The Average Joe Investor

What I'm Reading Today - Jan. 23, 2012

2012-01-23T09:56:00.000-08:00

I managed to get my hands on a review copy of Motley Fool contributor Morgan Housel's upcoming book on the economy, stocks, and the housing market. It's a really fantastic read, but unfortunately I can't point you to it yet because I was just reading an early copy.

You can, however, grab a copy of Morgan's previous book on Amazon. Or you can get a flavor for the kind of topics he covers in the new book by checking out his latest on Fool.com.

-AvgJoe

Investing Inspiried by Hunger?

2010-08-11T18:02:00.000-07:00

Ok, so admittedly my article today -- 7 Dividend Stocks Worth Owning -- wasn't inspired by drooling daydreams of cheese steaks, but the exploration of cheese steaks was inspired by a dinner that left me wanting last night.

However I think there are certianly ways that I could stretch the analogy a bit further:

Dividend stocks and cheese steaks have a good recipe going -- don't mess with it. If you hand me a Philly cheese steak with gruyere cheese on it I won't ask any questions, I'll just throw it right in the trash. Call it a wagyu steak sandwich with gruyere and I might try it, but don't you dare call it a cheese steak. I don't need anything flashy and forward-thinking in my dividend stocks either. Give me stable businesses with a history of reliable payouts and payout growth.

Unless you have cholesterol or blood pressure issues (which I guess, sadly, does cover a lot of people) a Philly cheese steak is a treat that can be enjoyed by just about anyone. Don't try to tell me you're a vegetarian. Eat a Philly cheese steak, you'll love it. Similarly, dividend stocks aren't just for widows and orphans -- they're an investment dish that can be enjoyed by all.

If you go into a fancy place with crisp, white table linens and waiters that call you "sir" and "m'am" and they have a cheese steak on the menu, it's probably lousy. Your best cheese steaks are found by scouring hole-in-the-wall-type joints. I don't think anyone ever said that Geno's has a beautiful building. Similarly, the best dividend payers are usually not going to be your fancy, flashy companies. In the article today I highlighted companies like Illinois Tool Works and Owens & Minor. Not exactly exciting ice breakers at the neighborhood pot luck, but good dividend payers.

While I often prefer my cheese steak in all of its natural glory, it's hard to go wrong with adding ketchup -- after all, ketchup is one of the few foods that perfectly balances sweet, salty, bitter, sour, and umami. Similarly, most dividend stocks are better with ketchup on them... Just checking to see if you're still reading. No? Ok, I'll stop here then.

-AvgJoe

In Theory It Works...

2010-08-09T13:27:00.000-07:00

Some quick thoughts about discounted cash flows...

For those not familiar with DCFs, the very quick overview is that you're taking all the future cash flows of a company and discounting them back to what they're worth today (because a dollar tomorrow isn't worth as much as a dollar today) and using that to come up with a value for a company.

In the theoretical version of a DCF you do an academically-inspired calculation to come up with the "cost of equity." That cost of equity is very important as it's typically (at least for companies that are primarily equity-financed) a larger weighting in the overall cost of capital, which is what you're using to discount the cash flows.

Now if that sounds a bit like academic mumbo-jumbo it's because it is... well, to an extent at least.

Let's say you've run through a very complex DCF on BuddahBarn (an ueber-successful karma-oriented seller of farming equipment and attire) and have concluded that the stock is undervalued by 25%. Should you buy? Well, here's the other thing -- upon calculating BuddahBarn's cost of equity, you came up with 6%. So while you apparently have a 25% gulf between today's price and what the stock is theoretically worth, the bottom-line returns that equity-holders can expect are pretty darn low.

Now there's method to this madness and basically it's that theoretically a more volatile stock is a more risky stock to own, while a less volatile stock is less risky to own. In order to own the former, you need much higher equity returns than the latter. The problem, of course, is that the way that risk is measured -- volatility -- is, for lack of a better word, whack.

So what do you do? My answer is a bit of common sense. I generally start with a cost of equity (which we can probably also think of as an equity returns hurdle) of 12%. From there, I base my investment decisions on the price/valuation discrepancy and a consideration of the actual risk -- that is, potential for permanent loss of capital -- from the stock.

