Posts tagged ‘Adam Smith’

Supply & Demand: The Key to Oil, Stocks, and Pork Bellies

Chart - Money

Commodity prices, including oil, are “crashing” according to the pundits and fears are building that this is a precursor to another stock market collapse. Are we on an irreversible path of repeating the bloodbath carnage of the 2008-2009 Great Recession?

Fortunately for investors, markets move in cycles and the fundamental laws of supply and demand hold true in both bull and bear markets, across all financial markets. Whether we are talking about stocks, bonds, copper, gold, currencies, or pork bellies, markets persistently move like a pendulum through periods of excess supply and demand. In other words, weakness in prices create stronger demand and less supply, whereas strength in prices creates weakening demand and more supply.

Since energy makes the world go round and the vast majority of drivers are accustomed to filling up their gas tanks, the average consumer is familiar with recent negative price developments in the crude oil markets. Eighteenth-century economist Adam Smith would be proud that the laws of supply and demand have help up just as well today as they did when he wrote Wealth of Nations in 1776.

It is true that overall stagnation in global economic demand in recent years, along with the strengthening of the U.S. dollar (because of better relative growth), has contributed to downward trending oil prices. It is also true that supply factors, such as Saudi Arabia’s insistence to maintain production and the boom in U.S. oil production due to new fracking technologies (see chart below), have arguably had a larger negative impact on the more than -50% deterioration in oil prices. Fears of additional Iranian oil supply hitting the global oil markets as a result of the Iranian nuclear deal have also added to the downward pressure on prices.

Source: Scott Grannis – Calafia Beach Pundit.

Source: Scott Grannis

What is bad for oil prices and the oil producers is good news for the rest of the economy. Transportation is the lubricant of the global economy, and therefore lower oil prices will act as a stimulant for large swaths of the global marketplace. Here in the U.S., consumer savings from lower energy prices have largely been used to pay down debt (deleverage), but eventually, the longer oil prices remain depressed, incremental savings should filter into our economy through increased consumer spending.

But prices are likely not going to stay low forever because producers are responding drastically to the price declines. All one needs to do is look at the radical falloff in the oil producer rig count (see chart below). As you can see, the rig count has fallen by more than -50% within a six month period, meaning at some point, the decline in global production will eventually provide a floor to prices and ultimately provide a tailwind.

Source: Scott Grannis – Calafia Beach Pundit

Source: Scott Grannis

If we broaden our perspective beyond just oil, and look at the broader commodity complex, we can see that the recent decline in commodity prices has been painful, but nowhere near the Armageddon scenario experienced during 2008-2009 (see chart below – gray areas = recessions).

Source: Scott Grannis – Calafia Beach Pundit

Source: Scott Grannis

Although this conversation has focused on commodities, the same supply-demand principles apply to the stock market as well. Stock market prices as measured by the S&P 500 index have remained near record levels, but as I have written in the past, the records cannot be attributed to the lackluster demand from retail investors (see ICI fund flow data).

Although U.S. stock fundamentals remain relatively strong (e.g., earnings, interest rates, valuations, psychology), much of the strength can be explained by the constrained supply of stocks. How has stock supply been constrained? Some key factors include the trillions in dollars of supply soaked up by record M&A activity (mergers and acquisition) and share buybacks.

In addition to the declining stock supply from M&A and share buybacks, there has been limited supply of new IPO issues (initial public offerings) coming to market, as evidenced by the declines in IPO dollar and unit volumes in the first half of 2015, as compared to last year. More specifically, first half IPO dollar volmes were down -41% to $19.2 billion and the number of 2015 IPOs has declined -27% to 116 from 160 for the same time period.

Price cycles vary dramatically in price and duration across all financial markets, including stocks, bonds, oil, interest rates, currencies, gold, and pork bellies, among others. Not even the smartest individual or most powerful computer on the planet can consistently time the short-term shifts in financial markets, but using the powerful economic laws of supply and demand can help you profitably make adjustments to your investment portfolio(s).

Investment Questions Border

See Also – The Lesson of a Lifetime (Investing Caffeine)

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing, SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

July 25, 2015 at 4:31 pm Leave a comment

Productivity & Trade: Pins, Cars, Coconuts & Chips

The concepts of productivity and free trade go all the way back to Adam Smith, widely considered the “father of economics,” who wrote the original capitalism Bible called the Wealth of Nations. Many of the same principles discussed in Smith’s historic book are just as applicable today as they were in 1776 when it was first published.

