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APOLOGIA OF A CENTRAL BANKER: WHAT DOES THIS TELL US?
In his recent speech, Chairman Greenspan took a curious turn, one that appears to have gone relatively unnoticed, but may be critical to understand the current marching orders at the Fed. Greenspan noted,
“Relying on policymakers to perceive when speculative asset bubbles have developed and then to implement timely policies to address successfully these misalignments in asset prices is simply not realistic. As the Federal Open Market Committee (FOMC) transcripts of the mid-1990s duly note, we at the Fed were uncomfortable with a stock market that appeared as early as 1996 to disconnect from its moorings.
“Yet the significant monetary tightening of 1994 did not prevent what must by then have been the beginnings of the bubble of the 1990s. And equity prices continued to rise during the tightening of policy between mid-1999 and May 2000. Indeed, the equity market’s ability to withstand periods of tightening arguably reinforced the bull market’s momentum. The FOMC knew that tools were available to choke off the stock market boom, but those tools would only have been effective if they undermined market participants’ confidence in future stability. Market participants, however, read the resilience of the economy and stock prices in the face of monetary tightening as an indication of undiscounted market strength.
“By the late 1990s, it appeared to us that very aggressive action would have been required to counteract the euphoria that developed in the wake of extraordinary gains in productivity growth spawned by technological change. In short, we would have needed to risk precipitating a significant recession, with unknown consequences. The alternative was to wait for the eventual exhaustion of the forces of boom. We concluded that the latter course was by far the safer. Whether that judgment continues to hold up through time has yet to be determined.”
Like the Chairman’s parting speech at Jackson Hole last month, there are some important revelations here. While maintaining the party line that you do not want to rely on central bankers to manage asset bubbles, he drops his prior strong stance that central bankers cannot identify asset bubbles in advance, and claims, correctly as I documented back in 1999 and 2000, that the Fed as early as the mid ‘90s identified a widening discrepancy between equity prices and equity fundamentals – aka, a bubble.
This in itself is an astounding about face for the Chairman. But even more astounding is his failure to explain why the Fed remained on the sidelines in the wake of this understanding. Previously, the Chairman argued the Fed lacked the necessary tools to adequately contain an equity bubble. The Chairman returns to his original position, now revealing the Fed knew all along it had an equity bubble on its hand, and it knew it had the tools to deal with it. Why, one must wonder, is the Chairman so visibly implicating himself in this irresponsible position, as he prepares for his well deserved retirement?
Let me suggest, in the light of the speeches of the past 2 months, the Chairman has undergone a visible but still conflicted conversion to the Reserve Bank of Australia approach with respect to the U.S. housing boom. The Chairman, while professing no central bank ability to identify bubbles until after the fact, has gone from depicting tiny pockets of froth in the real estate market, to a view that encompasses “widespread speculation”, with loans being made that will present “significant losses” to borrowers and their lenders. If this interpretation is correct, the Fed is positioning itself to tighten longer, and perhaps stronger than the consensus currently expects. Hence the more hawkish tone to post Katrina speeches. Unless the Fed is shocked by consumer data from October, or unless the housing boom visibly cools down, they may indeed overstay their hand.Link here.
Home-equity “wealth effect” fuels consumer spending, Greenspan finds.
Many analysts and investors are busy trying to understand the economic impact of hurricanes Katrina and Rita, and rightfully so. But Fed Chairman Alan Greenspan made clear this week that he and other central bankers are keeping their eye on an even more powerful force of nature: the red-hot housing market. Katrina’s impact began to grow clear last Friday as the government reported an unexpectedly sharp decline in personal spending and income in August, even though the monster storm only came ashore in the final days of the month. By all measures consumer sentiment has plunged in the aftermath of the storm, possibly signaling a tough holiday retail season ahead as consumers grapple with fuel costs that are far higher than they were a year ago.
Meanwhile the Fed chairman, whose term is ending in January, is stepping up the pace of remarks warning about the potential for a housing slowdown to act as a drag on economic growth. This week Greenspan revealed the depth of his interest in the economic impact of housing by unveiling a dense study on home equity drawdowns, only the second research paper he has put his name on in his 18 years as Fed chief.
The sharply rising value of housing in recent years has created a “wealth effect” that has contributed significantly to consumer spending growth – not unlike that created in the late 1990s by the boom in stock prices. In fact the housing wealth effect is even more powerful, with homeowners spending an average of 5 cents for every dollar in increased home value they enjoy, compared with 3 cents for every dollar in the increased value of stocks and bonds, said Richard DeKaser, chief economist for National City, a Cleveland-based bank. One reason is that it has become easier than ever to turn home equity into cash, either through cash-out refinancing or by drawing out cash as part of a “step-up” into a new and more expensive home.Link here.
Fed has “more to do” on rates.
The Federal Reserve’s 15-month interest rate hike campaign still has “a ways to go” before completion, Atlanta Federal Reserve President Jack Guynn said, adding inflation was a risk and growth on track. “We’re now at a point where we have removed a substantial amount of the extraordinary accommodation that was in place when we started this cycle. I still feel that we have a ways to go. We’re well along on that path,” he told Reuters in an interview.
The central bank has lifted the overnight federal funds rate in 11 consecutive quarter percentage point steps to 3.75% since June 2004, and financial markets are betting huge sums on how much further it plans to raise borrowing costs. A crucial source of speculation has been hurricanes Katrina and Rita that drove oil prices to a record high, leading some to fear the economy could topple into recession. But Guynn said the storms, which devastated part of the district covered by his Atlanta Fed, would not have a long-term impact on national growth, despite the human tragedy and considerable harm to the local economy.Link here.
HOW A YOUNG HARVARD ECONOMIST IS CHALLENGING THE TRADITIONALISTS IN HIS FIELD
What is rational about the sports fan who refuses to pay more than $200 to buy a Super Bowl ticket, but will not accept less than $400 for one he already owns? Or travelers who leave generous tips at restaurants they expect never to visit again? Or gamblers who, at the end of a losing day, bet on a long shot? It is one thing, though, for the psychoeconomists to say that people make foolish choices, quite another for them to turn this observation into a theory that can explain consumer decision making, stock market movements or economic cycles.
That is where Sendhil Mullainathan comes in. Born in a small farming village in India, Mullainathan lived there for seven years while his father moved to the U.S. to go to graduate school. On his 5th birthday, his father sent him a 3-piece suit. On the way, via oxcart, to have his photo taken, his uncle and grandfather spent the whole time arguing about whether the vest went over or under the jacket. In the photo a beaming Mullainathan proudly wears the vest on top. After moving to Los Angeles in 1980, Mullainathan left high school without graduating and went to Clarkson University, and then on to Cornell, where he took graduate-level courses in math and computer science. He studied under Richard Thaler Thaler, now of of University of Chicago Graduate School of Business but then at Cornell, who was injecting psychology into economics. Mullainathan was hooked and his research has become increasingly more empirical and less ivory-tower. He went to graduate school at Harvard, then became a junior faculty member at MIT. Harvard snatched him back last year with tenure.
One of his most provocative papers, just submitted for publication, suggests that tiny psychological effects can have potentially enormous impact on demand, more of an impact than price. In 2003 he and several coauthors worked with a bank in South Africa that sent out letters offering short-term loans. They varied the interest rate and also varied a number of cues designed to trigger psychological responses, such as a smiling photo in a corner of the letter and tables that provided more – or less – information and choice. The sample was large, more than 50,000 letters, and the study was randomized and controlled.
The impact of some of the small, nonfinancial cues surprised even the study’s authors, though it probably would not have been a shock to creative types on Madison Avenue. It turned out that having a wholesome, happy female picture in a corner of the letter had as much positive impact on the response rate as dropping the interest rate by four percentage points. The practical takeaway is that an insurance company can probably sell more auto policies by featuring Reese Witherspoon in its brochures than by slashing margins and sending out letters that scream “Unprecedented Low Rates!” Says Matthew Ryan, executive director at Boston ad agency Arnold Worldwide, whose clients include McDonald’s, Radio Shack and Fidelity Investments: “If behavioral economists can quantify more, that’s exciting. The ad industry will be looking at those things closely.”
Conventional economic theory says people accurately calculate costs and benefits, present and future. If they do not save much, it is because consuming more today makes them feel better. If they smoke, it is because the happiness they get from smoking outweighs the costs. Behavioral economists disagree. They argue that a hardwired lack of self-control prevents people from making rational choices. Mullainathan and Jonathan Gruber of MIT tapped a huge trove of data – surveys of self-reported levels of happiness conducted since 1973 by the U.S. and Canada. What did they find? The population was happier after excise taxes on cigarettes rose. The taxes, Mullainathan suggests, helped some smokers drop an unwanted habit.
A study in Malawi by one of Mullainathan’s students is looking at whether what psychologists call a “channel factor” – a stimulus that leads you to act immediately on your intentions – might increase the number of people who pick up the results of their AIDS tests. A puny incentive, equivalent in monetary worth to two cans of Coke, boosted the response from 30% to 70%. “Let the data build up; let’s see who’s right,” says Mullainathan.Link here.
