The Markets Are Making Almost No Sense

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About two hours’ drive south of Calgary, Alberta, there’s a place called Head-Smashed-In Buffalo Jump. It’s located in the Porcupine Hills, where the foothills of the Canadian Rocky Mountains meet the Great Plains of the North American interior.

Head-Smashed-In Buffalo Jump bears witness to a custom practiced by the native people of the plains for nearly 6,000 years. The native people were hunter-gatherers, so they understood both topography and animal behavior. And the native people killed large numbers of bison by chasing them over a cliff.

The bison used to graze on the plateaus adjacent to a deep river valley. The early human inhabitants would sneak up on the bison. Then they’d scare them with loud screams and burning torches. The bison would spook, run over the edge of a sandstone cliff and fall to their deaths on the rocks below. Then the natives would carve up the carcasses and leave the remains to the vultures and other scavengers.

People don’t herd buffalo over cliffs anymore. Smashing in the heads of large herbivores – by luring them into a deathtrap – has gone out of fashion. But still, there is something similar in our modern time. It’s called investing on Wall Street. Or so it seems.

Can you believe what is going on in the markets? Pardon me, but the markets are making almost no sense.

The future of the U.S. dollar looks terrible, yet the dollar is rising at a record-setting pace. And depletion is causing oil output in some areas to…well, fall off a cliff, if I may use that phrase. Energy and commodity stocks are tumbling like buffalo in the olden days of Alberta.

Let’s start with the U.S. dollar. It’s strengthening on world markets, but why? Is there some sort of good news about the U.S. economy we’ve missed? Is the U.S. tax code suddenly more capital friendly? Are national levels of wages and household incomes rising? Is the labor force suddenly more focused on producing goods that the world wants to buy by the boatload? Are government expenditures suddenly under control? How about none of the above? Really, where’s the good news?

Despite the lack of good news, for the past two months, the dollar has been strengthening. The euro, in turn, has been weakening as Germany and France have slid into recession. Pretty much in tandem with the rising dollar, the prices for oil and natural gas have been falling. And prices for precious metals have also been declining. It’s devastating the stocks in the Outstanding Investments portfolio.

Meanwhile, the U.S. banking system is badly hobbled. Back in January, in an Outstanding Investments weekly update, I predicted, “Three major banks will fail in 2008.” Now here we are in the ninth month of the year, we’ve bagged a good deal more than three banks and the list is getting longer. (Last week, an acquaintance who works at a government agency described Citigroup to me as a “dead bank walking.”)

Heck, the U.S. government just seized Fannie Mae and Freddie Mac. Don’t these firms count as major banks, what with their $5 trillion and more of liabilities? They’re both too big to fail, yet too big to bail. Really, does anyone have a spare $5 trillion lying around?

It used to be that the job of the Federal Reserve was, as former Chairman William McChesney Martin Jr. told it, “to take away the punch bowl just as the party gets going.” Now it seems like the Fed is laying a direct pipeline to the distillery to keep everyone loaded. And in the process of taking over Fannie and Freddie, the U.S. government is socializing the financial side of the national housing market. The cynical view is that the federal government will loan you the money to buy an overpriced house and your local government will tax you for the privilege of living there. But where is the money coming from?

And what’s going on with the price of oil? The other day, someone sent me an e-mail asking about the “plunge in oil prices.” Plunge? Not quite. If you want to see a plunge, go to Head-Smashed-In Buffalo Jump. But oil has not plunged. Or at least it depends on your time frame.

This time last year – September 2007 – a barrel of oil cost about $80, and rising. I remember being in Houston in October 2007 – sitting about 10 feet from T. Boone Pickens and his wife – when oil crossed the $90 mark for the first time. Pickens commented, “We’ll see $100 oil before we ever see $80 again.”

T. Boone Pickens was right. Today, a barrel of oil is trading for about $107, or about a 33% increase year over year. That’s no plunge.

OK, I know what people are talking about. Back in the spring and summer, oil ran up in price. Oil crossed $100 early this year and kept rising. By July of this year, oil traded for over $147 per barrel. At the time, I said that oil was “rising too far, too fast.” I said that a lot of things in this world stop working when oil gets to about $130 per barrel. And I also said – on Fox Business News one early morning in June – “Oil OUGHT to pull back to around $100-110 per barrel.” In the past two months, the price of oil has fallen by $40 or so.

That is, oil is down close to 30% from its recent high. But that’s after more than doubling in the past year. So the recent price retreat is not a plunge. It’s just a correction within a long trend of rising prices for energy.

Meanwhile, almost all of the world’s largest oil fields were discovered over 30 years ago and have been lifting crude oil for 30, 40 or more years. So crude oil output from many of the world’s oil fields is either flat (such as in Saudi Arabia) or falling (such as in Mexico).

Even Russian oil output is dropping this year. No less an authority than the head of Gazprom recently stated that oil should sell for $250 or more per barrel.

