OIl - Could It Be The Game Changer?

"Let me tell you something that we Israelis have against Moses.  He took us 40 years through the desert in order to bring us to the one spot in the Middle East that has no oil!" - Golda Meir

The Platts Annual Crude Oil Summit was held in London recently and the projections from the conference are incredibly interesting in particular as it relates to global growth and the outlook for the United States' global military footprint.  The expected trend in oil production could have a significant impact on how the world models itself in the coming decade and it gives the United States a wonderful chance to get its finances in order.  The question is will the opportunity be taken or lost?

The most amazing chart to me is the one below showing the expected flow of oil exports and imports.  In years past the heavy blue line would have been pointed directly at the United States but now that the oil found in the shale estimated to be a whopping 7.4 billion barrels, by 2018 it is expected that the United States will only be importing 3 million barrels a day.  This is down from a peak of 10 million barrels a day in 2005.

So most of the global oil production and particularly Middle Eastern production will be moving to China and this will change the global landscape tremendously.  First of all the United States will be less concerned with protecting its oil supply in the Middle East.  The United States has already limited their import to just a hand full of countries and this will more than likely shrink over time.  At present over 70% is imported from Canada, Saudi Arabia, Iraq, Venezuela, Mexico and Nigeria and this number should fall further allowing the United States the opportunity to pull back from its overextended military presence in the rest of the world.  At present the US spends $680 billion a year on its military (this does not include war expenditure and assisting veterans which takes the number a lot higher) and this number could be slashed closing the budget gap.

Second with more and more oil being sent to China it will become more common for payments to be made in Renminbi rather than dollars.  This will create the platform necessary to turn China's currency into a major global currency and will begin the demise of the dollar as the globe's de facto standard.  While this will be welcome in certain parts of the world it will have an impact on the United States' ability to finance their large budget deficits.  The simple reason is that if China is seen as being a global heavy weight then safety may be found outside of the US reducing foreign capital to finance budget deficits.

Third there is a chance that the oil market itself will become more regional much like the natural gas market.  So for example oil produced in the United States and used in the United States will command a different price from Middle East crude shipped to China.  As one of the main drivers of inflation is from oil inputs, if the United States can supply much of its own demand then inflationary shocks from limited oil supplies outside of its borders will have minimal impact on inflation.  This insulation would allow for a more stable inflationary platform from which to grow an economy.

Fourth is that the trade deficit will shrink and could even move to a positive number.  A trade surplus would be very welcome and would allow the country to reduce its reliance on foreign investment to finance deficits.  This is one of the reasons that Japan has managed to continue to raise its level of debt while remaining solvent (a situation that will more than likely reverse with the final push by the government to spend more than they should on wasted projects).

Fifth is that the wealth that will be created in the build out of mining operations and the subsequent revenues generated from operations will provide a nice boost to GDP.  On the back of this will come some much needed tax revenues which should help to shrink the budget deficit further.

All of this is positive news and gives the politicians another chance at repairing the economic damage but the main question remains, will they take the opportunity presented or once again squander it?  I am hopeful that the size of the opportunity is so large that even our lost leaders will not be able to destroy this opportunity.  If in fact they continue down the path toward fiscal austerity then this economic boost will be felt and could once again put the United States back in the pound seat in terms of an economic super power.  Furthermore as the country becomes more and more insulated the pressure will finally be off to police the rest of the world and that should help with national security which would be worth its weight in gold!

A Man Named Soros

"Markets are constantly in a state of uncertainty and flux and money is made by discounting the obvious and and betting on the unexpected." - George Soros

"Once we realize that imperfect understanding is the human condition there is no shame in being wrong, only in failing to correct our mistakes." - George Soros

George Soros, the Hungarian born investor, is an industry icon.  He has called more investments correctly than incorrectly and when he wins he wins big.  This ability to invest on the right side of the market has created enormous wealth for him and his investors.  He has also given away more than $8 Billion to philanthropic organizations over the years and is still active in his company at 83 years old.