IF HOUSING SLUMPS, HOW SAFE IS YOUR STOCK PORFOLIO?
If you take comfort thinking that your well-diversified investment portfolio is bound to fare well even if housing values decline significantly, think again. True, that rationale has panned out before. For example, someone who sold a house in the Northeast in 1991 and put the proceeds into the stock market would have missed a decline in real estate values and enjoyed stock market gains for the rest of the decade.
Investment strategists say it probably will not work that way next time around, however, because stocks and bonds – indeed, the whole economy – are now more closely tied to the real estate market than in the past. Although most experts think home prices would not drop more than 20% or 30% over a couple of years if the much-discussed bubble bursts, even a small drop in prices could do serious damage to equity and fixed-income portfolios, they warn. “If real estate cools dramatically, there goes half our economic growth,” says Barry Ritholtz, chief market strategist at Maxim Group. “There is danger of recession – and you know what recessions do to the stock market.”
As for hopes that the stock market would take over for a flagging real estate market, “I don’t think it’s that simple anymore,” says Barry Hyman, equity market strategist with Ehrenkrantz King Nussbaum in New York. He points out that a bread-and-butter index fund based on the S&P 500-stock index now has significant exposure to real estate through the financial-services and consumer sectors. The financial-services sector makes up 20% of the S&P 500 and has benefited from the mortgage refinancing boom driven by lower interest rates. This leaves companies in that sector vulnerable if trends reverse. In a Sept. 15 report, S&P credit analyst Victoria Wagner conducted a “stress test” on banks, assuming a 20% decline in home prices over two years (which she considers unlikely). The top 10 hardest-hit banks in that scenario included widely held stocks like Wachovia, Wells Fargo, and JPMorgan Chase.
Consumer-oriented stocks like retailers or restaurant chains, which make up 13 percent of the S&P, would also suffer if real estate declines. “There’s a very widespread fear that if property prices go down and the refinancing boom goes away, that consumers are going to have to cut back on spending. And that will be felt throughout the economy,” says Dan McNeela, a senior analyst at Morningstar.Link here.
Vacation or investment homes?
Who buys second-homes and how much do they pay for them? There are two very different markets-people who buy for investment purposes and those who want a vacation-home, says Al Mansell, chief executive officer of Coldwell Banker residential brokerage in Salt Lake City. Marsell is president of the National Association of Realtors (NAR). A recent study by second home buyers by NAR underscores the differences. Most vacation-home buyers (86%) do not rent out their property while most investment buyers do (79%). The typical vacation home was a single family detached home with a median size of 1290 square feet, while the investment home averaged 1,700 square feet in size. The median price of a vacation-home purchased between mid-2003 and mid-2004, according to the 2005 report, was $190,000 as opposed to $148,000 for investment-homes.
Half the buyers said their vacation-home was smaller than their primary residence, 13% said it was the same size and 37% said it was larger. Nearly one of five second-homes will become primary residnces after retirment, the report adds. But no matter what their purpose in buying a second-home, 92% see their property as a good investent.Link here.
Supply hits high in condo craze.
Developers eager to capitalize on the local condo frenzy of the past several years are planning some 47,000 units in dozens of projects that will hit the market in the Washington area in the next three years, according to a new report – about five times as many units as were sold last year. Demand is up, even compared with a year ago, when eager buyers routinely waited in early-morning lines for a shot at a contract, according to the report from Delta Associates, an Alexandria real estate research firm that tracks the condo construction market here. But supply is up even more sharply, as developers bet that the momentum will continue.
Nationally, the manic pace in condominium sales in markets such as South Florida, Las Vegas and California has made analysts question whether the sector has become overpriced and unbalanced. In the Washington area, many industry observers are questioning whether this region, too, may face a glut. One possibility, however, is that there may be more pent-up demand for projects than developers have been able to satisfy.
One reason there are more condos for sale is that many rental properties are being converted to condos. The trend has been alarming for renters who have been displaced, especially low-income people who had been living in relatively inexpensive apartment complexes. Some local officials fear a further erosion of the region’s already- diminishing pool of affordable housing. But many of the conversions involve upscale, top-priced rental projects heavy on attractive amenities, where upper-income renters can buy a unit if they wish or easily move elsewhere, in a rental market that has become looser in recent years. In addition, low interest rates and easy credit terms that permit people to buy homes with small down payments allow renters to own more easily, if they choose.
The biggest risk may be to developers and lenders. Nationally, the rate of condo conversions has more than tripled in the past two years, according a Fitch Ratings report in June. Condo-conversion companies are paying apartment-building owners top dollar for such properties – considerably more than the value of the properties as rentals – and are borrowing to do so. Fitch analysts said that many markets are “overheated”, making it harder for the companies to make the easy profits of past years, and the firm predicts that 10% of condo-conversion loans will default.Links here and here.
Percentage of Californians able to afford home in their state falls.
The percentage of California households able to afford a median-priced home in the state fell to 14% in August from 18% a year earlier, the lowest level since records began in 1989. In its monthly report on housing affordability, the California Assn. of Realtors said fast-rising home prices across the state have put increased pressure on California residents, who needed a minimum household income of $133,800 to buy a home at August’s median price of $568,890. That calculation was based on an average mortgage interest rate of 5.87% and assumed a 20% down payment with conventional financing.
As a comparison, the minimum household income needed to purchase a median-priced home at $220,000 in the U.S. in August was $51,740, the group said. The Santa Barbara region, where 6% of households were able to afford to buy a median-priced home, was the state’s least affordable market, the real estate trade group said.Links here and here.
Fraud booms with mortgage market.
As the U.S. housing market hits record highs, mortgage fraud appears to be rising from California to Florida, according to mortgage industry researchers and federal law enforcement agencies. “Criminals are opportunists,” says William Matthews, co-author of a recent report on mortgage fraud by the Mortgage Asset Research Institute. “If you’ve got a booming market, they’re going to get away with more fraud.”
While it is unknown how many fraudulent transactions take place in the $3 trillion mortgage market, the institute found that 26 states had serious mortgage fraud problems. Fraud is costing the industry at least tens of millions of dollars a year, Matthews estimates. According to an FBI report in May on financial crimes, “Mortgage fraud is pervasive and growing.” Lenders last year reported to the FBI 17,000 suspected incidents of mortgage fraud, and the FBI’s cases have grown from 534 in 2004 to 642 in the first half of 2005. At the IRS, criminal investigations of mortgage fraud from 2001 to 2004 have nearly doubled to 194 cases.Link here.
DO HEDGE FUNDS CALM MARKETS OR INFLATE BUBBLES?
Have hedge funds made markets work better or worse? With the explosion of hedge funds – there are now more than 7,000, controlling almost $900 billion in assets – there is no hotter issue in global finance. To some, hedge funds are reckless gamblers, using weird financial instruments to blow apart currencies and stocks, pushing up prices and creating speculative bubbles. To others, they are benign new pools of capital that help investors by spreading their risk, and they stabilize the market by taking up contrary positions.
Who is right? A study in the October issue of the Journal of Finance, an academic publication produced by the American Finance Association, suggests the funds are inflating bubbles, not damping them. If it is right, one of the main defenses of hedge funds has been weakened. And much of the marketing hoopla in which the funds like to cloak themselves will have been punctured.
“Hedge Funds and the Technology Bubble” by Stefan Nagel, assistant professor of finance at Stanford, and Markus Brunnermeier of Princeton, takes a look at how hedge funds actually trade. They took a sample of more than 50 hedge-fund managers – including big names such as Soros Fund Management LLC and Tiger Management LLC – and examined the public records of how they bought and sold stocks during the period 1998 to 2000. And what were the funds up to? Piling into every passing dot-com they could find, it turns out. “There is no evidence that hedge funds as a whole exerted a correcting force on prices during the technology bubble,” Nagel and Brunnermeier wrote. Indeed, among the few large hedge funds that did resist the bubble, the manager with the least exposure to technology stocks – Tiger Management – did not survive to see the bubble burst, they added.
True, it is just one study. Yet there is other evidence that hedge funds are essentially riding bubbles. For example, look at the levels of speculation by hedge funds in commodities this year. Or look at the way many within the oil industry have accused hedge funds of helping ramp up energy prices. It looks as if they are helping inflate a bubble – just as they did with technology stocks. Certainly the results strike some analysts as fair.
The main message of the Nagel and Brunnermeier research is that hedge funds are momentum investors (although with the important caveat that they are very skilled momentum investors who mostly managed to get off the bus before it crashed). That matters, for two reasons. One, lots of people would like to regulate hedge funds. If it can be proved they are inflating bubbles, their case will be a lot stronger. And if the hedge funds are to grow further they need to convince investors they genuinely have new approaches to investment. After all, we can all take a look at what is hot this week, borrow some money, and buy as much of it as we can. We do not really need to pay some guy a 20% performance fee to do that.Link here.
