Global Stock Market BLOG - Mike Burnick

First Half Follies for Global Markets

For global investors, the manic market climate in the first half of 2008 was a period worth forgetting. Stock markets around the world were caught up in an epic selloff as the ongoing U.S. subprime credit crunch began to take its toll on the “real” economy, and inflation became a "headline" problem around the world.

The first half ended with a bang… the stock market’s worst June performance since 1930 (think depression), and the biggest first-half losses since 1970 (think stagflation). The biggest twin-threats to the global economy seem to be an odd combination of soaring commodity-price inflation, and crippling asset-price deflation – both happening at the same time.

The economic news in the first half of 2008 highlights these fears. Global consumer price inflation soared to about 7% -- the highest level in nearly two-decades. Meanwhile, in the U.S., housing prices continue to slide, and employers cut 438,000 jobs so far this year.

No wonder consumer confidence has plunged to the lowest level in 15 years.

U.S. stocks of course “officially” entered bear-market territory in the first half of the year, with the Dow Jones Industrial Average falling over 20% from its high last October (the S&P 500 Index followed last week).

Global markets certainly didn’t fare any better either. In fact, for the first time in a long time, most markets outside the U.S. performed even worse in the second quarter. Mainland China (Shanghai Composite) fell another 21% in the second quarter, adding to a stunning 48% first-half loss. Fellow BRIC India dived 14% in the three months ended June, and is down 33.6% year to date.

So far this year the U.K. is down 13%, Germany 20%, France 21%, and Hong Kong 20.5%, however there have been a few bright spots (almost too few to mention). Japan, one of the world’s most undervalued major markets, advanced 7.6% in the second quarter, although it’s still down for the year. And the other two BRIC markets, Brazil & Russia, enjoyed second-quarter gains of 17.7% and 10.5% (in U.S. dollar terms).

All in all, it was a very mixed bag with a definite bias to the downside.

Commodities once again turned in the top asset class performance in the first half. The sky-rocketing price of crude oil – up nearly 40% in the past three months alone – drove the S&P Goldman Sachs Commodity Index to a 29% gain in the second quarter.

Commodity investors should be careful not to get too complacent with their good fortune, since a big reversal could be lurking right around the corner. It’s worth noting that last year at this time, China’s Shanghai Composite Index was one of the world’s best performers… and look at it now.

Refiners Caught in a Squeeze Play, But Your Can Profit as Oil Prices Fall

In my last post(Crude Oil Bubble Trouble), I pointed out that many investors are beginning to speculate the bull-run in energy – particularly crude oil – has reached bubble-like proportions. Some folks are saying that “speculators” have driven the price of crude to unsustainable levels, and that a painful correction is just around the corner.

There’s one sub-sector of the energy industry that would actually benefit big-time from such a crude-price correction: Refiners.

Since 2001, the price of a barrel of oil has risen more than 600% to a recent high of $145. The price of unleaded gasoline however has jumped “only” 300% or so over the same time frame, to a recent price of $4 per gallon.

Share Prices and Profits Plunging for Refiners

That math just doesn’t add-up if you’re in the refining business. The biggest factor in the price of gas is (not surprisingly) the price of crude oil, which accounts for 75% of the total cost for gasoline. The other next two biggest factors (at about 10% apiece) are taxes, and refining expenses.

There’s no way to avoid the taxes. One of the Presidential candidates proposed temporarily suspending Federal taxes on gas recently; until someone pointed out that nobody would be fixing the potholes or widening lanes on the interstate highway system if no gas taxes were collected!

So with taxes pretty much a “fixed cost,” and crude prices escalating, the companies that refine oil into unleaded gasoline and diesel have been caught in a squeeze play that has decimated their profit margins.

In fact, profits at U.S. refinery operators plunged 98% in the first quarter as they were caught behind-the-curve on skyrocketing oil prices. Refiners have been raising prices to be sure. But they just haven’t been able to hike prices for gasoline, heating oil, and jet fuel fast enough to keep up.

