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A survey this month by Merrill Lynch shows that 41% of global fund managers say they are "overweight" in cash, meaning they are keeping a bigger portion of their portfolios in cash than they do normally. That is up from 30% of the managers in July. Cash now represents 4.8%t of the average fund manager's portfolio, the highest percentage recorded by the Merrill Lynch survey since just before the start of the war in Iraq. "There's a tremendous amount of defensiveness in the marketplace," said Sam Stovall, chief investment strategist for Standard & Poor's. The fact is, investors haven't been paid to take risks this year. The Nasdaq composite, for example, has tumbled more than 13%t from its January highs. Shares of small companies have started to fare worse than blue-chip stocks. And "high beta" stocks - those with greater-than-average volatility, like technology shares - are being beaten by low-beta shares. But while money managers often move in and out of assets when they sense too much risk, individuals are often advised against making such moves. For starters, panic selling often means you may be selling just when stocks or bonds are about to make a U-turn. But more important, individual investors, unlike most professional money managers, must tend to long-term goals. And short-term fluctuations should not affect financial plans that are intended to meet targets 20, 30 or even 40 years out. Yet there are ways to reduce risk without upsetting the long-term apple cart. For starters, even a minor tweak in your mix of stocks and bonds can reduce your overall risk without giving up that much in potential gains. T. Rowe Price, the mutual fund company, recently studied the performance of various asset-allocation strategies from the end of 1955 to the end of 2003. It found that an investor who put all his money into the S&P500 stock index for this entire stretch would have earned 10.5% a year, on average. Had that investor moved just 20% of that stock portfolio into bonds, he would have enjoyed nearly as much in gains: 10% a year. And he would have earned those returns with 19% less volatility. Still, altering the long-term mix can be dangerous, even if the reason is to flee risk. Moving too much money from stocks to bonds, for example, could create a different risk: having an undiversified portfolio. Over the long run, investors must be willing to expose themselves to some degree of risk if they expect much in the way of returns. Even if you stick to your original mix, there is nothing that says you can't tweak the types of equities and fixed-income securities you own. These moves, often made by financial planners and investment advisers, are called tactical asset-allocation adjustments. "We won't abandon a category altogether," said Ronald W. Rogé, a financial planner, referring to his client's portfolios. "But what we'll do is over- or underweight certain types of stocks and bonds." For example, Mr. Rogé does not think small-cap stocks can shine again amid rising interest rates, so he has begun to lighten his clients' exposure to them. Three Factors Now at Work When making this type of tactical move, "it's important to understand what is creating the volatility in the first place," said James Stack, editor of InvesTech Research Market Analyst, a newsletter. He said three factors were now at work: "terrorism, oil prices and interest rates." It is prudent, he said, to avoid stocks that would be affected by the psychological reaction to another terrorist attack: perhaps airline and some leisure industry stocks. Because of rising oil prices, he is overweight in oil and natural-gas stocks in his model portfolio. And as interest rates begin to rise, stocks with high price-to-earnings ratios are likely to be hit hardest. So he is underweighting the technology sector, which has the highest average P/E ratio in the S&P500: 40.1, based on 2003 operating earnings. Can minor adjustments like this reduce risk? Absolutely. Consider an investor with 80% of his money in a diversified mix of large- and small-cap stocks, represented here by the Vanguard Total Stock Market Index fund, and 20% in a diversified mix of bonds, using the Vanguard Total Bond Market Index fund as a proxy. That investor would have earned 10.2% a year, on average, for the decade through the end of July. The 40-40-20 Split But say the investor decided to avoid high-risk small stocks, and wanted to emphasize large-cap value stocks because of their greater exposure to defensive sectors like energy and because of their greater dividends. So, instead of putting 80% of his money in the Vanguard Total Stock Market Index fund, he would put 40% of the total into the Vanguard Index 500, which tracks the S&P500, and 40% into the Vanguard Value Index fund. According to Morningstar, the investment portfolio allocated this way, though still with an 80-20 split between stocks and bonds, would have achieved almost exactly the same return over the past decade: 10.3% a year. But it would have reached that return with a bit less volatility, and would have an average P/E ratio of almost 23, based on trailing 12-month earnings, versus 26.2 for the original allocation. Ned Notzon, president of the Spectrum Funds of T. Rowe Price, warns individual investors against trying to do too much tactically. That is especially true, he said, for investors who don't plan constant monitoring of their portfolios. But if you do plan such an adjustment, he suggests, do so at the margins. For example, in the Spectrum funds, which are asset-allocation portfolios, Mr. Notzon has tweaked the equity portion of the mix. Instead of being 44% in large-growth stocks, 44% in large value and 12% in small caps, the funds are now closer to 47% in large growth, 42% in large value and 11% in small caps. Another strategy is what Harold Evensky, a financial planner, calls the "core and satellite" approach. To ensure some discipline, Mr. Evensky suggests investors put the bulk of their equity allocations, the core, in a low-cost, broad-based index fund. If you have $100,000 in stocks, for example, you could keep around $80,000 in a broad, diversified index portfolio. But if you feel the desire to make tactical adjustments to reduce risk, use the satellite portion - the other $20,000 - to play some defense. That way, most of your money is always on the table - just on different corners of it.
At Merrill Lynch, Peter Caruso was a top-ranked retail analyst in July 2002 and had a "strong buy" rating on Home Depot. According to the NYSE disciplinary action, he called the retailer's investor-relations director on July 11 and was told sales had been weaker than expected in May and June. He quickly crafted a research report that reversed his bullish projection for the home-improvement chain. But before releasing his report, he went to a lunch at Deutsche Bank AG offices in New York with two portfolio managers and two analysts from the bank's asset-management unit. He disclosed information leading them to believe Merrill was going to downgrade the stock, said the later NYSE complaint. Janina Alexandra Casey, a Merrill institutional saleswoman, also attended. After the meal, she went to an empty cubicle at Deutsche Bank and called three big investors and a friend, telling them she believed Mr. Caruso was downgrading Home Depot. When Mr. Caruso got back to his Merrill office, he held a conference call with about 55 other clients, plus some Merrill employees. "You've got, I think, the highest estimates on the Street" of Home Depot earnings, said one client on the call, according to the NYSE complaint. "I'm curious...whether you think you'd be lowering them very shortly." The complaint said Mr. Caruso responded: "Yes, you should expect to see me lowering them very shortly." More than 23 million Home Depot shares changed hands that day, about twice the average volume. Then, at 12:04 a.m., Merrill distributed a new report by Mr. Caruso on Home Depot. Citing competition and sluggish sales, it downgraded the stock by two levels, all the way to "neutral." In the next market session, trading volume roared to 46 million shares and the stock fell a further 7.4%. The NYSE complaint says Merrill terminated Mr. Caruso the following month. Merrill, Mr. Caruso and Ms. Casey settled the NYSE's complaint without admitting or denying it. Merrill, which calls the case "a highly unusual series of events," paid a $625,000 penalty for failure to properly supervise. The NYSE censured Ms. Casey, fined her $150,000 and suspended her for one month from employment with a member or member organization. Mr. Caruso, now at hedge fund Moore Capital Management, consented to censure, a $25,000 fine and a bar of four months from membership in the NYSE or employment by any member. Home Depot says it doesn't know how Mr. Caruso learned about its sales weakness. The SEC's Regulation Fair Disclosure, or "Reg FD," said in 2000 that a company releasing market-moving information to anyone had to disclose it publicly. New York State Attorney General Eliot Spitzer last year reached a settlement with brokerage firms designed partly to stop them from favoring privileged investors. The 2002 federal Sarbanes-Oxley law also takes a crack at analyst conflicts of interest by seeking to separate analysts from investment bankers. And both the NYSE and the National Association of Securities Dealers have stiffened their efforts to stanch information leakage in recent years. Some efforts to stop leaks of stock information to favored investors: • Regulation FD (2000) barred selective release of data by corporations. • Sarbanes-Oxley law (2002) toughened rules against analyst conflicts of interest. • Brokerage-firm settlement (2003) with SEC and N.Y. attorney general curbed special treatment of brokers' big clients. • Mutual-fund probe (2003) targeted funds' release to some hedge funds of extra data on holdings. But these efforts have not so much blocked the flow of valuable nonpublic information as shifted the channels. One venue that has risen in importance: Meetings that corporate executives often hold with small groups of investors -- where useful nonpublic information sometimes slips out, inadvertently or otherwise. Brokerage firms give special treatment to big investors who pay the most commissions, and that includes inviting them to those meetings with corporate executives. Meanwhile, last year's scandal involving rapid trading in mutual-fund shares revealed that some funds were regularly giving favored investors extra data about what stocks the funds owned. While regulatory action cracked down on that practice, several research firms have sprung up whose specific purpose is to find out what mutual funds are buying and selling and market the information. Another network of research firms helps big investors get an edge by linking them with industry experts, such as doctors, who can give extra insight into certain companies' prospects. Tips about stocks have always been a hot currency on Wall Street. In the 1980s, financier Ivan Boesky pleaded guilty to insider trading after paying bankers to tell him about pending mergers. But unlike that egregious case, much of the continuing Wall Street information flow to the well-connected either is legal or falls into a gray area. In a regulatory environment that limits what companies can disclose selectively, the supply of corporate insights is more coveted than ever, driving some investors to seek ever-more-creative ways to get them. One force behind this is a great proliferation of hedge funds. Hedge funds provide lush commission revenue at a time when brokers' other commission business is weakening because of competition from online discount brokers and electronic markets. Though hedge funds control less than 7% of U.S. invested assets, they pay an estimated 25% of commissions, by trading heavily and paying unusually high commissions of about five cents a share. Hedge funds and larger mutual funds could bypass big brokers most of the time and pay as little as a penny a share to trade on electronic networks. But then they wouldn't get in on invitation-only dinners with executives of the big securities firms' corporate clients. They wouldn't get heads-up e-mails and calls when an analyst is changing direction -- notices that go only to favored investors on the big brokerage firms' "first call" lists. They might miss out on a little extra insight into a company a securities firm is taking public. All of these perks are reserved for the biggest trading clients of brokerage firms. Sometimes big traders get more than perks. Last summer, a health-care analyst left Citigroup's Smith Barney after the firm suspected he had alerted a hedge fund about a coming report, says a person familiar with the events. The analyst, Glen Santangelo, declined to comment, as did Citigroup. Mr. Santangelo now works for Charles Schwab's Soundview Technology unit. Last December, an analyst at Morgan Stanley resigned after the firm concluded he'd told several clients privately about some extra information he'd found supporting his view of a stock, say several people familiar with the matter. The analyst, Steven Pelayo, recently joined hedge fund SAC Capital Management LLC. In last year's mutual-fund scandal, it emerged that hedge funds were gaining knowledge of the funds' stock positions and using it to profit by rapid trading of fund shares. Banc One Investment Advisors recently settled a case alleging such a pattern, brought by the SEC and Mr. Spitzer. The complaint said the Bank One unit gave hedge-fund manager Edward Stern, of Canary Capital Partners LLC, up-to-date nonpublic data on what stocks were in some of its mutual funds. Everybody else had to wait for portfolio data that mutual funds make public a few times a year. Regulators alleged that Banc One hoped to get money-management business from Mr. Stern in return. In settling the case for a $90 million penalty, Banc One neither admitted nor denied the allegations. Mr. Stern also settled with regulators, agreeing to be barred from managing others' money for 10 years. Just last week, the SEC filed an insider-trading suit against a hedge-fund manager it said twice traded on information about coming mergers that he had gleaned from corporate executives. The SEC said Gary Kornman of Heritage Organization LLC in Dallas had learned from an official of MiniMed Inc. that the firm was likely to be taken over soon. Mr. Kornman bought 6,600 shares of the medical-gear maker for about $38 each, and made $67,000 when it was taken over in August 2001 for $48 a share, says the SEC suit in federal court in Dallas. It alleges that Mr. Kornman similarly traded on a takeover tip given him by a director of Hollywood Casino Corp. Mr. Kornman didn't return calls seeking comment. At times, information that leaks out passes through many hands. In 2001, Banc of America Securities telecom analyst Andrew Hamerling heard from a salesperson at Qwest Communications International that broadband pricing was going to be weak and told several mutual funds and hedge funds, according to someone familiar with the matter. As the investors sought to get more information they circulated his e-mail, and it eventually found its way to Qwest's then-CEO Joseph Nacchio. According to a person familiar with the matter, Mr. Nacchio spurred an internal investigation and information on the analyst was uncovered and turned over to regulators. Mr. Hamerling left Banc of America Securities in 2002. The NASD, meanwhile, had been looking into his practices and last December fined him $125,000, asserting that favored clients of his got insights denied to the public. While publicly recommending SBC Communications, for example, the NASD said, Mr. Hamerling told one hedge-fund client that "it's gonna get REALLY ugly when the s- hits the fan" at SBC. Mr. Hamerling agreed to the NASD penalty without admitting or denying the allegations. Now at hedge fund Galleon Group, he said he would not discuss the NASD action against him. A Bank of America spokeswoman declined to comment. One sought-after kind of inside knowledge is what stocks mutual funds are buying and selling. An investor who knows that a fund has made a first small purchase of a stock can assume there is more buying to come, since mutual funds usually build their positions gradually. Andrew Brooks, head stock trader at fund firm T. Rowe Price has told the SEC of instances where he believes other investors knew what he was doing. "We get calls all the time from companies asking why we are selling their stock. I ask how they knew and they say, 'We have our sources.' " Trades go through a series of hands, from broker to clearing firm to a firm that settles the trades at day's end, and "the information slips out at one of these points along the way," Mr. Brooks says. Besides asking the SEC to investigate possible leaks from brokers to clients who pay fat commissions, Mr. Brooks asked the agency to crack down on firms that try to pinpoint big investors' trading and market this intelligence. "Information is not distributed equally -- it is bought and sold, like a commodity," Mr. Brooks says. The business of seeking to monitor the trading activity of big investors is burgeoning. One of these so-called surveillance firms, Chicago-based Ilios, says it has "proprietary databases, unparalleled knowledge of the institutional investment community and superior ability to navigate the custodian systems."
