Friday, April 28, 2006

The Truth About Inflation

We hear a lot about how much home prices have risen. It turns out that they haven't risen nearly as much as people believe they have. Not on average. Sure a lot of people have made a lot of money on real estate. But for every boom building market there's two two-light towns, backwater bungalows, and cities overrun with rowdy neighborhoods lined with row houses, mostly stagnant markets, lifted only by peer pressure and rising incomes.

At the same time, the term McMansion has arisen to describe suburbs filled with behemoth homes occupied by families of three instead of the perfect four.

That got me thinking, how much has the size of the average home increased. Answer: according to the National Association of Home Builders from 1,900 square feet in 1987 to 2,400 in 2005.

Meanwhile, the average home price has risen during that period from $127,000 to $292,000. Straight up that's 130%, or roughly 7.2% per year. That's somewhat significantly higher than the overall inflation rate of 5.7% calculated by the CPI.

However, and it's a huge however, calculating the change in home prices straight up is the wrong way to go about it. The average home has increased in size 26%. So the cost of building the average home has increased buy a similar amount. People choose to buy bigger houses. They don't have to. They do because they can. If they chose to buy the same size house as they did in 1987, what then would be the rise in value of the average home. The right way to calculate the real change in home prices, which no one ever does, is on a square footage basis. Divide the price by the square foot and then calculate the change over time. By that method the average home has increased in value 4.5% per year. Significantly less than the CPI!

And much of that gain has come in the recent housing boom. Through 2001 house prices on a square footage basis were only increasing a paltry 2.7% per year.

Reality check. Women went to work. Families with two working adults can buy bigger homes than families with one. People choose to buy bigger homes because they can. The data proves this too. Bureau of Labor Statistics data shows that the in 1997 people spent $11,272 annually on housing, in 2004 it was $13,918, an increase of 23.5%, or 2.9% per year. But household average weekly earnings have increased 34.9%, or 4.4%. So even with people buying bigger homes, their spending a smaller percentage of household income on housing.

Additionally, the overall CPI, including energy prices has increased 25.3% from 1997 through March, quite a bit less than household income.

posted at 4:45 PM 3 comments

The Legend of Phillips Curve

The Phillips Curve keeps coming back to haunt us, though it was proven unreliable and basically wrong, thirty years ago. Wikipedia has good write up on it so no need for me to bother. If you're interested in such economic topics, whatever that says about us, the history is worth reading.

posted at 3:44 PM 3 comments

Not Losing Sight of Being Right

With my reality check in mind, this blog enables readers to get a glimpse of the process I go through to come to the conclusions I do about the markets. To get to those conclusions involves learning a lot about a lot of things along the way and sifting through a lot of detail and hitting a lot of dead ends along the way. There's a lot of ideas and small conclusions along the way that lead to bigger more profound and useful conclusions.

I'll go for weeks on end where nothing really hits me and then I'll get on a role. It's a creative process, like how an author can crank one mediocre or bad book and the next is a hit. Being absorbed in the markets without drowning in the detail and the noise is the key.

There's been a fair amount of debate on recent posts, most civil and respectful, some not so. Be polite, whether you agree or not, debate civilly and I will most certainly give a civil reply whether it's agreeable or not.

These nuances that have been debated about how employment and inflation have been calculated in the past are irrelevant to the macro conclusions.

The conclusions are that people probably overestimating the magnitude of a housing decline and the impact on consumers. That would quite normal. It's also to be expected that the majority of people wouldn't see this and would be in denial of it. It's inherent, because that's what causes the exaggeration and overestimation. Consequently, it's to be expected that people would not believe me and would debate me on the matter. The RELEVANT data that I have presented suggests this is the most likely scenario.

Similarly, I've presented information suggesting that theirs a high probability that inflationary influences in the economy are likely to be near a peak. And since a peak in a market represents the point where the largest number of people wanted to be in that market, it's to be expected that a lot of people are going to be in denial at that point in time. Of course it's always possible that the market will do the unexpected. But the house doesn't make money betting on the unexpected, it makes money betting on the normal expectation.

So I'm saying to you that at this point in time I see evidence to suggest that both a slowing housing market and inflationary pressures from commodities probably won't be as bad as most people expect. And that's positive for the stock markets in general and you can readily come to the conclusion that it's more positive for some stocks than others. If that turns out to be right then it's a good place to start, already being on the right side of the market when people wake up to the reality they were unable to see.

posted at 3:25 PM 0 comments

Reality Check

I am an analyst by training and trade. I specialize in analyzing markets. Sometimes I'm right sometimes I'm wrong. I analyze that too and try use that to be right more and wrong less. My philosophy is simple. Be right. I have found that the process of writing, thinking about what I'm writing, considering what other people will think about it, considering other peoples opinions and debates about what I have written helps me to be right and come to conclusions about the markets that I would never have otherwise came too. It helps me to be right more often.

If I were a multimillionaire and made my living solely from my trading activities I would still write. That's the conclusion I've come to. The fact that I happen to write a blog is meaningless. Blog is just a word. It means nothing. If I write for a site called blogginwallstreet.com or a stockblog.com or anythingblog.com then I'm a blogger. That's a bunch of B.S. I'm an analyst that uses writing as a tool to convey my analysis and the process of that analysis to other people because other people find value in that. Take blog out of the domain name and don't call it a blog and it's not a blog, it's an article. The fact that it's more or less refined than certain accepted norms is also meaningless. The blog is just the innovation that makes it quicker and easier for me to provide my analysis to other people. It's efficient and that enables me spend more time doing analytical work and that means more output.

How many hours do academics spend formatting the findings of their research into complicated white papers in such a way that's deemed acceptable to their peers? Indeed complexity is an attribute. A shit load. I like writing a 'blog' because I can say shit load if I want to say shit load. Blogs are indie, because they don't conform to the socially accepted norms of the way information should be conveyed. Calling writing a blog has come to tell people not to have any expectations. No one is shocked that I used the words shit load, because it’s a 'blog'. Read it in the mainstream press and you will be saying to yourself, "Holy shit, he said shit, I can't believe they printed shit!"

That's what I love about presenting my work in a blog. I get to let my guard down and be myself. And that has nothing to do with quality or lack of quality in the work. They are completely independent.

I read a 'shit load' of academic papers. I have been reading then for a long time. The structure serves a purpose. But the competition to be complex among academics is a hindrance to the goal of conveying useful information. A read, or more accurately skim, a lot of whitepapers. I don't understand a lot of whitepapers, to be honest. But I know it's not just me. Having read hundreds upon however many more than a hundred, I don't know how many, I find that there's nothing consistent about them. You'd think that after reading so many I'd know and understand a common language and terminology used in them. But that's not the case. The first things I read are the abstracts and the conclusions. More often than not the abstract doesn't tell me what they are trying to figure out and the conclusion doesn't tell me what the conclusion is. But the title has keywords I'm interested in, so I proceed to the body of the paper to figure out what wasn't discernable from the conclusion. Why? Because, while I hate being wrong, academics can't be wrong. Their careers depend on it and one way to not be wrong is not to make any definite statements. It is what it is.

But it leaves a gap, more of a chasm really, for someone like me with nothing to lose and no expectations to step up, sift through the information, drill it down to a few sentences, or in my case runons and too many overly wordy paragraphs, and state an opinion about what it all means what value can be obtained from it.

Similarly, the mainstream media has personality issues, it has none. The medium doesn't allow much room for it. When writers do show their personality it is considered to be pulp, pop, editorial, or alternative.

Blogs aren't, as the mainstream media likes to describe them, faddish. Only bloggers are faddish. If enough people find a blogger to be entertaining, interesting, or informative and the blogger wants to blog they will have a place in society whether they cuss when they write or not.

I so really hate being wrong. That's probably a character flaw in personallity, but it's an attribute for being a market analyst. In the markets you make money when you are right and lose money when you are wrong. It's that simple. Writing about the markets people make money when I'm right and they act on that information, and vice versa when I am wrong. I always, always conscious and cognizant of that.

For that reason I don't like to get bogged down in meaningless detail and debate of nuances and subtleties that have no bearing on an end conclusion. However, I do have to sift through a lot of detail to come to meaningful conclusions. But generally speaking when people want to go all academic on me and try to show how much smarter they are, and they probably are, then I usually just feel like telling them to bleep off, ok I'll refrain from using that word here, though it's a word I drop plenty when no children are present and I know the people around me.