To Know When Refiners are a BUY Again... Keep an Eye on the Crack

As a result, refinery stocks in the S&P index have been clobbered for a 40% decline, even as oil prices set new record highs.  But the key to refinery profits is the crack-spread. And no, this doesn’t have anything to do with illegal drugs.

The crack spread is the theoretical profit margin a refiner should earn from processing three barrels of crude into two barrels of refined gasoline and one of heating oil. That spread has plunged 38% over the past year, taking industry profits down-the-drain along with it.

But crack spreads, like so many relative price relationships in financial markets are constantly shifting from peak to valley and back again. Last year the crack spread for refiners was almost $23, today it’s just under $14 – a big shift.

That’s mainly due to crude oil’s unusually strong advance. Falling crude prices however can actually be a boon to refiners. “You really want to own refiners when oil's going down, and not straight up,” according to Cambridge Energy Research.

But now energy-sector fortunes may be reversing. At least that’s what smart-money investors, including industry insiders and hedge fund mangers, are saying.

In the last month alone, refining company executives have purchased $2 million worth of their own shares, according to Bloomberg. That’s more insider buying at refiners that at any time since 2000. In fact before March of this year, insiders had been very consistent net-sellers of refining stocks – “dumping more shares than they bough every week since 2003.”

“Anyone right now buying the refiners would have to be banking on a pullback in oil prices,” according to one fund manager interviewed by Bloomberg.

A Lower Risk Way to Make Money Off A Widening Crack Spread

Buying the refinery sector now just might be your best-bet among the various energy sector investment plays, especially considering the “speculative” over-bought state of crude oil futures at the moment.

Unfortunately, there’s no ETF available that gives you a broad based bet on the refining sector, at least not yet. However, several leading refiners including: Valero Energy (VLO) and Tesoro Corp. (TSO) are among those stocks with big insider-buys recently, according to Bloomberg.

This should even make a good “pairs trade” strategy for you. Typically a pairs-trade involves going long one stock or ETF – in this case a refiner. Meanwhile, you would sell-short another – in this case a major integrated oil firm like say, Exxon Mobil (XOM) – at the same time.

But here’s a pairs-trade twist that goes long-long… perfect for retirement accounts.

Buy the ProShares UltraShort Oil & Gas (DUG), which is designed to go up in price as the overall energy sector declines. At the same time, buy your favorite refiner, and earn potential gains as the razor thin crack-spread widens again.

Crude Oil Bubble Trouble

Last week crude oil traded up to yet another record high price above $145 a barrel. Black gold is living up to its nickname, having jumped more than 72% over the past 12-months alone – and up a stunning 631% since the end of 2001!

There’s been much speculation of late about whether or not oil prices are in a “bubble” that’s destined to burst just like China last year, housing a few years before, and internet stocks before that. There are good arguments both pro and con to the oil-bubble notion. Let’s take a closer look…

Fundamental Imbalances Leading to High Prices

There’s no doubt that supply-demand imbalances are playing a very big role in oil’s meteoric rise. Decades of under-investment in new oil production and refining capacity when crude oil prices were low, over the last two decades set the stage for today’s energy crisis.

And many years of above-trend global growth this decade led to a sharp increase in demand from the emerging world. Meanwhile, global production capacity just hasn’t kept pace with the world’s growing thirst for oil.

More recently supply disruptions in Nigeria and Iraq and falling output from Russia, Venezuela, and Mexico – among others – has resulted in very tight global supplies.

Meanwhile, strong demand growth in emerging markets hasn’t let up, partially due to widespread fuel subsidies in many developing nations.

Signs of Excess Speculation in Bubbling Crude

Still, fundamentals may not account for the entire rise in oil prices. According to data from the Commodity Futures Trading Commission (CFTC), speculators have increased their share of outstanding futures contracts to about 70% of the total, up from just 37% in 2000.

