Southwest Ranch Financial, LLC
November 2007 Update
The S&P500 is at 1549 on 31-October-2007

This page can be linked to at   ( www.swranch.net/emails/2007-11.htm ).

The Southwest Ranch Financial Market Alert Timing Model is in the stock market.  Since the last buy signal in February 2003, the S&P has risen 87%.

Year to date, the S&P500 index is up 10.8% and the SWR Balanced Portfolio is up 8.6% (with half the stock market risk.)

  Here’s the year to date performance of the SWR Balanced Portfolio by asset class.

As of 10/31/07

Market Alert Model
The SWR core model is used to time large cap stocks. It’s currently IN the stock market.  Stay invested with proper diversification.

Year Ahead Timing Model
The YAT model is used to indicate periods of buy opportunities within the Market Alert Model’s timing cycle. The SWR Market Alert Model always trumps the YAT model. The YAT model is positive.

Interest Rate Model
The SWR Interest Rate model is negative on interest rates and long bonds.  

Gold Model
The SWR Gold Model is positive on gold.

Market Summary
International stocks have earned double the S&P500 this year. This is due to the decline of the dollar. Gold is up 24%.

The End of Cheap Oil
Oil is now above $90. A group of German scientists from Energy Watch Group recently released a statement on Peak Oil. Their report is a sobering analysis. I'm not going to explain all the details or attempt to convince anyone of its truth. Read it for yourself. There's an executive summary version and the long report. Here are the links.

Executive Summary 17 Pages
Full Report 100 Pages

The report debunks the idea that oil production can continue to expand. Exagerrated industry estimates that show large ground reserves are based on what oil producing nations say they have and not on any audited or proven facts. The oil companies know the figures provided by OPEC are not accurate. The German report looks at the actual production capabilities of oil fields by nation. Oil production is expected to decline by at least several percent each year going forward starting this year. Current oil production is about 81 million barrels per day. By 2020 production will be 58mbpd and by 2030 it will be 39mbpd. That's half of present levels. "The world is at the beginning of a structural change in its economic system." Resource scarcity and expanded national conflicts over energy are likely in the near future.

Oil Production World Summary
source: www.energywatchgroup.org

The scientists say that the International Energy Agency (IEA) continues to deny a supply crisis. The IEA publishes its yearly World Energy Outlook (WEO) forecast of production each year. It is the dotted red line in the graph above. You can read the long version of the report and learn about the IEA agenda and determine for yourself how valid their position is. The oil production forecast differences between the scientists and the IEA industry group could hardly be more dramatic.

Getting more oil isn't a matter of improving extraction technology. In addition, a mega-major oil field hasn't been found since the 1960's. There are no more giant wells to be found and it's simply not possible to pump current wells at a faster rate. Because of that, oil prices are rising.

Based on the body of evidence and the rising prices, it seems clear oil prices won't be going down except for after periods of over-speculation. Oil will get more expensive and these increasing costs will ripple into everything we buy. Some experts predict a growing level of poverty and social disruption as the poor bear the brunt of higher energy costs.

There's a belief in Washington with this administration that the private sector can solve all problems. The energy problem requres foresight and action and neither is making much headway. This really is an emergency situation. There are no energy technological breakthroughs on the horizon that will compete with cheap oil so get ready for much higher costs. Cost pressures will cause people to use less oil and this has many economic and social implications. It's very possible we'll see widespread economic and political disruptions across the world as the petroleum decline expands.

The US government is very much aware of the problem, but refuses to adopt an energy policy or provide much in the way of incentives for alternatives. World governments will have to agree to cooperate and move to alternative energy very soon or the strong nations will compete against each other for the remaining resources. Competing for energy will lead to conflict - sort of like a Mad Max world. That's the path we're currently on. There's a rational reason for that, of sorts.

America's economy and financial markets require constant growth. If the markets think growth will end then you can imagine what would happen to stocks. Without constant growth, the stock market and leveraged finance would crumble. Without growth, pension funds will fail and social security can't be paid. The rivets are already snapping with the subprime mess and we have declining housing prices. Rising oil prices are adding to the pressure. For this reason the government won't even talk about alternative energy or conservation because that would acknowledge the facts. Instead we get assurances that growth and the leveraged economy can be extended and everything is fine. It's not fine.

