(July 3, 2008)
Dear Subscribers and Readers,
First of all, I want to wish all our American subscribers a great July 4th. Have fun in your celebrations – and make sure to drive safely, as always (or better yet, avoid driving if you could). Since this is a truncated trading week, our upcoming weekend commentary may be brief, unless something unforeseen occurs later today or in Asia/Europe's Friday trading session. Finally, we will be heading to Catalina Island for some R&R on Monday and Tuesday of next week, so I would be absent from our discussion forum during trading hours, although I will definitely be checking emails and keeping track of Asia during the evenings.
In his seminal 12-volume work, “A Study of History,” the eminent historian, Arnold Toynbee, chronicles the rise and fall of 22 civilizations, from the ancient Egyptians to Feudal Japan to the ancient Babylonians, and asserted that civilizations tend to stagnate from too little challenges, or crushed if forced to bear excessive challenges. He also asserts that civilizations will only develop/evolve once they have met the most critical challenges, only to be met by another. Finally, the “creative minorities” tend to be the ones that derive solutions to these challenges – while others in positions of power then follow.
More important than the subprime write-downs (more than US$400 billion so far) or their multiplier effects (John Paulson of the hedge fund Paulson & Co. estimates total write-downs to be over US$1.3 trillion) are the challenges being posed in the energy sector today, specifically the shortage of cheap, conventional crude oil sources. Make no mistake: Crude oil is the lifeblood of the modern economy. As a society continues to evolve, energy consumption per capita tends to increase as well – as we rely on more power to run our supercomputers, communication devices, transportation vehicles, cooling and heating units (think the indoor skiing facility in Dubai), and entertainment devices. More importantly, as firms like Google continue to digitize human knowledge and distribute it over the internet (whether in text, audio, or video format) – most of what we touch will be electronic in nature, although we have also made rapid strides in lowering power consumption of our electronic devices as well. As I mentioned in our latest weekend commentary, conservation in the long run isn't the solution to our energy problems. Quoting our latest weekend commentary:
Whether the U.S. stock market can resume its bull market and sustain it over the next five years will depend on the potential improvements (and commercialization) of these alternative energy technologies going forward. Global economic growth – almost by definition – needs an ever-greater amount of energy (e.g. it costs tens of millions of dollars annually to maintain “Roadrunner,” the number one ranked supercomputer in the world at a speed of over one petaflops). Conservation alone is not going to cut it. Fortunately, in the meantime, there are some “stop-gap” solutions, including: 1) BP's “Thunderhorse” drilling platform, which just came online and is expected to produce 250,000 barrels/day of crude oil and 400 MMCF/day of natural gas by the end of this year, 2) The discovery and the rapid drilling of the Marcellus Formation, which is conservatively estimated to contain around 50 TCF (trillion cubic feet) of recoverable natural gas reserves, 3) The immediate availability of over 70,000 barrels/day of sugar cane based ethanol from Brazil, as long as Congress does away with its tariffs on ethanol imports, and 4) The continuing adoption of wind power and solar power, although the majority of these systems won't come online until 2009. For now, I am optimistic that the global capitalist economies will be able to find a solution to our energy constraints – and most importantly, to bring our energy infrastructure to the “next level” – an energy infrastructure which is capable of providing a nearly limitless source of energy for global consumers going forward. Should we fail, then get ready for some dark times, indeed.
At this time, there is no shortage in the physical crude oil market. The futures market – which drives the physical space – however, is saying otherwise. The speculators (or the indexers, whatever you want to call them) have their own reasons for buying commodity/energy futures (although some are definitely misguided) – but a substantial portion of these speculators, such as commodity hedge funds, are only buying and rolling forward their futures contracts because they anticipate future shortages in various commodities, especially crude oil. In other words – this price signal from the crude oil complex – is now screaming to us that there is a “future challenge” within the global energy complex, and is instructing us to find a solution to this challenge before things get out of hand (i.e. before global crude oil production actually experiences a year-over-year decline). While the last $20 appreciation probably has more to do with energy producers and hedge funds being forced to cover their short positions (note that raising margin requirements will make this worse, as the indexers are for the most part fully-collateralized holders of commodity futures contracts), it is safe to say that the U.S. capitalist system and (relatively) free/liquid markets have achieved their objectives once again. That is, it is warning us that our global energy infrastructure (through the price signal in crude oil) is deficient, and it is also motivating the scientists and the “clean tech” venture capitalists (i.e. the “creative minorities as postulated by Arnold Toynbee) – possibly with major government subsidies with a new President next year – to find viable solutions for our upcoming energy challenges. We should thank the speculators instead of demonizing them.
