Soaring oil prices were mostly to blame for the past week's stock market sell-off, but renewed concerns about US economic growth, corporate earnings and mounting angst about inflation pressures also featured prominently in determining the market's fate.

David Fuller (Fullermoney) commented as follows: "As the world's most important commodity by far, this surge in the oil price is bearish for the majority of stock markets. Consequently I would assume that rallies seen since March have either been capped or are unlikely to make much upward progress until investors see evidence that crude oil has commenced a medium-term correction."

The FOMC released the minutes from its April 30 meeting on Wednesday. Members acknowledged uncertainty about what constituted an appropriate monetary policy in the current economic environment, resulting in the rate reduction (by 25 basis points to 2.0%) being a "close call".

The surprise of the minutes was the Fed showing increasing concern about inflation expectations, as gleaned from the following: "... risks to growth were now thought to be more closely balanced by the risks to inflation ... several members noted it was unlikely to be appropriate to ease policy in response to information suggesting that the economy was slowing further or even contracting slightly in the near term, unless economic and financial developments indicated a significant weakening of the economic outlook."

Market participants were further unnerved by the Fed slashing its real GDP growth projections for this year (0.3% to 1.2% - down from 1.3% to 2.0% in January), together with raising its forecasts for PCE inflation (3.1% to 3.4% - up from 2.1% to 2.4%) and the unemployment rate (5.5% to 5.7% - up from 5.2% to 5.3%).

I will be braving 34 hours of traveling time from Cape Town to Laguna Beach in California later this week to attend Rob Arnott's Research Affiliates' annual gathering of its advisory panel. Our investment management company, Plexus Asset Management, has an exclusive licensing agreement with Research Affiliates for managing and distributing its enhanced Fundamental Index™ methodology in the Pan-African region.

I am thrilled about attending this event as it will afford me the opportunity to meet with financial luminaries such as Peter Bernstein, Burton Malkiel, Harry Markowitz and Jack Treynor for the first time. This has the prospect of being a truly "whoa" experience! Needless to say, my blogging activity will be rather light over the next week, but I am sure that I will return with an abundance of interesting investment ideas.

Before highlighting some thought-provoking news items and quotes from market commentators, let's briefly review the financial markets' movements on the basis of economic statistics and a performance round-up.

Economy
The Ifo World Economic Climate Index has worsened further in the second quarter of 2008, the indicator having fallen to its lowest level in six years.

Overall, last week's US economic reports failed to brighten up investors' mood. Weekly initial claims and the leading economic indicators data were mildly encouraging, but were overshadowed by inflation concerns tied to a gloomy Producer Price Index, the jump in oil prices and the downbeat statements in the FOMC's minutes. In addition, a stark housing inventory situation implied that additional price declines were in store.

BCA Research summarized the US economic picture as follows: "...policymakers remain nervous about the outlook, and are keeping their options open. The markets are pricing in a 50% chance that the Fed will hike rates by 25 basis points before the end of the year, but that seems premature given the prospect that the economy will continue to struggle."

Elsewhere in the world, the Bank of Japan elected to leave its official rate unchanged at 0.5%. The German ZEW economic sentiment index pointed to investors' outlook continuing to worsen, although the Ifo Business Climate Index edged up, suggesting German industry and trade are still doing well. The UK economy, however, seems to be heading for its most protracted slowdown since the early 1990s, according to detailed growth forecasts from the Bank of England.

WEEK'S ECONOMIC REPORTS

The next week's economic highlights, courtesy of Northern Trust, include the following:

1. New Home Sales (May 27): Sales of new homes are expected to have fallen in April. Purchases of new homes in March were down 62.1% from their peak in July 2005. Sales of new homes have declined by 36.3% from a year ago in March. Consensus: 522,000 versus 526,000 in March.

2. Durable Goods Orders (May 28): Durable goods orders (-0.5%) are predicted to have dropped in April largely due to aircraft orders that have risen for two straight months. Orders of defence items may have risen following a drop in March. Consensus: -1.1% versus -0.3% in March.

3. Real GDP (May 29): The net impact from recently published data is an upward revision of real GDP growth to 1.0% in the first quarter of 2008 from a 0.6% increase in the advance estimate. Consensus: 1.0%.

4. Personal Income and Spending (May 30): The earnings and payroll numbers for April suggest only a small gain in personal income (+0.1%). Auto sales fell sharply to 14.4 million units in April and non-auto retail sales were soft, which points to a steady reading for consumer spending with service outlays providing the offset. Consensus: Personal income +0.2%, consumer spending +0.2%.

5. Other reports: Consumer Confidence (May 27), Consumer Sentiment Index (May 30).

Markets
The performance chart obtained from the Wall Street Journal Online shows how different global markets performed during the past week.

Source: Wall Street Journal Online, May 25, 2008.

