Words from the (investment) wise for the week that was (May 19 – 25, 2008)
Soaring oil prices were mostly to blame for the past week’s stock market sell-off, but renewed concerns about US economic growth, corporate earnings and mounting angst about inflation pressures also featured prominently in determining the market’s fate.
David Fuller (Fullermoney) commented as follows: “As the world’s most important commodity by far, this surge in the oil price is bearish for the majority of stock markets. Consequently I would assume that rallies seen since March have either been capped or are unlikely to make much upward progress until investors see evidence that crude oil has commenced a medium-term correction.”
The FOMC released the minutes from its April 30 meeting on Wednesday. Members acknowledged uncertainty about what constituted an appropriate monetary policy in the current economic environment, resulting in the rate reduction (by 25 basis points to 2.0%) being a “close call”.
The surprise of the minutes was the Fed showing increasing concern about inflation expectations, as gleaned from the following: “… risks to growth were now thought to be more closely balanced by the risks to inflation … several members noted it was unlikely to be appropriate to ease policy in response to information suggesting that the economy was slowing further or even contracting slightly in the near term, unless economic and financial developments indicated a significant weakening of the economic outlook.”
Market participants were further unnerved by the Fed slashing its real GDP growth projections for this year (0.3% to 1.2% – down from 1.3% to 2.0% in January), together with raising its forecasts for PCE inflation (3.1% to 3.4% – up from 2.1% to 2.4%) and the unemployment rate (5.5% to 5.7% – up from 5.2% to 5.3%).
I will be braving 34 hours of traveling time from Cape Town to Laguna Beach in California later this week to attend Rob Arnott’s Research Affiliates’ annual gathering of its advisory panel. Our investment management company, Plexus Asset Management, has an exclusive licensing agreement with Research Affiliates for managing and distributing its enhanced Fundamental Index™ methodology in the Pan-African region.
I am thrilled about attending this event as it will afford me the opportunity to meet with financial luminaries such as Peter Bernstein, Burton Malkiel, Harry Markowitz and Jack Treynor for the first time. This has the prospect of being a truly “whoa” experience! Needless to say, my blogging activity will be rather light over the next week, but I am sure that I will return with an abundance of interesting investment ideas.
Before highlighting some thought-provoking news items and quotes from market commentators, let’s briefly review the financial markets’ movements on the basis of economic statistics and a performance round-up.
Overall, last week’s US economic reports failed to brighten up investors’ mood. Weekly initial claims and the leading economic indicators data were mildly encouraging, but were overshadowed by inflation concerns tied to a gloomy Producer Price Index, the jump in oil prices and the downbeat statements in the FOMC’s minutes. In addition, a stark housing inventory situation implied that additional price declines were in store.
BCA Research summarized the US economic picture as follows: “…policymakers remain nervous about the outlook, and are keeping their options open. The markets are pricing in a 50% chance that the Fed will hike rates by 25 basis points before the end of the year, but that seems premature given the prospect that the economy will continue to struggle.”
Elsewhere in the world, the Bank of Japan elected to leave its official rate unchanged at 0.5%. The German ZEW economic sentiment index pointed to investors’ outlook continuing to worsen, although the Ifo Business Climate Index edged up, suggesting German industry and trade are still doing well. The UK economy, however, seems to be heading for its most protracted slowdown since the early 1990s, according to detailed growth forecasts from the Bank of England.
WEEK’S ECONOMIC REPORTS
Source: Yahoo Finance, May 23, 2008.
The next week’s economic highlights, courtesy of Northern Trust, include the following:
1. New Home Sales (May 27): Sales of new homes are expected to have fallen in April. Purchases of new homes in March were down 62.1% from their peak in July 2005. Sales of new homes have declined by 36.3% from a year ago in March. Consensus: 522,000 versus 526,000 in March.
2. Durable Goods Orders (May 28): Durable goods orders (-0.5%) are predicted to have dropped in April largely due to aircraft orders that have risen for two straight months. Orders of defence items may have risen following a drop in March. Consensus: -1.1% versus -0.3% in March.
3. Real GDP (May 29): The net impact from recently published data is an upward revision of real GDP growth to 1.0% in the first quarter of 2008 from a 0.6% increase in the advance estimate. Consensus: 1.0%.
4. Personal Income and Spending (May 30): The earnings and payroll numbers for April suggest only a small gain in personal income (+0.1%). Auto sales fell sharply to 14.4 million units in April and non-auto retail sales were soft, which points to a steady reading for consumer spending with service outlays providing the offset. Consensus: Personal income +0.2%, consumer spending +0.2%.
5. Other reports: Consumer Confidence (May 27), Consumer Sentiment Index (May 30).
Source: Wall Street Journal Online, May 25, 2008.
The US stock markets were in the thick of things, as shown by the last week’s index movements: Dow Jones Industrial Index -3.9% (YTD -5.9%), S&P 500 Index -3.5% (YTD -6.3%), Nasdaq Composite Index -3.3% (YTD -7.8%) and Russell 2000 Index -2.3% (YTD -2.3%).
