Tag Archives: investment advice

Germany Is Delusional To The Point Of Insanity

global investingMy Comments: Assertive headlines such as what you see here are usually outside my comfort zone. For one it implies a pathology that I’m not trained to comment on and two, Europe and European values are different from mine, given that I’ve lived here in the US for the past 65 years. (Warning: this post is LONG.)

That being said, what goes on in Europe does influence what happens to our markets, and since investing money is an expertise I have, then knowing and trying to understand this sort of thing is important to me. And perhaps to you.

The Mercenary Trader / Jan. 21, 2015

“It is as if it’s accepted that the euro area’s modus operandi is to clear things with Germany, and for the ECB to constrain its actions to what is best for Germany.” ~ Athanasios Orphanides, former member of the ECB governing council

Most of the eurozone is experiencing deflation. Even the countries who aren’t – Germany etc. – are well below the ECB’s official 2% inflation target.

This is dangerous because deflationary conditions can tip into recession… and depression… and political extremism born of civil unrest. Deflation – or rather the extreme results of such, in the aftermath of harsh slowdown – brought us the Nazis in the 1930s. Post-Weimar economic implosion, not currency erosion, enabled the political conditions for Hitler’s rise to power.
Need we say more?

Apart from political unrest, deflation is like having no fuel in the emergency flight tank.

A lot of people will say “what’s wrong with deflation,” e.g. why is it so bad?

It’s important to clarify there is a big difference between falling inflation levels (disinflation) and inflation falling below zero. Think of a plane that stalls out.
When an economy goes negative, the risk is that the plane fails to overcome the stall… and crashes before it can pull up. Deflation (as opposed to disinflation) can lead to compounding “downward spiral” impacts, not unlike gravity’s increasing pull on a nosediving airplane.

The German attitude toward inflation, and debt, is pathological (indicative of mental disorder).

Germany is paranoid of inflation on a pathological level. Germany is also pathologically allergic to debt. Consider, for example, that Germany as a country has serious infrastructure needs… and there is real risk that Germany’s economy will slow in future. Right now, German interest rates hover above zero (or even dip below it). This is a historic opportunity for “good” financing… for logical spending on real needs, financed by incredibly low-cost debt.

Yet Germany is so debt averse, they aren’t willing to borrow for the future – not even for themselves – even with rates in the zero to one percent range. That’s almost the equivalent of turning down free money, even when it is badly needed for repairs… even when it has obvious strategic use. That is not frugality as a virtue, it’s more like a miser complex worthy of therapy.

Worse still, Germany is delusional about its own economy and dangers.

Think about this: What happens to the German economy when China really and truly slows? And what happens to the German economy when Japan goes “next level” in its competitive devaluation plan?

China is slow-motion imploding. No matter what happens, China has to switch from an infrastructure led economy to a consumer led one. This is very bad news for Germany, one of the world’s largest exporters. As is the increasingly competitive currency stance of Japan. Bottom line: Germany’s present economic strength could easily evaporate… for strong reasons that make logical sense. And how much cushion would they have in that event? None…

Bottom line: Germany would rather slit its own throat, economically speaking, than allow for a rational approach to inflation and debt.

That is a deliberately harsh phrase, it’s true. But the writing is on the wall. Germany’s commitment to austerity is not just pathological, it is economically suicidal.
The entire eurozone is at risk… and Germany’s own economy is too… and the lessons of history speak loudly. Yet Germany continues to live in a bizarro dream world where saving money has been elevated to a fetish regardless of surrounding circumstances.

We don’t choose to pick on Germany. We have friends who are German… family members and loved ones with German roots. It simply “is what it is.” The pathologies of a country, to the degree they go separate ways from rationality, are leading to economic disaster (and who knows what in the aftermath).

There are questions as to whether German provisions will “neuter” euro QE.

Draghi and the European Central Bank will announce some kind of quantitative easing on Thursday (sic). There is no question of it now. If they tried for another stall – more “wait and see” – European equity markets would simply go into freefall. Investors would start betting on accelerated odds of euro break-up.

But it remains possible that the “shock and awe” of euro QE will be neutered by German demands. Via the FT: To appease QE’s German opponents, which include the chancellor Angela Merkel herself, Mr. Draghi is expected to say that bonds bought will remain with national central banks, so losses will not be spread among eurozone members. But other eurozone countries, as well as the International Monetary Fund, fear the concession could reduce QE’s effectiveness…

OF COURSE giving Germany what it wants would reduce euro QE effectiveness!