Equities
After a number of major stock market indices hit four-month highs on Monday, a surge in oil prices and renewed growth concerns triggered a sharp turnaround, taking the MSCI World Index 2.4% lower by the close on Friday. No market, including emerging markets (-2.6%), was spared the downside. The Nikkei 225 Average (-1.5%) recorded the smallest decline among the leading indices.

The US stock markets were in the thick of things, as shown by the last week's index movements: Dow Jones Industrial Index -3.9% (YTD -5.9%), S&P 500 Index -3.5% (YTD -6.3%), Nasdaq Composite Index -3.3% (YTD -7.8%) and Russell 2000 Index -2.3% (YTD -2.3%).

The Dow Jones Transportation Index witnessed a big 4.2% drop, but is still 11.2% in the black for 2008. Gold and silver stocks (+0.1%) were some of the few to keep head above water during the sell-off.

Tim Bond, head of global asset allocation at Barclays Capital, offered the following advice: "Equity exposure should be narrowed to energy, basic resources, industrial goods and services and - once the write-offs are complete - financials. During inflationary periods, these are the only sectors that deliver positive real returns."

Fixed-interest instruments
Mounting inflation worries put strong upward pressure on government bond yields in most parts of the world. Although yields were almost unchanged in the US, this concealed a fair amount of volatility during the week.

Bill Gross, manager of the World's largest bond fund (Pimco's Total Return Fund), called Treasuries "the most overvalued asset". "If there was a bubble, the popping has produced a counter-bubble in quality securities. The safe haven has been way overdone. Treasuries are yielding 2% to 3%, there is no real return on that at all," he said. "This is an asset class that is held by sovereign wealth funds and central banks ... but that is not any reason to follow them."

Credit market stress increased as shown by the widening spreads in both the US and Europe. The CDX (North American, investment grade) Index rose back through the psychological level of 100 basis points to 109, and the Markit iTraxx Europe Crossover Index jumped by 50 basis points to 455.

Currencies
The US dollar could not manage to escape the Fed's downbeat economic outlook and record oil prices, dropping by 1.1% to a two-month low against the euro (where a rate cut by the European Central Bank does not seem imminent). The greenback also declined against the Swiss franc (-2.2%), the Canadian dollar (-1.5%), the British pound (-1.2%) and the Japanese yen ( 0.6%).

Rising commodity prices and hawkish comments from the Reserve Bank of Australia pushed the Australian dollar to a 24-year high against the US dollar, closing 0.5% higher at $0.9615 - not too far away from parity. The New Zealand dollar gained 1.8% against its US namesake on the back of unexpected tax cuts.

Commodities
Although the CRB Index (+1.1%) closed the week higher, the chart below shows that the commodities complex comprised both winners (energy and precious metals) and losers (agriculture and industrial metals).

Crude oil was again in the limelight, with West Texas Intermediate closing the week 4.9% higher at $132.19. Speculative action (notably short-covering), a drop in US oil inventories and huge demand from China ahead of the Olympics boosted prices. Long-term oil contracts (+15%) rose by even more than spot as the market braced itself for a "super spike" of $200 a barrel as predicted by Arjun Murti of Goldman Sachs. Prices for diesel (+6.7%), heating oil (+7.2%) and gasoline (+4.2%) all scaled fresh peaks.

Rising inflationary pressure as a result of the strong oil price, expectations that US interest rates will remain negative in real term for quite a while, together with a weaker US dollar, positively impacted on gold (+2.9%), platinum (+2.1%) and silver (+7.8%).

As far as agricultural commodities were concerned, wheat dropped to a nine-month low, having almost halved since its peak in February on the back of the prospects of an excellent crop.

Now for a few news items and some words and charts from the investment wise that will hopefully assist in steering our investment portfolios on a profitable course. And to our American friends, have a fabulous Memorial Day weekend.

Source: The Economist, May 1, 2008.

Bill King (The King Report): Tim Bond - structure portfolios for inflationary conditions
"Tim Bond, head of global asset allocation at Barclays Capital, offered the following investment advice:

• To invest successfully in inflationary conditions, portfolios need to be narrowly focussed on the handful of assets that cause - or benefit from - inflation.
• Portfolio diversification is deadly, destructive and will diminish wealth.
• Bonds of all types - aside from index-linked - have no place in portfolios at current yields.
• Even index-linked bonds' ability to protect wealth from inflation is currently hobbled by very low real yields.
• Equity exposure should be narrowed to energy, basic resources, industrial goods & services and - once the write-offs are complete - financials. During inflationary periods, these are the only sectors that deliver positive real returns.
• Maintain an overweight position in physical commodities.
• Accept that much higher-than-normal portfolio volatility is the price to pay for positive real returns when inflation is high."

Source: Bill King, The King Report, May 19, 2008.

Telegraph TV: Jim Rogers - Why the US dollar is doomed
"Jim Rogers, author, investor and co-founder of the Quantum Fund, tells Robert Miller why the dollar is doomed and the US Federal Reserve Bank is a disaster."

