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The Power Failure on Wall Street

by: Tim Price May 23, 2008    

Tim Price

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“Doubt is not a pleasant condition, but certainty is absurd.” – Voltaire.

Have there ever been bigger dislocations between the behaviour of financial markets and the likely fortunes of western economies? Has the reputation of Wall Street and the City ever stood at a deeper discount to the actualité? Does current market behaviour really tell us anything about the market’s longer term prospects?

There used to be a quotation above my father’s desk; it may still be there:

Finding the right answers is easy. It’s asking the right questions that’s difficult.

(This is only a variation on a theme: “Judge of a man by his questions rather than by his answers” (Voltaire); “Good questions outrank easy answers” (Paul Samuelson).) I used to find this quote trite but the longer I spend in the markets, the more pertinent it becomes. This itself is a little like a particular Mark Twain quote: “When I was a boy of fourteen, my father was so ignorant I could hardly stand to have the old man around. But when I got to be twenty-one, I was astonished by how much he’d learned.”

One of the innumerable problems with Wall Street and the City is that they never do seem to learn from their mistakes. Property market bubbles; whichever hedge fund John Meriwether is associated with this week; the venality of quasi-monopolistic agencies associated with credit, housing or debt ratings... Each generation seems obligated to re-experience the errors of its predecessors. There is little or no ‘race memory’ that might at least mean that this year’s crisis is brand new rather than a tired retread of past embarrassments.

And while Wall Street typically shies away from overly intrusive questions, it certainly seems to have all the answers. Where is the oil price headed? $141 a barrel during the second half of 2008, according to Arjun Murti of Goldman Sachs. (Could Goldman Sachs possibly have any material interest in oil trading?) Because Mr. Murti was also behind a prediction for higher oil prices in 2005, his apparent ability to foresee the future has led to his universal resource market canonization in the financial press.

Actually, the target is $150, says T. Boone Pickens, another presumably disinterested oil trader. The last time we saw this kind of easy momentum-chasing and price target leapfrogging was during the dotcom boom (Amazon.com (AMZN) – essentially impossible to value during its early hyper-growth phase, so easily justifying Henry Blodget’s $400 share price target even when it was already overpriced when trading at $242), and it did not end well. As the analysts at McCall, Aitken, McKenzie have suggested, welcome to “dot.oil.”

The difficulty with commodities prices, as Bloomberg’s Caroline Baum recently pointed out, is that unlike more traditional financial instruments such as stocks or bonds, there is no fundamental yardstick of value:

...metrics that allow us to quantify the degree to which prices have strayed from their fundamental moorings. Stock prices have an historical relationship with underlying earnings. House prices don’t stray too far from their “earnings” stream, or rental value... With commodities, no such quantifiable ratio exists.

So in assessing the valuation of commodities and natural resource prices, we are all left orienteering in the fog. Patrick Perret-Green of Citigroup has at least tried to square this circle using behavioural finance techniques. In his occasional ‘Chart of Shame’ he archly compares markets that have experienced classic booms and busts with contenders for the Emperor’s new clothes.

Back in January he cheekily overlaid a chart of the Nikkei (grotesque peak in 1989), Nasdaq (grotesque peak in 2000), the Saudi Tadawul All Share Index (grotesque peak in 2006) and the Shanghai Composite (grotesque-looking peak in, erm, late 2007). Chinese stocks have obediently collapsed since then. One swallow, of course, doesn’t make a Murti. Last week, Patrick somewhat ominously updated the ‘Chart of Shame’ but with the FTSE 350 Mining Index as the ‘bubble’ candidate.

As anyone who holds mining stocks will confirm, the sector dutifully collapsed, albeit in the short run. One can argue, as always, that “this time it’s different,” and that mining stocks trading on “just” approaching 20x p/e ratios and 1% dividend yields are hugely better value than internet stocks were in 2000 with p/e ratios approaching the infinite and no dividend yields. But, the charts have a fairly compelling power, and anyone sitting on gains of the order of 200-300% or more is wholly justified in a spot of profit-taking.