Why though do I feel that way? Because as an analyst I have one overarching long-term philosophy that I hold to. As an analyst who happens to make most of his living selling analysis to other people, in other words as a financial writer, or writer specializing in the financial markets, whatever you want to call it, I believe being right both on a cumulative basis and a percentage basis over time will grow my business better than any other strategy in the long-term. I'm no saint. But I'm no crook either. It's inevitable that someday I will look back at my work today and see much of it as naïve and immature, and probably overly arrogant, but I will at least be able to look back at it and be proud that it was honest work and better than most of what was available at the time.

So when you read this blog, and I thank you for reading it, even if you disagree with it, know that's where I'm coming from. I'm not going to let what people want to hear influence what I have to say. That's a personal pact I have with myself. Take it or leave it. Though few and far between, I believe there are enough people out there in the whole Internet using, English reading world that respect that for me to grow my business over time. I'm committed to that for the long haul because I'm passionate about it and being able to what I really want to say, right or wrong, makes it an enjoyable and fruitful endeavor.

posted at 3:03 PM 1 comments

Thursday, April 27, 2006

Unemployment and Inflation

Readers: If you're skimming the blog, this is one post you should read in its entirety. It contains an important economic realization.

In the prepared testimony Bernanke stated with regard to labor and capital utilization rates, "As the utilization rates of labor and capital approach their maximum sustainable levels, continued growth in output—if it is to be sustainable and non-inflationary—should be at a rate consistent with the growth in the productive capacity of the economy. Admittedly, determining the rates of capital and labor utilization consistent with stable long-term growth is fraught with difficulty, not least because they tend to vary with economic circumstances."

My sense has been that the Fed has been a little overly concerned about this risk. I believe that the market is better capable of sorting this out than in the past. It didn't do such a great job between in the five or so years of the late 90s and early 00s, but I think there are some key fundamental changes at work.

Specifically, I believe the labor market, mainly due to the Internet, is getting increasingly more efficient. Looking back at the history of unemployment, between 1948 and 1970 unemployment averaged 4.7%, roughly the same as today and that was not a period known for high inflation. The unemployment rate has averaged 5% over the past 10 years. However, he range of the unemployment rate during the 50s and 60s was between 2.5% and 7.9%, while in the past ten years it has been a substantially less volatile range of between 3.8% and 6.3%. This is The Great Moderation Bernanke has written about and did also mention in his testimony. So we're not at levels that should be a cause for concern.

But even more importantly, the data actually shows strong positive correlation between the unemployment rate and the CPI going back to 1948, which means that when unemployment rises inflation rises. What's most interesting is that there's a lag indicating that as unemployment is rising it leads to future inflation.

On a one for one basis there's a small positive correlation of 0.22 between unemployment and inflation, with a one year lag it jumps to +0.52, 2 years = 0.64, and then it heads back down to 0.63 at 3 years, 0.47 at 4, and 0.39 after five years. This is describing how the unemployment rate relates to annual changes in the CPI X years later. The smoothness and consistency of the relationship, rising, peaking, and then falling back suggest that the relationship is not a spurious one.

Why would this be so and what does it tell us? I think it relates to the nature of the business cycle. Rising unemployment tends to be followed a few years later by rising prices. In other words, when things are getting better economically at the fastest rate. It says that what we're seeing now is normal, that whenever we come out of recession there's a tendency for prices to increase, but it peaks after a two or three years then begins to wane. And there are indications that that is exactly what is happening in the economy today, that there's some leveling off in price increases.

The overall implication of this information is that there's a high probability based on historical evidence that the worst of our inflation problems may be nearly over.

posted at 3:49 PM 7 comments

Bernanke: More Than Meets the Eye

I always get a kick out of watching the Fed president testify on capitol hill. The politicians repeatedly set political traps attempting to get the Fed president to trip up an say something that can later be quoted as being consistent with whatever agenda the politician is promoting knowing that viewership and press interest is high. The Fed presidents adroitly maneuver around every trap in their path.

Typically, little gets said that hasn't already been said, or isn't already common knowledge. This time was somewhat different, however. For a change I think the media picked up on the correct key comments in Bernanke's prepared testimony.

The FOMC will continue to monitor the incoming data closely to asses the prospects for both growth and inflation. In particular, even if in the Committee's judgement the risks to its objectives are not entirely balanced, at some point in the future the Committee may decide to take no action at one or more meetings in the interest of allowing more time to receive information relevant to the outlook. Of course, a decision to take no action at a particular meeting does not preclude actions at subsequent meetings, and the Committee will not hesitate to act when it determines that doing so is needed to foster the achievement of the Federal Reserve's mandated objectives.

The market responded to those key lines almost immediately taking the major indices from negative to positive. But then the indices bounced between negative and positive for a while as the information was absorbed in more detail. In the preceding sentence Bernanke said referring to the March meeting, "In my view, data arriving since the meeting have not materially changed that assessment of the risks." By assessment he was referring specifically to the Feds conclusion and decision to raise rates another quarter point to 4.75%. Put it all together and he's quite clearly saying one and pause, then maybe done, maybe not. All things being equal the Fed is going to take a rest.

But beyond the clarity I think there are also some hidden subtleties, as well. Whereas, other lower ranking Fed members will at the beginning of a speech typically state that they are speaking for themselves and not necessarily the Fed, Bernanke's testimony was entirely on behalf of the Fed. And it wasn't entirely consistent with we've heard from Donald Kohn recently. So it appeared to me that Bernanke was somewhat subtly taking the reigns, while conveniently and simultaneously meeting both the expectations of the markets, leaving his path open to change, and appeasing those members that might be somewhat contentious where his views differ from Greenspans.

In a word, checkmate! He's saying hey lets just take a little, no harm in that. But perhaps a month or two leads to three or four and before we know it we're on our way back down to 4%. Or perhaps not. Bernanke did stress concerns about energy and commodity prices passing through into core prices. But I believe this is his subtle way of getting his way of backing off in light of his economic view that if there is a 'global savings glut' that implies a lower Fed neutral rate tan if a flat yield curve is the result of investors excepting to low of a risk premium because they are underestimating inflationary risks, which was Greenspans view. And that's probably a bone of contention between the current and past Fed presidents, less talked about, but more important than the inflation targeting debate.

posted at 2:27 PM 0 comments

Wednesday, April 26, 2006

A Good Place To Start

This is reader response day, which I particularly like doing because I am so often confronted with questions and debates that I can be passionate about and chances are if they are on the minds of one person they are on the minds of many.

With this improved understanding of how the oil companies relate to the futures markets what's an investor to do?

That's the million dollar question, or for the small investor perhaps the thousand dollar question. I have no shame in admitting that I don't know the right answer to that. Anything I would suggest would be highly and ironically speculative.

What I can do is set the record straight; distinguish truth from lies; and pseudoscience from junk.

Knowing what to do with that information is something altogether. Sometimes the answer is obvious. Other times it's not. With oil it's most certainly not because of the global and complex nature of the market.

You might notice that I don't write a lot about precious metals here, though they've risen in price similarly. There are two reasons for this. The primary one is because they aren't all that relevant to the overall economy. They are mostly speculative. There's a lot of historical rules-of-thumb about gold having certain indicative properties. But they are mostly just more unproven pseudoscience that's gone out the window now. In one of my few posts on gold I showed, quite importantly, that most of the recent escalation in prices has been related to the relatively new gold ETFs.

The other reason is that those markets are easily manipulated. I don't mean to be conspiratorial sounding, but that's the reality. They are small markets on a global scale and they are open to the globe. This is someone no one seems to have a complaint about, but should. American speculators play in these markets by a different set of rules than foreigners do. What's illegal for an American speculator to do goes ignored when other players do it. The Chinese government for example stockpiles and buys and sells large market moving quantities of silver, and front runs its own activity by making massive favorable bets in the futures market.

These markets are especially susceptible to the influence of stockpiling, and manipulation. So I just stay the heck away.

Oil is similar in that the global pricing is so incredibly complex, geopolitics, the irrationality of world prices reflecting slight gyrations in U.S. inventory levels, on and on. It's a highly emotional and irrational market. A market that behaves too rationally offers little profit potential. A market that behaves too irrationally is too risky.