That would mean that I'd consider buying, say, McDonald's (which I do own) at a smaller discount than I'd demand for Blackstone (which I also own).

Another way to get around this cost of equity issue, is to not set a cost of equity at all. Instead, set all of your other variables, plug in today's price, and back into an implied cost of equity. Then -- again, based on actual risk for the stock -- decide whether that rate of return is really adequate compensation.

-AvgJoe

Bad Water

2010-08-05T16:12:00.000-07:00

If you're a lover of coffee like me, here's a bit of advice to never pooh-pooh: using good water to make your coffee. For the past couple days I've been making my coffee with tap water and the end result has been rubbish (to put it very, very nicely). The idea of using bottled water to make coffee seems odd, but I'm actually considering it.

Well, anyway, fair warning to my fellow coffee drinkers.

And while this may seem way off topic, to me it's not. Without ample coffee, there's no way you're going to make it through financial filings -- particularly when it comes to banking or utilities -- so bad coffee is a terrible blow to the serious financial analyst.

Ok, you got me, it was way off topic.

-AvgJoe

Wake Up Congress!!!

2010-08-05T11:40:00.000-07:00

Watching the financial overhaul bill snake its way through Congress I came to have a distinct hatred for the word "procedure." Some of the very best amendments to that bill were tied up in ridiculous procedural rules that lawmakers used as a shield to make sure that those amendments never saw the light of day.

"Ok, fine," I said to myself, "this is financial reform and the government is screwy. What should I really have expected?"

Then comes this vote on health care coverage for 9/11 first responders. And what happens? Procedure rules the day again. Of course Congressman Anthony Wiener was having none of it. Good for him, we need more folks like that in Congress.

Credit where credit's due, Jon Stewart highlighted this on The Daily Show.

-AvgJoe

An Ode to Coca-Cola

2010-08-02T19:27:00.000-07:00

An article I did for Fool.com today about Coca-Cola and companies of its ilk. The company has been a favorite of Buffett's and I'm a big fan of it as well -- and even saw an opportunity to pick up some shares last year.

-AvgJoe

An Oasis for My Soul

2010-08-02T11:46:00.000-07:00

It's been a while since I've posted here and I originally my plan was to post something about stocks, but sometimes something else just pops up and screams at you, "You must post me!"

This is from Colony Capital's Tom Barrack (via Krugman's blog, via the Financial Times). Apparently Barrack took some time off and stumbled upon... Twilight.

... after “an agonisingly tough couple of weeks” he took some “yacht time” and chanced upon his daughter’s copy of Twilight. “I don’t get it … but I feel it. Taking the agenda-less time to absorb a point of view that I had ignored while loved ones around me relished it was an oasis for my soul.”

So folks, yet more evidence that hedgies are people too. People that can take home billion dollar paychecks and still have a seventh grade girl's appreciation for literature.

Of course I jest (or do I...?)

-AvgJoe

A Must Read

2008-10-24T14:29:00.000-07:00

If you haven't caught the Forbes cover article this month (written by Steve Forbes), then it's time you headed over to the Forbes site and get your read on.

-AvgJoe

The market's flubber bounce

2008-10-13T13:50:00.000-07:00

I've been sitting here for a few minutes now wondering what exactly you say on a day like today. Happily, it doesn't involve finding some new way to describe a continually plunging stock market. In fact, quite the opposite. I'm sure you've seen already, but each of the three major US indexes is up more than 11%. Let me just go ahead and repeat that: over 11%.

How does this rank historically? From what I've got from Yahoo!Finance, it looks like this is the sixth largest percentage gain on the Dow (note: ignore the hoopla over the point gain, that's meaningless -- focus on the percentage). Ominously, all of the single-day percentage gains higher than today's were during the Great Depression.

Now I know this will make everyone jump to the conclusion that this means we're in the same situation as back then. I don't believe it does, so I'm not going to drag out the comparison any further.

What I will say is that there are two primary factors that are going to be front and center for me going forward: 1) the economy's reaction to the global efforts to jump start the credit markets and 2) how far the repricing of risk goes and how persistent it is. The reason for #1 is that if the economy falters then the companies that we're investing in (broadly) will be hurt by pinched sales and profitability. Simple as that.

