Monday, October 31, 2005

What's ahead for the energy markets?

A reader asks me if I could briefly explain this refining economics issue.

In a nutshell:
The common misconception is that refiners high capacity utilization rate is correlated to high oil prices. Actually, they are correlated because people believe this should be true, or at least pretend too. I don’t know where this myth started. I first heard it around the beginning of the year. It’s in Hot Commodities, which was published last December, and what I heard the financial news saying was almost verbatim.

If refiners are limited in how much gasoline and other products then can produce, then they are also limited in how much oil they need to buy to produce those products. They may be able to raise the price of the end products they sell if there’s more demand than they can meet, but this would not be a reason for the price of oil to rise. Quite the opposite. The price of oil should be stable or fall because refiners can’t process all the oil that oil producers have to sell them.

Not in a nutshell:
So there’s a massive inconsistency. Actually there a bunch of inconsistencies. We hear that there are refining bottlenecks. Yet, inventories of all refined products are quite normal. They are not being drawn down. In fact they are being added too, because refiners are producing more product than we are buying. The only supply disruptions we’ve had lasted for only a week or two right after the hurricanes. And that was never because there wasn’t enough gasoline; rather there were distribution issues. We are told that capacity utilization rates are at all time highs. We are told that we haven’t built a new refinery in somewhere around 30 years. Also true. But who, besides myself, is telling you that refiners don’t build new refineries because it’s cheaper, faster, and more efficient to expand the production of existing refineries. And it’s cheaper, faster, and more efficient for refineries to supplement their own supply with supply from other countries. Refiners are running at high capacity utilization because running at low capacity utilization is bad.

Does a car plant just run during the day? Know, they run on three shifts to maximize their capacity utilization. I used to work on the computer systems of large insurance companies, which are very data intensive operations. The companies never had enough server and mainframe capacity to handle the peak loads of quarter ends. There were always temporary business interruptions at times when the systems were being taxed heavily. But it didn’t make sense for companies to double their hardware costs to meet a demand peak that only came once a quarter.

Similarly, refiners aren’t going to build out their refineries to handle the highest demand when they can just import the balance. The most efficient point of operation is probably somewhere around the point of average demand. So naturally they’re going to run at high capacity utilization rates. It doesn’t mean they will have trouble meeting demand. It just means that they have to rely on outside sources and inventories to make up for fluctuations. There just operating more efficiently than in the past.

Another reason they are able to meet demands more efficiently is probably due to technology advancements. I’ve never worked in the industry so I can’t speak specifically as to what advancements have been made in refining and how much more productive they are, but speaking from experience in other industries that I have worked I think it’s safe to assume that supply chain management software, B2B commerce, etc… have made it possible for refiners to operate more on a just in time basis than in the past. But when people say that there’s a refining bottleneck they never consider that perhaps the refiners are just operating more efficiently.

I say what bottleneck? Prove it. I’ve never seen any data that does. And over the past year I’ve looked at a heck of a lot of data, till my eyes go buggy and my contacts dry out, literally. So the inconsistency is that if there was a refining bottleneck we should have seen inventories drop with possible supply disruptions, pricing power over gasoline and other refined products, and somewhat of a cap on oil prices. But if there’s not a bottleneck then gasoline prices should be competitive and refiners should have had their margins squeezed for having to pay more for oil. In reality though, the largest oil companies control every point in the distribution from producing oil, refining it, and distributing it, and reselling it to retail customers. Since gasoline prices have risen by a larger percentage than oil prices, the oil companies are winning at every point in the network. That’s not the way a competitive market is supposed to work.

So what does that mean for refiners profits? As long as the majority of people believe the misinformation they’re being fed, the refiners will keep getting high margins. As the chart in the last post illustrates spot prices have followed futures prices. I haven’t done a similar comparison between spot gasoline and unleaded futures, but I think it’s a safe assumption that I’ll find a similar pattern when I do. What this implies is that the spot price is related to the futures price, which currently has more to do with speculation than actual current supply and demand. The proof of this is in the fact that the highest futures prices have consistently been at the nearest month. If oil prices were really being driven by concerns about future supply problems and increasing demand, then the price of farther out futures should exceed the price of front month futures. That’s not the case.

Even Alan Greenspan has said that the oil supplies are tight. I hear it nearly constantly. Though that’s not what the CEO of Exxon Mobil says and nor does the data. When you compare world production and consumption data nothing is out of the ordinary. No one who says there’s tightness ever bothers to show any data to prove it. They talk about China using more oil, but they never talk about whether or not China is producing more oil. It goes on and on like this.

When you look at all the various data pertaining supply, demand, and prices for oil and refined products the only data that stands out as being odd is the futures prices and the spot prices tagging along behind. How do we fix the problem? It’s not windfall taxes, to be sure, that would just make the problem worse. I hate to say it, but I’m gradually coming to the conclusion problem lies in the pricing power of single companies controlling the entire network of oil production, refining, and distribution. It’s similar in some ways to the Wall Street conflicts of interest that arose between firms venture capital and retail businesses. They funded/produced companies, created/refined the stock, and distributed the stock. The result was too much control and collusion. Retailers got the short end of the stick. The same with the relationship between mutual funds and hedge funds. So I’m wondering if the similar relationship combined with the excessive speculation isn’t the root of the problem. Not to suggest that there’s a conspiracy. The oil companies are acting in their own best interest. It makes sense for them to operate in the whole spectrum. But that might not be in the consumers’ best interest or in the interest of a competitive market place.

So what to make of investing in refiners as this is the question the reader had that I’m finally getting around to answering. My view is that gas and oil prices will go where the futures go and the futures are driven by speculation. And speculation is speculative. If traders get jittery, and think all the easy money has been made, they could get out of the energy markets en masse. That’s a real risk. On the other hand, the relationship between oil companies and the distribution process helps support prices. When you consider that 40% of the world’s oil is produced by a cartel that makes matters worse. The market should be competitive, but it’s not. I don’t think refiners are going to build new refineries here in the U.S. even if our government makes it easier to do so. I think they will import, buy foreign refiners, build refineries in other countries with less stringent environmental laws, and continue adding on to existing refiners. But whether refiners continue to profit like they have been, in my view, is largely dependent on whether or not crude prices remain high. In the past when crude prices and gas prices have been low, refining hasn’t been known for being a tremendously profitable business to be in. That’s what I hear, but I don’t know it for a fact. The gist is that it’s probably not what you want to hear, but if oil and gas futures stay high then oil companies and refiners will do well and if the futures prices drop traders will take the stocks down too.

posted at 5:32 PM 0 comments

Attack of the Blogs - Forbes.com

Attack of the Blogs
Web logs are the prized platform of an online lynch mob spouting liberty but spewing lies, libel and invective. Their potent allies in this pursuit include Google and Yahoo.

Interesting. I'd like to think BlogginWallStreet isn't any of those things. I don't hesitate to state my opinion, disagree, and I love to stand up against injustices and misinformation, but I don't think I've spewed any invective. Sounds like something I might do if I got the bird flu.

posted at 3:51 PM 1 comments

Spot vs. Futures

And the rally continues!

Stocks up, energy prices down. That’s what I like to see.

I’ve been doing some thinking about the relationship between futures and spot prices. Does the tail wag the dog? That sort of thinking. Apparently, I’ve been thinking about it a bit too much because I woke up to an insight that just popped into my head in a moment of unprovoked clarity, the you stand in front of a person and can’t remember their name then it suddenly pops into your head when your not thinking about it at all. At least that’s the way it works for me, or else I’m nuts. I guess my brain had been processing the problem in the background, when I wasn’t even consciously thinking about it. How convenient.

What occurred to me is that as the number of futures contracts increased they would make up a larger percentage of oil production and therefore likely have a greater influence on spot prices.

Currently, I’m looking into academic research on this relationship. It’s still quite unclear to me specifically how the two are correlated. I was reading some information I Googled up from the IMF of all places because the information was recent and deals specifically with the relationship between spot and futures prices. Should I be surprised to find the information fraught with inconsistencies and the same old rhetoric? It seems even the IMF read Jim Rogers’ Hot Commodities, because they didn’t get the basic economic relationship between refiners and oil prices right either. “Given crude prices are determined in a global market, however, localized refining capacity constraints by themselves are unlikely to increase crude oil prices.” When the IMF says that localized refining constraints are unlikely to increase oil prices due to the global scope of the oil markets it implies that the relationship is such that constraints equals higher prices, or rather if the restraints are great enough it could cause higher oil prices. We’ve been over this gazillion times now, so you know that the correct relationship is that refining constraints limit the demand for oil and therefore prices.

The fact that even the IMF doesn’t understand such a basic concept truly fascinates me.

For a number of years I’ve belonged to an email group of speculators. The group includes some high and low profile hedge and portfolio managers, academics, and professionals from many walks interested in the markets. As with any large group of people thrown into the mix are a fair share of them aren’t the most open-minded persons. What most of the members, myself included, have in common are big egos and strong opinions. Ironically, this group of supposed market philosophers as a whole is in my experience far less open-minded and open to new ideas than the general public. Though there are some that are far more open-minded than average and on the whole it’s a volatile and not very accepting group due in large part that they, like myself, also tend to be very skeptical and not ready to believe anything that isn’t proven or well-thought out. Consequently, you probably imagine that my brashness pushes peoples buttons and I’ve managed to alienate myself from many of them, by choice.

One particular die-hard fundamental analyst who I never seem to agree with on much of anything tells me that one person can’t possibly be responsible for moving an entire market complex and I shouldn’t insult the great minds of the markets and the email group with such nonsense. Others say I shouldn’t have opinions and I shouldn’t talk bad about journalists and one person says I shouldn’t say anything more at all.

But really interesting thing is that I was contacted directly by a number of the most revered members, some names you would likely know well, and applauded for having the courage to say the things I say. The best minds in the markets are the most open and the most excepting of controversial ideas. Not to imply that I consider myself in any way a great mind of the markets, but one thing note about such people and strive to emulate is that they say what they think and what they believe. They don’t apologize for it. They don’t start out a debate by saying something like, “with all due respect.” They just say what they think. Most don’t spend hundreds of hours writing white papers either. But they spend hundreds of hours reading white papers and contemplating the meaning of them, then drawing useful conclusions for other peoples work.

When I say that Jim Rogers has influenced the commodities market the closed-minded person thinks I’m a conspiracy theorist nut job windbag. That’s because the closed-minded person thinks in black in white. They see Jim Rogers and prices. They don’t see the complex web of relationships at work that come together to make things happen. No, I don’t think that Jim Rogers single handedly drove prices higher. I think he directly contributed via his hedge funds in a modestly. But indirectly I think the cumulative effect is much greater. I’m also told that his book couldn’t have had much of an influence since Hot Commodities has only sold around 45,000 copies. But there’s much more to a sphere of influence than the number of copies of a book sold.

Warren Buffet need not ever have published a book and I don’t think it would have diminished his sphere of influence in the slightest. People have emulate Buffet in their approach valuing companies for many years now. He’s impacted the way people think about stocks and therefore the prices of stocks.

I think Nassim Taleb of Fooled By Randomness would also agree with my theories at least generally because it validates a source of black swans. Other major players would have a hard time legitimately denying such a theory to the extent that they’ve influenced and been influenced. But no die-hard fundamental analyst is ever going to admit to believing that such a thing is possible, because it throws everything they believe about the markets right out the window. If it’s possible for one person to have a significant impact on prices, then where does that leave fundamental valuations?

But taking that one step further, if you believe in Soros’ Theory of Reflexivity, which I do. Then fundamental analysis itself is driving prices, not just the fundamentals. In other words, the fundamental analyst makes fundamental analysis work. When they buy a stock because its PE ratio is low they are buying value. They make buying value work. Without the fundamental analyst buying value, what would drive the price higher?

What is the source of the misunderstanding about the relationship between refining capacity and oil prices? I don’t know who first said it. But I can say that the first time I ever heard it said was after Hot Commodities came out and I heard it repeated numerous times and now even the IMF is getting it wrong. I’m inclined to think that without the excuse of such a widespread misunderstanding traders may have been more apprehensive about holding onto long energy positions. Maybe prices would never have gotten so high in the first place. Maybe they would have any way. No one can say for sure.

But what I can no for certain from it all is that it is possible for large groups of people to collectively believe things that aren’t true, even otherwise obvious things. Some of those people help to spread the disinformation by repeating what they’ve heard elsewhere without really thinking about what they are saying. Some do see the problem and never do anything about it. Others intentionally take advantage by spreading the misinformation and benefiting from it.

When you put it all together the markets are a mash and mesh of self-fulfilling prophecies with the prophecies of the most renowned investors carrying the most weight, collective misinformation, inefficiency, efficiency, corporate valuations, earnings, technical analysis, statistics. People using a variety of methods or no method at all are all pushing and pulling prices simultaneously. Where prices end up depends on whose pulling the hardest at any given time.

That’s where I’m at with spot and futures prices. At times the fundamentals of spot prices are driving futures prices. Futures exchanges want us to believe that this is the case all the time. But that doesn’t seem to be the case now. I compare spot and futures price data in the chart below. The chart shows that futures prices have been leading spot prices, the amount of lead is increasing, and the difference between the futures price and spot price has also increased. This has effect has steadily grown as the number of futures contracts traded has grown both in overall volume and as a percentage of oil production. I believe that this shows how speculation is playing an increasing role in the futures markets, that the speculation has become increasingly less concerned with the fundamentals of the market, and is having more of an influence on spot prices. If this were not true then spot and futures prices should be more in line with one another.

posted at 2:03 PM 0 comments

Friday, October 28, 2005

Hands Off The Windfall

Hands Off The Windfall
As for refineries, the industry spends billions of dollars a year to upgrade and expand existing plants. They don't build new ones because it's a bad use of capital. When mega-refiner Valero (nyse: VLO - news - people ) bought Premcor this year, it paid $8 billion for refineries that would cost at least $11 billion to build from scratch. Until the cost of building new is less than the cost of buying old assets, there's no incentive to build new refineries.

The plus side of the idiotic windfall proposal is that it's bringing out the truth about refiners. When you start seeing people saying these things in the mainstream media, traders get nervous about being long, fearing sentiment will shift against them. We may be witnessing the bursting of a bubble.

posted at 4:04 PM 1 comments

Thursday, October 27, 2005

The Wave

We got a preponderance of economic data this morning. What do you need to know about the GDP data? The numbers were good. Investors like what they saw. Moving on…

I sometimes like to step back and reflect on previous posts. It’s interesting, reflective, and sometimes painful to have your thoughts archived potentially in perpetuity. But you can look back and see how far you’ve come and how naïve you once were.

Even jumping back a month can be telling. Have I been cool handed, over reactive to the news of the day, complacent, logical, sufficiently quantitative? It’s a balancing act.

In What really moves the markets… I made some very specific forecasts for the way I thought the earnings season would play out. It was a logic-based opinion on market action as opposed to quantitative. But this was something that could, and should, have been tested. It wouldn’t have been overly difficult to do so. I’m selective about what I choose to quantify because doing so can be very time consuming and carries with it opportunity costs. In this case the logic seems reasonable, but could have been tested and proven. The approach I would have used would be to first identify various important market shocks, then relate that to earnings data of say S&P stocks, and then relate the earnings season to changes in the indices and specific key earnings announcements to daily changes.

I’ve put this on my white board list of things to test. Significant market shocks like the hurricanes come fairly regularly. In recent years there’s also been specific dates associated with terrorism, corporate scandal, mutual fund scandal, war, Y2K, LTCM, etc… Having an understanding of what might typically happen after such events adds to the toolbox. Over time you’ll start to collect a lot of tools so that you’ll have one for a variety of situations and be able to call on them frequently. The majority of people just forget. So having such tools at your disposal can be a profitable advantage.

And I believe that events that happen seldom can often be the most predictable in terms of market action, because traders are less apt to jump all over them thinking they know what to do in advance. For example, how tradable is the January effect? It’s become very untradable.

But on the other hand there seems to be a direct correlation between the disenfranchisement with stocks over the last five years and the level of interest in commodities. When you look back at the 70s the pattern was similar. I like to pick up old trading and investing books whenever I happen on them. I recently realized that I have a lot of commodities books from the 70s and the newer ones were mostly new editions of books also first published in the 70s. When you compare the CRB to the S&P and Dow during the 70s and from 2000 through today, there appears to be an inverse correlation that fits well with history, logic, and reason.

It might not happen again until I’m an old man, but the next time people become severely disenfranchised with stocks I’ll be getting long commodities in as big a way as possible. I’ll put that in my toolbox of market lessons. What’s interesting is that it is a uniquely insightful observation, but unfortunately as is typical one made in hindsight. Rogers was calling for a rally in commodities in 2003. Maybe he saw it coming for the reasons I’ve cited. But if he did, it wasn’t among the reasons he has provided the public with. So I think his recent success and now accidental failure in the commodities market may have been nothing more than coincidental timing, because the demand related reasons like the one involving refiners that I’ve cited aren’t very well grounded from an economics standpoint. My friends Niederhoffer and Kenner pointed a number of these economic inconsistencies out back in 2003, and did so far more eloquently and deeply than I am capable of in their article Adventures with a globetrotting investor.

I’m always spouting off about how markets regress to the truth. But what is the truth. Clearly in this case economic logic hasn’t prevailed for quite some time. In 2001 through 2003 the truth was that money managers would take the path of least resistance. If they couldn’t sell a domestic equities growth story, they had to present a different growth pitch. That turned out to be an international equities and commodities story. They’re both bogus stories for reasons I’ve set pen to paper on many times in the past. But one truth of the markets was that people were positioned to be taken in by such bogus pitches. A bigger and broader truth is that in time investors wake up to bogus stories. It’s looking like we may have reached that point in time with commodities. But it’s very hard to say for sure.

The inflation scenario will probably be a major determining factor. If inflation starts to creep into core prices in a significant way, then commodities will likely remain hot, which scarily to say will further exacerbate the core problem. Then we do have a 70s situation again. If the Fed and other market forces manage to keep prices out of the core then the pressures will likely reverse course and producers will push back on commodity providers. In which case commodities will fall back out of favor. I really do think the latter is the most likely course, because it’s the path of least resistance. The consumer is taxed, so the producer has difficulty passing on costs. But many commodities providers are experiencing record margins. So whom are the producers going to push on? They’re going to push commodities suppliers for better prices. If the system is a wave consumers are the trough, producers are in the middle, and commodities suppliers are the peak. As the wave regresses toward equilibrium the consumer has to be pushed up, and commodities down. But for the time being the markets are experiencing a hurricane of their own.

posted at 6:15 PM 0 comments

The power of free speech is not exclusive...

I picked up Jim Rogers’ book Hot Commodities yesterday. I hated to pay for it, but I don’t want to be a critic without having read it. I didn’t have to delve very deeply before I hit on the inconsistencies, misinformation, and use of reflexivity.

The thing you must realize about Rogers, Soros, and a few other of the market royalty is that it’s hard to believe anything they say. They are living examples of the liar paradox. What’s strange is our desire to believe them. Soros has long admitted to practicing reflexivity in the markets.