The Dow Jones Transportation Index witnessed a big 4.2% drop, but is still 11.2% in the black for 2008. Gold and silver stocks (+0.1%) were some of the few to keep head above water during the sell-off.
Tim Bond, head of global asset allocation at Barclays Capital, offered the following advice: “Equity exposure should be narrowed to energy, basic resources, industrial goods and services and – once the write-offs are complete – financials. During inflationary periods, these are the only sectors that deliver positive real returns.”
Bill Gross, manager of the World’s largest bond fund (Pimco’s Total Return Fund), called Treasuries “the most overvalued asset”. “If there was a bubble, the popping has produced a counter-bubble in quality securities. The safe haven has been way overdone. Treasuries are yielding 2% to 3%, there is no real return on that at all,” he said. “This is an asset class that is held by sovereign wealth funds and central banks … but that is not any reason to follow them.”
Credit market stress increased as shown by the widening spreads in both the US and Europe. The CDX (North American, investment grade) Index rose back through the psychological level of 100 basis points to 109, and the Markit iTraxx Europe Crossover Index jumped by 50 basis points to 455.
Rising commodity prices and hawkish comments from the Reserve Bank of Australia pushed the Australian dollar to a 24-year high against the US dollar, closing 0.5% higher at $0.9615 – not too far away from parity. The New Zealand dollar gained 1.8% against its US namesake on the back of unexpected tax cuts.
Crude oil was again in the limelight, with West Texas Intermediate closing the week 4.9% higher at $132.19. Speculative action (notably short-covering), a drop in US oil inventories and huge demand from China ahead of the Olympics boosted prices. Long-term oil contracts (+15%) rose by even more than spot as the market braced itself for a “super spike” of $200 a barrel as predicted by Arjun Murti of Goldman Sachs. Prices for diesel (+6.7%), heating oil (+7.2%) and gasoline (+4.2%) all scaled fresh peaks.
Rising inflationary pressure as a result of the strong oil price, expectations that US interest rates will remain negative in real term for quite a while, together with a weaker US dollar, positively impacted on gold (+2.9%), platinum (+2.1%) and silver (+7.8%).
As far as agricultural commodities were concerned, wheat dropped to a nine-month low, having almost halved since its peak in February on the back of the prospects of an excellent crop.
Now for a few news items and some words and charts from the investment wise that will hopefully assist in steering our investment portfolios on a profitable course. And to our American friends, have a fabulous Memorial Day weekend.
Source: The Economist, May 1, 2008.
Bill King (The King Report): Tim Bond – structure portfolios for inflationary conditions
• To invest successfully in inflationary conditions, portfolios need to be narrowly focussed on the handful of assets that cause – or benefit from – inflation.
Source: Bill King, May 19, 2008.
Telegraph TV: Jim Rogers – Why the US dollar is doomed
Source: Telegraph TV, May 20, 2008.
Financial Times: Buffett – effects of crisis “far from over”
“Mr Buffett was speaking at a press conference in Frankfurt, where he is meeting German family-owned businesses as part of a four-country tour of Europe.
“‘It is rippling – there are secondary and tertiary effects. I think the Wall Street crisis is mostly over although I don’t know. The [Federal Reserve] with its Bear Stearns rescue largely stopped that. But I don’t think we are half way or even a quarter of the way through the impact in the general economy,’ he said.
“The ‘Sage of Omaha’ said the effects of the crisis were beginning to be felt not just by those who had behaved the ‘silliest’ but also now by people ‘who did sound things’.
“Mr Buffett on Monday began his first big business trip to Europe as he seeks buying opportunities among the Continent’s largest family-owned companies. His visit will include Germany, Switzerland, Spain and Italy as he looks for candidates for what would be only his second major acquisition outside the US.”
Source: Francesco Guerrera, Financial Times, May 18, 2008.
Willem Sels (Dresdner Kleinwort): More credit woes to come
“He says that while liquidity tensions are easing, the market is entering a second phase of the crisis. Real credit losses are accelerating and many areas of the market have yet to see the worst of the crunch. He says corporate defaults have only just started rising and he expects high yield defaults to accelerate sharply to 7% to 11% by mid-2009, particularly in the US.
“The market, however, is only currently pricing in a 6% rate of default, he estimates. Mr Sels says rising corporate and consumer defaults will lead to real losses in portfolios, leading credit spreads wider, especially for non-financials.
“He notes the weakness in the housing market seems to be gathering momentum and could still provide a shock to the economy.
“‘Even if we get a W-shaped economic recovery, the current mid-cycle credit rally seems overdone,” says Mr Sels. ‘We believe the recent rally has been exacerbated by investors who are ‘afraid to miss out’ or who are too impatient to recognise the lags with which the economy and the profit cycle typically react to shocks.’
“Bank risk appetite will remain low and lending will therefore remain depressed, leading to a long period of sub-trend GDP growth and weakening corporate profit margins, Mr Sels believes.”
