The Well-Timed Strategy

Economic & Stock Market Analysis for the Discerning Investor & Executive

www.peternavarro.com

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This Week: The Fed-ECB Chess Match

The Markets

Last week, treasury yields hit their highest levels of the year.  This can mean one of two things.  Either the economy is recovering, and the bond market is predicting an up-tick in demand-pull inflation.  That’s bullish.  Alternatively, the economy is not recovering and the bond market is predicting an up-tick in cost-push inflation – the bearish stagflation scenario.

Watch this carefully – along with the chess match currently underway between the U.S. Federal Reserve and the European Central Bank.  At stake is the relative value of the dollar to the euro together with the fate of oil and commodity prices, which are tied to the dollar.

At this point, the Federal Reserve is likely done with cutting rates and the only question is when (and if) it will raise them.  The currency markets understand this and have been bidding up the dollar relatively to the euro.  As for the Fed, perhaps it has finally figured out that cutting rates is merely debasing the dollar, driving up the “oil tax” on American consumers and businesses, and having a net contractionary rather than expansionary effect.

Across the pond, the ECB goes back and forth between wanting to cut rates (to rescue Italy and Spain) or to raise rates (to cater to the German obsession with inflation).   However, with the dollar firming because the U.S. Fed is done cutting, a falling euro puts into play an ECB rate hike.  This is because a falling euro will contribute to inflation concerns and raising rates will prevent the euro from falling.

Of course, this all seems like a “damned if you cut, damned if you don’t cut” for both the Fed and the ECB,.  This is why I think we are closer to a world of stagflation in which interest rate policy is ineffective than a Keynesian world where central bankers can solve one problem such as recession without exacerbating the other problem of inflation.

And by the way, the relevance of this seemingly arcane discussion to your trading should be obvious.  The trends for the bond, currency, and stock markets will all ultimately be determined by monetary policy and its effect on interest rates and the dollar and euro.

Presidential Politics

Click here for an interesting analysis in U.S. News and World Report of the presidential race.  It shows McCain leading Obama by 281 to 257 electoral votes and McCain leading Clinton by 277 to 261 electoral votes.  What’s most interesting is that the swing states are very different depending on which candidate – Obama or Clinton – is the nominee.

In the McCain-Obama race, target states and their electoral votes include Connecticut (7), Delaware (3), Hawaii (4), Kentucky (8), Missouri (11), New Jersey (15), Oregon (7), South Carolina (8), Virginia (13), Washington (11), and West Virginia (5).

In the McCain-Clinton race, you have Alaska (3), Colorado (9), Indiana (11), Massachusetts (12), Missouri (11), Montana (3), New Jersey (15), North Carolina (15), North Dakota (3), South Carolina (8), and Virginia (13).

Note that only a few states are on both lists: Missouri, New Jersey, South Carolina, and Virginia

This seems to be an argument on the Democratic side for the “unity ticket”

THE CHINA EFFECT

Please see my latest You Tube report on the Sichuan quake.  The backpack picture is beyond words.

Reader’s Write

I get a lot of email from folks and much of it is very, very good.  I reproduce here a missive from Candy T. on DHL.

“Looks as if the #3 player in the US  express market is in full retreat. DHL is closing many of it's non-metro  stations and will turn the shipments to these areas over to USPS. DHL just cut a deal for UPS to fly and sort all of their shipments and will no longer operate a domestic air system. They will close their hub in Wilmington,Oh and lay off about 6000 workers.

I believe this is the first major step to turn over all US operations to UPS. The yellow  vans will soon be only a memory.

This is good news for UPS and FDX. The rates charged by DHL were well below cost.

This is also bad news for the likes of DELL. I was a contractor for DHL and we had a shipment come down the line that was from DELL, it weighted about 75 lbs .DHL charged DELL $5.75 for the door to door charges. These dirt cheap rates will end with DHL out of the market. For DELL  it is like a drought in Brazil is to Starbucks.

In the long term this means the domestic market will be divided into 2 parts instead of  3 and the two parts no longer have a pressure of rates to worry about.

Oil at $130.00 put DHL  in a panic mode and into a deal with UPS with UPS having the upper hand. UPS  fills their unused capacity on aircraft with low paying ground freight, soon the will use the space to fly DHL  overnight freight at a much higher rate. A hugh increase on rev without no increase in cost.”

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The Well-Timed Strategy

Economic & Stock Market Analysis for the Discerning Investor & Executive

www.peternavarro.com

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This Week: The Three Scenarios Redux

The Markets

We’ve spent quite a bit of time in this column over the last several months on the three possible economic scenarios facing us and their implications for asset allocation and geographical diversification of your portfolio.

