Rational Advisor

This week I am in Nova Scotia.

But before I leave here are some interesting points on what’s going on

Interest Rates

What does a quarter point do?

Is it meant to provide confidence? Is it a quarter point because they think they can ward off a recession? Which is silly, because it would be the first recession in history that was ever pre-empted by a quarter percentage point rate cut.

I am concerned that investors will wake on Wednesday morning after the Fed announcement feeling let down and wondering when the next cut is coming.

Are they going to give me another couple of quarters or another 50 basis points?.

And I think if there is a lack of confidence in the market that they are going to get that, then you go into October with all the issues that October is going to bring - further credit issues for the mortgage issuers and further economic issues. Another thing to consider is the exit time for people in hedge funds is around the corner, this could be large.

The only thing that would make a difference would be if the Fed obviously telegraphed that more cuts are on the way - which is what I don’t think they’re going to do.

But markets could very likely be running smack into further headwinds with the third-quarter reporting season right around the corner and the likelihood of further pressures on the U.S. economy as mortgage defaults rise - issues unlikely to be fixed by a quarter-point rate cut.

The second-quarter season didn’t cause many hiccups because it wrapped up before the squeeze on financial markets flared up in early August.

We completed that earnings season before a lot of this mess hit the fan - but now we’ve hit the fan.

For starters, there has got to be an impact on financial sector performance. Issuance of paper, issuance of securities that are asset linked and all that where firms had been getting a lot of revenue - there’s a possibility that revenue growth is not going to be affected, maybe negative growth.

Canadian manufacturing firms will have their own special set of problems because they have had to deal with a dollar around the 97 cent US level.

And the Canadian marketplace could be in for extra added pressure if commodity prices flat amid lower growth.

The currency’s gains have also come on the back of a limping U.S. dollar.

The softer-than-expected U.S. retail numbers further weighed on the US$, increasing expectations that the U.S. Federal Reserve will cut its key funds rate from the current 5.25 per cent level when it meets next week.

That would narrow the Canada-U.S. rate gap in favour of the Canadian currency as the Bank of Canada is expected to leave its key overnight rate steady at 4.50 per cent when it next sets policy on Oct. 16.

The Canadian dollar’s recent strength has renewed talk of parity with the US$, something that hasn’t happened since November 1976.

It would be a fool who said that it wasn’t possible, because it’s trading so closely off commodity prices that all it takes is to have a day with a surge in commodity prices and we’d get there.

But I don’t think it would be sustained there, because I think ultimately we come back to the productivity gap and we still have a very substantial productivity gap with the U.S.

Domestic data showed Canadian labour productivity rose 0.2 per cent in the second quarter. That contrasts with United States, where productivity in the second quarter surged 0.9 per cent in its strongest performance since the third quarter of 2005.

So what this means is that the economics does not justify a high C$, it’s high because of commodity prices - read below about Oil.

House Prices

The average price of a resale home in Canada’s major markets fell in August for the second month in a row amid slower sales, new figures show.

The average price in 24 major markets was $325,881 last month, compared with $332,442 in July and $335,180 in June.

The figures were released Friday by the Canadian Real Estate Association (CREA) and are based on sales through the MLS system.

August’s decline was due largely to drops in Alberta, where the average price in Calgary fell $13,000 to $423,801 and Edmonton’s average slipped $8,100 to $345,809.

Canadian home price increases are not sustainable in the long term, a report from the Bank of Nova Scotia economics department says.

“Affordability is becoming increasingly stretched for many would-be buyers after almost a decade of rising home prices. More recently, economic risks have increased in the wake of the intensifying financial market turmoil stemming from the U.S. subprime mortgage problems.”

Additionally, “from a long-term perspective,” there is growing overvaluation in some parts of the country, “a precursor to a period of softening conditions,” the report says.