#2 comes from the fact that over time investors tend to determine their required returns differently depending on how scared they are. People are very scared right now and want a big return to take pretty much any risk. If that continues to be the case, valuations for stocks will continue below what they had been before this drop began.

As for tomorrow... who knows? It's hard enough evaluating the market when fundamentals are in the driver seat. When investor psychology takes over -- particularly when there are a lot of unknowns -- things get interesting.

-AvgJoe

Finance on SNL

2008-10-12T09:39:00.000-07:00

So who couldn't use a laugh right now? (and if you answered "not me" then you need a laugh more than the rest of us)

Check out this Update from Saturday Night Live. About halfway through is the "Fix It" bit, which is pretty much how I feel at this point.

-AvgJoe

Run and hide or stay and fight?

2008-10-09T13:21:00.000-07:00

That's a really good question right now, especially since the Dow finished today down 39.4% from last year's peak. That's worse than the 37.8% drop that the Dow saw from peak to trough during the post-Internet Bubble blow-up. It now only trails two periods of stock market malaise -- the Great Depression and the extended down market during the late 60's and 70's.

During the Great Depression stocks declined 89% from summer 1929 to summer 1932, then spiked back up from 1932 to 1937 only to plunge another 52% from 1937 to 1942. In all it took 25 years for the Dow to recover its 1929 high.

After peaking in early 1966, the Dow had plunged 42% by Fall of 1974. And though '74 was the bottom, the market bounced up and down until 1982 when it finally started showing some real life again.

So are we in for a long period of terrible stock performance? I don't think so. Now I fully realize that I have been wrong on a lot over the past year, and certainly wasn't on the leading edge of this recent melt-down (and my portfolio shows this). I've now jumped on the "cyclical bear market" bandwagon, but, as others more prescient than myself have pointed out, this bear market really started back at the turn of the millennium. Right now we're down about 27% from the peak of 2000. And if you'd invested in the Dow in early 1998, you would have been roughly flat over the past 11 years. In other words, if this is a cyclical bear market, then we're well into it.

But that doesn't really help with the pressing question does it? So what do we do with our money? Well, I don't have the answer for any particular individual (when you need the money is a big question), but I'll tell you what I'm doing: I'm staying put. The problem with starting to freak out right now, or with trying to guess where the bottom is, is that there's a good likelihood that you'll miss out on some of the recovery -- which can happen fast.

How fast? After the bottom in 1932, the Dow rallied over 70% in two months. After bottoming out again in 1938, the market bounced back up over 20% in the next five months. May of 1970 was one of the many bottoms during that period and the market was up almost 35% over the next year. December of 1974 was the bottom of that period and over the next six months the Dow was back up 43%. And I could go on.

The point is that as violent and fast as this decline has been, the recovery can be equally so and trying to guess when to get out and when to get back in is more likely to get you in trouble than really get you market beating results. When markets start trading more on emotion than fundamentals, keeping a cool head is your best weapon.

If you've been investing all along in stable companies with good balance sheets that produce a good or service that's in real demand, then staying put is probably your best bet.

-AvgJoe

For the last time, this isn't just about Wall Street!

2008-10-08T16:03:00.001-07:00

I'm going to puke if I hear the phrase "Wall Street bailout" uttered one more time. Ooops, just puked, I guess somebody, somewhere just said it again. Why? Because people around the US still seem to believe that this is a bailout that "helps Wall Street, even after Wall Street destroyed our economy."

There's two parts to this, and in this blog I'm going to cover Wall Street destroying our economy. Did Wall Street play a part in what is going on? Sure! But there's no way that any of this could have happened without the help of good ol' Main Street.

Oh no Average Joe, you're not going to say something bad about the good, hard working people on Main Street, are you?

You bet I am.

Look, I don't have anything against Main Street -- heck, I'm part of Main Street and I'm getting nothing but lumps from what's going on right now. But at the core of all of the problems -- which has already been pretty well hammered home -- is the demise of waves of mortgage loans, subprime and not.

What Wall Street did was complicated, but the problems that it created are relatively simple. They took mortgage loans, packaged them into securitized vehicles, and sold them off to third party investors. This allowed lending banks to lend more because the securitizations took loans off of their books, and it also made investors more inclined to dip their toes into riskier credit profiles because they believed that the securitization vehicles were priced and structured such that they would still deliver acceptable returns.

