Heading towards depression?

A 40 % drop in the Dow Jones Industrial Avg in a year (Oct 09, 2007 to Oct 09, 2008) is not something that happens every 5 years, it doesn't even happen once in 10 years. This has only happened twice before in the last 100 years! The last time the Dow lost more than 40% in a 12 months period was in 1973-1974. Of course, before that the Dow lost almost half its value in the 1932 depression.
So are we heading towards a depression? Here are some reasons I think that the stock markets are a poor indicator of the current state of the economy and that we are in a state of panic and fear rather than depression.
- The world economy is very interlinked now - more than it was in 1974 and definitely more than 1932. Even a slight chance/indication of an economy the size of the US will result in the financial gurus/experts/government officials to do anything and everything in their power to get this behemoth back on track.
- The government now is far more proactive and keen to avert a crisis like that. Far too much is at stake now. They will beg, borrow or steel (from China. UAE, Saudi Arabia and even India) to have some mobility in the financial wheels of this country. The US has knows what it feels to be a super power and to let that power slip from it's hands is unthinkable, unimaginable and frankly, impossible. You might as well say goodbye to the world as you know it if a 1932 like situation is to happen again.

So talks of depression - please.. in fact, there were signs that the stock market was looking to touch the bottom on Friday, Oct 10th. If that were to happen, here is an interesting piece of information/fact/history for you.
Below are the worst and best years of Dow in terms of percentage.

WORST
1 1931 -52.67
2 1907 -37.73
3 1930 -33.77
4 1920 -32.90
5 1937 -32.82
6 1914 -30.72
7 1974 -27.57
8 1903 -23.61
9 1932 -23.07
10 1917 -21.71

BEST
1 1915 81.66
2 1933 66.69
3 1928 48.22
4 1908 46.64
5 1954 43.96
6 1904 41.74
7 1935 38.53
8 1975 38.32
9 1905 38.20
10 1958 33.96

Do you see a pattern?
After dropping 31%in 1914, it gained 82% in 1915. After dropping 23% in 1932, it gained 67% in 1933, went up 38% in 1975 after dropping 27.60% in 1974 etc. As a matter of fact, we haven't seen a big gain like that since 1975. So the big question is - are we due one this/next year? I am willing to bet this will be the top most thought of traders in the coming weeks/months.
So what can you do? It is a common belief that it is very hard to catch a falling knife - and you can never predict when the knife is going to hit the floor (because you don't know where the floor is) so put is a fixed sum of amount in equities regularly, preferably once every week or 2 weeks. This is also known as dollar cost averaging

(Free*) Advice for Federal Reserve

Yesterday the Federal Reserve voted to keep the interest rates at which banks lend money to each other (pretty much the mother of ALL interest rates, except may be the mortgage rate) unchanged at 2%. They also noted that inflationary forces are somewhat higher, whereas the winds of recession are waning. So - in effect, they did nothing - nothing except talking. Here's the more surprising part - I don't blame them for not doing anything - partly because they CANNOT DO ANYTHING. These are such extraordinary times that they don't know what has hit the economy - well OK - they know - but they are definitely not doing anything about it. For the rest of us - let me try to explain.

A. This downturn started because of the credit crisis that began in August of last year (remember the subprime mortgage meltdown - the Bear Stearns collapse - the billions banks wrote off) that resulting in millions losing their homes - and its effect on the housing market.

B. The reason for A. was all the cheap money (practically free) that was available from 2000 onwards - till they started raising interest rates again in 2005. Everyone who wanted to buy a home was able to obtain a loan - irrespective of their ability to pay them back (Countrywide got sued recently for that). However, as soon as the interest rates jumped - they were unable to pay back their home loans - once there were enough people doing this - the mortgage industry, and by association, the housing and financial industry went bust. But I digress - there is enough juice in this saga to inspire a few PhD theses.

C. Because of A. and B. the economy as a whole began to tumble. The stock markets, the hedge funds, the whole deal. This caused a panic in the hedge funds and the pension funds industry as they were unable to make money for their millionaire investors. So they turned to oil!. And the rest, as they say, is history.

D. More and more money flowed into the oil industry, sucking the US stock market dry. This had an adverse effect on the US and the world economy as a whole.

E. Oil has reached 140 dollars a barrel and has threatened to destroy (if not already destroyed) the fabric of our economy and in some ways, our way of life. Every thing that we depend upon for our day to day living is, in one way or the other, dependent on oil. THIS IS THE CAUSE OF THE INFLATIONARY FORCES THE FEDS ARE NOTICING. Not the usual, cyclical inflation the economy observes when there has been a period of modest growth, low unemployment, strong currency! The high price of oil has caused the price of food to go up (high cost of corn because of ethanol), high cost of transportation, of course, high cost of air travel, high cost of heating/energy etc.

So here is my advice:
- lower the interest rate so the economy gets going
- lobby congress to legislate tighter regulation of the futures market where speculators are making millions if not billions because of high oil prices.

Once the price of oil comes down, the charm of high return from the futures market will dissipate forcing the hedge funds, banks and investors to re-examine the US and world stock market. More money will flow in the stock market - with higher market cap, companies will be more confident to innovate, spend on R&D - the whole economy prospers.

* I doubt they have money left over after they filled up their tank!

How oil can be back to where it was 12 months ago - PART II.

Part I of this post described the problem of why the price of crude oil is touching 140 dollars a barrel where only a year ago, the price was hovering around the 60 - 70 dollar mark. This post will discuss different ways we can be in the vicinity of the 75 dollar mark instead of the 150 dollar mark.

A) US Dollar makes a comeback - we have seen that happening already. The Federal Reserve has been working hard on making sure that the USD regains its lost value. It has been helped by the recent statements from the EU bank when it said that they are not going to raise interest rates in the coming future to deal with the rising inflation.

