Trader’s Narrative

Source: Tom Toles

As Homer Simpson would say: “It’s funny ’cause it’s true.”

• Refinance Boom is Over
• Unemployment in Past Recessions
• Duration Of Unemployment - A Really Scary Chart
• The US Consumer Rediscovers Frugality

This bear market we’ve just had (is it over?) has been one fit for superlatives. So why not its inevitable counter-rally (or is it a bull market?).

The chart below is from economist David Rosenberg who now plies his trade at Gluskin & Sheff. In it he points out that what we’ve seen since the spring of this year is the Sharpest Equity Market Rally Ever in the Context of Pricing Out of the Recession:
(Click to see a larger graph open in a new window)

That’s a 54% rise from March 9th 2009 to September 11th, 2009. The closest rally in comparison is 44% in 1929-1933.

Is this recession over? No one really knows. But the sharpest rally ever from within a recession is just one more notch in the belt of this bat$hit insane market.

I, for one, look forward to becoming a curmudgeon and poking my grand kids with my walnut walking stick as I regale them with tales from the bear markets of 2000 and 2008.

As a corollary to yesterday’s deflation discussion, I thought I’d cover the consequence for gold and gold stocks. The relationship between gold and deflation is a contentious one so I don’t think it will ever be put to rest. In any case, I wanted to point out an interesting relationship which you’ll be hard pressed to find elsewhere.

Referring back to the chart in our previous discussion on the consequences of deflation you can see that we’ve had several periods of negative real interest rates. Naturally, these are when the inflation rate is higher than the nominal interest rate.

These periods coincide with great opportunities for buying gold and gold stocks. For example, in early to mid 1970’s and again in 2003. This doesn’t always hold true however. For example, the gold mini-bull of the mid 1980’s happened without a negative real interest rate environment.

In the 1970’s inflation was rampant and pushed real interest rates below zero. Until Volcker’s ‘take-no-prisoner’ style of monetary policy choked off inflation and brought real rates above zero. But of course, the situation in 2003 wasn’t that we had excess inflation but that nominal interest rates were being kept much lower than they should have been by the Federal Reserve (and we all know how that played out eventually).

Since deflation usually arrives at times of economic slack, one way to try to measure the relationship between the performance of gold and deflation is to look at how it did during recessions. Click the thumbnail to the left to take a look at a spreadsheet showing this data since 1945. The data is courtesy of EWI - they are also giving away a free 60 page eBook on Understanding Deflation which is chock full of similarly interesting tidbits.

The average performance of gold during recessions since 1945 is a miserly 4.8%. What about this most recent recession? We know the start of it but while many are prognosticating its end, we don’t have an official end date from the NBER. So let’s see how gold has done since December 2007:

That’s much better than the average but much lower than the outlier from the mid-1970’s. Still, it is not even enough to marginally move the average over the past 11 recessions. So according to this, holding an investment in gold during deflation is not usually a smart idea.

Trading gold and gold stocks however is still lucrative. One of my favorite indicators is the K-Ratio which is a ratio of gold stocks to gold itself. Here are two long term charts of the K-Ratio (using the Philadelphia Gold Bugs Index and the CBOE Gold Index to approximate gold stock prices):

Right now, the K-Ratio is trading mid-way and not really giving any signals. If it does fall again to previous lows, then we could have another set up for a ramp higher. Until then, I’m not too excited about gold.

While the crude oil market has sharply corrected from its bubble heights, there is reason to believe that it still does not truly reflect the underlying demand and supply equation at the heart of price discovery.

Here’s a chart showing OPEC’s spare capacity in millions of barrels over the past 8+ years:

Source: Bloomberg

We are right back to where we were at the beginning of the year in 2000 and 2002. Since this isn’t relative (to total production or demand) it is difficult to look at this data series over time. But assuming that 9 years isn’t that long, it is still valuable.

Of course, there are many variables that go into determining the price of a barrel: total capacity of production, how much oil is flowing from OPEC, how much demand there is from the global economy, as well as the demand from institutions not for use but for investment.

This last rationale has been the driving force in recent years as ‘animal spirits’ have taken hold. While last year’s crude oil bubble returned to normalcy, it looks like it is reflating right back up again. And the same basic script is being used as large institutions and hedge funds plow money back into this market.

Considering the extreme economic downturn, crude oil should have fallen to $20 - previous support from 2002. That’s just my own guess. Or it could have not gone up so much in the first place. Instead of acting as a ballast to rescue the global economy when it most needs it, it has instead been acting like an anchor, dragging it down further.

Here’s a chart of crude oil futures for the same time period showing each time that spare capacity reached above 6 million barrels:

Looking at these two charts together makes one wonder if the crude oil market is ignoring the excess spare capacity or whether it successfully discounts it. For example, most recently by falling from $147 in 2008 to less than $40 in early 2009 as spare capacity shot up to multi-year highs.

It is impossible to speak on behalf of a collective such as the market but my hunch is that, for the past few years, the oil market has been driven by tectonic shifts in asset allocation more than that which can be explained by fundamental analysis (such as supply and demand variables).

While we’re at this discussion, here’s an intriguing thought experiment. Imagine if instead of crude oil, we had to rely on a cartel such as OPEC in setting the price of a ubiquitous commodity like say, water. How would the price of water be set? would we just go along? or would we simply refuse to allow a cabal to dictate the price of water by turning their spigots on or off?

No doubt, you’ve probably seen a chart of the unemployment rate recently. And you know about the surprise dip in last month’s unemployment rate.

By the way, that reduction has been roundly dismissed as a statistical mirage because more than not, it was caused by people who gave up looking for a job, rather than people actually finding a job.

If you think the level of unemployment is alarming, you’ll find the chart of the average duration of unemployment in weeks downright frightening:

Source: St. Louis Fed

The shaded bars, of course, represent instances and durations of recessions as determined by the NBER.

Since the Department of Labor started collecting data for this statistic in the late 1940’s, we haven’t seen unemployment last this long. The latest data is for July 2009 at 25.1 weeks - in other words, almost 6 months!

No wonder people are giving up looking for work. You would have to have the patience and fortitude of Job to persevere through such a harrowing episode. And remember, this is an average, so there are many who have been unemployed for much longer.

This means that the stock market recovery we’ve seen so far has not only been mostly a profitless, revenue-less one but also it is shaping up to be a jobless recovery. But then again, the stock market is famously supposed to be ahead of economic measures like unemployment.

Take the previous highest peak in the average duration of unemployment: July 1983 at 21.2 weeks. If we travel back in time to those days, it isn’t hard to imagine that we would be equally frightened at this statistic. However, thanks to hindsight we now know that by July 1983 the stock market had already bottomed and gone on to gain an astonishing 70% (for the Standard & Poor’s 500 index). So far, we’re only up about 45% since the March 2009 bottom - if it is indeed the floor.

So while the above chart may send a chill down everyone’s back about the health of the US economy, it doesn’t mean that the stock market is on borrowed time. More importantly, how can anyone look at it and still be worried about inflation?

Despite all the stimulus, the US economy is far, far away from reaching capacity and inciting inflation worries. I guess that is the narrow silver lining in this dark cloud.