Trade Journal 2/27/12

At the start of the year we devised our investment thesis stating our held belief that the first quarter (January and February more specifically) would be strong for the US equity markets based on our behavioral and fundamental analysis. We were fortunate enough to lay out our strategy at the start of the year and have reaped the rewards of that plan of action thus far.

As we have stated several times over the past week, with our 2012 year-to-date performance for both our equity and enhanced yield portfolio up over 30% and 20%, respectively, we have taken partial profits to lock in our returns and continue to have subdued exposure to current market activity. We are comfortable with that stance and hold a sound portion of our portfolio in cash, as we await the next round of instruction from our market models.

As the adage goes, “the pigs get slaughtered”, so we have decided to take partial profits and await further direction from our models. We anticipate one of three likely scenarios pressing forward. (1) The market hits near-term resistance and corrects slightly from these levels. In our opinion this is the most likely scenario which will prompt us to stay in cash during the minor correction and redeploy assets when the market models indicate. (2) The market breaks through current resistance levels on greater than average volume and continues its ascent higher. In that case, we will continue to keep our subdued market exposure intact and build on our existing gains for the year. (3) A major market catalyst or geopolitical event turns the market and we experience a more serious correction, possibly the start of a bear market (defined as a 20% decline in equity prices). In this case we will take the rest of our profits and start building positions that will move counter-intuitive to the market, or in the case of our enhanced yield product, increase our hedge position to protect against downward action.

Bottom Line: We are prepared to take action in the event of any of these scenarios. Thinking as a logical mathematician, it’s better to err on the side of caution. Given our gains to date, the greater payoff at this point is to protect our profits than to risk missing additional upside.

Doomsday scenario #3

At the start of the year we outlined the three greatest risks to our portfolio for 2012. We indicated a possible default of Greece sovereign debt, a meaningful breakdown in corporate earnings forecasts and conflict in the Middle East as the most likely causes of asset volatility and depreciation. Without discounting the risks involved, the euro debt crisis and corporate earnings picture have improved somewhat and have taken a slightly less-dominating role in market direction.

Our concerns over Mid-East strife have increased of late. Recent action in the price of oil and the pending election season may have an impact on stock and bond prices going forward.

Oil prices rallied to a nine-month high with light sweet crude almost touching $110 a barrel last week, approximately a 6% gain in just a week. It is our opinion that this is explained by a risk premium that is being built into the price of crude based on increasing tensions with Iran and the possibility of supply disruptions and/or perhaps even military action.

Add on top a presidential election season in the US and the general public is sure to hear pending doomsday scenarios from both sides of the isle. This will hurt consumer sentiment and in turn can hurt our economy.

Supply and Demand

This past week, we have researched several studies in an attempt to capture the true effects of oil shocks on the economy and the markets. One item that should be understood immediately is the difference between demand induced oil shocks and supply induced oil shocks. The former states that the rise in oil prices and energy costs stem from actual and perceived global economic growth, the faster the economy grows, the more oil that is needed to fuel that growth, hence a rise in price. The latter states that the rise in oil and energy costs are a direct result of oil supplies coming out of the market.

For the purposes of examining the effects of the recent oil spike on our economy, we need to make the assumption that the current spike in oil is indeed increased risk premium due to the markets bracing for a supply disruption from the closing of the Strait of Hormuz or an Iranian boycott.

A 2011 working paper produced by the International Monetary Fund, researched and written by Tao Wu and Michele Cavallo explicitly prove these different types of oil shocks have different outcomes on the economy. They found that exogenous (supply disrupting) shocks have had a much more substantial effect on the economy over the past two and a half decades than that of demand induced shocks.

They found that on average, our GDP starts to suffer approximately three months after an oil price shock and the negative effects of that shock last on average for 24 months, with the worst response 18 months after the initial shock. They state, “over the 24 months following the shock, the implied cumulative output loss is equivalent to 6.8 percent of a month’s real GDP, or about 0.6 percent of annual real GDP in two years.”

Oil shocks also have a direct effect on inflation. They go on to report, “The CPI shifts up immediately on impact, and the peak response arrives three months after the shock.” If the geopolitical turmoil in the Middle East were to take a turn for the worse, we could see an immediate ten basis point rise in inflation. This would prove quite troublesome for the Federal Reserve that has indicated several years of overly accommodative monetary policy.

There are two schools of thought on the appropriate monetary policy procedures in the face of rising oil prices. If the increase in oil prices is demand driven, a tightening of policy would be required to stem an overheated economy and an increase in inflation. Our belief is that this is not the case and the Fed would be unable to accommodate. If the increase oil prices are supply related in an already weak economy, further easing may be necessary. Once again, in our opinion, the Fed may be unable to accommodate. It will be interesting to witness how Chairman Bernanke handles this new development.

A similar research report produced by the United Nations Department of Economic and Social Affairs, Economic Monitor and Assessment Unit indicate the differences between supply and demand shocks. Demand shocks are a cause of higher oil prices while higher oil prices are a consequence of supply disruptions. They state that in the case of country income transfer, global recessions and inflation expectation, the latter supply disruption is much more significant than demand shocks.

Bottom Line: The economy is affected more by oil shocks as a result of supply disruption than by global demand. Therefore, the closing of the Strait of Hormuz or military conflict in that region will absolutely have a negative effect on our tepid economic recovery.

Oil and the Stock Market

While there is a direct correlation to supply disruptive oil shocks and the global economy and inflation trends, there is less of a link between oil prices and the stock market. Research done by the Vanguard Group, University of Melbourne and Monash University indicate aggregate stock prices appear insensitive to changes in the price of oil. While the stock market may decline because of perceived economic downturns or perceived inflationary risks, there is little evidence that an oil shock on its own will cause a crash in the stock market.

Bottom Line: As stated earlier, we have adopted an investment policy to err on the side of caution. Better to protect our gains and take a defensive stance. Should geopolitical turmoil boil over in the Middle East, we are prepared to raise additional cash or take advantage of any market weakness. Should the market continue higher, we will stand pat in our subdued long posture.

News from the Right

Higher prices at the pump will surely take money out of the economy. Just two weeks ago, we have seen discount retailers report earnings that were lackluster, Wal-Mart being the main culprit blaming higher energy prices for decreased sales and margins.

That said, there are differing views as to the severity of an oil shock to the economy and the markets.

“State-run Iranian news agency Mehr said last week that "no country" could cope with the shock to oil prices if the strait is closed. "If the strait was shut, we estimate a $40 to $50 per barrel rise," said Gary Hornby, energy market analyst at Inenco, one of the U.K.'s longest established energy consultancies. That's nearly a 50% jump over the current price. Transferred to the pump, it's a gas price of $6 to $8 per gallon…At $6 or $8 per gallon, it's an increase, respectively, of $4,400 or $6,600 per household per year over the cost in January 2009.” - Payroll Tax Cut Isn't Enough To Save Struggling Families - By RALPH R. REILAND – IBD Opinion -2/24/2012.

This is just one example of the rhetoric from the right that will dominate the news headlines as this event turns into a major campaign issue. This type of catastrophic clairvoyance though, really should be viewed with suspicion because in the end, much of it will be for the purpose of political advancement.

We will also hear how the anti-fossil fuel Obama Administration’s refusal to “drill baby drill” is a major cause for higher gas prices, despite oil production being near all-time highs for this country.

Bottom Line: The Right should stop the doomsday framing and scare tactics for political gain. In fact, the political rhetoric from the right may have a more damaging effect on the economy by influencing public opinion than the actual increase in oil prices. This shock stems from supply side disruptions not demand side necessity. While domestic energy production should be addressed and increased, “Drill baby drill” has been taken out of context for this particular circumstance.