America's energy policy is oil and that's why we're at war. Perhaps they've done the math and know alternatives can't sustain the economy on a growth path. I never believed the US was spending $1 trillion dollars on the Iraq war to bring democracy to Arabs or to hunt for WMD. A few weeks ago I was at a shop for some car repairs. A woman there also had to wait for 90 minutes so we went out to breakfast. She was 27 and an army seargant with orders for Iraq. She told me that the senior NCOs routinely tell troops headed to Iraq that the war is about oil - plain and simple. It's amazing how difficult Americans find that fact despite Alan Greenspan saying the same thing. Turn down Oprah or your Rush Limbaugh program and think about it for a second or two. Anthrax is naturally occuring and can be manufactured in a college chemistry lab. Poison gases and chemicals are also easy to create. Iraq had no nuclear program and its best missles were inaccurate scuds. For heavens sake, what rational nation invades another to shut down chemistry labs. Sure there are other factors influencing the war, but it's mostly about maintaining access to oil in the Middle East. The US government knows huge oil shortfalls lie ahead and is acting preemptively to assure resources and protect supply lines in the region.

Energy is also a major concern to both China and Russia. China is in the game trying to lock up reserves and is supporting Iran with weapons and technology. The Russians are providing Iran with materials for a nuclear program and benefit from tension induced higher oil prices. The Iraqis are sitting on 10% of the world's known reserves. Iran has another 10%. This area is the center of the storm. The proponents of war say Iran wants nuclear weapons to gain regional hegemony and to spread Islamofacism around the globe and therefore we have to invade to stop them. Iran though is Shite and not Sunni like most of Arab states in the region. It has a weak economy and its oil industry is in such a shambles that they have to import gasoline. Everyone agrees that an Iran with nukes is not a good thing. Iran says they have a legitimate need for nuclear energy. Maybe so. But, with the major powers after their oil, perhaps security concerns are another explanation. None of this is simple or all black and white. Nevertheless, people should excerise common sense and not believe extremists foreign or domestic.We're at the point in history where we must accept the reality of the energy situation and work cooperatively. Allocating remaining supplies must be done in a fair way. The only other course is warfare.

Why doesn't the press write about the oil production collapse and the connection to the ongoing and future wars? It's the same reason the press doesn't ask tough questions of the candidates. It's the same reason why Bush held many Town Hall meetings with hand-picked audiences asking powder-puff questions and got away with it for a year. It's why FEMA held a phony news conference about the California fires and almost got away with it. We live in a Wag-The-Dog society where the news is choreographed. Frankly, the American people, as a group, are probably too over-worked, broke and stuptified to give a damn.

Alternative Energy
Wind power, solar, and wave energy are the best alternative energy prospects, but are costly relative to oil. They will probably never ever be able to replace the rate of declining oil production. Ethanol fuel from corn is a fraud and its production consumes more energy than it makes. This is a misallocation of resources and a giant giveaway by congress to agriculture states. Oil sands are a very costly oil source, energy intensive and consume vast amounts of fresh water. Higher oil prices mean nations will use a lot more coal for electric power plants, but liquid fuels are needed for cars in use now. We'll likely see more electric cars in the future and higher transportation costs.

Some countries are positioning themselves for an era of scarce oil. I saw a PBS story last week on how Germany has a national goal of obtaining 25% of its future energy needs from solar over the next 20 years and is ahead of plan on that objective. Germany isn't exactly in a sunbelt area. You'd think America with its open spaces and sunny south could do much better with both solar and wind power.

Alternative energy will be an interesting investing theme in the years ahead, but it will be slow to ramp up. That's because so few companies are pure plays on energy saving technology. There's a couple of alternative energy mutual funds available, but I wouldn't buy one until the government begins to offer big incentives in the form of tax credits and guaranteed pricing for energy buybacks onto the power grid.