Commodity index funds and other pooled investments have poured about $250 billion into commodity trading strategies over the past five years alone. In other words: the hot money is chasing performance in one of the best performing asset classes this decade.

To be sure, some of this increase comes from diversified investment strategies adding commodities to enhance returns. And some of the increase in oil market speculation includes investment firms involved in hedging strategies (going both long and short) for their clients, according to the CFTC.

However, several analysts caution that a big share of the recent run-up in oil is pure speculation, and that prices could correct sharply, closer to the marginal cost of oil production... that’s about $65 to $70 a barrel!

Congress Debates Tighter Regulation, Higher Margin Limits

Now Congress, feeling the heat of higher energy costs, is proposing that the CFTC rein in oil market speculators by, among other things, suggesting a huge increase in margin requirements.

Currently, many investors in crude oil futures get away with putting up initial cash collateral (margin) of just a few percent of the underlying position value.

A $500,000 purchase of crude contracts on margin might cost just $25,000 to $50,000 in cash up front. In the stock market, a trade of similar size would require initial margin of $250,000 in cash.

And that’s exactly what Congress is talking about, raising margin requirements to 50% on futures! They’re also looking into barring pension funds from investing in commodities altogether.

As this debate rages on, one thing is certain, high energy prices are already resulting in “demand destruction” in the U.S. and other developed economies.  In fact, the domestic slowdown already underway will reduce crude oil demand by 240,000 barrels a day this year.

The battle between the oil bulls and bears is really beginning to heat up. It ought to be a good fight with lots of "fireworks".

There are some interesting energy-sector bets you can make that should pay-off in big profits - even with crude oil prices falling. I’ll give you more info in Monday’s blog, so stay tuned.

Have a happy July 4th holiday weekend!

Will the 'Cold War' Against Inflation Heat Up?

Another Federal Reserve Bank official said in a speech yesterday that he is: “taking the recent inflationary pressures very seriously,” and that “Policy needs to react decisively” to keep expectations of higher inflation in check.

So is this just more lip service from the Fed in an attempt to jawbone inflation (and perhaps support the dollar)? Financial markets aren’t so sure, as Fed funds futures continue to price-in a Fed rate hike sometime this year.

The major economies of the developed world are experiencing a sharp slowdown in growth, and bracing for recession. In fact, the U.S. economy expanded at a feeble rate of just 1% in the first quarter.

And we may have already entered recession, when data for the second quarter ended June finally gets reported.

But even as the economy slows, consumer price inflation in the U.S. rose to 4.2% in May, while wholesale prices rose 7.2%.

Meanwhile, emerging market economies continue to enjoy very robust economic expansion, expected to average 6.7% this year. That compares quite favorably to growth estimates of just 1.3% for developed countries including the U.S. and Europe (the U.S. will grow just 0.5%).

While inflation is running above the Fed’s comfort level in the U.S. (and the ECBs target in Europe), inflation in the emerging world has become an even bigger threat. In fact, inflation exceeds double-digit rates of 10% or more in 50 economies around the world, nearly all of them emerging markets.

This is an economic environment that looks shockingly similar to the “stagflation” era of the 1970’s and early 1980’s.

Famed investor Warren Buffett highlighted the dueling threats of slower growth and faster inflation recently saying: “I think the ‘flation’ part will heat up and I think the ‘stag’ part will get worse.”

While the Fed continues waging its war-of-words on inflation, the ECB gets to act on it tomorrow. Stay tuned.

Inflation or Deflation... Pick Your Poison

The U.S. economy, and most other developed nations continue to be squeezed between two opposing economic threats.

Commodity-price inflation and asset-price deflation are creating havoc with financial markets, while global consumers, businesses, and central bankers are caught in the cross-fire.

The U.S. Federal Reserve appears to be caught like a deer in the headlights, unable to reach consensus last week about the correct monetary policy prescription for dealing with the twin flations. The FOMC decided to hold-the-line, keeping the fed-funds rate steady at 2%.