News from the Left

We will also hear from the left that the price of oil is beyond the control of any single political party (true) and that the current administration is pro-exploration and production given that fossil fuel extraction is at all-time peaks (False).

“While production is up under Obama, this has nothing to do with his policies, but is the result of permits and private industry efforts that began long before Obama occupied the White House. Obama has chosen almost always to limit production. He canceled leases on federal lands in Utah, suspended them in Montana, delayed them in Colorado and Utah, and canceled lease sales off the Virginia coast. His administration also has been slow-walking permits in the Gulf of Mexico, approving far fewer while stretching out review times, according to the Greater New Orleans Gulf Permit Index. The Energy Dept. says Gulf oil output will be down 17% by the end of 2013, compared with the start of 2011.” 5 Biggest Whoppers In Obama's Energy Speech – IBD Opinion – 2/23/12.

“Energy executives and other industry players gathered for the North American Prospect Expo (NAPE) in Houston shredded administration assertions that it is opening up areas for oil and gas exploration and that its policies are responsible for increased oil and gas production on President Obama's watch. "These have been the most difficult three years from a policy standpoint that I've ever seen in my career," Bruce Vincent, president of Houston oil and natural gas producer Swift Energy, told the Houston Chronicle. "They've done nothing but restrict access and delay permitting," he added. "The Obama administration, unfortunately, has threatened this industry at every turn."” Oil Execs Say Obama Led Us To 'Energy Abyss' – IBD Opinion – 2/23/12.

“The administration on Tuesday blamed last month’s shelving of the Keystone XL pipeline on “political” acts by Republicans in Congress. In fact, Obama ditched Keystone — which would have brought Canadian crude oil to Gulf

Coast refineries — to keep his greenie base happy.

And the pipeline is but one of many Team Obama decisions that have left America’s oil supply more vulnerable to the vagaries of world events.

* Under Obama, the American Petroleum Institute notes, leases on federal lands in the West are down 44 percent, while permits and new well drilling are both down 39 percent, compared to 2007.

* In the wake of the BP oil spill, Obama shut down most Gulf of Mexico drilling; there’s been a 57 percent drop in monthly deepwater permits over the last three years, according to the Greater New Orleans’ Gulf Permit Index.

* The EPA continues to block drilling off the coast of Alaska — where an estimated 27 billion barrels are waiting to be tapped.” Bam’s gas-price plan – New York Post Opinion – 2/22/12.

“As for domestic energy, Mr. Obama rightly points to the rising share of U.S. oil consumption now produced at home. But this trend began in the late Bush Administration, which opened up large new areas on and offshore for oil and gas drilling that are now coming on stream. Mr. Obama sneered at expanded drilling as a candidate in 2008 and for most of his term has done little to expand it.

In early 2010, he proposed to open some new areas to drilling but shut that down after the Gulf oil spill. According to the Greater New Orleans Gulf Permits Index for January 31, over the previous three months the feds issued an average of three deep-water drilling permits a month compared to the historical average of seven. Over the same three months, the feds approved an average of 4.7 shallow-water permits a month, compared to the historical average of 14.7.

Approval of an offshore drilling plan now takes 92 days, 31 more than the historical average. And so far in 2012, an average of 23% of all drilling plans have been approved, compared to the average of 73.4%.

Oh, and don't forget the Keystone XL pipeline, which would have increased the delivery of oil from Canada and North Dakota's Bakken Shale to Gulf Coast refineries, replacing oil from Venezuela.” - 'Stupid' and Oil Prices – Wall Street Journal Opinion – 2/24/12.

Bottom Line: The Obama Administration should quit playing populist politics. Rhetoric on aggressively taxing oil and gas exploration companies is wrong. Exploring alternative and “green energy” policies, while noble, should not be done at the expense of our gas and oil energy needs. This country needs a concrete energy policy that addresses our long-term needs and shouldn’t be subsidized by the government.

And a Word to Both Parties

One can only hope the populist propaganda discharged from both parties will refrain from bringing back the blame of higher oil prices to “speculators”. The free market (despite OPEC) is the most efficient way to price certain commodities.

