Friday, October 24, 2008


The cheapness of the US stock market has reached 1982 levels by a growing list of measures. Stocks were very cheap in 1982. Overnight, stocks in Japan, Korea and London were down again. How low can they go?

Bond investors have always included the smartest of investors. While bond investors must ultimately guess, just like the rest of us, their business has much more straight forward math involved. In recent weeks, bond buyers, by nature a conservative bunch, have been willing to buy long fixed rate bonds instead of buying TIPS (variable rate inflation protected securities). Many of these buyers are 100% bond buyers; the charters they hold forbid them from buying anything other than fixed income securities. These buyers are currently willing to lock funds into 3.6% for ten years rather than earn a variable rate starting at 2.5% for 10-years. The implication is that inflation rates will stay low for 10 years. The difference between 3.6% and 2.5%, with relatively minor adjustments (as can be seen on the Cleveland Fed Web Site) is the markets inflation forecast. Inflation expectations are at 1.1%!

Sock investors should be elated. Stocks do very well when inflation rates decline. Investors often times miss an important distinction here. Investors frequently assume that stocks do well when inflation rates are low. Stocks do best during the move from high inflation to low inflation. Victor Canto has frequently made this point. In "Understanding Asset Allocation" he included a table that shows: average monthly returns during times of decreasing inflation rates. From 1948 to 2004, the average monthly return on stocks was 1.17% during times of decreasing inflation and .33% during times of increasing inflation. Bonds and stocks are distant cousins. Bonds and real estate are more like the Hatfields and the McCoys. From 1948 to 2004, the average monthly return on treasury bonds was .3% during times of decreasing inflation and negative .44% during times of increasing inflation. I don't have the numbers from real estate handy but real estate returns are almost inversely related to bond returns. Please note that the risk of loss is much higher in bonds than it is in stocks.

OPEC just met and lowered production quotas by 1.5 million barrels per day. The people of the world are drowning in oil that is 10 feet deep and OPEC just lowered the level to 8.5 feet. The wholesale price of gasoline is down another 11 cents this morning. Retail gasoline should sell for $2.04 within 2 to 4 weeks. By the way, it is true that a wholesale price increase would have been reflected in the retail price quicker, but so what? If you were in the gasoline business, you too would be slower to lower prices than to raise them. Do your part by shopping for the lowest price. You can check prices on line and avoid going out of the way to save a few dollars per fill up. The station that is slow to lower prices will get the message quickly.

While we obsess over the price of gasoline, we miss the big movers. From 2005 to 2007 the shipping rate index for bulk commodities went from 1,000 to 11,500. It has taken less than a year for the rates to fall all the way back to 1,000. The number of supertanker sized ship loads going from Chile to China has fallen rapidly.

In 2000, the supply of palladium, a metal used in automobile catalytic converters, were tight. Prices soared. By 2001, Ford Motor felt forced to buy stockpiles to prevent having to shut production lines. That decision ultimately cost Ford a Billion Dollars. The invisible hand of Adam Smith is always at work. The world finds always finds substitutes when necessary.

It is the folly of man to believe that he can force substitutes on the market. In recent weeks, the prices of numerous metals have fallen 50% or more. Palladium is an interesting metal. Because it can absorb 900 times its volume of hydrogen, it is seen as a "metal of the future". The problem is that the push to build hydrogen fuel cells (and wind mills and ethanol plants) loses its economic reason to be when supplies of oil are abundant. The reason the price of oil has fallen from $147 to $63, 57%, is because supplies are abundant. Cuba just raised its estimate to 20 Billion Barrels for a field that is common to the USA. When Nancy Pelosi was blocking off shore drilling, she and her friends used very old USGA estimates. The old survey estimated total recoverable off shore USA oil of 18 Billion Barrels. If the one field next to Cuba has 20 Billion Barrels, how much oil do you think there might be in more than 10,000 miles of coastline? Back when the survey was done, the 70 Billion Barrels off the coast of Brazil had not been discovered. Do you think that the estimates might have been higher had it been known that Brazil found 70 Billion Barrels under two of 13 known formations off their coasts? Do you think similar formations off the coast of the US will be explored in the future?

It is unfair but fun to compare the current situation to that of WWII. Back in those days, inflation rates were negative. Around the world, much time and effort were spent recycling everything. Can you imagine a soccer mom driving a dually truck to haul a couple of school kids during those days? Consumers would have used more of many things had they been available but supplies were rationed. It is the height of hypocrisy for politicians to ride in massive SUV's while recommending tax increases on the pension funds of Exxon owners. The experience of WWII shows that the price changes of goods can be negative for a very long time and interest rates can go very low. The stock, bond and commodity markets are all suggesting that inflation is going to virtually disappear.