The cliff is common to many drug companies. Some, such as Schering-Plough Corp., have already been hammered by generics. But Pfizer thinks it can use its size to muscle its way out of trouble. Thanks to two megamergers in the last four years, a company that wasn't even in the industry's top 10 a decade ago expects revenue of $53 billion this year, about 40% bigger than No. 2 GlaxoSmithKline PLC. Size especially matters in two areas. Pfizer is licensing many of the most promising new drugs from biotechnology or specialty pharmaceutical companies, overpowering rival bidders by committing its cash and huge sales force in an effort to turn the drugs into blockbusters someday. And in negotiations with major prescription-drug buyers in the U.S., Pfizer is using its clout to win favored treatment for its drugs. "When you're the No. 1 company," says Pfizer Chief Executive Henry McKinnell, "that gets you a seat at the table and the flexibility to do things that other people can't do." Being a giant has its downside. Bureaucracy at Pfizer has grown as the company's work force has more than doubled to 122,000 people over the past five years. Throughout the industry, research productivity has tended to fall as labs grow larger. Although Pfizer has spent more than $21 billion on research and development since 2000, the last big drug to emerge from its own labs was Viagra, which went on the market in 1998. Nonetheless, most executives in the drug industry believe bigger is better -- as the spate of mergers in recent years suggests. Earlier this year, Sanofi-Synthelabo SA of Paris agreed to acquire French-German rival Aventis SA, creating the world's third-largest pharmaceutical company. The deal was spurred by the French government's fears that the companies separately were too small to challenge Pfizer and other giants in the all-important U.S. market. Pfizer's products include Norvasc for high blood pressure, Viagra for impotence, Zoloft for depression and Celebrex for arthritis pain -- all top sellers in their areas. Lipitor, which will see its patent expire in 2011, is the world's biggest-selling medicine. Such breadth gives Pfizer leverage in negotiating with insurers and U.S. drug-benefit managers, the companies behind the drug cards that patients present when they pick up a prescription. Benefit managers represent big employers that pay most of the cost of prescription drugs used by employees. Using Bigness vs Benefit Managers Pfizer's main goal is to get as many of its drugs as possible on the benefit managers' lists of preferred drugs. These carry a lower co-payment, or out-of-pocket cost for the patient. It's about $19 on average versus $29 or more for drugs that are included on the benefit managers' list of approved drugs, but don't have preferred status, according to the Kaiser Family Foundation. The preferred drugs usually grab the most market share. Pfizer's bargaining strategy is simple, says Mike McEnroe, an executive in charge of contract strategy: The more Pfizer drugs buyers commit to putting on the preferred list, the more the buyers can save. "If you take everything, you're going to get the best terms we can offer," he says. That's an attractive pitch to drug-benefit managers. With a single deal, they can lock up discounts on Lipitor and fill up their preferred list with other discounted drugs. One executive at a Midwestern pharmacy-benefits company says buyers who agree to favor other Pfizer medicines can get as much as a 15% discount on Lipitor. A Pfizer spokeswoman says some buyers could get 15% off on Lipitor even without deals on other drugs, but declines to say how. Playing hardball with Pfizer is tougher. Suppose for instance that a benefit manager gives Merck & Co.'s pain reliever Vioxx a better position than Pfizer's Celebrex. This could mean that the benefit manager will have to pay more for Pfizer's Lipitor and Zoloft. Other companies try similar tactics, but don't have such a broad menu of drugs to use as a negotiating tool. Of course, benefit managers could cut off Pfizer altogether, but that would probably lead to a backlash from patients who want popular Pfizer drugs at the lowest co-pay. "You're not going to have a formulary without a Pfizer drug, just because they're so big," says the Midwestern executive, who asked not to be named because of confidentiality clauses in Pfizer contracts. Benefit managers say -- and Pfizer confirms -- that it drives a tough bargain on contract terms. It insists on prohibiting benefit managers from promoting other companies' drugs if Pfizer has a competing drug. It also shuns clauses -- common among other companies -- that allow either side to end the contract after giving 30 days' notice. Some critics of Pfizer say its tough style has morphed into arrogance. This January, Pfizer eliminated discounts for some hospitals that had been offered by Pharmacia, another drug company that Pfizer acquired in April 2003. In New York, hospitals are paying about $13 million this year for Pharmacia drugs now sold by Pfizer, with an average price increase of 24% for the drugs, according to GNYHA Ventures Inc. The for-profit subsidiary of the Greater New York Hospital Association contracts with a national buying co-op, Premier Inc., to pool drug purchases for more than 200 New York City area hospitals and affiliated facilities. The buying group estimates that the cost to those hospitals of the former Pharmacia drug Depo-Medrol, a long-acting steroid for cancer and other diseases, will rise 28% to nearly $600,000 this year. "Among the top 25 companies, Pfizer is the only one that doesn't discount to hospitals," says Lee Perlman, president of GNYHA Ventures. "Their hard and unique line puts us in a spot where we have to seek alternatives to their products." A Pfizer spokeswoman says that the company's policy is to offer the same price to all hospitals, and that it raised the prices of the Pharmacia drugs when that company's contract expired, in order to be consistent with Pfizer policy. All of Pfizer's tough bargaining won't do any good, of course, if the company doesn't have big drugs to sell. Several of its most popular drugs -- including Norvasc, Zoloft, and the antibiotic Zithromax -- are losing patent protection in the next three years. After that, inexpensive generic equivalents will take their place. Pain and epilepsy medication Neurontin, which had 2003 sales of $2.7 billion, faces generic competition from Ivax Corp. starting this month. Using Bigness of the Sales Force That's why Pfizer is also using its muscle to snap up promising medicines from small companies that need a marketing partner. Amid a research drought among big companies, the competition among them to acquire or license drugs has become increasingly ruthless. Pfizer has captured some of the biggest prizes, including treatments for multiple sclerosis, insomnia, and lungs weakened by smoking. In the past four years, Pfizer has snared rights to seven experimental drugs in the late stages of clinical testing, according to Windhover Information. These drugs are the most sought-after because they can bring profits quickly and are less likely to fail because of unexpected side effects. Pfizer got the most late-stage drugs; GlaxoSmithKline was in second place with six. One Pfizer acquisition was Macugen, a drug developed by Eyetech Pharmaceuticals. The medicine treats the leading cause of blindness in people over 50, a condition called age-related wet macular degeneration, in which the retinas deteriorate. Two years ago, half a dozen drug companies entered serious negotiations with Eyetech to license Macugen. Eyetech Chief Executive David Guyer got a demonstration of Pfizer's size and seriousness when it sent 60 scientists, lawyers, marketing specialists and licensing experts to Eyetech's cramped offices in Manhattan's garment district. At the time, Eyetech employed only 50 people. "We had to rent chairs because they brought in such an army," recalls Dr. Guyer, an ophthalmologist by training. Pfizer initially had no record selling drugs to eye doctors. But during the summer of 2002, Pfizer strengthened its position by agreeing to buy Pharmacia, whose glaucoma drug Xalatan is the biggest selling eye drug world-wide. Xalatan came in handy in negotiating with Eyetech. The small company wanted to build its own sales force. Pfizer agreed and offered to pay Eyetech's sales people to pitch Xalatan while the Food and Drug Administration reviews Macugen. Eyetech got higher bids than the $745 million package that Pfizer offered to co-market Macugen, Dr. Guyer says. But Eyetech chose Pfizer because, he says, "we wanted to go with people who knew how to handle blockbusters." Eyetech went public in February, raising nearly $160 million, and moved into plush quarters overlooking Times Square. Chief Financial Officer Glenn Sblendorio says the deal with Pfizer gave his company extra legitimacy in the eyes of investors. An FDA decision on Macugen could come as soon as January 2005. Pfizer is already trying to persuade insurers to reimburse the cost of Macugen, which analysts estimate may run $5,000 a year. Another Pfizer deal in December 2002 brought it Indiplon, a sleeping pill from Neurocrine Biosciences Inc. that the FDA is expected to approve next year. Neurocrine sought a partner that would help it grow into a full-fledged pharmaceutical company. Pfizer agreed to let Neurocrine market Indiplon to specialist doctors, leaving Pfizer to concentrate on tens of thousands of general practitioners. As part of the deal, Pfizer will train Neurocrine's planned sales force of 200 and pay for them to promote Zoloft, the Pfizer antidepressant, to psychiatrists. Kevin Gorman, a Neurocrine executive who worked on the deal, says other companies offered for co-promotion only drugs that had lost patent protection or were no longer main-line therapies. "That wouldn't get you the best sales force, and that won't build the relationship with the doctor," he says. Mr. Gorman says Pfizer also presented research that analyzed the sleep-medicine market in far more detail than anything other suitors prepared. Neurocrine Chief Executive Gary Lyons says he preferred Pfizer because it has the expertise and budget for an advertising blitz to expand demand for sleep medicines. Using Bigness to Buy-Out Your Competition In the most recent major deal, completed last December, Pfizer plunked down $1.3 billion to buy the tiny biotech company Esperion Therapeutics Inc. after spending less than a month evaluating the company's prospects. The object of Pfizer's desire: an experimental drug that melts fatty artery blockages by mimicking the effects of HDL, the so-called good cholesterol. Since 1990, Pfizer had been working on a pill to raise good cholesterol. Esperion's drug, an injection, worked like Drano for the arteries, in the words of some doctors, shrinking fatty buildup in the coronary arteries by more than 4% after five weekly treatments. That was an extraordinary result because other drugs could at most stop the deposits from expanding. More than a half-dozen companies knocked on Esperion's door after the results were published last November in JAMA, the Journal of the American Medical Association, say people familiar with the negotiations. One of them was Pfizer's archrival, Merck, which also has a strong franchise in anticholesterol drugs. Merck sought a conventional licensing deal, which would have given Esperion payments gradually as the drug progressed through human trials, people familiar with the deal say. Pfizer trumped that by offering to buy Esperion outright, giving the small company's investors a rich payday immediately. A Merck spokesman declined to comment. Pfizer's Mr. McKinnell says, "We won it by moving faster. We essentially pre-empted the licensing discussion." All of these experimental drugs might fail in final tests or run into problems at the FDA. Also, Pfizer splits the revenue for licensed drugs with the inventor, so they are less profitable than those discovered in-house. Still, Mr. McKinnell predicts that the acquisitions will help Pfizer make it past the cliff. Now the projected sharp drop in sales, he says, "is looking like a flat patch instead."
