World Markets 101

Is Oil Cheap?

That is the question I have been pondering lately with all of the so-called experts pounding the table stating that energy stocks are a screaming buy.  However it is unlikely that energy stocks will move higher without a move up in oil.  So if oil needs to go up before energy stocks gets moving again than it is worth determining whether oil is undervalued or overvalued.  Since it has come down from $147 to the low sixties, it must be a bargain right?  Not really. 

I built a model that determines whether or not oil is undervalued or overvalued based on the economies of the four largest oil consumers: the United States, China, Japan and Germany.  In addition to taking into account the economies of these four nations it also takes into account the strength in the dollar, which has an extremely high correlation to the price of oil. 

So what did I find?  Obviously hindsight is 20/20, but the model would have told you back at the end of June 2008 that oil prices were around 40% overvalued.  As oil was trading close to $150, this model says that it should have been trading at $90 based on the strength of the world economies and where the dollar was trading.  Interestingly enough, oil was undervalued for most of 2007, as much as 30%, finally reaching fair value in November of 2007. 

Where are we today?  According to the model, yesterday we were very close to fair value, but we were not undervalued.  If the world stock markets turn, that will obviously help oil, but I would like to see a situation where oil is undervalued based on the strength of the dollar and the world’s largest economies before I begin to look at energy compared to other industries.

The top 20 oil consuming nations:

Courtesy of http://www.nationmaster.com/graph/ene_oil_con-energy-oil-consumption

S&P to Rate Securities Issued by a Group of Cows

In a shocking, or not so shocking, testimony today in front of congress, S&P discussed internal emails that had floated around the company basically saying that their ratings models were flawed.  But we’ve all known these guys couldn’t predict the probability of an outcome if their life depended on it and that they didn’t care about anything, but increasing their revenue, so why should we care?  Because the emails were classic!

One analyst wrote that the complex mortgage deals were “ridiculous” and that S&P should “not be rating it” referring to the security.  His co-worker replied, “we rate every deal, it could be structured by cows and we would rate it.”

In another email by an S&P manager the manager says they were helping to create an "even bigger monster -- the CDO (collateralized debt obligation) market.”  Then he says “Let's hope we are all wealthy and retired by the time this house of cards falters."

The weakness in the ability of the ratings agencies to adequately rate securities due to the major conflict of interest that exists in their business model has caused billions of dollars in collateral damage around the world. 

 

Who Will Be Left Holding The Bag?

Tomorrow payments are due from the 350 banks and investors that insured Lehman Brothers’ debt through credit default swaps.  These insuring parties will have to come up with a cool $365 billion dollars or approximately 9c on the dollar of the total outstanding debt.  According to the London times some of the largest investors include PIMCO, Citadel, and AIG.  JP Morgan also released some names that are expected to take substantial hits.  The list included Deutsche Bank, Barclays and UBS among other investment banks.  It’s been rumored that some of the parties that wrote the contract have been selling assets in the open market to prepare for tomorrow.  Keep in mind the CDS market is an unregulated market without capital requirements.

Do you think anyone will be unable to come up with the funds? 

“Be greedy when others are fearful and fearful when others are greedy”

Warren Buffet wrote an op-ed piece for the New York Times last week telling readers that he has been buying American stocks.  It's important to point out that CNBC reported that he was buying when the Dow was under 8500, then when the Dow started to rally above that level he stopped buying, at least that day.  Either way it's a great piece from the world's best investor.

http://www.nytimes.com/2008/10/17/opinion/17buffett.html?_r=1&dbk&oref=slogin

A “Rip Your Face Off Rally” of Historical Proportions

Today’s surge in the markets not only represented the largest point gain in history, but also the largest one-day percentage gain in history.  Last Thursday I wrote that we were close to a bottom and I said the market would panic Friday morning, then rally in the afternoon, implying that one should buy the panic. The VIX showed a record spike in fear on Friday while volume was the highest in history as stocks, as they say, went from “weak hands to strong hands”.  Buying the panic would have allowed you some breathing room on your positions in case bank regulators did not act as I had outlined in the post.

For once, regulators actually got it right, and they took steps that I believe will help get LIBOR down and get the credit markets moving again.  Do I think the economy is great? No, but I do think regulators are making the right moves that will prevent a crisis that could have been worse than the great depression.  Is this “the bottom”? I don’t know, nobody knows for sure, but I think it is “a bottom”.  Personally I saw tremendous values Friday morning unlike I’ve ever seen before and I couldn’t resist buying as the market fell below 8000.  The markets are an irrational place; sometimes irrationally exuberant, or in this case, irrationally pessimistic.  It is up to investors to take advantage of the opportunities as they are presented by "Mr. Market" as Ben Graham would say.

The rally today shows why it is critical to stay in the markets and not panic.  Throughout history when markets plunge over a five-day period they almost always stage a quick recovery the following week.  Only twice, ever, did they not come right back and that was during the great depression; our economy is nowhere near a great depression.  I understand that buying the panic is not easy, things can always get worse, but in the markets it pays to be a contrarian.

I'll leave you with this stat from this week’s Barron’s “Consider that $1 invested in stocks from February 1966 through May 2007 would have grown to $16.58 in that period.  That’s a 7% annual return.  By contrast, investors who were out of the market in the five best days each year during that same span were left with only 11 cents.” If that’s not a good case for a buy and hold mentality than I don’t know what is.

S&P 500 Off 42% from Just One Year Ago

It has felt like a slow motion crash, but the deterioration in the credit markets has cratered world stock markets in the past year.  So what needs to happen to get the credit markets moving again?  Two things are critical: the G7 needs to create a policy that guarantees interbank lending and focuses on getting LIBOR rates bank down to earth.

Credit conditions are completely driving the stock markets as business fundamentals go out of the window.  Fear in this market is at all time highs, mutual fund redemptions are at all time highs, non-cyclical companies are beginning to sell off hard, one-third of stocks are down 50%, and a mere 4% of stocks are trading above their 200 day moving average: all of these signs are pointing towards a near term bottom, but the markets will not improve until the credit markets improve. 

We will probably open down tomorrow morning as “dumb money” sells in a panic.  But the commercial paper markets are improving, and there is hope, a glimmer at least, that by the afternoon investors will focus on the outcome of the G7 meeting this weekend, which could lower LIBOR substantially and spark a huge rally. 

The Many Faces of Dow 10,000

$810 billion and all I got was this crummy T-shirt!

We experienced a classic “buy the rumor, sell the news” scenario today; the Dow fell over 400 points from it’s high today once the bill’s passage was confirmed.  Normally, $810 billion would be a lot of money, but in the context of the debt that is held in America, which amounts to around $50 trillion of which $12 trillion is mortgage debt; the amount seems nominal. 

Is the price right?  I would imagine that determining the size of the bill was difficult; on one hand you want to minimize sticker shock, on the other you want to make sure it is enough to get the markets moving again.  Probability would suggest that their estimates are on the low side rather than the high side, given that they would have seen it necessary to minimize the cost to taxpayers, which in turn would increase the bill’s chance of being passed.

Fundamentals are still deteriorating, unemployment is likely to hit 7% in the coming months and that will only continue to put pressure on consumers that are trying to pay their mortgages.  World deflation will get us some relief at the pump, but what good is it if you don’t have a job to drive to?  The problem is that we have too much leverage in the system.  The system needs to deleverage and that is going to continue to be a painful slow process.

Credit Default Swaps: The Last Nail in the Coffin?

As the deleveraging continues another black cloud lingers over the U.S. economy; the $62 trillion credit default swap market. Credit default swaps are insurance-like contracts that promise to cover losses on securities in the event of a default. They typically apply to muni bonds, corporate debt and mortgage securities and are sold by banks, hedge funds and other financial institutions. The buyer of the insurance pays premiums over a period of time in return for protection in case of default.

The scary part is that this huge market, which is twice the size of the entire U.S. stock market, is completely unregulated.  They were created just over a decade ago while the economy was booming and the risks of defaults were low.  Because they are unregulated firms can issue them or trade them to others without capital requirements.  It’s very possible that many holders may believe they are protected, but in the wake of a wave of defaults, many counter parties could default due to insufficient capital to cover losses.

“I’ll Be Back” for $7 Billion

California’s Governator is looking for a $7 billion dollar emergency loan from the federal government to pay for day-to-day operations and all state funded services. 

California State Treasurer Bill Lockyer had issued a statement saying that because of the national financial crisis, California "has been locked out of credit markets for the past 10 days." 

Lockyer also said “the State's cash reserves will be exhausted near the end of October” if the economic crisis doesn’t subside and the state cannot raise short term funding.