Striking a Balance

I can't begin this dispatch without a word about the events of yesterday's (9-29-2008) trading day. What a ride! I've got to tell you it was like watching one of those TV dramas where the star is trying to defuse a bomb. Does he cut the green wire...the red wire...the green wire...the red wire? Holy Hanna...Holy Crap...Holy Hanna...Holy Crap! With fractions of a second left he cuts the orange wire. THE ORANGE WIRE!!! Fade to black with the voice over, "Tune in next time for the explosive conclusion." Wow!

What a day. The DOW Industrials drops over 700 points. A one day decline of approximately 8 percent. If you watched CNBC today you really would have had a hard time catching your breath. In percentage terms today's 8% decline represents the 17th worst market drop. For instance it pales in comparison to the 22% one day drop experienced during the dot com implosion at the beginning of the decade.

Over the past month I've been doing some research on the events that led up to the current state of economic affairs. Next week I intend to begin a series of posts summarizing some of that research. I intend to keep it at the 5000 foot view. Close enough that you can get some understanding but far enough away to keep you from falling asleep at your terminal. I think the value to you will be the ability to stay calm and make rational decisions in the face of chaos. Now, on to the subject of this special dispatch...

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In response to my last post, "The Price of Oil", GF wrote: "I still feel deregulation played a major roll in this recession we are in. Without the checks and balances we get with regulation of critical industries (that can significantly impact the economy as a whole) you get what we got. Banks failing left and right.

"While I agree that competition in industry is good, you must be prepared for the the outcome, when you gamble incorrectly or mismanage your corporation.

"The impact of failure of certain industries in this country can have (has had) a catastrophic impact to the economy as a whole. [Therefore you] need regulation to prevent failure when they gamble and gamble wrong."

This is a great email. I spent a lot of time over the weekend gauging my response from several perspectives. It's no secret that I'm a free market/states rights kinda guy. In my estimation we would be best served by a federal government that stuck to building and maintaining infrastructure, defense of the country and managing the national debt. But, decisions made from that viewpoint or any other extreme viewpoint rarely wins the day. In fact, the art of compromise and finding the middle ground may be counted among our greatest assets in building the economic base that we have today.

I also realize that, at times of crisis, the federal government is in the best position to provide the grease to get the gears moving. It just seems unfortunate that the government - typically due to their own self interests - doesn't seem to know when to stop applying the grease. But I digress...

Yes, to an extent I do agree that there are times when government regulation is necessary. For instance, during WWII the federal government instituted rationing of all necessary materials. They also instituted a windfall profits tax to thwart companies from extorting the supply/demand equation due to that rationing. However, imagine if those regulations had been left in place after the war was over. History tells us that the end of WWII heralded the beginning of a period of tremendous economic growth lead by - drum roll please - housing! Had war-time regulations been left in place, the end result would have been concentrated wealth and stunted economic growth.

Still, the argument over regulation vs. deregulation seems to be a moot one. Since it appears that legislation today is geared more toward regulation on a wholesale basis rather then targeting specific industries. For example, I live in a more rural area where cell-site towers are an unwelcome site. In response local legislators passed laws to thwart their erection. Many of these laws were struck down in court. As a counter-measure new legislation was introduced that restricted the building and use of all towers.

There is also evidence of this on a national scale with legislation governing offshore drilling and EPA regulations regarding the compliance rules for building refineries. While these laws are not "regulatory" per se they are, in effect, targeted at a specific industry.

When I returned to the drawing board of my mind it dawned on me that the real common denominator here is money. More specifically, our money which is merely fiat money! Remember, the Dollar is backed by the full faith and credit of the United States Government - nothing more. That's great when we're in the midst of a boom cycle...not so much at times like we find ourselves in today. We need to return to a currency backed by and pegged to the value of gold (as it was prior to 1975). As the reserve currency of the world, returning to the gold standard would instantly re-establish credibility to the dollar and increase purchasing power of the dollar in the domestic and international arenas. Further, the ability to adjust the peg - i.e. the price of an ounce of gold in U.S. dollars - would give the government another tool in its arsenal to act as a gas and brake pedal for inflating and deflating the economy as events within the cycle warranted.

Finally I wanted to address your comment regarding, "...banks failing left and right." As of August 2008, there were 8,430 FDIC commercial banks in the U.S. Since 2007 there have been sixteen bank failures (the full list can be viewed here).

Yes, there have been several investment bank failures - Bear Sterns, Lehman Brothers, and Merill Lynch among the most notable. But, despite the grandiose headlines, I think it is a bit alarmist to characterize these events as banks failing left and right.

Thanks again for the email. Your comments were thought provoking.

billmazzacca@gmail.com

The Price of Oil

I - correction we - are watching the drama of the investment banking crisis unfold. Yet the media, chasing its most recent opportunity to increase ad sales revenue, has become virtually mum on the issue of oil. Prior to September 25th every other story had to do with the price of oil and the effects on the economy. the "R" word (Recession) was bandied about as a foregone conclusion.