Closer to home, let’s take a quick look at Mexico. Crude output from Mexico’s Cantarell oil field – the third largest in the world – is falling at its fastest pace in 12 years. For the past two decades, Petroleos Mexicanos (Pemex) has badly underinvested in field upgrades and new exploration. So Cantarell oil output has fallen 34% within the past year.

Indeed, Mexico may cease to be an oil exporter as early as 2010 and, in all likelihood, no later than 2012. In all candor, even the “lack of investment” argument holds a large element of spin. It may well be that no amount of new investment can reverse Mexico’s oil output decline.

Along these lines, I surely do not envy the next U.S. president. One of these days, the morning National Intelligence Brief will begin, “Mr. President, we have some really bad news about Mexico’s oil exports to the U.S. Pemex told us that within the next two months, it just can’t deliver the oil that we’re expecting. And none of the other oil suppliers in the world can begin to make up the difference.”

Yet in the face of all this, the market is currently selling off oil and other energy players. The market is selling off oil field service companies, infrastructure companies, precious metals companies and even basic metals.

So how do we deal with this? I hate to see what’s happening to the Outstanding Investments portfolio. It’s painful to watch such great companies decline in value. But I also have to keep my eyes on the future.

And what does the future hold? The dollar will weaken, what with all the new credit being created to bail out banks, and probably the automakers, and everybody else with a hat in their hand, it seems. And the energy and resource plays are going to stage a comeback. Of that I am convinced.

For now, just be careful when you walk next to any cliffs. Remember what happened with those buffalo out in Alberta.

Until we meet again…

Byron W. King
for The Daily Reckoning Australia

Byron King
Byron King currently serves as an attorney in Pittsburgh, Pennsylvania. He received his Juris Doctor from the University of Pittsburgh School of Law in 1981 and is a cum laude graduate of Harvard University. Byron is also co-editor of Outstanding Investments.
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Comments

  1. The market makes no sense because most players haven’t got a clue.

    Gold up – gold juniors down (margin calls and perceived dinance risk I guess)

    More liquidity – market rally (in the face of a cliff fall I guess. Idiots still assuming a return to bull conditions abound.)

    I’m still learning more about synthetic CDOs each day and each day brings new surprises. My gut feel at the moment is that about 50% of what was sold on the Aussie market will be wiped out – but who knows? maybe less, maybe all of it. Clearly the products were misrepresented by the promoters. In any case I still feel sad for the Lehman staff in Australia – and as usual it is the little people who cop abuse over the phone after the key bosses have walked.

    A trip to the Rocky Mountains would certainly clear the breathing!

    Coffee Addict
    September 19, 2008
    Reply
  2. Students of Physics know a sun expands rapidly before it collapses.

    Reply
  3. New Dow high in boom then bust

    “Indeed the temporary breaks in the market which preceded the crash [of October 1929] were a serious trial for those who had declined fantasy. Early in 1928, in June, in December, and in February and March of 1929 it seemed the end had come” (John Kenneth Galbraith, “The Great Crash”, p.98).

    History suggests, as I have argued before, that the Dow will peak in the McCain presidency and then the bust will come. The events of this week encourage me that the final rally of the ‘bull’ market that started in early October 2002 is near or underway.

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  4. Really, very good article for the fact that it doesn’t focus on one specific area, but rather views the whole debacle as a number of interconnected odd business manglings. Isn’t this business ride we’ve been introduced to seem oh so exciting?! Regulations put in place during Roosevelt’s Presidency to avoid the pitfalls of the Great Depression got nixed by McCain’s economic advisor, Phil Gramm. He slipped it into a bill at Xmas time, that all those rich congressmen didn’t bother to read, and we started the whole Depression style of losing the ol’ home to the bank bit again. Aren’t we having fun now? Phil Gramm says we’re all a bunch of whiners in a mental recession. Gee, I guess if I was a multi-millionaire that had sucker punched a whole country, I might be arrogant enough to have that attitude too. But in the final analysis, I’m just a regular joe blow in no position to act that cocky about an economy around me that looks like its shrinking into a black hole. Oh, why does my gut turn as I keep wondering where the bottom is. Is this it, are we there yet?

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  5. You shouldn’t complain about the Fed’s rescue efforts. Would you like to see a rerun of 1929-32 when the Federal Reserve sat on it’s hands while the financial system and the economy collapsed? That must haunt present day policy makers.

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  6. DP,

    The 1929-1932 was created by a huge expansion in money supply 10 years prior to that by guess who – the Fed! It’s very similar to today. They increase the money supply and keep increasing to keep the bubbles going (“roaring” 20s?) and then it all comes crashing down as a huge correction, for which no amount of printing money is going to solve it. The Fed actually increased the M1 during the 1929-1932 period by 30% but M3 still shrunk because of all the unwinding in the financials. The Fed was powerless then as it will be now.

    Reply

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