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Too Much Fuel Will Extinguish The Fire

February 19, 2013 Leave a comment

Stocks continue to climb inexorably: 21 of the 33 trading days this year have seen stocks end the day higher. About the only market that is doing appreciably better is gasoline. Retail gasoline prices have risen 33 of the past 33 calendar days, and front Unleaded has risen 22 of the 33 trading days in 2013.

This brings us, of course, to the question: if gasoline rises every day, then how long will it be until higher gasoline prices start to affect equity prices?

The question is not quite as straightforward as it appears. On the surface, we have two competing effects: first, stronger economic activity will tend to support both gasoline prices and corporate earnings, giving a lift to equities. And some recent data, such as last Friday’s hefty upside surprise in the Empire Manufacturing figures for February (+10.04 when -2.00 was expected), suggests that growth in Q1 may not be slowing too much further although the European, Japanese, and US economies each contracted in Q4.

(By the way, did you realize that? Each of the three biggest First World economies contracted in Q4 and the US equity markets declined -1.0%).

Not that equities necessarily must pull back when growth lags (if they did, then all good economists would also be good traders), but when you’re talking about markets that are pricing in a continuation of historically wide margins and historically high price-earnings multiples, it would seem that a pullback when there is weakness economically is as good a time as any. Stocks can’t go up in a line forever, can they?

Actually, they can, but we’ll get to that in a minute. I mentioned two competing effects that are apparent, with one of these being the stronger economic activity will tend to support both gasoline prices and earnings. The other is that higher gasoline prices have a depressing effect on discretionary expenditures. Along with the higher payroll taxes which manifested in January and the lower Q1 incomes as a result of dividends being pushed into Q4, the higher gasoline prices may have contributed to what a finance VP at Wal-Mart described as “a total disaster” start to February. This is an “automatic stabilizer” effect at work: higher growth tends to produce higher energy prices, which tend in turn to dampen economic growth – and vice-versa.

So which effect dominates? Can gasoline prices and stock prices keep going up together?

The answer is that their nominal prices can absolutely continue to rise together, but their real prices cannot. If I double the price level, then no matter what happens to growth or the marginal rate of substitution between gasoline and all other discretionary goods and services, both nominal gasoline prices and nominal corporate earnings (and therefore, quite likely equity prices) will both rise. However, higher real energy prices imply lower real equity prices eventually. But that’s not a day-trade; in the fairly short run (say, several months) the price level is roughly constant so that one of these two markets is likely to decline in nominal terms.

Frankly, the odds in my mind are on stocks breaking first. But as the chart below (source: Bloomberg) shows, the ratio of gasoline to stocks is not really out-of-whack one way or the other. This is unleaded regular gasoline divided by the S&P level…and what’s fascinating to me is how regular the relationship has been (especially in 2010!).

gas over stocks

By the way, the distinction about nominal and real prices also is relevant for the observation some have made that gasoline inventories are reasonably adequate, but prices continue to rise. Gasoline prices are high in nominal terms, but not as high in real terms. In nominal terms, unleaded has risen 105% since the second Bush inauguration, but only 65% in real terms. That still sucks, mind you, and is one reason that growth hasn’t been robust in a while. As of December 2004, gasoline was 3.934% of the average consumption basket; according to the BLS (new numbers are out today!) that became 5.274% as of December 2012.[1] Therefore, we spend about 1.34% less of our total consumption on other things than we did in 2004.

With gasoline, medical care, and college tuition all squeezing us (not to mention taxes, which is not a consumption item and therefore not in the CPI), it isn’t surprising that we’re spending a smaller proportion of our consumption basket on apparel and housing than we used to (for a longer-term view, see my comment from a couple of weeks ago “Fun With the CPI”). These are long-term, secular trends. What could hurt the market in the shorter-run is that when there is a significant move in energy prices, we can’t change the amount of housing we consume to compensate. We stop buying the Wal-Mart things. And we save less.

And eventually, we stop buying stocks. Don’t we?


[1] N.b.: that doesn’t mean we spend 35% more on gasoline now; as noted, gasoline has doubled in price. But 35% more of our consumption is spent on gasoline, than we spent previously. It is interesting that with a 65% increase in the real price of gasoline, our gasoline consumption has only risen 35% (due to smaller cars, better gas mileage, more air travel, more mass transit, etc).

Two Storms Coming

October 29, 2012 2 comments

Since the financial markets are almost shut today due to “Frankenstorm,” and will in fact close early today, I am writing this article early on the notion that (a) it will be difficult to write later and (b) there will be little additional news worth writing about.

Not much paradigm-changing economic data has come out recently. Thursday’s Durable Good numbers were approximately on-target (ex-transportation +2.0% versus +0.9% expected, but with a revision to August’s figures of -0.5%), as were Initial Claims (369k, right in the middle of the range) and Friday’s initial release of the Q3 GDP report (2.0% vs 1.8% expected, with Personal Consumption +2.0% vs +2.1% expected). Today’s Personal Consumption and Spending reports were as-expected, as were all of the price deflators. The Dallas Fed Manufacturing Report was a bit stronger-than-expected but is merely back in the middle of the 3-year range.

