When Bubbles Collide

John Mauldin | Thoughts from the Frontline
June 6, 2008

I remember in the summer of 2006 I would face my blank computer screen on a Friday and wonder, what I could write about? The media was all Goldilocks, all the time. Today, there is such a target-rich environment. I could probably write three letters a week, there is so much happening that is worthy of our attention. The problem today is trying to decide what not to write about, which means I get emails from readers wondering why I don't mention their areas of particular interest. But at eight pages, I just have to stop. You need a break!

Today, we have to look at the unemployment numbers, and the connection between the credit crisis and the rise in oil of about $16 dollars a barrel in just two days! If there is still room, the dollar is certainly being pushed and pulled by central bankers, who are also worried about inflation. And I doubt we will have room to cover what is a very important rise in inflation in Asia. It is all connected. (And you HAVE to look at the picture of my daughter and associate Tiffani at the end of the letter. Too much fun!)

But first, a quick note. I will be in Las Vegas July 10-12 for the annual Freedom Fest Conference, where I will speak several times, and the line-up of speakers is as strong as for any conference I have ever been to: Denish D'Souza will debate Christopher Hitchens; and Steve Forbes, Ron Paul, Stephen Moore (Wall Street Journal), Charles Murray, George Gilder, John Goodman, and about 100 other speakers, each impressive in their own right, will be there, as will 1,500 freedom-loving attendees. You can go to http://www.freedomfest.com/promo.htm and click on the list of speakers to register. Mark Skousen is the driving force behind the conference, and he does it right. I hope to see you there.

Unemployment Jumps to 5.5%, On Its Way to 6%

The headline number said the US lost 49,000 jobs in May, somewhat fewer than expected. The details were much uglier. It is no surprise that construction saw losses of 34,000, but "goods production" also saw a drop of 57,000 and manufacturing was down 26,000. What was up? Health care (34,000), bars and restaurants (11,000), and government added 17,000 (though, as Phillippa Dunne and Doug Henwood of The Liscio Report noted, the gain was all from local governments, as federal and state governments shed jobs).

So, with all the large losses and few gains, how did we show a loss of only 49,000 jobs? As long-time readers will guess, it is our old friend, the birth/death model, which is the estimate of new jobs created by new and small businesses, which are not covered in the survey. Contrary to some opinions, it is not a conspiracy by a government agency to "cook the books" in an attempt to show a number better than it really is. (If it was, they are doing a really bad job!) It is simply a moving-average projection of the past few years. Like any trend-following system, it will be wrong (sometimes badly) at the inflection points of the change in the trend.

Thus, the Bush administration was right to be upset when the birth/death model significantly understated the growth in jobs during the recovery from the last recession, as Democrats talked about the "jobless recovery." Subsequent revisions showed that in fact there were a lot of jobs being created.

And now? As the economy rolls through a recession, the system is overstating the number of jobs created. It is just a function of the model. The BLS is very open with the numbers it uses, if you care to dig into them. In October the BLS will announce new benchmarks and apply them in March 2009, although they will only be applied through March 2008. The number of lost jobs through last March will be revised significantly upward, just about the time the recovery is underway. And also in time to help modestly understate the jobs being created in the recovery. As my friend Dennis Gartman likes to say, anybody who trades on the employment numbers deserves the spanking they get.

For the record, "March was revised down by 7,000, and April by 8,000. We've now had four consecutive months of downward first revisions, and also four consecutive downward second revisions - unusual strings that support the picture of a weakening employment trend." (The Liscio Report)

And the birth/death model? This month it added in an estimated 217,000 new jobs. But looking into the details, the model suggested that 42,000 construction jobs were added. The survey showed lost jobs in construction, but the birth/death model added more construction jobs than were lost. Given the current economic climate, that is highly improbable. Ditto for the 77,000 in leisure and hospitality. Do we really think 9,000 jobs were added in financial services or another 9,000 in small manufacturing start-ups?

The reality is that we probably saw a decrease in jobs of at least 100,000. The market was upset with 40,000. What will it do when the monthly number prints 100,000 later this year? And it likely will. The Federal Reserve projects that unemployment will rise to 6%. That means there are a lot more jobs to be lost. And that is if unemployment stops at 6%, which would be a very mild recession indeed.