Source: Telegraph TV, May 20, 2008.

Financial Times: Buffett - effects of crisis "far from over"
"Warren Buffett ... on Monday said he thought the effects of the financial crisis were 'far from over'.

"Mr Buffett was speaking at a press conference in Frankfurt, where he is meeting German family-owned businesses as part of a four-country tour of Europe.

"'It is rippling - there are secondary and tertiary effects. I think the Wall Street crisis is mostly over although I don't know. The [Federal Reserve] with its Bear Stearns rescue largely stopped that. But I don't think we are half way or even a quarter of the way through the impact in the general economy,' he said.

"The 'Sage of Omaha' said the effects of the crisis were beginning to be felt not just by those who had behaved the 'silliest' but also now by people 'who did sound things'.

"Mr Buffett on Monday began his first big business trip to Europe as he seeks buying opportunities among the Continent's largest family-owned companies. His visit will include Germany, Switzerland, Spain and Italy as he looks for candidates for what would be only his second major acquisition outside the US."

Source: Francesco Guerrera, Financial Times, May 18, 2008.

Willem Sels (Dresdner Kleinwort): More credit woes to come
"The worst of the credit crisis is not behind us, warns Willem Sels, head of credit strategy at Dresdner Kleinwort.

"He says that while liquidity tensions are easing, the market is entering a second phase of the crisis. Real credit losses are accelerating and many areas of the market have yet to see the worst of the crunch. He says corporate defaults have only just started rising and he expects high yield defaults to accelerate sharply to 7% to 11% by mid-2009, particularly in the US.

"The market, however, is only currently pricing in a 6% rate of default, he estimates. Mr Sels says rising corporate and consumer defaults will lead to real losses in portfolios, leading credit spreads wider, especially for non-financials.

"He notes the weakness in the housing market seems to be gathering momentum and could still provide a shock to the economy.

"'Even if we get a W-shaped economic recovery, the current mid-cycle credit rally seems overdone," says Mr Sels. 'We believe the recent rally has been exacerbated by investors who are 'afraid to miss out' or who are too impatient to recognise the lags with which the economy and the profit cycle typically react to shocks.'

"Bank risk appetite will remain low and lending will therefore remain depressed, leading to a long period of sub-trend GDP growth and weakening corporate profit margins, Mr Sels believes."

Source: Willem Sels, Dresdner Kleinwort (via Financial Times), May 19, 2008.

Bloomberg: Paulson - financial markets showing signs of progress
"US Treasury Secretary Henry Paulson speaks in Washington about the US housing and credit markets, the impact of the fiscal stimulus plan on the economy and recommendations for financial regulation."

Source: Bloomberg, May 16, 2008.

Ifo: Renewed decline in Ifo World Economic Climate Index
"The Ifo World Economic Climate has worsened further in the second quarter of 2008, the indicator having fallen to its lowest level in six years. The decline is mainly due to more unfavourable assessments of the current economic situation, but also the expectations for the coming six months have again been revised downwards.

"The worsening in the Ifo World Economic Climate has again affected above all North America and Western Europe. The strongest decline in the climate indicator ... was in the US. Here, however, the fall was attributable exclusively to the clearly less favourably assessments of the current situation whereas the expectations for the coming six months are no longer quite so pessimistic. In Western Europe above-average declines in the indicator have been reported in France, Italy and Spain. The indicator has worsened relatively less strongly in Germany, Austria and Switzerland. The climate indicator has also fallen in Asia, especially in South Korea and Hong Kong. Also in Japan negative economic expectations continue to prevail.

"Inflation expectations in the US for 2008 at 3.5% are much higher than the price increases reported by World Economic Survey (WES) experts for 2007 (2.8%). Also in Western Europe inflation expectations for 2008 at 2.9% are considerably above the reported rate of inflation for 2007 (2.1%). In Asia the picture is similar, where the inflation expectations for 2008 are one percentage point higher than the average price increase for 2007 (3.9% vis-à-vis 2.4% in 2007).

"As in the previous survey, a majority of WES experts expects a decline in central bank interest rates. In contrast, long-term interest rates will rise at a moderate pace in the coming six months, in their opinion.

"Especially the US dollar and to a lesser extent the Japanese yen are still seen as undervalued. In contrast, the WES experts consider the euro to be overvalued. Independent of the fundamental assessments of the currencies, they expect the US dollar to continue its weakening trend in the coming six months."

Source: Hans-Werner Sinn, Ifo Institute for Economic Research, May 20, 2008.

Financial Times: Moody's launches review in wake of errors
"Moody's has initiated an external review of its ratings of $4 billion of complex debt products after revelations that the agency had awarded incorrect ratings because of a bug in its computer models.

"Charles Schumer, the New York senator, called Wednesday for the SEC to investigate the matter, which triggered a fall of 16% in its share price. Mr Schumer also said, if a probe proved mistakes had occurred, that the US regulatory agency should impose 'appropriate sanctions' in the form of fines.

