2008 mid-year review: In a word—Oil By Ernie Ankrim, Ph.D., Chief Investment Strategist Russell Investments July 2008 Last December, I published my forecast, "2008 and the Rip Van Winkle Strategy." I wrote that things would get worse before they got better. As of the end of June, 2008, I was right about the first part. Things have gotten worse. The year-to-date returns for the Russell 1000® Index were -11.2%. For a while it appeared the second part of my forecast was coming true, too. Following the Fed's moves to protect the financial system with the collapse of Bear Stearns, from March 17 through May 16, the Russell 1000® gained 11.5%, nearly bringing us back to where we started 2008. However, the next 45 days saw the index lose another 9.7%. What happened? Where was I off? In a word, "OIL". Admittedly the economy is weak and the U.S. financial system is far from out of the woods. Nevertheless, most of my forecasts that are in jeopardy of missing by year end have been undermined by the dramatic, and by some measures unprecedented, run-up in oil. That's what I want to discuss in this column. But first, let's take a look at my eight predictions and where they stand at mid-year: 1. We'll move from meltdown to liquidity. Transparency and then liquidity for structured investments with mortgage re-sets diminishing substantially in Q3 and Q4. Outlook: We'll see. Stresses continue in financial institutions' balance sheets and housing finance, but some transactions are taking place. It's too early to make this call. 2. The "dead cat" won't bounce. Housing prices likely will decline through Q1 and Q2. While transactions may pick up in the second half, prices will not rise for years. Outlook: The S&P/Case-Shiller Home Price Index year-to-date numbers through April have declined. There's a good probability my outlook was accurate. 3. "Big Stocks Don't Cry." Large, internationally diversified companies should continue to outperform their smaller, domestically oriented siblings in the U.S. equity market for the second year in a row. Outlook: Maybe not. While the large caps, measured by the Russell 1000® Index, started the year with a slight advantage, small cap stocks, measured by the Russell 2000® Index, have won since the Fed's Bear Stearns intervention. We still have months to go, but for now I've missed on this. 4. Uncle Sam "cowboys up." The dollar's value should stop declining thanks to better trade numbers, continuing slower domestic growth, international investment in-flows, and expected monetary and fiscal restraints. Outlook: All of the factors listed here have been correct (save the expectation that the Euro Central Bank would have begun cutting its lending rate), however, I'm wrong so far. 5. That kid down the street sure is growing. Tighter monetary policies will take a toll on developed economies — U.S. and non-U.S. but with growth rates slowing only slightly. Outlook: Good. It's happening. 6. High prices but no inflation. Commodity prices should remain high, but both commodity and broader price-level inflation should remain contained with oil staying under $100. Outlook: Looks bad as oil futures climbed to $140 on June 30 and gasoline prices reached over $4.50 in many areas of the U.S. indicate. At the same time, core inflation hasn't accelerated yet. It may not end this way, but for now I missed the oil price by a mile and the inflation numbers are still in the ball park. I'll discuss this in a moment. 7. "The sun will come out tomorrow!" An upturn in the economy in Q3 and Q4 should create optimism for 2009 — particularly after the election. Outlook: Consumer confidence is weak and demand for investment safety reigns. However, I'm not giving up here. We still have half a year left. 8. We'll make it up on volume. In the two previous downturns, homebuilder stocks did very well a year or so after the bottom in housing prices. They should bounce back before the year ends. Outlook: Not great. The S&P Homebuilders Index was up 28% by April 3 this year. However, by June 30, the index had fallen dramatically, leaving the index down 25% year-to-date. This sector is quite volatile, but I still think it could end the year much higher — we'll see. The question on everyone's lips Everyone's asking: Will oil prices keep going up? Oil now appears to be, in some ways, the new store of wealth for people fleeing currencies. It's not unusual that the price of oil varies with the value of currency, in our case the dollar. In a global commodity market, if the dollar goes down, the price of oil goes up. Yet we've seen recently that even with some strengthening of the dollar against the Euro, oil continued to rise. One or both of two factors would seem to be in play:   Supply and demand: Demand is up worldwide, but it has actually grown by less than was expected — due primarily to higher prices and slower economic growth all around the globe. At the same time, oil production by non-OPEC countries is higher than had been expected 12 months ago. There are still sources of concern. Israel is concerned over Iranian nuclear ambitions, political unrest in Nigeria makes their production uncertain and Venezuela production is trending lower under its nationalized and aging plant and equipment. In any case. Slower-than-expected global demand growth and greater-than-expected supply growth seems like a strange recipe for higher prices. Investors' attraction to commodities: Agricultural, primary industrial and oil all have done astonishingly well in the last year. From February 2007 to February 2008, spot oil — West Texas intermediate