Serious Money: Markets, according to the textbooks, are supposed to be driven by a wide range of complex factors, most of which - if not all - cannot be known in advance.
That's the theory at any rate. In practice, asset prices have an annoying habit of making a nonsense of academic predictions. One aspect of pricing behaviour that constantly confounds the theorists is the way markets latch on to relatively few key drivers. Occasionally, just one important variable seems to determine everything.
In the 1980s, if you knew where the weekly US money supply data were likely to move you also were able to make a lot of money trading stocks, bonds and currencies. For a long time in the 1990s, monthly US balance of payments statistics were a key driver of everything. US monthly payroll reports have long had iconic status.
Fashion and fad play a surprisingly large roll in all of this. But there is also the very human search for something manageable: the information overload facing any investor means we all have to search for a small number of key indicators. There was some sense (but not much) in the obsession with money supply numbers: shifts in the stock of money were thought likely to prompt changes in short-term interest rates. And if there is one constant in financial markets, it is the belief that insight into the Fed funds rate will lead to instant riches.
These days we are all weather forecasters. Or, to be more precise, forecasters of the weather in the northeastern US. The price of oil is now the obsession of markets. We are all experts at talking about supply and demand for oil and we all know that if it's going to snow in New Hampshire rising global demand for crude will drive prices up dramatically. If it's going to freeze in Vermont we are all heading for trouble.
Rising oil prices caused two big recessions in the 1970s and one small one at the start of the 1990s. The run-up in energy prices over the past couple of years has so far failed to prompt a global collapse in economic activity, but many analysts believe it is just a matter of time. High oil prices should be bad for bonds (because of inflation) and bad for equities because that inflation problem will have to be cured by higher interest rates. That tightening will, as it always has done, cause a recession.
Of course, things haven't quite gone to plan, at least not yet. We have learned that there is a world of difference between a supply versus a demand shock. Those big recessions of the past occurred after Opec had simply decided to raise the price of oil. This time around, oil prices are high because global economic growth has been so strong. And it helps that we are much more energy efficient than we used to be - those past price rises led to less energy-intensive modes of production.
Over the last year or so, some experts have confidently predicted oil will soon be $100 per barrel. A smaller minority of forecasters think prices will collapse. The oil industry itself has generally been in the latter camp - bosses of Exxon Mobil and BP have both recently been confident predictors of lower oil prices. We might be tempted to think that the heads of the world's largest oil companies would be in a good position to know about these things. Sadly, some cynics think their views might be just a tad tainted. Oil executives are extremely worried about the possibility of windfall taxes on their profits. Talking down the oil price might help to head off political pressure to raise taxes.
Serious Money is, like everyone else on the planet, an oil expert. All of the analysis that suggests the era of cheap energy is over looks eminently sensible to me. But that does not justify oil prices at $70. Prior to hurricane Katrina, it was odd to see oil prices steadily rising while inventories of crude oil were also going up, exceeding levels seen at similar points in the past. Rising inventories are usually signs that supply shortages - the reason for high prices - are being corrected by market forces.
And then there were the reasons for those ever-increasing oil prices. From instant punditry about the politics of Saudi Arabia to detailed geological knowledge about the finite nature of oil reserves that are going to run out next year, we witnessed every possible post hoc rationalisation of why oil prices were rising.
But the weirdest analysis came with the sudden explosion of expertise in oil refining. Prior to the hurricane season, whenever we got news about refining shortages we saw the oil price go up. Now, shortages of refining capacity tell us a lot about refining profit margins but nothing about the oil price. In another odd twist, the market now explains falling oil prices in terms of shortages of refining capacity. Come on guys, you can't have it both ways.
Back to weather forecasting. The obsession with weather in the northeastern part of the US is understandable but a bit limited. Oil and oil products are consumed in one or two other bits of the US, if not the rest of world.
Serious Money is willing to bet that the oil price could now surprise on the downside. The flaky analysis of high oil prices leads me to suspect that there is still some air to come out of the oil price bubble. Oil company shares are still a good long-term buy if oil settles at a long-run average of $40-$50. But if oil does fall to that level, 2006 will see lower oil prices than in 2005. And equity markets will once again surprise on the upside: all those inflation and interest rate fears will ebb with the oil price. Equities will jump for joy.
Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.