Investment pros say several things have sent them shopping abroad. The dollar, though up slightly this year, has been in an extended bear market for much of the past two years. So returns in overseas stocks look better when translated back into the U.S. currency. The Dow Jones Euro Stoxx 50, for instance, gained 16% last year in euros but 39% in dollars. Nearly half of this year's U.S. foreign investments were made in Japanese stocks, reflecting a popular belief that Japan's economy is on the rebound. Global portfolio managers also argue it is a disadvantage to limit a portfolio to the U.S when many of the world's best companies and fast-growing economies are found abroad. The slipping U.S. stock market also is driving the trend. "People may be noticing that our stocks aren't doing so well, so it's time to look elsewhere," says Steve Bleiberg, global strategist for Citigroup Asset Management. While the Dow is down 3.3% this year, Tokyo's Nikkei Stock Average is up 2%. The Dow Jones Stoxx Index of 600 European companies is down a modest 0.1%, and emerging markets are down 2.4% after soaring 52% in U.S. dollar terms last year. Mutual-fund numbers suggest that it's not just pension funds and large institutions venturing overseas. Flows into foreign-stock mutual funds aimed at individuals are rising, too. The acceleration of money into these funds has been greater than that of new money into U.S. stock funds, according to AMG Data Services. Overseas equity funds saw inflows of $32.7 billion through Aug. 18. That is closing in fast on 1994's full-year record of $34 billion. Japanese stock funds, meanwhile, have seen inflows of $4.5 billion, already surpassing record totals in 1999. Some of the top-performing funds that invest primarily in stocks abroad include the AIM International Emerging Growth fund, the American Century International Opportunity fund, and the Oppenheimer International Small Company fund, all of which have returned between 20% and 23% annually over the past three years. Even so, overseas investments represent a small fraction of the money Americans spend on domestic shares. U.S. investors historically have shown a strong home bias, looking abroad only when foreign prospects appeared particularly bright relative to the U.S. Moreover, foreign stocks often come with additional risks and costs. If the dollar has a big rally, then returns in overseas stocks would be lower when converted back into dollars. Corporate-governance standards vary around the world, and many places don't have the same level of disclosure that is required of U.S. companies. Fees also are higher: The annual expense ratio for the average foreign-stock fund is 1.74% of assets, compared with 1.5% for the average diversified U.S. stock fund, according to Morningstar. And in an increasingly globalized economy, the performance of the U.S. stock market and most major foreign markets have become more closely correlated, so that in recent years the diversification benefits of buying foreign shares have been muted. But major US sectors such as retailing and banking still react more to local conditions than to global trends. Some argue that momentum from the U.S.-led global recovery is shifting overseas. Two years ago, the U.S. was trying everything to stimulate its economy and markets. The Federal Reserve was slashing interest rates, the government was cutting taxes, consumers were refinancing their mortgages and companies were retooling their balance sheets. The cumulative effect helped drive last year's global stock-market rally. "Now people look out on the horizon and wonder what's going to be the pleasant surprise for the U.S. stock market," says Christopher Smart, director of international investment at Pioneer Investments. "There may be more opportunities ahead in Europe and Japan." Interest in foreign stocks has shifted from one corner of the globe to another as some economies heat up and others cool down. Excitement over China's locomotive economy in 2003, for instance, helped stoke interest in Asian stocks beyond Japan. These purchases soared to a record $26.5 billion, or 37% of all foreign purchases. U.S. net purchases of Brazilian stocks came to $1.9 billion. This year, concern about China's effort to slow its economy has dulled some of the enthusiasm for Asian companies and Latin American markets that export commodities to China. But fresh attention to European shares, which account for 39% of foreign purchases, and Japanese equities (46%) has more than compensated, so that total foreign purchases continue to climb. Dominic Freud, an international portfolio manager with Oppenheimer Funds, argues that with many industries now much more globalized, it doesn't make sense to ignore U.S. competitors based abroad. "It's fundamentally illogical not to invest internationally," he says. In the auto industry, he notes, GM and Ford compete with Toyota as much as each other, and in the oil industry Exxon Mobil and BP and Royal Dutch Shell are very similar companies that offer similar products, even though the latter two are based in Europe.
In the late 1990s, the Standard & Poor's 500-stock index had an unprecedented winning streak, notching five consecutive calendar-year gains of over 20%. That was followed by three consecutive losing years, something that hadn't happened in 60 years. Since then, stocks have continued their craziness, with the S&P 500 soaring 28.7% in 2003 before falling flat in 2004. How Rare is Normal? So when are we going to have a normal year, when the S&P 500 earns something similar to the long-run average of 10.4%, as calculated by Chicago's Ibbotson Associates? Don't hold your breath. Sal Miceli, a fee-only financial planner, took a look at the Ibbotson data, which goes back to year-end 1925. His discovery: Most years, stock returns weren't even within spitting distance of 10%. The S&P 500 scored a calendar-year gain of between 8% and 12% in just five of the past 78 years. In the other 73 years, returns were either 7% or less or 13% or more. "People are always hearing that stocks give you 10% a year, and they have come to expect it," Mr. Miceli says. "But the markets aren't ever normal. In fact, they aren't even close." It isn't just that 10% calendar-year gains are rare. Even the longer-run averages are all over the map. If you scan Ibbotson's 78 years of S&P 500 data, you see two painfully long rough patches, 1929 to 1949 and 1966 to 1982. How Bad is Sub-Normal? How bad were these rough patches? Over the 19.25 years through mid-1949, the S&P 500 climbed just 1.5% a year, slightly behind the 1.6% annual inflation rate. The 16.5 years through mid-1982, the S&P 500 clocked a mere 5.1% a year, well behind the 7% inflation rate. If you hung on through those rough spells, you would eventually have got your reward, because both periods were followed by dazzling gains. But that assumes you had both the time and the tenacity to hang on. Unfortunately, many folks don't. For lots of us, our period of hard-core stock-market investing lasts just 20 years. Because of the financial demands of buying homes and paying for college, we may not amass a decent stake in the stock market until we are age 50. Two decades later, we are beginning to scale back that stock exposure, as we shift to more conservative investments and start tapping our nest eggs for income. How stocks fare during the intervening 20 years is critical. If the market is buoyant, we will likely enjoy a prosperous retirement. But if things are grim, our golden years could be badly tarnished. My worry: Starting in March 2000, we may have begun one of those long grim periods. That augurs badly for folks who are in the midst of their hard-core stock-market investing. "In terms of stock-market returns, 20 years can be a very short time," says William Bernstein, an investment adviser. "Over 20 years, it's not unusual to have real stock returns that aren't much above zero. I'd be willing to bet that the 2000-2019 era could be just such a period." All this once again highlights the importance of owning a well-balanced portfolio that includes not only stocks and bonds, but also a wide array of stock-market sectors, including large, small and foreign shares. That sort of broad stock-market diversification paid off nicely during the S&P 500's wretched 1966-82 stretch. While blue-chip U.S. stocks struggled during those 16˝ years, small and foreign shares fared considerably better, thus bolstering performance. My hunch is that we will look back a decade from now and see a similar pattern. Start Early to Improve Your Odds To improve your odds of earning decent returns, also aim to get time on your side, by building up substantial stock-market exposure in your 20s and 30s. Even then, however, I wouldn't bank on earning the 10.4% long-run historical average. Fact is, that 10.4% probably won't be the average going forward. Remind to Decrease Your Expectations To understand why, consider some additional numbers from Ibbotson. The folks there broke down the 10.4% average into its component parts. They found that 4.3 percentage points came from dividends, 4.7 percentage points came from the growth in earnings per share and 1.1 percentage points came from the rising value put on those earnings, as reflected in the market's higher price-earnings ratio. (For a couple of technical reasons, these three figures don't add up to 10.4.) Meanwhile, over the same period, inflation ran at 3%. Today, by contrast, the market's dividend yield is under 2%. To make matters worse, stocks are currently at 21 times trailing 12-month earnings, well above the historical average of 15. That suggests a further rise in the market's price-earnings ratio is unlikely. What about earnings per share? Let's be optimistic and assume earnings outstrip inflation by three percentage points a year. If inflation rivals the 78-year average and runs at 3%, that would mean 6% annual growth in earnings per share. Tack on today's dividend yield and we are looking at annual stock returns that are just shy of 8%. If I am right and this sub-8% is indeed the new "normal" return, there's one thing you can be sure of: Even if stocks average roughly 8% over the next two decades, there will probably be precious few years when we will actually earn that 8%.
After a heated debate over the outlook for demand, the oil officials -- including officials from the OPEC and major international oil companies -- stood firm, according to four participants. Fearful that prices would collapse again as they did in 1998, no one was ready to raise spending sharply. "The OPEC countries said they would wait and see if there was a structural shift up in demand," said one participant. "But that could take years." With prices soaring as much as 50% this year and nearly hitting $50 a barrel last week, oil titans from Texas to Tehran are awash in record revenue. But as the money floods in, they are spending little extra in finding and extracting more petroleum. Essentially, that's because what's good for the world economy -- ample spare capacity -- carries big risks for Western oil majors and OPEC, which have been burned by past supply gluts. This has led to one of the biggest potential disconnects between supply and demand in the 150-year history of the oil business. The world currently has about the same buffer of spare oil-pumping capacity -- about a million barrels a day -- as it had on the eve of the 1973 Arab oil embargo. But as a percentage of total demand, the buffer is only about 1% now versus 2% in 1973, as consumption of oil has risen about 44% in the past three decades. OPEC officials privately estimate that a buffer of 4% is needed to keep prices in equilibrium. Cash Flow Up Big, New Investment Up Small The top six U.S. and European oil majors are expected to rake in a record $138 billion in cash flow this year, up 28% from $108 billion in 2003, says consultancy John S. Herold Inc. But capital spending by the Big Six will inch up only 8% to about $68 billion from $63 billion a year ago, and this largely due to higher costs, predicts Herold. Fewer than 2,500 rigs are drilling for new oil and gas around the world, less than half the peak number in 1981. And oil-refining capacity has been stuck at roughly the same level for 25 years. The parched oil-project pipeline could leave the world vulnerable to growth-choking price shocks in the coming decade. Each rise of one percentage point in the global growth rate requires roughly a 500,000-barrel-a-day jump in oil use, calculates Global Insight, a forecasting firm. If supply fails to keep up, whenever the world expands fast, as now, prices could rise to levels that brake economic growth and curb demand. In that sense, the world is already starting to experience a mild shock. The U.S. growth rate slowed to 3% in Q2 from 4.5% in Q1, in part because of higher energy prices. "That's where we already are," says Daniel Yergin, chairman of Cambridge Energy Research Associates. "We'll pay through lower economic growth." Investment is bound to rally eventually if prices hold firm. And prices could drop suddenly if hedge funds and other short-term buyers piling into the market decide to retreat. Crude-oil futures for October delivery tumbled 3.9% to settle at $43.47 a barrel, down $1.66, at the New York Mercantile Exchange, as word circulated that the U.S. and other industrialized nations are considering dipping into their strategic petroleum reserves. Wester Majors Face Competition Meanwhile, a potential balance to the West's reluctant oil majors could be emerging in Asia, where large national oil companies are also accumulating cash. Many of these companies, such as India's Oil & Natural Gas and China National Offshore Oil, are becoming more aggressive about seeking out oil overseas, in part because their home countries lack adequate energy supplies to support their rapid economic growth. But even an instant boom in drilling would be too late to alleviate the current tight market, driven mainly by robust demand amid a strong global recovery following years of lackluster investment in new fields. Oil projects take two to 10 years to get up and running. So, today's paucity of oil-pumping