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Up to Our Necks in it

It is amazing to reflect on the fact that the stock market last week experienced its worst 5-day span to open the year ever. I haven’t independently confirmed that; it seems incredible to me that in a hundred and whatever years we have never started with a 6% loss – but that is what is being widely reported. In any event, it has been a bad start and the market is back to the levels it last saw in August, before the inexplicable Q4 blast-off. Easy come, easy go.

Why is the market down? The harder question is the question of why it was up in the first place. Stocks have been persistently far above fair value measured by CAPE, Tobin’s Q, or any other traditional value metric. The argument that stocks were high because bond yields were low is perhaps the best explanation; this is after all part of the whole “portfolio balance channel” effect that the Fed has been trying to create with QE – raise the price of a good (bonds) and the prices of substitutes (corporate bonds, stocks) should also rise. (Left unsaid, of course, is why it is a good thing to move asset prices away from fair value. The ‘wealth effect’ is small, and zero-sum at best unless prices can permanently be moved away from fair value.)

But if this is the explanation for sky-high stocks, it doesn’t explain why commodity indices – which are obviously also a substitute for stocks and bonds – are at multi-decade lows. Why should the price of that substitute move in the opposite direction? Before you say “weak global growth,” or “overproduction” (as this article has it) remember that not only is oil low, but so is Corn. And Hogs. And Sugar. And Cocoa. What, are we overproducing everything? Is China not eating, either?

I actually really like that article. When oil was at $120, everyone (including fancy Wall Street dealers) published breathless articles about $200 oil. Today I saw an article saying oil is going to $10 – which would be the lowest real price, I think, since oil was discovered. This article could have been written any time in the last 20 years and pointed to some new mine, or crop production technique, or oil field, or railroad, or the development of horizontal drilling, etcetera. It’s just when prices are very low that this is suddenly viewed as an epiphany that Aha! This must be why prices are low! There are big mines opening!

There are, of course, some problems of overcapacity in some commodities because cheap money made possible, for example, the massive draws from Baaken shale. But overcapacity in every commodity? Overcapacity in gold?

And global growth is, indeed, weakening. I would caution any analyst that wants to read into the surprising strength of Friday’s Payrolls report. It is a December measurement of the employment picture: notoriously difficult to seasonally adjust. Some have argued that exceptionally warm weather in December may have increased payrolls beyond what the seasonal adjustment calls for. I am not sure that argument works, since most of the seasonal adjustment is due to seasonal workers and I am not sure why you need more seasonal workers if it is warm. More in construction, perhaps…but the important point is that the error bars on the December are so large that you are supposed to ignore it in almost all circumstances. You simply cannot reject virtually any null hypothesis. What you believed before the number was released, in other words, you should still believe. And as for me, I believed that global growth was weakening – not collapsing, but weakening and probably headed for a recession.

And what a shame. What a shame that central bankers didn’t re-load when they had the chance, and let markets and economies get back to normal. What a shame that the federal deficit wasn’t pushed close to balance when the economy was growing over the last few years.

As David Bowie almost said, [What a] shame [they]’ve left us up to our necks in it.

But if in reaching that conclusion you have come to hate commodities along with stocks, you have come too late. Commodities were worth hating four years ago. But it is hard to see the upside of their downside, now.

This is not true, however, with equities.

Categories: Commodities
  1. Eric
    January 12, 2016 at 5:10 pm

    I just looked this up because I was curious. From one barrel of oil you can get over 30 gallons (combined) of gas and diesel. That means the oil-based cost (net of taxes, refining, shipping, retail markup, etc.) of a gallon of gas right now is about a dollar. How crazy is that? It also means that if they were giving oil away for free, the price of gas would only go down by about 50%. Which means that the increased demand due to lower prices is already pretty much maximized. US production is dropping like a rock. But foreign imports are compensating. The only explanation is that the KSA is waiting until they can see the white of the US petroleum industry’s eyes. They not only want to bankrupt every producer, but they want to bankrupt the vultures who try to buy up the distressed assets.

    You combine that with the fact that crazy “austrians” probably drove the price of gold up too high–and so it had a natural fall over the last 2-3 years, and its not THAT surprising that everyone thinks commodities are in crisis and want to sell them all.


    • January 12, 2016 at 6:38 pm

      Not surprising at all! But a great opportunity!

  2. Eric
    January 13, 2016 at 6:19 pm

    well, major risk off day today but some commodities up (in fact usci 50 bps), so maybe you are starting to get your way.

    • January 13, 2016 at 6:21 pm

      one day does not a trend make, but … it’s the right direction.

  3. CharlesD
    January 15, 2016 at 7:50 pm

    Hope all is well. Good Stuff. Very informative. Usually agree with 95% which I guess is most any two people ever agree One question on this note: You say “what a shame the federal budget wasn’t pushed close to balance…..” My understanding is that the budget could only have been balanced by increasing taxes or reducing spending or both. These actions would have directly reduced private sector incomes ( to the tune of,say, $400B! for a balanced budget) This would likely have pushed us into recession some time ago. Isn’t it good that this did not happen? Or do you think I am missing something? Thanks.


    • January 18, 2016 at 4:15 pm

      Well, that lack of a recession (or postponement of one) comes at a cost! If it didn’t, why don’t we increase the deficit every year forever? The important thing to realize about a deficit is that it draws from future growth to create current growth – some day, we will either have to raise taxes or cut spending to pay off that debt (unless the government can borrow at zero or lower real rates forever). Moreover, it isn’t ENTIRELY clear how much running a deficit helps current growth, since if you run the deficit you help private sector incomes but you have to take money from private savers that would otherwise have gone to private borrowers. The question is whether the government is better or worse at using these borrowed funds to create real growth (and the considerable evidence is that it is much, much worse). So, the $400bln that the government sucked from private borrowers by issuing bonds to cover the deficit went to private incomes, but it could have gone to a small business wanting to borrow money.

      In any event, the earliest recession is the best recession. The old rule about running deficits to help growth in recessions always contemplated that you would run surpluses in expansions. Turns out that people are always excited to fill in the valleys but aren’t so keen on shearing off the mountain tops to do it!

      • January 18, 2016 at 4:15 pm

        p.s. good question.

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