Thursday, February 5, 2015

S&P 500 & VIX Both At Highs: Who Blinks?

by Dana Lyons

We have written quite a bit about the behavior in the volatility indexes of late due to their noteworthy and in some cases, peculiar, behavior. Once again, these volatility indexes, like the VIX (Volatility Index on the S&P 500), measure the market’s expectations of future volatility. One example of peculiar behavior from the VIX was the subject of our Chart Of The Day today. The VIX and the S&P 500 (SPX) typically go in opposite directions. As stocks rise, the VIX normally declines and vice versa. Therefore, it is unusual to find both the VIX and the SPX near 52-week highs.


After bottoming in July, the VIX has been generally trending upward since. Smoothing out the spikes along the way by using its 10-week moving average (approximate 50-day moving average), we find the VIX trading at a 52-week high. At the same time, the S&P 500 is presently within 2% of its own 52-week high. This is an unusual circumstance that has occurred on just 4 other unique occasions since the VIX’s inception in 1986.

From early 1996 to late 1997, there were no fewer than 23 weeks that saw both the VIX 10-week moving average at a 52-week high and the SPX near its high as well. These occurrences followed one of the lowest volatility periods in the stock market’s history. Between 1993 and 1994, the S&P 500 traded within a total range of 11%. For perspective, the Flash Crash in 2010 saw the market nearly equal that range in one day. In 1995, the market broke out and trended upward in a rally so smooth, it makes 2013-2014 look like a roller coaster ride. That was the end of the historic low-volatility period, however.

Beginning in 1996, volatility began to rise. But not because of any significant market damage. Stocks continued their epic upside blowoff the rest of the decade, capping off the secular bull market. Volatility simply could not remain as low as it was in the mod-1990’s period. You could say that volatility expectations simply returned to more “normal” levels. You could also say that in the standoff between the two indexes at their highs, the VIX blinked, as the S&P 500 continued to power higher in the face of the rising VIX.

The other instances were a bit different. From 1998 to 2013, there were just 3 weeks that saw the VIX 10-day SMA at a 52-week high while stocks were also near a 52-week high. One week was in March 2000 and 2 were in September 2007. I probably don’t need to describe these two periods to observers (just peek at the chart in case you’re unsure of what I mean). Obviously the S&P 500 blinked on those two occasions as stocks immediately rolled over into cyclical bear markets. Those two instances were cases of volatility expectations rising (correctly) following 4-5 years of persistent stock market gains.

It is not our intent to “fear-monger” regarding the stock market’s prospects. Our M.O. is simply to point out what is happening and we are seeing a very similar development as in 2000 and 2007 currently. The market is almost in year 6 of a cyclical bull market and the VIX is beginning to rise, in spite of higher stock prices. 2000 and 2007 each saw the VIX bottom 8-10 months before the stock market topped. It has now been over 7 months since the July VIX low was put in. While the market does not need to follow the same pattern as the previous two tops (indeed, no 2 cycles are exactly the same), this is a characteristic that we saw at the 2000 and 2007 tops.

Perhaps the S&P 500 will roll right over this signal like it did in March of 2014. This occurrence is a bit different, however, in that the VIX is showing a much more demonstrative move higher. In our view, expectations for higher volatility ahead are clearly being demonstrated. Can the VIX and stocks co-exist at these levels for much longer? We doubt it. Odds are we’ll see one of them blink. And we would not be surprised if it is the stock market this time.

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3 Things - The 5.6% Lie, Dividend Cuts, Valuation

by Lance Roberts

Jim Clifton Strikes Again - 5.6% Unemployment Is A Lie

I recently published a piece analyzing Jim Clifton's, CEO of Gallup, comments regarding the potential overestimation of employment by the Bureau of Labor Statistics (BLS) due to the birth/death adjustment utilized. To wit:

"We are behind in starting new firms per capita, and this is our single most serious economic problem. Yet it seems like a secret. You never see it mentioned in the media, nor hear from a politician that, for the first time in 35 years, American business deaths now outnumber business births.

The U.S. Census Bureau reports that the total number of new business startups and business closures per year -- the birth and death rates of American companies -- have crossed for the first time since the measurement began. I am referring to employer businesses, those with one or more employees, the real engines of economic growth. Four hundred thousand new businesses are being born annually nationwide, while 470,000 per year are dying.

This is an extremely important point as it suggests that employment, as presented by the BLS, has been significantly overstated over the past six years. If we take the differential as stated by Gallup and compare that to the annual birth/death adjustment used by the BLS we find that jobs have been overstated by 3,678,000 or more than 613,000 annually.