"The letter to Christopher Cox, SEC chairman, was in response to a report in Wednesday's Financial Times that detailed how some senior staff at Moody's knew in early 2007 that the ratings on products known as constant proportion debt obligations - complex derivative instruments conceived at the height of the credit bubble - had incorrectly received triple A ratings. Some of the CPDOs should have been rated up to four notches lower due to a computer coding error that was later corrected.

"'The ratings inaccuracies that were disclosed are deeply troubling,' Mr Schumer wrote in a letter sent Wednesday. 'However, the fact that Moody's only downgraded these incorrectly rated products in January of 2008, nearly a full year after they became aware of the problem, is much worse, and is indicative of a culture of shirking responsibility that must end.'

"Moody's said Wednesday night: 'Moody's recognizes the seriousness of questions raised by [the] Financial Times article concerning the analytical models and methodologies used in our European constant-proportion debt obligation ratings process.

"'The integrity of our ratings and rating methodologies is extremely important; as such, when the questions were recently raised to us, we retained the law firm of Sullivan & Cromwell and initiated a thorough external review of our European CPDO ratings process. Upon completion of the review, we will promptly take any appropriate actions.'"

Source: Sam Jones, Paul Davies, Stephanie Kirchgaessner and Joanna Chung, Financial Times, May 21, 2008.

Goldman Sachs Global: Houses in the industrial countries - built on rock, or on sand?
"We find that a further cooling of real house prices is likely. In the UK, Spain and Ireland, much has been said about the drag to growth from residential investment, but whether the private sector's spending behaviour materially changes as a result remains a very open question.

"Countries that look relatively more vulnerable to both a correction in home prices and possibly a broader economic adjustment are New Zealand, followed at a distance by Denmark and Finland. In New Zealand, we continue to recommend gaining long exposure to the front-end of the yield curve and shorting the currency.

"The increase in real house prices in Canada, Norway and Australia, and the related deterioration in house purchase affordability, need to be viewed against the backdrop of a large favourable terms of trade shock from commodity exports.

"Property markets in Germany, Japan and Switzerland all stand to benefit from the decline in long-term interest rates that ensued from the bursting of the US housing bubble."

Please click here for the full report.

Source: Goldman Sachs Global, May 14, 2008.

Bloomberg: James Galbraith - US housing problem to last "long time"
"James Galbraith, an economics professor at the University of Texas, talks with Bloomberg's Matt Miller from Austin, Texas, about the outlook for the US economy and the challenges facing the next president, the impact of Federal Reserve monetary policy on inflation, and the state of the US housing market."

Source: Bloomberg, May 16, 2008.

Financial Times: Wall Street fears prolonged credit crisis
"According to Meredith Whitney and a team of analysts from Oppenheimer, the extended credit crisis will result in further multi-billion dollar revenue reversals at the major banks.

"'We believe the real harrowing days of the credit crisis are still in front of us and will prove more widespread in effect than anything yet seen,' Ms Whitney said.

"The culprit is less the writedowns themselves than the 'shut-down' in the securitisation market which at its height provided 66% of household borrowings in the first quarter of 2007.

"Without that market, consumer credit losses may be 'far worse than what is currently estimated, even by the most draconian of investors'. Ms Whitney and her colleagues also slashed their 2008 earnings estimates for the large-cap banking stocks they cover by an average of 17%."

Source: Jeremy Lemer, Financial Times, May 20, 2008.

Bloomberg: Barton Biggs - golden age of Wall Street is over
"The credit meltdown runs so deep that the prosperous years on Wall Street that began in 1982 are probably drawing to a close, says Barton Biggs, 75, managing partner at Traxis Partners, a New York- based hedge fund.

"'We had a spectacular era of financial success that was extended by the subprime mortgage mania to 2007,' says Biggs, who was chief global strategist at Morgan Stanley until 2003. 'But I think the golden age of Wall Street is over.'"

Source: Edward Robinson, Bloomberg, May 21, 2008.

BCA Research: The Fed - Nervously on hold
"The latest FOMC minutes noted that the April decision to lower rates was a 'close call'. The Fed's economic expectations are subdued with a mild first-half recession, followed by a moderate upturn. But there is no appetite for a more aggressive easing given lingering concerns about upside risks to inflation. The reduction in credit market strains is a further reason to stay on hold.

"Nonetheless, the minutes, together with recent remarks by Vice-Chairman Kohn, highlight that policymakers remain nervous about the outlook, and are keeping their options open. The markets are pricing a 50% chance that the Fed will hike rates by 25 basis points before the end of the year and that seems premature given the prospect that the economy will continue to struggle."

Source: BCA Research, May 23, 2008.

MarketWatch: Statistical con game to be exposed
"No matter who's elected president, America will soon see a massive statistical curtain pulled back, exposing a con game of historic proportions. And when that happens, you and I will suffer another ear-splitting global meltdown, bigger than today's housing-credit crisis, dragging us deep into a recession and bear market for years."

