Friday, June 27, 2008

Maybe Oil isn't a Bubble after all

If there's one characteristic that every previous market bubble has exhibited, it is this:

Few people knew it was a bubble until it burst, and by then it was usually too late to avoid large losses.

The two most recent examples were the housing bubble that peaked in 2005, and the tech/stock market bubble that peaked in 2000.

Many of the market "experts" in 1999 and 2000 were convinced that a new era of stock valuation was upon us, and that it made perfect sense for run-of-the-mill large companies to have P/E ratios of 40 or higher, rather than the historical average of 15. Most investors obviously bought into the hype, because people kept buying despite the insane valuations. On the other side, most investors didn't give up on the dream until well into 2001 or 2002, after already suffering huge losses in their investments. Indeed, sell-offs and reduced investor enthusiasm are really one and the same thing, so it's impossible for the majority of investors to avoid the eventual downturn. It's simply a matter of time and how soon the change-of-heart happens.

Similarly, the news in 2005 was not about the coming housing collapse, but rather the amazing non-stop run-up in home prices. Television was loaded with seminars and infomercials touting ways to make large profits with real estate. The realization that it was a bubble gradually dawned only as prices started to fall.

Today there's a great deal of talk about the "oil bubble" ... but that's precisely the problem. If potential speculators think that oil prices are in a bubble, then it means that those speculators are on the sidelines, waiting for prices to come down. If you don't own something, then you can't sell it, and if you can't sell it, then you can't contribute to any price collapse. Bubbles simply don't form when people are expecting a bubble, so the more I hear talk of an oil bubble, the more I fear that it isn't a bubble at all, but rather a real and long-term increase in the price of oil.

There are fundamental reasons for higher prices in this case, and the most obvious is the changing balance between supply and demand. On the demand side, it's no secret that emerging economies around the globe are using more and more energy as they expand and modernize. If the rest of the world were to eventually reach our level of automobile use, then the total oil consumption would be about 5 times what it is today. I can't think of any scenario which would reduce the global need for oil, except perhaps a world-wide economic recession, and even that would only be temporary.

On the supply side, there's little hope of any substantial increase in drilling, pumping, or refining worldwide. OPEC countries are enjoying huge profits right now, and have little incentive to increase production. Oil importers like the United States are strangely reluctant to increase their own supplies, thanks to environmental concerns, distrust of "big oil," and general antipathy towards unsightly energy infrastructure.

So the mathematics of the price of oil is pretty simple: the demand is increasing steadily, and will continue to do so for decades as long as economies are growing, while the supply will remain steady at best. There may be short-term zig-zags in the price due to world events, but in the long run I'd say high prices are here to stay.

Thursday, June 26, 2008

Market decline is accelerating

As this chart of the S&P 500 shows, the slope between each of the last four successive lows has been increasing. A parabolic trend like this can't last forever, but it can take the market much lower before the trend reverses. In a previous comment section I pointed out that when double-bottoms are re-tested they rarely hold, so we may be about to blow past the double March lows of 1273-1276.

Wednesday, June 18, 2008

Demographic trends and the market

One of my loyal readers asked for my thoughts on how the market might be affected by population trends such as Baby Boomer retirement and the growing middle class in emerging economies. I appreciate the question because it's encouraged me to actually look at the numbers. It also gives me an opportunity to put another spin on my overall stock market philosophy.

There is some tantalizing evidence that Boomers have already influenced the stock market. Depending on exactly how you measure it, the Baby Boom birthrate in the U.S. peaked sometime between 1957 and 1960, and the excess number of births at the peak was about 50% higher than the long-term rising trend throughout the 20th century. Someone born around 1958 would start to build a meaningful stock portfolio in the mid 1980's or 1990's, and that's just when we had our historically unprecedented bull market. The Dow 30 rose 1200% between 1982 and 2000, which works out to an average of 15% per year - significantly higher than the historical average of around 10%. If the Baby Boomers had no effect on the stock market, then it's a curious coincidence that the market chose that period for a record bull run.

At the other end, the folks born in 1958 will be retiring en masse around 2023, potentially making that the worst year for "cashing out." However, I suspect that any retiree sell-off will be spread out over may years due to a gradual shifting of assets from stocks into bonds, annuities, and other fixed-income investments. Indeed, the strategy recommend by most investment advisers today is to gradually reduce one's exposure to stocks well before retirement, so the Baby Boom sell-off may already be under way.

But the Baby Boomers are not the only story in town any more. Thanks to the internet, economic globalization, and rapid modernization in many countries around the world, the distinction between markets or investors on different continents is vanishing. Today anyone in the United States can invest in Chinese stocks, and vice-versa. ETFs that are indexed to countries or regions have made this particularly easy: one click in an online account can get you a diversified portfolio of hundreds of stocks of companies that you've probably never even heard of. The best evidence of this merging of markets is shown in the chart below, which compares the last 12 months of stock market performance in North America (blue), Europe (red), and Asia (green):

This coherent movement of stock markets reflects that the economies of these regions are increasingly linked, and that the average stock trader is buying and selling stocks with little regard for the geographical location of the underlying company.

