My Economy Notebook: How Stock Indices Lie To You

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Includes: EPS, IVV, LLSP, RSP, RWL, RYARX, SDS, SFLA, SH, SPLX, SPUU, SPXL, SPXS, SPXU, SPY, SSO, UPRO, VFINX, VOO
by: Dennis Viliardos

Summary

Being unable to grasp basic fundamental data, makes setting a reasonable price target impossible.

So we need to find a real metric that can give as meaningful insights as to what economic phase we are currently at.

Energy prices are affected by way too many variables and therefore cannot be used to gauge the actual economic development.

Metal prices on the other hand, decline since 2008/2011 and are an integral metric to verify the economic state we are at.

Index price levels lie. QE programs around the globe (US, EU, Japan, China etc.) have completely distorted this metric.

I quite recently read a fairly optimistic article, in which the author stated that World Markets (and especially the US stock market) are healthy and that the S&P (SPY) and SEE Composite Index (Shanghai, China) declines are "irrational". The writer then expanded, claiming that commodity prices have also no reason being at current levels.

Moving away from fundamental data analysis, makes setting a reasonable price target nearly impossible these days. Promoting ideas that are not backed by actual publicly released numbers, makes such statements more of a belief than an opinion.

In order to confront the writers thoughts in a constructive manner, I will start discussing how we can derive a better idea of where the economy is heading, by analyzing the prices of energy and metals instead of stock indexes.

A world that runs on energy

We all pretty much know how much of an important component the energy industry is to the Economy. Extracting "energy" (oil and gas drilling), contributes about 4.5%-6.5% (2014 data) to the world's GDP. If we were to add all other segments that relate to energy products (investments, technology, transportation etc.), then the percentage would rise up to 12-15%.

Now, based on those numbers, we can comprehend the immense effect a large price fluctuation can have on the world economy. The current situation, has an effect both on the "sellers" of energy and on the "buyers". Specifically:

● Besides looking at it from a company perspective, in which case lower prices mean forgoing investments, reduced revenues, reduced profits, lower ratings, higher interest rate charges on loans and issued bonds etc., the country perspective is also very interesting. Lower prices, means lower revenues to a country (taxes), with twice the effect (lower company taxes, lower consumption taxes). This in turn will create trouble on these countries budget and might even generate a trade deficit (depending on the amounts exported). Eventually, foreign exchange reserves are drying up, making it harder for these countries to import goods and pay off foreign debt obligations (debt will increase in domestic currency terms, so the country must either use up even more foreign reserves or pay more).

● On the buyer's side, our normal reaction would be "man, are they lucky". Taking Germany as an example, this country has an immense benefit from low prices. Being a major importer of energy, it makes industrial production and internal cost of consumption a lot cheaper. And while this statement is a fact, low prices have indeed a positive effect on the country's economy, but only if they were to stay low for a short period of time. In a short period of time, the effect is purely beneficial: The earnings that would otherwise be posted for companies that export energy, are literally being transferred to German corporations (importers of energy). These corporations used up the cheap energy, produce at higher margins and export the goods to the energy seller (let's assume they are absolute trading partners) at the same (!) price as before. The extra profits generated for these German corporations, are the "would have been earnings" of the energy sellers. But… that works only short term. With energy prices plunging for more than 12 months (might even continue to do so beyond 24 months), energy sellers have cut back on investments and stopped ordering extraction and refining equipment from Germany. Germany's export value has started declining* in that sector. Deflation risk, caused by low prices is also another danger the country now faces, as a result of the prolonged energy crisis.

*be aware that in the example above, we assumed that Germany has only one trading partner. While its balance of trade surplus growth rate has started to decline, the country has also many other profitable sources to overcome the reduced demand for heavy equipment - namely a) Eurozone internal trade, b) a devalued euro (if it had its own currency a surplus would increase its value), c) immense inflows of funds, since it is considered a safe haven for deposits (check out the country's current account surplus that has an increasing growth rate), d) de-industrialization of Europe's countries (Poland, Italy, France), that grants Germany space to enter markets there.

So now we know that prolonged low energy prices, eventually damage all sides and hence the world economy. This means that even if the world economy was healthy before the plunge in prices, after more than 12 months (and will probably continue), there will be quite some negative effects catching up. Store that for now, as we will continue our discussion by going through the causes of low energy prices, to see which commodities can best be used to measure the economic state we are currently at.

The decline in Energy & Metal Prices

Energy prices (oil and natural gas), have many reasons to decline. Luckily, current levels (and below those) are not justified. Like for any product, the price of oil depends by rule on demand and supply. While demand might have declined in recent years, the world is still energy thirsty. Yet, there are a couple of developments that interfere with that notion:

1. The ongoing oil supply war, has meant lower prices, beyond reason. Saudi Arabia trying to penetrate more markets (China, Europe), the US lifting the 40 year old ban on oil exports policy, Iran stepping up production, Russia flooding the European and Chinese market etc., are all moves that will continue to drag the price of oil (imagine the benefits the privatization of Aramco would grant Saudi Arabia, in its war for market leadership. It's hard to believe it will actually deliver on its "promise" though, or at least go public with more than 10% of its shares).

