Monday, January 10, 2005


The wisest man to ever live, Solomon, knew that "there is a time for everything''. Now may be the time for caution. The problem is that we face a couple of very big unknowns.

The first big unknown is in regard to energy. The low point in the price of oil is usually in late November, December or early January. We have had a very mild winter but the price of oil has stayed high. Shares in coal and uranium have stayed relatively strong. There is an "Iraq attack election premium" but more importantly there is the risk that world demand will continue to push prices until significant new supplies or conservation policies can be implemented. Germany and other European nations are in or nearly in recessions and "hot" Asian economies have slowed. On the other hand, it has been years since a major energy field has been found.

The American consumer on average is making only modest adjustments. Hybrid cars are selling but are a very small percentage of all cars on the road. At the same time, RV, SUV and conversion vans are selling well. The price has not gone up enough to cause consumers to adjust. The price will have to inflict a little pain before behaviors change. Since it takes a long time to build power plants or to develop new oil fields, we are probably in for a protracted period of high energy prices.

The second unknown is how the bond market and stock market will rationalize themselves. In a chart published by M.S. Howell & Co. today, it was shown that the S&P earnings yield is at the highest ratio to bond yields since a year after the market crash of October 1987. In 1995 the ratio was also very high. In 1989 and 1995 the rationalization occurred at least partly by a rise in stock prices and to a lesser extent by a fall in bond prices. In the 1970's, the rationalization started with a rise in stock prices but eventually went to the opposite extreme when bond prices fell dramatically.

The fact is that we are at "clearing price" levels. When a wide spread develops, market psychology can only push the spread so far. Economic forces and the invisible hand of Adam Smith must come to bear and "correct" the spread.

In recent days, we have been seeing a market rotation. Small, high beta, technology stocks have taken some of the worst hits. On the other hand, the S&P 500 has gone down only 1% since the first day of the year. Within the S&P some sectors are up and others are down but the index itself has changed little.

For the past several weeks, I have encouraged the purchase of defensive issues. The past two days have been interesting in this regard. The consumer staples sector was the strong sector but energy was not far behind. In the consumer sector, Adolph Coors (RKY) was up 4.39%, Avon Products (AVP) was up 3.06% and PepsiCo (PEP) was up 2.5%. In the energy sector, Williams Oil (WMB) was up 2.41%, Devon Energy (DVN) was up 1.63% and Andarko Petroleum (APC) was up 1.62%.

Going back 4 weeks, one finds that consumer staples are right behind health care in leadership (2.74% versus 2.94%) while energy was the worst sector during this time at down 3.68%. One must remember that oil peaked at around $55 per barrel and fell hard afterward. Since then it has been fairly stable in the low to mid 40's.

I am a stock market bull and a bond market bear. I believe that stocks and bonds will be reconciled by a decline in the price of bonds and an increase in the price of stocks. However, one should be careful to own defensive stocks. Stocks that offer E/P ratios that are higher than bond yields.

Again, consumer staples offer the most defense but one should hedge ones bets with a smattering of energy related issues. The health care sector also offers attractive stocks but the news cycle is beating the sector down prior to the start of a very long good run. I have started buying health care issues but may be early. The current correction is taking the whole market down a peg or two. No reason to panic but plenty of reasons to be careful.

Solomon asked for wisdom and also received great wealth. Wisdom is all it takes to become very wealthy. The wise always seem to be slow, steady and careful.