• Germany wants to reduce fiscal exposure to weaker eurozone members.
• But establishing a united support front is the whole idea in the first place!
• The house is on fire and liquidity crisis measures (firehoses) are needed…
• But Germany wants to avoid charges for the water…
• And make sure any fires are segregated away from itself…
• Thus increasing the odds the whole thing burns down.

The German justification for not wanting to participate is ridiculous.

The stance of Germany is essentially, “Why should we pay for these bums? Why should we create more risk exposure for ourselves? We are savers, they are spenders… why should we waste money on them?”

The answer is that Germany should have asked those questions SEVENTEEN YEARS AGO. Saying “Nein!” to an insanely stupid monetary union would have been very logical, and the best thing for all… circa 1998 before the euro actually launched! But now it is too late to avoid responsibility for actions.

What’s more, it is no longer a “moral” question… but a question of WHAT THE RISKS ARE.

This is the other amazing / maddening thing about the German stance. Germany still acts as if there is room to say “no” on moral grounds… when the final question is what will happen, not what is right or wrong. When a course of action is highly likely to invite DISASTER, the question of right or wrong has to be put aside…

Because of Germany, we don’t know how euro QE will come across… but we are willing to short more FEZ against our euro position. Our EURUSD position has a sort of partial absolute hedge in short European equities. If Germany throws a spanner in the QE works, and “Super Mario” disappoints, EURUSD could spike in a big short squeeze. But European Equities (NYSEARCA:FEZ) would fall hard in that instance. Conversely, if Draghi and the ECB come through in a big way, the reverse could occur – EURUSD goes into freefall, FEZ rockets higher. So they act as de facto hedges of each other…

Another scary thing… even if Draghi gets his “big bazooka” QE… what good will it do?
The other frightening thing to consider: It may be too little, too late for Europe no matter what size of QE they get. There is little point in lowering eurozone bond yields (already pressing zero). And there is little real hope in stimulating bank lending. So the true point of euro QE would be… what? Making the euro a hell of a lot weaker to stimulate exports one supposes. What else is QE supposed to do?

One argument is that, once euro QE starts, it never stops… until it goes nuclear…
Some argue it doesn’t really matter how much QE the ECB starts with… because QE just gets bigger from that point no matter what. We can’t be sure this is true. Germany might try to stop a “failed” QE program. Then again, if things get really ugly – e.g. if Germany falls into recession too – then maybe it keeps going and going…
And the ECB finally winds up going “nuclear,” taking a page from Japan. Understand this: There are plausible scenarios where the euro goes to 85 cents before all is said and done. That outcome would not be too hot for risk assets. (Hello understatement!)

15 Reasons To Sell Most Stocks Now

profit-loss-riskMy Comments: I’m starting to sound like a broken record. If you are not in a position to profit from a bear market, you need to talk with me.

Bert Dohmen, Founder, Dohmen Capital Research Group Jan 15, 2015

The start of the year has been one of the worst ever for the stock market. The bulls have been shaken, but they haven’t given up pounding the tables with their bullish message. We haven’t even seen concern break out, much less bearishness. Such lack of concern and fear in an environment of great excesses is always a flashing yellow light for me.

