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Newsletter 24A: The Dark Side
In the conclusions to my latest newsletter I noted that, “Nearly every analyst is saying the market has come too far too fast and needs a pullback. Great, let’s have one.” Today I want to consider the pullback scenario further. While it’s true that when “nearly every analyst” says something that thing is probably wrong, still I think it might be reasonable for investors to take steps to protect the portfolio gains of the past couple of months in preparation for a potentially serious pullback.
Let’s hope that it is truly “always darkest before the dawn” because the real economy to which the stock market is eventually linked is looking fairly dark right now. U.S. consumer spending, employment and business cap. ex. are all still falling, the auto industry contraction has further to go [it’s not clear to me that G.M. and Chrysler won’t ultimately be liquidated], and in Europe things actually look worse than they do here. In the northeast real estate agents tell me the standard bid for a house is 20% - 30% under the asking price, which bodes poorly for a leveling off in housing prices any time soon. The only positive indicator I know is the rising Baltic Dry Index - plus recent stock market gains.
Whether or not the U.S. economy can turn positive during the next 6 - 9 months is looking increasingly like a race between
1. reflationary forces, mainly spending by the Federal government, continued spending by wealthier Americans from their savings, and the growth of China and some other developing economies (Brazil, India, and Singapore maybe) against
2. deflationary forces including weak consumer spending by the growing number of unemployed and the worried-they-are-about-to-be-unemployed, cutbacks by state governments that must balance their budgets, the continuing downsizing of the auto industry and other businesses and downsizing by the even more desperate economies of Europe (especially Eastern Europe), Russia, and the third world.
It’s not clear to me that the forces for re-flation will work quickly enough and be strong enough to outweigh the deflationary forces of continuing job losses and continuing consumer de-leveraging. If not, then a return to economic growth may simply take a lot longer to achieve than anyone wants to think.
What de-leveraging means for economic recovery is that consumers will not use new borrowing to increase their expenditures and thus will not compensate for the continuing growth of unemployment that takes place during the last part of a recession and the early stages of a recovery.
John Mauldin said it well in his most recent weekly newsletter. Here’s an excerpt that concludes with his key point (in my opinion) that “we have not seen a deleveraging recession in the US for 80 years.”
From John Mauldin 5/16/09: The typical pundit keeps telling us unemployment is a lagging indicator, and that the recovery will be well under way before it shows up in the job numbers. Therefore, you should buy what they are selling, because the recovery is on its way. But that may not be the case this time. One of my favorite reads, when I get to see it, is the economic analysis from Bridgewater. They are among the best thinkers anywhere, and everyone who follows them gives them a great deal of credence. This is what they wrote about unemployment being a lagging indicator last month:
“Normally, labor markets lag the economy because incremental spending transactions are financed via debt, stimulated by interest rate cuts [my emphasis]. But as long as credit remains frozen, spending will require income, and income comes from jobs. And debt service payments are made out of income. Therefore, in a deleveraging environment job growth becomes an important leading, causal indicator of demand and other economic conditions [my emphasis].
… The deterioration in employment markets will continue because companies’ profit margins are so deeply damaged that a little bounce in growth won’t do much to alter their need to cut costs. This deterioration in labor markets will undermine demand and continue to pressure loan losses, which will keep the pressure on the banks and elevate the cost of capital for tentative borrowers, inhibiting credit expansion.
This again illustrates the problem of using past performance to project future results. You have to look at the underlying conditions in order to get a real comparison, and we have not seen a deleveraging recession in the US for 80 years. [my emphasis] Using the past data in today’s world is statistical masturbation: it may make you feel good, but it is not producing anything really useful, and may be harmful to your portfolio.
I would point to another factor holding back growth of OECD employment: the continuing impact of globalization. Competing with China, Mexico and other low-labor-cost countries for jobs (in the name of “free trade” which may be free but is certainly not fair) has been extremely debilitating to U.S. job creation for many years. It is still a headwind that the OECD worker must fight against.
Many simple souls (not PhDs in economics who know all about “comparative advantage”) have long asked how developed countries can compete against poor countries that have no social safety net or environmental controls without ultimately bankrupting the developed economies. Well, we may be finding out that such competition is not feasible on a sustained basis and that the developed countries will in fact be bankrupted in the long term if they keep exporting their jobs.
Implication for equities and oil
It’s always difficult to draw causal relationships between some forecasted economic scenario and the actions of the stock market. But it seems pretty clear that if the economy fails to show any sign of recovery over the next six months stocks are not likely to do well.