Economics at its core is the thirst for efficiency and productivity for the sake of profits. Ultimately, for the countries that successfully practice these principles, a higher standard of living can be achieved for its population. For the U.S. to thrive in the 21st century like we did in the 20th century, we need to embrace productive technology and efficiently integrate proven complex systems. To illustrate the benefits of productivity in a factory setting, Smith wrote about the division of labor in a pin factory. Murray N. Rothbard, an economic historian, and political philosopher summed up the takeaways here:

“A small pin-factory where ten workers, each specializing in a different aspect of the work [18 steps], could produce over 48,000 pins a day, whereas if each of these ten had made the entire pin on his own, they might not have made even one pin a day, and certainly not more than 20.”

 

Dividing up the 18 pin making steps (i.e., pull wire, cut wire, straighten wire, put on head, paint, etc.) lead to massive productivity improvements.

Another economic genius that changed the world we live in is the father of mass production…Henry Ford. He revolutionized the car industry by starting the Ford Motor Company in 1903 with $100,000 in capital and 12 shareholders. By the beginning of 1904, Ford Motors had sold about 600 cars and by 1924 Ford reached a peak production of more than 2,000,000 cars, trucks, and tractors per year. Although, Ford had a dominant market share here in the U.S., the innovative technology and manufacturing processes allowed him to profit even more by exporting cars internationally. This transformation of the automobile industry allowed Ford to hire thousands of workers with handsome wages and spread 15 million of his cars around the globe from 1908 to 1927.

Comparative Advantage: Lessons from Smith & Ford

Foreign trade has continually been a hot button issue – especially during periods of softer global economic activity. Here is what Adam Smith had to add on the subject:

“If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage.”

Smith believed that parties with an “absolute advantage” in manufacturing would benefit by trading with other partners. Today, it’s fairly clear the U.S. has an absolute advantage in creating biotech drugs, Hollywood movies, and internet technologies (i.e., Google), however in other industries, such as industrial manufacturing, the U.S. has lost its dominant position.

David Ricardo, an English economist who authored the famous work On the Principles of Political Economy and Taxation, is attributed with extending Smith’s “absolute advantage” concept one step further by introducing the idea of “comparative advantage.”

Producing Coconuts and Computer Chips

Let’s explore the comparative advantage concept some more by investigating coconuts and computer chips. As we hemorrhage jobs to other countries that can accomplish work more cheaply and efficiently, increasingly discussions shift to a more protectionist stance with dreams of higher import tariffs. Is this a healthy approach? Consider a two nation island able to produce only two goods (coconuts and computer “chips”), with the U.S. on one half of the island, and the Rest of the World (R.O.W.) on the other half.  

Next, let’s assume the following production profile: The R.O.W. can choose to produce 10 coconuts or 10 chips AND the U.S. can produce 4 coconuts or 8 chips.

 

Scenario #1 (No Trade): If we assume both the R.O.W. and the U.S. each spend half their time producing coconuts and chips, then the R.O.W.’s production will create 5 coconuts/5 chips and the U.S. 2 coconuts/4 chips for a combined total of 7 coconuts and 9 chips (16 overall units).

If we were to contemplate the ability of trade between R.O.W. and the U.S., coupled with the concept of comparative advantage, we may see overall productivity of the nation island improve. Despite the R.O.W. having an “absolute advantage” over the U.S. in producing both coconuts (10 vs. 4) and chips (10 vs. 8), the next example demonstrates trade is indeed beneficial.

Scenario #2 (With Trade): If R.O.W. uses its comparative advantage (“more better”) to produce 10 coconuts and the U.S. uses its comparative advantage (“less worse”) to produce 8 chips for a combined total of 10 coconuts and 8 chips (18 overall units). Relative to Scenario #1, this example produces 12.5% more units (18 vs. 16) and with the ability of trade, the U.S. and R.O.W. should be able to optimize the 18 units to meet their individual country preferences.

If we can successfully escape from the island and paddle back to modern times, we can better understand the challenges we face as a country in the current flat global world we live in. Our lack of investment into education, innovation, and next generation infrastructure is making us less competitive in legacy rustbelt industries, such as in automobiles and general manufacturing. If the goal is to maximize productivity, efficiency, and our country’s standard of living, then it makes sense to select trade scenario #2 (even if it means producing zero coconuts and lots of computer chips). The coconut lobby may not be happy under this scenario, but more jobs will be created from higher output and trade while our citizens continue on a path to a higher standard of living.

The free trade strategy will only work if we can motivate, train, and educate enough people into higher paying jobs that produce higher value added products and services (e.g., computer chips and computer consulting). There is a woeful shortage of engineers and scientists in our country, and if we want to compete successfully in the modern world against the billions of people scratching and clawing for our standard of living, then we need to openly accept the productivity and trade principles taught to us by the Adam Smiths and Henry Fords of the world. Otherwise, be prepared to live on a remote, isolated island with a steady diet of coconuts for breakfast, lunch, and dinner.

