Oak Street Wealth Management's Market Commentary 2-28-11

Barron's - All eyes are on Saudi Arabia. If the House of Saud falls, oil prices are likely to increase and stock prices to fall in the U.S. and abroad. If the kingdom's rulers once more display great skill at assuaging the religious establishment, and thus the citizenry, oil prices will most likely decline, and emerging markets and U.S. stocks advance. "As long as Saudi Arabia quiets things down, everything is OK," a senior trader at a top Wall Street bank said Friday, asking to remain anonymous because he isn't allowed to speak to the press. Because the price of oil plays such a central role in determining the direction of stock prices, many sophisticated investors are constructing defensive hedges on the U.S. stock market that would be triggered by a rise in oil prices. The idea is that rising prices will hurt economic growth because inflationary pressures will damp the consumer spending vital to the U.S. economy. Gluskin Sheff - The risk that the turmoil in the Arab states spreads further could very easily touch off further gyrations and upward pressure on energy prices, especially with Chinese demand showing no sign of abating ... yet. After all, pricing in Libya supply disruptions is one thing but what if this social unrest spreads to Saudi Arabia, which holds 20% of the world's oil? If Libya can spark a $10/bbl response, imagine what a similar uprising in Saudi Arabia could unleash. Do the math: we'd be talking about $200 oil. If equity risk premia do not manage to rise in this environment then we most certainly are in a total new era — of complacency. As it stands, even $100 a barrel is a dead weight drag on cycle-high profit margins and discretionary consumer spending. Remember when oil first reached the $100 mark in March 2008 the unemployment rate was 5%, not 9%, and fiscal policy was about to be loosened in a dramatic fashion, not tightened. The Fed had 300 basis points of rate cuts in its chamber, not zero. And while the impact will be felt in the real U.S. economic aggregates as a rising price deflator cuts into real-side activity, the effects are even harsher in emerging markets, who's economies are far more energy-sensitive (and less energy efficient) than is the case in the developed world. Crestmont Research - Al Pacino, Dionne Warwick, Jack Nicklaus, Peter Fonda, Raquel Welch, Ringo Starr, and Smokey Robinson—what do they have in common with secular stock market cycles? They were all born in 1940 and were subsequently impacted by secular bull markets. The choice of that year, which is not precise but was chosen for illustration, is that people born around 1940 aged into their forties by 1980. Most people and families accumulate savings slowly, if at all, during their twenties and thirties. By their forties, and certainly fifties, they begin to build retirement nest eggs. Therefore those born around 1940 had the opportunity to build sizable retirement savings during the 1980s and '90s if they invested well as they reached their prime saving period. David Brinkley, Shelley Winters, Walter Matthau, and others born in 1920 were saving during the secular bear market of the 1960s and '70s. With little stock market gain over that period, their savings would be filled with contributions that earned little additional investment income. That modest capital base, however, then encountered the secular bull market of the 1980s and '90s, and though the nest was small, the eggs from it were abundant. This walk down memory lane illustrates several points. First, secular stock market cycles deliver returns in chunks, not streams. Second, most investors live long enough to have the relevant investment period extend across both secular bulls and secular bears. Third, investors do not get to pick which type of cycle comes first. Fourth, investors need to be aware that they will likely encounter both types of cycles. Those who experience secular bears during accumulation are generally better prepared than investors who are spoiled by a secular bull. A secular bull market is a pleasant surprise to retirees who endured a secular bear on the way to retirement. For retirees who grew to expect a secular bull during accumulation, the unexpected secular bear can be considerably disruptive. Given where the stock market and valuations are today, the circumstances are quite different for people across different age groups. Gluskin Sheff - Have a read of the sad but true article on the front page of the WSJ titled Retiring Boomers Find 401(k) Plans Fall Short. The statistic in there was pretty scary but it does tell us that the savings rate will resume the upward trend that was temporarily broken last year. The median household headed by a person between the ages of 60 and 62 with a 401(k) account has put away less than one-quarter of what is needed to meet their standard-of-living needs in retirement. Yikes. Remember, there are 78 million boomers that are going to turn from being net borrowers and spenders towards net creditors and savers. This is definitely bullish for long-duration bonds, by the way, which is the most detested asset class on the planet right now, confirmed by the latest Merrill Lynch survey of global portfolio managers. Barron's - If oil were to remain between $90 and $100 this year, a roughly 20% markup from 2010 levels, overall economic growth could decline by 0.8 of a percentage point, estimates Vadim Zlotnikov, chief market strategist at AllianceBernstein. But growth in big-ticket spending more sensitive to oil prices could fall 5%. The U.S. economy can probably handle higher gas prices or higher mortgage rates—but not both, says Strategas Research economist Don Rissmiller. His rough rule of thumb: Risks of a downturn increase when the numerical sum of gasoline prices (currently below $4) and mortgage rates (approaching 5%) exceeds 10. We're still working our way through Kleiner Perkins' Mary Meeker's excellent analysis of the financial condition of the United States. Here's the one chart you need to see to understand why the US is messed up. This is the "income statement" of the United States in 2010. "Revenue" is on the left. "Expenses" are on the right. Note a few things... First, "Revenue" is tiny relative to "Expenses." Second, most of the expense is entitlement programs, not defense, education, or any of the other line items that most budget crusaders normally howl about. Third, as horrifying as these charts are, they don't even show the trends of these two pies: The "expense" pie is growing like gangbusters, driven by the explosive growth of the entitlement programs that no one in government even has the balls to talk about. "Revenue" is barely growing at all. The US cannot grow its way out of this problem. It needs to cut spending, specifically entitlement spending. We hereby announce that we'll give a special gold star to the first "leader" with the guts to say that publicly. Conclusion - When we discussed “risk” in last week's conclusion, we were in no way looking for a quick 3-day market drop that ensued from Tuesday morning through early afternoon on Thursday. Our thoughts on risk are strictly of the long-term sort that focus on the structural issues at hand (Mary Meeker's report above, sovereign debt issues, etc.). So to find out that the latest source of risk is due to Twitter reports from Libya (and the rest of Northern Africa/Middle East is a bit disconcerting considering (A) we don't have a Twitter account to follow these updates and (B) trying to invest (i.e. trade) based on this information is next to impossible (for the record, the market jumped 1% on Thursday due to an erroneous Tweet that Gaddafi was killed.). With financial markets as sensitive as ever to “new” media, investors should have an added level of awareness to the short-term risks that we as financial advisors try to ignore as we concentrate on the forest through the trees. Then again, reading articles about Libya's new civil war, the US government's possible shutdown in a few weeks and other topics du jour make us think those saplings are quickly turning into mature redwoods and may require more of our attention.