The consumer price index of housing will not be growing fast

The long-term evolution of consumer prices partially defines the fundamental environment for stock prices. When consumer prices for various goods and services have different but sustainable trends an opportunity arises for long term investments. Observations show that some of these sustainable trends have clear turning points which provide investors with invaluable information on buy/sell decision. In this article, we investigate the past and future evolution of the consumer price index (CPI) of housing and demonstrate that it will likely be falling till 2021.  

Four years ago we published a paper on the presence of long-term sustainable trends in the differences between various components of the CPI in the USA. We started with the difference between the core CPI (i.e., the CPI less food and energy) and the overall CPI. Then the consumer price index of housing, which comprises approximately a half of the headline CPI, was analyzed. In the beginning of 2008, we successfully identified a turning point in the difference between the CPI and the housing index and predicted the housing index to fall relative to the CPI during a lengthy period of eleven years. Here we revisit this prediction and demonstrate the turning point timing and the duration were almost exact.

Figure 1 displays the evolution of the difference between the CPI and the housing index (both seasonally adjusted) since 1967. The BLS started reporting on the hosing index in 1967.  There are distinct time segments with the difference growing and falling at approximately the same pace, except the period after 2008.

Figure 2 shows three consequent quasi-linear trends in the difference with the relevant regression lines and equations. These regressions are characterized by higher coefficients of determination, R², between 0.76 and 0.93. The current trend has been evolving since July 2008. Considering the current trend, we expect that the housing price index will demonstrate negative growth relative to the overall CPI, which includes the housing index by definition.

There are two CPIs (food and energy) which are often excluded from the overall CPI in order to remove high amplitude fluctuations and to obtain a smoother long-term estimate of consumer prices. It is instructive to compare the housing index with the core CPI. It should be noticed, however, that some portion of the index of energy is included in the housing index. Another improvement might be achieved when the core and housing CPI difference is normalized to the core CPI. This ratio removes the dependence on the index level and thus provides a more reliable estimate in terms of econometrics (effectively, we reduce an I(1) stochastic process to I(0)). Figure 3 depicts the difference between the core CPI and the CPI of housing normalized to the core CPI. The trajectory of the normalized difference is much smoother and demonstrates sharp turning points, with the latter in June/July 2008. Moreover, all regressions are characterized by higher R². Interestingly, the slopes have a tendency to increase in absolute terms: from 0.0062 y^-1 to 0.0086 y^-1. The relative rate of the housing index fall is now 40% faster than that between 1986 and 1996.   

Having these rates of the relative price growth one might be interested to estimate the length of the current trend and its peak value. Figure 4 presents such an estimate based on the naïve assumption that the future repeats the past. (Figure 5 illustrates the possibility of sharp timing of the turning point.)  The red line in Figure 4 repeats the difference (black line) shifted by 26 years. If the past pattern will be repeated in the future one may expect the relative fall in the housing index will extend into 2021.

Concluding this short study we would like to highlight two principal findings related to investors. First, the good and services included in the housing index will be growing at a slower pace than those related to other categories of CPI.  Second, this situation will last longer than a few years and will likely end only after 2021.  We will revisit the difference between the core and housing CPIs in several months.

Figure 1. The difference between the headline CPI and the CPI of housing.   

 Figure 2. Linear trends in the difference between the headline CPI and the index of housing.  

Figure 3. The difference between the core CPI and the CPI of housing normalized to the core CPI. Three distinct periods with sustainable linear trends are marked with the relevant regression lines and equations. 

Figure 4. The difference between the core CPI and the CPI of housing normalized to the core CPI. Red line is the difference shifted by 26 years ahead. 

Figure 5. Same as in Figure 4 between 2000 and 2015.

As predicted, the PPI of steel and iron has been declining

Two months ago we predicted the current fall in the producer price index of steel and iron in the fourth quarter of 2012: “The index of steel and iron will likely be falling in absolute terms in the fourth quarter of 2012 and the first quarter of 2013.”  Couple days ago the BLS reported various PPIs for November 2012. It’s time to revisit our prediction.  

