This week we see what oil has to do with the price of tea in China, what they both have to say about the US stock market and the implications for the ongoing recovery. Plus, we travel a little far afield, from Rotterdam to Saudi Arabia, Iran to Venezuela, and then end up in your back yard to see what you can do to shed some light in Myanmar. It will make for a very interesting e-letter.

Let's start at the School of Management at Erasmus University in Rotterdam. Three professors (Gerben Driesprong, Benjamin Maat and Ben Jacobsen) are circulating a paper that is an eye-opening study. (http://ssrn.com/abstract=460500) My good friend, Michael Williams, who is the Chairman of the Texas Railroad Commission (which is the state governmental agency which oversees the oil patch in Texas), sent me their paper.

The Connection Between Oil and Stock Prices

"We find that changes in oil prices strongly predict future stock market returns in many countries in the world... The impact of this predictability on stock returns tends to be large."

They point out that there is a whole host of papers on the effects of oil prices (especially shocks) and the economy. There has been little done relating oil prices and stock prices.

I called Professor Jacobsen and am going to summarize their paper and our conversation. First, let's look at what they actually analyzed.

Prior to 1973, looking at an oil price chart was boring. Things changed very little form year to year, as the "Seven Sisters" (the large oil companies) effectively managed oil pricing. Then, starting with the Yom Kippur war, the chart looks like an EKG on crack cocaine.

They analyze the stock markets of 18 major countries (in local currencies) and 33 emerging market countries. Using regression analysis, they compare the stock price data with various oil price indexes (Brent crude, West Texas Intermediate and Dubai) to see if there is any correlation.

It turns out there is. In 12 of the 18 countries, changes in oil prices significantly predict future market returns on a lagging monthly basis. Not surprisingly, a rise on oil price suggests a lower stock market and a drop in oil price infers a rise in stock prices. The magnitude of the oil price shift is also carried over into the magnitude of the expected increase/decrease in stock prices.

They checked the model for various times, to see if there was an "outlier" effect. By that we mean that the results could have been skewed because of some events in one period of time. The rest of the time there was no correlation. That does not seem to be the case. In any event, the effect is stronger in the later years.

What about the normal ebb and flow of the market and oil? We know that oil tends to rise in the summer as gasoline demand increases. We also know of the so-called "Halloween" effect or the May-September bias in the market. (Selling in May and buying in October is a known seasonal effect which can produce increased returns with lower volatility over time.) They also checked the January effect. Statistically, at least, you could not explain the correlation between stock and oil prices by those two factors.

The study then looks at whether you can use the price of oil as a "market timing" tool. The answer is that in many countries you can. Basically, the method they used had them either being long the market or in cash. While their methods were not intended to be a sophisticated timing model but rather a general indication, it is clear that paying attention to the price of oil can "add alpha" on returns over buy and hold. In some countries it tends to be quite significant.

I sent the paper to fellow analyst Greg Weldon, and he wrote the following in his letter this morning:

"Of specific interest from OUR perspective, are several conclusions:

Asia tends to be more insulated from oil price shocks, than Europe, by a factor of nearly 2-to-1, with Germany, Switzerland, Italy, Sweden, and the Netherlands being more vulnerable ... against which Japan, Singapore, and Hong Kong are LESS vulnerable, stock-market wise. The United States is the second MOST 'vulnerable', in terms of the potential negative influence on the broader stock market, via rising oil prices ... second only to the Netherlands. Further, within the dynamic as influences the US stock market, we note the following conclusions reached by the report: Cyclical Services are MOST negatively influenced when oil prices rise. Cyclical Consumer Goods are second most negatively influenced. Financials ... third most negatively influenced stock market sector.

"Indeed, there is BUT ONE macro-conclusion to be reached as a result of THEIR macro-sector conclusions ...OUR ORGINIAL thought process is VINDICATED ... as CONSUMER DISCRETIONARY spending takes the biggest hit. And thus it is ... amid LOW Savings, and ERODING income, and RECORD debt, that the US consumer is MOST vulnerable, at this moment in history, to rising oil prices."

(Greg has finally gotten some help. To learn more about his letter you can email weldonfinanical@comcast.net)

Let's look at the conclusion (and important question) the professors offer:

"We find strong evidence that changes in oil prices forecast stock returns. This predictability is especially strong in the developed markets in our sample countries and the world market index... and is robust over time and cannot be explained by [other market effects]. While one might expect that this predictability is related to the size of specific sectors in different countries we find this is not the case. The predictability tends to be country specific. This suggests that this is a macro economic phenomenon.

"It might be that this predictability is related to a lagged reaction of the market to the general impact of oil price changes in the different economies... But even if we are able to determine the source of the predictability, we have not idea why the financial markets react so slowly to this information in the oil price. That remains the real puzzle to be explained."

