As the title suggests, excessive speculation does indeed reign supreme in the trade of a growing number of financial markets across the landscape these days, making the task of prudent investing difficult for all, even the experienced. The net result of this phenomenon has been a rotation of interested parties from one market to another causing increasingly volatile price swings, and the establishment of 'bubble dynamics' that must ultimately be unwound at some point, where the late comers are always left holding the bag. So, with the oil market exhibiting bubble like characteristics presently because of a large build up in speculative interest, one would think a popping should be expected at some point, as all such instances normally lead to this outcome in the end. The question then arises, "what are the implications for other inter-related markets if this were to occur?" This question will form the cornerstone of today's excursus, where our conclusions may not fit in with the consensus view out there these days.
If one were to watch the tape across the gambit of markets lately, our recent assertion that oil holds the key to a bullish near-term outcome in both debt and equity markets alike should be very apparent to you, as there has been a significant discounting of lower petroleum prices in precious metals already, with the stocks markets following the lead to a lesser extent. What's that, lower oil prices will lead to higher precious metals prices? Yes, just in case you are not clear on this point, this is the situation. Why? Put very simply, because the world is now on a quasi-fixed budget. How could such a statement be true with money supplies going through the roof? Again, put very simply, which I find is always a good practice, because the evidence tells us this is the case. What Evidence? The proof of this hypothesis is in the gold market, and it's lack of relative strength against commodities, including of course, oil. (See Figure 1)
The picture above is one of a 'deflationary signature', where whether it is a result of misplaced speculation or not results are the same, the market thinks this spike in commodity prices is temporary, and that macro-conditions in the nexus are not sufficiently regenerative under current circumstances to maintain growth in the North American economy, which as you know is a fully mature environment, increasingly dependent on service industries due to life cycle constraints. (See Figure 2)
At first glance, the above picture would make one think the situation in the States is improving however, and likely to do so into the foreseeable future because industry is recovering as a result of the lower Dollar. The problem with this assumption is it does not take into consideration the true costs of a depreciating currency, where inflationary factors are outstripping real purchasing power for consumers, as outside of official statistics, the cost of living is far exceeding any wage gains being experienced. (See Figure 3)
With input prices up some 22 percent in 2003 (i.e. the CRB), and holding, while wages were up less than half a percent as measured by the Employment Cost Index, one has to wonder how this new high cost environment is ultimately going to impact macro-conditions given US consumers are already heavily indebted, aging on mass, and for these reasons less likely to extend their burdens much further, if any, especially if the cost of money were to rise. (See Figure 4)
Of course inflationists will counter this concern with the assumption monetary growth rates will sufficiently outstrip this negative drag, but a more realistic observation of recent trends is definitely showing consumers have reduced their appetite for credit, which is putting even more pressure on monetary authorities to actually get those aging horses to drink once shown water, no matter how bloated they are already. (See Figure 5)
Returning to our original thought process, where have placed pivotal importance on oil in the formula currently, as any further strength here will sufficiently tax an already over-taxed consumer to the point it may tip the balance in the matrix, we will now further extend this observation into some potential scenarios for the markets depending on which way crude (i.e. and its derivatives) break in the near-term, where at best over an intermediate-term time horizon, one can expect range bound activity until a higher price levels for the petroleum sector are digested. (See Figure 6)
As you can see above, and with the exception of the 1970's, when of course real wage gains were quite healthy, GDP has expanded considerably over the past twenty plus years along with money supply, a declining cost of money, and stable input prices, with particular importance in this regard being placed on oil, as its factored multiplicity across aggregate pricing metrics in the economy is of primary significance within the basket of variables. Therein, and applying this knowledge to what we can expect to see in the financial markets moving forward, where buoyant oil pricing will act as a significant inhibitor on positive outcomes, particularly in the interest sensitive sectors like financials and precious metals under current circumstances, one must remain cognizant of key technical pricing levels in petroleum's as their trend(s) will have a direct bearing on the trends in other inter-related environments. And, because of the economy(s) inability to get a more firm footing off of recent election based fiscal policy measures, along with of course the constant reinforcement of the Fed via stimulative monetary policies, we appear to be at a particularly important time in this regard as to expectations one should adopt regarding the markets both now, and looking past November. This concern is best expressed in the lack of regenerative capacity in M1 presently, where despite a rapid growth rate in broader money measures, cash and cash equivalents are being tapped to pay for rising costs not only in terms of inputs directly (i.e. think oil), but of course the rising costs of all the things oil affects, which is just about everything. (See Figure 7)
Indeed, it should be of little wonder to you that with rising input (oil) prices, and the effect this condition will have at the margin on price inflation, M1, which as you know from previous discussions is particularly important regarding precious metals pricing, where gold will be bought with increasing cash measures, not less, we are witnessing relatively depressed pricing against the box presently (i.e. the deflationary signature against the CRB), and where unless regenerative multipliers reassert themselves soon, we may witness a problem period in the not too distant future. (See Figure 8)
Turning to the technical condition in oil now, where certainly from a more fundamental view, we do not expect to see lower prices last for long, we do have a particularly good set-up for falling prices soon, although it may remain stubbornly high for longer than one might expect because of geopolitical concerns, production / life-cycle constraints, and of course because it is a necessity. Barring this outcome however, with OPEC likely to increase production quotas by 2.3 million barrels per day this week if Saudi Arabia doesn't act like a tyrant again, a seasonally high pricing period upon us, and very large / bearish speculative long position(s) in the petroleum futures market(s) presently, there is a preponderance of evidence pointing to lower prices in the oil complex sooner than later, where both channel and Fibonacci based retracement metrics put crude at the $36 per barrel mark at a minimum. (See Figure 9)
If this were to occur, one would expect PM's to take this development well because of the reasons outlined above, with the all important relationship in Figure 1 receiving some relief to the upside, taking much of the deflation concern out of the trade. And, if you think deflation is not the primary source of concern right now, particularly for those in official capacities, then one has wonder why the Senate almost unanimously passed legislation last week that would lower the capital gains tax on precious metals from 28 to 20 percent, the same as on stocks and other commodities, and is applicable not only to just gold / silver, but platinum and palladium as well. Yes sir, one would have to wonder if this was not the case.
For the rest of the story, and if you are interested in keeping abreast of how the conditions described above, along with the technicals in the market(s), can affect your portfolio as we move through the balance of the year, and into the next, give us a visit at the link provided below. Many pundits are drawing parallels to current circumstances against that of the 1970's, which we think is a dangerous and potentially expensive mistake, where failing to see what 'is', as opposed to what one 'wants' to see is a perilous practice. This particular condition, although possibly devastating to most, offers great opportunity for others who maintain an unbiased view. The question then arises, "where will you fit in down the road?"
Good investing all.
