Saturday, October 27, 2007

Oil and the markets

The U.S. equity market experienced a contraction in value of biblical proportion beginning in 1973. In real dollars, it took the market 20 YEARS to recover. The catalyst was oil and currency issues (sound familiar?)

The following is from

“The stock market crash of 1973–4 was a stock market crash that lasted between January 1973 and December 1974. Affecting all the major stock markets in the world, particularly the United Kingdom,[1] it was one of the worst stock market downturns in modern history.[2] The crash came after the collapse of the Bretton Woods system over the previous two years, with the associated 'Nixon Shock' and United States dollar devaluation under the Smithsonian Agreement. It was compounded by the outbreak of the 1973 oil crisis in October of that year.

In the 694 days between 11 January 1973 and 6 December 1974, the New York Stock Exchange's Dow Jones Industrial Average benchmark lost over 45% of its value, making it the seventh-worst bear market in the history of the index.[2] 1972 had been a good year for the DJIA, with gains of 15% in the twelve months. 1973 had been expected to be even better, with Time magazine reporting, just 3 days before the crash began, that it was 'shaping up as a gilt-edged year'.[3] In the two years from 1972 to 1974, the American economy slowed from 7.2% real GDP growth to -2.1% contraction, while inflation (by CPI) jumped from 3.4% in 1972 to 12.3% in 1974.[1]

Worse was the effect in the United Kingdom, and particularly on the London Stock Exchange's FT 30, which lost 73% of its value during the crash.[4] From a position of 5.1% real GDP growth in 1972, the UK went into recession in 1974, with GDP falling by 1.1%.[1] At the time, the UK's property market was going through a major crisis, and a secondary banking crisis forced the Bank of England to bail out a number of lenders.[5] In the United Kingdom, the crash ended after the rent freeze was lifted on 19 December 1974, allowing a readjustment of property prices; over the following year, stock prices rose by 150%.[5] However, unlike in the United States, inflation continued to rise, to 25% in 1975, giving way to the era of stagflation.
All the main stock indexes of the future G7 bottomed out between September and December 1974, having lost at least 34% of their value in nominal terms, and 43% in real terms.[1] In all cases, the recovery was a slow process. Although West Germany's market was fastest to recover, returning to the original nominal level within eighteen months, even it did not return to the same real level until June 1985.[1] The United Kingdom didn't return to the same market level until May 1987 (only a few months before the Black Monday crash), whilst the United States didn't see the same level in real terms until August 1993: over twenty years after the 1973–4 crash began.”

While the Arab oil embargo did not precipitate the market collapse, the peaking of oil production in the U.S. several years earlier and the collapse of the Bretton Woods agreement in the years just prior to 1973 probably began what the embargo most emphatically accelerated and the Iranian crisis of 1979 finished.

Fast forward to 2005-06: The world enters peak production of crude oil and condensates, and perhaps all liquids. How many years before the effects of our current currency problems and declining oil availability begin their inevitable demand destruction within the American economy? Not many, in my opinion.

“Between January and October of 1978, the Dollar lost fully 25% of its value against a basket of the currencies of its major trading partners.” The Privateer Market Letter

We are perhaps a third of the way through that decline, and I do not believe that it is an exaggeration to say that the U.S. Dollar is currently in free fall, nor do I believe that I am out of bounds in my belief that the U.S. Dollar has MUCH, MUCH, MUCH further to go in terms of declining purchasing power, particularly versus energy, metals, and agricultural commodities than it did in 1978.

So here’s the deal:

As in the 1970’s, as this energy crisis gets going the real estate downturn will morph into a full-fledged crisis. While the equity markets MIGHT head higher in NOMINAL terms (certain commodity based equities will head higher in REAL terms) due to the eruption of hyper-inflation, in real terms, and in terms of employment and compensation, the contraction within the financial services industry will be quite pronounced.

Metro New York City’s real estate prices will collapse in real terms, as will South Florida, Boston, California and other areas that had experienced out sized gains… so much so that the Federal Reserve, in an effort to protect, perhaps even save, the U.S. banking system, will aggressively devalue the U.S. currency in a bid to spare the banks from defaults on loans to properties whose values have fallen below the mortgage lien. Not that it will work – it won’t – but they will feel that they must at least try. This action will only serve to worsen commodity inflation. Think back to 1979-80: Gold, Silver, Oil… all at record prices. Yes, those prices fell back as that energy crisis subsided. This energy crisis will not subside in our lifetime.

