Some Thoughts on the Markets

On The Fed
Having a conversation with my Dad a few weeks back I was explaining how the Fed is really between a rock and a hard place and that Bernanke honestly has no clue what the future has in store for the U.S. economy. He then asked me a very simple question yet it answered the entire predicament for Federal Reserve policy as I know it. “Do you think Bernanke knows what’s coming?” Yes, I answered. “So then if you were Ben Bernanke what would you do differently?”. The truth is that I’d do everything the same. The Fed is there not for the speculators but for the economy. If faced with rising inflation and a declining housing market, as Bill Gross said “He really has no choice”.

It is also interesting to note once again that the Fed is there for the support and well-being of the economy as a whole. Not for global interests and not for the speculators in Greenwich, CT. Although rates are supposed to be calculated for 6-12 months in advance, right now he sees fear of recession and it’s his job to cater to it.

On Housing
The real question for housing is no longer will prices fall further but by how much. Any one with a brain in their head could have predicted a decline in housing prices (for those of you who weren’t sure when look no further than the Newsweek front-page “Housing Boom”). We have a definite inventory issue and that can and will only be settled through a decline in price – otherwise read as – an increase in demand.

Interest rates are a major part of that equation. The lower rates go the higher the floor for housing prices.

On The Economy and Long Term Rates
The next issue is a matter of mortgage and loan options, supported primarily by the housing industry, crunching up with banks less eager to loan out money (albeit at higher interest rates, something that inevitably force the Fed to raise short-term rates). This would not only affect the coming recession (if you’re still questioning that you may be all too liberal) but also the economic consensus over the next 10 years.

Interest rates will rise, it’s just a question of when and by how much. When that happens you can bet that people’s ideas will change from “how to make another dollar” to the frugal “how to save another dollar” mindset as higher materials prices and the credit “consolidation” (sounds a bit less harsh than “crunch”, no?) make this decade a tougher environment for business expansion and investment.

The Currencies
We are once again playing the famous game “who can cause their currency to depreciate faster”. It sounds amateur but in today’s global trade game that’s essentially what they are doing. The Fed instead of merely lowering rates, are flushing the market with “liquidity” – a BS term meaning more accurately – a weaker dollar. Why you ask? Well any Austrian will tell you that price is the differential between supply and demand. Problem in this case is that the price and demand for houses and commercial real estate – as well as commodities (“assets”) – go hand in hand. So naturally the Fed is ready for another round of inflation if it helps along the housing bubble, and they can’t take the chance to wait and see.

Extend this scenario to Great Britain’s Pound (Remember Northen Rock) and Europe’s Euro (think Spain’s housing bubble), and you can bet that those currencies have a lot more than just China to worry about. Meanwhile the Yen and Yuan seem to be holding up fairly well for these countries are on the way into financial speculation not out. As for Switzerland? Yeah, I think the Franc should hold up just fine. Oh, and as for the Loony, Real (someone say Buffett?), Ruble and Aussie Dollar the future never looked so bright. Which brings me to the next subject…

Oil and Gas
The thirst quencher of the world economy… and Canada, Brazil, Russia and Australia stand to profit some. Throw in the rest of the drilling, mining and farming subsidiaries and they stand to profit plenty. $100 oil and then $200, it’s inevitable. Remember that green energy plants are not here to substitute for fossil fuels – they are here to change an industry. It took years for the U.S. to migrate from coal to oil and it will take years to wane from it. Meanwhile oil wells will deplete completely if prices don’t rise high enough. People say $100 is dangerous but was the $99 a barrel we saw a few weeks ago not? Obviously prices have further to gain.

Many investors believe that gas prices follow oil but this may not be correct. Gasoline also has a futures market and is subject to the same speculation oil is prive to. Expect higher prices at the pump.

Stock Market
It’s all in the earnings. Remember that the stock market is a voting mechanism in the short-term (if you doubt this look at the Dow on Fed Meeting days) and a weighing machine in the long-term. What has been reflected in the prices of stocks has taken much of the past into account and some of the future, but not all of it. There will be surprises (yes, there is such a thing) in the future and this will be reflected in the Stock Market albeit on a more immediate term basis (think MBIA, Freddie, Fannie and Citibank).

There will be opportunities but I doubt there will be any significant bottoms at least until the recession officially begins. Even then remember that this is just the guillotine – we have a heck of a consolidation ahead of us. And bear in mind that during the second mini-bear market of the 70s (that of the 1974 business downturn) price-per-earnings ratios dropped significantly even from where we stand today. It may be a great company but expectation must wear out completely. Much like commodities…

The Goods
By now we’ve seen a historical high in just about every commodity from copper to wheat to eggs to soybeans to oil. Some have gotten close like gold, while some still lag their historic peaks (lumber, sugar, coffee). But some day this decade each of the above will have their day(s) in the sun. Visiting plants from water to honey over the past few months two things stick out every time. The first is that farmers and retailers can’t believe it. Some who have been around for year including the mighty 70s can’t remember times when prices were so strong.

At the same time they seem somewhat skeptical that prices will continue to rise. You hear the wheat producer complaining about all the speculation (I explained to him that this is made to help farmers not hurt them), and you hear how China seems still hesitant to jump into the precious metals arena.

But when demand is high and supply is low prices must rise, and if by any means they are manipulated or capped they will rise further in no different a logic than the what lead to most of the current problems in housing.

~~~~~~~~~~~~~~~~~~~~~~~

So what in 08?
There isn’t much we can be sure of in the next year other than the fact that more volatility and election jargon will be stuffed down our throats. It does seem plausible to point out a simple mistake I think much of the street is making. There is this general conception that during a recession prices of just about everything goes down. I assume that the logic behind this idea is that as demand slacks off, from the U.S. and then eventually from the rest of the world, prices will fall as well.

My problem with this may be understood from a reverse comparison. The above train of thought seems to permeate Keynesian economic theory. The theory the way I understand it, originating from John Maynard Keynes’ General Theory (circa 1936) states that as the economy and productivity rise this will subdue inflation and at the same time increase wages as the prosperity is filtered out to the labor market.

This theory almost went into oblivion during the inflationary 70s as just about every objection of logic and reason became obsolete. During the 60s wages rose minimally while a decade of rapid inflation followed.

This brings us to our current major business-cycle. The 80s saw a rapid expansion of industry while commodity and goods prices stagnated (improperly appropriated to the “ingeniousness” of retailers’ ability to increase capital efficiency and properly manage increasing corporate debts). This was followed by the 90s and the Internet Revolution when theories of a “new economy” arose increasing speculation of man’s ability to advance the world into euphoria and everlasting prosperity for all with yet another technological innovation.

It would seem reasonable to assess that as the economy grew and demand for goods and services grew in greater and greater capacity (after all every man, woman and child would never have to work another day in their life due to the ever rising stock market)… that commodity prices would rise in tangent. The exact opposite was true. Inflation fell and real rates soared. Wages may have risen but then fell, thus proving once again that economic prosperity has little or nothing to do with the price of goods. Yes a retailer may have temporary sale to work off excess inventory but he will eventually be selling at a loss, often intentionally, so at least to raise capital to implore elsewhere.

Recessions do decrease demand, but with a decrease in demand comes a decrease in productivity. Add in speculation for higher prices and it seems plausible that Wall Streets assumption of $50 oil in 2008 or declines in the precious metals may be way off target. In the event that commodities – even those associated with the economic downturn (lumber, copper, oil) – do for whatever decline in the short-term this should be seen as a buying opportunity.

The bull market in commodities is well underway and is set to continue for some time. I think that the coming recession will catch many investors with their pants down.

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