capacity is the product of decisions made years ago. Low Returns = Low Investment It's easy to see why oil people are gun-shy. In the West, executives fear that investors will hammer them for taking on risky or low-return projects. They complain that opportunities to invest in the richest oil fields -- in the Middle East -- are largely off limits. Thus, even giant oil companies that see a shortage looming have been unwilling to splurge on extra projects. Robert Castaigne, chief financial officer for the French oil giant Total SA, says his company has no intention of lowering the bar on returns, even though it needs to start identifying new projects now to keep its oil-production growth humming along later this decade. "We remain cautious," says Mr. Castaigne. "We'll give the money back to shareholders if we have to." Indeed, the Big Six Western majors are buying back shares at a record pace and raising dividends. Share buybacks among the Big Six are expected to total $25 billion this year, estimates Herold, up from $12.4 billion last year. Meanwhile, even though energy companies are holding back on spending to find oil, Wall Street firms are laying out plenty to hire people to trade it. Low Investemtn in Development from OPEC Countries Oil states have even more restraints on their spending. OPEC producers collectively have spent two decades holding output capacity steady, waiting for demand to catch up. That psychology of restraint remains strong. Now, some governments are using their oil windfall to firm their grip on power, leaving less for investment. Hugo Chavez, president of No. 5 exporter Venezuela, just won a tough recall election in part by tapping the state oil company to shower the poor with $1.7 billion in housing subsidies and other goodies. Rather than investing in output, Iran is pouring its oil bonanza into its once-depleted foreign-currency reserves, which swelled to $21.8 billion in the year ended March 2003, up from $7.9 billion in 1999, according to the IMF. That's in spite of the fact that Iran's oil output, after inching up, is stuck at some four million barrels a day, just two-thirds of the levels reached before the Iranian Revolution of 1979. In the Persian Gulf -- home to two-thirds of the world's oil reserves -- reformers have pushed for years to open up the fields to foreign capital to bring in much-needed investment and technology to wring the most oil out of aging wells. But they've run into a wall of nationalistic resistance. Big Oil has always delivered more fuel after past pinches -- but has sometimes paid dearly for it. The last big investment binge began with the oil shocks of the 1970s, when anxiety about long-term energy supplies was running high. OPEC nations such as Saudi Arabia nationalized their industries, booting out Western firms. Western governments offered incentives to boost production, including subsidies for new refineries. Those incentives, combined with oil prices that surged as high as $73 a barrel in today's money, encouraged a surge in exploration and drilling. The number of drilling rigs in operation soared to a peak of about 6,200 in December of 1981 from less than half that level five years earlier, according to Baker Hughes, a Houston oilfield-services company. But by 1985, the spending binge left the world awash in overcapacity of 10.7 million barrels a day -- an estimated 18% of global oil demand then, according to Cambridge Energy Research Associates. Prices crashed, and so did investment. The industry spent slightly more than $1.1 trillion on new infrastructure in the 10 years beginning in 1975, adjusted for inflation, according to Citigroup's Smith Barney unit and Economy.com. In the next decade, that dropped to less than $900 billion -- even though oil demand increased more than during the previous decade. Global rig counts fell to less than 1,200 in 1999, and though they have since rebounded, they remain just under 2,500. Wall Street & Oil Changes in investor sentiment factor heavily in the cautious approach. In the U.S. and Europe, stock-market investors responded to the price crash by imposing brutally tough standards of low risk and high returns on investments by oil companies that only the best-run handful of giants could fully meet. Exxon Mobil, the most successful at the new game, championed an ideology of "capital discipline" that has been ingrained in a generation of oil executives. While the frothy technology sector sucked in cheap capital in the 1990s, the energy sector saw its capital costs rise. This prompted a conservative approach by majors fighting to keep their place in the portfolios of big investors. Adding to the challenge is the widely held view that, while there may well be large quantities of oil left in the world, much of it can be found only in hard-to-reach places that require substantially greater investments than past finds. With the Middle East closed and many other major oil-producing regions in decline, "all the relatively low-risk areas have been taken," says Fereidun Fesharaki, a senior fellow at the East-West Center. Oil companies that step out of line have had to contend with the likes of William Ferer, president of W.H. Reaves, a Jersey City, New Jersey, company that manages $1.5 billion in funds, including oil stocks. "History is replete with price spikes that didn't last," says Mr. Ferer. He says there is already some "creep" up in oil companies' capital spending, mainly because of higher costs. If companies start bumping up investments because of higher oil prices, he says, "I'd look at that skeptically. I approve of higher dividends and [share] buybacks." That makes life especially tough for the companies that are eager to put new capital into the ground. McMoRan Exploration Co. of New Orleans this year struck "dry holes" that failed to yield oil or gas and recorded two quarterly losses. It has seen its stock plunge about 33% in 2004, even as stocks in the S&P's energy index have risen more than 10%. James R. Moffett, co-chairman, says the tension between the industry's need to take long-term risks to sate demand and Wall Street's insistence on quarterly gains is unsustainable. As the oil industry seeks new finds in remoter places, investors will have to develop a greater tolerance for dry holes. Meantime, he's looking off Wall Street for some capital. McMoRan recently clinched a deal with an unidentified company willing to invest at least $200 million in exploration drilling. "I am trying to give investors a bigger return on a high-risk play," says Mr. Moffett. Some on Wall Street are coming around to that view. Rich Bernstein, chief U.S. strategist at Merrill Lynch, says investors need to fundamentally change the way they look at oil and gas companies if the economy is to get the fuel needed for strong growth. Energy, he argues, has replaced "new economy" businesses as the biggest long-term growth story now after a decade in which investors favored "every cockamamie idea in the tech industry." He urges investors to reward oil companies for growth instead of return on capital, which stifles investment. Bill Miller, portfolio manager of the huge $14 billion Legg Mason Value Trust, hasn't owned anything in energy and basic materials for many years. But in a recent letter to shareholders, Mr. Miller said he was now sniffing around the oil patch. Chages Could Come from Kuwait and Saudi Arabia In OPEC, too, some change may be afoot. Next month, the parliament of Kuwait will vote on a plan, in the works for nearly a decade, to allow international firms to invest in the oil sector. If Kuwait opens up, that could put pressure on neighbors such as Iran to follow suit. The world's ability to ride out a crunch in the next two years will hinge in large part on Saudi Arabia -- the No. 1 exporter and the only country with huge fields that can be put into action quickly, as little as two years. Saudi Arabia has two plans on the shelf, one to increase capacity to 12 million barrels a day from the current 10.5 million, and a second to ramp up capacity further to 15 million barrels a day. But Jeffrey Currie, a commodities analyst at Goldman Sachs in London, says the project pipeline remains far too thin. The industry will need to spend some $2.4 trillion over the next 10 years to meet demand, he estimates, nearly triple the spending in the 1990s, but is nowhere near that. Unless OPEC and the majors grow more bullish about prices, that extra spending won't materialize soon. Stanley Luckoski, spokesman for ChevronTexaco Corp., says the company has made no major shifts in investment plans because of the price boom. "Our long-term price guidelines are around the low $20s" for U.S. benchmark crude, well below the average of $29 at which oil has traded since 2000. At a recent conference, an analyst asked the high priest of capital discipline, Exxon Mobil Chairman Lee Raymond, whether the world's most-profitable oil company wasn't being too "risk-averse." Mr. Raymond said the oil giant had taken some bold bets on projects in places such as Angola. But he stuck to his guns on capital discipline. "We don't run around and try to participate in every little thing regardless of the circumstances," he said. "You may call that risk averse. I call it prudent management."
The average closing price for the front-month U.S. light sweet crude oil contract in the year before Saddam Hussein's invasion of Kuwait on Aug. 2, 1990, was $19.72. Oil prices took a brief trip up to $24 (January 1990) and a brief dip down to $15.00 (June 1990), but they were pretty much a non-issue until the Kuwait invasion. Crude oil settled at $21.54 the day before Saddam violated Kuwait's sovereignty. Oil didn't trade consistently above $30 a barrel until September, and the spike to $40 in October was short-lived. While it can be debated what effect the rise in oil prices had on an already weak U.S. economy, it's just plain false to attribute the cause of the recession to the rise in oil prices. Cause has to precede effect. The recession started in July 1990, according to the official arbiter of the business cycle, the National Bureau of Economic Research's Business Cycle Dating Committee. What part of cause and effect don't the folks claiming oil caused the recession understand? The year-over-year growth rate in real GDP had already slowed to 2.4% in the quarter before the invasion from a peak of 4.5% in Q2-88, as the Federal Reserve raised its benchmark overnight rate to 9.75% in February 1989. The banking system was reeling under the weight of bad real estate loans: more banks and thrifts went under than at any time since the Great Depression. The press blithely repeats the myths promulgated by Wall Street. While much has been written on the increased energy efficiency of the U.S. economy since the 1970s (less energy used per unit of GDP) and on how inflation-adjusted gas prices are well below their 1981 peak, I'd like to focus on an issue that hasn't been discussed, no less mentioned. What's striking about the claims that the rise in oil prices ``caused'' all the recessions of the last 30 years is the omission of what else was going on at the time. Correlation is not causation. No one can quibble with the fact that higher oil prices preceded the 1973-1975 recession and the back-to-back recessions of 1980 and 1981-1982. Don't Forget the Fed. Maybe, just maybe, central bank policy had something to do with the ensuing recessions? Let's go to the video tape. OPEC imposed an oil embargo on the U.S. and raised prices for Western Europe in October 1973 in retaliation for support of Israel in the Yom Kippur War. The official price of Saudi light crude quadrupled: from $2.59 a barrel in September 1973 to $5.18 in November and $11.65 in January 1974, according to the U.S. Department of Energy. The U.S. went into recession in November 1973. What else was going on at the time? Following Richard Nixon's re-election in November 1972, Fed Chairman Arthur Burns began to raise the federal funds rate to tame soaring inflation. The funds rate rose from about 5.5% in December 1972 to 13% in August 1974. (I say "about" because the Fed wasn't targeting a funds rate back than. In retrospect, it's hard to ascertain what the Fed was targeting in its disastrous monetary management of the 1970s.) The funds rate stood at 11% when the recession began. Inflation, as measured by CPI, was rising at a 2.7% year-over-year rate in June 1972 and peaked (for the cycle) at 12.3% in December 1974. The Iranian Revolution in 1979 and subsequent Iran-Iraq War triggered another cutback in oil supplies from the Middle East, sending the price of a barrel of crude skyrocketing to almost $39 a barrel by early 1981. By that time, Paul Volcker was ensconced as the Fed and engaged in whipping inflation. It took a funds rate of 20% to bring the year-over-year increase in the CPI down from a peak of almost 15% in 1980 to sub-2% in 1986. To talk about the oil shocks of the 1970s -- true oil shocks, with the rise in price a result of reduced supply -- in a vacuum is to tell half the story. Such analysis ignores the stranglehold on the economy from tight money and high interest rates. Crude oil at $47 and a funds rate at 1.5% is not a prescription for recession. (It may be a prescription for future inflation, but that's a topic for a different day.) Increased oil demand has encouraged an increase in supply from all OPEC and non-OPEC countries with spare production capacity. There's been no cutback in global oil supplies even though fears of a disruption are encouraging speculation in energy markets. "Despite record high prices, oil consumption is growing at a breakneck pace," the Paris-based International Energy Agency said in its July oil market report. World demand rose 2.2% in 2003, and is expected to increase 3.2% this year and 2.2% in 2005, according to the IEA. The increase in demand is eliciting an increase in supply, which is how the price mechanism works. While it may be a shock to pay $2 a gallon to fill the tank, it's not a "shock" in the sense of supply constraints. What's more, for every oil importer paying more to satisfy energy needs there's an exporter benefiting from higher prices.
