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Natural gas has become a very cheap and abundant source of energy


Yesterday I stumbled across an interesting article in Salon entitled "Everything you've heard about fossil fuels may be wrong." The thrust of the article was to highlight the huge increases in proven and exploitable reserves of natural gas that have been discovered in recent years thanks to "fracking" technology, and what this means to the search for alternative energy sources and U.S. energy independence.

As everyone who follows news about energy knows by now, in the last decade the technique of hydraulic fracturing or "fracking," long used in the oil industry, has evolved to permit energy companies to access reserves of previously-unrecoverable “shale gas” or unconventional natural gas. According to the U.S. Energy Information Administration, these advances mean there is at least six times as much recoverable natural gas today as there was a decade ago.

So I thought it would be interesting to compare the relative costs of natural gas and crude oil as sources of energy, and produced the chart above. What it shows is that since 2003 the price of natural gas has fallen from the equivalent of about 20 barrels of crude per 10,000 BTUs, to less than 5 today. In other words, natural gas has become 75% cheaper relative to crude oil in the span of just eight years, thanks to huge increases in natural gas supplies. (Natural gas futures traded around $5-6 per million BTUs in 2003 and today trade around $4-5, while crude oil has soared from $30/bbl to $100.)

This indeed has enormous implications for future energy use and industrial development. It isn't often that we see such huge changes in relative prices that have such a huge potential for changing the way our economy works.

The employment situation continues to improve


After the recent string of unexpectedly weak economic statistics (e.g., the ADP report, the Case/Shiller housing price slump, and the ISM manufacturing index) I was pleasantly surprised this morning to see that the jobs numbers weren't bad at all. Yes, private sector jobs only increased 83K in May, after a downwardly-revised 251K in April, according to the establishment survey. But the household survey, which is often overlooked, reported a gain of 373K private sector jobs in May, after a loss of 11K in April. These two surveys can often move in different directions, but over time they move together, as the top chart above shows.


Both surveys are now showing that in the past six months, jobs growth has actually picked up, as we see the chart above. Abstracting from the May weakness in the establishment survey, which is most likely due to the same tsunami- and weather-related disruptions that impacted the ISM and ADP numbers, private sector jobs are growing at almost a 2% annualized rate, the fastest we have seen since early 2007. That's not a great number, but it is enough to bring the unemployment rate down over time—albeit very slowly, and in fits and starts—as the next chart shows.



The other encouraging part of today's jobs report—from a taxpayer's perspective—was the news that public sector jobs are declining at an accelerating pace. As shown in the chart above, according to the establishment report the public sector has pared over half a million jobs (ignoring the census-related bulge last year), while the private sector has created about 2 million. We haven't seen public sector job losses of this magnitude since the recession of 1981-2. I've been arguing for a long time that cutting back on the size of government and on government spending is necessary, and on balance a net positive for the economy. Government spending has grown so much in recent years that it is suffocating the private sector, so cutting spending should be stimulative. We are now seeing evidence that a significant shrinkage in the bloated public sector workforce doesn't necessarily lead to a painful result for the economy as a whole. In fact, cutting back government spending can free up resources that can be put to better use by the private sector, making the economy stronger over time. This is a trend that is now firmly in place, and that's very good news.

On a related note, the bulge in weekly unemployment claims data over the past month or so continues to look like faulty seasonal adjustment factors have been the real culprit, rather than any meaningful deterioration in the economy. Auto sector layoffs that typically occur in July were moved forward, and that was not anticipated in the seasonal factors. That means that as we approach July and the expected layoffs fail to occur, we should see a "surprising" decline in the weekly claims data. By then it will be clear to the market that all the recent gnashing of teeth and wringing of hands was misplaced. The economy may have hit a mild soft patch, but it is not sinking and is likely to continue to grow. Optimists will once again be rewarded for their patience.

A moderate case of the jitters


As a follow-on to yesterday's post, here is another way to measure how pessimistic the market is, and how much actual deterioration in the fundamentals there has been. The chart takes the Vix index of implied equity volatility and divides it by the yield on 10-yr Treasuries. The higher the Vix, the higher the degree of market uncertainty and fear; the lower the yield on Treasuries, the weaker the economy is perceived to be. So a higher ratio is bad, and a lower ratio is good.

This ratio has recorded some pretty spectacular spikes over the years, but today's level is only moderately elevated (6.26). This jibes with the other indicators I showed yesterday, with the conclusion being that the market is definitely concerned about the outlook and the fundamentals, but not to any alarming degree. I could say the same thing for Euro 2-yr swap spreads, which at 52 bps are definitely above average, but not by a lot.

