Summer of Capitulation

When I was a new bond trader working for the capital markets division of First Interstate Bank, Charlie, a wizened old trader assigned to be my mentor, told me repeatedly: "Remember, you make your money when blood is running in the street." I was sitting next to him on Black Monday, October 19, 1987. He smiled and chain-smoked his way through the day. In the midst of the carnage he went to work setting his bond positions. He made a ton of money.

That image of Charlie calmly smoking his way through what seemed to me to be the end of the world has stayed with me for over twenty years. I have found it to be very reassuring as I have tried to guide clients and investors through every major financial debacle since then. Some have been willing to ride out the storms; some have not. But I can honestly say that those who patiently stayed the course have come out alright.

We call it a "capitulation" when the market melts down and there seem to be no buyers left on the planet. They are periods of raw fear. They are unreasoning and unrelenting and they can try even the hardiest of souls. Yet they can also produce some of the most compelling buying opportunities. Sometimes capitulations happen like Black Monday, cascading in ever increasing volume over a very short period of time. Such capitulations are dramatic and very rare. More typically, capitulations happen over a period of weeks or months, gradually wearing down investor resolve and picking up momentum as they roll along.

We are in the latter type of capitulation right now. Between rising oil prices and the ongoing credit crisis, there is plenty for investors to worry about. I cringe every time I pull into a gas station or stop by the grocery store. Yet stocks are cheap! If you take company-by-company earnings projections for every stock in the S&P 500 for the next 12 months and compare them to the current level of the S&P 500 (which closed just below 1,300 today), the stock market is close to its cheapest levels of the last 20 years. In fact, you would have to cut the latest earnings projections by another 30% before you would get the P/E ratio back to the average level of the past 20 years!

At times like this I like to ask myself what Charlie would do. I'm sure he would be buying.

U.S. Stocks are UNDERVALUED: Morningstar

Morningstar publishes an interesting chart on market valuation. Every day they calculate what they consider to be the "fair" price of every publicly-traded stock in the U.S. and compare that to each stock's actual market price. If the market price is below the fair price, the stock is undervalued. Conversely, if the market price is above the fair price, the stock is overvalued. Morningstar aggregates these individual valuation measures into an index that measures the market's overall relative value.

Morningstar currently sees stocks as undervalued (see the chart above.) While this indicator is not meant to be a trading signal, it is one more piece of evidence supporting our decision to hold steady despite the market's frustrating ambivalence.

You can access Morningstar's valuation index directly at: http://www.morningstar.com/cover/pfvgraph.html

Housing Market: Near the Bottom?

The financial press has done a good job reporting the bad news on the housing market over the past year or so, but they may have gone too far. I'm beginning to see news articles that have pockets of good news buried within them that tell me we may be nearing the bottom of the housing market correction. Looking at the various statistics together brings more optimism.

On May 23rd, CNN headlines read "Home sales dip; prices fall sharply," based on the news report from the National Association of Realtors that existing home sales dropped 17 percent from April 2007. An analyst quoted in the article said "this was the latest in a long string of disappointing results." Median home prices were down 8.5 percent since April 2007. By the tone of the article, everything was gloom and doom, leaving readers wondering when the massive bleeding would stop.

Yet the raw data from the NAR clearly show that existing home sales have stabilized around 4.9 million units (seasonally adjusted) since December of 2007, a fact buried by the author. Are home sales down compared to the unrealistic days of lax underwriting standards? Of course! But a five-month trend of stable home sales is a comforting statistic to me, especially compared to the drops of 4.5 percent in August and 7.1 percent in September.

Then on June 9th, CNN reported "Pending sales up 6.3 percent; prices seen falling." Again the author had a hard time containing his pessimism by claiming the report gave "mixed signals." This week the U.S. Census Bureau announced that construction of new homes fell 3.3 percent in May, but in the Northeast new home construction jumped 61 percent over April, the highest number since October.

Taken individually, these statistics do not yet indicate trends and they are lost amidst the gloomy tone of the news articles. Yet taken in aggregate, they may be signaling that we are at or near the bottom of the housing market. Absent a major crisis in the credit markets or oil rising above the expected $150 per barrel, I expect the media will turn more optimistic in September or October, as we get further away from last year's housing collapse. Then, in November, we will elect a new president who has the leadership to restore our hope and confidence.

All of this is good news for the financial markets, too. Less fear and greater optimism in the economy will help to settle the nervous stock and bond markets.

Gas at $5/gallon?

I've been conducting a (very) informal poll for the past couple of weeks. I've been asking people this question: If you could enter into an agreement that would lock in your price of gasoline for the next year at $5 per gallon, would you do it? The responses have been mostly negative, but the question has sparked some very interesting discussions.

The answer to this question interests me because it reveals the degree to which the recent acceleration in gasoline prices have affected a person's expectations for further price gains. The mostly negative response to my question tells me that inflation expectations have not yet become deeply entrenched (at least among my clients and friends) and this is very important. Inflation does its greatest damage when expectations for high inflation get baked into general perceptions about the future. When that happens, it becomes very difficult and painful to wring inflation expectations out of the economy.

As a case in point, consider the U.S. experience in the 70's after the 1974 oil embargo. At that time, year-over-year core inflation (or, inflation excluding food and energy) averaged 7.9 percent. Beginning in 1979 and continuing through the early 80's, it took the Fed's "tough love" approach--including 18 percent interest rates and a very nasty recession--to finally squelch those expectations. The impact of that "tough love" lingered for many years. In 1988, when I bought my first house, my mortgage rate was 9.375% and I thought it was a great interest rate.

