A Distilled Markets and Macroeconomic Letter: February 2007
Stocks - Short Term - Negative Outlook but Positive Mode
The market is still in a positive mode. I believe that caution is strongly warranted. The VIX (the “fear gauge”) is at 11.45 (1/29/07), which is very low and can be a contrary indicator. There seems to be little fear in the markets. On a valuation basis, I believe that the market is expensive. The housing downturn may weigh heavily on stocks.
Stocks - Medium Term - Negative Outlook
I believe that the risk is the market averages may have quite low returns for some time or potentially flat/negative returns when inflation is taken into account.
Bonds - Inverted yields pointing towards recession?
Yields are up a bit but the yield curve is still inverted. In the short run bonds may rise in price with a slowing economy but the longer-term bonds (5 year and longer) may eventually fall significantly.
Gold and gold stocks have been rising from early October. It’s relatively high at the moment at $648.60 (1/29/07).
Oil - Probably Stays High Unless...
Oil fell to $50 during the past month and is now back to $54.12. Factors for increased price near-term: terrorism, war, or other supply disruptions. Factors for a reduced price near-term: an economic slowdown, less terrorism, Middle East Peace.
Housing continues to be slow and new car sales are still off. Consumers are loaded with debt.
The Dollar has continued to come back up but it’s near a key resistance level (stockcharts.com ticker: $USD). I feel that dollar based assets may be at risk in the medium to long-term. Near-term I would not be surprised to see the Dollar move higher as there may be too many betting the other way.
The Fed funds rate is at 5.25%. The Fed has continued to make comments that they are concerned about inflation. The risk is that the economy is slowing much faster than the major media pundits would have you believe.
Today (1/29/07) on iTulip.com there’s an interesting video on the potential for increased efficiency to reduce our energy dependence (if you don’t see it on the front page look in the archive). Obviously the potential is great for reducing oil, gas, and electrical usage. I think it’s important to note that many of the potential changes that could take place would have to be phased in over many years. In the short run, though, terrorism, wars, and other disruptions could cause serious problems. The political pressure on the Chinese leadership to continue the economic expansion in their country is significant. This should continue to stimulate raw material and energy costs well into the future. Are the Chinese using newer, highly efficient, methods of energy production? I don’t think so, but I’m not sure. I think this is interesting to note as China’s potential for growth and consumption over the coming decades is massive.
As noted above, I expect, baring an economic slowdown, oil prices will stay at least relatively high. If there is a significant economic slowdown oil prices may continue to correct. If we have recession and supply disruption we could have the worst of both worlds. I’m, of course, hoping for the best.
In talks with investors who are concerned about the factors mentioned in my commentary as well as iTulip.com and other like-minded resources, I often become concerned that an overly aggressive stance is being taken. I believe that it is a real mistake to go too heavily toward betting on the destruction of the Dollar or very high Oil prices. Diversification strategies are prudent but heavy bets are only for the highest of high risk investors. What constitutes too heavy of a bet? That can be very hard to define as everyone’s situation is so different.
The Dow is near record highs. The Transports are still not confirming, which is not good for those betting that stocks are in a new bull market. I suggest reading Richard Russell’s excellent articles on this topic. Earnings are at record highs by about 100%. If earnings were at the historic median level, the market would then be judged to be very expensive. Most commentators are ignoring this. Take a look at John Hussman’s work.
I believe that the above is still quite valid. John Hussman’s recent commentary points out that there are some interesting current conditions in the markets that have, in the past, presaged rather ugly declines. Also see his most recent comments.
The yield curve is still inverted. Or, in other words, short duration bonds are higher in price when compared to longer duration bonds. This inversion along with other indicators point to a higher likelihood of a coming recession.
Gold has now been moving higher and may be close to breaching key technical levels on the upside. If gold now moves lower, I will be concerned that it is pricing in a recession.
Reminder: fiat currencies are not tied to anything of tangible value. They are only worth whatever the market, and the public, feels they are worth. As more fiat money is created the value of this paper money should go down. In my opinion, the U.S. is creating too much money and so are China, Japan, and Europe.
Dollar | Currencies
The Dollar continues to have a mild bounce up. Long-term I’m still negative on the Dollar. The real story is the Dollar against gold, where the Dollar has lost a huge amount of value and may lose much more.
Oil is at $54.12 (1/29/07). The risk is that oil stays high. If oil prices move downward substantially, they may be pricing in a recession.
Peak Oil/USD: There was a great comment made by “Finster,” on the January issue of Transparency, regarding peak oil and how the price rise in oil can also be viewed in terms of a decline in the Dollar. I agree. I think it’s also key to note that, in inflation adjusted terms, oil is still pretty cheap when compared to the high 1970s prices. I also feel that if oil is eventually priced more in other currencies there could be real issues for the US and our currency.
For many of the current concerns, oil, the Dollar, housing, etc., a significant factor is how fast change might occur. Generally, the faster the change the higher the risk for disruption in the markets and the economy.
The Fed is in pause mode and it seems that they will stay in pause mode for a while. If housing and the economy slow enough the Fed should start cutting rates again. Richard Russell thinks that there is risk that the Fed will not cut even in the face of a recession in order to support the Dollar.
I feel that the housing picture could become much worse.
Barron’s reported (8/21/06) some interesting statistics on housing: 10% of all home owners with mortgages have no equity in their homes and $2.7 trillion dollars in loans will adjust to higher rates in 2006 and 2007.
I believe that many consumers have less home equity now than before because they have taken money out of their homes and spent those funds. Consumer savings rates are very low or negative. I believe that consumers are being gradually squeezed by high oil prices on one side and rising interest rates on another.
My concept is to bring you a the most transparent look possible on the economy/markets via a quick read with plain language. This letter is geared toward the busy executive/business owner. If you are really short on time just look at the Snapshot section where I keep everything as brief as possible. In the Detail section I try to give a little more insight into my thinking without delving so deep that I stifle the reader.
When constructing portfolios, I take the client situation into consideration first and then combine that with the current economic/market factors presented in this letter along with well researched asset allocation strategies.
If you have specific questions on where I see things, or would like to discuss your portfolio, please feel free to contact me. Eric Hodges
Stahlschmidt Financial Group
925 906 4600
500 Ygnacio Valley Road
Walnut Creek CA 94596
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