One of my friends happens to have a direct link to Soros and has commented to me that while I continue to expect the market to fall precipitously, Soros has continued to enjoy the fruits that the market is producing for him.  His thought is that as long as the central bankers of the world continue to print money unabated, the stock markets around the world will continue their upward spiral.  I happen to agree with him to a certain extent but the issue is that most investors are not as shrewd as Soros and will be taken to the cleaners when the market capitulates.

There is a famous story about Soros that occurred many years ago when at a meeting of the top 10 traders in New York each trader put forward their best trading idea.  Soros spent his time explaining in great detail why his best trade was to be long the US dollar.  Other traders put forth their ideas and the last person to go was the newest member to the group.  He was very intimidated and did not want to say what his trade was, but under duress he confessed that he was heavily short the United States dollar for the many reasons that he then described.

The next day he woke to find that the dollar was being pounded into the dust making him a lot of money.  His thoughts turned to Soros when suddenly the phone ran and it was Soros.  Expecting to hear a sob story from him he was surprised to find George in a very good mood.  Soros then explained that after listening to the trader that he realized that he was wrong so he had switched his position from long to short and was also making a fortune!

The reason for the story is that while I agree with Soros in the short term the trade is becoming more and more dangerous with every tick higher.  For the average investor who gets wedded to a position or just blindly adds to his or her mutual fund it is not the time to go all in but if you have the ability to trade the market there may still be some upside left but be very careful.

Another All Time high

"Experts often possess more data than judgement." - Colin Powell

One thing I try to do when I review data is to make sure that I am not fitting the data to my hypothesis as doing this would play right into the quote above.  This week I spent some time looking at data from the S&P 500 stocks.  These companies are the 500 largest represented on the United States stock markets and they command a huge slice of the economy.  In addition as the economy seems to be skewed towards the larger capitalized businesses this group should be performing well to drive the stock market to its new highs.

I looked at the historical company earnings as company earnings drive stock prices.  I then created two charts that show the relationship.  As the most recent quarter's numbers are not yet completed I could only take the study to the end of 2012.  Each chart shows the trailing twelve months earnings per share for the S&P 500 in blue and the S&P 500 stock index in red.  The first chart goes back to the year before the bubble burst (2007) and the second looks at earnings from December 2011.

As you can see in the first chart the blue line (company earnings per share) is falling while the red line continues to rise.  When I drill into those numbers a bit more in the second chart you can see that the fall off in earnings per share is relatively steep while the market trajectory continues unabated.  The obvious answer to the market's continued trajectory is that investor expectations are that this is a short term lull before earnings once again ramp up.  However at just past the half way mark through the earnings season it is looking like earnings may not grow.  Worse than that only 44% of companies that have reported have beaten their revenue projections.  So while a number have beaten their earnings numbers, these numbers are being squeezed out of a shrinking lemon.  As an example IBM missed revenues by $1.3B!

Today however the market is higher by more than one percent to fresh all time highs on the back of some decent looking employment numbers.  As I have mentioned repeatedly the economy will not get into its stride until the employment picture improves so on the surface it seems that the market has what it wants (in order for earnings to accelerate, revenues need to grow and this will only come from the consumer).  More jobs means more spending and after a decline in retail sales in March, the market is buying that this will mean a resurgence in spending in April.  The opposite is likely as most of the job growth came from part-time workers.  In fact the average number of hours worked per  week fell.  If the savings rate resumes its normal level of 3.5% it is likely that April retail sales will decline for a second month.

This is not good news for a market that is buying future growth however once you have taken a sip of the juice it is hard to see straight.  Further with the tail wind of continued government stimulus there is no reason to think that the market will drop any time soon (tongue in cheek as you should know by now)!  This is precisely why I am not long as this is exactly what it felt like in 2000 and again in 2007.  I remember all too clearly the pundits applauding more stimulus and a forecasting the Dow at 20,000 in a few years and it appears to be more of the same but looking at the two simple graphs above the earnings signals are clear. 

In addition margin accounts at brokerage companies are once again at levels not seen since 2007 right before the market crashed so as painful as it is to watch I have stepped aside.  This is the only prudent thing to do if you have data to validate your hypothesis and you have ensured that you have not manipulated it to fit your theory.

Is Deflation Even Possible?