Scenario One is the “U.S. as locomotive” that pulls down the rest of the globe if the U.S. is in a recession.  That’s bearish for equities, energy, gold, and commodities but bullish for bonds and global diversification provides no safe haven.

Scenario Two is “decoupling” in which Asia and Latin American continue to boom and Europe grows robustly even as the U.S. is in recession.  That’s bullish for equities internationally as well as for energy, gold, and commodities but bearish for bonds.

Scenario Three is stagflation – simultaneous recession and inflation.  That’s a very bearish scenario as both stock and bond prices move down, making asset allocation hedging difficult.  While gold may be a decent bet, there’s not much else to bank on.

I raise these issues because the latest round of economic news has pushed us closer to the stagflation scenario – very bearish news indeed.  That news has included: A hot core PPI in the U.S. and an inflation warning from the Fed, a continued drumbeat of warnings from the European Central Bank, and a $135 a barrel oil coupled with China’s earthquake and its already double-digit inflation.

We now face the prospect of rate hikes in the coming months by central banks all over the world – and the Fed Funds futures are now putting the odds of a rate hike in October at better than 50-50.

Europe is facing perhaps the most difficult task.   On the one hand, Germany is cranking on all cylinders, primarily because of its export of capital equipment to Asia – that argues for a rate hike by the ECB.  However, Italy and Spain are basket cases – and that argues for a rate cut.   Look for fissures to develop in Euroland over the next year as deficit spending by the countries in trouble put the internal currency parities out of whack.

As for China, the recent earthquake may wind up shaking the political establishment as much as China’s terrain and structures.  While the government has thus far gotten kudos for its relief efforts, protests are beginning to erupt in the affected areas as corrupt or inept officials fail to provide adequate water, food, and shelter – even as some skim some of the money for their own pockets.

Maybe the best place to be right now is Brazil.  With food and fuel two of its primary exports and with its own domestic markets developing apace, this country may finally overcome the bon mot: “Brazil has a great future – and it always will.”

My bottom line for the week is, as I hinted at last week, selling now in the end of May and going away may be the best strategy for those of you who fit more into the trader camp than the investing camp.   For the more adventurous, you may also want to think about a short on the oil sector.  This looks as much like a parabolic rise as any I’ve seen.  It will be difficult for the global economy to withstand the stagflation shock and IF the global economy does succumb to recession, oil will head back down towards $100 a barrel a less – at least until secular forces fuel another upward move.

  Presidential Politics

An L.A. Times/KTLA poll in California shows Obama beating McCain but a significantly wider margin that Clinton beats McCain.  What’s interesting is that the poll showed no signs of Clintonites abandoning Obama while Obama does better with independents than Clinton.  The interesting question is whether this is a California phenomenon driven by more liberal views of race and gender or a phenomenon that would also show up in places like Florida, Kentucky, and West Virginia.    Me thinks the former rather than the latter.

I sure wish SOMEBODY would do a poll that did a Obama-McCain matchup and then compared it to a matchup of Obama/Clinton versus McCain to see if Hillary on a “dream ticket” provides any bang for the buck.

THE CHINA EFFECT

Please see my latest You Tube report on the Sichuan quake.  The backpack picture is beyond words.

Please forward this newsletter to a friend!

Aftershocks continue to pepper the area – more than 20 of 5.0 or above on the Richter scale. 

The death toll will continue to climb and will surely top 50,000. The official death toll is likely to significantly understate the real total.

Potential threats continue to loom:

1. Several nuclear facilities are in the area.  China has a research reactor, two nuclear fuel production sites and two atomic weapons sites in Sichuan, according to a French nuclear watchdog. All were 40 to 90 miles (60 to 145 kilometers) from the epicenter.
2. A number of dams have suffered cracks and run the risk of collapse.   People have been evacuated.
3. Landslides have dammed some portions of the river, raising flood possibilities
4. Unsafe food and lack of access to safe water, facilities for personal hygiene and safe sanitation arrangements all create a real risk of outbreaks of infectious diseases.   (Diseases often kill more people than the natural disaster itself.)

The biggest economic impact is likely to be an increase in inflationary pressures.

1.      Sichuan is an important agricultural province, providing about 6% of China’s grain output while 12.5 million head of livestock were lost, mostly poultry.   With food inflation already troublesome, this can’t help.

2.      Possible supply shortages may also result because of disruptions in transportation and create bottleneck inflation

The economic impact on China’s manufacturing base is likely to be small because Sichuan province is one of the poorest and least developed areas of China. 

1. Toyota Motor, and Yamaha Motor, are among the companies that have suspended operations at their factories in Chengdu, the capital of Sichuan province, while they inspect the damage caused by the earthquake.
2.  Before they can resume production, many factories need a restoration of electricity and water supplies. Sichuan province lost 4 gigawatts of electrical capacity while neighboring Shaanxi province lost another 1.5 gigawatts after the earthquake knocked out 10 power stations and transformers in the two provinces, according to State Grid Corp. of China.