I look at the technical aspects of the markets, which includes ‘sentiment’ and measures of money flow and exposure. Here are 15 warning signals I see for investors in 2015:
1. Every money manager seems to be fully invested, and many hedge funds are fully margined. That means they have borrowed money to buy stocks. That breeds instability. When everyone has the same opinion, it’s logical that all capital devoted to stock market investments is already in the market.
2. The AAII (individual investors) survey of its members now has the highest percentage of bulls since the year 2000 market top before that big crash. Combine that with the record high margin debt, and you have the evidence of “everyone being in.” That’s when the change can only be for the cash flow to reverse, from in to out. During such a decline, fundamentals don’t matter. Stocks must be sold just to raise cash.
3. Is Margin debt another measure of excessive stock market enthusiasm? That’s the amount of money borrowed to buy stocks. Margin debt, as a percent of GDP, is now the highest in 85 years. It even exceeds the level of the enormous speculative peaks of 1999 and 2007. It’s a huge bubble and a signal that the market is vulnerable. When so much stock is bought with borrowed money, even smaller shocks can trigger a big margin liquidation episode.
4. The bulls are counting on a strong economy this year. What if the economy weakens in the second half because of the global shrinkage in the energy sector? Hundreds of billions of dollar in credit will implode in the energy sector. Markets look ahead. Even if GDP growth numbers are strong in the first half, largely because of statistical aberrations, there is not enough additional money going into the market to offset the smart money coming out.
5. During the 5-day decline since Dec. 30 and the first part of January, the least weak index was the DJI (30 stocks), and the weakest index in the US market was the RUSSELL 2000 Small Cap index (2000 stocks). That’s a bearish message. Obviously the action of 2000 stocks is more important than that of 30 stocks.
6. My technical indicators have been on short-to-intermediate term sell signals since January 2, 2015.
7. There are large divergences on the major indices, which usually precede meaningful market declines. The widely-watched indices, DJI and the S&P 500, made new all-time highs in December. They are easy to manipulate upward. At the same time, the broad indices, such as the NYSE COMPOSITE, didn’t make a new high. The latter includes all the stocks on the NYSE and is thus much more important. In fact, it has made a series of lower highs
8. There were major trend changes in various markets and spreads starting just before July 1, 2014. Something happened around that time to set the current negative trends in motion. That’s when oil, commodities, and the broad stock market indices made their peaks. Bear markets start beneath the surface and then spread. By the time the DJI makes a top, the downward trends in most stocks are already well on their way. The important internal market top in 2007 was made in July (identified in our Wellington Letter at the time) while the DJI made its top in October, three months later.
9. The charts suggest that around July 1, 2014 a decision was made to push the oil price significantly downward. Look at the chart of oil. There are no reasons for a bottom yet.
10. According to Kimble Charting Solutions, over the past 50 years, the SPX was down the last day of the year and the first three days of a new year only once: in the disastrous year of 2008.
11. Furthermore, since 1950, there were only 6 instances when the market was down the first 3 days of the year: the worst 3 day declines were the year 2000 and the year 2008, which were also the worst years for the stock market.
12. These rare events were taking place at the same time we had one of the weakest “Santa Claus rallies” late last year. It was the 3rd worst in 65 years. The only ones that were worse were in 1990 and 1999, which were followed by bad years.
13. Journalists who have spoken with workers in the oil areas such as the Bakken say that the workers don’t expect to have jobs by the end of the month. That will create great pain and affect many other areas of the economy.
14. As we wrote in our award-winning WELLINGTON LETTER issue of January 4, the big negative effects of dropping oil prices are still ahead. We are still in the early phases of the dire consequences.
I would not listen to those who say cheap gasoline is bullish. It’s cheap for a good reason: massive global deflation. My favorite investment area for last year, (up 51% since Jan. 1, 2014), is still my favorite for this year (up 7.2% so far this year). It’s in a very conservative sector. But you can’t just “buy and hold.”
15. Money managers have now been “trained” to think that every market decline should be bought. That works…until it doesn’t and the bargain hunters get killed.
There you have 15 reasons to be cautious in the markets right now. I expect great opportunities for active investors and traders who are prepared and have the most experienced guidance, just as we saw during the crisis of 2008. Such times create fantastic profit opportunities in the markets, first on the way down, and then at the bottom.

The past five years were dominated by the central banks intervening with trillions of dollars of money creation and the “ZIRP”, zero interested rate, policy. These produced incredible financial speculation, at huge leverage, and mal-investments which were undertaken only because money was so cheap. Now that interest rates are practically zero, what tools do the central bankers have left? That is the big question for the next two years.

The world has never seen such huge money creation, and therefore, no one can know the extent of the potentially disastrous consequences.

Buy the Rumor, Sell the News

My Comments: As a financial advisor for almost 40 years, you’d think by now I would have this all down cold. That I’ve survived in this profession suggests I have at least a reasonable understanding of how “investing money” is supposed to work. Either that or I’m very good at talking people into doing dumb things.

Anyway, I’ve not been particularly aware that we have been in a bond rally. Scott Minerd says “Economic strength in the U.S. and the announcement of QE in Europe could spell the end of the recent bond rally”. Interest rates are very low, have been declining for many years. At some point they are going to start going the other way and that spells doom for bond holders. Here’s a chart I happen to have that seems to support this idea.


So with increasing odds that the stock market will soon hit a wall, and with this expression by someone I respect saying the current bond market rally could end, what are we supposed to do? I have some thoughts, but we’re looking at some deep water in front of us. If you have concerns, you should get in touch with me.

January 16, 2015  Commentary by Scott Minerd, Guggenheim Partners

One year ago, a 10-year U.S. Treasury bond yielded around 3 percent, up from around 2.50 just months earlier. At the time, the market fretted that rates would continue to rise; our view was the opposite. Today’s market is a different beast, however. With rates now around 1.8 percent—the lowest level since May 2013—we see Treasuries as overvalued and the recent rally getting long in the tooth.