With gasoline now at close to $4.50 per gallon, a rise above $5 per gallon is very possible. Some pundits claim we will see it breach that level and go much higher. Whether they do or not is anybody's guess. But the thing I will be watching is how those price gains effect general inflation expectations.

Coping with the Oil Crisis

After paying $4.41 per gallon in San Jose the other day, I decided to take action. For $500 I reserved a production slot (#2,366 to be precise) for the new Aptera hybrid vehicle being developed in Carlsbad, California. When delivered sometime in 2010, this vehicle will cost about $30,000, get over 200 miles per gallon and will have a top speed of about 85 miles per hour. Plus, it looks cool. Check it out at www.aptera.com.

Oil & the Urge to "Do Something"

There is a very interesting story on the front page of today's Wall Street Journal. Under a headline reading "Regulators Step Up Probes of Trading in Oil Markets" the article describes efforts by a newly-invigorated Commodity Futures Trading Commission* (CFTC) to get tough on alleged manipulations in the energy futures market.

While the article provides an interesting look at the latest effort by politicians to "do something" about the rise in oil prices, I think is important to understand that the massive run up in oil and gasoline prices probably has very little to do with chicanery or fraud or manipulation (though bubbles always bring out the worst of these sorts of things.) It is much more likely that the ballooning price of energy is simply a product of the same dynamics that caused the other bubbles in recent memory: big money, small market, and no diversity of opinion. When these factors are in place, you can bet there will be a bubble.

These three factors appear to be in full force in the oil market right now. As I discussed in my last post, the influx of levered financial players into the oil market has resulted in huge increases in demand for oil futures. While oil is hardly a "small" market, it has traditionally been narrow, meaning it was typically dominated by oil industry players with a few intrepid speculators mixed in. In recent years, however, large financial players have moved into the oil patch. Pension funds, hedge funds, and mutual funds have devoted very large portfolios to oil. Even non-specialty funds have moved into oil and other commodities to broaden out their asset allocation. The new financial players in the oil market do not bring a balanced set of opinions about oil. They are in oil only because they believe prices are going higher.

With this being the case, I'm not sure how effective the CFTC's latest actions will be at curbing the spiraling price of oil. In fact, if history is any guide, political efforts to tamper with markets are more likely to cause a host of unintended consequences much worse than the problem they were trying to solve. Remember the Nixon-era price controls?

A better approach is to let the market run its course. In time, the high price of oil will do three things: 1) it will make alternative energy sources look that much more attractive; 2) it will draw more oil supply onto the market; 3) it will encourage the development of new technologies that help us better use our existing resources.

As these three effects begin to take root and the price of oil stops going up, financial investors will likely decide it is time to move on. After all, oil produces no dividend and earns no interest. The only return a financial investor can expect comes from rising prices. Financial investors can be very fickle and impatient. They are driven by expectations about the future and when expectations for excess returns from oil evaporate, so will their demand for oil.


*The CFTC is the government regulatory watch dog commissioned with the the task of making sure that futures markets function properly and are free from fraud and manipulation.

Oil -- The Latest Bubble?

Perhaps I am in denial, but I have mistrusted the surge in oil prices almost from the beginning. To me, the magnitude of the rise in oil prices is as suspicious as the rally in tech stocks in the late 1990's and the rise in home prices since the tech sector crashed.

I understand--and agree with--most of the arguments in favor of rising in oil prices: China has emerged as a huge consumer of oil just as political disruptions have pinched oil supplies. Still, I have a hard time believing that these events justify a 433% increase in prices since the end of 2000 or a 76% surge in the past 12 months. In my view, this rally looks like another bubble.

According to the U.S. Department of Energy, world demand for oil has increased at an average rate of about 1.6% each year for the past 7 years. This is in line with past growth rates (and past estimates of future growth rates) so it can hardly be considered a "surprise development." At the same time, the growth in the supply of oil has slowed slightly from about 1.6% per year to 1.5%. This mismatch in growth rates is certainly grounds for some upward pressure on prices, but it hardly seems to warrant the magnitude of price increases we have experienced.

In my mind, a much more plausible explanation for the rapid rise in oil prices is the increased involvement in this sector by "non-traditional" players such as hedge funds, pension funds, mutual funds and individual speculators. As a group, these investors control trillions of dollars. Even a small allocation into oil by these portfolios would account for tens of billions of dollars of marginal demand for "paper barrels" - a huge influx for a narrow market for commodities like oil. And while the price of a futures contract is usually thought to be a derivative of the spot price of the underlying commodity, the algebra that governs the relationship between the two could just as easily allow the spot price to be driven by the value of a futures contract--at least in the short term.

The chart at the top plots the spot price of oil along side the number of outstanding contracts for oil futures. I think it is telling that they rise in near lockstep with each other. While statisticians would argue that a tight correlation hardly proves a causal relationship, I contend that the strong interrelationship between the two is hardly coincidental.

As with most bubbles, there are plenty of people who refuse to see it. Some think the rising price of oil is a sign of the end of the world as we know it. Others believe it is a product of rising inflation expectations and a falling dollar. Many believe oil is a one-way trade, that it must go up over time. Often, they argue that prices aren't in a bubble because they keep going higher - a circular form of reasoning that seems to defy gravity.

My feelings are just the opposite. After the d0t.com crash and the real estate debacle, I think we should all be a little smarter about bubbles. Bubbles have a tendency to pop and when they do, the bottom can be a long way down.