At first glance, these trends seem to bear out a popular bit of wisdom around Wall Street these days: That even at $50, oil still is relatively cheap when adjusted for inflation over the long haul and thus not that harmful to stocks or the economy. Amid last week's record oil prices, though, a certain question began to nag some market watchers: What if that supposedly cheap-by-historical-standards oil keeps rising until it is expensive by any measure? What if the inflation-adjusted highs of more than $70 a barrel from the early 1980s point the way toward where prices are headed, rather than why prices aren't so bad now? Fretful thinking often accompanies surprising market moves, such as what has happened with oil. Still, energy stocks are behaving in a strange and contrary way, when compared with the worrying. The Dow Jones oil-companies secondary index -- which excludes such huge integrated companies as Exxon Mobil and BP but includes major explorers, producers and refiners such as Amerada Hess and Sunoco -- is down 5.1% during a period when oil prices have soared nearly 10%. The Dow Jones oil-drilling, equipment and services index, which includes Halliburton and Schlumberger, is off 6.3% this month. Some analysts see the decline in energy stocks as anticipating an oil-price retreat. Even with a retreat, few analysts expect oil prices to move swiftly back into the $20s anytime soon. After all, analysts broadly agree the supply-demand balance in the oil market remains extraordinarily tight, with little relief close at hand. China's demand for oil has continued to surge, on top of supply worries exacerbated by terrorist fears and the war in Iraq. One factor, however, is the role of speculative betting in the oil markets. Some analysts think speculators, famous for short attention spans, are adding $3 to $9 a barrel to the price of oil. If they leave the oil markets, that could lead to some price relief. In that context, some strategists say last week's stock rally -- which included a 2.9% rise in the Dow Jones Industrial Average -- seems almost like a counterintuitive sign, because it shows the true day of oil-related reckoning still may lie ahead for stock-market investors. "There's a tipping point, but we don't know whether that's at $45, $50 or $75 a barrel," says Tobias Levkovich, chief U.S. stock strategist at Citigroup brokerage arm Smith Barney. "What energy prices do is give you another reason to be concerned about economic stability." Oil futures rose $1.28 a barrel on the week, or nearly 3%, to $47.86. That included an 84-cent decline Friday on the New York Mercantile Exchange, after futures briefly had topped $49. For the year, the commodity has soared 47% at the Nymex. "It's a really evenly divided marketplace in terms of sentiment," says Mike Thompson, director of research at Thomson Financial. "People are still trying to figure out where the head winds from the oil price are." Looking ahead, it is no surprise that analysts expect a 29% rise in energy companies' earnings in the third quarter. But they also expect a 70% rise in the basic-materials sector's earnings -- a sector that theoretically should suffer from rising oil -- and a 34% jump in technology profits, according to Thomson data. By contrast, analysts expect lackluster earnings from telecommunications, utilities and consumer-staples companies. The outlook for both winners and losers seemed to be on full display last week, as analysts raised their profit expectations for Deere, Goodyear Tire & Rubber, Amerada Hess and Occidental Petroleum, and cut their outlooks for Nicor, AT&T and Nextel Communications, according to Thomson. As they watched energy prices surge for most of the week, some Wall Street pros who follow broader market and economic trends issued dire predictions. Stephen S. Roach, a longtime bear and chief economist at Morgan Stanley, issued a report in which he said an "oil shock" could bring on a recession next year. Many observers' reactions were more shaded. James Paulsen, chief investment strategist at Wells Capital Management, says expensive oil is certainly a long-term threat to the economy. However, he also thinks the latest increase is mostly because of terrorism concerns ahead of the U.S. election, which would mean prices could fall somewhat if the voting goes smoothly. Mr. Paulsen says a 1970s-like energy crisis isn't likely, because U.S. companies have become more energy-efficient, as well as more service-oriented. Many economists, however, believe energy-efficiency gains topped out in the late 1980s. A spike in oil prices ahead of the Persian Gulf War contributed to a subsequent recession that helped frustrate George H.W. Bush's re-election efforts in 1992. "The bottom line is oil's impact on company balance sheets now isn't anywhere as close to what it would have been 20 years ago," he says. "Back in the 1970s, we didn't have falling sticker prices, zero-percent financing, $19.99 digital cameras and tech deflation. It's not as significant a reality now." But rising oil prices compound other, less-heralded signs of cracks in the economy, Mr. Levkovich says. He cites last month's lackluster job numbers, as well as rises in other commodity prices. Strategist Howard Simons of Bianco Research in Chicago has put together a list showing the correlation between daily price moves for industry groups in the S&P 500 relative to the oil price. His list shows that energy-related sectors -- such as oil and gas drilling, exploration and production, equipment and services, and refining and marketing -- had the highest positive correlation to oil prices. Hypermarkets and supermarkets, airlines, systems software, household products, and air freight and logistics had the most negative correlations. Drillers are likely to benefit most from the run-up in oil, followed by the fully integrated oil companies such as Exxon Mobil, Mr. Paulsen says. Of course, investors who have been around awhile might recall that rapid development and spending in the oil-services sector in the 1980s ended with the collapse of some companies. "People are wary, and they learned the last time that it's people who you don't expect who are going to capture the money flow," as Bianco's Mr. Simons puts it. Indeed, finding and extracting oil is an expensive business, what with the cost of offshore leases and equipment, and few companies are willing to risk so much. Nationalization of oil companies and pipelines also is always a concern for energy producers. Outside of the U.S., Europe and the emerging markets could be hurt by a sustained high oil price coupled with rising interest rates and a stronger dollar. "If the dollar starts to strengthen on higher interest rates or growth, and you're a country that's linked to the euro and imports a lot of oil, then it's a double whammy," Mr. Simons says.
A throng of strategists on Wall Street argue that rising crude prices do not hurt as much as they have in the past because the economy is not as energy dependent as it once was. The amount of energy needed to generate $1 in gross domestic product has fallen by roughly 50% in the past three decades, according to Morgan Stanley. But as Mr. Roach pointed out, a price spike like the one that has occurred this year can have consequences. And if the past is any guide, they are not pretty. What is pushing oil prices? First, there are the fundamental factors related to increased consumption and a decline in exploration and extraction over the past 20 years. Global oil consumption is up about 2.5 percent this year; in the United States, demand rose 3.5% in Q2-04 over Q2-03. As Jan Hatzius, an economist at Goldman Sachs, said in a recent report, oil prices are likely to stay high in the coming years because capital spending on energy exploration has lagged badly since the 1980's. Mr. Hatzius estimated that $2.4 trillion worth of capital spending - nearly three times the amount spent in the 1990's - will be necessary over the next decade to meet expected growth in demand. High oil prices will pay for that new investment. But another factor is compounding the effects of supply and demand on oil's price. That is the rush by speculators into the relatively illiquid oil markets in recent months. These investors, immensely frustrated by the trendless stock market and the static bond market, have latched onto oil as one of the rare world markets that have momentum and produce profits. No one knows, of course, where oil prices could go. But Mr. Roach said that recent levels are approaching oil-shock territory. And that makes the United States economy especially vulnerable to a recession. Mr. Roach said the price of oil must stay at current levels for between three and six months to produce a true energy shock. It may not. But if it does? In the past, Mr. Roach found that oil shocks have always been followed by recessions. The shock that followed the first oil embargo led to the severe downturn of 1973 to 1975. The oil run-up after the 1979 embargo helped produce the recession of 1981-82. And the shock generated by the Persian Gulf war contributed to the relatively mild decline of 1990-91. What all three events had in common, Mr. Roach said, was that the economy was stalling when the oil shock hit. In both 1973 and 1990, the economy was growing 2.2% annually. In the second half of 1979, growth was even weaker, averaging 0.6%, annualized. An oil shock, he said, "rarely comes at a time of economic strength and resilience when we can shrug it off and keep growing." Fast-forward to 2004, and the economy is slowing in a similar fashion, Mr. Roach noted. "The current recovery in the U.S. economy has been the most anemic on record," he said. "History tells us that the stall speed and a shock are a lethal combination." To be sure, the price of oil could turn down, removing the recession threat. But Mr. Hatzius at Goldman Sachs said that the recent increases look more permanent than past spikes. His evidence is a sharp rise in oil futures contracts, especially those with five-year terms, which have risen above $35 a barrel. For the past 15 years, he said, these contracts traded in a narrow range of around $20 a barrel. This move in the futures market suggests that substantially higher oil prices are here to stay, Mr. Hatzius argued. Making a global forecast based on oil prices is risky, Mr. Roach acknowledged. "There could be a huge breakthrough in Iraq and some supply could come on from Russia or Venezuela," he said. "But my guess is that some lasting damage has been done at these price points, and we're likely to have a significant haircut on growth next year." Maybe that's why stocks can't get out of the rut they're in.
But try selling that academic line to Neil Macneale, who edits a newsletter called "2 for 1". This service's model portfolio is based on the notion that stocks that have recently split their shares are likely to outperform the market. And Macneale's track record seems to be proving that notion right. Since November 2000, in contrast to a 4.2% annualized loss for the Wilshire 5000 index, Macneale's portfolio has produced an 8.7% annualized gain. That's a spread of nearly 13 percentage points on an annualized basis. Macneale's approach is the epitome of simplicity: Each month he purchases one stock that has recently undergone a split, and sells the stock that he purchased 30 months previously. With few exceptions, his model portfolio therefore always holds 30 stocks. Furthermore, he engages in no market timing. To be sure, since each month there typically will be lots of recently split stocks from which Macneale must choose his one purchase candidate, his track record reflects not just the performance of stocks undergoing splits. It also reflects whatever other factors he takes into account when making his choice. But recent research suggests that Macneale owes much of his success to the abnormal returns of stocks undergoing splits. Ironically, that research comes from academia, which for so many years had pooh-poohed the very idea. One such study ["What Do Stock Splits Really Signal?" by David Ikenberry, University of Illinois at Urbana-Champaign, Graeme Rankine, Thunderbird, American Graduate School of International Management and Earl Stice, Hong Kong University of Science and Technology] found that the average stock undergoing a split outperforms the market by 7.93% over the year following the split's announcement, and by 12.15% over the three years following that announcement. These excess returns follow an announcement return of 3.38%, indicating that the market underreacts to split announcements. The evidence suggests that splits realign prices to a lower trading range, but managers self-select by conditioning the decision to split on expected future performance. Pre-split runup and post-split excess return are inversely related, indicating that our results are not caused by momentum. Why should this be the case? Prof. Dave Ikenberry of the University of Illinois at Urbana-Champaign, one of the authors of this study, believes the typical company likes to have its stock trade in a "sweet spot" below $100 per share. Though that sweet spot is not precisely defined, companies will not split their shares if they believe there is a significant probability that their prices will fall back into that range by themselves. In effect, therefore, stock splits are a signal from management that they have confidence in their companies' future.
But now, they are starting to worry again. The fundamental problem: Oil prices are kicking up inflation across the world, at precisely the same time that economic growth appears to be slowing. If oil prices keep climbing, and inflation rates exceed growth rates, some economists say the U.S., Asia and other regions could face a troubling scenario in which policy makers have to fight some of the same demons that plagued the U.S. back in the days of disco. "Oil at $45 a barrel is a stagflation problem," warned economists at UBS Ltd. in a recent research report. By their reckoning, sustained prices at that level would slow global growth rates by almost half a percentage point in 2005 and by about one percentage point in 2006. Perhaps more important, such prices would push inflation up by about the same amount -- giving the world its first taste in years of what stagflation can be like. In Europe, the surge in oil prices at a time when the economy is only slowly recovering from a three-year slump has also ignited fears of stagflation. Europe is somewhat shielded from the effects of pricier oil thanks to the euro's strength against the dollar. That makes buying oil, which is quoted in dollars in international markets, relatively cheaper. Nevertheless, inflation in the 12-nation euro zone at 2.4% is above the European Central Bank's inflation target of "less than but close to 2%." And growth in Q2 slowed to 0.5% from 0.6% in Q1. Some economists fear that the ECB might react by raising rates earlier rather than later to fight the spike in inflation, and in the end dent growth. But the ECB believes that inflation will subside next year, and appears likely to leave its key rate at a postwar low of 2% for some time. For now, the stagflation concerns seem to be most pressing in Asia, though they could intensify elsewhere if oil prices stay high. That is because Asia's burgeoning manufacturing sector forces it to burn more fuel as a percentage of economic output than the more service-oriented economies of the West. That lack of energy efficiency is conspiring with a quickening pace of price rises in regional powerhouses such as China and India. In China, inflation hit a seven-year high in July -- with prices up 5.3% from a year earlier -- even though a host of recent indicators have suggested that China's government is succeeding in efforts to slow its overheated economy. "A large part of Asia is already in stagflation," contends Sung Won Sohn, a Wells Fargo economist in the U.S. who follows Asian economies. By his definition, a country can be in stagflation if inflation is rising and the economy is growing slower than its long-term potential. Consider South Korea, Asia's fourth-largest economy. While exports are up significantly compared with last year, high levels of consumer debt have curtailed consumer spending. Economists have scaled back their Korea growth estimates for 2004, as a hoped-for recovery in consumer demand has failed to materialize. Despite the slack demand, inflation is accelerating, due largely to oil. In July, consumer prices were up 4.4% from a year earlier; in March, prices were only 3.1% above those of the year-earlier month. Korean policy makers confront a conundrum that perplexed U.S. economists during the mid-1970s. Should they cut interest rates to boost growth, even though that might spur more inflation? Or should they raise rates to ward off rising prices, even though that could slow the economy further? On Aug. 12, South Korea's central bank made its move, cutting its key interest rate by 0.25 percentage point to an all-time low of 3.5%. This time, the U.S. is taking the opposite tack, raising interest rates even amid signs that the economy could be slowing. To be sure, a lot of economists don't buy the notion that Korea -- or any major country, for that matter -- is close to stagflation. In the case of Seoul's economy, they note that growth could still reach 5% or better this year -- hardly cause for panic -- if exports stay healthy. Moreover, if global growth slows a lot more, it could bring prices back down, snuffing out inflation before it becomes a major problem. That has occurred in many past periods when inflation rose. But some economists worry this time could be different. Recent estimates indicate that members of the Organization of Petroleum Exporting Countries now have spare capacity of just 500,000 barrels a day, less than 1% of the world market of more than 83 million barrels a day. With so little room to spare, some economists say oil prices could keep rising even after global growth slows. For that reason, some economists are advising Asian governments to abandon or reduce recent efforts that some have made to keep their currencies artificially low, a tactic that has boosted manufactured exports but reduced consumers' buying power. If those governments take that advice, it could trigger sizable changes in the world economy, making Asian economies less competitive in the short run -- but improving the prospects of exporters in the U.S.