Here, in the midst of this new, bigger "crisis", I heard one reporter throw out this statement, "If Congress doesn't come to a quick resolution to sure up the credit markets we will definitely be pushed into a recession." Maybe the oil "crisis" wasn't so bad afterall! That makes this a great opportunity to take a more pragmatic look at "The Price of Oil".

The stories of price fixing and colusion within the oil industry have been told so loudly that Congress actually held hearings on the matter. You don't need a smoking gun for the conspiracy theories to fly all over the place. We, as a people, tend to love our conspiracy theories. Probably because we so love a good story.

Because of its importance in our day-to-day lives, oil is a very special commodity. Gold is nice but its price can easily be tied to the value of the dollar and serves as a hedge against inflation.

Corn seems to be getting a lot of attention but that has more to do with government regulation on the rate of ethanol production versus the amount of land being devoted to it. In fact, prior to the new governmental regulations, farmers had been devoting more and more acreage to the production of soybeans and corn prices had mimicked the typical supply/demand scenario with adequate supply for the marketplace.

Perhaps because of its importance in our day-to-day lives, pricing oil is not a straightforward process. In fact, pricing oil has roots in four key areas.

The Supply/Demand Ratio.
Due to the equity lines established with higher home values we have had the luxury of buying bigger: cars and homes to begin with. And buying more stuff - gas, appliances, furniture, gizmos, do-dads, gadgets, whatever.

With the exception of oil, much of this stuff came from China. More and more native Chinese have moved from rural farming regions to the cities to take advantage of the increased demand for labor and higher wages. The price of oil and gas in China remains artificially low through the use of two mechanisms: a fixed currency and goverment subsidy. From a manufacturing standpoint, that combination helps to keep wholesale prices lower allowing increased production in China and increased consumption in the United States.

China wasn't alone in the increased demand for oil. India too emerged as a global powerhouse using its well-educated, cheaper workforce to provide outsourcing services to mid- and large-size corporations in western Europe and the United States. Naturally this economic evolution brought with it an increase in demand for oil with no offsetting reduction within the more developed economies. In fact, gas climbed to $4.00+ per gallon before evidence emerged that folks were gradually changing their habits with respect to the use of various fuel products.

The Speculators.
There has, for the first time that I can remember, been a lot of talk about speculators in the marketplace. This perhaps, is the most complicated piece of the puzzle. In the simpliest terms, speculators range from individuals like you and me to larger interests such as hedge funds that buy and sell oil futures contracts anticipating that the price of oil will increase or decrease according to the laws of supply and demand. [By the way, this extends to all types of commodities including metals, currencies, grains, dairy products, etc.]

Speculators basically feed off the price action that results from the producers that sell and the distributors and large consumers (i.e. airlines) that are buying to meet current and future demand. Speculators will sell their positions before the contract due date. In other words, they do not take delivery of the product. All other players intend to deliver or receive the product according to the purchase price paid.

In this current economic cycle, large speculators such as hedge funds exploited a loophole. You see, large speculators are typically limited to the number of contracts that they can buy at any given time. So, they found a work-around: sell other assets - i.e. stocks - but instead of receiving cash, they took the equivalent dollar value in oil futures contracts.

Remember that commodity markets are a zero sum game. For every winner there is a loser. The markets are cash settled at the close of business every trading day. Speculators enter the market expecting an increase in capital. However their presence also helps to insure that price fixing does not occur between the producers and distributors.


The Value of the Greenback.
You may not realize this but the U.S. Dollar is the reserve currency of the world. That means oil - like gold - is priced in U.S. Dollars. You might be paying in Euros, Japanese Yen or whatever but you'll be paying the equivalent sum of U.S. Dollars. Now, between 2001 and 2008 the U.S. Dollar has slid from $1.20 to .75 cents against other currenices - a 62.5% decline. Over the same period oil has increased from $20.00 to $140.00 per barrel! That increase, as I've outlined, is a combination of factors including the value of the greenback.

Recent rallies of the Dollar have helped to abate the price of oil somewhat. This despite recent threats by Iran and the presence of hurricanes in the Gulf of Mexico.

The Fear Factor.
How much oil is out there? I mean really. Do you know? Does anyone "know"? I know there is something called "proven" reserves. I know that there's oil in the Arctic, in Alaska. And, I know that oil companies are still discovering ways to find and extract oil. Yet, fear of the unknown is a very powerful motivator. For example, after the 9/11 terrorist attacks, open market purchases were made to increase reserves held by the U.S. Government.

In this particular round of price increases fear of high oil and gasoline has enticed people to buy smaller cars, swap out standard lightbulbs for energy efficient models, increase the purchase of solar and other alternative energy products. In fact, this year we coined the term "staycation" to describe vacations that people are taking close to home rather then flying or driving great distance. All of this, by the way, has played a part in GDP growth for the year. Necessity remains the mother of invention.