Please understand that when I speak of real estate I do not mean just housing. Office, retail, and commercial vacancy rates will become higher than at anytime in history, and landlords will be forced to lower rents for the remaing tenents. Some properties will do well, such as agricultural and warehouse properties at railroad yards, for example. After all, farmland can always be rented to farmers, and rail shipping will survive trucking. But areas that relied on workers commuting to and from work via personal automobile will be in for some tough times. Matt Simmons of Simmons International, Wall Street’s largest investment bank to the energy industry, is fond of saying that we could “free” the workforce by allowing perhaps as many as 10 million office workers to work from home saving a great deal of gasoline, which I have no doubt will be required at some point. The question I have is what are we going to do with the office space vacated by 10 million workers? How do the property owners service the debt on those buildings? How do the banks survive those defaults? We are talking hundreds of billions of dollars here – and that is just for office space. What about gas stations, auto mechanics, parking facilities, etc… What about the merchants and vendors that serviced these “freed workers”?

The U.S. currently has over 17 MILLION vacant homes. 17 MILLION! And I do not believe that figure includes the 6.8 million second home market. So now we have 24 million vacant homes (getting to and from those 6.8 million second homes in an energy crisis requiring some kind of rationing will no longer be possible). Who is going to pay the mortgage on these properties? This is why I tell my clients that South Florida’s real estate market will likely NEVER recover. NEVER.

Unemployment will rise, perhaps spectacularly, wages will stagnate, and inflation will rage, similar to the stagflation of 1970’s, just worse. For a businessman or professional in his early to mid 50’s or younger, the new environment will be like nothing in their experience. The concept of “savings” in U.S. Dollars, or equity in a suburban home, will be laughable, a major reason that commodity prices have only just begun their ascent. Once John Q. Public figures out just how worthless their paper currency has become the scramble to exchange it for hard assets like commodity futures, bullion, land, timber, livestock, etc… will be nothing short of a deluge, like the breaking of a dam. Unfortunately, I cannot be more specific in this forum.

With the increase in inflation and unemployment (1970’s stagflation on steroids) will come overcapacity for nearly every business and industry in the U.S. If you think that means every body EXCEPT YOU, well, that will be a quick trip to bankruptcy court. Survivors will be those that DELEVERAGE their businesses. We will get through this, perhaps, but the adjustment period is going to be quite painful in economic terms. Of course, there are many variables: the political and leadership talents of our elected officials and the governments of other countries, the American people's willingness to accept that forces beyond their control is the cause of this, not the Chinese, or greedy OPEC, etc... Such variables are beyond our ability to calculate effectively.

The world economy, and the U.S. economy in particular, will contract severly. Is it a recession, a depression, or will the new environment get its own special designation? I don't know and could not possibly care less - you and I are not running for President. Therefore, this is all about you, personally. (I say this because I constantly hear people, when confronted with the energy data for the first time, say: "we should do this" and "we should do that". I always want to ask: "who's we?" And "what power do you have to enact any of your silly, arrogant, and ill conceived ideas?" Everybody's an expert.)

The 2 important financial items for You, Inc., are your income and your assets. The store of value that you choose for your assets will determine what you have left over from your efforts, and how you manage your contribution to the economy will determine your income. If your income depends on an industry that depends on cheap and abundant energy… well, let’s just say that you will need to find a new way to make a living. If your store of value is the U.S. Dollar or bonds denominated in U.S. Dollars, the purchasing value of your savings will plummet. Don’t do this to yourself. For those of you who don't think this could possibly happen, did you think it was possible for the Soviet Union to politically collapse in a matter of days? Did you think it was possible to kill 3000 Americans in lower Manhattan with a couple of passenger jets?

Life will be good, but the economic rules are changing. If you don’t deal with the change, the change will deal you out. For those that get it right, this will be like a slow pitch down the middle of the plate. For those that get it wrong, it’ll be more like 2 guys carrying you off the battle field on a stretcher. By mathematical necessity, most folks will get it wrong - and there just ain't enough stretchers.

I know that many will not appreciate my analysis, it isn’t what you WANT to hear. Too bad - because whatever it is, it is, and whatever it ain’t, it ain’t - it does not give a damn what we appreciate.

Yours for a better world,

Mentatt @ yahoo (d0t) com

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