Read Full NetMBA Article on “Comparative Advantage”

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper.  

www.Sidoxia.com 

*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and GOOG, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

August 24, 2010 at 11:17 pm Leave a comment

Jumping on the Globalization Train

What happens when you mix a group of Saudi Arabians, Germans, Chinese, French, and South Koreans with billions of dollars? This is not the lead-in question to a politically incorrect joke, but rather a teaser related to a multi-billion infrastructure project currently under a bidding process in Saudi Arabia.

The proposed $7 billion, 450 kilometer high speed Saudi Arabian railway connecting Islam’s two holiest cities (Mecca and Medina) is expected to ease congestion of the 2.5 million Muslims making the annual journey to Mecca as part of the Hajj pilgrimage.

Amidst the fallout from the recent global financial crisis, the benefits of capitalism, globalization, and free trade have come under attack. There obviously were some horrible decisions made and the collapse of financial institutions around the world underscored the necessity to shore up our regulatory system. Nonetheless, this microcosm of a project is proof positive that globalization is alive and well (see also Friedman Flat World article). How else can you explain China Railway Construction Corp./Beijing Railway Administration (China), Siemens (Germany), Hyundai/Samsung (South Korea), Alstom  (France), and Saudi Binladin Group (Saudi Arabia) coming together on a multi-billion project bidding process?

Oil Rich Countries Think Strategically

Saudi Arabia is not the only oil-rich country that has used the dramatic increase in oil revenues to fund investments in the future. Beyond Saudi Arabia, other oil rich areas like Qatar, Russia, and the UAE (United Arab Emirates) federation are examples of regions wanting to join the 21st Century global party rather than sitting around idly. The billions of black gold being pumped from the oil reservoirs is getting poured into infrastructure, such as technology, roads, bridges, hospitals, and yes…railways. These countries realize the importance of diversifying their economies away from the dependence on any one sector. Leadership from these regions understand the damaging economic impact of boom-bust energy price cycles, therefore they are doing their best by diversifying into other economic areas – including infrastructure. How serious is Saudi Arabia when it comes to investments? Well, the United States stimulus program was a drop in the bucket (single digit percentage of GDP) relative to Saudi Arabia,  which according to BusinessWeek had the largest stimulus package among the Group of 20 (69% of GDP).

The Case for Free Trade

As protectionists and trade union organizers scratch and scream in response to expansion of globalization, competing countries around the world have their economic foot on the pedal when it comes to extending trade borders.

Tariffs, quotas and various other taxes only serve to drag down the competitiveness of our country’s most treasured industries.

These economic trade concepts are not new. Adam Smith, considered by some as the “father of economics” wrote about the “invisible hand” in his famous book Wealth of Nations (1776) and economist David Ricardo explained “comparative advantage” in his book On the Principles of Political Economy and Taxation (1817). Without getting into the nitty-gritty, suffice it to say the advantages to free trade have been well documented over the centuries.

As the standards of living climbs for hundreds of millions of people in developing countries, these populations are becoming fertile ground for the sale of U.S. technology, pharmaceuticals, appliances, automobiles, and other goods and services.

Rather than pouring sand into the gears of innovation, incentives need to be established to motivate product excellence. Otherwise, capital  and jobs will migrate to other countries. Intel CEO (INTC) Paul Otellini, who was recently quoted in a New York Times article, is urging Congress to improve business, tax, and education incentives. Thanks to  China’s tax policy and availability of a skilled labor pool, Intel is able to save $1 billion on  a $4.5 billion plant being constructed this year – not exactly chump change.

Certainly, rules need to be created that promote fairness and credible enforcement of penalties, otherwise the benefits of trade become diluted.

Overall, the recent financial crisis caused economists, politicians, and various pundits to question the validity and benefits of capitalism, globalization, and free trade. In the vast spanning web of global commerce, the recent high speed Saudi railway may only represent a very tiny thread in the whole world’s infrastructure spend. Nonetheless, this multi-billion project integrating international heavyweights from all over world proves that despite the shortcomings of globalization, capitalism, and free trade, the benefits remain substantial and there is still time to jump back on the train.

Read The Financial Times article on the Saudi Arabia railway project.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing had no direct positions in Intel (INTC), China Railway Construction Corp., Beijing Railway Administration, Siemens, Hyundai/Samsung, Alstom, and Saudi Binladin Group or any security mentioned in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

March 22, 2010 at 12:32 am 1 comment


Receive Investing Caffeine blog posts by email.

Join 1,806 other followers

Meet Wade Slome, CFA, CFP®

More on Sidoxia Services

Recognition

Top Financial Advisor Blogs And Bloggers – Rankings From Nerd’s Eye View | Kitces.com

Wade on Twitter…

Share this blog

Bookmark and Share

Subscribe to Blog RSS

Monthly Archives