At current levels of overvaluation, the only factors holding interest rates down are the expectation of declining inflation as a result of the oil shock and the prospect of quantitative easing in Europe. This means we may be facing the old Wall Street adage of “buy the rumor, sell the news” when it comes to Treasury prices. Once the one-time effect of declining oil prices has passed, inflation is likely to return to the underlying trend, which is higher than today. This, combined with a European Central Bank announcement of quantitative easing, could mark the end of the recent spike down in interest rates.

Even at a paltry 1.81 percent, U.S. 10-year Treasuries easily compete with Germany’s 0.41 percent bund yield today. While there is some prospect that QE in Europe will be announced at the ECB’s meeting in March, any announcement, especially if done in January, is likely to limit QE to a size smaller than what will be ultimately necessary. But if the ECB is able to implement a QE program of sufficient scale, the monetary elixir should cure fears of economic contraction, causing rates in Europe to rise. Likewise, while the oil supply shock has created a spike in Treasury prices, it is transient. When we emerge from this oil tantrum, we are likely to experience a fairly vicious snapback up in rates.

A key indicator that rates in the U.S. are nearing an unsustainable degree of overvaluation is the divergence of real 10-year Treasury yields, currently 0.40 percent, from the University of Michigan Consumer Sentiment Index, which shot up to 98.2 in the latest reading, an 11-year high. Real 10-year yields usually rise as the economy, and hence consumer confidence, improves.

We are currently witnessing the widest divergence between real rates and consumer confidence since May 2012 (see Chart of the Week). Then, as today, real yields headed south while consumer confidence shot upward. Subsequently, from July 2012 to December 2013, the nominal 10-year yield rose by 153 basis points, which closed the divergence. The current surge in consumer confidence suggests that the real yield should be somewhere around 3 percent (rather than its current reading of 0.40 percent). This large of a divergence is something to watch, as it is not sustainable.

While the near-term risk remains that interest rates in the U.S. may head even lower—we could easily get some piece of news that pushes the yield down to 1.6 percent—I believe this recent flight to ultra-low rates will draw to a close by the end of the second or third quarter. The bottom line is that we are closer to the end of this rally than its beginning.

As for the equity markets, the near-term outlook for major advanced economy stocks is positive, despite recent volatility. In addition to a brightening economic outlook due to falling energy prices and lower mortgage rates (which has led to a surge in new purchase applications), the expected announcement of quantitative easing by the ECB should help to push stocks higher over the next few months. Recent QE programs in the U.S., Japan, and the U.K. saw local stock markets rally in the months after they were announced, which is a near-term positive for equities, and Europe in particular.

The Stock Market Is Overvalued, No Matter How You Measure It

My Comments: Some of you will think I’m an alarmist. And perhaps I am. But the signals that have been present for some 18 months are getting louder, much louder.

I’ve not included all the charts that appeared with this article as there are too many of them and they are all negative. Here’s a link to the article itself: http://goo.gl/tIiQgQ  You should know I don’t have the talent to do this on my own.

Perhaps I’ll find some good news to share with all of you later this week. I hope so, because it’s on us to be prepared and avoid the inevitable mess.

• The US stock market remains overvalued relative to the broader economy.
• We have reached the limits of monetary policy, and it is now time for fiscal policy makers to act.
• Over indebtedness continues to be the problem and de-leveraging the solution.

“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.” – Charles Mackay, Author, Extraordinary Popular Delusions and the Madness of Crowds

I believe investors would be wise to exert caution at this time in the economic cycle. We have seen the (NYSEARCA:SPY) market rally some 187.74% from the 2009 lows, and market levels are now overvalued by virtually every metric. In my previous piece “5 Themes for 2015″, I articulated the likelihood that indexers will be outperformed by stock pickers this year. This is because I believe the market is extremely overvalued on the whole, and investors need to be selective about what they own. There are parts of the market that remain undervalued as I have previously highlighted. But on the whole, stock indexes are overvalued when viewed using many different measurement methods as seen in the chart above:

Yes…This Is a Stock Market Bubble
Any who contends that we are not in the midst of a stock market bubble is ignoring the truth of the economic and historical financial data we have available. Many believe that the market can continue to push higher, and indeed we may see additional advancement in equity indexes, on account of capital coming in from overseas and investors continuing to search for yield in a low yield world. Ultimately, I believe this will only make the ending of this market cycle that much more severe.

I continue to believe that the macro-economic situation points investors to the Long-Term Zero Coupon U.S. Treasury market as a stable port in the deflationary storm. The marginal gains that may be had from any potential upside in equity markets pale in comparison to the enormous draw down that I believe will eventually occur.

