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Wednesday, August 26, 2009

Will Oil Be the Last Asset Standing?

Stocks and commodities gained last week while the dollar – as is often the case these days – fell.

As you recall from last week's update, the correlation between these three assets has unusually close. The see-saw today has stocks and commodities on one side and the dollar on the other.

Investors must ask themselves how long this party can continue, and which of these assets they should be left holding when it ends.

To be perfectly honest, when the party ends it will probably end for all three assets, with stocks, commodities, and the dollar all losing value. However, while all three will go down, only some will be down for the count...

THE RESILIENCE OF OIL
Leaving aside the dollar for the moment, let's focus on stocks and one key commodity, oil.

Our feeling is that oil prices have greater staying power over the long-term than stock prices. Unless you just walked in the door, you won't be surprised to hear us say that. But let's look at two of our most important reasons.

Right now, increased demand for oil stems from the part of the world where economic growth is highest – the emerging economies and especially China.

(Recently someone argued that Chinese growth is not really sustainable because the Chinese consumer accounts for only a small part of China's economy. We disagree that this situation constrains the economy. Chinese consumers are starting to step up their purchasing. We've seen a huge jump in Chinese auto sales for instance, to the level where they surpassed the car sales in the U.S. And retail figures suggest that the Chinese consumer is becoming more of a leader than a follower.)

Overall, Chinese industrialization, infrastructure building, and the rise of its consumer should prevent any collapse in oil demand.

On the other side of the equation, oil production is unlikely to overtake demand unless oil prices rise dramatically. Right now, producers need a minimum oil price of $70 a barrel to justify investing in new production.

And a temporary spike above $70 (like we have now) won't cut it. If anything, producers need to feel confident that $70 will be the bottom of oil's price range for the foreseeable future.

Given oil's huge spike and subsequent plunge in 2008, oil will need to get a lot more expensive and stay expensive for quite a while before producers get brave enough to start bringing new supplies online.

If oil prices fall back to under $70, oil supplies will remain at a level where they cannot keep up with even lackluster economic growth. Eventually, the world would not have enough oil available to increase production of other commodities or manufactured goods. With a fixed or even declining oil supply, Americans and other Westerners would have to consume less – gallon per gallon – in order for China and the emerging world to consume more.

And that's not a scenario anyone wants to see (especially since the developing world would win the contest).

Bottom line: we need oil prices to remain above $70 to sustain any growth whatsoever.

Meanwhile, U.S. consumers have problems of their own. They have sustained a serious blow, in the form of a $13 trillion drop in their collective net worth, which has them focused on saving more and spending less for the first time in decades. Under these conditions, higher commodity prices will act as a tax, giving consumers even more reason to stop spending. Eventually, it will hold back U.S. economic growth too.

How high can oil prices go before they start to impact economic growth? Actually, it's a question of both price and time. If oil prices remain in the mid-$70s between now and the end of December 2009, that would do it. It would mean we had a year-over-year increase of more than 80% - the level at which our Long Term Master Key would issue a “sell” signal on the overall stock market.

We are betting that oil (and commodities in general) will have more staying power as this scenario unfolds than stocks. Oil is in a cyclical uptrend whereas stocks are trapped in a trading range. However, you should know that both groups will decline in the short-term if that signal is reached.

By now, you may be wondering, “What do we do in the meantime?”...

FOLLOWING THE IRRATIONAL HERD
All we can say for now is that today's market is irrational to be following a path in which both stocks and commodities rise together. It's also irrational to see the most speculative, high risk stocks such as AIG or Fannie Mae accounting for the lion's share of market volume. Yet this has been the case on many recent trading days.

However, markets can stay irrational for some time. All we can expect, while we're waiting for the correction, is that the market leaders will continue to lead. Despite the incredible risks in today's economy the “high beta” (high risk) stocks may continue to outperform.

So if you are impatient and want to make some gains while waiting for the music to stop here's what to do...

First, hold on to gold and zero coupon bonds as a hedge for when the correction comes. Same with the conservative defensive/offensive stocks we mentioned last week.

With that protection in place, and only to the extent of your risk tolerance, you can pursue gains among our high beta choices. Our recommendations here are long-term keepers. Even though they could come down hard in a correction, they are also likely to lead the market in the meantime. They include:

Potash (POT) and Mosaic (MOS), the world's two leading fertilizer producers.
Fluor (FLR), the world's leading engineering and construction company, which will benefit from any drive to raise energy supplies.
Intel (INTC) and Apple (AAPL) as Information Technology plays.
Oil service companies, such as Transocean (RIG), Nabors (NBR), Schlumberger (SLB), and National Oilwell Varco (NOV).
While these stocks will surely decline when the overall market tanks, they are still good stocks to own for the long haul, as they are set to dramatically outperform the market that’s destined to be erratic in the foreseeable future. And with our recommended hedges in place, you should get through the decline, when it comes, in much better than average shape.

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