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Three Events To Expect In 2008

by Joseph Dancy, LSGI Advisors, Inc. | January 9, 2008

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Many developments observed in the investment world are long-lasting trends. We research economic, political, regulatory, and sector specific developments, review conference calls and industry conferences, read a dozen papers daily, and analyze market data and reports in an attempt to find trends that will generate excess returns for our portfolio. Many of these trends have not been widely recognized by analysts or are considered short term events � which creates market inefficiencies we try to exploit.

With that said, we see the following three events as having a substantial chance of occurring in the upcoming 12 months � events that could deliver substantial excess returns to investors.

1. Global Grain Prices Will Set Records in 2008

In 2008 we will experience the lowest carryover of global grain inventories, relative to consumption, on record. This issue extends across the grain spectrum, not just to corn and ethanol-feedstock inputs. Record low carryovers of wheat, rice, and soybeans are also expected.

While spot prices have reflected these shortfalls the cause � increased demand from rapidly developing nations such as China, combined with supply shortfalls in many producing areas due to weather-related issues � is a long term problem.

We expect record futures prices will be set in 2008 in two or more of the following grains: corn, wheat, rice, oats, soybeans or barley.

Regardless of whether grain prices reach record levels, firms in the agricultural sector will generate impressive revenue and profit growth. Like the energy sector, more capital needs to be allocated in the agricultural sector to expand production to meet growing global demands.

Politically the higher prices could generate �food riots� and unrest in less developed countries. In more developed nations expect political actions which attempt to limit the impact of higher prices (export controls, or tariffs on grains or agricultural products). Central banks will reluctantly focus on the sector as a measure of inflation.

The explosive demand growth for grains and higher end food products from China and developing countries, added to the demand for grains for use in making alternative fuels, is the change in the agricultural sector that we have not seen historically. Expect much higher agricultural prices in 2008.

2. Crude Oil Will Reach Record Levels in 2008

We did not see $100 a barrel in the crude oil futures market last year � but we expect we will reach triple digit levels in 2008. Many areas of the globe have experienced robust economic growth, increasing energy demands on the global marketplace.

Developing countries have energy inefficient economies and require much more energy input per unit of growth than in North America. Recent global forecasts by international energy agencies expect demand for crude oil to increase by over two percent next year. Global production gains have been offset by unexpected production outages, disruptions, delays in project completion, and natural field declines. Excess crude oil deliverability, always difficult to estimate in the translucent global oil markets, appears to have declined to levels not seen in decades. Global inventories are also trending downward.

Should global demand for crude oil approach or exceed available supplies for any length of time prices will skyrocket well into triple digits. Resource nationalization issues and hoarding behavior could become more common in this environment. Higher prices seen in 2007 for crude oil has not significantly impacted demand, although a severe recession in the developed economies could reduce demand and moderate prices.

We expect the market for North American natural gas will also tighten over the next year. While supplies of natural gas in storage are at or near five-year highs, demand for natural gas from electrical generation peaking plants and for heating use could reduce inventory levels to more bullish levels. Long term winter forecasts expect a mild winter in North America � then again the long term hurricane forecasts made last summer were not all that accurate.

Decline rates remain very high for new wells, natural gas imports from Canada will most likely decline, and while Barnett shale wells here in Texas have been very productive we think in the longer term the supply/demand relationship is favorable for investors. Not as favorable as crude oil, we think natural gas prices will do well � but unlike oil will not reach record levels in 2008.

The coal and uranium markets should also remain firm in 2008. Investment funds that hold uranium have grown to the extent that they now can influence spot prices. The long term trend for nuclear power is very positive. We see uranium prices firming in the second half of 2008 with demand but see no new pricing records.

Longer term we think the demand of a growing global economy, and supply issues arising from political and physical factors, will keep energy prices higher for years to come.

3. The Russell 2000 Small Cap Index Will Gain 20+% in 2008

In 2007 the monumental run for shares of tiny companies came to a halt. The Russell 2000 Small Cap Index, a measure of the performance of companies with market values of roughly $250 million to $2.5 billion, trailed the Standard & Poor's 500 Index, which tracks stocks of large companies with a market value � by 6.4%.

It was the first time since 1998 that small-cap stocks have posted lower returns than large stocks � ending a nine-year streak of out-performance for small stocks. This small cap run was second only to a 10-year run from 1974 through 1983 according to Ned Davis Research.

Many analysts are predicting that larger company stocks will lead the market going forward in 2008 and beyond. We have heard that argument a dozen times in the last few years, and respectfully disagree for the following reasons:

Historical Returns. Historically, over the longer term, smaller firms have outperformed larger companies according to Ibbotson & Associates. Since 1925 small caps have returned on average 12.5% per year versus the 10.5% return of larger cap stocks. So over time the wind is at the back of small cap stocks.