To the extent that there are increasingly more people around the world with access to stock markets, there will be an increase in demand for stocks which will at least partly offset any effect from the Baby Boom sell-off. More to the point, when two billion people in China and India are becoming both more productive and wealthier to the tune of 8% or more per year, it can't help but have a positive effect on the global economy and on stock markets.

Now, I'm not clever enough to know which effect will be stronger for the next two decades (retirees vs. global growth), but the fact that there are two offsetting trends tells me not to worry about it too much. A large bear market from 2000-2002 was immediately followed and erased by a bull market in 2003-2007, and I doubt that any struggle between Boomers and new Chinese investors had much to do with either trend. Sure, the value that the S&P 500 and other indexes reach in 2030 will be affected to some degree by retirees in North America and middle class investors in Asia, but my hat is off to anyone who can see a number that far into the future. Besides, between then and now there will be more bear markets, bull runs, and bubbles that burst, and as long as dividend yields remain as low as they are today, I think there's far more money to be made in those trends than buying-and-holding through the major dips.

Tuesday, June 17, 2008

Gimmick ETFs don't pan out

Last year I was optimistic about two of Claymore's new ETFs: The Claymore/Clear Spin-off ETF (CSD), and the Claymore/Sabrient Defender ETF (DEF). I had already given up on them by the end of 2007, but I'd like to revisit them once more to emphasize an important point.

The Spin-off ETF (CSD) has an interesting strategy of investing only in recent spin-off companies. The idea is that these companies are often under-valued at the beginning when index fund managers are forced to dump these mid- and small-cap shares from their large cap index funds. Unfortunately the performance has been unimpressive, especially since the current bear market began.

On the other hand, the Defender ETF (DEF) was supposedly ready-made for a bear market, as its name implies. This ETF adjusts its holdings every quarter, and tries to pick the stocks which will perform the best on days when the market goes down. It's a nice idea, but as the chart below shows, DEF has fallen in almost perfect lock-step with the S&P 500.

So much for "defending."

The bottom line is that we shouldn't expect specialty stock ETFs to beat the market in the long run. As far as I'm concerned, buying and selling a broad ETF at the right time is far more effective than trying to cherry-pick stocks for a buy-and-hold strategy.

Tuesday, June 10, 2008

NASDAQ makes it a clean sweep

Although the S&P 500 and Dow 30 have been in a medium-term declining pattern for a while now, The Nasdaq Composite Index was still in an ascending channel formation as recently as Friday.Today it looks like the Nasdaq has officially broken out to the downside.

Now, I prefer sticking to the S&P 500 in my forecasts and in my investments, and I don't normally worry about what smaller groups of stocks like the Dow and Nasdaq are doing, but it doesn't hurt to have unanimity among the most followed indexes.

Saturday, June 07, 2008

Buyback Mania by the Numbers

The following chart graphs the quarterly earnings, dividend payments, and stock buybacks of the S&P 500 companies from 1999 through today. (The data is from the Standard & Poor's website)

The first obvious feature on the chart is that the total of stock repurchases and dividend payouts began an explosive growth phase in the middle of 2003, starting from a low of $65 billion in 2Q 2003 and reaching a high of $231 billion in 3Q of 2007. Most of that growth was in the buybacks, which rocketed from $28 billion to $171 billion - an increase of 510% in 4 years. At the peak, corporate stock repurchases accounted for approximately 5% of all stock purchases. It doesn't take a rocket scientist to realize that the added demand for stocks due to these buybacks contributed to the bull market of 2003-2007.

The most disturbing feature of this trend is that the surplus earnings - left over after dividend and buyback payouts - shrank to almost nothing in 2006 and turned negative in 2007. (Notice that the brief shortfalls in 2001 and 2002 were more than made up for by surplus earnings pre-2001 and in 2003 and 2004.) The projected earnings in 2008 and 2009 don't improve this picture, as they fall about $80 billion per quarter short of the most recent dividend+buyback peak. This means that corporations will have to borrow hundreds of billions of dollars to maintain the pace of repurchases, or else they will have to drastically reduce the buybacks. The former solution would create a long-term debt burden which would hurt corporate profits, while the latter would have an immediate negative impact on stock prices, since buybacks have accounted for a significant fraction of the price-sustaining buying pressure over the last several years.

The bottom line is that the buyback mania cannot be sustained. This has bearish implications for the stock market because it means that buying pressure will eventually be reduced in the coming years. This has little to do with the economy - it follows from the simple math of a buyback trend that has outpaced earnings. It would eventually happen with or without a recession, but the current economic slowdown will probably hasten the end.

New trend taking shape

The S&P 500 closed at 1360 on Friday, down 5.5% from its intra-day high of 1440 on May 19. Since breaking through the lower trendline on May 21, the S&P has formed a series of lower lows, which is one of the hallmarks of a downtrend.

The S&P high on May 19 came with an additional cautionary signal which hinted that the rally was over: the Money Flow Index (MFI) was lower on May 19 than during the previous S&P peak on May 2-6.

There's still plenty of room for more pessimism in the sentiment gauges, and there's no technical indicator of a bottom yet, so I don't think this selloff is finished yet.