Is China the Future?
Everyone seems to believe that China is a sure thing for the long run. We've all read the predictions about a rosy future and the booming growth in China/India. I agree economic growth in those areas will exceed that of the US. Regardless, building and expanding a modern national infrastructure during a period of rapidly rising energy costs will be very costly. In fact, it's implausible unless China transitions to a different economic model from America and invests massively in alternative energy. This could happen quickly since China is an oligarchy. Think of it as a massive S-Curve innovation wave that sustains future growth while the West flails for more oil. Either China will transition to a new model or it will try to grab some huge oil reserves. China won't engage in years of chest thumping and UN talk-a-thons. They have a different mindset and will move dramatically and that would mean major conflict.

As investors, we need to look at reality and plan ahead. With severe oil production declines ahead and rising energy prices, I simply don't see how US economic growth can continue like in the past. For that matter, I also don't believe the predictions that China will grow into an enormous economic powerhouse and surpass America and Europe. How is that possible? They burn a tremendous amount of oil and are very inefficient in its use. How can a poor country like China afford an American style car culture when oil hits $150 to $200? Will China's Yuan replace the dollar as a world reserve currency and provide them with a dramatic purchasing power advantage? It's more likely that reduced oil supplies will affect energy costs for everyone on the planet with heavy users having the most to lose. China is already a heavy importer of oil and now has to import even coal.

The tone towards China's growth is surreal. I've read investment articles stating that you don't have to worry about a recession in China because the central planners in the government won't allow it. Apparently, Alan Greenspan has more than met his match in China's oligarchs. This all sounds like bubble talk to me.

The Economy in Transition
Rising oil prices and falling home prices are not conducive to strong economic growth, but the US economy is weathering high energy prices and financial turbulence quite well. Employment is solid. The US economy will enjoy low FED interest rates until the 2008 election. The FED is lowering interest rates to maintain economic stimulus while the presidential contenders blather about safe issues like gun control, abortion and how religious they are. None of them talk about the impending energy problems, none address the US debt problem, the real reason for the Iraq war, or the dangers of the Patriot Act. Yet these issues all will have a huge impact on every voter. What does that tell you about people living in an entertainment culture? The public will continue to get platitudes along with increasing inflation and poor returns for savers. Inflation is still low enough that the FED can play games with rates. Economic contraction is likely (inflation adjusted) at some point as oil prices bite and employment takes a hit starting in 2009. By that point it will be too late for most investors.

It will be interesting to see how long the housing contraction lasts. Goldman Sachs thinks home prices in California could decline by 40% and expert Robert Shiller says house price declines have no end in sight. As for the government bailing out homeowners, forget it. Here's how the subprime and housing affordability problems are likely to be fixed. Homeowners will hand back the keys when they realize their $300,000 house is only worth $215,0000. Who is going to scrimp to pay off a mortgage when they can mail in the keys and rent a house across the street for half as much? Lenders have no recourse against homeowners who are upside down on their house equity. Some big financial services firms will be going broke. Because of the solvency concerns there's a huge crunch going on in the commercial paper market - this is the grease businesses need for short term liquidity financing. Your money market accounts should be invested primarily in US government treasury bills and not in commercial paper. It's not worth stretching for a tiny amount of yield on a money market fund.

Inflation is rising a bit, but the outlook isn't that bad yet. The economy will stay resiliant until unemployment rises. We'll see dips in oil prices as deflationary forces occasionaly take over, but the trend is up. I believe investors should own some gold to hedge their pension or dollar holdings against inflation. As I explained last month, if you need $30k a year to live on then holding that much gold may be a good idea. If your pension or savings declines by 5% yearly, the gold will make it up. Is $786 gold too expensive? Perhaps short term it is, but I doubt it will be cheaper in 2009.