The political impact may turn out to be large depending on several things:

1. How the government handles the disaster relief efforts.   This could be the Communist Party’s version of what Katrina did to the Bush Administration.  So far, the government gets relatively poor marks on allowing foreign experts to swiftly enter the relief zone with high tech equipment used to find survivors.  This slow response has probably cost thousands of lives because survival is very difficult after the first 72 hours.
2. How many of the deaths and injuries are due to faulty construction of buildings because of government corruption.  This is very volatile as many of the victims were school children learning in buildings “made of tofu.”

Perhaps the only good thing about the quake for China is that it has helped shift world opinion away from Olympic protests to sympathies for the Chinese people – an unintended “wag the dog” event orchestrated by Mother Nature.

The Well-Timed Strategy

Economic & Stock Market Analysis for the Discerning Investor & Executive

www.peternavarro.com

Read it and Reap!

This Week: Sell in May???

The Markets

Since the March low, U.S. indices have rebounded more than 10%.  I went back and reviewed this newsletter to see if I missed calling that rally.  While I remained bearish throughout March, on April 4^th I wrote:

“The tape is telling us that the major U.S. market indices are now in a clear technical rally.  It is not exactly clear as to why this is happening, but both the DOW and QQQQ are technical-indicator longs while SPY is moving close to the long side.  (A technical bounce for the dollar is perhaps helping.)  This is the kind of technical rally you should feel free to trade IF your horizon is relatively short.  However, the emerging fundamental situation seems just too bearish for there to be a sustained upward trend. “

Along with my call to go to cash last November – which turned out to be dead on -- this April call once again to the long side isn’t too bad as a market prognostication record. 

My April call on technicals also helps justify the way I like to look at the markets.  I am first and foremost a macro trader who looks for market moves based on broad macro fundamentals.  However, I always do a technical analysis check on the trend suggested by fundamentals. 

On a technical note, the S&P 500 remains well off its October high and thus has a bit more work to do before hitting the possibility of what could be a very ugly triple top situation.  The U.S. indices are now all overbought as well, suggesting at least a small pullback.  In the meantime, the perennial question this column seeks to answer is: which way is the market likely to turn over the longer term.  I have no definitive answer for that question this week but here are some considerations.

First, the current rally has been driven in a significant way by the ongoing boom in oil and commodities.  For that boom to continue, the rest of the world will have to decouple from the slow-growth U.S. economy.  So far, China and India appear to be weathering the U.S. storm.   More surprisingly, France and Germany (but not Spain and Italy) are doing a lot better than one might expect with the euro where it is at.

Second, the current rally is also being driven by something I noted several weeks ago in the newsletter.  This is the possibility that the economy might actually not succumb to negative growth, i.e., a technical recession.  I note hear that Ed Leamer of the UCLA forecast was first out of the gate to stake this claim about the economy and he did it months ahead of the pack.  While I still have my doubts, clearly a lessening fear of recession has helped boost the market.

Third, these positive trends notwithstanding, we are entering the stock market’s historically “cruelest month” whereby New York “sells in May, and then goes away” to the Hamptons and elsewhere.  This behavior may already be in evidence as volume as been low on market up days.

O Canada

Loyal readers may have noted the absence of the newsletter last week.  I was up visiting our Northern friends – two speeches to financial advisors in two different cities on the state of the economy and vagaries of the market.

The best part of the trip was a 17-hour rail journey from Edmonton to Winnipeg – Canada’s breadbasket.  It was truly startling in the middle of a global food crisis to see unending stretches of flat wheat land for virtually the entire journey.   If global warming does indeed hit, this land will grow ever more valuable, and Canada will become ever more hospitable from a climate point of view.  (It hits 50 below in Winnepeg in Winter.)

Quick Takes

1. Be sure and catch “Confessions of a Short Seller” in this week’s Barron’s.  Best précis of the art I’ve seen in a long time.
2. One stat that caught my eye this week was from a WSJ column.  Toll Brothers is selling only one house per month in each of the company’s 300 communities across the U.S.

Presidential Politics

John Edwards endorsement of Barack Obama right after Hillary Clinton won the landslide in West Virginia was brilliant politics that effectively neutralizes the Clinton win.  It will be interesting to see if she can run the rest of the table and how the super delegates might react.    