Originally, we reported on the difference between the overall PPI and the PPI of steel and iron in 2008. Then we revisited the difference in 2010 and February 2012. We predicted the index of steel and iron to return to the long term trend, which express a higher rate of growth of the producer price index than that of steel and iron. Our general approach is based on the presence of long-term sustainable (linear and nonlinear) trends in the evolution of the CPI and PPI in the United States [1, 2]. The difference between various components of these indices is not a random one but is rather a predetermined process. Using these trends, one can predict consumer and producer price indices for select goods, services and commodities.  

Figure 1 compares the difference between the PPI and the index for iron and steel (101). The difference is characterized by the presence of a sharp decline between 2001 and 2008. Between 1985 and 2000, the curve fluctuates around the zero line, i.e. there was no linear trend in the absolute difference. In 2008, our main assumption was that the negative trend observed before 2008 should start transforming into a positive one after 2008. In Figure 1, the (expected) new trend is shown by green line. This trend suggests that the PPI grows faster than the index of steel and iron by approximately 2 units of index per year.  

Figure 2 demonstrates the most recent period and confirms that our prediction for 2012Q4 was correct – the difference has touched the green line. One may foresee the difference to fluctuate around the green line in the near future. The price of iron and steel will likely be declining.

 

Figure 1. The difference of the PPI and the index of steel and iron updated for the period between September 2012 and November 2012.

 

Figure 2. Same as in Figure 1 for the period between January 2005 and November 2012. Green line predicts the evolution of the difference after 2008. Red circles represent the difference between April 2009 and November 2012. The difference has been increasing during the reported period and reached the new trend (green).

Successfully sold the S&P 500 index

Just two weeks ago we reported on the evolution of S&P 500 in December 2012 and expected to sell the index at 1430, which we had bought at 1352 in November. On Wednesday, December 12, the index was slightly above 1430 (high 1438) and closed at 1428. For technical reasons not related to our investing decisions, we were able to sell the whole lot only on Friday at 1420. As expected, the return from November is 4.7%; and from May 2012, when we first formulated this tactics, we made around 15%. As mentioned in our previous article, we expect to buy the S&P 500 when it is below 1400 and will obtain another 10% return selling at 1550 in October 2013. Our investing tactics is simple and straightforward – we follow the trajectory of the S&P 500 observed during the previous rally.

In March 2012, we first published a graph which showed that the S&P 500 index would have a local fall in May 2012 at the level 1300.  In a few sessions, we bought S&P 500 index in May/June 2012 at the level 1287 to 1322.  The initial idea was to sell by the end of 2013 at 1525 and get a 12% to 14% return. In September, the S&P was at 1450, which was far above the expected level, and we decided to sell and wait a negative correction to 1350 to 1375 to re-enter the index. Selling at ~1460, we obtained an approximately 10% return in September.  In October, the S&P 500 fell to 1350 as had been predicted in September and we re-entered in two sessions at 1348 and 1355. By the end of November the S&P 500 regained 4.5% (1416). Two weeks ago, we expected the index to rise to 1430 to 1450 in December 2012. This was considered as the best time to sell before the next negative correction in December 2012/ January 2013.

Below we present the evolution of the S&P 500 and the step-by-step assumptions illustrating the decisions we have made since March 2012.

Figure 1 shows the evolution of the S&P 500 index since 1980. After 1995, the index behavior reveals some saw teeth with peaks in 2000 and 2007. The current growth resembles those between 1997 and 2000 and from 2003 and 2007.  There are two deep troughs in 2002 and 2009 which are marked by red and green lines.  For the current analysis we assume that the repeated shape of the teeth is likely induced by a degree of similarity in the evolution of macroeconomic variables. The intuition behind such an assumption is obvious – in the long run the stock market depends on the overall economic growth.

