There has been a curious delinkage in the marketplace for gasoline relative to the price of oil as it has run to new highs over the last week. The price of a barrel of crude is now above $80, yet the price of unleaded gas is just $2.50 locally. Last time oil was around $77/bbl, gas was running $3.50/gallon. So why would gas prices lag by one-third? Surely it is not out of a sense of altruism from the oil companies. They have consistently managed to keep the price hikes up with any excuse including higher oil prices over the last few years or more. But once the price of oil falls back down, gas prices take a lot longer to return to ‘normal’ allowing a nice long drink at the profit trough for the oil companies at consumers’ expense. Oil may be priced for fear and turmoil in the international political arena, but with several top producers spending every dollar of oil revenues, any price drops will incite production increases rather than the rational expectations of constraining supply. Venezuela and Russia are probably two of the oil producers who need revenues at current levels in order to avoid dipping into reserves to maintain spending policies. The issue, however, is that in Venezuela’s case there are no reserves to speak of suggesting that they will be among the irrational producers due to the imperative to maintain social programs or risk losing power to political rivals. Demand may also be tailing off if US economic conditions are in fact moving towards recession as the preponderance of data would suggest to us. If so then oil will take a big fall into ’08.

Money Supply (MZM) Model Chart

Source: Bloomberg Charts and Summit Analytic Partners Technical Research

The Fed elected not to pump up the market - a significant departure from Gspan – the Discount Cut today however is not…

Gas prices staying below typical parity to crude trading levels could be explained by softer US demand. As consumers get further into debt coupled with sub-prime initiated defaults spiraling higher on the back of housing woes, the ability to maintain previous spending on consumer items so necessary for economic growth to occur. If demand is slackening from consumers then some of the early indicators would likely be drops in restaurant sales, slower theater box office sales and negative retail comp sales statistics. All three appear to be operative at the moment. We have noticed a marked reduction in traffic on the last few weekends when travel normally is heaviest as well. Until more data becomes available, particularly jobs data which could be expected to drop more rapidly through the zero line that has served as a very reliable recessionary onset indicator over the last 60 years or so, then the demand thesis would gain credibility for why gas has evidently delinked from oil prices.

With the sub-prime crisis coming into full bloom with the resets of last summer now coming into a second round of resets to even higher levels than before for any consumer that could not find a way out of their ARM loan. But to exacerbate the situation a second class of mortgage holders have gotten their first round of resets; worse these new resets represent roughly 2.5x as many potentially troubled mortgages as last year’s crop which precipitated the sub-prime crisis to begin with. The second class receiving resets will now run into the same problems as last year’s class, only much bigger and on top of the existing problem. Our Double-Down thesis calls for as many as 70% of the total reset ARMs numbers to require higher payments than last year due to the 2^nd reset for last year’s class plus 2.5x more for this year’s class, minus the lucky few who were able to refinance out of ARMs due for resets. The balance of the 13.4m ARMs holders since 2003 have to live with sharply higher rates or walk away from their loans and their homes if they can't sell at prices at or above the loan amount.

The reality seems to be that any home purchased before 2004 and many of those bought in 2003 were at price levels that are underwater or very close to it given the approximately 20%-35% drop to what realtors call pre-’04 price levels. This fairly dramatic slide in pricing actually fits well with the notion that option ARM loans made it possible for buyers to afford homes that otherwise were well beyond what economics would suggest. So once the liquidity spigot was turned off then prices had to fall back to levels that preceded the irrational buyers at least. Over time we would expect, based on corrective periods in a number of markets that we have studied, that home prices will fall back down towards recession levels or the LT trend support lines from those lows before any sustainable rallies can occur. Until then it will likely be a bear market for housing with occasional corrective bounces and lots of foreclosures along the way. For the lucky cash-rich players, it’s a fortune in the making.