There are two unemployment surveys. One is for businesses, called the establishment survey, and for whatever reason that is the one most people pay attention to. When they do the household survey, they found that the number of employed people fell by 617,000 last month, spiking the unemployment rate to 5.5%. Some on CNBC said it was just teenage unemployment showing up in the numbers, but that is not true. Teens, according to Phillippa, accounted for just 0.2% of the rise. Adult unemployment rose to 4.8% and accounted for 0.3% of the rise. (By the way, technically, for the three people with no social life actually watching the scorecards, the household survey dropped 250,000 jobs; but after you adjust for factors in the establishment survey and seasonally adjust, you get 617,000.)

One of the best indicators of the direction of employment is temporary employment. If the workload is shrinking, the first thing you do is lay off your temporary help, or simply do not hire them. Normally, unemployment is a lagging indicator, but temporary help is at least a coincident if not a leading indicator. Temporary employment is down 5.7% year over year and is showing continued monthly deterioration with each passing month since last October. That does not bode well either for future employment or consumer spending. We will watch to see when temporary help begins to rebound, to give us a hint that a recovery may be in our future.

What the Tax Numbers Show

Philippa Dunne & Doug Henwood write The Liscio Report. They focus on interpreting the employment numbers and doing in-depth research on tax collections at the state level, plus a lot of interesting "inside" information not typically known by the public. When you see an analyst talking about tax collections at the state level, there is a high likelihood that the source of the number is actually the work of Dunne and Henwood. I find their letter very useful, as I get analysis very quickly after the report comes out, and you always get "the rest of the story" not revealed in the press releases and the media. (www.theliscioreport.com) If I ran a trading desk I would want their reports on my desk.

I called Phillippa about a report they sent out this week. Basically, sales tax and income tax collections at the state level are either down or flat. You can do all the surveys and polls you like, but one of the rules of life is that no one pays a penny more in taxes than they have to. The flip side of that premise is that sales tax collections are a VERY good barometer of economic activity.

Phillippa was kind enough to send me a chart to share with my readers. The have a diffusion index which tracks how well states are doing in meeting their projections for tax receipts. This does not show the level of receipts, as a state could be "positive" in this index if it projects lower receipts and meets that target. In general, states have been lowering their projected income.

As it turns out, this index is a fairly consistent indicator of the direction of retail sales, as the graph below will attest. The green bar line is their sales tax diffusion index, and the red bars are retail sales growth. Their index has dropped precipitously in the last few quarters, leading retail sales down. And it suggests there is more pain in retail sales to come.

But wait, didn't we read yesterday that retail sales were up? "Wal-Mart sales, for stores open at least one year, increased 3.9%; Costco US showed a 7% US gain and a 15% foreign gain. BJ's Wholesale Club sales surged 13.4% on gasoline and food sales. BJ reports gasoline sales jumped 6.6% and perishable food sales surged 11% but general merchandise was flat!!!" (The Bill King Report)

Retailers that did not have food and gas to boost their sales showed considerable weakness. GAP was off 14%, JCPenney down 4%, and Limited Brands down 6%. Even the high-end stores like Saks (-9%) were down, and Nordstrom projects that June will be down 22%. Given the sales tax numbers, I would not be buying the retail stocks on the dips. There is an old saying about trying to catch a falling knife.

Auto sales have fallen precipitously on the lack of demand for trucks, which were the most profitable item for car manufacturers. Is it any wonder they are cutting back and closing plants?

Wages declined by 0.2 in April in nominal terms, and forget about it in real, after-inflation numbers. David Rosenberg of Merrill Lynch notes that the 0.2% decline in real spending on durables and semi-durables was the 6th decline in a row, which has never happened in the 49 years that such data has been tracked. He notes there has never been a time when consumer spending on durables (like cars and appliances) and semi-durables (like clothing) have contracted for two quarters when the economy has not been in a technical recession.

But there are other reasons for the slowdown in consumer spending. Since 2001, the average income of the bottom 90% of wage earners dropped by 0.9%, from $32,371 to $32,080 in 2006, in constant 2006 (inflation-adjusted) dollars. The further down the income scale, the more pressure on the consumer. (source: Center for American Progress)

The top 10% have seen their incomes rise from $221,000 to $254,000, a rise of 15%. Side bet: we will see the average income of the top 10% come down in 2008 and 2009.

From Goldman Sachs: "We estimate that the US government ran a budget deficit of $160 billion in May, about $92bn wider than in May 2007. Most of this reflects tax rebates (about $50bn) and calendar effects (about $27bn). The remaining $15bn is true deterioration, reflecting reduced tax revenue growth as the economy stagnates. In particular, withholding of income and payroll taxes was flat and corporate payments (usually tiny in May) fell."

