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Generational Dynamics Web Log for 8-Jun-2008
Stock markets plunge on unemployment and historic oil price spike

Web Log - June, 2008

Stock markets plunge on unemployment and historic oil price spike

Are we near some kind of tipping point?

The world's financial markets became extremely volatile last week, with the greatest volatility occurring on Friday.

Economic indicators worsen <font face=Arial size=-2>(Source: nytimes.com)</font>

Economic indicators worsen (Source: nytimes.com)

As the adjoining graphic shows:

The unemployment rate, which has been steadily increasing since early 2007, suddenly spiked from 5.0% to 5.5% in May, the sharpest monthly spike in 22 years.

The global price of oil, which has been steadily increasing since late 2006, suddenly spiked $10.75 to $138.54 per barrel, the sharpest daily spike in history. Reports on Sunday indicate that the national average price of gasoline now exceeds $4.00 per gallon for the first time.

Panicky investors sent the Dow Industrials down $394.64 points, now at 86% of the high reached on October 9, 2007.

Add to these statistics the following that I've discussed frequently:

The recent substantial worldwide increases in food prices, and

The incredible surge in the price/earnings stock index.

With these dramatic moves beyond historical trend values, there's good reason to wonder if we're reaching some kind of tipping point. Let's explore that concept.

Stein's Law and the Tipping Point

Back in 2002-04, when I was alone in the wilderness predicting a stock market crash and a new 1930s style Great Depression, people who stumbled on this site simply thought I was a nutcase. An argument that was made to me frequently was the following: If you're wrong, you'll never admit it, because all you have to do is claim that the stock market crash simply hasn't happened yet.

Actually that was never true. My conclusions were based on long-term trends that I described last year in "How to compute the 'real value' of the stock market." As I told people in 2003, I would be perfectly happy to admit I was wrong if America's public debt started falling, or if the balance of trade deficit started falling. Since both of these have continued to grow exponentially, I haven't had any reason to change my mind.

The argument that I'm using is based on a semi-humorous law formulated by the late economist Herb Stein:

Stein's Law: If something cannot go on forever, then it won't.

In other words, if something isn't done to deflate the credit bubble gradually, then it must stop growing for some other reason -- namely a crash.

I've been using the phrase "tipping point" a lot in recent months when referring to the meteoric rise in food prices. Rice prices have tripled since January (though they've come down a little from their highs in the last couple of weeks), and the price of food in general has doubled in the last year. With more and more millions of people foraging through garbage dumps just to find enough food to stay alive, this situation cannot continue. (See Stein's Law.)

The commodities bubble

Commodities like oil, wheat, rice and gold are definitely in a bubble. That's easy to prove just by comparing today's prices to the long term historical price trend for each of them.

But there are two distinct kinds of bubbles:

Bubbles caused by speculators who try to "corner the market" in some commodity. They hoard quantities of the commodity, forcing prices up, and then sell off the entire hoard at bubble prices.

Bubbles caused by a temporary supply/demand mismatch. In this case, there may be a supply disruption (such as a war), or there may be a rapid increase in demand, or both. The market will resolve this problem in time by destroying demand and encouraging suppliers.

When evaluating these, not all commodities are the same. It's easy to hoard gold, since it takes up so little space, and so it's quite possible that the current gold bubble is caused purely by speculation.

But it's much harder to hoard food, and almost impossible to hoard oil.

In 2004, I posted the article, "Bear Stearns predicts oil prices will fall by almost half." At that time, oil was at $50/barrel, and Bear Stearns (may it rest in peace) was predicting a fall to $25/barrel:

"[Bear Stearns'] reasoning is as follows: During the last year, concerns about oil supplies have caused companies to increase their own private inventories of oil. Indeed, U.S. commercial inventories of crude oil are 5% above last year's level, according to the Wall Street Journal.

Therefore, the Stearns reasoning continues, this almost panic-like stocking up of oil inventories has created an "oil bubble." Once the inventory build-up ends, according to Stearns' research, the actual market fundamentals support only a $25 per barrel price. Prices close to $25 would be maintained even if a terrorist act caused a temporary supply shock, because of the large inventories of oil on hand."