Source: Willem Sels, Dresdner Kleinwort (via Financial Times), May 19, 2008.
Bloomberg: Paulson – financial markets showing signs of progress
Ifo: Renewed decline in Ifo World Economic Climate Index
“The worsening in the Ifo World Economic Climate has again affected above all North America and Western Europe. The strongest decline in the climate indicator … was in the US. Here, however, the fall was attributable exclusively to the clearly less favourably assessments of the current situation whereas the expectations for the coming six months are no longer quite so pessimistic. In Western Europe above-average declines in the indicator have been reported in France, Italy and Spain. The indicator has worsened relatively less strongly in Germany, Austria and Switzerland. The climate indicator has also fallen in Asia, especially in South Korea and Hong Kong. Also in Japan negative economic expectations continue to prevail.
“Inflation expectations in the US for 2008 at 3.5% are much higher than the price increases reported by World Economic Survey (WES) experts for 2007 (2.8%). Also in Western Europe inflation expectations for 2008 at 2.9% are considerably above the reported rate of inflation for 2007 (2.1%). In Asia the picture is similar, where the inflation expectations for 2008 are one percentage point higher than the average price increase for 2007 (3.9% vis-à-vis 2.4% in 2007).
“As in the previous survey, a majority of WES experts expects a decline in central bank interest rates. In contrast, long-term interest rates will rise at a moderate pace in the coming six months, in their opinion.
“Especially the US dollar and to a lesser extent the Japanese yen are still seen as undervalued. In contrast, the WES experts consider the euro to be overvalued. Independent of the fundamental assessments of the currencies, they expect the US dollar to continue its weakening trend in the coming six months.”
Please click here for the full report.
Source: Hans-Werner Sinn, Ifo Institute for Economic Research, May 20, 2008.
Financial Times: Moody’s launches review in wake of errors
“Charles Schumer, the New York senator, called Wednesday for the SEC to investigate the matter, which triggered a fall of 16% in its share price. Mr Schumer also said, if a probe proved mistakes had occurred, that the US regulatory agency should impose ‘appropriate sanctions’ in the form of fines.
“The letter to Christopher Cox, SEC chairman, was in response to a report in Wednesday’s Financial Times that detailed how some senior staff at Moody’s knew in early 2007 that the ratings on products known as constant proportion debt obligations – complex derivative instruments conceived at the height of the credit bubble – had incorrectly received triple A ratings. Some of the CPDOs should have been rated up to four notches lower due to a computer coding error that was later corrected.
“‘The ratings inaccuracies that were disclosed are deeply troubling,’ Mr Schumer wrote in a letter sent Wednesday. ‘However, the fact that Moody’s only downgraded these incorrectly rated products in January of 2008, nearly a full year after they became aware of the problem, is much worse, and is indicative of a culture of shirking responsibility that must end.’
“Moody’s said Wednesday night: ‘Moody’s recognizes the seriousness of questions raised by [the] Financial Times article concerning the analytical models and methodologies used in our European constant-proportion debt obligation ratings process.
“‘The integrity of our ratings and rating methodologies is extremely important; as such, when the questions were recently raised to us, we retained the law firm of Sullivan & Cromwell and initiated a thorough external review of our European CPDO ratings process. Upon completion of the review, we will promptly take any appropriate actions.’”
Source: Sam Jones, Paul Davies, Stephanie Kirchgaessner and Joanna Chung, Financial Times, May 21, 2008.
Goldman Sachs Global: Houses in the industrial countries – built on rock, or on sand?
“Countries that look relatively more vulnerable to both a correction in home prices and possibly a broader economic adjustment are New Zealand, followed at a distance by Denmark and Finland. In New Zealand, we continue to recommend gaining long exposure to the front-end of the yield curve and shorting the currency.
“The increase in real house prices in Canada, Norway and Australia, and the related deterioration in house purchase affordability, need to be viewed against the backdrop of a large favourable terms of trade shock from commodity exports.
“Property markets in Germany, Japan and Switzerland all stand to benefit from the decline in long-term interest rates that ensued from the bursting of the US housing bubble.”
Please click here for the full report.
Source: Goldman Sachs Global, May 14, 2008.
Bloomberg: James Galbraith – US housing problem to last “long time”
Source: Bloomberg, May 16, 2008.
Financial Times: Wall Street fears prolonged credit crisis
“‘We believe the real harrowing days of the credit crisis are still in front of us and will prove more widespread in effect than anything yet seen,’ Ms Whitney said.
“The culprit is less the writedowns themselves than the ‘shut-down’ in the securitisation market which at its height provided 66% of household borrowings in the first quarter of 2007.
“Without that market, consumer credit losses may be ‘far worse than what is currently estimated, even by the most draconian of investors’. Ms Whitney and her colleagues also slashed their 2008 earnings estimates for the large-cap banking stocks they cover by an average of 17%.”
Source: Jeremy Lemer, Financial Times, May 20, 2008.
