Centre Street Cambridge Corporation

Private Investment Counsel


July 2008

Jimmy Carter had the right idea after all. During an earlier era of high oil prices in the late 1970s, the sweater-clad president used the occasion of his “fireside chats” to encourage Americans to go easy on energy use and change their lifestyles a little. We freely admit to paying about as much attention to the president’s talks as the average person, but eventually we came to the conclusion that an energy-intensive way of life would eventually be unaffordable and proceeded to order our life accordingly (we haven’t owned an automobile in over 25 years, for example). Unfortunately, the millions of gas guzzlers that have come and gone since the Carter years offer proof of the difficulty human beings have in planning ahead collectively—without being prodded by some external threat or incentive—until it’s too late. The fact that oil prices—within the space of a few months—have matched and far exceeded the inflation-adjusted records of nearly thirty years ago may finally be compelling us to come to terms with a social structure based on what may very well turn out to have been an historically fleeting experience with cheap fuel.

We could conceivably be in the midst of an epic change with respect to energy. While we can imagine a scenario (a world-wide economic recession, for example) in which oil prices temporarily “collapse” to levels that gladden the hearts of SUV owners, over the long term it seems likely that the era of cheap petroleum is behind us. There are several factors that tend to support the view that the latest spike in prices is not a temporary one to be followed by a significant and lengthy retracement, as has been the experience since the 1970s. For one, there have been few new discoveries of large pools of crude oil since the 1980s. Finds of any size that have occurred (recently, in deep waters off the coast of Brazil) will be exceedingly difficult and expensive to exploit. Most of the older producing areas—Mexico, Alaska, the North Sea, and now Russia—are in decline. Some even maintain that Saudi Arabia’s vast reservoirs have reached peak production capability. To maintain these older fields even at current production levels will require huge expenditures. Furthermore, the facts of geology make increased rates of production from reservoirs an ill-advised and short-lived step. All this in the face of relentless demand growth means that even drilling in all the world’s nature preserves, or under miles of seawater, will make any potential contribution from those sources marginal at best.

“Alternative” sources of fuel offer little relief to those hoping to maintain the status-quo. Subsidy- and tariff-dependent ethanol in the U.S. is turning out to be, as we feared from the beginning, a vast misallocation of capital that is, at least on the margin, exacerbating a growing shortage of foodstuffs. Biofuel production from non-food organic materials is barely out of the laboratory and far from being viable. More exotic energy sources, such as hydrogen or fuel cells, offer promise, but have their own, higher costs relative to those of the past. Great ingenuity will be required to deal with these challenges; hopefully, through a variety of approaches, we will be able to engineer a gradual weaning of the world from its dependency on fossil fuels.

If European-like gasoline prices in the U.S. are not enough to unsettle the economic outlook, a list of additional new challenges is assaulting our way of life and pocketbooks. The housing downturn and related credit crisis will probably require Americans to save more of their income going forward (the savings rate has actually been negative in recent years). A drop in spending of some magnitude portends, promising slower economic growth. As energy has become dearer, so, too, have the prices of most other commodities increased dramatically, adding costs at all levels of the economy that must ultimately come out of consumers’ wallets. Higher prices for and shortages of food will also crimp income available for other things. On a final note, the Chinese cost advantage in manufacturing is eroding due to their own rising internal costs (including wages), as well as appreciation in the value of their currency. Besides forcing manufacturers to move on to other low-wage countries, this may mean the end of an important inflation safety valve and a rise in import prices. It could also be positive for U.S. manufacturers, making domestic manufacturing attractive for the first time in decades. It will be interesting to see if manufacturers are prepared for such a change after years of sending operations overseas.