How does this compare to the cumulative number of jobs as reported by the BLS since 2009? It is quite substantial."


Now, Jim Clifton is back stating that not only is BLS wrong in its assumptions about employment activity, but also that the 5.6% unemployment number is "extremely misleading."

"The official unemployment rate, as reported by the U.S. Department of Labor, is extremely misleading.

Right now, we’re hearing much celebrating from the media, the White House and Wall Street about how unemployment is 'down' to 5.6%. The cheerleading for this number is deafening. The media loves a comeback story, the White House wants to score political points and Wall Street would like you to stay in the market.

None of them will tell you this: If you, a family member or anyone is unemployed and has subsequently given up on finding a job -- if you are so hopelessly out of work that you’ve stopped looking over the past four weeks -- the Department of Labor doesn’t count you as unemployed. That’s right. While you are as unemployed as one can possibly be, and tragically may never find work again, you are not counted in the figure we see relentlessly in the news -- currently 5.6%. Right now, as many as 30 million Americans are either out of work or severely underemployed. Trust me, the vast majority of them aren’t throwing parties to toast 'falling' unemployment."

Of course, Jim is once again correct. Many arguments of low labor force participation rates have focused on the retirement of the baby-boomer generation. Therefore, to exclude that argument, even though those over the age of 65 that are currently employed is at the highest level on record, we can look solely at the group of individuals that should be actively employed (16-54 years of age.)  The following chart, which is the labor force participation rate of solely 16-54-year-olds, shows the real problem with the BLS's employment figures.


Considering that only 46% of that age group are currently employed suggests that an unemployment rate of just 5.6% is highly misleading.

Of course, you already knew that didn't you?

Dividend Cuts To Impact Personal Incomes

Political Calculations brought out a very interesting point recently discussing the rise in dividend cuts due to the deteriorating economic backdrop.  To wit:

"Going by the number of publicly-traded companies that acted to cut their dividends in January 2015, the U.S. economy didn't just experience recessionary conditions during the month. Instead, it outright contracted."


"Or perhaps a better description of what happened is that the U.S. oil industry's efforts to push its luck as far as it could has run out of good luck to push.

By that, we're referring to the consequences of falling oil prices, which are forcing an increasing number of companies tied to oil extraction activities in the United States to take the dramatic step of slashing their dividends. With 57 U.S. companies taking that action in January 2015, the number of companies taking that action in a single month is consistent only with previous months in which the U.S. economy either experienced contraction or in response to major dividend tax rate hikes.

January 2015 saw no major tax rate hikes on dividends, so contraction it is."

Importantly, another impact of the decline in dividend payout will be a reduction of the amount of dividend income that makes up part of the personal income and spending reports. The chart below shows the monthly net change of a few components of the personal income figure. Notice that in the most recent month personal interest income is negative due to the plunge in interest rates and dividend income was marginally positive.


Considering that the decline in oil prices is supposed to good for the consumer, even though personal spending declined in the most recently reported period, the decline in dividends will certainly have a negative effect on those depending on those dividends. As I showed recently, the current detachment between spending and the stock market will likely be corrected rather harshly at some point.


2nd Most Overvalued Market In History

I recently gave a presentation at the 2015 World Economic Conference (see full slide deck here) in which I discussed varying aspects of the market that should have investors fairly concerned. High yield spreads on the decline, extreme deviations from the long-term mean, and margin debt levels should all be at the top of the list.

One point I did not include, but should have, was noted recently by my dear friend Doug Short.

"The peak in 2000 marked an unprecedented 147% overshooting of the trend — nearly double the overshoot in 1929. The index had been above trend for two decades, with one exception: it dipped about 13% below trend briefly in March of 2009. But at the beginning of February 2015, it is 91% above trend, down from 95% above trend the month before. In sharp contrast, the major troughs of the past saw declines in excess of 50% below the trend. If the current S&P 500 were sitting squarely on the regression, it would be around the 1060 level. If the index should decline over the next few years to a level comparable to previous major bottoms, it would fall to the low 500 range."


"Incidentally, the standard deviation for prices above and below trend is 40.6%. Here is a close-up of the regression values with the regression itself shown as the zero line. I've highlighted the standard deviations. We can see that the early 20th century real price peaks occurred at around the second deviation. Troughs prior to 2009 have been more than a standard deviation below trend. The peak in 2000 was well north of 3 deviations, and the 2007 peak was above the two deviations -- as is our current level."

