Monday, November 10, 2008

Another Big Surprise?


As a result of falling input costs, including falling fuel costs and falling interest costs, factory output costs fell last month. Factory output prices fell by 1% while factory input costs fell by 5.6%, the largest decline on record. Oh what a surprise! The quarter after oil prices and industrial metals prices fell from 55 to 95%, factory input costs fell by at a record pace.

Gasoline companies are slowly adjusting retail pump prices to input prices, putting consumers in the same boat as factory managers. Seeing the lower wholesale prices, gives us confidence that further price declines are on the way. As prices fall, we know that ultimately we will enjoy higher real incomes.

The formulas are simple: input prices down by more than output prices equals increasing profit margins; lower output prices encourage sales; flat or increasing sales times fatter margins equals increasing profits; higher profits discounted at lower interest rates equals higher stock prices.

This morning, the futures markets have reacted positively to the 500 Billion Dollar stimulus package announced by China. If enough governments pump-in enough money in enough places, there will be "reflation", but that does not mean that commodity prices are going to soar relative to the price of consumers goods. The price of metals and oil bounced this morning but retail prices have not caught up with the previous declines in wholesale prices. Even if the wholesale price of gasoline were to bounce 20 cents, the retail price would still trend down because there is currently an above average spread between the wholesale price and the retail price. Commodity input prices will come down more in the months ahead. This morning UK markets are up 3% with the biggest gains in basic materials but most sectors are rising.

A flood of liquidity, supplied by governments, is not going to convince consumers to go back to buying monster houses or monster cars. Rising incomes will be spent on other things and it is in other things where the opportunities for great profits lie.

New CAFE standards will dramatically limit the available supply of new monster cars. Auto makers are required by law to sell higher mileage fleets. The easiest way to achieve this goal is to reduce the average weight of fleets. The easiest way to reduce weight is to sell smaller cars. The second easiest way is to use lighter materials.

Once auto makers retool to use graphite parts in place of steel, the relative use of steel will forever be lowered. The 500 Billion stimulus package in China will not be spent trying to make the same heavy cars that were being made during the last boom. During boom times, consumers have tons of money and even more tons of credit. They buy to keeping up with the Jones family. During tight times, the brag from the Jones Family is the payoff of a credit card.

We are currently dealing with the Paradox of Saving. Stimulus packages such as the $600 checks sent out earlier this year are considered Keynesian stimulus packages, but Keynes was well aware of the Paradox of Saving, which is that recessions are largely the result of an increased propensity to save. Give the public a rebate check right now and he is likely to use it to reduce his debts. Once again, there is a big difference in short term results and long term results. In the long term, savings are necessary for economic growth, but in the short run a rise in savings results in slower economic growth.

The great news is that new products are in the marketplace and there is pent up demand. The Wii has been a huge success but it is just now coming out of the early adoption phase. The Kindle has been a huge success but it is just coming out of the early adoption phase. Knee replacements have been a huge success but the baby boom generation is just reaching the peak demand phase. The real per seat mile cost of airline tickets is at 50 year lows just as the retiring baby boom generation is ready to travel.

Having mentioned the Kindle, I must say again that Billions of Trees and Trillions of Dollars of other resources are going to be saved now that an excellent mobile reader has been developed. Last week, US News and World Report announced that its content is being moved to the Internet. Over the next several years, you should expect a massive move away from the printed page. The world wide resource savings will be more stimulative than all the government bailouts combined.

Thousands of free books are available. Thousands of bloggers will go mobile. Trillions of dollars will be earned by millions of people who published books in the past. Billions of bloggers will enjoy getting paid for their work.

Anne Coulter has sold millions of books by calling democrats dumb. Democrats politicians are smart. The blocking actions of Senate Majority Leader Harry Reid cost our short term economy dearly in many areas, but exit polls showed that 30% of the people who voted democratic did not know who Harry Reid is. Politically smart blocking actions helped Obama win, even though these actions hurt the economy. Obama is likely to govern far to the right of Harry Reid; still left of center. Obama's new chief of staff is a partisan bully but his economic philosophy is far to the right of Harry Reid's philosophy. We will learn a lot when we see the next stimulus package. A "good package" will encourage investment.

Using Larry Kudlow's analogy, mustard seeds are being sown. The decline in fuel and other commodity prices are providing more stimulus than all the government programs combined. The natural cycle is stronger than government. All the stimulus packages of all the governments cannot stop the relative decline in commodity prices. Sometimes it seems that the government would try to stop the fall of leaves from trees.

Martin Pring breaks the economic cycle into six phases: 1) stocks up 2) commodities up 3) bonds down 4) stocks down 5) commodities down and 6) bonds up. These 6 phases can be drawn by placing them as points on a wheel or as three smooth but out of sync sine waves. In other words, there are overlaps, during the early expansion phase of the economic cycle, bonds are still going up when stocks begin to climb but by the middle expansion phase commodity prices start to rise soon before or soon after bond prices begin to fall.

There is always "noise". Outside events happen. While the economic cycles are not as smooth as our weather cycles, they are just as certain and nearly as uncontrollable.

The more commodity prices go down, the more likely the price of bonds will go up and the more bonds go up, the more likely the price of stocks will go up. Last week, the value of the 5-year UK bond made one of the largest price climbs ever.

Number 6 in the cycle is bonds up and number 1 is stocks up. Just as winter follows fall, stocks will go up after bonds go up. No surprise here!