The uncertainty caused by all of these threats to the existing order is affecting the financial markets. “DOW Suffers Worst June Since Depression” screamed a recent headline. Stock investors, especially those with exposure to the financial sector, have been having a tough time of it so far in 2008. U.S. market indexes were down 13% to 14% at mid-year. Some foreign markets were particularly hard-hit—Chinese stocks, for example, fell 48% (down about 50% from their highs) and German equities lost over 20%. European markets overall have declined over 20% from peak levels. A broad spectrum of investors has sought refuge in a range of money market funds, commodities, and “alternative investments.” Hard to believe it’s been only a year since credit flowed freely, risk was ignored, and Wall Street chatted about the inevitability of the first $100 billion buyout deal. Market participants may have to face up to the possibility that the current unpleasantness could last a while. That would actually represent a healthy return to normalcy; markets do not always go up, and instilling a little fear once in a while keeps the “animal spirits” under control.

Long Ago in a Galaxy Far Away

At a social event we attended at the time we first went to Wall Street, we met a smug young man who, when asked what he did for a living, replied: “I live off my investments—treasury bills at 14%.” For those with a sense of history, his response dates the gathering to the period just before the great bull market in stocks took off in 1982. Unfortunately for the young man in question, a sense of financial history was lacking; fourteen percent on AAA quality short-term paper certainly looked very attractive at the moment, but such yields were very unusual and unlikely to last (in fact, yields on short-term treasuries declined sharply in the following years). At the same time equities were priced about as cheaply as they have ever been, holding great promise for future gains, as well as paying juicy dividends in the meantime. In all fairness, our young friend was not alone in failing to correctly analyze the options, and fears of inflation and recession—not to mention the lure of double-digit “risk-free” securities—deterred many from putting money in a very attractive stock market that was soon to commence one of the great bull runs of history.

Economic phenomena and investment decision-making are in some respects like supernovae. A supernova is the catastrophic destruction of a star that has run out of its nuclear fuel; it appears as a bright flash in the heavens. With supernovae, because of their distance from us, we typically only learn of them long after the explosion has occurred—sometimes centuries or even millennia afterwards. In a similar fashion, there can be long lead times before the ultimate impact of economic events and policy decisions are noticed. As alluded to earlier, our energy challenges today may have been quite different had we chosen to limit the growth of our hydrocarbon use thirty years ago. Investment decisions also have a long-term impact. Starting and sticking with an investment program early in life, for example, can form the basis for significant wealth in one’s mature years. Asset allocation—whether or not to hold stocks, bonds, or other securities and in what proportions—impacts one’s ultimate return on investment over time. Engaging in more speculative activities, such as trading in and out of the markets, or taking fliers on new companies, usually ends in disappointment. How many individuals have looked back in regret at not following sensible, if unexciting, investment principles over the years?

Investment decisions involving asset allocation need to be weighed as carefully as those entailing security selection. The young investor from the summer of 1982 made exactly the wrong decision; there was no logical reason for a young person of means to put his money into “risk-free” fixed-income securities at a time when “risky” stocks were selling at bargain levels not seen since. Today, when investors see fearsome market fluctuations, substantial operating losses in some industries, and great uncertainty over the course of the economy, it is important that they not lose sight of these lessons. History shows that times such as these, in which investors operate in an atmosphere of maximum uncertainty and fear, tend to create good opportunities for wealth enhancement in future years. Markets, whether rising or falling, are always uncertain. Most people prefer the rising variety, but falling markets serve a useful purpose for investors in that they reduce prices and create long-term values.

Unattractively priced in recent years, stocks are in some cases becoming more reasonably valued, among them the shares of some important companies in significant industries. Real bargains, however, are still rare. In the modern marketplace large investment funds continually scour the markets looking to take advantage of market dips and drops in the prices of individual stocks. The huge sums involved act to put a floor under stock prices, at least over the short-term. Nevertheless, the managers of these funds are subject to the same fears and emotional excesses as everyone else. If the current turmoil continues, it would not surprise us to see more instances of panic selling among the big funds, in which case, far from being a stabilizing force, their actions will drive down prices to attractive levels. Such is one scenario under which current market nervousness could create opportunities. Under these circumstances it is important for investors not to lose their nerve and permit emotions to override rational decision-making. History is on the side of the patient long-term investor.


Dennis Butler, MBA, CFA