Liquidity & Monetary Easing. Global central bankers are flooding the global economies with liquidity as can be seen in the accompanying chart (from Richard Russell�s Dow Theory Letter).

Some argue the global economy faces a �solvency� crisis versus a �liquidity� crisis � so the money supply growth will be ineffective. We think the jury is still out on this issue � no-one knows. Central banks will error on the side of caution and will be more aggressive than not. Conceptually, more paper money chasing a set amount of assets should increase the value of those assets � whether the assets are equities or commodities.

The Federal Reserve is expected to continue to ease monetary policy, which has been very positive for stocks historically. In the 14 easing cycles since 1954, the S&P 500 was higher one year later in all but one instance. The exception was in 2001 because of the Sept. 11 terrorist attacks. The average gain for stocks during the 12 months after the first rate cut was 18.8%.

Insider Activity. One measure of insider interest in buying stocks that are considered undervalued is the �Gambill Oscillator�. When this measure of insider purchases exceeds 25% of insider sales the Oscillator considers this a strong buy signal. This signal has correlated very closely with market performance as can be seen in the chart at right from Hays Advisory.

Since 2002, when this indicator was first created, whenever the Oscillator generated a strong buy signal the stock market as measured by the Russell 3000 has been up over 10% in the following six months and up 22% over the next year.

The Oscillator is well over the 25% buy level at month end. The IBES relative valuation model also remains very bullish for stocks.

Sovereign Wealth Funds. As we have seen in December, Sovereign Wealth Funds (SWF) could invest billions in companies listed on the U.S. stock markets. This infusion should help the less liquid and efficient sectors of the market. The United Arab Emirates, Norway, Kuwait, Singapore, and China all have SWF�s in excess of $200 billion � and Saudi Arabia announced last month they would also form a fund, one that will most likely dwarf the other entities.

Volatility. In 2007 we saw the volatility of the markets spike with surprises in the banking, finance, and real estate sectors. The surprises were mostly negative � billions in write-offs by the financial firms, with numerous failures connected to the real estate and real estate finance sectors.

The Russell 2000 index has always been one of the most volatile of the major indexes. It tracks firms that are less liquid and which trade in the most inefficient part of the market. Negative market news is magnified in the illiquid small cap market. Conversely, positive news is also magnified by this segment.

One measure of returns and portfolio volatility is called the Sharpe ratio. It essentially is the return divided by the volatility of the portfolio, measuring the units of return versus the units of risk. Over the last 72 months the Sharpe ratio indicates that when markets are volatile the Russell 2000 will be disproportionately impacted � both positively and negatively.

Investors in the Russell 2000 index can expect 0.56 units of gain for every unit of upward volatility, as compared to 0.27 units of gain for every unit of upward volatility for the Nasdaq Composite index and even lower gains for the other major indexes (see chart).

While we expect plenty of negative surprises ahead in 2008, in our opinion a large number of the concerns have been identified and discounted by the market. We think any positive developments will be reflected and magnified by the small cap market in 2008 � with substantial gains to the upside.

Seasonality. The winter months are by far the best months to be invested in the market � long or short term.

Data for the last eight years indicates the Russell 2000 index was the most volatile and most �seasonal� of any major market index � delivering substantial excess returns. We think the trend will continue � with the small cap return differential intact.

LSGI Micro Indicator. Last, our long term LSGI micro cap moving average indicator has turned bullish. The indictor is comprised of micro cap firms in our portfolio � firms so small they are dwarfed by the Russell 2000 index. But they have been a very good leading indicator of the performance of the Russell 2000 � and this indicator is advising us to become more fully invested.

All will not be positive in 2008, however. The homebuilding sector will experience continued pains � with one or more public firms filing bankruptcy or agreeing to highly dilutive re-capitalizations. Housing prices will continue to fall nationwide in the first part of the year.

The related real-estate credit and finance markets will remain problem-prone, with billions of more in write-offs and re-capitalizations in store. A number of large hedge funds holding toxic credit instruments will surface belly-up over the next few months. The global auto industry will experience weakness, along with associated parts manufacturers, as the credit markets and higher fuel prices reign in demand.

In the end we expect 2008 will be a volatile year for the markets. The world economy will still grow at a fair clip - with Asia growth taking up any slack. Global growth is estimated to hit 4.6 per cent in 2007. Because China, India and Russia now account for more than half of global growth that rate is unlikely to fall below 4 per cent in 2008.

We don't expect the market averages to rocket upward. But when all is said and done we think the equity markets will be higher at year end � lead again by the Russell 2000 Small Cap Index.

© 2008 Joseph Dancy

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Joseph Dancy, Adjunct Professor, Oil & Gas Law, SMU School of Law, Advisor, LSGI Market Letter | Joseph Dancy's Book Reviews | E-mail

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