Much of this letter is about the economy and the stock market because both were front page news for much of the past month. Oil is not much in focus for the investing public. Oil has tended to rise in price when the focus is elsewhere.
Macro Economy
There is little question that the U.S. economy is falling into the pooper. It is going down with the consumer and with the price of her home. It won’t be saved by any bailout that has or will be passed by Congress. Yet stocks have been strengthening of late. Can it be that you and I see the economic reality but the stock market does not? Seems unlikely.
More likely is that the market sees lower interest rates going forward which is the single most important positive indicator for stocks. They makes stocks more attractive compared with cash or bonds and they increase the present value of future corporate earnings, both of which propel stocks higher. The market also sees that many “U.S.” companies make their profits outside the U.S. where economic growth is still healthy and may well remain healthy regardless of the U.S. So a well positioned company like General Electric, for example, may continue to grow even as U.S. GDP declines.
The stock market also sees a strong farm economy and strong energy markets. It sees continued pressure on the dollar thanks to low interest rates and a weak U.S. economy which means that foreign earnings when translated back into dollars become greater. And it sees that as the dollar drops, U.S. products and services become more competitive, which tends to boost the earnings of companies that make products or sell services internationally from the U.S. All these factors are positive for stocks in general and for some in particular.
On the other hand, some companies seem doomed for the short term. I don’t follow the whole market, but it seems like homebuilders and related consumer staple makers, companies that cater to the disposable income of Americans, particularly upper income Americans such as travel companies, financial institutions, and high end retailers may not have earnings growth for a long time. These companies make up a big part of the U.S. economy and their stocks, and others like them could put downward pressure on the stock market.
There are often conflicting pressures on the stock market from different phenomena, but the pressures today in both direction are strong and help explain the unusually high volatility that the market has been experiencing.
Not Your Father’s Credit Crunch
We’re going into an unusual sort of credit contraction period and that is because we are coming out of an unusual credit creation period. Normally credit creation gets out of hand when regulated banks make a lot of stupid loans. Then credit contraction starts with an inflationary risk that the Fed decides to counter by raising interest rates to make banks reduce their lending. So we associate a recession with both credit contraction and higher interest rates.
In this current mess, it is the “shadow banking system” that has been profligate in creating new credits, not so much the regulated banks. So hedge funds, investment banks, and derivative securities with funny initials were the problem. Such markets are shutting them down and traditional banks are pulling in their horns out of uncertainty. Those are the sources of today’s credit contraction.
Meanwhile the Fed is actually trying to support the availability of new credits by pumping money into the system and reducing interest rates. So in this credit contraction, unlike past ones, interest rates are actually declining, or at least staying low. Thus stocks are being driven in opposite directions by opposing forces. Derivative markets are contracting rapidly and pushing high-risk rates up and some stocks down. Meanwhile the Fed is expanding credit which pushes rates on safe debt down and thus tends to push all stocks up.
The recent high levels of stock market volatility may continue for some time until one force overwhelms the other. If you believe the old slogan, “never bet against the Fed”, you might well be bullish now even during this period of unusual credit contraction because the Fed is working the bullish side.
What Comes Next?
The real question in my mind is how the market will absorb the next round of truly bad news. I think we’ll have some frightening surprises from time to time before housing prices reach an equilibrium and stop falling. Perhaps the next huge bankruptcy will be Dubai. That country is very long on speculative real estate and short on oil revenues. A bad combination. In fact Dubai is the world’s current poster child for wretched excess, what with ski areas inside buildings where the outside temperature is above 100 degrees. And that is among their lesser sins of energy and capital profligacy. If I knew a way to short Dubai, I might do it (not in the EIS account). Can anyone tell me how?
Whatever the next disaster is - whether Dubai or something else - the market’s ability (or inability) to absorb it without falling apart will be a test of the market’s true strength. Will the next problem ricochet around the world causing other problems, like the subprime mortgage problem did? A good test of whether we have licked this credit and housing train wreck is the degree to which markets can absorb bad news without causing secondary impacts and without going lower on a sustained basis.
Investment Posture and Performance
If we expect stock prices to be both trendless and volatile over the near term and we think there could be more potential unexpected shocks to the global financial system, as the discussion above suggests, why do we want to be fully invested? I think that question answers itself: we do no want to be fully invested. That is why the EIS portfolio was 5% in cash and 15% short at the end of March. A similar conservatively bullish stance will be maintained.
