A Dash of Insight: Weighing the Week Ahead: Energy Price Hikes

Great stories sell newspapers -- and blog posts.

The rise in energy prices qualifies on several levels.

It is a part of everyday life and easy to understand.
The politics are easily (over?) simplified. Everyone gets to have an opinion about Middle Eastern countries they probably don't like and also could not find on a map. You can also speculate about the likely impact of additional drilling rights. You are invited to use alliterative slogans. What fun!
There is uncertainty, and that means fear. Fear sells.

The challenge for the investor is to sort through the popular stories and reach some objective conclusions about the energy issue. I will offer a few suggestions, but let us first do our regular review of last week's data.

Background on "Weighing the Week Ahead"

There are many good services that do a complete list of every event for the upcoming week, so that is not my mission. Instead, I try to single out what will be most important in the coming week. If I am correct, my theme for the week is what we will be watching on TV and reading in the mainstream media. It is a focus on what I think is important for my trading and client portfolios.

In most of my articles I build a careful case for each point. My purpose here is different. This weekly piece emphasizes my opinions about what is really important and how to put the news in context. I have had great success with my approach, but some will disagree. That is what makes a market!

Last Week's Data

The economic news was very good last week. The continuing threat from energy prices still seems a major market threat.

The Good

Most major economic indicators remain in positive territory. There is growing recognition that the economic rally now has a self-sustaining character.

Economic growth is still improving. The ECRI Weekly Leading Index moved slightly lower. The growth index reached another fresh peak, 6.4%, the highest since May, 2010. This is a signal of solid growth for as far ahead as they are willing to forecast.
Risk as measured by the St. Louis Fed Stress Index, remains very low. This measure tracks a lot of market data in the eighteen inputs. It is not a poll, nor opinions, nor a collection of anecdotes. We should all pay attention to some real data. The value moved to +.032, slightly lower than the -.019 from last week. For more interpretation, the St. Louis Fed published a short paper with a very nice chart that helps to interpret this index. The chart does not reflect the recent continued decline in stress, but it identifies the dates for important recent events. The paper also has a longer version of the chart, illustrating past stress periods. I am not going to run the chart each week, but I strongly recommend that readers look at the paper. In the 2008 decline there was plenty of warning from this index -- no sign right now. The report cites data as of 2/25, reported on 3/3. I would expect the index to move a little higher next week.
Employment showed solid growth. The employment situation report matched rising expectations, and was certainly better than I thought we would see. The pace of job growth is now enough to decrease unemployment, although we still need a much better pace of growth. The only negative was flat hours worked and hourly wage.
Initial Jobless Claims continue to improve, below 400K again and the lowest 4-week moving average since 2008. This strength was not part of the payroll employment reporting period, so it suggests continuing improvement next month.
Shutdown Averted. As I predicted last week, the Washington leadership reached a compromise to avoid a government shutdown. This would have been very bad for the economy as well as for vital services. While the measure is temporary, I continue to forecast that a shutdown is extremely unlikely.
Small Business Hiring Plans are improving. This indicator has been slow to come around. As Calculated Risk notes, "Baby steps in the right direction."

All signs of progress in a modest growth environment.

The Bad

The bad news was about uncertainty in the Middle East, energy prices, and the market reaction.

Gas prices posted the second largest two-week increase in history, thirty-three cents per gallon.
Middle East tension increased in Libya, and fear of contagion is mounting. There are reports that Iran is behind uprisings in various oil-producing states. So far, the situation in Saudi Arabia seems stable.

The Energy Consequences

Last week I wrote that markets hate uncertainty -- the basis for the spike in energy prices. It is difficult to see how this uncertainty could be resolved in short order.

For the worst case our go-to source is David Rosenberg. Calling the increase in prices a "game changer" Rosenberg notes that there have only been five such cases in 70 years (some of us would turn the page right there) and that four of these instances led to a recession. He goes on to explain why this indicator does not bat 1000. Check out the full story and chart at The Big Picture.

For a more quantitative approach, we look to James Hamilton. He analyzes the auto sales data, noting the reduced role of large vehicles in the fleet. His conclusion is that the oil price increases, while still a negative, would have a lesser effect. "I conclude that the recent oil price run-up can't cause the same dollar reduction in GDP today that we watched occur in 2008." Check out the full article for the comprehensive analysis you would expect from Prof. Hamilton and some helpful charts.

