Can Oil and Equities Mix?

Dear Investor –

As media concerns about the continuing high unemployment levels have given way to the historical changes underway in the Middle East, the equity markets have demonstrated anxiety about oil supplies, oil prices, and its impact on inflation and the consumer. With oil prices having bolted to over $100 per barrel with commensurate increases in gas prices, Americans are beginning to feel it in their wallets, and this may put the economy at somewhat of a risk should these rises continue. Theoretically, with the Saudis able to ramp up production, however, the oil supply lines should continue with limited impact on longer time prices, helping to stabilize the markets in the coming weeks. Moreover, rising oil prices are beneficial for certain regions of the country (and Canada), and increase profitability and development in alternative energy.

For those with short memories, however, many oil experts sounded a similarly rosy refrain in 2008 not long before oil prices rocketed to nearly $150 per barrel, helping propel the economy into a steep decline. What we came away with from that experience is that commodity prices can be extraordinarily volatile beyond any measure of reason, and can present rude shocks to the system. While we feel that price pressures are less intense now and the impacts of oil price increases should not significantly impact inflation, we have to keep a watchful eye on oil more because it could act as a brake to economic recovery.

Perhaps trumping the increase in oil prices: the key economic fundamentals are becoming robust. Not only are corporate earnings strong as predicted, manufacturing and retail sectors are strengthening significantly. Productivity is at very high levels even as American workers are, well, overworked. Even the troubled housing market appears to be showing signs of a slow turnaround in several key geographical areas, and suggests a real downright revival next year. Most importantly, jobless claims and employment numbers are showing significant improvement. That confidence comes because we are showing consistent jobless claims under 400,000 -- a critical threshold, and because we are continuing to add a significant number of private sector jobs to the economy. At this rate, it will still take several years before we’re at the pre-recession employment levels, and many who are working are doing so for less pay. It may still feel like a recession, but the fact is that this economy is growing.

As a byproduct of the improving economy – we expect to see GDP growth of perhaps 4% or more this first quarter -- the Federal Reserve is now having to consider moving from a focus on helping spur economic growth and jobs to mitigating concerns about inflation. The Fed's easy money has probably been a big part of the equity run-up, and while this easing will soon come to an end on its own, it may be important for the Fed to actually send a message that it has inflation on its radar, and begin to take some tightening measures, although any tightening is not expected until summer if at all, and might be actually delayed if high all prices continue to put pressure on the economy.

 

The Markets. Despite the recent volatility in the equity markets, however, the S&P 500 index has logged gains of nearly 25% over the last 6 months. While this volatility may continue for some time given the geopolitical issues, with the economy in a rebound and with borrowing rates low there is good reason to believe that the equity markets will continue their climb for the foreseeable future. However, given the fact that the S&P has enjoyed such significant growth, a correction might be expected, but should still be considered of a short term nature. Long term prospects are looking, frankly, very favorable, and this bodes well for strong long term equity performance, short a major geopolitical trauma.

Fixed income investors have a more complicated picture, however. As long term bond yields have risen, the values of long term bonds, particularly Treasuries, have fallen. While they may rise during this period of Mideast turmoil in a flight to safety, we still feel that long-term bonds remain at significant risk in a rising interest rate environment. As a result, our focus has been more on intermediate term corporate bonds, higher yielding bonds, preferred stocks, and high quality municipals. We also are pursuing high-quality dividend paying stocks which we feel have the ability to perform well in an increasing interest rate environment. We feel that gold and silver remain solid hedges.

Despite our generally optimistic mid-term and long term outlooks, again, we do expect continued volatility. While we will remain vigilant to the kinds of issues that might precipitate a prolonged market slump, we feel that current gyrations are likely to be short-lived, and worth enduring.

 

Wishing everyone an early Spring.

Peace,
Ron Stein

Good Harvest Financial Group
631.423.6501
rstein@goodharv.com