PowerShares has come up with something in the middle. It launched two such ETFs in May 2003 and is now seeking approval for 21 more, according to a July filing with the SEC. PowerShares' inaugural ETFs track "enhanced" or "intelligent" indexes -- created by the American Stock Exchange and called Intellidex Indexes -- that attempt to outperform their respective market-segment benchmarks rather than merely represent a market segment. Each index evaluates companies across a variety of categories, including fundamentals, valuation and risk. The indexes rebalance quarterly and resemble a quantitative mutual fund. "What the indexes are designed to do is to have representation of a market sector, but then what they attempt to do is give you that exposure by owning the highest quality stocks or those with the greatest investment merit," said Bruce Bond, president of PowerShares. Essentially, it attempts to achieve "outperformance with less risk." While the costs of the new ETFs have yet to be disclosed, PowerShares' existing products are pricier than most: PowerShares Dynamic Market Portfolio and PowerShares Dynamic OTC Portfolio both carry expense ratios of 0.6 percentage point of assets. That's much higher than the average domestic stock ETF, which charges 0.36 percentage point, according to Morningstar. The cheapest ETF, the iShares S&P 500, charges 0.09 percentage point and the popular Nasdaq-100 Index Tracking Stock, known by its trading symbol QQQ, charges 0.18 percentage point. The new ETFs also will carry a sales charge of 2%, something ETF investors aren't accustomed to. In fact, one of ETFs' biggest draws is the fact that they are so inexpensive. But "by having the 2% load on there," Mr. Bond said, "it allows us to introduce the product using the syndication process, which will introduce it quickly, more like a closed-end fund or an IPO of a company." By incorporating the sales charge, PowerShares hopes to create an incentive for financial advisers and brokers to sell the product. The charge applies to buyers during the initial subscription offering only. After that period is up, investors will have to pay only the applicable brokerage commissions and expenses to which all ETF investors are subject. Mr. Bond says the SEC requires that initial investors must receive some sort of benefit. In this case, he says small investors might spend less paying the 2% rather than paying full-service brokerage commissions. It's hard to judge a fund with less than a three-year history. Nevertheless, PowerShares' existing ETFs have done well so far: Its Dynamic Market Portfolio is up 18.02% over the past 12 months through Wednesday, compared with 7.34% for the Standard & Poor's 500-stock index, while its Dynamic OTC Portfolio has risen 11.96% over the period, compared with a 3% gain for the Nasdaq Composite Index. Twenty-one of PowerShares' new ETFs will track the Intellidex indexes, including the PowerShares Dynamic Large Cap Growth and PowerShares Dynamic Large Cap Value Portfolios, as well as ETFs dedicated to midcap growth, midcap value, small-cap growth and small-cap value. Several others will track sectors ranging from biotechnology and genomes to pharmaceuticals, telecommunications, media and semiconductors. The ETFs also will mimic indexes created by other parties, the SEC filing said, including PowerShares Halter Golden Dragon China Portfolio. It will seek to track the USX China Index, comprised of U.S. exchange-listed stocks of companies that derive a majority of their revenue from mainland China.
"The market is going to grind higher [this] week," said Ken Fan, interest-rate strategist at ABN AMRO in New York, who said he believes the recent spate of negative news on the U.S. economy will persuade some investors to pare back bearish bets. "Between now and the end of the year, a lot of money managers are facing a strategic decision about their asset allocations. I think the net result is going to favor bonds," he said. Terrorism concerns also should keep Treasurys supported, Mr. Fan said. But Mark Jordahl, chief investment officer at U.S. Bancorp Asset Management, said he doesn't see much value in the Treasurys market right now. "We think Treasurys are overbought," he said. "A 4.25% 10-year note is too rich." Fair value for the 10-year note moving into 2005 is roughly 5%, or an inflation-adjusted yield on the 10-year of about 3%, Mr. Jordahl said. Treasury yields have been pushing lower amid evidence of a weakening economy, led most notably by the softening rate of hiring. Consumers continue to spend. While it isn't a totally bleak picture, the market got another reminder of brewing troubles Friday with news of a 19% increase in the June trade gap. Its magnitude led economists to reduce estimates of second-quarter growth. Despite such concerns, the Fed has continued to strongly suggest that more rate increases are in the cards. In lifting the federal-funds rate target Tuesday, the Fed discounted recent weakness as a factor of higher oil prices and said strong growth is the most likely path for the U.S. economy. It is a story that not many in the market are buying. Goldman Sachs forecasters said in a research report that energy prices simply haven't risen enough to account for all the pullback in growth. They added that the surge in the trade deficit wipes away the positive implications of improved retail spending in July, another blow to the outlook.
The study was done by two money managers, Clifford Asness, the managing principal at AQR Capital Management, and Anne Casscells, formerly the chief investment officer for Stanford University's endowment and now chief investment officer for a unit of Aetos Capital. They found that stock pundits routinely mix apples and oranges when they cite the P/E ratio to bolster bullish statements about the market. Stock prices are straightforward enough, the authors say, but corporate profits are not. There are many ways to calculate them, and the different definitions of the earnings component of P/E ratios are the source of much confusion. One widely used definition relies on analysts' projections of what companies will earn over the coming year, while another focuses on what companies actually earned over the previous four quarters. In addition, some analysts focus on earnings as reported by companies; these figures may include one-time accounting adjustments that can seriously distort corporate performance. Others exclude these nonrecurring items, instead using what are known as operating earnings. All of these distinctions can lead to big differences in the reported overall P/E ratio of the stock market. Using projections from Standard & Poor's analysts of operating earnings over the 12 months through mid-2005, the current ratio of the S.& P. 500-stock index is 15.5. But if calculated by using earnings that were actually reported by these companies over the 12 months through June 30 of this year, the ratio is 19. Mr. Asness and Ms. Casscells do not take a position on which earnings definition is best. They say the important thing is to be consistent, especially when assessing where the market stands in relation to its historical norms; otherwise the comparisons aren't valid. Consider the statement, often repeated these days on Wall Street and in investment newsletters, that the market's current P/E ratio is not abnormally high. The argument, as Mr. Asness hears it from fellow money managers, goes like this: "Currently the S&P500's price-to-earnings ratio is in the mid-teens. Comparing that to an historical average of about 15 shows the market to not be more expensive than average." But that argument relies crucially on a "sleight of hand," Mr. Asness says. The market's current ratio is in the mid-teens only if it is calculated by using projected operating earnings. Yet the long-term average ratio is as high as 15 only if it is calculated by using trailing reported earnings. It is bogus to compare the two figures. If advisers want to focus on P/E ratios based on predicted operating earnings, the proper historical comparison is to historical P/E ratios that were also calculated by using predicted operating earnings. And the average of those ratios is a lot lower than 15. How much lower? Mr. Asness and Ms. Casscells estimate that, calculated this way, the median ratio from 1871 through 2003 is around 11. (They cannot be more precise because data on analyst projections is incomplete for some long-ago years.) Their estimate is about 20% lower than the 13.7 median for P/E ratios that use trailing reported earnings. Far from being average, then, the S&P's current ratio of 15.5, based on predicted operating earnings, is some 41% above the norm. Bullishly inclined brokers will not be able to wriggle out from the force of this conclusion by focusing instead on trailing reported earnings. Calculating the S.& P. 500's ratio by that method, the current level, 19, is still 39% above the historical median. Mr. Asness and Ms. Casscells conclude that as long as advisers rely on an "honest apples-to-apples comparison," they will find that P/E ratios "of any stripe are very high versus history." Mr. Asness concluded that "stocks ain't cheap, and you have to cheat to call them cheap." This doesn't guarantee that stocks will fall, he said, "since they could just return less than their historical average forever while staying expensive." But he said it does mean that, at current levels, "nobody should be calling stocks undervalued or even fairly valued."
But don't mistake these managers for inveterate Chicken Littles whose defensiveness produces safe but paltry returns over the long term. Over the last 10 years, according to Morningstar, when the Standard & Poor's 500-stock stock index gained 11.1 percent, annualized, FPA Capital returned 17.7 percent; Clipper, 16 percent; and Longleaf Partners, 14 percent. Each fund produced those above-average returns with lower risk than the S.& P. 500. "When I see really good managers saying there is little out there that is a good value, that sends a sobering signal," said Russel Kinnel, director of fund research at Morningstar Inc. "It tells me something about the risk premium in the market, and that this is not exactly a time to double down." Value players who find a dearth of investment opportunities say that they are not making a broad market-timing call; a common refrain is that they have no idea where the market is heading, nor do they care. Despite their bold cash moves, value managers don't like being tagged as market barometers.
Prospective companies must have a positive historical five-year dividend-per-share growth rate and a five-year average payout ratio no greater than 60%, and the average daily trading volume (determined annually) must be more than $1.5 million. To keep the strategy intact, the index is rebalanced once per year, and each company's weighting is then determined by its annual dividend. The fund boasts a respectable expense ratio of 0.4% and a current yield of 3.35%, and it pays dividends quarterly. All in all, these traits should make it a welcome addition to any income-oriented portfolio. One caveat: Though the fund excludes real estate investment trusts (REITs) in its screening process, Dividend Select does have a somewhat heavy exposure to financial and utility stocks. Now, this exposure doesn't particularly worry me, as I happen to be bullish on several companies within both sectors. Still, though it partly goes with the territory of being a dividend investor, these types of securities can increase interest-rate-related volatility.
Oil shocks also make life difficult for the Federal Reserve, which has been planning a slow, steady step-up in short-term interest rates over the coming months. When Fed policymakers meet tomorrow, they are thought likely to stick to plans to raise the short-term rate for the second time this summer. But they will also debate whether to continue that course through the fall. Oil prices, which briefly hit an all-time high (not adjusted for inflation) of $44.73 early Friday, may be doing the job of curbing consumer demand for them. But they could also lead to higher inflation if workers win compensating wage gains. There have been plenty of upbeat numbers to offset the recent weak data. Auto sales rose smartly in July. Consumer confidence numbers remain high. And some measures suggest the job picture isn't so bleak. While Friday's labor-market report showed weak job creation in July, it also showed a modest gain in factory payrolls, a longer work week, decent pay gains and a drop in the unemployment rate to 5.5% -- the lowest level in nearly three years. Still, economists and some investors aren't nearly as bullish as they were when the summer began. A month ago, Macroeconomic Advisers was projecting growth in Q3 of 5%. Now, the forecasting firm is estimating just 3.6%. High oil prices aren't the only thing weighing on the market and the economy. Another factor is the fading effect of the stimulus policies that were designed to counteract the 2001 recession and sluggish recovery. Some economists believe consumers needed the steroids of repeated tax cuts and successive rounds of mortgage-refinancing to sustain their remarkable spending binge from late 2001 through the spring. With that stimulus wearing off and Treasury and the Fed in no position to administer more, consumers may finally be retrenching partly in response to the high debt levels they've taken on in recent years. This year's surge in oil prices isn't as dire as the shocks of the 1970s. In constant 2004 dollars, today's price is still some 40% below the record price hit in 1981. And the U.S. is more fuel-efficient than it was back then. However, the doubling of petroleum prices since early 2002 still represents one of the largest sustained increases since 1979 and has significantly crimped disposable income for consumers. Weakness in consumer spending may now be ricocheting into job growth. The retail and hospitality industries were two principal job losers in July. Both are sensitive to consumer discretionary spending. Retailers shed a net 19,000 jobs (including 2,600 at gasoline stations), while employment in leisure and hospitality fell by 2,000. Earlier oil-price run-ups were primarily caused by a withdrawal of supply, or fear of one. This time around, most of the increase results from strong demand, especially in fast-growing China. World oil consumption is expected to grow by 3.2% this year, or 2.5 million barrels a day, according to the International Energy Agency. Growth was generally around 2% or less for most of the prior decade. The strong global demand for oil has left the petroleum industry with almost no spare capacity to cushion any disruptions in supply, which has been growing far more slowly than demand. The world's oil producers are thus operating with a tiny margin of spare pumping capacity of just one million barrels, in a market of 80 million barrels a day.