What makes markets so intriguing today is that equities seem largely immune to a combination of $120+ oil, softening housing markets and a likely collapse in western consumer spending. Arguing that several trillion dollars currently either sheltering in money market funds or rapidly accumulating thanks to petrodollar wealth in sovereign wealth funds will ride in to support stock markets (a.k.a. greater fool theory) only logically goes so far in the face of such sizeable challenges. But some confusing short-term resilience on the part of stock markets does not invalidate the need for caution, it rather reinforces the need for patience.

On a separate note, James Ferguson of Pali asks whether it might be time to commit heresy and talk, not of $200 oil (or $1000 oil, has anyone on Wall Street tried that yet ?), but merely $100 oil? “The last three times, in the 7-year bull run that West Texas Intermediate (crude) has enjoyed, that the oil price got more than two standard deviations above trend, it precipitated an almost immediate profit-taking that resulted in an average -28% drop.”

Wall Street’s venal salesmanship and management of subprime goes some way to underpinning its credibility in other markets, so its bandwagon-chasing on oil can be largely discounted on fundamental trustworthiness. The bigger question is how long equity markets can hold their poise in the face of the world’s mounting unbalances, and that question touches on government bond valuations too in the face of the smoke of the battle around inflation.

Sir Francis Bacon once wrote:

If a man will begin with certainties, he shall end in doubts; but if he will be content to begin with doubts he shall end in certainties.

In the face of almost insurmountable doubts (over likely economic slowdown, the impact on consumer confidence of softening residential property prices, the robustness of Asian fundamentals in the face of the ongoing commodity rally, the impact of $130+ oil, and the health of government bond markets given growing doubts over the under-reporting of inflationary pressures) it makes absolute sense to assume ongoing and substantial macro uncertainties. That argues, in turn, for nuanced and highly selective exposure to equity market risk, to capital preservation strategies in bond market terms, and to a healthy degree of ‘absolute return’ (quality hedge fund) as opposed to long-only market positioning, not to mention further asset diversification.

Markets may not yet be flashing red, but there seem to be more than usually strong headwinds about. Unfortunately, an especially discredited Wall Street establishment now has peculiarly weak authority in either recommending appropriate strategies or taking advantage of the resultant dislocations in markets. Happily, evolutions in financial products and the rapid democratisation of more sophisticated investment vehicles make it easier for independent asset managers and private individuals to try and resolve these questions for themselves, rather than simply overpaying to engage with a mountain of conflicted interests.

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This article has 13 comments:

  •  
    May 23 11:00 AM
    Love the philosophy quotes and especially those regarding certainty. Voltaire and Bacon ftw...=)
    Reply
  •  
    May 23 02:01 PM
    As devil's advocate, Amazon is currently trading at over $400 per share, split adjusted to when Blodget made that call. Off by 8 years, but a much better performance than say the negative return on Citigroup since that time.
    Reply
  •  
    May 23 06:01 PM
    Superb comprehension of the challenges we face. One magazine reporter interviewed me a month ago, noting the other six analysts were bullish, so why was I continuing to be bearish for over a year, other than the allowed-for rally into early May; my response, that they are all bullish should be the answer.

    Your allusions to 'risk-aversion' and caution about chasing yield ring true, and should think your clients have been appreciative. Might I add to your 'oil' comments the indirect flow through banks (shows as being commercial traders, when it isn't) as banks/brokers have to buy when clients buy Calls on Oil, is probably part of what propels a parabolic here

    again kudo's on a good article and good work!

    gene inger
    Reply
  •  
    May 24 10:20 AM
    Well, if oil really is bubble, it will of course be the most called bubble in history.

    This is probably one of the reasons why oil may be a little ahead of itself, but it is not a bubble.

    The second reason is Paul Krugman. Considering the political corner he comes from, I took for granted, that he would clearly identify oil as a bubble. But to my surprise: NO. It's not a bubble. Krugman knows, that you can only do two things with oil: Store it or consume it! Since inventories are anything but skyrocketing it stands to reason, that it is being consumed.

    What amazes me is not that oil (to be more precise: WTI, folks tend to generalize when it comes to oil) is north of 130$. What amazes me is the hatred even Wall Street people have towards oil. Even the 'super-tough' Jeff Mackey suddenly calls for the government to step in.
    Sorry, but I have to say this: What a b****! Either you're a capitalist or not!

