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Oil Over $50, Dow Under 10,000 What To Do Now?

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
September 28, 2004

IN THIS ISSUE:

1.  The Economy Slowed A Bit In August

2.  Crude Oil Prices Top $50 Per Barrel

3.  Another Buying Opportunity In Stocks

4.  Time To Take Some Profits In Bonds

5.  How To Get Back In The Markets Today

Introduction

The economy slowed marginally in August based on the latest reports, but GDP growth in the 3Q should still be a solid 3-3½%.  This week, we look at the latest numbers. Crude oil prices topped $50 per barrel for the first time in history this morning.  In this issue, we look at the reasons why oil just keeps going up.  The Dow closed below 10,000 on Monday.  Are we in a bear market, or is this another good time to be buying?  Bonds have done surprisingly well of late, thus offering investors another chance to take some profits.  Finally, I offer my advice on how you should be investing in today’s uncertain markets.  We have a lot of ground to cover this week, so let’s get started.

The Economy Slowed In August

Most economists still expect 3Q economic growth to be around 3½% in GDP, following the 2.8% increase in the 2Q.  The latest Wall Street Journal survey of 55 leading economists had an average forecast of 3.6% growth in GDP in the 3Q and an average expectation of 4% for the 4Q.  Yet if the economic reports for August are any indicator, we will be lucky if the economy makes those numbers.  Let’s take a look at the latest reports.

In perhaps the most troubling report, the Index of Leading Economic Indicators (LEI) fell 0.3% in August.  That marks the third consecutive monthly decline in the LEI.  Fortunately, the three monthly declines have been minimal.  This index bears watching closely.

The Conference Board reported that consumer confidence fell sharply in August (-7 points), but the University of Michigan’s consumer sentiment index fell only slightly in August.  While I would look for a revision in the Conference Board’s number, consumer confidence appears to be softening, especially with oil prices soaring again.

Along the same line, retail sales eased 0.3% lower in August following a rise of 0.8% in July.  Back to school shopping was not as strong as expected.  At the same time, auto sales dropped sharply in August by an estimated 12% overall.  Keep in mind that consumer spending accounts for over two-thirds of GDP.

On the manufacturing side, the ISM Index fell from 62 in July to 59 in August.  While any reading above 50 in the ISM Index indicates growth in the manufacturing sector, the slip to 59 in August is not a good sign.  Industrial production fell 0.3% in August following a rise of 0.4% in July.  Orders for durable goods fell 0.5% in August following a gain of 1.8% in July.

There was some good news in August.  The unemployment rate fell to 5.4%, the lowest level in three years.  Since August of last year, 1.7 million new jobs have been created.  For all of 2004, economists now expect over 2 million new jobs will have been created.

There was also very good news in the housing sector.  Housing starts rose 0.6% in August to a new high and are up 10.4% over August 2003.  New home sales jumped a whopping 9.4% in August to the highest level ever and way above expectations.

In summary, the economy remains on a solid growth track, but maybe not as strong as previously thought.  We had a generally strong month in July, which convinced many analysts to conclude that we had gotten past the so-called “soft patch” in the economy.  Now, the August numbers are raising renewed concerns.  Numbers for September remain to be seen.  I would not be surprised if the 3Q GDP number comes in closer to 3% than the 3.6% suggested in the latest WSJ survey.   

Oil Prices Top $50 Per Barrel – A Record

Oil prices have once again soared to new highs with crude trading above $50 per barrel as this is written, and this continues to take a toll on consumer spending and the economy.  The latest spike has been spurred by the string of hurricanes which have slowed or halted oil production in the Gulf of Mexico and elsewhere. 

The hurricanes have also slowed imports of oil at Texas and Louisiana ports where some of our largest refineries are located.  Several refineries are actually low on crude.  As a result, President Bush is expected to authorize at least three releases of oil from the Strategic Petroleum Reserve (SPR) to affected refineries.  The Bush administration has never approved a full release from the SPR and has maintained that oil should only be released in the event of a national emergency.  However, because the oil refineries’ requests amount to a temporary partial release, to be repaid in full, we are told that President Bush has, or will, grant the requests.

While the disruptions from the hurricanes may be only temporary, and while oil prices may dip back to $40 or lower afterward, the supply/demand fundamentals for oil continue to suggest the days of cheap oil are over.  World oil demand is growing at the fastest pace in 24 years. China's economic juggernaut is draining oil from all around the world.  Chinese crude imports are up 40% so far this year and are forecast to keep rising next year as car ownership surges and power generation needs grow.  The US economy remains strong as discussed above, and we consume apprx. 25% of all world oil production.  Demand from India and Asia also remains very strong.