Having two peaks and troughs between 1995 and 2009, what can we say about the current growth in the S&P 500? Before making any statistical estimates, in Figure 2 we have shifted forward the original curve in Figure 1 in order to match the 2009 trough (blue line).  When the 2002 and 2009 troughs are matched, one can see that the current growth path closely repeats that after 2002. The first big deviation from the blues curve in Figure 2 started in 2011 and had amplitude of 150 units (from 1210 to 1360).  The black curve returned to the blue one in August/September 2011. From December 2011, we observed a middle-size deviation of about 100 units.

Figure 1. The evolution of the S&P 500 market index between 1980 and 2012.

In April 2012, we predicted a drop in the S&P 500 to the level of 1300 by the end of May. Figure 2 shows the predicted behavior in April and May 2012, with the predicted segment shown by red line. We expected that the path observed in the previous rally would be repeated with the bottom points coinciding.  When this prediction realized, we invested at the average price 1320. In May 2012,the expected exit level was 1500 in October 2013.

 

Figure 2. The original S&P 500 curve (black line) and that shifted forward to match the 2009 trough (blue line). Red line – expected fall in the S&P 500: from 1400 in March to 1300 in May.

Figure 3 shows the evolution of the S&P 500 monthly closing price between May and August 2012. The S&P 500 closing level for August was 1430 and reached 1469 in the middle of September. This level provided a ten percent return over approximately 4 months. One can see that the observed level was far above the expected level (blue line). The return and the deviation from the expected level both made us think that this was the best time to exit. We sold the index on September 21 (1460) anticipating strong turbulence (economic, financial, and political) and an overall fall to 1375 at a few month horizon.   

Figure 3. Same as in Figure 2 with an extension between May and August.

Figure 4 shows the evolution of the S&P 500 monthly closing price in September-November 2012. The October’s closing level was 1411. On October 26 , we put the November’s level down to 1375. One can see that the red line intersects the blue curve. The previous history of the black and red lines intersection with the blue one made us think that the time to enter the market (S&P 500 index) was approaching. We expected to buy at 1350 to 1375.  

 

Figure 4. Same as in Figure 2 with an extension between September and November 2012. 

Finally, Figure 5 depicts the current (December 15) state of the S&P 500.  The index had a local minimum of 1347 in the middle of November and recovered to 1416 on November 30. This was 15 points less than the expected level of 1430 in December 2012. The red line intersects the blue one in January 2013 and then a negative correction to 1400 (or less) is expected again. Figure 5 shows that the S&P 500 may regain 10 points in February. Therefore, we have in view to buy the S&P 500 in January at 1400 (or below) and obtain another 10% return selling at 1550 in October 2013, as the blue line implies. Since the blue curve is from the past we do not link the fall in December/January to any financial or political events.

 

 Figure 5. Same as in Figure 4 with an extension into February 2012. 

Re-published from Oilprice.com: Oil Prices Could Drop Substantially: An Interview with Michael Levi

This article is re-published from Oilprice.com and is in line with my prediction from 2007 that oil price would peak and then fall down to $30 to $60 in 2016.

Oil Prices Could Drop Substantially: An Interview with Michael Levi

There's been plenty of talk about potentially radical US foreign policy changes as a result of the shale boom. While one shouldn't expect any dramatic US foreign policy move away from the Middle East, factors are influencing a greater focus on Asia. Only one thing is certain in this transforming world: The shale boom is real and the implications are many and difficult to predict.

In an exclusive interview with Oilprice.com publisher James Stafford, energy security expert Michael Levi, the David M. Rubenstein Senior Fellow for Energy and the Environment and Director of the Program on Energy Security and Climate Change at the Council on Foreign Relations (CFR), discusses:

• Why oil price stability is still all about the Middle East
• Why the oil and gas industry is heading towards transformation
• Why oil prices could drop substantially
• Why the US shale boom is real
• Why the shale oil boom won't lead to major US foreign policy changes
• Why Keystone XL is pretty much non-essential
• Why we won't see any radical change in renewables in the next five years
• The best way to achieve meaningful results on climate change

James Stafford: What is the number one threat to energy security today?