Source: Arroyo Grande, MarketWatch, May 20, 2008.

Asha Bangalore (Northern Trust): Leading indicators - premature to rule out recession
"The Index of Leading Economic Indicators (LEI) moved up 0.1% in April, matching the increase seen in March. The two consecutive monthly gains of the index follow five consecutive monthly declines. The spokesperson from the Conference Board indicated that the index is indicative of weak economic conditions but ruled out the possibility of a recession.

"From the chart, we know that strongly negative readings of the year-to-year change in the LEI are associated with recessions, with the exception of 1966-67. On a year-to-year basis, assuming the April reading is the second quarter reading for the LEI, it was down 1.86% from a year ago. On a quarterly basis, the year-to-year change in the LEI is negative in four out of the five quarters ended first quarter of 2008. We need information about May and June to confirm the reading for the second quarter. The drop in consumer expectations in May and current readings of jobless claims point to negative contributions of these two indexes. It is premature to rule out the occurrence of a recession based on these monthly readings."

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, May 19, 2008.

Asha Bangalore (Northern Trust): Chicago Fed National Activity Index signals recession
"The Chicago Fed National Activity Index (CFNAI) dropped to -1.17 in April from -0.98 in March (previously reported as -0.78). The CFNAI has posted negative readings every month since July 2006. Negative values of the CFNAI indicate below trend growth and positive values point to above trend growth.

"According to the Chicago Fed, 'when the 3-month moving average of the CFNAI moves below -0.70 following a period of economic expansion, there is an increasing likelihood that a recession has begun.' The 3-month moving average of the CFNAI declined to -1.24 in April from -1.05 in March. April is the fifth month when the CFNAI has held below the -0.70 cut-off mark. Also, April's CFNAI is the lowest reading of the index since the months associated with the recession in 2001."

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, May 20, 2008.

Asha Bangalore (Northern Trust): Fed's projections for GDP, inflation and unemployment
"The Fed published projections for GDP, inflation, and unemployment in 2008, 2009, 2010. These are forecasts of the members of Board of Governors and the presidents of the Federal Reserve Banks. Projections of unemployment rate, the growth of real GDP, of PCE inflation, and of core PCE inflation are central tendencies which exclude the three highest and the three lowest projections for each variable in each year.

"The central tendency of projections for real GDP for 2008, at 0.3% to 1.2%, is lower than the forecast presented in January. The economy is predicted to gain momentum in 2009 and grow at close to or above trend in 2010.

"Projections of the growth of real GDP are percent changes from the fourth quarter of the previous year to the fourth quarter of the year indicated.

"Consistent with the below trend forecast of GDP growth in 2008, the unemployment rate is expected to move up (5.5% to 5.7%) in 2008. As the economy grows, the unemployment rate is projected to edge down in 2009 and 2010.

"The revisions of the inflation forecasts for 2008 reflect the steep increase in energy and food prices. The slightly higher predictions for core inflation imply a pass through of higher food and energy prices and the impact from higher import prices. Inflation was predicted to show some moderation by 2010."

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, May 21, 2008.

Asha Bangalore (Northern Trust): Wholesale prices present a troubling issue
"The Producer Price Index (PPI) for Finished Goods moved up 0.2% in April, following a 1.1% increase in the prior month. The steady reading for food and a 0.2% drop in the energy price index helped to tame the overall wholesale price index. On a year-to-year basis, the PPI for finished goods increased 6.5% in April versus a 6.2% increase in 2007. In the first four months of the year, the energy price index has risen at a seasonally adjusted annual rate of 18.0% and the food price measure has moved up 7.3% compared with a 17.8% gain in energy prices and a 7.6% increase in food prices in 2007."

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, May 20, 2008.

Bloomberg: Pimco's Gross says US underestimating inflation
"Pimco's Bill Gross said the US underestimates inflation through the methodology used to track consumer prices, making some emerging economies better real growth investment candidates.

"Changes in the way the Bureau of Labor Statistics measures prices over the past 25 years have led to the understating of inflation by at least 1%, Gross, said in a commentary on the company's web site today. The Federal Reserve's focus on 'core' instead of 'headline' inflation has also helped understate the increase in prices, Gross said.

"Pimco favors commodity-based assets and foreign equities that are denominated in currencies that demonstrate 'authentic' real growth and inflation rates. Investors should shun US Treasuries and Treasury Inflation Protected Securities, or TIPS, because of their negative 'unreal' yields as a result of 'artificially low inflation,' he said.

"'Investors might suddenly awake to the notion that US inflation should be and in fact is closer to worldwide levels than previously thought,' Gross said. 'Foreign holders of trillions of dollars of US assets are increasingly becoming price makers not price takers, and in this case the price may not be right.'

"Emerging-market countries with economies similar to those of Brazil, Russia, India and China are 'obvious' candidates for investment as inflation quickens, Gross said.