But I'm interested in the irrationality of the oil markets because they influence other markets. Not so much as they once did, but that in itself is relevant. So instead of betting on oil directly I prefer to bet against the idea that exaggerated fear that oil will cause an inflation spike. That might eventually happen. Especially, if oil prices go even higher. But it's doubtful and certainly we can see that it hasn't happened yet and stocks have been a good place to be, for the last six months especially. And during that time the perma-bears were out in full force giving every reason not to want to buy stocks. They were wrong, wrong, wrong.

Similarly I'm saying there's a good chance the housing market won't perform as badly as the analysts, media, and the majority of people have come to believe. The result of that would be that consumer spending wouldn't slow so much as expected and that would be an unanticipated positive for stock prices. There might be other reasons why stock prices don't do well, like oil prices climbing higher, and I don't know what those would be, certainly not the trade deficit, but it's very possible that a housing slowdown won't be one of them.

What I prefer to focus on is when a typically rational market or stock acts irrationally because it will tend to go back to being rational again rather quickly. That's had me on the right side of the macro trends over the past year, and that's always a good place, a necessary place to start.

posted at 2:03 PM 0 comments

Why Hedge?

In response to the following comments in the post Crude Dysfunction:

You're saying oil producers would be willing to pay to insure a small profit but not a large one... If oil shouldn't be anywhere near this high in price, and the reason it is this high is because of (long) speculators, some of whom are big oil producers flush with cash to play the market with, then what's keeping it from being far, far higher? Why isn't it $700 instead of $70? Conversely, if oil shouldn't be $70, much less $700, then there's almost no risk to the oil producers hedging their entire output at these levels. Almost no risk that oil prices go higher and therefore cause oil producers to wish they hadn't hedged.

First off get back to the most important consideration. The question to ask is without speculation where would oil prices be? Is there sufficient demand to for the existing supply to have driven prices to where they are no.

The obvious, and fundamentally provable answer, is no. There has consistently been as much supply of oil as anyone wants to buy. Quite regularly analysts and the media, even the President, will talk about the market being tight and there not being enough spare capacity. There's not a lot of truth to this either.

What is capacity? This is widely confused. Typically when people talk about capacity in the context of oil they are inappropriately referring to refining capacity because the data is widely available. But there are two flaws in this view. The first is that capacity is tighter in large part because refiners have become more efficient. That's a good thing, not bad. Who defines refinery capacity anyway? No one ever considers whether the data is even reliable. Refiners report it to the EIA. But most importantly of all is the fundamental irrefutable truth that limited refining capacity puts downward pressure on crude prices, not upward. Except of course when the market isn't very competitive because the major oil companies also own many refineries.

Ok, so I've established, for the gazillionth time now, that refining is a minus for crude prices, not a plus, minus being downward pressure, or at least limiting upside potential.

What about crude production capacity then? We are told its tight. Good luck getting that data. It doesn't exist. People are pulling that statement right out their asses. It's a convenient one too because it's just as hard to disprove as it is to prove. A lot like my astrology example telling people what will happen to them IF they don't make changes in their lives. When the prediction doesn't come true, chalk it up to changes, when it does come true that's a mark on the win side. Market pundits like to count their results this way, of course bank accounts don't care for it too much. By the way, the expression 'chalk it up' needs modernized. We should be saying 'blog it up' these days.

The information we do have about crude supplies is supply, consumption, and inventories. Supply and consumption are always in balance, so they don't tell us much. And when we talk about inventories we're only talking about the U.S., while oil is produced, priced, and stored globally. What do we know about inventories around the rest of the world? We don't know jack. Oil futures go up and down based on modest, irrelevant, weekly fluctuations in U.S. inventory levels, which don't tell us darn thing about what's happening with oil inventories worldwide. There's nothing rational about it. But, what the heck, enough wrongs do make something right.

Now to whether or not oil companies are hedging oil prices. They are not, is exactly what I'm saying.

Mark Haines asked Oppenheimer's Senior Energy Analyst, Fadel Gheit, about this very thing this morning. Coincidence? Perhaps.

Mark – Fadel, do major oil companies sell their product forward? Do any of the major oil companies hedge their products, sell them forward?

Fadel – No! Not at all.

Mark – With oil up near 75 bucks a barrel might not that be a good idea?

Fadel – Well the whole idea is that you are an investor, not in the commodity, if you want to invest in the commodity you just go out and buy oil futures. But if you want to invest in the company they are managing the future for you.

Mark – (suspiciously) Yeah, alright. Still I think a lot of people are gonna get hurt here if oil comes down. These stocks are going to come down because they are totally unhedged.

Fadel – But Mark, now listen to this, you know if you had hedged, if they listened to this advice and hedged their oil at $50 last year they would be out-of-pocket $25. So obviously they are enjoying the fastest rising oil prices in history and that will continue.

Mark – Yeah, I guess so. I guess they really are kind of at the mercy. Ok.

There's the answer. The proof is in the profits. If the oil companies were locked in forward, profits wouldn't be rising as they are.

But that begs a new question. If the oil companies aren't using the futures markets to hedge prices, what then is the purpose of the oil futures market? Well, there are other hedgers. There are people that want to lock in the price they can buy oil at. They want to limit their exposure to more upside risk. There are many companies that want to do this and they use the futures markets for this purpose. But the vast majority of the transactions being made are speculative in nature.

Why don't prices just go right to $700. For the same reason the Dow doesn't go right to 100,000. We tried that once, and it didn't go so well. Speculators speculate on both sides of the market. The speculative price is a balance between the long and short speculators. The market stops rising when it gets to a price high enough to interest more speculators in taking the short side and or dissuade long speculators. The market is dynamic. All these forces are interacting simultaneously.

posted at 1:24 PM 0 comments

Refinery Regulation

The claim: Refiners don't build new refineries because regulations are too restrictive; hence we have refining bottlenecks and high prices at the pumps.

The truth: Refiners don't build refineries because they don't need to. Existing refineries supply all the gasoline we want to buy. There's this pesky new fuel mix thing going on now causing some minor supply chain issues, but the total finished product demanded is still roughly the same.

When demand sufficiently incentivizes refiners to increase output they do so. This can be seen plainly enough in the historic output data and in the newspapers and with your own eyes by the fact that we never have any serious supply issues and you are always able to get as much gasoline as you'd like to buy.

A gradually increasing portion of the gasoline we consume also comes from other countries. Having that source available helps to avoid disruptions and problems with temporary outages like those after Hurricane Katrina shut down roughly 10% of the reefing capacity.

Overregulation might not be a good thing, but it has very little to do with the supply of refined products. If the demand is sufficient, refiners will find ways to meet that demand, and wholesalers will find the supply. It just means that the finished products will get made somewhere else and shipped to the United States like so many other products.

If we can ship in the crude, and distribute the finished products to thousands of filler-up stations around the country, if all the gasoline crossing the Continental Divide through Colorado via I-70 can make it up and over and around the steep, windy, narrow, and often snow covered Loveland Pass (the location of my favorite place to ski, Arapahoe Basin, aka A-Basin, aka The Legend, also famous for staying open through The Fourth of July weekend, and the awesome tail-gaiting parties), well then we can certainly ship in more finished gasoline.

So the next time you hear someone spouting off about regulations keeping refiners from building new refineries and that's the reason gasoline prices are so high, you'll they've sniffed too many fumes.

Gasoline is expensive because the oil used to make gasoline is expensive. It's as simple as that. I've read that some distributors are even taking losses on gasoline right now, concerned that rising prices too much will kill demand. Of course, they're cleaning up on the oil production side so they can do that and still make huge profits.

posted at 11:55 AM 1 comments

Tuesday, April 25, 2006

Who you fooling?

The President's so nice. He says the government will graciously not buy any oil for the Strategic Petroleum Reserve (SPR) so there will be more for the markets.

Newsflash! They haven't been buying any oil anyway! Nothing significant.