It’s Different This Time
Investors continue to articulate the old adage “It’s different this time.” They are right, in the sense that we are in unknown waters with the Federal Reserve’s extraordinary monetary policy, but the lessons of financial history have a way of repeating themselves, and reminding us it is not, in fact, different this time.

The Federal Reserve has expanded the balance sheet to over $4 trillion, and yet we continue to see lack luster velocity and inflation below the Fed’s target rate, illustrating the strength of deflationary forces. The US is in danger of entering into a Japanese-style deflationary trap where there is no escape from QE, and higher GDP growth rates continue to elude us, necessitating more QE. This cycle in danger of continuing for some time, until we realize that debt is the problem and deleveraging is the only solution, painful as it may be.

Future stock market returns will likely be in the low single digits as a result of this QE influenced market rally, which we can see in the P/E 10 at 26.52. The Fed’s extraordinary monetary policy has proven disastrous to savers, and has created a stock market built primarily on financial engineering and excess liquidity in the banking system, demonstrating that economic policy and investment policy are not always aligned.

I believe that caution is warranted, as it is completely plausible to see a significant downward move in the market at a magnitude larger than any one sees coming. Most down trends come with little warning, and investors are left asking “What happened?” Current equity market valuations are not supported by the economic data. The US has only 2.5% GDP growth in the first three quarters of 2014, there is subdued wage growth, and bubbles in lending fueling consumer spending, and excess leverage, fueling stock speculation. With equity markets at all time highs and Main Street continuing to suffer, the bond market continues to predict the coming storm.

With No Wage Growth, Debt Takes the Place of Income
The United States economy has not shown a change in the real median household income for nearly twenty years.

The economy continues to show a lack of true wage growth. Feeling the lack of income growth, consumers are resorting to adding additional debt to their balance sheets, reversing a healthy period of deleveraging after the financial crisis. Consumption today, financed by debt, means lower consumption in the future. Positive economic growth cannot be fueled by mounting debt burdens.

Globally, debt levels have reached unsustainable levels in both the public and private spheres. In a previous piece, I talked about the deleterious role over indebtedness can play in stifling economic growth. Moving forward, I see these trends playing out over a long time horizon that will likely leave the Fed on hold in raising rates, and will see the long-term US treasury yields continue to ratchet lower. Velocity continues to remain weak, as do wages, the PCE, and other measures of economic health. Perceived strength in the employment situation is really driven by decreases in the labor force participation rate. The economy is hardly healthy, despite the continued rise in equity prices to lofty levels.

The put created by excessive QE has driven margin debt to an all time high and created the same environment that was the catalyst for the financial crisis, over indebtedness.

The solutions to the challenges we face are not easy, and the responsibility does not rest solely with the Federal Reserve. I believe we have reached the limits of what can be achieved through monetary policy. The toxic effects of over indebtedness continue to plague real GDP growth, thus it is now time for fiscal policy makers to work together for the good of the country, and to put the nation on sound financial ground.

Given this reality and the case I made here, I continue to hold a portfolio predominantly composed of the US Dollar, (NYSEARCA:ZROZ) 30-Year Zero Coupon US Treasury Bonds and Swaps, and a focused group of select, undervalued equity securities. I believe this portfolio strategy can continue to outperform benchmarks in this slow-growth world that will characterize the global economy for some time.

Supply Shock and Awe

oil productionMy Comments: The driving economic story these days is about the price of oil. That the sudden and dramatic drop will have global repercussions is a given. The challenge for financial planners is how to help clients take advantage of these repercussions.

Right now, having a few hundred extra bucks to spend on something else or to save is very satisfying. But it will come to an end and the landscape will have changed. This has happened before and when it did, some people profited and others lost money. What will be your fate?

Commentary by Scott Minerd, Chairman of Investments and Global Chief Investment Officer, Guggenheim Partners – January 17, 2015

If the mid-80s’ supply-driven oil crisis is a guide, we should expect further declines and a prolonged period where oil prices remain depressed.

In just one week, oil prices skidded by more than 10 percent, sparking a sell-off in U.S. equities of 3.5 percent, a Treasury rally of more than 20 basis points, and global headlines of growth fears and tumult. Surprisingly, I’m not talking about this week. The week I’m referring to was in early December, and it is rather similar to the present oil price action and market response.

During the week of Dec. 8, oil fell 12.2 percent to around $58 a barrel, the yield on U.S. 10-year Treasuries approached 2 percent from around 2.30 percent, and equities declined over 3.5 percent. At that time, I published a commentary establishing a downside target for oil at $50 a barrel and said that the yield on the U.S. 10-year note would slip further to around 1.9 percent. Many of those predictions seemed pretty extreme at the time, but here we stand. At the time of writing, oil is around $48 per barrel, and the yield on U.S. 10-year Treasuries is 1.96 percent.

