March Smart Investing Strategies and Global Investment Trends

March 2008 Smart Investing Strategies and Global Investment Trends By William Parmenter, Editor Dr. Kenneth Sleeper of Sierra Investment Management Inc. talked about investment trends to the AAII Mutual Fund Group at the Fairview Library in Santa Monica on March 1. His talk was well received by the almost score of attendees. The mutual fund group, directed by Dr. Gunter Hagen, meets every other month. Dr. Sleeper elaborated on five investing trends in his talk, entitled Smart Investing Strategies and Global Investment Trends. The five investment trends shaping our future are: 1) global demand for energy and natural resources; 2) growing prosperity in the third world; 3) the housing slump after the unprecedented appreciation of residential real estate; 4) continued pressure on the U.S. dollar, coupled with banking turmoil; and 5) potential for low returns and high risk in the U.S. stock market. The question for investors is: can we stay ahead of the negative implications of these trends? Highlighting the five trends 1. The end of cheap oil: From 2005 to March 2008, the price of a barrel of oil went from $46 to $108. The developing world has required more commodities, such as steel, copper and aluminum, putting upward pressure on their prices. PIMCO Commodity Real Return mutual fund has gone from 100 in 2006 to 160 in 2008, a 60 percent appreciation. But one must manage risk when the price goes parabolic, as this fund went from 120 to 160 in 2008, and it will probably correct soon. One implication of higher energy and resource prices is the threat to our way of life, which is based on cheap energy. Higher energy prices are a tax that reduces spending in other areas. Energy and natural resources are not located in places friendly to the U.S. These implications bode for a decline in lifestyle for Americans. 2. Growing third world prosperity Chinese manufacturing has grown at 15 percent compounded for the last 15 years. China will soon be the world s largest manufacturer. China s technological prowess is indicated by it being only one of three countries to put a man in space. Asian market stocks went from a base of 100 in 2000 to 350 in 2008. During the same period the South American market went from a base of 100 to 340. The S & P 500 was essentially flat during that time period. Much interest has developed in emerging markets, but one must watch out for Table of Contents Kenneth Sleeper Global Investment Trends...p.1 Jack Bowers...Coming Era of Energy Scarcity..p.4 Francisco Martin Investing in BRICs. p.6 ddon Gimpel..Education Nuggets...p.7 1

risk. Some mutual funds mentioned by Dr. Sleeper were: Direxion China Bear 2X, DWS Latin America Equity, T. Rowe Price Africa, Middle East (a brand new fund), and ING Russia (a volatile fund). Implication for the third world ascendance include: there is increased demand for the same natural resources and energy that drive the economies of first world countries. An abundance of cheap labor can displace U.S. workers. Competition for global capital for development projects will be greater. There will be increased environmental degradation, for example the high levels of pollution in Shanghai, Beijing and Mexico City. 3. Housing slump: Housing prices became the greatest financial bubble of all time with the housing gold rush hitting a peak in 2005. If the U.S. housing market follows the example of Japan, the appreciation of Japan s housing prices lasted about 10 years, and then took 14 years to go back to the mean. One characteristic of a bubble is to think that it will be different this time. Well, it has not been different. The housing foreclosure rate zoomed up 802 percent from a year earlier in the first quarter of 2007. Characteristically the last ones to get caught up in the euphoria are the ones to get hurt. Home foreclosures are expected to hit two million this year--650,000 are normal. Dr. Sleeper mentioned that Profunds Short Real Estate fund had moved up from a base of 75 in 2007 to 110 in 2008. Long real estate funds, such as Alpine Realty Income and Growth; and Profunds Ultra Real Estate have lost money. A few statistics show how inflated the real estate bubble was. Two of every five new jobs were in housing related sectors. At the peak, 90 percent of GDP growth was due to consumer spending and residential construction. Sixty percent of new California mortgages were interest only or negative amortization. Fortytwo percent of all first time buyers and 25 percent of all buyers made no down payment. Implications for the real estate decline include: loss of wealth when housing prices decline; consumers will not spend as much. Marginal borrowers are at risk for foreclosure. Construction and real estate activities will slow. Only about one-third of the problem is showing above the surface. 