The "book" says that consumer staples reach their relative price peak right at the end of the expansion phase. This is part of the natural flight to safety. The book also says that commodity prices start coming down hard during the early contraction phase. Many commodity prices have now been falling for a year but even the stragglers have been falling for at least 4 months. The book says that bond values go up during the late contraction phase. Bonds peaked by some measures in June of 2006 and by many other measures by July of 2007. According to the bond market, we have been in the late stages of contraction for 15 months. Finally, still in the late contraction phase, the book says we will see a V bottom in financial stocks. Since the July 11 "bottom", the S&P 500 Index has fallen 27.5%, the KBE S&P Banking Index has fallen 3.9%, the TLT 20 year treasury index has gained 4.6% and the KRE Regional Bank Index has gained 12.9%!

The "book" goes on to say that the market bottom will be made before the economic recovery starts. The market bottom will happen soon after the turn in financial stocks and consumer cyclical stocks will be the first stocks to jump after the bottom has been made. The official declaration of a recession will not be made until well after stocks have risen sharply.

The ROW (rest of the world) gets hit harder during real estate recessions than does the USA. This morning, the US Dollar has once again soared. The US economy is relatively strong. It is other countries which need to cut their interest rates and they are obliging. The brakes are gradually being let up in one country after another. As the dollar soars, the price of gold and oil falls, but there is more to the price of gold and oil than the strength of the dollar. In the last few months, the dollars needed to buy one Euro has fallen from $1.58 to $1.26. After this big move, the price changes of oil in terms of Euro Dollars are getting close to the levels seen in terms of the US Dollar. The point is that the price of oil, money and other commodities went up around the world and now these prices are coming down around the world.

Japan has been in an economic funk for 18 years. Japan, as a major importer of raw materials, will benefit greatly from the decline in commodity prices. Even so, it appears that Japan will be forced to lower interest rates. Sony, a major consumer cyclical products company, just took a big hit on lower earnings and a weak forecast. Once again, the market keeps telling us that we are in the late contraction phase, where bonds are increasing in value and where financial stocks are showing relative strength and in many cases real gains, but where we have not quite reached the market bottom. We have not quite reached the point where consumers find 100's of billions of unspent gasoline and heating oil dollars in their pockets.

It does not take a rocket scientist to see that wholesale gasoline priced at $1.44 is going to flow through pipelines and reach consumers at around $2.04 in 2 to four weeks (retail prices have already hit $2 in Texas and Oklahoma). One can use simple arithmetic to estimate the savings Americans will see over the next year. A year of oil at $147 would have cost Americans more than 1 Trillion Dollars. A year of oil at $63 per barrel would cost Americans 460 Billion. The difference in a year of each price works out to 613 Billion Dollars. The savings from lower prices of everything from money to corn chips will be substantially more than the savings from energy. Politicians are anxious to do a 150 Billion Dollar stimulus package so that they can take credit for the turn; a turn that will result from annual savings to US consumers of more than 1.4 Trillion Dollars. A savings of about $12,000 per household! As we saw last time, a stimulus package where the government borrows 100 Billion to give out $600 checks does not stimulate the economy. Forcing consumers to borrow $600 does not make them want to spend money. A fall in the price of gasoline from $4.11 per gallon to $2.04 per gallon has nothing to do with borrowed money. The owners of oil reserves are hurt and the consumers of oil benefit, but those hurt did not have their property confiscated by the government. The person who finds an extra $40 in his pocket after filling up his tank does not have extra debt hanging over his head.

A few months ago, consumers, businesses and countries around the world were playing the same game Ford played in 2000. There was a rush to buy up all the supplies of raw materials possible; before the prices went higher. Now that the world wide recession has hit, it will take many years for stockpiles to be worked off. Capital intensive mines run during good times and bad. At the height of the craze, investments were made in new production facilities. Many of these projects will be completed. For example, the Willow Creek Mine in Nevada will spend the next several years finishing the development of a 6 million acre project while knowing that supplies will be more than adequate when the project finally goes into production. Mines will continue to produce as long as all marginal costs are covered. The huge capital cost will have to be recovered during the strong times of the next cycle.

The price of raw materials is substantially higher today than they were in 2002. The price of copper went from below 50 cents in 2002 to above $4 in 2007. It is now around $1.80. I don't want to guess when but it will probably make it back to 50 cents. As raw materials prices fall, the inflation rate as measured by the CPI will fall. Interest rates will fall but real interest rates will rise. As US real interest rates rise, the value of the US Dollar will continue to rise and the price of Gold will continue to fall. If gold prices fall, the owners of DZZ will make as much as 200% of the decline in prices. This is one way to "win" while the market makes it's way to the bottom.