Technically speaking, after breaking through the support level of $50 a barrel, the measured move for oil is now $34 a barrel (based on the minimum downside potential price according to the rules used by market technicians). I believe we are in for a prolonged period where oil trades in the $40 to $50 range and possibly lower. In fact, I have the investment teams running stress tests based on oil trading at $25 a barrel for an extended period of time.

Twenty-five dollars a barrel? Isn’t that a bit extreme? I would guess, but so were our stress tests in 2008, which assumed short-term rates could go to zero for an extended period of time. The current bear market for oil is the result of a supply shock brought on by fracking. Based on the unwillingness of global oil producers to reduce production, the current supply shock will take a while to work its way through the system, and oil prices have yet to find a bottom. Better to evaluate the downside scenarios now than to be unprepared.

The difference between this bear market in black gold and the bear market of 2008 or the 1998 experience, which was associated with the Asian crisis, is that both of those were demand shocks. The best historical comparison to what we’re witnessing today in oil prices is actually the supply-shocked world of the mid-1980s.

The 1985-86 bear market in oil was the result of oversupply—too much oil was brought online relative to demand. During that period, prices declined more than 67 percent over four months or so. When oil prices started to rise again in April 1986, credit spreads started to tighten a few months later and within 12 months, the stock market was up over 20 percent. If history is any guide—and in this instance, I believe it may be—we are likely to see a similar situation play out today.

But investors beware in the near-term. Even at $48 per barrel, oil is still a falling knife—I believe there remains another significant downside move. If we hit the $34 a barrel price target, which I believe we could, that would be another 30 percent decline in oil prices. Typically, people would rightly characterize a 30 percent decline as a bear market. We’ve already had a decline of over 55 percent from the high, so we’ve already been in a bear market, but if we started over today we’re going to have another one.

With the development of fracking, we’ve had a huge increase in the supply of oil. By most estimates, fracking ceases to be profitable when oil prices hit somewhere in the neighborhood of $40 a barrel. Once the frackers stop drilling new wells, the following 24 months should see oil output gradually declining, allowing for prices to stabilize and ultimately rising to something viewed as normal above $60. Until supply begins to contract, oil will continue to languish. Between now and then, anything energy output-related should continue to suffer from weak oil prices.

Over the past 30 years, there have been six major declines in the price of oil (defined as a greater than 50 percent cumulative decline). The current decline now stands at around 55 percent, matching the magnitude of some of the worst historical oil crashes. However, most of the past declines have been due to faltering global demand, whereas the current slump is due to a glut of oil. Therefore, the best comparable decline is that of 1985-86, when a supply shock caused the West Texas Intermediate price to plunge by more than 67 percent over the course of four and a half months. With no near-term signs of supply letting up, oil prices could continue to fall.

Economic Data Releases

US economyMy Comments: These data points come from Guggenheim Partners. For some of you this is meaningless nonsense; for others, a quick review is intented to give you a glimpse of what is happening in the world, including the US.

To put some of this in perspective, I saw an article this weekend that compared the results of the DOW Industrial Average, from its theoretical inception in 1817, to now. When Obama became president in 2008, it was roughly 9,000. By the end of this past December, it was roughtly 18,000. The point was it took 190 years to get halfway to where it is now the other half happened since Obama was elected.

My point of this is no President is entitled to the credit for this nor is he entitled to the blame. It generally happens regardless of who is in the White House. However, I urge you to remember that market declines can happen and do happen regardeless of who is in the White House, and happen even when the economy is relatively strong. We are due for a correction.

Continued Strength in Payrolls but Wage Growth Falters
• Non-farm payrolls increased by 252,000 in December after an upwardly revised 353,000 in November.
• The unemployment rate fell by 0.2 percentage points in December to 5.6 percent, in part due to a lower labor force participation rate.
• Average hourly earnings slowed to 1.7 percent year-over-year growth in December, the slowest 12-month rate since October 2012.
• The ISM manufacturing index was weaker than expected in the December reading, falling to 55.5 from 58.7, a six-month low.
• The ISM non-manufacturing index missed expectations in December, falling to a six-month low of 56.2.
• Factory orders dropped in November, down 0.7 percent. Orders have now fallen for four straight months, the first such streak since 2012.
• The S&P/Case-Shiller 20-City Home Price Index showed continued slowing home price growth in October, with the year-over-year reading declining to 4.50 percent from 4.82 percent.
• Pending home sales rose 0.5 percent in November, slightly better than expectations.
• Construction spending fell in November for the first time since June, down 0.3 percent. Public construction spending led the drop.
• The Conference Board’s consumer confidence index ticked up in December, rising to 92.6 from an upwardly revised 91.0. The present situation index experienced a large gain, but expectations fell.
• The trade deficit narrowed in November, contracting to -$39.0 billion, a nearly one-year low.