What puzzles me at this juncture is why the national media is running polls on comparing how Obama does relative to McClain versus how the “dream ticket” of an Obama-Clinton or Clinton-Obama ticket might do.    I’d love to see those numbers.  My sense is that the Obama-Clinton whole is far more powerful than either of the parts when it comes to beating McCain. (I’d also like to see an Obama-Edwards poll against McCain.  Edwards would be formidable – Bill Richardson would not be.) 

The fact is: this is going to be another close race that is going to come down to a battle over a few swing states like Florida and Michigan.   That’s incredible given the low standing of Republicans in the polls.  However, that’s the power of John McCain.

Besides his independence, one of the best things about John McCain is his likeability.  It’s clear, however, that he is going to go right after Barack Obama with the gloves off, with national security the top hit.  I’m not sure the electorate is going to be able to remain enchanted with the guy if that is going to be his campaign M.O.  He might wind up playing right into Barack’s “healing hands” message.

THE CHINA EFFECT

   GO TO YOUTUBE.

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The Well-Timed Strategy

Economic & Stock Market Analysis for the Discerning Investor & Executive

www.peternavarro.com

Read it and Reap!

This Week: Oil and Gas Tax Economics

The Markets

Is the U. S. stock market a leading indicator of the U.S. economy?  That’s the presumption I have historically followed as a self-professed “macro trader” –  see, for example, my trading book “If It Rains in Brazil, Buy Starbucks.”

The “markets as leading indicator” view, however, is a presumption that has been increasingly subject to slippage.  One major “problem” is that U.S. markets are increasingly driven by international currency issues.  For example, the domestic economy might be in trouble but with a weak dollar, a lot of big, U.S.-listed multinationals might do well because of foreign earnings – and make U.S. markets look bullish.   A second reason U.S. markets might not properly signal economic strength or weakness is because of the powerful effects of particular sectors like energy and commodities.

That said, my claim for the past several weeks that the strength of U.S. markets has been merely reflective of a “technical bounce” must be reevaluated in light of recent economic data showing at least a slowing rate of job losses.  If it turns out that we are headed more for a “shallow V” recession than the “deep U” many are worried about, that would certainly be bullish.  Stay tuned.

Presidential Politics and Oil Economics

Based on John McCain’s self-professed ignorance of economics coupled with his ties to a gaggle of “tax cut advisors” like Jack Kemp, I was not particularly surprised that McCain is calling for a moratorium on the gas tax.   I was, however, absolutely floored when the Clinton campaign, which has a much more sophisticated economics team,  jumped on the gas tax bandwagon.

Let’s be really clear about this: A short run cut in the gas tax is sheer economic, fiscal, and environmental lunacy.   Such a tax cut would do little or nothing to cut gas prices in the short run, provide the absolutely wrong incentives for energy conservation over the long run, and contribute to a burgeoning budget deficit – while denying necessary funds for public infrastructure.

The “journalist’s view” of gas tax economics, as mouthed by pundits all last week, is that a gas tax cut would increase gas demand and thereby push the price back up to previous levels.  This is an easy idea for  John Q. Public to understand, but it is likely (almost) totally wrong.   Prices won’t rise so much because of increased demand but rather something far more troubling.  To understand the issue requires just a little bit of heavy economic principles lifting.

To wit, with any tax cut or tax increase, who bears the benefit or burden of the cut or increase depends on both the elasticity of supply and the elasticity of demand in the market.   In the case of gasoline, short run demand is very inelastic – that is, it is very unresponsive to price.  However, in the short run envisioned for the gas tax holiday – the summer driving season – the elasticity of gas supply is close to perfectly inelastic.  This is because of severe refinery constraints in many parts of the country.

Conclusion: If the elasticity of gas supply is perfectly inelastic, any cut in the gas tax would simply result in an almost one-for-one increase in the pump price.  In other words, the gas tax “holiday” for consumers would be no holiday at all but merely another windfall for gasoline refiners.

And speaking of windfalls, I found it amusing that the weekend WSJ took Barack Obama to task for advocating a windfall profit tax – while giving him only the very faintest of praise for not falling in with McCain and Clinton on the gas tax holiday.

In fact, the economics of a windfall profits tax are far more compelling than the WSJ lets on.  Economists view a true windfall tax as a one time event administered retroactively to a period of profit activity over and above those profits which might be earned in a competitive market.  Such a one-time windfall profits tax is the ”best of taxes” in that it has absolutely no impact on resource allocation, e.g., it wouldn’t depress oil production.  Such a point got lost, however, in the WSJ translation.

QUICK TAKES

1. One of the reasons I like reading the Financial Times is that it runs front page stories about things like the price of camels tripling.  The reason: with fuel expensive, more and more farmers are turning in their tractors for camels.  Now somebody tell me how I can go long the camel market.
2. My concern that Obama will be torn apart in the general election seems hardly misplaced as the gutting has already begun.   Reverend Wright