By contrast the European Central Bank (ECB), confronted with the same economic data as the Fed, has reached the opposite conclusion. The ECB is threatening to raise interest rates at its upcoming policy meeting.

Data out today shows Eurozone inflation ticking higher to 4% - the highest ever. It seems this pretty much seals the deal for an ECB rate hike.

Of course this makes life difficult for the U.S. dollar. There is the slight matter of “yield differential”, which my friend and colleague Jack Crooks has discussed at length.

The dollar “yields” just 2% (the Fed funds rate) while the euro already yields 4% (the ECB benchmark rate) and is likely to go up at least another quarter-percent this week.

That’s why Treasury Secretary Paulson is in the middle of a four-day, whirlwind tour of Europe today, trying desperately to talk ECB finance ministers into a less-hawkish stance on inflation.

After all, higher Euroland rates could send the dollar plunging further, which in turn will lead to even higher commodity-price inflation. A vicious cycle if ever there was one.

The dilemma for central bankers around the world is trying to figure out which is the greatest threat to economic stability at present: 

A. The threat to growth from deflation in real estate and equity market values amid the housing recession and credit crunch.

OR

B. The threat to purchasing power that results from accelerating inflation rates around the world.

The Fed has focused more on the de-flation threat, while the ECB is more concerned with in-flation at the moment - and financial markets are caught in the cross-fire! Stay tuned...

Fun Facts on Inflation: Or, Why $140 Oil Looks Dirt-Cheap Compared to Other “Necessities”…

Investors are fretting over $142 a barrel oil this morning, and gasoline is well above $4 per gallon, but a recent story on CNBC.com shows how the high price of crude really stacks up against several other “necessities.”

The conclusion… oil’s actually pretty cheap at these levels... so quit complaining.

In fact, a trip to your favorite neighborhood sports bar will really give you sticker-shock. A barrel of Budweiser beer will set you back $447.25.

Would you like some Tabasco hot sauce for your chicken wings? That’ll cost you $6,155.52 a barrel! Hmm…I’ll take mine mild.

Switching to water to quench your thirst instead of beer won’t save you much either.

A barrel of Perrier will set you back $300.61 per barrel.

How about a trip to your local neighbor Starbucks instead? Cost: $954.24 a barrel – that’s only IF you take your coffee black.  Adding milk will cost you another $163.38 a barrel. 

Of course you can always just stay home, and drown your inflation sorrows in a pint of Ben & Jerry’s New York Super Fudge Chunk instead; cost: $1,609.44 a barrel!

Clearly it’s belt-tightening time for the average American amid these soaring prices for everyday “necessities” – just cut back on the luxury items and you'll be ok. After all who can afford Chanel No. 5 at a cost of $1,666,560 a barrel?

My wife will just have to do without!

Ben Bernanke and the Honey Pot

When my two girls were a few years younger, they were huge fans of Winnie the Pooh, one of the true children’s classics. At bedtime I would read them episodes from Pooh’s adventures in the hundred-acre wood nearly every night. They just couldn’t get enough.

One Pooh story in particular comes to mind this week. In this tale, Winnie the Pooh is so intent on licking the last drop of honey out of the pot that he gets his head stuck in the jar.

Ben Bernanke apparently never heard this story as a child – or certainly didn’t take the lesson to heart. That’s because Bernanke and the Fed are now “stuck.” It’s an unenviable position, but it's of their own making.

The Fed has been all over the map in response to the credit crunch that began last year. First they ignored it in the summer of 2007, keeping rates steady at 5.25%, while saying the fallout from subprime would be limited.

Later, after $400 billion in Wall Street write-offs, the Fed decided to slash rates to the bone, and bail out Bear Stearns with $39 billion in taxpayer money.

