The Almighty Dollar

Do not do to others what you do not want them to do to you
   —One version of the rule of reciprocity, the Golden Rule

I only hope that we don't lose sight of one thing—that it was all started by a mouse
    —Walt Disney

Each week I look at the economic and energy data. While there are indeed some actual green shoots in the monthly reports, I can not escape the feeling that our society is like Disneyland, a magic kingdom where life is a fairy tale and dreams really do come true. I call it Disneyland because the crazy rise in the S&P 500 and the oil price in recent months has happened despite, not because of, fundamentals in the economy.

The disconnect between the markets and the economy is almost total. The markets reside in a fantasy realm, while most of us must deal with depressing day-to-day realities. There will eventually be a downward "correction" in the markets, but only because there's no avoiding the fact that reality always gets the last word.

These market price movements do not happen by accident, of course. The "logic" behind these market rallies is best explained by movements in the value of the Almighty Dollar. Amy Jaffe and Kenneth Medlock of Rice University's Baker Institute further confirmed that view this week with the release of their study Who Is In the Oil Futures Market and How Has It Changed?

This view of America as a Magic Kingdom will never be popular. People vested in a crazy system—consider the wacky idea that an economy can thrive based on trading in residential real estate while household debt grows and real income languishes—will remain vested in that system long after it has ceased to function.

I don't know why I should take the world seriously if the world is no longer a serious place. Altruism is dead. Morality is considered quaint. Many of us are left with a survival problem—that is the only truly serious business at hand. We've been abandoned in the economic wilderness, left to fend for ourselves. Speaking of life, no one ever told me "you'll need to be a currency trader if you want to survive the worst of it."

Before turning to the dollar and the Baker Institute study, let us take a brief excursion through the Magic Kingdom. The first stop on our tour is not the must-see Indiana Jones™ Adventure, but rather the S&P 500 P/E (price to earnings) ratio as it exists today. The guided tour comes with a special Magic Kingdom graphic to enhance your chart-gazing experience.

Figure 1 — Barry Ritholzt's Chart of the Day: S&P 500 PE Ratio from August 21st. "The price investors were willing to pay for a dollar of earnings increased during the dot-com boom (late 1990s) and the dot-com bust (early 2000s). As a result of the recent plunge in earnings and recent stock market rally, the PE ratio spiked and just peaked at 144 – a record high. Currently, with 97% of US corporations having reported for Q2 2009, the PE ratio now stands at a lofty 129." Starting in about 1983—it's always 1983 when the trouble starts!—stock prices became more and more disconnected with actual earnings. But that growing unreality was nothing compared to now. The S & P 500 P/E ratio is now in Disneyland.

Figure 2 — From Recent Concentration of Volumes in Financial Stocks: Coordinated Capital Infusion? C = Citigroup, FNM = Fannie Mae, and FRE = Freddie Mac. Trading volumes for these 3 stocks have been accounting for 40% of NYSE volume lately. Is this a coordinated capital infusion? Does a bear defecate in the woods? Thus, "the directionality of the involvement suggests that large financial institutions are systematically buying the beaten-up shares of the poster children for TARP: C, FNM, FRE, AIG, and the like. It is worth noting in this regard that other major (healthy) financial firms, such as Goldman Sachs (GS, alternative trading symbol = GVS) and J.P. Morgan Chase (JPM), have seen no such surge in their volume or their trading prices. Zero Hedge rightly wonders why this hasn’t triggered alarms at the exchange. And why is it happening with only the weakest financial institutions?" Well, that's an easy question to answer: They are way too big to fail but they must be recapitalized on the sly.

Figure 3 — The Magic Kingdom meets the oil price. World oil demand is about 2.5 million barrels per day lower now than it was in the 3rd quarter of 2007, but the price of oil is the same. OPEC cuts have boosted the price, but it was the dollar trade that got us where we are today. There seems to be some "resistance" in the $72-74 range as reality intrudes. I'll discuss the current oil price in some detail below.

Analyst Dave Rosenberg wants to know What Growth Is the S&P 500 Pricing In?

Based on past linkages between earnings trends and the pace of economic activity, believe it or not, the S&P 500 is now de facto discounting a 4¼% real GDP growth rate for the coming year. That is what we would call a V-shaped recovery. While it is possible, though in our opinion a low-odds event, it is doubtful that the economy is going to be better than that. So we have a market that is more than fully priced for a post-recession world — any further gains would suggest that we are moving further into the “greed” trade...

