From the Editor - November 05

The commentary below is from our monthly newsletter and is provided here as a convenient reference for our readers.

Energy Worries

The year 2005 has been the year of worry for energy prices. Even before hurricane Katrina, gas prices at the pump had been headed higher. Many were in a state of shock when prices shot above $3.00/gallon on the east coast, and briefly appeared to be headed still higher. Since then prices have once again declined, but the worries post-Katrina remain. The media continues to debate the impact of higher energy prices on the economy, with a number of commentators suggesting various negative outcomes ranging from increased inflation to a slowing economy to an outright recession.

There is no question that higher gas prices can and will have an impact on the economy. What seems to be missing in the midst of all the “sky is falling” rhetoric is an actual look at just how high gasoline prices have risen. Surprisingly, with the declines over the last several weeks prices are now only about 20% higher than they were 12 months ago on average. Granted, oil spot prices remain near record highs, and this could be cause for concern, but for the average consumer the price they pay every day for fuel is not all that much higher than a year ago. It just feels much higher because we all have yet to recover from the “horrors” of $3-a-gallon gasoline (a price that the rest of the world considers extremely cheap).

We are not suggesting that there is nothing to fear in the higher energy prices—it definitely costs more to travel these days and heating our homes this winter will definitely be higher—but chances are the impact on the economy is going to be less than that which is being postulated by some. Of course, there is a bright side to higher energy prices. Six of the 21 stocks in our Model Stock Portfolio are energy related. On the whole these have done quite well because of rising energy costs.

Housing Problems?

It is now considered old news to talk about a housing bubble. Indeed, in several parts of the country housing costs have become outrageously expensive. We have talked in this newsletter previously about how prices in most part of the U.S., when adjusted for inflation and considered on a per-square-foot basis (houses today are twice as large as they were 50 years ago), today’s prices are not all that out-of-line. But the counter argument to this fact might be simply, in accepting the reality that people expect larger houses today, the costs for the average homebuyer are much more expensive today than in the past, adjusting for inflation. After all, one pays for a house based on total square footage, not the per-square-foot cost.

Greenspan has all but said he plans to stop the housing bubble from getting any bigger. This is his real motivation for continuing to raise interest rates, not the threat of inflation. Higher rates will discourage higher housing prices because of higher mortgage costs. People infer from Greenspan’s efforts that the housing bubble will burst and the economy may suffer a recession as an outcome. What is far more likely an outcome is that housing prices will flatline for a while (and fall in some of the overheated areas of the country), but not harm the economy. What will certainly occur is that homeowners will curtail the practice of “spending” their homes through borrowing via a home equity line of credit to make other consumer purchases (got to have that new 50” plasma TV, after all). This does suggest slower economic growth ahead as people’s piggy banks (in the form of their house equity line) dry up.

Assuming Greenspan has his way in letting some air out of the housing bubble, should The Prudent Investor readers be concerned? After all, this month’s number one and two most highly ranked stocks in our Model Stock Portfolio are homebuilders. We do believe there may be some unpleasant and higher-than-expected volatility in these stocks. However, their success does not depend on rising housing costs. Well-managed homebuilders can and will continue to do well in most economic cycles. We believe this is particularly true of KBH and TARR, our two highest-ranked stocks.

Stay the course

After another down month in the stock market, we wish to remind our readers to stay the course in investing. As we mentioned in last month’s newsletter, historically the period from November through May of each year is quite strong. We are expecting that to be true this year as well. The Federal Reserve is likely to finish its interest rate tightening in January or February of next year. As soon as the markets believe this is going to happen, much of today’s current market uncertainty should melt away so that we see higher prices by next May, and likely by the end of this year. October was a buyer’s month for many stocks in our portfolio. We hope you didn’t miss the sale!