If the perma-bears are right and the global capitalist system can't find a viable solution to $140 crude oil, then yes, all hell would eventually break loose as each major country competes for dwindling natural resources. But given the technological advances we have already seen in solar power, cellulosic ethanol, and battery technology over the last few years, that is indeed a stretch. With the ingenuity of US, Japanese, German, Chinese, and Brazilian scientists – and backed up by an unprecedented amount of private global capital now flooding into “clean tech technologies” – my sense is that the optimists will triumph over the long run. More importantly, solving the current energy crisis and our “foreign addition” to crude oil prices would also allow US society to “develop to the next stage” (to paraphrase Toynbee) – thus paving the way for the next great bull market. While the stock market can definitely decline further over the next few weeks, I now believe this is a great long-term buying opportunity. In fact, any further dips and declines in the US stock market (with an emphasis on technology and biotechnology), Japan, Taiwan, and South Korea over the next 12 to 18 months should be bought and held for the long run.
Let us now take a look at the oversold conditions of the global, regional, and country-specific equity markets by consulting our Global Overbought/Oversold model. Under normal circumstances, we usually use our monthly Global Overbought/Oversold Model as cues to either go long in a substantial way or cut back on long positions (overbought indicators are notoriously bad timing indicators), and this is what we are going to do in this instance. This model was first discussed in our August 2nd commentary. As we mentioned in that commentary, the inner workings of this global overbought/oversold “model” are rather simplistic. For each country or region, we first compute the month-end % deviation from its 3, 6, 12, 24, and 36-month averages. Each of these % deviations are than ranked (on a percentile basis) against all the monthly deviations (against itself only, not deviations for other countries or regions) stretching back to December 1998. This way, we are comparing apples to apples and can control for country or region-specific volatility. We also added the CRB Total Return Index since our August 2nd commentary. Following is our Global Overbought/Oversold Model as of the end of June 30, 2008 (note that this does not take into account last yesterday's global decline):
Aside from equity markets in Latin America, Emerging Europe, and the Middle East, the vast majority of the world's equity markets are now oversold (below the 15th percentile, or approximately one standard deviation below the average – these cells are highlighted in yellow). Specifically, both Belgium and Ireland are now oversold on all timeframes (3, 6, 12, 24, and 36 months). India, with a 0% percentile ranking over the last 3, 6, and 12 months, is now extremely oversold in the short run. Interestingly, both Japan and Japan small caps have been faring relatively well in the latest global decline. Not surprisingly, both Canada and Norway are doing well in light of stubbornly high crude oil and natural gas prices. Meanwhile, the United States is now oversold on both a 12 and 24-month timeframe for the first time since this bull market began in October 2002. Should the U.S. broad market decline an additional 2% to 3%, it will no doubt be oversold in all timeframes with the exception of the 36-month timeframe.
Another way to look at the overbought/oversold condition of the U.S. stock market is through the percentage of NYSE stocks above their 200-day exponential moving averages, as illustrated in the following weekly chart (courtesy of Decisionpoint.com):
As can be seen in the chart above, the percentage of NYSE stocks above their 200-EMAs has been at or below the 50% market since early November 2007. In other words, it has now been below the 50% market for eight consecutive months. The last time this percentage has been at or below the 50% market for such a long stretch was during the July 2002 to March 2003 period – when US investors were capitulating en masse in the aftermath of the late 1990s technology/telecom bubble. Similar stretches (as circled in the above chart) occurred during 1990 and the majority of 1994. All four episodes preceded major rallies and were ultimately very profitable who bought – even if one was a few weeks early.
Henry To, CFA