4. U.S. Dollar and banking turmoil The dollar has been falling in value. The dollar, worth 120 in 2000, slumped in value by 2008 to 78, according to a dollar index. In this situation the Fed can only lower interest rates. After 17 previous raises, the Fed already lowered interest rates twice in 2008. The question is, can the Fed restore stability to the credit markets? Los Angeles County Meeting Schedule Westside Computer Group Don Gimpel, 310/276-9875 dgimpel@prodigy.net Sat. April 5, at 10:30 a.m., Veterans of Foreign Wars Memorial Bldg. Culver Blvd. & Overland Avenue, Culver City, Topic: Analyzing Stocks With Key Financial Ratios Pasadena Group Pasadena Library 285 E. Walnut Street, Topic and date TBA Mutual Fund Group Gunter Hagen 310/457-7404, ghagen1@yahoo.com. 10:30 a.m. Sat, date and topic TBA, in the community room of the Fairview Branch of the Santa Monica Public Library, 2101 Ocean Park Blvd., Santa Monica. The meeting is free to the public Stock Selection Group Norm Langhout, 310/391-6430, normlang@comcast.net. Fourth Wednesday of the month at 7 p.m. Fairview Branch of Santa Monica Library, 2101 Ocean Park Blvd., Santa Monica. Topic TBA San Fernando Valley Group Mid Valley Library Community Room, 16244 Nordhoff St. North Hills, Topic, TBA IBD Meet-Up/AAII CANSLIM Group Santa Monica Library, Fairview Branch, 2101 Ocean Park Blvd., Santa Monica Los Angeles Chapter Mtg. Meeting dates through 2008: April 19, May 17, June 28, July 19, Sept. 20, Oct. 18, and Nov. 15 (no August or December meeting) Speakers at the Skirball April 19 meeting will be: Frank Barbera on The Housing Crisis and the Credit Market Deflation; Howard Spielt, Searching for Stock Ideas With Technical Analysis 2

Some mutual funds to consider include: SEI Emerging Market Debt, (up 30 percent in 2008); PIMCO Low Duration Institutional, (up 15 percent since 2006); and PIMCO Total Return, (up 18 percent). Implications of the declining dollar for investors include: U.S. goods are much cheaper and foreign goods are more expensive. Foreign assets will appreciate as the dollar declines. U.S. assets are cheaper for foreign investors. States and cities will find it difficult to raise capital and to finance new projects. Municipal bond funds have been rapidly declining. 5. Potential for low returns and high risk in the U.S. market. The S & P 500 was essentially flat from 2000 to 2008. During the same time money markets returned 30 percent. Some large mutual funds with expert managers have shown very little growth. For example Vanguard Managed Growth for 10 years was up only.23 percent. In a secular bear market sometimes 20 years will pass with no gain. In March, 2000 the great bull market ended and a secular bear market began. Implications of the secular bear market include: buy and hold investors may go years without profits. Wide swings in price are possible as the secular bear market searches for a final bottom. Unknown risk factors clouding the outlook include: manmade disasters (another 9/11 attack?); and natural disasters (another Katrina hurricane?). Sleeper s conclusions Some investments for prudent investors to avoid now: individual stocks, individual corporate bonds, and individual municipal bonds. Treasuries, CDs and money markets instruments should be avoided as a long-term strategy. (CDs, the money market and Treasuries are okay for the short term.) Avoid precious metals as being too volatile. Stay away from speculative real estate. A smart investing strategy is helpful for realizing important goals, such as: maintaining current lifestyle in retirement, enjoying life and taking more trips, meeting health and long-term care expenses, helping your children and leaving money to your grandchildren. Due to advances in longevity, people need to plan prudently for retirement. Back in 1955 on average people only spent one year in retirement, retiring at age 68 and living until age 69. By 2005 people spent an average of 16 years in retirement, retiring at age 62 and living until age 78. Some financial mistakes to avoid include: discounting the effect of inflation and taxes; investing to target homeruns instead of reasonable goals; not having a sell discipline; and not having the flexibility to change when market conditions change. Sierra Management was started 20 years ago, using a room in Dr. Sleeper s house. As clients were acquired, the company moved to