Now, before I sound too breathless, let me point out that this method, while adding alpha or excess returns over buy and hold, is still volatile as heck (that's a technical term) and is wrong over 40% of the time in most countries. It is just that when it is right, the returns are excessive. Which also means that there could be certain random entry/trend following variables, about which the professors would obviously not agree. To use this system you would have to be a very disciplined trader. It is probably more useful as something to keep an eye on than as opposed to using the system as a rigorous model.

But even given those caveats, the study clearly show that oil prices and stocks, especially if there are big moves in oil, tend to go in opposite directions.

The Effect of Oil on Muddle Through

From some time, I have been thinking the price of oil should come down. We all know the propensity of OPEC members to cheat. Indeed, only Indonesia and Venezuela are currently producing under quota, and not for lack of trying to cheat. OPEC is currently producing 1.22 million barrels of oil per day above their quotas. That is HUGE.

Every major oil producing region increased production in November. Iraq brought on more supply and is bringing on more if they can get the security on the oil pipeline fixed.

The world is awash in a tidal wave of oil. If you had asked me a year ago, given such production, where I thought the price of oil would be, I would have said down. In fact, if I go back and check the record, I probably predicted a drop in oil prices for this year. If I did not, I certainly privately thought so.

World wide demand is up as a recovery starts to manifest. The Wild Card? Can you say China, boys and girls? Marshall Steeves, oil analyst for Refco, told me that strong demand, especially from China and the US is pushing the price of oil up. Supplies are quite tight, he notes. Weldon tells us (where does he get his stats?) that refinery production capacity is at 94% and in California it is at 97%, even as the supply of gas in California is dropping. That is well above seasonal averages.

It is not just the price of gasoline. Heating oil prices are up and supplies are down. Natural gas is through the roof. In fact, I got this email from a public oil company executive today:

"You are a big proponent of hedge funds, but I'd like to know your thoughts on how the "hedge funds" (I hate to lump all together, but bear with me please) are apparently creating extraordinary volatility in the commodities markets (NYMEX), particularly natural gas. It appears that the pure speculative players are making a mockery of what the markets are to provide to users & sellers...that is a place to hedge actual use of product, be it selling or buying.

"It seems the speculators are only looking for movement, driving the prices up and down dramatically from day to day, mostly on the hype of the day, and totally without regards to any actual use. Further, it appears a large contention of speculation is coming from hedge funds.

"As a producer and user of natural gas (and crude oil), it is sickening to see so much activity and control of pricing in the hands of manipulative gamblers. Am I being too harsh on the hedge funds that engage in this commodity speculation? Thanks. Your writings are always interesting and insightful."

Frankly, Ken, I wish we could lay it at the feet of traders and hedge funds. Unfortunately, that is not the case.

Just like in oil, there is a clear trend of dwindling surplus supply in natural gas for the last six weeks. Traders and hedgies can clearly move markets in the short term, but supply and demand will win over time. The "specs" (speculative traders) simply add liquidity to the market. They are not large enough to move the market for more than a short period. And when there are violent swings, far more often than not it is from emotion and systematic driven trading than from the ability of funds to actually create any long term effect.

If we want the price of Natural Gas to go down, the answer is simple. Figure out how to produce more or reduce demand. If you are looking for blame, I would suggest our lack of a coherent national energy policy and over-regulation is far more of a factor than a few traders. We could cut gas demand by a huge factor whenever we want. We simply have to allow (and encourage) nuclear production of electricity in places besides Iran and North Korea. Or if you are of a more green persuasion, fund renewable and alternative sources of power. But that's a different letter.

The Oil Tax

In my discussion with Professor Jacobsen, as he was looking for a possible "transmission" mechanism for the relationship between oil and stocks, I suggested that he look at the effect of oil prices on consumer spending. Money spent by consumers on oil is not spent on other goods and services. That squeezes profits and sales on a host of businesses. It also increases the production and transportation costs of businesses, creating a double whammy on profits.

What did Greg note above? The stocks of cyclical services and cyclical consumer goods were the two areas most negatively affected by rising oil prices.

And now we come to the heart of the problem. If oil and energy costs continue to rise, this study suggests that the stock market could be in trouble over the next few months. Is it a perfect predictor of a drop? No. But it is just one more factor weighing on a market which is already at nosebleed valuations. Carl Swenlin (www.decisionpoint.com and one of my favorite sources for charts) shows that on a trailing basis, the S&P P/E ratio is now over 30, on a GAAP reporting basis. That is almost double the long term historical average.