    Since someone mentioned AMZN up there. They pay without blinkin' an eye a forward P/E of 50 for that company, which doesn't make that much money. I mean 4 or 5% profit margin is not really much. On top of that, should a smarter, better competitor pop up, a company like AMZN can be wiped out in a heartbeat, just look at SBUX.

    But back to oil, since we all live in industrialized nations, oil is the very basis of our existence. I don't think people comprehend, what our lives would be like without oil. I mean we couldn't even get water too our homes without oil, couldn't go to work and, and, and..

    Another thing, that really shocked me over the last couple of weeks is, how US centric people are. There are people managing billions coming on TV an calling oil a bubble, because the US is using 400.000 barrels a day less. They suddenly seem unable to comprehend, that there is a "second" economic power popping up on the other side of the pacific. Why is it so hard to understand, that there is more demand than it used to be. These guys grow close to double digits. Why wouldn't oil demand go up?

    Oil is not a tech stock or single family homes or tulips. Oil is the reason we call ourselves civilized societies. You couldn't even maintain a police force without it, not to speak of food production.

    Oil demand may fluctuate, but it will not disappear until we find another source for a transpiration fuel. One that is independent from fossil fuels.

    As for the supply side: Just read the WSJ story over that IEA study. They finally figured out, that oil fields have a limited lifespan.

    [ED - COMMENT EDITED TO REMOVE ABUSE.]
    Reply
  •  
    May 24 10:23 AM
    Sorry, that must be transportation fuel. Funny.
    Reply
  •  
    May 24 10:44 AM
    I too have grave doubts about the sanity of the markets, but they are always right, so I try and keep these sentiments to myself.

    As for the oil price I am afraid that neither Econ 101 or Econ 201 covered that part of price theory where not only is the supply curve perfectly inelastic, but the demand curve is too.

    Simple logic, visulaizing two vertical, or one vertical line (supply) and one nearly vertical line (demand) tells me that the prices are highly volatile and that more or less any price is possible.

    If I woke up tomorrow (well Monday) and found the oil price was $70 I would be no more or less surprised if it was $150.

    Having said that I do accept that the supply curve is vertical and furthermore I understand why. What amazes me is how many people do not accpet that it is vertical, or have no clue about where it is. That includes governments, heads of corporations and various other talking heads.
    Reply
  •  
    May 24 10:46 AM
    oil bubble will pop when the hedge funds unload their futures & options.
    Reply
  •  
    May 24 01:01 PM
    I have read lots of articles arguing that the futures market is the cause of $135 oil. I have also read lots of articles that have commented, in one way or another, on that hypothesis. I have never read anywhere the following commentary:

    Maybe I'm wrong, but I thought the $135 we experienced a few days ago was the SPOT price of oil on that day. Now I do understand that the futures price can have some impact on the spot, we must remember that the spot price is established by ACTUAL transactions of real buyers and sellers (ie, buyers are taking delivery at that price).

    So, the spot price identifies a real market price.

    Of course, even the spot price can be a bubble, but the impact of the futures market on THAT bubble is attenuated. I do recognize that some of the buyers are not using all the oil they buy, but rather, are storing it. There are two types of storers--those who are storing it for a rainy day (ie, SPR's--strategic petroleum reserves) to enahnce security, and speculators, who are storing oil so they can sell it for more tomorrow.

    The first group of storers are pretty unlikely to dump their oil, so we don't really have to take them into account in our BA ("bubble analysis"). But we do have to take the second group of storers into account. There is no question they could easily dump their oil and lower oil prices, but how much of a factor is this?

    I have read that there might be as many as 20-30 tankers storing oil in the Middle East. How much oil is this at 2 million barrels per tanker? 60 million barrels? Double that? Three times?

    OK, let's get wild and say there are 200 million barrells stored around the world on ships, in pots and pans, wherever. That is less than 2.5 days of global consumption (of 85 MBD). Also, keep in mind that a fair portion of that stored oil is reputed to be sour crude, not useable in most refineries and which trades at a large discount to the $135 oil we talk about (WTI). So the impact of a bunch of sour crude dumped on the market will be to lower the price of sour a fair bit, but the impact on WTI will be attenuated.

    Is it realistic to expect, as some have argued, that dumping of this sour oil will take us back to $75 WTI?

