September 13, 2006. Crude dominated the headlines and folks were freaking as it traded above (gasp!) $60/barrel. The media was awash with the conventional wisdom that if oil prices retreated, it would serve as a de facto tax-cut that would spark equities higher When Texas Tea briefly dipped, financial outlets loudly embraced it with a group hug and a circle smirk. "Falling Oil Prices May Help Spell Relief for Consumers," opined the Wall Street Journal on September 13, 2006. "Stocks Rise as Oil Prices Keep Falling," wrote the Seattle Times the same day. "Falling Oil Prices Fuel Blue Chips to Jump 101.25," rationalized the Wall Street Journal in a separate column Dick Green, president of Briefing.com, proclaimed, "The notion that lower oil prices are bad for the equity market is 'rubbish'... the decline in commodity prices is bullish for stocks." Minyanville Editor-in-Chief Kevin Depew took a different tact and wryly offered, "Yesterday I heard on television that anyone who thinks commodities are going to lead stocks lower is 'stupid.' Well, I guess I'm with stupid. So is Australia, and much of the Asia-Pacific region." I offered a similar take at Minyans in the Mountains III a month earlier: "The rub, for lack of a better word, is that the long-held and universally accepted notion that lower energy prices would bode well for the consumer, and as an extension the stock market, is entirely misplaced. If the commodity complex begins to spin lower, the odds-on-bet is that equities will follow their lead." Fast-forward eighteen months. Crude was racing towards $140 and equities, defying gravity, meandered above S&P 1400. What was the mainstream media perception? "Man, stocks are already strong -- imagine what would happen if crude actually traded lower -- stocks would rip even higher!" It was then we penned, "Oil of Oy Vey," a column that delved into the thesis that lower crude would be endemic of slowing global growth. We mapped the first (of many) Minyanville Bubble Comparison Charts and offered a warning that as oil slicked lower, stocks would get the living... well, stocks would trade off in sync. It sounds easy and intuitive now but at the time, it might as well have been Pig Latin Portuguese. It's one thing to opine that the oil bubble would burst. Some would argue that was the "easy trade" and simply a matter of time. The more daunting dynamic, as postured by Mr. Practical, was that all roads ultimately lead to deflation. As we witnessed less than two years later, they most certainly did. Not only did watershed deflation arrive like a clap of thunder, it almost took down the entire capital market construct in the process. That was the natural, free-market path; debt destruction, asset class deflation, and the medicine of time and price. The reactive policy employed on the fly staved off the cumulative comeuppance but was laced with unintended consequences and societal implications, such as eye-popping bonuses at banks such as Goldman (GS), Morgan (MS), JP Morgan (JPM), Bank America (BAC), and UBS (UBS). As we ready for the next iteration of the I.V. drip -- perceived by many to be a win-win for the markets -- we can only hope policymakers have learned from the past. The alternative is an ‘in too deep’ dynamic and the potential that psychology, the single most important metric in the marketplace, challenges the credibility of our decision-makers. I leave you with a passage from Mr. Practical, for it's as apt now as it was when he wrote it in 2008. And I quote:
Banks and dealers have produced one thing over the past several years: various forms of loans in paper form. When banks value a loan there are two primary variables: default rates and interest rates. Default rates estimate the probability of getting your money back; interest rates how much you get paid for taking that risk. Banks and dealers made gobs of loans valuing them way too high because they under-estimated default rates and over-estimated the interest rates they'd receive (the bank gave full value to the paper assuming the borrower would successfully be able to pay higher rates when the lower teaser rate converted to a higher fixed rate). So all this paper was carried on the books at a high price: The banks showed profits by marking up the value of the paper. That brings us to our paradox. Now we know that those variables were fallacious: higher default rates and lower interest rate assumptions are forcing those banks to write-down the value of those loans. But they still haven’t written down the paper to where realistic default and interest rate assumptions lie. Real buyers are now assuming realistic assumptions where banks still aren't. If banks assume higher interest rates so they get more cash over the life of the loan, they must then assume higher default rates for those go up when interest rates, the cost of a loan, goes up. So there's no place the banks can go except to write-down more the value of the enormous debt they are carrying on the books. Those buying financial stocks now say the loans have been written down enough. The problem with this logic is that if they are right about default rates they are wrong about how much banks will earn off the loans. Even if those loans are near correct valuations for now, the stifling of the great credit machine will (has) caused a recession. The consumer's in no shape to borrow and with the decline in the value of the dollar that need is rising not falling. As the recession takes hold the value of the loans will fall again (higher default rates) and the deflation cycle will continue until vast amounts of debt is written off. This story's not about three 400-point rallies in the Dow over the last month or so. This is a much bigger story: one that will unfold over the next few years. Traders will get chewed up in market volatility, we will be fed new saving regulations by government bureaucrats, and the media will misinform us all along the way. I have always believed that Minyanville is not about catching the next few hundred point rally; with this volatility there are no odds in trying to predict it. With this volatility being short stocks is very risky and making money that way will be left to only a very few traders. I believe Minyanville is one of the few venues where the truth is discussed with no hidden agenda. That's going to be very valuable over the next few years. Higher stock prices aren't less risk: They're more. With treasury rates so low it's obvious that a good amount of people are seeking lower risk while central banks want them to seek higher risk. You have to decide for yourself where we are and all I can do is present some real facts for you to make that decision. The best advice I can give is the same. Stay out of debt, try to save money (even though the government is making it nearly impossible to do so) and keep risk low.
Thanks for your continued Minyanship. As always, we hope this finds you well. R.P.
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Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at todd@minyanville.com.The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
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