Michael Levi: I am not a huge fan of using the word 'energy security' because it means different things to different people, and that makes it very easy for people to talk past each other. What I would say the number one risk to the stability of global oil prices--which can have big economic and security ramifications--is the potential for major conflict in the Middle East and instability in oil-producing countries.

James Stafford: Are there any other regions that have this same destabilizing potential?

Michael Levi: The Middle East is always the place where focus is rightly drawn, because it is the place where you can have outsized disruptions. One of the things that I tend to emphasize is the need to focus and prioritize concerns, and it is very easy to get [drawn into] every 100,000 or 200,000-barrel-a- day change somewhere in the world that might have big consequences for one particular country, but does not necessarily have outsized global consequences or national consequences that policymakers need to think about. If I spend my time trying to think through what policymakers should be paying attention to, my focus, when it comes to disruptions to the oil system, tends to come back to the Middle East.

James Stafford: The UK-based think tank Chatham House has published a new report seeking to demonstrate how the oil and gas industry is under significant pressure that will lead to a transformation. How do you see a potential transformation of the industry taking shape?

Michael Levi: I think it is important to start with a distinction, particularly one that is important in the US: the oil and gas sectors, to some extent, are becoming two genuinely separate sectors, rather than one integrated one.

In the past, most natural gas was produced as associated gas together with oil, and that made oil and gas as a single entity very clear, something that made a lot of sense. Now you have a lot of non-associated gas; gas being produced separately, often by companies that do not engage in much oil production. They really have distinct challenges and opportunities, and as a result, different sets of pressures.

For the natural gas industry, at least in the US, the big challenges are low prices in the glut of gas on the market that is not being matched by demand. A big part of this is certainly idiosyncratic; there are people who are drilling to hold leases and cash flow, and they are doing that en masse, which is a problem for the whole industry.

At the same time, they have not been able to coalesce around the efforts to boost demand.
The oil world is a completely different story and you have pressures from different directions right now. On the one hand, you have a surge in opportunities for development in countries where geopolitical risks are relatively low. In the US, Canada, and Brazil you may need to still worry about regulatory changes, but you are not worried that terrorists will come and capture your workers.

At the same time, for a lot of the companies, that is not enough and they are still looking globally, and they still face challenges from nationalism and unstable regimes. On top of that, they are entering a period in which there is probably more uncertainty in prices than there has been for a long time. You have this collision of growth and supply from
outside OPEC, together with potential Iraqi growth and substantial investment from within OPEC that really opens up the possibility of a big, if temporary, price drop in the next five or
so years. That complicates the outlook for companies, on top of everything else.

James Stafford: Really? You believe that prices could drop in the future?

Michael Levi: I think prices could drop substantially. If you look at the most recent IEA report or the most recent OPEC outlook, you see that if all currently planned investment goes ahead, then at prices resembling current ones, supply would greatly outstrip demand.
Either countries will pull back with production and investment in OPEC and allow supply to match demand at relatively high prices--and I think that is the most likely outcome--or they will not be able to decide who has to pull back, and there will be an excess of supply on the market that pushes prices down quickly. That is self-correcting, because low prices cannot sustain the big gains in North American production. But you can still have temporarily low prices that really shake things up for some producers, depending on the properties of their investment.

James Stafford: Speaking of the IEA report, predictions that the US could pass Saudi Arabia to become the world's largest oil producer by 2017 have come under a lot of criticism. What do you think of the IEA's predictive mathematics?

Michael Levi: Predictions are always wrong in one way or another, and I am not going to second-guess those who have thought to a much greater depth in these analyses. There is a range of estimates out there, but the IEA ones are relatively modest.
The bigger issue is: what are the implications? Everyone likes to talk about how their projections show that the world is being reborn anew, and will be fundamentally different from what it was in the past.

There is a temptation to oversell, and I think it is reasonable that people react negatively to efforts to oversell the consequences of the changes going on in energy.

James Stafford: What are your views on the shale boom? Do you believe it can live up to the hype?