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Mind you, nothing here is "ground breaking". These forces have always been at play and will remain so. Speculation may have run a bit higher because of some hedge funds that found a loophole to exploit but, in some respects, that's their job: to increase returns on their client's investments. There's nothing new there and, in a growing economy, that kind of action is normally applauded. Still, there are some politicians and media types calling these funds to task. And, just for good measure, they want to call the oil companies to task. Their gambit: the Windfall Profits tax. The idea of which is to tax profits above a "normal" limit. Now, I don't know what constitutes normal, who defines it, what timeline they use, or any other criteria they may use. But I do see problems with the tax.

To begin with, companies don't sit on profits. They don't leave that money in the bank to collect dust and interest. They put it to work. Among other things oil companies would probably use those profits to maintain and improve existing systems; on R&D - i.e. to discover new sources for oil, systems to extract oil safer and more efficiently, alternative energy systems; and to reward executives at the helm when those profits were earned. [Hell, everybody wants to take their money away when a company flounders, they should get extra when their company does well. Don't you think?]

Taxes on profits would have the unintended effect of producing less. I mean, if I'm Exxon and the government tells me I'm going to be hit with a Windfall tax, I might as well produce just enough to avoid the tax. Right? Of course there would be those unintended consequences: since 70% of GDP in this country is generated by consumers purchasing goods and services extra taxes would thwart economic growth. You would also face increased shortages at the gas and oil pumps. In the land of supply and demand that means higher prices for all oil products on a permanent basis.

In short, A Windfall Profit Tax may make a nice headline but it's a longshot that will probably never see the light of day regardless of who is elected President or, which political party controls the Congress.

I was talking to a friend of mine recently. He said, "I think the problem is deregulation of the power industry." My take is that bureaucracies move at a snail's pace. They are not designed to react aggressively to positive and negative changes in the economy like the consumer can. We have seen evidence of that with the "Staycations" that I mentioned before. Sure, it's inconvenient, painful even. We don't like to make the adjustments. So, we appeal to the government and ask them to make it better for us. Given the choice, I'd rather rely on the wisdom of the individual versus the collective bargaining of the United States Congress.

Please email your comments and questions to billmazzacca@gmail.com

Are We At The Point of Capitulation?

Students of the stock market know that market rallies typically begin when price-to-earnings (P/E) ratios are below 15. This ratio really answers the question, "How much are you willing to pay for each dollar of company earnings?" Generally, those rallies begin to fade when P/Es begin hitting the mid to high twenties. The ensuing decline is never pretty, it's never well organized, it typically overshoots to the downside, and it often begins because of some bubble or perceived crisis. After all, high P/Es really indicate optimal conditions. In fact, it may be more appropriate to say that markets with high P/E ratios are priced for perfection. Some shock to the system (and it doesn't have to be a big one) is enough to send people and institutions running for the hills, selling their investments and sending the markets into a tailspin. From this perspective it is easy to see that the S&P 500, with a reported P/E of 24, reflects a market priced for perfection and not tolerant of any "problems".

An oft overlooked ratio is the price-to-sales (P/S) ratio. Similar to the P/E, the P/S answers the question, "How much are you willing to pay for each dollar of sales?" Numbers below one are ideal. Again, referring to the S&P 500, I'm seeing a P/S of 1.2. Not what I would consider a value priced market.

A great index for clues about the future direction of the market indices is the Volatility (VIX) Index. Currently at 36, it has topped out in the low 40s in 2001 and 2002 and bottomed out around 10 in 2005 and again in 2006/2007. The markets have a saying about this, "When the VIX is high it's time to buy. When the VIX is low, it's time to go!" Since February 2007 the VIX has begun a slow, steady climb from 10 to the aforementioned 36. During the same period, the S&P 500 has performed in lackluster fashion.

So how can the P/E, P/S and VIX help us decipher these whirlwind markets?

First off, if your only investment option is a fund, get out and stay out. Move your money into an interest bearing money market account and sit tight. In fact, someone asked me for that very advice today. They said, "Look, should I put my money in a money market account or move it to the bond fund?" Without hesitation I said, "Move it to the money market fund and take the steady interest for the time being." The fact is, interest rates are low. For companies to raise their earnings they need to increase sales relative to expenses and/or raise prices. We've already seen some evidence of rising prices and if the solution includes raising prices even further, you may see higher inflation which will trickle down to higher interest rates. If that does happen the bond fund will produce a loss too. This is the time to move to safe ground and wait for the dust to settle.

Stocks are a different story. This market, raging with disgust, is a stock pickers market. This isn't about short term trading. I'm talking about the long term investor. This is the time to be looking for quality, low P/E, low P/S stocks. For instance, last week I bought shares of a paint company with those characteristics and solid financials. My logic here was quite simple: if you have to sell your home in the current housing market, you definitely need to dress it up to make it stand out. If staying put is your best bet, you'll probably do things to make your space a little more comfortable. In either case, paint is a relatively inexpensive solution.

Are we at the point of capitulation? Well, I think we're close but not there just yet. The P/E must move lower and there are only three ways that this can happen: lower stock prices, increased company earnings or, a combination of the two. With a slower economy increased earnings are unlikely at the moment. That leaves lower stock prices. For the indexes, I'll be a real believer when P/Es get back to a point below 15. As for individual stocks, right now there are great opportunities out there with more to follow. The keys here are research and patience.