Matt’s Market Insights

Ahh … supply and demand, the two magical forces that free market capitalists hang their hat on. Conventional economics would tell us that the price of any asset is a function of supply and demand, and is typically set at the intersection of these two curves, see below. This relationship generally holds in the long-run, but short-term pricing has another component. You can call it psychology, emotions, or fear, whatever you like. In the short-run this intangible component can have a much larger impact on price than either supply or demand.

Let’s take a look at the price of oil as an example. With oil spiking to its highest level in nearly nine months, it begs the question: has supply tightened or has demand increased?

On the supply side, if we compare current conditions to 18 months ago when oil was about $90 per barrel, we find that supplies have increased. We currently have almost 30 million more barrels in storage now than back then. The US is also producing more oil than it ever has, with production up 15% during 2013 and up nearly 12% so far this year. Clearly supply restrictions are not the cause of higher prices.

Now what about oil demand? If the supply of oil has been increasing, it would follow from basic supply and demand principles that the higher price must be a result of increased demand that has outpaced supply. However, that’s not the case. The usage of gasoline in the US peaked in 2006 and has been trending down. As a result of improved technologies and standards, the US is using about 8% less gasoline now than back then.

Increasing supply and declining demand is the recipe for lower prices, so why is the price of oil skyrocketing? Because traders and speculators in the commodity are fearful and have driven prices up. So far not even one barrel of oil has been disrupted by either the situation in Ukraine or Iraq. But what has been disrupted is the peace of mind of energy traders. In anticipation of possible supply related problems, speculators have driven the price of oil above its natural equilibrium. If and when tensions de-escalate, we should see oil come back down a bit.

Even in “free markets,” it is not just supply and demand that matter. The expectations of supply and demand are just as important. After all, investors must position themselves for how supply and demand will be in the future, not now things sit currently.

Expectations are a strange thing, and erroneous distortions of those expectations may be even stranger. Let’s use last week’s Retail sales figures to explore this. Prior to the data being released, analysts were “expecting” a 0.7% increase in retail sales. When the “actual” retail sales increase was released, it came in at 0.3%. All day long I entertained articles and commentary about how retail sales were “weak,” and that this was a partial driver of lower stock prices. What it seemed as if no one was paying attention to, was that the prior month’s retail sales were revised higher from a 0.1% gain to a 0.5% gain. Had last month’s number not been revised higher, we would have seen the expected increase and analysts would have been content with “meeting” expectations. So much for logic.

Sometimes I think distorted perceptions like this are the result of our natural human tendency to force information to fit pre-existing biases and to enable us to maintain contiguous stories. We all rely on pattern recognition for survival and often perceive data and events in a manner that fits our personal views. We’re constantly telling ourselves a story of reality and if we have to tweak a few interpretations to make that story hold, so be it. It was a down day in the market so why not use the “weak” retail sales number as part of that explanation?

These types of distortions can be profitable. The real takeaway was that retail sales are doing fine. Those that misinterpreted this information are disadvantaged in that their read of the broader economy is weaker than what may otherwise be the case. I saw the retail sales figures and last month’s revision upward as indicative of a slowly but continually improving economy. But remember that I’m just as guilty of distorting my interpretations to fit my own biases and desires, so take my stance with a grain of salt!

Markets are trading mostly flat today as investors watch events unfold overseas and await the upcoming Fed meeting this week. Regarding the Fed meeting, there is little chance of any change in the pace of tapering. The new guessing game has to do with when the Fed will begin to raise rates. This has some folks terribly worried. Easy-money enthusiasts look at Fed tightening as nearly apocalyptic. I think Fed tightening, which may negatively impact asset prices across the board, will be beneficial in the long-run.

Prior to the housing run-up, the Fed had erred on the side of keeping rates too low for too long. This, combined with other problematic developments, helped fuel the housing bubble which ultimately collapsed. We now find ourselves in that same situation. With stocks back to new all-time highs and after years of substantial increases in home prices, it makes one wonder whether the time has come to back off the accelerator. I think the Fed will be very cautious about not throwing the economy back into recession, but it’s important the Fed gets off the zero bound prior to another economic slowdown. Their “fire power” is very much muted when interest rates are zero, which is why we’re seeing central banks experiment with exotic forms of stimulus.

The Dow and Transports are off their recent highs but look to be finding support. The last Dow Theory bull confirmation was provided last week when the Transports hit a new-high on Monday and the Dow followed suit on Tuesday. The only major average with a decisive move today was the Utilities, up almost 2%. Not surprising that defensive positioning is being favored while things sort themselves out abroad.

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