AIA Advocate for Absolute Returns : Russia-Georgia Conflict

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...

Week of 08/21/2008

Research & Editorial Staff — Thu, 21 Aug 2008 17:23:00 GMT

In This Issue:

Inflation Spike Seems Unlikely To Last
The Dollar Rally Gathers Strength
Russians In Georgia Have Investors Spooked
The Outlook Is Good For U.S. Defense Companies
In A Low Yield World, Dividends Shine
The Bottom Line This Week

The stock rally lost some ground last week which made many investors worry that the run may be coming to an end. That fear was justified since the main engine behind the rally -falling oil prices- continued to play their part. Even with oil moving down to the $112 range, the Dow fell 0.6% for the week.

Small stocks moved in the opposite direction to their larger cousins as the Nasdaq posted a 1.6% advance. In its own way, the small stock upturn also made investors nervous. The bounce was another in a long list of confusing situations that are at work in the market today.

Some of the fog lifted this week when the Nasdaq got back in step with the Dow. Unfortunately, new concerns about the financial sector pushed the direction down for both of them, which wasn't what investors had hoped to see. By Wednesday afternoon the two indices were off 242.4 points and 63.4 points respectively.

Inflation Spike Seems Unlikely To Last

One reason the summer rally appears to be stumbling is inflation numbers for July were disturbing. The Labor Department said its Producer Price Index rose by 1.2%, more than double the expected rate. It was also the fastest pace we've seen in 27 years.

A second look, however, makes the inflation spike seem less threatening. July was the third month in a row when oil prices made record highs. Under the circumstances, inflation was bound to shoot up. Because energy costs take two or three months to fully impact the economy, we can expect the August inflation rate will also be high.

The good news, of course, is the recent plunge in oil prices should bring inflation back down later this year. We just need to be patient until the lower costs start to give the economy a much-needed boost.

The Dollar Rally Gathers Strength

Another reason the outlook for inflation probably isn't as bad as it appeared to be last month is the U.S. dollar is continuing to rebound. As measured against the euro, the greenback is up 8% since its April 22 low. If the dollar gains additional ground, it will take fewer of them to buy the products we need, and inflation will drop proportionately.

As we said in several recent issues, we think deep-seated problems with U.S. debts, the balance of payments deficit, the housing market, and the economy will start to push the dollar back down a few months from now. Shorter term, however, the greenback should deliver additional profits to aggressive currency investors.

If the dollar rally continues as expected, the PowerShares Dollar Bull (UUP) will reflect the gains. http://finance.yahoo.com/q/pr?s=UUP The ETF mirrors the movements of our currency against the euro, Japanese yen, British pound, Canadian dollar, Swedish krona, and the Swiss franc. Taking a broad measure of the dollar's value is a good way to even out the price swings that often occur in the foreign exchange market.

One of the biggest advantages of the dollar ETF is it is easy to buy and to sell. Just as importantly, you can place a stop loss order on the ETF to protect your position. Using a stop will allow you to participate in the dollar rally for as long as it lasts, and be out automatically once it comes to an end.

Russians In Georgia Have Investors Spooked

In addition to the new worries about inflation, investors are also concerned about Russia's decision to leave many soldiers in Georgia. Although it appears the shooting has stopped, the war could start up again overnight.

Strategically, Georgia is of little importance by itself. However, analysts believe that Russia is using the country to send a message to the Ukraine, Poland, and Central Asia to stay in line, or else. Russia wants them to be free of U.S. missiles and to reject making any new military alliances with the West.

Some political analysts believe that Russia's aggressive action in Georgia indicates that a new cold war may be starting. If so, it won't be good for the stock market. However, many defense issues should prosper.

The Outlook Is Good For U.S. Defense Companies

As it turns out, many leading defense companies are attractive whether or not relations with Russia deteriorate. Many billions of dollars worth in military equipment has been trashed by five years in the harsh environments of Iraq and Afghanistan. Replacing it all should keep the defense industry in clover for several years.

Investors who may be interested in taking a diversified position in the defense industry, should consider the Fidelity Select Defense & Aerospace Fund (FSDAX). http://finance.yahoo.com/q/pr?s=FSDAX This no-load fund holds all the major military suppliers in its portfolio including United Technologies, Boeing, Lockheed Martin, General Dynamics, Northrop Grumman, Raytheon, and Rockwell - to name only a few.