In sum, stocks rose after mid-March on relief that the banking system is not going to collapse. They kept going up on the hope for a V-shaped recovery. But the market will be disappointed if growth fails to appear in Q3 and Q4. If that turns out to be the case I suspect the market will get wind of it before it happens and will decline well in advance of the economic data being released. Such a decline could re-test of the March lows. If we get a re-test and it fails….ooops.
In terms of oil, a failure of the economy to start expanding has a less predictable impact. Yes, there is quite a bit of speculation to the $60 price of oil. A withdrawal or reversal of that speculation could bring oil down into the mid- to low-$40’s. On the other hand there are factors beyond the economic fate of OECD economies that could boost the oil price. They include political tensions - particularly in Iran and Nigeria - continuing rapid declines in existing oil fields, continuing lack of investment in new production, and the continuing growth of China, the Middle East and other developing economies that increases oil demand.
Bottom line: I’d still hold some equities related to oil, China, and “future energy needs” but I’d also add some hedges against potential broad market declines. I would sell cyclical non-oil stocks. I would not add to positions until there is some evidence that the economy is starting to stabilize. Simply having a lower rate of decline is no longer comforting to stockholders.
Whether or not markets do retreat over the next few months, it’s always good to remind ourselves that the amount of equities held in a portfolio should relate to one’s “tolerance for risk” - which means the amount of the portfolio that one is willing to see disappear in the short term in order to obtain the potential for it to appreciate significantly in the long term.
Here’s one way to quantify the issue: Assume that the downside risk to equity holdings is 33% from here (or you pick a number you like better). Visualize your current un-hedged holdings being worth 33% less. Would you still be sleeping well? If not, cut your un-hedged stock holdings back to the amount that would let you be comfortable or add hedges to the portfolio (stocks or options that will rise in a falling market).
Tags: peak oil investments
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27 responses so far ↓
1 Larry // May 19, 2009 at 8:03 pm
Jim,
Unfortunately, I agree with your analysis. These are very, very scary days we are living in right now. All this talk of green shoots is crazy, if you look at what we really know about the future. It is very hard to see how corporate earnings for the next few years will justify the current stock prices. Hopefully we will both be wrong. Of course, I would stay out of China right now also, but better investors than me, such as Jim Rogers, agree with you.
2 Karol // May 19, 2009 at 11:20 pm
The new filly:
She’s a dark horse and we don’t have a clue how well she can trot but she has strong hind legs. She’s sure not to be a racehorse of more then 3/4’s of a mile. Who is she?
She’s Lowe’s. Her counterpart is Home Depot. Lowe’s is still opening stores while HD is sucking all the cash registers dry.
Who will win?
When times are tuff do you button-up the hatches or do you spread out you anchors?
Market moving to fast for you or are you just learning to watch how the tide changes?
3 KV // May 19, 2009 at 11:27 pm
Jim,
Mauldin can’t come to say 1929! Instead he uses deleveraging recession in the US for 80 years…
I think we will be entering Regan era of stagflation, which is the fastest way to create poor people until inflation erodes fixed debt to managable levels.
Our society is too violent to have 1929 repeated. So, only option is inflation, but, it can not happen until old inventory is used out.
From Bloomberg: Japan economy shrank 15.2%… Link:
http://www.bloomberg.com/apps/news?pid=20601068&sid=aeZ_K.uTF0bs&refer=economies
However, as inventory clears production resumes, from the article:…Honda plans to increase production in Japan this quarter as dealerships clear inventories, the Wall Street Journal reported last week.
4 Karol // May 20, 2009 at 1:34 am
Have a great one?
Pull back bear … bear run … bull start… bear run… just what is a great one?
nothing clear and nothing going to give a clue
That would be to simple.
A pull back in this bear market is fighting the “fed’s”.
This is where being in and out becomes an investor’s gamble.
Devilish.
5 robert essian // May 20, 2009 at 11:40 am
Professor, risk tolerence is relative I guess.
I do know that world wide depletion is 6% (+ or -) per year.
I do know that Nigeria, Chavez, Mexico are in trouble.
I do know that the KSA, and all other countries that subsidize oil will use alot more of it as they expand.
I do know that Russia planted a flag, declaring hands off to the oil someplace in the frigid north. Even threatening us, and everyone else militarily.
So oil has been declared an extremely necessary commodity. We all know that though.
I do know that Iran is a potential nuclear issue, and as time goes forward we are getting close to taking some form of action. When?