Scotiabank surveyed 15 cities, and all except St. John’s, N.L., have inflation-adjusted prices above their long-term trend. The national average deviation was eight per cent, ranging from one per cent in Ottawa to 25 per cent in Edmonton.

“Some deviation from underlying trends is to be expected at the late stage of a housing boom,” the report observed.

“At the peak of the prior two housing cycles in 1976 and 1989, national home prices were 12 per cent and 18 per cent, respectively, above their long-term trend. The smaller degree of overshooting this time around, and the sustainability of price appreciation, may reflect in part an undervaluation of Canadian real estate prices in the late 1990s and into the early part of this decade.”

they cautioned: “The further domestic home prices climb above underlying economic fundamentals, the greater the risk of an eventual correction.”

Oil

Oil’s rapid rise from $69 (U.S.) a barrel less than a month ago has been propelled by falling U.S. oil inventories, concerns about growing demand and speculative buying by large investment and hedge funds. But several analysts are now sounding alarms, arguing that oil’s rally isn’t supported by fundamental reasons.

In recent days, the Organisation of Petroleum Exporting Countries (OPEC) has said it will increase output, which should reduce some of the supply concerns, and the International Energy Agency has cut its global demand forecasts. Oil inventories are falling in the U.S., but remain at record levels. And gasoline demand has slowed down with the end of the summer driving season.

The combination of comfortable inventories in the upstream crude-oil market and weak product demand growth at the far downstream end of the petroleum complex suggests overall price weakness, not strength.

Perhaps the most important read on Oil, was in this weeks Barron’s

Where Is Oil Headed? A Contrarian Says $45
Interview With Mike Rothman, Senior Managing Director, ISI Group
By SANDRA WARD

AS THE ORGANIZATION OF THE PETROLEUM Exporting Countries convened last week in Vienna, we naturally turned for the inside scoop to Mike Rothman, head of integrated oil research of the ISI Group, an economic research and investment-strategy firm based in Manhattan. A regular at OPEC meetings since 1986, a top-ranked energy analyst and a consultant to governments, Rothman is nothing if not in the know. Before joining ISI in 2005, Rothman was the former chief energy strategist at Merrill Lynch, where he worked for 20 years. It has been his contrarian contention the past few years that the dynamics surrounding the spike in oil prices have been out of whack with certain fundamental industry truths, and a day of reckoning is at hand. Here’s his case for $45 oil and why investors should be underweight the energy sector.

Barron’s: What’s the view from the OPEC meeting? The Saudis agree to increase output and crude goes to new highs.

Rothman: That’s not the story. The story is not the increase, the story is why the Saudis are pushing for an increase in production. A big part of the answer is that it seems that the Saudis want to try to take the froth out of the oil price because they are concerned about what higher prices have done to supply and demand. Over the past year, Saudi Arabia has had to cut its production by almost a million barrels a day to accommodate the impact of non-OPEC supply growth and because of weaker-than-expected world oil-demand growth. It wasn’t that they were depriving people of barrels, but OPEC had less demand for their oil — and the bulk of the cuts occurred in Saudi Arabian production. The Saudis are about to bring on a big field in the fourth quarter, Khursaniyah, that’s an 800,000-barrel-a-day project, and they are looking at demand numbers that are being revised downward. World oil-demand growth hasn’t been at nearly the pace people thought it would be.

What are your forecasts for demand growth?

My forecast for the fourth quarter, excluding Angola and Iraq, is for about 26.6 million barrels a day. Their production right now is about 26.8 million barrels a day.

Mike Rothman
Zero growth?

From these levels it doesn’t look like they have to raise output. Mind you, it’s not the consensus view. The consensus view, which is from the International Energy Agency, is that demand is going to be about a million and a half higher than what I am talking about, and most people use the IEA forecast. OPEC is producing at a level that even their internal supply-demand model suggests is probably the right number for what they would need to supply — in other words, what the market is going to demand. Qualitatively, you should know nobody is being deprived of barrels. Now, with the Saudis pushing for a higher quota, it is not about making barrels available to meet demand. It’s about sending a signal or trying to lever down oil prices. The reason they want to do that is because the higher average price levels we’ve seen for the last couple of years have affected demand growth, and they have affected supplies from non-OPEC countries and for alternative energy supplies. The Saudis are the ones bearing the brunt of that because as demand for their oil has dropped, they have been the ones that have had to cut back.

