Wednesday, July 9, 2008

News - July 2008

Unlike the fictional Jed Clampett who discovered oil on his property in the classic television series, “The Beverly Hillbillies,” many speculators and some investors are being handsomely rewarded by betting on oil and energy. Corporations that have made investments in commodity and energy production continue to strike it rich as well.

While there is certainly a valid fundamental case that can be made to support the current high price of oil, it does seem as though additional demand was predictable during the past several years. A reasonable person could assume that there is some amount of speculative froth in oil prices that have advanced nearly 50% in 2008 and more than doubled over the past 12 months. Who didn’t understand a year ago that growing Chinese and Indian economies wouldn’t require additional energy consumption in concert with that economic development?

The advocates of the temporary bubble scenario like to compare current oil prices to past bubbles as the charts and investor sentiment mirror many past manias. Any asset that appreciates as rapidly as oil, and some of the other commodities, is very prone to corrections based on the shear magnitude of the price changes over the past few years. If the price of oil were to decline 50% over the next few months, it would still have gained 500% over the past ten years.

The flip side of the argument are those who argue that the high prices are completely justified and are likely to go higher in the future as demand continues to increase. They argue that the markets are working and slowing demand via higher prices as supply fails to keep pace with rising demand.

Oil supply and demand are currently drawing closer to parity at about 87 million barrels a day. There is some concern as to whether the current suppliers of oil can increase output and to what level. Some have opined that Middle Eastern suppliers have excess capacity, while others are not optimistic that the Saudis and others can boost their output. A component of the variance of opinions is the relative lack of specific information regarding the reserves and output capability by the OPEC nations.

It has been well documented that the new demand is coming from emerging economies, not from the already developed nations of Western Europe, Japan and the United States. Chinese citizens use about one-tenth of the amount of oil that the average American citizen uses on a daily basis, while an Indian citizen consumes less than 5% of the oil that the American citizen consumes on a daily basis. These two booming economies have the potential to surpass the U.S. demand for oil as their large populations acquire wealth and their lifestyles increasingly require energy consuming modern conveniences.

While political solutions to the rising costs of energy and other commodities abound, we are quite certain that the marketplace will adapt to these higher prices. High prices will encourage more development of current energy sources and inspire new technologies and efficiencies using alternatives and substitutes. Unfortunately, no solutions are immediate and consumers in the short run are sure to use a larger percentage of their incomes buying food and energy or adjusting their habits.

Over the past month, the markets have retested the general low levels reached by the stock market in January and March. While the Dow Industrial Average has eclipsed its lows reached earlier in the year, the S&P 500 and other broader measures of the equity market have not achieved a significantly lower low during 2008 as of June 30th. While it is not our position that these technical measures (such as eclipsing certain numerical milestones) are particularly meaningful, the fact remains that they do have some importance to many investors and traders who use these statistics to shape their investment philosophies.

June was a difficult month for most investors. The Dow Jones Industrial Average, one of the worst performing measures, plunged 10% for the month of June to bring the year-to-date totals for the highly followed average down 13.4% for the year. The S&P 500 was down 8.4% for the month and 11.9% for the year; the NASDAQ was down 9.1% for the month and 13.2% for the year, and; the Russell 2000 (small stocks) was down 7.8% for the month and down 9.4% for the year.

The broad international markets as measured by various ETF’s also performed poorly in June. The developed international markets lost 8.8% during the month and have lost 10.9% for the year. The emerging markets were off by 9.3% for the month of June and have lost 8.7% for the year. India’s and China’s stocks have been very poor, each posting negative returns in excess of 20% for 2008 through June 30th. Latin American and Canadian stocks have balanced out the falling Asian markets, gaining 11.6% and 3.6% for the year through June 30th. Many of the best performing international markets this year, such as Brazil and Canada, are benefiting from appreciating commodity prices.

Financials maintain their position as the poorest performers, falling a nearly inconceivable 30% for the year and an equally astounding 18.4% during the month of June alone. Some of the major brokerage firms reversed their predictions that the financials were on their way to recovery and instead downgraded the financials amid further concerns regarding the credit crunch and slumping housing market. The banks are raising huge sums of capital to meet requirements and to provide much needed liquidity, which is good for business, but these actions will dilute the earnings for equity investors as the earnings recover.

The remaining two areas of the market that remain positive for the year are commodities and materials stocks. Oil ran up about 10% during the month of June along with the broader measure of commodity prices that produced a positive return for the month of 9.2%. Oil, as we previously mentioned, is up roughly 50% during 2008, while a broader blend of commodities have returned 27% from January 1st 2008 through June 30th 2008. The materials stocks have posted a slight gain for the year at positive 0.8%, but fell 5.9% for the month of June.

Many of our portfolios have outperformed the broader indices, benefiting from greater exposure to commodities, energy and materials stocks during 2008. Several mutual funds we own for our clients have large positions in these outperforming sectors. It is nearly impossible to predict with absolute certainty which sectors of the market are going to do best, to what degree, and for how long.

We do make an effort to responsibly allocate our portfolios in a way that takes advantage of those areas of the market that are the likeliest to benefit from the current economic environment. A popular mantra is: “There is always a bull market somewhere,” however, that is only a small piece of the equation for investors as no bull markets last forever. We do believe that stocks will rise over long time horizons, although there will be pitfalls of various durations along the way.

Extreme bull markets such as the commodity run often end violently, which is why we would never suggest owning only such a narrow segment of the market. Portfolio diversity is essential in order to reduce portfolio risk and avoid catastrophic events that can derail your plan for financial security. As investment advisors, we take our responsibility of balancing potential rewards and the risks in the markets very seriously. This professional approach to investing is precisely why we feel our services are valuable to investors during difficult periods.

1 comment:

Anonymous said...

As usual, great monthly recap. Lots of good info. Enjoyed the BH reference.