professional office space. Currently the company manages around $600 million in assets of mostly west Los Angeles retirees. The company s latest venture is to start a mutual fund, Sierra Core Retirement Fund. For more information contact: 1-866-738-4363, or www.sierracorefund.com. Investing in the Coming Era Of Energy Scarcity By William Parmenter, Editor Jack Bowers, editor of Fidelity Monitor, a newsletter with 7,000 subscribers, talked on the investment outlook in the coming era of energy scarcity at the AAII meeting on March 22 at Skirball Center. Problem of NOCs A principal shift affecting oil prices and availability has been the movement of oil reserves from international oil companies (IOCs) to national oil companies (NOCs). In 1949 NOCs controlled 35 percent of oil reserves, while the IOCs controlled 65 percent. Then the IOCs, such as ExxonMobil, 3

BP, Shell, Chevron and Total were project rich. By 2005 the balance had shifted such that the NOCs controlled 77 percent of reserves and the IOCs controlled only 23 percent. Prominent NOCs such as Saudi Aramco, PDV, PetroChina and Pemex are government operated and often do not invest much to replace reserves. Resource nationalism has replaced geology as the top bottleneck on the supply side. The bulk of the world s oil reserves are in the hands of national companies that do not care if the world market is well supplied. Greed is not good when it comes to nationalism, as the national oil companies heavily subsidize the price of gas to domestic consumers. Iran, the fourth largest oil producer, imports half of its gas, and has begun to ration consumption. Mexico, the fifth largest producer, uses antiquated technology, and its giant Cantarell field is fading fast. Venezuela, the eighth largest producer, has seized assets and is diverting oil revenue to social programs, such as food, education and fuel subsidies. A number of problems have emerged with the behavior of NOCs. They cut budgets for exploration and development. The NOCs best employees leave for the private sector. Subsidized motor fuels encourage domestic consumption. When oil supply disruptions take place the NOCs hoard supplies, causing sharp price hikes on the world market. Geological Constraints The problem of geological constraints is putting upward pressure on oil prices. The world s major oil fields are old enough that depletion rates are in the four to five percent range. To grow output by one to two percent a year means supplies equal to the output of Iran must be brought on line each year. Oil production in the U.S.A. peaked in the 1970s, and production has declined by about one half from the peak. On a global basis, oil production has exceeded new discoveries since the 1980s, and now relies on very large old oil fields. Nearly all the world s super-sized oil fields have been discovered and significantly depleted. It takes dozens of small field to replace a giant one. The world s top six oil fields account for about 15 percent of global production, but their average age is 64 years. Deep-water drilling and natural gas liquids have augmented supply in recent years, but in the future they may not be able to fill the shortfall. Demand Pressures Some of the strongest growth in oil demand is coming from the Middle East, flush with oil wealth, where consumers are buying air-conditioned houses and large vehicles. Their increased consumption leaves less oil for export. China s oil demand is growing rapidly, a country where car sales are soon projected to hit five million a year. India s growing demand for oil will increase as Tata Motors plans to introduce a $2,500 car in 2008. South Africa has experiences a growing demand for diesel to drive electricity generators during a period of a severe shortage of electricity. All future nuclear production is expected to be swallowed up by the expanding electrical grid. No one knows where the fuel will come from. Current oil demand in millions of barrels per year in various countries include: U.S.A., 25.l; Mexico 6.6; China, l.8 and India,.8. With world demand currently at 85 million barrels of oil per year, it is not possible to have sufficient supplies in the future. Oil Alternatives Biofuels: production is limited to 10 percent of demand. Ethanol pushes up the cost of food prices, is not very energy efficient. Oil sands: they will take a decade to get to 15 percent of demand. The tightening of environmental rules makes it more costly. 4