In Don Luskin's book "I Am John Galt", the section on Alan Greenspan makes the interesting observation that Greenspan was pursuing a stealth gold standard as Fed Chairman from 1987 through the late 1997. The Fed funds rate fairly closely tracked the price of gold, which is what one would expect to see if indeed the Fed were on a gold standard. During that same period, inflation was fairly low and relatively stable, and there was a noticeable lack of market panics. But after 1997 the Fed started raising the funds rate even as gold and commodities declined. Greenspan apparently switched from his Randian focus on gold and adopted the more popular Phillips Curve vision of inflation. Phillips Curvers were very worried in the late 1990s that the U.S. economy was "overheating" and that too much growth would prove inflationary. The facts proved them and Greenspan wrong, however, since the economy slipped into recession in 2001 (as it usually does when monetary policy becomes too tight) and inflation fell to very low levels. In fact, we came pretty close to experiencing outright deflation in 2002 and 2003. That put the fear of God into Greenspan, since he subsequently decided to pursue an extraordinarily accommodative policy for the next several years, and that contributed to inflate the housing bubble. With monetary policy cut loose from the anchor of gold, is it any wonder that the Vix/10-yr ratio has experienced such extreme volatility in recent years?

Must-read: "I Am John Galt"

I've finished Don Luskin's "I Am John Galt: Today's Heroic Innovators Building the World and the Villanous Parasites Destroying It", and I can now very highly recommend the book to anyone who believes in the power of free markets and individual liberty. But if you haven't read Ayn Rand's Fountainhead or Atlas Shrugged, then by all means read them first.

Luskin gives new life to Ayn Rand's books, logic, and philosophy, by showing how timeless they are. Each of her major characters has a counterpart in today's world, and the major themes are still being played out today:

The Individualist: Steve Jobs as Howard Roark, the man who reinvented four industries just because it was so cool.
The Mad Collectivist: Paul Krugman as Ellsworth Toohey, the man who preaches socialism from the pages of America’s newspaper of record.
The Leader: John Allison as John Galt, the man who walked away after building America’s strongest bank.
The Parasite: Angelo Mozilo as James Taggart, the businessman who co-opted government and nearly wrecked the U.S. economy.
The Persecuted Titan: Bill Gates as Henry Rearden, the businessman who created revolutionary technologies and was criminalized for his success.
The Central Planner: Barney Frank as Wesley Mouch, the politician who meddled in the economy and almost destroyed it.
The Capitalist Champion: T. J. Rodgers as Francisco d’Anconia, the modern Renaissance man, and agent provocateur for capitalism.
The Sellout: Alan Greenspan as Robert Stadler, the libertarian who became an economic czar.
The Economist of Liberty: Milton Friedman as Hugh Akston, the academic who showed the world the connection between capitalism and freedom.
Don has written a lively and engaging tour de force that, if widely read, could help set our politics and our economy back on the track of growth. Don't miss it, and help spread the word.

I Am John Galt: Today's Heroic Innovators Building the World and the Villainous Parasites Destroying It

Putting the ISM news in context


Going into today, we knew that manufacturing activity in May was disrupted in the wake of the Japanese tsunami, terrible weather, and early auto shutdowns, but nevertheless the market is having a problem digesting the news that the May ISM manufacturing indices were weaker than expected. Still, as the chart above shows, even with a significant drop in the main ISM index, there is no reason to expect that GDP growth in the current quarter is going to be any weaker than it was in the first quarter. The current level of the ISM index is consistent with GDP growth of 3-4%.


The employment component of the ISM index also fell sharply, but it is still at historically strong levels, levels that have been seen only a handful of times in the past several decades.


A decline in activity had little impact on the inflation fundamentals, with the prices paid index still registering rather elevated levels of price pressures.


Export orders fell sharply in May, but they are historically volatile and still consistent with growth.


Meanwhile, all major commodity indices have turned up from their May lows, including my favorite (above), the CRB Spot Commodity Index.


The May Challenger tally of announced corporate layoffs remained very low, but the May ADP estimate of new private sector jobs dropped much more than expected. Conclusion: hiring plans were disrupted in May, but there is no sign that employers want to reduce employment levels.


I think the proper conclusion to all this is that while economic activity was indeed disrupted meaningfully in May, there is no reason to think that conditions or fundamentals have permanently deteriorated or are getting worse. Indeed, commodity prices are signaling that things are are already on the mend. Consequently, it is likely that U.S. markets are overreacting to the downside, and we should expect better news in the weeks to come.

How to tell that the market is pessimistic


When everyone's optimistic about the prospects for the economy and financial markets, you've got to think twice before becoming optimistic yourself. Likewise, when the market is pessimistic, bad news is priced in and that gives optimists a cushion, or room for error. The market is full of clues as to whether its optimistic or pessimistic, if you just know where to look. Here's a quick recap of some key indicators which all suggest that the market is clearly pessimistic about the economy's ability to grow, about corporation's ability to sustain profitability, and about the Fed's ability to stimulate the economy.