Hedge funds railing against registration
Paul Atkins, the SEC commissioner who tried and failed to block a rule requiring hedge fund registration, continues to rail against the notion that 500 agency examiners can effectively regulate 8,000 private partnerships. “You can’t put a lifeguard on every beach,” he told an audience of hedge fund industry managers at a seminar arranged the Managed Funds Association, the industry lobbying group. The sentiment was well-received among executives who are increasingly preoccupied with the looming Feb. 1 deadline and convinced that incoming chairman Christopher Cox will do nothing to block it.
The registration will force funds to retain every email, hire a chief compliance officer and devise detailed compliance manuals that must be updated and would be subject to sudden inspections. “I can guarantee you that the cost of registration will eventually be passed on to the investors,” Atkins said. “I look forward to working with you as you join the ranks – the happy ranks – of registered advisers.” The industry has no choice but to comply and for the most part, hedge funds are pragmatic entrepreneurs. During the seminar, the MFA released its first manual on “Sound Practices for Hedge Fund Managers”, a bible of advice on topic as diverse as risk monitoring, valuation of illiquid assets, leverage and soft-dollars arrangements.Link here.
THREE QUESTIONS THAT COUNT
You want to maximize your chances of getting good results from stock picking? I have a system, and it boils down to focusing on just three big questions. They are not what you might expect – say, questions about the market’s price/earnings ratio or interest rate forecasts. Rather, they have to do with your own psyche. Overcome your psychological failings and you can be a better investor.
First question: What do you believe is true that is actually wrong? If you are captivated by some market myth, other investors probably are, too. Figure out what that popular but wrongheaded belief is and you can disassociate yourself from it. You can bet against it. Example: Most investors believe that years when the market is trading at a high multiple of its collective earnings are bad years in which to invest and low-P/E market years are good times. This popular belief is contradicted by the evidence, as I have outlined in earlier columns. So when you see folks freaked out by high-P/E markets, you can bet against them.
Question two: Can you fathom the unfathomable? If you have the right instinct for turning market statistics into buy-and-sell signals, you seek correlations first, then causal relationships that would explain them. For example, the main force driving cycles when growth stocks do well versus value is time-lagged shifts in the yield curve. The historical pattern has been that about 9 to 12 months after the yield curve gets flat, growth stocks start beating value stocks, and they continue to beat value until the curve gets very steep again. A flat yield curve reflects a reluctance of banks to lend to commercial borrowers. And value stocks are very borrowing-dependent, while growth stocks are not. At the moment the yield curve has gone close to flat – the yield on 10-year Treasurys, 4.1%, is not much more than the yield on two-year Treasurys, 3.9%. So mid-2006 is the time to prefer growth to value.
Question three: What is your blind spot? It takes time and effort, but you can learn. For example, if you are myopic and suffer confirmation bias, you are a trend-follower and will miss upcoming changes like the capital expenditure and agricultural booms starting in 2006.Link here.
LONG BONDS IN COFFIN SPIRAL
Military pilots call it a “coffin spiral” – when their plane is so out of control that they cannot recover. That is the situation today for long-term bonds, those with maturities over 10 years. The reason is that a killing turbulence of inflation is on the way, pushing bond yields up and prices down. The first sign is energy’s rising price – filling up the tank is twice as expensive as two years ago – and that affects all corners of the economy. Thousands of companies are about to suffer. Higher fuel costs jack up the price of doing business not just for obvious consumers like Delta and FedEx but also for thousands of other operators, from lawn cutters to aluminum smelters to pizza delivery guys. With unemployment now below 5%, companies will also find pressure to raise wages to keep their commuting workers whole.
Do not expect the current oil spike to be short-lived. History demonstrates that high oil prices do not fall quickly. During the 1973-74 embargo, oil reached a peak of $42 a barrel (adjusted to 2005 dollars), spurring double-digit general inflation and a painful recession. By 1975, with the embargo a memory, oil prices fell only 7% from their peak and stayed in this sharply higher range for the next five years. After the second oil shock in 1979-80, oil’s price hit a new high of $98 (again, in today’s money), dropping only 12% a full year later. Long Treasurys saw yields break 15%.
Nowadays conditions are worse, not better. Both the 1973-74 and 1979-80 oil shocks occurred when supply was abundant. That is, spigots were being turned down in a manipulative way. That no longer is the case. Demand for oil and gas has fully caught up with available supply. Demand has far outstripped new discoveries for the past 19 years. Given the increasingly sophisticated discovery techniques employed in the last 10 years, it is unlikely that huge new finds are out there awaiting drilling. Of the 20 largest fields in existence today, the last significant find was in 1979 in Tengiz, Kazakhstan.
Buyers of long bonds are living in a fool’s paradise. The 10-year Treasury, at 4.2%, trades near its lowest yields in 40 years. Buying these makes little sense. With inflation, including energy costs, running at a 3.6% annual clip, your real yield is down to 0.6%. Add in taxes and your bond income is negative. Under the circumstances it is quite plausible that the interest rate on the 10-year Treasury will climb a percentage point, causing the bond’s value to immediately fall 8%. A 30-year Treasury would fall 16% in value. What to do? Keep the bulk of your money in blue-chip stocks, which inflation likely will not harm, and the balance in short-term bonds (those due in a year or less). With the cost of medicine on the rise I would opt for pharmaceutical stocks for part of the equity component.Link here.
BIG BANKS TO GET BIGGER?
The Federal Reserve is considering a rule that is likely to encourage further consolidation in the financial industry. It would allow banks to take on more debt to finance acquisitions. At the current rate, the number of banks is likely to fall soon to half as many as operated 20 years ago. There were 7,630 commercial banks in the U.S. at the end of last year, according to the FDIC, the government’s banking regulator. In 1984, there were 14,496 banks. However, fewer banks is not anything consumers need to worry about, according to some banking industry officials. “It’s a good thing, because banks are getting strong,” FDIC spokesman David Barr said.
Under the Fed’s proposal, banks with assets up to $500 million could use debt to finance as much as 75% of the purchase price of another financial institution. Currently, only banks with assets up to $150 million can carry so much debt for an acquisition. The Fed is trying to make more funding available to small banks to allow them to grow through acquisitions, Fed officials said in congressional testimony. The proposal is in the public comment stage and could become final within months if regulators do not modify it.
In a recent example of the industry’s consolidations, Wachovia Corp. last month said it would buy auto-loan financier Westcorp for $3.91 billion. Wachovia, with $459.5 billion, is ranked fourth in total assets among commercial banks. Wachovia, Bank of America, JP Morgan Chase and Citibank control more than one-third of the nation’s $8.7 trillion in banking industry assets. “They have a lot of liquidity,” Mr. Barr said. “The banking industry is extremely healthy in the U.S.” With interest rates low – though climbing – and banks earning record first-quarter revenue of $34.2 billion this year, big banks are using their excess cash to capture a larger share of the market.Link here.
E-DAY! – THE FINAL CHAPTER
These guys just will not shut-up! Your editor’s colleagues continue debating the implications of $70 oil. Despite debating the consequences of “peak oil” for several days, these guys have failed to exhaust either themselves or their supply of worthwhile investment insights. As I mentioned last week, these guys do not seem to realize that the Internet in general, and email in particular, is the domain of useless conversation and inane jokes! So without further ado, please allow us to present the third, and positively final, installment of the debate over “peak oil”.Link here (scroll down to piece by Eric J. Fry).
An oil boom – without the oil.
Courtesy of the late deceased Woodrow Wilson and Franklin D. Roosevelt, we also live in a monetary world, in which the national currency is a fiat currency accounting gimmick. That is, the U.S. dollar is not backed by any substance of immutable value, such as gold. And in this current monetary world, the number of dollars in circulation has been increasing for 92 years, courtesy of the Fed (and more recently, increasing exponentially at the behest of the world’s most famous central banker). For many decades, the increasing monetary base did not overwhelm the linear production phenomenon. But at Peak Oil, that is all about to change. The future is now.
When you throw the U.S. fiat currency debacle up against the Earth’s rather linear material-energy system, you get a world that has raced through its reserves, consuming them and depleting the resource base at an artificially high rate. We see the direct result on a daily basis. There is an acute scarcity of oil (as well as a scarcity of a good many other natural resources), which is driving up the nominal cost of oil and of most other commodities. There is not any time to spare for the world to make many dramatic changes to its consumption patterns. I tend to make few predictions about the future. But I assure you that the world faces the next 10, 20, or 30 years after the irreversible post-Peak Oil decline kicks into gear, when a lot of rice bowls are going to get smashed. It will not be pretty.
Will mankind figure a way out of it? Beats me, amigos. But whatever happens, I believe that it is always better to have little debt and lots of money in the bank. What form of money, and where is the bank? That is a trick in and of itself. Just keep in mind that you may as well do your best to keep your head above the troubled financial waters.Link here (scroll down to piece by Byron King).
Oil stocks are no longer easy prey; they are barbed lures.
