Market Update - 11/07/07
Several significant events happened today which I think are worth noting.
Oil Prices Hit New Record High
Oil hit a new high of $98.62 before closing at $96.70. USO, the Crude Oil ETF, is up over 45% for the year.
While this development is bothersome, it was to be expected as there has been an unprecedented draw in inventories over the last 13 months. Since the beginning of October ’06, energy inventories are down 7.5%.
In June, I made my first post suggesting that oil prices would continue to climb in light of the draws in inventory. Since then, the rate of inventory draws has accelerated. Initially, the climb in oil prices was a subtle confirmation for me but now it just flat out scares me. I’m very concerned about oil prices and where they might go.
It is currently estimated that the world is consuming around 88M barrels a day and only producing 85M. Production is going to continue to decline as the 40 year-old “elephant fields” lose production capacity. There hasn’t been a major oil discovery in over 4 decades and even if there is one tomorrow, it will take years for it to begin producing. If there are any supply disruptions in the form of weather or geo-political instability, the ensuing rise in energy prices could be detrimental to the entire global economy.
With that said, prices should pull back at some point. But that was my sentiment in October and I was wrong then so I could be wrong again. Prices may continue to climb until prices choke off demand.
The US$ down over 10% YTD!
As of today, the US$ trade-weighted index is down over 10% YTD. This means that most of the stuff we buy from overseas is now 10% more expensive than it was 10 months ago and everything we make here is 10% cheaper to foreigners. Wall Street will tell you that this is good for “multinationals” like MMM, CAT, BUD, ect. The government will tell you that this development will benefit our trade deficit. There is much debate whether either of these are true. What I do know is true, is that these trends have resulted in hardships for my 89 and 92 year-old grandmothers who are struggling to pay their utility bills and nursing home dues.
A falling US$ will lead to more inflation, higher interest rates and quite possibly a significant sell-off in US equities.
Gold reaches new cyclical high
Given the prior two trends, it’s certainly not shocking that Gold closed at another cyclical high today, not far from its all time high of 870 – a level which should get taken out soon, but possibly after a pullback. The two primary Gold ETFs, GLD and IAU, are up 30% YTD.
While Gold is near its all-time highs when priced in US$’s, it is still very cheap when priced in oil and other commodities and still well below its cyclical highs when priced in Euros and other established foreign currencies.
GM Takes $39B Write-down
Of all of today’s developments, the GM story is the most intriguing to me. Today, they announced a $39B write-down. According to an article by the Associated Press, the primary driver behind this write-down is “a $38.6B non-cash charge related to accumulated deferred tax credits in the U.S., Canada and Germany.”
But the article went on to say:
But the markets aren’t buying it, sending GM stock into a mild decline. That’s because there’s plenty of other bad news. Just a few years ago, General Motors Acceptance Corp., the financing arm that’s 49 percent owned by GM, was the company’s life preserver, with robust profits from loans relating to the housing boom. Now it’s an albatross, contributing a $757 million loss in the third quarter–virtually all of it attributable to mortgage write-offs.
On CBSmarketwatch, the following was said…
GM said that confidence has been shaken by sluggish earnings growth in its core North American automotive market and setbacks at GMAC Financial Services, its lending business.
GM said there was a “significant” decline in net income at GMAC and increased corporate expenses. GMAC, of which General Motors holds 49%, lost $1.6 billion. It was caught up in the subprime turmoil that has rocked mortgage and credit markets.
What makes this intriguing for me is not that GM’s stock got hammered today because of this news. I am neither long nor short GM (Although I do drive a GMC Envoy). It’s intriguing because it is representative of how much our nation’s earnings are tied to the financial space. While “financial” stocks only make up 22% of the S&P 500’s capitalization, there are a lot of non-financial companies that derive a substantial part of their income from “financial activities”. Therefore, earnings from “financial activities” accounts for even more earnings in the S&P than earnings from “financial stocks” alone.
And why is this important? I have long argued that the earnings in the financial space are a sham, which it is finally becoming apparent that I was correct. (It didn’t take a genius to figure this out, banks have always “cooked their books” and when they issued blow-out earnings in Q1 despite the troubles in housing, it was pretty evident that something was amiss.) Since earnings in this space were questionable at best, I have also argued that we should discard their earnings when trying to value the S&P 500. As of Q2, the average P/E for the S&P, including the financials, was in the neighborhood of 18, higher than its historical average of 14.5 but not grossly so. But if you take out the financial stocks, whose P/E was under 10, you have an average P/E in the 20+ range, significantly higher than the historical average. But what if financing activities actually account for 30+% of S&P earnings? Now we’re north of the 21-22 neighborhood and approaching extreme valuations particularly given the inflation picture.
