Week of 08/28/2008

Research & Editorial Staff — Thu, 28 Aug 2008 17:25:00 GMT

In This Issue:

Tensions Between The U.S. And Russia Are Serious
Oil And Commodities React To The Threat
Defense Stocks Look Even Better Than Last Week
And So Does The Dollar
Inflation vs Deflation Contest Heats Up
But Inflation Should End Up With The Gold
The Bottom Line This Week

Last week the stock market revealed that it has more underlying strength than world events would seem to justify. If the market is once again acting as a leading indicator of the future, the outlook is brighter than is generally supposed.

Despite the fact that a new cold war seems to be underway, the Dow was only off 0.3% last week. The Nasdaq declined 1.5%. The market dropped 242 points when it reopened on Monday, but it regained nearly half the loss on Tuesday and Wednesday.

Our feeling is that investors want to be buyers and can only be held back by disturbing news. That's a big difference from a bear market mentality when bad news drives prices and good news is ignored.

Tensions Between The U.S. And Russia Are Serious

Investors' underlying optimism aside, the prospect of another cold war is not a trivial concern. Russia has been using very harsh language about what it sees as an American attempt to surround it with NATO states and U.S. anti-missile batteries. There is a chance the arguments could have serious consequences.

Vladimir Putin of Russia promised that his country would respond to the threats, and that is clearly happening in Georgia. In addition, on August 18 Russia sent a large fleet of naval vessels towards the port city of Tartus in Syria. The goal appears to be to obtain an agreement to build a naval facility in the country. If so, it would give Russia its first base on the Mediterranean Sea. Washington won't like that at all.

Russia was also very unhappy with the West's approval of Kosovo's independence from Serbia, a traditional Russian ally. Mr. Putin made it very clear that the argument for Kosovo's independence applied equally well to Abkhazia and South Ossetia in Georgia. On Tuesday of this week, Russia decided to formally recognize the independence of both regions. Now the world is waiting to see what the American response will be to the latest Russian moves.

Oil And Commodities React To The Threat

Although U.S. investors are taking the problems with Russia in stride, the same is not true everywhere. Global markets are finally pushing oil prices up in anticipation that supplies could be cut. That's a sharp departure from the resilience of oil during the early days of the conflict in Georgia.

Gold, industrial metals, and several other raw materials also jumped in price last week after falling sharply earlier this summer. As with oil, investors are nervous that supplies could be disrupted.

The bottom line is that readers should consider the growing problem with Russia as they make their investment plans. There is no need for undue alarm but neither should investors have a cavalier attitude towards the events.

Defense Stocks Look Even Better Than Last Week

One part of the stock market that is likely to profit from increasing global tensions is the defense sector. Our recent recommendation of the Fidelity Select Defense & Aerospace Fund (FSDAX) http://finance.yahoo.com/q/pr?s=FSDAX and Raytheon http://finance.yahoo.com/q/pr?s=RTN could not have been more timely. Both investments stand to gain from the possibility that another cold war may be starting.

Orbital Sciences (ORB) is also in a very good position to appreciate over the next few years. http://finance.yahoo.com/q/pr?s=ORB When the company was formed in 1982, nearly everyone in the aerospace industry laughed at the effrontery of the young firm that thought it could enter the space business from scratch and with only a few million dollars.

The guffaws came to a halt 16 years ago when Orbital Sciences launched its first space vehicle. Since then, the company has delivered over 110 satellites and space-related systems to its customers.

Orbital Sciences' niche is providing small, and often reusable, launch systems. The company is the developer of the unique Pegasus rocket that is released from an aircraft at high altitude and then shoots into orbit. The Taurus series of rockets are ground-based variants of the Pegasus.

The company also produces the Minotaur rocket. It is the only U.S. launch vehicle that can be deployed from all American spaceports, including those operated by commercial interests. Taken together, the company's rockets offer the most efficient means to place small payloads in orbit.