More recently, inflation is the Fed’s main concern. The Fed hinted strongly that rates must go higher to backstop the value of the slumping U.S. dollar, and to keep inflation in check. Yesterday, however the Fed did nothing, leaving rates unchanged. More empty talk from the Fed.

In its official policy statement the Fed said on the one hand: “Recent information indicates that overall economic activity continues to expand...”

But on the other hand: “uncertainty about the inflation outlook remains high...” due to “increases in the prices of energy and some other commodities.”

So in conclusion: “Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased.”

Bernanke’s in a box. The Fed is stuck in a honey-pot of indecision while the twin threats of asset-price deflation and commodity-price inflation take a heavy toll on the economy.

When you net out all the Fed’s double-talk, they appeared to adopt a tightening bias yesterday, but of course didn’t raise rates. So the worst of all worlds continues: stagflation!

In a TV interview yesterday Warren Buffett shared his views on the economy and inflation. He said: “I think the `flation' part will heat up and I think the `stag' part will get worse.”

When asked what he’d do if he were in Bernanke’s shoes he said: “I'd probably offer my resignation.”

Hog-Wild Grain Prices Putting the Pinch on Livestock Farmers

Iowa livestock farmers aren’t living high on the hog these days.

Recent flooding in this key section of America’s farm belt dealt yet another blow to farmers who are already in a bind due to sky-high feed costs and low livestock prices.

“Livestock farmers and meat producers across the country have been dealing with soaring feed costs for nearly two years,” explains a recent Wall Street Journal article.

“Now, heavy flooding in Iowa is sending corn prices even higher. Thursday, the corn futures contract for July delivery closed at $7.27 a bushel on the Chicago Board of Trade, up about 13% from two weeks ago.”

Livestock prices just haven’t kept pace with other soaring commodities, including the grain that's used to fatten them. Both farmers and meatpackers are seeing their profits squeezed as a result. In response, some big processors are liquidating their breeding herds, and family farmers are calling it quits.

“Shaun Greiner, a 39-year-old hog farmer in southeast Iowa, says he has been losing money selling his pigs since November.” It costs him over $170 in feed and overhead expenses to fatten a 15-pound piglet into a 280 pound whole-hog that’s ready for market.

The trouble is he can only fetch about $150 apiece when it's time to sell the animal at current market prices. That math just doesn’t compute.

Still, Mr. Greiner remains cautiously optimistic: “The wheel's going to turn and things are going to get better, and when they do it's going to be like shooting fish in a barrel, but I don't know when that's going to happen.”

We’re in the midst of a long-term bull market in commodities. In this kind of cycle, all commodity prices eventually soar to record highs, but performance is uneven from commodity to commodity.

While everyone is focused on soaring crude oil prices, some of the best values in commodity markets are in the agricultural sub-sector – especially livestock prices (lean hogs and live cattle).

According to my colleague Eric Roseman: “Over the last six years, live cattle and lean hogs have gained just under 30% in nominal terms, or up barely 4% adjusted for inflation.”

Livestock has essentially been standing-still compared to soaring grain and energy prices. In fact, over roughly the same time frame, crude oil is up over 600% in value!  Corn prices (a key feedstock for livestock) are up 120% in the past year alone!

You might say Eric is hog-wild for livestock, and I believe he’s right on the money.

Something’s got to give. Livestock farmers are already thinning the size of their herds, or calling it quits altogether, in response to soaring grain prices. Inevitably this results in reduced supply amid growing demand... sound familiar?

The next big round of commodity market gains are likely to come on the hoof.

Holding the Line…

Will they or won’t they? That seems to be the hotly-debated question as the Federal Reserve wraps-up a two-day policy meeting today.

There’s already some dissension within the rate setting Federal Open Market Committee (FOMC) with some members voting in recent meeting to hold the line on further interest rate cuts, or even talking about the need to raise rates to combat inflation.

Inflation worries are leading to lots of lost sleep these days for global central bankers. In fact, the European Central Bank may actually raise rates at its July meeting.