It's precisely the steadily rising demand, however, that is worrying the market. Unlike in the 1970s, the problem this time isn't primarily a supply shock in which the world's biggest oil spigots have been shut off. It's that, even though they're wide open, the world is consuming pretty much everything that comes out of the ground. The resulting fear is that isolated supply disruptions -- a change in government in Venezuela, say, or a terrorist attack in the Middle East -- could push prices even higher (see related articles on Venezuela and on oil prices). "If the world can return to equilibrium, I think that, in the near term, there's adequate supply," says J. Robinson West, chairman of PFC Energy, a Washington-based energy-consulting firm. But, he adds, "in the long term, unless demand is dealt with, this is not a good sign for the global economy." China and India Demand Cause Oil Price Hike The world is estimated to be consuming an average of 81.7 million barrels of oil per day this year. That's up 2.5% from a year ago -- a big jump. The biggest demand surge is coming from China and India. China's government said yesterday that the country's oil refineries have processed 17% more crude so far this year than in the like period last year, and that crude imports have risen nearly 40%. India's government-owned refiner, Indian Oil Corp., said it expects India's crude imports to rise 11% during the company's 2004-05 business year. In the U.S. -- the world's biggest oil consumer and thus the market that sets global prices -- demand in Q2 grew 3.5% over the year-earlier quarter. Still, commercial inventories of crude oil are 5% above last year's level, and gasoline stocks are up 4.5%. Some observers see the U.S. inventory levels as evidence that there's plenty of oil to meet growing demand and that today's oil price is largely the result of excessive speculation. Trading volume has soared in recent months as hedge funds and other fast-moving traders have headed into the oil markets. "I don't think the fundamentals support prices anywhere close to this level," says Kyle Cooper, an oil analyst at Citigroup in Houston. He believes prices should be closer to $30. The Bush administration has so far refused to tap the Strategic Petroleum Reserve, reiterating that it should be used only to address serious supply disruptions, not to manage prices. But officials acknowledge the lack of spare capacity today would be an important factor in deciding whether a new disruption was severe enough to merit tapping the stock. A White House spokeswoman says the policy of using the reserve only to protect national security "is unchanged." Absence of Cushion Causing Oil Price Hike What's making oil prices frothy is that the cushion of extra supply is so thin at a time when trouble is popping up in major oil-producing nations. In Iraq, where insurgents yesterday sacked facilities of the state-owned South Oil Co., output is running about half of its potential because of pipeline sabotage in the oil-rich south. In Russia, a political brawl is raging between the Kremlin and oil-rich OAO Yukos, which pumps about 2% of the world's total oil output. In the past four weeks, Nymex crude has risen $8.12, or 20%. Year-to-date, crude oil is up 50%, or $16.18 a barrel. The market isn't betting on a quick fix. In a big change from past experience, this time it isn't just the price of today's oil that's surging. Futures contracts through May 2006 delivery are above $40. The contracted price of oil to be delivered six years down the road is also rising. After years in which they hovered between $20 and $25, these so-called six-year futures now are trading around $35. Such long-term futures contracts are notoriously volatile and relatively thinly traded, but the rise has attracted notice. Federal Reserve Chairman Alan Greenspan highlighted this runup in the price of long-term oil futures in a speech in April, saying it has "received relatively little attention for an economic event that can significantly affect the long-term path of the U.S. economy." Stephen Roach, chief economist at Morgan Stanley and a noted bear, said in a message to investors yesterday that prices are now 62% above the average per-barrel price that prevailed since early 2000. Such levels don't match the quadrupling that followed the Arab oil embargo of 1973-74, but he maintained that "if oil prices hold around present levels, this would qualify as a shock." Mr. Roach said chronic high prices "could lead to recession in 2005." Prior Oil Shocks Thus far, the drag appears more muted than in prior oil shocks. U.S. GDP grew 4.2% in 1973 but swung to a decline of 1.9% in 1974, according to Credit Suisse First Boston. In 1978, the year before Iran's revolution began, U.S. growth was 6.7%. It was zero in 1980. This time, the declines are much milder. The U.S. economy grew at a 4.5% rate in the first quarter of this year and 3% in the second. John Felmy, chief economist for the American Petroleum Institute, figures about one percentage point of that difference is attributable to the rise in energy prices. "That's not enough to push us into recession," he says. The U.S. economy is less dependent on oil now. The amount of oil and natural gas used to produce a dollar of GDP dropped by 55% between 1973 and 2003, Mr. Felmy says, as energy-intensive sectors became more efficient and growth shifted toward less energy-intensive areas such as telecommunications. But the bulk of that improved efficiency occurred prior to the mid-1980s. Since then, it has slowed. One big reason is the transportation sector, which accounts for the biggest chunk of fuel use. During the past two decades, the average fuel economy of U.S. cars and light trucks has gotten worse. Today, industries from autos to airlines to chemical manufacturers are trying to cut their energy use, but it's a slow and expensive slog. Europe has zipped past the U.S. in energy efficiency, largely because it has slapped high taxes on energy. The U.S. consumes 70% more oil per unit of GDP than Germany or the U.K., according to the National Institute of Economic and Social Research in London. Yet expensive oil hurts Europe too. The Organization for Economic Cooperation and Development estimates that a $10 rise in the price of crude oil reduces economic growth in the Euro zone by 0.2 percentage points a year. Economists say the harm could be greater if oil prices pose enough of an inflation threat to prompt Europe's central bank to step up interest rates. In the U.S., the Fed has expressed similar concerns. The U.S. burns about 140 billion gallons of gasoline each year, the American Petroleum Institute says. That means that every penny increase in the retail price of gasoline takes $1.4 billion out of consumers' pockets. Oil Price Effect by Sector The rising oil prices hit some businesses harder than others. Worse off are those that sell directly to consumers and find it tough to pass on costs. For instance, Swiss-based Nestle SA, the giant food maker, blamed sluggish first-half sales and profits in part on oil prices, which drive up the cost of plastic packaging. Companies that sell to other businesses, rather than directly to the consumer, can sometimes shift some of the pain. "We can and are passing through a lot of these costs," says Dale Spiess, a division president at plastics maker Nova Chemicals Corp., based in Pittsburgh. There's not much excess capacity in chemicals, he says, "so there's not much place for customers to go." Meanwhile, the higher energy prices keep makers of competing packaging products, such as paper bags, from stealing plastics makers' business. Mr. Spiess worries about the broad slowdown he thinks could occur if oil prices stay high. "It could pull back demand for our products," he says. The trucking industry has added surcharges to cover its increased cost of diesel fuel. Industry officials estimate the surcharges add 5% to 10% to the rates customers pay, which vary widely but average about $1.35 per mile. Stephen Russell, chairman and chief executive of Celadon Group Inc., a trucking firm based in Indianapolis, recalls that the industry wasn't able to levy such surcharges during earlier price runups, making the pain of those shocks far more severe. This time, "our industry is tight on capacity. So basically, folks are paying it." In the auto sector, SUVs, particularly the most expensive ones, are taking longer to sell in the U.S. than a year ago, J.D. Power & Associates said in a report last week. It also said they sold in July for an average of 2% less than a year ago, even though overall new-vehicle prices climbed a bit. Oil Price Effect by Nations A chronic oil-price crunch would have different impacts among nations. Some European leaders maintain that the Continent could better weather a long-term price rise than the U.S. because it has made more progress in shifting to renewable fuels. French Energy Minister Patrick Devedjian said yesterday that France's reliance on nuclear power for 80% of its electricity would limit the economic damage of high oil prices. Germany is investing heavily in wind and solar energy. Its government said this week that renewable sources now provide 10% of Germany's electricity. Improving energy efficiency takes a long time. But it can be done, says a longtime advocate, Amory Lovins, chief executive of the Colorado-based Rocky Mountain Institute. He says that between 1977 and 1985, real GDP in the U.S. grew by 27% while oil use fell by 17%. By his calculation, if the U.S. kept reducing oil use at that pace, every year and a half the U.S. would decrease its daily oil consumption by some 2.5 million barrels, about the amount it currently imports from the Gulf. "It's a measure of how much we did the last time we paid attention," Mr. Lovins says.
A look at the performance of companies that have reported their earnings and given guidance shows that trimming the future earnings outlook - or just giving guidance below Wall Street forecasts for the quarters ahead - can offset what was otherwise a strong earnings announcement. Of the 33 companies from the S.& P. 500 and the Nasdaq 100 whose guidance was lower than market expectations when announcing second-quarter profits, shares of 27, or 82 percent, declined on the first trading opportunity after the news, based on an analysis of data collected by Birinyi Associates, a research and money management firm in Westport, Conn. The stock of 23 was still down through Wednesday. The performance of companies that raised their guidance - saying, in effect, that Wall Street was underestimating their earnings for coming quarters - shows a similar, but reverse, relationship. Of the 45 companies that issued such guidance, shares of 31, or 69 percent, rose on the first trading day after the news release; 33, or 73 percent, were up through Wednesday. The data also shows that leaving a company's guidance unchanged can hurt a stock's performance, just as it often is not good enough for a company only to match its earnings expectations. Of the 309 companies through Wednesday that didn't change their guidance, 49 percent fell on the trading day after the announcement.
"The investor who pulls out of long bonds into short-term bonds or cash is losing income while they wait for rates to rise," said John Miller, a fixed-income portfolio manager with Nuveen Investments. "If rates don't rise, they may not be made whole." Even when bondholders are correct in their interest-rate predictions, it can take a long time to make up what was lost in interest income by sitting in lower-yielding investments. Investors have been encouraged to adjust their bond portfolios to protect against what is expected to be an environment of rising rates and falling bond prices. Among the most widely touted is advice that says investors should move to short- and intermediate-term bonds with maturities of 10 years or less. Bonds with shorter maturities provide less in returns, but they also lose less in value when rates rise. Plus, their shorter lifespans allow investors to escape low interest rates sooner. The most obvious risk of this strategy is that rates don't rise as expected, in which case people who moved lower on the yield curve would have given up higher returns for nothing. In 2001, for example, some investors were convinced that rates were set to tick higher after hitting historic lows. Instead, rates continued to set new lows for the next several years. Even when bondholders are right in their interest-rate predictions, they lose interest income while they wait in shorter-term bonds or in cash for rates to rise. Consider, for example, that the Federal Reserve starts raising interest rates as expected, but that it has the effect of flattening the yield curve. In other words, rates on short-term bonds rise, but rates on long-term bonds don't follow. In that situation, anyone who moved to the short end of the yield curve would face an even longer waiting period before they could reinvest in long-term bonds. Depending on how long you wait, where you wait and what rates you finally nab, it could take years to make up the losses, said Roy Youngman, senior vice president at FMSbonds Inc. a Boca Raton, Fla., broker-dealer firm specializing in municipal bonds. Mr. Youngman crafted a scenario to demonstrate this problem in 2001, when he was trying to convince investors of the merits of not trying to time interest rates. The scenario had one investor with $100,000 who invested immediately in tax-free bonds at a rate of 5.6%. After four years, the investors saw a return of $22,400, not including compounding. A second investor with the same amount of money waited six months to invest until he could lock in a rate of 6%. In the meantime, he invested in cash at a rate of 2.25%. Despite his waiting for the higher rate, it took the second investor more than four years to catch up to the first investor's returns.