Well, the Bear Stearns prediction certainly didn't come to pass, did it?

I've heard similar claims when oil went to $60 per barrel, then $70 per barrel, then $80 per barrel, but they've never turned out to be true.

There are people today claiming that speculators are hoarding oil, and that without speculators the price would fall to $90, $80 or even $50 per barrel. The problem with that argument is that the hoarded oil would have to be sitting somewhere, perhaps in a thousand huge tankers, and there's no evidence of such hoarding. You can't hoard oil the way you can hoard gold.

The same argument applies to rice, wheat, and other staples. It might be possible for some speculator to rent some huge warehouses and store grain in them, but these price surges have been going on for a couple of years now, and if that were happening then it would have been widely reported in the news by now.

I think it's quite possible that Friday's spike in oil prices was caused by panic buying, and I think it's quite possible that some part of the price of oil -- say $10-20 per barrel -- might be caused by panic buying or speculation. In that case, the price of oil would be about $115-120 per barrel without speculators, still very high. A similar statement could be made about wheat and rice prices.

I can't prove this, but my intuition tells me that some sort of tipping point has been reached -- perhaps a structural limit in the markets that can't be cured in the short run. It might be that all easily available land is used up, or perhaps the worldwide transportation and shipping infrastructure is so overloaded that it's locked up in some way, and can no longer expand in the short run. I think that we're seeing the Law of Diminishing Returns in action. In "normal" times, these situations would be self-correcting in a few months, but some long-term structural limitation is keeping the supply/demand mismatch from clearing up.

The problem apparently is that demand appears to be increasing faster than the supply can increase and faster than the markets can adjust. China and India put hundreds (or is it thousands?) of new cars on the roads every week, and these cars suck up gasoline. China puts two new power plants on line every week. Power plants use coal, but use of oil-based energy is going to increase along with the power plants.

In the case of food, we can be more certain of what's going on because we have published statistics.

On the supply side, a United Nations food summit was held in Rome last week and officials announced that resolving the food crisis would cost $30 billion per year, essentially to spawn a new "Green Revolution", like the one that was launched in 1948. That Green Revolution didn't produce results for almost 20 years, and even if the $30 billion per year could be found, the new Green Revolution wouldn't produce results for at least ten years.

More meat-eating in developing nations <font face=Arial size=-2>(Source: csmonitor.com)</font>

More meat-eating in developing nations (Source: csmonitor.com)

On the demand side, there's the diversion of wheat for ethanol, but more important is the fact that people in developing countries are eating more meat. Feeding grain to a cow and then feeding the meat to a human uses up considerably more grain than just feeding the grain directly to the human. And there are close to 4 billion people in China and India alone who are "moving up the food chain" and consuming more meat, milk and maize.

And so, it seems much more likely than not that these price surges, that have been going on for years already, are going to continue. In the case of food, the United Nations has said as much.

This leads us back to:

Stein's Law: If something cannot go on forever, then it won't.

What does Stein's Law mean if the oil and food bubbles cannot be deflated slowly by policy in the short run? It means:

A financial crisis that will bring the increasing demands for oil and food in China and India to a screeching halt.
A war crisis that will reduce the demand for food for many reasons that needn't be outlined here.

The only question that's left is the timing. The recent spikes in oil and food prices seem very compelling. Things cannot continue this way much longer, although the exact timing cannot be predicted.

