It’s hard to believe with oil approaching $100 per barrel, but the U.S. will consume over 1 billion (that’s 1,000,000,000) more gallons of gasoline in 2007 than in 2006. As a certain President once said, we are energy junkies.  We keep craving more regardless of the price.   Ask yourself this: Are you plugging more stuff into the wall each year? That requires even more oil, natural gas or coal. China, India and the other new economies also consume more energy each year.  Political instability in Nigeria, Iran, and Venezuela could limit supply. And, there’s only so much oil (natural gas and coal) in the ground. I’m not suggesting we’ll run out but it will become more expensive to extract it.

 

How can you ease the pain every time you fill up? Or better, how can you benefit from higher energy prices? By investing in energy companies. There are two ways to do this. You can buy a Natural Resources sector fund or you can buy a Value fund which holds energy stocks. The sector mutual fund is the “pure play.” It holds energy stocks and, probably, stocks of minerals i.e., iron ore and copper, mining companies. The risk with a sector fund is that there aren’t a lot of them to choose from and they aren’t diversified. Don’t get me wrong. A sector fund is diversified within its focus area, i.e., owns a number of energy and mining companies, but any fund which investors in only one part of the economy is inherently riskier then a broadly diversified mutual fund. The other way to “play energy” is through a large cap or mid cap value fund. These funds typically have some energy exposure. The downside of this approach is that value mutual funds have only a portion of their assets invested in energy stocks.

 

With either a Natural Resource fund or a Value fund (or any fund, for that matter), don’t just go by the name. Check the fund’s holdings to see if they match your expectations. Different fund managers view and approach their mandates differently. You can find a list of the top rated Natural Resource and Value funds and their top holdings at MUTUALdecision. You can drill down (no pun intended) further by going to the fund’s website for a complete list of its holdings.

 

Which investing approach is right for you? It depends upon how much risk you’re willing to take and how your other assets are invested (think diversification of your entire portfolio). Having an energy investment might ease the pain the next time you fill up.

The market enjoyed a good week last week with the popular averages increasing by more than 2%. The market focused on good earnings growth from technology companies, continued strong international demand, and reassuring news about the mortgage morass. The market shrugged off $90 oil and forgot about its principal worry of the preceding week – Structured Investment Vehicles (SIVs). Energy and SIVs are serious concerns. Squeezed refiners margins, and fear of government action, have limited the increases in the price of gasoline but how long can that continue? Further increases in the price of oil will have to be passed along, if not now, next spring when gasoline demand begins its seasonal increase. Even more worrisome is the impact of cold weather on home heating costs. SIVs are off balance sheet investments (remember Enron), so nobody really knows what going on with them but its safe to say that the question of the quality of their investments hasn’t disappeared in one week. 

 

Two key events take place this week: the Fed meets on Tuesday and the employment report is released on Friday. A cut in the Fed Funds rate would be greeted as a positive by the market but what would it really accomplish? It won’t help the mortgage market because most mortgages are priced against LIBOR (which the Fed can’t control). It won’t help the homebuilders or homes for sale because price is far more important than a small change in mortgage rates in build and buy decisions. Friday’s report will be the more important of the two. Employment figures will give us a further clue as to whether the economy will continue growing, albeit slowly, or if we’re moving closer to a recession.

 

Economists have a poor record of predicting big swings, such as oil going from $30 to $90 a barrel, and major shifts such as a recession. They can’t hit the curveball, but neither can most of us. We’ll only strikeout if we try to chase every pitch, every economic signal. We need to be long term investors. If there is no recession, the market will be significantly higher by next spring, as I’ve written about over the last few weeks. If there is a recession, the market will retract by some 20% but then it will start up again before the recession is over and, probably, when the outlook is bleakest.   This isn’t the time to take risks but to stay in the stock market and stick to your long term investment strategy.