Monthly SPR Stocks:
08/05 700,726,000
09/05 693,659,000
10/05 685,238,000
11/05 685,630,000
12/05 684,544,000
01/06 683,458,000

Weekly SPR Stocks:
03/10/06 684,800,000
03/17/06 685,200,000
03/24/06 685,700,000
03/31/06 686,300,000
04/07/06 686,457,000
04/14/06 686,896,000

Since the beginning of the year only a few million barrels have been added to the SPR. We burn through more than 600 million barrels a month. We're talkin' about 1/600th, less than 2 tenths of one percent (0.17%). Yeah, that's gonna make a big difference, as if we even needed it! Well, he did fool the oil traders, but that isn't saying much.

posted at 3:42 PM 2 comments

Crude Dysfunction

With the U.S. Oil Fund ETF (USO) proving so popular, pushing towards a few million shares traded today, it seems like a good time to revisit the relationship between spot and futures prices. The USO differs from the gold ETFs in that it doesn't physically store the underlying commodity. The fund only buys futures contracts which are rolled from month to month and managed to approximate the front-month futures price.

However, research does show that where futures markets are concerned the tail does indeed wag the dog. The futures exchanges, of course, don't want people thinking that futures contracts could have a negative impact on markets, so they tend to put out information to the contrary and that tends to be the extent of the publics knowledge on the matter.

The relationship between futures prices and spot prices is a difficult one to wrap your mind around. Steel prices have also risen substantially and there's nowhere near the futures market for that commodity as there is for oil. But, then again steel is considered a semi-finished product and its price is influenced by the components used to produce it, which includes coke, from coal, for which there is a futures market. So it's not entirely an independent example of a non-futures traded commodity. And there are steel futures contracts trading overseas, just not in the U.S. yet.

But the obvious just occurred to me. Oil being such an extreme example, turn this around and ask the question, "What if there were no futures market for oil? Would the price of oil have gotten this high if you had to take delivery and physically store oil every time you speculated on the price unless you could find a buyer at the last minute to take the oil off your hands. The answer is quite obvious when you think of it this way. No way. Prices wouldn't have hardly risen at all because oil was never in short supply and speculators wouldn't be so willing to bet on the future price, not willing enough to absorb the storage costs.

A friend suggested something I had assumed to be true, but hadn't given much thought to, which is that the oil companies have probably been big buyers of futures contracts. The more I thought about that the more I thought it was probably true and probably more telling than it initially appears to be.

With prices having been so high for so long now, along the way there has been very little incentive or need for oil companies to use futures contracts as a means to hedge prices, which is really what the futures markets are supposed to be for. Producers typically buy sell futures contracts as insurance to lock in prices. A farmer will sell corn futures to get a guaranteed price for his crop next fall. The speculator on the other side of the trade, takes the chance, accepts the risk, for the crop.

For the speculator the contract might be a small piece of a larger investment portfolio. So the speculator's risk is diversified and minimized. Whereas, the farmer has everything tied up in that crop. The farmer is willing to invest in insuring his price. Speculators on the whole are rewarded for their risk. But, individually when there are a lot of speculators that reward is squeezed. The more speculators there are wanting to take the farmers risk, the less the farmer has to pay for his insurance.

What defines speculation is really intent. That's not very quantifiable because it boils down to what's in someone's head. In the simplest futures situation you have the farmer who is buying insurance. He's not speculating. He's transferring risk. But the person who takes the other side is always a speculator. In the real world, farmers are also often speculators using their knowledge to play both sides of the market in various commodities. And farmers are also often large corporations that can absorb risks individual farmers can't.

Open up a futures market and make it so that futures contracts can be closed out without delivery and now you have a new game altogether. Farmers can still hedge their crops in such a market because contract profits will offset problems with their crops. But, now the market is open on both sides of the contract to pure speculators who have no desire to take delivery. The exchanges tell us truthfully that this adds liquidity and price discovery to the market.

But as we're seeing in the oil markets it also opens the market up to rampant, runaway, crazed speculation. Let's say that it costs an oil company $15 to deliver a barrel of oil. If oil is going for $18 a barrel an oil company might very well want to pay to insure that price and guarantee a small profit. But at $70 a barrel when it still costs the company the $15 to produce oil, the risk of loss is almost nonexistent, an extremely low probability. So there's need for an oil company to buy an insurance contract to protect itself against a sharp decline in prices, when the oil company is a big winner at any point above say $20 to $25 a barrel. Therefore, any involvement in the oil futures market the oil company has at that level is almost entirely speculative and unnecessary.

In other words, just about every single trade made at these prices is purely speculative. And it's safe to assume that the oil companies around the world, with their massive profits, are right in there playing both sides of the market. They've got nothing to lose. It's all icing on the cake. The profits are so huge, they can reinvest substantially in obtaining and selling more oil, buy back stock effectively paying the executives very handsome dividends, and still have gads of money left over to play the market with.

I don't have the answer to the problem, but I have come to realize more clearly, though I've been preaching it for over a year now, that if it weren't for the futures markets we wouldn't be in this mess right now.

posted at 3:08 PM 2 comments

On Gibberish

I can't stress enough how important understanding the basics of statistics and thinking logically are to trading and investing. Without these fundamental skills results are mostly random. This is severely deemphasized in the popular literature. Why? Because obtaining these skills requires a lot of work and discipline.

I was an economics major. I took a quantitative track, heavy on math and statistics. Still, it has taken me quite a few years of trial and error, and self-study to learn how to apply the basics I got in college to the markets. And I'm admittedly an ignorant amateur compared to the stat-arb traders and programmers I know working in the hedge funds. I only know enough to know how much I don't know.

Fortunately, that's a heck of a lot more than the average trader and investor with beliefs about the markets that tend more toward astrology than astronomy, more towards pseudoscience than science, quackery over quantitative, credulity and unquestioning over rational, skeptical, systematic, investigative, and scientific.

All one has to do to see that this is true is skim through the investment section of any sizable bookstore. Title after title filled with pseudoscience and outright lies.

I had this driven home when I was working from my local bookstore's café yesterday sandwiched between the investment section and a particularly pseudoscientific conversation. I voyeuristically jotted down just a tiny bit of what was said before putting on my headphones to eliminate the distraction.

"America is a sinking ship being driven by the Bush's."
"My mother is one of the countries leading astrologers."
"Astrology is like a roadmap. She'll tell you what's going to happen if you don't make the changes you need to make in your life."

Leading astrologer? This came early in the conversation. It caught my ear because I wasn't sure if she had said leading astronomer or astrologer. Big difference, the former being quite impressive. Certainly the kind of thing that would have most people listening in on the conversation. So I listened more intently. The banter turned weird quickly. It didn't take long to determine that she had said the latter.

How convenient. She's right when she's right and still right when she's wrong. It's an obvious fallacy when committed by an astrologer, not so obvious when committed by respected and well-known market pundits with impressive academic and career credentials. But they do it all the time. Only in business and the markets we call it CYA, cover your ass.

Often times though, it's intended to manipulate the audiences thinking. And of course it works. As I'm working from the café I spy on the books people look at the most when they head over into the investment section. They spend a lot more time just to left in real estate, but then I live in a resort community so that's to be expected. But it's hard to not notice how people tend to gravitate toward the get rich quick titles. It's not something I have any desire to gather statistics on, it's just fun to watch. They're like rats finding their way through a maze to the cheese (pun intended).

I stress again how important and fundamental this is. The smallest statistical misinterpretation of causality can be the butterfly that flaps its wings and puts a trader completely on the wrong side of the markets. You might have an opinion that the S&P 500 will go up or down over the next say six months. There are only really two possibilities. The third possibility, that index ends exactly the same, is probabilistically unlikely enough to ignore it for this purpose.

If you believe that the S&P 500 will be lower because you believe that home prices will decline and the consumer will spend less. In a vacuum you've got roughly a 50/50 chance the market will do what you expect. Actually, it's less than a 50/50 chance when you consider that prices tend to drift higher over time do to corporate earnings growth, but for hypothetical purposes it's 50/50. So you'll be right roughly half the time, but that doesn't mean you're right for the right reasons. It might just be luck and randomness. Did people spend less because their homes were worth less? Did that cause investors to sell their stocks?

The popular commodities bull Mr. Rogers, for example, was on record back in 2003 saying that he expected commodities prices to go higher and stocks to go significantly lower. He was dead wrong on stocks, as his forecast marked almost precisely the recessionary bottom, and right on commodities mostly for the wrong reasons, which I've gone into previously. So the overall forecast was no better than randomness. Junk science.