Bloomberg: Barton Biggs – golden age of Wall Street is over
“‘We had a spectacular era of financial success that was extended by the subprime mortgage mania to 2007,’ says Biggs, who was chief global strategist at Morgan Stanley until 2003. ‘But I think the golden age of Wall Street is over.’”
BCA Research: The Fed – Nervously on hold
“Nonetheless, the minutes, together with recent remarks by Vice-Chairman Kohn, highlight that policymakers remain nervous about the outlook, and are keeping their options open. The markets are pricing a 50% chance that the Fed will hike rates by 25 basis points before the end of the year and that seems premature given the prospect that the economy will continue to struggle.”
Source: BCA Research, May 23, 2008.
MarketWatch: Statistical con game to be exposed
Asha Bangalore (Northern Trust): Leading indicators – premature to rule out recession
“From the chart, we know that strongly negative readings of the year-to-year change in the LEI are associated with recessions, with the exception of 1966-67. On a year-to-year basis, assuming the April reading is the second quarter reading for the LEI, it was down 1.86% from a year ago. On a quarterly basis, the year-to-year change in the LEI is negative in four out of the five quarters ended first quarter of 2008. We need information about May and June to confirm the reading for the second quarter. The drop in consumer expectations in May and current readings of jobless claims point to negative contributions of these two indexes. It is premature to rule out the occurrence of a recession based on these monthly readings.”
Source: Asha Bangalore, Northern Trust – Daily Global Commentary, May 19, 2008.
Asha Bangalore (Northern Trust): Chicago Fed National Activity Index signals recession
“According to the Chicago Fed, ‘when the 3-month moving average of the CFNAI moves below -0.70 following a period of economic expansion, there is an increasing likelihood that a recession has begun.’ The 3-month moving average of the CFNAI declined to -1.24 in April from -1.05 in March. April is the fifth month when the CFNAI has held below the -0.70 cut-off mark. Also, April’s CFNAI is the lowest reading of the index since the months associated with the recession in 2001.”
Source: Asha Bangalore, Northern Trust – Daily Global Commentary, May 20, 2008.
Asha Bangalore (Northern Trust): Fed’s projections for GDP, inflation and unemployment
“The central tendency of projections for real GDP for 2008, at 0.3% to 1.2%, is lower than the forecast presented in January. The economy is predicted to gain momentum in 2009 and grow at close to or above trend in 2010.
“Projections of the growth of real GDP are percent changes from the fourth quarter of the previous year to the fourth quarter of the year indicated.
“Consistent with the below trend forecast of GDP growth in 2008, the unemployment rate is expected to move up (5.5% to 5.7%) in 2008. As the economy grows, the unemployment rate is projected to edge down in 2009 and 2010.
“The revisions of the inflation forecasts for 2008 reflect the steep increase in energy and food prices. The slightly higher predictions for core inflation imply a pass through of higher food and energy prices and the impact from higher import prices. Inflation was predicted to show some moderation by 2010.”
Source: Asha Bangalore, Northern Trust – Daily Global Commentary, May 21, 2008.
Asha Bangalore (Northern Trust): Wholesale prices present a troubling issue
Source: Asha Bangalore, Northern Trust – Daily Global Commentary, May 20, 2008.
Bloomberg: Pimco’s Gross says US underestimating inflation
“Changes in the way the Bureau of Labor Statistics measures prices over the past 25 years have led to the understating of inflation by at least 1%, Gross, said in a commentary on the company’s web site today. The Federal Reserve’s focus on ‘core’ instead of ‘headline’ inflation has also helped understate the increase in prices, Gross said.
“Pimco favors commodity-based assets and foreign equities that are denominated in currencies that demonstrate ‘authentic’ real growth and inflation rates. Investors should shun US Treasuries and Treasury Inflation Protected Securities, or TIPS, because of their negative ‘unreal’ yields as a result of ‘artificially low inflation,’ he said.
“‘Investors might suddenly awake to the notion that US inflation should be and in fact is closer to worldwide levels than previously thought,’ Gross said. ‘Foreign holders of trillions of dollars of US assets are increasingly becoming price makers not price takers, and in this case the price may not be right.’
“Emerging-market countries with economies similar to those of Brazil, Russia, India and China are ‘obvious’ candidates for investment as inflation quickens, Gross said.
“Global headline inflation stands at 7%, Gross said. Prices rose 3.9% in the 12 months ended in April, down from a 4% year-over-year gain in March, the Labor Department said on May 14.”
Asha Bangalore (Northern Trust): Downward descent of home prices likely to persist through 2008
“The House Price Index is down 3.7% from the peak reading in April 2007. Incoming data from the housing market suggest that additional price declines should not be surprising, particularly given the large inventory of unsold homes.”
Source: Asha Bangalore, Northern Trust – Daily Global Commentary, May 22, 2008.
Asha Bangalore (Northern Trust): Existing home sales – Inventories remain a prickly problem
“The sales and price data of existing single-family homes suggest that there is a possibility of stability in this market in the near term. However, inventories of unsold homes remain a prickly problem. The inventory of unsold existing homes moved up to an 11.2-month supply mark in April, up from a 10-month supply in March. The stark inventory situation implies that additional price declines cannot be ruled out.”