We realize that the market has to climb a wall of worry and that it will often price in a lot of bad news, but for the first time ever, it has rallied nearly 50% amidst a two-million job slide since March. That is either whistling past the graveyard or at the lows the market was indeed pricing in a full-fledged depression. Whatever the market was pricing in at the March lows was obviously a pretty bad outcome, but isn’t that what we saw in the end? To be sure, the government established a floor under the financials, but when you go back and think about the fresh lows posted in late 2002, it was about earnings and the economy, not about financials.

In the four months after the recent lows in March, employment plunged by two million, which is as much carnage as we saw in the entire 2001 recession — and we are talking about the entire cycle including the jobless recovery that spanned from March 2001 to June 2003! We will guarantee you one thing — it is doubtful that the two million folks who lost their jobs are going to be heading to the malls, dealerships or restaurants anytime soon. And while that is only a sliver of the 130 million U.S. workforce, change does occur at the margin.

Rosenberg understands that 4¼% annual real GDP growth will not happen anytime soon. As recently as 2002, when we were well into the Bubble Era, markets still moved on "earnings and the economy." That doesn't happen anymore, things are different in the Disney Era. I will quote again from the New York Times' Rise of the Super Rich Has Hit A Sobering Wall—

Without a financial bubble, there will simply be less money available for Wall Street to pay itself or for corporate chief executives to pay themselves. Some companies — like Goldman Sachs and JP Morgan Chase, which face less competition now and have been helped by the government’s attempts to prop up credit market — will still hand out enormous paychecks. Over all, though, there will be fewer such checks, analysts say. Roger Freeman, an analyst at Barclays Capital, said he thought that overall Wall Street compensation would, at most, increase moderately over the next couple of years.

[My note: See my article The New Gilded Age.]

The recent rise in the S&P 500 is the financial bubble that makes it possible for Wall Street to pay itself the princely fortunes they think they so richly deserve—this is the "greed" trade.

The rally in S&P 500 is as phony as a three dollar bill. It's hard to know exactly how, and by whom, the market has been manipulated. We have important hints, of course. Trading volumes have been dominated by financials (Figure 2), volumes are generally low, and most trading is done by machines (Figure 4).

Figure 4 — From the Wall Street Journal's Rivals Play Catch-Up As Goldman Thrives: "Goldman is known on Wall Street for its sophisticated computer-trading platform. It has become a dominant player in high-frequency trading, in which computers use complex formulas to conduct rapid-fire trades in markets around the world. In the week ending July 3, Goldman accounted for 24% of all program trading, or computer-generated trading, on the New York Stock Exchange, according to NYSE data, making it No. 1." I don't think any additional comment is required.

Turning to the oil markets, it can easily be demonstated that the price of crude moves with the S&P 500 (Bloomberg, August 14, 2009).

The Standard & Poor's Index added 0.7 percent to 1,012.73, while the Dow Jones Industrial Average increased 0.4 percent, to 9,398.19. The S&P 500 has a correlation of 0.8 with New York oil futures in the past year. A correlation of 1 means the two move in lockstep.

Bloomberg reported on such tandem moves back on June 29th. The already record-setting simple correlation has only gotten stronger since then.

The S&P 500 has added 37 percent from a 12-year low in March, increasing on 56 percent of the days during that span. The Reuters/Jefferies CRB Index of commodities has advanced 27 percent from its trough, rising 58 percent of the time.

The gains pushed correlations between the indexes to 0.74 this month, based on percentage changes over the past 60 days. That’s the highest in at least five decades, data compiled by Bloomberg show. A reading of 1 means two assets move in tandem, while zero means no relationship.

The correlation never rose above 0.66 before this month. 

Let's sum up what life looks like in Disneyland—

• The S&P 500 "rally" is phony.
• Oil moves with the S&P 500, so the oil price is phony too. (See my Mr. Market Gets It Wrong Again.)
• We no longer live in a society that bothers to pretend that things are on the up and up. The markets are manipulated in plain sight.

I don't think this is what Adam Smith had in mind when he wrote about the wondrous powers of the "invisible hand."

Janet Tavakoli, founder and president of Tavakoli Structured Finance, explains whey she has liquidated almost all her market positions—

I just went to (almost) 100% cash in my favorite hedge fund, my personal portfolio...

