Posts tagged ‘supply and demand’

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

Supply & Demand: The Lesson of a Lifetime

Solutions

Between all the sporting events, road trips, and parties, I had a difficult time balancing my academic responsibilities just like any other college student. Nonetheless, after a few jobs and a few decades post my graduation, it is refreshing to see my economics college degree was able to teach me one valuable lesson…”supply & demand” actually works.

Emotions and animal spirits can separate fact from fiction in the short-run, but over the long-run, the economic forces of “supply & demand” will ultimately determine the direction of asset prices. If you can think of any bubble market, ranging from tulips and tech stocks (see Bubbles and Naps) to commodities and houses, sooner or later new supply will enter the market, and/or some other factor, which will prick the demand side of the bubble equation.

The same economic rules apply to currencies. Gut-based, day-traders may be skeptical, but economics’ longest enduring axiom shined last week when we saw the Swiss franc spike +20% against the euro in a single day. On the heels of a weakening euro currency and heightened demand for the franc, the Swiss National Bank (SNB) decided to remove its artificial peg to the euro. Effectively, the SNB has been selling francs and buying $490 billion in reserves (the majority of which is in euros and U.S. dollars). As a result, exports of Swiss army knives, watches, and industrial equipment will be more expensive now, which could potentially crimp demand for the country’s goods and services. The SNB, however, could no longer afford to buy euros and dollars to artificially depress the franc. Swiss bankers were very worried about the possible amplified costs of a currency war in the face of this week’s expected European Central Bank (ECB) announcements on quantitative easing (QE) monetary stimulus, so they decided to allow the franc to free-float versus global currencies.

Another asset class heavily impacted by volatile supply-demand dynamics has been the oil market. Weaker demand from Europe/Russia combined with the higher supply from U.S. shale has created a recipe for a crude price collapse (> -50% declines over the last year). Thus far, OPEC (Organization of Petroleum Exporting Countries) has remained committed to maintaining its supply/production levels.

Interest Rates and Supply-Demand

Not every asset price is affected by direct supply-demand factors. Take for example the stock market. I have been writing and commentating about the fascinating persistence and accelerated decline in global interest rates recently (see Why 0% Rates?). Near-0% rates are important because interest rates are just another name for the “cost of money” (or “opportunity cost of money”). When the Prime Rate was 20% in the early 1980s, the cost of money was high and a 16% CD at the bank looked pretty attractive relative to rolling the dice on volatile/risky stocks. Any economics, finance, or accounting student knows through their studies of the “time value of money” that interest rates have a tight inverse correlation to asset values (i.e., lower interest rates = higher asset values, and vice versa).

More practically speaking, we see stock prices supported by the lower borrowing costs tied to low interest rates. Just look at the $500,000,000,000+ conducted in share buybacks over the past 12 months (chart below). Economics works quite effectively when you can borrow at 3% and then purchase your own stock yielding 6% (the inverse percentage of the current 16x P/E ratio). What makes this mathematical equation even more accretive for corporate CFOs is the 6% rate earned today should double to 12% in 10 years, if a company resembles an average S&P 500 company. In other words, S&P 500 earnings have historically grown at a 7% annual clip, therefore the 6% earnings yield should double to 12% in about a decade, based on current prices. This basic arbitrage strategy is a no-brainer for corporate execs because it provides instantaneous EPS (earnings per share) growth with minimal risk, given the current bullet proof status of many blue-chip company balance sheets.

Source: Financial Times

Source: Financial Times

I have provided a few basic examples of how straightforward supply-demand dynamics can be used to analyze market relationships and trends. Although supply-demand analysis is a great rudimentary framework at looking at markets and various asset classes, unanticipated exogenous factors such regulation, terrorism, politics, weather, and a whole host of other influences can throw a wrench into your valuation conclusions. Until rates normalize, the near-0% interest rates we are experiencing now will continue to be a significant tailwind for stock prices. As interest rates have been declining for the last three and a half decades, it appears I still have time before I will need to apply the other important concept I learned in college…mean reversion.

Investment Questions Border

 

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own a range of positions, including positions in certain exchange traded funds positions , 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.

 

January 19, 2015 at 7:11 pm 1 comment


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