"Global headline inflation stands at 7%, Gross said. Prices rose 3.9% in the 12 months ended in April, down from a 4% year-over-year gain in March, the Labor Department said on May 14."

Source: Lester Pimentel, Bloomberg, May 22, 2008.

Asha Bangalore (Northern Trust): Downward descent of home prices likely to persist through 2008
"The OFHEO (Office of Federal Housing Enterprise Oversight) House Price Index declined 3.1% in the first quarter compared to a year ago. On a quarter-to-quarter basis, the OFHEO House Price Index fell 1.7%, marking the third consecutive quarterly drop of the index.

"The House Price Index is down 3.7% from the peak reading in April 2007. Incoming data from the housing market suggest that additional price declines should not be surprising, particularly given the large inventory of unsold homes."

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, May 22, 2008.

Asha Bangalore (Northern Trust): Existing home sales - Inventories remain a prickly problem
"Sales of all existing homes are down 32.4% from the peak level in August 2005. The decline in single-family home sales in the current cycle exceeds the pace seen in prior business cycles. The median decline in sales of existing single-family homes during the prior business cycles (1969 - 2001) was 24.8%. The April reading of existing single-family sales is down 31.6% from the peak in September 2005, which is slightly smaller than the 31.9% drop recorded for December 2007.

"The sales and price data of existing single-family homes suggest that there is a possibility of stability in this market in the near term. However, inventories of unsold homes remain a prickly problem. The inventory of unsold existing homes moved up to an 11.2-month supply mark in April, up from a 10-month supply in March. The stark inventory situation implies that additional price declines cannot be ruled out."

Source: Asha Bangalore, Northern Trust - Daily Global Commentary, May 23, 2008.

Barry Ritholtz (The Big Picture): Housing Price to Rent Ratio
"All those Housing Bottom callers should consider the Housing Price to Rent ratio. It argues very loudly against a bottom anytime soon."

Chart courtesy of Janet Yellen, President, Federal Reserve Bank of San Francisco.

Source: Barry Ritholtz, The Big Picture, May 23, 2008.

BCA Research: US home builders - No light at the end of the tunnel
"Sentiment among US home builders remains at rock bottom levels - builders expect no improvement in sales over the next six months.

"The fundamentals for housing remain weak, especially since the employment outlook has deteriorated this year and mortgage rates have not fallen in line with policy rates. The budding rebound in mortgage refinancing activity faltered the minute Treasury yields blipped up, underscoring that borrowing rates are too high to support the housing market. The spring selling season so far has been disappointing, implying that inventories will remain excessive.

"Bottom line: The housing market will stay depressed for the foreseeable future, acting as a limit on the upside in Treasury yields."

Source: BCA Research, May 20, 2008.

John Authers (Financial Times): US house prices critical for financial markets
"Nothing now creates more uncertainty for markets, and nothing has greater import for the future, than the course of house prices in the US.

"US housing, of course, lit the fuse for the credit crisis. Among measures of housing, price is most important because of its link to the risk that owners abandon their homes, and thus to the risk to the value of the mortgage-backed securities that sparked the crisis. The best indicator of the coming rise in subprime delinquencies was the slowing in house price rises two years ago.

"House prices are also the greatest imponderable for those trying to model the future. There is no precedent for big falls, in nominal terms, in US house prices or for a situation where Americans' percentage of equity in their homes has dropped below 50%. Both have happened recently.

"It would appear, however, that if house prices fall and homeowners move into negative equity, the risk that homeowners will abandon their houses increases greatly. So moves in price to clear the housing backlog could have a greater impact than falls in construction (for which there are some precedents).

"It is extremely difficult to discern a long-term 'fair value' for housing. Research by Robert Shiller of Yale University suggests that prices are 90% overvalued compared to their average ratio to rents over the past 80 years - but they are actually slightly undervalued compared to disposable incomes per capita.

"So far, prices have followed construction activity down. Permits for new housing ticked up in April, sparking hopes that an end was in sight. But futures on the S&P Case-Shiller house price index suggest prices could fall 13% over the next year, and 20% by the end of 2012. That shows the depth of the uncertainty. How it is resolved is critical for markets far beyond US housing."

Source: John Authers, Financial Times, May 19, 2008.

Financial Times: Pimco's chief piles into mortgage debt
"Bill Gross, the manager of the world's biggest bond fund, has switched gears to make a big bet on mortgage debt, almost tripling his holding of it to more than 60% of the fund.

"Mr Gross's $130 billion Pimco Total Return fund pulled sharply ahead of rivals in the past year after the manager predicted a housing downturn and sold out of housing-related securities and corporate bonds.

"The fund has returned 12.6% over 12 months, beating 99% of its peers, according to fund tracker Morningstar.

"Mr Gross said his decision to raise exposure to mortgage debt in recent months was based on the US government's implicit guarantee of Freddie Mac and Fannie Mae, the government-sponsored mortgage agencies.

