Bull for President, Oil, and Fed Funds

by

Ross M. Miller
Miller Risk Advisors
www.millerrisk.com
June 7, 2004

This week, things become a two-ring circus. Rigged: The Novel of Financial Deception makes its debut with Chapter 1 over at RiggedOnline.com and here I will deal with some of the questions that have been directed at me in response to earlier commentaries. (Navigation buttons on the left-hand side of each page facilitate seamless navigation between the two sites.) In particular, I look at the November presidential elections, how hoarding affects the supply and demand of oil, and the probabilistic mathematics of the Fed funds futures.

Let me begin by noting what a huge difference eight weeks have made to the financial markets. When I started posting these commentaries, the central concern of the markets appeared to be what would happen after the November elections—it was taken as given that the vast right-wing conspiracy would prop everything up until then to keep the incumbent in office. Between the mess in Iraq and terror-influenced Spanish election, the concern has shifted from what happens after the elections to whether we can even survive until then.  I have been asked if I thought that a regime change in the U.S. might be a bad thing for the stock market, so I'll begin with the quick answer to that question.

If history is any indication, it does not matter which major-party candidate wins the election. Indeed, from an economic performance perspective, Democrats appear to have a slight edge. (Given the relatively few "modern" elections, changes in political party make-up, and the emergence of various third and fourth party candidates over the years, I am wary of drawing any conclusions from this sparse data.) Furthermore, legislative gridlock, which is extremely likely if the challenger wins, may be the best of all possible worlds for the U.S. economy, though again that may be reading too much into the data. A few analysts already take the ousting of the incumbent as a fait accompli and given the substantial evidence that a weak economy (and stock market) precedes any change in administration, they figure that we are in for a rough ride. But this argument may well reverse cause and effect. While incumbents are clearly at an electoral disadvantage when the economy and stock market are weak, it's not obvious that if the incumbent is vulnerable for largely non-economic reasons that the likelihood of his being voted out of office will hurt the economy or the stock market. Without wasting any more space on this matter, my bottom line is that there are better things to worry about.

Many people are worrying about crude oil, though the past week showed signs of sanity creeping into the market. Beyond the still-remote possibility of a supply disruption, there is a fundamental concern that the demand for oil fueled by global growth, especially in China and India, will outstrip the extractable supply, which some analysts (who invoke the name "Hubbert") think may already have happened. Having fastidiously avoided the myriad geology courses at Caltech because, to paraphrase Evan Dando, I'm not the outdoor type, I'm the last person to pontificate on the state of the world's oil reserves. I do, however, have something to say about the immediate supply and demand situation.

When the financial media write and talk about the increase in the demand for oil, they invoke images of the billions of people in China and India suddenly driving SUVs and depleting the world's oil supply like the last keg at an Aggies-Longhorns game. They ignore the fact that a good chunk of the current spike in demand is not actually being consumed, but is being hoarded either as a hedge against a future disruption in supply or for purely speculative purposes. If you like to think in terms of equations (and who doesn't), total demand = consumption demand + speculative demand.

The other thing that the media like to play up is that oil producers are already pumping at close to capacity and that they might have great difficulty supplying more oil even if they wanted to. What they overlook is that in the short-run the supply of oil can temporarily exceed what producers can pump out of the ground by a large amount. This is possible because yesterday's speculative demand (the stuff being hoarded) will become part of today's supply as soon as prices start falling. Of course, this added supply causes the price to fall farther and faster. Even if the world has a long-term problem with the supply of crude oil, that does not preclude a major rout in the energy markets in the short term.

The conceptual limitations of the financial media extend beyond supply and demand and into the realm of probability. This past week as the Fed funds rate implied by the July Fed fund futures hit 1.25%, certain prominent financial media outlets stated that this meant that there was a 100% probability of a 25-basis-point (bip) rate hike when the Fed meets at the end of June. Leaving aside the simple fact that there isn't a 100% probability of anything, not even of the sun rising tomorrow morning (the National Weather Service may bear some of the guilt for this 100% misinformation—they round their numbers to the nearest 10%, so a 96% precipitation probability becomes 100%), their math is just plain wrong. What they fail to consider is that the 1.25% also includes a real possibility of a 50-bip hike to 1.50%, which must be balanced by a nearly equal likelihood of no rate hike at all as well as the miniscule chance of a rate cut. Even now, with the futures pointing to a rate of 1.27%, which the media interpret this number as representing a 100% chance of a 25-bip hike and just a 8% chance of a 50-bip hike, it is still possible that the Fed won't hike rates, no matter what probabilities financial media reports.

To the extremely limited extent that I am able to think like Alan Greenspan (it makes my head hurt and gives me wrinkles), I am not sure why he would want to raise rates this month. From his public statements, Greenie thinks inflation is still contained. He could change his mind when May's PPI and CPI arrive, but the latest revision of the CPE, a Greenspan favorite, was encouraging. Furthermore, the economic growth and job creation numbers are not accelerating and may even have peaked. Still, a reasonable argument for a hike now is that the markets expect it and Greenspan will not only get away with it, but would upset the financial markets if he doesn't play the rate-hike card at the end of the month. Furthermore, by hiking rates by 25 bips now and then again in August (this is the consensus view of what constitutes a "measured" removal of policy accommodation) he has more arrows in his quiver if there is a "destabilizing event." (The conspiracy theorists out there see the recent rise in the money supply as a sure sign that the Fed has advance knowledge of an adverse event of truly monumental proportions that is in the works.) Given that May's employment numbers were healthy, if not up to the standards of March and April, I'm not willing to bet against the Wall Street consensus, but it is just worth noting that whatever the probability of June rate hike is, it is not 100%, not even by National Weather Service standards.

One should feel uncomfortable about applying any notion of probability to the actions of Alan Greenspan and his merry band of Fed Governors. They are neither roulette wheels nor approaching storm fronts, but rather human beings who presumably have some control over their actions or can acquire that control pharmaceutically. Next week, I will examine why only a fool would think that the world is ruled by randomness in my commentary, "Rigged, Not Random," which, of course, ties in with what is going on over at RiggedOnline.

Copyright 2004 by Miller Risk Advisors. Permission granted to forward by electronic means and to excerpt or broadcast 250 words or less provided a citation is made to www.millerrisk.com.