In the markets reflexivity means that if you are trying to predict the future, then your predictions and actions related to those predictions impact the future. This is somewhat meaningless to us normal people. But when someone managing enough money to move markets says they practice reflexivity, it’s a fancy way of saying they manipulate markets. They make their prognostications come true. If they say they think that there will be a bull market in commodities, they are trying to make a bull market in commodities. What we never know is whether they really think there would have been a bull market in commodities even if they hadn’t used their powers of persuasion and suggestion to help create it.

If you believe that predicting a bull market in commodities will make it actually happen, well then why let the truth get in the way of making money? You’ve got a virtual money making machine. Buffet, the big brokers, the massive hedge funds, they all do it.

One of the first things that caught my eye in Hot Commodities was the following passage citing reasons for higher oil prices: “The U.S. has not built a new oil refinery since 1976—and the number of domestic refineries has actually decreased by more than half since 1982 (from 321 to 149).” Long-time readers of this blog know that I’ve complained numerous times about how the media and analysts were frequently stating these misleading statistics. Now I know where they were getting it. If Rogers says it, it must be true, right?

I’ve been critical and suspicious of Rogers’ intentions. But one thing I’ve not criticized is his intelligence. No doubt he’s extremely intelligent. Now a far less intelligent person with only a modicum of business savvy can see right off what’s wrong with the refining statistics. The problem is two fold. First off is the one I’ve covered most often here, which is the fact that limiting refining capacity limits oil consumption. If refining capacity is limited then refiners demand for oil is limited and there fore demand for oil is capped, which of course should cap the price of oil. I have to give credit to reader Paul Teetor who insightfully pointed this out back in April. The second flaw is a very basic business one. The number of refineries does not necessarily have anything to do with output. You can make a million widgets in one really big factory or one hundred smaller factories. It’s a million widgets either way. This is precisely the case with refining. Refiners have had no trouble whatsoever increasing output from existing refineries. They can increase the output of existing refineries without having to navigate the rigorous approval processes to build new ones. Also, they can just import more. And that’s what they are doing. How difficult is it to get a new refinery approved to be built just over the border in Mexico? Slip the right authorities a few hundred Gs? Seems to me, they’d love to refine our gas, especially at more than $2 a gallon. Obviously, since the hurricanes put several refineries out of commission and inventories of refined products keep building anyway, we don’t have a refining issue and even if we did it should push down oil prices.

This is coming from a book that’s spent time near the top of Business Week’s Business Best Seller list. It’s in just about every major bookstore, even my smallish local Borders, which has a horribly limited and mainstream selection of books on the markets. People read this book. The subtitle says that the commodities market is the world’s best market. Of course you want people to believe that if you’ve got say a billion dollars invested in them.

Like I said this is a very smart guy so I have a hard time believing that he believes any of the nonsense I quoted above. If he does believe it, he’s not as smart as I think. If he doesn’t, then he’s a manipulative bastard and the media, analysts, and investors are bunch of gullible, ignorant, idiots.

When oil prices were hitting the high $60s before the hurricanes hit one of the most common reasons cited by said idiots was the quote above. We heard the excuse over and over again as Rogers’ funds raked in the profits.

Now you’ll never hear me say a guy shouldn’t be a speculator or shouldn’t profit from a change in prices when he can. I’m not out here calling for some idiotic regulations or windfall taxes. But if Rogers has the right to say such things, then I have just as much right to say what a bunch of manipulative B.S. it is.

posted at 3:14 PM 2 comments

Sensationalism creates opportunity

The first thing I heard when I turned on the TV this morning was a bold voice over asking rhetorically if energy shortages will continue forever.

WHAT SHORTAGES? I felt like shouting out in frustration. Here we go again, I thought. Can I take another day of immersion in sensationalism and hype? Maybe it’s just getting to me this week. Maybe I just need a little break. But it seems to me that ever since the hurricanes news began to grow stale the level of sensationalism has been elevated. The mainstream media is like a heroin addict. As soon as the high of one story wears off they’re looking for a new fix. It doesn’t seem to really matter whether a story is newsworthy or not.

In music it doesn’t matter much whether the latest teen pop sensation can sing or not. The producers can make a star out of anyone with the right look and moves. The media can do the same thing with any story. A few out of context interviews, some emotionally directing sound, selective video editing, and the MSM can make a story out of anything.

The secret to making a story out of nothing is that the audience can’t know or understand the facts. The MSM wants people to believe that bird flu is going to run rampant through our country. Never mind that the virus can only be transmitted from a bird to a person, and it can barely do that. The media just says that the bird flu is spreading. They don’t bother to tell you that it’s spreading in birds, not people. They don’t bother to tell you that only about 60 people have ever been killed by it since 1987, while 20,000 people die of the regular flu in the U.S. alone every single year. They just keep saying over and over again that the bird flu is spreading. Take cover.

The media keeps saying that the president is in big trouble over his Supreme Court nomination. They never say what was bad about it. They just keep saying that the president is in trouble for it. The same with the CIA leak investigation. The president is in trouble over that too, according to the media. But they never say what he’s in trouble for. They just use a lot of adverbs and adjectives to describe how much trouble he’s in, and I guess it’s a lot. Why should he even care? It’s not like he’s going to be impeached and it’s not like he can run again.

Between the nonstop media flap about the bird flu, the Supreme Court, the CIA leak investigation, etc… the financial media has barely even given coverage to the earnings season. To listen to the little bit of coverage there has been you’d think earnings were coming in horrid when in fact somewhere around 70% of S&P 500 companies have beaten expectations, while only about 15% have missed and 15% met expectations.

It seems that almost everything I hear from media lately is sensationalized to the extreme.

Have you ever gone to the gas station and not been able to get gasoline? Has natural gas stopped flowing to your furnace? Has the fuel oil truck not shown up to fill your tank? Has there been a run on the little one-quart bottles of motor oil? WHAT SHORTAGE?

The hurricanes hit and took out a sizable chunk of our crude, natural gas, and refined products production. Yet ever since then, supplies and inventories of most products have been climbing. Why? I for one have been lighting a fire in the wood stove every night for more than a month now. My natural gas furnace only kicks on sporadically. It would be running almost constantly otherwise. Up here in the mountains it’s been below freezing most nights for a quite a while now. I’ve also been driving a used car that gets decent gas mileage more often than my beloved old jacked up full-size Jimmy. Am I the only one that’s made an effort to conserve? Obviously, I am not. It’s showing up in the data every week.

The energy bulls still come on TV and talk about how much production is shut in, shortages, disruptions, etc… But the industry experts are mostly now saying that stocks of heating oil are fine, the flow of natural gas is adequate, and refiners will be at 100% of previous capacity utilization by the end of the year. So where’s the price of oil and gasoline going to go when refiners are pumping out as much as they were before and we’re still demanding less?

Really prices should fall all the way back to late nineties levels. In an efficient and competitive market they would. If producers are making more than people want to buy they should have to compete to sell and margins should fall to the point that inefficient producers have difficulty profiting and competing to sell.

But that’s not the case when a market is driven by speculation such as the energy markets have been. Speculators have used the excuse of future problems to justify higher prices today. But there’s nothing logical about this. Why should a futures contract for oil to be delivered next month price in the world demand growth ten years from now? It shouldn’t.

This has been caused by an increase in stock investors playing the futures markets and not understanding the game. That’s why the commodities markets have gotten so out of whack. The stock investors price future demand into contracts that expire in a month or so. If they believe that demand for oil will increase they should be buying futures contracts for delivery well into the future. Apparently, nobody really believes the growth hype because you can lock in a barrel of oil for delivery in 2011 for just $56, while a barrel in December will cost you more than $60.

Now I hear energy bulls using the excuse that we’ve still got production shut in to justify $60 oil. So why then, did oil hit $67 weeks before the Katrina? At least one thing is working in the market. Inventories are climbing and prices are lower, despite the supply disruption.

But it’s darned frustrating to listen to people talk about demand outstripping supply when the producers keep having to put supply in storage tanks because no one wants to buy their product.

At least I can laugh at all the sensationalism and feel good about myself knowing that I’m putting out the truth.

The way I visualize the markets is that the correct price represents a nebulous truth surrounded by prices that represent misinformation, misunderstanding, and manipulation. Truth is the gravity of the markets. Prices might defy the truth for a while, but eventually they are pulled back in. When you think of the markets like that, misinformation equals opportunity, as hard as it might be to stomach at times.

posted at 12:57 PM 0 comments

Wednesday, October 26, 2005

Fed futures indicating three more hikes at least...

The February fed futures dropped 0.0350 today, down to 95.5550, indicating an expected rate of 4.45% almost fully pricing three more quarter point rate hikes under Greenspan’s watch. The April futures dropped a whopping 0.550, to 95.4150, indicating an expected rate of 4.59% for which the markets are starting to price in the possibility that Bernanke will continue to hike rates.

posted at 3:30 PM 0 comments

Tempted

Amazon.com’s 3rd quarter results included an ‘unanticipated’ $40 million charge related to the settlement of a patent infringement case in which the company got a dose of it’s own medicine. You may recall that a while back Amazon.com sued Barnes and Noble unsuccessfully over its ridiculously broad 1-Click shopping patent.

The stock’s down big today after an onslaught of articles have said that the company is overvalued and the outlook isn’t all that good. Off $6 and change, the stock is tempting.

posted at 2:41 PM 1 comments

Energy Markets Being Politicized

I normally steer wide around anything of a political nature on this blog. But I’ll make an exception in the case of the ‘windfall’ profits tax that has been proposed to punish the oil industry. I’ll cut to the chase and say right up front that this might be the most economically ignorant proposal I’ve ever heard.

Early in the year Social Security reform was at the forefront for a month or so. I have long been against the idea of putting social security money in the stock market because such a program wouldn’t be secure and we’d have to call it the Social Insecurity program. I said these things when Social Security reform was just being talked about, well before the president came out with his ignorant and naïve plan, which turned the reform issue into a political battle with the democrats against using the stock market and republicans for it.

I stuck to my belief all along. It had nothing to do with politics. Completely independently I came to the conclusion that putting social security money into the stock market was a bad idea. I based my conclusion on my understanding of markets. Most people don’t understand that the markets are a product much like any other product. There’s a certain supply of that product available at any given time. When demand for stocks rises, the IPO market booms. The IPO market is the factory that manufactures stock certificates. The downside of the fact that we no longer hold the paper stock certificates is that we’ve lost touch with the reality that there are only so many certificates available at a given time. When demand for stocks rises, prices rise. Nor do most people fully understand the extent to which the markets are subject to certain inefficiencies such as manipulation, emotions, and sector rotation.

I just went to Amazon.com to look up the publication date of Jim Roger’s book Hot Commodities and front and center before I had searched anything was this:

Customers with similar searches also purchased:
Hot Commodities
According to Jim Rogers, "commodities get no respect." Here are a few reasons why he thinks they should: they are easier to comprehend and study than stocks and behave more rationally since they are…

Maybe commodities did behave more rationally than stocks or maybe not. They certainly haven’t behaved rationally ever since the book hit shelves at the end of last year, just one year after the mutual fund scandals sent portfolio managers scurrying into the underground world of hedge funds bringing billions in assets with them.

The markets always regress to the rational, but they never behave rationally. When you think of a stock as a partial claim on a companies assets and profits, that’s rational. When you think of a bond as a loan to be paid back with interest in the future, that’s rational. But the secondary and futures markets are anything but rational. Bond values ebb and flow for all sorts of reasons. If you hold a bond from issuance to maturity you know exactly what your return will be, though it may be hard to say what that money will be worth on an inflation adjusted basis. But if you buy and sell bonds in the secondary markets you’re at the mercy of the markets.

Traders have been bemoaning a lack of day-to-day volatility in the markets since the bubble burst. But in the bigger picture sense the markets have been anything but static. Take a moment and seriously ponder just how variable stocks and commodities have been over the last ten years. It should be incredibly obvious to everyone that such markets are a horrible place to put Social Security funds. We might as well give it over to venture capitalists.

It was interesting and humorous that some readers, following along with the political aspects of the social security reform debate, thought that my views made me a democrat. I was just being an independent thinker and got caught in the middle. The truth of the politics is that if the president had said that it was a bad idea to social security money in the stock markets, then the democrats likely would have said we should put money in the markets and the republicans were trying to keep the working class in their place by denying them access to the benefits of the rich. And readers would have called me a republican.

Over the same period of time I’ve been ranting and raving about speculation being the key driver sending commodities prices higher. I think it’s important to understand why something in the markets is happening and not be in denial about it. By speculation I simply mean that there’s been an increased interest in commodities such that the demand for commodities as an investment vehicle has exceeded supply. In turn rising prices can create a hording mentality so that people buy more than otherwise of both the actual commodity and the futures contracts if they are concerned that prices will continue to rise. Only when prices get very high does demand destruction begin to outweigh this hording and speculative mentality.

Now the energy markets are being politicized. Don’t think that because I’ve adamantly written about speculation in the markets that I think a ‘windfall’ tax is a good idea.

posted at 1:33 PM 0 comments

Rogers fights back by suing Refco

Rogers fights back by suing Refco
Investment guru Jim Rogers suffered a black eye in the Refco Inc. collapse, but he's now taking some swings of his own.

posted at 10:12 AM 0 comments

Tuesday, October 25, 2005

Dittmer to the Rescue?

Dittmer to the Rescue?
The former Refco CEO is reportedly building a $2.5 billion warchest to bid on the company's futures brokerage business

posted at 2:57 PM 0 comments

The Great Bernanke Google Bias

Consider that part of the reason that the media is giving so much attention to Bernanke's deflationary comments is because it's the third item of 406k in a Google search. Just because he's spoke about deflation does not mean he's not an inflation hawk too. Perhaps it's just he felt that all the attention was going to inflation when deflation could also be a problem and no one has been addressing it since the last time it happened here was 70years ago vs. inflation 30 years ago. But since it's happened in Japan it makes sense to address the possibility.

It's logically flawed to impose on Bernanke that he doesn't care about inflation just because he's made an effort to understand deflation. Of course the media never bothers to read anything he's written, preferring to just copy off each other’s notes. In his November 2002 Deflation remarks he said, "...I believe that the chance ofsignificant deflation in the United States in the foreseeable future is extremely small..." It wasn't until the summer and fall of 2003 that analysts started talking incessantly about deflation and that sentiment went away when the Fed changed its bias at the beginning of 2004. Bernanke was a voting member of the FOMC from 1% up through 2.75% in March of this year.

posted at 2:47 PM 0 comments

Hurricane Destruction

This has nothing to do with the markets, but I thought it was interesting enough to pass along:

Hurricane Destruction
Could science end Mother Nature's seasonal menaces?

posted at 1:13 PM 0 comments

We already have an inflation target...

I don't see what all the fuss over inflation targeting is. Bernanke might not be as hot on inflation targeting once he’s in charge. Any rigidity in an inflation target is the same as giving up power and control. A Fed governor can have an inflation target that drives policy without an official targeting plan. Indeed, Greenspan has certainly had one. The only thing that would be different about an official target would be that it’s official because no doubt the target would be a fairly wide range of say 0.5% to 3%.

Here’s an interesting little chart I worked up. You can see that the average for the CPI before in all the years prior to Greenspan was actually lower than during Greenspan’s tenure at Fed. However, that is deceiving because the deflation of Great Depression pulled the overall rate down. You can see that prior to Greenspan the CPI was far more volatile with an annualized standard deviation of 7.65% from 1921 to 1987, compared to only 2.96% under Greenspan.

CPI	Avg.	Avg. Annual	Stdev	Stdev Annual	Var.	Var Annual
1921 - 1987	0.23	2.72	0.64	7.65	0.41	4.88
1987 - 2005	0.26	3.06	0.25	2.96	0.06	0.68

posted at 1:05 PM 0 comments

What really moves the markets...

I could give you a list of Bernanke articles to read. Google News shows nearly 2000 such articles. But Bernanke’s already old news. I don’t think he’s going to move markets until he takes the chair position and people are antsy to see how he meshes with the FOMC members. I won’t go so far as to say it’s over-hyped though. It is an important and interesting topic.

Today the contrarians have been out in full force simply buying everything that was down yesterday and selling everything that was up. There’s nothing much else moving the markets right now. Bernanke overshadowed earnings. Over the rest of the week I expect to see earnings move back into the driver’s seat.

The Refco saga continues to be interesting: Flowers dropped out of the bid for Refco

Here’s a fun little tidbit: Savvis CEO on leave amid strip club flap
$240k? Yow. The strip club should go public.

posted at 12:11 PM 0 comments

Monday, October 24, 2005

Were did all the gloom go?

Bernanke is getting almost unanimous approval from analysts, economists, past Fed leaders and especially investors and traders who have pushed the DOW up 125 points thus far today. After almost two straight weeks of selling at the beginning of the quarter the move is a breath of fresh air.

posted at 3:12 PM 0 comments

Bernanke: Fed Chairman Nominee

Wall Streets not talking about much of anything except Bernanke the new Fed chairman nominee. We’ve got a very nice rally in the works on word from the White House.

Here’s a link to Bernanke’s comments on Deflation:
Deflation: Making Sure "It" Doesn't Happen Here

posted at 2:39 PM 0 comments

New Fed Chairman to be announced 1PM

The WSJ is reporting that Ben Bernanke will replace Greenspan as the chairman of the Fed. The official announcement is to come at 1 PM EST. You can get that information more readily from traditional media sources. I’ll digest what the markets have to say about that decision and respond from that perspective. If Bernanke is confirmed we might see an additional pop in stocks as some uncertainty is removed.

posted at 11:23 AM 0 comments

Friday, October 21, 2005

I’d take a little deflation about now...

The deflation of the 1930s was obviously a very serious economic problem. Basically, people were unwilling to spend at any price. So producers went out of business and people were put out of work, multiplying the lack of spending problem. When the banks and brokers failed, people put what little money they had left under their mattresses. The economy just shut off.

In the 1970s was different because the problems were tied to higher commodities prices. People still wanted to spend, they just didn’t get as much for their money. Less than half as much by the time the 70s were over. What kept the economy of the 70s from tipping over into a 30s like depression was the fact that inflation causes people to spend more, not less. When prices are rising, you have to buy things right now before prices go up any further. It causes panic buying and stockpiling.

The deflation that everyone was talking about two years ago was a bunch of hooey because it was entirely related to an increase in purchase of foreign goods. If China wants to lower prices on the goods we buy from them, then we are better off all things being equal, meaning not taking into consideration the flow of manufacturing and jobs to that location. But there was never any threat of local deflation due to a decrease in consumer spending. Ironically, pundits were simultaneously congratulating the consumer for spending throughout the recession helping to make it a modest one and complaining that consumers were taking on too much debt and not saving enough.

