Oil Pressure Not Helping an Economy Under Stress

In last week's report, we noted that stock indexes had moved into a critical testing zone that would answer the question of whether the rebound from the mid-March lows was merely a bear market rally or the start of a larger advance. We certainly don't want to read too much into one week's market action, but the weight of the evidence points to a bear market rally that ended last week.

In an abrupt downward reversal characteristic of bear markets, the Dow fell nearly 700 points from last Monday's highs, and the S&P 500 fell 65 points, as stocks broadly suffered their worst weekly decline since early February. Spiking oil prices garnered most of the headlines last week (for good reason), but the other predominant features of this bear market were also in evidence, particularly evidence of ongoing stress in the financial and housing sectors.

The existing home sales report released last Friday refuted the notion that the housing market has reached a bottom. The volume of existing home sales declined another 1% in April. It was the eighth time in nine months that sales dropped. Despite weak sales volumes, a flood of additional homes came on the market in April, resulting in a 10.5% jump in the supply of unsold homes. At the current pace of sales, the inventory of unsold homes climbed to a 10.7 month supply, a 23-year high. Historically, approximately six months of inventory is considered healthy for the market. In all likelihood, a further drop in home prices is going to be required to work off the excess inventory. According to a recent report from Lehman Brothers, as many as 10 million homes now have zero or negative equity, and there will be 2.6 million foreclosures over the next two years. It is difficult to reconcile the reality of a further loss of home equity, combined with a weak employment market, massive commodity inflation, and declining real wages, with the view that the economy is going to begin to strengthen in the second half of the year.

For a U.S. economy already under a variety of recessionary pressures, the recent surge in oil prices could not have come at a worse time. Oil prices, which reached a record $135/barrel last week, have more than doubled over the past year and have soared 20% just in the month of May. Given that every recession since 1970 has been associated with a spike in oil prices, it is not surprising that the stock market reversed sharply lower last week.

Much has been written of late about the reasons for the surge in oil and whether prices will be sustained at these lofty levels. Opinions run the gamut from those who think prices will hit $150/barrel this year to those who think oil is in a classic speculative investment bubble that is destined to crash. A number of factors have been cited in efforts to explain oil's spectacular rise. The bullish, longer-term fundamental situation of steadily increasing global demand outstripping a finite supply can hardly justify a 100% price spike over the past year. Other contributing factors have included speculation, the increasing acceptance of commodities as an asset class in longer-term portfolio allocations, a short squeeze (at least in recent weeks), weakness in the U.S. dollar (the currency in which oil is priced on global markets) and loose monetary policies by the U.S. and foreign central banks, especially in emerging markets.

Of these factors, we think monetary forces have been the most significant. Oil has risen $60/barrel since the Fed reversed its monetary policy stance last August and prepared to slash interest rates beginning in September. The Fed's policy of dropping the fed funds rate from 5.25% to 2% does not appear to have done much to arrest the fall in home prices or absorb the glut of unsold homes. However it has exacted a great price in terms of loss of purchasing power, which can be measured in a variety of ways: (1) the huge increases we have seen in the price of commodities; (2) the devaluation of the U.S. dollar (if the dollar was valued at parity with the Euro, oil would currently cost $84/barrel); and (3) the inability of conservative savers to earn a rate of return on cash balances that compensates them for inflation. As the experience with the housing and credit bubble demonstrated, a negative real interest rate invites destabilizing speculation and pricing extremes. We may now be seeing a replay of this phenomenon in the energy markets.

Frankly, we have no idea whether the next $20 move in the oil price will be to the upside or downside. The odds would appear to favor a downward correction, given how overbought the market is, and how bullish investor sentiment is towards oil, but momentum-driven markets have a way of surprising everyone with how far they can move. Is oil in a speculative bubble as many assert? Maybe, but that doesn't tell us anything about when it will end or how far it will go. What we do know is that oil prices pose a significant further risk to an already fragile economic and financial backdrop and represent another reason to maintain a cautious investment posture.

Comments

[Paul Killinger:]

Yes, oil prices are too high to sustain our nation's economic growth and vitality. We've already seen the first wave of bankruptcies in the transportation sector. More will follow and this will spread to other sectors of our economy, as well.