The trouble is, higher interest rates don’t do much to combat this kind of inflation, which involves mainly soaring food and fuel costs.

Headline inflation in food and energy prices has so far not spilled over into rising wages, the biggest input cost for most businesses. The reason is a globalized economy that has made labor markets much more flexible.

In fact, employment in the U.S. is already on the decline. Consumer and business confidence in both the U.S. and Europe has already fallen to the lowest levels in years, if not decades.

The Fed must continue to “talk tough” on inflation, if for no other reason than to keep the dollar from free-fall. The U.S. dollar is down about 40% this decade alone against a basket of world currencies. This fact has as much to do with rising oil and other commodity prices than global supply-demand imbalances.

Talk is cheap, but I expect the Fed to stick with a war-of-words against inflation – rather than a major policy shift. The latest housing data show foreclosures up over 40% last month – with bank repos of now abandoned homes nearly doubling.

With continued pressure on housing, consumer confidence at record lows, and employment falling, the Fed is not likely to begin raising interest rates.

I expect the FOMC to hold the line on interest rates today, but continue to talk tough about inflation. The Fed’s bark is worse than its bite.

BRICs Crumble Under Threat of Inflation

Don’t look now... but the BRICs are falling! The group of fast-growing emerging market countries which includes: Brazil, Russia, India, and China are facing their biggest economic challenge this decade. Inflation is accelerating in the BRIC economies and central bankers are responding by raising rates and tightening monetary policy.

While these moves may be necessary to combat inflation, tight money policies are usually a very unfriendly environment for stock investors.

India is the latest BRIC under fire. With wholesale price inflation running at 11% – the highest level in 13 years and climbing – the Reserve Bank of India responded last week by raising its benchmark lending rate to 8%. Global investors are signaling a vote of “no confidence” however, as they send Indian stocks plunging.

India’s currency, the rupee, is also under attack, having lost 8% of its value against the dollar this year – the worst performance for the rupee since 1993.

Inflation Looms as Biggest BRIC Threat

Spiraling inflation has reached a tipping point, where rising import prices (particularly food and energy) are hammering consumer spending power. The result has been a dramatic reversal of fortune for India, including an erosion of investor confidence in its currency and its capital markets.

Overseas fund managers were big buyers of Indian stocks in recent years, but have turned into net sellers. After $19.5 billion flowed into Indian stocks and bonds last year, foreign investors yanked $5.3 billion out of the country’s exchanges so far this year.

India is in the riskiest position among the BRICs in this environment of soaring commodity inflation. That’s because India is a net importer of most resources, including 75% of its oil.

Brazil meanwhile is a leading exporter of agricultural products and metals, And thanks to a growing energy industry and new offshore oil fields, Brazil should become energy self-sufficient this year.

Russia of course is one of the world’s largest oil producers, so it too enjoys a favorable trade balance. And China has a record $262 billion trade surplus, in spite of the fact that it too is a net importer of just about everything. Also, China has the world’s largest currency reserves at $1.7 trillion and growing at nearly $2 billion a day.

Is India an Early-Warning Sign for the BRICs?.

Still, the BRIC economies are all under serious threat of seeing their economies crumble under the threat of runaway inflation. India’s troubles are perhaps just an early-warning sign. Inflation in China is running close to 8% in spite of several interest rate increases last year. Inflation just topped 15% in Russia. Brazil, which suffered a painful hyper-inflationary past, recently raised interest rates after inflation crept up to 5.4%.

Stock investors, seeing this threat on the horizon, have been busy pulling money out of the BRIC markets. China’s CSI 300 Index is down over 50% from its 2007 high, while India’s Sensex Index has plunged by one-third in value. Share prices in the first two markets of the BRIC alphabet, Brazil and Russia, have so far held up well. This is due in no small part to their favorable trade terms. 

All of the BRICs are threatened by the risk of inflation. As an Indian government official put it, “Until inflation slows, this crisis is only going to widen.”