Unfortunately, Wall Street used faulty assumptions -- like that the real estate market doesn't go down -- and so when the supposedly unthinkable started to happen, the value of all these securitized securities (most of us know them as MBSs, CDOs, etc) tanked. This caused cascading problems because many of these securities were rated very highly and therefore treated as gold by many banks, insurance companies, etc. The end result, among other things, is the credit lock-up that everyone is so scared of right now.

That's a very very brief overview of Wall Street's hand in this mess, but I certainly didn't want to ignore their handiwork. Now on to Main Street.

This is even simpler. If the core of the problem here is defaulting mortgages then we've got a heck of a lot of people out there that took out loans (which, remember, are agreements to pay back a certain amount of money) and decided not to pay them back. Easy as that. Now this is where the staunch defenders of Main Street come in with vehement arguments, so let's take a look at a few of them:

1) "But there was predatory lending!" -- I fully accept that there were lenders out there that were out and out fraudulent and hid details of the loans from people. But let's think about the scope of this mess and consider whether we really believe that there was really that much fraud out there. Without solid proof I'm very skeptical of that many predatory loans being foisted on people. In fact, I'll go ahead and give you 5% of the defaulting loans over the past couple years as predatory and fraudulent -- I think that's a pretty high percentage, but that still leaves 95% that we have to explain.

2) "People didn't understand the terms of the loan!" -- This argument just makes me shake my head. I think about the amount of research the average Joe Sixpack will do when trying to figure out what TV to buy and I wonder why we don't expect a commensurate amount of proactive research out of Joe Sixpack when he's looking to take out a loan for, say, $200,000. If you don't fully understand what you're signing your name to, why in the world would you borrow that kind of money??

3) "The mortgage brokers misled the buyers!" -- Fraud notwithstanding (see above for fraud), the mortgage brokers are salespeople. I'm not saying that they should be holding back information, but at the end of the day their job is to sell a loan to the home buyer, not make sure that the home buyer is getting the best deal possible. Referring back to #2, how many of those Joe Sixpack TV buyers implicitly trust the Best Buy salesmen? Yet they seem to expect that mortgage brokers are the guardians of their best interests.

I could go on, but I think you get the point. The bottom line is that I think we're overlooking the whole concept of personal responsibility when it comes to people taking out these huge loans. And when we talk about buying up faltering mortgage loans and renegotiating them with the home owner -- I mean, come on, talk about moral hazard!

Forgive me if this seems one-sided -- I do fully believe that most of the people that are defaulting should never have been given the money in the first place, let alone at the terms they got it on. But I think that when we're talking about the ingredients for the current mess it's a big mistake to leave the borrowers out of the equation, and that's exactly what has happened. Give Joe Sixpack a free ride and you're basically telling him that it's OK to take out a loan and then blame the lender when you realize that you got yourself in over your head.

Will the rhetoric change? Not a chance. During an election year (and really, what isn't an election year?) there's no way your going to hear anyone from the government scold the normal, everyday, hard working Americans. When they're getting ready to hit the voting booth, they can do no wrong!

So I'll keep cringing at the characterization of the current economic mess, but at least I've logged my protest. Am I selling out my fellow average Joes? I don't think so, I think I'm just asking for the best out of them. I think we can be a country that lives to a higher standard, and that means owning up to mistakes all around.

-AvgJoe

For the last time, this isn't just about Wall Street!

2008-10-08T16:03:00.000-07:00

Joe is on Twitter

2008-10-07T18:08:00.000-07:00

Brevity is in for Average Joe! Check out my new page on Twitter: http://twitter.com/KoppTheFool.

-AvgJoe

Cafferty on Palin

2008-09-30T14:27:00.000-07:00

I'm a little behind lately, but I just saw this reaction from Jack Cafferty to the answer that vice presidential hopeful Sarah Palin gave to a question about the $700 billion bailout package.

Now I try to leave politics out of this blog, but this is definitely a cross-roads between politics and and finance (and there's been a lot of that lately). I really can't add too much to what Cafferty said, the answer that she gave is really pretty pathetic and to an issue that will be one of the biggest facing the new administration -- whomever that will be.

