January 2006
Monthly Archive
Thu 26 Jan 2006
Over the past couple of years we’ve all felt the crunch from higher oil prices. As the price of crude neared $70 a barrel, we’ve had to tighten our belts, turn down the thermostats and forego that long drive to visit a sick aunt. Last fall consumers complained about record revenues and profits for oil companies. Oil company executives have whined despairingly about how there is little they can do in the face of growing world demand and supply shortages. Those companies will soon be reporting more eye-popping revenue and profit numbers, so expect to see another hue and cry from consumers and congress about possible price gouging.
Perhaps investors shouldn’t be surprised that energy remains the top-performing industry sector. Over the past quarter, energy and natural resource funds have returned nice gains for investors. Below is a chart showing how some of these funds fared during the period since November–a little less than three months.
First look at the purple line. That is qqqq, the Nasdaq-100 Index Tracking Stock. During this period, it has gained 0.73%–a paltry performance during a period when many investors seem to believe that the markets have done okay. In contrast, Merrill Lynch Oil Service HOLDRS (OIH), has gone up 23.06%, as shown by the red line. The yellow line is Select Sector SPDR - Energy (XLE), up 14.72%. The green line is iShares Goldman Sachs Natural Resource Index Fund (IGE), up 14.19%. Other energy and natural resource funds have posted similar returns.
Obviously investors holding energy positions over the past quarter have been pleased with the results. But the overall impact of high oil prices on the stock market is bad. If you look closely at the chart, you’ll see that the Nasdaq tends to dip when the energy funds spike. Wall Street knows that rapidly rising oil prices is bad for business. The higher prices impacts the economy much like an increase in income tax. It means consumers have less money to spend on other goods and services. It also impacts businesses who must pay higher costs for things like transportation and utility services.
Now I’m going to include another chart.
This time I’ve extended the period to the past year. I’m still showing Merrill Lynch Oil Service HOLDRS (OIH) with the red line. The green line is is qqqq, the Nasdaq-100 Index Tracking Stock. And I’ve added a yellow line for streetTRACKS Gold Trust (GLD). The price of gold has risen sharply over the past quarter, gaining about 13%. During that period, the price of gold has been closely correlated with the price of oil. That isn’t always the case. In this instance, gold is rising in step with oil because oil prices are at record levels and gold traders know that higher energy costs are going to be passed through the economy.
When oil prices started their major upswing about four years ago, many businesses avoided passing on the price increases by cutting back and by improving productivity. The initial hope was that oil market stability would return and prices would drop. That hasn’t happened. And most businesses have reached the point where they can no longer keep absorbing increased energy costs.
The major engine for gold prices is inflation or the threat of inflation. Gold traders are looking at the oil situation and feel confident that inflation must rise as a result.
After such a dramatic rise is the bull market for oil nearing an end? Energy investing is a volatile game. Certainly it does not appear that demand for oil will lessen in the near future. Oil supplies are also not likely to increase dramatically in a short time. So while oil prices are likely to remain volatile, a significant decline that lasts for an extended period seems unlikely. Investors who can handle daily price swings of up to 10% will probably continue to make money in this sector.
Thu 19 Jan 2006
Major market averages have retreated somewhat after reaching new five-year highs. The intermediate trend has turned negative so for the next few weeks, markets are likely to have a downward bias. The action of the past week points out some of the problems of trying to follow the markets based on mainstream media reports. The talking heads on financial news networks tend to be late with their observations and they often have trouble sifting the chaff from the wheat.
Once the Nasdaq, Dow and S&P 500 peaked last week media reports made it sound like stocks were taking off on a new major bull rally. Based on the commentary, one would think the upward move was massive and those who were invested were getting rich while those who weren’t were missing a huge opportunity. While there has been some upward movement, it isn’t as dramatic as you might think. Since December 2005, the Nasdaq is up less than 3%. The S&P has gained about 2% and the Dow is up less than half a percent. So if you were out of the market and kicking yourself about missing this move, don’t sweat it.
On the other hand, during the same period there were significant gains in select market sectors. Most people probably won’t be surprised to learn that energy has performed well over that time. After all, the price of crude oil is back in the $65 a barrel range. But some international funds have done equally well.
I’m including a chart that shows some of these top sectors.