I’m not convinced that when we pull out of Iraq that issues in that entire region won’t get worse. Alot of Iraq’s citizens have been harmed or they have lost a loved one during our tenure. What crazies have we produced wanting some form of revenge? Not an expert but a Nigeria type thing comes to mind.
I sense that Peak Oil is becoming main stream and hoarding will be common. Strategic oil reserves in China, U.S., and elsewhere is a form of that.
I do know that we have under invested in the planned production of oil, and maintenence of the oil infrastructure. Refineries are blowing up, and I’m concerned enough to raise an eyebrow.
We have had 2 pretty good draw downs in our oil inventory , and next Wednesdays EIA report if it shows another may convince the market of a trend developing. It’s likely because of Memorial Day weekend. Maybe oil goes to $65-$70. It seems to always over shoot, and undershoot (we’ve just experienced both in the last 8 months).
With summer driving season just getting started, and gasoline at a more reasonable price it’s very likely that people will hit the road. When they do that they spend money, and it floats around a bit making the economy look better.
Oil and gas stocks are cheap, we all know who the players are, and they have put their rigs to the tall grass. Supply will be a problem in the near future.
The DOLLAR (printing presses), will cause inflation, it will not be managed well when pulling it out so oil covers the inflation trade.
So assessing risk I ask myself if not now when. I can research the 52 week lows, and if the stocks I’m in go and retest so be it. I just feel the risk is worth it. I will keep my stops in place just in case though. Wacky world we live in, and as always I look forward to every day…Peace
6 Greg // May 20, 2009 at 5:53 pm
This is ridiculous. “Every analyst” has been predicting deflation now for almost two years. As you say, when they all agree, they are probably wrong.
There is “deflation” in financial assets (deleveraging is not the same as deflation, but you don’t seem to understand the difference), but inflation in all other asset types.
Have you read the news lately? Check out healthcare costs — they are UP (inflation) by 8-10% every year. Education, whether property taxes or college tuition, is UP 7-8% every year.
The money supply is growing leaps and bounds — but quite predictably to everyone outside Wall Street, the money is not being spent on overpriced financial assets.
Increasingly the inflation is appearing in government services, which Wall Street inexplicably says “don’t count”. Please, that has to be the dumbest idea Wall Street ever had, and they have had some doozies.
Here are the facts: a net debtor like the U.S. government could never survive long term deflation — they need inflation in order to survive. The folks with the money printing press have choice.
Geithner and Bernanke are pretty dumb — so lets bring in just about any banana republic dictator you want. Even though it eludes the dummies at the Fed / Treasury, dictators have known for decades how to create inflation.
The problem only seems to elude these alleged PhDs.
Stop whining about deflation. Its not happening; the government would not survive if it did happen; and every banana republic dictator knows how to fix deflation.
Really Jim, one of the worst posts you have ever done.
7 Karol // May 21, 2009 at 3:54 am
Regarding this post:
I tend to like
Jim’s warning to protect gains if you have any. And if you were in cash to stay that way I add.
Greg’s wording “could never” is only as good as Greg could never be right. I’m of the thinking that things “can” be. And I think this can be a great time to ready for a serious pull-back. This is what I understand Jim to be saying.
A very nice post Jim!
8 Larry // May 21, 2009 at 4:39 am
It seems to me that you are misreading what Jim said, to a certain extent. He grouped some activities into “inflationary forces” and some into “deflationary forces” and speculated about which might have the greater effect on the economy. That is not the same as saying there might be inflation or deflation.
Still, we have obviously had deflation in financial instruments, real estate, and commodities, and if the economy keeps tanking we might have further deflation in those assets in the short to intermediate run. Of course, if you are willing to wait for the long run, we will almost certainly have high inflation (but not necessarily high economic growth) then. But the short run could be a pretty wild ride.
9 Karol // May 21, 2009 at 4:44 am
I’d like to expand on the deflation problem.
From my first hand experiences I saw/see prices drop at lots of places. This is what I understand deflation to be. This fall in prices were at some places very steep. It was in selected items. It as, I figure, was/is a calculated risk by companies to project the images of “you the consumer are under our ever protecting-you wings”. We help you save!
But!
The prices of other items inflated. They were and are being pushed up and displayed in the most possible way right in your face. Hence…buy consuming secukr buy!
Here’s the dig.
