Tuesday, September 27, 2005
On August 18, prior to the Hurricanes Katrina and Rita, we took a look at the prospects for the stock market in the year ahead via our Barnyard Forecast. The forecast is a big picture analysis of the position of the major components of the economy and how they resolve themselves on-balance. You may want to review the previous post for a more expansive explanation of how we view each component. Economy: In the Barnyard model, economic growth above 3.5% is considered negative because its means the Federal Reserve will be applying the brakes by raising interest rates. Prior to the hurricanes, GDP had been growing at about 3.6%, which we ranked as neutral for stocks. The hurricanes are now expected to chop near 2% off GDP growth over the remainder of this year. That would seem to imply that the Fed's long string of rate hikes is nearing an end, which would be good for stocks. The only problem with this view is that the rebuilding of the Gulf Coast area will provide a huge stimulus to the economy and probably push economic growth in the early part of 2006 back above the caution level of 3.5%. I still rate the economy neutral for stocks, 1 point. Inflation: This is the wild card in the deck. The stop and go nature of the economy for the coming year assures volatile readings. I believe the core CPI will average near the caution level of 2.5%. This will be neutral for stocks, 1 point. Earnings: There will also be a stop and go quality to corporate earnings during the next twelve months. With business currently slowed or stopped in the Gulf Coast region, in the near term, earnings will be lower than expected; but the uptick in the rebuilding process will also lift earnings growth next year above 7%, which is the threshold required to achieve a positive score. Positive 2 points. Interest Rates: I still rate interest rates neutral. The 10-year T-bond is currently yielding 4.25%. That is about the same as it was at the beginning of the year, as well as a year ago. Interest rates could drift a little higher in the early part of 2006, but I do not see long-term bond yields or mortgage rates being much higher a year from now. Neutral 1 point. Opportunity: The model scores 5 points (1+1+2+1), which is the same as it did on August 18, before the hurricanes. It may be hard to believe, but the hurricanes have done little to the longer-term outlook for growth of the economy or corporate earnings. Certainly, there will be some rearranging, with a slowing followed by a return to stronger growth, but the net effect is a reading that is about the same as a month ago. I do believe, however, that the Fed will stop raising rates in 2006, and as it becomes clear that they will do so, stocks will likely have a strong advance. Stocks are very cheap now. Earnings are up nearly 13% over a year ago, yet prices are down. This divergence cannot hold, and I believe it will be resolved by stocks moving higher.
Wednesday, September 21, 2005
With the recent devastation of Hurricane Katrina and another storm on the way, there were many who believed that the Federal Reserve may interrupt there long string of rate increases, in favor of a wait and see attitude. Thus, the stock market has registered its displeasure with the Fed’s announcement of another .25% hike by selling off nearly 150 points. But we believe the stock market has it wrong because a close reading of the news release that accompanied the rate hike contains some good news about the long-term strength of the US economy. Before we analyze the Fed’s statement, it is important to remember that the Federal Reserve’s responsibility is to set interest rates consistent with maximizing economic growth and minimizing inflation in the long-term. The operative word here is long-term. The Fed’s accompanying statement stated the following regarding the impact of Hurricane Katrina: “While these unfortunate developments have increased uncertainty about near-term economic performance, it is the Committee's view that they do not pose a more persistent threat. Rather, monetary policy accommodation, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity.” We believe their statement is very straight forward and very good news. The Fed is the most sophisticated economic data gathering entity in the world. They have looked at this data and other instances of natural disasters, and they have concluded that in the short-term the hurricane’s damage to the overall economy will be readily contained, and the long-term prospects for the economy are still very good. The Fed is making its decision to hike rates based on its long-term view of things, not the current news of the day. In our judgment, it is this focus on the long-term that has allowed Alan Greenspan and Company to navigate through countless crises during his 18 year reign as Chairman of the Federal Reserve. There are many politicians and media-types, who are lambasting the Fed’s rate hike as being insensitive to the plight of the suffering. To the contrary, if the Fed believes there are untamed inflationary pressures building, they would be just one more body of governmental body shirking their responsibilities if they took a pass. The stock market and some politicians may not approve of the hike, but we are actually encouraged with the language of the press release and relieved that the Fed believes, as we do, that Katrina will not take the wind out of the US economy in the long run.