On Monday, Austin Goolsbee, one of President Obama’s economic advisors, told The Daily Show’s John Stewart that the large deficit is necessary, TARP backed us away from the brink of disaster, and the stimulus is working. If only words were magic. Many more banks are in trouble, a chunk of housing activity is due to foreclosures/short sales/resales (the $8,000 housing incentive often went for down payments from people who couldn’t scare up one of their own), credit card problems are on the rise, one-quarter to one-third of all mortgages in the U.S. are underwater, the mortgage “modification” program is a failure with only around 200,000 done so far—half of which are already failing (the same fraudsters who got us in this mess are modifying mortgages), 3,000,000 mortgages are in serious default (90 days or more past due), the unemployment picture is grim, the cash-for-clunkers fake auto stimulus is a non-green short-term artificial pump-up, profits seem due to inventory management and cost cutting rather than demand, and industrial production has plummeted (other than military production which is up). More TARP money will be needed for many smaller banks that are in trouble due to current and coming loan losses. The international picture is mixed, but I’ve even liquidated those positions.

As Ms. Tavakoli knows all so well, we are in a giant game of Survivor. You're on your own. If you're skillful & lucky, you might not get kicked off the island. The Revolution will not be televised. In fact, The Powers That Be have postponed The Revolution indefinitely. They hope you will enjoy watching re-runs of Friends or Seinfeld instead, assuming you still have a roof over your head and you can still pay your exorbitant cable TV bill.

Let's turn to the Baker Institute study to show how fluctuations in the value of the dollar drive market movements.

The Almighty Dollar

The next two graphs show how the markets have moved with the dollar in the 21st century.

Figure 5 — The chart is taken from U.S Dollar/S&P 500 Correlation (August 28, 2009). "A serious [inverse] correlation between the US$ and the US equity markets has developed over the last 9+ years. This correlation is strong and for policy makers in Washington, rather disturbing. The relationship is as follows: If the US$ loses value the equity markets have rallied and if the US$ strengthens equity markets have sold off."

Figure 6 — The graphic is from Medlock and Jaffe. "Analysis of the dollar-oil price data for 2001-2009 shows a dramatic change in price correlation from historical patterns. Figure 6 indicates the daily oil price and daily value of the dollar against the currencies of major U.S. trading partners. For the period January 2001 through August 2009 [in the bottom panel], these two measures are very highly correlated, exhibiting a simple correlation of -0.82 [inverse correlation]. However, for data from a prior period—January 1986 through December 2009 [top panel]—the correlation was -0.08, implying virtually no correlation during that period. The strong -0.82 measurement implies that oil prices and the value of the dollar tend to have a negative [inverse] correlation. In plainer terms, depreciation in the dollar will very likely coincide with a rise in the price of oil or vice versa."

Medlock and Jaffe are describing how the simple numéraire effect, in which the price of a commodity traded in dollars reflects changes in the dollar's value, has overwhelmed fundamental (supply & demand) conditions in the marketplace. This has happened because non-commercial traders who could care less about physical oil are the ones doing most of the trading. (Of course the technical picture is more  complicated than this, e.g. longs versus shorts, how futures prices push up spot prices, and so on.)

It just so happens—I am unhappy to report—that up until the recent Fall/Winter dollar bounce due to the view that Treasuries were a safe haven, the dollar had declined for 7 straight years. It appears now that dollar has now reverted to trend (i.e. it is declining again). Thus the price of oil has been rising since March at a time when the fundamentals are particularly weak (Figure 6).

I am not going to go through the Medlock and Jaffe paper in tedious detail. I just want to make the obvious points that need to be made, so read the original paper if you want to know more about how the Commodity Futures Modernization Act "effectively cleared the way for more lax regulation of new oil risk management products, including index funds and price swaps, setting the state for a rapid increase in financial players' participation in over-the-counter (OTC) markets."

The oil market has been financialized in the sense that it serves as a means for investors to hedge against a rising or (mostly) falling dollar. What can one say about this? I believe Judy Dugan, research director at Consumer Watchdog, put it best—

Using an essential commodity as [an investment tool] is crazy. If you want a double dip recession, let's just get $100 oil again."

