8/4/2008                 

Our goal is to minimize damage as the market drops and be there when it recovers!

Emotions – aside from crooks – are the most dangerous part of investing.

Mary Dean

For clients who can and do follow our model portfolios (which are the majority), we are accomplishing our goal.  The returns were above those of the average balanced fund in the strong years, 2003 through 2007, and about equal to the average balanced fund in 2008.  Our portfolios have not been plagued with credit crisis instruments/investments (mortgages, auction rate munis, high allocations to banks, heavily leveraged real estate, etc..).  We have not bought agency notes for several years.  Nor were we heavily laden with emerging market funds some of which fell 30% to 50% in 2008.  

Still no one wants to experience a down year.  It is harder for some than others.  History keeps things in perspective.  It balances the negative and positive.  It allows logic to overcome emotions.  Historians have a better idea of what happened.  More information is disclosed as the years pass and they have time to analyze it.  The information about today’s economy is incomplete.  Listening to daily stock market commentaries and checking monthly statement balances is emotional and focuses attention on short-term, incomplete information or even worse, guesses.     

Fortunately we have several periods in history with an economic crisis similar to today’s.  The most similar is the period from 1970 through 1980.

We are facing an energy crisis and are unraveling a credit crisis.  Our primary concern is the energy crisis as explained below.

Unraveling the Credit Crisis

Credit is still available as evidenced by my clients who are buying new homes.  The government thwarted a major credit crisis in March and billions are being pumped into credit markets.  On July 13, 2008 the Fed granted the Federal Reserve Bank of New York authority to lend to Fannie Mae and Freddie Mac, the Federal agencies who buy bank mortgages.

Keeping credit available will not save all banks nor stop all foreclosures.  Experts in the field discussed this last March.  The stock market and the economy can survive this.  We did so as numerous savings and loans failed in the 1980s.

1970 through 1980 Oil Crisis

The stock market was extremely volatile during this period.  The Dow Jones Industrial Average ended the decade at about the same level where it started.

Market timing does not consistently work so we are not trying to time the recovery.  We are using history to determine whether we are closer to the top or the bottom.  

Price per Barrel – 1861 through 2006

Can the government perform the same magical “bail out” with oil prices as it continues to do with the credit crisis?  Using the 1970s as an example, any impact was long-term.  See the 7-7-08 e-mail “1973 Oil Crisis” from “Wikipedia.”  Just as now there was a national movement to conserve, discover additional fossil fuel reserves and develop alternative energy sources.  The movement gathered momentum and direction as the years passed.  Oil prices peaked in 1980 then collapsed finally reaching a bottom in 1998.

There was no “quick fix.”  There were periods of relief.  Oil prices fell during 1975 once the oil embargo was terminated.  The U.S. economy was strong.  Companies were still hiring and wages were rising.  The stock market reached bottom in 1974 then recovered almost all its 1973 through 1974 losses by 1976.  It remained volatile until the early 80s but never tested the 1974 lows again.

Oil prices have jumped to far higher levels than in the 1970s when the average domestic barrel of crude rose a little over 11 times in actual dollars from $3.39 ($18.77 inflation adjusted) in 1970 to $37.42 ($97.68 inflation adjusted) in 1980.  Since 1998 the average domestic barrel of crude has risen from $11.91 to July 7, 2008’s price of about $140 per barrel, an almost 12 times increase.  The price per barrel has more than doubled over the last 12 months!

The EIA (Energy Information Administration) issued a long-range forecast to 2030 which said that the world is not close to abandoning fossil fuels and that energy demand would grow 50% over the next two decades.  The outlook largely assumes no mandatory international agreements on capping green house gases.  The price per barrel in 2030 is expected to range from $113 to $186.  Assuming about a 2% inflation rate, the $113 would equal $70 in today’s dollars.  The $186 would equal $141.  For more details, see the “San Diego Union Tribune” 7-3-08 article “World Use of Energy Predicted to Soar.” 

Inflation is threatening the economies throughout the world.  China may need more oil to fuel its growth but it can not grow by selling inflated products.  Chinese imports cost 4% more in 2007 than in 2006!  China has recently lifted its price controls on oil which will result in more inflation.  Its stock market has dropped about 50% this year!  The same applies to a lesser extent to India.  That stock market has dropped about 30% this year.

In short, buying natural resource stocks at this point seems untimely.  We could be looking at a bubble.  Energy demand is projected to grow long-term but this could be another 1975 where oil prices drop temporarily.  Therefore, there are two possible scenarios, either the world will enter a recession as oil prices rise or oil prices will drop then resume rising at a slower pace.  Even if oil prices continue rising, natural resource stocks may fall since a slowing economy may reduce consumption of their products. 

Usually prices are tied to supply and demand but there are other factors in this economy, speculation and hording.  Still speculation and hording can only survive so long until they are affected by economic forces.

Investment Recommendations

Since an oil induced global recession is still a possibility, my recommendation is to maintain 50% in low volatility via low volatility equity funds, fixed annuities and CDs/bonds.  If the market recovers to 12-31-07 values or interest rates rise on high quality taxable paper to 6% with a 5 year maturity, we may switch to 50% low volatility equity funds and 50% fixed annuities, CDs/bonds. 

Exhaustive studies performed by a MIT engineer turned financial planner suggest no more than 50% in CDs/bonds.  This assumes that market timing does not work.  Most market timing managers are no longer in business.  Our economy is too complex to consistently time the market. 

Attached are the pros and cons of different low volatility alternatives:

(c) Dean Consulting & Associates