"Mr Gross said Pimco was buying primarily mortgage agency debt and 'not the subprime garbage'.

"The Total Return fund is now invested about 61% in mortgage debt, compared with just over 20% a year ago.

"Mr Gross was heavily overweight US Treasury bonds in the early 2000s but is now scornful of them and the fund is using derivatives to gain from any downturn in Treasuries. He called Treasuries 'the most overvalued asset'.

"'If there was a bubble, the popping has produced a counter-bubble in quality securities. The safe haven has been way overdone. Treasuries are yielding 2% to 3%, there is no real return on that at all,' he said. 'This is an asset class that is held by sovereign wealth funds and central banks ... but that is not any reason to follow them.'"

Source: Deborah Brewster, Financial Times, May 22, 2008.

John Authers (Financial Times): Misplaced equity optimism
"... the success of equities at the moment comes from ... extreme optimism on corporate earnings. This is hard to square with the still lukewarm outlook for the economy, or with the historically high profit margins with which the corporate sector entered the slowdown."

Source: John Authers, Financial Times, May 21, 2008.

David Fuller (Fullermoney): Surge in oil prices bearish for stock markets
"Rising oil prices are usually a headwind for most stock markets, although less so when the advance is gradual. However crude oil has risen more rapidly recently and today's move represents trend acceleration. We know from past experience that such moves are unsustainable beyond the short term. They are climactic and therefore followed by sharp reactions. However there is still no evidence that oil has peaked.

"As the world's most important commodity by far, this surge in price is bearish for the majority of stock markets. Consequently I would assume that rallies seen since March have either been capped or are unlikely to make much upward progress until investors see evidence that crude oil has commenced a medium-term correction."

Source: David Fuller, Fullermoney, May 21, 2008.

Richard Russell (Dow Theory Letters): Third phase of bull market is going to be speculative "explosion"
"Let's get back to the markets. As you know, I've been bullish. As a matter of fact, I'm exceedingly bullish. Here's what I think, wrapped up in a nutshell. The greatest bull market in history was born in the early 1980's. It turned out to be a very unorthodox primary bull market. We've gone through the first and most of the second phase of the bull market with the third phase maybe beginning now or maybe just a bit ahead.

"The third phase is going to be 'something else'. It's going to be the greatest speculative stock market 'explosion' the world has ever seen. It's going to include (include, hell, it's going to be led) by the BRIC nations (Brazil, Russia, India, China) along with most of Asia and Europe, and it's going to rub off on the poor old indebted US - BIG TIME!

"Right now most of the world's potential investors are sitting on the sidelines reading about 'how tough it is, and how this is a horrendous real estate disaster and how every other American is going to lose his home due to foreclosure.' But wait - so far the markets are telling us something different. As my subscribers and readers of Barron's know, it's been telling us that the stock market has discounted the bad news and the 'coming disaster' and is preparing itself for better times ahead.

"I think there's a mighty third phase coming. Most of the world is sitting with cash. There's $3.5 billion in US money market funds. There's God knows how much cash in bonds on the sidelines. There are tens of trillions in sovereign wealth funds that will be looking to be invested. The oil and commodity nations are choking on cash. The planet is up to its neck in fiat money, and once the third phase of the bull market starts cranking up, this money will want to be in stocks."

Source: Richard Russell, Dow Theory Letters, May 19, 2008.

Michael Masters: Testimony on commodity prices before US Senate
This interesting testimony points the finger squarely at Commodity Index Funds for the recent acceleration in food and energy prices. Here is an extract:

"The following Chart shows this dynamic at work. As money pours into the markets, two things happen concurrently: the markets expand and prices rise.

"One particularly troubling aspect of Index Speculator demand is that it actually increases the more prices increase. This explains the accelerating rate at which commodity futures prices (and actual commodity prices) are increasing. Rising prices attract more Index Speculators, whose tendency is to increase their allocation as prices rise. So their profit-motivated demand for futures is the inverse of what you would expect from price-sensitive consumer behavior.

"You can see from the Chart that prices have increased the most dramatically in the first quarter of 2008. We calculate that Index Speculators flooded the markets with $55 billion in just the first 52 trading days of this year.19 That's an increase in the dollar value of outstanding futures contracts of more than $1 billion per trading day. Doesn't it seem likely that an increase in demand of this magnitude in the commodities futures markets could go a long way in explaining the extraordinary commodities price increases in the beginning of 2008?

"There is a crucial distinction between Traditional Speculators and Index Speculators: Traditional Speculators provide liquidity by both buying and selling futures. Index Speculators buy futures and then roll their positions by buying calendar spreads. They never sell. Therefore, they consume liquidity and provide zero benefit to the futures markets.