After a nasty slide in global liquidity signs are showing that liquidity will bounce back in time

Another theory may explain the delinkage of oil and gasoline pricing: inflation. With the rapid rise of inflationary pressures in the US economy, the willingness of foreign investors to hold dollar-denominated assets has fallen. The latest inflow report showed that even China has defected and turned into a net seller of US assets after standing alone for quite some time as other Central banks moved to diversify away from dollar holdings. The virtuous cycle of US over consumption fueled by recycling dollars back into the economy via foreign investment appears to have broken down after a remarkable 5 year run. Saudi Arabia has allowed its dollar peg to lag by not matching the rate cut from the Fed. This may be a clever middle ground but the effect is to cast into doubt the notion that the dollar can hold its ground. If other dollar pegs break then the selling pressure on the currency could spiral out of control. The consequences could be ominous leading the economy to run into credit constraints as liquidity dries up and consumption runs out of borrowing power. Still a fascinating aspect of the dollar chart is that a 2-yr wedge pattern is now exactly on the projection low target. If the wedge fulfills it could carry the dollar higher, to as much as 90+ on DXY. What would cause such a powerful rally? Perhaps an international incident or a major global bank going under due to sub-prime problems. It may not be so far fetched given Carlyle group’s July performance that wiped out 60% of the new money and took the fund down 24% YTD. And that was just July!

Once credit becomes restricted then over consumption must grind to a halt. Prices would then follow the housing example, dropping back to the level of sustainable demand as a first adjustment, but very probably not the last. Inflation erodes Central bank reserve holdings of dollars. China holds two Trillion dollars give or take and has big inflation problems of its own. Accordingly when dollar pegs like China and Argentina have to be adjusted subsequent to the Fed’s aggressive liquidity injections and rate cuts, the economies of pegged currencies must also cut rates in order to maintain the peg. The problem is that China is currently tightening its monetary policies fairly aggressively, not to mention raising taxes and other restrictive measures meant to cool inflation. For China to hold its peg, the government must allow inflation to heat up, obviously not a workable situation. Once the dollar pegs around the world break down, selling pressures are likely to accelerate rapidly. The euro and yen are the likely replacements for what dollar holdings remain in the developed countries’ Central banks.

The dollar hit resistance in what could be a very bullish wedge reversal pattern – but must sustain or risk a big drop ahead!

The implications of mass dollar selling are that US inflation will spike higher and asset values priced in dollars will fall; so too will the ability to maintain oil priced in dollars. The pricing of oil in dollars as inflation heats up means that crude must be priced higher than would normally be the case in order to maintain economic parity with the value of oil in other currencies. This relationship may explain the price rise of oil better than any other theory. American hegemony around the world will eventually follow the acceptance of its currency and the widespread use of its language. Barring changes to the current trajectory of Fed policy, inflation may be the straw that breaks America’s back relative to economic and political power around the world. A sobering thought.

What is needed is a strong dose of fiscal responsibility coupled with consumer prudence and discipline to reverse the huge mountain of debt that threatens to push the economy into a serious recession. The recession cannot be reasonably avoided but it can be managed. In order to return to health what the US needs is another Internet-like burst of economic activity such as the one that in a number of ways saved the day back in ’94 when the market was signaling a potentially nasty downturn. Where that comes from is beyond us but we can hope! Meanwhile the Fed remains the wild card, with the ability to disrupt trends, yet not sufficient to change them for any length of time. The risk as we see it is that the Fed elects to inflate the economy in order to try to avoid a recession. That would make the dollar the key indicator going forward. If the dollar does not rebound soon it will have entered an extremely bearish pattern that could have scope to significant devaluations ahead, perhaps as much as 15%-25%. The impact of such a devaluation would be to make dollar-based assets pariahs of the international investment community, driving prices sharply lower as everyone who can exit does so as quickly as possible. Without jobs growth beyond the breakeven level of almost 2.9m new jobs per year, wealth creation is difficult to accomplish. Lacking wealth creation of meaningful magnitude, paying down debt will take a long, long time much like Japan experienced from ’90 on until recent times. Hence the solutions appear to be far away while the problems are looming like icebergs while the bulls bravely soldier on but it may be a titanic in the making. For us the big question is whether the Fed can resist the political pressure to inflate away the debt problem, but at what cost.