Investors who might prefer a more direct defense investment should consider Raytheon (RTN), a major producer of sophisticated command and control electronics, guidance systems, and related equipment. http://finance.yahoo.com/q/pr?s=RTN Raytheon supplies all branches of the U.S. military with systems that are years ahead of what is available elsewhere.

Some readers may worry that the defense industry might only do well if Senator McCain wins the presidency. However, there is little doubt that Senator Obama will also support rebuilding our military. Maintaining a strong national defense is part of both Republican and Democratic platforms.

In A Low Yield World, Dividends Shine

One of the most frustrating problems investors face today is trying to get a decent return on their cash. The outlook for relief anytime soon is poor because the Fed's expected interest rate hikes have been tabled due to the weak economy. We don't expect to see a change in that policy anytime soon.

Meanwhile, several blue chip stocks have declined so much in price that their dividend yields have become quite attractive. Of course, buying high-yielding stocks makes no sense if the company's financials are so weak that the dividends may be cut.

Fortunately, several firms with good yields are likely to hold their dividends steady. A few of them may actually raise their payouts to attract investors. Among the latter, General Electric (GE) looks especially promising. http://finance.yahoo.com/q/pr?s=GE

GE is in the bargain basement primarily because it has a substantial financial service operation that isn't doing well. However, investors are overlooking GE's much larger industrial strengths. The company makes everything from locomotives to wind turbines, all of which are high-margin items that are sold worldwide. Thanks to its industrial operations, the company has an AAA bond rating.

GE is currently paying an attractive 4.20% dividend. Not only is the dividend unlikely to be cut, several analysts think the company may raise it later this year.

As much as we like GE's yield, it is the potential stock appreciation that we find most appealing. Although GE made some mistakes in the past, and is saddled with a financial service operation, the company is a multinational powerhouse. When global economic conditions improve, we think GE will be a top performer.

Another company we like very much is Kraft Foods (KFT), one of the world's leading food and beverage suppliers. http://finance.yahoo.com/q/pr?s=KFT Although the company's 3.30% yield is lower than you can get with GE, the company's position in a defensive industry is appealing. That's one of the reasons that Warren Buffett of Berkshire Hathaway purchased 10% of the company.

Kraft is currently out of favor on Wall Street because the company's profits have been hurt by soaring oil prices that pushed food costs sharply up. However, with energy prices coming down, Kraft's costs should soon begin to drop. In any event, the company is finally starting to pass its higher costs onto consumers.

Thanks to the new policy, Kraft's second quarter profit rose from $707 million to $735 million. With some 80 new products on the way, the company should be on track for another good year.

The Bottom Line This Week

Higher inflation numbers from July, plus the Russia/Georgia conflict, appear to have put the summer rally on hold. However, lower oil prices and a stronger dollar should get it going again. The near term aside, investors with an eye to both dividends and capital appreciation should profit from adding General Electric and Kraft Foods to their portfolios.

Until Next Week

Week of 08/14/2008

Research & Editorial Staff — Thu, 14 Aug 2008 17:22:00 GMT

In This Issue:

Surprise! Oil Prices Can Plunge As Well As Soar
Russia-Georgia Conflict Shows Oil Retreat Has Legs
The Dollar Is Rebounding By Default
We Know We've Said This Before, But "Buy The Bargains"
The Bottom Line This Week

Last week, the stock market continued to make the big swings that started several days earlier. This time, however, we were delighted to see that the pattern was skewed towards the positive. Thanks to a 332 point gain on Tuesday and another 303 point jump on Friday, the Dow and the Nasdaq ended the week up 3.6% and 4.5% respectively.

Those were very nice numbers for a five day period, especially since poor economic news –and the Russian/Georgian war- continued to dominate the headlines. However, none of it could overcome the enthusiasm investors had for the recent plunge in oil prices that brought the magic $100 level within sight. If oil gets that low we will see rejoicing on both Wall Street and on Main Street. We might even raise a glass ourselves.

Meanwhile, Mother Market is testing our resolve. After rising 49 points on Monday, stocks dropped 250 points through Wednesday. More gyrations are undoubtedly on the way.