There was talk they would delay increasing output because of concerns about the impact on prices.

That issue, of how do you engineer a soft landing, is really a tricky issue because the amount of speculative paper in oil has increased dramatically. The level of open interest in crude on the New York Mercantile Exchange has tripled in the last three years. The over-the-counter market, according to data from the Bank of International Settlements, suggests outstanding positions in oil about 20 times as big as the Nymex. Now we didn’t have a big OTC market back in ‘85, ‘86 or ‘88 or ‘94, nor in the ‘98-’99 price crashes, so the big concern right now is when the unwind happens, it could be terribly disruptive. If you look at an oil-price chart back to 1983, when crude started trading on the Nymex, all you will ever see in the price patterns are V-tops and V-bottoms. What happens when hedge funds who have been net long in crude since October ‘03 decide to go short or sell? You can understand the concern. It’s not just about easing prices; there is the potential for a blood bath.

So how do you explain crude prices rising to new highs after the Saudis announced they would increase production?

It would be an understatement to say I was taken aback by that. In a few days, the market went from expecting no hike in production, to expecting a largely symbolic increase, to getting a final agreement to inject 500,000 barrels a day above existing levels — which is the equivalent of a 1.4-million-barrel-a-day boost in quotas. The big question at the meeting is, “What is bolstering the price?” I’m not sure, except the market seems to still believe the world is running out of oil.

What about the demand from China and India and the notion that supplies have peaked?

The data doesn’t show it. If you look at the International Energy Agency industry data and you do an apples-to-apples comparison of non-OPEC supplies, supplies from all of the countries outside of OPEC, you will see growth rates are running substantially higher than people believe to be the case. Growth in non-OPEC supply this year looks like it will be about 1.3 million barrels a day, and that number is about twice what people believed would be the case. And the Saudis clearly have the barrels available. They are bringing on new fields. Khursaniyah is coming on in the fourth quarter, Nuayyim next year and Shaybah next year and Khurais in 2009. These are fairly big additions.

So what are people missing?

I have never seen the gap between reality and the perception of reality as big as it is right now. The perception of what I call Chindia, the idea that demand growth globally is robust and is going to be led by the emerging-market economies of China and India, is still strong. It is a great idea. But when you look at the data, you will see it doesn’t match, and when you talk about peak oil and see what is happening to non-OPEC supply, there is a problem because supply growth this year is going to be one of the largest in almost 30 years, and next year looks like it is going to be similar to this year. Guys like me care about the totality of non-OPEC supply growth, even biofuels, or non-oil fuel, which are a subset of the non-OPEC supply curve. Biofuel supplies, which include soybeans for diesel fuel and corn for ethanol, will be up this year roughly 350,000 a day versus last year. That’s a big number, about 40% in terms of its volume. It is going to be up by a similar volume in 2008. This is in response to higher average oil prices and concerns about availability.

Why the big disconnect between perception and reality?

I’ve got to tell you I don’t know what the answer to that is. I do feel like I’m going through the reverse of what I went through in 2000 through 2003. In 2000, I was described as a “foaming at the mouth” oil bull. At Merrill Lynch we had a view the oil price would average in the mid- to upper 20s. We thought OPEC would adjust production, and when we spoke with investors about our views, they looked at us as if we were taking drugs. The catalyst that actually repriced energy equities and moved the whole back end of the oil-price curve was when Royal Dutch Shell wrote down reserves in early 2004. That was the catalyzing event.