But let’s not carry this short term orientation too far. This portfolio’s objective is long term capital gains, not short term trading. As a Tsunami Investor, I am committed to own stocks for the long term. So enough trading already. Moreover, stocks have already seen a 20% correction from their July highs, a standard recession decline. If this proves to be no more than a garden variety recession, there could be a substantial, rapid and sustained bounce in stock prices at some point. So a trading posture could well be a loser. Nonetheless, I am still not ready to buy speculative, non-core stocks.
Oil and Stocks
The two risks to the EIS portfolio, as always, are the possibility of lower oil and gas prices and the possibility, discussed above, of lower stock prices. My attitude toward oil prices, as always, is that they will rise substantially when oil supply becomes noticeably weaker, which may be two or three years away. In the short term bears point to over-speculation in the futures markets and lower U.S. demand due to a recession. In fact, it was recently reported that revised January data indicate lower U.S. oil demand than in any month since April, 2005, and that U.S. oil usage is lower by 445 kbpd which is over 2% less than one year earlier. That sort of drop nearly offsets the growth in demand from China.
On the other hand if you look over the last dozen or so posts I’ve made, they point mainly to problems of oil supply in the near term, particularly in Mexico and Russia. And, as noted here, Chris Skrebowski had an interesting comment that we may see “seasons of Peak Oil” before we see a general condition of Peak Oil. Such a season could possibly be upon us sometime this year.
I have written that I expect the 2008 range of oil prices to range between $85 - $115 with prices ending on the strong side possibly breaking out as high as $125. Recent oil price declines have failed to go much below $100, but I don’t think that means oil could not test the downside area around $85. So I would not be at all surprised to see such a test, particularly if the economy weakens substantially.
Despite its hedges the EIS portfolio under-performed the broad averages and oil stock indices in March, although on a year to date basis it has done substantially better than both . It was off nearly 7% in March, an awful performance. There are plenty of excuses to mention - mostly the extraordinary volatility of the markets in March as Bear Stearns fell and it was unclear if the whole investment banking universe might be at risk. March was “one tough market.” That said, I made some serious trading errors which made the situation worse, not better. While I had a lot of company that does not make the loss less painful or excusable.
Rice and Oil
There is a shortage of rice that seems to be getting worse. A front page story in the Financial Times on Saturday, April 5 noted recent large price increases “as African countries joined southeast Asian importers in the race to head off social unrest by securing supplies from the handful of exporters still selling the grain in the international market.” Numerous countries have recently prohibited the export of rice; there is a growing problem of hoarding; and the price of “rough rice” on commodity exchanges has risen 50% in a matter of weeks. That is very big news for about 3 billion people in Asia, where rice is the staple. The Times and the Journal have been largely silent. What is happening?
Here is one explanation from a Voice of America report:
There are several reasons for the worsening rice shortage in Asia. Consumption has gone up while crops have been destroyed by more frequent typhoons, flooding and droughts. Farming areas are shrinking, as they are being used to build industrial or recreational areas.
Are we seeing the first serious impact of global warming? Is it a function of rapid third world economic development? It looks like both but I wonder if there may not also be a connection with high oil prices. This is only speculation on my part, but high oil prices mean that some potential consumers of oil - generally the poorest people - are not getting all the oil they want. Asian rice farmers are among the world’s poorest oil consumers. Could it be that some rice producers are not getting the fuel they need to cultivate their fields and bring the rice to market? Are we seeing another huge connection between Peak Oil and poverty?
A shortage of rice in Asia is an echo of the protests in Mexico against rising taco prices. In that case energy shortages are clearly connected to a food shortage. Many people, including even some in Congress, are now aware that the U.S. policy of using food sources to make fuels is beyond stupid. It hurts the environment and the economy. It must be reversed and I suspect that in the next Congress it will be. If so, look for a speculative boost in oil prices and a fall in natural gas prices. (NG is used to make ethanol from corn.)
The bigger picture in regard to the rice shortage is clearly the humanitarian crisis it could engender. This is not a problem to which there is an obvious and near term solution as far as I can see. In that respect it is sort of a “preview of coming attractions” for the situation we will face when oil supplies become truly scarce.
Best wishes for stable markets and enlightened governments and God bless the world’s poor.