2. Technology, has played a key role in 2014 and 2015, when even more advanced techniques for extracting oil and gas emerged. The shale oil and gas industry pulled down prices and the US's ability to export oil now, has set new bottom prices.

3. The US dollar effect, has become particularly evident in mid October 2015 (graph below), with a 5% appreciation of the dollar translating into a 10-20% decrease in the price of oil:

Click to enlarge

4. Speculation on lower prices has added more pressure. Large institutions and Banks press releases and comments are not helping the situation. For example, when Morgan Stanley and Goldman Sachs among others, state that oil might reach the price of $20, naturally, panic and speculation is triggered.

5. El Nino and its hot weather effects, keep demand lower and hence prices too.

Natural gas, will mostly have to follow suit (so will renewable energy prices), since lower oil prices, will keep away demand from other energy sources. The El Nino effect, technology (shale gas) as well as speculation, have pushed down prices for NG too.

So after discussing the causes that have kept energy prices low, we must admit that this commodity sector depends and is affected by way too many variables and therefore cannot be used to gauge the actual economic development, since this would entail too much deviation risk. What we realized though, is that low prices must have already damaged the world economy severely.

Instead, we can use the price development of metals (excluding Gold and Silver, that are affected by political and central bank choices), to reveal how well the real economy is going:

The decline in prices since 2011 (or if we take it from their peak in 2008, then since 2008), means either better technology, in which case prices drop (holds for energy too: shale gas/oil), which is good since technology generates additional new workplaces to cover the decline in GDP due to lower prices, or lower global demand, which is bad for GDP and denotes a recession. Both trigger a deflationary effect.

In our case (metals), demand is mostly the reason (¾) and technology much less (¼). So lower demand, verifies that the condition of the real economy is different than what stock indexes denote. Below I have added a graph that illustrates the different stages of the economic cycle and how commodity prices can help us understand where we are currently standing:

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So according the illustration above, the world is currently in a recession. Yet, we might still be at the start of the downslide and not at the bottom of it, nearing the recovery phase. The reason why we might be running on an early stage of a recession, is explained below.

The Economic Cycle & the misinterpreted stock indexes

Eventually, low commodity prices, pretty much the raw materials that give our world the ability to create products and make services relevant, will help certain countries sustain some investments that will in turn boost neighboring economies as well. This is the time when the Economy starts "rolling" again, the return to growth, assuming that there will be a solution for the debt burden that has been piling up (government and private sector debt). From a geo-economical viewpoint, this debt-deficit relationship between countries (ex. Germany vs Eurozone), will eventually push for "mergers", like in businesses (i.e. the creation for example of the United States of Europe) or war.

The article I mentioned at the beginning and that made me write this one noted, that currently world indexes are enormously undervalued and that there is no reason for the decline (and for further decline). I believe most institutions around the world would not agree and neither will I. The key counter-argument lies within Central Bank quantitative easing programs.

Quantitative easing effects are particularly evident on the S&P, but are easily identifiable in the case of EU indexes, after the ECB decided to set out a $1.6 trillion easing program in the beginning of 2015. At that very period, the German DAX 30 index started increasing with seemingly no end, reaching approx. 12.400 points. The index had also been picking up from the time the US announced their QE program, setting the start for a US-EU stock market interrelation, to an extent like never before (funds "printed" were traveling across US borders, setting foot on EU corporate soil).

So why did markets react so positively to these QE programs? Wasn't' QE meant to revive the real economy instead of the "paper" economy? True! But you see, banks (especially in the EU), decided that investing in bonds or giving out loans to the private sector was a) too risky in times of a recession (and they knew the world was entering one back then) and b) would not generate the returns required to deal with the already (back then) increasing bad loans. So, the financial institutions around the globe decided to invest their money in the stock market instead. Deutsche Bank's heavily leveraged balance sheet, is proof of the deliberate actions the ECB took on.

Even though financial institutions also invested in the commodity sector, influencing a sector that greatly depends on real economy demand, was a strategy soon abandoned. So even the metals sub-sector is probably still not a perfect metric to gauge the economy. But indexes are much worse of a choice. The S&P price today compared with the development (prospects) in earnings of its components, will reveal a part of that truth:

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Source: zerohedge, Data: Bloomberg

And now let's also add the same type of graph, constructed for the 2008 stock market crash period:

Click to enlarge

Source: zerohedge, Data: Bloomberg

Do you see my point? My point is: don't use the index as a means to measure the economic phase. It will lie to you. Instead, use prices of metals (excluding gold and silver) to get a better idea. Additionally (and I will perform such an analysis in the future), one must look at the fundamentals from many viewpoints. Example: US unemployment rate vs workforce development vs real wages. Why? Because many of us might have read a well-known book called "How to lie with statistics". Now it's time to write a second book on "how central banks lie with QE".

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.