Most of the mainstream pundits believe that current energy prices are manageable, but there is risk. There is speculation in oil at $200/barrel. A change in the Saudi government is the big wild card.

The Obama Administration, via new Chief of Staff Bill Daley, floated a trial balloon on Meet the Press. Daley suggested that they might tap the Strategic Petroleum Reserve if necessary to control energy prices. The market did not give much initial credence to this idea, mostly because traders questioned the imminent necessity.

This shows two things:

The limit to market fear. There is also not much contango in the foward curve.
The willingness of the Administration to act if the time is right. It is something to keep in mind.

Our Own Forecast

We base our "official" weekly posture on ratings from our TCA-ETF "Felix" model. After a mostly bullish posture for several months, Felix has turned more cautious. Several weeks ago we said it was a close call, and switched to neutral. Four weeks ago it was still close, but we shifted back to bullish in the weekly Ticker Sense Blogger Sentiment Poll, now recorded on Thursday after the market close. We remained bullish this week. Here is what we see:

79% of our 56 ETF's have a positive rating, down from 86% last week.
45% of our 56 sectors are in our "penalty box," exactly the same as last week. This is still an indication of significant short-term risk.
Our universe has a median strength of +14, down from +20 last week.

The overall picture remains slightly bullish. We are fully invested in trading accounts since there are several strong sectors, but we are watching the indicators quite carefully. This has been a very close call for several weeks.

[For more on the penalty box see this article. For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly email list. You can also write personally to me with questions or comments, and I'll do my best to answer.]

The Week Ahead

There are a number of minor reports this week, but here is what I will be watching.

Energy prices! Like everyone else.
Initial jobless claims. Let us see if the trend continues.
The JOLTS report. The BLS reports about job turnover. The understanding of this report is pretty low and it does not move markets. That spells opportunity for those in the know I plan a closer look at JOLTS and job creation.
College basketball -- especially the Big Ten tourney and the resurgent young Wolverines. This is the month when TV's on trading floors switch from (the muted) CNBC feed.

Investment Implications

The reaction of investors for the last two weeks was been interesting. Many were willing to sell at the first sign of trouble--in this case rising energy prices. For many, this was the start of the long-awaited correction. Many are opining that the Fed will be forced to change policy.

Here is a useful investment suggestion. Do you think the Fed is important for the economy and the market? If your answer is "yes" then you should be interested in what the Fed policy is going to be -- not what someone thinks it should be.

The Fed has been quite transparent. Chairman Bernanke is watching M2 and so should you.

Comments

scm - I agree that the auto impact could be worse and that we should watch carefully.

James Hamilton did the best work on this a few years ago, and I plan to keep that in mind.

Perhaps we do not yet need to bet. There are a lot of economic factors and we will see signs of trouble. You do not need to speculate about problems any more than about improvements.

Thanks for highlighting a key point, which we should all watch.

Jeff

Posted by: oldprof | March 09, 2011 at 10:38 PM

Dr. Jeff, we've done a little work on autos as well, and aren't entirely as sanguine. It appears we're still in an auto restocking deficit; we're scrapping more than we're buying (so sales remain below replacement rates), and the average age of cars on the road is at an all-time high (10.3 years). No doubt, some of that is related to better quality, and possibly changing lifestyles. Still, I think it's also a measure of consumer stress. While many other indicators across the economy are flashing a little better, car sales remain depressed. Why?

A car purchase remains a really big financial decision for the average household. If we're talking new, we're talking about $33k, with the banks requiring about $7k down. The rest gets financed. (I'm referring to the latest consumer credit data release from the Fed.)

Now, what we don't know is how consumer purchasing patterns may change with $4 gas. We'll know soon enough, because it's coming.

I think high gas has a chilling effect -- fewer consumers are willing to lay out the risk of a big-ticket purchase. New car sales slow, fewer miles are driven, which includes fewer trips to the mall, and fewer discretionary purchases. Everyone watches and waits. The consumer economy slows.

Time will tell. Place your bets and take your chances.

Posted by: scm0330 | March 09, 2011 at 07:17 PM