Of course it's crazy. Investing in stocks to hedge against a deteriorating dollar is one thing, but jacking up the price of gasoline for everyone so a relatively few non-commercial players can cover their ass is quite another. Welcome to Disneyland.

Let be clear about what I am not saying. I am not saying that—

• All the price rise during 2003-2008 was due to dollar hedging, not the collision between a demand shock and a supply ceiling (peak oil). I covered this material in my article It's Not Black Or White. Medlock and Jaffe say "analysis must also take into account that the physical crude oil market had to be tight in order for speculative activity to be able to exert such extensive upward pressure on price. Thus a more complete discussion of the physical characteristics of the market and its interactions with speculative trader behavior is needed for a more conclusive analysis." This is not quite right because speculative activity is indeed exerting upward pressure on the oil price in the absence of a tight market.

The rumor on the street is that the CFTC is going to impose position limits on non-commercial oil traders. (This linked document is really worth reading if you care about these issues.) In the absence of new regulation of the oil market, and if no bona fide attempt is made by the Central Bank and the Federal Government to defend the dollar in future years, then the oil price, however high the fundamentals might drive it, will be higher still because of dollar hedging on the NYMEX.

So the future of the oil price becomes, to some extent, the future of the dollar, to which I now briefly turn.

The Future of the Dollar

A lot of ink has been spilt arguing about the future of the dollar. I am not going to add much fuel to that raging fire. Suffice it to say that—

1. No serious attempt has been made to defend the dollar as far I can see.
2. The official projected Federal deficit has now been raised to $9,000,000,000,000.
3. The United States was already the biggest debtor nation in the history of the world and now we have lots more debt to look forward to.
4. The Federal Reserve is printing lots of money to implement the financial system bail-out. They say they have an exit strategy. We'll see.

Medlock and Jaffe add another important factor to the discussion. The large trade imbalance contributed to the dollar's precipitous decline since 2000.

Figure 7 — The U.S. trade balance from Calculated Risk. Medlock and Jaffe say: "The high oil price contributed to a weakening of the dollar through mounting trade deficits and U.S. debt. In 2007 and 2008, dramatically rising oil prices fed the U.S. trade deficit leading to increased U.S. indebtedness. This, in turn, contributed to an even weaker dollar, which further drove oil prices higher in a self-perpetuating pattern. Oil-linked index funds became an asset class for investors wanting to escape the falling dollar and weakening stock market, adding to the speculative fervor in oil." Theoretically, a declining dollar boosts exports and inhibits imports. The graph shows that the balance of trade has narrowed considerably since the economic crisis began. However, imports and exports are both down considerable.

Medlock and Jaffe are describing a dollar/oil death spiral, a positive feedback loop in which the declining dollar raises oil prices, which further deflates the dollar through the trade imbalance, which raises oil prices, and so forth.

I am not a seer of the stature of Nouriel Roubini. So let's have him gaze into his crystal ball to discern how the dollar might fare in coming years. 

There are also now two reasons why there is a rising risk of a double-dip W-shaped recession. For a start, there are risks associated with exit strategies from the massive monetary and fiscal easing: policymakers are damned if they do and damned if they don’t. If they take large fiscal deficits seriously and raise taxes, cut spending and mop up excess liquidity soon, they would undermine recovery and tip the economy back into stag-deflation [recession and deflation].

But if they maintain large budget deficits, bond market vigilantes will punish policymakers. Then, inflationary expectations will increase, long-term government bond yields would rise and borrowing rates will go up sharply, leading to stagflation [recession and inflation].

Another reason to fear a double-dip recession is that oil, energy and food prices are now rising faster than economic fundamentals warrant, and could be driven higher by excessive liquidity chasing assets and by speculative demand. Last year, oil at $145 a barrel was a tipping point for the global economy, as it created negative terms of trade and a disposable income shock for oil importing economies. The global economy could not withstand another contractionary shock if similar speculation drives oil rapidly towards $100 a barrel.

Roubini thinks there are two possible outcomes: recession plus deflation, in which the purchasing power of the dollar will go up here at home, or recession plus inflation, in which the purchasing power of the dollar will go down. It is impossible to understand—at least, for me it is—how either scenario will affect the overall value of the dollar on international markets (the exchange rate) and thus the price of oil. There are too many variables to consider.

Almost anything is possible in Disneyland, and most of it is not good.

Contact the author at dave.aspo@gmail.com