"It is easy to see now that traditional policy measures will not work to correct the problem created by Index Speculators, whose allocation decisions are made with little regard for the supply and demand fundamentals in the physical commodity markets. If OPEC supplies the markets with more oil, it will have little affect on Index Speculator demand for oil futures. If Americans reduce their demand through conservation measures like carpooling and using public transportation, it will have little affect on Institutional Investor demand for commodities futures.

"Index Speculators' trading strategies amount to virtual hoarding via the commodities futures markets. Institutional Investors are buying up essential items that exist in limited quantities for the sole purpose of reaping speculative profits.

"Think about it this way: If Wall Street concocted a scheme whereby investors bought large amounts of pharmaceutical drugs and medical devices in order to profit from the resulting increase in prices, making these essential items unaffordable to sick and dying people, society would be justly outraged.

"Why is there not outrage over the fact that Americans must pay drastically more to feed their families, fuel their cars, and heat their homes?"

Please click here for the full testimony.

Source: mCADForums.com, May 20, 2008.

Eoin Treacy (Fullermoney): Commodities - keep an eye on further regulation
"The Michael Masters piece is a clear indication that the focus of public opinion is turning towards further regulation, of how large a speculator's positions can be in key commodities. This is important and it would be advisable to keep an eye on government announcements relating to this issue.

"It is easy to forget, with the hyperbole in the media that commodities are in a secular bull market. Regardless of their recent advance, they remain a long way from their inflation-adjusted highs posted in the 1970s. While the impact Commodity Index funds is being examined today, any fresh regulation is unlikely to derail the long-term bullish fundamentals for the sector."

Source: Eoin Treacy, Fullermoney, May 23, 2008.

John Authers (Financial Times): Speculators cannot take all the blame for price spike in commodities

Source: John Authers, Financial Times, May 20, 2008.

Bloomberg: Blame Wall Street for $135 oil on wrong-way betting
"Oil's rally to a record above $135 a barrel came as traders bought crude to cover wrong-way bets that prices would decline, according to data from the New York Mercantile Exchange.

"The number of outstanding futures contracts, known as open interest, fell 8.1% in a week to 1.36 million at the same time that prices rose 2.6%, the data show. Falling open interest and rising prices are signs that traders are buying to exit so-called short positions that would profit if oil fell, and lose money as they rose.

"'In a market like today, which is trending higher while open interest is falling, it's a sign that money is moving out of the market,' said Stephen Schork, president of Schork Group in Villanova, Pennsylvania. Open interest in Nymex crude futures peaked this year at 1.5 million on March 13."

Source: Alexander Kwiatkowski and Grant Smith, Bloomberg, May 22, 2008.

Bloomberg: OPEC says it's powerless to stop rally
"Crude oil rose to a record above $135 a barrel as OPEC ministers said they could do nothing to stop a rally that may be heading to $200 a barrel.

"Oil has risen 19% this month as analysts increased their price forecasts because of supply constraints and demand growth. OPEC has 'no magic solution' to the surge, Qatar's oil minister said. Prices are 'out of the hands' of the organization, according to Libya's top oil official.

"'Everyone's jumped on the bandwagon,' said Anthony Nunan, assistant general manager for risk management at Mitsubishi Corp, Japan's biggest trading company, in Tokyo. 'There's agreement that $200 is possible and that's getting more people into the market. We have very little supply cushion going forward and that's playing into the minds of investors.'"

Source: Mark Shenk, Bloomberg, May 22, 2008.

CNBC: Why Goldman's oil guru predicts a "super spike"
"Arjun Murti remembers the pain of the oil shocks of the 1970s. But he is bracing for something far worse now: He foresees a 'super spike' - a price surge that will soon drive crude oil to $200 a barrel.

"Mr. Murti ... is not bothered much by the prospect of even higher oil prices, figuring it might finally prompt America to become more energy efficient.

"An analyst at Goldman Sachs, Mr. Murti has become the talk of the oil market by issuing one sensational forecast after another. A few years ago, rivals scoffed when he predicted oil would breach $100 a barrel. Few are laughing now.

"Mr. Murti, 39, argues that the world's seemingly unquenchable thirst for oil means prices will keep rising from here and stay above $100 into 2011. Others disagree, arguing that prices could abruptly tumble if speculators in the market rush for the exits. But the grim calculus of Mr. Murti's prediction, issued in March and reconfirmed two weeks ago, is enough to give anyone pause: in an America of $200 oil, gasoline could cost more than $6 a gallon.

"Mr. Murti is hardly alone in predicting higher oil prices. Boone Pickens, the oilman turned corporate raider, said Tuesday that crude would hit $150 this year. But many analysts are no longer so sure where oil is going, at least in the short term. Some say prices will fall as low as $70 a barrel by year-end, according to Thomson Financial.

"Experts disagree over the supply of oil, the demand for it and whether recent speculation in the commodities markets has artificially raised prices. As an energy analyst at Citigroup, Tim Evans, reportedly put it, trading commodities these days is like 'sticking your hand in a blender'."

Source: Louise Story, CNBC, May 21, 2008.

Continue to Part II