Source: Asha Bangalore, Northern Trust – Daily Global Commentary, May 23, 2008.
Barry Ritholtz (The Big Picture): Housing Price to Rent Ratio
Chart courtesy of Janet Yellen, President, Federal Reserve Bank of San Francisco.
Source: Barry Ritholtz, The Big Picture, May 23, 2008.
BCA Research: US home builders – No light at the end of the tunnel
“The fundamentals for housing remain weak, especially since the employment outlook has deteriorated this year and mortgage rates have not fallen in line with policy rates. The budding rebound in mortgage refinancing activity faltered the minute Treasury yields blipped up, underscoring that borrowing rates are too high to support the housing market. The spring selling season so far has been disappointing, implying that inventories will remain excessive.
“Bottom line: The housing market will stay depressed for the foreseeable future, acting as a limit on the upside in Treasury yields.”
Source: BCA Research, May 20, 2008.
John Authers (Financial Times): US house prices critical for financial markets
“US housing, of course, lit the fuse for the credit crisis. Among measures of housing, price is most important because of its link to the risk that owners abandon their homes, and thus to the risk to the value of the mortgage-backed securities that sparked the crisis. The best indicator of the coming rise in subprime delinquencies was the slowing in house price rises two years ago.
“House prices are also the greatest imponderable for those trying to model the future. There is no precedent for big falls, in nominal terms, in US house prices or for a situation where Americans’ percentage of equity in their homes has dropped below 50%. Both have happened recently.
“It would appear, however, that if house prices fall and homeowners move into negative equity, the risk that homeowners will abandon their houses increases greatly. So moves in price to clear the housing backlog could have a greater impact than falls in construction (for which there are some precedents).
“It is extremely difficult to discern a long-term ‘fair value’ for housing. Research by Robert Shiller of Yale University suggests that prices are 90% overvalued compared to their average ratio to rents over the past 80 years – but they are actually slightly undervalued compared to disposable incomes per capita.
“So far, prices have followed construction activity down. Permits for new housing ticked up in April, sparking hopes that an end was in sight. But futures on the S&P Case-Shiller house price index suggest prices could fall 13% over the next year, and 20% by the end of 2012. That shows the depth of the uncertainty. How it is resolved is critical for markets far beyond US housing.”
Source: John Authers, Financial Times, May 19, 2008.
Financial Times: Pimco’s chief piles into mortgage debt
“Mr Gross’s $130 billion Pimco Total Return fund pulled sharply ahead of rivals in the past year after the manager predicted a housing downturn and sold out of housing-related securities and corporate bonds.
“The fund has returned 12.6% over 12 months, beating 99% of its peers, according to fund tracker Morningstar.
“Mr Gross said his decision to raise exposure to mortgage debt in recent months was based on the US government’s implicit guarantee of Freddie Mac and Fannie Mae, the government-sponsored mortgage agencies.
“Mr Gross said Pimco was buying primarily mortgage agency debt and ‘not the subprime garbage’.
“The Total Return fund is now invested about 61% in mortgage debt, compared with just over 20% a year ago.
“Mr Gross was heavily overweight US Treasury bonds in the early 2000s but is now scornful of them and the fund is using derivatives to gain from any downturn in Treasuries. He called Treasuries ‘the most overvalued asset’.
“‘If there was a bubble, the popping has produced a counter-bubble in quality securities. The safe haven has been way overdone. Treasuries are yielding 2% to 3%, there is no real return on that at all,’ he said. ‘This is an asset class that is held by sovereign wealth funds and central banks … but that is not any reason to follow them.’”
Source: Deborah Brewster, Financial Times, May 22, 2008.
John Authers (Financial Times): Misplaced equity optimism
Source: John Authers, Financial Times, May 21, 2008.
David Fuller (Fullermoney): Surge in oil prices bearish for stock markets
“As the world’s most important commodity by far, this surge in price is bearish for the majority of stock markets. Consequently I would assume that rallies seen since March have either been capped or are unlikely to make much upward progress until investors see evidence that crude oil has commenced a medium-term correction.”
Source: David Fuller, Fullermoney, May 21, 2008.
Richard Russell (Dow Theory Letters): Third phase of bull market is going to be speculative “explosion”
“The third phase is going to be ‘something else’. It’s going to be the greatest speculative stock market ‘explosion’ the world has ever seen. It’s going to include (include, hell, it’s going to be led) by the BRIC nations (Brazil, Russia, India, China) along with most of Asia and Europe, and it’s going to rub off on the poor old indebted US – BIG TIME!
“Right now most of the world’s potential investors are sitting on the sidelines reading about ‘how tough it is, and how this is a horrendous real estate disaster and how every other American is going to lose his home due to foreclosure.’ But wait – so far the markets are telling us something different. As my subscribers and readers of Barron’s know, it’s been telling us that the stock market has discounted the bad news and the ‘coming disaster’ and is preparing itself for better times ahead.