I don’t think people are aware that demand has really fallen off so much. The rate of global oil-demand growth has really slowed pretty dramatically since ‘04. I’ve had to make a large downward revision for the second quarter, and it looks like I am going to have to make another one for the third quarter. A chart of the OECD [Organization for Economic Cooperation and Development] countries shows demand growth has been negative, with the exception of a small gain in the second quarter; that’s the first time since 2005 that there’s been some growth in demand, and it was modest. That’s the worst showing since the ‘80-’82 recession.

What about demand in the U.S.?

We have seen a very recent significant slowdown in U.S. oil-demand growth. Also, jet-fuel demand historically has been a leading or coincident indicator for the economy, and jet-fuel demand has turned negative. That is not an economic forecast. But when jet-fuel demand is really soft, you have got to worry about whether something’s going on with the economy.

Well, is demand slowing because of high prices or because the economy is slowing?

That is hard to say. Guys like me count barrels. But when you see oil-demand growth slow, you figure there are two things going on: There is substitution and there is conservation. People try to do more with the same number of barrels or they use alternatives. They may use more coal. They may increase their burn of natural gas in place of oil. They drive less. They may car pool. I’m not going to sit here and make up answers that I don’t know. I just know that the rate of oil-demand growth has really been much lower than what has been forecast. I know I have had to make very big negative downward revisions in demand over the last three years, and it tells me that higher prices affect consumption. Three of my five kids drive, and last summer two of them stopped driving because I wouldn’t buy their gasoline.

But in the bigger picture, global demand was supposed to be so strong that it wouldn’t affect oil prices.

That’s the “Chindia” story. I don’t debate that demand in developing countries will grow. But the argument is that it is going to grow as it did in ‘04, at 15% or 16%, regardless of oil prices.

And you say 2004 was an aberration?

I haven’t seen anything like it in 26 years. It wasn’t even clear that what happened in ‘04 truly represented consumption. We don’t know if some of it was stockpiling for precautionary reasons by developing countries. When you measure oil demand in a developing world economy, you’re looking at disappearance, because the data for actual consumption by countries is very difficult to come by, and in many cases nonexistent. Then the question is whether that volume makes sense given other types of data. All I know is that for the last three years, I’ve revised my numbers down for China. It is not that they are not having oil-demand growth, but it is not 15%. It is 5%. It is 4%. It is 6%. It is 3%. It ain’t 15%.

So if you were the “foaming at the mouth” bull back in 2000, what would you call yourself now?

It is very hard for me to say that I am a bear when I think oil is going to land at $45 to $50; historically, oil prices eventually settling at $45 to $50 is quite high. But compared to what the market is pricing and compared to probably most of my contemporaries, my forecast makes me a bear. We recommend underweighting the sector right now.

I’d say nearly a 50% price drop is bearish.

The concern is about the magnitude and speed and timing of the unwind given a precipitous drop in prices. It will be painful for companies. I have seen this movie before. There are a huge number of similarities between ‘99 up to now and the ‘73-’80 cycle.

Thanks, Mike.

http://online.barrons.com/article/SB118981090977228146.html?mod=article-outset-box&apl=y

Conclusion

Equities are likely to remain volatile until there is more clarity on the degree of exposure of financial institutions to subprime debt and the impact of tightening financial conditions, weak housing and rising delinquencies on corporate earnings and GDP growth.

However I expect equity markets to stabilize with the U.S. Federal Reserve cutting rates and other central banks remaining on hold and intervening, as needed, to unfreeze liquidity. This, combined with attractive valuations and healthy earnings, should enable stocks to recover their July-August losses and end the year higher.

Despite increasing concerns of a housing-led U.S. recession, growth and inflation outlook remains supportive of equities. While the subprime problem and the liquidity crisis are likely to slow U.S. GDP growth, they are unlikely to push the U.S. economy into a recession or slow global growth significantly.