For the past couple of months, investors have been frantically chasing after oil stocks - the shiniest and tastiest prey in the stock market. But the feeding frenzy has reached a dangerous stage. Oil stocks are no longer easy prey; they are barbed lures. We fear that investors who continue to strike at these shimmering equities will soon find themselves gaffed, filleted and pan-fried. For many months, your editors have been ardent and faithful fans of energy stocks. We still are … for the long term. But for the near term, we have become a bit nervous about them.
The group has become much too popular for its own good. The same oil stocks that so many “experts” now advise buying are the very same stocks that the experts feared buying one year ago. But, of course, that is when savvy investors were buying them. Most major oil and gas stocks have advanced at least 50% over the last 12 months – gains that seemed entirely appropriate in the context of $65 oil and $13 natural gas. Unfortunately, some of the bullish fundamental trends within the energy sector are beginning to erode. Supplies of crude oil, for example, are beginning to swamp demand. And even the “tight” gasoline market may be somewhat less tight than widely advertised. “We are swimming in crude oil right now,” one oil analyst remarked last week. Apparently, $65 crude oil has a way of coaxing additional supply into the market.
Meanwhile, demand for crude oil and for refined products has been falling. U.S. gasoline demand averaged 8.8 million barrels a day during the past four weeks, 2.8% below the same period a year earlier. Rising supply, coupled with falling demand, is not the typical bull market equation. To the contrary, the deteriorating “technical condition” of the crude oil market suggests that yesterday’s steep selloff will not be the last steep selloff. An ominous “head and shoulders” formation has developed on the price chart of crude oil.
As veteran technician, John Murphy, observed late last week, “The September bounce has fallen well short of the late-August peak (the head) and is about equal to the early August peak (left shoulder). It’s now challenging its 50-day average and may be headed for a test of the neckline near 62.50. A close beneath that support line would turn the short-term trend down. That would weaken energy stocks even further. I’m not suggesting that the long-term bull market in energy is over. I am suggesting that it’s come too far and is in need of some correcting. I also believe that the price spikes from the two recent hurricanes have probably been overdone. What better time to take some energy money off the table when TV stations are talking about nothing else. One TV station showed a chart of the XLE yesterday and said it was a good thing to buy when oil prices are rising. That’s the ‘kiss of death’ in any rally.”Link here (scroll down to piece by Eric J. Fry).
(two days later …)
Immediately after Wednesday’s dispatch, the oil stock sector began swimming in “sell” orders. Over the next two trading days, the major oil stock indexes cascaded more than 6%, bringing their losses over the last five trading sessions to more than 12%. Suddenly, the stock market’s sexiest stocks seemed anything but. Even we were surprised by the severity and ferocity of the oil sector’s collapse. But now that so many energy shares have fallen so far, we must consider the possibility that a “buying opportunity” is presenting itself … without ignoring, of course, the possibility that a “selling opportunity” continues to present itself.
Swift, ferocious selloffs are the hallmark of bull markets. So whenever they occur, the savvy investor steps into the fray as a buyer. At least that is what the “savvy” investors all tell us after the fact. Unfortunately, bull markets have a way of becoming bear markets at very inconvenient times … like, for example, immediately after we buy a stock. Obviously, we cannot know until after the fact whether long-term investors should be buying or selling oil stocks during today’s trading session … but we can guess.
The weight of evidence – and valuation – seems to be moving in favor of the oil stock buyers, rather than the sellers. In other words, a buyer of oil stocks in today’s session may well regret his buying tomorrow, but he will not likely regret his buying six months from now … in our humble opinion. That said, buying an oil stock at this very moment is a bit like trying to hitchhike from inside the fast lane of a Los Angeles freeway – catching a ride seems far less likely than catching a fender across the femur. Net-net, we do not mind embracing the short side of the energy sector for a short while, but we would embrace it like we would embrace Grandma … sincerely, yet briefly.Link here.
TAKING THE BULL BY THE HORNS
Global stock markets, long-dated government bonds and commodities go through cycles that can last for a while since it takes a long time for the crowd, which participated in a market bubble, to realize that it is not returning after a few years. Instead, they experience a rolling sequence of medium-term bearish and bullish phases, which persist for at least several months, but seldom more than three years. This ex-bubble environment leads to a gradual reassessment in which people become more cautious, leading to valuation contraction before those who remain are joined by a whole new generation of investors, who participate in the next cycle of valuation expansion. Generally and logically, the bigger the bull, the longer the subsequent bear, and vice versa.
So, where are we today, in terms of secular bull and bear trends? Two mega-trends became apparent over two-and-a-half years ago – industrial resources (including precious metals) and emerging markets. They overlap in a number of instances because the economies of many developing countries are primarily exporters of commodities. Natural resources experienced one of the biggest and longest secular bear markets in modern history, particularly if one adjusts prices for inflation. The main reason was overcapacity, which understandably led to caution by producers. When demand not only picked up once again, but also surged as the economies of China, India and other developing countries grew rapidly, supply inelasticity drove resources prices higher, particularly among industrial metals. Following historic lows in 2001, prices for the major industrial commodities subsequently formed secular uptrends.
Of these resources, the most important in terms of economic implications is the energy sector – from oil to coal and uranium. Arguably, crude oil’s bull market was not really underway until it maintained a break above $40, completing a massive base formation. Understandably, some analysts do not accept that oil is in a primary uptrend, because this has not happened before. While the price of oil will certainly fluctuate, as we have seen with the recent reaction following the move over $70 as Katrina struck, there are two crucial differences between the current overall uptrend and spikes in the 1970s. The spikes in the 70s were caused mainly by OPEC price hikes and production cutbacks. Prices subsequently fell back because there was no real shortage so additional supplies soon flooded the market. Today, the key driver of prices is demand and OPEC production being near capacity.
We have supply inelasticity and a demand driven secular bull market for oil and its alternative sources of energy. This is also true of industrial metals, where the China-led increase in demand is much greater than for oil. Consider this: China’s Government estimates that somewhere between 300 and 500 million people will move from rural areas to the cities by 2020. This unparalleled migration will require massive urban building, requiring according to some estimates, the equivalent of two metropolises the size of New York City every year for the next 15 years. India’s infrastructure and urban development requirements are also massive. This has changed the demand trend for industrial metals, some of which are in scarce supply, for at least a generation.
Scarcity, supply inelasticity, and rising demand are also apparent for precious metals. And while industrial usage has not, and will not take off to the same extent as we have seen with industrial metals, Asia’s newly and increasingly affluent consumers ensure a rising trend in demand for jewelry. However, what is likely to be the biggest source of demand, which we are only beginning to see, will occur as gold and other precious metals are increasingly remonetized in the eyes of investors. This is occurring, evidenced by new multiyear highs for the price of gold in U.S. dollars, sterling, euros and yen, because no country wants a strong currency. Why? First and foremost, it is due to intense competition in manufacturing due to globalization and the accompanying fear of deflation. A country keep its currency from appreciating by printing more of it, literally, and electronically through credit creation. We live in a world of stealth inflation, where the amount of paper money in circulation is increased faster than the rate of GDP growth – sometimes a lot faster.
As a rule of thumb, the bigger the bear, the greater the subsequent bull. Thereafter, in addition to a fairly well known supply/demand story, the key variables will be government policies, not least regarding liquidity and interest rates, plus crowd psychology. I suspect this will be a very big secular bull market for industrial resources and precious metals. And as with all long-term trends, when advances accelerate too rapidly, there will be significant corrections lasting from a few months to possibly up to three years, although the latter would be a rare occurrence. Currently, price data shows that most industrial metals are in lengthy medium-term corrections, with nickel and tin leading a pullback towards support levels prior to the next upward moves of consequence. Oil, post Katrina, is experiencing a consolidation that could last for a few weeks.Link here (scroll down to piece by David Fuller).
WATCH OUT FOR THE HINDENBURG OMEN
Should we pay any attention to this indicator? “Yes” is the answer from quite a few of the investment newsletters I monitor. Indeed, in recent days so many advisers have referred to the warnings that the indicator is emitting that investing blogs are all abuzz. And, naturally, more than a few of you emailed me to ask that I devote a column to it. Let me start by reviewing the Hindenburg Omen. The core idea behind it is that it is bearish whenever there are a large number of both new 52-weeks highs and new 52-week lows on the New York Stock Exchange. From what I can tell, it was created in the 1970s by a fellow named Jim Miekka, who was editor of a newsletter called The Sudbury Report. Credit for christening this indicator the “Hindenburg Omen” goes to Kennedy Gammage, who used to edit a newsletter called The Richland Report.
Why would a large number of both new highs and new lows be bearish? Peter Eliades, editor of The Stockmarket Cycles newsletter, recently provided an answer: “Under normal conditions, either a substantial number of stocks establish new annual highs or a large number set new lows – but not both.” When there are high levels of both, “it indicates that the market is undergoing a period of extreme divergence. … Such divergence is not usually conducive to future rising stock prices. A healthy market requires some semblance of internal uniformity, and it doesn’t matter what direction that uniformity takes. Many new highs and very few lows is obviously bullish, but so is a great many new lows accompanied by few or no new highs. This is the condition that leads to important market bottoms.”