Euro Zone Enters Deflation

• The euro zone Consumer Price Index fell into deflation in December at -0.2 percent year over year, lower than forecasts had expected. The core CPI inched up to 0.8 percent.
• The euro zone manufacturing Purchasing Managers Index was revised lower in the final December estimate, but still recorded an increase from the prior month at 50.6.
• Euro zone retail sales beat expectations in November, up 0.6 percent for a second consecutive month.
• Germany’s December CPI dropped more than expected on a year-over-year basis, falling to a five-year low of 0.1 percent.
• German industrial production unexpectedly declined in November, down 0.1 percent.
• German exports decreased for a second consecutive month in November, falling 2.1 percent.
• Industrial production in France was down 0.3 percent in November. Production has not risen since July.
• The U.K. manufacturing PMI unexpectedly fell in December, down to 52.5 from 53.3.
• The U.K. services PMI dropped much more than expected in December, falling to a 19-month low of 55.8.
• China’s official manufacturing PMI fell for a third straight month in December, reaching an 18-month low of 50.1.
• China’s non-manufacturing PMI ticked up in December, increasing to a four-month high of 54.1.
• China’s HSBC services PMI ticked up for a second consecutive month in December, reaching a three-month high of 53.4.
• The Chinese Producer Price Index dropped more than expected in December, falling to 3.3 percent year over year.
• Chinese consumer prices inched up in December to 1.5 percent year over year.

Current Oil Price Decline May Set Stage For Price Spike And Global Recession

oil supply+demandMy Comments: There are relatively high taxes on the sale of gasoline at the pump where I live. In spite of this, we are almost at the $2.00 per gallon level. As I’ve mentioned before, this is both a good thing and a potentially bad thing.

The bad is that money invested to bring us domestically produced fuel and money invested to develop fuel efficient cars and trucks will be diverted and will appear somewhere else. Long term that is not a good thing for us. The world is evolving, as it has forever, and anomalies like what we are now seeing will have consequences.

Zoltan Ban / Dec. 30, 2014

• Current oil price decline is likely to lead to significant investment cutback, which will affect supply for many years to come.
• When the price of oil starts to recover, it will very probably spike, as there will be no supply mechanism able to react fast enough.
• A price spike will only be broken by a recession. It could be the beginning of a period of repeating such cycles.

For a few months now, there has been a very spirited debate in regards to the net effect lower oil prices will have on the economy. There are some who point to lower prices potentially bankrupting a large number of oil & gas companies, especially those that are mainly reliant on high-cost unconventional resources, such as shale oil, therefore it is bad for the economy. Others point to consumer demand being stimulated by the lower price of oil, which effectively acts as a tax cut for most households.

My take on the entire argument is that it is not as relevant as the fierce debate surrounding it might suggest. The effect on the economy might be a slight positive and the longer the lower price lasts, the stronger the effect. But there is no denying the fact that there are many oil extraction projects around the world that are not profitable at current price levels, therefore it is only a matter of time before the current price decline will lead to a drop in global production. Furthermore, even countries where the oil industry is mainly dominated by state-owned enterprises and production costs may be lower than the current price level, there will be a significant cutback in capital spending, because many of these governments are very dependent on oil revenues for their budgets. It makes perfect sense for a country like Russia for instance to cut investments in new projects until prices recover, in order to free up revenue for other government needs.

The effect of some investment cuts will be more immediate as may be the case with oil sands and shale oil. In the case of other expensive projects such as deep-water, the effects may only be felt many years from now. We have no way of knowing yet how deep the cut in production potential will be over the next few years, in part because we don’t know yet how much capital will be cut next year. Goldman Sachs projects that there may be a need for as much as a 30% cut in non-government owned projects around the world in order for the industry to avoid collectively taking a loss. ConocoPhillips (NYSE:COP) announced it will cut spending by 20% next year and it should not come as a huge surprise if it will cut even more as the year progresses (link). Many companies involved in shale drilling already announced they will cut their drilling activities next year. The announcements of plans for lower oil & gas investment are now coming in at a fast pace.

We have to realize that it will in fact not take much of a cut in the rate of growth in global oil production in order to close the relatively small glut in oil supply. The gap between supply and demand will be only about 400,000 b/d in 2014. It would have increased to about a million barrels per day by next year, if the supply/demand forecasts for 2015 would have turned out to be more or less accurate.