It's a vast improvement, when the perma-bears are claiming that home prices will fall because the Fed keeps hiking rates, to inquire and posit what has happened in the past to home prices when the Fed has taken rates higher. The answer turns out to be nothing. There's no correlation between the two. And historically, the Fed taking rates higher has meant more like 10%, not the relatively paltry 4.75% we're at now.

Does that imply that home prices won't fall? No, of course not. That conclusion would be based on a fallacious causality. So I'm not saying that. All I did was present the facts. What we can conclude is that in the past the Fed hasn't impacted new home prices noticeably, or consistently. If home prices fall it could be for some completely different reason, or it could even be because enough people believe that what the Fed does matters. It suggests, however, that the mainstream media and perma-bearish pundits and prognosticators might be exaggerating and overestimating the likelihood that home prices will fall.

Indeed a February 2005 report by the FDIC U.S. Home Prices: Does Bust Always Follow Boom? studied booms and busts by city back to 1978 and determined that there had been 63 booms and 21 busts, but only 9 followed booms. So booms have led to busts only 14% of the time. And less than half of the busts have been related to booms. In other words there's very little correlation between the two events. Again that's at the city level. There's only been one overall price decline in that time period.

The point is, if you're going to let a slowing housing market influence your investing and trading decisions, you'd better do your homework and make sure it's for the right reasons, rather than just random guess work and herd following mentality.

posted at 12:50 PM 4 comments

Monday, April 24, 2006

Four-Hour Factoid

Four hours refers to the approximate amount of time I had to spend to come with what amounted to this tiny tidbit of information. Getting good home price data turns out to be tedious and frustrating. Then there's the added complication of having to convert time series data to matching periods.

The conclusion, however, was worthwhile. It turns out that there's zero historical correlation between housing prices and the Federal Funds rate!

I wondered whether or not there might be a historical correlation with the Fed having recently targeted a housing bubble. What then has the Fed Funds rate meant for housing prices in the past? Nothing. Negative 0.05 to be exact, which isn't statistically distinguishable from zero. That's the correlation between the average annual Fed Funds rate and the average annual percentage change in new-home prices from 1963 through 2005.

An important reality of this is that if fed funds rates as high as 20% haven't had a noticeable impact on housing prices then how the heck is 5% going to do anything!

Furthermore, in more than 40 years, new-home prices have only experienced a decline in two years: 1970 and 1992. Those weren't even years with high interest rates. The largest gains came in 1973 and 1978. Homes, remember, are one of best inflation hedges going. So if investors expect inflation, then they'd rather own real estate than bonds. Now though we've got alternatives, namely inflation adjusted treasury securities and the very popular gold ETFs.

posted at 6:01 PM 3 comments

My Friend Fred

Readers, meet Fred. Fred is the St. Louis Federal Reserve's database of government statistics. It's the best source of free economic time series data available. Whenever I'm confronted by economic allegations that seem questionable this is the first place I think to turn in search of the truth.

When someone recently commented that inflation was measured differently in the 1970s and was more closely tied to oil than today and therefore isn't comparable, over the wires and through routers I go.

Fred always has a feast of data waiting for me. Today I turn to the core CPI data. That's the consumer price index less food and energy related prices. Fred keeps data going all the way back to 1957, half a century. Ok, the first thing you need to know about the core CPI is that whenever there are major changes in data calculations the government data collectors go back and recalculate the old information according to the new methods. Sometimes, when there is perceived to be value in maintaining access to both the old methods and the new methods they will create a new data series. That's the case with the CPI for which there are now three different measures.

But, whichever measure you choose, core is core. Core is not tied to directly to energy. Though it is true that the economy of the 1970s was more heavily influenced by energy being more industrial.

"If we calculate inflation like we did in the 70's, inflation would be running at over 8%." I don't know if this person has an ulterior motive, a mental illness, or just has nothing better to do than post ridiculous, ludicrous claims on Web sites. Usually, I would just ignore such nonsense or suggest that readers ignore the post, but in this case it occurred to me that there's a lot of misconception and confusion about inflation and it would be worthwhile to explain again why we had such a serious inflation problem in the 1970s and not now.

Below you'll see a series of charts. The first depicts the annual percentage change in the core CPI data from 1957 through to the most recently available data. The second is a smoothed version. It's a continuous, or rolling, ten-year average of the data in the first chart. The smoothed format is helpful in viewing inflation in a more macro way. It shows that inflation peaked in late 1983 and early 1984. So the worst inflationary period was from 1974 to 1984, precisely what we'd expect to see.

The third chart compares core CPI to the CPI for energy related prices. Chart four and five are just zoomed in versions of chart three. What they show, just in case it doesn't pop right out at you, is how the sensitivity of inflation to energy prices has changed compared to the 1970s.

The final chart puts all the pieces together, interest rates and inflation. In this chart you can see a sharp rise in the Fed Funds rate even before the rise in energy prices and core prices. But most importantly it shows again just how sensitive the economy was to the energy shock. In about a years time the 30% rise in energy prices was accompanies by a 10% rise in core prices. Ten percent! Today we're fussing over 2% to 3%. We've all but forgotten what bad inflation is. But, this is why the Fed has been watching so closely for any sign of a change in inflation expectations and trickle down of energy prices into core prices. It's what happened before.

But here's something really interesting about the economy of the 1970s, at least I think it is. The Fed led the inflation in both 1973 and 1978. Sharp increases in the Fed Funds rate were followed by rises in energy and core prices. Was this because the Fed foresaw rising price, caused rising prices, or coincidence. Rising interest rates are supposed to slow economic growth and therefore keep prices in check. But throughout the 1970s and early 80s the economy was rocked by stagflation, rising prices and a weak economy. Taking interest rates up to astronomical levels didn’t normalize prices. What we don't know is whether or not high interest rates kept us from hyperinflation, runaway prices.

To some degree interest rates are like energy prices, they are both inflationary and recessionary. High energy prices can trickle down into core prices because it costs more to manufacture goods and therefore producers should need to charge more, but it also costs consumers at the pump and at other touch points so they have less to spend. Similarly, high interest rates should reduce borrowing and therefore consumption, but to the extent that people and companies borrow anyway they experience higher costs, which is inflationary. If companies have higher borrowing costs they will want to pass those costs on to consumers just as with any other cost. So if an economy is doing well and consumers are spending then producers can pass on those higher costs.

The one thing that's different today compared to the 1970s is that we have increased diversification of product sourcing through globalization, increased competition, which has made it more difficult for producers to pass on cost increases whether it be from energy prices or higher interest rates. And since consumer spending hasn't slowed people companies need to keep producing and therefore absorbing all these higher costs. Consequently, the primary impact of higher energy prices and rising interest rates is modest corporate growth. Not bad, mind you, because demand is still strong, but not spectacular either.

posted at 3:29 PM 2 comments

Friday, April 21, 2006

Growth and Inflation

Is global growth necessarily inflationary? I don't think so. Not so long as the natural resource companies can keep up with finished goods companies. Also, much of the global growth we're experiencing now, much more so than compared to the past, is information technology and electronics related, ie information related services and devices that are not natural resource intensive. The reality is that a flat panel screen uses far less natural resources than the big, tube driven, wood clad furniture style, console TVs of the past. And MP3 players use far less materials than the Sony Walkmans of the 80s.

We're making more stuff, but we're also making stuff more efficiently. It isn't a given that there has to be inflation with growth. However, global growth would necessarily drive up the prices of some goods, particularly those used in natural resource intensive endeavors such as road and building construction. But that's only if suppliers can't meet demand. And as prices rise more companies are incentivized to become suppliers, or invent alternatives.

posted at 1:35 PM 4 comments

Oil Dynamics

Schlumberger profit jumps 38 percent
Schlumberger Ltd. (SLB), the world's largest oilfield services company, on Friday said quarterly profit rose 38 percent as energy producers continued to spend briskly to raise oil and gas output in North America.

There's no getting around the economic certainty that a helluva lot more oil is headed for the pipeline. I suspect production will increase worldwide by a lot more than most people have been expecting. And out of that will come some good. OPEC will likely loose pricing control. As more oil comes out of the more remote regions of the world, the price of oil will eventually reach a fundamental consensus based on oil flowing in from many new sources, rather than OPEC manipulating output. Eventually, it will come to the point where if OPEC tries to cut production they will just be giving sales over to their competitors. There's no greater incentive to get out there and get more oil out of the ground than these irresistibly high prices.

