Oh my God! Oil prices are falling! The economic recovery is stalling! The green shoots are wilting! The stimulus package is a failure!

This emerging consensus, that falling oil prices are a sign the recovery is stalling, is odd to say the least. Rising oil prices are not an indication of economic recovery but rather potentially a sign of inflation. If anything oil prices are inversely correlated with economic growth as recessions are often preceded by rising oil prices. One need only think back an entire year to find such evidence. When oil was on its way to $147/barrel, was anyone cheering this as evidence of an economic boom? If so, I don’t remember it.

This concentration on oil prices is just the latest example of investors extrapolating the recent past into the far future. Oil prices fell during the recession, so ceteris paribus, falling oil prices mean recession. Of course, all other things are not equal and this faulty reasoning leads to the absurd conclusion that rising costs are a sign that things are getting better. That oil prices are now falling, after more than doubling from their lows, may in fact be a sign that the recovery is advancing, not receding. To reach that conclusion, you have to understand why prices rose in the first place.

Oil prices have risen over the last six months in the face of record inventory and a continued fall in demand. The rise would not seem to be explained by the fundamentals. So why did prices rise? Was it in anticipation of economic recovery? Hardly. The oil market earlier this year was characterised by a condition known as super contango. What this means is that future prices are much higher than current prices. In most commodity markets, contango is a fairly normal condition as future prices have to take into account the cost of storing the commodity as well as the financing costs associated with holding it. The contango that existed in the oil market was so steep though that a buyer of oil for delivery today could cover the storage cost and still lock in a guaranteed profit as long as cheap financing was available. The problem of course, was that cheap financing was not available. 

The super contango developed primarily due to the freeze in credit markets. The price of oil for future delivery had to embed the higher cost of financing as well as the storage costs. Anyone with access to cheap capital could take advantage of this situation by buying oil for immediate delivery, selling it immediately in the futures market for a profit and storing it until the delivery date. I know the situation existed because I tried to take advantage of it, but without the cheap financing, I couldn’t complete the transaction. Unlike me though, there was a group with access to cheap capital. JP Morgan, Goldman Sachs, Morgan Stanley - and their clients - had access to cheap financing through the wonders of TARP. And they have taken advantage of that cheap financing by doing exactly what I described above. They bought crude oil in the spot market and stored it wherever they could, even going so far as to lease tankers for that purpose. And as they deliver this crude to the market to fulfill their contracts, the supply of oil is rising and therefore the price is falling.

Furthermore, now that the difference between current prices and future prices has been reduced, the demand for current oil to purchase and store has dropped and also affected the price. It is not a sign that the recovery is stalling but a sign that the recovery is more likely to persist. Capital that was dedicated to exploiting this oil market anomaly can now be used for more productive purposes. The drop in oil prices is evidence that the credit markets are healing and it also means lower energy costs for consumers and businesses. In the real world that is good news, not bad.

The stock market has fallen for four consectuve weeks for a total correction of about 7%. Much of the drop can be attributed to the fall in commodity company stocks and more specifically to the drop in energy company shares. As doubts about the economic recovery have risen, the best performing sectors have been the defensive sectors such as food and drug company shares. Sentiment has quickly turned negative. The AAII poll of individual investors shows just 27.9% bullish versus 54.7% bearish. That’s the worst reading since the March lows and spells opportunity to this contrarian.

The economy is still in the bottoming process but the data continues to improve. Last week did not change that trend. Mortgage applications rose, reversing a recent trend. The ISM non manufacturing index continued its rise toward the 50 level that indicates expansion. Jobless claims finally breached the 600,000 level falling to 565,000 although there are doubts about validity of that figure. The trade balance also continued to improve as exports rose and imports continued to fall. Trade has improved so much that 2nd quarter GDP may actually come out positive.

Most of this improvement has been due to the efforts of the Federal Reserve. The stimulus spending has barely begun and while I don’t think it was necessary or helpful in the long term, it cannot help but have a short term effect on GDP as government spending is included in that calculation. The recent gloating by the Republicans that it has failed and the expressions of a need for a second stimulus package by Paul Krugman and Laura Tyson are both off base. While those who opposed the bill (and I count myself among them) are right about the long run effects, it is a mistake to believe that the spending won’t have any effect in the short run. Government spending financed through deficits gives us benefits today at the expense of tomorrow. It only “works” by borrowing growth from the future. And those who favored the bill such as Krugman and Tyson either didn’t read the bill (like most of those who voted for it) or have expectations about government efficiency that are unrealistic. Government spending doesn’t happen quickly and enacting another bill with even more spending and more debt before the first one has even taken effect is overkill we don’t need and future generations can’t afford.

The stock market correction may have more to run, but I think we are in the midst of a cyclical recovery in the economy and stocks. It will not be a straight run up and I remain negative about the longer term effects of the debt being accumulated, but over the near term, surprises are likely to be positive. Earnings season will start in earnest next week and if it turns out like last quarter, most companies will be reporting numbers better than the consensus. Last quarter 62% of companies reported earnings better than expected and while estimates have been rising, I suspect the analysts are still behind the curve. The drop in payrolls and rising productivity will mean the same thing this recovery as last - corporate profit margins and earnings will benefit more than wages as the recovery takes shape.

Selected charts

Crude oil, despite its recent fall, is still quite high

Corporate Bonds are usually correlated with stocks and are still rising:

The stock market correction is mild so far and not anything out of the ordinary for a cyclical bull market:

Chinese stocks have not corrected as much and look better technically:

The dollar has stabilized for now, but I still expect the next move to be lower:

If the dollar resumes its downtrend, foreign bonds should continue to outperform US Treasuries:

 Commodities are at support and should also rebound as the dollar falls:

Asian real estate may be presenting a good entry point: