4th Quarter 2006: Fourth Quarter Review

Fourth Quarter 2006
Market Commentary

Fourth Quarter Preview

As we enter into the final quarter of the year, we thought it might be helpful to review the various cross currents of what has been a choppy, summer market, address the issues and forces causing these cross currents, and render our opinion as to what may have recently changed, what factors may be new or different, and where these forces may be taking us.

We have commented extensively in the past about budget deficits, trade deficits, and how the forces of globalization have created a change in the way we manufacture and buy goods and services. We have also commented on the imbalances that result from these trades. These financial imbalances have created deficits of such magnitude, that they have caused the Federal Reserve to address these imbalances with a series of progressively higher interest rates. In turn, these interest rates are beginning to have a negative impact on economic growth, and have begun to slow down the economy.

Budget deficits are estimated at $250 billion this year, while at the same time, trade deficits have catapulted to an annual rate in excess of $800 billion. The combination of the two exceeds $1 trillion annually.

As we stated in our most recent July commentary, our trade deficits arise from two primary forces. The first are goods and services produced overseas by peoples of emerging nations, who are willing to work for wages that are only a small fraction of what we pay for labor in the United States.

Apart from the deficits arising from importing foreign made goods, the other driving force in our financial imbalances is and has been oil. We've also commented extensively in the past about oil, specifically, A) the demand-supply relationship of oil, B) the difficulty and cost of finding new sources of reserves, and C) the geopolitical aspects, and attendant problems of those countries from which we import much of our oil.

All the forces which we have commented on for the past year and a half, have been, and were in place, until approximately the end of August 2006. During this timeframe, we had a climate in which the price of oil kept rising along with increasing worldwide demand for oil, but most specifically from the emerging nations of China and India. Those two countries were not only increasing their demand, they were increasing it at an accelerating rate - an unsustainable rate given the supply limitations that have been in place.

Oil has more than tripled in price over the last 2½ years, as we all know from both the headlines in the media, and the prices at the pump. When the price of oil hit $79 in July, many were calling for $100 oil or higher, predicated on the concerns listed in A, B, & C above. Subsequent to that $79 price high, we are now looking at a price of oil at $59.50 (October 12th) a barrel, a decline of 20% in a period of approximately six weeks. This decline has several ramifications which may affect both the market and the economy in the weeks ahead, which we would like to expand on in this quarterly commentary.

 

New Factors Affecting Oil

Apart from the three (A, B, C) factors referred to above, there are three other factors that have become a component of the pricing mechanism of oil. The first is a fear that we are running out of oil, as discussed in our April commentary. The second factor has been a slowdown in the overall economy not only in the U.S., but all throughout the world, which in turn, has led to a temporary reduction in the demand for oil. The third factor is geopolitical concerns.

1) The Fear of Running Out of Oil

On September 3rd Chevron, along with Devon Energy of the U.S. and Statoil of Norway, announced that they have discovered a major oil field 175 miles southeast of Louisiana in the Gulf of Mexico. Chevron announced that this oil field could contain anywhere from 3 billion to 15 billion barrels of oil. Chevron also announced that this find occurred 20,000 feet under the ocean floor, which in turn, was under 7,000 feet of water. On the one hand, recognizing Chevron has been extremely conservative historically in estimating their reserves, revenues and earnings, the market immediately focused on the higher 15 billion barrel number. The 15 billion barrel number is significant because the proven land reserves of the U.S. oil industry within the U.S. proper is approximately 30 billion barrels. As a consequence, fears of a supply problem seem to have vanished overnight and the price of oil dropped from the $79 in July to $59 today. Chevron also announced that it would not be very easy to get this oil out, and it would come at a great cost. They felt it would take at least four years to get any production there, and then only if current economic conditions warranted its production. The market, however, riveted on the positive supply aspect of this, whereas the reality of actually producing and developing this field does not really address the near or intermediate term aspects of supply; but it could be very meaningful for containing the longer term price of oil.

2) A Slowing Economy

The 17 successive rate hikes from the Federal Reserve have raised the Federal Funds rate from 1% in June 2004 to 5.25% today. There is generally a lag effect on the economy from these changes in monetary policy. These changes normally take anywhere from 12 to 18 months to develop. As mentioned above, the indications are that the rate hikes are beginning to have an effect on the U.S. economy; a significant one in the case of housing and a lesser effect as it relates to other aspects of the economy. The U.S. economy grew at 4% in the first half of 2006, but indications are that it will slow to 3% in the second half, and stay at that level or slightly lower for the first half of 2007.

The latest economic reports pertaining to housing would indicate that the long boom in residential real estate is finally slowing down. The latest numbers in August, show the median value of homes across the country fell by 1.7% in value, according to the National Association of Realtors. This was the first annual, monthly decline since 1995.

In addition, both housing starts and building permits have begun to decline, while (unsold) home inventories have risen. Recent reports also indicate that sales of existing homes and new home sales have both declined 12.6% and 17.4% respectively, year over year.

 

The Federal Reserve Bank, which has been the driving force behind the rising interest rates that have slowed down housing, have observed the same data points, and have left rates unchanged for the first time in over two years last month.

Further, comments by the Fed and Fed watchers to the effect that interest rate hikes may be over - at least for awhile - seems to indicate that the Fed senses that they may have gone too far - or at least far enough for now, and that pressure will be off rates for awhile.

Many investors have responded to this data by sniffing out the possibility of a recession and/or a reversal in Fed policy, and have shifted funds out of both real estate and energy to invest in bonds. As a consequence, bond yields (which are inverse to price), have fallen sharply, with the ten-year U.S. Treasury yielding 4.75% on October 12th, compared with 5.24% in June. Recent weakness in commodity prices would also seem to suggest an economic slow down, as the demand for loans and resources weakens.