Labels: The Fed
Thursday, September 15, 2005
The Wall Street Journal reported that US gasoline consumption has fallen by 4.3% since Hurricane Katrina hit the Gulf Coast. The Journal went on to explain that few analysts are ready to project a continuation of this trend, but as I said last time, I am. I think the uncertainty of the oil supply is finally reaching the consciousness of Americans, and I believe they will embark on a mini conservation program that will result in a slowing of per capital energy consumption. For years we have been warned repeatedly that our mobile lifestyle was being made possible by such "rock solid" bastions of democracy as Indonesia, Russia, Iran, Saudi Arabia, Venezuela, and Nigeria. But since there have been few alternatives and oil has remained available and cheap, we have looked the other way. But, oddly enough, Hurricane Katrina has done what OPEC and terrorism could not do: it has shown us how fragile our supply of oil really is. One big storm knocked out 50% of the refining capacity of this country. Emergency oil supplies have been released and gasoline prices have fallen from near $3.40 gal. (Indiana) on the day of the storm to $2.90 gal. today, but I do not believe prices are destined to go significantly lower in the coming year. Indeed, gasoline prices now have three tail winds pushing them: A terrorism premium, a storm or natural disaster premium, and an emergency supply premium. The first two premia are obvious, but the third needs some explanation. If you are a major US organization with large energy needs, whether you are a government or commercial enterprise, you must now consider the merits of having an emergency fuel supply as a backup for your needs. This kind of emergency fuel storage build up occurred during the last energy crisis in the late 1970s in very large numbers, as governments, businesses, and individuals installed storage tanks to buy ahead of the perceived inevitable price increases in oil prices, but also to provide an emergency supply of energy. I believe, at some level, this better-safe-than-sorry type of hoarding will happen again. Indeed, the probability of this kind of hoarding would increase dramatically if gasoline prices were to rise above the recent hurricane-induced price spike of $70. The same motive forces that will compel institutions to add emergency energy storage capacity will also compel consumers to go on something of a energy diet. But more importantly, it will cause a dramatic increase in demand for for fuel efficient automobiles, appliances, and houses. This conservation and efficiency ramp up will not wait on solid cost-benefit solutions, but will spring first from a sense of buying "insurance," and then, as innovations become abundant, will evolve into a kind of Y2K stampede toward smart cars, houses, and cities. Again, the first step will be conservation, but the next step will be a huge increase in demand for high-mileage cars, especially, hybrid cars and diesels. With home prices in a persistent uptrend in most areas of the US and low unemployment, the average family in this country feels pretty well off right now, and buying a high-mileage hybrid car or a diesel powered car in response to the heightened awareness of the fragility of our energy supply, will trump the normal cost-benefit analysis. Americans have been awestruck by the devastation and human toll of Hurricane Katrina. But the subliminal message in every heart-rending picture from the storm's aftermath is that those who were able to take care of themselves fared much better than those who waited on the government. I am not slamming the government here. There are enough people doing that. I am just stating that we are a nation of doers. Most of us are in this country because we or someone among our forbearers decided to move on. We are a freedom loving people, and one of our most prized possessions is our lifestyle. Most of us are not willing to move back into the city and use public transportation. Someday smarter cities with a more people friendly attitude may pull that off, but until that happens, we will move heaven and earth to fight for our way of life. I believe that the cumulative effects of terrorism, unstable or hostile governments in control of the oil supply, and the shocking events of a natural disaster, will stick in the crawl of most people, and little by little, they will take steps to use less energy. It is not something that you will see start tomorrow morning, or next week, or next month. It may not show up in the economic statistics for a long time, but I am convinced a new attitude about energy consumption is underway. It will change the profitability of a lot of industries. We are already making some changes in your portfolios that we believe will take advantage of the new forces at work. When we are finished, I will discuss some of our views on individual companies in more detail. Next time, I'll take you through an update of the Barnyard Forecast. Not to fear, the forecast for the economy and stock prices is still good.