As I stated during my presentation, we can certainly "hope" that the markets will continue to march endlessly higher. However, "hope" has never been an effective portfolio management strategy.

See the original article >>

Charts showing the long-term GDP-energy tie (Part 2 – A New Theory of Energy and the Economy)

by Gail Tverberg

In Part 1 of this series, I talked about why cheap fuels act to create economic growth. In this post, we will look at some supporting data showing how this connection works. The data is over a very long time period–some of it going back to the Year 1 C. E.

We know that there is a close connection between energy use (and in fact oil use) and economic growth in recent years.

Figure 1. Comparison of three-year average growth in world real GDP (based on USDA values in 2005$), oil supply and energy supply. Oil and energy supply are from BP Statistical Review of World Energy, 2014.

Figure 1. Comparison of three-year average growth in world real GDP (based on USDA values in 2005$), oil supply and energy supply. Oil and energy supply are from BP Statistical Review of World Energy, 2014.

In this post, we will see how close the connection has been, going back to the Year 1 CE. We will also see that economies that can leverage their human energy with inexpensive supplemental energy gain an advantage over other economies. If this energy becomes high cost, we will see that countries lose their advantage over other countries, and their economic growth rate slows.

A brief summary of my view discussed in Part 1 regarding how inexpensive energy acts to create economic growth is as follows:

The economy is a networked system. With cheap fuels, it is possible to leverage the expensive energy that humans can create from eating foods (examples: ability to dig ditches, do math problems), so as to produce more goods and services with the same number of workers. Workers find that their wages go farther, allowing them to buy more goods, in addition to the ones that they otherwise would have purchased.

The growth in the economy comes from what I would call increasing affordability of goods. Economists would refer to this increasing affordability as increasing demand. The situation might also be considered increasing productivity of workers, because the normal abilities of workers are leveraged through the additional tools made possible by cheap energy products.

Thus, if we want to keep the economy functioning, we need an ever-rising supply of cheap energy products of the appropriate types for our built infrastructure. The problem we are encountering now is that this isn’t happening–more energy supply may be available, but it is expensive-to-produce supply. Our networked economy sends back strange signals–namely inadequate demand and low prices–when the cost of energy products is too high relative to wages. These low prices are also a signal that we are reaching other limits of a networked economy, such as too much debt and taxes that are too high for workers to pay.

Looking at very old data – Year 1 C. E. onward

Some very old data is available. The British Economist Angus Maddison made GDP and population estimates for a number of dates between 1 C. E. and 2008, for selected countries and the world in total. Canadian Energy Researcher Vaclav Smil gives historical energy consumption estimates back to 1800 in his book Energy Transitions – History, Requirements and Prospects.

If we look at the average annual increase in GDP going back to the Year 1 C. E., it appears that the annual growth rate in inflation-adjusted GDP peaked in the 1940 to 1970 period, and has been falling ever since. So the long-term downward trend in world GDP growth has lasted at least 44 years at this point.

Figure 2. Average annual increase in GDP per capita, based on work of Angus Maddison through 2000; USDA population/real GDP figures used for 2000 to 2014.

Figure 2. Average annual increase in inflation-adjusted GDP, based on work of Angus Maddison through 2000; USDA population/real GDP figures used for 2000 to 2014.

A brief synopsis of what happened in the above periods is as follows:

  • 1 to 1000 – Collapse of several major civilizations, including the Roman Empire. Metal was made using charcoal from wood, but this led to deforestation and soil erosion. Egypt and the Middle East had extensive irrigation of crops using river water. Some trade by ship. Most of the population were farmers.
  • 1000 to 1500 – Early use of peat moss for heat energy for industrialization, particularly in Netherlands, leading to increased trade. Continued use of wood in cold countries, with deforestation issues.
  • 1500 to 1820 – European empire expansion to the New World and to colonies in Africa, allowing world population to grow. Britain began using coal. Netherlands added wind turbines beside greater use of peat moss.
  • 1820 to 1900 – Coal allowed metals to be made cheaply. Parts of farm work could be transferred to horses with greater use of metal tools. Coal allowed many types of new technology including hydroelectric dams, trains, and steam powered boats.
  • 1900 to 1940 – Expanded use of coal, with beginning use of oil as a transportation fuel. Depression was during this period.
  • 1940 to 1970 – Post war rebuilding of Europe and Japan and US baby boom led to hugely expanded use of fossil fuels. Antibiotic use began; birth control pills became available. Food production greatly expanded with fertilizer, irrigation, pesticides.
  • 1970 to 2000 – 1970 was the beginning of the great “oops,” when US oil production started to decline, and oil prices spiked. This set off a major push toward efficiency (smaller cars, better mileage) and shifts to other fuels, including nuclear.
  • 2000 to 2014 – Another big “oops,” as oil prices spiked upward, when North Sea and Mexican oil began to decline. Much outsourcing of manufacturing to countries where production was cheaper. Huge financial problems in 2008, never completely fixed.

