“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” — Chuck Prince, CEO Citigroup, July 10, 2007
I know what you’re probably thinking. How can stocks keep going up when things look so terrible? The U.S. is running trillion dollar deficits, ( $1.5 trillion for 2011), the unemployment rate is stuck over over 9%, ( double that figure if you look at U6 and count discouraged workers), capacity utilization and business investment is below normal, housing prices have fallen, vacancies are high, consumer credit remains anemic, and there are riots in the streets. Under these circumstances stocks must be in a bubble.
Despite all of the above, the S&P 500 has risen close to 620 points from its March 6th lows in 2009 to its recent high (as of me writing this) of 1284.15 on January 31st, 2011, a gain of more than 90%. The markets now, like back then, are riding a sea of liquidity created by central banks around the globe. The message of the markets is “On with the dance.”
I could easily pen a long essay and describe what is wrong with this picture or scare the bejeebers out of you by describing how badly this could end. But that is not where we are despite the lamentations of the bears.
The music is playing and investors are dancing, including ourselves. Rather than waste your time with why the markets shouldn’t be going up for whatever reasons proffered by the pessimists amongst us I would rather focus on what could cause the music to stop playing.
There are a number of things we are watching and at the top of the list are oil prices. As shown in the graph below every recession in the last four decades has been associated with higher oil prices.
Source: Bloomberg, PFS Group
Higher oil prices raise the cost of goods produced, cuts into profit margins for companies as costs go up, and reduces the spending power of consumers as the cost of goods and services rise. Our modern industrial and technologically driven economies run on fossil fuels and will remain that way for decades to come despite politicians promising energy independence or a greener economy. All that green stuff they are talking about takes energy to produce from photovoltaic panels to wind turbines, to gas or nuclear power plants.
In addition to the cost of producing goods and services you have to deliver those goods and services to where they can be used or bought and that means transportation. Planes, trains, boats, and automobiles run on liquid fuels. Once again were talking about fossil fuels. Fedx runs their jets on jet fuel, transport ships use diesel fuel as do trains, barges, and those brown trucks that deliver packages ordered on the internet. It takes energy to deliver the goods to the store where we buy the goods we eat and consume.
When oil prices go up it not only costs more to produce the goods we eat or consume but it also costs more to deliver those goods to the point of purchase. So energy matters. Higher oil prices mean more expensive goods, higher transportation costs, and less purchasing power for consumers. When they get high enough, along with higher inflation and higher interest rates, we get recessions and bear markets.
At the top of our list of factors to monitor is energy. There are numerous books out there as to what caused the credit crisis and the worst recession this country has experienced since the 1970s. Very little has been written on the role triple-digit oil prices played in the recession of 2007-2009. However, oil at 7 a barrel was a major factor in the last recession. Higher oil prices along with a sea of central bank liquidity led to higher inflation rates which in turn led to higher interest rates and the bursting of asset bubbles.
Watch oil prices as I believe we will see triple-digit oil prices this year. Unlike 2007-2008, western economies aren’t as strong as they were a few years ago so I don’t believe it will take 7 oil to bring this economy to its knees. Oil prices in the 0-5 range would certainly do the trick. The EBER placed the beginning of the U.S. recession in December of 2007. Oil prices in December of 2007 hadn’t yet crossed the 0 level.
The next area we are monitoring is interest rates, especially the widening gap between foreign central bank rates and our own fed funds rate. As shown in the graph below, like 2007 to 2009, they are widening again. The widening gap between foreign and U.S. interest rates led to a 10% drop in the dollar. The result was rising commodity prices, inflation and exports. With large fiscal stimulus out of the question with a Republican controlled house bent on deficit reduction, monetary policy will have to carry the ball.
Source: Wolfe Trahan & Co. Portfolio Strategy, Bloomberg
The Fed is trying to engineer lower interest rates at a time foreign central banks are raising them. Countries who have pegged their currency to the dollar such as China are experiencing higher inflation rates. The result is that they are tightening monetary policy. The gap between U.S. and foreign rates should continue to widen. It is highly unlikely that we will see this gap close any time soon. Reported inflation rates remain low if you exclude the stuff you need to buy on a daily basis such as food and energy. The bond vigilantes are also asleep as to America’s growing deficits. ( CBO projections for 2011 call for a US budget deficit of .5 trillion) Instead the vigilantes are currently focused on Europe’s sovereign debt problems. For the moment, the Fed is getting a free ride. Not until reported inflation rates rise to around 4% and bond yields surpass 5% will the fed have a problem. In the meantime, the Fed will do what it does best which is print, print, print.
Finally, there is the relationship of the dollar, oil, and the stock market. Stock markets love liquidity and we’re swimming in an ocean of money.
Source: Bloomberg, PFS Group
The graph below depicts all three with the dollar inverted. Eventually, this cozy relationship will begin to diverge and end as it did in 2007. The S&P 500 peaked back in the fall of 2007. Oil prices headed higher as the Fed kept interest rates low and the dollar depreciated. The result was a speculative blow off in oil and commodity prices, which ended in July of 2008. We see the trend in higher commodity prices continuing this year, especially energy, white metals like platinum and palladium, copper, and the ags.
Right now there are many positives for both the U.S. economy and the stock market. We have the December Obama/GOP stimulus package and QE 2. Reported inflation rates are still low, the LEI’s have been trending up since last fall along with a similar trend in the ISM reports. At the moment it looks like things are improving for the US economy in the short-run.
Regarding the markets, valuations aren’t low nor are they high. Near zero interest rates virtually compel fund managers to find something, almost anything, that offers a positive return. Even investors are becoming tired of zero returns on cash. Speaking of cash, corporations are flush with cash on their balance sheets, cash that will need to be deployed. That cash will lead either to share buybacks and dividend increases or M&A activity. We continue to like energy, industrials, materials and tech.
Right now the music is playing so we’ll try to keep dancing with an eye on the exit door. For at least the short-run, the positives outweigh the negatives for both the economy and the markets. Eventually the music will stop. The factors listed above are the clues we are looking at to time our exit off the dance floor. However, three factors are keeping us dancing for the meantime:
- Our proprietary FSO Financial Stress Index remains neutral.
- Our macro models all remain positive, a few shared above.
- Finally our three proprietary technical indicators are also positive with only a short-term divergence in one of our short-term technical indicators.
The music is playing so on with the dance.