As I noted last week, this economy is stimulus driven. Rising energy prices counter that stimulus. Indeed they are negative. Given that most countries are producing all the oil they can, it is hard to see where a significant increase in production is going to come from. Perhaps Saudi Arabia could be persuaded to squeeze out a few more barrels, but they are already running significantly above quota. Now, OPEC thinks demand will soften next year and Marshall Steeves thinks things might balance out, so a major rise does not seem likely (barring the ever present danger of a terrorist attacks, political unrest in Nigeria or Venezuela or any of the dozen odd places with lots of oil and poor populations).

But it also suggests that the stimulus I was hoping would come from a major drop in oil prices is becoming more of a wish than even a mere hope.

The Dollar and Oil

Note: Oil is priced in dollars. Europeans have not seen a rise in oil prices. Indeed, they have seen a significant drop in recent years. Those countries who have competitively devalued their currency against the dollar have seen their oil rise in price. How long before the rise in oil price becomes a real deterrent to growth and they are forced to let their currencies rise?

Some of the major buyers of dollars like China, Hong Kong, and Malaysia are pegged to the dollar. Other countries like Korea, Thailand, Taiwan and Singapore have hardly moved, aggressively keeping their currencies in check so as to be able to sell to the US consumer. This means they pay a double price for keeping the currencies low: they buy depreciating dollars and are forced to pay higher energy prices.

But this all brings up the problem of the dollar and ultimately the price (in dollar terms) of tea in China. Martin Wolf writes a very perceptive article in the Financial Times on the dilemma faced by the world. Quoting:

"In the old Bretton Woods era, there were just two groups of countries: the US and the rest. The US, as the core country, adjusted to the policies of everybody else until, in 1971, it ceased abruptly to do so. Today, however, the world economy is divided into three parts: the US is the first; in (Deutsche Bank analyst) Peter Garber's terminology, the "capital-account zone" is the second; and "the trade account zone" is the third. Countries in the capital-account zone target domestic monetary stability, while letting private capital flows set exchange rates. Countries in the trade-account zone fix exchange rates, while trying to sterilize the domestic monetary consequences.

"The objective of countries in the trade-account zone is growth. In Mr. Garber's words: "The fundamental global imbalance is not in the exchange rate. The fundamental global imbalance is the enormous excess supply of labor in Asia now waiting to enter the modern global economy. The exchange rate is only the valve that controls that rate of entry." In order to maximize growth, Asian mercantilists lend the US the money with which to purchase their surging exports. When they demand repayment, the US will devalue and so partially default. The Asian strategy is to grow by giving.

"Consider the implications of this tripartite division of the world economy. The US has a growing current account deficit, which has now reached 5 percent of gross domestic product. As these deficits have piled up, the country has become a huge net debtor. At the end of last year, net liabilities were 25 per cent of GDP. The structure of the external sector, together with the political imperative of full employment, or what economists call "internal balance", is driving these deficits. At recent dollar exchange rates, internal balance has been possible only in combination with a huge external imbalance.

"The growing external deficit appears to be structural: since 1990, US exports of goods and services have been growing at 5.7 per cent a year, in constant prices, while imports have been growing at 8.8 per cent. To avoid a continuing deterioration, one alternative is for the US to grow more slowly than the rest of the world. But Mark Cliffe of ING argues that it would need an 11 per cent fall in US GDP, relative to trend, to reduce the current account deficit to 2 per cent of GDP. It should go without saying that the US would not tolerate such a slump. There are two possible escapes from the recessionary trap: depreciation of the real exchange rate and faster growth in the rest of the world. But, according to Mr. Cliffe, it would take a 36 percent increase in the rest of the world's GDP, a 34 percent decline in the trade-weighted dollar, or some mixture of the two, to reduce the current account deficit to 2 per cent of GDP.

"So vast an increase in the rest of the world's relative GDP is infeasible. But depreciation is also at least partially blocked by the Asian mercantilists. In 2002 and the first half of 2003, foreign official purchases have financed a quarter of the US current account deficit. Between the beginning of 2002 and September 2003, Asian foreign currency reserves rose by $546bn. But the pressure on the US currency remains downward. It has been displaced, from the Asian mercantilists on to countries in the capital-account zone.

"Imagine, as a first possibility, that this continues, to give the US the overall depreciation suggested by Mr. Cliffe. Then the euro would be more than EUR1.60 to the dollar and the yen possibly back at 80. This would be a recipe for deflation in the eurozone and even deeper deflation in Japan.

"The second possibility is for members of the capital-account zone to join the Asian mercantilists in supporting the US currency. The monetary consequences would be expansionary. But though such an expansion would be welcome, it would be insufficient to reduce the US current account deficit. The result would be a faster global economic expansion, probably ending in worldwide overheating and a dollar collapse.

