The Bull Case for Stocks
The Fed increased the target for the federal funds rate to 3.75% today. The Fed’s statement included: “Higher energy and other costs have the potential to add to inflation pressures.”
The market tanked. Everything on my “My Yahoo” page went from green to red in a moment.
High energy costs and increases in materials costs (most likely due to high energy prices) are causing the Fed to raise their target rate. And all of these factors are weighing on the market. But, I would argue, the risks are overblown.
The story goes: high energy prices slow down the economy but high energy prices also increase the price of goods and inflationary pressures. Soon, people start having nightmares of 1970s stagflation.
The Fed, by raising its target rate, said that the risks of inflation outweigh the risks of stagnation; or, alternatively, that it’s going to keep the same playbook despite the risks of stagnation due to the Hurricane. (I wonder: would we be concerned about stagnation instead of inflation if the Fed had not raised rates?)
High energy prices are being double-counted. They are leading to lower growth assumptions and higher discount rates (through a higher inflation assumption). So, if we buy stocks now we have a large upside if energy prices decline. Not a bad position given that energy prices should come down.
Based on recent articles I’ve read, the cost of producing a barrel of oil is somewhere between $25-35. From Econ 101, if the cost of production is less than the price, there should be more entrants, forcing the price down.
I have no clue how long it is going to take to be back in equilibrium — where the cost of production is equal to the price — but when it does, I bet the price will be lower than the $66 it’s trading at right now. And when oil prices go down, growth should increase, inflationary pressures should ease, and stocks should do well.
Of course, the worst could happen — our oil wells could run dry, new technology could not be developed to tap new fields, and new technology could not be developed to reduce our dependence on oil. But I wouldn’t bet on it.
An aside: I’m not good at economic forecasts and my timing is usually horrible, but I have done well over the long-run. Also, I don’t recommend trying to predict the direction of commodity prices but rules are made to be broken…
kocaar said,
September 21, 2005 @ 2:00 pm
You might want to take a look at where the S&P would be without the run up in the energy sector…
The focus on inflation has been on the “Core rate”. People are quick to take energy out of the inflation equation but don’t do so on the returns side. The S&P 500 would have lost over 7% this year without the gains made in energy.
This is a double edge that I don’t think a lot of people see. Yes it would be nice to see oil come down but there may be less up side to the market than people think.