Let’s dispel the notion once and for all that index funds are only for passive investors. Sure, the original index funds tracked the S&P and were meant for investors who either believed you couldn’t beat the market or didn’t want to try. Since their beginning, index funds have expanded their breath. You can find a fund which tracks any of the major indices and most industry sectors, such as health care and technology. The first cousin of index funds, Exchange Traded Funds (ETFs), do the same thing – they track indices. Between index funds and ETFs you can mirror any major index, small index, industry sector, industry sub-sector (i.e., biotech or software), global region or individual country. You can also try to outguess the indices if you want. For example, you can buy a S&P index fund which weights all 500 stocks equally or one which weights them by market cap, and so on. (Note to investors: make sure you know what you’re buying.) Thus far, we’ve only focused on equity funds but index and exchange traded funds also are available for fixed income securities. These funds are particularly suited for fixed income investments (Treasury, corporate or muni) because they can buy and sell bonds at much lower spreads than individual investors.

 

The proliferation of index and exchange traded funds means you can construct an entire portfolio of these funds to meet almost any investment strategy and risk level. A combination of a S&P fund, mid-cap and small cap domestic equity funds, foreign funds and fixed income funds of varying maturities, and a real estate fund would fit many investors objectives for a diversified portfolio with good growth potential and reasonable risk.

 

A mix of funds with individual securities or using a fund to fill a gap in your portfolio is an equally good idea. For the investor who wants to participate in, for example, biotech or emerging markets, a fund will enable her to achieve diversification in that sector (and the riskier the investment, the more important diversification becomes) with only a small investment.

 

Index funds can be bought and sold once a day; some ETFs as frequently as every hour. The larger funds are liquid investments and, in many cases, more liquid than their underlying securities (bonds and small cap stocks, for example). Transaction costs are modest, perhaps nothing for a no load fund (subject to certain holding period requirements) and typical stock commissions for an ETF.

 

So what’s the downside? There’s a body of academic literature and models which “prove”’ that a small group of fund mangers can outperform the market, think Peter Lynch and Bill Miller. If you believe this, and I do, or you just want to hedge your bet (I shudder as I write those words because investing is not a bet, it’s hard work and serious business), you can mix some actively managed funds in with your index funds and ETFs. The other issue you have to consider is that index funds/ETFs can take different investment strategies to for the same index. I gave the example above of two S&P 500 funds that are constructed differently. They will perform differently as a result. Structure and performance differences are even more pronounced as you invest in riskier/smaller indices. Taking biotech, for instance, one fund may broadly diversify, another may invest in the ten largest biotech companies, and a third may take a different investment approach. As a result, their performance will widely differ. So, again, make sure you understand your fund’s approach.  You can’t tell a book or a fund by its name.  Index funds and ETFs have a place in your portfolio; they’re no longer just for passive investors. 

 

The stock market celebrated the twentieth anniversary of the crash of ’87 with a 2.5% decline on Friday. Unlike 1987, the market averages are still up 6 – 8% for the year. Not surprisingly, the financial sector is the exception, being down about 9% for the year, with many financial stocks trading at prices approaching their August lows. Last week, the market reacted to some old news and some new news.

 

The old news was financial institutions reporting poor third quarter results. No surprise here. This was expected because of the mortgage, securitization, and residential real estate market problems. And, when a company knows it’s going to have a bad quarter it writes-off/down as much as possible, takes as many reserves as possible, to better position itself foe the future. I suspect this went on with the financials. Caterpillar’s results showed weak domestic demand and strong foreign demand. No surprise here, either. We know the U.S. market for construction is weak, primarily in the residential sector, and foreign demand is strong. Some investors interpreted Caterpillar’s forecast of a weak U.S. economy in 2008 as evidence of a recession but that’s not what the company said. Slow GDP growth is not a recession. No new news here.

 

What about the price of oil hitting $90 a barrel? At what point does it take such a big bite out of consumers pocketbooks that it drives us into a recession? It appears rising gasoline prices won’t deter the consumer but what about rising heating prices? The fall has been mild so far. A harsh winter may show that $90 oil, and correspondingly high prices for other energy sources, may be the tipping point for the consumer.

 

The new news last week was the public emergence of the SIV (sounds like something out of Star Wars) problem. Structured Investment Vehicles are off balance sheet entities -- black boxes.  Some SIVs hold subprime loans and other risky securitized debt. A SIV meltdown will paralyze the entire securitized debt market resulting in a full blown liquidity crisis. The SIV bailout pool announced with great fanfare by the banks and the Treasury Department won’t solve this problem. It’s going to buy the best performing SIVs. However, it’s the weak SIVs that need attention and banks have to come clean about the true extent of the problem before it will resolve itself. 