Growth in GDP in Figure 2 generally follows the pattern we would expect, if fossil fuels and earlier predecessor fuels raised GDP and the great “oopses” during the 1970-2000 and 2000-2014 periods reduced economic growth.

Population Growth vs Growth in Standard of Living

GDP growth is composed of two different types of growth: (1) population growth and (2) rise in the standard of living (or per capita GDP growth). We can look at these two kinds of growth separately, using Maddison’s data. My discussion earlier about cheap energy having a favorable impact on the amount of goods an economy could create relates primarily to the second kind of growth (rise in the standard of living). There would be a carry-over to population growth as well, because parents who have more adequate resources can afford more children.

If we compare the population growth pattern in Figure 3 with the total GDP growth pattern shown in Figure 2, we notice some differences. One such difference is the lower population growth rate in the 2000-2014 period. Compared to the period before fossil fuels (generally before 1820), the population growth rate is still exceedingly high.

Figure 3. Average annual increase in world population, based on work of Angus Maddison through 2000; USDA population figures used for 2000 to 2014.

Figure 3. Average annual increase in world population, based on work of Angus Maddison through 2000; USDA population figures used for 2000 to 2014.

If we look at world per capita GDP growth by time-period (Figure 4), we see practically no growth until the time of fossil fuels–in other words, 1820 and succeeding periods.

Figure 4. Average annual increase in GDP per capita, based on work of Angus Maddison through 2000; USDA population/real GDP figures used for 2000 to 2014.

Figure 4. Average annual increase in GDP per capita, based on work of Angus Maddison through 2000; USDA population/real GDP figures used for 2000 to 2014.

In other words, in these early periods, civilizations were often able to build empires. Doing so seems to have allowed greater population and more building of cities, but it didn’t raise the standard of living of most of the population by very much. If we look at the earliest periods, (Years 1 to 1000; 1000 to 1500, and even most places in 1500 to 1820), the average per capita income seems to have been equivalent to about $1 or $2 per day, today.

I earlier showed how world per capita energy consumption has grown since 1820, based on the work of Vaclav Smil (Figure 5).

Figure 5. World Energy Consumption by Source, Based on Vaclav Smil estimates from Energy Transitions: History, Requirements and Prospects together with BP Statistical Data for 1965 and subsequent divided by population estimates by Angus Maddison.

Figure 5. World Energy Consumption by Source, Based on Vaclav Smil estimates from Energy Transitions: History, Requirements and Prospects together with BP Statistical Data for 1965 and subsequent divided by population estimates by Angus Maddison.

It is clear from Figure 5 that the largest increase in energy consumption came in the 1940 to 1970 period. One thing that is striking is that world population took a sharp upward turn at the same time more fossil fuel use was added (Figure 6).

Figure 6. World population growth, based on data of Angus Maddison.

Figure 6. World population growth, based on data of Angus Maddison.

While this increase in population holds for the world in total, analyzing population growth by country or country grouping yields very erratic results. This is true all the way back to the Year 1. If we look at percentages of world population at various points in time for selected countries and country groups, we get the distribution shown in Figure 7.  (The list of country groups shown is not exhaustive.)

Figure 7. Share of world population from Year 1 to 2014, based primarily on estimates of Angus Maddison.

Figure 7. Share of world population from Year 1 to 2014, based primarily on estimates of Angus Maddison.

Part of what happens is that economic collapses (or famines or epidemics) set population back by very significant amounts in local areas. For example, Maddison shows the population of Italy as 8,000,000 in the Year 1, but only 5,000,ooo in the Year 1000, hundreds of years after the fall of the Roman Empire.

Per capita GDP for Italy dropped by half over this period, from about double that of most other countries to about equivalent to that of other countries. Thus, wages might have dropped from the equivalent of $3.oo a day to the equivalent to $1.50 a day. None of the economies were at a very high level, so most workers, if they survived a collapse, could find work at their same occupation (generally farming), if they could find another group that would provide protection from attacks by outsiders.