crude — rose 64%. At the same time, the S&P GSCI™ Commodities Index agricultural subsector was up 71% and the S&P GSCI Commodities Index industrial metals subsector was up 13%. You can definitely argue that markets had moved in favor of commodities across the board. A disconnect But not uniformly. From the end of February 2008 to the end of May 2008 — before the floods in the Midwest — industrial metals fell 13%. Agricultural commodities fell by 17%. Demand and supply seemed to be working. Except that over that same period oil rose another 25%! This last month, the rains drove up agricultural prices by 18%, industrial metals by 5%. Oil wasn't slowing down either, up 10%. So when commodity inflation is rampant — oil is with the crowd; when commodities are undergoing a price correction — oil bucks the trend? We've seen oil price movements like this before. In 1990, when Iraq invaded Kuwait, crude oil prices rose 100% (adjusted for inflation) during a 12-month period. But that was an unexpected event that might have had very serious oil supply implications. Generally, markets handle modest supply-demand variations reasonably well. If, a year ago, the market sensed either a huge demand increase or a huge supply decrease, the price would have been bid up then instead of in the last several months. It's just hard to point to any events that explain how you get a 100% increase in the price of a commodity when growth of both supply and demand have been within shouting distance of forecasts made a year ago (and in both cases missing expectations in the wrong direction). Bubble dynamics I'm proposing that supply-and-demand dynamics do not explain today's oil prices. I believe we're looking at a speculative event that will eventually correct. Recently, investors holding denominated currencies have been penalized by falling currency prices. Many have sought to diversify with commodities, by rolling contracts in the futures market as they come due. They're implementing an investment strategy that pays off when oil continues to rise. Don't confuse these investors with the stereotypical short-term risk taker that most folks associate with the word "speculator". Pension funds, foundations and sovereign wealth funds have invested in commodities in general, including large exposures to oil. That could explain some of the price movements in oil futures and spot prices, the price you'd be quoted if you wanted to buy the commodity today, that rise along with them. The dramatic movement in oil prices looks eerily similar to other strong price movements we've seen in the recent past. Often investors become drawn to acquiring and holding assets after they've gone up. As of the end of May 2008, adjusting for inflation, the real price of crude oil rose about 95% over the previous 12 months. It's no surprise that my phone has been ringing with questions of "how to play the oil run". It's probably hard for you to remember but the price of oil (adjusted for inflation) actually fell by 16% between January 2006 and January 2007. You didn't hear a lot of people talking about commodities being a great asset class for protection then. Returns on oil and commodities in general (like may other assets) are volatile. In this light, I believe that while the demand for oil is growing globally, it's not growing as fast as had been expected twelve months ago. I suspect some part of oil prices at the $130 and $140 a barrel mark is a function of investors piling into an asset class that has performed really well for the last year. In my experience, incorporating assets into a portfolio for "diversification purposes" almost always coincides with recent good performance. In the late '90s, you couldn't get anyone to put Real Estate Investment Trusts (REITs) in their portfolio. Not so today. In the early 2000s, global diversification as a long-term strategy was under question. Now, we wouldn't consider having only U.S. equities in our portfolio. I'm seeing a performance-chasing mentality. Today's high oil prices seem suspiciously similar to the underweighting then overweighting of technology stocks, REITs and offshore equities experiences of our last twenty years. Speculation's positive side Let me say that I have nothing against speculators, a term often misunderstood. Clearly some activities are illegal and aimed at market manipulation (see Enron). However, nearly all investors in long/short commodity futures are legitimate return-seeking investors or oil consumers/producers. Excluding the producers and acquirers of oil, when commodity investors are right they receive generous returns. They also help society allocate capital to asset classes or to points in time where rewards are greatest. This is the way markets behave. Moreover, if we are running out of oil — right now we're not, but let's say we were — we'd be better advised to conserve our stores of oil now to have some later. Speculators encourage us to do that by driving up the price until we find ways to reduce our oil usage (e.g., it might be better to have $150 barrel of oil today and have prices rise modestly from here than to have low prices now, only to be hit by supply squeezes and $350 in four or five years). Might the speculators be wrong? T. Boone Pickens, one of the great oil investors of our times, forecast in early 2007, when oil was weak, that prices would go up strongly. He made a lot of money for his investors. Coming into 2008, Pickens said oil would go down to $80 a barrel. Now he's putting his money into energy alternatives like wind and solar. Time will tell if he's right. Rational