Relevant and even prescient commentary on news, politics and the economy.


Oil prices are collapsing as West Texas intermediate is now trading at just over $11/bbl

Oil prices move to the point where the marginal supply is profitable or unprofitable. In today’s world the marginal oil supply is US fracked oil. But the economics of fracked oil differs from traditional oil in that the current cost of production is very high as compared to most traditional sources where current costs are relative insignificant and the bulk of the cost is sunk or fixed costs.  Even if the prices make production unprofitable, it still minimizes losses to continue producing as long as you are covering your variable costs. That use to describe most US oil production.  But now the variable cost of fracked oil is very high and the oil companies will not continue to drill fracked oil at these low prices.

It appears that Russia and Saudi Arabia are acting together to drive the price of oil below the level where fracked oil would be profitable.  Historically, low oil prices were very much a favorable development for the US economy.  But that is no longer true and at current prices the US will suffer deep drops in oil production and a major widening of the US trade deficit.

It is going to be interesting to see how Trump reacts to two of his best buddies severely harming the US oil business and economy.

S&P 500 PE

As of the market close on 11 March 2020 the S&P 500 PE had fallen to 18.2. This makes the market cheap in my valuation model as it has fallen below my fair value band.

Moreover, with interest rates still falling to new record lows the fair value band is also rising.  In the chart the fair value band is based on February data while the last PE observation is based on the 11 March 2020 close. But with yields approaching the zero lower band it becomes questionable whether or not even lower rates can generate a significant rebound in the market PE and the market.  On the other hand the PE has room to move significantly higher just by rebounding to the top, or above, the existing  fair value band.

On Wall Street the consensus still is forecasting a significant rebound in 2020 earnings.  But if the Coronavirus  does have a significant economic impact, 2020 earnings are more likely to fall rather than rise.  That appears to be what this market correction is starting to discount even though company managements are not yet revising their guidance.  Consequently, bottoms up analysts are also probably still too optimistic.  With the market now cheap, it has room for falling earnings to drive the PE on trailing earnings back up to within or above the fair value band.  Thus, we could see the market having a very muted reaction to further easing by the Fed but rebound nicely when company managements and analysts cut their 2020 earnings estimates.

Personal report from Italy

My brother lives in Lucca, Italy ( near Florence) and sent the following report.

We’re not quite at the “Bring Our Your Dead” stage. Schools & museums are closed, flights are being canceled, but all in all life in Lucca is quiet & normal.  Many shops are closed for their usual breaks this time of year. There are virtually no tourists, but this is the slow season. Nancy just spent the weekend in Florence and found it to be delightfully empty.
Tuscany is not in the area where travel is being restricted—as yet. Bars and restaurants are open for the most part, but are told to keep one meter of space between customers.
The authorities are being quite active to do what they can. One reason that Italy has reported so many cases is they they have tested so many more people than the US, for example.
To add to the chaotic nature of all this, today there were riots in 27 prisons throughout Italy after the bosses cut off family visits


The Stock Market in Presidential Terms

Before the recent swoon stock market market performance under Trump had been quite favorable. The market gain since his inauguration (100) had been (144) similar to those under Clinton (141) and Obama (150). At this point Ike actually had the best return ( 170) but Ike and Truman are not included  in the chart because it is too cluttered already.

After the recent market drop he is now more or less in the middle of the pact for recent presidents  — even with JFK-LBJ and behind most democrats and ahead of most republicans.

But if he wants a strong market-economy going into the election it is easy to see why he strongly favors the 50 basis point cut by the Fed. The market doesn’t seem quite sure what to make of the Fed’s actions, first rallying strongly and then turning negative.  It still does not have a handle om what economic impact to expect from the coronavirus. Maybe the Fed fears a bigger impact than markets were already discounting. Or, maybe the Fed is just taking out insurance in the face of extreme uncertainty.