 

The stock market reacted to the SIV and energy questions.  Caterpillar’s forecast, layered on top of these issues, resulted in greater recessionary worries.  Pending some clarity on these issues, the stock market will mark time. Keep in mind, even weak economic growth forecasted for 2008 includes an approximate 8% growth in earnings. (See Christmas in October and The Government was the Last to Know.) It this comes to past, the market will advance significantly from its current level.

Why could the U.S. be heading into a recession? The most likely reason is the housing market – a multi-faceted subject. There’s the new home building sector.  It’s important because it employs so many people, not just in construction but, by extension, in the industries that supply materials to the homebuilders – lumber, concrete, appliances, and even retailers like Home Depot. Think about all the “stuff’ that goes into a home and how much you buy when you move. A slowdown (or collapse) in new home building has a ripple effect throughout the economy and could drive up the unemployment rate. 

 

Housing market problems are not limited to new home sales. The value of your home and the market for sales of existing homes is falling. By how much and for how long is the big question. But the problem here is the equity we have in our homes is evaporating. Even worse, those of us who have recently purchased homes or have taken money out of our homes, through refinancing or home equity loans, may have no equity left. A reduction in home values reduces homeowners net worth, causing them to pull back on spending.

 

The mortgage market mess is the last, but the not least, of the housing market issues.   The big problem is not subprime mortgages, it’s adjustable rate mortgages. Bumps in mortgage payments due to contractual provisions or an increase due to a rising LIBOR rate – most mortgages are tied to this rate and it may rise even if interest rates fall in the U.S. – will force consumers to cut back spending in other areas.   Lastly, will more stringent lending standards exacerbate the new home construction and/or existing home value problems?

 

There are other economic concerns as well – consumer spending (beyond the impact of the housing market), rising energy prices, the U.S. balance of trade deficit (are jobs being exported as a result?) So, if you’re concerned about the possibility of a recession, and who shouldn’t be, how do you invest?

 

The stock market, according to classical wisdom (or folklore) anticipates a recession by six to nine months. Since it’s currently at record highs (at least the Dow and S&P) this suggests a recession is not in the offing. But the market could change direction at any time. There’s a saying that the stock market has predicted ten of the last five recessions.   So maybe it’s not such a perfect predictor after all. The stock market also anticipates economic recoveries.  Add to the mix the psychological difficulty of investing in stocks when things are the bleakest (the best time to buy) and it demonstrates the difficulty (impossibility, for most of us) of trying to time the market. 

 

Most investors should be in the stock market to take advantage of growth in principal value and income which comes through the long term ownership of equities. Stocks which do best in recessions are those of the strongest companies and companies whose products consumers must keeping buying (think toilet paper not cars). The stocks to focus on are big cap companies, consumer staple products and health care. There’s an overlap between many big cap stocks and consumer staples and health care companies. I’d also add to this list companies with significant international sales. (Did you know that a majority of McDonald’s, and many other U.S. companies, sales are overseas?) There’s also a substantial overlap between big cap and international sales. You can find many good mutual funds which focus on these areas.

 

Will this investment strategy provide a positive return during a recession? Not necessarily but it will keep you in the stock market with a minimum amount of risk and the long term investor will be well positioned if there is no recession or for the upturn in stocks after the recession occurs.

 

What about bonds, you ask.  Don’t they do well during a recession? Yes, if interest rates decline as a result, but that may be occurring just when stocks are beginning to rally again. With long term U.S. Treasuries yielding below 5% (some good money market accounts have higher yields) how much lower can interest rates go, so how much higher could bond prices go? Focus your risk-taking investments on the stock market and keep the rest of your capital in cash.

The stock market was flat last week. Not a bad performance given that the popular averages are up between 10% - 14% (S&P 10%, Dow 13%, NASDAQ 14%) thus far this year and the market is wrestling with the question of continued economic growth (and, if so, how much) or recession. Last week, the market digested mixed reports on corporate earnings, more bad news about the housing market, a benign PPI number, a continued low level of business inventories, and record oil prices.