Greenspan is right when he says that home equity has infused flexibility into the economy. Refinancing to lower rates and tapping into home equity carried a heck of a lot of people through job losses a few years ago. In the Denver suburb I was living in at the time houses were for sale or rent everywhere you looked and the job market absolutely sucked due to Denver being so heavy on telecom and other tech related jobs. But home prices never fell. They stagnated for a bit then jumped higher by about 20% over a couple of years. Fed rates of 1% had a heck of a lot to do with that. It enabled mortgage lenders to drop rates considerably while maintaining a sufficient margin between short and long rates. A lot of tech workers suddenly became mortgage experts filling the demand for refinancing and home equity loans.

There’s no doubt that the Fed stimulated the housing bubble and that the ease of tapping into home equity enabled consumers to weather the recession better. But in order for that to work again in the future, people have to recharge that source of savings.

We were never at any risk of 30s like deflation because when prices of foreign goods deflate we can buy more with our money. And that’s a good thing. Now we’re concerned about inflation. And that is very real. The increase in home prices is inflationary. To the extent that home prices have risen faster than income that makes it harder for people to become homebuyers for the first time. Thankfully, the rise in commodities prices is mostly a speculative one. Any increase in demand that we’ve seen has probably had more to do with a panic inflationary buy now attitude rather than an actual consumption need. Commodities producers can supply us with most of the commodities we need at much lower prices so long as the commodities they use to get commodities also fall. For example, Caterpillar complained today that because demand for commodities has increased so much it can’t keep up with demand for its machinery and is experiencing production bottlenecks. At the same time it’s paying higher prices for the commodities it uses to make its machinery and that’s cutting into profits.

What CAT needs is a healthy dose of deflation in the prices of the commodities it uses to make its machines. And I think it will get it eventually, because I think there’s been a lot of stockpiling of non-perishable commodities in addition to rampant speculation in the futures markets. That means that at some point in the future producers are going to need to work through excess commodity supplies both from stockpiling and increased production stimulated by the increase in prices.

posted at 1:10 PM 0 comments

But they said the problem was deflation...

Fed officials have given me a lot of homework lately. I’ve read through most of what Fed members have had to say in recent speeches and there have been quite a few. That’s helps me to get a feel for the overall tone and sentiment of the Fed and how their going to react to the economy.

When you put all the recent comments together the overriding sense that I get is one of uncertainty and frustration over the economic data they are seeing. Prior to the hurricanes the Fed was on a path to a neutral level. Since the Fed never really says just what a neutral rate is, that has been a point of disconnect between the Fed and investors. I’ve pointed this out numerous times. Investors have only recently begun to understand that the Feds neutral rate is higher than they like to think it is. The neutral rate isn’t an exact point it’s a range probably starting at around 4.5%. Fed officials have expressed this somewhat subtly by saying that they’re still heading toward a neutral level at a measured pace.

After the hurricanes the Fed is still saying it is heading towards a neutral level at a measured pace. But members are leaning more towards the possibility of having to increase the pace of rate hikes than towards pausing. That’s despite the fact that they recently began to express concerns about the toll increased energy prices is likely to take on consumers and companies. But simultaneously they began to talk more about another source of inflation being wage pressures. The beige book noted that the labor market has tightened slightly.

The net sum of the situation through the Feds eyes is that headline inflation numbers are dangerously higher. That’s does two things; Erodes consumer spending on non energy related goods and services and raises producer costs. Thus far producers have eaten higher production costs. But the Philly Fed survey indicated that some producers were starting to pass on higher costs. If that increases then we will start to see core prices rise. If that happens there will be a serious and rapid erosion of consumer spending. But the 70s showed that producers can and will pass on costs even when demand is declining, which is an important point because it goes against economic theory. So the worst-case scenario is that producers pass on costs to consumers who can’t buy as much, producers make less, economic growth declines, companies stop hiring or even begin to lay off workers, and recession ensues.

Ironically, Fed rate hikes also serve to slow the economy. But it boils down to the worst of two evils; a moderate economic slow down due to tighter interest rates or a serious economic slowdown if prices are allowed to rise and sap the consumer’s ability to spend. In the latter case we’d get even higher short-term interest rates and serious yield curve inversion because the Fed would essentially need to reboot the economy. They’d need to completely shut it down and start it back up because the only way to contain prices would be to slow spending and therefore demand for the commodities driving higher prices.

Personally, I don’t think things will get that bad because the escalation in commodities prices is almost entirely a speculative one and speculators could very well turn around and speculate prices right back down again as soon as it becomes obvious to everyone that demand isn’t there then the speculators ‘should’ take their game somewhere else.

I’m hoping with Refco’s failure and Rogers now on the hook for several hundred million in commodities investments that that will be the catalyst to flush the excess speculation out of the commodities markets. With oil prices now dropping we haven’t heard from the multi billion-dollar oil hedge fund manager T. Boon Pickens in a while. Fundraising for Phase III of OSU’s Boone Pickens stadium has been put on hold. Reminds me too much of Enron Field, Invesco Field, Conseco Field House and all the other stadiums that have taken names from ego- and megalomaniacs along the way. When we do hear from T. Boone, it’s a safe bet it’ll be to try and prop up oil prices.

You should expect that at the first significant uptick in the core CPI the Fed will jump rates by 50 basis points, probably even between meetings, and keep on raising at that pace until the core numbers of inflation go back to basically zero. The Fed will go straight up to 6% - 10% without hesitation if it has too. Greenspan warned us of this possibility in his flexible economy speeches when he said that the Fed is notoriously behind the curve. Greenspan was saying that once the higher headline numbers begin to hit core prices, the Fed is already behind. So it’s likely that as soon as there’s any sign that core prices might be going to rise significantly, the Fed is going to lean towards the safe side by trying to catch up to the curve. And it will do so by raising rates by much more and much faster than anyone is currently anticipating.

Could we be so wrong? Yes, of course. Two years ago the pundits were all worrying about deflation and a Japanese like prolonged slowdown with negative interest rates. They had it 180 bass ackwords.

For now it’s still trying to balance inflation with sustainable growth, its two primary responsibilities, but its first responsibility is to stable prices.

posted at 12:31 PM 0 comments

Thursday, October 20, 2005

Gold Fever

There are no sure indicators that a market bubble is going to pop. And you never know for sure that there’s been a bubble until after it does pop. But there are side affects, one of which is excessive greed. Enron, WorldCom, and others were side effects of the late 90s bubble. In the 80s Milkin, Boesky and others were side effects of the raiding and junk bond trading of that era. There have been countless others throughout Wall Street’s history and they all had one thing in common, gold fever. When money gets easy, people get greedy. The Refco fiasco is a side effect of the recent excessive interest in commodities markets. Apparently, Jim Rogers is now a side effect of a side effect. One of Rogers commodity funds had $362 million in unsecured funds with Refco. The irony of it is that Rogers has been a big instigator of the commodities bubble via his book hot commodities and publicly advocating commodities as an investment. His advocacy drew public attention to the commodities market, which supported the trend in commodities speculation that enabled Refco to go public this year and made funds readily available for rapscallions like Refco’s Phillip Bennett who hid hundreds of millions in debt.

Woops. That’s what you get Jim for your part in instigating a speculative mania in commodities that’s now afflicting the economy with a resurgence in 70s like energy and commodity inflation that’s siphoning off consumer spending worldwide, all just to pimp your funds and pump up your wealth by taking advantage of innocent and ignorant average people.

posted at 4:17 PM 2 comments

More on Diesel

With regard to the response to the diesel fuel post. The input is appreciated. Anonymous comments are fine. I read each for content. For all I know my own parents could comment and would likely be inclined to disagree with me. So I’m conscious of trying not to be condescending or overly arrogant. But I won’t shy away from a debate, particularly if it involves logic and reason. Do feel free, however, to tag a first name on to the end of comments, as it makes it easier to reference them.

Everyone has an opinion on the energy markets, but the vast majority of people don’t fully understand them because they get their information from the mainstream news and local newspapers following politics and such. But the mainstream news does not get into futures aspect of energy prices and therefore people only get part of the picture.

In the case of diesel fuel there aren’t any exchange traded futures contracts. But, as I understand it, the price is set at relatively stable premium to heating oil, which of course does have exchange traded futures contracts. The same is true of sour crude, except that it trades at a discount to light sweet, but that discount has narrowed recently as more refiners are now able to extract the higher level of sulfur and essentially purify it to and produce end products of the same quality as from light sweet. Valero, which also owns the Diamond Shamrock retail distribution network, is a leader in this capability.

As most readers are probably aware that heating oil has been trading higher in part due to concerns that refiners are behind in reallocating crude from gasoline to heating oil for the winter. But we saw a massive build in natural gas stores last week despite serious problems. We also got significant builds in crude and gasoline inventories. The sudden spike in prices after the hurricanes was sufficient to stimulate conscious conservation as retail consumers seek to minimize the financial impact of higher energy prices.

In my opinion such conservation will be somewhat sticky, meaning that even if prices drop substantially people will have gotten used to conservation efforts and won’t fully return to an complacent attitude towards energy consumption. For example, people with fireplaces are apt to order in a stock of wood and burn it throughout the winter, regardless of natural gas and heating oil prices, which will result in a surprising collective reduction in demand throughout the winter.

Back to diesel. The main difference between diesel and heating oil is that diesel has a lower sulfur content. Hence the premium for diesel over heating oil because there’s a cost associated with removing the sulfur. And this is why the price of diesel is generally more closely related to heating oil than gasoline. There is a seasonal pattern of diesel being higher than gasoline in the winter during the months of higher heating oil demand and lower than gasoline during the summer. But the EIA had this to day about diesel prices remaining higher than gasoline throughout last summer, “Generally, the summertime is dominated by gasoline demand here in the United States but, this year, surging global distillate demand in Europe and Asia has retail diesel selling at a premium over retail gasoline.” You can probably guess that I don’t buy this explanation. From December 2003, which represents the height of the mutual fund scandals and the start of the extremely sudden and otherwise unexplainable speculative interest in the energy markets, the price of crude rose to a maximum gain of about 130%, heating oil 150%, and gasoline more than 300%. The rampant speculation in the energy markets permeated all energy related contracts including propane, natural gas, coal, and electricity. All the energy markets were trading substantially higher than a couple of years ago even before the hurricanes hit. The increases are directly related to the increase in interest that started in the oil futures markets and spread over into the other energy related futures contracts.

The upcoming changes to diesel formulation do not explain current higher prices. According to the EIA there is no specific requirement to change diesel fuel, but rather a requirement of the EPA that starting with model year 2007 diesel engines have to meet more restrictive pollution standards. And the equipment needed to meet those standards requires a lower sulfur diesel fuel. So refiners will have to provide a lower sulfur diesel by the time the 2007 models come out in mid 2006. If it doesn’t cost any more to refine diesel now, then there shouldn’t be any additional premium yet. I’ll stick with my speculation explanation. The price of diesel is being driven by the price of heating oil futures, which are in turn driven by crude oil futures. So for diesel we’ve got a speculative double whammy. And since prices of gas and distillates have increased by a larger percentage than oil, the refiners are most definitely beneficiaries.

posted at 12:02 PM 3 comments

Wednesday, October 19, 2005

CRB

Here's a chart of the CRB going back to '75 where you can see how the spike between '75 and '80 looks just like the one over the past several years. And it wasn't just driven by energy. PPI components that exclude energy prices show the same pattern. The common denominator is an increase in interest in commodities speculation, which correlated with a prior decrease in interest in the equites markets.

posted at 5:33 PM 2 comments

What about diesel?

A reader asks:

Something that I just don’t seem to be hearing about anywhere is the price of Diesel fuel. It was always my understanding that it cost less to refine diesel fuel, therefore the price would be cheaper than regular gasoline. If that is true, then why have we continued to see the price of diesel fuel above that of gasoline for a while. Obviously higher diesel fuel cost impacts everyone, given the importance that trucking plays in delivering goods to market. So everyone is paying for this.

My questions are simple:
1. Why is diesel fuel still higher?
2. It would seem refiners are winning here with higher diesel prices, is that true?
3. Will the price ever come down below gasoline again?
4. Is there a trade out of all of this?

Some of you may remember when gas prices spiked back in 2000 – 2001. There were complaints of price gouging and states were even so concerned about the economic implications that many temporarily repealed their gas taxes. But it wasn’t just gasoline prices that spiked. Natural gas also shot up. Why did prices spike and what was the connection between the two? It was speculation then, just as it is now. There was no fundamental explanation and no connection between the two commodities.

Notice that I’ve never claimed that there’s any sort of conspiracy, nor have I ever said that people shouldn’t speculate. I am just interested in the real reasons that things happen regardless of whether they are good or bad.

Speculation is chaotic. Markets are not perfectly efficient. Markets do not reflect perfect information. Nor are they random. The reality is that they are the sum of all of these things. They are somewhat efficient reflecting some of the available information, often times misinterpreting the available information, and at times acting quite chaotically.

The answer to #1 is that diesel prices are still high for the same reason as gasoline prices. Much of the reason for high gas prices is due to high oil prices. But much of the reason is purely trading related.

The answer to #2 is the crack spread, which is the difference between the price refiners pay for a barrel of oil and what they get for the refined product. Generally speaking the rise in prices has been good to the refiners, but the crack spread has been volatile to be sure. But it’s more complicated as to how companies benefit because most refiners are owned by oil companies and / or own distribution networks. BP, for example, produces oil, refines it, and distributes refined products. So BP has profited at every possible point in the energy network. Diesel is just one of the numerous refined products. But I don’t think there’s any sort of real conspiracy at any of these points. Cartels certainly don’t help matters. And there’s probably a lot of price collusion going on, particularly overseas. But those things have always went on, so they have nothing to do with the recent rise in prices.

As to #3, I do believe that prices will begin to more accurately reflect the supply and demand for the various energy products in time. This will happen when speculators lose interest in the energy markets. I can guarantee that they will, but it’s hard to say when.

I’ve been doing some thinking recently about similarities between today’s markets and the 70s. My personal theory, or rather explanation, for why there’s been such an increase in interest in the energy markets is that it’s directly correlated with the disinterest in the equity markets. People got pretty beat up in the equity markets between 2000 and 2003. Then came the mutual fund scandals and mass fund redemptions. Mutual funds were closed and consolidated. Fund managers were fired. Since few funds were hiring they started hedge funds and the timing couldn’t be better for getting assets. They stole disenfranchised high net worth investors from the funds they used to manage. All of a sudden we’ve got hundreds of money managers out there with billions to invest who previously could only buy stocks. Now they can do just about anything they want. Naturally they’re going to want to try their hands in the futures markets. They take the path of least resistance. The start of the rise in commodities prices correlates perfectly with the mutual fund scandals. Jimmy Rodgers puts out a popular book telling the world to buy commodities. Of course he runs commodities related hedge funds. Commodities were the easy sell.

Looking back at the 70s there was a lot more going on than just the problems with oil. The Dow stalled out around ’65 and didn’t go higher again until the early 80s. The S&P performed nearly as badly. People were very disenfranchised with the equity markets in the 70s just as they have been recently. Commodities speculation took off then just as it has recently. A plethora of books on commodities came out in that era. I have quite a few out of print books on my shelves that I’ve picked up in small town book sales over the years. It was a heyday for commodities speculators. Commodities were simply acting as a substitute for equities as an investment. The result was that prices doubled in five years time. Not just energy prices. All prices. Producers absorbed higher prices for a short time, but later they passed on almost all of their increased costs even in a bad economy.

So the answer is that diesel prices won’t get back to where they should be until the speculators lose interest. Will that be before or after they cause a recession? I really don’t have a clue. I’m not a bear, but I am acutely aware of the possibility of more serious inflation and recession. That’s precisely what the Fed has been trying to warn us about.

People like to blame the Fed for ‘monetizing’ the inflation of the 70s. They blame the Fed for monetizing the bull market of the 90s. They blame the Fed for every bad thing that happens in the economy. To be sure, the Fed makes mistakes. But every mistake the Fed makes is a reaction to our own excessive greediness and propensity to speculate. There are always lots of reasons for what happens in the economy.

A recent article by Bill Fleckenstein blamed the Fed for monetizing the stock market bubble of the late 90s. I don’t agree much of anything that Fleckenstein has to say and this was no exception. Though in ‘03, when just about everyone was crying deflation and talking about similarities to the 30s he did warn about inflation. I did also in February of last year when I wrote Don’t Shortchange the Dollar. I said, “About the same time the Fed decides it's time to raise rates, expect a re-commitment to the dollar's strength from the U.S. government, because the two go hand-in-hand. A weak dollar puts upward pressure on the prices of goods imported into the U.S., and therefore is a potential source of inflation. At the point where the economy is deemed sufficiently on sound footing, and the threat of inflation becomes detectable, the Fed will likely look to raise rates and support the dollar in the currency markets.” But I believe the advent of online trading had a whole lot more to do with the bubble than Fed rates. All of a sudden any average Joe, including myself, could plunk down a few thousand bucks and for about the price of a movie bet on the direction of stock prices. Just about everyone was suddenly a stock trader. What did the Fed have to do with that? I don’t know anyone who borrowed money at short-term interest rates to play the stock market. Though there were plenty of people who borrowed at the highway robbery rates their credit cards charged, borrowed from their 401k plans, and against their homes.

So the price of diesel fuel is likely to remain chaotic as long as there’s rampant speculation in the energy markets.

Is there a trade? There’s always a trade, but it’s not for everybody. Obviously, the energy futures markets are extremely risky. But I’ll go out on a limb and suggest that oil, gasoline, diesel, heating fuel, and natural gas will all be lower six months from now than they are today. Though I’d also expect the energy markets to get very jittery as summer approaches over hurricane concerns. Then I’d short the spikes because they will be emotional, reactionary, unfounded, and overdone.

posted at 5:01 PM 1 comments

The Disconnect

In comment to the It’s Speculation I Tell You post a reader replies that he believes I’m misunderstanding the supply and demand implications on energy prices. You can read the comments at the link above where this person talks about global demand, supply, geo politics, terrorism, etc… as reasons for higher energy prices.

First of all, let me say that I have no intention of insulting the readers’ intelligence. This person’s comments are quite typical and normal. The things said are the things said in the media day in and day out. If you ask people why they think energy prices are so high 99.99% of people will give you some variation of the reasons stated by this reader. People who know I write about the markets ask me all the time what I think about the energy markets. Mostly they want to know how much they’re going to have to pay for natural gas this winter and where gasoline prices are going. Just yesterday getting my son from the bus a neighbor said that energy prices were high because of deregulation.

Market experts, economists, traders, and even exchange officials still barely understand the complex relationships between futures contracts, spot prices, and the economics of supply and demand. Keynes is the first economist credited with recognizing and trying to understand disconnects between supply, demand, employment so on and so forth. I don’t want to get into the beliefs of various economists, Austrian schools of thought and all that. But I will say that our understanding of disconnects is still very crude. What I can tell you about them is that investors, traders, academics, and pundits alike prefer to ignore them in favor of thinking in “all things being equal” theoretical terms where the models are simplest. Disconnects break basic economic models, which is inconvenient, because when you bring in disconnects the models quickly become too complex.