"Unemployment is sky-rocketing; deflation is in our future for the first time since the Great Depression.  I don't care whose fault it is, it's the truth." - John Mellencamp

Economics is a very strange discipline.  It tries to work out what will happen to an economy given certain inputs and structural changes.  For example, how will a change in the tax rate help or hurt the economy or how will massive stimulus from the Federal Reserve stimulate economic growth?  The problem with economics is that there are just so many moving parts that the chances of actually get the answer right is pretty much impossible.  What you can do is hypothesis about the future and base it on historical data points and then rely on your instinct to guide you.  Changing your mind is part and parcel of the process as new data is constantly available and there is always the Black Swan event lurking around that will throw all assumptions out of the window and create havoc with your hypothesis.

When I look at the massive quantitative easing program of the Federal Reserve the questions are is it working and will it result in inflation?  Consensus says that it is working (at least that is what it appears when you look at the stock market) and that inflation, while it will rise will be moderate.  At present I disagree with both of these views which is why I am in the camp that is negative on the market because if it is not working and inflation will not be moderate in the future then the market is setting everyone up for a massive reversal.

Now what if we are all wrong?  What if inflation not only remains subdued but due to all of the easing we end up with deflation?  I have mentioned in last week's blog that Japan is already exporting deflation to the rest of the world, but what if deflation takes hold globally?  If I look at the Federal Reserve who has increased their balance sheet by almost $3 trillion you would expect massive inflation but at present it seems relatively mute.

Consider this equation created by Irving Fisher that GDP = MV.  That is to say the size of the economy is equal to the money supply multiplied by the velocity of money.  Now if the velocity of money remains constant (does not change) then by increasing the supply of money through the Federal Reserve monetary expansion then GDP has to increase.  This is inflation.  Now as there is minimal inflation at present and GDP is not growing very fast (if at all) let's dig a bit deeper to see what is going on in the inner workings of the equation.

Money supply as measured by M2, the monetary base, expanded by $277.5 Billion last quarter as the Federal Reserve expanded its balance sheet by that amount.  M (money supply) however declined by $55 Billion to $10.45 Trillion.  This is only possible if the money multiplier shrank.  The money multiplier is the value assigned to the expansion of the money supply when a bank lends out a dollar.  This expansion occurs because the dollar lent does not just stay in your wallet but is used to buy goods and services and is then spent again and again.  This one dollar multiplied itself by a factor of 9 in 2007 when the economy was booming, but today that number has fallen to 3.6.  So the first problem that the Federal Reserve has is that it cannot create demand by printing money.

The second part to the equation is the velocity of money.  Velocity of money was thought to always remain stable but it turns out that this too is a variable.  It appears that the only way in which the velocity of money can remain stable or expand is through lending to increase production.  Lending to finance consumption does not generate a productive income stream and it cannot create resources to repay the debt so therefore velocity collapses.  In fact the current velocity of money stands at a six decade low.

Now the inflation advocates point to the fact that once things turn around you will have an increase in the velocity of money and an increase in the money multiplier and a huge increase in the monetary base and this will lead to outlandish inflation.  The problem is that the money printed is being used to finance consumption and this could result in a spiral into the abyss that is deflation.  This is what Japan has been dealing with for decades.  They too have and are pumping money into an economy in the hopes that it will eventually get their economy started but after more than 20 years there is still no sign of life.  Worse than that they now owe more than 200% of GDP in government debt.

This could easily be the outlook for the United States and if it is then the euphoria of the stock market will quickly turn to dismay.  The reason is that deflation is the worst possible world for the stock market.  The economy is essentially shrinking as prices fall and consumers put off purchasing goods and services as they learn that these will be cheaper in the future.  Businesses struggle to grow and can only keep profits up by stealing market share from others or by cutting overhead such as labor.  If this sounds familiar then you are right as this is where the United States is now.  The problem is that the market and most pundits expect inflation to begin any time soon and as the market looks forward the expectations for inflation are now baked into the prices.  Should this expectation change as the reality sets in then the market will be in for a long downward spiral.  In Japan the market has recently rallied to over 13,000 but that is still a long way from 38,916 which was the all time high set in December 1989!

