A Look Ahead

That volatility is a symptom of the extraordinary market and economic environment we currently face. Global markets have just been through one of the sharpest declines in history. Since Sept. 1, the S&P 500 has fallen 30 percent and is off 39 percent over the past year. And commodity markets have been no picnic either, with the CRB Commodity Index soaring to record highs in the first half of the year only to fall sharply after July 1.

The market continues to face headwinds, but there’s a silver lining: The most dangerous and panicky markets always offer investors the best opportunities. In mid-October, Warren Buffett penned an op-ed piece for The New York Times entitled “Buy American. I Am.” To summarize, Buffett revealed his one simple rule when buying stocks: “Be fearful when others are greedy and greedy when others are fearful.”

There’s no doubt that investors are fearful right now and are pricing in a glass-half-empty outlook for the global economy. As a result, valuations for many high-quality stocks are compelling; I suspect two years from now, we’ll look back on October/November of 2008 as an outstanding buying opportunity.

This isn’t the time to panic but the time to rationally evaluate the prospects for the economy, stock and commodity markets with an eye toward taking advantages of opportunities in coming months.

Here’s a rundown of where we are and what to look for in the months ahead.

The US Economy

There’s no doubt that the US economy is in recession and has been since late 2007 or early 2008. I suspect this recession will be longer than either the 2001 contraction or the down-cycle of the early 1990s.

Don’t be fooled: The official definition of recession is not two consecutive quarters of declining gross domestic product (GDP). Rather, the start and end dates for recessions are set by the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER), and NBER takes into account a wide variety of economic indicators in making its determinations.  

My favorite measure of US economic activity is the Index of Leading Economic Indicators (LEI). The LEI is nothing more than an index that summarizes the performance of 10 key economic indicators, including building permits, stock prices, interest rate spreads and manufacturing orders.

When the year-over-year change in LEI turns negative, it signals the US is in recession. Although no indicator is infallible, the LEI has accurately flagged all of the recessions since the ’60s. Since the LEI turned negative in late 2007 and shows no real sign of a turn for the better, I’d conclude that the US has been in recession for roughly one year.

The last two recessions in the US were short, totaling eight months each. This recession will be more severe, perhaps lasting 16 to 18 months, putting it on a par with the recession in 1973-74 and 1981-82. If that proves correct, the US should begin to see recovery in the latter half of 2009.

Some global economies are already in recession. For example, the United Kingdom is working through a residential property bust every bit as dramatic as the housing cycle in the US, if not more so. Other economies in the European Union are also sputtering; in fact, the EU announced Friday that the 15 member states that use the euro common currency are officially in recession.

But the developing world will remain more resilient. Economic growth in China and India is likely to slow but not turn negative. These countries are also in an outstanding financial position to stimulate growth in their economies.

As my longtime friend and colleague Yiannis Mostrous discussed on the financial blog At These Levels earlier this week, China’s debt-to-GDP ratio currently hovers around 16 percent, and the country has USD2 trillion in foreign exchange reserves. The Chinese government announced a USD586 billion fiscal stimulus package earlier this week, and this is likely only one in a series of stimulus measures to come.

The severe credit crunch that gripped global markets in September and October undoubtedly deepened what was already a nasty economic contraction.

The key gauge of credit market health I follow is the TED Spread. This spread is the difference between the yield on three-month US Treasuries and the three-month London Interbank Offered Rate (LIBOR).

The three-month US Treasury yield is essentially a risk-free interest rate. LIBOR is the rate that banks charge to lend each other money. The TED Spread is, therefore, a measure of how much risk is being priced into the interbank lending market. The more elevated the TED Spread, the more pervasive the sense of fear in credit markets.

The TED Spread has tracked the credit crisis fairly accurately since it began in the summer of 2007. The spread hovered around 50 basis points (one-half of 1 percent) for most of 2006 and early 2007. That means that banks were only paying a small premium to the risk-free rate to lend money to one another.