The media and analysts have been telling us for two years that energy prices are rising because global demand is rising. They say China is growing and demanding more and more oil. These things are true. They also say that the cost of obtaining oil is increasing. These things are true. But it’s a one-dimensional way of thinking about the problem that ignores the influence of the futures markets.

To the people who say these things I ask what does that have to do with the spot and front or close month futures prices for oil? Of course it’s a rhetorical question and of course I’m going to tell you why they have nothing to do with each other. If you think that in the future demand for oil will exceed supply because of global consumption growth then you should want to invest in futures contracts far in the future. China’s need for oil ten years from now should have absolutely nothing to do with oil prices today. The oil backing a December futures contract is going to be delivered, refined, consumed roughly speaking within the next several months. So to say that a barrel of oil is worth $60 today because China is going to want more ten years from now makes no sense whatsoever.

If you think that demand is going to outstrip supply in the future because of growth in China, terrorism, or whatever, then logically you’d hedge or speculate on contracts far in the future. Apparently, people either don’t understand this concept, don’t really believe what they are saying, or are not convinced enough to put their money where their mouths are. This list of recent prices for oil futures contracts shows that you can lock in the price of a barrel of oil in 2011 for quite a bit cheaper than you can right now.

Contract Last
Dec '05 62.42
Dec '06 61.25
Nov '07 59.08
Dec '07 58.75
Dec '08 56.9
Dec '09 55.76
Dec '10 54.86
Dec '11 54.36

What that says is that people think oil will be cheaper six years from now than it will be today. But how can that be? After all, demand has grown enough in the past five years to warrant prices tripling. If demand keeps growing at the rate it has shouldn’t prices triple again to $180 a barrel? No of course not. This is the disconnect. The fact is that hedge funds are buying near month contracts and rolling them over staying long.

The price of a barrel oil isn’t just related to the supply and demand for oil right now. It’s also tied to the supply and demand for futures contracts. When a lot of people want to be long futures contracts the price of those contracts goes up. Another way to think of it is that when there are a lot of people who want to be long, the price of a contract reflects the level at which someone is willing to be short. If someone buys a contract someone has to write it. And when prices are rising crazy out of control people want a lot of money to take the short side. That’s where the price is now, which has very little to do with the current supply and demand for oil.

posted at 3:21 PM 0 comments

Tuesday, October 18, 2005

Mixed economic signals

We had mixed reactions in the markets today due to conflicting economic information. Greenspan’s said that energy prices would be an economic drag for the entire world. But simultaneously, we got a PPI reading of 1.9%, the highest level in fifteen years. Core producer prices increased 0.3%, which on an annualized basis of 3.6% is definitely on the high end of acceptable inflation levels for the Fed.

There’s a tug of war going on as to whether the Fed will expect energy prices to drag the economy down to where it needs to be or whether it will continue to raise rates. The bond king said that he thought the Fed would pause at 4% to 4.5%. Personally, I put his opinions right up there in the same category of tainted as the superspike oil report. There are massive conflicts of interest, the power to persuade, and an aversion to an inverted yield curve. I believe the Fed will keep right on hiking.

There’s a big picture implication of Greenspan’s two resiliency speeches, the speech on the economic harm of high energy prices, and the various hawkish speeches by FOMC members. The reason for Greenspan to stress the resiliency of the economy was to say that if the economy can take 9/11 and two hurricanes then it can take higher interest rates. His intention was to head off the negative sentiment surrounding higher interest rates. It was warning to expect them. The hawkishness of other Fed members backed this up. Then he says that there’s nothing he can do about high energy prices and if the economy weakens it will be because of energy prices, not interest rates. In other words don’t blame him.

He’s painting a picture. And the picture is telling us that the Feds first obligation is to price stability. The Fed has an obligation to sustainable growth as well, but it’s secondary to price stability and also dependent on price stability. The way the Fed sees it is that inflation would choke off growth. Higher interest rates will choke off growth too, but only temporarily and minimally since the economy is more resilient than ever before. And finally, blame high energy prices, not the Fed, when the economy does slowdown.

The picture is telling us to expect high interest rates, high energy prices, and an economic slowdown. It’s a bleak picture, but it isn’t inevitable. It’s also possible that just the beginnings of an economic slowdown could lead to less energy demand, the speculators either lose interest in the energy markets or get on the other side helping to drive prices lower, prices stabilize, and sales declines are offset by lower energy costs.

In that scenario speculators begin to take an interest in stocks again and stay out of energy. But it all hinges on energy prices, which we know have been artificially elevated.

posted at 3:38 PM 0 comments

It's speculation I tell you

For most products prices are set at the point of maximum profit. That’s not the point of maximum margin or maximum revenue. A company can sell a lot of something so that it has very high revenues. But if the margins are too small, then overall profits will be low. Vice versa a company can have very high profit margins but sell very few items and again have low overall profits. A producer seeks to maximize profits.

Say that the product is a game-playing machine. Some companies want to sell the game machine cheap so they can sell games, accessories, and future upgrades. They may even be willing to take a loss on the machine. In that case the company is trying to create a market. But imagine that it is just interested in maximizing profits. Finding the perfect price for most goods isn’t an exact science. In fact it’s incredibly complex because generally don’t have perfect information. This is why with new products prices often start high and then gradually fall.

For a new game machine with a price tag of $200 the company thinks it can sell say one million units. It also knows that there’s an initial pent up demand and that unless the game machine is put on a podium by consumers, with a ‘must have’ faddish mentality, then future demand at $200 is going to wane once the pent up demand is met. The company also knows that people know they can wait and prices will fall. So if they lower prices there is a new demand level waiting to buy at the lower price level.

Now say at one million units the average cost to manufacture and market the unit is $150, so the company has a $50 profit margin on each unit sold for a total profit of $50 million.

What happens if the company drops the price to $150? You’re probably thinking that the company is going to break-even. But at $150 let’s say the company can sell three million units and at that level the cost of production, marketing, and other costs of doing business drop to $125 per unit. If, for example, the company spends the exact same amount on advertising, let’s say $50 million, then the cost of advertising is $50 per unit at one million units, but drops to just $16.67 per unit at three million units.

So now the company’s profit margins have been cut in half to $25 per unit compared to $50 per unit previously. All the time I see investors punish stocks that have declining margins. Sometimes it is warranted. If margins are declining, but sales are relatively static, then profits will decline. But often times investors don’t go so far as to figure out what the real impact of a declining margin means for a company. In our example this game machine company is now selling three times as many units at half the margin. So the company’s margins are down 50%, but it’s total profits have increased from $50 million to $75 million, a profit gain of 50%. Obviously, the company is better off operating at the lower margin. And this is a reasonably realistic scenario.

The company seeks to find the point of highest profit. But it’s not always that simple. It might not have perfect information about demand at various price levels. And there are costs associated with ramping up production.

However, the demand for a game machine is far more complex than for an energy commodity. Game machines manufacturers compete with only a few other companies, each of which offer a unique experience and a certain amount of brand loyalty due in part to the ability to play games made for previous models. So really the game manufacturers are competing to increase their share of the total gaming population and to increase the gaming population. The energy companies don’t try to increase the number of energy users, except maybe in third world countries. And for the most part they don’t compete on brand loyalty. There is some level of brand loyalty for gasoline at the pump, but it is minimal and the gasoline generally doesn’t care who refined their gasoline or who produced the oil. A person may go to the same gas station for years believing that their station has better gas than across the street, when both order from the same distributor who in turn gets gas from the same refiner. Maybe the two stations are even refilled from the same tanker. Or maybe they go to one station just because it’s a right turn instead of a left, has better coffee, or the newspaper they read every day.

Energy commodity prices are set by three things the current demand of refiners and other obtainers of oil such as the government for the SPR, by the expectation for future demand relative to supply, and the expectation for prices. At the spot level if there’s more gas than refiners want to buy, producers may store oil for sale in the future, may reduce prices to the point that the refiner wants to buy it and store it in the future, or both. A refiner might use futures contracts to lock in a price for a future delivery, it may use futures to hedge price changes, or it may simply speculate. Speculators and hedgers may make bets on the future relationship between supply and demand or, as we’ve seen recently, ignore fundamentals altogether and just bet on price changes. What’s happened over the past couple of years is that the number of people solely interested in betting on price changes has increased dramatically. The commodities exchanges use trading activity statistics to try to prove otherwise, because they don’t want people to believe that prices are being pushed around by speculative greed. But the truth is that the hedge funds are interested in buying, holding, and rolling contracts, more so than being day traders in the energy markets. Of course the exchanges know this. To hide this information they control our access to statistics and feed us only the statistics that benefit them.

Unlike the price of a game player, energy commodity prices should be highly competitive. One oil company has little edge over another and thus every oil company for the most part gets the same price for its oil. Compared to a game player there’s little an oil company can do to make its oil sell for more than other companies. And there are gads of producers all over the world selling into the worldwide market. So spot prices should always reflect a level of lowest operable margin for producers. Futures prices may very based on expectations of future supply and demand, which may be affected by weather and other factors. But even if say a futures price twelve months out is $10 higher than the spot price if nothing happens between now and eleven months later, then the value of the futures contract should fall towards the spot price, which remains set relative to profit margins. This, however, has not been the case recently. Spot prices have been pulled higher by futures prices and the profit margins for producers have increased dramatically, which is not an economically logical price movement.

Again if we go back to the game machine example, such a company can’t expect to be able to jack up prices unless there’s a sudden drastic increase in demand. If a company develops new technology that significantly increases realism and just about every teen and every guy who grew up on an Atari 2600 wants one for Christmas, then the company might expect that consumers will want to buy more than it produced. In that case the company may be able to hike prices to say $250 a unit through the holiday shopping season.

But the gaming company can only hike prices if it expects that demand will significantly exceed supply and there will be supply disruptions at a lower price point. There has to be a real disruption or a realistic expectation of a disruption. When consumers are going out of their way to track down units and paying a premium of say $50 over retail for machines being auctioned off on eBay then the company knows it’s not produced enough and/or priced them too low. In fact eBay is a great pricing tool for companies.

But well before the hurricanes came along spot prices and profit margins for oil and gasoline were extremely elevated. Yet at the time there were no disruptions and no reason to expect future disruptions, especially not great enough to warrant prices tripling over the last five years. Then along come the hurricanes, which pretty much caused the worst amount of devastation to the industry that we could ever reasonably expect. In other words, it would be unreasonable for the markets to always be pricing in such large-scale massive destruction to the industry. It would, however, be reasonable for the markets to continuously price in modest problems. That equilibrium price would be at a level in which both consumers and producers would share the burden such that a larger than normal problem would hurt the producer without devastating it and a smaller than normal problem would be offset by margins slightly higher than if no problems were priced in.

So we had just about the worst possible disruption aside from say WWIII, in which case we’d have all sorts of things to worry about in addition to energy supplies, yet consumers only experienced just a few days of isolated and very limited supply disruption. Now experts are saying that they expect there will be plenty of natural gas, oil, and gasoline with inventories actually building for all three. So if companies are competitive and supplies are more than adequate even under severely disruptive conditions, then why are we still paying outrageous prices at the pumps? There really is only one explanation and that is excessive speculation. The futures markets play an important and valuable role, but if you took away the effects of futures prices then realistically oil prices would be competing to sell oil at spot prices representing minimal profit margins.

Greenspan got it all wrong in his speech in Tokyo. He clearly hasn’t done his homework on this subject. The oil markets aren’t tight. Even the CEO of ExxonMobil has said repeatedly that there’s plenty of oil. If the market was tight there would have been supply disruptions, which there weren’t even under the worst of circumstances. There hasn’t been a single time ever, not even in the crises of the 70s, that people haven’t been able to get gas the gasoline they needed to get to work and do their jobs. Even in the 70s the disruptions were isolated incidences. The real problem of the 70s was never not being able to get gasoline, but rather the impact of high gasoline prices, inflation trickling down into other goods, extreme interest rates, and economic recession.

There is absolutely no economically sensible explanation other than the impact of the futures markets to explain the extreme prices we’re experiencing. And the fact is that economists still don’t fully understand how futures markets and the prices of various commodities interact.

posted at 2:22 PM 1 comments

Monday, October 17, 2005

Get the Joke

As my good day trader friend likes to say, “Get the joke.” I never know what he means. I'm slow to get a joke. But here are a few things that make me laugh at the markets.

The continued saga at Krispy Kreme makes me chuckle. A franchisee and affiliate 70% owned by Krispy Kreme has filed bankruptcy and the company’s stock has been halted all morning. Its largest franchisee also sued the company recently over various issues that you can read about in the link above.

Krispy Kreme was once referred to as a darling stock. It was one of the few companies performing well through the recession. But to me it was just proof that the majority can be and often is wrong in the end. When Krispy Kreme’s came to Colorado about four years ago it was all anyone around here seemed to want to talk about. I don’t think it would be much of an exaggeration to say that it got nearly as much attention as 9/11 and more than the bird flu is getting now. It was hilarious to me because I had moved from Indiana a year before that and left behind stale Krispy Kremes sitting in plastic cases all day in gas stations all over the state. I couldn’t see what the big hoopla was.

The trading in the doughnut makers stock reminded me of the brief reincarnation of K-Tel during the go-go dotcom days. K-Tel’s brand and advertising ranked right up there in same cheesiness factor as the chia pet and the clapper. It’s hard to believe but all are still around and pretty much every one still knows what they are even though we haven’t had to suffer through one of their commercials since cable came along and saved us from the combined misery of Tom & Jerry and Leave it to Beaver reruns on the UHF band. In the summer of 1998 K-Tel was getting as much attention as Amazon.com and was believed to have the potential of becoming the Amazon of Music, but K-Tel turned out to be a dotbomb working off excess inventory of Foghat Live albums leftover from the 70s. (Note to K-Tel and Foghat: It’s a joke. If you don’t know you epitomize the 70s you need to wake up or sober up. I shouldn’t have to say it, but I do since Def Leppard actually got mad over Kid Rock saying “Def Leppard sucks” in the movie Joe Dirt, which only served to dredge up memories of the tasteless one-armed drummer jokes that went around in the late 80s.)

If you didn’t think this had anything to do with the markets, well I actually happened on a one-arm economist joke:

WANTED: ONE ARMED ECONOMIST

"Give me a one-armed economist!" demanded President Harry S. Truman.

President Truman was the first president to appoint a council of economic advisers. He preferred clear recommendations, not long discussions of the advantages and disadvantages of a particular course of action. He quickly grew tired of economists who gave a good recommendation, and then began, "On the other hand..."

Are you starting to get what a joke I thought Wall Street’s impression of Krispy Kreme was? Probably most people except the company’s executives knew what a joke the stock was. Don’t get me wrong, the company makes a mean doughnut and I love the way a fresh one melts in your mouth like cotton candy just as much as the next person. But the stock was total joke. I remember looking into shorting Krispy Kreme back when it was around $80 a share before it split a couple of times around the turn of the century, but it was on the no short lists because there weren’t enough shares available to lend. Of course you can always buy puts if they are optionable. But the problem with Krispy Kreme puts was that the stock had to fall something like 50% in just a few months before the put became profitable. Obviously, a whole lot of people thought the stock was a joke. As it turned it the management was just as big a joke as the stock.

It never ceases to amaze the way so many people can lose their heads. You would have thought people had learned their lesson with the dotcoms but they didn’t. These days its energy everyone’s chasing. And there’s been some pretty ludicrous stocks run up lately too. Sears / Kmart for one, which booyah boy was a big supporter of. Speaking of, I actually heard the Cramart of stock tips tell viewers that when he says BUY, BUY, BUY he really means do your homework and research the stocks and it should take a couple of hours. He expressed concern and surprise that some of his audience might actually take him literally. You think?

Watching the show is like watching a tent revivalist at work. It’s like Steve Martin’s Leap of Faith five days a week. I love the line where Jonas Nightengale tells Debra Winger’s character that he’s not as bad as all the other sneaky crooks because he’s obvious. Obviously though, such people aren’t obvious to everyone. Some people are really that gullible. The difference between sneaky and obvious in the markets is the difference between say the superspike report and the spam I get every day hyping penny stocks.

For kicks follow this link to a Google search of “booyah” and check out the sponsored link at the top of the search results. I wonder if the guy’s got the copyright on booyah.

Boobyah!

Seriously, the Krispy Kreme fiasco is a sad story. The Website has some great pictures of the company going back into the 1930s. A heck of a lot of good came out of stock mania at the end of the last century. But the craziness led to the demise of some good old companies too like the double bankruptcy and bailout of FAO Schwartz. K-Tel passed out in the middle. FAO, Enron and WorldCom partied all night long. Krispy Kreme, booyah boy, and this energy enigma are the hair of the dog that bit us.

posted at 3:55 PM 2 comments

Friday, October 14, 2005

This aint the 70s

The chart below plots the percentage change for the CPI and Core CPI over the previous ten years. Each data point represents the change for the previous ten years. This is something I worked up in Excel to see how prices have inflated over a ten-year period and how one period compares to another.

The most important thing to glean from this chart is really how little we know about inflation. We’ve only experienced significant inflation twice in the last century. In both cases wartime expenditures were likely the primary cause. The second time it was wartime spending combined with an energy crisis. Some people will be quick to point out the similarities to today. And there are some. As a percentage of GDP I don’t think we’re spending nearly as much on our efforts in Iraq and Afghanistan as we did in Vietnam and WWII. Nor do we have nearly the disruption to the economy in terms of human capital. But, when you combine the war efforts, high energy prices, and the hurricane rebuilding it seems to me that the Fed is right to be concerned about inflation going forward.

Analysts keep pointing out the fact that high energy prices still aren’t showing up in the core CPI and that the Fed has no control over energy prices. But that’s like saying winter’s not coming because it’s warm outside. Looking back at the seventies it did take quite a few months of an increased overall CPI driven by higher energy prices before the core CPI began to follow suit.

The chart illustrates common sense, which says that eventually producers are going to begin to pass on higher production costs. In the seventies you can see by how much the core CPI rose that they did just that, and they were able to do so in spite of a weak economy, recession, and weak demand. The economics of it dictates that producers can only absorb a certain number of months of increased costs. At some point they either have to raise prices or they have to stop producing. As prices rise demand falls, but it doesn’t shut off completely. People will buy many goods even at elevated prices. But overall they can’t buy as many goods, especially discretionary ones.

The seventies were a horrible time for the stock markets. As you can see from the chart the CPI and the core CPI increased in tandem, but the CPI outpaced the core CPI throughout the decade. Producers absorbed some of the increased costs and passed on some. Companies operated at increased costs, reduced margins, and reduced demand. So they sold less and profited less.

