Oil... The Speculative Bubble

The June sell-off sent equities into negative territory for the quarter and dropped the S&P 500 to its lowest level since March 17, 2008. In a familiar tune, soaring energy prices, rising food costs, tight credit conditions and deteriorating consumer confidence remained the widely accepted causes for the market weakness and volatility.

Where do oil prices go from here? Obviously, it is impossible to tell. Certainly no one expected oil prices to soar 57 percent from already elevated levels in the first six months of the year (from $91.00 per bbl to $142.00 per bbl). Granted, urbanization and improved living standards in developing economies have created a structural shift in global demand for many commodities (please be sure to read our Market Letter entitled “Rough Rice” that will accompany your quarterly report in the coming weeks). However, in the short term, we believe this recent spike in energy prices has been fueled as much by speculation as it has by fundamentals. As such, ultimately these prices will prove unsustainable in the face of decelerating global growth. In short, the economic tightrope that must be traversed in the months ahead is as follows: Global economic growth needs to decelerate to a rate that will effectively pierce the current oil price bubble, without tipping the global economy into a synchronized recession. At this juncture we believe a global recession will be averted.

What do we think of stocks at these levels? Though valuation has historically proved a poor timing tool, with the S&P currently selling at 15 times trailing earnings, stocks have not been this cheap since 1990. On a positive note, equity multiples are already discounting a “garden variety” recession and current investor sentiment is quite bearish.

Does recent market action warrant an asset allocation shift? No. Apart from municipal bonds and short-term corporate obligations, with comparatively modest bond yields and mounting inflation risks, it is hard to make a case for bonds.

When might the tone of the market get better? As we stated in our market commentary of January 22, 2008 and reiterated in our transmissions on February 27 and May 29, “our best guess is that the first half of 2008 will remain very challenging for equities (i.e., volatile). Though tepid economic growth may persist into 2009, we believe the economy and the equity market will trough sometime in the second half of the year.”

As always, please do not hesitate to contact me or your portfolio manager with any questions or comments you may have.

Best regards,

George W. Hosfield,
CFA Chief Investment Officer