    In this regard, here is a prediction: IF that stored oil gets dumped, and has an unacceptable (from OPEC's point of view) impact on prices, I will bet that OPEC will REDUCE production in order to soak up the excess in a couple of months. Of course, even before the production cut actually begins, the simple announcement from OPEC that it is reducing production by 2 MBD to soak up this excess will ITSELF cause the price drop to be muted.

    OPEC has made it clear that it is happy with $130 oil, and will not let sweet crude go much below $110 to $120. Despite the idiots in Congress who believe we can sue sovereign nations who are not subject to our antitrust laws and who are pursuing their own self-interest, OPEC will continue to serve the financial and political interests of its members, while hurting our financial and political interests.

    This is the way it will continue to be until Americans go to rehab and get off their oil addiction.

    Jack
    Reply
  •  
    May 24 01:24 PM
    The oil "bubble" will "burst" when either one of two things happen:
    1. There is a world-wide economic slowdown; or
    2. One or more alternative energy sources increase output to start taking pressure off of demand for oil.

    This is a classic bubble resulting from inelastic supply upper limits; the only elasticity is in demand. So far in this cycle demand has not shown much elasticity. The desirable source of elasticity is from item 2. (above). Unfortunately, because of short-sighted planning (and lack of planning), both political (public) and economic (private enterprise), the most likely elasticity relief will be item 1.
    Reply
  •  
    May 24 03:53 PM
    I think we have a long way to go before the world-wide economic slowdown influences crude prices. The last time I was on a freeway in the U.S. the traffic on I-5 between San Diego City and North County was bumper to bumper with 90+% single occupant cars. As those of you who drive in the U.S. have you seen a noticeable change in the driving habits of Americans, my guess is "no' and why? Not because gas prices are not cutting into their disposable income but because they have few options. Americans live 25 to 50 miles from work, live in a suberb where there is no grocery store within walking distance and will drink cheaper beer and go out for pizza less before taking that dreaded step of car pooling even when it is possible. Most working couples today have no idea how to budget or economize with pre-washed salad greens and packaged foods so there will have to come some very painful changes in the majority of Americans lifestyle before crude prices drop due to an economic slowdown.
    Other countries pay less of their budget for gas and most Europeans know how to budget and live within their means plus there is no hard evidence that there will be a "world wide" economic slowdown.
    Reply
  •  
    May 24 07:11 PM
    Whoa....does not this author understand that crude is a finite
    " Thingy" despite the so called " veracity " of Saudi and Kuwait comments to the contrary. Sure Boones and Goldman may have some ( well, more than just "some" perhaps ) vested comments in $150+ barrel oil...yet have their vested predictions gone awry? Well, personally glad than I followed this band of " lemmings."

    The facts, jack, are that peak oil is already a past participle and Gaia is scrambling for what remains.....sad but true....you'd of thunk that every house had solar panels by now and everyone drove a Privia at 50 mpb.....it's not that history repeats itself with every debacle, rather it's human nature. I have call options every which way you wanna go, buddy.....and then I'll build my solar paneled fortress high on the mountain top.
    Reply
  •  
    May 25 02:23 AM
    john s. gordon: "oil bubble will pop when the hedge funds unload their futures & options."

    Bingo! But, where will that hot money go next?
    Reply
  •  
    May 26 01:15 AM
    THIS IS OIL BABBLE NOT A BUBBLE; we need a energy movement across the USA. Every state to supply one nuclear reactor; except our populated states on the COAST. THEY MUST SUPPLY 2 WITH LOCAL BONDS AND 3 IF THEY WANT FEDERAL MONEY.
    YES, OFF SHORE DRILLING WITH RIGS SIMILAR TO THE EIFFEL TOWER SO AS NOT TO BE OFFENSIVE; TWO NEW LNG TERMINALS ON EACH COAST TO PERMIT CNG OR LNG CARS; ELECTRIC HYBRID, DRILLING IN ALASKA AND WIND MILLS EVERY WHERE ENCLUDING YELLOWSTONE AND THE WHITE HOUSE LAWN.
    ULTRACAPACITOR BUSSES, AND MINI COOPER ELECTRIC HYBIDS
    AND SOLARIZE ALL THE ROOFS OF SOUTHER CALIFORNIA ESPECIALLY WHERE I LIVE IN NORTHRIDGE-PORTER RANCH, CALIFORNIA
    Reply
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