Actually, it's kind of funny in a way. Watching her fumbling answer I was reminded of the investment banking interviews I did coming out of college. I studied economics in college and I didn't stray too far in my studies into finance, so I wasn't nearly as prepared as the business undergrads from my school. Being young, I also wasn't all that good at interviewing and didn't have the whole "if you don't know it, don't try and fake it" thing down.

Anyway, while watching Palin muddle through whatever the heck she was talking about, I literally could feel the nerves and stress that I got the few times that I did try to fake my way through an interview answer. Needless to say, the times that I faked it, it didn't work out well for me, and this catastraphic answer certainly hasn't worked well for Palin. I guess I'm just counfounded that her people didn't have her so, so, so ready for this question -- it's not like it came out of the blue.

I guess at least we got an absolutely hilarious SNL skit out of it...

-AvgJoe

The Bailout Plan

2008-09-28T15:36:00.000-07:00

I'm pretty bummed that I've been crazy busy lately and unable to post here as we go through what will likely be the most (or at least one of the most) memorable financial events that we'll see in our lifetimes. I'm encouraged that today it sounds like a deal has been struck that we can move forward on. And, yes, I said "encouraged," meaning that I am in support of the plan.

I'll keep it short and sweet, but here's how I feel about it. When somebody is sick and has an elevated fever, the first step is to treat the patient's fever so that it doesn't kill him before you have a chance to treat the underlying sickness. The financial system is currently burning up with fever and the Treasury's plan is aimed at bringing that fever back down. It won't fix the underlying problems that need to be addressed in the economy, but it will help quell the panic and allow us to address those issues (hopefully!).

Rather than try to reinvent the wheel, I'll direct you to this article from the AP that talks about the potential winners and losers from the plan being pushed through. I have some slight differences in places, but overall I like what they've said.

Tomorrow certainly will be interesting!

-AvgJoe

Yesterday's Oil Spike: More Than Meets the Eye

2008-09-23T11:40:00.000-07:00

Kind of like Transformers, yesterday's big spike in oil wasn't exactly what it seemed to be. In short, yesterday was the expiration of monthly oil contracts and it appears that traders decided to go after some players that were short going into expiration. The result was that you had a big pop as the short sellers rushed to cover and some people went long to try and play the big move.

It was funny to me that most media outlets didn't seem to pick up on this. Up to the end of the day, the AP articles on Yahoo!Finance were still saying that oil was getting bid up as a result of the $700 billion financial bailout plan. I have to give props to CNBC, though, because they were all over it -- probably one of the few useful things I've gotten from watching that manic channel.

Basically that's it, not much need for further explanation. Today, a quick check over at the Nymex shows that now that the new contracts are trading, we've got crude back at under $107 per barrel.

-AvgJoe

Oil Trader Reclassification

2008-08-05T15:08:00.000-07:00

Couldn't help but take notice of this article, which says that the Commodities Futures Trading Commission just revised its numbers on how much of the open interest on oil futures is held by speculators. The number was at 38% and they upped it to 48%. So nearly half of the open interest in NYMEX crude futures are held by speculators... yeah, no chance that speculators could be moving the market.

What's even more intriguing is the fact that the article says it looks like just one trader was reclassified in bringing up that number. They don't really give any more info on that, but if that's true, then it means that there's some really big money out there swinging at oil.

-AvgJoe

Loving the Bears

2008-07-31T08:36:00.000-07:00

What's my favorite part about the bears out there right now? This quote from a Bloomberg article today illustrates it well:

"The markets don't like it,'' said Peter Boockvar, an equity strategist at Miller Tabak & Co. in New York. "You listen to a market of optimists who think the worst is over and that it's gonna be OK, but this data is showing you it's not.''

Similar to Mr. Boockvar, most of the bears out there seem to think that they're in the minority, fighting to get the rest of the market to understand that there's trouble ahead. Maybe I'm reading the wrong news sources, but most of the news and commentary I'm reading these days is pretty pessimistic. Plus, as I noted back in June (and Merrill Lynch recently updated), fund managers are pretty darn bearish across the board.

And in case everyone forgot, the S&P is still down nearly 20% from its peak -- and last I checked stocks decline when more people are bearish than bullish. If we were surrounded by nutty optimists, I'd guess that we would've seen more of a recovery.