Surprise! Oil Prices Can Plunge As Well As Soar

When oil started to drop sharply, many investors doubted that the move would go very far. Most people had come to accept the argument that the world's increasing population, and its expanding economy, could only make oil more expensive.

Long term, we think the arguments for higher priced energy are correct. However, prices depend on the delicate balance between supply and demand, which can fluctuate widely nearer term. With a high volume commodity like oil, where a gusher is produced every day, it only takes a small decrease in demand to create a flood of excess product. The market adjusts to the surplus by dropping prices, as it is doing now.

The oil bulls also forgot that markets often get ahead of themselves. Speculators pushed the price of oil to a level it probably won't reach due to market forces until late 2009 or 2010. As a result, oil was due for a rollback even if demand had not dropped.

Russia-Georgia Conflict Shows Oil Retreat Has Legs

We were given a preview to oil's most likely near-term performance when Georgia made the mistake of poking the Russian bear in the backside two weeks ago. Because Georgia has a major pipeline that carries Caspian oil to Turkey, and on to Europe, the war should have sent prices soaring. That's especially true since Russia dropped a few bombs close to the pipeline. Nevertheless, oil fell another two dollars to the $113 area.

We must conclude from oil's weakness during the Russian-Georgian conflict that its fundamentals have deteriorated significantly. It's another indication that we could see oil drop below $100 before the correction ends, although some reversals must be expected.

One caveat is in order. If the U.S. or Israel attacks Iran, oil prices will shoot back up within hours.

The Dollar Is Rebounding By Default

Another abrupt change that analysts were not expecting is the recent upturn in the value of the U.S. dollar. As you probably know, the greenback had been on a losing streak for several years. As measured against the euro, the dollar fell from $1.06 in January 2000 to $0.63 in April of this year, a 40.6% decline. Now the greenback is up to $0.67.

At first glance, it is surprising that the dollar is getting stronger. The U.S. economy is slow, the federal debt is soaring, the credit crunch is in full swing, and housing prices are still falling.

Nevertheless, the value of the dollar is largely set by interest rates. For months, most currency traders were convinced that Europe would soon be forced to raise its interest rates to fight inflation. Then the European economy started to slow down which is taking pressure off inflation. As a result, Europe –horror of horrors- might actually lower interest rates. The bottom line is that the U.S. dollar, and dollar-based investments, became competitive again.

As with oil, however, the longer term outlook for the dollar isn't good. We continue to believe the dollar won't make a lasting rebound until the U.S. recovers from its seven year borrow-and-spend binge, and its costly aftermath. That process could take several years.

We Know We've Said This Before, But "Buy The Bargains"

When it comes to making investment recommendations we hate to sound like a broken record. On the other hand we've found that clients never get bored with making money. To that end, we will say once again that investors should use the reversals in oil prices and the dollar to pick up bargains. When the powerful forces that drove the investments in opposite directions over the past few years begin to reassert themselves, we will see the primary trends return. If you want to participate in those plays, you must take positions while most investors are bailing out of them.

The dollar is the easiest rebound to play. Nothing could be simpler than opening a foreign currency account, or buying a foreign currency CD, in a U.S bank. If your bank doesn't have them, we recommend EverBank World Markets that has many strong currencies available. www.everbank.com

Alternately, you can invest in a good foreign bond fund. The pick of the litter continues to be the T. Rowe Price International Bond Fund (RPIBX). http://finance.yahoo.com/q/pr?s=RPIBX The no-load fund seeks to provide high current income and capital appreciation by investing in bonds from France, Japan, the United Kingdom, Austria, and similar advanced countries.

As you can see from its price chart, the fund has declined 0.57% over the past 30 days, which reflects the rise in the dollar. When the dollar turns back down, the fund will rebound. We think RPIBX is an excellent hedge against the costly financial problems that are doing so much damage in the U.S.

Longer term investors should also consider the T. Rowe Price International Stock Fund (PRITX). http://finance.yahoo.com/q/pr?s=PRITX This no-load fund invests the majority of its assets in stocks of established non-US companies in both developing and developed countries. PRITX offers investors a broad position in the growth of the world economy that is still in its infancy.