The good news for this time around is that prior to the hurricanes there really wasn’t any supply or demand shocks in the energy markets whatsoever. The higher prices were caused by nothing more than speculation. The data proves this absolutely. I’ve shown it here many times and you can search the blog for those posts if you haven’t read any of them. The hurricanes caused a real disruption. That’s a problem. But, it’s increasingly looking like a short-term one. The lack of supply has been largely offset by decreased demand due to the high prices and conservation. Also, we’re being told that the refineries will be back up to 100% by the end of the year. Though I doubt it will happen, if demand remains somewhat reduced for gasoline and refineries are back up to their full potential, then pump prices should fall drastically. The irony of that would be that it has been the refineries raking in the profits over the past year, but they would get squeezed if oil prices don’t fall. And as long as the government keeps the EPA restrictions lifted we’ll get even more gas coming in from other countries. There’s still some problems with getting back up to capacity with gulf oil production, but we can import more oil easier than we can import more refined products.

The gist is that I don’t see prices getting out of control, but I do think that the Fed is justified in taking rates to a non-accommodative level. We don’t want to make it any easier on producers to pass those costs on. If energy prices come down significantly, which I believe they will, then we will have managed to escape a repeat of the 70s scenario.

posted at 2:51 PM 2 comments

Click!

I turned off the TV when sick chickens came up again, as I said I would. A commentator actually asked if it was safe to eat chicken. The bird flu isn't even in this country. This is the most blatant sensationalism I've seen in a long time. They just have to have something as sensational as the hurricanes and when they don't have it they make it up. The thing to take from it is just how common sensationalism is and that it goes on even about things that are legitimate. For example, after the hurricanes the financial media sensationalized the need for a Fed to pause. That was dead wrong and contributed to traders moving fed funds rates from completely pricing in a September rate hike, to not pricing it in, and back to pricing it in again, all in a matter of a couple of weeks time. Sensationalism does influence markets and you can profit from being contrarian to it. Though, not in this particular case because I don’t believe that the market is reacting to the news. It’s just so ridiculous and far-fetched that it’s funny. No, it’s not funny that people are dying from the virus. But it is frustratingly funny to watch the financial media try and stretch it into a market related event.

posted at 1:41 PM 3 comments

Earnings Status Report

I like to keep an eye on the tally as the quarterly earnings roll in. The media tends to focus in on a few companies and generally we don’t have a clear sense of what is going on as a whole. In previous quarters I’ve noticed a tendency for the markets to not immediately take notice if earnings are coming in strong. My favorite site for viewing this information is Zacks, which keeps track of earnings surprises. So far this week Zacks has reported 33 upside to the upside and 19 to the down. What I am lacking is historical data to compare this information to previous quarters. But, thus far the quarter is looking very good relative to what the markets have done over the past week.

posted at 1:36 PM 0 comments

Thursday, October 13, 2005

Enough about the sick chickens already...

If I hear another thing about sick chickens I think I’m going to have to turn off the TV and leave it off for a good while. I’m sorry that Romanians might get sick and die. But I fail to see how that has anything to do with the markets, beyond perhaps the stock prices of Tyson, other chicken dependent companies and vaccine manufacturers.

We eat a lot of chicken in this country, but if I never ate a piece of chicken again for the rest of my life, I think I could live with that. I would just eat all those other things that people say tastes like chicken. Frog leg McNuggets would be fine with me.

I even saw one article insinuating that the recent market declines were correlated to the increased number of sick chicken headlines. That’s about as spurious as you can get and this was a person that I know should know better. What a bunch of hooey.

Is there a single reader out there who in the past week sold stock because they were afraid of sick chicken pandemonium, or sold because they thought other people were selling for this reason? I think not, and more importantly I hope not, because if there is then they haven’t learned anything from this blog.

posted at 2:44 PM 0 comments

Back up that call...

Did you watch the Angels Whitesox playoff game last night? If so you already can guess where I’m headed. A flat out incorrect call cost the Angels the game. A pitch that the catcher caught cleanly was called in the dirt. If it had been called clean it would have been the third strike and third out to end the inning for the Whitesox. Instead the batter ran to first when the catcher who knew it was a clean catch didn’t make the tag. A couple of batters later a homer into left field won the game for Chicago.

The lack of the use of instant replay was to blame. Long before the ump and Angels coach were done disputing the call TV viewers new beyond any shadow of a doubt that the ball had been caught cleanly. I don’t blame the umps much. The ball was very close to the dirt. At that speed and without the hindsight of knowing to very carefully I don’t see how the umps could know for sure. My only gripe in that regard is that without knowing for sure, without a puff of dust, or other evidence the pitch should have been given the benefit of the doubt and called good.

Without the benefit of instant replay the call stood, though it was clearly a bad call. It was a very frustrating feeling as viewer to know absolutely that the call was wrong and there was nothing you could do about it. It reminded me of a line from the movie Win a Date With Ted Hamilton where the guy from That 70’s Show is rejected by the girl he loves and the father of the girl tells him that sometimes Goliath kicks the shit out of David. He says, “It’s just that no one ever bothers to tell that story.”

In the markets very often no bothers to tell the truth or even cares to hear it. The frustration I felt over that bad call was similar to knowing the truth about the energy markets and having to listen day in and day out to supposed experts getting it dead wrong. The major difference, however, is that the game of the markets never ends. It just keeps going on and on, day in and day out. People can realize their mistakes and in many cases back up and correct them. When they do it’s usually at a loss, because that’s what a mistake is in the markets, a loss. And when they do it’s usually to the benefit of those on the side of truth.

posted at 2:27 PM 0 comments

The absurdity of American corruption...

More evidence that American companies are actually less corrupt. Today the Department of Justice announced that the Korean company Samsung would pay $300 million, the 2nd largest anti-trust settlement in the DOJ’s history, for leading a widespread international conspiracy to fix the prices of DRAM chips. Hynix, another Korean chip maker, and German chipmaker Infineon Technologies have already paid fines. In total the three companies will pay $646 million to the DOJ. American chipmaker Micron Technologies received immunity for blowing the whistle on its foreign competitors. Three German nationals have spent time in U.S. prisons. The industry had been colluding since the late 90s causing consumers and American computer manufactures Dell, Compaq, IBM, Apple, HP, and Gateway to pay more to purchase and manufacture computers.

Earlier in the year an overview of recent developments within the DOJ’s Antitrust Division said that in the last five years 80 individuals have been served prison sentences including 18 foreign nationals from 9 different countries. International cartel investigations account for more than a third of the Division’s grand jury investigations. Since the beginning of FY 1997, the Division has prosecuted international cartels affecting well over $10 billion in U.S. commerce. The Division has prosecuted international cartels operating in a number of sectors including vitamins, textiles, construction, food and feed additives, food preservatives, chemicals, graphite electrodes (used in steel making), fine arts auctions, ocean tanker shipping, marine construction, marine transportation services, synthetic rubber and dynamic random access memory. The cartel activity uncovered in these cases has cost U.S. businesses and consumers many hundreds of millions of dollars annually.

Since the beginning of FY 1998, roughly 50 percent of corporate defendants in criminal cases brought by the Division were foreign-based. In FY 2001, the percentage of foreign-based firms charged by the Division rose to nearly 70 percent, and then returned to around 35 percent over the past three years.

The Division has prosecuted foreign executives from Austria, Belgium, Canada, France, Germany, Italy, Japan, Korea Mexico, Norway, the Netherlands, Sweden, Switzerland, and the United Kingdom for engaging in cartel activity, resulting in heavy fines and, in some cases, imprisonment. Since FY 2001, roughly one-fourth of the individual defendants in our cases have been foreign nationals. Foreign defendants from Canada, France, Germany, Sweden, Switzerland, the Netherlands, Norway, the United Kingdom, and Japan have served, or are currently serving, prison sentences in U.S. jails for violating U.S. antitrust laws.

You probably noticed one particular country not making that list. In China price fixing and other harmful business practices are actually encouraged by the communist government as a way to grow the countries industry. That’s why I find it so frustrating, yet humorous, that ignorant and gullible American investors want to own shares of Chinese companies owned by the communist government and they are even willing to place a higher valuation on them than American competitors.

The myth of American corruptions has been perpetuated by equally ignorant financial advisors, who in most cases have had know formal education in the area of international economics, regularly recommend that average Joes from middle America send as much as 25% of their savings overseas to be invested in companies these people have never even heard of. The fact that American investors are willing to place a higher value on shares of the 70% communist state owned CNOOC than on many of their own oil companies when they really have know way of knowing what CNOOCs earnings are, is absolutely ludicrous. It amounts to a serious disconnect that in my view is more serious than the so-called trade deficit problem.

Speaking of the trade deficit the headline this morning was that the trade deficit was the third highest ever! We’re supposed to be shocked by this? I’ve got news for you. As long as the country is growing the trade deficit is going to grow. When the trade deficit stops growing people aren’t going to be talking about the trade deficit any more because they’ll be too busy worrying about the fact that our economy isn’t growing. Then they’ll be saying we’re losing our status as a world leader. They’ll blame globalization and our lousy educational system.

Speaking of our educational system. Besides the usual counter point that if our system is so bad then why do so many foreigners come here to be educated, which is actually a major export for our country, Alan Greenspan made an interesting point in his most recent version of the Economic Flexibility speech. He talked about the growing numbers of people that now continue their educations all throughout their careers and cited the spectacular growth in our community colleges. It’s an important point. Maybe some other countries students are more adept at mathematics when they get out of high school, but what other country has a continuing education system evenly remotely close that of the U.S. None. And one of the great things about continuing education is that people are more likely only to study those things that are relevant.

For example, the requirement for me to learn Spanish in college was in my view a waste of my time and my money. It amounted to little more than an economic inefficiency. It might be a nice thing to know, but taking those courses didn’t make me any worldlier or compassionate and it was knowledge that I quickly and completely forgot. I resented having to take those courses then and resented the college for making me take them. And I was right. The only time I’ve ever used Spanish was to communicate with a taxi driver during spring break in Cancun trying to make my way back to my hotel after breaking my hand riding a mechanical bull drunk, which I didn’t even realize at the time, and puking on the beach. But I didn’t even need it then because all that was necessary was for me to slur out the name of my hotel, the rest was completely unnecessary and amounted to nothing more entertainment, or more likely an annoyance, for the driver.

Of course there’s nothing wrong with choosing to learn Spanish, but I had to work very hard to pay for those classes, which for me at the time amounted to a couple of weeks worth of loading UPS trucks and left little money for a decent safe place to live. Now if I have a need or desire to learn and use Spanish I’ll buy a book or take a class at the local Colorado Mountain College.

But the point that makes the divergence relative is that extensive continuing education system of the U.S. is one of the reasons that American companies are so innovative even if they aren’t as competitive in terms of labor costs. And from that perspective they should be valued higher than say a company that’s 70% owned by the communist Chinese government.

That has nothing to do with being patriotic; it’s just a matter of seeing things clearly, for what they are. In this it’s seeing that if you’re heavily invested overseas in a bunch of companies you no nothing about, sooner or later you’re going to get burned. It’s just a matter of time.

posted at 2:00 PM 2 comments

Wednesday, October 12, 2005

In a rare bit of international transparency…

Angela Ahrendts an executive vice president at Liz Claiborne will be heading Manchester, England company New Burberry for a pay package worth U.S. $27 million over the next five years.

Mind you that person is currently an EVP, not a CEO, getting a massive pay package to run a British clothing company that on an international scale is a medium sized company. Its revenue is about a fourth of Liz Claiborne’s. By comparison Liz Claiborne’s CEO gets $9.7 million per year. On a percentage of revenues basis the American CEO is getting 0.2%, while the British CEO is getting 0.4%. So the British CEO is getting paid twice as much per unit of revenue.

Of course there’s absolutely nothing statistically significant about this exercise, but it was fun any way to point out a real example a foreign company paying a relatively higher salary than a comparable American company.

posted at 5:34 PM 0 comments

In the News...

News worth following:

Snow Urges China to Develop Markets, Make Yuan More Flexible


Prudential Equity ends tech research
Firm lays off technical analysis veteran Acampora

Ex-Refco CEO charged with securities fraud


Fed News:

Fed fears energy prices will spur inflation

Interest Rates: Still a Way to Go
Upcoming statistics will likely confirm inflation's renewed muscle. Figure on three more quarter-point hikes before Greenspan & Co. are done

Remarks by Chairman Alan Greenspan
Economic flexibility

Remarks by Governor Mark W. Olson
Update on the U.S. Economy and Fiscal Outlook


Noteworthy Headline:

Can Technical Analysis Provide Foresight into the Stock Market?... Technical Analysis after all is a relatively new concept in the emerging forms of alternative investing methods (with fundamental analysis being the primary ...

Actually, technical analysis has a much longer history than fundamental analysis and was the only method used in the early days of the markets. Technical analysis has its roots in the mysticism of ‘reading the tape’ when all trades were printed on the ticker tape. The vast majority of technical analysis is fortune telling phony baloney, but then most of fundamental analysis is no better at predicting future stock prices. Nothing beats common sense. But it’s not in the best interest of financial intermediaries and the financial media for you to know that. Markets regress to the truth.


Other News:

The Truth About Transparency : )

posted at 4:54 PM 0 comments

Crude Sense

Just heard on the news. Crude oil prices rose today on speculation that demand would increase next year. Ok, let’s see if I have this straight. The price of crude oil futures for oil to be delivered next month rose because people are going to want more oil next year? Does this make sense? Heck no it don’t. It exemplifies how the energy markets got so out of hand in the first place.

posted at 4:33 PM 0 comments

The Truth About Transparency

ABN Amro, Acer, Adecco, Adidas-Salomon, Aegon, Air France, Airbus, Alcatel, Allianz, Aluminum Corp of China, Amvescap, Audi, AXA, Bank of Ireland, Barclays, BASF, Bayer, BMW, BNP Paribas, BP, Brasil Telecom, Bridgestone, Brilliance China Automotive, British Airways, British American Tobacco, Brother, BT Group, Business Objects, Cable & Wireless, Canon, Cap Gemini, Carnival, Casio Computer, Cemex, China Eastern Airlines, China Life Insurance, China Mobil, China Netcom, China Petroleum & Chemical Group, China Southern Airlines, China Telecom, China Unicom, CIBA, CNOOC, CommerzBank, Credit Lyonnais, Credit Suisse, CTRIP.com, DaimlerChrysler, Daiwa Securities, Ducati, Ericsson, Fiat, Fortis, France Telecom, Fuji, Fujitsu, GlaxoSmithKline, Gucci, Hanson, Heineken, Hitachi, Honda, HSBC, Huaneng Power International, Hutchison Whampoa, Hynix Semiconductor, Hyundai, ING, Isuzu, Kawasaki, Kia, Kubota, Kyocera, Lafarge, LG Philips, Lloyds, L'Oreal, Matsushita, Mitsubishi, Mittal Steel, NEC, Nestle, Netease.com, Nikon, Nintendo, Nissan, Nokia, Nomura Holdings, Novartis, NTT, Olympus, Pentax, Petrobras, Petrochina, Peugeot, Pioneer, Portugal Telecom, Prudential PLC, Reed Elsevier, Remy Cointreau, Renault, Reuters, Ricoh, Rio Tinto, Roche, Rolls-Royce, Royal & Sun Alliance, Royal Bank of Scotland, Royal Dutch, Samsung, Sanofi-Aventis, Sanyo, SAP, Schering, Seiko Epson, Sharp, Siemens, Sinopec, SK Telecom, SMI, Societe Generale, Sodexho, Sony, Swiss Re, Taiwan Semiconductor, Tata Motors, Telefonica, Thomson Multimedia, Tom Online, Tomkins, Total, Toyota, Trend Micro, Unilever NV, Unilever Plc, United Microelectronics, Vivendi Universal, Vodafone, Volkswagen, Volvo, Woori Finance, Yamaha, Yanzhou Coal Mining, Zurich Financial

What do these companies have in common? None of them are American companies. There’s some great and some not so great names on this list. Most are multi-billion dollar companies. Most trade their stock on U.S. exchanges. Many have brands every bit as recognizable to the U.S. consumer as major American brands. Toyota and Honda, for example, are just as recognizable as Coke and Pepsi. This is just a small sampling of well-known and/or large foreign companies. Many large foreign companies are privately held.

How much do you suppose the CEOs of these companies make? Some of them report their earnings, particularly the European companies, and most of those that do are comparable to that of similar American CEOs at around a million a year. But what are the total compensation packages of the CEOs of these companies? Good luck trying to find that information out.

I’m not going to get into whether or not CEOs are paid too much. That’s outside the scope of this blog, as I see it, and I get to see it any way I want. But what I do want to emphasize is how the way we think is biased by the media and by the data that is available versus what is not.

When you look at the list of companies you have to ask yourself realistically if the executives of those companies make significantly less than those of similar American companies. I seriously doubt that they do. In fact, I will even go out on a limb and suggest that many of them make far more. I’m not suggesting that they are richer than say Bill Gates, but I am suggesting that perhaps the CEOs of Toyota and Honda make just as much if not more than the CEOs of Ford and GM. Don’t take me specifically, but rather generally. It might not be true for those examples, but I strongly suspect it’s true for many other examples. The reason I believe this is because wherever there’s a lack of information or transparency there’s an opportunity for people to take advantage. Communist governments, for example, maintain their power by limiting the flow of information. They keep people in the dark.

In the early part of the last century there were numerous magnates of business that were able to accumulate wealth on par with Bill Gates on a real inflation adjusted basis. They were able to do so because they were able to corner markets and because people didn’t know how much they were making. It’s only been very recently that people have known just how much American CEOs make as a total pay package including bonuses and options. Now there are several publications and surveys that compile this data. And people don’t like what they see. But it doesn’t imply that American CEOs are better paid than comparable foreign counterparts. American CEO pay got to where it’s at only after years of climbing higher with people being in the dark.

Well, we’re still in the dark about most foreign companies. I’m sure you could dig up some surveys somewhere on the web. But I’d be suspicious of the accuracy of the data. In many countries an executive isn’t going to be obligated to tell the truth, and therefore isn’t likely too.

The French have been particularly critical of the wealth of our business leaders. But when you look at the list closely you’ll see quite a few multi billion dollar international companies headquartered in France. To the French I say that they’d better look closely at their own companies before they complain about ours. And that’s not a slam on the French; so if you’re reading from there don’t take it that way. It’s just a good example.

It’s helpful when analyzing the markets to be able to see the truth and the big picture. What that means is thinking independently. If the media says ‘American’ CEOs are paid too much, you should be asking, “But what do other CEOs make?”

When the media says that oil prices are shooting higher because people are picketing in Peru or Venezuela, you should be asking, “But how much oil are the pickets impacting in terms of the total world supply?”

If people are overreacting to such things, then eventually they will simmer down. You can make good money in the markets being the cool hand.