Now obviously I'm an optimist here, and so maybe I'm pulling the same stunt, but the cries of "oh, everything is terrible and nobody else besides me seems to understand that!" are getting a little old.

-AvgJoe

This Time It's Different?

2008-07-24T15:03:00.000-07:00

Ahh, that fateful phrase.

I'll keep it short and sweet here, and I'm likely not offering anything that you haven't heard before, so think of this more as a friendly reminder. For the seven years from 1973 to 1980 average annual oil prices rose about 690% or roughly 34% per year during that period. After the peak in 1980, oil spent the next eight years in decline and fell a total of 60%.

Over the past 10 years, the average price for oil is up around 720% (using average price for 2008 as opposed to current price), or roughly 24% per year.

I can already hear people saying that it's different this time because it's not an artificial supply side shock as in the 70s. Ok, could be... but I'm certainly not banking on it.

-AvgJoe

Cramer Addendum

2008-07-24T09:42:00.000-07:00

I couldn't help but share this to follow up on the previous blog post. Apparently now banks are a buy? Hmmm...

Don't get me wrong, I share Cramer's new view -- in fact, I own both Bank of America (NYSE: BAC) and American Express (NYSE: AXP). I just find it astonishing that his opinion changed that drastically in so short of a time. I can only assume that's a philosophical difference in investing based on fundamentals and investing based on timing the market.

But hey, how can you not love Cramer?

-AvgJoe

Cramer Calls a Bottom?

2008-07-21T08:36:00.000-07:00

I don't know how many people caught this, but I read the same article on TheStreet.com last week. In short, Jim Cramer got ultra bearish last Tuesday saying that there was little hope on the horizon and that there won't be a turn until we see a number of additional, high profile, bankruptcies. From the article:

The bottom line here -- there is too much going wrong right now, too much to put us anywhere near sound footing. I suspect that every rally will be met with selling until we see a multitude of collapses like IndyMac. ... Someone asked me yesterday, "When do we bottom?" I said it wouldn't be until all the banks that have to fail do so and GM files bankruptcy along with Ford. I said it matter-of-factly, because I meant it and because it is obvious.

As we know now, that article perfectly preceded the big rally in financials last week on the back of stronger than expected earnings from bank majors, including Wells Fargo (NYSE: WFC).
This week started off on a good note for the financials as well, with Bank of America (NYSE: BAC) also surprising to the upside.

If you've read much of this blog, then you know I don't do market timing and I won't be the one calling tops or bottoms. But if the market does recover from here, that will have been pretty bad timing for Cramer to have unleashed his inner polar bear.

-AvgJoe

Disclosure: I own shares of Bank of America.

Couldn't Help Myself: Yet More On Oil

2008-07-18T17:00:00.000-07:00

I couldn't just leave well enough along, right?

The reason for the additional post was the fact that I clicked through the Yahoo! Finance front page to this article.

Though I certainly wouldn't mind it if this week's price action was the sound of the oil bubble popping, I'm not primarily concerned with that (on a side note, the title of this article is fairly poor because we aren't told whether it's the biggest dollar drop ever or biggest percentage drop. Given the high price of oil, it wouldn't be nearly as impressive if it was simply the biggest dollar drop ever). What I am interested in, though, is some of the commentary in the article which again brings me back to my "oil is not being driven by supply and demand alone" thesis.

For instance:

"Some brave traders used the week's pullback in oil prices as a chance to buy barrels that suddenly seemed to be on sale. But oil analysts were advising investors to beware."

or

"Still, with oil recording yet another drop on Friday, some industry experts who just days ago thought there was more juice left in oil's meteoric run are reconsidering."

or

"'Buying here is an opportunity if you are a deep believer in $200 (a barrel), otherwise we think that caution would be better applied,' analyst Olivier Jakob of Petromatrix in Switzerland said in a research note."

Do these sound like commentaries on a global commodity market being driven by supply and demand or a frothy financial market that's being closely watched by traders? In fact, I looked up Petromatrix's website and here's a bit from the firm's description:

"After 15 years experience in the commodity trading industry we have created Petromatrix as we found the market lacking independent coverage of the oil markets. At Petromatrix we are not offering any financial or brokerage services, all we care about is reading the market right. ... Our clients include oil majors, trading companies, international banks, hedge funds, down to private individuals. They value our track record, our concise reports, our speed at delivering analysis, our trading focus and experience."