Production is now at one million barrels a day and could go to three million barrels a day. Natural gas liquids: the best hope, but they are capital intensive and it could take three decades to build up the infrastructure. Hydrogen-powered vehicles: hydrogen will never be a viable alternative, because it is too costly to produce, store and transport. It is the least realistic option. Coal: gas can be obtained from coal, but it is neither easy nor cheap. Electric: we are just getting started on electric transportation. High battery costs will limit volumes for the next five years. Nissan and Volvo are teaming up on a battery car. Other experiments are in various stages of progress. Diesel: you can go 30 percent farther than gas, as it has more energy content than gas. But it is more expensive than gas, driving up the cost of shipping goods by truck. Energy Conclusions Expect $100 barrel oil through 2008. By 2012 it could get ugly if deep water drilling projects stall out, large fields slip into decline. Auto sales could set records and we could maintain a high standard of living, but will be forced to drive and fly less. Some Europeans are already paying an equivalent of $220 a barrel for oil. Wind, solar and nuclear will help little in the short run. The electrical grid already faces its own shortage of capacity. One advantage of electric cars is that 90 percent of the energy goes to the wheels, compared to only 25 percent with gas cars. The drawback is that it will take 30-plus years to replace gas cars with electric ones. Economies of the next 10-15 years Expect higher inflation from energyintensive goods and services, including: food, electricity, water, fertilizer, transportation, shipping and basic materials (concrete, rubber, plastic, paper and metals). Real returns from cash will turn negative. (Money market funds are already losing two to three percentage points on purchasing power.) Expect lower multiples on stocks. (They are still the best asset class for keeping ahead of inflation.) Most energy and soft energy groups will outperform, but alternative energy will likely disappoint. How to structure your portfolio Dedicate 80 percent of your portfolio to conservative funds, i.e. steady performers and dividend stocks. Put the other 20 percent of your portfolio in the energy sector. Four Fidelity Select Funds in energy: Natural Resources; Energy; Energy Service; and Natural Gas. Consider Fidelity Select Funds in soft energy groups: Consumer staples; Industrial; Materials; Transportation; and Utilities Growth Power of Conservative Strategies Conservative mutual funds enjoy the sweet spot on the efficient frontier, and typically have small losses. Consider Fidelity Puritan, founded in 1947, which has a 60-year average return of 11.7 percent. It has a 60/40 mix of value stocks and bonds. Other stock/bond conservative funds include: Fidelity Balanced; and Fidelity Global Balanced. Lifecycle funds are attracting interest from retirees, too; such as the 2010, the 2015, the 2020, the 2025, stretching out to 2050. In the question and answer session, Bowers pointed out that Fidelity will not come out with ETFs. Eighty percent of Fidelity s select funds outperform the S & P 500, and managers make money on them (which they cannot do with ETFs). Investing in BRICs By William Parmenter, Editor Martin Francisco spoke on BRIC Investing: Marketing Gimmick or True Opportunity, at the March 22 AAII Skirball 5

meeting. Francisco is the Managing Director of Martin Asset Management. Recently much attention has been put on the fast growth of the BRICs (Brazil, Russia, India and China). China, for example, could overtake the GNP of the U.S.A. in a little over 30 years. Some figures illustrate the projected BRIC growth rate. In 2003 the BRICs GNP was 20 percent of the global total. By 2010, it is expected to increase to 35 percent, and by 2020 to advance to 45 percent. Conditions for growth include: stable macroeconomic policies, stable political institutions, openness and high levels of education. Examining the BRICs one by one: Russia: a land of great opportunity, which can expect the greatest growth. It has 12 percent of the earth s territory, 2.4 percent of world population, and 30 percent of the world s mineral resources. Martin is bullish on Russia, as it has averaged six percent growth since 2000. In 2005 the per capita income of Russians was $5,369, (compared to $42,101 for the U.S.A.); now it is up to $7,000. Of BRICs, Russia has the largest middle class, which is important since the middle class drives consumption. Martin is more optimistic about Russia than China, because it is more capitalistic, and it has a larger middle class. Russia s economy is expected to surpass Germany s by 2028. Critical issues facing Russia are what will