Monday, November 5, 2007

News - October 2007

Commodity prices, especially those related to energy, are spiking yet again this year. Oil, which averaged trading at about $23/barrel as late as the year 2002, is now hovering around the $95/barrel mark. High oil and gas prices paired with a national downturn in housing prices (although figures vary significantly from one region to the next) and the fact that many of the largest financial institutions are struggling to value their financial assets might typically provide a backdrop for a sinking stock market, not a resilient environment for investors that we have seen this year through October 31st 2007.

The conditions working in favor of a rising, healthy stock market have been the Federal Reserve aggressively lowering interest rates and the continuing growth in foreign economies. The Federal Reserve is trying to alleviate some of the pressure on financial institutions and individuals who are now sensitive to defaulting mortgage loans and a less liquid mortgage-backed securities market. The broader stock market has reacted positively to the lower interest rates. Interestingly, financial stocks, the focus of the rate cuts, continue to falter. As a result, many economic observers are expecting additional rate cuts necessary to stabilize the financial institutions.

Another situation that is increasingly covered by the financial media is the weakness of the US dollar compared to the other major currencies. The weak dollar is actually a beneficial component in the outperformance of our international investments. A weaker dollar is a predictable response any time the Federal Reserve reduces interest rates while other nations are raising or keeping rates constant. As we have discussed, a lower US dollar benefits those US companies exporting goods and doing business abroad. Positive currency effects, from a weak dollar and strong foreign currencies, generate additional value for US investors of foreign entities and corporations.

Another cursory effect of a weaker dollar is its affect on dollar denominated commodities. Some have voiced the opinion that commodities priced in dollars (like oil and gold) are rising simply as a natural offset to the weakening of the US dollar compared to other currencies (as the dollar goes down, commodities tend to go up). Higher commodity prices are benefiting many companies trafficking in such businesses and their alternatives. Some argue that commodity prices are artificially high and have risen in part from speculation.

In addition to the currency effects, old fashioned supply and demand theoretically should have the most significant affect on commodity prices. Some are astonished that energy and commodity prices can rise while many of the developing countries economies show some signs of slowing. That observation may actually point to higher future commodities prices, as we try to gauge the impact on prices when (and if) the US, developed Europe and Japan experience higher economic growth in the future.

One question that may be on investors’ minds is why inflation has not been more pronounced in the wake of higher materials, agricultural and energy costs, and how is it that the economy can sustain fairly healthy growth when food and energy prices are rising. Productivity and technological progress are two major influences that enable the economy to gracefully absorb these potential pitfalls. As society makes technological progress, we become more efficient users of natural resources. While many individuals choose to drive vehicles that are not much more fuel efficient than cars and trucks of the past, we certainly do have more options and can transition to fuel efficient vehicles if higher fuel costs become a burden.

October saw the Dow Jones Industrials achieve all-time highs before settling October 31st at just 70 points below the 14,000 milestone. The quick action in the markets signifies precisely the concept cited by market theorists who say that timing the market is nearly impossible and that staying consistently invested is typically the most prosperous strategy. Of course it’s essential to stay broadly diversified across many sectors and assets classes because the different groups within the market fall in an out of favor as economic conditions and sentiment evolve.

Since the Fed unexpectedly cut the discount rate in August, the Dow Jones Industrials and the S&P 500 have advanced 8% while the NASDAQ has advanced a stellar 16% in only 2½ months. For the month of October, the S&P 500 gained 1.6%, the Dow Jones Industrials advanced 0.4%, the NASDAQ added 5.9% and the Russell 2000 (small cap stocks) gained 2.9%. All of the major large cap indexes are in the black by at least 10% with the NASDAQ advancing a very strong 19.1% for the year. Growth significantly has outperformed value during the year and that trend held during the month of October.

Emerging Markets continue to significantly outperform the domestic stock indices. A popular Emerging Markets ETF returned 11.87% for the month of October and has advanced 46.17% for the year. A notable catalyst to the Emerging Markets gains is the well publicized performance of Chinese stocks this year. An ETF tracking 25 Chinese stocks has nearly doubled since the beginning of the year, increasing by an incredible 96% and an equally astonishing 21.39% just for the month of October. Many analysts and prognosticators have expressed the opinion that Chinese stocks are entering bubble territory. Valuations in China are much higher than is typically sustainable, however the Chinese economy continues to grow at staggering rates. The developed international markets have also done well making 17.59% for investors year-to-date, and 4.25% for the month of October.

As would be expected with commodity prices rising, the energy and commodity stocks are doing very well this year, outperforming the broader market. A popular ETF consisting of energy related stocks has gained 32% for the year, rising 2.5% in the month of October. An ETF tracking actual Oil prices has increased 42.59% this year while an ETF tracking a basket of commodities has moved ahead 13.69% for the year and advanced 3.46% for the month of October. Materials stocks, which tend to benefit from a strong global economy, and demand for raw materials have also bested the broader market, gaining 27.3% for the year and returning 4.16% for the month. Technology stocks are once again starting to garner some attention as the NASDAQ 100 tracking ETF has moved higher by 27.8% for the year and 7% for the month of October.

Financials and Real Estate, as we have previously mentioned, along with retail stocks have been laggards all year long. The retailers have both high energy prices and weakness in home prices working against them, but retail stocks do may perk up if energy and commodity costs trend lower. Real Estate is showing some signs of an improved environment as the Federal Reserve has shifted towards a lower interest rate policy. Even though REITs are still in negative territory for the year, they have done much better over the past three months gaining 13.05%.

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