Long Bond Yields vs The Long Wave

Different  bloggers  have been posting their favorite charts of 2019 this January.  So I decided to post my favorite chart of the past 20, or more, “years of the long bond yield versus the long run trend.”  Bond yields are now below their long run trend and may be at or near a secular bottom.  Of course no one rings a bell at the turning point so we probably will only identify the bottom long  after it actually occurs.


In October the real trade deficit fell to $79,133 (million 2012 $) from the third quarter average of $84,713 (million 2012 $), a 6.6% improvement. This implies that the fourth quarter is starting with trade making a significant large boost to fourth quarter real GDP growth. Remember, the trade balance is the difference between two very large numbers so a small change in either exports or imports can generate a large change in the balance.  The year over year percent change in exports is down -0.6% and imports have fallen -4.1%.  But since the December, 2018 peak, the real trade balance has contracted -13.2%.

When you look at the details of US real trade, the changes in trade stem largely from oil and consumer goods. Other trade categories,  like food, industrial materials, capital goods  are each showing relatively small changes that are largely offsetting each other. For the most part both imports and exports of other goods have been stagnant for the past year.  The drop in auto and consumer goods imports reflects several points.

The new world of the US being an open economy after the leap  .  .  .


Chairman Paul Volcker Died at age 92

I first met Volcker when I was a junior international economist in Washington in the late 1960s. He was the Treasury Under Secretary for International Economics. I was going to a luncheon at the National Press Club for the Indian Finance Minister.  As I got on the elevator, Paul Volcker and John Kenneth Galbraith — among other things he was the US Ambassador to India under Kennedy –followed me on.   I am 6’2″ — or at least I was back then — but they were both well over 6’6″.  I honestly believe that was the only time in my life that I was the shortest economist in the room.

This was back when they had the annual International Monetary Fund( IMF) meeting in Nairobi, Kenya.  The standing joke was that they had the meeting in Nairobi so everyone could compare Volcker to an actual giraffe.





With the presidential election still a year away, Wall Street is starting its normal analysis that if a democrat is elected it will cause a devastating stock market crash.  One would think that after all these years of such claims being proven dead wrong that the street would finally give up on it. In the post WWII era from Truman to Obama it is 70 years and each party has had bad candidates in office for half that time.  Truman was only President for seven years and five months so the Democrats only had 35.4 years in office while the Republicans had 36 years in office.  Over these years the average annual S&P 500 gains was 15.9% for Democrats and 6.6% for Republicans. If you look at the actual returns, you would think if anything; Wall Street analyst would be warning about the dangers of a Republican President for the stock market.

Because the chart is already so cluttered I left Truman and Ike off.  But it seem so obvious that the record shows that it is Republican Presidents that investors should fear.  Just to clearly show that stock market gains have been more that double under Democrats versus Republicans I’ve also presented the data in a table.





Despite all the recent stock market volatility the actual S&P 500 PE on trailing operating earnings is almost exactly where my model says it should be.

The biggest problem is that the market PE  is about 19 and bond yields are under 2%.  The quick and dirty rule of thumb is that a 100 basis point change in yields should generate a 100 basis point change in the S&P 500 PE.    With bond yields already under 2% the upside potential for the market PE is under 200 basis points — driving the PE to the upper limit of the fair value band.

Consequently, further market increases are almost completely dependent on earnings growth. But currently, unit labor cost are rising faster than prices as measured by the non-farm business deflator and world economic growth remains very weak.  While this spread is a powerful determinate of earnings growth you have to be careful with it as the most recent observations are subject to significant revisions.

Given these conditions the stock market downside risks clearly looks larger than the upside potential.


Economic and Market Risk

The use of drones against Saudi Arabian oil facilities changes the economic-market risk significantly.

Until now the oil producers have done an excellent job of preventing terrorist attacks from disrupting oil supplies. But the use of drones significantly changes the risk of future oil disruptions.   How do we prevent future drone attacks on the choke points in the oil supply line?

I, for one, am surprised that the stock market reaction has been so muted.

Am I wrong in believing that the game has changed?