Let’s start with the light blue line first. It is QQQ, the Nasdaq tracking ETF. As mentioned, since the start of December this fund is up 2.6%. The purple line is Merrill Lynch Pharmaceutical HOLDRS (PPH). For the same period, this ETF is up 8.38%. Better still is the 11.51% gain turned in by iShares MSCI - Emerging Markets Index Fund (EEM), indicated by the yellow line. The green line is energy–specifically Oil Service HOLDRS OIH, up 14.75%. Other energy ETFs are not doing quite as well, but most have double-digit returns for this period. Finally, the red line is iShares MSCI - South Africa Index Fund (EZA), up 19.46%.
These are not all the ETFs that have done well during this time. I have chosen them because they are representative of sectors. For example, IShares S&P Latin America 40 Index Fund (ILF) is up 8.04%. Select Sector SPDR - Energy (XLE) is up 11.22%. IShares MSCI - South Korea Index Fund (EWY), the top-performing ETF in 2005, is up 9.96% over this period. StreetTRACKS Gold Trust (GLD) has gained 10.12%.
A listing of the top-performing ETFs during this time frame is dominated by international funds and energy funds. If that sounds familiar, it’s because it is the same situation we saw most of 2005. There were brief periods when other sectors would pop up for a few weeks, but for most of the year, energy and international funds produced the better returns.
Going forward, I’m suspicious of energy, because I’m not certain oil prices will continue to rise significantly above the current level. Higher oil prices bring the threat of inflation and run the risk of stalling current economic growth. So there will be a lot of pressure to keep oil prices constrained. But that doesn’t mean it will be possible to do so.
International funds–particularly the emerging market funds–obviously remain in an uptrend. And one of the oldest and truest adages of Wall Street says that you don’t bet against a trend. If I had to make a forecast, I don’t see any compelling reason why these funds won’t continue to do well going forward.
Have a great weekend. We’re currently buried in snow and I hoping for a sunny day so we can start to dig out.
If you haven’t had a chance to check out Strategis Financial Group’s FundTrader program, you really might want to take a look. Final 2005 numbers are in and net return for two of the three models were in the triple digits. Here is a link with more information:
http://www.strategisfinancial.com/fundtrader/fundtrader.php
Thu 12 Jan 2006
As 2005 was nearing a close, technical indicators seemed to be pointing to a correction at the beginning of 2006. Instead, stocks rallied and major indices reached the highest levels in more than four years.
As I began writing this commentary, the weather outside my window was sunny. It was a warm winter day with temperatures in the mid-40s. Weather forecasters warned that the day would be wet with up to an inch of rain in the valleys and two feet of snow in the mountains. The storm they predicted never made it this far south. We ended up getting a little rain and sleet, but not nearly the amount that was predicted.
It isn’t unusual for the weather forecast to be wrong. In fact, my wife chooses to ignore weather forecasts because of their inaccuracies. I tend to think the forecasts are right most of the time. I also spend a lot of time in outdoor activities. So if any sort of a storm is forecast, I err on the side of caution and make certain I am equipped for whatever might occur.
Forecasts about market activity are less accurate than weather forecasts. In fact, being wrong is so common that there are sentiment indicators that assume the majority opinion of what stocks will do will be wrong. One of these is the AAII Index. AAII stands for American Association of Independent Investors. In his most recent weekly market commentary, Tobin Smith forecasts a continuing major rally, based partly on a bearish sentiment reading from this indicator. (you can sign up for his free weekly newsletter at: www.changewave.com.) Here is how he assesses the situation:
“To put this into context, after following this index for 15 years, my research shows that when the index gets to 60%+ bullish and less than 10% bearish, the market hits a sentiment top — that is, all who CAN buy stocks HAVE bought stocks. Last week’s reading was the lowest bullish sentiment of the last 36 months! Maybe this explains the $3 trillion sitting in money market funds and accounts in the U.S.
RALLY ON
I used to corroborate this sentiment gauge with the broker/dealer margin. (When margin hits record highs and the AAII index is at a 50-point or more surplus of bulls to bears, watch out below!) But hedge fund margin usage clouds this statistic somewhat these days. The other sentiment metric that works almost as well is mutual fund cash flows as reported by TrimTabs — and there, too, instead of record highs we see record lows in equity funds going into U.S. stocks.
Given the following factors:
- Huge underperformance of U.S. buy-and-hold stock indexes to foreign indexes (excluding energy and Internet stocks, that is).
- Horrid sentiment of individual investors.
- Accuracy of the “as goes the first five days of January, so goes the market for the year” statistics (87.5% of the time equaling an “up” year).
- Underinvestment in U.S. equities by foreign investors.
- Falling dollar (which allows foreign buyers to get more bang for their euro, yen or other currency).
This rally looks to have long, luxurious legs … I’m talking Brooke Shields legs.