Thing is however that many projects take years from beginning till completion, so the effect may be felt only a few years from now. There will also be a slowdown in global production growth, especially in North America, where much of the global increase in production comes from since 2008, which will have a more immediate effect. Oil sands and shale oil projects do not have such a long lead time. If there is to be a reduction in supply in order to bring the market back into balance, it will most likely start with a decline in North American production growth, or even a decline in production.

As we can see from the chart, the US and Canada provided all the growth in oil production that the world needed since 2008. If the current low oil price will persist, it is probable that the shale oil industry in particular may suffer significant and probably permanent damage. The industry is vulnerable in large part because to date there has been very little self-sustaining growth in the industry. In other words, revenue re-investment is not sufficient by itself to push production volumes up. The main ingredient in the shale revolution has been the availability of credit. One of the main outcomes of the shale revolution has been the accumulation of about $170 billion in junk debt by many companies which are rated below investment grade (link). If the market will cut the industry off from continuing to accumulate debt, production will eventually stagnate and possibly decline as companies will have no choice but to cut back on drilling.

The production decline should help to stabilize the price of oil and eventually work towards the old plateau established starting from 2010, as long as there will be no global economic slowdown. The main problem I see is that when the price of oil will start to move back up, in response to a tighter supply/demand situation, there will be no mechanism in place to prevent the price of oil from overshooting. In other words, it will not stop at the tolerable $100 level we learned to live within the past few years, but continue climbing until demand destruction will occur. That means we are most likely looking at a global economic slowdown.

The reason I believe that the price will overshoot, is because just as there has been very little to keep the price of oil from falling in 2014 as for the first time in years there is a significant level of over-supply, there will also be little to keep the price from spiking as prices will rise too fast for new supply to catch up. The cuts in investment we are seeing right now will affect supplies for the next five years and even beyond. The extra spending companies will engage in once prices recover may in fact provide extra supply only once it will be too late. The recession inducing price spike could happen within a period of just a few months once the upward trend is established, while new supply may take many years to come online in response to the higher prices. In fact, the new supplies may come online only once the price of oil crashes again as a new recession takes a bite out of demand.

Future nostalgia for $100 oil plateau.
At an average price of about $100/barrel in the 2010-14 period, it was not a pleasant situation by any means. That price range was much higher than historical trends and it took out a bite out of potential global economic growth, given an economy that was built around much cheaper oil in past decades. Now that the price of oil is at a level that is more in sync with the economic needs, most of us feel much better about things overall. Pimco recently upped its estimate for global economic growth, citing lower oil prices, which will stimulate more consumption of all goods.

Needless to say that even though the economy feels better with the current oil price levels, many of the oil companies involved in producing the oil are not feeling all that great right now. That is especially the case with shale oil producers. What is worse, their financiers are not feeling all that great about them either and probably will be more cautious of them even when the price of oil will increase. As I pointed out in a previous article, there can be no shale oil production growth without the backing of lenders, because the industry cannot sustain itself from production revenue, which was the case even when the price of oil was in the $100 range (link). This is a very important fact to keep in mind, because resources such as shale oil and Canadian oil sands are the resources which could be the fastest responders to the price signal sent once oil prices start rising again.

With the response to the price increase much delayed and insufficient, there will be nothing else to stop the price from rising, except demand destruction and as we well know, demand destruction of oil means a recession, because oil is a very inelastic product. A recession will in turn cause prices to go back down again, which means that oil producers will have no choice but to cut back on investment once again, just as they are increasingly doing now. It is possible that we will be caught up in a long period of repeated cycles of oil price spikes and plunges, with the price failing to stabilize as it did after the 2009 price drop. The resulting effect on the global economy can potentially be devastating.

There is only one potential factor which could help prevent such a situation and that is OPEC action. All indications are however that OPEC is no longer in the business of oil price stability. I will not speculate on the possible reasons why Saudi Arabia seems to be unwilling to stabilize the global oil market, because there has already been plenty of speculation in that regard already. We can only go on what we actually know right now, and what we do know is that OPEC is currently dysfunctional. As I pointed out many times in the past year and a half or so, the current WTI price range that is sustainable more or less from both the consumer and producer perspective seems to be $80-120, with the price ideally spending most of the time in the middle of that range. We are now obviously very far outside that range, and when prices will recover, there is a very good chance that the price will overshoot the ideal range. If we will be unable to once again stabilize within the range I suggested, we will be looking at a period of great economic upheaval for many years.