If we look at the trend in population shown on Figure 7, we see that the semi-arid, temperate areas seemed to predominate in population in the Year 1. As peat moss and fossil fuels were added, population of some of the colder areas of the world could grow. These colder areas soon “maxed out” in population, so population growth had to slow down greatly or stop. The alternative to population growth was emigration, with the “New World” growing in its share of the world’s population and the “Old World” contracting.

Each part of the world has its own challenges, from Africa’s problems with tropical diseases to the Middle East’s challenges with water. To the extent that work-arounds can be found, population can expand. If the work-around is cheap (immunization for a tropical disease, for example), population may be able to expand with only a small amount of additional energy consumption.

One point that many people miss is that Japan’s low growth in GDP in recent years is to a significant extent the result of low population growth. In the published GDP figures we see, no distinction is made between the portion that is due to population growth and the portion that is due to rise in the standard of living (that is, rise in GDP per capita).

Growth in Per Capita GDP in the “Advanced Economies”

As noted above, the big increase in per capita energy use shown in Figure 5 came in the 1940 to 1970 period. No breakdown by country is available, but this period includes rebuilding period after World War II for Europe and Japan, and the period with a huge increase in consumer debt in the United States. Thus, we would expect those three country/groups would benefit disproportionally. In fact, we see very large increases in per capita GDP for these countries, as fossil fuels were added, particularly oil.

Figure 8. Average increase in per capita GDP for the United States, Western Europe, and Japan, based on work of Angus Maddison.

Figure 8. Average increase in per capita GDP for the United States, Western Europe, and Japan, based on work of Angus Maddison for 2000 and prior, and USDA real GDP and population data subsequent to that date.

These three economies (Western Europe, USA, and Japan) are all fairly high users of oil. If we look at long-term world oil production versus price (Figure 9), we see that growth in consumption was rising rapidly until about 1970.

Figure 9. World oil consumption vs. price, based on BP Review of World Energy data after 1965, and Vaclav Smil data prior to 1965.

Figure 9. World oil consumption vs. price based on BP Review of World Energy data after 1965, and Vaclav Smil data prior to 1965.

In fact, if we calculate average annual increase in oil consumption for the periods of our analysis, we find that they are

  • 1900 to 1940 – 6.9% per year
  • 1940 to 1970 – 7.6% per year
  • 1970 to 2000 – 1.5% per year
  • 2000 to 2013 – 1.1% per year

Growth in oil production “hit a wall” in 1970, when US oil production unexpectedly stopped growing and started declining. (Actually, this pattern had been predicted by M. King Hubbert and others). Oil prices spiked shortly thereafter. The situation was more or less resolved by making a number of changes to the economy (switching electricity production from oil to other fuels wherever possible; building smaller, more fuel efficient vehicles), as well as ramping up oil production in places such as the North Sea, Alaska, and Mexico.

Oil prices were brought down, but not to the $20 per barrel level that had been available prior to 1970. Most of the infrastructure (roads, pipelines, electrical transmission lines, schools) in the USA, Europe, and Japan had been built with oil at a $20 per barrel level. Changing to a higher price level is very difficult, because repair costs are much higher and because an economy that uses very much high-priced oil in its energy mix is not competitive with countries using a cheaper fuel mix.

Figure 10. Percentage of energy consumption from oil, for selected countries/groups, based on BP Statistical Review of World Energy 2014 data.

Figure 10. Percentage of energy consumption from oil, for selected countries/groups, based on BP Statistical Review of World Energy 2014 data.

In the 2007-2008 period, oil prices spiked again, leading to a major recession, especially among the countries that used very much oil in their energy mix. With these higher prices, the leveraging impact of oil in bringing down the cost of human energy was disappearing. All of the “PIIGS” (countries with especially bad financial problems in the 2008 crisis) had very high oil concentrations, up near Greece on the chart above. Japan’s oil consumption was very high as well, as a percentage of its energy use. When we looked at the impact of the recession, the countries with the highest percentage of oil consumption in 2004 had the worst economic growth rates in the period 2005 to 2011.

Figure 11. Average percent growth in real GDP between 2005 and 2011, based on USDA GDP data in 2005 US$.

Figure 11. Average percent growth in real GDP between 2005 and 2011 for selected groups, based on USDA GDP data in 2005 US$.