Me likee!
What could change my forecast?
- China choosing to drastically change its U.S. treasury portfolio, sparking a 200-basis-point crash in 10-year T-bills.
- A big crack in U.S. residential housing prices on a Fed tightening past 5% short-term rates.
- An Arab energy embargo as a result of Israeli-led destruction of Iranian nuclear fuel enrichment assets (and the complete destruction of the Iranian Air Force and missile silos to protect Israel from retaliation) and $75 oil for six months or more.
- What’s the likelihood of these three market killers happening this year?
- About the same as Fox News Channel getting an exclusive interview with Hillary Clinton.”
In contrast, there are currently many other experts who believe stocks are on the verge of a significant bear market correction. I’m borrowing some comments today from Tim Chapman, who is a consultant for Strategis Financial Group’s Asset Commitment strategies.
“No one can accurately predict the future but there are some interesting things to watch for in 2006. As always it is easy to find an “expert” pontificating on either side of the issues so I will give you both sides of the three arguments I hear most often:
“1. Pessimists (realists?) point out that the current bull market is now 38 months old if you measure from the October 2002 low, or 33 months old if measured from the March 2003 low. In either case it is getting long in the tooth when one considers the average bull market since World War II lasted for 38 months. Optimists agree but are quick to add that the typical bull market advance is 80% and the current advance has only been 61%, therefore they believe there is still some upside left. If the Bulls are right it would mean an additional gain in the S&P 500 of about 10%.
“2. The Fed raised short-term rates 14 times during the past few years and in the last week of December the yield curve inverted. That means short-term rates were higher than long-term rates. For example, right now T-bills pay a higher interest rate than 10-year bonds, which is unusual because typically investors demand a higher yield in exchange for tying up their money over a longer period. Bears know that inverted yield curves have historically been a bad sign for our economy, signaling a coming recession. The last time the yield curve inverted was early 2000, right before the last bear market began. The Bulls agree that inverted yield curves have been a precursor to bad times in the past but they believe this time is different primarily because of the foreign demand for U.S. bonds.
“3. Bears point out that the market is now overvalued or at least fairly valued based a current Price-to-Earnings (P/E) ratio of 17.8, which is slightly above historical levels and well above P/E levels one would expect at the beginning of a sustainable rally. Bulls believe that historically low inflation rates, with no apparent threat of increased inflation on the horizon make the realistic market P/E much higher. Plus they believe 2006 will bring continued strong growth in corporate earnings. For 2005, S&P 500 earnings was about $70 and analysts projections for 2006 put earnings in the $75-80 range. If earnings do reach $80 and P/E ratios stay at 17.8 it would mean an S&P 500 index value of 1424, which is 14% above the 2005 closing price.
“What Does It All Mean?
“What it means is no one really knows what will happen in the next 12 months. There is validity to the argument put forward on both sides. That is why we do not go into the year with a predetermined mindset and we think it is a huge mistake for a client to position his or her portfolio in such a way that it can only be successful with one specific scenario. If you get locked into the Bulls argument, you win if they are right but risk suffering big losses if they are wrong. If you blindly side with the Bears, you might miss rewarding returns that could be needed to meet your long-term retirement goals. In closing, it is important to be ready to react not quick to predict.”
I have to agree with Tim Chapman. I have no idea what the market will be doing for the next 12 months. But if your portfolio is correctly allocated, that should not matter. When I mention allocation, I am not talking about traditional allocation models espoused by Modern Portfolio Theory (MPT). (Is it still accurate to call it Modern Portfolio Theory when the theory is now more than 50 years old?) Instead, I am referring to an active allocation approach. Rather than divide our portfolio among several asset categories and then just passively wait to see what will occur, we want to actively allocate our assets among the strongest sectors, indices and other investment vehicles at any given time. At the same time, we always need to be concerned with risk and its management.
When MPT was first introduced, investing was still primarily an activity for the wealthy. There were no sector funds or exchange-traded funds (ETFs). There were no short funds or enhanced beta funds. Stocks trades had to go through a broker and there were hefty commissions. A long-term buy-and-hold approach to investing made sense primarily because there was no good alternative. Today we live in a world of cell phones, personal computers, and wireless transactions. In spite of all the advancements of the past 50 years, many people still adhere to investment practices that were developed when their grandparents were entering the work force.
Today individual investors have tools and instruments that were unimagined even a decade ago. Many of these allow investors to profit in both up and down markets. By learning how to use these tools and investments we can lower the cost of investing and find other ways to help stack the odds in our favor.
Thu 5 Jan 2006