Michael Levi: It depends on what hype we are talking about. I think the shale boom is for real. I think that a lot of the criticism that we do not know long-term production rates and so on are important to look at. But even if you assume that returns on wells are substantially lower than most people think they are right now, our projected output is still quite high, because producers' economics are dependent primarily on what happens in first few years after they drill. We know roughly what happens in the first years after producers drill.

The hype that says that this will all replace coal without any government intervention, gas prices will be $3 forever, or that we will be the dominant exporter in the world, are out of contact with reality. We have temporarily depressed prices, they will rise a bit. Hype always has the ability and the tendency to outstrip reality, but in this case, reality is pretty radical itself.

James Stafford: Could the shale boom lead to a change in US foreign policy priorities, away from the Middle East?

Michael Levi: An economic analyst will typically tell you that the US shale boom will fundamentally change US vulnerability to energy events in the Middle East. But not every policymaker listens to their economic advisors.

I do not think that US policymakers will step back and say, 'We need to revisit our strategy in the world, because of this oil boom.' I do think that what is happening will weigh on ongoing
discussions that already exist about future US priorities.

The most obvious one is the discussion from the US Department of Defense over how much to shift from the Middle East to Asia. Within that existing debate, I have no doubt that people who want to see more of a shift will emphasize what is happening in US energy. I think it will have some influence, but ultimately, I do not see a radical change as being likely.

James Stafford: Now that Barack Obama has won a second term, what do you see happening with the Keystone XL Pipeline? Will it go ahead? Is it essential to US energy security?

Michael Levi: I made a prediction once on the Keystone XL Pipeline, so I have lost my license to make future predictions. The Keystone XL Pipeline is non-essential to US energy security; it is also not disastrous to climate change. It has been overblown by both sides in the debate. It is one pipeline that would carry a modest, but non-trivial amount of crude, and that would help create economic incentives to increase production, again, by a modest but not earth-shattering amount.
The more fundamental question is whether the US is going to let economically-rational infrastructure go ahead. I think if you replicate a pattern like the one that some would like to see for Keystone and you start blocking pipelines all over the place, then that becomes a larger economic problem.

In the end, will it make the US more secure in any meaningful way? I doubt it. Prices for Canadian oil rose more during the Libya conflict than the prices for Brent Crude, or WTI. It is hard to say that Canada gives the US potentially more security aside from in extreme circumstances.

James Stafford: One would have thought that the natural gas boom would be good for the environment, but the cheap gas prices have also hit coal prices, and we are seeing Europe sucking up unused US coal. Is this a trend we can expect to continue?

Michael Levi: I think it is a trend we can expect to continue to some extent, particularly if Europe does not make stronger moves away from coal. The state of our knowledge about global coal markets is pathetic. All we can say right now is, directionally, more gas in the US means cheaper coal, which leads to more exports, but we are still far from being able to really put quantitative meat on those bones, and making some meaningful net assessment.

James Stafford: What do you believe is the best way to achieve meaningful results on climate change? How much of an influence will Hurricane Sandy have on this debate?

Michael Levi: I think Hurricane Sandy has put the debates into a prominent place, which is essential to moving it forward.
Ultimately, I still believe that carbon pricing in one form or another is essential to achieving deep cuts in economically-sensible ways. That can come in the form of a tax, resurgent cap and trade, or clean energy standard; there are all sorts of ways to do carbon pricing. In the long haul, I think you come back to that, particularly if you care about doing this is an economically-efficient way.

James Stafford: What changes in public interest on climate change have you noticed over the years? Do you think that at this rate climate change will ever gain the support it needs to be effectively tackled?