A Shudder Is Felt

"Excuse me, why have the engines stopped?  I felt a shudder." - Rochelle Rose as Countess of Rothes in Titanic

This week it was evident that there is trouble in global markets.  Now not to discount the fact that the Federal Reserve and other central bankers of the world will rush to support the one beacon of success the stock market, surveying the movements in the markets this week seems to point to a shift in the bullish stance.

The first graph that I look to in these times is our old friend Dr. Copper.  As you can see from the chart below there is a lot of concern about global growth.  China in particular is looking weak and this is feeding into global growth projections and notably the copper price.

Gold also took a tumble recently as concerns for inflation are being replaced with concerns for deflation.  That said I still believe in the value of allocating a portion of your portfolio to this metal as it appears that the gold haters one this round but the long run bull market for gold is still intact.

Deflation is being fueled by the Bank of Japan's massive quantitative easing program as their disdain for their currency is giving them the ability to undercut their rivals and hence export their deflation to the world.  This in turn is fueling their stock market which too is spiralling higher, but the repercussions of Japan's move will be felt throughout the globe and will not have a pleasant impact on their trade partners.  As an example expect Toyota to take market share from the resurgent US automaker as they will be able to under cut their their American competitors.

All of this news and some poor earnings from the some of the US bell weather stocks is having an impact on the performance of the stock market.  As I mentioned before though the Federal Reserve will put in a big effort to support this market as it is the shining beacon of its success. 

So whether this is just a brief pullback or the start of something bigger the global metrics continue to point to weakness and this will fuel a large pullback at some point in the near future.  I believe though that when that time comes, much like the Titanic, there will be little time to exit so make sure you heed the warnings early.

A Lot of Data

"This is referred to as data mining.  They slice and dice these numbers a thousand different ways.  They analyze patterns.  If your NSA, you look for suspicious patterns." - Leslie Cauley

The first thing that you always have to be careful of when look at a lot of data points is that you are not mining data to fit your theory rather than looking at all the data points from a rational perspective.  It is an easy trap to fall into as we are normally biased towards our own opinions and can spend hours explaining the virtues of our position (just listen to any sports enthusiast arguing about the referee calls).  However when the data points overwhelmingly in your favor you have to act and that is one of the arts of trading.

Recently there has been a slew of poor information and it all points to the economy slowing and at a far more rapid pace (actually all the analysts are expecting growth) than was anticipated by the market consensus.  The first and most recent data point was that PC sales fell by 14%.  This is the largest decline in the history of PC sales.  Pundits tried to push this aside as a migration to the tablet and the mobile phone and while I will admit that a lot of people have migrated to those platforms the underlying trend is worrying.

There is no way that the market implosion of PCs is only related to tablets.  This is a direct result of very weak consumer spending and a weak global economy.  Ask anyone who owns a tablet how much business they actually do on a tablet and the answer is normally not much.  This weakness will feed into weak chip sales, chip development, software and numerous other industries.  Remember when the NASDAQ was flying and technology was the place to be well it appears that those days are over and to me this is even more scary as without a technological recovery I am not sure what other industry can drag the global economy back on its feet.

The next data point is poor consumer spending numbers which have fed poor retail sales.  As I have mentioned repeatedly, the tax effects and increased costs of health insurance and other expenses combined with little to no job growth or increases in pay will have a massive impact on consumer spending.  This is starting to raise its ugly head as retail sales fell 0.4% in March.  Following this up was another poor number out of the consumer as consumer sentiment fell again in April.  Admittedly this is a preliminary number but it is not a good omen.

The final data point I want to talk about is the revelation from Pimco's Bill Gross that the Federal Reserve is now publishing different reports for different groups.  The Federal Reserve issues a separate release to lobbyists and congressional staffers.  In addition there are certain funds and banks that receive the data sooner than others!  Now why is it that some are insiders and others are not?  So much for independence and for looking out for the benefit of the economy!  No it is certain that they are cherry picking those who they want to benefit at the expense of everyone else and this is outright discrimination and needs to be stopped immediately.