There were several short, sharp spikes in the TED Spread throughout late 2007 and the first half of 2008; most of these spikes saw the TED Spread rise to around 250 basis points. But the real turmoil began following the Lehman Brothers bankruptcy back in September. In light of that failure, banks began to doubt the stability of their fellow financials; banks simply hoarded cash and refused to lend to even seemingly creditworthy borrowers. As a result, LIBOR rates spiked and the TED Spread topped out above 500 basis points in October.

Concerted government action is now calming credit markets. Governments are pumping capital directly into banks by purchasing special preferred shares. This capital is alleviating the fears that gripped the market last month; the TED Spread recently fell back under 200 basis points.

I suspect we’ll see credit markets continue to normalize in coming months. Although credit will be harder to come by and more expensive for many borrowers, the total credit freeze we saw in October is behind us.

As I noted earlier, the S&P 500 has experienced a severe selloff in 2008 as economic woes have deepened. The most severe wave of selling occurred as the credit crunch intensified in September and October.

I suspect that the broader market is currently putting in a low for the year; we should see a rally that lasts at least through year’s end and possibly into early 2009. From a fundamental standpoint, the main catalyst for this rally will be continued normalization of global credit markets. Improvement in credit markets will alleviate fears of an outright collapse in the global financial system.

From a trading perspective, the market is currently showing all of the signs of a classic bottom. Most market lows are accompanied by extremes of emotion and panic among investors; I watch the S&P Volatility Index (VIX) for signs of panic. The VIX is a measure of how much volatility is priced into the S&P options market. Suffice it to say that when the VIX is elevated, S&P options traders expect large moves to occur in the underlying index. A high reading on the VIX indicates significant market uncertainty and fear.

During the heat of the selloff in October, the VIX spiked to above 90 intraday. This represents a record high for the VIX, higher than the readings witnessed immediately following the Sept. 11, 2001, terrorist attacks.

The final months of the year are typically seasonally strong for the broader markets, even during bear markets. Given how stretched many stocks are to the downside right now, this end-of-year rally should be impressive, powering the S&P 500 to as high as 1,200 by early 2009. 

That said, I doubt the bear market is over. Next year we’re likely to see the averages at least retest their lows as the weak economy will once again take center stage.

The good news is that 2009 will likely be an inflection year for the broader market as well; there’s a good chance we’ll see a more durable rally in the latter half of 2009 as the market begins to price in a stabilization and recovery for the US economy.  

Another factor that’s likely to underpin a rally into year’s end is a lull in institutional liquidations. Liquidations occur when institutional investors must sell their stocks to raise cash. For example, hedge funds have seen hefty redemption requests from their investors in recent months as the market tumbled; these funds must honor those redemption requests, and that means selling off their portfolio regardless of fundamentals.

As a result of this cash-motivated selling, many stocks are currently trading at distressed valuations. This offers a huge opportunity for investors with a longer time horizon to pick up high-quality stocks at decade-low valuations.  

The good news is that most funds have a 45- or 90-day redemption window; in other words, investors must give the managers 45 days’ notice if they wish to withdraw funds. For funds with a 45-day notice period, investors must have their redemption requests in by the end of this week in order to get their cash by year’s end.

As we move into next week, funds will know exactly how much cash they will have through year’s end and will no longer need to sell stocks to fund year-end redemption requests. This should bring an end to liquidations at least into early 2009.

Crude oil prices have tumbled from their summer highs above USD147 a barrel to recent lows under USD60. The primary fundamental driver of the selloff is concern over global demand.

Due to the weak US economy and high gasoline prices over the summer, US oil demand is falling. According to the Energy Information Administration’s (EIA) most recent Short-Term Energy Outlook, developed world oil demand is projected to decline by 2.2 million barrels per day between 2007 and 2009, with most of that decline coming from the US.

This will be offset by a 2.3 million-barrels-per-day day jump in developing world oil demand. But with oil demand growth of just 100,000 barrels per day in 2008 and 2009 combined, this will represent the slowest rate of demand increase globally since 1993. The most recent EIA outlook showed a big downward revision in expected oil demand from the developed world. 

The downward revisions in 2008 and 2009 oil consumption are a direct consequence of the severe credit crunch that gripped the market in September and October. The initial decline in oil prices from the USD150 per barrel region to around USD90 to USD100 was warranted in light of slowing global demand. The correction to recent levels was due, in large part, to the credit panic that kicked off this fall.

