The past year has not been kind to investors. Between problems in the housing market and rising oil and food costs, Many Americans are feeling as much economic pain as they have in the past 20 years. And for the foreseeable future, the economic and stock market pictures don’t appear to get any better.

Below is a chart showing how major indices have done since a year ago. The black line is the Nasdaq. You can see that it is off about 7% since last summer. The Dow Jones Industrials (gold line) have declined by 12%. Weakest of the three is the S&P 500, which is down about 13% over the past 12 months.

This chart also shows that right now there is no discernable trend among these major indices. That makes it very difficult to anticipate where the next move will come and how assets need to be allocated.

Complicating things for investors right now is that there are also no long-term, low volatility trends among the sector categories. Traditional defensive positions like government bonds, health care, and utilities are generally in the same kind of sideways funk as everything else.

The good news is that these types of situations are unusual and normally don’t last for an extended period. While we would all like to be invested in something that is going up, for now the best course of action is to remain on the sidelines until we can clearly see some sector and market leadership.
F.S.

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Like many of you, I am frustrated almost to the point of anger by the recent unprecedented rise in the price of oil. I’m upset because we’ve known about the potential for this kind of situation for almost four decades and have done almost nothing to prevent it nor to prepare for it. I’m unhappy because even now the government seems to show little concern for this situation.

The chart below shows Fidelity Select Energy (FSENX). You can see how the recent rise in the price of oil is unprecendented, even though this is an extremely volatile sector.

One argument I’ve heard repeatedly in recent days is that gasoline is still more expensive in places like Europe than it is in the United States. The implication is that somehow people in those countries are superior because they are able to adjust their lives to accommodate higher energy costs.

Unfortunately, most of us do not have the variety of transportation alternatives available in places like Europe. I would be happy to take mass transit to work each day, but it isn’t a practical option in my area. I also have horses and a horse trailer that can only be pulled by a heavy duty truck. Although I will travel with them less frequently, I am still essentially forced to drive a gas guzzler. 

We are a nation of homeowners, not a nation of apartment dwellers. A home with two cars in the driveway is not just the American Dream, it is the dream of virtually every country whose citizens aspire to have the type of lifestyle we enjoy. I’m not ready to give that up just because some oil company has decided to triple the cost of their product.

Much of my anger is focused on our government, which has done nothing to avert or to deal with the current situation. Alternatives to crude oil already exist and have for some time, yet there has been little effort to develop them in the U.S. For example, public buses in Iceland have been running on hydrogen for more than a decade. So obviously that technology already exists. The United States has an abundance of natural gas. Vehicles that run on natural gas cost about the same to produce as traditional cars. Here in Utah natural gas is currently selling for 64 cents a gallon. 

I’m upset because we are being told that any solution to this problem is still a long ways off. Here is an example: A few weeks ago, Utah introduced a commuter rail line called Front Runner. Plans are currently underway to extend that rail line to communities in the county where I reside. The projected date for that service is 2030. That is 22 years to extend the line about that many miles! It took less time to build the transcontinental line across the entire United States which was finished in 1869.

During World War II factories were retooled in a matter of weeks to stop producing consumer goods and start producing weapons. Factories that made washing machines and cars were quickly switched over to making tanks and fighter planes. Why were we able to make the conversion so quickly? Because we believed our way of life was threatened. People were trying to take away our freedom. 

I believe the situation today is just as dire. If a conquering power told us that we would all have to take a 40% cut in our lifestyle, we would be outraged. Yet that is essentially what is happening. Are we prepared to live in a society were 800-square foot apartments constitute the vast majority of all housing? Are we going to accept families with only one child because that is all we can afford? Are we ready to sacrifice the opportunity for our children and grandchildren to travel to Disneyland for summer vacation? If oil costs continue to rise, those are the choices we will face.