In short, wherever you look, tax receipts are down. That means income and sales are down. There is no spin that trumps tax receipts. And Phillippa told me that her sources at the various states she surveys are not optimistic about a real recovery in the latter half of the year.

I would not want to own any stock whose earnings are tied to the US consumer. Between rising input prices and falling sales, earnings are going to be squeezed. Today's almost 400-point drop in the Dow is just a precursor to the direction of the market, until consumer spending starts to recover. This time, there will not be large mortgage equity withdrawals to bail out the economy. We will see a slow growth/no growth Muddle Through Economy for at least another 12 months.

What's Up With Oil?

The price of a barrel of oil was up $16 in the last two days, to $138.54, a violent 13% move. Is it those nasty speculators? Are fundamentals at work? Is the world worried about Israel bombing Iran? There are numerous factors involved, but the combination produced a kind of perfect storm in the trading pits. Let's look at several items and see if we can find a connection.

First, there is a real connection between the price of dollar and the price of oil. In dollar terms, oil rises as the dollar falls and vice versa. The weak dollar policy that this country has had (in spite of denials) is having an effect. This week, Ben Bernanke took the very unusual stance of commenting on the weakness of the dollar and its possible role in inflation. Typically, the value of the dollar is the responsibility of the US Treasury Department, and the Fed does not get involved. You can bet that Secretary Paulson knew in advance and approved Bernanke's statement. That put a bid under the dollar and hit oil and commodity prices in general.

No one should think that the Fed or the Treasury is getting ready to intervene in the market, which would be a rather futile effort. Rather, it was a clear signal that the Fed is "on hold" and is unlikely to lower rates in the current environment. Since the market felt that the next move from the European Central Bank (ECB) would be to lower rates in response to a weakening environment in Europe, that served to push the dollar higher against the euro.

Note that a German 2-year bond pays 4.64%, and the US 2-year note pays 2.39%. That difference helps put a bid under the euro. Also, note that interest rates in Europe are starting to get flat across the curve.

Then, as the US markets opened on Thursday, Jean Claude Trichet, the president of the ECB, shocked the markets. Let's let Dennis Gartman rewind the tape for us:

"Mr. Trichet made it clear that a number of ECB policy committee members actually support raising rates very quickly, and he suggested that the committee could move to raise rates as soon as the next policy meeting in the first week of July! Mr. Trichet said yesterday that

" 'after having carefully examined the situation, we could decide to move our rates (by) a small amount in our next meeting in order to secure the solid anchoring of inflation expectations.... I don't say it's certain. I say it's possible [for] we had a number of us thinking that, all taken into account, all information, analysis of risks, we had a case for increasing rates... A number of us considered that there was a case for increasing rates, but later some amongst us considered there was not necessarily that case... [yet].'

"Mr. Trichet went on further to say that the ECB is on "heightened alertness" about inflation. At recent meetings Mr. Trichet has made it clear that the decision to keep policy steady was unanimous, but yesterday he said the decision was a consensus, and was not a unanimous decision. That obviously suggested that some on the committee were already voting to tighten, and that, we must admit, caught us off-guard. At the question and answer period following the meeting, Mr. Trichet was asked, following his statement that the decision to hold rate steady was a 'consensus,' why the committee had not moved to raise rates. He said that firstly the committee had to signal to the market that it was on the alert; that the debate had shifted from dead center to the edge; that the needle on the monetary tachometer was moving off of top-dead centre. We do not wish to parse things too severely, but it does seem that the committee is prepared to move at the next meeting, and that is a material change from our perspective, for we had thought that the Bank was poised to do nothing for several more months, and that the next move would instead have been to ease, not tighten. Clearly we had that wrong, and now the facts have changed."

It is not just Dennis who was caught off guard. The entire currency and commodity futures trading markets were surprised (including your humble analyst). The euro exploded up from $1.5395 to $1.5555 in a matter of minutes. Oil rose $6. Gold and grains moved violently. Soybeans "gapped," as commodities of all sorts responded to a weakening dollar.

If Trichet wanted to "signal" the market, it worked. He got everyone's attention very quickly.

There was a lot of short covering in the various markets, but especially in oil. But let's dig deeper.

I have been pondering for a few weeks about whether the long-only commodity index funds are really affecting the markets. Basically, these funds have become a huge part of the commodities market. It is clear that enough buying and in size will affect any market, but these funds do not take delivery. They "roll" their exposure as they get close to expiration, so they are not involved in the spot price. In theory, the spot price should be a function of immediate supply and demand.

