Investors will recognize: Stock market remains undervalued

The S&P 500 gained 1.9% in the 4th quarter and gained 4.2% for the year.  Nearly all the return for 2006 came from November 1st through the second week of December, with the S&P 500 peaking for the year on December 14th, but sliding 2% by year end.  In October, we wrote:

“Investors won't step up to buy stocks until energy prices stabilize or go lower, the Federal Reserve finishes raising rates (probably another 0.75% over the next three meetings or the US makes some progress in extricating itself from Iraq.”

Three months later, each of these factors has made modest improvements, but not enough to bring investors back to stocks in a big way.  So our start of year target of an 8% gain in the S&P 500 was not achieved, even though earnings growth exceeded our expectations while interest rates remained lower than our expectations.  Eventually, investors will recognize that the stock market remains undervalued.

Oil

Our expectation at the start of the year was that crude oil would trade in a range of $40-48/barrel.  In fact, the range was $55-71, with a September peak coinciding with hurricanes Katrina and Rita, which closed down about half of the Gulf Coast production and refining capacity.  About 28% of production and two refineries totaling 300,000 barrels/day are still offline 3 months later.  However, inventories of crude are 9.3% higher than year end 2004, and 19.2% higher than year end 2003.  Economics 101 says higher supply results in lower price, so why has oil doubled since

October 2003 and quintupled since December 1998?  Worldwide demand is growing faster than the average 2% increase in demand in the US.  There is still about a $5-8 “terror premium” built into the price against interruption of supply.  OPEC countries, especially Saudi Arabia, are at the limit of current production capacity, so there is less “cheating” among OPEC members.  Two bad hurricane seasons have disrupted US production two years in a row.  Finally, there are a lot of “trend followers” among hedge funds who have piled into the oil markets the last year or two. 

We believe that if the hedge funds piled out of the oil trade, the price would fall precipitously below $50.  But perhaps we’re wrong.  Perhaps $50/barrel or better is the new oil price.  If prices haven’t come back down below $50 by June 2006, we would buy companies that produce energy without relying on conventional oil (solar, tar sands, methanol, nuclear) and other companies that increase the efficiency of using oil (companies that make components that go into hybrid cars, for example.)  If oil should fall back below $40, none of these companies are economically viable, so we have to be careful.

Read the entire commentary here.