People think that American executives are overpaid and American companies are corrupt. Over the past several years American’s have poured more money into international equity funds than they have into domestic funds. But, what you should be asking is whether or not American companies are really more corrupt and whether or not American executives are overpaid on a relative basis. We don’t know the answer because foreign companies are less transparent. But I do believe that if the foreign companies in which Americans have been putting their money, suddenly had to be just as transparent, if the executives suddenly had to honestly report their total pay packages, and the companies had to undergo the kinds of forensic accounting that our companies that have been caught playing accounting games have had too, then we’d all suddenly be seeing a very different picture and it wouldn’t be such a pretty one. People are seeing international companies through rose-colored glasses. And I’m not talking just about foreign international companies. One of the reasons that large companies get so international is because they can be less transparent. Companies like AIG made Bermuda the haven for international companies and finances that it is today to hide assets and cover their tracks. That’s a fact that everyone knows, but that know one could prove until AIGs relationships came to light recently. We’ve all known that the Bermuda business scene has been the equivalent of the Swiss bank account. There’s no reason to even have a Swiss bank account unless you have something to hide. It’s no different with the Bermuda company. It’ the Bermuda triangle. All the bad stuff just disappears.

Take off the rose-colored glasses and see things as they really are. Eventually, investors are going to begin to understand the value of transparency. And when they do billions of dollars are going to flow out of the international equities markets back into the U.S. And this could happen much faster than people realize because a bit of selling in the international equities markets combined with a rally in American stocks, could trigger a multiplicative effect in which selling begets more selling and foreigners start sending more money to the U.S. Eventually, this will happen. These things go in cycles. Foreign countries are increasingly opening up their markets and becoming more transparent, but most aren’t nearly as transparent as U.S. companies. And that’s a plus, though people don’t see it that way right now.

posted at 4:25 PM 0 comments

Tuesday, October 11, 2005

FOMC Meeting Minutes

Fed meeting minutes are out. Here's the link:
Minutes of the Federal Open Market Committee
September 20, 2005

I'll be reading and seeing if there's anything noteworthy. I just expect it to confirm my long held belief that the Fed will continue higher than people previously expected. But in recent weeks the consensus has come around to seeing things through the Fed's eyes. So I don't expect the minutes to change peoples opinions much.

posted at 3:20 PM 0 comments

Psychopathic CEOs

In the previous post where I commented on CEOs being psychopathic liars I was thinking back to an article that many readers enjoyed some months ago. It’s worth reposting:

Is Your Boss a Psychopath?
Odds are you've run across one of these characters in your career. They're glib, charming, manipulative, deceitful, ruthless -- and very, very destructive. And there may be lots of them in America's corner offices.

posted at 2:57 PM 0 comments

Analysts are like brain eating zombies...

Anonymous says with regard to why analysts now say speculation was behind the rise in oil prices:…learning to wonder 'why now' is perhaps the model?

Precisely. We know that analysts are acting in the interest of their firms and themselves. There are only three reasons for them to be on TV; personal name recognition, company name recognition, and manipulation. Let’s be realistic. They don’t come on TV to educate us. In most cases they are on TV for all three reasons. If they’re talking up oil, it’s because they’ve recommended oil to their clients or they own it themselves. If oil does well, they get bigger bonuses. So you know when analysts are all talking about oil and ignoring fundamentals that they already own it or have recommended it their clients. Conversely, if we start to see more people coming on and saying that all the smart guys are short oil, then you know why.

I believe you can get a fairly accurate read on the consensus for where these guys want prices to go next. This is sometimes well correlated to fundamentals and other times not. On average they’re going to take the path of least resistance, which at times can go against fundamental logic. From a statistical perspective this consensus consists of suspect data because the financial media often makes the story up and then finds people to corroborate it. But I suggest usually you can get a sense of the direction the markets are being manipulated by the story that analysts are telling. Use it to your advantage. But it’s just one piece of the puzzle.

Personally, I sincerely hope that the hedge funds are turning around and getting on the short side of oil because they’ve caused a lot of havoc to the economy. But then again, maybe the good thing that comes out of it is that we have been sufficiently incentivized to be a little more conscious about our energy usage. That can’t be a bad thing.

In the short run it seems like oil prices are at a balancing point and speculators are debating on whether to be long or short. It’s hard to say where prices are going next. My hope is that the uncertainty and a lack of upward momentum will drive speculators out of the market and in turn promote speculative shorting for a while.

In the medium term prices will eventually drift towards an equilibrium point that pays more attention to the fundamentals. The optimal price is one that’s not too high and not too low because the oil companies also have to be sufficiently incentivized to prospect. It the oil supply has gotten tighter over the past five years it’s probably has a whole lot more to do with the ultra low prices in the late 90s of around $10 a barrel, then it has to do with the amount of oil in the ground.

In the very long run, say ten years from now and beyond, prices will probably be quite a bit higher than they were five years ago. But in the meantime, we’re likely to experience a boom and bust. Five years from now we’re likely to see prices down drastically because of the economic incentives created by the current high prices. Oil companies have been reluctant to act on higher prices initially because they didn’t think the rally would last. Oil prices went far higher than anyone ‘sincerely’ could have believed they would.

I complain a lot about people being biased and unethical. We probably all know or have known people that lie and exaggerate all the time. Some kids are especially prone to this. They are so practiced at it that they often believe what they are saying. They don’t really stop and think about what they are saying. There’s some kind of detachment. They get so good at it that when they are around people they don’t know, people believe what they are saying. Many of these people grow up to be CEOs and other high level executives. I had a friend like this in school and I always called him. He really hated when I did that. People don’t like to be called out from their lies. They like to think they’re getting away with something. Most often they aren’t, but no one wants to confront them. It’s easier just to let it go.

Letting the analysts lie is how we got to $60 oil prices. The mainstream media has a conundrum. They have a responsibility to report the facts and seek the truth, but they also rely on the analyst’s opinions on the markets. If they beat on the analysts and call them out, they won’t come on the air. They’re only going to come on the air if they can lie and deceive without anyone really debating them. Most of the analysts that come on TV are doing sales and PR work first and market analysis second. What keeps those things together is that they want to sound intelligent. This often means being right. But in the case of the economics of the energy markets, they were able to lie as much as they wanted because their audience was ignorant about these markets.

So I feel good about calling the slime balls out because knowledge is power. But I’m equally interested in taking advantage of the fact that they have no soul or morals and their lying is consistent and predictable.

Analysts are like horror movie zombies. They have one-track minds programmed to eat your brain. But their predictability makes them easy to outwit.

posted at 2:51 PM 1 comments

Spurious Correlation Explained

Anonymous asks:
Refco is in the news today. Have you a comment on it? Too many stories of down right dishonesty. America seems to have more than it's normal share of corrupt people. It has become a daily occurrence! How sad for a great country to loose it's ethics, and to forget what the truth really means.

I am more interested in commenting generally on dishonesty and scandal in business as it relates to logic and statistics than about the specifics of the Refco fiasco. This gives me the perfect opener for a lecture on basic statistics, which is highest level I’m qualified to lecture on. A first step towards asking the right questions about the markets starts with recognizing common errors in logic and reason. In this case (no offense towards the commenter intended) Anonymous has made a very common deductive error. Anon has deduced that the increased frequency or volume of business scandals in the U.S. implies that the U.S. has become increasingly more scandalous and that the U.S. is more corrupt than other economically leading countries.


People attribute all sorts manner of lunacy, crime, and debauchery to the full moon. If there were any statistic that increased during the full moon it would probably be attributable to the increased amount of natural light. But studies show that there isn’t any significant increase in any of the events typically attributed to a full moon. People just imagine that there are more suicides and accidents during the full moon. When people put the two events together there’s a kind of mysticism attached that causes them to remember those events more so than events occurring during regular moons. An article on The Skeptics Dictionary website provides a number of reasons for why people believe this.

Understanding why people misinterpret the full moon as being related to various nefarious and unwelcome events is a good start towards understanding the scandal problem.

Another good analogy is one I wrote about throughout the summer. Before the hurricanes hit, when oil prices were well above where they are now analysts, pundits, commentators using the mainstream media as their podium blamed refinery disruptions for high oil prices. There were two logical flaws in this frustratingly, yet laughably, ignorant explanation for high oil prices. The first was that high refinery problems mean that refiners need to buy less oil and therefore the price of oil should go down, not up. The second was the assumption that there were an abnormal number of refining problems. The skeptical minded person immediately wants to know whether there were actually more problems than normal, or whether we were just more sensitive and alert to problems because the high price of oil was calling more attention than normal to energy related news. Since there didn’t seem to be any reason for there to be an abnormal number of refining problems, I suspected that the latter was the case. And while was not able to readily locate statistics on refinery outages, there was nothing abnormal about refinery output. If there were an unusually high number of refining problems then there would be less output. We can see that this is true in the weekly energy reports, which over the last month have shown significant declines in output due to the hurricanes. But prior to the hurricanes when the business media was sensationalizing refinery fires and other outages there was no noticeable impact to output, indicating that there was probably also no increase in the number of problems.

The problem with surmising that the increased number of business scandals indicates that people are becoming more corrupt and that the U.S. is more corrupt than other countries is a fallacy of interpretation known as spurious correlation. This fallacy is made when it is assume that if B follows A, then B must be caused by A.

The movie October Sky, a favorite of mine, is a true story about four boys from a West Virginia coal mining company town in the 1950s where most of the boys ended up down in the mine before finishing high school. The boys avoided the mines by getting scholarships in science after winning a national science fair for their experiments in rocketry.

When there was a forest fire near the coal-mining town the boy’s rockets were blamed for starting it. Officials assumed that the rockets must have started the fire. This incentivized them to learn more about trajectory and the physics of rocket flight. This enabled them to find the lost rocket and prove mathematically that their rocket couldn’t have started the fire because it couldn’t have flown far enough. It turned out that an aeronautical flare from a nearby airport started the fire.

The officials believed that the fire (B) came after the rocket (A) was launched, then the fire (B) must have been caused by the rocket (A).

The case of business scandal is very similar. An increase in the number of business scandals does not necessarily imply that businesses and people have become more corrupt. In fact that is not true at all and it’s highly probable that people are actually less corrupt now than previously and U.S. businesses are less corrupt than other comparable countries.

It’s certainly likely that U.S. has had more than its fair share of corporate corruption. After all Americans are very entrepreneurial and innovative. The bulk of the world’s technological innovations over the last 100 years are attributable to Americans. Probably more so than all the rest of the world combined. Yes, we’re arrogant, but that’s irrelevant of the facts. The reasons for our innovativeness are numerous. One key factors is that economic success feeds upon itself. Productivity enhancing innovation enables people to divert their efforts. Such innovation enabled Americans to divert more of our efforts to making even more innovations and even more productivity enhancements. Paradoxically, we’ve worked very hard at finding ways to not work as hard. Another important factor has been our relative freedom to profit from our innovations. We are motivated by money more so than the people of many other countries. To that extent it’s to be expected that we relatively frequently succumb to greed and with that comes both good and bad.

Much of the economic progress of our country is attributable to people driven by greed. There’s a long list of American corporate magnates that treated people badly, cheated, lied, and stole. They were corrupt, unethical, and in many cases uncompassionate. But they built our railroads, mined the steel that helped us win wars, put the automobile on the assembly line, got the farmer out from behind the plow, and made it possible to communicate over long distances efficiently.

The U.S. business climate is not even remotely as corrupt as it once was or even compared to just a decade ago. The reason so many corporate executives have gotten caught with their hands in the cookie jars in the past five years is because the free market flushed them out. When the stock market tanked the crooked companies had the rug pulled out from under their feet and it was the rug that they had been sweeping their dirt under. The scoundrels were relying on outrageous stock valuations to cover their tracks. I’m quite certain that there were very many companies that were able to keep their dirt covered up until the stock market improved and saved their rear ends. AIG almost got away with its corporate accounting scandals. If it hadn’t been for its relationship with MMC the problems probably would never have been found out. Unlike Enron and WorldCom, AIG wasn’t having any financial problems to call attention to its wrongdoing.

The reality is that before stock market flushed out the corporate corruption it was probably very rampant and very commonplace. All the evidence suggests that our companies are less corrupt now than in the past.

And there isn’t any evidence to suggest that our companies are more corrupt than those of other countries. The most likely explanation is that we’re just doing more to fix our problems than other countries are. In the short run that’s bad for our stocks. It makes them seem less desirable than those of other countries where such scandals haven’t erupted. But in the long run what it really means is that the books of American companies will be more transparent, which means that on a relative basis the books of American companies will be less risky, more reliable, and less volatile per dollar of earnings than comparable companies in other countries. If the stocks of companies in other countries are rising faster it’s for two reasons. First the scandals in U.S. companies and investment advisors who sell to their clients via the path of least resistance has increased the interest in the stocks of foreign companies. Second in order for such companies to be a worthwhile investment they should pay a higher risk premium. For the time being people are buying foreign stocks because they are deceptively less risky. If the governments of other countries aren’t going to call attention to their companies problems then people perceive that there aren’t any problems. But nothing could be further from the truth.

Take CNOOC for example. People have been very willing to invest in Chinese communist state owned companies in which there is zero transparency of the books. There might as well not be any books at all, because they can’t be trusted from our perspective nor do they even exist. How many Americans that own stock in CNOOC do you suppose actually bothered to read any of its financial reports? Darn few, you can be sure. They’re speculating on the company, pure and simple, the same way they’ve been speculating on oil prices without regard to fundamentals. Just in the last few days CNOOC has been back in the news after being censured by the Hong Kong Stock Exchange for a couple of disclosure issues over the past few years. I read three articles on what CNOOC did wrong and what was abundantly clear was that the reporters had no idea, because I couldn’t make heads or tells from any of the articles exactly what the infractions were. But this is to be expected. If you can’t hide the truth, then muddle it. Garble the facts so that no one can tell what really went on. If we can’t understand it, then we’re going to have a hard time complaining about it.

posted at 1:39 PM 1 comments

Monday, October 10, 2005

Those slimeball analysts...

I couldn’t believe my ears. The first thing I heard when I turned on the TV this morning was an analyst talking about the energy markets. He said that he’d talked to an economist that had been pounding the table about speculation driving energy prices. Supposedly, this economist was now saying that the speculators had dropped out of the market.

The first thing that caught my attention was that for all these many months on the way up everyone who’s anyone was saying that energy prices were being driven by supply and demand, growth in China, etc… Almost unanimously speculation was denied as a cause of higher energy prices. Now though with prices beginning to fall back a bit we have an analyst coming on suggesting that it was speculation all along. Another analyst brought on to debate the subject agreed with him. He suggested that the hedge funds were now all getting short.

Huh! I’m suspicious to say the least.

On the way up the firms the various analysts represent don’t want to admit that speculation is the key driver, because their firms are long energy and speculation doesn’t provide a sound base for prices to go higher on. So it’s better if people believe there are real supply and demand issues causing higher prices. If people believe this, as they have, then they will want to be long because prices should continue higher.

Conveniently, when firms are getting short the slime ball analysts slither out of their holes to tell us that it was speculation and not supply or demand that was driving prices all along. They want us to sell our energy holdings. Want to take bets on how long it is before we hear from the consummate perma-energy-bull T. Boone Pickens with a bullish forecast?

The second thing that occurred to me was if this analyst was citing yours truly. I’ve yet to come across any economist or anyone else for that matter that’s been pounding the table even remotely as hard as I have on the matter. That would explain the lack of attribution given that I’m hardly a respected economist, I’ve been critical of the financial news, and they are competing with me starting so-called blogs of their own.

posted at 3:19 PM 2 comments

I'm a stock market rebel

Another reader writes:
Blogs are so yesterday.

Blogging isn’t about the site or the blog itself. It's not about the person or person’s that create it. It's about the blogger. The blogger is yesterday, today, and tomorrow.

The blog itself is like the Carson show; little more than a desk and a few chairs. People tuned in to hear what Carson had to say, obviously not to look at his set. Very many television talk shows have copied his minimalist style. Some have been successful and many have failed. People vote for the personalities, the shtick, the niches they like the most. The best shows stick around.

It's no different with blogs except that blogs give everyone a chance to have their own show and let the people decide which ones are worth visiting. It’s as if everyone who wanted to could have their own radio talk show and the ones that drew the most money from advertisers survived, while the rest just gradually dropped off. It’s perhaps the most efficient way of attracting the best talent.

Some sports are more efficient than others at attracting the very best talent. Take baseball. Any kid just about anywhere in North America and a few other parts of the world who’s good enough to become a professional baseball player can do so for little more than the expense of a used baseball glove, bat, and some cleats. And in many of these places a significant percentage of people try their hand at the game at some point in time, little league, or whatever. The ones that are very good at it early on are more apt to stay involved longer. So you know, for the most part, when your watching an MLB game you’re seeing the very best people in the world at that particular sport.

At the other end of the spectrum there are sports with barriers to entry and obscure sports. When you watch auto racing your seeing the best drivers that were able to circumvent the many barriers to entry. There may be many people who would be better drivers if they had the same chances, practice time, and equipment. Then there’s dodgeball. In the humorous movie of the same name a bunch of nobodies find the sport in Obscure Sports Quarterly magazine and with almost no practice go on to become dodgeball champions.

So having a television talk show is like being a top racecar driver where not just anybody can do it. A radio talk show is more like dodgeball because just about anybody can do it, but in an obscure corner of the spectrum, on the AM side of the dial, in a small market. But blogs are like baseball. Everyone in the world with an Internet connection can see your blog. They probably won’t with the millions of blogs out there to choose from and language barriers. But the best blogs in niche markets that are updated frequently will rise to the top.

And when I look at the most popular blogs, their success has little to do with web design. Most of them are horrid from a web designer’s perspective. So it’s all about the value created by the bloggers. It’s the personality, charisma, content.

I don’t have much of any of those things, but what I do have working to my advantage is the fact that the so very many market information providers are either crooked, full of baloney, full of propaganda, uninsightful, or sensationalistic. And a bit immodestly, I do spend a great deal of time learning and thinking about the markets, particularly about what’s not true and what doesn’t work. I’ve been fortunate to get to know quite a few extremely knowledgeable people whose thoughts I borrow and finesse, and I practice thinking logically so as to be less apt to be taken in by market insignificant market gyrations and information intended to lead me astray. Mostly, I’m just observant.

I’m no angel and no genius. I’m simple, unsophisticated, and uncultured. I like to ski, hike, fish, hunt, cut my own firewood, and fix my own cars most of the time. I’m a little bit redneck, though most of the friends I grew up with probably think I’ve gotten a little too hoity-toity and brainy. I’m biased about lots of things and I’ve got an attitude. Mostly, I’m intolerant of pretentious people and organizations that rest on the laurels of their degrees and status in society, or use their power and popularity to take advantage of people.

They’re going to do what they do best, which is to make other peoples’ money their own. More power to them, so long as they are doing so legally and ethically. For me that’s what makes the markets so stimulating and fascinating.

I revel in the thought of outwitting and outsmarting people who are supposed to know more than me. It’s an ego booster. There’s nothing wrong with that. Winning is fun. All professional athletes have big egos and the ones who don’t act like it are just better at not showing it. Being right is what gets me excited about following the markets day in and day out and writing this blog. Most mornings when I get up about the same time as the opening bell is ringing out on the east coast I have no idea what I’m going to write about that day. I put on the TV and get my coffee. It’s usually not long before someone says something absolutely ludicrous and that sets the tone. For me it’s like watching a game and yelling at the TV when the ref makes a bad call. People passionate about the game are compelled to tell the ref through the TV what a lousy call he made and explain out loud even when they are alone exactly how it should have went down. I find myself doing the same thing with the business news, sometimes out loud, but then I have the blog and the ear of many thousands of people to vent my frustrations on. If someone’s trying to take advantage or manipulate, then I’m not going to sit quietly and keep my mouth shut.

