The Oily Bubble


“No morning sun lasts a whole day.” – Benjamin Franklin, Poor Richard’s Almanack

I hope that all my readers are enjoying the Thanksgiving weekend and are not too affected by Black Friday shopping madness, which has now spread overseas. It seems to be the week for it: On our own shores, an upward revision to third-quarter GDP led to a bout of madness in the investment media and fund business. High stock prices are fueling a fever on Wall Street that Main Street has not caught.

This is a holiday edition of MarketWeek, so I will try to briefly review the main considerations as we head into the end of the year.

The underlying growth rate of the economy hasn’t changed. An upward revision to the annualized, seasonally adjusted growth rate for the third quarter led to a print of 3.9% for the quarter where 3.3% was expected and 3.5% had been the previous estimate. As always, a consensus beat means over-the-top exaggeration from Wall Street.

The four-quarter rate of nominal GDP (not adjusted for inflation) now stands at 4.05% instead of 3.93%. The average has been about 4% for the last four years, the growth rate has been about 3.9% over that time, and the rate is set to fall again after the fourth quarter. The upward revision came from adding about $4-$5 billion to the quarterly output estimate – or about 0.02% of the annual total, well within the margin of error – and then annualizing it.

Equity valuations are at nosebleed levels. Stock prices don’t fall because valuations are too high; they just fall a lot further once the descent starts. The ratio of equity market capitalization to GDP is at 2000 levels and rapidly approaching the all-time high. The Shiller P/E ratio is at 27.15; the 2007 peak was 27.55. A little higher and it will be the third-highest level in the last 130-odd years, surpassed only by the two manias of the tech bubble and 1929. Charts of long-term technical levels should not be shown to children or acrophobes. All of the foregoing makes me very worried indeed, but I don’t see anything overturning the traditional calendar effect in the near term. Prices should pull back for a bit and we may be at or very near the year highs already, but negative Decembers are quite rare.

Market optimism is dangerously high. This condition can be remedied by a minor pullback of a couple percent, but some of the recent peaks suggest an overall flat market for the next six months. Investors continue to place almost total faith in

Central bank omnipotence for equities. One of the main props under the market is the coming week’s European Central Bank (ECB) meeting on Thursday. Recent moves by the central banks of Japan and China have created a semi-permanent state of exaltation amongst bulls, impatient for the ECB to get going and give another push to the tulip mania. Finally,

Oil prices are now the wild card. Unseasonably cold temperatures everywhere but California and Florida, along with rising natural gas prices, are offsetting some of the benefits of falling oil prices, though one doesn’t hear much about that aspect.

Any big price move is invariably accompanied by wild-eyed predictions about the further extent of the move, and oil is no exception. That said, I freely confess that I don’t know where oil prices are going. Though greatly oversold, the momentum trade is very much against them and OPEC now seems content to wage a price war, or at least a battle, against producers with higher marginal costs (i.e., the U.S. and shale oil). Policy decisions are impossible to rely on, as OPEC’s surprise decision proved yet again. The price bottom is only a guess.

I’m not sure what it will mean for the current business and market cycle. While low energy prices are a strong positive for the U.S. economy overall, they are not so great for oil-producing countries – which we have just become again. Lower energy costs do not increase income, so total consumer spending doesn’t change, but it is a benefit for discretionary spending categories. It’s a much bigger benefit for corporations, where it flows to the bottom line, but declines usually take about four to six quarters to work their way through to real increases in the broad economy.

In the last forty-plus years, falling oil prices have usually, though not always, come about from recessions. All the hoopla about U.S. production and global surplus neglects the fact that China was the main driver behind increased oil demand since the year 2000; this year, its consumption growth is barely registering. We may be getting a foretaste of a Chinese recession. Japan is in one now, and Europe and Russia are flirting with one. The front page of the weekend edition of the Wall Street Journal ran a headline on “Fresh Signs of Global Slump.” Perhaps oil prices aren’t falling simply because of U.S. shale oil production.

I fear that the equity markets are going to go higher yet, perhaps ruinously high, only to fall further in the end. Time will tell, but in the meantime, I hope you are all enjoying the beginning of the holiday season.

The Economic Beat (holiday edition)

Most of the week’s data came in on the light side of consensus, prompting downgrades to fourth-quarter GDP estimates. The exception was the revision to third-quarter GDP, which increased to a seasonally-adjusted, annualized rate of 3.9%. However, 4-quarter nominal GDP, much less sensitive to annualizing a difference of a few billion dollars, only ticked up to 4.05% from 3.93%. The baseline rate remains 4%.

The annual appreciation in existing home sales prices eased to 4.9%, according to the latest Case-Shiller reading. New-home sales have been virtually flat the last three-months, at least on a trailing-twelve-month (TTM) basis, leaving the growth rate this year at 3.3% through October. It may end up being less than that, as revisions have been persistently to the downside in recent months. Pending home sales fell by 1.1% in October and are 2.2% higher than a year ago. Existing home sales have been very near the flat line all year, but mortgage-purchase applications are at a 13-year low.

Regional indices were scattered, with Dallas flat, Richmond easing, and the Chicago Fed National Activity index (which relies more on real data, rather than surveys) virtually at zero. The Chicago PMI, which has had inflated readings since it became the property of a stock exchange, reported its index at 60.8. It’s a precipitous drop from the previous month, but the stock market is paying much less attention to the report now than it once did.

As usual, all eyes are on retail sales this weekend, but November sales weren’t especially robust coming into the week, with reports of significant early discounting. The theme may end up being higher sales and lower profits this year. Part of what’s holding back sales is the anemic growth in personal income, which registered another 0.2% increase in October. Real disposable personal income was up its usual 0.1%. Despite this, favorable year-ago comparisons increased the TTM rate to 2.5%. Real spending was up 2.2%, using the PCE basis.

The downward revisions to GDP stemmed in part from a poor October durable goods report, which showed new orders declining excluding defense (-0.6%) and transportation (-0.9%). Shipments have been down the last two months, along with orders in the business cap-ex category (-1.4%).

The highlights of next week are the November jobs report on Friday and the ECB meeting on Thursday. The trend in year-to-date jobless claims data is starting to converge with last year and is showing much less improvement than a year ago, suggesting a modest jobs report may lay in store. Others have suggested the same.

Apart from that, the ISM manufacturing survey – which has lately corresponded more with sentiment than production – is Monday, with the non-manufacturing edition and the Fed’s Beige Book released on Wednesday. Friday will also see reports on international trade and factory orders.

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