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Friday, June 10, 2005


Kirby Thibeault

I am very excited and pleased to read that Professor Hamilton is publishing his macro views on this blog and outside the academic literature, although I enjoy the literature very much as well. I have two comments to make about his recent postings.

First, I agree with his view that the Federal Funds rate is headed higher. In fact, I have written about and do expect that the Federal Funds rate is on its way to 4.0 percent between now and July 2006 assuming no unexpected shocks hit the market to derail the Fed. As the Fed continues to state, their stance on monetary policy remains 'accomodative' at present. That is, and especially with the continued stimulus building at the long end of the yield curve, the cost of capital for long-term consumption and investment decisions continues to remain very stimulative. In my view, the largest macro risks at present are in the housing sector and energy market. Real estate asset prices will correct in time and with respect to energy stock prices, Professor John Cochrane's work has shown us one simple finance fact: high stock prices imply lower expected future stock returns; especially from a sectoral perspective.

Second, I too expect energy prices to drop due to a slowing in the growth rate in demand and an increase in supply. In my opinion, books such as Hubbert's Peak are simply fueling the expectational fire at the moment much like many books in the late 1990s fed the Internet boom. It is my view that the market is simply demonstrating the Nobel winning work of Kahneman and Tversky at present, decision making under uncertainty, where investors continue to overweight the current information set in the energy market in an excessively bullish manner. Meanwhile, and on the Toronto Stock Exchange at least, many of the more speculative energy stock prices have dropped considerably during the past quarter along with the fact that liquidity has dried up considerably. Moreover, I met with a new IPO about 3 months ago and the Chairman advised me that their C$25 million IPO had Institutional demand for over $300 million of stock. My response was that fact was another signal that speculation in the energy market is far too high at present. Once energy prices drop, I expect the equity financing market to fall as well and many of the energy Trusts too will fall as many are reliant on high energy prices and financings to make their distribution payments to shareholders.

Finally, all one has to do is simply graph how cyclical energy prices and stock returns have been over the past to gain insight into this sector and detach from the view that 'this time it's different or a new world.' I can recall quite vividly how bullish energy price expectations were just before the collapse in energy prices during the late 1990s. Energy stock prices collapsed and so did the equity financing market at that time while the US economy remained in an expansion. Many Canadian energy companies went bankrupt due to the unexpected balance sheet shock as their working capital deficiencies could no longer get met through equity financings and firms did not have sufficient assets to pledge for debt financings. Thus, when energy prices drop, I expect that expectations will play a stronger role than fundamentals on the way down and that many financial market participants will look back and wonder what variables were influencing their bullish information sets in a continious manner in a discrete market....

John Beck

Real estate prices have direct impact of stocks and equity price rates with as the source effect of purchasing price parities .

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