On the negaive side, yesterday they were talking on TV about how the gasoline distributors have been reluctant to take prices to $3.00 a gallon, seeing that as a magical point which would trigger significant demand destruction. They were saying that some were selling under wholesale prices, losing money. What they didn't tell you was that most of these same companies are getting filthy rich on the oil side of their business. Exxon Mobil and BP, for example, own every profit point in the oil business. They pump out of the ground, refine it, distribute it, and retail it. So when it's still costing them $10 to $20 a barrel to get oil out of the ground and they can sell it, to themselves in many cases, at a 300% to 600% percent profit what do they care if they lose 25 cents on a gallon of gasoline. The inevitable outcome is serious. In the long run, retail gasoline suppliers will not be able to compete unless they are also producing oil. An independent refiner or distributor would be squeezed buying raw crude or refined products at high market prices and not being able to mark up its prices enough to profit. So what's going to happen is that as they struggle the big oil companies will come in a buy them up.

Oil production will get more competitive and that should eventually help get oil prices to back off, but the retail end will get less competitive.

posted at 1:14 PM 0 comments

Demand Destruction

The media keeps chatting up the summer driving season. At $2.80 a gallon I keep asking myself, and now you, what summer driving season? It's more likely to be the summer flying season.

If we hit $3.00 a gallon this summer I imagine there will be significant demand destruction. We're already starting to see some even as prices climb. The four week average demand growth has slipped to 0.9% from 1.5%. It's wait and see whether demand will keep slowing or even fall.

posted at 12:28 PM 3 comments

Catching the Tiger By the Toe

What can be said about the stock market's rally this week? It's been a strange rally. It seems that investors can't decide what to invest in next. They want to own the markets, but they don't want buy up the same kinds of companies they went crazy for in the late 90s, Google excepted.

But I'm not too sure about some of the sectors that are being held up as the latest hot markets. Railroads? C'mon. What you've got to ask about a rally in a sector like that is, will investors still be talking about railroads a year from now? I doubt they'll be talking about them a few months from now. Investors roll in and out of sectors like this all the time.

Last summer utilities, of all things, were all the rage, thanks to Warren Buffett's backing. Not surprisingly, after a year of climbing, buying amidst last summer's excitement would have gotten you near a top. They've gone nowhere for a year now.

Investors keep bidding up companies with low growth potential. For these kinds of companies it doesn't take much of a rise in price before you are paying too much for the future growth and dividends. Consequently, by the time you're hearing about them in the media the best is usually already over.

No one was talking about Norfolk Southern (NSC) a year ago when it was trading at $30 and change. It's getting a lot press after not so gradually climbing 85%. Where's the growth going to come from to keep the stock climbing? Popularity contests in the markets end badly for investors that get in near tops. The kind of press that the railroad stocks have been getting recently is just what the pros wait for to quietly lock in profits taking the floor out from under the stock.

posted at 12:09 PM 0 comments

Wednesday, April 19, 2006

Core CPI Spike Within Normal Expectation

Getting this 0.3% surprise increase in the core CPI, I was reminded that we saw a similar spike about a year ago. A headline reporting the largest increase in one year induced me to indulge in a little number crunching. It's been a while since I've dug up anything particularly exceptional out the economic data, so I've been overdue.

As it turns, such volatility in price increases is completely normal. And though not consistently seasonal, the March core CPI increased 0.3% the previous two years. So this is the third year in a row for this event. There was only one year in the last ten that the core CPI didn't spike up to an increase of 0.3% at least once in the year. That's happened 26 times in the past 10 years, twice per year on average.

Historical average monthly increase in core CPI:
1957 – Present: 0.33
1986 – Present: 0.25
1996 – Present: 0.18
Last twelve months: 0.17

Conclusion: The current amount of core inflation is historically normal.

Below is a chart comparing seasonally and non seasonally adjusted core CPI data for the past ten years (click on the image to increase the size):

posted at 5:05 PM 2 comments

Economy

The economic information in recent days has been a lot to take in. Numerous Fed members have been speaking publicly, Fed president, Janet Yellen, sent the Dow up 200 points yesterday indicating the possibility that the Fed was nearly finished, the Fed released its March meeting minutes, and today we got significant CPI and energy data. So what kind of picture is all this information painting for the economy?

Naturally, after I make a comment the comment that if energy prices aren't showing up in the core CPI data by now, then they probably aren't going to and then we get the CPI data and see that core prices rose 0.3%. Last fall and into the winter with the core CPI increasing 0.2% I wrote that if we then got a jump up to 0.3% that could be seen as an upward trend going from 0.1% all through last summer and notching up to 0.2% last fall. But, that didn't happen. Core inflation went back to the 0.1% rate of increase again for a few months. Now we have this 0.3% increase out of the blue, not really looking like an upward trend and being taken by the markets as a blip. So what are we to make of it? It's hard to say. It might get revised back down. It might really be just a blip. Or it might be that high energy and commodities prices are starting to get passed on more.

One thing I can say with relative certainty is that the economy isn't even remotely as sensitive to the spike in oil prices as it was back in the 1970s. Therefore, we don't expect that king of inflation or jump in interest rates.

The next question is with the Fed repeatedly stating that it's looking at the data as it comes in, what then does oil over $70 a barrel and a core CPI of 0.3% mean?

I think it says that, while even the Fed may have thought it would be done, it may not be. I thought there was more of a possibility of a surprise pause at the last meeting than was being priced in the fed futures market. Actually, fed futures were showing a 100% probability of a quarter point hike, and I didn't believe this was a rational pricing, given the economic data and remarks made by Bernanke up to that point. But we got the quarter point and now were obsessing over what's next. Though Yellen has indicated they might be done, the futures are still saying one more. And with energy prices where they are and a core CPI of 0.3%, I'd say that's probably on target.

posted at 3:40 PM 2 comments

Tuesday, April 18, 2006

Reality Setting In

Oil's up 700% in seven years. If it hasn't caused inflation by now, by cracky it ain't gonna.

posted at 4:22 PM 2 comments

Headline

Funny, at least to me, I wrote that last post then, then coincidentally I go to my open browser tab and refresh MarketWatch.com and see this headline:

Hopes, stocks rise
Rate speculation takes spotlight off crude oil

posted at 3:38 PM 0 comments

What this economy really needs...

It just occurred to me, as I'm reading through the March Fed meeting minutes released today, that what this economy needs is another good old fashioned stock market bubble. Yeah, I know that sounds completely crazy. But this economy really only has one problem, Oil.

Oil's got some real geopolitical issues backing prices up. I won't deny that. And they're now a bit worse than in recent years. But only a bit. Not so much worse to make oil worth 700% more than seven years ago! We're still hearing the tight supply and demand line even as inventories rise like a rain-swollen river week after week. I've even been hearing a whole lot of analysts blaming refining issues for oil prices again.

It's been a while since I've explained that economic reality so here goes again. A refining bottleneck limits the amount of oil being demanded. Refiners only need to buy as much oil as they can refine. Thus refining issues should depress the price of oil, not increase it. Yet regularly I hear professional industry analysts coming on TV saying that refining issues are partly to blame for high oil prices. Give me a break. What does that say about the professionalism out there that they either don't understand such a simple economic concept, or they are liars. It's either one or the other. There's no other explanation.

I've been saying for more than a year that the rise in oil prices is mostly speculative and a bubble at that. A characteristic of a bubble is that speculators ignore fundamental information. And that's exactly what's keeping oil prices from being at a more fair and normal level of say $35-$40 a barrel factoring in all geopolitical hubbub.

You want to get the speculators out of oil? There's only one way. Give them something better to do with their money. When they've got somewhere else they'd rather invest they'll get out of oil and go there instead. The stock market would certainly be a healthy place to put it. The stock market can get crazy out of hand too, but it can absorb a lot more money than any one commodity and at least the money is reinvested somewhat productively in new technologies. Oil companies just invest in finding more oil, though not a bad thing, and as some have done recently in buying back their own stock, which by the way is the equivalent of an major bonus to the executives that doesn't get counted in the usual figures of salary, bonuses, and stock options.