On the supply side, new oil reserves are becoming harder to find and more expensive to develop. Many of the oil provinces outside OPEC are mature, which means that new finds are smaller, need more costly technology to develop and fall faster from peak production.

OPEC, which holds around two-thirds of the world’s oil reserves, has pushed its production to the highest level in 25 years in an effort to keep prices under control.  Most OPEC members are already producing flat out to meet demand.  This has left little spare capacity except for Saudi Arabia.  The strain on the world supply system has left it more vulnerable to supply disruptions and increased the likelihood of price spikes.

Iraqi exports have been repeatedly hit by sabotage attacks, keeping its supplies below pre-war volumes.  There are growing fears that Islamic militants may be planning attacks on oil facilities in Saudi Arabia.  Should that happen, oil prices would shoot higher once again.  Supply concerns have spurred many countries to increase strategic inventories, thus withdrawing more supply from an already tight market.

In the US, environmental concerns have ruled out development of known reserves.  In addition, environmental regulations have resulted in significantly higher refining costs by forcing companies to build expensive new facilities and making it harder to ship supplies between regions.  As a result, US refining capacity has not kept pace with demand.

All of this points to continued high oil and gasoline prices.  The question is, should oil prices be above $50 per barrel or below $40?  The answer is, if we continue to see supply disruptions, then we may have to get used to $50 (or higher) oil prices.  On the other hand, if the supply chain can get back to normal, then I would expect to see oil prices retreat to the $35-$40 range.  Don’t forget that oil is still a commodity, and in commodities, what goes up also comes down.

Another Buying Opportunity In Stocks

Concerns about rising oil prices have pushed stocks back to the lower end of the trading range.  As this is written, the Dow Jones is hovering right around the 10,000 level.  The major stock market averages have been in a trading range all year with the Dow meandering between 9,800 on the downside and 10,600 on the upside.

I have money with one particularly savvy equity options trader in New York who just loves this kind of market.   He sells options on both sides of the market and hopes it stays in a trading range.  If it does, he gets to keep the option premiums paid by the buyers.  So far, he’s having a banner year while most equity managers and investors are struggling to stay even or are losing money.

Of course, selling options on stock indices is a very high-risk strategy, and I would never recommend that investors try to do this on their own.  In fact, I don’t even recommend that investors purchase options since the vast majority of options (90% or more according to some sources) expire worthless – meaning the buyers lost ALL of the money they invested.

At this point, it remains to be seen if stocks will: 1) remain in a trading range; 2) breakout to the upside; or 3) breakout to the downside.  I continue to be on the optimistic side as I have been since just before we went to war in Iraq.  I base that opinion on the outlook for a continued strong economy for the next year or so and the improvement in corporate earnings and business spending.  Corporate profits are expected to have risen over 14% for the current quarter.

Another thing I like is the fact that “investor sentiment” has plunged to the lowest level in almost two years.  Over 60% of investors are bearish at this point according to several groups who track sentiment and “contrary opinion.”  Likewise, the number of bullish Advisors (professional money managers) has plunged to the lowest level in two years as well.  Equities tend to reverse higher when too many people turn bearish and reverse down when too many people turn bullish.  People are too bullish at the tops and too bearish at the bottoms.

While I have been bullish on stocks since just before the war in Iraq, I continue to have the bulk of my equity portfolio with active professional managers that have the ability to “hedge” their positions or move partially or fully to cash. 

Two excellent managers that can do this are Niemann Capital Management and Potomac Fund Management.  You can see their long-term performance records at my website.  Niemann requires $100,000 to invest in their programs; Potomac accepts accounts as small as $25,000.  I highly recommend both.  Past results are not necessarily indicative of future results.

Interest Rates – Bonds Do Well, But.…

Bond investors have enjoyed a nice surprise over the last few months.  Despite concerns about rising inflation and despite the third Fed rate hike this year, Treasury bonds and notes have performed well since June.  The 10-year T-Note, for example, has dipped slightly below 4% as this is written, down from near 5% in May and early June.  The 30-year T-bond has fallen to a yield of 4.7% as this is written, down from 5.7% earlier this year.

The question now is, how much lower can long rates go?   Will they match their historic lows reached in mid-2003 when the 10-year note fell to 3½% and the 30-year bond fell to near 4¼%?  I don’t think so.   Unless there is a major negative surprise to the economy, I would expect we are near the lows in long rates now.  In fact, some professional bond managers are using this opportunity to take some profits and move to the sidelines or to other types of bonds.