Outside of that they did caution that the duration of their quantitative easing strategy was under consideration to be shortened.  In effect they are finally admitting that it is not working as why else would they start talking about curtailing it when nothing has recovered?  Should they stop printing I would expect a huge market correction for the simple reason that they are manipulating the market openly.  Stop manipulating and down it goes as all that the market will have for a backstop then will be poor economic data and outlook. 

As you all know I have been calling for this for a long time and I have been wrong to date but until the economic indicators turn themselves around there is no reason to be long the market particularly when the people controlling it are openly manipulating the data and providing it to their friends first!

Markets Rise Everywhere With No Jobs To Support Them

"Double, double, toil and trouble; Fire burn and cauldron bubble." - The witches chant from William Shakespeare's Macbeth

This morning the United State reported disastrous employment news.  It really should not have come as a surprise as I have been reading of layoffs from large and small companies across the country for months now.  I am now also watching as the S&P 500 which dropped over 1% on the news claw its way back towards the gain line once again.  It is certainly apparent that no matter what the news, the markets are going to go higher and if you listen to CNBC or one of the other market cheer leading channels within minutes you will be told just why things can only go higher from here!

Let me lead you through a number of very poignant metrics and you can make your own conclusions.but suffice it to say that I have now put on some S&P puts!  Not a large amount but enough to make me feel better. :)

First off you need jobs to create a strong economy.  Look at any model of economic strength and you will see a low unemployment number.  Jobs are the economy.  No jobs, no economic recovery period.  At present looking across the globe you have the Euro zone with unemployment above 12% the highest it has ever been and this masks the disasters that are Greece and Spain where unemployment is well past the Great Depression levels.  The United States has unemployment at north of 14% if you include the underemployed and some metrics have it as high as 20%.  Worse still is that 48 million people are now on food stamps in America up from 28 million just 5 years ago.  That is 11% compounded annual rate of growth!  What portfolio would not die for that number over the last five years?  So we have mounting unemployed and 15% of the people cannot feed themselves without government aid and the United States is supposedly the richest country in the world.

Without jobs the consumer has no spending power.  With no spending power companies cannot sell their products and profits slip (I expect a lot of companies to miss or lower their earnings targets going into this quarter's earnings reports).  So why is the market continuing higher?  It is very simple, the Federal Reserve is pumping money into the system and that money has to be invested.  With bond yields at historic lows the stock market and real estate are the direct beneficiaries.  Real estate is up over 8% nation wide while the yield on junk bonds has fallen to less than 3%.  Both of these are unsustainable.  First off housing prices cannot keep up this pace as consumers do not have the ability to purchase the houses.  The house prices are being propelled by large funds that are scooping up millions of houses at once because they can borrow money for next to nothing and this investment creates a better yield on their investment than the bond market.  This is not consumer demand this is speculation at its worst.

Furthermore with treasury yields falling to next to nothing bond buyers have once again ratcheted up the risk by buying junk.  This demand has pushed the price of these high risk bonds up reducing the yield to next to nothing.  The risk is not being met with commensurate return and this is a disaster waiting to happen.  To me it is not a case of if it will unravel but when.  Trying to even hazard a guess as to when this will unravel is futile as it will only occur when there is a loss of faith in the Federal Reserve's ability to control the markets.

For this reason sentiment indicators are worth watching and the most recent one was consumer confidence which dropped precipitously to 59.7 in March from 68 in February.  Consumers are starting to feel the very real pinch of lower income as another bite is being taken out of their pay with the tax increases, health care increases and gasoline and food price increases.  While this is not a good signal the Federal Reserve continues to believe that printing more money is the answer and is cajoling money printers around the world in Britain, Japan, Switzerland and others to join in the party.  This juice is what is fueling these speculative frenzies in the stock, bond and real estate markets.  Switch this juice off (which they will have to eventually) and all of these markets die virtually instantly as we have seen with the end of each of the previous 3 rounds of quantitative easing (or is it four, there have been so many I can barely keep up).

Do not get sucked in.  Keep your money in cash, gold or something that is safe and protected against a downturn as that is the best way to survive the storm as it appears that there are more than a few black clouds on the horizon.