The first chart, above, shows the level of yields on 2- and 5-yr Treasuries, and the spread between the two. Yields and spreads have a predictable pattern as the economy moves through the business cycle. Yields typically rise in advance of a recession, because every recession since WW II has been caused by a tightening of monetary policy which, in turn, was motivated by the Fed's desire to reduce inflationary pressures. Tight monetary policy pushes up short-term interest rates more than longer-term interest rates, with the result that the yield curve flattens in advance of recessions, and usually inverts (i.e., when short-term rates are higher than longer-term rates, that is a good sign that a recession is on the way). Once a recession hits, the Fed begins to ease, and short-term interest rates fall faster than longer-term rates; the yield curve steepens. Following a recession it typically takes a few years before the market and the Fed realize that a recovery has set in. The Fed then gradually raises rates and the yield curve gradually steepens.

This time is no different. We are still in the early stages of a new business cycle, and the market and the Fed remain quite doubtful about the economy's prospects. The yield curve is still quite steep, and short-term rates are as low as they have been in many decades. 2- and 5-yr Treasury yields are dominated by the market's expectation of future Fed policy, so for them to be this low implies that the market expects it will take a long time before the Fed starts to raise rates, and when they do, it is likely to be very slowly. That, of course, means the market holds out very little hope for a robust recovery any time soon. The market seems to be screaming that the Fed is "pushing on a string," and that monetary policy is virtually powerless to stimulate the economy and/or to push inflation higher.


This next chart shows the level of option-adjusted spreads on corporate bonds, arguably the best measure of the market's expectations of corporate defaults. As this chart shows, spreads are still elevated from an historical perspective, and about at the same level today as they were a couple of years following the 2001 recession. Spreads are still substantially above the levels that prevailed during the optimism that permeated all markets in 2007. Today's spread levels are consistent with a market that is still quite concerned that a weak economy (and possibility lingering deflationary pressures) will threaten the viability of corporate borrowers in coming years.


Similarly, the Vix Index of implied equity option volatility remains elevated, and is still substantially higher than what we see (e.g., 10-12) during periods of relative economic and financial market tranquility. It's not alarmingly high, of course, but that is not to say that the market is not concerned about the future.


This next chart is quite impressive, since it shows that the yield on long BAA corporate bonds (which comprise the majority of investment grade corporate bond issuance) is lower than the earnings yield on the S&P 500. This is a rare occurrence, since it means the market would rather accept a lower yield on bonds (which do not participate at all in a rising equity market, but have first claim on profits) than take the risk of the higher total returns that normally accrue to equity owners, who today are able to fully participate in the upside in addition to "earning" a higher yield. This can only mean that the market is unusually skeptical about the ability of corporations to sustain current levels of profitability. Looked at from a different perspective, corporate profits are very close to all-time highs, both nominally and as a % of GDP, but since PE ratios are below average (15.3 vs. 16.7) the market apparently assumes that the outlook for profits is dismal.

In short, if you are at all optimistic about the future, or just less pessimistic than the market, then equities offer attractive valuations.

Housing update: still soft, but probably not a double-dip




The release of the March Case Shiller home price index, which showed the non-seasonally adjusted number falling to a new post-recession low, is apparently confirming the view among many analysts that housing is now in a double-dip. That may be an irrelevant and premature assessment, however, given that the March number reflects the average of prices in the months of Nov., Dec., and Jan. Nevertheless, as these charts show, prices were indeed softening late last year and early this year.

The top chart shows the seasonally-adjusted Cash Shiller series, as well as the Radar Logic home price series. Both are telling approximately the same story. The second chart shows the inflation-adjusted version of the Case Shiller series measuring home prices in 20 major markets, while the bottom chart shows the Case Shiller series measuring 10 major markets, but extending back to 1987. On an inflation-adjusted basis, home prices on average have fallen almost 40% from their peak.

As to whether housing prices are still declining from their January levels, it's anyone's guess, but I am hearing anecdotal evidence to the contrary, at least here in So. California. Three homes in one neighborhood I'm familiar with sold within days of being listed, one for a price I thought was impossibly high. My nephew who is a mortgage broker in the Inland Empire reports that May was his busiest month ever, and he sees evidence of firming prices. Additionally, the chart below is an index of the equities of major homebuilders, and it shows no sign of weakness.


Much has been made of the big May selloff in commodities, but even that appears to have been temporary and not indicative of any economic downturn. The chart below of a diversified index of commodities shows that prices have already recovered over half of their early-May losses. Plus, copper prices have not declined at all in May.


In any event, I would argue that any weakness in housing should be viewed as an opportunity to buy, rather than a reason for despair.