But, it is not that simple, as Louis Gave reminded me. Looking at recent CFTC data, investors known as "commercials" were long 827 million barrels of oil. In the early part of the decade it was 3-400 million barrels. Commercials are supposed to be those who are hedging their production of oil. But large oil companies rarely hedge, and smaller producers only hedge a portion of their oil (see more below). Has supply increased over 100%? I think not.

Where is the increase in commercial interest coming from? The clear answer is long-only commodity index funds and ETFs. They simply buy baskets of commodities at whatever the price is, speculating on the rise in the price of the overall commodity market. It is a one-way trade. Jim Rogers is probably the most famous exponent of such trades, but there are scores of funds which mimic what he does. But there are limits to how much exposure speculators can buy, because the CFTC will allow a speculator to only buy so much of any given market, to keep large players from getting a corner on the market and driving up prices, a la the Hunt brothers and silver in 1980. These limits are known as "position limits."

There are no position limits for commercials who are hedging. They are in theory hedging their physical exposure to a given commodity they are selling or buying. Think of a farmer and General Mills. Both want to lock in the price of wheat so they can plan for the future. Speculators are useful in that they provide liquidity to the markets. In fact, they are essential to a properly functioning market.

The CFTC created a loophole when they allowed investment banks to be classified as commercial investors. So, when a long-only commodity index fund wants to buy a million barrels of oil, they can go to the investment bank, who will sell them a "swap" on the price of oil, and then immediately hedge their exposure in the futures market.

To be sure, the long-only index fund can now create positions far in excess of the position limits that are enforced upon normal speculators. These funds can grow to be huge - multi-tens of billions of dollars. Even though they are speculators, they are not included in the data as speculators. Because they get their exposure from an investment bank, they are ultimately listed as a commercial. In total, they represent an enormous part of the commodities markets. But they are providing liquidity, so what's the problem? They are not actually hoarding the commodities. The price is still set at the spot price. But.

But that is not the whole story. They are making it difficult, if not dangerous, to short the market. When massive buying comes into the market, it moves the market and sends the signal to the market that prices are rising. Momentum players move in, and prices rise some more.

In fact, as the price of oil has risen from $90 to $100 and higher, normal speculative open interest has declined, as who can afford to fight the tape? At the least, I expect the CFTC to require those "commercials" that are really long-only index funds to provide transparency. Politicians are demanding that something be done. It is entirely possible that they will impose position limits on the long-only funds. As I said last week, when the elephants are dancing, the mice should leave the floor. And Congress and the regulators are very serious elephants indeed. Let's hope they do whatever they are going to do quickly.

I think smaller investors should take the profits they have made over the last few years in these funds and move to the sidelines until it becomes clear what the rules are going to be. Let me also make it very clear that I am only talking about long-only commodity index funds. Funds that are managed by commodity trading advisors which can go both long and short have the potential to profit from volatility (and of course, they can also lose). In these types of markets, I like funds which are "long vol." (To be long volatility means you have the potential to benefit from volatile markets.)

Now, let's look at how the credit crisis is contributing to the problem. Let's say you are a small oil producer or grain company. You go to the futures market and hedge your oil production or the grain in your silos; and if the price goes up, you don't care, because you are going to deliver the grain at a cost you already know. But there is the matter of that margin call, and you need to borrow from your local bank to meet that call.

You are hedged. Your profits are locked in at some point in the future. But the margin clerk is calling today. And your bank is having a small problem with its capital base. What is the cover story in the Wall Street Journal today? "Real Estate Woes of Banks Mount." Banks, mostly smaller ones, may have to write off as much as $165 billion in bad real estate loans made to developers and commercial builders. Regulators are "encouraging" banks to raise capital and increase their lending standards.

So banks have less capital to lend. Your banker looks at you when you ask for more money to meet those margin calls, and says, "There are two types of problems. Mine, and not mine. Yours is of the latter variety." And you have to cover your hedges. Enter the margin clerk (the person who calls you and tells you to come up with more money or they will sell out your position at whatever the market price is.)

When Bubbles Collide

So, what happens? Bernanke talks the dollar up and commodities and oil go down. Two days later a French president of the ECB gets inflation religion and the markets react swiftly. Commodity prices rise and more money comes into the market. Traders start covering their shorts as quickly as possible.

