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Markets: Tread Carefully
New York: January 16, 2006
By John R. Stephenson

The start of a new year is often a time of optimism. But the mood out in investment land seems to be one of concern. The general consensus is that 2006 will be a challenging year for investors. The reasons? Investors cite economic headwinds in the form of a weaker U.S. consumer and dollar as well as a possible recession. All this adds up to a weaker stock market in the year ahead. With a weak market and a possible recession at home, then surely this is bad for commodity stocks and investments in general. Or is it?

To be sure, there are lots of problems on which to fixate. The biggest? Perhaps it is our economic dependence on continued consumption. The sustained low interest rate environment has encouraged people to spend. With the cost of borrowing cheap, households have continued to binge on a range of consumer goods such as zero interest cars and other household goodies.

But with wage growth largely stagnant, people have continued to party by utilizing a newfound source of wealth — their homes. By using the inflated value of their homes as an ATM (mortgage refinancings/home equity loans) the party has continued. So much so that the U.S. consumer is the single greatest economic force in the world.

So what's the worry? The economy seems to be doing fine. After all, economic growth was a very respectable 4% or so last year. The problem? Without the home ATM subsidy, economic growth in 2005 (estimated to be $600 billion) would be a paltry .25%.

If rising house prices drive continued economic expansion, then what happens if house prices begin to tumble? No one knows, but the answer is probably not good news. The most likely scenario if house prices tumble is a dramatic slowdown at home.

But in an outsourced and globalized world the casualties are unlikely to be only domestic ones. Our trading partners could get hit as well. With an increasing reliance on not only cross border trade but also cross border financing, the fate of one nation increasingly impacts the fate of others.

The huge consumption binge and the intertwined nature of nations are plain to see by examining the U.S. trade deficit (exports minus imports). Increasingly, we have become hooked on low-cost imports to sustain our way of life. How much so? The trade deficit has mushroomed from $688 billion in 2004 to $806 billion in 2005. Foreign manufacturers have been all too happy to send us lots of stuff and buy our dollars in exchange.

By buying so many of our dollars, foreign governments (mainly Asian governments) have helped to keep a lid on our interest rates. With strong demand for dollars, we haven't needed to raise interest rates to attract investment and as long as our consumers continued to buy clothing, household appliances and big screen televisions, everything has worked out well. Of course, we have to borrow against the value of our homes to keep this party going, but all of this works out — provided home prices keep rising.

But many pundits think the unprecedented size of our trade deficit is unsustainable. How long can consumers, who have a negative savings rate, continue to spend to prop up the economy? Do foreign governments really want to hold an increasing percentage of U.S. dollars in their treasuries? Currently, they hold $1.5 trillion.

So if the appetite for U.S. dollars weakens or U.S. consumers turn skittish then this could be positive for the trade deficit but bad for our economy. If foreign investors, worried about the heavy concentration of dollars in their treasuries, become sellers rather than buyers of dollars — a weaker U.S. dollar is the likely outcome.

The most likely scenario and the one that economists worry about is that in order to stabilize the dollar and chock off a speculative bubble in housing, interest rates get ramped up too far too fast. Faced with higher borrowing costs, consumers could beat a hasty retreat taking their spending and economic growth with them.

If economic growth at home falters, then surely there is a ripple effect abroad. If we aren't buying their electronics, then perhaps they won't buy our coal, copper or oil & gas. In a three-legged race if your partner stumbles isn't the likely outcome that you will stumble? Or so the theory goes.

But if we stumble and they stumble then surely this is bad for investors. Possibly. And this is the reason for so much pessimism. Market strategists are becoming increasingly pessimistic (bearish) as they consider the likely end game of too much debt, too little productivity and too much inter-dependence. The key variable in all of this is the willingness or ability of the U.S. consumer to continue to spend in the face of rising interest rates, stagnant real wages and growing uncertainty. No doubt about it — a tall order indeed.

So what's a wise investor to do? For one, diversify. While commodity investing was the order of the day for 2005, simply dart throwing in 2006 is less likely to produce stellar results.

Investors should diversify across asset classes and across geographies. Why take the chance that the home fires continue to burn brightly? A simple way to get broad diversification and avoid being swept away in a corporate accounting scandal is to consider buying exchange traded funds. ETFs are simple, inexpensive and as easy as a stock or bond to buy.

If the U.S. dollar does weaken, holding some exposure to gold or gold producers could be a cheap form of portfolio insurance. If the dollar weakens, then gold, as it always has, will soar in value.

While times could be tough if China and India's economic growth slows, the likelihood of an all-out slowdown in commodity land remains remote. Strong demand, struggling supply and long lead times for developing producing properties continues to plague the commodity sector. While some producers may struggle if demand slows, the producers with the longest reserve lives and access to supply in politically stable regions are likely to be investment winners in the years to come. Oil, natural gas, coal and metal producers are your best investment bets as these are resources that the market (U.S., China and India) desperately needs and they have limited ability to supply domestically.

Dividend-paying stocks have always been important but they are even more crucial when the stock market is weak. Stocks with a strong record of healthy dividend payouts outperformed the broad U.S. markets last year and are likely to do so again. While capital gains may be sexy, nothing is surer and allows you to sleep at night more easily than getting regular cash infusions to your portfolio in the form of dividend income.

With everyone predicting a slow-down for investors, the opposite is just as likely to be true. But without any strong investment theme to cling to, investors should play great defense by diversifying the sources of return in their portfolios and learning to tread carefully.


StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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