Crude Reality

- 2008 2nd Quarter

As I sit to write the Market Commentary for the 2nd quarter of 2008, I cannot help but shake my head in sheer amazement as to what has transpired over the past 90 days (actually for the 2nd quarter of 2008).  In many ways, the quarter was like the old movie "The Good, (April) The Bad, (May) and the Ugly (June)".   

The purpose of the Market Commentary is to attempt to clearly explain the events that have occurred in the market place over the last quarter and to tell you what we expect in the coming months, and the remainder of the year ahead.  I will talk in detail about the Fed, the oil saga and our continuing struggles with the Housing Market and Credit problems. I will also attempt to tell you where we go from here.

As we entered the 2nd quarter, we were all very stunned by the results of the 1st quarter - the S&P fell sharply, losing 9.45%.  The talk, when describing the Market, was that we were in or headed towards a recession, and the lead story that caused the sharp drop in the 1st quarter was the ‘Credit Crunch’. The ‘Credit Crunch’, which began in late 2007, was the result of the banks having written off tens of billions of dollars.  Having been burned by defaulted loans, the lending institutions reacted by making it so difficult to borrow money that people with excellent credit were, and continue to have difficulty getting a loan.  While previous loan standards were virtually non-existent, they have now become so strict that lending activity has come to almost a virtual halt.  In reaction to the events that transpired in the 1st quarter, the Fed slashed interest rates by 2% and then by another .25% early in the 2nd Quarter.

While many experts applauded the promptness and creativeness with which the Fed reacted during the 1st Quarter, many are now blaming the Fed for making a bad situation even worse.  During the 2nd quarter, the fear of recession changed to a fear of inflation.  While the problems with housing and the ‘Credit Crunch’ remain unchanged, the monster that jumped out and scared us all was the price for a barrel of crude oil.  We started the quarter with crude at $101.58 a barrel and ended the quarter on June 30th with crude at $142.12.  That is an increase of 39.9%, which is like nothing we have ever experienced.

"How did we get to this point?"  Unfortunately, there is no easy answer.  While the market and all of its moving parts are so volatile, if too many adjustments are made, as in the case of the Fed, the fall-out is disastrous.  In the 4th Quarter of 2007 and 1st Quarter of 2008, the Market was in a free fall as a result of the ‘Credit Crunch’.  The Fed believed that by lowering interest rates, they were making money cheaper to borrow, which historically has been enough of a stimulus to spark the Market.  In our current Market cycle, what was seen as the major problem was the slumping housing market.  If money could be obtained cheaper, people would be more likely to buy their dream home.  However, the catch was that while the Fed made money cheaper, the ‘Credit Crunch’ made it more difficult to borrow the “cheaper” money.  It does not matter how cheap something may be, if you are not able to purchase it.

So the Fed’s strategy failed as far as helping the housing market and it further hurt the general economy in that the lowering of interest rates made the dollar cheap compared to other currencies around the world.   Its effect was that we felt the impact of a weak dollar by paying more for food and gasoline.  Crude oil, which directly correlates to gasoline, has been on the rise at an alarming rate as evidenced by the costs listed below:

From the above table, you can see that the increase has been dramatic.  It has been on the substantial rise since the end of 2005, and in about 3 years, has almost tripled in cost.  This kind of increase is so far above inflation, that it is a commodity that has the ability to drive the market.  An unfortunate occurrence is that with the rapid rise of oil prices and inflation, the market has been driven in a negative direction.

"Where do we go from here?”  Well, the road ahead will certainly not be an easy one.  We believe that the attempts by the Fed to make things right, have made things worse.  In the months ahead, we believe the Fed will attempt to fix its most recent problems by increasing interest rates.  We believe that between now and the end of the year, the Fed will raise rates 2-3 times between .50 - .75%.  The result will be a mixed bag of tricks.  By raising interest rates, we should immediately see an improvement in the value of the dollar and a decrease in inflation.  Since our dollar will be worth more globally, prices on certain major items should go down.  These items include food, and of course, crude oil.  Many experts believe that the fair value of a barrel of crude should be around $125.  Later this year, we are hoping to see oil prices dip to this level.  With this said, the long-term outlook of oil is that it will be going up.  Today 1 in 3 Americans of driving age owns an automobile.  In China, that number is 1 in 10.  They are going through a business growth their country has never seen, and that number is expected to change in the next 10 years to 1 in 6 owning automobiles.  With that many more cars in circulation, it is not unreasonable to see the price for a barrel of oil to be at or above $200 in the not-so-distant future.

While we believe the Market will show improvement when the Fed increases rates, all problems will not go away.  The slumping housing market will continue for sometime.  The fact is that with interest rates going up, loans and mortgages will not be as cheap.  They will still be a good deal, but not as good as it is today.  The other key ingredient remains the stagnant ‘Credit Crunch’.  Banks need to get back into the banking business to help the market and economy heal itself.

Through the end of 1st Quarter, the S&P 500 was down 9.45%.  It went up 4.87% in April, up 1.3% in May, and then dropped 8.43% in June.  For the quarter the market was down 2.73%, and year to date through June 30th is down 11.91%.

We as plan participants have experienced three consecutive quarters of negative results.  We are frustrated in that we have quite a bit lessmoney invested than we did a year ago.  Many have considered making a move within their portfolio, and some have made a move.  So what is the right thing to do?  The answer is to do nothing.  We have discussed this in past Commentaries, but the simple answer is that by exiting now, you are selling your investments while they are down, thus, locking in your loss.

For example, the worst period of the market took place from January 1, 1973 through October 1, 1974.  Let's assume that a participant invested $1,000,000 in the S&P on January 1st 1973.  Here's how it did:

6 Months Later $588,130
1 Year Later $602,470
2 Years Later $632,590
5 Years Later $732,300
10 Year Later $934,620

What you can see from the above is that while you stopped the bleeding of the down market, 10 years later you still had $65,000 less than you started with. The alternative to the above is what we are recommending today, "Stay the Course." Let's assume you understood the market has peaks and valleys, and you stuck with it. Here is what would have transpired had you have done that:

6 Months Later $771,570
1 Year Later $792,620
2 Years Later $1,034,040
5 Years Later $1,247,680
10 Year Later $2,444,340

By staying the course, in just 2 years you are back to your original investment and in 10 years, you have almost $1,500,000 more than you started with!

As we look at the events of the last 9 months, we certainly are not happy, but we can feel confident that we have prepared for the Market we are currently experiencing. We do not know if it will take 1 or 2 years or longer, but we will recover our losses, and if we stick to our strategy and investments, we will come out ahead.

In forecasting the remainder of 2008, we do see things getting better, but by no means do we foresee 2008 being a good year in anyone's viewpoint. While the 1st half of 2008 left us with a market of -11.91%, we see the 2nd half getting a little better. We think the 2nd half will be up in the 5-7% range. This will make 2008 a negative year in the -4 to -6% range, but I do remain confident that we will end the year in a better position than where we are sitting today.

For those participants in the AdviseMe! program, the silver lining is that in almost all instances we are beating the benchmarks, and are very well positioned for the months ahead.  Our primary objective has been to do well in good markets, and to do extremely well in bad markets.  At this time, extremely well means controlling the losses, and we have continued to do so. 

While the market has us shaking our heads in frustration, I remain optimistic.  We want to continue to stress to all of you as Participants that you are not all alone in this market.  Our basic education motto is that we are not here to make you into Investment or Retirement experts.  We are here for you, and available at anytime either via email, phone or in person to review your account, and make sure you are well positioned for whatever the market may throw at us.  Again, if we can help, please do not hesitate to contact us.

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