B) Congress acts on the opacity of the futures market and the illegal practices being carried out behind the black curtain. This will have the biggest impact of all. A signal from the US congress that it will close all loopholes and only let market forces dictate the price of commodities will cast the biggest shadow over the oil markets.

C) Drastic cut-down in the demand of oil - this is the most unlikely of options. Thousands of commercial airliners have to keep flying - Gas is still subsidized in India and China. The US is not designed for mass transit and foot traffic.

Once oil price per barrel starts to drop $3-$4 per day, more and more traders will try to sell to make any profit at all on oil.

These are good way to cut down the price of oil - thereby creating a lesser demand in the futures market - forcing traders to short their oil commodity holdings. Once that bear mentality sets in the traders, more and more will start selling in order to make any profit. This will result in a big domino effect whereby every index fund manager and hedge fund manager will sell their commodities assets (remember the dot com crash of 2001-02?). The result of this crash in oil price will be seen on the pump withing 1 week. Another huge impact of this crash will be on the world stock market. Money will flow into the stock market instead of going to the commodities black hole.

How oil can be back to where it was 12 months ago - PART I.

George W. Bush would have you believe that oil is where it is because India and China are using more of it (he did that for food!!) - as if they've just started using twice the number of cars in just the last 12 months! Their economy is growing pretty fast - but not that fast. There is only one reason why oil is at 140 dollars a barrel - people are buying oil on the mercantile exchange as you and me would buy the stock of yahoo on Nasdaq. They are betting that the price of oil would go up next week - and when it does, they make a huge profit.

Here is a simple FAQ on how speculation drives up the cost of crude oil (arguably the most important commodity that is traded in the New York Mercantile Exchange (NYMEX) and its sister exchanges)

Q) So how does it all work?
A) Oil futures are traded in the 2 main exchanges - The New York Mercantile Ex (NYMEX) and the InterContinental Ex (ICE) in London.

The way these futures markets are supposed to work, is that both the producers (sellers of futures contracts) and end users (physical buyers of the commodity), have a market place to negotiate market prices in the future, to take some of the risk out of fluctuating daily market prices.
However, there is one more player in the game, the speculator. The speculators role is to keep the market liquid by betting on the price going either up or down of any given commodity on any given day or future day.
Speculators can make huge gains or losses in the futures market because the futures contracts are leveraged. Speculators control the value of the contract purchased with only a fraction of the money out of pocket.

Now that you have the basics, heres how the price get manipulated:
It's called cornering the market. Cornering the market has a long and checkered history. There are many techniques a group of speculators can use use if they buy up a majority of the open interest in the outstanding contracts in one commodity. By simply owning most of the contracts, the speculators refuse to sell until they can receive a much higher price.

(source: oil speculation - how does it work?)
Have some time on your hand? Read 'The Economic Purpose of Futures Markets and How They Work'.

Q) Who are these 'Speculators'?
A) These are no ordinary Joes. They are huge investment banks that owns hedge funds and pension funds. Banks like Goldman Sachs, Morgan Stanley etc. They are neither producing oil nor the end users - they just invest their big investment dollars in the hope that a (well predicted) change in price will result in huge profit.

Q) Why speculate on oil?
A) Since the US economy is slowing down (if not in recession already) resulting in a poor ROI in the stock market, the crash of the real estate market, the falling US dollar, the hedge funds and the pension funds are finding it hard to make money for their millionaire customers. That's where futures trading in crude oil comes in. They can, very safely - one can say, bet that the price of oil is on the up - for some time to come. Their reasoning is not entirely flawed. After all, the entire world runs on oil and the demand of oil is going up - while the supply is always under a huge question mark (stability in Iraq, confrontation with Iran, unstable Nigeria, new flexing of muscle of Russia, growing power of Venezuela etc etc etc), the demand is not going to go down any time soon (think China, India, F-150s, Toyota Sequoias, Tata Nanos). In short - its a low risk, high return investment.
I doubt there is any other commodity in the market that would give them a 100% profit in 12 months.

Q) Shouldn't the futures market reflect the fundamental law of supply and demand?
A) Of course they should. The futures markets were created to let users of commodities 'lock in' the price of the future today. For ex. airlines and home heating oil companies locking in the future price of oil today. The speculators, however, create a false sense of over-demand driving the price higher.

Q) How about regulation?
A) Good question. Shouldn't all this be regulated? After all - this is a good case of for regulation - right? Actually - there is a regulatory authority - it is known as the Commodity Futures Trading Commission (CFTC). They were created by the congress to make sure that the laws of supply and demand are met by the futures market. This is all well and good as long as the trading is done in the US. Th crude oil futures (that have an impact on the price in the US oil) are also traded in ICE as mentioned above. These trades are not regulated by the CFTC - thereby allowing manipulative practices and excessive speculation. BTW - it was the Bush administration that gave ICE the permission to trade US crude oil futures (Big Surprise!!) (source: this article from author F. William Engdahl)

Q) So who is making all this money?
A) 2 words for that - Hedge funds. Actually - no one really knows. The opacity of this whole deal is phenomenal. The information about who is buying the options at ICE and who is involved in this mess is protected by European laws.

Q) Isn't OPEC in control.
A) In one word - NO. It's out of their hands - and into the hands of hedge fund and pension fund manager sitting in an office on the Wall Street.

Q) What about the developing economies?
A) Oh - they are just a convenient, easy to understand people to blame - nothing more. As I wrote above - their economy is growing - but at a decent rate of 7-8% Not 70-80% per year as some would have you believe.


So here is the trillion dollar question? How does the price of oil come down?
That will be covered in Part II of this most important topic.