In spite of Federal Reserve Chairman Bob Bernanke’s assurances that all is well and a recession has been avoided (simply a way to hint that interest rates will be rising again soon), plenty of evidence still points to a weakening economy. Each of us can get an idea of how these higher prices will impact the economy by looking at our own families. Less disposable income means fewer meals at restaurants. One movie a month instead of three. Making the old car last another two or three years because you can afford a higher car payment because the price of gas is higher.

As we approach the next presidential election, I am looking for a leader who can solve this kind of problem. I want someone who can stand up and say: “In five years we will no longer need to depend on any other nation for oil. Here is how we can accomplish that.” I don’t want a president who is going to ignore this problem if the price of oil drops or who is willing to defer until the next president or the one after that.

I don’t want executives at British Petroleum or Chevron to dictate the type of lifestyle my grandchildren will enjoy. 

Here is hoping that someone in Washington will find the courage to do what needs to be done to protect our way of life.
F.S.

Volatility might be one of the most misunderstood aspects of the financial markets. In general, investors think volatility is a bad thing–at least when it works against them. In actuality, we don’t mind volatility when it is working for us. You never hear anyone say: “That stock I bought has gone up 10% a day for the past month. I’m getting dizzy trying to keep track. I just wish it would slow down.”

Another investor misconception is that volatility equates to risk. While there is often a high correlation between risk and volatility, that is not always the case. A good illustration is shown on the chart below. The gold line is the daily price activity over the past six months of OIH, an oil ETF (exchange-traded fund). The black line is Northeast Investors Trust (NTHEX), a high-yield bond fund.

Notice that the price movement of OIH is much more volatile than NTHEX. Yet over the period shown here, OIH gained more than 15% while NTHEX lost about 4%. Looking at the chart, almost every investor would say that they would rather be invested in OIH during this period than NTHEX. The reality of the situation, however, is that many if not most investors probably could not have endured the emotional turmoil of being invested in OIH during this time.

Consider that at the end of the first month, OIH was up about 10%. But over the following month, OIH gave back that entire gain plus an additional 10%. That is a 20% loss in just over two weeks. As a financial advisor, my experience is that not many clients could withstand that type of market action. They would be calling and canceling their accounts. We could try explaining that we believed oil prices would continue to rise and that when that occurred, OIH would recoup its losses and post good gains. But it would be difficult to convince investors to hold their positions when there remained the possibility of additional losses.

On the other hand, an investor who owned NTHEX during this entire period might not be too worried even after seeing a 4% decline, just because day-to-day price movements are slight. The investment does not have the emotional roller coaster of OIH which can gain or lose 4% in a single day.

Volatility is uncomfortable when its direction is uncertain.

Perhaps the most commonly used tool to measure investment volatility is standard deviation. Standard deviation is a reflection of how much an investment’s price varies from its mean price over a specific period. But as already explained, variance from the mean price is only bad when it is below the mean. Investors have little trouble with volatility above the mean.

A better tool to measure negative volatility is called the Ulcer Index. This indicator was devised by Peter Martin in 1987. It is designed to measure volatility in the downward direction. The name is derived from the idea that it is only this negative volatility that causes investors stress that can lead to ulcers. To learn more about the Ulcer Index including exactly how it is calculated, you can follow this link: http://en.wikipedia.org/wiki/Ulcer_Index

By virtually any measure, this year has been uncomfortable for investors. There are virtually no sectors with any kind of long-term trend. The chart below shows the price action of the Nasdaq over the past six months and its action is similar to the other major indices. So far the Nasdaq is below where it started the year and the past few weeks the index has been unable to mount a sustained advance even though technical indicators like RSI, MACD, and a 50-day moving average are all positive.

 
Although technical indicators might be positive, most fundamental indicators are currently negative. Investors are currently weighed down by factors such as rising inflation, a weak housing market and lagging consumer confidence. It will be hard for investors to feel warm and fuzzy about the markets until after market volatility swings strongly to the positive side.

F.S.