Some financial books say the dollar will collapse and investors should move all their cash into Euros or Yuan or whatever. I have to admit that the dollar's continuing decline makes for great headlines and the US debt is a big problem. It's very hard to predict the future movements of currencies and I don't believe betting big against the dollar is a wise tactic for small investors. It is smart to hedge your investments by holding some foreign stocks. Moving everything to another currency strikes me as extreme. The theories for a wholesale dollar collapse are based on the assumption that the huge US debt overhang means America must inflate for decades to prevent an economic depression. The coming worldwide, oil-led economic contraction will impact all the world's economies and possibly trump standard currency macro economics. In addition, if I'm right about a period of increased global conflict ahead, then betting the farm on the Yuan and investments in China might look pretty dumb in retrospect. I think it's smarter to diversify among asset classes and not engage in a one-way currency speculation. Commodities, gold, foreign stocks, and even large US multinationals all provide some dollar hedging. Meanwhile, like I predicted in my book, Congress is planning huge tax law legislation and the effect will be higher taxes and probably reduced social benefits. Rising taxes and reduced social costs are required to control the deficit and will be supportive of the dollar if congress gets a grip on things.

Line up your ducks here at home and get ready for the oil crunch. The seals will start blowing out on the economic engine once the politicians are re-elected. They'll have to cut the rate of spending and raise taxes or the dollar will crash. These actions will slow the economy and cause rising unemployment. By that time, we may have a military draft to soak up the unemployed.

I expect the stock market to do well for a while yet. This is an excellent time to rein in speculations in mutual funds and other investments you don't fully understand. Cash may be a loser short term, but will bounce back when the next presidential clone takes office and rates are raised again. If rates are held too low for too long, the dollar could indeed collapse. As an alternative to holding bonds, I'd park money in a treasury money market or move a small portion into the aggressive LSBRX bond fund. Small Cap allocations can be split between US and foreign small company stock funds. Stocks grow on average at the rate of their earnings growth. As world economic growth slows, the PE ratios on stocks will contract. Like Alan Greenspan, I'm not very positive on the stock market in the years ahead, but don't expect a crash. It's important to own some stocks despite a lower growth economy. Get out of debt.

We are very close to negative interest rates and that's why gold is moving higher so quickly. Over the last month, gold has risen from $725 to $786.

Gold and Interest Rates
The chart below is very important. It shows the relation between gold prices and the rate spread between inflation and money market rates. The real return on money is the Money Market Rate - Inflation = Spread. So, if money market rates are 5% and inflation is 3% then the Spread, or real return, is a positive 2%. The spread between inflation and money market rates is on the horizontal (X) axis. The vertical (Y) axis shows the subsequent year over year increase in the price of gold. When inflation is greater than the savings rates, we have "negative interest rates". Holding cash is then a losing game because money is losing to inflation. This causes gold to rise as money seeks the safety of inflation hedges. When the spread is positive, gold returns are generally low or negative.

When spreads are positive and over 2, people hold cash and gold does poorly. When inflationary expectations rise and the spread is below 1, gold does well on average. The chart below shows the same data, but annualized rather than monthly.

Clearly, negative interest rates are very positive for gold. As of October 2007, the spread is .30 and this suggests good times ahead for gold if the FED continues to cut rates. I think war talk and the falling dollar has gold hyperventilating at $786 with the worst case scenarios being built into investor expectations. Likewise, oil also looks frothy. If things cool down, I'd buy gold at lower levels. In a rising market, buying at the 200 day moving average is a good strategy. As I discussed last month, the next twenty years may be very profitable for investors willing to swing trade GLD.

I realize that this month's eletter isn't very upbeat about the stock and bond markets. I still believe investors should maintain a balanced portfolio because the indexes will still move up and at least keep pace with inflation - if it's gradual.

Best Regards,
Southwest Ranch Financial, LLC    (www.swranch.net)
Tom Gleason, Manager & Researcher

Author of: How To Invest If You Can't Afford To Lose

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Disclaimer:.
Investing involves risk and the future performance of the models cannot be guaranteed. SWR is not a registered investment advisor and nothing published by SWR should be considered personalized investment advice. Any investment recommendations made by SWR should be made only after consulting with your investment advisor and only after reviewing the prospectus or relevant financial statements.  SWR does not receive any compensation for mentioning stocks, funds, or financial products.