Getting back to Figure 9, after the financial crisis in 2008, oil prices stayed low until the United States began its program of Quantitative Easing (QE), helping keep interest rates extra low and providing extra liquidity. Oil prices immediately began rising again, getting to the $100 per barrel level and remaining about at that level until 2014. The combination of low interest rates and high prices encouraged oil production from shale formations, helping to keep world oil production rising, despite a drop in oil production in the North Sea, Alaska and Mexico. Thus, for a while, the conflict between high prices and the ability of economies to pay for these high prices was resolved in favor of high prices.

The high oil prices–around $100 per barrel–continued until United States QE was tapered down and stopped in 2014. About the same time, China made changes that made debt more difficult to obtain. Both of these factors, as well as the long-term adverse impact of $100 per barrel oil prices on the economy, brought oil price down to its current level, which is around $50 per barrel (Figure 10). The $50 per barrel price is still very high relative to the cost of oil when our infrastructure was built, but low relative to the current cost of oil production.

Figure 12. World Oil Supply (production including biofuels, natural gas liquids) and Brent monthly average spot prices, based on EIA data.

Figure 12. World Oil Supply (production including biofuels, natural gas liquids) and Brent monthly average spot prices, based on EIA data.

If a person looks back at Figure 9, it is clear that high oil prices brought oil consumption down in the early 1980s, and again for a very brief period in late 2008-early 2009. But since 2009, oil consumption has continued to rise, thanks to high prices and the additional oil from US shale.

The low prices we are now encountering are a message from our networked economy, saying, “No, the economy cannot really afford oil at this high a price level. It looked like it could for a while, thanks to all of the financial manipulation, but this is not really the case.” Meanwhile, we see in Figure 8 that for the combination of the EU, USA, and Japan, growth in per capita GDP has been very low in the period since 2000, reflecting the influence of high oil prices on these economies.

Growth in Per Capita GDP for Selected Other Economies

In recent years, per capita GPD growth has shifted dramatically. Figure 13 below shows increases in GDP per capita for selected other areas of the world.

Figure 13. Average growth in per-capita GDP for selected economies, based on work of Angus Maddison for Year 1 to 2000, and based on USDA real GDP figures in 2010 US$ for 2000 to 2014 .

Figure 13. Average growth in per-capita GDP for selected economies, based on work of Angus Maddison for Year 1 to 2000, and based on USDA real GDP figures in 2010 US$ for 2000 to 2014.

The “stand out” economy in recent growth in GDP per capita is China. China was added to the World Trade Organization in December 2001. Since then, its coal use, and energy use in general, has soared.

Figure 14. China's energy consumption by source, based on BP Statistical Review of World Energy data.

Figure 14. China’s energy consumption by source, based on BP Statistical Review of World Energy data.

If we calculate the growth in China’s energy consumption for the periods we are looking at, we find the following growth rates:

  • 1970 to 2000 – 5.4% per year
  • 2000 to 2013 – 8.6% per year

A major concern now is that China’s growth rate is slowing, in part due to debt controls. Other factors in the slowdown include the impact pollution is having on the Chinese people, the slowdown in the European and Japanese economies, and the fact that the Chinese market for condominiums and factories is rapidly becoming “saturated”.

There have been recent reports that the factory portion of the Chinese economy may now be contracting. Also, there are reports that Chinese coal consumption decreased in 2014. This is a chart by one analyst showing the apparent recent decrease in coal consumption.

Figure 15. Chart by Lauri Myllyvirta showing a preliminary estimate of 2014 coal consumption in China.

Figure 15. Chart by Lauri Myllyvirta showing a preliminary estimate of 2014 coal consumption in China.

Where Does the World Economy Go From Here?

In Part 1, I described the world’s economy as one that is based on energy. The design of the system is such that the economy can only grow; shrinkage tends to cause collapse. If my view of the situation is correct, then we need an ever-rising amount of  inexpensive energy to keep the system going. We have gone from trying to grow the world economy on oil, to trying to grow the world economy on coal. Both of these approaches have “hit walls”. There are other low-income countries that might increase industrial production, such as in Africa, but they are lacking coal or other cheap fuels to fuel their production.

Now we have practically nowhere to go. Natural gas cannot be scaled up quickly enough, or to large enough quantities. If such a large scale up were done, natural gas would be expensive as well. Part of the high cost is the cost of the change-over in infrastructure, including huge amounts of new natural gas pipeline and new natural gas powered vehicles.