Eventually, one of three things can happen to alleviate this dilemma. We can increase our traditional energy resources, curtail demand for energy, or hope for some technological breakthrough. Ideally, all three factors could occur more or less simultaneously.

Of the three, the only viable short term target is increasing supplies. We seem to have fallen down on this one for now, but I'm optimistic that $6-8 a gallon gasoline will bring the anti-oil and gas crowd to their senses.

Of course, the longer we wait (...possibly YEARS!) the more economic structural damage will take place. In the meantime, the only practical hedge I know of is to invest in traditional sources of energy.

2008 May 27 12:13 PM

[HinesBrad:]

I think we're missing some very obvious things that have happened in the last few years with the oil markets. One key observation I have made is that American cars overall have gotten bigger. The proportion of Americans driving big trucks, SUV's and vans has increased significantly in the last decade. Even cars - like the Nissan Altima, Honda Accord and Toyota Camry are about Double the size that they were 15 years ago. They also seem to get poorer fuel economy relative to what they did 15 years ago. Yes, the engines are better and more efficient, but those benefits are canceled out by having to haul a substantially larger car. I had a 1989 Honda Accord that got about 35 miles to the gallon highway. My new 2007 Accord gets 26 because it's much larger. The Civic of Today is the same size an Accord of yesteryear was.

What this means is that there are a few obvious benefactors: Alternatives are finally becoming competitive with oil in price/benefit analysis. It means people will finally start scaling back on their consumption. People will also start buying smaller cars (which is FANTASTIC news for Hyundai, Kia, Honda, Toyota and Nissan). It also means that solar panel manufacturers, Biodiesel and other alternatives can finally get the capital infusion they need to become competitive with big oil. I'm actually excited to see oil go even higher - lower carbon emissions, a better chance for more market choices, and less jerks on the freeway going 20 miles an hour under the speed limit in their suburbans.

Disclaimer: I hold positions in a Solar ETF: KWT, and I am also a shareholder in Honda Motor Company.

2008 May 27 02:01 PM

[Tom in Kans...:]

I had a VW bug in 1974 that got 35 MPG and by now we should be expecting double that 34 years later...


On May 27 02:01 PM HinesBrad wrote:

> I think we're missing some very obvious things that have happened
> in the last few years with the oil markets. One key observation I
> have made is that American cars overall have gotten bigger. The proportion
> of Americans driving big trucks, SUV's and vans has increased significantly
> in the last decade. Even cars - like the Nissan Altima, Honda Accord
> and Toyota Camry are about Double the size that they were 15 years
> ago. They also seem to get poorer fuel economy relative to what they
> did 15 years ago. Yes, the engines are better and more efficient,
> but those benefits are canceled out by having to haul a substantially
> larger car. I had a 1989 Honda Accord that got about 35 miles to
> the gallon highway. My new 2007 Accord gets 26 because it's much
> larger. The Civic of Today is the same size an Accord of yesteryear
> was.
>
> What this means is that there are a few obvious benefactors: Alternatives
> are finally becoming competitive with oil in price/benefit analysis.
> It means people will finally start scaling back on their consumption.
> People will also start buying smaller cars (which is FANTASTIC news
> for Hyundai, Kia, Honda, Toyota and Nissan). It also means that solar
> panel manufacturers, Biodiesel and other alternatives can finally
> get the capital infusion they need to become competitive with big
> oil. I'm actually excited to see oil go even higher - lower carbon
> emissions, a better chance for more market choices, and less jerks
> on the freeway going 20 miles an hour under the speed limit in their
> suburbans.
>
> Disclaimer: I hold positions in a Solar ETF: KWT, and I am also a
> shareholder in Honda Motor Company.

2008 May 27 02:11 PM

[John Pseudonym:]

Think about this...

Lower oil prices would put $$$ in the pocket of Joe Shmo. That would stimulate the economy, increase demand for oil, raw material prices rise...

Round and round we go!