There is, though, some positive economic news although it will take some time to be realized in the official figures. Gasoline futures recently approached the lows for the year (although in the last few days the approach of Hurricane Sandy and the general tightness in the delivery markets has caused a not-negligible rally), and retail gasoline prices which were recently threatening $3.90 are back to $3.54 (I wait with bated breath to see whether the people who shriek about the inflationary impact of gasoline rising will shriek with joy now that it’s falling – this volatility, folks, is why the Fed focuses on core inflation…not because they don’t drive). This is an unmitigated positive, if a small one, for the economy. While gasoline prices are still a multiple of where they were at the 2008 lows, they are only 18% above where they were to end 2007 (see chart, source Bloomberg).

Set against that, however, is the unmitigated negative of the election and the fiscal cliff. A Wall Street Journal story from late last week identified something we have seen in our business and which has been reported anecdotally by a number of our contacts.

Here is why dozens of chief executives have inserted themselves into the debate over reducing the federal budget deficit: Some say uncertainty over the looming “fiscal cliff” of tax increases and spending cuts already is hurting their business. “It’s a pause button,” Robert Swanson, executive chairman of Linear Technology Corp., told investors Oct. 17, after the semiconductor maker reported a 3% drop in fiscal first-quarter profit. Chief Financial Officer Paul Coghlan said companies that use Linear’s chips are growing more cautious before the election and the Dec. 31 deadline.

It isn’t merely the fiscal cliff itself. I’ve heard from a number of potential clients (in the financial industry and elsewhere) that there is great uncertainty associated with the results of the election itself. While the ‘fiscal cliff,’ a collection of tax increases and spending cuts that automatically kick in at year-end if Congress and the President do not agree to an alternative budget, could cause great short-term damage to growth in 2013, business-owners also believe that for the first time in the last half-dozen or so elections the results of the Presidential contest will have a significant effect on the business climate going forward. From a taxation perspective, on the basis of the future of Obamacare, on the degree of regulatory intrusiveness, the candidates seem to differ much more significantly than were McCain v. Obama, Bush v. Kerry, Bush v. Gore, Clinton v. Dole, or Clinton v. GHW Bush. Arguably Dukakis vs. GHW Bush showed a meaningful difference, and certainly Reagan v. Mondale, but it has been a generation since the election was thought to matter very much to business. This year, it certainly does. A storm is coming on November 6th, but like Frankenstorm it will pass.

But that doesn’t mean the election frees the stock market. I believe that a Romney victory (which is the current odds-on bet since undecideds typically break heavily for the challenger and he already has a lead overall and is tied or ahead in every important battleground state) would send stocks lower, while an Obama victory would send them higher – in the short term. The reason I believe this is that I think investors will interpret a Romney victory as producing a greater chance of fiscal austerity (relatively, that is – we’re not getting any important austerity in this country for a while) and a greater chance of a less-accommodative Fed over the next couple of years especially when a President Romney would replace Bernanke (whose term is up in January 2014) with a hawkish Chairman. These things would be more likely to produce a deeper recession in 2013 than we are already likely to get under Obama.

However, let me be clear: I think the Romney policies are closer to the correct policies, and I am highly confident that the stock market in five years would be significantly higher under Romney’s stated policies than under Obama’s. But the stock market is full of short-term-focused investors these days, and the more immediate focus would be on the near-term implications of a change from a relatively profligate fiscal and monetary policy (that anaesthetizes near-term pain even as our limbs are sawed off) to one that aggressively moves to address the nation’s financial future sanely, at a somewhat higher short-term cost.

The data seems to support this. Below is a chart combining the Intrade market for the probability of President Obama’s re-election (in white) and the S&P 500 (Source: Bloomberg), showing that this phenomenon has existed for a while. There is some argument that the causality runs the other way – that a lower stock market indicates a slower economic outlook and therefore a lower likelihood of Obama’s re-election, and I agree there is some circularity there. But I suspect the current consensus view, that a Romney victory is a big win for “risk-on” assets, is wrong in the short-term.

Now, I should say that I think Intrade investors are far off on the actual probabilities, but the point is the direction of movement. Also note that because the Intrade market is a binary option that either ends up at 100 or 0, it will naturally gain volatility as the market gets closer to election day. A similar effect will happen in the equity market, but it will not of course be as pronounced. (See my note on the subject of option-like market behavior here.)

I expect to get some partisan vitriol on this article. Save it – the power is going to be out, and so your anger will go unrequited! (Do you think it was an accident that I wrote this article today?!) Good luck to all in the hurricane’s path. It’s going to be a bumpy ride.

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