People are losing and or have lost jobs. I see no signs of new jobs being formed or hiring. There are people that still have cash to spend and don’t have a real relationship with the current down turn. I see it as these are the ones keeping the wood worms out of planking of sinking ships.
The school of fish that swim in the stock market…
What about them? A shark here and a rock cod just a little deeper. I think there are more sharks in the water these days. The sharks need to die-off somewhat before the Cod’s return in strength.
10 KV // May 21, 2009 at 5:10 am
Greg: Except your comment - Geithner and Bernanke are pretty dumb - you are on right track.
It is inflation that will save the day, not deflation in high unemployment, called depression. Even if an apple goes down to 1 cent, you got to have a cent! Unemployed don’t have a cent!!
G & B team and the US Govt, republicans and democrats together, are trying to light the fire of inflation, and they will succeed. We will pump up India and China as the consuming nations and life will go on. We were looking for Russia and old soviet countries to do this, but they are too entranched in their old ways. We need a sink for junk we humans produce, and it is time for India and China to step up consumption and bail the rest of the world out.
11 KV // May 21, 2009 at 6:24 am
On the lighter side…
Hormel 2Q profit edges up, beats view
Spam maker Hormel 2Q profit climbs as consumers stock up on canned meats, Mexican products
Karol, according to Hormel, Hawaii eats most Spam products per person, including President Obama’s Spam roll!
May be we can park money in the Spam!
12 Greg // May 21, 2009 at 6:55 am
Karol — I stand by the “could never” happen comment.
When backed into a corner, forced to chose between ending their term in power or inflating the currency like mad — politicians have always chosen inflation. Every politician without exception — Egyptian pharaohs, Summartra ministers, Greek city governors, Roman Emperors, European monarchs, Chinese Emperors, Russian Czars…. to say nothing of all the dictators of banana republics in Latin America and Africa
Anyone debtor who is smart enough to find Washington DC when they live in Washington DC can prevent deflation from happening. Its so simple even Ben and Tim can figure it out.
Heck, its so simple, even a bank CEO can figure it out.
As long as Uncle Sam is a net debtor, we do not need to worry about deflation happening.
Wall Street is telling you to buy cash and Treasuries, much like they told us to buy mortgages and dot-com companies in past years. These people haven’t given the best investment advice to be gentle about it.
If you really believe a net debtor like Uncle Sam will experience deflation, you should be dumping his debt as fast as you can. Deflation hurts debtors, while inflation helps them.
Billionaires like Warren Buffet, Jim Rogers and Julian Roberts are warning about inflation. I am going to take my investment advice from them
Jim Kingsdale might be forgiven for mentioning deflation 8-9 months ago — but now he is just regurgitating Wall Street foolishness
13 Isaac // May 21, 2009 at 8:28 am
This is just my opinion- Jims thoughtful postings deserve a much higher level of response than some are posting here. You may not agree with him, but that dosn’t mean you need to embarass yourselves in public.
I see strong merit in the notion that our economy is structurally weak, and that diminshing collective income will be a downward wind affecting basic aspects of our economy, such as real estate prices, and likely stock prices and company earnings. Prices may go up, but this be due primarily to the diminshing relative value of the dollar. And sure, we will do our best to gradually inflate our way out of this mess- in effect defaulting on our loans. We really don’t have any other choice.
14 Greg // May 21, 2009 at 9:37 am
Isaac — did you read your own comment?
First, you whine about people not agreeing with Jim.
Then you say in essence the exact same thing!!!
“Prices may go up, but this be due primarily to the diminshing relative value of the dollar” — better known as inflation
You continue: “And sure, we will do our best to gradually inflate our way out of this mess- in effect defaulting on our loans. We really don’t have any other choice.” — saying we have no choice but inflation is just rephrasing what I already said
America is in much bigger trouble than finances– the population has no reading comprehension skills in its native language
15 KV // May 21, 2009 at 10:49 am
Greg - There! There!
Isaac is reiterating what has been said by many here. Yes, inflation in negatively growing (demand destructed) economy is a key worry and salvation. So any fixed income investment is for the birds. I think somewhere Jim mentioned about hedging, and I think that is the best, especially in tax-deferred accounts.
16 barry bernstein // May 22, 2009 at 12:10 am
Time is an importent element of investing.I agree with all the risks that Jim points out.I have all my investable funds in natural resource stocks.My time horizen is ten years.If at the end of that period,I have lost money or not made very much,I will be disappointed.What happens to my stocks before the end of the ten years is not inportent to me.If I had more discipline,I wouldn’t even look at the quotes until Dec. of 2019.Do any posters have an opinion where the dow will be on that date?
