil is that it has the potential to become a currency hedge. People have often called oil “black gold.” If fiat currencies, particularly the dollar, run into serious problems, as some analysts have been predicting of late, the price of gold - and oil - would almost certainly escalate as a hedge to depreciating currencies. Investors would look to commodities as a refuge during an inflationary environment, and oil would almost certainly be one of their first choices.
Inflation warnings come mostly from “monetarists”, who believe that inflation is a function of the money supply. If the money supply expands too rapidly, they believe, it inevitably results in inflation. These days they point to the vast funds injected into banks and into the economy at large by the various recent federal bail-out and rescue plans - some $2 or more trillions by some estimates. Huge and growing federal deficits are another cause of inflation concerns and they in turn become more scary when demographics and U.S. entitlement program liabilities, particularly Medicare, are projected into the future.
One could ask - as I have - how come we are approaching a deflationary condition if all this inflated money supply is out there? The reason, as I recently posted, is that money supply is only inflationary if the velocity of money is not contracting. That is, if people are hoarding cash and saving more than they spend, an expanding money supply by itself won’t immediately cause inflation because the declining velocity of money negates the increasing quantity of money in circulation.
What causes the velocity of money to increase or decrease is in large part the rise or fall in people’s asset values and their confidence or fear regarding employment. If their asset values - mostly their houses and their stock portfolios, but also the values of private businesses - are growing and consumer confidence grows, then so does the velocity of money. Then inflation can take place if money supply is not managed properly.
Looking forward, an economic recovery will be coincident with a bottom in housing prices and very likely will follow a rise in stock market prices. As jobs losses eventually stop and the economy actually begins to grow again, a renewed confidence in asset values (and job security) will cause the velocity of money to expand. At that point, given continuing huge federal budget deficits and the vast amount of money already injected into the economy, there is a reasonable fear that inflation could be ignited.
Is that a year away? Two years? Three years? Nobody can know exactly but the Chinese, America’s real bankers, are already sounding the alarm. Team Obama say they are aware of the risk of inflation and they will work hard to bring the federal budget into balance as soon as they think it is safe to raise taxes and cut spending. Still, there is a reasonable concern that in a few years - say 2011 or 2012 - we could see inflation begin to occur.
Interestingly, 2011 and 2012 is exactly when my analysis suggests that declining oil production in existing fields along with rising demand will begin to overpower any new oil production and reduce spare capacity to alarmingly low levels. If that period also corresponds with a more general problem of inflation in the global economy, it seems likely that a rising price of oil could be exacerbated by speculative forces attempting to hedge their currency risks.
Of course, a highly elevated oil price would act like a tax on the economies of oil importing countries. It would tend to cause economic contraction. Oil importing countries could fall back into a contraction once again. As commodity professionals are want to say, “the cure for high prices is high prices.”
That possibility is a little too far into the future to have any claim to likelihood or to base any action on right now. But it is one reason that I am not optimistic about seeing another long sustained bull market in stocks as we saw, with a few short interruptions, from 1982 - 2008.
The solution to a coming commodity shortage must lie in new technologies. We must get our transportation fleet converted to electricity and find better ways to generate that electricity, among other things. But the problem from an investing perspective in hoping for a technology fix is that it cannot be implemented sufficiently by 2015 - my longest investment horizon - to make much of a difference.