New renewables, such as wind and solar photovoltaic panels, aren’t solutions either. They tend to be high cost when indirect costs, such as the cost of long distance transmission and the cost of mitigating intermittency, are considered. It is hard to create large enough quantities of new renewables: China has been rapidly adding wind capacity, but the impact of these additions can barely can be seen at the top of Figure 14. Without supporting systems, such as roads and electricity transmission lines (which depend on oil), we cannot operate the electric systems that these devices are part of for the long term, either.

We truly live in interesting times.

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Are Emerging Markets Ready for the Housing Earthquake?

by Alessandro Rebucci

In some parts of the emerging world, housing markets have grown well ahead of income in recent years. US interest rates are about to rise, and international capital will revert to the center, seeking higher and safer yields. This will bring about an earthquake in housing markets at the periphery of the global financial system.

Since the 2008-09 global financial crisis, housing markets around the world have cruised at different speeds. While in many advanced economies they either contracted or stagnated, housing prices in emerging markets recovered quickly and kept rising.

According to the Global Housing Watch of the IMF (Figure 1), for instance, house prices (and credit) in Brazil, China, and Turkey are still running well ahead of inflation, even though income growth has long slowed in these economies. Particularly worrisome in Brazil and Turkey, inflation is high and the current account deficit is quite large; these economies are still overheating and relaying on foreign borrowing to spend beyond their means. In contrast, prices in India and Russia are falling as domestic problems have already poked the housing bubble.

China’s fundamentals are seemingly more solid. But the occasional hiccups in the domestic financial systems and the erratic policy response of the central bank remind us that the ongoing transformations are challenging and far from complete. Liberalizing the financial system while rebalancing growth toward consumption with high debt and an overvalued housing market is difficult at best. It could easily turn into a systemic threat to financial stability if the easy credit policy that supports demand fails to perform the rebalancing act.

The Fed is about to raise interest rates for the first time since December 2008 when it took them to zero to fight the crisis. The US economy could be approaching full capacity and some wage pressures have already started to surface, although headline inflation remains subdued partly thanks to falling energy prices. Asset prices are at all time high while credit growth has picked up. These are all healthy signs of a rehabilitated economy capable of standing on its feet. And the Fed is worried about falling beyond the curve, repeating the mistake of 2002-04 when it raised rates too little and too late.

Historically, when the Fed tightens, capital flows reverted to the center causing earthquakes at the periphery. The ignominious Tequila crisis was preceded by a sequence of US interest rate increases, the second last and the largest of which was in November 1994. Mexico was caught off guard: after an ill-conceived attempt to defend the exchange rate earlier that year, on December 20 it capitulated under a massive speculative attack and devalued its currency in the midst of the deepest recession since the 1982 debt crisis. The banking system went under a wave of mortgage defaults triggered by the sudden increases in interest rates and unemployment. The mortgage market never recovered completely.

When capital flows out, house prices tumble, the current account balance suddenly swings into surplus, and consumption has to adjust dramatically. Loosening domestic monetary conditions and depreciating exchange rate can help cushion the blow. If borrowing is in foreign currency, however, there is only so much that can be done other than painful adjustment, like in the case of Mexico in 1994.

With limited scope for rescuing the economy after a crash, the best that can be done is to try to engineer an orderly housing correction before it is too late. Tightening the regulatory parameters of the financial system in a precautionary manner—the so-called macro-prudential policies—is one way to go. This would not only cool off housing and credit markets, but would also put them on more solid footings to face the financial earthquake that is about to come.

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The Lesson of Greece: Only Collapse Makes Real Change Possible

by Charles Hugh Smith

Of the many lessons we can learn from Greece's difficult path to rejection of debt-serfdom, the most important is perhaps the most obvious: no real change is possible until the Status Quo can no longer fulfill its promises, i.e. it effectively collapses.

The collapse of the Status Quo has two distinct features: the process is highly variable, and the process affects the social classes in different ways.

The process of collapse is neither sudden nor smooth. Things do not necessarily cease to function overnight; rather, the decline to effective collapse operates much like energy states in physics: systems decay and then drop to a lower energy level, where they are stable until further decay causes the next drop to an even lower level.

Pension payments provide a ready example. The pension payment is reduced, and the recipient tightens his/her belt and gets by. The next reduction (either outright or via inflation) forces drastic changes in consumption, and subsequent reductions reduce the pension to a supplement that cannot possibly support a retiree, much less their family.

The pension is still issued, but the promise of a pension that could support a household at a modest level of consumption has collapsed. Though the system for issuing pensions still exists, it no longer fulfills the original purpose.