happen after Putin? And, how will Russia transition from an oil, minerals and commodities-based economy? In a country that was run by the KGB, how will Russia deal with corruption? Investors in Russia can get in with the ETF of RSX, which has an $800 million market cap and a.59 expense ratio. Brazil: expect the GDP growth to average 3.6 percent over the next 50 years. Its economy could surpass Germany s by 2036. Challenges facing Brazil are lack of education, openness, lower savings and investment, and higher public and foreign debt. Foreign and public debt is critical issues. One can invest in Brazil with the I-Share of EWZ, which has a market cap of $7.5 billion and an expense ratio of.69. China: by 2020 China s growth falls to 5 percent. In 2041 China becomes the world s largest economy. China has a high investment rate. The critical issues facing China are financial reform, and political transition. One can invest in China with ETFs, for instance FXI in Hong Kong; and PGJ with a $530 million capitalization. Also, CHN, a closed-end fund is available, with a $447 million capitalization and a 1.2 percent expense ratio India: expect its growth to remain above 5 percent, and for it to overtake Japan s economy by 2032. By 2050 India s per capita income will increase by 35 times. Critical issues for India are education (especially for the poor), and policy coherence. To invest in India, there is the ETF of EPI with a $107 million market cap, and a.88 expense ratio. Entering the Market The right time to invest in BRICs is right after a downturn. If you are a long-term investor, with a timeline of 10 years, you could expect about a 12 percent return. Put up to 30 percent of your portfolio in BRICs. In the question and answer session, Martin said that ETFs are probably the best way to invest in any country or sector. If you invest in an emerging markets mutual fund, you dilute the investment you would get with a singlecountry ETF. One mutual fund choice, however, is VWO, Vanguards Emerging Markets. 6

Education Nuggets By William Parmenter, editor Don Gimpel, AAII s one-man education committee, discussed the high price of gas in relation to the international price of oil, to introduce the March 22, AAII meeting at Skirball Center. Gimpel pointed out that though the price of gas at the pump is going up, the price of oil is going down. Yes, going down. To reach that conclusion, Gimpel made a relative strength chart, comparing the price of oil to gold. On the relative strength chart that Gimpel projected on the screen, the price of oil tracked that of gold until some time ago. Then, while gold continued to trend up in value, oil started trending down. Oil is so expensive today, because the value of the dollar is going down. Gimpel noted also that the Saudi Arabians, who compare the price of oil to gold, might not be able to increase their production of oil. Note to Pro Forma Contributors Please have your copy emailed to the editor by the fifth of the month. Letters and comments are welcome. If you want to email a polemic about global warming, the price of oil, or some other looming economic catastrophe, you will have a chance to alarm or to amuse Pro Forma readers. Book reviews are welcome. Mail disks to: 319 Walnut Ave., Apt. 2, Long Beach, CA. 90802, or use email to contact the editor at wparme1@lausd.net. My home phone is (562) 437-2412. Pro Forma Pro Forma Editor Pro Forma Editor, Emeritus William Parmenter Orvis Adams SIG GROUP CHAIRMEN Asia Pacific Group IBD Meet-up/ AAII CANSLIM Mutual Fund Group Pasadena Group Palm Springs Group San Fernando Valley Group Westside Computer Group Robert Hsu Norman Langhout Gunter Hagen Ivan Wong Patti Gammino Evan Press Don Gimpel Pro Forma is offered free of charge exclusively via email and is also available for downloading from the Los Angeles Chapter web site at: www.aaiilosangeles.org. The American Association of Individual Investors is an independent nonprofit corporation formed for the purpose of assisting individuals in becoming effective managers of their own assets through programs of education, information and research. Pro Forma is published for advising members of the groups' activities and for sharing information. All material compiled without verification of accuracy to a specific task or computer system. All material provided in the ewsletter is for educational and illustrative purposes only. Comments are the views of their author and no other person or organization. Investing is an inherently risky business. Investors may loose their entire investment or more. Past performance is not a guide to future return. 7