According to Morningstar, there are 6,700 stock, bond and money-market funds, up 40% from 10 years ago. With this rapid growth has come increasing specialization. Forget vague promises that a fund will invest in U.S. stocks or in foreign shares. Today, funds tend to stick with well-defined market niches. This specialization has changed the whole fund-picking process. Before, investors sought talented managers who could deliver decent returns year in and year out. Now, with funds focused on narrower market niches, investors also need to give serious thought to the market sectors they are tapping into. The new strategy: First, decide which market sectors you want exposure to and what percentage of your portfolio you will invest in each. Next, for each sector, pick a top-notch fund to give you your desired market exposure. In effect, funds have become portfolio building blocks, rather than being viewed as stand-alone investments. Monthly Employment Stats
Details of the report suggest flagging consumer spending has affected hiring. Payrolls fell by 19,000 at retailers and by 4,600 at hotels. Financial services lost 23,000. Even gasoline stations trimmed payrolls by 2,600, or 0.3%. [From The NY Times 8-06: Banks, movie studios and phone companies all reduced their workforces too. Government employment remained flat, as it essentially has for the last few months. Hospitals and other health-care companies continued their long rise in employment, meanwhile, and construction companies added jobs as well.] By contrast, more business-oriented sectors improved: professional and business service employment rose 42,000. Meanwhile, manufacturing eked out a 10,000 gain in jobs, suggesting that business capital spending and exports are keeping that sector's recovery alive. Government payrolls were unchanged. The weak jobs numbers raised the prospect that recent economic weakness is more than just a soft spot, as Mr. Greenspan has referred to it, but a sign that something more fundamental is undermining the expansion. As yet, many economists still think it's a soft spot. Surveys of businesses and consumers and weekly tallies of unemployment insurance claims show a still-bullish picture of job creation and hiring prospects. Furthermore, much of the weakness in recent months appears due to a sharp increase in energy prices. The more pessimistic interpretation is that consumers, the pillar of the economy since 2001, are finally flagging. "The cumulative evidence suggests something may be churning in the household sector which, at 70% of gross domestic product, is the be-all and end-all of the outlook," said George Magnus, chief global economist at UBS AG. "The interest rate-refinancing stimulus is pretty much over. Fiscal stimulus is turning into fiscal drag. Oil has also become a drag. As an offset to these three headwinds, the only tailwind was significant employment growth. Without it, we're facing an uphill task to recover the momentum of growth." [From The NY Times 8-06: The best sign in an otherwise grim report may have been the gain in earnings for rank-and-file workers, who make up about 80% of the workforce. Their average weekly pay rose $3.25, to $529.09, after dropping last month. Over the last 12 months, though, weekly pay has risen only 2.4 percent — considerably less than inflation, which has been running above 3 percent. Average hourly earnings of nonsupervisory workers increased 5 cents, or 0.3 percent, to $15.70.] Prior Employment Updates: May 2004, April 2004, March 2004 Just the Facts Slowing Corporate Health Care Cost Comes at a Price for Workers Vanessa Fuhrmans, WSJ 8-27 Employers believe they can slow the rate of increase of their soaring health-care costs to just under 10% in 2005, but only after shifting even more of the expense to employees, a new nationwide survey said. That forecast comes from preliminary results of an annual survey of nearly 3,000 employers by Mercer Human Resource Consulting. The 916 employers that have so far responded to the survey said they believe the total cost of health-care benefits per employee will rise an average 9.6% next year. Many employers will manage to whittle their health-care spending only after raising workers' deductibles and copayments, cutting back some health benefits and limiting the number of plans they offer, said Blaine Bos, a senior health-care consultant at Mercer and the survey's chief analyst. Were employers to take no new measures and simply continue with the health-benefit plans they currently have, the employers say their costs would rise more steeply -- an average 12.6%. Health-care policy analysts say they worry that the steady paring of benefits and the rising share of costs being shifted to employees -- particularly for workers' family members -- is contributing to the growing number of uninsured people. Earlier this month, a study from the Center for Studying Health System change, a Washington-based independent policy-research group, estimated that the number of Americans with employer-sponsored health benefits fell to 63% from 67% between 2001 and 2003. Great Expectations Morgenson & Bayot, NY Times 8-24 Individual investors began this year with high hopes. In January, two-thirds of the 800 investors surveyed by UBS said that they felt somewhat or very optimistic about where stocks would be in 12 months. UBS said it was the highest level of investor optimism since January 2000, the height of the stock market mania. Even now, with the market well off its highs for the year, the chasm between what investors seem to be expecting from the stock market and what they will probably receive remains wide. An astonishing 18% of investors polled in August said they expected to generate profits of 10-14% in their portfolios over the next 12 months, while 28% said they expected to generate gains of 5-9%. Just under half of the investors polled this month said that they were either somewhat or very optimistic about the performance of the stock market over the next 12 months. ROE vs. MPG Scott Burns, The Dallas Morning News 8-11 The Burns family started driving a Toyota Prius hybrid last year. By my calculations, trading in my 18-miles-per-gallon turbo New Beetle for the 45-mpg Prius saves about 500 gallons a year. At $2 a gallon, that's $1,000 a year. To have $1,000 a year to spend on gasoline, I would need to have $1,176 in dividends before the 15 percent tax rate on a stock investment. And to earn $1,176 in dividends from the companies of the S&P 500 index, I'd have to invest $78,431 - since the S&P 500 yield is only about 1.5%. To have $1,000 to spend on gasoline, a person in the 25% tax bracket would have to earn $1,333 in pre-tax interest. With five-year Treasury obligations yielding about 3.73%, you'd need to invest $35,746 to come up with $1,000 for the gas pump. Is there a message here? I think so. The market is telling us there's more opportunity in how we select the car we drive than in how we invest our savings. All you have to do is exchange a low-mileage car for a better-mileage car. The improvement doesn't have to be heroic. Suppose you replace your 15,000-miles-a-year, 18-mpg car with a moderately more efficient 24-mpg car? You'll save 208.3 gallons a year, or $416.67. To generate the necessary money in stocks, you'd need to buy a portfolio worth $32,680 - or bonds worth $13,889. U.S. Investors Buying Foreign Stocks at a Record Pace Craig Karmin, WSJ 8-04 U.S. net purchases of overseas shares jumped last year to a record $72 billion, according to the U.S. Treasury Department, easily eclipsing the former mark of $63 billion from 1993. This year, appetite for foreign stocks appears to be even greater: Through May, U.S. investors bought $36.7 billion more in non-U.S. stocks than they sold, which puts them on pace to be net buyers of $90 billion for the year -- a 25% rise over last year's purchases. The flow of money into foreign-stock mutual funds aimed at individuals is increasing at a faster rate than that of new money into U.S.-stock funds, according to AMG Data Services. U.S. investors have been net sellers of $17 billion in foreign bonds over the first five months of this year. IPO Stat Gary Rivlin, NY Times 8-01 More than 5,000 companies went public between 1989 and 2000, according to Richard Peterson, chief market strategist for Thomson First Call. Nearly one-third of those companies are down 50% or more since their stock market debut, Mr. Peterson said - if they are even still in business. Only one-fifth are worth at least twice their opening day price. Moreover, this year has been a terrible one for technology companies new to the stock market. Two dozen technology-related companies have gone public in 2004, Mr. Peterson said; collectively they were down more than 10% as of Friday's stock market close. That compares with a gain of about 1% in the share price for the nontechnology companies that have gone public this year. Quick Facts, Stats & Opinions Today, only 65 percent of American households are listed in a telephone directory, a decrease from the 72 percent who were listed two years ago, according to Survey Sampling International, a company that keeps a nationwide database of white pages listings. (Matt Richtel, NY Times 8-30) In a research note last week, David A. Rosenberg, Merrill Lynch's chief North American economist, observes that dividends historically have represented 40% of the stock market's total return. He points out that this year, dividend-paying stocks in the S&P 500 are up 4.2% in price as a group, while nonpayers have suffered an 8.4% average drop. This 12.6-percentage-point gap "wipes out around half of last year's relative gain by the nonpayout segment." Companies, on average, are disbursing 33% of their earnings in dividends currently, but that's still well below the historical level of 55%. (Shirley Lazo, Barrons 8-30) You need not be a believer in index funds to benefit from their ascendancy. The indexers, with roughly a one-sixth share of the stock-fund business, bring intense, relentless competition to bear on active managers, pressing them to keep their performance up and their costs down. (Chet Currier, Bloomberg 8-24) A recent report by the Bank Credit Analyst, noted that capital gains from securities accounted for more than half of the increase in total assets among households from 1982 to 2000. (Morgenson & Bayot, NY Times 8-24) "It appears that a conservative set of habits is building among consumers after multiple periods of comfort with higher levels of risk and speculation in the stock market and then its successor, the housing market," said Richard Hastings, retail analyst at Bernard Sands. "The speculative momentum to drive markets is simply not there." Recent inflows into stock mutual funds seem to confirm this view. July's inflows were $8.9 billion, the second-lowest figure this year and well below the $21 billion average monthly inflow generated during the first six months of 2004. (Morgenson & Bayot, NY Times 8-24) "In our opinion, the market's risk has not been removed as a result of stock indices being near their 2004 lows," writes Smith Barney's Tobias Levkovich in a note dated Aug. 5. "Our analysis supports the view that caution is still appropriate, since complacency seems to be the primary emotion of investors currently...stocks are not yet cheap and earnings estimates are slipping." (SmartMoney 8-17) Researchers at the SANS Institute's Internet Storm Center estimate that an unprotected PC will be compromised within 20 minutes of being connected to the Internet, down from an estimated 40 minutes last year. The estimate is based on observations of vacant IP addresses, which received reports approximately every 20 minutes. According to the researchers, if those reports come from Internet worms, the unprotected machine would likely become infected within 20 minutes, which is especially troublesome because most patches that would protect the computer take longer than that to download and install. Scott Conti, network operations manager for the University of Massachusetts at Amherst, said that, as a test, his institution recently put two unprotected computers on the school's network, and both were compromised within 20 minutes. (CNET 8-17) The net underfunding of the traditional pension plans of companies in the blue-chip Standard & Poor's 500 index narrowed to $165 billion at the end of 2003 from $219 billion a year earlier, S&P said in a report Wednesday. For the 362 companies in the S&P 500 with so-called defined-benefit pension plans, assets grew 17.2% to $1.11 trillion last year while the long-term amount owed to pensioners rose 9.3% to $1.28 trillion, S&P said. In 1999, at the height of the last bull market, S&P 500 companies' pension plans overall were overfunded by $280 billion. At that time, 296 plans were overfunded and 86 were underfunded. At the end of last year, just 46 plans were overfunded and 290 were underfunded. (Reuters via LA Times 8-12) On a GAAP basis, the Standard & Poor's 500 is trading at a trailing price/earnings multiple of 19.3, compared with its 20-year average of 21.5, according to Standard & Poor's. On an operating basis, the S&P sports a trailing P/E of 17.4, compared with its historical average of 20. Each of the 10 sectors in the S&P 500 is trading below its historical average multiple. (Monica Rivituso, SmartMoney 8-11) In 2040, the number of Americans either under 18 or 65 or older will exceed the number of prime working-age adults by 21 percent. In 2000, by contrast, prime working-age adults outnumbered dependent children and elderly adults by 14 percent.(Albert Crenshaw, Washington Post 8-08) Far more stocks are setting 52-week lows than highs. On the Nasdaq Thursday [8-5], 139 stocks hit new lows, vs. 17 new highs. On the New York Stock Exchange, 68 made new lows vs. 20 new highs. (John Waggoner, USA Today 8-06) The Short Interest Ratio on the NYSE has moved up to 5.82 percent, which is well above its February lows of 4.50 percent and within striking distance of its peak reading of the year and only 1 percent away from a five-year high. (Dan Sullivan, The Chartist Mutual Fund Letter via Washington Post 8-01) Home Page Previous Factoid Top Sites
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