“I think there’s a mighty third phase coming. Most of the world is sitting with cash. There’s $3.5 billion in US money market funds. There’s God knows how much cash in bonds on the sidelines. There are tens of trillions in sovereign wealth funds that will be looking to be invested. The oil and commodity nations are choking on cash. The planet is up to its neck in fiat money, and once the third phase of the bull market starts cranking up, this money will want to be in stocks.”
Source: Richard Russell, Dow Theory Letters, May 19, 2008.
Michael Masters: Testimony on commodity prices before US Senate
“The following Chart shows this dynamic at work. As money pours into the markets, two things happen concurrently: the markets expand and prices rise.
“One particularly troubling aspect of Index Speculator demand is that it actually increases the more prices increase. This explains the accelerating rate at which commodity futures prices (and actual commodity prices) are increasing. Rising prices attract more Index Speculators, whose tendency is to increase their allocation as prices rise. So their profit-motivated demand for futures is the inverse of what you would expect from price-sensitive consumer behavior.
“You can see from the Chart that prices have increased the most dramatically in the first quarter of 2008. We calculate that Index Speculators flooded the markets with $55 billion in just the first 52 trading days of this year.19 That’s an increase in the dollar value of outstanding futures contracts of more than $1 billion per trading day. Doesn’t it seem likely that an increase in demand of this magnitude in the commodities futures markets could go a long way in explaining the extraordinary commodities price increases in the beginning of 2008?
“There is a crucial distinction between Traditional Speculators and Index Speculators: Traditional Speculators provide liquidity by both buying and selling futures. Index Speculators buy futures and then roll their positions by buying calendar spreads. They never sell. Therefore, they consume liquidity and provide zero benefit to the futures markets.
“It is easy to see now that traditional policy measures will not work to correct the problem created by Index Speculators, whose allocation decisions are made with little regard for the supply and demand fundamentals in the physical commodity markets. If OPEC supplies the markets with more oil, it will have little affect on Index Speculator demand for oil futures. If Americans reduce their demand through conservation measures like carpooling and using public transportation, it will have little affect on Institutional Investor demand for commodities futures.
“Index Speculators’ trading strategies amount to virtual hoarding via the commodities futures markets. Institutional Investors are buying up essential items that exist in limited quantities for the sole purpose of reaping speculative profits.
“Think about it this way: If Wall Street concocted a scheme whereby investors bought large amounts of pharmaceutical drugs and medical devices in order to profit from the resulting increase in prices, making these essential items unaffordable to sick and dying people, society would be justly outraged.
“Why is there not outrage over the fact that Americans must pay drastically more to feed their families, fuel their cars, and heat their homes?”
Please click here for the full testimony.
Source: mCADForums.com, May 20, 2008.
Eoin Treacy (Fullermoney): Commodities – keep an eye on further regulation
“It is easy to forget, with the hyperbole in the media that commodities are in a secular bull market. Regardless of their recent advance, they remain a long way from their inflation-adjusted highs posted in the 1970s. While the impact Commodity Index funds is being examined today, any fresh regulation is unlikely to derail the long-term bullish fundamentals for the sector.”
Source: Eoin Treacy, Fullermoney, May 23, 2008.
John Authers (Financial Times): Speculators cannot take all the blame for price spike in commodities
Source: John Authers, Financial Times, May 20, 2008.
Bloomberg: Blame Wall Street for $135 oil on wrong-way betting
“The number of outstanding futures contracts, known as open interest, fell 8.1% in a week to 1.36 million at the same time that prices rose 2.6%, the data show. Falling open interest and rising prices are signs that traders are buying to exit so-called short positions that would profit if oil fell, and lose money as they rose.
“‘In a market like today, which is trending higher while open interest is falling, it’s a sign that money is moving out of the market,’ said Stephen Schork, president of Schork Group in Villanova, Pennsylvania. Open interest in Nymex crude futures peaked this year at 1.5 million on March 13.”
Bloomberg: OPEC says it’s powerless to stop rally
“Oil has risen 19% this month as analysts increased their price forecasts because of supply constraints and demand growth. OPEC has ‘no magic solution’ to the surge, Qatar’s oil minister said. Prices are ‘out of the hands’ of the organization, according to Libya’s top oil official.
“‘Everyone’s jumped on the bandwagon,’ said Anthony Nunan, assistant general manager for risk management at Mitsubishi Corp, Japan’s biggest trading company, in Tokyo. ‘There’s agreement that $200 is possible and that’s getting more people into the market. We have very little supply cushion going forward and that’s playing into the minds of investors.’”
CNBC: Why Goldman’s oil guru predicts a “super spike”
“Mr. Murti … is not bothered much by the prospect of even higher oil prices, figuring it might finally prompt America to become more energy efficient.
“An analyst at Goldman Sachs, Mr. Murti has become the talk of the oil market by issuing one sensational forecast after another. A few years ago, rivals scoffed when he predicted oil would breach $100 a barrel. Few are laughing now.