In terms of genealogy, the Hindenburg Omen is a descendant of an indicator called the High Low Logic Index, which Norman Fosback, editor of Fosback’s Fund Forecaster, devised in the early 1970s. According to Gammage, the Hindenburg Omen is also “derived from a New High – New Low indicator developed by Gerald Appel many years ago.” Appel is the editor of the Systems & Forecasts newsletter. Both Fosback and Appel have good track records, so I tried to contact both of them to see what reactions they might have and whether they believe that the market will soon crash.
Fosback had not responded by the time I filed this column, but Appel told me that while the simultaneous appearance of many new highs and new lows is not a positive development for the market, one should not exaggerate its bearishness. The market’s prospects following such a development are “sub-par”, but not “calamitous”. Appel also pointed out that there have been some noteworthy cases in which a large number of both new highs and new lows have not presaged a market decline. He mentioned in this regard the situation prevailing prior to the bull market taking off in 1982. To be sure, Miekka, Gammage and other devotees of the Hindenburg Omen have always insisted that the new high/new low data must be interpreted in the light of several other indicators, and that in conjunction with them the false signals are kept to a minimum.
According to Robert McHugh, editor of McHugh’s Financial Forecast & Analysis, the two other indicators that have traditionally been looked at when interpreting the new high/new low data are the NYSE 10 Week Moving Average (it must be rising), and the McClellan Oscillator (it must be negative). (The McClellan Oscillator is a measure of market breadth.) McHugh has proposed adding yet two more preconditions. According to McHugh, the market historically has declined 87% of the time once all five of these preconditions have been met. And the market has actually crashed 27% of the time. All of these preconditions were met in September, which is why so many advisers are worried.
The proof of the pudding is in the eating, of course. But it is a statistical sleight of hand to back-test a system’s performance over the same period that was used to jerry rig it in the first place. The only real proof comes when testing a system over a different period than the one used to devise it. This is why statisticians usually insist on real-time tests of any system that is jerry-rigged to fit past data. And given how rare it is for all five preconditions associated with the Hindenburg Omen to occur, it will take years for us to know whether these five preconditions, taken together, truly represent an increased probability of a market crash.
But think of it this way. There are other newsletters among the 180 or so that I monitor that currently are as bullish as the devotees of the Hindenburg Omen are bearish. And they have devised market timing systems that have just as much superficial plausibility as the Hindenburg Omen, but which currently are quite bullish. Take your pick.Link here.
JUNK GETS JUNKIER
Here is what happens when you have too much money sloshing around. In August mattressmaker National Bedding announced that it wanted to borrow $520 million. The Illinois company drew 150 investors offering five times the $520 million. This despite the company’s junk rating and that the loan would increase debt to six times earnings before taxes, interest and depreciation. Emboldened, National Bedding cut the interest rate it was offering on its 6-year loan by as much as half a point, to two percentage points over LIBOR. Two and a half years ago a BB- company like this one would have paid double the spread.
The same tide of easy money that has produced cheap mortgages has led to crazy pricing of corporate loans. But now a relatively new breed of junk lender has emerged, stuffed with money from insurers and pension funds. Standard & Poor’s estimates these loan pools and their counterparts for individual investors, called prime rate funds, have raised $16 billion more in the past year and a half than they have been able to put into loans. Thus the race to lend to the diciest of borrowers.
The number of these new lenders has more than tripled to 400 since 2000. The portfolios, known as collateralized loan obligations, hold $230 billion in junk loans, based on JPMorgan Chase data. “Virtually every deal is oversubscribed now,” says Steven Miller, head of junk loan research at S&P. Miller says pension funds and insurers view these funds as a safe haven. In case of corporate bankruptcy, loans in these portfolios get paid back before bonds. Adding to the appeal is that the loans are adjustable and so will not get hurt if the Fed continues to raise rates.
But that assumes that the companies that borrowed are able to make higher interest payments. Default rates on junk loans are now at 1.75% versus 6% four years ago. They can only go up from here. Another worry: All the new CLOs have made it easier for the few big bank syndicators of junk loans to play CLOs off one another, forcing managers to take iffy loans out of fear they will get cut out of later deals. The biggest beneficiaries of the rise in CLOs may be the hedge funds specializing in the debt of distressed companies. Some are husbanding money in anticipation of tough times.Link here.
STEEP RISE IN INSIDER HOME BUILDER STOCK SALES
Insiders at some of the nation’s leading publicly-held home builders have increased their sale of their company’s stock, according to a published report. Reported data from Thomson Financial that shows insiders at the 10 largest home builders by market value, including D. R. Horton, KB Home, Toll Brothers and M.D.C. Holdings, have sold nearly 11 million shares, worth $952 million, so far this year. That is a huge jump from the 6.8 million shares, worth $658 million sold in all of 2004.
Many of the company’s shares are trading at or near record highs, the paper reports, as continued strength in the new home market, fueled by low interest rates, has lifted earnings and sales. The paper said that officials at the home builders say the stock sales are not a signal that they believe the property boom is waning. Instead, most executives said that they were selling because they needed to diversify their personal wealth.
“The stock sales have nothing to do with the state of the market. It has everything to do with diversification,” said Toll Brothers chief financial officer Joel Rassman, who has sold 105,000 shares worth $8.1 million. That is almost double the 60,600 shares he sold last year for about $4 million. He said the same is true for other Toll Brothers executives. “Even after all of the sales that have taken place, (CEO) Bob Toll still owns about $1.2 billion, plus or minus, in company stock and options,” said Rassman. “Any investment adviser would tell Bob Toll that he should be diversifying to an even greater extent than he is.” Executives at other companies said they see no downturn in profitability ahead.
But some analysts are not so sure the motivation to sell is so benign. Richard Bernstein, chief U.S. strategist at Merrill Lynch, issued a report in late August saying that insider sales at home builders mimicked what happened in the technology sector before those stocks peaked in 2000. “People say these companies are closely held and that the executives are trying to diversify, but why now?” asked Bernstein. He added that similar sales levels were not apparent in other top-performing industries this year. “They could have diversified their holdings 2, 5 or even 10 years ago,” said Bernstein.
Many economists have worried that the run up in home building and home prices in itself represents a market bubble, and that a rise in mortgage rates could hit the housing market high. Some suggested the run up in home builder stocks, and the insider sales, could signal another housing-related bubble is about to burst. “The previous times we’ve had insider selling that was that high, it was followed by a 20 percent decline in the index of home builder stocks,” said Mark A. LoPresti, senior quantitative analyst with Thomson Financial.Link here.
END OF THE BOND CONUNDRUM?
The Federal Reserve began raising the federal funds rate on June 30, 2004, after it had sat at 1% for the better part of a year. At the time, the FOMC was worried about deflationary pressures. It is too bad they did not look at the charts for crude oil and the CRB Index, as they were confirming a bottom. Crude oil bottomed out just above $17 per barrel in November 2001, two months after 9/11. A year later, prices moved above $25. The upward speculative momentum for oil took off at the end of 2003 from around $32.50 a barrel. Where was the deflation?
The CRB Index formed a major double bottom on its monthly chart off of 183 in the first half of 1999, with a retest in October 2001. It seems to me that the FOMC’s hike of the funds rate to 1% on June 25, 2003, signaled speculators to buy commodities, as charts show a clear upward momentum from 234 on the CRB at the end of June 2003. In its worries over deflation, the FOMC flooded the world with liquidity, forcing the dollar much lower vs. the euro, and tempted traders and hedge funds to speculate not only on commodities, but also on real estate. The FOMC helped the stock market bottom out between July and October 2002 with the funds rate at 1.75%. The Fed filled the punch bowl and the party continues, despite 12 rate hikes made by the Fed since June 2004 – an attempt to reverse the mistake it made when it pushed the federal funds rate below 3% after 9/11.
The graph clearly shows that the bond “conundrum” – Alan Greenspan’s catch phrase for the fact that long-term yields were declining while the Fed was raising short-term rates – is ending. It began before the FOMC made the second of its 12 rate hikes, when the yield on the 30-year Treasury declined through and stayed richer than its 200-day simple moving average (5.112%) on August 6, 2004. There were several points at which it appeared the conundrum might end, but each time the 200-day simple moving average held as support: December 3, 2004 (5.059%), March 23, 2005 (4.917%), and August 9, 2005 (4.621%).
The pattern appears to be changing now. With the federal funds rate at 3.75%, and likely at 4.00% on November 1, the yield on the 30-year is poised to trend above its 200- day SMA at 4.540. The close on Sept. 30 was also cheaper than its 5-month modified moving average at 4.507, which shifted the monthly chart profile to negative, another sign that the bond conundrum is now over. Another signal for higher yields would be if the 50-day SMA rises above the 200-day SMA, which, as the chart shows, could happen next week.Link here.