Michael Levi: Ever is a long time. I think we are back in a building phase. If you look at the first decade of this century, you had a solid 5 or 6 years that was really about building broad support for action on climate change, about test driving different approaches, and by the time you got to 2008, there was actually pretty broad support, particularly in the Senate for action on climate change. You had 2 presidential candidates competing to see who had the best climate strategy. Then you had the financial crises. You had intense polarization. You had a deep, deep recession, and climate action became a much lower priority.
A lot of people got used to saying in early 2009 that we would come back to climate change when the economy got better. The only mistake that people made in that analysis was thinking that that was only a couple years off. It turns out that it is even further off.
One of the emerging barriers to action on climate change is that doing things to exploit oil and gas have been set up as 100% incompatible with serious efforts to deal with climate change. That stark choice makes it very difficult to build coalitions that will move anything forward. We have actually moved in the last couple of years into a considerably more difficult situation than we were even 4 years ago, when a candidate like John McCain could say, 'I support oil and gas production, and I support a strong cap and trade system.' The president talks about things like that today, but gets considerably weaker support for it, and that ultimately needs to change.

James Stafford: How can this change?

Michael Levi: I have a book out next spring, talking about this. The first step is for each side to recognize that accepting a lot of what his opponents want will not fatally undermine what it wants. Oil and gas will need to understand that serious action on climate change will not fundamentally undermine what they want to accomplish in the next decade or two. People who want to take action on climate change need to fundamentally understand that expanding access to US oil and gas production will not fatally undermine their own goals. Compromise is not an oxymoron.

The second thing that needs to happen is there needs to be some rebuilding of trust. That is difficult; you do not just do it by hanging out more at the bar. You need to do small deals that show that you can work together.
You can think of all sorts of ideas; you could tie royalties from increased oil and gas production to financial support for renewable energy. You could provide support for carbon capture and storage demonstrations that support enhanced oil recovery. You can work to improve environmental permitting so it is easier to build pipelines and power lines that take renewable energy to places where they can be used.
There are a host of things that are small (but not trivial) win-wins that might help rebuild confidence. Ultimately, both sides need to accept that a political deal is better than trying to go for an outright win.

James Stafford: What role do you see renewable energy playing in the future?

Michael Levi: In the near future, renewable is cost-competitive in niches, but it is still not broadly competitive in the US economy. It has a potential to be.
Renewables have cost and intermittency challenges. There is important progress that is being made in renewable energy. I think a lot of that story has been buried in the oil and gas discussion in the last couple of years, but we are seeing record-low prices across the board, and we are seeing record-high deployments. It is important to remember that we still need government support in all these areas if you actually want to see costs come down meaningfully.

James Stafford: How do you define the ‘near future'?

Michael Levi: I do not see a radical change in the relative price of renewable energy and fossil fuels in the next 5 years. Ten years is more difficult to predict, but I would be skeptical. When you start to look ahead one or two decades, particularly when you add in policy uncertainty, it is very difficult to predict what will happen.

James Stafford: Can the US afford to turn its back on nuclear energy?

Michael Levi: If you mean by turning its back, you mean a phasing-out of nuclear energy, I do not think that is sensible to do. Nuclear energy provides 20% of our electricity, and the marginal cost of production is extremely low for existing power plants. The real question is can the US afford to turn its back on nuclear in the future as a source of zero-carbon energy growth? The answer is: we do not know, because we do not know what the alternatives will be, or if there will be significant alternatives. So you want to keep nuclear alive as an option; that means trying to figure out ways to bring down costs, particularly financing costs. It means looking for ways to resolve, or at least partly resolve the waste questions, and it means looking for ways to potentially innovate on small modular reactors to provide a different economic model and a different construction model for nuclear power.

Working paper on five banks

I have re-arranged my post on the comparison and modelling of five banks in the form of a working paper. This paper is now  available via RePEc:

Cross comparison and modelling of Goldman Sachs, Morgan Stanley, JPMorgan Chase, Bank of America, and Franklin Resources

Abstract
We have studied statistical characteristics of five share price time series. For each stock price, we estimated a best fit quantitative model for the monthly closing price as based on the decomposition into two defining consumer price indices selected from a large set of CPIs. It was found that there are two pairs of similar models (Bank of America/Morgan Stanley and Goldman Sachs/JPMorgan Chase) with a standalone model for Franklin Resources. From each pair, one can choose the company with the highest return depending on the future evolution of defining CPIs.