17 KV // May 22, 2009 at 6:02 am
Barry: why don’t look up the components that make up “natural resources” in the dow, and find out what will they contribute in the dow if they doubled, trippled, etc.
Now, also consider if 2019 were to be like 2009! You could have sold in early 2008, and may be in 2012 in future… Man, establish measurable goals!
18 robert essian // May 22, 2009 at 2:17 pm
Barry, you’re not a day trader, you are a long term investor. That’s good. However, as KV points out (somewhat) there are times when you can reward yourself, and take some profits.
In the case of last year there were really nice profits to take.
Additionally, you better follow all aspects of the market regularly (Jim’s site is great) because going to cash as KV is intimating would have protected you from grave loses late last year, and early this year. Then pour it back in as things look to change thus rewarding you with greater profits.
Anyways my good fellow I’m pulling for you…Peace
19 barry bernstein // May 22, 2009 at 9:32 pm
To Robert If I knew when the market was about to change direction I would do as you suggest.I just don’t have the ability to call the turns so I just buy what I like and stay put.I have done it this way for 45 years and it has worked out pretty well.
20 barry bernstein // May 22, 2009 at 9:55 pm
Just one additional thought.I know Jim believes in peak oil as do I.I put all my funds into oil and other natural resource stocks and really plan to hold them for the rest of my life.In the past almost five decades I have gone through some really wild swings in the market,but I just ride it out.My best stock was Geico.I bought it in 1974 because I read that Buffett had bought %10 of the company.I paid $1 per share and held it until Berkshire took over the whole co.at $190 per share 20 years later.I am still annoyed at him for taking away my stock which today would be worth at least $500 per share.
21 robert essian // May 23, 2009 at 3:58 am
Barry, I wasn’t being disrespectful or challenging just sharing some thoughts.
However, I own 4 times more stock today than I did at the same time last year.
Had I stayed pat I might be feeling somewhat depressed, and out of the market entirely because the losses would have been too great to bear (80% decline).
As it stands now I’m in the black looking at a pretty strong return if the prices in these stocks just go back to halve their values anytime in the future. In addition these companies have added additional reserves. It comes down to risk tolerence I guess as Jim remarks, and a plan as KV suggests.
Personally I hope you make more money than you can count…Peace
22 KV // May 23, 2009 at 6:12 am
RE - Pretty smart and prudent for you to capitalize and reinvest.
23 robert essian // May 23, 2009 at 8:08 pm
KV, I so thoroughly enjoy every minute spent researching, and learning. Thank you for your kind words…Respectfully
24 Karol // May 25, 2009 at 3:02 am
THE DARK SIDE
How fitting!
North Korea does a NUCLEAR BOMB test on Memorial weekend in the United States of America.
People tell me everyday that we humans are smart and we can talk things out or get things done in a non-human life cost way.
Tell that to all the dead. All those who gave there lives which we celebrate today.
What does this mean to energy investors?
…
In the long term if N.K sends a BOMB to Japan…in the long term if Iran hits Israel..?
Well?
I don’t have a clue.
People around the world could just stop driving and there would be no need for oil.
People around the world could want and need food and the demand for oil could hit the moon like a ringer at the circus.
Take your pick but give thanks for and to our dead.
25 robert essian // May 25, 2009 at 11:54 am
Karol, “give thanks for our dead”. I can go with you on that. One hellava sacrifice…Peace
26 PB // May 27, 2009 at 12:57 am
To Robert If I knew when the market was about to change direction I would do as you suggest.I just don’t have the ability to call the turns so I just buy what I like and stay put.I have done it this way for 45 years and it has worked out pretty well.
27 robert essian // May 27, 2009 at 2:54 am
PB, as Jim suggests many times “don’t try to figure it out”, I listen.
I too agree with buying what I know and believe it will work out well. However, when Leeman Brothers (sp) went belly up and was allowed to fail I payed very close attention to the market from that point on. Hoping things would stay as they were but tightening my stops in the event I was being too optimistic, and emotional.
As luck would have it I took a hit like everyone else but I didn’t loose my shirt. Maybe chipped a tooth but didn’t loose my shirt.
So following the experts like the Professor, listening to them, doing other research, I believe you can do better for yourself than just buy and hold.
I found KV who writes often on the Professors site, and is obviously well read to have been very important to me as I balance the yen and yang of the market.
So again, to each its own and to all I wish you well…Peace
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