Hedge funds confounded by U.S. bond prices.
Hedge funds are still betting on lower prices for U.S. Treasury bonds because they think rising U.S. interest rates will eventually outweigh the strong Asian demand for Treasury issues, according to hedge fund managers. Rising rates would normally mean lower bond prices and higher yields, but it has not happened to any significant degree this time, and many hedge funds, particularly in the United States, are having a tough time. In June 2004, when the U.S. Federal Reserve raised benchmark overnight interest rates by a quarter of a percentage point from a historical low of 1%, yields on 10-year Treasury notes jumped to around 4.8%. By September of last year, they were around 4.0%, and they are now about 4.35%. The Fed, meanwhile, has raised benchmark interest rates to 3.75%. “It’s against all historical precedents,” said Simon Smith, a strategist at Weavering Capital, a British hedge fund. “It’s caught a lot of hedge funds off guard.”Link here.
THE LESSON OF FIDELITY’S MAGELLAN FUND FALL FROM THE TOP
News item: Fidelity Magellan, which long ago gave up its title as the world’s largest mutual fund, is not even the biggest fund at Fidelity anymore. Magellan, which still invests $52.5 billion for its shareholders, recently took a back seat to Fidelity’s Contrafund and its $55.7 billion under management. The fund that has been Fidelity’s flagship investment product for roughly two decades had been surpassed previously by Vanguard’s giant index fund tracking the Standard & Poor’s 500 and later by three mutual funds offered by the American Funds.
Magellan shareholders should lose no sleep over their fund’s declining status as an industry behemoth. Funds that grow too big generally find the bulk an impediment to delivering good investment returns. But the shift in status between Magellan and Contrafund illustrates a compelling question for the entire mutual-fund industry. Do investment companies that narrow the focus of mutual funds to fit retirement account menus go too far for their own good?
Retirement account sponsors and their consultants want funds that offer specific types of investment styles, focusing on things like small-cap value stocks or large-cap growth shares. Investment firms began to comply by the later 1990s because they saw 401(k) plans and other retirement accounts as their main source of new business. Fund managers were given clear orders and monitored by internal style police. Many of them chafed at restrictions they said made it harder to deliver superior returns.
This played out in dramatic fashion at Fidelity, where managers had been famously independent and investment stars were born. Bob Pozen, then president of Fidelity’s investment arm, became the enforcer, and he made quick work of the old cowboy culture. Magellan and its manager, Bob Stansky, are the clearest examples of how much things changed. Stansky, a skilled stock-picker in his earlier Fidelity career, has managed a Magellan portfolio that looks and acts strikingly like the S&P 500. Fidelity and Stansky insist he never has been required to cling to the big stock index, but a long record consistently says otherwise. The results are never terrible, just a little disappointing year after year.
Meanwhile, Contrafund seemed to avoid most of the style restrictions. As its name implies, Contrafund was created to zig when the market zagged. Contrafund did not go off wildly in different directions, but it did move around, and the portfolio reflected a broad investment selection. Fund manager Will Danoff’s current top holding is cash, representing more than 8% of his portfolio. Danoff took advantage of big investment trends and avoided the worst of the tech stock crash. Over time, he produced a stellar record.
The experience of Magellan and Contrafund illustrates this: Excessive portfolio restrictions intended to attract business become a self-defeating strategy when they damage performance. Investors offered every style of mediocre performance by active investment managers will soon discover index funds do the same job better.Link here.
SIGNALS OF THE END OF THE DOLLAR STANDARD
I am an economist who worked for 25 years in large investment companies in South Africa. I “retired” to the UK a few years ago. For most of my career I lobbied for policies such as money supply targets and later inflation targets that were (implicitly) intended to substitute the role of gold as an independent anchor for the monetary system. I was never an advocate of any form of gold standard, unlike the current Fed Chairman, now ironically testing the fiat money system to destruction.
However, in recent years the scales have fallen from my eyes. As Voltaire said in 1729 “paper money eventually goes down to its intrinsic value – zero.” Every fiat paper currency before or since has confirmed to this prediction. A fiat paper currency that is also the global reserve currency becomes this problem writ large. A U.S. Treasury official of old – Sam Cross – put it this way: “if you postulate a system that depends on one country always following the right policies, you will find that sooner or later no such country exists. The system is eventually going to break down”. In my view the Dollar Standard system is irretrievably breaking down, as signaled by four recent developments.
The flight from paper assets (and especially dollars) towards hard assets is now underway in earnest. There is still time – this is a multi-year trend – for investors to switch from devaluing dollars to rising gold. Those ahead of the herd are moving but the herd itself is yet to stir.Link here.
BRITISH GAMBLING CRAZE GAINING SPEED
Between 1992 and 2002, Britain has gone through a gambling explosion, with the number of lotteries more than doubling and the number of casinos shooting up 44% (Office for National Statistics). The gaming boom has only grown lately, and to capitalize on it, Britain’s largest seashore resort town, Blackpool, started thinking last year about turning itself into “the Las Vegas of the U.K.” And by the looks of it, Blackpool may soon get its wish.
The UK government is putting the country’s gaming industry through the “biggest overhaul since the 1960s” (BBC). The new rules have already allowed casinos to advertise and made it easier than ever for people to throw the dice. Gamblers can now “go straight into a casino and start betting,“ whereas before they had to first get a membership and then cool off for 24 hours. The government also wants to build a “super-casino” – in fact, initially they wanted 40 of them! The location of the first one is being debated right now, and the two prime candidates are Glasgow and Blackpool.
And that is just half the story. Nowadays, “traditional” gambling such as sports betting or black jack seem almost old-fashioned compared to the new, wildly popular “spread-betting” on financial markets, or wacky wagers like “how many sips of water the chancellor will take during his budget speech.” There is even a special gambling channel on British TV called Avago (as in, “have a go”), where viewers can use their TV remotes to place bets from the comfort of their armchairs, says The New York Times.
While for many British gambling is simply about “having a laugh”, its widespread and growing popularity could be a sign of the times. When we studied historical gambling patterns in the U.S., we saw a connection between the trend in social mood – as reflected by the U.S. stock market – and gambling. In bull markets, people focused more on investing their savings. In bear markets, they tended to gamble with their money. “Gambling is the bear market manifestation of an urge that in a bull market results in investment and speculation,” was our conclusion.Link here.
THE HARD-TO-SWALLOW CRUDE OIL STORY
Here is some food for thought: On October 5, a 13-foot Burmese Python in the Florida Everglades exploded mid-swallow, while trying to consume a live, six-foot alligator. Talk about biting off more than you can chew. Call us cold-blooded but the story does bring this thought to mind: From snakes to shareholders, sooner or later the same fate will befall those investors who make a steady diet of conventional economic wisdom. In other words, trying to stomach the cause-and-effect logic of finance – that external events “cause” changes in a market’s price trend – often leads to painful bouts of indigestion.
On October 5, oil prices plunged to a 2-month low. Problem is, the dip came in the midst of a highly BULLISH fundamental backdrop that included these details: 1.) October 4: Federal Minerals Management Service revealed that 90% of oil production in the Gulf of Mexico remains shut down. 2.) October 5: Energy Department estimates as much as 15% of the country’s refining capacity might be out of service for weeks, as processing plants repair the extensive damage caused by Hurricanes Katrina and Rita. 3.) October 5: Department of Energy weekly data shows a sharp DECLINE in petroleum and crude inventories.
By these snippets, crude prices should be crossing through Cassiopeia by now, not sliding below levels unseen since early August. Not to mention the fact that oil’s decline was joined at the hip by a sharp drop in US stocks: On October 5, the DJIA fell to a 3-month low. Oil down & Stocks down? – Please pass the Alka-Seltzer.
But the fact that the fundamentals failed to explain the fall in crude is just half the story; it was also more than a month late in calling the start of the downtrend to begin with. Chew on this: the current selloff in oil got started on August 30 – right after prices soared past the all-time record $70 price level. And, in the August 29 Short Term Update, we proposed that is was time to pay attention to crude’s downside. In our words: “As a sneak preview, there are a number of interesting factors converging to suggest that oil is at or very near the end of its recent surge. Some measures of bullish sentiment are at 10-year highs and anecdotally, there have been long lines and fist fights at some metro area Atlanta gas stations. This is a trend that appears to be peaking …”
As a follow-up we slithered in to fill in the missing details, mainly a labeled chart showing a major divergence between the future price of crude oil and the price of a share of Exxon Mobil. Our bottom line: “These extremes, combined with street-level fears of a gas shortage and the explosion in oil-shock books confirm the message that the coming ‘shock’ is not that oil is booming, but that it will fall.” Since our analysis went live, crude oil prices have fallen nearly 12%.Elliott Wave International October 6 lead article.