I’m a stock market rebel.

posted at 2:30 PM 0 comments

When NOT to take losses...

A reader writes:
I try to get the feel of the market invest in different ways depending on the stock and not afraid to take a loss early (probably my biggest discovery).

Don't be afraid not to take a loss either. Actually, the decision to take or not to take a loss shouldn’t have anything to do with fear or emotions. Losses should be taken when you are wrong and profits when you are right. Strive toward being able to weather all the gyrations in between these two points. If you find that you cannot, then your probably overexposed, with too much of your assets in one place. If you’re overexposed then you will be fearful, and you should be.

Mathematically, it works out better this way. If you find that the math isn’t working out to your advantage, it’s not because of looser stop losses. It could be that your skills and knowledge of the market you are trading is such that you’re being right or wrong is quite random. In that case you’re going to bleed to death. You could even be wrong more often than you are right. It could be that your reasons for trading are not logical and rational, or do not take into consideration all of the factors impacting the market, such as the actions of other traders who all think they are smarter than you. Maybe they are.

Contrary to popular belief the markets are NOT a zero sum game. Wealth is created by something in which the market represents. In the case of stocks, a company might use a basket of commodities to create something worth more than the summation of the commodities alone. In doing so the company increases the value of its stock for all investors. And to the extent that some participants in the futures markets actually use futures contracts to hedge particular risks, they are expect, nay hope, that they will take a loss on their futures contracts. They gain risk reduction and speculators gain from their premium. Similarly, currencies can gain in value due to the production of the country for which a particular currency represents. As countries produce goods and services, innovate and advance technology everyone gains. People get more for their money on the whole, even as some people may lose. In the case of corporate bonds the company gains investment capital, from which it strives to produce profit, which may benefit shareholders. And the bondholder gets the interest, which the company is able to pay because of the wealth they create. This even applies to government bonds and though it may be a very inefficient wealth creator, it nonetheless is. Think of protection against enemies and infrastructure such as roads, utilities, etc… These things help make is possible for companies to operate more efficiently. But if you rely on arbitrarily placed stop losses your going to get less of the wealth that’s being created.

One of the main differences between what we refer to as the ‘smart money’ and Joe Schmo in the markets is that a big wiggle, apt to rattle Joe’s cage, isn't going to keep Mr. Millionaire from missing a tee time.

Imagine that both of them have the same theory on the S&P and both buy one futures contract. Joe has $100,000 to invest and moneybags has $1,000,000. Joe has 20% of his ass on line. Moneybags is only putting up 2% of his ass to cover the $20k margin.

The slightest wiggle in the wrong direction and Joe is cutting his losses, while moneybags is hanging tight. In the end they’re both right, but poor Joe Schmo is poorer and Mr. Millionaire is richer. Say Joe cut his losses just as the contract is hitting the maintenance margin of $15,750. Poor Joe just took a loss of more than 4% of his assets and 20% of his investment, or speculation rather. Say the S&P 500 then promptly moves higher to the extent of doubling the value of the millionaire’s contract who then proceeds to happily accept his profits, but remains unemotional about it because for him this is the norm.

Sometimes he wins and sometimes he loses, because sometimes he’s right and sometimes he’s wrong. Not because of some ridiculous arbitrary stop loss plan. The next time the market wiggles the millionaire doesn’t even know about it because he’s sipping rum runners on a beach in Barbados. He spends half the profits on a nice vacation and pockets the other half. Meanwhile, Joe Schmo is trying to figure out how he’s going to tell his wife that he’s lost a sizable chunk of their savings. He’s throwing change in a jar, saving for the annual trip to Florida.

So the millionaire only had a profit of 2% of his assets, but he came out of the trade with $24,250 more than Joe did, which may have been half of Joe’s annual income. And maybe for the millionaire it’s only a few house payments, but still it’s clear whose coming out ahead in the long run.

What should Joe have done differently? He could have bought an E-Mini contract instead for a margin $3,938, less than 4% of his total investment capital. That’s gives him a lot more wiggle room and puts him a lot closer to being on an even playing field with the millionaire. Outright, he’s not going to make as much in profits as the millionaire, but on a relative basis he’s going to make more and be one step closer to being a millionaire himself.

So you seen money management is the key. Not arbitrary asinine stop losses. I don’t mean to sound like a conspiracy theorist, but the trading industry actively promotes such stop losses, which in the short run equates to more turnover and more commissions generated, even if it equates to less investment capital and turning traders into investors in the long run.

This is not to suggest that there isn’t a time and place stop losses, especially in positions with unlimited loss potential, but usually money management is to blame. Also, not everyone with money manages it well in the markets. Many people with money are going to trade just as haphazardly as someone with much less. But on average the people with money, and the wherewithal to withstand the markets gyrations, are the people who are best able to keep it and add to it.

As to how to be right about the markets more often than you're wrong, that's the easiest thing to do. If you buy stock in companies that are producing goods and services of value, stockholders 'should' benefit either from the company returning some of its profits to investors or as the company increases what it produces and therefore its profits. It's really that simple. As to how to get more money out of the markets than most other people? Well, that's where things get exponentially more complicated and out of the scope of this post.

posted at 1:02 PM 2 comments

Friday, October 07, 2005

Blogs Rule

If it’s not one thing it’s another with the sensationalism of the mainstream media (MSM). Since I started this blog at the beginning of the year I’ve gone back and forth about whether or not I should avoid alienating myself against the MSM. I’ve written for some well known investment sites, may very well do so again in the future, and would like to keep that door open. But after ten months straight of blogging I still love doing it so much more than I ever did writing for the MSM. And it’s infinitely better than all the cubicle jobs I once had. It’s time I fully come to the realization that I’m a ‘blogger’ and I’m part of the evolution of blogging. What I really am is part of a solution to a problem, filling a niche created by a deficiency within the MSM as it relates to the public’s need for information. The MSM is constantly at odds with balancing between what draws in the most numbers and quality of content, which frustratingly aren’t very well correlated.

Actually, I have that same dilemma on a smaller scale. I know very well, what things are going to push peoples buttons and what isn’t. I’d get more readers by alienating half of my audience, because I’d create loyalty among the other half. The most insightful and potentially money making posts seldom get commented on. I’m more apt to get a comment about a typo. But write about New Orleans, and I’m running for cover to avoid a flame war.

Well I’ve not given in to the writing what people want to here on this blog. I’m no saint, but I’ve held on strongly to the principle telling the truth as I see it, writing what I think and believe are a superior strategy in the long run. The fact that the vast majority of market information sources tell people what they want to hear leaves a small niche for the minority of people who want to be educated rather than just entertained.

For the MSM and the majority of its viewers watching the ebb and flow of their 401k plans while reading Suze Orman’s books, the markets are a never-ending reality show.

Blogging is like a disruptive technology. The MSM media feels threatened by it and has been critical of bloggers saying that we’re unreliable sources of information, don’t adhere to standards, and don’t have any credibility. Yet the MSM is simultaneously trying to embrace blogging, quite unsuccessfully, in my opinion. The MSM doesn’t understand what it is about blogs because it doesn’t understand what it is about them that people are attracted too. In most of the MSM blogs I’ve seen they are populated with posts written by their commentators. The MSM thinks that they can out compete the real blogs with their personalities.

The problem with this approach is that commentators are generally speaking people with communications and journalism backgrounds. They are middle-men. They are well trained in the art of interviewing, entertaining, and sensationalizing. For most of them economics and the markets are secondary and coincidental. Most of them probably fell into the financial world coincidentally and would otherwise be local news anchors reporting on politics and traffic jams. They are not necessarily passionate or knowledgeable about the markets or economics. So when a commentator offers up their own opinion whether it be in print, on TV, or in a blog it’s taken with a grain of salt.

What the MSM media isn’t getting about blogs is that they are like bringing on an expert and giving them an hour to say everything they ever wanted to say about the markets, what they really think and feel. The media doesn’t do this. They ask questions. They steer the conversation and constrain time. In interview after interview we hear, “Sorry, but we’re out of time. We’ll have you on again another time.” We’re left with the feeling that the interviewees aren’t finished saying what they want to say, often being cut off before they’ve gotten to their most important points, they are frustrated with the experience, and may have even been taken out of context or were attacked and not given a chance to defend their arguments.

There are plenty of bad blogs out there just as there. One commenter recently tried to infiltrate this truth-oriented blog by guiding readers over to another blog hyping penny stocks. That’s bad, but you know what, I don’t think it’s near as bad as big Wall Street firms hyping the energy markets because they take advantage of their reputations and their ability to influence large numbers of people. Anyone gullible enough to fall for a penny stock scam is doomed to financial failure regardless. But when Goldman Sachs says oil could go to $105 a barrel, people take that seriously. Well, $105 was a bit much and people didn’t take it all that seriously. But if they had said $80 people would have taken it seriously and they would likely have bought oil futures contracts on that information. Indeed they take the consummate oil bull T. Boone Pickens seriously, even though T. Boone runs a multi-billion dollar energy hedge fund that’s long oil and he’s constantly ratcheting up his predictions to a new point above whatever the current price is.

What I’m seeing with regard to the evolution of blogs is that if the standard for being judged is the size of the audience then people relate to information sources they way they relate to professional sports. Professional athletes are judged solely by their ability to draw crowds, which usually is related to their abilities. At one time it was expected that professional athletes would come up through the ranks of college ball. Now NBS players are plucked up off the streets and baseball players are brought up from the Dominican Republic. They are judged based on their abilities, how those abilities can help the team, and the fans approval of both the individual and how that individual contributes to the team.

Professional sports and the financial markets are similar in the fact that there is very little discrimination. Yes, Wall Street firms and colleges discriminate. But, anyone who is good enough can become a professional athlete. And anyone who is good enough can make money in the markets and with blogs have a respected opinion about the markets. The key in both cases is exposure. A good street ball player has to be seen by recruiters. They’ll probably play in various amateur tournaments. They have to play a lot, and be seen a lot. They can’t just expect to have a few good games and go pro. Similarly, bloggers get audiences by being insightful or entertaining. None of the usual criticisms of the MSM pertain to the top bloggers accurate.

In some ways bloggers are actually held to higher standards than professional journalists and commentators because when we are wrong we get instant feedback. And being wrong gets far more feedback than being right. If people think I’m full of it they’re going to tell me, as they have on occasion. And they won’t read my blog. By contrast people have to come to accept that the MSM is not only going to comment on the news, but also create it. Bloggers are only going to get the spotlight if they are doing something right.

So I’m coming to grips with the reality that I’m a blogger, whatever that means. For me it means independence and freedom of speech. It means that I can relate my frustrations, be sarcastic and cynical, poke fun at others, and myself, and tell the truth about the markets instead of telling people what they want to hear.

I’m not going to hold back any more. I’m going to tell it like it is.

posted at 4:33 PM 7 comments

Give the Fed a break

I’ve had technical problems with the blog all day, so my posts are abnormally late. My apologies.

CNBC commentators almost unanimously thought the Fed should and would stop hiking rates after Katrina. The Fed did not and as I told you they would, they’ve been signaling even further rate hikes. CNBC has been very critical of the Fed’s recent outspokenness and particular critical of Richard Fisher.

Back in June in a “First on CNBC” (and probably last) they interviewed Richard Fisher the president of the Dallas Fed and FOMC member. In that interview he said that the Fed was in the 8^th inning of its rate hikes. Recently, Mr. Fisher has been hawkish and CNBC has really been letting him have it for allegedly changing his stance so abruptly.

The Fed can’t win with the media. They complain when the Fed isn’t telling them anything and they complain when they are outspoken accusing members of being media hounds. They get Fed representatives on the air and then they stab them in the backs taking their words out of context.

CNBC has been all over Fisher for his 8^th inning comment but hasn’t bothered to replay the brief interview with him so people could hear what he really said. Well I found the Richard Fisher interview online and clearly he’s been taken out of context. Additionally, CNBC has conveniently forgotten that at the time they said repeatedly that Fisher was new and probably wasn’t speaking for the Fed.

For your convenience I’ve written out most of what Mr. Fisher had to say in that interview:

Fisher: We’re clearly in the 8^th inning of the tightening cycle. We’ve been doing 25 basis points per inning. It has been very transparent and very well projected by the FOMC under the chairmanship of Alan Greenspan. We’re in the eighth inning. We have the ninth inning coming up in June. We feel very strongly that we’ve been getting good fast hard pitches right down the pipe. 4%, 3 ½ +, 4% growth. And by the way, if you think of baseball between the knees and the letter of the 1 to 2% inflation. In the first quarter we had some curveballs and some knuckleballs, but we stood in our batter stance and hit another single 25 basis point rise.

We’ll have a ninth inning round probably at the next FOMC meeting, at least that’s my bias at this juncture. I think there’s room to tighten a little further and then we’ll see. We’ll see how we’re standing against inflation, we may go into extra innings in that contest against inflation, but if we’re going to err on the side of anything presently I think we’re growing fine. It’s a big $12 trillion economy growing at over 3 ½% according to recent numbers. Don’t see a reason for that to change even despite these recent data released the last few days.

The job of the Federal Reserve is to make sure that inflationary mold does not plague or infect our household and we’re going to fight that inflation to make sure it doesn’t become a problem. Meanwhile, the economy continues to grow and I think we’re in a, I think we’re playing a pretty good game right now.

Commentator: Before you were talking about perhaps a time to reassess, what would be the reasons why the Fed might stop…and why it might push ahead?

Fisher: We have a double mission here. The chartered mission, the obligation, the duty of the Federal Reserve is to keep the virus of inflation at bay and to maintain economic growth and we have to get where you have that stasis where you’re neither stimulating inflation nor you’re discouraging economic growth. We’re not quite there yet. We’re getting closer. And as to when we get there, stay tuned.

If Fisher was guilty of anything it was nervousness and innocence. His answers came across as seat of the pants. The media took the 8^th inning comment and ran with it, leaving the rest of what he said out. Fisher was naïve to trust the media and not hedge his words better. He said what he really thought and they took advantage of him.

In recent criticism they’ve conveniently left out the comments about having to go into extra innings. They took him context and sensationalized the story. They’ve painted the Fed as not having a clue as to what it’s doing. They’ve ignored all the facts of the situation and any sense of rationality.

If you go back to June you will recall that at that time even energy prices were settling back down temporarily. Oil prices had fallen back into the $40’s, growth was strong, and inflation was settling down. The fact is, every negative thing about this economy is tied to high energy prices. Most of the inflationary data at the producer level is in one way or another traceable back to petroleum costs. As Fisher said economic growth was good. If energy prices were under control we wouldn’t have a problem. In June it looked like energy prices might be getting back under control. That turned out not to be the case.

Recently some analysts and economists have been making the argument that the Fed shouldn’t hiking rates because it’s monetary action won’t control energy prices, which is the primary inflation driver. They say that the Fed is just going to kill the economy. They might be right about that, but they are dead wrong to say that the Fed shouldn’t hike rates. They are incorrectly assuming that the Fed has become more hawkish in order to fight back higher energy prices.

Recall that oil prices were actually quite a bit higher before the hurricane’s hit than they are now. Then the Fed was still on a path of heading to just this side of neutral. Fisher was absolutely right about that. You can read the August meeting minutes and see for yourself. Before the hurricanes the Fed was in the final innings of its rate hike cycle. It was trying to get rates to the balance point between growth and inflation. That point is one that promotes modest growth without stimulating inflation, as Fisher said. All indications are that the Fed views that level as being somewhere around 4% to 4.5%. A neutral level in the Fed’s view is probably about 4.5% to 5.5%, with 6% tipping over to the side of protraction. All indications were that the Fed was headed for precisely where Fisher said it was. And then the hurricanes hit. That changed the game. I don’t see how anyone can logically blame Fisher for that.

So the Fed is now more hawkish and we’ve heard from a number of members in this regard because they are trying to prep us for higher rates than it had thought would be necessary before the hurricanes. The Fed isn’t fighting energy prices. It’s fighting demand growth, which is what it always does when it fights inflation. It’s not doing anything new here.

Economists have said that the hurricanes won’t add to growth because they just amount to redistribution of money. What they have said is that income from the hurricane rebuilding will be offset buy the money we give to the government in the form of taxes and bond buying. But in reality there is only a partial offset. In reality if the government offers new debt to cover the expenses, it will drive long-bond yields higher, which will do two things. It will attract foreign capital that might otherwise have gone into say German bunds instead of U.S. debt. And the steeper yield curve will help our financial institutions and probably make our economy stronger by keeping capital flowing.

So there will be a net gain from the rebuilding and that means there will be growth in demand, which is exactly what producers need in order to pass on their higher costs. From the Feds view it would be better to have a period of slow growth than having prices ratchet permanently higher or even worse yet stagflation. The way stagflation can happen in this case is that free flowing government money and the need to act quickly in the rebuilding enable companies to price goods higher despite the impact to demand in other parts of the country. In other words a lumber company isn’t going to care if you don’t want to pay $5 for a board if they can get $5 for it somewhere else. You might buy less boards at $5 if you’re used to paying $4, but when you do need a board you’ll have to pay the $5 regardless. Eventually, demand could subside, but prices of many goods tend to be sticky. Once they go higher, they’ll be slow to come back down. They’ll wait for economic growth and income levels to catch back up, but they’ll also contribute to slower economic and income growth. That’s stagflation.

Consequently, the Fed now sees the need to balance economic growth and control demand in order to control prices. Forget all the Keynesian bullshit you’ve been hearing on the TV. It’s not that complicated. The Fed needs to make borrowing money more costly to limit the amount of money people are willing to borrow, which limits growth and the ability of companies to pass on their higher costs. In turn, if consumer demand slows then producers won’t need to buy as many commodities. And if producer demand for commodities slows, then the energy bubble will burst.

I REALLY hate to say it, but it’s possible that a slight slowdown is exactly what this economy needs to get back on track. Either way it’s not a pretty picture. If we grow we’re going to get inflation and high interest rates. Slowing down stinks too. These high energy prices have little to do with supply or demand. We know that because now that we have a very real and significant disruption to the supply of oil, prices are actually lower than they were before. It’s speculation and the psychology of the speculator that’s driving prices in the short run, much more so than supply and demand. And the only way I see to wring the speculation out of the energy markets is for the markets to become uninteresting. The way for that to happen is for there to be a significant and prolonged decline or leveling in demand, and that can only happen if there’s a decline in growth.

posted at 4:25 PM 0 comments

Thursday, October 06, 2005

Will Bird Bug Rock the Markets in 2008?

