Inflation / Commodities

Many people are comparing today’s economy to the economy of the late 70’s because of the run-up in oil prices. Some people think that inflation will come roaring back like it did in the 70’s. There is one big difference, however, between today’s economy and the one that existed in the late 70’s – home prices are falling today while they were rising rapidly back then. Rising commodity prices are certainly a concern and yesterday’s headline inflation numbers – a yearly jump in price of 5.6% (2.5% core rate when energy and food are excluded) – is a surprise to no one who has filled up their gas tank or gone to the grocery store lately. The Fed is trying to fight rising commodity prices (which are inflationary) on the one hand while at the same time trying to prevent a collapse in home prices (hugely deflationary) on the other hand. By keeping interest rates low, the Fed has decided to fight the deflationary impact of falling home prices. We do not anticipate a rise in home prices in the near future and believe the Fed has taken the right course in keeping interest rates low as deflation is much harder to fight than inflation.

The speculative bubble in commodities prices has been deflated in the past few weeks. We have seen oil prices drop from $147 a barrel to below $113 today. Other commodity prices have also fallen dramatically. Listed below is the percentage drop in the price of certain commodities from their recent highs of July!

Russia / Georgia Conflict

The death of the dollar was vanquished by Russia’s attack on Georgia. It was only a few months ago that some people were discussing the end of the dollar and the rise of the Euro as the world’s currency. Russia attacking Georgia was a wake-up call to the former Soviet states and Europe as a whole. Europe unfortunately has spent a lot of money on social programs instead of its military over the past few decades and is not prepared to fight the Russians if it is needed. As a result of this, we believe many Europeans are moving money to the dollar for security. If I lived in Poland, I would certainly be moving money to the dollar to protect my assets. The dollar has risen about 5% against the euro since the attack. We expect more gains in the dollar as Russia holds Europe hostage on energy and uses force to reassert their power.

Russia’s attack on Georgia should also serve as a wake-up call to our politicians. Being dependent on oil from countries that are not our friends is a precarious position for the United States. Russia’s attack on Georgia further amplifies the fact that oil producing countries can hold non-oil producing countries hostage. For our own security, we need to use our own oil and not rely on other countries. Some people claim that alternative sources of energy are the answer. It currently takes seven years to bring American oil to the market. Using alternative energy sources will take significantly longer – for example, wind provides less than 1% of our energy needs today. We can not afford to wait 20+ years for alternative energy sources to become a major source of energy for us – Russia, Iran and Venezuela will certainly try to hold us hostage before that time. We do believe we should continue to explore the use of alternative energy sources, but know that it is many years away before they will have any major impact our energy needs.

We believe we should start drilling for oil on our shores as soon as possible. This will bring down the price of oil immediately as future traders take into account an increase in oil supply when pricing oil out in the future. This is the best way to fight the Russian problem – as well as our dependence on oil from other countries. Remember, Congress’s record on alternative sources of energy has been a complete flop. It tried to promote the use of corn ethanol. What happened – food prices sky rocketed. Maybe the first election primary should be moved from corn producing Iowa to Alaska. If it had been, drilling in the ANWAR province would have happened already!!

Summary

Our investment model has proven to be very good at avoiding areas that are suffering the most. For the past year, we have been significantly under exposed to banks as banks suffered major losses earlier this year. We also currently have our lowest exposure in international equities since our founding in 1992. I don’t think anyone truly thought the financial crisis would be as bad as it has been and that Russia would attack Georgia. Many advisers have moved 40-50% of their client’s assets over the past 2 years into international stocks/mutual funds. We, on the other hand, have moved the other way. Our underweight position is starting to pay off. We believe the dollar will appreciate even more when these advisers exacerbate the problem with the euro as they start moving money out of international stocks in the months ahead. When international stocks become cheap, we will be ready to invest more money in this area – as we did in 1998.

The flood of money to the US and the drop in commodity prices is setting the stage for the market to rebound. When foreigners buy US stocks, as they did in the mid-90’s, the money is usually directed into large growth companies – the part of the market where we are overweight at this time. We also see other factors that are pointing to a rebound in the market in the near future: 1) There is a ton of cash on the sidelines as money market assets have grown 28% over the past 12 months; 2) Investor sentiment is currently lower than it was in 1994 and July 2003 –a very good contrary indicator; and 3) Stocks have not been this cheap compared to Treasury Notes since the early 80’s – a great time to be in the market.