INVESTMENT BANKERS DOING WELL, BUT BEWARE
Muted applause is in order for Goldman Sachs, which recently turned in record quarterly earnings – up a pleasing 84% from last year’s results. White-shoe firm Lehman Brothers is breaking records too, with Bear Sterns and Morgan Stanley in hot pursuit. The Amex Broker Dealer Index (XBD) is powering to new heights. Hooray for the investment bankers, minting cash in their Savile Row suits and Hermes ties. These natty boys have the world on a string. … But they also have a tiger by the tail. At the same time that Goldman shines, so does the “barbarous relic” known as gold. At 17-year highs, the atavistic yellow metal is within sprinting distance of $500, even as the investment bankers cash registers are ringing. Strange, that.
It is stranger still that gold would rise from the ashes at the very apex of worship for that august institution, the Federal Reserve. This past summer, graduate student Erin Crowe opened an informal gallery of 18 sketches and portraits she had done of the great man himself, Chairman Alan Greenspan. After CNBC picked up the story, the phone rang off the hook. All pieces were sold at prices ranging from $1,000-4,000. According to The Washington Post, several visitors to the gallery were “telling stories of how they adored the Fed chairman, how he had saved the world and made them millions.” Gold’s ascent to 17-year highs would seem to signal that inflationary pressures are also on the rise. If so, we all know what comes next: Rising interest rates and market pain, which means hard times for the investment banks. But this time around, for this strange interlude, both are sharing an upward trajectory. One or the other – Goldman or gold – is due for a fall from grace. But which?
The investment banks have long been riding a wave of persistent – and deliberate – asset inflation. When excess liquidity is pumped into the system, those who truly prosper are the ones best placed to dip their hands in the river. As the Greenspan cash sloshes and flows throughout the U.S. asset markets, savvy players divert the cash flows toward themselves … just like a farmer irrigating a field. The investment bankers, masters of prestidigitation, divert cash from many different activities, usually in the name of “advising”. They massage the cash and trade it and hedge it, whisper in the ear of corporations deluged by it, and profitably surf the growing swells of debt created by it. There’s no business like flow business.
It is an establishment-sanctioned rip-off, of course. Aggressive asset inflation is portrayed as a good thing, all the more so with John and Jane Doe participating via manic housing appreciation. But the real estate pump is a Ponzi scheme, designed to sustain the unsustainable via lines of credit. The government does its part by rewarding reckless borrowers (tax-advantaged home equity lines of credit [HELOCs]) even as it punishes modest savers (capital gains taxes, hidden erosion, paltry returns on interest).
Like a home electricity meter steadily ticking over, life grows more costly by the hour, if not the day. But as asset values are pumped up with abandon, inflation measures are kept “benign” by the damping effects of stagnating wages and the quirks of our government’s inflation-measuring mechanisms. And as asset values continue inflating, the bankers “make the middle” with big smiles on their faces. Yet while optimists swear the sky is still blue, an ominous buildup of offshore debt is the dark counterpart to this falsely created prosperity. None of this paper happiness is free. The piper’s payment is simply delayed and delayed and delayed some more. When the center finally gives way, the man on the street (you and I) will find himself on the hook for it all – in the form of sharply higher taxes, sharply lower purchasing power or both – and facing the possibility of jarring societal disruption to boot.
When it happens, it will not be “just one of those things” that could not be foreseen or prevented. It will be the inevitable result of a deliberate policy – reckless asset inflation for dubious purposes – that has enriched the few at the expense of the many, with the many playing along out of greedy shortsightedness and an ignorance of history. This rant is not anti-capitalist or anti-free market, by the way. Capitalism shuns redistribution in all forms, and heavily managed markets are not free. The policies of the Federal Reserve and the gross failings of government, however, qualify on both counts.
But back to the original topic: If the investment bankers are riding high on an asset-inflation wave, gold is cresting on a far more ominous one. Those who buy gold anticipate the day when this supposedly benign asset inflation turns malignant. The inevitability of the coming mess might be “good news” for gold investors, but bad news for the world economy at large. In the end, the inflationary triumvirate of profligate government, accommodative Fed and self-serving bulge- bracket banks, so long a united front, will be carping loudly and blaming each other bitterly before all is said and done. And gold will be looking on … and cheering loudly.Link here (scroll down to piece by Justice Litle).
STINKY WATER, SWEET OIL IN SHALE COUNTRY
You will not think much of Rio Blanco County if you ever drive through it. In fact, unless you take a right turn off Interstate-70 West at Rifle, head north on Railroad Avenue and then west on Government road to Colorado state highway 13, odds are you will never even step foot in Rio Blanco County. But even if you keep heading west toward Grand Junction, through the town of Parachute and the shuttered oil shale refineries from the 1970s, you will see the Book Cliffs geologic formation on your right. For miles and miles. It is a bleak landscape. Almost lunar. At first glance, it is the kind of land you would never want to explore, much less settle down in.
In the small world of geologists, though, the region is well-known. In fact, you might even say it is the single most important patch of undeveloped, unloved, and desolate looking land in America. But you would never guess this particular corner of the Great American Desert may play an integral role in America’s strategic future just by looking at it. You would never guess that the whole stretch of brown, red, and orange land contains enough recoverable oil and gas to make you forget about the Middle East for the rest of time.
There are places in Rio Blanco County like Stinking Water Creek, named after the smelly mix of oil and water the first white settlers found there, that tell you oil has always been around the Rocky Mountains. It is just not always been easy to find. It is one thing to find oil that bubbles out of the ground in liquid form. It is quite another to drill a thousand feet down, and encounter oil locked up tight inside a greasy rock. The energy reserves of the Piceance Basin, upon which Rio Blanco County sits, contain massive petroleum reserves of a very unusual nature: Oil shale.
The destruction of Hurricane Katrina shows the importance of a strategic petroleum reserve, or, more accurately, a strategic energy reserve. But the SPR in Louisiana only holds about 800 million barrels of emergency, enough to get the country through about 90 days of regular oil usage. That is barely a band-aid for a country that faces a potential energy heart attack. In other words, the future of oil shale may have finally arrived. Extracting oil from shale is no simple task, which is why the reserves remain almost completely undeveloped. But an emerging new technology promises to unlock the awesome potential of the oil shale. “The technical groundwork may be in place for a fundamental shift in oil shale economics,” the Rand Corporation recently declared. “Advances in thermally conductive in-situ conversion may enable shale-derived oil to be competitive with crude oil at prices below $40 per barrel. If this becomes the case, oil shale development may soon occupy a very prominent position in the national energy agenda.”
Estimated U.S. oil shale reserves total an astonishing 1.5 trillion barrels of oil – or more than five times the stated reserves of Saudi Arabia. This energy bounty is simply too large to ignore any longer, assuming that the reserves are economically viable. And yet, oil shale lies far from the radar screen of most investors. To summarize my findings, oil shale holds tremendous promise, but the technologies that promise to unlock this promise remain somewhat experimental. But sooner or later, the oil trapped in the shale of Colorado will flow to the surface. And when it does, it will enrich investors who arrive early to the scene.Link here (scroll down to piece by Dan Denning).
Sphere Analysis is these days one of the more useful tools available in our analytical toolkit. There is the Economic Sphere that comprises the makeup and functioning of the real economy (production, services, distribution, imports/exports, employment, spending on goods, services, and investment, etc). It receives most of the attention from conventional analysts. And there is the Financial Sphere, loosely embodying the Credit system, financial and asset markets, and the financial system generally. Its dynamics are of critical significance today, although it does not fall within the context of most analytical frameworks and tends to be ignored.
Credit inflation, by its very nature, is a product of Financial Sphere expansion. Inflationary manifestations, on the other hand, are both Financial Sphere and Economic Sphere phenomena, very much depending on the interplay between the nature of the financial system and the structure of the real economy. The types of predominant inflationary effects vary considerably depending on commanding monetary processes and the structure of the underlying economy, along with expectations for prices, business profits and financial returns.
I believe that the Fed made a serious policy error when it aggressively cut rates during the second-half of 2002 and held them at 1% through the first-half of 2004. And while I appreciate the conventional Wall Street view that the global economy was facing serious deflationary risks, this threat was exaggerated. Importantly, the dollar Bubble was already in the process of bursting as the Fed initiated its ultra-aggressive monetary stimulation.
I argue strongly that monetary processes had played an integral role in shaping atypical inflationary manifestations during the 1999 to 2002 period – domestically as well as globally. Historic credit inflation was becoming deeply rooted throughout the U.S. Financial Sphere, although the created liquidity/purchasing power was having its most pronounced effect on U.S. asset markets – first technology stocks/telecom debt and later U.S. bonds and housing. Endemic excess liquidity and asset inflation was nurturing an enormous and aggressive speculator community, with contemporary finance commissioning the community with armaments of astounding sophistication and power.
It has been remarkable to observe pundits fixate on the deflation thesis throughout history’s greatest credit inflation. The Fed and conventional analysts focused their inflation analysis on the Economic Sphere. For sure, a rather convincing argument was presented that productivity and globalization had forever altered inflation dynamics, analysis that neglected the nature of evolving Financial Sphere and inflation dynamics. It also became popular to refer to inflated home and securities values as “wealth creation.” This was all well and good, except for the reality of a massive and relentless Financial Sphere inflation.