"The third, and most benign, possibility would be for the Asians to decide not to play this game much longer: the reserve accumulation is too large and the US political backlash against rising deficits too powerful. These countries would then let their currencies rise, not dramatically but by a good margin against the US dollar."

We are at an incredibly delicate point in time, not in terms of days but in terms of the next few years. The Fed, as noted here for some time, is trying to manage the decline in the dollar, keep rates low and also wanting to maintain an easy monetary policy. It is a very difficult process. They have managed to do all of the above so far. The world wishes them well, for the first two conditions described by Wolfe above would be pleasant for no one.

We will visit the implications of the continuing fall of the dollar many times over the coming year, as we have in past years. It is the dominant story of the economic period.

But now let's turn our minds and hearts to something more in keeping with the spirit of this time of year.

Turning on the Light in Myanmar

My good friend Walt Ratterman of Knightsbridge was recently struggling through the Myanmar jungle, smuggling medicines and a solar lighting system for a medical clinic into the country. Make no mistake, if he was caught by the Myanmar government on the wrong side of the border in Myanmar, he would not be coming back. He was bringing aid to the Christian Karen tribe, who are subject to severe persecution by their government. (For obvious reasons, we will not go into details as to how he got there. Let's just say that the word "struggling" does not adequately describe the process.)

To make a long story short, Walt is an expert on solar lighting systems. He was setting one up in a clinic deep in the jungle. He noted that the doctor in charge was going over the construction of the system in great detail. He asked his guide why the gentleman was so hung up over the details.

"He wants to know how to fix it and make sure he can keep it running. Let me show you a picture." He reached into his bag and pulled out a photograph of the doctor doing a leg amputation at night (the result of a land mine). The doctor was operating with a flashlight held in his mouth. "He understands more than you can imagine the value of light."

Think about that. Without going into details, there are doctors who fly in and bring medicines and training to these people. God Bless Them. But in addition to medicines, they need ten more solar lighting systems for their clinics.

It costs about $3,000 to buy a system and smuggle it into Myanmar on mule and human backs. These simple devices will save lives and much pain.

You can write a check for any amount and they need it. But some of us can write one for $3,000. We can sit back in our comfortable worlds and Walt and friends will do the heavy lifting, not to mention facing the very real danger. Every little bit helps. As you think about the need for a few more tax deductions this year, see if you can find a few dollars for Walt and Knightsbridge.

Make the check out to Knightsbridge International, and write "light" in the for line on the check. Send it to: Knightsbridge International, P.O. Box 4394, West Hills, California 91308-4394. Website is www.kbi.org and you can make online donations through Paypal.

Sir Ed Artis and the guys at Knightsbridge are the greatest of the good guys in the world. They travel the world, putting life at risk, going where few others dare to go, and they do not take a salary. They often pay their own expenses. They help lots of kids, but were also the first group into Afghanistan when the recent war started, bringing massive amounts of food and meds even while the bombs were dropping. They could do that because they had the local contacts, having been there before when no one cared about the northern Afghan tribes. National Geographic did an hour long feature story on Ed and the team. Check them out at the web site and then write a check. Of course, it is tax deductible. It will also add to your account in the hereafter. For some of us, we could use a little extra to balance our current deficits.

I know that a lot of newsletter writers read this letter. Bill, Addison, Richard, Porter, Steve, Mark? The rest of you? Come on guys, copy, paste and help raise a few bucks from our readers. And there are more than a few money managers and hedge funds who could pony up a few bucks. Let's light up Myanmar.

The Whole Clan and More

It's time to go. I have promised my bride a weekend away (maybe a little shopping), and it is time to put paid to the promise. Then the whole clan (all seven kids) will gather for Christmas. Having the kids under one roof again is such a true pleasure. I was talking about that simple joy today with Bill Bonner of Daily Reckoning fame, who also has six kids. His horde is migrating to Paris to be with him this year. There is no greater satisfaction. Although, he did get a great Christmas present as his book, Financial Reckoning Day, went to #1 on the New York Times business list this week. Congrats! It is a well-deserved reward.

There will be no letter next week, as I am going to actually take a few days off and spend time with the kids. Imagine that. But what more important thing to do? We can take up the cares of the world next year, but let's enjoy the blessings that God has given us in the here and now, without worrying about the global economic situation.

I want to give a special thanks to you, dear reader, for letting me come into your home (or office). I am grateful for the privilege, and take the honor you accord me with great seriousness. May God richly reward you in the New Year and have a very Blessed Christmas. Let's all resolve to spend more time with family and friends this next year.

Your expecting 2004 to be the best year ever analyst,

John Mauldin

P.S. If you like my letters, you'll love reading Over My Shoulder with serious economic analysis from my global network, at a surprisingly affordable price. Click here to learn more.

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