Then this morning, the margin clerks of the world go to work and oil spikes as the pits smell blood. Morgan Stanley issues a call for $150 oil in July. The euro rises to $1.5778! Interest rates drop. The stock market falls large at the open.

And rumors of an attack on Iran? An Israeli politician says that Israel would need to bomb Iran to keep them from getting a nuclear weapon, just as it becomes clear Obama might be the next president and would not act to prevent such a problem?

Who can aggressively short in this environment? In a conversation with Dennis Gartman this afternoon, he commented that it felt like the NASDAQ. But is it 1999 or 2000? The oil market will continue to go up until it doesn't, and no one knows when that is. It will continue to rise until all the shorts that are not strong hands have been covered. The margin clerks are in control, and they will have their way. Was it all over today? I rather doubt it.

I wonder if some of the majors aren't tempted to sell some of their production at $138? I mean, really. If you don't think that is a reasonable price, and they tell us they don't, then why doesn't Exxon just go in and start taking all the bids they can? They and the other majors would be the ultimate strong hand. But then, what do I know?

Central banks, short covering, a respected analyst issuing a near-term call for a $20 rise in oil, conspiracy theories and Iran, long-only funds buying, everyone scared to short, margin calls, and a credit crisis all give us the perfect storm.

Add to that the ugly employment numbers, and the Dow drops almost 400 points. The S&P 500 violates all sorts of technical signals to the downside. The market sold off big at the close. Monday should be interesting.

Three quick points. I think oil is lower at the end of the year. Inflation in Asia and rising subsidies are going to force more and more Asian countries to allow the price of oil to rise and send the proper signals to consumers to use less oil. Over the next decade, oil will be much higher, but I think the pressure over the next year will be to the downside. But don't ask me how high it can go in the short term. Ask the margin clerks.

America on a Diet

Second, corn is going to go higher. Bad weather has meant that not enough got planted, and that will probably hurt yields in the fall. This is going to mean even higher meat prices and ethanol prices. Corn ethanol is such a bad idea. This is what happens when government decides to mess with the market.

Anecdotal inflation note: I eat two chicken fajita pitas without cheese from Jack-in-the Box for lunch about three times a week (after the gym!). I throw away the pita bread and just eat the chicken at my desk. The last three days the price has been the same, but the amount of chicken is noticeably smaller, perhaps 25% smaller. Where's the hedonic price adjustment in the BLS statistics for that? A friend of mine notes that the filet from his favorite steak house is now seven ounces instead of eight. But the steak is still the same price. Maybe portion control will finally get America to go on a diet.

Finally: George Friedman told me that the Saudis are taking in something like $10 billion a week! The entire gulf is awash in dollars. He thinks it may have nowhere else to go but to the stock markets of the world. We'll see. Unintended consequences.

Montreal, A New Book, and a Wedding

Next week Tiffani and I go to Montreal to speak at a conference for Canaccord, and we will get to have dinner with Martin Barnes and Pierre Casgrain. And it looks like Dennis and Margaret Gartman may be able to join us. Now that will be a fun dinner. I should get some fodder for next week's letter.

Tiffani (my daughter, who in fact runs the business and lets me research, travel, speak and write - what a deal!) and I are going to take the train from Toronto to Montreal so we can work on a new project. Basically, she has an idea for a new book that we can write together, and we are going to use the time to think about how we go about it. But we are going to need your help. I will let you know in a week or so, but it is going to be great fun for all of us.

And speaking of Tiffani, she is getting married to Ryan on August 8 (08-08-08). Plans are coming together, as well as expenses. This is going to be a most different wedding, as those of you who know Tiffani might suspect. Not traditional at all. One of the best photographers in Dallas has been working with them. Because they are willing to try different things, he is getting them to do things he has always wanted to do but never had a couple adventurous or "fun enough" to do. The following photo is just a sample. This is a groom that is definitely in for a challenge. If you want to see more pictures (the underwater photos are fun, the "Hillbilly Tiffani and Ryan" is a hoot) you can go to www.fatedlove888.com and click on the picture. Dad is only a little proud.

There are 20 college-age kids from my daughter Amanda's cheerleading instruction team at the office watching the baseball game, and three of my other kids. (You can watch the game from my office balcony.) Of course, the Rangers are losing. I am literally writing with foam ear plugs, trying to concentrate, so I think I will just hit the send button and enjoy my kids.

Your doing my best to stimulate the economy with wedding expenses analyst,

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