Saturday, September 03, 2005
There has been an odd dichotomy is the energy markets for the last couple of years. By all accounts, the available supply of crude oil has been consistently in excess of the demand, but the demand for gasoline has been nearly 100% of the supply. At first this seems to be a circular statement that makes no sense. That is until you realize that crude oil and gasoline are not the same commodity. The difference, of course, is that gasoline is refined. In essence, there has not so much been an oil shortage, as a refining shortage. Refineries are big and smelly and not welcomed in many areas of the country. The last refinery to be built in the US was the Garyville, Louisiana facility, which started up 29 years ago in the 1976. It was one of the eight refineries shut down by Hurricane Katrina, but reports say that it and three others will be back in operation by Monday. The huge Chevron refinery, which suffered a lot of damage, is said to be nearer to coming back on line than was originally thought. The release of oil from the Strategic Petroleum Reserve by the President was crucial in bringing some measure of stability to the oil markets. This is because many of he oil production platforms in the Gulf are adrift or damaged and may be months away from operation. Thus the crude released by the President gives vital feedstock to the refineries, which the experts say have been damaged but are mainly awaiting power to come back online. In addition, the International Energy Association is releasing 2 million barrels of crude oil per day to the US. These two sources of crude oil pushed crude oil prices down by nearly $2 on Friday to approximately $67.50. I am not as worried about the energy situation in the short run as are many analysts. My reason for modest optimism is something called the elasticity of demand. This is a very basic concept in economics that says as prices rise, demand slows. Many of the commentators that you hear spouting about oil prices going through the roof believe that oil consumption is inelastic. That is, oil consumption is not responsive to price. History would appear to be on their side because oil consumption has, indeed, risen over the years, even in the face of rising prices. Where I differ from these commentators is that it has been my observation that things change during crises. Crises make people stop and think. You might say tough times make people count the costs. With gasoline prices at $3.40 per gallon and the horrors of Katrina fresh in our minds, in my judgment, prices will bite and oil consumption will begin to moderate. I want to keep reminding you of what happened the last time we had an oil crisis that actually reached the consciousness of the American people. That was in 1979 during the Iranian revolution. The Shah of Iran had fled the country and the radical Islamic Ayatollah Khomeini and his followers seized power. They may have known something about revolution, but they knew nothing about oil production, and Iranian oil production collapsed, causing oil prices to skyrocket world wide. Because American's saw prices explode and realized supplies were likely to be uncertain for a long time, they began a conservation and substitution campaign that was utterly remarkable. In 1979 the US imported 32 million barrels/day of oil from OPEC. Three years later that figure had fallen to 19 million barrels/day. I don't foresee a pullback in consumption of that level, but I believe Americans will begin to become more conscious of their gasoline consumption and in doing so their consumption will slow. This sounds like a bold statement without much to back it up, but I have observed time and again that when events appear to be spiraling out of control, people will almost always insert their own attempt to control events. There is only one thing they can do: cut back on consumption, and I think that is what they will do. I still believe the economy will dip between now and the beginning of the year, but I completely disagree with those people who are calling for a recession. In my mind, that would be almost an impossibility. Prior to Katrina, most estimates had GDP growth above 4% for the third and fourth quarters. I do not believe it is possible to shut down an $11 trillion economy so fast as to push us into recession. I expect the economy will be accelerating by the early part of 2006. The rebuilding of the Delta region will be a massive stimulus to the economy for the foreseeable future. I admit that my view of the unfolding events is optimistic. I think you also know that my attitude is that most people overestimate the negative effects of natural disasters. My experience tells me as bad as things may seem, repairs will be made, the lights will come on, the water will leave New Orleans and a rebuilding process will begin. The only obstacle I can see that would slow the coming economic stimulus is if a debate breaks out about the wisdom of rebuilding a city that lies below sea level. I am hearing some rumblings of this. If it becomes widespread, the rebuilding may be delayed until next spring. If that were to happen, the economy will slow after the first of the year. I'll have more comments in the days ahead.