Time to Step Aside

Greetings from snow-bound Crested Butte. CO.  I was supposed to be driving to California this weekend for two weeks on a Sausalito houseboat, but the gigantic west coast storm moving in my direction changed my schedule. The storm may be fortuitous – and symbolic. It provides time for reflection on the storm that raged in the stock market last week. And also the Iowa electoral storm that shook up the political world.

The stock market looks a lot like last August when the credit and mortgage market problems were becoming apparent to everyone. Investors decided then that the risks might be serious and sold a lot of stock. I did the same and wrote in Newsletter #4, “Late in August I decided that the risks of a serious U.S. economic decline have become sufficiently high that a new strategy is required to reduce the EIS portfolio’s exposure to a serious market downturn… It could be 3 - 6 months before we know if a serious U.S. recession will occur. I intend to maintain a low investment profile during this period of uncertainty.”

Well, my portfolio has been generally cautious since then, but still has been about 80 – 90% net long. Now, about four months later, it is becoming clear that the U.S. economy is slowing significantly. As the brilliant and award-winning analyst John Mauldin poignantly points out, the weak government economic statistics released last week understate the real weakness in the economy because the numbers are inherently behind the curve. Moreover, substantial losses in the most sophisticated financial instruments of the credit markets have yet to be fully felt by global financial institutions.

I am convinced that the unusual fall in stock prices this past week does indeed point to important future weakness in the U.S. economy. Not only is Mr. Mauldin’s analysis, among that of other economists,  compelling, but common sense also points in the same direction. We know the consumer is tapped out. His home mortgage ATM account is declining along with the value of his home.  That is, unless he’s in even worse shape as one of the millions who will be in mortgage foreclosure over the next two years.

In addition to standard economic indicators, let’s note those consumers who are voting with their ballots. The Iowa caucuses resulted in one huge word being trumpeted to the rest of the country: CHANGE.  Iowa voters – who are a pretty good sample of Iowa consumers – are saying they are very unhappy with the direction of the country. Now, the voting may have been partly about Iraq and maybe also about the emerging virulence of a disease called the military-industrial complex that Ike warned us about. But it was probably also about people not feeling very comfortable in their financial outlook.   So the caucuses were a broad poll that gives us another reason to suspect we are in for economic weakness.

In sum, we are in a period of declining home values on a scale that may be unprecedented since the Depression. Homes are most people’s major investment, so a serious decline in homes values will reverberate. If, on top of this, stocks also keep falling, a vicious cycle could be unleashed that could potentially make the stock market decline serious.

Opposing these American problems is the vibrant global growth propelled by developing countries. It is not clear to what extent a U.S. demand slowdown and further losses by financial institutions will impact the global economy. If all the strum und drang could be limited to our shores then the impact on stocks – and on oil – might be limited. After all, the U.S. is only 25% of oil consumption and less than that of global GDP. Moreover, “U.S.” companies are very largely international. To the extent that they operate outside of the U.S., a U.S.-only recession would have far less impact on their earnings.

I wish I could offer an informed judgment on whether a U.S. recession will spread but my sense is that nobody can have an informed judgment because we are in a new set of circumstances that does not have a good historical analog.  But it seems we live in an ever more linked world, so the likelihood of “containment” is perhaps not great. Plus we have the following evidence to guide us.

- The American housing-based disease is directly linked to global financial institutions, and thus other economies, via the derivatives markets.

- High oil prices are essentially taxing the global economy, providing a demand damper like a high-tax global fiscal policy gone wrong.

- When U.S. markets fall, global markets tend to go the same way.

- The Chinese market has clearly been in bubble mode during most of 2007 and thus could be especially vulnerable to a crash. That could link a weak U.S. market to a decline in the Chinese economy’s growth rate.

On the other hand, we also know there are great pockets of global liquidity. Both the Chinese and the oil exporting countries are swimming in cash. Absolutely swimming. Neither one would be happy to see a global recession. Thus, it seems likely trouble in the stock market, either in the U.S. or in China, would be met with actions to counter it. I suspect there would be large inflows of capital to any troubled financial institutions, as we have already seen, not only from central banks but also, importantly, from the huge state pools of capital. There will also be more – probably many more – acquisitions of all or parts of very big companies by such state funds. These will provide moments of hope for the markets.

Another mitigating factor is that short tem interest rates are very likely to keep on falling.  That would tend to bolster stocks provided that long rates also fall.  Predicting long term interest rates is well beyond my pay grade.  I would only say that stocks usually fall going into a recession regardless of interest rate moves.  Moreover, this particular recession, if it comes, will be coincident with strong inflationary influences that may well temper any movement toward lower rates. 

When all is weighed in the balance, it seems to me more likely than not that the coming months will see further weakness in stocks. The stock market retreat that now totals nearly 10% from the prior high point, and 5% in the past week, could well go another 10% or 25% before it is finished. The history of markets is that they tend to over-shoot, so even more of a decline is possible. Therefore, I am going to take further actions to protect the EIS portfolio from losses.

What about oil? I recently posted five news items that all suggest we are in for higher oil prices near term. They relate to political turbulence and OPEC producers being unable to increase production. But global economic weakness would likely reduce the growth in oil demand, if not the absolute level of demand, which would tend to reduce the price of oil.

Whichever direction oil prices move from here OPEC is likely to become involved in a counter-move. If oil prices drop, OPEC will want to protect their profit margins by reducing supply, as discussed in Newsletter #9. If for some reason oil prices keep rising despite economic weakness, OPEC likely would try to push them lower with promises, if not acts, of greater supply. Why might oil prices rise? Nigeria could be one reason; political instability spreading from Pakistan is another.

Weighing these oil vectors, I suspect oil prices are more likely to fall in the short term than not, but I would not bet a lot on that.

Natural gas is more of a weather matter. Gas has been strong lately, but that could mean little if the weather warms from here.

In general, my sense is that this is a time to stay away from virtually all markets. Such is the opinion of my friend and student of investments, Harry Newton. I am further reminded of a recent lesson in Texas Hold’em that I received courtesy of my great good friend Nick Rayder. The bottom line in that game, it seems, is to have patience. When your draw does not provide you with a distinct advantage, stay out of the betting. That seems to be a good analog for investing too, despite the miserable record of most market timers, myself very much included. Good luck to us all.

Tags: energy investments

This entry was posted on Sunday, January 6th, 2008 at 5:23 pm and is filed under Investment Ideas, Price of oil, price of natural gas. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.