Wednesday, July 8, 2009
Markets are in a tizzy of late, as the assets that rose in price from early March through early June now head south (e.g., equities, oil, gold). Treasury bond prices are doing just the opposite, a natural reaction from a market that views economic weakness as a source of deflationary pressures. Hopes of a recovery are now being called into question. Governments are threatening to pile on more regulations and more taxes in an effort to fix the mess. These are times that try men's souls, especially those who are optimistic.
The market is clearly moving against my position. I've been highlighting green shoots and the beginnings of a recovery for months now. I've argued that the economy was doing better in spite of all the counter-productive policies coming out of Washington. The market seems to be telling me that my optimism is badly misplaced.
Am I wrong, or is this just a typical correction? To help answer the question I've posted the above charts. In the first chart I compare gold prices to spot commodity prices. I've long thought that gold was a leading indicator of a lot of things, commodities being one. Gold has clearly led commodity prices in many instances. Although gold and commodity moves since 2001 look coincident, gold turned up in early 2001 while commodities didn't turn up until late 2001. Gold prices have since risen far more than commodity prices, and gold fell a lot less than commodities last year. If gold is still a leading indicator, it is telling us that commodity prices still have plenty of room to rise. And in any event, just a glance at the chart tells me that the decline in prices of the last few months is perfectly consistent with the normal ups and downs you see in almost all markets. I don't see any indication that the upward trend in commodities and gold has been broken. The monetary fundamentals support this view as well, with the Fed trying very hard to avoid any generalized price decline.
The second chart tells pretty much the same story: the recent price decline does not suggest any change in the upward trend of oil prices, and prices haven't wiggled any more now than they have many times in the past. Nothing moves in a straight line.
I would feel a lot more nervous about my position if the fundamentals had shifted, but I don't see that they have. Monetary policy continues to be very accommodative; the recent, modest decline in the Fed's balance sheet doesn't change that at all. Fiscal policy continues to be counterproductive, as it has been for the past year or so (tax rebates and bungled bailouts and the stimulus bill don't do anything to stimulate growth, but they do increase future tax burdens), but on the margin I detect a slowing in the pace of Obama's lurch to the left, which if true, would be a definite positive. (See my earlier posts from today that point out growing resistance to a big-government agenda.)
Market-based indicators also continue to point in a positive direction. As noted above, the downturn in commodity prices doesn't look significant, meaning they are still in an upward trend and reflect both improving economic growth fundamentals as well as accommodative monetary policy. Credit spreads are way down from last year's highs, and swap spreads and agency spreads are almost back to "normal" levels. Implied volatility in both the stock market and bond market is way off earlier highs. The TED spread is back to normal (35 bps today). Global trade still looks to be improving, with the Baltic Dry Index trading at many multiples of late-2008 lows, the four-week moving average of the HARPEX index I've highlighted before turning up for the first time since last July, and container shipments out of Los Angeles and Long Beach turning up. Consumer confidence has improved significantly. Housing affordability has improved dramatically. Used car prices have moved sharply higher. Corporate layoffs are way down. The ISM indices are way up. Money velocity is no longer plunging and looks to be stabilizing. The ECRI leading indicator is way up. Deflation fears have all but vanished. All of these things and more are discussed in prior posts.
There's one important dynamic that I can't document but which I think is the force behind a lot of the improvements noted above. It's the reason I have maintained an enduring optimism, especially when confronted with a market that was priced for the end of the world as we know it. It's the reason the U.S. economy has survived serious challenges in the past. It's my belief that free people and free markets (which have taken some hits of late but which are still the norm) want very much to work and make money, and that often involves making adjustments as circumstances change. We've had plenty of time for changes to take place, and relative prices have changed dramatically in many markets. On the margin, in the nooks and crannies of both the U.S. and global economy, I think there are many positive developments taking place that will eventually spread to the broader economy.
In short, I don't see this as the beginning of another big market decline. I think this is a normal correction; a bout of nerves that will soon pass.
Posted by Scott Grannis at 10:35 AM