Sounds to me based on this that there are an awful lot of investing / speculative players out there looking for data on oil. Is it possible they're also participating in the market? And I have to imagine that Petromatrix is only one of many firms offering this type of independent coverage of oil price expectations.

Things that make you go hmmmmm...

-AvgJoe

More On Oil Prices

2008-07-18T14:43:00.000-07:00

Much to my chagrin, there isn't a whole lot of back-and-forth on my blog (though I'm surely at fault for that with my unreliable posting schedule), but there was a great response to my blog post yesterday about oil prices and I wanted to make sure to highlight it and respond.

I'm not going to pretend that a big part of the reason that I like the response isn't because it happens to agree with my own view. However, I think it does really underscore some of my own thinking. Here's what Michael over at The Macro & Micro has to say:

To answer your question - well you seem to have already done so - S/D have not changed that much... it is the speculation that has changed. While the economist suggests we not 'blame the speculators' (http://www.economist.com/opinion/displayStory.cfm?source=most_read&story_id=11670357), I still find myself disagreeing.

One line in the article "But they do so based on their expectations of future trends in supply and demand, not on whims." is frankly not true. Often speculator 'expectations' may be 'educated whims' - that are wrong. The index funds and the smarter players make a move and everyone else who knows nothing follows - typical herd mentallity.

For example:

1. "On January 17, 2006 crude oil for February delivery rose by USD 2.38 (3.7%) to USD 66.30 a barrel. This was the highest increase since early October 2005." (http://en.wikipedia.org/wiki/Oil_price_increases_of_2004-2006)

2. This jump was a futures market response to the Nigerian violence... in which a temporary 250,000 barrels per day was not produced from Nigeria.

3. According to the 'profit fromthe peak' front flap (I'm seriously considering this book), oil consumption is 86m barrels a day. 250,000 is not even 1 percent of that.. its like .3% - however oil prices rose 3%. less than .5% is barely a drop in the bucket, but the price raise was hardly warranted. It was speculation.

Can I say I couldn't agree more? One of the things I've tried to do is actually sit down and put together some sort of supply and demand curve (the stuff of Econ 101) for oil. Now I understand that it's hard to substitute in many of the places where oil is used, but frankly I couldn't come up with a reasonable graph that would explain the change in the price of oil over the past few years.

As for The Economist, yeah, that was pretty disappointing for me to read. The Economist is easily my single favorite publication ever and I can't help but think they missed the boat on this one. Is all the price action due to speculators? No. But I think there's a healthy margin that is. And as Michael pointed out, it's wrong to assume that all those buying and selling oil futures are fundamental driven investors looking at oil consumption and production statistics. You've got plenty of technical analysts and trend followers out there who are going to be basing their trading on price action and chart patters, not real supply and demand.

So, as I said before, I welcome responses and thoughts -- even if they differ from my own. We're talking about a huge global market here and so I certainly can't claim to have all the answers.

-AvgJoe

The Oil Price Conundrum

2008-07-17T16:44:00.000-07:00

Ok, so here's where my brain bends when it comes to oil prices and what's driving the spike. In a market that's driven primarily by supply and demand -- particularly a massive global market, like the one for oil -- I don't think it's crazy to expect relatively orderly price movements. Sure prices can move up or move down, and do either drastically, but if it's really supply and demand driving it either way, I'd expect to see those changes be spread over a period of time.

By contrast, in a market driven by some sort of speculative force, drastic price swings would be expected as speculators anxiously try to read the tea leaves and capture the maximum profit before pulling their parachute right at the top.

Now look at the price action of oil just over the past couple days. Have supply and demand conditions really changed that much to warrant such a big swing in price? And how about the price action of the past year, has supply and demand really diverged that much to cause (roughly) a doubling in price? (Judging by the statistics from BP I don't think so...)

I'd love to get readers opinions on this, so feel free to chime in the comment section below or send me an email and let me know what you think.

In the meantime, I'm about to crack open the review edition of Profit From the Peak that Wiley & Sons was nice enough to send over to me and see if that has the answers I'm looking for. I will be sure to let you all know what I think when I finish.

-AvgJoe