In the energy industry we continue to favor exploration and development (E&D) companies. Every time we hear another politician say "drill, drill drill" we think "money, money, money." Even if the U.S. coastlines aren't opened up for energy extraction, there will be a lot of E&D elsewhere. The bottom line is clear, if the world wants more energy it will need to spend the enormous amounts of money that will be needed to find it.

There are several good E&D companies with bright futures. If you can own only one, we think it should be Transocean (RIG). http://finance.yahoo.com/q/pr?s=RIG The company specializes in finding energy in difficult areas including miles below the sea, and in festering tropical swamps. If there is any more oil to be found –and we think there is- Transocean will be a big winner.

We are also recommending Suncor Energy (SU) http://finance.yahoo.com/q/bc?s=SU&t=1y, EnCana (ECA) http://finance.yahoo.com/q/bc?s=ECA&t=1y, and Sasol (SSL) http://finance.yahoo.com/q/bc?s=SSL&t=1y All three secure energy stocks are down sharply with oil's decline because they have high production costs. The same lever will swing the other way when oil prices bounce back up. These three stocks are great long-term buys.

While you are waiting for the previous stocks to pay off, our shorter-term recommendation of Valero Energy (VLO) should keep you from getting bored. http://finance.yahoo.com/q/pr?s=VLO As we predicted in our July 24 issue, America's leading oil refiner has been caught in a pinch between rising oil costs and extreme price resistance at the pump. Now that oil costs are coming down more rapidly than gasoline prices, Valero's outlook is turning around – and so is its stock. Valero is one of the few energy plays that can gain when oil prices retreat.

Timing: In a declining market, bargain hunters should resist the impulse to make their purchases all at once. A better plan is to buy a little at a time as the situation unfolds. That way you will get at least part of your portfolio at the lowest possible prices.

The Bottom Line This Week

The oil correction is showing that it has stronger legs than most investors expected. It is impossible to know how far the price will drop, but we are only about $14 away from the psychologically-important $100 mark. We should hit it by the end of the year, and perhaps a lot earlier. Meanwhile, energy stocks are very attractive.

Similarly, the dollar's rebound could run several months. Buying foreign currencies along the way should prove to be a very profitable strategy longer term.

AIA Advocate for Absolute Returns : Russia-Georgia Conflict

Week of 08/28/2008

In This Issue:

Tensions Between The U.S. And Russia Are SeriousOil And Commodities React To The ThreatDefense Stocks Look Even Better Than Last WeekAnd So Does The DollarInflation vs Deflation Contest Heats UpBut Inflation Should End Up With The GoldThe Bottom Line This Week

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

Until Next Week

Week of 08/21/2008

In This Issue:

Inflation Spike Seems Unlikely To LastThe Dollar Rally Gathers StrengthRussians In Georgia Have Investors SpookedThe Outlook Is Good For U.S. Defense CompaniesIn A Low Yield World, Dividends ShineThe Bottom Line This Week

Inflation Spike Seems Unlikely To Last

The Dollar Rally Gathers Strength

Russians In Georgia Have Investors Spooked

The Outlook Is Good For U.S. Defense Companies

In A Low Yield World, Dividends Shine

The Bottom Line This Week

Until Next Week

Week of 08/14/2008

In This Issue:

Surprise! Oil Prices Can Plunge As Well As SoarRussia-Georgia Conflict Shows Oil Retreat Has LegsThe Dollar Is Rebounding By DefaultWe Know We've Said This Before, But "Buy The Bargains"The Bottom Line This Week

Surprise! Oil Prices Can Plunge As Well As Soar

Russia-Georgia Conflict Shows Oil Retreat Has Legs

The Dollar Is Rebounding By Default

We Know We've Said This Before, But "Buy The Bargains"

The Bottom Line This Week

Until Next Week

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

Inflation Spike Seems Unlikely To Last
The Dollar Rally Gathers Strength
Russians In Georgia Have Investors Spooked
The Outlook Is Good For U.S. Defense Companies
In A Low Yield World, Dividends Shine
The Bottom Line This Week

Surprise! Oil Prices Can Plunge As Well As Soar
Russia-Georgia Conflict Shows Oil Retreat Has Legs
The Dollar Is Rebounding By Default
We Know We've Said This Before, But "Buy The Bargains"
The Bottom Line This Week