3) Geopolitical

The third factor is geopolitical concerns, arising from the fact that much of our oil comes from the Middle East, where there are significant difficulties within the governing forces of many of the Middle Eastern states. In addition, as we have also mentioned, other major producers such as Venezuela have expropriated assets of U.S. based and European based oil companies, thereby exacerbating the supply concern.

Further, there are increasing insurgencies in Iraq and other mid-eastern countries, as well as Nigeria, where recent uprisings have cut production by over 500,000 barrels a day. All of the countries just mentioned are net suppliers to the U.S., with Venezuela and Nigeria among the top five. The other three of our top suppliers are Mexico, Canada, and Saudi Arabia. Mexico just went through a tight election wherein the loser, Lopez Obrador, decided to contest the election, and even camped out in the street of the Plaza de la Reforma, the main road in Mexico City. (Hugo Chavez of Venezuela pulled a similar tactic in Venezuela after he lost that election, but in his case, was able to force a second election more to his liking). Not to get off-track, it is noteworthy that Obrador, a known socialist with leftist ties to Cuba and Venezuela, campaigned on reducing ties with the U.S., and cutting our supply of their oil.

Saudi Arabia is our third largest supplier, and our fear is that the Sunni-Shiite quarrels within Iraq and Iran could easily spread to threaten Saudi Arabia as well. That leaves Canada alone, among our top five suppliers, as presenting a safe harbor politically, from which to export reliable and safe deliveries of oil.

Each of these three factors represents some part of, or a component of the price of oil. In our opinion, that premium could have been as much as 33%, but probably closer to 20%. Thus, if our estimates are correct, and if all those three factors went away or became less of a concern, the price of oil would, or could drop anywhere from $75 down to a range of $50 to $60 (33% and 20% drops respectively from the $75 high).

These geopolitical concerns appear to have been shoved under the rug, but they are as threatening as they have ever been, in our opinion. The fact that there is a temporary truce in the fighting between Israel and the Lebanese Hezbollah has been referred to as a major pivot point in Mid East relations. We're not buying into that one, and believe that not only is the Israeli - Lebanese / Palestine conflict still alive and ugly; but we're also seeing an acceleration of insurgency in Iraq, much of which is being fueled by Iran. Keep in mind that Iran is also a major exporter of oil, controls the Straits of Hormuz, which 80% of the Persian Gulf oil flows through, and is building nuclear centrifuges. So in our judgment, whatever premium one might put on the geopolitical concerns should only be increased, not decreased.

Market Environment - A Reason For Hope?

The Dow Jones Industrial Average, which has been moving sideways for some period of time, is now back to it's 1999 levels. On the cautious side, one might note that the Standard & Poors 500 remains 12.5% below its record close, and the NASDAQ is still 55% below where it was in March of 2000. On the positive side, however, we are cognizant of, and have been bullish about the fact that U.S. stocks, particularly large cap multinational industrial companies, are about the only major asset class that is not significantly above its price level of five to seven years ago.

So where does this lead us? First, we appear to be in a cooling off period for oil - whereby the energy sector - which has led the market over the past year and a half, will probably rest until the three factors described and discussed above are re-ignited.

Second, what's bad for oil is good for the economy, so the oil price drop not only helps the consumers; it takes pressure away from the Fed's posture of raising interest rates. This is because inflationary expectations, among other things, go up and down with the price of oil. Further, the decline in oil prices as described above has caused the recent price of gasoline to fall, which also comes after the seasonally strong summer months wherein travel is at a high level.

Third, not all news is bad. As we reported in our last quarter's commentary, the corporate sector is quite strong, and we are now looking at what might well be the 15th consecutive quarter of double-digit earnings gains by the Standard & Poors 500 stocks, despite the overall economic slowdown described above.

Worldwide economic growth is still historically strong also, despite the slowdown, and overall profit growth has far outstripped share prices in recent years. In fact, the price/earnings ratio's of S&P 500 (now 17.4 times) is down considerably from five to six years ago as the index as a whole has basically been trading in a sideways trend while earnings growth has been strong. Further, as earnings of the largest U.S. companies continue to grow, they are beginning to look relatively cheap to other asset classes even if the U.S. economy slows. Many large cap, brand name U.S. companies that have had huge earnings growth cost less today than they did five to seven years ago.

Fourth, in the meantime housing, which had been attracting large flows of investment dollars in recent years, has become expensive and has begun to cool (even with the drop in the 30 year treasury), and interest rates with low long term yields are not too attractive either. Thus, global investors, with lots of trade and petro dollars to recycle have begun to take notice, as have domestic investors.

Fifth - S&P 500 corporations are sitting on over two trillion dollars in cash, the largest cash reserves in history. Moreover, as discussed in previous commentaries, dividends are increasing at an increasing rate, and the tax rate on (qualified) dividends is still only 15%. Finally, corporations are also buying back their own stock in record numbers providing some support to the market. In fact, Standard and Poor's reports that S&P 500 companies repurchased a record $116 billion worth of shares last quarter and that over 40% of the companies in the S&P 500 have reduced their shares outstanding with buybacks during the quarter.

Conclusion

We are in an environment wherein the economy is slowing, interest rates are temporarily going down, inflation is falling along with the price of oil, and earnings are still rising. This is a framework (in our opinion) for a gradually rising stock market, a relatively flat bond market, and an overall scramble for yield.

Within this framework we tend to favor high quality - internationally oriented blue chips - as represented by the S&P 500, and by the Dow 30, who are leaders in their markets, and utilizing their cash hoards, to keep increasing their dividends, and repurchasing their own stock.

As always, thanks for your support. Please call us with any questions you might have.

 

Bill Schnieders
Principal

Jim Schnieders, CFA
Principal

John Schnieders, CFA, CFP®
Principal

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