Retail sales were up a surprising 0.6% in September. This increase was posted in spite of unseasonably warm weather (ask Al Gore) which reduced demand for winter apparel. Retailers are already bemoaning anticipated weak Christmas sales. Christmas before Halloween?   What happened to the Christmas selling season starting after Thanksgiving? (The good news is that retailers are setting a low bar for investor expectations.) Retail sales are important, consumer spending comprises two-thirds of our economy. The key to continued consumer spending will be what happens to home and energy prices. If home prices continue to decline, consumers will retrench in response to their declining net worth.

 

Oil hit a record high of $83.60 last week. Anyone who doesn’t think there’s a global energy shortage should read South American Nations Face Energy Crunch in the New York Times, October 13th. Our economy has been remarkably resilient to rising (soaring) energy prices, unlike our experience in the 1970’s. At some point rising energy costs will force the consumer to cut back spending in other areas. In the meantime, rising energy prices worsen our balance of trade deficit and force us to keep looking over our shoulder for signs of inflation. 

 

The stock market is priced at a reasonable forward P/E of 14. As I talked about last week (See The Government was the Last to Know), assuming the consensus corporate earnings growth for 2008 and no recession, the stock market should work its way some 8% higher over the next few months.  A very handsome return.  Suppose thought that you want to be in the market but are worried about a recession. How should you invest? Come back on Wednesday and I’ll tell you.

Alan Greenspan writes extensively about the global economy in The Age of Turbulence. 

He believes there are common dominators to economic success. One is a cultural desire for growth, which includes government integrity, the acceptance of a certain amount of income inequality, incentives to take risk and the willingness to let market forces determine supply and demand. Markets are the antithesis of government decision making. The fall of Russian communism showed the fallacy of central planning. The socialism of Western Europe and the populism of Latin America are lesser forms of substituting the wisdom of government for the marketplace. Western Europe (India and elsewhere) suffers from bureaucracies with extensive approval processes which slowdown change and bureaucrats who substitute their judgment for the market. Restrictive work rules imposed on employers drive up costs and reduce the incentive to take risk, resulting in lower growth and, perversely, higher unemployment.

 

A second factor in economic growth is education. It speaks for itself. A third is a young, or growing, population.  Workers who save money (accumulate capital) and contribute to their heath and retirement plans aid economic growth. Non-workers, such as retirees, who consume these services, which have been promised to them by their government but have not been funded, place a strain on economic growth. As the ratio of workers to retirees shifts, due to the aging of the baby boomers and increases in longevity, the burden of these transfer payments on an economy/society increases.

 

The last determinate of economic prosperity is a strong rule of law, defined as a protection of property rights (and, by extension, individual rights). This is a major theme of Mr. Greenspan’s. Property rights include real estate, intellectual property, goods and, broadly, commercial transactions.  A strong rule of law is not a dictatorship, in fact, it’s just the opposite.  Individuals/companies will take risk, and invest for the future, if they can see a clear and consistent set of rules. As a corollary, risk premiums will be lower in this environment, meaning the cost of capital will be lower, promoting growth.

 

 We can extrapolate from Mr. Greenspan’s thinking as to the best international areas for investment.   So let’s go for an around the world tour. Western Europe has a strong rule of law but their bureaucracies, aging population, restrictive immigration which could otherwise offset an aging population, and expensive social services means their economic growth will be limited. Eastern Europe is on its way to a well developed rule of law and does not suffer from the problems of Western Europe (yet). It’s overcoming its Communist legacy and production costs are low.

 

Russia has inconsistently applied laws which vary with the whim of its rulers. It also has the Western European population demographics. A currency inflated by the high price of oil and gas exports is another limiting factor. However, abundant natural resources, an entrepreneurial spirit, and burgeoning consumer market are positives. Russia has great potential but equally great obstacles to overcome. 

 

Japan has greater population problems than Western Europe in terms of age and immigration and a bureaucracy structured to prevent companies from failing, limiting imports, and preventing foreign companies from operating in Japan. Yes, it has a strong rule of law but it is very Japan-centric. Is it any wonder that the Japanese economy has been stagnant for the last 15 years? Mr. Greenspan says that it will no longer be the world’s second largest economy by 2030. 

 

China is the global wildcard. Its growth has been impressive and it has moved towards a comprehensive rule of law.  But a Western-style rule of law and the personal freedom which it, and economic growth, brings are in conflict with a ruling autocratic party. One or the other will have to give way at some point.   Mr. Greenspan believes that China’s growth will continue, and although he doesn’t come out and say it, China will surpass Japan in GDP by 2030.