2008 May 27 03:52 PM

[Paul Killinger:]

So the answer is... just starve the poor bastards...? Well, that's the attitude of the D's in Congress certainly, boycotting increasing domestic oil and gas supplies. Didn't they used to talk about how they were for "the little guy?" Guess all that fame and money must have got to 'em.... Like Obama called us, "...Bitter folks clinging to our guns and religion." Wow! (Unfortunately, that attitude is becoming more pervasive in the R party, as well. I'd say we're in trouble, guys!)

2008 May 28 12:38 AM

[sivere:]

At this juncture in history, we are getting hit with multiple punches simultaneously. We have a speculative bubble unlike anything we have ever seen (i.e., tulip bubble, etc.). This bubble CREATED the housing crisis. We have a serious energy problem, caused at least by a combination of US foreign policy (Iraq invasion), middle east geopolitics (related to the first point- Iran vs. US and Israel, Israel vs.the rest of the middle east, US support for Israel, Europe vs. US, etc.). Add to that the dynamic growth in China, India, and Asia in general, vying for the same oil, with no easy way to crank up production, plus an at least temporary food shortage, and we are potentially in a heap of trouble.

Now the peak oil folks are saying, 'see, we told you so' (high gas prices, political turmoil), and the environmentalists are saying ,' see, we told you so ' (food shartage, storms, bad weather).

We need to keep cool heads at this point. First, there is evidence enough that the various political situations, including relative falling petroleum supply (i.e., we cannot just crank up oil supply to meet demand) coupled with a panicked rush to commodities due to the financial collapse and various derivative contracts, shorting, etc. are big factors in the energy issues.

Now, peak oil eventually may be real, and with half the world waking up and developing, we need to take the underlyiong theory seriously. I think $120+ barrel oil may end up saving us IF we act NOW to start developing alternatives. We need tax incentives, government sponsorship, as well as good old American ingenuity to kick in NOW.The $120/barrel oil creates the economic framework to make alternatives possible.

This is not the time to give up as some of the more liberal peak oil advocates imply we should. A wise Catholic Saint once said something like 'Know that God can do anything, but act as though He will do nothing'. Let's not forget there is a God, and He could be testing us, He could be punishing us. We do not know for sure. But do not give up. Turn back to some of our basic Christian values (and natural law in general), think about what we are doing and why, and let's roll up our sleeves to solve this issue- not just prepare for the end, and hide in the wilderness. It is not all criticism for the more liberal peak oilers- some of their ideas about reviving urban living are not all bad, and make sense certainly in the short to medium timeframe. Much of their criticisms of suburbia deserve some consideration.

Let's also not get all tied up with Gore gloom and doom over highly speculative theories about disasterous human induced CO2 warming of the planet. In fact we may be headed for a little ice age! Let's develop any energy source we can, and not let the environmentalists tell us (especially the U.S., China and India which have extensie coal reserves) that coal is out because of the CO2 problem. This is pure insanity at this juncture. If the peak oil problem is allowed to play out because of our inaction, you will see an environmental disaster of unimagineable proportions. Even the anti-Christian Malthusian Darwinists could not create a scenario so hororible (though God knows they keep trying).

Turn back to basic values, including. God, country and family, roll up your sleeves, do not give up, and let's work together (with the rest of the world) to solve the problems ahead of us.

siv0.com
TakeBackTheFed.com

2008 May 28 12:33 PM

[Jason Rines...:]

Good comments Sivere. My thoughts on God: He does not punish, you reap what you sow as an individual of part of a larger society. That which is taken unfairly from you such as your life are replaced and added measure. Certainly, Americans have gotten the basics of life covered and then some. HUMANS GET BORED. Then humans find unhealthy ways to fight boredom. Those at the top are bored. Sure they are enjoying some perks but yet still bored. How about the guy with 9 houses? Think he/she ever has time to visit them all? How many yachts can you ski behind?

When your bored, it's the game at the top to attempt to gain all the riches in the world as the best capatalist/politician/... I am not saying it is right, some moral realignment is indeed in order. What I am saying is pain often spurs necessity and values like sharing, communication, sacrifice, honor, love.

Did God allow or cause 911? Neither, America wasn't paying attention because in the 1990's it was broads, booze and fighting boredom, thinking about how all the world shares our values and about how great it would be to conquer the entire globe economically at the same time. Fighting boredom indeed :)

2008 May 28 04:32 PM