The New Low model is pointing to a potentially significant sell off soon…

The bull case is that the Fed or the Canadians can actually solve the problem, or that the manifold issues confronting the economy and therefore the economy are not really that bad after all. The outcome of a successful foray by the Fed would be to rally the market, probably to new highs. The key will be a turn in the dollar, something that is definitely in the cards but has to be demonstrated, and soon or the pattern will revert to a bearish one. The driver behind a rallying dollar, and the formation if fulfilled would call for a powerful rally not just a bounce, will need to be a very significant one to move the economic needle. The scope of such a catalyst might be a combination of export strength, business investment and Fed intervention. The inflationary case is tougher to foresee but would likely make the SPX diverge further from gold while prices would rise in a ‘70s pattern of spiraling wage and cost hikes. Stocks can benefit from this type of debasement of the currency but would need to be able to pass on the full costs of inflation to the consumer. While we are doubtful about the veracity of this scenario, we cannot fully discount it away and have been caught on the wrong side of the equation more than once.

The SPX is positioned to make a potentially big move in the relatively near future. The downside case would be that wave-2 of a larger 3^rd wave from the July-highs. This scenario would unfold along the lines of a sub-prime crisis gathering steam perhaps from our Double-Down thesis where resets continue to rise sharply precipitating greater and greater numbers of defaults which in turn drive housing prices lower and consequently causing more defaults. The dollar again will be the key indicator along with vacancy rates for houses in the mid-sized cities around the Country. We checked in March and found a 10%-12% vacancy rate in five cities but that number may be considerably different today with the declines in new home sales and pricing in general. The housing stocks are scrambling to conserve cash and brokers may be doing the same. The risk is that a major bankruptcy occurs that reveals further fault lines in the economy. That the SPX has retraced considerably more than a normal bearish bounce would be expected to accomplish suggests that either this pattern is a wave-2 bounce rather than a bearish correction or that new highs are in the offing. So far the Put/Call ratio is acting much like it did in prior selloffs but the New High/Low data is hanging on the edge of a dilemma: if it recovers soon the signal would be a very bearish one calling for a significant selloff in the near future. If it breaks down or even stays the same for much longer then it will give an ‘all clear’ signal that the worst may be over at least for now.

SPX has arguably completed a 3-wave correction or wave-2 (up) but needs to confirm with a price drop soon

The Supply/Demand data is still bullish with strong price/volume but surprisingly weak momentum behind it. If this situation continues it would argue compellingly for a sell signal and selloff to follow. Pre-announcement season is a week away so there will be plenty of data points to drive the market reaction, but as before SarBox may delay some misses until regular earnings come out 3 weeks hence. Meantime we are watching the behavior of the SPX for clues as to the timing of an imminent turning point. The dollar may tell all, but oil and rates could as well.

RTW

A turn here could be the start of a wave-3 decline

The ’02 rally is close to the ’75-80 wave up arguing for an expanded flat count where wave-1 equals wave-5 then a bear market

Hourly S/D is on a sell signal – a selloff could follow soon

VAP is turning down – RSI made a lower high suggesting selling pressure is building up now

S/D is giving an extended buy reading – suggesting another down leg could be just ahead

VAP made a slightly higher high – Momentum has lagged badly perhaps presaging a downturn

Housing sold off seriously in the top twenty cities – the rate of decline is not materially slowing

Certifications and Disclosures

© 2007 Richard T. Williams, CFA, CMT
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Richard T. Williams, CFA, CMT
Senior Software Analyst
Summit Analytic Partners
Jersey City, NJ
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