Friday, November 21, 2008


It is painful not to have made a fortune off the decline in oil prices. For months on end, I wrote that conventional wisdom was wrong. I repeatedly said that the price of oil was not going to keep going up but that it would ultimately come back down to the marginal cost of production, which is less than $35 per barrel for most of the oil produced. I wrote thousands of words but I blindly continued to invest in other areas. As far as I know, not a single reader, including myself, bought inverse oil funds or shorted the price of crude.

Now we are in a treasury bond bubble. In this case, I wrote hundreds of times that bonds would rise to a peak after commodities begin to fall sharply. Unfortunately, I kept wanting to believe the optimistic story that the decline in gasoline prices would show up quickly in lower home mortgage rates and an increase in consumer spending. I invested with emotion while ignoring my own words about the natural order of progression. I said that stocks will go up after the bond market rally. I skipped ahead and bought stocks when I should have bought bonds.

Obviously, I was very wrong about the economic downturn. Forty years ago, I understood that once the Fed tightens short term interest rates to the point of inverting the yield curve that a recession is likely to follow about a year later. The yield curve was flat to negative from June of 2006 to July of 2007 and I failed to pay attention.

Now there is talk about deflation. Once again, the talk is late to catch up with reality. The fact is that there has already been a tremendous deflation in asset values. Three of the big four asset classes have deflated substantially, real estate, commodities and stocks. The forth asset class, bonds, has set long term record highs and lows at the same time.

Yesterday, the price of treasury bonds soared to new highs, highs not seen since the 1950's. The yield on the 10-year note dropped to under 3% yesterday. The drop in the value of corporate bonds has roughly parallel to the drop in the stock market. Baa and lower quality bonds are at prices I have never seen. Yesterday, the markets were clearly in a capitulation mode. There was a true "flight to quality". Investors decided that it does not matter how cheap a security has gotten, they want the "safety" of short term treasury bills paying as little as .03%.


How high can the price of treasury bonds go? The thirty-year bond is trading at 3.5% while the effective rate on Fed Funds has traded for around .4% for the past several weeks. The 3.5% to .4% makes for a nicely positive yield curve, suggesting economic recovery ahead, but the hidden story is in the inflation adjusted curve.

The inflation adjusted curve is inverted. It indicates that there will be "negative inflation" in the short run and even a negative average rate for 5 years. Over the next 10 years, the inflation adjust yield curve is forecasting average compounded inflation of just 1% or so.

On the other hand, the most recent CPI numbers showed the biggest drop in inflation in 60 years! One number does not make a trend, but big drops in wholesale prices are feeding into the CPI. The wholesale price of gasoline indicates a retail price of $1.65 within 10 days. The long term, inflation adjusted average price of gasoline in 2008 dollars is somewhere in the $2.25 range. Gasoline is already selling well below its average inflation adjusted price and very near the its all time low price (think in terms of how many hours work it takes to buy one gallon, people who remember .19 cents per gallon for gas fail to mention in the same breath that they made two dollars per day for their labor).

The see-saws are making big moves. The market is discounting the probability that a democratic president with large democratic majorities in the house and senate will make the same mistakes made in the past. However, government bureaucrats on the left and the right have generally learned from past mistakes; the odds that another Smoot-Hawley type trade bill will pass is remote. Democrats in congress are holding up the free trade bill with Columbia, but the economic team being assembled by Obama is not stupid. They understand that raising taxes or restricting trade during an economic downturn would be counter productive. It is also clear that the public has no stomach for more massive bail out bills. A deal to release the previously passed $25 Billion to the auto companies is likely, but even that is likely to come with strings attached.

One of the really big see-saws is the increase in real income that is being poured on the typical worker. About 95% of the people in America who want jobs have them and another several percent are drawing benefits while they look for work. The sharp drop in commodity prices, including the cost of money is flooding the world with purchasing power. In the short run, this flood is being used to pay down debt.

The price of a 7% auto loan has gone from very cheap to very expensive! When the inflation rate was 5.5% last summer, a 7% car loan had a real cost of 1.5%, much less than the average annual wage increase. Do the loan as a tax deductible home equity loan and consumers were being paid to buy cars now instead of later. Today, with the inflation rate negative by perhaps 2%, the real price of that old auto loan is 9% and the worker is not confident that he will get any raise and it makes good sense to wait to buy one of the new energy efficient designs that are on the way. The swing from 1.5% to 9% is a 600% increase in the cost of the loan. While people often say irrational things about financial matters, as a group, they tend to behave rationally; they follow the crowd to big mistakes but also to big corrections of mistakes. An individual may not have a clue that his real cost of credit has gone up but he is instinctively paying down debt.

In the short run, we are caught by the "Paradox of Saving". The more we save, the worse the economy gets. However, the probability that a family will travel to the beach this spring goes up each time the price of gasoline comes down a penny. On the way up, only the number and volume of complaints went up as gasoline went up, until we got close to the $4 range. Now on the way down, people are talking about the declines but they are not ready to spend their savings just yet. I suspect that gasoline at $1.65 per gallon will encourage more travel. The invisible hand of Adam Smith is hard at work. The economy will recover.

Today, one can buy high yield bond pools that offer unprecedented yields. The symbols for some of the funds are PHF, COY, MSY, HYF, HYI, HYP, and PHB. As an amateur private investor, I cannot recommend these funds but I can suggest that they are worth investigating. Where is the bottom? I don't know but, by a number of measures, we have never been this low before!