In addition, inflation is easing, providing central banks room to cut rates. The current market environment is more favorable for large dividend oriented equities than in earlier crises with more-attractive valuations and healthier earnings.

Bonds are likely to continue to benefit from the flight to quality as credit and stock markets remain volatile with fear, uncertainty and risk-aversion persisting. Bonds are also likely to benefit from slower U.S. and global growth and Fed rate cuts. In the Future, as demographics means more people are retiring, Pension funds will need to increase their bond exposure, so the demand for good bonds will go up.

It is my experience that you have three primary concerns when it comes to your investments: 1) Catastrophic losses of principal; 2) Outliving your money; and 3) Knowing who to trust. Am I right? I know those fears are increased by extreme market movements like we have experienced in the last few weeks. True?

So I thought it might be helpful to give you some perspective on market volatility from various authors who I know and respect. From Dr. Benoit Mandelbrot1, in The (Mis)behavior of Markets:

From 1916 to 2003, the daily index movements of the Dow Jones Industrial Average do not spread out on a graph paper like a simple bell curve. The far edges flare too high: too many big changes. Theory suggests that over time, there should be fifty-five days when the Dow moved more than 3.4 percent; in fact there were 1001. Theory predicts six days of index swings of more than 4.5 percent; in fact, there were 366. And index swings of more than 7 percent should come once every 300,000 years; in fact, the twentieth century saw forty-eight such days.

What this mjeans - There is far more volatility in the markets than most people realize. That is Dr. Mandelbrot’s central message. Rather than ignore this risk, investors should take advantage of it.

From Nassim Nicholas Taleb2, in Fooled by Randomness:

Prices swing more than the fundamentals they are supposed to reflect, they visibly overreact by being too high at times (when their price overshoots good news and when they go up without any marked reason) and too low at others. The volatility differential between prices and information meant that something about ‘rational expectation’ did not work.

What this means - Prices swing more than the underlying fundamentals because markets are driven by the human emotions of fear and greed. Neither of these have anything whatsoever to do with the underlying fundamentals.

From Ed Easterling3, in Unexpected Returns:

The average annual change for the Dow Jones Industrials Average stock market index, as a simple average, is just over 7% over the past century, 1901-2003… Over that period, what percentage of the years would you expect the annual change would occur in the range of -10% to +10%? Most investors seem to guess a number between 60 to 70 percent—that a clear majority of the years would be inside the range. What range would be required to include half of the years inside that range? … It is very surprising to most investors that the yearly range in the stock market has been inside the range of -10% to +10% only 30 percent of the years. Remarkably, to include half the years inside the range, it has to be expanded to -16% to +16%.

Of course, that also means that 50% of the years had a return of greater than ±16%, too. For an investor who looks at his or her portfolio value as a measure of success, those swings would be pretty scary. For a cash flow investor, who measures success by the amount of income a portfolio can generate, and by extension, the sort of lifestyle the portfolio can sustain, those market swings should be irrelevant.

Finally, there is this from Peter Bernstein in, Against the Gods: The Remarkable Story of Risk,

For true long-term investors—that small group like Warren Buffet who shut their eyes to short-term fluctuations and that have no doubt that what goes down will come back up—volatility represent opportunity rather than risk, at least to the extent that volatile securities tend to provide higher returns than more placid securities.

This is the approach I take to volatility. Volatility is my friend, not the enemy.

Rational

A young lady visited a computer dating service and made her request.
She asked, “I’m looking for a spouse. Can you please help me to find a suitable one?”
The matchmaker said, “What exactly are you looking for?”
“Well, let me see. Needs to be good looking, polite, humorous, sporty, knowledgeable, good at singing and dancing. Willing to
accompany me the whole day at home during my leisure hour if I don’t go out. Be able to tell me interesting stories when I need a companion for conversation and be silent when I want to rest.”
The matchmaker entered the information into the computer and, in a matter of moments, handed the results to the woman. Buy a TV set!

Comments RSS