In a paper entitled Speculation and Recent Volatility in the Price of Oil, James Einloth from the Division of Insurance and Research at the FDIC notes, “Speculation did not play a role in the historic rise in oil price to $100 per barrel in early 2008, though it is likely that the building of speculative stores did contribute to the rise in price from that level to the peak price of over $140 later that year. The following collapse in price was due to a demand shock rather than the unloading of speculative positions. Finally, the recovery in price in the first half of 2009 has been accompanied by inventory held for speculation.”

He goes on to state, “It is important to understand that the presence of speculative stores is not a sign of market inefficiency or investor irrationality. It is rational to store oil if the expected increase in price (as reflected in the futures price) exceeds the cost of storage. Rather than adding to the volatility of price, this should, on average, reduce it. If investors are correct that price will be higher in the future, then storing oil will moderate price, raising it while inventory is built up and lowering it when inventory is drawn down (presumably when demand is higher).”

“The evidence demonstrates that the collapse was caused by an unanticipated decline in demand, a conclusion that is consistent with the worldwide recession. Oil speculators were not the only ones who failed to predict the recession. Stock “speculators” did as well; the price of stocks worldwide declined by the same order of magnitude as the price of oil in latter 2008. The US Department of Energy was also wrong with respect to oil prices, predicting in the summer of 2008 that prices would remain near their current levels or rise in the foreseeable future. But we should not expect investors to be wrong on average, so speculative stores should, on average, moderate prices. It is also important to recognize that it is not economically inefficient to store oil above ground. It is a technological feature of oil production that capacity cannot be expanded quickly. This means that oil in the ground is not a substitute for oil above ground. Therefore, if demand is expected to grow in the near future, during times of excess capacity some production should be set aside in storage.”

“While the nature of storage in these limiting cases renders it impossible to infer changes in inventory from convenience yield, it also makes the issue of speculation’s effect on price moot. Kaldor explains that for commodities with a highly elastic supply of storage, price is entirely a matter of speculation. If a supplier expects a certain price in the future, he would not sell it for any less today. For commodities where storage is not practical, speculation and storage cannot have any effect on price since all supply must be consumed immediately. “

One must remember that the basic premise of supply and demand is what drives oil prices in the long run. When oil is taken off the market due to supply disruption, inelasticity is quite small, estimated to be -0.02 to -0.08. That means that because oil and gas energy are so vital to our living needs, there is little to no reduction in our purchases despite the higher prices. On the other side of the coin, when the price of oil rises due to increased demand, inelasticity ranges from 0.5 to 1.5 historically. As the price rises, market participants tend to buy more.

This has been labeled “speculation” in the past when it is actually the laws of supply and demand at work. If market participants believe the price is going higher, they will store it for a later date to sell it if possible. This is actually good for the free market because it increases price stability over the long-term.

And as prices increase, it offers an incentive to those that extract the energy (barring excessive regulation) to increase production that will also bring down the price over time.

“Ironically, the best therapy is a higher oil price. It makes it profitable to bring into production more costly resources around the world. The rise in recent years to $100-plus a barrel is a godsend. Peak oil theorists are being refuted; so are greenies who imagined a towering oil price would usher in a carbon-free future. The opposite is seen to be true. Oil sands, shale hydrocarbons and even biofuels have been made profitable with existing technology, and of course technology can be counted on to advance.” What’s Right with Gas Prices - Holman W. Jenkins, Jr. – Wall Street Opinion – 2/25/12.

Bottom Line: Near-term shocks to the oil markets are not the doing of sinister traders or dominating politicians. The markets will self- adjust over time but our job as asset managers is to determine and implement the best possible investment thesis given the current market environment. Taking all the noise out of the picture, our belief is that we are prepared for whatever knowns and unknowns may lay ahead to the best of our judgment.

Joseph S. Kalinowski, CFA