“Mr. Murti, 39, argues that the world’s seemingly unquenchable thirst for oil means prices will keep rising from here and stay above $100 into 2011. Others disagree, arguing that prices could abruptly tumble if speculators in the market rush for the exits. But the grim calculus of Mr. Murti’s prediction, issued in March and reconfirmed two weeks ago, is enough to give anyone pause: in an America of $200 oil, gasoline could cost more than $6 a gallon.
“Mr. Murti is hardly alone in predicting higher oil prices. Boone Pickens, the oilman turned corporate raider, said Tuesday that crude would hit $150 this year. But many analysts are no longer so sure where oil is going, at least in the short term. Some say prices will fall as low as $70 a barrel by year-end, according to Thomson Financial.
“Experts disagree over the supply of oil, the demand for it and whether recent speculation in the commodities markets has artificially raised prices. As an energy analyst at Citigroup, Tim Evans, reportedly put it, trading commodities these days is like ‘sticking your hand in a blender’.”
Source: Louise Story, CNBC, May 21, 2008.
Bill King (The King Report): Top could be forming in oil price
“The past few years, gasoline has topped after the 4th of July. In 2006 Goldman sharply cut the weighting of gasoline in its commodity indices, which forced funds to sell.
“Last year, gasoline soared after the Labor Day weekend, which is the end of drive season and the strong seasonal gasoline bullishness. This was short covering and reacquisition of long positions because of the underlying fundamental strength in energy. But the global economy is much softer this year.
“Media accounts have Iran and China stockpiling crude oil in tankers and elsewhere. Iran fears that either Bush or Israel might strike before Obama takes over.
“China is stockpiling energy and food for the Olympics. At some point during the Olympics in August, China should know if it has surplus inventory above Olympic demand and possibly earthquake-induced demand. Then China might start dumping surplus commodities – not only to lessen inventories but to push commodities lower to generate better buying opportunities later.
“China has been very adroit in hammering copper and key commodities when prices get too exuberant. Then they buy after the collapse and enter into long-term contracts with producers at the better prices.
“Ergo, there could be short-term tops in oil and gasoline next week and near the 4th of July and then a more significant peak near the Olympics and/or Labor Day.”
Source: Bill King, , May 20, 2008.
David Fuller (Fullermoney): Gold – where are we in the cycle?
“There have been plenty of other reasons to be bullish of gold, discussed by this service, but the present outlook review is mainly concerned about what happens next.
“We have often pointed out that platinum was usually the lead precious metal, both up and down. Since its early March peak, platinum has seen a sharp correction to nearly $1800, successfully tested that low earlier this month, and rallied above some lateral resistance. Consequently, platinum would now need to fall back beneath $2000 to reaffirm resistance from the year’s earlier high.
“This is an impressive performance, reasonably consistent with earlier support building phases following accelerated peaks, although they continued for much longer. This was also true for gold and silver.
“I recently pointed out that gold had approached an area of potential support from the mid-$800 region and the moving average. It has subsequently rallied from this level and a close beneath $845 is now required to suggest further easing rather than a period of support building at sideways to higher levels.
“Silver tends to lag platinum and gold in the earlier stages of an advance, before finally attracting strong speculative support which causes it to perform like high-beta gold once again. Nevertheless, silver is now technically interesting as a recovery candidate, following its decline to nearly $16, and would have to close beneath this price to suggest further weakness rather than the sideways to higher support building presently indicated.
“In summary, technical action for precious metals indicates that they are now in accumulation zones, although historical action suggests that they are best purchased on easing during these phases, as ranging can be lengthy. This remains a real prospect, of some concern to me, not least because this is not usually a bullish period seasonally, as I have mentioned before. We are likely to see some central bank selling and perhaps also from the IMF. The traditionally bullish buying in anticipation of Christmas, the Chinese New Year and Indian wedding season occurs between 4Q and 1Q.
“Could it be different this time? If precious metals have a shorter support building phase before retesting their highs and extending the overall upward trends, what would be the catalyst?
“I can think of two factors – liquidity and inflationary expectations. Central banks have pumped plenty of liquidity into the system, as we know, and many investors are currently sitting on historically high levels of cash. Today, few investors remain in denial regarding inflation.
“In conclusion, I think precious metals are in accumulation zones. Given the possibility of further support building, I favour the ‘baby steps’ tactic of nibbling on easing and for traders, lightening on rallies.”
Source: David Fuller, Fullermoney, May 19, 2008.
Financial Times: Food prices forecast to stay high for 10 years
“The report, by the Organisation for Economic Co-operation and Development and the UN’s Food and Agriculture Organisation, will say food prices have moved to a ‘higher plateau’ because of rising demand from the biofuels industry and developing countries such as China.
“But the Agricultural Outlook 2008 to 2017, due to be published next week, does offer a respite in the short term, forecasting prices will ease from this year’s record levels, according to a summary seen by the Financial Times.