 

India has a strong rule of law but a bureaucracy which makes Western Europe’s look like a Ferrari. Its growth has been impressive but it hasn’t kept up with China due to severe infrastructure problems and cultural crosscurrents preventing its markets from freely functioning. Latin America is cursed with populism (take a look at Venezuela), Brazil being the possible exception. Severe income inequality, education and rule of law (government instability and corruption) problems abound.

 

Emerging economies, Mr. Greenspan cites Vietnam, are where the biggest money will be made. Of course, they carry great risk.  Nonetheless it will be exciting to see new economic hotspots emerge as the world looks for low cost production areas and certain counties seize the opportunity. Lastly, the United States looks pretty good by comparison to the rest of the world, despite our problems. Mr. Greenspan predicts we’ll still be the biggest and the best in 2030, although a smaller part of a bigger global pie. 

 

How do you invest globally? Stick with Mr. Greenspan and go with a strong rule of law. Invest in Europe, East over West and, if you can take more risk, invest in China and India. Constantly look for changes in law, or a shift in attitude towards a change, and watch for emerging gems.

 

There were 110,000 new jobs filled in September, slightly above forecast and a good showing. The July and August numbers were revised upwards. The August revision was startling, going from a net loss of 4,000 jobs to 89,000 new jobs created. The discrepancy was due to the underreporting of jobs filled in the government sector. Gives you a lot of confidence in the government and their reports, doesn’t it? It also shows the danger of reacting to one month’s data, i.e., August’s initial report. The three months taken together suggest continued, albeit slow, economic growth.

 

The stock market, as usual, anticipated the stronger than thought economy. It had recovered almost all of its losses since its July high and, on Friday, the S&P 500 and Dow both had record high closes. Goes to show, you shouldn’t try to out guess the market and the wisdom of investing for the long term.

 

With new jobs creation receding into the background, at least until next month, the primary driver of the market becomes third quarter corporate earnings reports. Analysts are looking for a down quarter overall, due to the August credit market problems. If the aggregate results exceed expectations it will be a positive for the market.  Given current earnings projections for 2008, and assuming no recession looming, the Dow and S&P should work their way higher by about 8% between now and late-spring of next year. Add in the dividends you receive on your stocks, and your return will be greater. If this market movement  occurs over the next six months, with dividends, it could approximate a 20% annualized return, very respectable when compared to a sub-5% annualized yield on Treasuries and a 2 – 3% annual inflation rate.  So, the stock market is the place to be.

 

We’ll still watch retail sales, the price of oil and the monthly trade numbers but, for now, our primary focus will be on earnings reports and whether analysts adjust their 2008 projections up or down as a result. Assuming the status quo, the stock market will gradually work its way higher in a saw tooth pattern.

Last week we received further evidence that the August credit crisis is resolving itself in orderly fashion. The First Data buyout went through and investors eagerly snapped up the debt to finance it.  The buyers of Harman and Sallie Mae reneged on their purchases. The prices were just too high in today’s rational debt world. Credit market problems and subprime mortgages are old news. As I’ve written about before, adjustable rate mortgages that re-set based on LIBOR will be a problem (see The Economic Crises of 2008 and On the Rebound), so the housing/mortgage market isn’t out of the woods yet.

 

New homes sales dropped to their lowest level in seven years (still, not bad compared to the long term average for annual new homes sales) and the sales prices dropped by 8%. This is a cyclical slowdown in the new homes market and is separate from any mortgage problems, but if it is coupled with a decline in value of existing homes it likely will plunge us into a recession. Further Fed cuts won’t prop up home values, what will mitigate it is a growing economy and that brings us to our final point. 

 

This Friday, the September jobs report will come out. (Remember, August’s was a disappointing 4,000 new jobs created.) The preliminary indication is 100,000 new jobs created in September, a number sufficient to suggest that the economy will keep growing, albeit slowly.

 

The market is craving economic news so it can determine if we’re heading for a recession or continued economic expansion. Housing values and mortgage rate adjustments will play out slowly over the remainder of the year. This week, the market will focus on Friday’s jobs report and will market time until then.