But, the last thing the Fed needs to be doing is worrying about the labor markets. They wouldn't even be an issue if it wasn't for the combination of high oil price pressures with not all that significant wage pressures. We need the strong economy to turn speculative interests to more productive investment opportunities.

posted at 3:34 PM 1 comments

Fed Spotting

Fed watching is front and center these days. It's gotten a bit like whale watching. "There's one over there! See him blow!" "Behind you there's another one over there!" "They're all around us now!" "Look that one's surfacing! It's gonna splash!"

San Francisco's Fed President Janet Yellen was the latest to surface. Her comments have been taken to be dovish in nature and cited as the source of today's market rally. Yesterday Roger Ferguson was spotted starboard and Michael Moskow port. Last week Mark Olson and Donald Kohn were making waves. Kohn made the biggest splash swamping the deck.

There does appear to be some disagreements among Fed members as to what is the proper course for Fed policy. Kohn, for example, is for full steam ahead inflation fighting, while Yellen is concerned about going to far. This shouldn't come as any surprise. Polite disagreement would be expected, as Fed members are being led by a chairman whose views are somewhat divergent from his predecessor.

Coincidentally, the changing of the guard has come at a very pivotal time. If Greenspan's right you hike rates more. If Bernanke is right you stop now, or very soon, and possibly reverse course. There are several conundrums really. Bernanke and Greenspan don't see eye-to-eye on the cause of relatively low yields on the long end of the curve. How can Fed members, after sucking up to Alan for years, be expected to turn on a dime on this issue? Now they've no reason to kiss Bernanke's butt because he's young and apt to be at the helm for a long time come.

So there's a political conundrum. Have Fed members always been honest and said what they thought, or have they appeased Greenspan? If the latter, then do they change their tune now and risk seeming inconsistent, or do they stick with the story they told under Greenspan?

That's why honesty is the best policy and why you won't find any inconsistencies in this blog to speak of. I reserve the right to be wrong and change my opinion, and I have done that at times and I never mind admitting it. You have to be flexible, but not so flexible as to get caught up in the fray, when you're following the markets for a living.

Another conundrum the Fed faces is to what extent high energy and commodity prices might trickle down into core prices, or slow the economy. In the past high energy prices led to inflation immediately. This time around the impact has hardly been noticeable except at the gas pump. And the Fed keeps talking about inflation fear reflexively leading to inflation, another 70s phenomenon that hasn't resurfaced as a problem.

So if high energy prices aren't causing people to obsess over inflation and aren't impacting the prices of other goods and services much, then question is what the heck is the Fed fighting? And if a flat yield curve isn't a problem, why raise rates so high as to make it a problem?

posted at 2:20 PM 0 comments

Monday, April 17, 2006

More Exchange News

NYSE Acquisition Talks Signal Faster Consolidation of Exchanges
The New York Stock Exchange said it's considering acquisitions, providing the latest indication that the pace of consolidation in the global equity markets is about to increase.

This is what I'm talking about.

posted at 6:10 PM 0 comments

A Better Bet

It's not supposed to work like this:



Over the past year the stock prices of financial companies have risen steadily in tandem with short-term interest rates. According to old market adages financial stocks should be performing poorly during periods of rising interest rates. The logic is that the margin between borrowing and lending gets squeezed and therefore earnings fall. Why then has this not been the case? I first illustrated this divergence from the expected results back in January in The Financial Sector Myth. A quarter later this divergent trend continues.

Why has the Financial Select Sector SPDR (XLF) ETF increased 16% over past year? Earnings have been good. And they've been especially good for the Wall Street firms that have been exposed to commodities and International investments. Goldman Sachs (GS) has risen more than 50%, Merrill Lynch (MER) 44%, Morgan Stanley (MS) 24%, The Bear Stearns Companies (BSC) 49%, and Lehman Brothers (LEH), which has a interest in real estate, has risen 65%! Holding back the XLF has been the traditional banks with the most exposure to interest rate fluctuations, but there less substantial gains have likely in part been a matter of substituting Wall Street financial companies for bank holdings.

For the same reason that we've yet to experience significant core inflation, and it has nothing to do with the Fed raising rates. Up to this point the Fed has just been getting to neutral with interest rates having been 'accommodative' along the way. The reason is that the revenues of financial companies have become increasingly diverse and globalized such that they are far less sensitive to interest rates than in the past.

In hindsight the Wall Street companies were another smart and relatively safe play on the price rise in commodities, and international and emerging markets stocks. You could have gotten just as good of returns buying these bad boys (pun intended) as investing in commodities and International stocks. Somewhat surprisingly the streetTRACKS DJ Global Titans (DGT) ETF is up only 6%, the CRB only 15%, while the streetTRACKS Gold Trust (GLD) ETF is up 42%, and the iShares MSCI Emerging Markets (EEM) ETF is up 52%. That seems like a far less risky proposition to me, especially since there's almost never been a bad time to buy financial stocks.

posted at 6:06 PM 0 comments

Right Like a Broken Clock

A reader asks:

"With commodities prices still rising, does this mean that Jim Rogers was right? I am almost to the point of crying "uncle" and buying 100% commodities. (I would never really do it.) It just seems like you have to remember that sometimes you can't fight the tape, regardless of the facts. (see Internet bubble of the late 90s) I have to wonder if folks have already forgotten the lessons of the late 90s."

This reader is referring to the publicly proclaimed anticipation of a long-term bull market in commodities by Mr. Rogers. The prediction has coincided with the creation of several commodities related funds, the publication of the book Hot Commodities, and most recently being ensnared in Refco debacle as a major customer.

What was the source of this prediction? According to Mr. Rogers it was the observations of global growth made during world travels, which he wrote about in his previous books Investment Biker and Adventure Capitalist. But I suspect there's another unpublicized reason. In hindsight any global speculator in business through the 1970s could have and should have seen that investors would be open to a commodities come back on the heals of the 90s stock bubble and the recession that followed.

What happened in the 1970s was in a word inflation. That was the key factor driving all markets from the early 70s into the early 80s. In a non-globalized economy when oil prices rose sharply, producers of goods and services began to raise prices almost immediately and by enough to compensate them for most of their cost increases. There simply wasn't enough competition to keep prices in check. Simultaneously, the Fed responded by raising short-term interest rates and the banks by raising lending rates.

The combination of inflation and high interest rates caused investors to lose all interest in stocks. With very high short-term interest rates CDs were providing higher returns than stocks could be expected too and commodities and other physical assets like real estate served as inflation hedges.

We've seen all the same asset classes and alternative investments rise in recent years that rose back then. But there's a key difference. There's no inflation to support the interest we're seeing in these other asset classes and the relative disinterest in stocks. Many of the global speculators like Jim Rogers have expected inflation that has never come. They were able sold investors on it, however. Without the inflation argument they've had to turn to a global growth argument saying that there won't be enough commodities to go around. Instead of inflation, this time around there has been a sort of perfect storm supporting commodities prices. One factor was the timing of peoples' disenfranchisement with stocks after getting clobbered. Another is the Internet, which has made it relatively easy and cheap for speculators to overcome the barriers to entry into alternative investments and learn about investing in those assets. Related to that has been the emergence of ETFs that are opening up those markets to average retail investors. Finally, we had a catalyst in the mutual fund scandals. Oil prices started to climb just as the mutual fund scandals were heating up. This was no coincidence.

Very many mutual fund managers jumped ship or were fired as they're fund families lost assets, closed funds, and cut back staff. What is a forsaken fund manager to do in an industry on a downtrend? Start their own funds. Well, it's much easier to start a hedge fund than a mutual fund. And that's just what they did.

What does a new hedge fund invest in? Whatever they can sell investors on. They take the path of least resistance to obtaining the largest amount of assets possible. All of a sudden you've got all these business and finance major, MBAs, and CFAs that have always been long only stock and bond investors buying yield, discovering value, tracking indices, and researching new technologies, and now they're running relative free-for-all hedge funds. It's a new game.

Consequently, the picture that's been painted is that commodities are not predicting and pricing increased global demand so much as there's simply been an increase in demand to have commodities to be a larger percentage of peoples investment portfolios. This is no different than why we've seen Treasury yields stay so low. More people around the world have now want to purchase yield.

I don't see this demand going away, but I do see it leveling off and probably falling off before finding a new equilibrium. It is a bubble. It's just a matter of when it pops, or rather how much it deflates. Look at gold. I've shown recently via some pretty good research, if I do say so myself, how most of the increase in prices in the past 6+ months is directly attributable to increased interest in the gold ETFs. These ETFs lock gold up, take it off the market, and horde it. It could be in the future that we're going to have to look at whether or not this is a good thing because if things keep going as they are the ETFs will basically corner the market.