or irrational? We want to believe that the oil market will adjust. But as John Maynard Keynes stated, "Markets can stay irrational longer than you can stay solvent [liquid]." Still, I wouldn't give up hope. Why oil might drop Speculation eventually becomes self-destructive. In innovative economies, people figure out how to get by on less gasoline, heat their homes more efficiently and develop alternative energy sources. This doesn't happen quickly, and it won't increase the oil supply or change demand in the short run. But looking out one to three years, it's hard to imagine that these factors won't bring oil prices back down to more historical levels. I recently asked a top oil analyst, Mike Rothman of International Strategy and Investment, to identify a price for oil in June 2009 that would leave him indifferent to an over/under wager on his call (where he thought the chances of being too high were equal to the chance of being too low). He chose $70. Frankly, I could be a lot less liquid before we see $70. But even if we find ourselves under $100 in the next 12 months, my 2008 forecast has a dramatically better chance of coming to fruition. Looking ahead I still believe that earnings and the economy won't necessarily have to rise dramatically for this market to do well. Yes, big changes are taking place globally. Ultimately, oil prices should reflect supply and demand. A year from now, I may well turn out to be right by saying that oil today is substantially overpriced. In early 1999, I said that equities were too high-priced. I was ultimately correct, but it took 15 painful months before I was proved right. I believed that REITs were overpriced in 2004. I was "wrong" for two years before we had a 30% correction. Yes, it's possible that the price of oil will continue to go up. If so, I'll continue to be mystified — and my 2008 forecast will get blown out of the water. But every bubble bursts eventually. Until it does, the best thing investors can do is stay properly diversified (there's more to diversification than commodities), avoid chasing past performance and keep a sense of perspective. The United States boasts the world's most resilient economy. The sun will come out one of these tomorrows. Fund objectives, risks, charges and expenses should be carefully considered before investing. For a prospectus containing this and other important information call Russell at 1-866-676-7680 or go to the prospectus and reports page to download one. Please read the prospectus carefully before investing. These views are subject to change at any time based upon market or other conditions and are current as of July 3, 2008. The opinions expressed in this material are not necessarily those held by Russell Investments, its affiliates or subsidiaries. While all material is deemed to be reliable, accuracy and completeness cannot be guaranteed. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns. Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment. Russell 1000 Index: The Russell 1000 Index measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index and includes approximately 1000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 92% of the U.S. market. Russell 2000 Index: The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. S&P 500 Index: An index, with dividends reinvested, of 500 issues representative of leading companies in the U.S. large cap securities market (representative sample of leading companies in leading industries). S&P GSCI Commodity Index: A composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. Agriculture sector: This subsector of the S&P GSCI Commodity Index includes companies that grow or process wheat, red wheat, corn, soybeans, cotton, sugar, coffee, and cocoa. Industrial metals sector: This subsector of the S&P GSCI Commodity index includes companies that mine or process aluminum, copper, lead, nickel, zinc. S&P Homebuilders Index: The S&P Homebuilders Select Industry Index seeks to provide an effective representation of the homebuilders subindustry portion of the S&P Total Market Index (TMI). S&P/Case-Shiller Home Price Indexes: A group of indexes that tracks changes in home prices throughout the Untied States. The indexes are based on a constant level of data on properties that have undergone at least two arm's length transactions. Case-Shiller produces indexes representing certain metropolitan statistical areas (MSA) as well as a national index. Although stocks have historically outperformed bonds, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the market. Copyright© Russell Investments 2008. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an as is basis without warranty. Russell Investment Group is a Washington, USA corporation, which operates through subsidiaries worldwide, including Russell Investments, and is a subsidiary of The Northwestern Mutual Life Insurance Company. Securities products and services offered through Russell Financial Services, Inc. (formerly Russell Fund Distributors, Inc.), member FINRA, part of Russell Investments. For information on the Financial Industry Regulatory Authority, go to www.finra.org. RFD-08-0742. USI-1036. First used: July 2008			Subscribe to our Education Center RSS Learn more about using and subscribing to RSS   Comment on this Perspective What is your impression of Ernie Ankrim's insights? Provide your feedback.   Why Russell? See the difference Russell's investment approach can make   Printer friendly version of this page Send feedback or comments Site Search

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