Safe deposit boxes

Related Articles

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What's coming next: Understanding the deflationary spiral: Why are the dollar and the yen getting stronger, while the euro is getting weaker?... (27-Oct-2008)

Roubini: The situation is "sheer panic," as hundreds of hedge funds are going bust: Policy makers may need to close markets for one or two weeks.... (24-Oct-2008)

There's never before been a day like this on Wall Street.: Possible exception: One of the days just before or after the 1929 crash.... (11-Oct-2008)

Ben Bernanke's Great Historic Experiment is at the brink: Desperation sets in as credit markets continue to seize up.... (25-Sep-2008)

Government promises to buy bad debt to end the credit crisis: Stock markets stage huge comeback as giddy investors pile in.... (19-Sep-2008)

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As commodities plummet worldwide, the meaning is unclear.: We speculate on some possibilities.... (11-Aug-2008)

Alan Greenspan calls this a "once in a century" liquidity crisis.: Says that the "big surprise" is the "impressive" American economy... (3-Aug-2008)

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Questions from readers on finance and investing: On fraud, the FDIC, China, and other subjects.... (23-Jun-2008)

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Just to repeat what I've said many times before: The global financial system is in a deflationary spiral, which means that the amount of money (i.e., the US dollar) in the world is decreasing every day, and the value of this money is therefore increasing. We will see deflation and NOT hyperinflation, as some people are predicting. Thus, for most people, the best investment today is cash or short-term T-bills or FDIC-insured bank certificates of deposit.

Gold is in a price bubble, and makes a very poor investment. Buying gold today costs roughly $900 per ounce plus fees and commissions, and the historical trend value of gold is $300-500 per ounce, which is the amount your gold will be worth after the bubble bursts.

However, if you DO own gold, then you have a problem with how to store it. For example, you can hide it at work or in your home, or you can hide it in a bank safe deposit bank.

A recent blog posting by Michael "Mish" Shedlock is entitled "How safe is my gold?" and describes problems with storing gold in bank safe deposit boxes - that the contents are vulnerable to seizure by government officials.

The article quotes an ABC news investigative article entitled, "Not-So-Safe-Deposit Boxes: States Seize Citizens' Property to Balance Their Budgets," and a a Telegraph article titled "Safety deposit box raids yield �1bn of drugs, cash and guns." Both of these articles describe recent government raids of safe deposit boxes of perfectly innocent people.

If any web site readers have thoughts about how to handle this safety deposit box problem, send them along and I'll post them.

The earnings game begins for the second quarter

Regular readers know that every week or two I post the table of S&P 500 average corporate earnings estimates, based on figures from CNBC Earnings Central supplied by Thomson Reuters. What this table shows is that analysts' earnings estimates can't be trusted.

Here's the final version for first quarter earnings:

  Date    1Q Earnings estimate as of that date
  ------- ------------------------------------
  Oct 23:             +10.0%
  Jan  1:              +5.7%
  Feb  6:              +2.6%
  Feb 29:              -1.1%
  Mar  7:              -4.3%
  Mar 14:              -7.8%
  Mar 21:              -7.9%
  Mar 28:              -9.3%
  Apr  4:             -12.2%
  Apr 11:             -14.1%
  Apr 18:             -14.6%
  Apr 25:             -14.1%
  May  2:             -15.0%
  May  9:             -17.4%
  May 16:             -17.5%
  May 23:             -17.5%
  May 30:             -17.5%

On January 1, at the beginning of Q1, analysts were saying that Q1 earnings would be 5.7% higher than Q1 of last year. Those estimates fell, week after week, and the final results are that earnings were 17.5% lower than Q1 of last year.

Now the earnings estimates for the second quarter are becoming available, and we're starting to play the same game. Here's the table so far:

  Date    2Q Earnings estimate as of that date
  ------- ------------------------------------
  Jan  1:              +4.7%
  Feb  6:              +3.5%
  Apr  1:              -2.0%
  Jun  6:              -7.3%

Analysts started out a little more realistic this time. The first day of the second quarter was April 1, and on that day analysts' estimates were for 2% earnings negative growth.

By this past Friday, June 6, the earnings estimates had fallen to a 7.3% negative growth.

This continued fall in earnings estimates means that either price/earnings ratios will continue to rise into even higher bubble levels, or else the stock market will continue its downward path.

I've estimated that the probability of a major financial crisis (generational stock market panic and crash) in any given week from now on is about 3%. The probability of a crisis some time in the next 52 weeks is 75%, according to this estimate. (8-Jun-2008) Permanent Link
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