Where will commodities go? That's hard to say. Some say that comments like the one made by this reader is indicative of a market top, that point when the most people wan t to get in to an investment. The comments are somewhat contradictory. Get in because people haven't learned their lesson and you don't want to miss out on a big rise. But, on the other hand, there's already been a big rise, that has lasted almost as long as the major part of the stock move did in the late 90s, and the lesson then was that buyers in 2000 got burned big time. That's the other side of the lesson. Ask yourself do you want to repeat that mistake? Six years later the S&P 500 is still off it's index investing driven highs. Will there be a turning point for commodities that will take 6+ years to overcome? Possibly.

The gist is that Rogers has been right but for the wrong reasons, and very wrong on stocks. At the market bottom of 2002/2003 he was calling for stocks to fall much further and capitulate. He was also anticipating an inflation spike that's never came. So in my view the correctness of his call on commodities has been little more than happenstance and hardly better than a broken clock being right twice per day.

I can't in good conscience recommend either chasing or fading the commodities boom. My best advice is the same as I've been giving for a year now on this blog and more than a year before that going back into previous writings. That is to steer clear of such insanity. There are much better, safer, and more certain ways to make money off these things. For example I've been talking up the CME since I first wrote about it two years ago for The Motley Fool and it's up about 500% in that time. Why? One reason is that the exchange has been a major beneficiary of the increased interest in commodities and the stock has increased by more than the value of the commodities the exchange specializes in.

posted at 3:10 PM 0 comments

Thursday, April 13, 2006

Fed Infighting?

It appears that there may be jealousy issues lurking in the Fed. Donald Kohn was considered to be Greenspan’s most likely personal choice as his replacement. It appeared to me that Greenspan wasn’t all that happy with the choice of Bernanke. He never really backed him up or had much of anything good to say, just standing there during the confirmation and I don’t recall him even giving a speech to show his support for Bernanke, But then again he didn’t publicly back any other candidate either, so I might be reading too much into it.

Speaking to a group of business leaders in Oklahoma City Kohn came out with a view was atypically hawkish, which to me seemed somewhat inappropriate and not in line with what we’ve heard from Bernanke. The last Fed statement also appeared to be inconsistent with Bernanke’s speeches and past research. Kohn is known to take Greenspan’s side on just about everything, including his view on inflation targeting.

In his speech Kohn made reference to a report produced by the Fed Board of Governors titled The Recent Decline in Labor Force Participation and its Implications for Potential Labor Supply (link to PDF). The gist of the 97 page report, which admittedly I’ve only had time to skim over thus far, is that the labor force participation rate is expected to decline sharply due to retiring baby boomers and this would result in an inflationary labor situation. But in my initial analysis of the report I find that it completely misses two very important critical offsetting factors. Throwing all professionalism out the window, as if I had any, by critical I mean it had me dumbfoundedly saying to myself, “Good God, what a bunch of dumb asses! How could they completely miss this?” With my professionalism out went the little bit of respect I had for Fed research, because I have often referred to Fed research in the past, and much of it has been very good.

The report made zero consideration for immigration, guest workers (as the President is calling it), outsourcing. The only thing the report had to say about it, as far as I could tell, was this, “Net immigration is particularly difficult to estimate and project…” What a joke, really. In 1998 I took a job as a business analyst with IBM working on a contract with Lincoln Financial Group in Fort Wayne, IN. As best I could tell LFG needed to hire a company like IBM to come in and get their Y2K issues in order because there was no way that LFG could find enough qualified people in Fort Wayne to get through their millions of lines of code. IBM brought in their workers, recruited people to come to Fort Wayne, farmed some of the work out to other locations, and hired other smaller consulting firms to bring in green card workers from wherever in the world they could get them, mostly from India. I worked with a number of very talented and hard working Indians that to the best of my knowledge returned home after Y2K was over, work slowed, and the recession set in.

In the late 90s the Fed was fighting wage pressures then too expecting inflation that never materialized. I mostly blame our own greed in overpricing equities for the recession, but the Y2K wind down and the Fed simultaneously jumping rates up by 50 basis points to 6.5% certainly contributed, though I don’t think that the 6.5% rate alone would have been enough to cause a recession.

But the bigger point is that the Fed was wrong then and is wrong again now. And Kohn is grandstanding this Greenspanian Victorian view. I believe that the baby boomers will be less inclined to retire than people realize. They are the healthiest bunch of retirees the country had ever seen and many of them will choose to work beyond normal retirement age. There isn’t really a normal retirement age anymore. That changed when we became a service economy. Many more people than in the past are doing jobs that they will be capable of and will want to keep right on doing. So the retirement trend will be more gradual than in the past. Furthermore, a surprising number of them will want to start their own businesses. What’s the commercial goes something like, “It’s always been a dream of mine. It’s time to stop chasing the dream and do something about it.” They will also be very active investors and they will seek out ways to profit in their retirement rather than resting on the laurels of a pension.

On the other side of the equation as companies find themselves shorthanded before they are willing to pay very much more to get workers they will try harder to find them for the same wage. They will bring sponsor foreigners to come work, not immigrants, but guest workers. And what jobs they can’t fill here they will outsource overseas. Exactly what they did in the late 90s when wage inflation never really amounted to anything, as you can see clearly in this chart of the core CPI.

So it appears that there may be some infighting and harbored resentment within the Fed, something I’d like to think Fed members are above, but that’s naïve. Will the Fed get it wrong again, or will Bernanke oust Kohn and take charge? My view is Kohn’s got it all wrong and needs to go.

posted at 3:02 PM 6 comments

Wednesday, April 12, 2006

The Meaning of Trade

I’m not going to make a big deal about the trade deficit falling back in February. If I do surely enough it will have climbed in March putting egg in my face, though I’m not sure why that’s a bad thing because I do like eggs just fine. I take them scrambled with ketchup, or better yet salsa and hot sauce, the hotter the better, and bacon on the side.

We don’t seem to know a whole lot about what the deficit means. Not even Bernanke or Greenspan. The only thing we know for sure, as a mathematical certainty, is that when our economy is doing well, not just well, but relatively better than that of the rest of the world the deficit widens. That has to be so and the data concurs.

That doesn’t mean, however, that we have to be growing faster than other countries. The math doesn’t work that way rather it works like this: If country A is worth $1 billion and country B is worth $1 trillion and they both grow 4%, then country A gains $40 million while country B gains $40 billion. Country B has $39.96 billion more to spend.

Simple economic thinking about money and where it comes from says that the government prints it and we acquire it by selling things, therefore we must export something in order to acquire money, otherwise we are simply circulating money amongst ourselves. Money is seen as a zero sum game. We acquire it from someone else and therefore they have less than they had before and we now have more. If we print too much money prices will rise because people will be willing to spend more of their money to get the same things.

Really though money should be thought of in terms of what we don’t buy, or the money we save. A simple example is to imagine a town consisting of two people, just a doctor and a farmer. The doctor needs to eat and the farmer needs to stay well to produce food. You can think of a tribe, if that suits you, consisting of food gatherers and a medicine man. The farmer supplies the doctor with food. If money is used the doctor pays the farmer for the food. If the farmer never gets sick or has a need for the doctor then the doctor will have no money to buy food with and there will be no doctors. But, if the farmer needs the doctors services he pays for them and the doctor once again has money to buy food with. So the money just keeps going back and forth like that. In such a simple system there’s not much need for money. The two can trade services. The farmer agrees to feed the doctor and the doctor agrees to care for the farmer.

But the farmer works very hard to feed both himself and the doctor, while the doctor hardly works at all. And if the farmer does become sick neither of them have food except what they have saved. So perhaps what works better is a ratio of ten farmers to one doctor. Each farmer is working less to pay the doctor, the doctor is fully employed, and everyone eats. Still, no money is necessary. A simple government can efficiently take care of the problem. All farmers chip in a certain amount of food to support the doctor so that the doctor can eat all the time, and not just when he heals someone. Or they just trade services and the doctor is ‘paid in kind’ for services rendered taking food home with him.

Money comes into play when people want to pay the doctor in goods he doesn’t want or need or another community farm goods this one doesn’t