In this sense, the collapsed pension system becomes much like the phantom legions of the late Roman Empire: the paymasters and officers still received the legion's pay, but there were no real soldiers; the legion was a bookkeeping entry in a skimming operation, not a fighting unit.

The financial Aristocracy (i.e. the kleptocracy) in Greece avoided much of the pain of debt-serfdom. What's the point of running things if you can't distribute the pain to others? I addressed this is Greece at the Crossroads: the Oligarchs Blew It (January 27, 2015).

The powerless classes were stripmined first. Bamboozled into voting for the Kleptocracy in previous elections, the powerless lower classes felt the brunt of austerity for the simple reason the kleptocracy knew there would be no blowback, as long as a few shreds of swag were being distributed.

This highlights the critical role of complicity in maintaining a corrupt, venal and parasitic kleptocracy: the passivity and silence of recipients of social welfare are bought very cheaply, as these classes will fear the loss of the miserable coins tossed to them.

This fear is a potent form of financial terrorism: any resistance or protest might trigger the loss of the reduced social welfare benefits, and so the powerless choose to remain powerless rather than rise up and take the risk of bringing down the parasitic kleptocracy.

The statist bourgeoisie (a.k.a. state-funded upper middle class) were the last to lose faith in the kleptocracy, for the simple reason that their share of the swag was sufficient to maintain the facade of middle-class comfort. It was also enough to sustain the illusion that the kleptocracy's abject kow-towing to the Lords of the European Central Bank (ECB), the European Union (EU) and the International Monetary Fund (IMF) would magically become a winning strategy for Greece, rather than a one-way ticket to permanent debt-serfdom.

When the kleptocracy lost a significant percentage of this top 20%, they sealed their fate. When the state apparatchiks, institutional functionaries, professionals, small business owners, etc. finally lose faith in the the Status Quo, the Status Quo is doomed, though it can stage a rear-guard action by brutally suppressing this class (see Venezuela for an example of this doomed defense of a failed Status Quo).

In the U.S., the top 10% are doing very well, the next 10% are getting enough to sustain the illusion that they may yet recover their former status and wealth, and the bottom 80% have been bought off with social welfare or the promise of social welfare. Some variation of these percentages are in play in Europe, China, Japan and the emerging economies that haven't already imploded.

When the illusion that the Status Quo can fulfill all its promises to everybody dies, the Status Quo starts the terminal slide to effective collapse.

Unfortunately, no real change in the social order or power structure can occur until the effective collapse of the Status Quo has taken down everyone but the kleptocrats, their high-ranking apparatchiks and the piteously delusional.

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Traders: Sell Stocks & Bonds - Buy Gold & Silver

by Marketanthropology

With consideration to our variant methodologies for establishing a context for the downtrend in long-term yields, we believe the move has reached the dregs of the trend. Over the past year, we've posted the following 10-year yield charts ad infinitum, with the idea that long-term yields were poised to retrace a significant portion of the move that had reached a relative performance extreme at the end of 2013.

Last Friday, 10-year yields closed just 2 basis points higher (1.68%) than the May 1, 2013 close - which served as the power low for the subsequent taper-tantrum. From our perspective, the risk/reward for traders long Treasuries here is no longer compelling. Moreover - and as alluded to in recent notes, the significant move by the ECB last month to begin quantitative easing should provide further incentive and traction over an intermediate timeframe away from the safe haven shores of long-term Treasuries.
Upstream, we continue to find constructive action in burgeoning reflationary trends - namely, in gold and silver, that have led what we suspect will become a broader pivot in other downtrodden hard commodities such as oil and copper. We reiterate our call that TIPS look attractive relative to nominal Treasuries, with the more aggressive reflationary trade still found in silver then gold. On the immediate horizon, gold has become vulnerable to completing a quick retracement back to ~$1230, before we see it attempting to break out above its highs from last March and challenging it's first major retracement level above $1400. In either scenario over the next week, precious metals remain one of our favorite positions and would look to increase long-term allocations, primarily relative to U.S. equities - but also now with respect to long-term Treasuries as well. 
Overall, the moves from the most recent deflationary scare have continued to follow the exhaustion sequence witnessed at the end of 2008, when a much larger deflationary squall hit the markets and inflation expectations. Despite the sharp retracement in equities this week, we are looking for the SPX to resume its downtrend - with a pivot inverse to what we expect will become a cyclical low in inflation expectations.

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