Qaddafi, Bernanke & Stock Markets
David R. Kotok
August 21, 2011
News reports continue to show the progressive demise of the Qaddafi regime in Libya. Rebel forces have apparently taken more of the country’s oil refining (Zawiya) and processing infrastructure (Brega). Most observers give the Qaddafi regime limited time before a full regime change takes place in Libya.
Watch what happens to oil prices if and when the Qaddafis lose and leave. In short order, Libyan oil production will ramp up. As it does, oil prices in world markets will fall and oil futures markets will reflect the expected increase in production of oil from Libya. The key prices to watch are those trading in Europe, like Brent. US oil prices (WTI) are no longer the leading indicator of world prices intersecting with world supply/demand. Excess inventory at Cushing, OK is complicating the pricing structure.
We expect oil prices to fall when highly desirable, sweet Libyan crude production is fully resumed and enters the pipeline. Maybe, they are going to fall by a lot. This will come as a much-needed boost to the US economy and to others in the world.
Remember: the oil price acts like a sales tax on consumption. To clarify this relationship we convert crude oil prices to gasoline prices and then estimate what a change in gas price will mean for the American consumer. Roughly, a penny drop in the gas price per gallon gives Americans 1.4 billion more dollars a year to spend on other than gasoline. That is a huge stimulant to the economy. The ratio is different in Europe because the gas taxes are so much higher there. Nevertheless, it is still significant.
Lower gas prices could not come at a more needed time. With weakening economies around the developed world, the lowering of the consumption “tax” from high oil prices will be a welcome boost. In the US, it is possible we will see gas prices with a $2 handle, instead of the $4 handle of a few months ago. This is a large positive change for the US economy, and it is not being incorporated in the gloomy forecasts that we see.
Lower oil prices also mean a lessening of inflation pressures in the energy sector. We expect to see that appear as well. “Gasoline prices moved up 4.7% in July and accounted for half the increase of the CPI. The energy price index has risen 19% in the twelve months ended in July. The core CPI, which excludes food and energy, increased 0.2% in July, which works out to a 1.8% increase during the past year. The year-to-year change in the core CPI bottomed out in October at 0.6% and has climbed steadily each month.” (Source Asha Bangalore, Northern Trust)
At 1.8%, the core CPI is still below the Fed’s informal target. Future inflation may be a serious concern for the three dissenting presidents on the FOMC. Real growth and risk are clearly the dominant and majority view. Bernanke fears a softening of the economy and a resumption of deflation risk. He is trying to get some growth and a little more inflation. Oil price declines may get him the growth. There seems to be a long way to go before the inflation side becomes the serous threat.
In May of this year, we took our then overweighted energy position to an underweight in our US stock portfolios. We were at 18% against an S&P weight of 13%. We are still underweight today. The S&P energy sector is 12.6% now; we are at 6%. Energy is the third largest sector weight in the S&P 500 index.
Exxon and Chevron are large capital weights in the Dow-Jones average. Both Dow and S&P averages are in steep downtrends and both are influenced by the energy component’s relative weakness.
We intend to remain underweight energy for some time and will wait out the Libyan regime change and subsequent rebalancing of the world oil price and world oil markets. Meanwhile we are more optimistic than most about the US.
We believe there is a large difference between a full recession vs. a period of very slow growth and low inflation. We think about this in terms of 1-2% real growth and 1-2% inflation. Taking the center points in each, one sees a 3% nominal rate of GDP expansion in the US. That will keep the employment situation weakly improving, and it will mean a continued slow recovery. It will also mean higher profits for business.
The stock market correction since the April 29 high has been vicious. We sold in early May. That was a good call. We entered in July. That was a bad call. We continue to rebalance and have recently raised our stock allocation and lowered our bond allocation in balanced accounts.
Our sector weighting, like the change in energy, has helped mitigate the damage. However, there is still damage. Volatility in markets remains very high. Fear and panic are seen in investor behavior and sentiment. These are usually the signs of buying opportunities and stock market bottoms. We think that is true today.
We have written about the valuation metrics we use and how they indicate that stocks are strategically cheap. We are looking at some of the financials for the first time in four years. I know, everyone thinks the world is ending, and the financials are decimated. That is the old news. Tell me some new news.
This is one of the most washed-out sectors one can imagine. After fours years, after many adjustments, after ongoing consolidation, after the mortgage fiasco, after Lehman-AIG—after all this, we now see banks and other financials selling well below their book values, and with substantial reserves for losses.
We are on the buy side now and believe that stocks present an unusually good entry point for a strategic investor. For a short-term trader this is much more difficult.
Did we have a selling climax or an interim one on August 8-9? Moreover, how much volatility is due to algorithmic trading? Most investors do not understand this force, which is driving “vol” higher and thus causing market swings to appear wild.
We expect the rocky period to continue for a few more weeks. Eyes are now focused on Ben Bernanke’s remarks in Jackson Hole this Friday. We agree that the speech is critical. However, we are not taking our eye off the events unfolding in Libya. They may help Bernanke and US policy more than many expect.
We are nearly alone in our contrary market positions. We have witnessed a rapid 20% bear-market correction since April 29, when the S&P 500 hit 1363. Its intraday low was 1100 on August 8-9. It is testing that low now. It may go lower or the interim low may hold.
The question is: where will it be in 5-7 years? By then the US economy is likely to be $20 trillion in nominal GDP. Our view: it will be higher or maybe even very much higher. We have a longer-term target of 2000 or higher on the S&P 500 index. In addition, dividend yields now exceed treasury interest while we wait. 10% of our US ETF model is in Wisdom Tree dividend ex-financial ETF. (Symbol-DTN) It has outperformed the market by 500 basis points on the way down. We are bullish.
David R. Kotok, Chairman and Chief Investment Officer