It is my view that we are in the early stage of some rather profound changes in inflationary manifestations. Not only is there today a global liquidity glut, U.S. securities markets are underperforming much of the rest of the world. Will the U.S. dollar and securities markets enjoy the traditional benefit of safe-haven status come the next episode of global financial tumult? Inflation expectations have evolved to the point where businesses and governments around the world have serious concerns with regard to procuring necessary energy supplies (along with other commodities). Here at home, we are at the cusp of a full-fledged energy crisis. Policymakers, executives, business owners, and households will now fear a cold winter, then a hot summer and another active hurricane season and another winter …
Financial Sphere expansion and rooted monetary processes have for too long directed cheap finance for the construction of too many large homes, too many inefficient vehicles, and too much asset inflation-induced over-consumption. Worse yet, unending Financial Sphere expansion is providing a horde of purchasing power to global economies to compete against us for a limited supply of energy resources. Monetary processes have fostered an economy that consumes too much energy and produces too little, concurrently with stoking a global liquidity environment conducive to price spikes and shortages. It is difficult to see this dynamic sustained for much longer.
Housing and retail stocks are signaling that an important inflection point has been passed. To some, developments point to a healthy moderation of growth that will temper inflationary pressures and lend support to the bond market. To others, the economy is at the edge of a cliff. I am not so convinced of either. Barring financial crisis, it will take some time (and dislocation) before significant resources are redirected from the housing/consumption boom. In the meantime, the Time is of the Essence Project Energy (not to mention hurricane recovery) will place increasing demands on the system. Those zestfully awaiting the bursting of the housing Bubble for another (NASDAQ bursting-like) bond market gravy train may instead face something much less hospitable.
There are major Financial Sphere and Economic Sphere developments in the offing. There is too much credit being created and much of it misallocated. There is, as well, excessive and destabilizing speculation. These credit bubble facets – seemingly innocuous for quite some time – are finally imparting conspicuously deleterious effects on an increasingly maladjusted Economic Sphere. For good reason, the Fed is getting nervous. And global central bankers have at this point surely given up hope that the Global Financial Sphere would commence the process of returning to some semblance of order and sustainability with the imminent slowdown in U.S. housing finance. It is going to be a very interesting – and I will bet tumultuous – 4th quarter.Link here (scroll down to last section of article).
U.S. STOCKS: BE AFRAID, BE VERY AFRAID?
From October 3 to October 7, the S&P 500 and Nasdaq Composite saw their worst weekly losses since April, while the Dow Jones Industrial Average suffered its steepest loss since June 30. As for the WHY the blue chips were being battered, the mainstream press offered “Fear”. In this case, “fear” of inflation, continued rate hikes by the Fed, higher energy costs, another terrorist attack on U.S. soil … etc… See, in the eyes of the public, not even a fall in crude oil to 2-month lows – OR – an upward revision in August jobs growth – OR – bullish earnings from big business could calm the “worried psychology” weighing on investors. And, thereby, weighing on stocks.
Makes perfect sense, if it were not for just one little problem: The real data that shows the approximate level of dread and/or daring among investors tells a completely different story. On this, the October 5 Short Term Update steps in with a labeled chart of the S&P 500 versus the International Securities Exchange (ISE) sentiment index over the last year. One look at this snapshot and the following detail becomes plain as day: October 4 and 5 saw back-to-back readings over 200 in the ISE Sentiment Index, meaning there were more than two calls bought relative to every one put. In laymen’s terms: Where the highest concentration of fear should show up, there is a tad, if that, compared to the size of the decline in prices. As for the last time such a muted response was seen from investors in the midst of such a major selloff in stocks … well … where the index went following the reading might just scare your pants off.Elliott Wave International October 7 lead article.
LEGACY OF DEBT AND DELUSION
In recent months, much has been written about the legacy of Fed Chairman Alan Greenspan, who, after 18 years, will retire in January. Most of the legacy discussion has been based on the steady hand of the Fed Chairman – a steady hand that has resulted in an era of low reported inflation and mild recessions, while fostering sustained growth through what many have hailed as superb monetary policy. Others do not see it that way. Some believe that the Greenspan legacy will be one of debt and delusion – debt of all kinds piled high, lingering far into the future, and delusion in reflecting back, at how we have all behaved during recent years.
More debt has been created in recent years than anyone could have possibly imagined just a short time ago. A “culture of debt” has been created – from the Federal Government all the way down to Wal-Mart credit cards. Over the course of nearly two decades Alan Greenspan has facilitated this debt – he has overseen a system that has supplied the credit that has created the debt that has sustained an entire nation. An entire nation that has been the envy of the world for its dynamic growth. Growth which is based to an ever-increasing degree on new debt creation, and a populace willing to continue its profligacy.
Up until the 1980s, most people probably still agreed with Benjamin Franklin’s view toward debt, “Rather go to bed without dinner than to rise in debt”, and Adam Smith’s wisdom as well, “What can be added to the happiness of a man who is in health, out of debt, and has a clear conscience?” Today, as individuals and as a nation, we accept debt as an integral and necessary part of a lifestyle to which we have become accustomed, but a lifestyle that we increasingly can not afford.
Wealth is defined as “goods and resources having value in terms of exchange or use”. Surprisingly, it maintains no relationship with debt. Debt does not offset wealth, they coexist. An individual or a nation can be very wealthy at the same time that they are hopelessly indebted to others. It is under these circumstances that time becomes a factor, as wealth is converted into money to service the debt. Our nation has acquired much wealth in the last two decades, under the stewardship of Alan Greenspan. The quantity and value of goods and resources has increased dramatically - so has debt. Rising values for stocks and now housing have made many Americans much wealthier than they could have ever imaged just a short time ago.
Apending money borrowed against the rising value of homes has been called the “wealth effect”. They have become wealthier, and they have acquired more debt. One problem with wealth, however, is that it is not constant – it can change over time. Since wealth is based on the value of goods and resources, wealth changes as the market value of these goods and services change. Debt, on the other hand is constant. Debt service can change with fluctuating interest rates, but the debt itself remains as is, until it is added to or paid down.
Some people believe that today’s high housing prices and hence individual wealth, have become far detached from fundamentals and are not likely to continue into the future. They feel that the masses are being misled – not with respect to the current wealth of homeowners, this is real, but in the expectation that housing prices will maintain current levels or continue to rise. There are questions about whether current wealth will endure.
Many people believe there is nothing unusual about a home, unchanged from five years ago, which is now valued at say, $300,000 more than it was then. It is valued at this level because other people are able and willing to pay that much for similar homes, and hence the homeowner, who may also be unchanged from five years ago, is now $300,000 wealthier than before. Moreover, the homeowner believes his current wealth will be projected into the future. Time and stability have a way of reinforcing beliefs such as these. Most homeowners today truly feel wealthy; otherwise we would not see home-equity driven consumption at the levels that have been witnessed in recent years. If they suspected that maybe they were being misled regarding their prospects for continued wealth, they likely would not spend this wealth at current rates.
So, what kind of legacy will Alan Greenspan leave? Surely it will be a legacy of debt. There is so much debt at all levels – personal, business, government – and this debt will not go away quickly. It will linger, and it will need to be serviced. Will it all be repaid? Likely not. Many individuals are in far over their heads and do not have the same advantage that the government has in paying future debt with a currency which loses value. But what else will the legacy consist of?
The legacy could also consist of continued wealth – current wealth could continue at these levels or rise as we charge into the future. But that depends on many factors. Most individuals today are wealthy due to rising real estate prices – if this trend does not continue, or worse, reverses, much of this wealth could disappear. The Fed Chairman has been warning of this scenario often lately. With the way individuals have unwittingly overextended themselves recently, it is a good bet that much of this wealth will disappear in the years ahead – that many loans will go bad, home prices will decline, and wealth will decrease. So, can housing wealth be replaced with wealth created from some other source?
After the 1980s bond and real estate boom went bust, it was replaced with a technology boom. After the 1990s technology boom went bust, it was replaced with another bond and real estate boom. If the most recent boom goes bust, what will replace it? That is the key question. If there is something to replace housing as a source of wealth in the future – a technology boom in renewable energy, or nanotechnology perhaps – then in the years ahead the Greenspan legacy may be thought of as one of debt and wealth. Not bad really. As long as wealth stays ahead of the debt, things will be fine. This has worked well so far.
However, if in the years ahead, it becomes clear that there is no new asset class that can be inflated to generate wealth for the millions and millions of Americans accustomed to rising debt to support their standard of living, then maybe people will look back at this period of time and think that maybe they have been misled. Maybe people will realize that they were duped into acting in ways that they now regret and were swept up in a mania, the likes of which the world has never seen before. The Great Real Estate Bubble. At that point, they will realize that they were misled, deluded.
This is the scenario that seems to make more sense – that the Greenspan legacy will be one of debt and delusion.Link here.
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