One of our clients asked us to expand our thinking on the energy stocks, wondering whether or not the market had “accepted” high energy prices as being permanent or not. It is an excellent question and deserves at least a crack at the answer. We answered as follows:

How we would know the answer is if we saw that the prices of the energy stocks were beginning to discount the Fair Market Values intrinsic in the current price of oil. As the current intrinsic value of energy stocks at current oil prices is well over 125% higher than current actual market prices, clearly there is a long way to go potentially.

While we have seen a good climb in the valuations of the energy stocks - by which we mean the price/book values which is how we measure the changing valuation levels - they are not much beyond their usual high parameters for the past 25 years. It is true that the energy index has broken out over a 25-year high at 2 1/2 times book value and gone to the SG Price (about 3.5 times adjusted book value) but this is not particularly "courageous" of the market and it has been here before (in the late 1970s). It is just a bit 'out of line' with the more recent past. We would conclude that the market "sort of thinks that higher energy prices will remain with us, but that current prices may be aberrant". There is no wholesale stampede to get into energy stocks and the action of the market in the past few days would indicate that many investors are sitting on pins and needles worrying that they have overstayed the rise in energy stock prices. So do we sense a point of acceptance? In a word (or two), not yet.

The real question that follows necessarily is therefore, will it happen? The answer is quite possibly. One scenario that could unfold: IF energy stocks corrected – as they have been doing – and the stock market corrected as well as we expect, and the price of oil and gas did not correct very much, and then the market bounced with energy prices going higher although not necessarily to new highs, THEN we might see the dawning of the realization that SOMETHING may be out there and perhaps "we" (the investor at large) had better have energy stocks. This is all a supposition on our part, however. It may more or less fit the apparent facts, but we have not seen - yet - the wholesale conviction that YOU MUST OWN ENERGY STOCKS OR ELSE YOU ARE MISSING THE BOAT. In other words, it could be like the high tech bubble in late 1999-2000, where "you don't understand if you aren't buying oil stocks". This kind of stampede is possible but is certainly not here yet, and may not have time to develop.

We hope that this helps our clients understand our point of view. Trying to reconcile huge potential, long term shortages, and powerful earnings with a skeptical market while remaining as dispassionate as possible and recognizing the possibility that a recession in 2006 may [temporarily] disrupt the communications between long term fundamentals and shorter term pricing is some balancing act. We will do the best that we can but I hope that you also recognize that shorter term swings are inherently unforecastable.

Finally, we add in the "X" factor - the nitwit (short term speculatively oriented, as opposed to long term investment) element of the rapidly swinging and ever-vacillating hedge funds, which can really confound the best of well-intentioned forecasts, especially in the shorter term. A mass hedge fund panic (out) here can have totally random outcomes over shorter periods, which is why we are cautious about energy stocks in 2006 no matter how good the very long term fundamentals may seem to be.

Why Are We Bearish On 2006?

Another client has taken at least mild issue with our apparent strongly held bearish expectations for the markets in 2006. He has asked for some further clarification of our approach to market analysis for the coming period. We answered as follows:

The short term floor for the S&P will be the Growth (G) Price - about 2 times adjusted book value - which has been a very reliable and solid floor for the S&P for the past 12 years since 1993. We fully expect that if the S&P 500 gets there that there will be a [usual] 8-10% bounce there and it will take some time before that floor is likely to be penetrated. IF the floor is penetrated however - a market breakdown - then the next downside target is the HC Price which is about 30% below the G Price (28% to be dead accurate).

We do expect that 2006 will be a bear market. For one thing, the 4-year cycle has been working with great certainty for many years. For another, the US consumer is close to being tapped out and is borrowing at a prodigious rate just to stay even. For a third, strong commodity cycles usually signal market peaks. You saw the PPI number on Tuesday (+6.6%) meaning that costs (and inflation) are escalating rapidly. One more straw on the camel's back.

China and India will become part of the problem in later 2006 if the US slows down because so much of their own growth depends on the US. That in turn backs up into commodity demand which is driving the Canadian market with not so happy consequences (we surmise).

Finally, what is the Fed doing? Raising interest rates. What kills expansions? Rising interest rates especially coming on top of rapidly rising prices, including housing prices.

But what about the "wealth effect", you might well ask? Surely rising housing prices produce more wealth and consumers can afford to consume more. Alas and sad to say, housing prices are not like stock prices - you can't sell off a bit of your house and spend the money: you have to borrow against it to get it out, adding to your total debt service costs. In addition, rapidly rising housing prices are sterile: nothing comes of them in terms of investment in productive capital goods, but they do leave a lot of debt on consumer's balance sheets.

We see this as a lethal combination for 2006 and 2007, regardless of the self-serving rubbish that we see coming out of the Fed, economists etc.

The bottom line here is that if you feel differently that we do and wish to stay with the market in a fully or at least heavily invested position, then do so. IF the Growth price for the S&P is violated however (it is roughly 1080-90) it will tell you that the market is heading much lower (800, the HC Price and next downside target at a guess) and your portfolio will be damaged considerably, in which case defensive action will be strongly called for and – if not sooner – then at that point, large cash positions should be undertaken.

China and India will become part of the problem in later 2006 if the US slows down because so much of their own growth depends on the US. That in turn backs up into commodity demand which is driving the Canadian market with not so happy consequences (we surmise).

Finally, what is the Fed doing? Raising interest rates. What kills expansions? Rising interest rates especially coming on top of rapidly rising prices, including housing prices.

But what about the "wealth effect", you might well ask? Surely rising housing prices produce more wealth and consumers can afford to consume more. Alas and sad to say, housing prices are not like stock prices - you can't sell off a bit of your house and spend the money: you have to borrow against it to get it out, adding to your total debt service costs. In addition, rapidly rising housing prices are sterile: nothing comes of them in terms of investment in productive capital goods, but they do leave a lot of debt on consumer's balance sheets.

We see this as a lethal combination for 2006 and 2007, regardless of the self-serving rubbish that we see coming out of the Fed, economists etc.

The bottom line here is that if you feel differently that we do and wish to stay with the market in a fully or at least heavily invested position, then do so. IF the Growth price for the S&P is violated however (it is roughly 1080-90) it will tell you that the market is heading much lower (800, the HC Price and next downside target at a guess) and your portfolio will be damaged considerably, in which case defensive action will be strongly called for and – if not sooner – then at that point, large cash positions should be undertaken.