“‘Food prices would be considerably higher in nominal terms than in the past but below the current records,’ said an official familiar with the report. “Compared with average prices for 2005 to 2007, the report forecasts that in 2017 the price of wheat, adjusted for inflation, will be 2% higher, rice 1% higher and corn 15% higher. Oilseed prices are expected to be up 33%.
“The price projections imply falls from the current records but suggest that food inflation will continue to be a long-term problem, particularly for poor countries.”
Source: Javier Blas, Financial Times, May 21, 2008.
BCA Research: Bank of Japan on hold
“The BoJ opted to leave policy rates unchanged at 0.5%, as expected. Despite the bounce in Q1 GDP, our central bank monitor suggests that economic conditions are sufficiently weak to prevent any monetary tightening this year. In the comments which followed the policy decision, BoJ Governor Shirakawa acknowledged that rising oil and raw-material costs are likely to have ‘a negative effect on capital spending and consumption’.
“Indeed, Japan’s terms of trade has a highly negative correlation with crude prices: the business sector is heavily geared towards manufacturing and industrials and contains no resource companies. In turn, rising commodity prices have presented a significant drag on growth and have helped contribute to the dramatic collapse in both business and consumer sentiment over the past several months.
“Bottom line: We remain bearish the yen and overweight JGBs within a global hedged fixed income portfolio.”
Source: BCA Research, May 21, 2008.
Financial Times: Protracted UK slowdown looming, says Bank of England
“The central bank’s forecast for economic growth is significantly below that of the Treasury for the first time since 2005. But with inflation rising and expected to stay high, the bank’s Monetary Policy Committee (MPC) made it clear that a long period of weakness was needed to bring inflation back under control.
“The Bank of England’s central forecast – issued on Wednesday – is for economic growth to slip from 3.3% in 2007 to 1.5% in 2009. The MPC also thinks that in 2010 – likely to be an election year – there is an even chance growth will be below 2.4%.
“This contrasts with the Treasury’s most recent forecast from March, which expects growth of 2.25-2.75% in 2009 and 2.5-3% growth in 2010.
“The chancellor still sees the growth picture as much rosier than the Bank of England. He told the CBI employers’ organisation dinner on Tuesday: ‘While the global outlook remains uncertain, I remain optimistic about the underlying strength and resilience of the British economy.’
“The Bank of England also published minutes from the May MPC meeting. The committee voted 8-1 against a rate cut …
“Despite what the minutes described as ‘subdued [growth] for much of the forecast period’, the MPC noted the inflation outlook had also deteriorated in recent months. With bad news on both growth and inflation, the majority of the MPC thought a slowdown ‘was likely to be necessary for inflation to settle close to the target around two years ahead’. Any cut in interest rates would create the impression it cared more about growth than hitting the 2% inflation target, the members worried.
“With markets less confident than at any time in the past decade in the Bank’s ability to control inflation, the MPC added that ‘the committee’s behaviour was likely to have a material influence’ on inflation expectations.”
Source: Chris Giles, Financial Times, May 21, 2008.
Financial Times: UK commercial property
“He notes that commercial property values continued to fall last month – although the pace of decline has clearly slowed. He adds that confidence and activity remain fragile, notably amongst debt-funded buyers who are largely shut out of the market.
“But Mr Dannhauser believes that with capital values now 17% below their peak of last year and initial yields at 5.5%, there is unlikely to be much more downside for the market as a whole.
“‘The work-out in the commercial property sector should not be prolonged. Unlike the early 1990s, the problem is not one of excess supply, at least outside the City of London office market.’
“He goes on: ‘There are clear downside risks from tighter credit conditions, banks’ reduced willingness to lend and the closure of the commercial mortgage-backed securities market. Debt-funded activity is likely to be much reduced into next year.
“‘However, with commercial property now looking fair-to-good value versus gilts, and UK institutions awash with cash, there could well be increased equity interest later on in the year.
“‘Sterling weakness is also likely to be a boon for commercial property prices, as foreign funds plough money into the cheaper UK market.’”
Source: Jamie Dannhauser, Financial Times, May 21, 2008.
Gavekal: Germany facing a rough patch
Source: GaveKal – Checking the Boxes, May 21, 2008.
David Fuller (Fullermoney): ECB unlikely to cut rates as long as oil remains strong
“Even if it had a growth mandate, the size the of the German economy relative to the rest of the Euro zone means it would have a much greater weighting in any decision making than a country such as Spain.
“Inflation is presently making headline news as oil continues to push higher on an almost daily basis; however food prices have stabilized and are not currently contributing to increases in inflation.
“A stronger euro is one tool against the negative impact of higher inflation from imported commodities, but it is also having a negative effect on companies that consolidate foreign earnings in euros. If oil enters a medium-term correction then it is possible that the ECB will cut rates relatively soon after, but they are unlikely to do so as long as oil remains so strong.”
Source: David Fuller, Fullermoney, May 21, 2008.
1 comment to Words from the (investment) wise for the week that was (May 19 – 25, 2008)
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