For investors who are knowledgeable about the high yield bond market, now may be a good time to take some profits in traditional bond holdings and look to the world of junk bonds.  High yield bonds have the potential to appreciate when the economy is growing and in spite of a rising interest rate environment.  High yield bonds were the big winner in 2003 but have not yet moved that much this year.

I continue to recommend Capital Management Group for high yield bonds.   You can see their long-term performance record at my website.  CMG invests in large, highly diversified high yield bond mutual funds.  CMG can be fully invested, partially invested or fully in cash depending on what their sophisticated systems are signaling about interest rate trends. 

I realize that high yield bonds are not suitable for some investors.  I do not recommend that investors get into this market on their own.  Even I don’t do it on my own; I only do it under the guidance of a proven professional bond manager like CMG.  Past results are not necessarily indicative of future results.

Conclusions

The economy should average 3-4% growth in GDP for the second half of the year.  The Bank Credit Analyst and most economists expect growth of 4% or better in 2005.  However, if oil prices remain in the high $40s or low $50s, this will present a serious headwind to the economy, both in the US and globally.

Regarding oil, there is an old saying in the commodity markets: “the solution to high prices is high prices.”  What this means is that the longer prices remain high, the lower they will fall eventually.  High prices lead to higher supply, reduced growth in demand and lower prices eventually.  In the case of oil, the bulls tell us there’s no way to significantly increase production, and China will cause demand to continue to soar.  But do not forget that oil is still a commodity, and commodities have a history of topping out when it’s least expected.

If the economy continues to grow at 3-4% or better as expected, I believe that provides a window of opportunity for stocks over the next six months to a year.  I look for stocks to break out of the trading range to the upside later this year, perhaps after the election.  And I think stocks could surprise on the upside yet again if there are no major negative shocks (terror, etc.).

Yet I also recognize that I could be wrong.  Despite the firm economy and improving corporate profits, it is possible that this seeming national malaise could, due to an absence of buying, send stocks even lower.  That is precisely why the bulk of my equity portfolio is actively managed by proven professionals who can “hedge” their positions or move partially or fully to cash if need be.  The same goes for most of my bond portfolio.

If I am correct and stocks do trend higher, most investors will miss the move.  There is still a mountain of cash sitting on the sidelines in money market funds and CDs.  These investors are not buying stocks today.  And they will probably be too scared to get in when (and if) it becomes clear that the trend has turned higher.

That is why having professional active managers makes so much sense.  Successful money managers have time-tested systems in place which are designed to get them in the market if the trend turns higher, in some cases even before the trend turns clearly higher.  Just as important, those same systems are designed to signal them to hedge their positions or move to cash if the markets should roll over to the downside. 

And they will roll over to the downside at some point, perhaps in a major way.  While the economic outlook is positive for the next year or so, there will be another recession.  I happen to believe it will be a serious one.  I will talk more about that in upcoming issues. This is another reason why I believe you need carefully selected active managers overseeing a good portion of your investment portfolio.  Past results are not necessarily indicative of future results.

Give Us A Call – What Could It Hurt?

At my company, we help investors all over the country; we have clients in every state, many of whom I have never met in person.  Yet we work with each client individually and help them structure their investment portfolios to meet their goals and risk tolerance. In addition to the professional money managers mentioned above, we also have various other investment programs available.

I have a talented staff of Investor Representatives, including a Certified Financial Planner, who are among the nicest and most professional people you would ever want to meet.  Everyone on my staff is on salary; no one is paid commissions; and there is never any pressure to invest.  Also, your information is strictly confidential.  See our Privacy Policy.

So, if you are sitting on the sidelines or are under-invested in the markets, I invite you to give us a call at 800-348-3601.  Or visit our websiteWe can help you put proven professionals on your team, and we can introduce you to the world of alternative investments.

Wishing you profits,

Gary D. Halbert

SPECIAL ARTICLES

Liberal Christopher Hitchens laments the sad
state of the Democrats & the Kerry campaign.
http://politics.slate.msn.com/id/2107193/

The disgraceful treatment of Iraqi Prime Minister
Ayad Allawi last week during his trip to the U.S.
http://www.weeklystandard.com/Content/Public/Articles/000/000/004/672upfks.asp?pg=2

The Florida Myth – the truth about 2000.
http://www.opinionjournal.com/editorial/feature.html?id=110005682

Why Kerry & Kennedy were & are again wrong about Iraq.
http://www.weeklystandard.com/Content/Public/Articles/000/000/004/690vbgoe.asp?pg=2


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Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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