Lastly, the company is a major supplier of interceptor booster rockets that will carry kill vehicles to destroy long-range enemy missiles in midcourse before they reenter the atmosphere. Another system intercepts enemy missiles in the early phase of flight when they are most vulnerable. Both developments are part of the layered missile defense system the government is in the process of placing around the world. The program will be worth many billions of dollars over the next few years.

And So Does The Dollar

At first glance it might seem that the dollar should weaken if America faces a period of rising tensions with Russia. Instead, the dollar has been strengthening.

One reason the dollar is strong is countless people around the world are becoming nervous about the euro, our currency's main competition. That's because many European countries share a border with Russia. In addition, several of them have joined NATO, a move that Russia vehemently opposes.

There is also a purely economic reason for the euro's weakness. The European economy is weakening which means the EU Central Bank is unlikely to raise interest rates as expected. If the European economy slips much more, the bank might even lower rates. The poor interest rate outlook is making the euro less attractive than the dollar.

As with our defense stocks, the PowerShares Dollar Bull ETF (UUP) also looks better this week than it did last time. http://finance.yahoo.com/q/pr?s=UUP The same is true for ordinary dollar accounts, CD's, and T-Bills. The returns from the interest they pay is pathetic, but the dollars themselves are starting to buy more of what you need – especially imported products.

Inflation vs Deflation Contest Heats Up

During the past several years, the biggest monetary threat Americans faced was rising inflation. Although the official rate remained low, the government conveniently took food and energy costs out of the equation to make the numbers look better. For real people who like to eat and keep their homes comfortable, the cost of living has been rising steadily.

However, when the credit crunch began billions of dollars started to disappear from the economy. Every bankruptcy, foreclosure, and layoff reduced the amount of money in our system. The hemorrhage was as least as large as the amount of money and credit the Fed was pouring into the economy.

In July, the money supply actually shrank. Data compiled by Lombard Street Research show that M3 (broad money) fell by almost $50 billion during the month, the biggest thirty day decline since modern records began in 1959. It shows that deflation gained the upper hand in spite of the Fed's efforts to control it.

But Inflation Should End Up With The Gold

In a deflationary environment, the value of money goes up, and that's what we are seeing today with the dollar. At the same time, precious metal prices usually decline, which has also been happening.

If we believed that deflation would continue for any length of time, we would make several changes in the recommendations we made in recent months. However, we think the deflationary period will be brief and inflation will come back. Most likely, the turnaround will occur before the year is over.

If we are correct, you should use this period to buy inflation hedges at today's bargain prices. Gold and silver, for example, are less expensive now than they were earlier this year.

We also think energy stocks will rebound within a few months. Again, if we are right, you should use this time to buy more of the industry leaders while they are cheap. At the minimum, we think you should own the Fidelity Select Energy Service Fund (FSESX) that holds the major exploration and development companies in its portfolio. http://finance.yahoo.com/q/pr?s=FSESX

As we explained last time, the official inflation number should continue to climb for another month or two because it reflects changes that have already happened. It won't be the first time Uncle Sam tells you one thing, and the real world tells you just the opposite.

The Bottom Line This Week

Rising tensions between the U.S. and Russia are having very little effect on the stock market, at least for now. However, if the situation gets much worse we can expect the market to decline. This is a time for investors to be cautious.

One sector that should benefit from the tiff with Russia is defense. The dollar is also benefiting from the threat of a new cold war, and from economic problems in Europe.

Lastly, energy stocks are still very cheap despite the small uptick in oil prices we saw this week. As with the defense stocks, it's time to buy more energy shares.

Until Next Week

The AIA "Advocate For Absolute Returns", a weekly publication of The Association for Investor Awareness, Inc., tracks market trends, industry news, the SEC, global trade and finance and Washington developments for you because they affect your investments. But who doesn't? Many sources report these issues as abstract facts. We feel that's not enough. The AIA Advocate's job is to warn you of what's important and how these developments translate to ground-level forces and threats that directly affect your wealth as well as your current investment opportunities. Not just information, but information you can use. Until next Thursday...

AIA Advocate for Absolute Returns : Inflation, Commodities