As we head through 2009, however, the market will refocus attention on the supply side of the oil equation. Earlier this week, the International Energy Agency (IEA) released its annual World Energy Outlook.

One of the key points of the report is that global oil supply is troubled. Specifically, the IEA projects that the world will need to spend more than USD26 trillion dollars between now and 2030 to meet rapidly growing demand for oil from the developing world. Although 2008 and 2009 may mark a temporary lull in demand, the long-term consumption growth story is very much intact for countries such as China and India.

That amounts to more than USD1 trillion annually on energy infrastructure, exploration and development. Without that level of spending, supplies will fall short of demand, and prices could shoot sharply higher.

Current depressed oil prices are insufficient to attract spending on the order of USD1 trillion annually. In fact we’re already seeing evidence of a retrenchment in spending in certain regions of the world. For example, Brazil will likely have to delay the production of its massive deepwater fields because the Brazilian drilling contractors it was planning to employ just can’t raise enough capital to build crucial equipment.

And many smaller and mid-size producers in the North Sea and parts of Africa are traded on London’s Alternative Investment Market. Many of these firms were funding their drilling in large part with debt capital. That major source of funding has dried up, and they’re pulling in their capital spending plans. Ultimately, this will lead to falling global oil supplies.

If I’m correct in my estimate that the US recession will end in the latter half of 2009, global oil demand should reaccelerate into 2010. That demand will be tough to meet with global oil supplies falling. This leaves open the very real possibility of a super-spike in oil prices to USD150 to USD200 per barrel as early as 2010. The longer prices and spending remain depressed, the higher oil prices will ultimately run.

In the very short term, I suspect that oil prices will continue to follow the broader market averages. Earlier this year, oil prices were negatively correlated to the stock market; in other words, when oil fell, the market tended to see upside as investors felt that lower oil prices would support the consumer.

Now, the opposite is true--oil is positively correlated to the stock market. The reason is that both the S&P 500 and the market for crude are worried about the severity of the US recession. Any news that suggests economic weakness has been prompting a selloff in the stock market as investors fret over the impact on corporate earnings. For crude, a weaker economy means a continued slump in demand. Therefore, I see crude participating in the short-term, year-end rally I outlined above.

Natural gas and oil aren’t interchangeable commodities, nor are they driven by the same fundamentals. Like oil, gas prices have fallen sharply since mid-year, but the reason for that drop-off is primarily supply, not demand.

Natural gas demand is driven by factors such as winter heating demand and electricity consumption. Neither is particularly sensitive to economic conditions.

The real problem for gas this year: The strongest growth in domestic supply in decades. Just five years ago, most pundits were discussing how much natural gas the US would need to import in the form of liquefied natural gas (LNG) to meet domestic demand. Now, there’s a very real possibility the US will overtake Russia as the world’s largest natural gas producer; many in the industry are actively discussing the potential to build an LNG export terminal to support gas exports overseas.

The change in expectations is due to strong supply growth from US unconventional gas plays such as the Barnett Shale of Texas and the Haynesville Shale in Louisiana. These shale reserves were once thought uneconomic to drill but have become increasingly prolific producers thanks to two relatively new technologies: hydraulic fracturing and horizontal drilling. I discussed these technologies and the US supply picture in more depth in the Aug. 29, 2008, issue of The Energy Letter, Gushing Over Gas.

The fear has been that strong supply growth would swamp demand. But producers are scaling back their spending plans and drilling activity due to lower gas prices; these steps should continue to keep inventories under control.

Meanwhile, demand for gas will generally rise in coming years. Gas is the most environmentally friendly fossil fuel; it emits half the carbon dioxide of coal and a tiny fraction of the sulphur dioxide, nitrous oxide and mercury. As more stringent environmental and carbon dioxide regulation is likely in the US over the next few years, natural gas is one of the only ways of meeting demand for electricity and cutting emissions.

Longer term, due to the abundance of US gas I expect to see more talk of an LNG export terminal and the potential use of compressed natural gas (CNG) as a transportation fuel.