The hurricanes are old news. That, at least, is the perspective of the mainstream media. So they’ve moved from sensationalizing old news to sensationalizing new news. Now it’s the bird flu. The President mentioned bird flu in a speech last week as an example of the kinds of things that the federal government needs to be prepared for. Ever day since CNBC has been annoyingly reporting on the risks of bird flu and how such an event would impact the markets.

What makes the bird flu so tempting to the media is how incredibly deadly it is, killing roughly half the people who get it. It’s no matter to the media that the bird flu can’t even be passed from person to person. You have to get it from playing with chicken poop and infected chickens or other birds. Last time I looked out the window I didn’t see any sick chickens running around trying to infect people. So unless you live on a chicken farm your risks of getting such an illness are about as likely as dying in a bungee jumping accident if you’ve never bungee jumped and never intend too. It’s no news, yet the MSM acts as if it’s spreading across our country at this very moment or will within the next few years, killing millions.

Sure it’s a problem in Asia. Asia’s mostly third world countries and cities with chickens running loose in the streets. People in third world countries still keep chickens for their own nutrition. Very few people do so in the U.S. anymore and those that do are mostly very isolated living in rural locations where it would be more difficult for the virus to spread. It’s such an annoying non-issue that I find myself shutting off the TV.

But it is a great example of the constant sensationalizing that the MSM bombards us with. Recognizing this, is good practice for understanding how the MSM also blows everyday market news out of proportion and how they cause investors to overreact in such a way that can be profitable for the less gullible.

posted at 3:01 PM 4 comments

Market View

Normally I don’t give much heed to consumer sentiment surveys and indices. But, in this particular case the negative sentiment along with a spate inflationary economic data, hawkish comments from FOMC members, and early earnings warnings have sparked a sudden sell off of nearly 3% in the S&P 500 this week.

It’s risky to say the least, but I believe that the current negativity in the markets will soon be offset by stronger than expected earnings. Analysts are fairly negative too and therefore aren’t expecting much from companies for 3Q. Most people expect that high energy prices and the hurricanes pretty much killed growth.

I believe that investors are being overly negative, overestimating the damage done by higher energy prices, and nearly unanimously underestimating the 3Q earnings. I expect this earnings season to be a very volatile one. Investors will be particularly tuned in to the earnings of key companies, just as they have been paying more attention than usual to otherwise unstimulating economic reports.

It could even be that institutional investors have been making portfolio adjustments to hedge against the possibility of major drop in the markets as a just-in-case insurance policy. October is psychologically associated with severe market declines, even if there is nothing mechanical or logical about it.

In my view investors are right to be cautious, but that will only add to the upside surprise should the net of corporate earnings come in good relative to the current market sentiment.

The biggest positive surprises could come in less energy and retail sales sensitive areas such as tech and healthcare. I give specific ideas on how to play this possibility in The Market Spectator newsletter service.

posted at 1:09 PM 0 comments

Wednesday, October 05, 2005

Lose – Lose Situation

Yesterday the markets tanked on concern about inflation and higher interest rates. Part of that concern stemmed from a 5.8% jump, to 59.4, in the Purchasing Managers Index (PMI) of the September Manufacturing ISM Report on Business. There were jumps in new orders, production, deliveries, inventories and backlogs. But the worst jump came in prices, which increased by a whopping 15%.

Then today the markets dropped again as the Business Activity component of the September Non-Manufacturing ISM Report on Business fell 11.7%, to 53.3. Investors are more focused on the prices component, which increased 14% in the services sector, than on the economic ramifications of changes in activity.

It’s a bad situation any way you look at it. Companies are having trouble passing on higher costs. This eats into profits, which is bad for stock prices. If companies can pass on the costs, then the consumer can’t buy as many goods and services, which also eats into profits and is bad for stocks.

Investors, though, still seem to view inflationary data from the perspective of higher interest rates being bad for stocks. They should be applauding the rate increases and begging for them at this point because if a neutral rate of say 5% is enough to keep prices in check, then that would likely offset any negative impact on growth. And if it slows the inflation of home prices too, that certainly wouldn’t be a bad thing. Having home prices appreciate faster than our income only makes it harder for people to transition from renting to home ownership. Some people are able to capitalize on price increases. But the net effect is increased consumer debt, less home for the same money, and more people paying rent, longer.

For all the negatives I am more neutral on the markets than bearish in the short run. The price inflation businesses are experiencing has been driven almost entirely by higher energy costs. The balance is the result of short-term supply disruptions to imports and chemical manufacturing in the New Orleans area.

We’ve seen demand for gasoline drop. There was a drawdown in gasoline inventories for the week ending September 30, but that has come after a month of solid increases. We appear to have reached a limit in the amount of gasoline people are willing to buy at the current prices. The thing to realize about gasoline consumption is that it relates to our habits. When gas prices were creeping up slowly we continued to demand just as much gasoline at all prices because we resisted changing our day-to-day patterns. But, when prices shot higher suddenly after Katrina hit, we were shocked into changing our habits. People apparently began to make a conscious effort to conserve, both to avoid supply disruptions and to avoid paying such high prices. Consequently, I strongly believe that Katrina triggered a potentially long-lasting change in our behavior. Thus far the decline in demand is more than outweighing the disruptions to supply.

Refineries will soon be running at full speed once again, but it’s very possible that demand will remain reduced even if prices fall. The result ‘should’ be that refining capacity utilization will fall, refiners will demand less oil, and oil prices will begin to fall. But for that to happen the hedge funds have to stop being blind buyers of oil futures contracts.

As a related aside there was an interesting debate earlier today on CNBC between an analyst calling for hedge fund regulation and the interviewer. The commentator said that there was no evidence that hedge funds were impacting the markets. The analyst responded that they were and cited data that within the natural gas market the percentage of trading done by hedge funds had increased from single digits in 2000 to 25% in 2004. The commentator said that increased activity doesn’t necessarily correlate directly to the higher prices. He said that the analyst’s statement was an allegation and that he disagreed.

I say good for the commentator for pointing out the fact that the statement was alleged and not entirely proven. We need more of that. What disturbs me, however, is the fact that the MSM alleges things all the time and then picks and chooses what they want to let their interviewees get away with alleging.

At the beginning of the summer the MSM jumped all the hedge funds speculating and alleging which ones were blowing up over GM’s debt being downgraded to junk status. In the end it was purely speculative. The MSM could never point to a single fund that went belly up because of the debt downgrade, or even one that was substantially hurt by the event. They did make a big deal about every single fund that closed up shop around that period of time and insinuated that the two must be related, but it was never explained whether or not the number of fund closures were normal. With many thousands of hedge funds now in existence, on any given month there are sure to be funds opening and closing.

In the case of the energy markets the MSM has been consistently willing to let interviewees speak allegedly in terms of supply and demand issues as the reason for higher prices, but not with regard to anyone pointing to speculation as the cause. I allege that there are simply too many important players with an incentive to keep energy prices high: Wall Street firms, Oil companies, hedge funds, the exchanges, etc… all benefit in the short-run from high energy prices. They all have an incentive to shoot themselves in the foot, because in the longer-run high energy prices are hurting the economy and the consumer. But when an analyst says oil prices are higher because of demand from China, the MSM never says the analyst is speaking allegedly? Why is this? What is the agenda of the MSM? I ‘allege’ that it’s because high energy prices have made for a steady stream of sensational news about a subject that is easy to sensationalize because people no so little about it.

But to say that speculation has played a significant role in higher energy prices is a fact, not an allegation. We can’t get the data we need from the exchanges to prove that hedge funds have been net long buyers of oil futures contracts because the exchanges don’t the futures exchanges don’t want the futures being blamed for increased volatility in the markets driving prices incredibly higher. If it were conclusively proven to be true that speculation alone has been responsible for oil prices quintupling in the last five or so years, then we’d have to take a hard look at the possibility that something more than just supply and demand economics can drive prices.

But this can be proved, and I have proved it in numerous posts here, through a process of elimination. If you can prove, which I have done, that there have been no supply and demand imbalances (pre Katrina), then all that is left to explain price changes is speculation. The fact is, as the data shows conclusively, that supply and demand have risen in tandem and in fact supply has outpaced demand slightly such that prior to the hurricanes inventories were rising week after week. Yet prices kept climbing, while analysts and the MSM kept giving us all sorts of illogical reasons for it. And the MSM media never bothered to point out that these analysts might have had a conflict of interest.

Now days (post dotcom blowup), reporters ask analysts if they own the stocks they talk about, but they never ask analysts if they own oil futures contracts or if the firms they represent own them. In many cases the answer is yes. For example, when Goldman Sachs issued the now famous SuperSpike report calling for $105 dollar oil, the report included a first page disclaimer stating the fact that the firm may have had a conflict of interest, which is now the way the industry gets away with hyping and manipulating legally. The firm, which derives the majority of its revenues from trading activities, was in fact anticipating increased volatility in the energy markets, it admitted with regard to its quarterly report.

posted at 1:54 PM 1 comments

Dallas Hawk

When Dallas Fed president Robert Fisher talks people listen. And they didn’t like what he had to say today at the Greater Dallas Chamber Economic Forum. What makes his comments so important to investors is that they reflect opinions that reflect an intimate knowledge of most recent FOMC meeting, which we won’t be privy to until the end of the month. It is reasonable to assume that Mr. Fisher is at least to some degree communicating the consensus opinion established in that meeting.

Highlights of that hawkish speech:

“Other negatives for Texans include increases in the costs of doing business. Rebuilding efforts will push up prices for construction materials. Many industries are likely to encounter higher fuel, freight, utility and transport costs—a heavy burden for those sectors, like airlines, already facing hardships. Consumers will have to pay more for winter heating bills and possibly gas at the pump, so they may have less to spend at retail stores and restaurants.”

“Yet, even with these drags on the economy, it appears that the hurricanes’ net effect will be slightly positive for Texas.”

“Dallas Fed economists expect the Texas economy will continue to grow and may well accelerate in the aftermath of the storms.”

“Before Katrina and Rita, higher energy prices had begun to exact a toll on many consumers and businesses. Much of the Federal Reserve’s monetary policy accommodation had been removed. Many homeowners with adjustable-rate mortgages tied to short-term interest rates were about to have their mortgage rate reset. And sales of automobiles and light trucks were bound to slow after an incentive-induced summer surge. These factors help explain why the national economy appeared to be transitioning to a phase of slower growth.”

“Inflation has been on a slight upward tilt the past couple of years. Now, the inflation rate is near the upper end of the Fed’s tolerance zone, and it shows little inclination to go in the other direction. We now face higher energy prices and businesses’ desire to pass the increased costs on to their customers. Combine the energy spikes with spending increases by governments at every level in the aftermath of the two hurricanes—John Maynard Keynes seems to be the patron saint of both liberals and conservatives these days—and you have new demand pressures added to the old ones.”

“The FOMC has taken note of the fiscal situation, as shown by this pre-Katrina passage from the released minutes of the Aug. 9 meeting: ‘Few signs were evident that greater fiscal discipline in the budget process would emerge any time soon.’”

“In this environment, the markets, if left to their own devices, would produce higher interest rates to ration money and balance the demand and supply of capital. If the Federal Reserve were to resist the upward pressure on interest rates, it would in effect monetize the burgeoning fiscal deficits. The Federal Reserve has staunchly resisted monetizing deficits for more than a quarter century, and I feel strongly that it can ill afford to monetize them today.”

posted at 11:08 AM 0 comments

Tuesday, October 04, 2005

Dollar Reaches 16-Month High Versus Yen on Growing Yield Gap

Dollar Reaches 16-Month High Versus Yen on Growing Yield Gap
The dollar rose to a 16-month high against the yen and traded near a three-month high versus the euro on speculation the yield advantage of Treasuries over Japanese and European debt will increase.

Signs of U.S. manufacturing strength have mounted in recent days, bolstering speculation the Federal Reserve will push interest rates higher. The Commerce Department today reported factory orders higher than forecast for August, and indexes of factory expansion nationally and in the Chicago area also exceeded expectations.

A weak dollar is the downside of ultra low interest rates. It makes a case for a neutral to modestly accomodative rates so long as inflation can be contained at that level.

posted at 1:59 PM 0 comments

Crude Oil, Gasoline Futures Plunge as Higher Prices Curtail Use

Crude Oil, Gasoline Futures Plunge as Higher Prices Curtail Use
Crude oil and gasoline plunged on signs that record prices are curtailing fuel demand as refiners repair units damaged by Hurricanes Katrina and Rita.

``We are starting to see a change in consumer behavior,'' said Michael Fitzpatrick, vice president of energy risk management with Fimat USA in New York. ``Consumers are cutting back because of high prices, rising interest rates and signs that the housing bubble is ending. Prices have probably begun the long steady process of grinding lower.''

posted at 1:55 PM 2 comments

Economic Indicators Front and Center

Looking forward at the economic indicators for the rest of the week:

WEDNESDAY

ISM Services report for September: Market expects the index to come in at 60. August was 65. Recent business indicators suggest that the index could be higher than expected and seen as inflationary driving the fed funds futures yet lower. This report will get attention because of its timeliness. It will be interesting to see how the ISM manufacturing index released yesterday differs from the services index.

EIA Petroleum Data: Look for more builds in gasoline inventories. If that were combined with a lower than expected draw down in crude, it could motivate stock buying.

THURSDAY

Initial Jobless Claims: Jobless claims spiked in early September but have already fallen back to year ago levels. A significant drop in jobless claims could be indicating hiring directly and indirectly related to hurricane reconstruction, which would serve to validate the growth in manufacturing orders and would therefore be seen as additional inflationary evidence.

FRIDAY

The Employment Report: This is the biggie. It’s September data. The consensus is for unemployment to climb to 5.1% from 4.9%. It will be widely watched as a measure of the impact the hurricanes might be having on the macro economy. Economists will likely try to use this to understand what might happen to the 3Q GDP released near the end of this month.

September economic data will be rolling in steadily throughout the month. The data will be more widely watched than otherwise, and will likely move the markets. Here’s a list of some of the important releases to keep tabs on:

10/11 FOMC meeting minutes
10/14 CPI
10/14 Retail Sales
10/14 Industrial Production
10/14 Business Inventories
10/18 PPI
10/19 Building Permits
10/19 Housing Starts
10/20 Leading Indicators
10/27 Durable Goods Orders
10/31 Personal Income

Note that the FOMC meeting minutes should give us some indication of how the Fed saw the hurricanes, home prices, and energy prices relating to inflation and growth.

posted at 1:41 PM 0 comments

Monday, October 03, 2005

Here come the 50s

Fed funds futures are now anticipating a high probability of quarter point rate hikes for both of the next two meetings taking rates to 4.25% by the end of the year and a small probability that the Fed will increase rates again at the beginning of February. The January fed funds futures are now at 95.7950.

One hundred minus the fed funds futures gives you the expected rate and a point from which to calculate the probability of a certain level being obtained. In this case 95.7500 equates to 4.25%. A futures price of 96.0000 would equal 100% probability of rates being at 4% and a 0% probability of getting to 4.25%. Thus the price of 95.7950 represents a high probability of obtaining 4.25%.

If we get any more inflationary looking data I wouldn’t be surprised to see the price drop below 95.7500, which would mean that 4.25% is fully priced in and there’s a small probability that the Fed could hike rates faster than a quarter point at a time.

I’m not at all certain that the Fed would do so, but I can say that pre Katrina FOMC meeting minutes leaned more towards the possibility of having to raise rates faster than towards being able to stop hiking altogether. The Fed had been saying that it felt it could continue to raise rates at a measured pace. It was saying that for the time being it could be measured, but was uncertain that it could continue to be measured, in which case it would have to raise rates even faster.

I’m starting to be inclined to believe this may be very likely because if inflation is already looming and beginning to hit home, then the Fed needs to be at an non accommodative level to stave off inflation. It appears to me that in the Feds view such a level would be greater than 4.5% and as high as 6%. If the Fed were to raise rates by 50 basis points at a time it would be at 5.25% after the February meeting, three meetings from now.

When you stop and think about it, this doesn’t really seem all that inconceivable. Investors have gotten used to measured hikes, but actually they are not at all the norm. In the history of the Fed faster rate changes are very common. Just a few years ago the Fed was dropping rates 50bp at a time and even dropping rates between meetings reacting quickly to the recession. It would be naïve to think that the Fed wouldn’t react just as quickly to stave off inflation if it thought the outlook for future price stability was no longer contained.

It’s very possible that this was actually what Greenspan was hinting at when he said, “…administrative or policy actions that await clear evidence of imbalance are of necessity late.”

This implies that if we have clear evidence of inflation, then the Fed has acted too slowly and would therefore need to increase its monetary action. When Greenspan spoke about the economy’s resiliency he wasn’t talking about the ability to overcome inflation, rather he was talking about the ability to overcome higher interest rates and rate inversions. We don’t really know if our new economy is resilient to inflation or not because we haven’t experienced any significant inflation in 25 years. We do know, however, that the financial institutions are better able to weather sharp changes in interest rates than they were in the past. And the more I think about it, the more I’m inclined to believe that the primary purpose of the Economic Resiliency speech was to prepare us for such an event, something that hasn’t registered with the majority of analysts and pundits as of yet.

But many of the contrary things I’ve had to say on this blog have managed to find their way into the popular thinking. So it will be interesting to see if that is the case once again.

posted at 5:46 PM 2 comments

Do I hear 50?

The ISM index rose to 59.4 for September from 53.6, a significant jump. However, the prices paid index leaped to 78 from 62.5, the largest increase in 15 years indicating significant inflation in production costs.

Orders and backlogs both rose. After seeing large increases in a the Chicago PMI last week and other measures of production it’s looking more and more like the impact of Katrina reconstruction efforts are already showing up.

This is very inflationary from the Fed’s perspective. When Greenspan gave his Economic Flexibility speech recently one of the points he emphasized was the difficulty of recognizing problems ahead of time. He said on this matter:

“It is important to remember that most adjustment of a market imbalance is well under way before the imbalance becomes widely identified as a problem. Individual prices, exchange rates, and interest rates, adjust incrementally in real time to restore balance. In contrast, administrative or policy actions that await clear evidence of imbalance are of necessity late.”

It looks like inflation might be bearing down on us quickly and the Fed has still been raising rates at a ‘measured pace’ and remains in its view at an accommodative level. I’ve said all along since Katrina hit just over a month ago that it would be an inflationary event and the Fed wouldn’t halt its rate hikes. Now we seem to be seeing the results far sooner than just about anybody expected. This is precisely why the Fed should never play politics and cater to the markets, which would have them cease hiking rates altogether.

Today’s ISM index and other recently released data reflecting September’s business activity has to spark concerns about whether or not the numbers will keep growing over the next several months. Now I’m all for growth and business, but the economic fundamentals of the matter rule dictate that business growth equals pricing power, which in turn means that we could start to see higher prices trickling down to the core CPI as economists have long been expecting. It’s very likely that if we keep seeing jumps in business related data that the Fed could step up to 50 basis point hikes and could even intervene between scheduled meetings.

posted at 5:12 PM 0 comments