Is the global economy headed for a titanic crash or is it overheating and returning to 1970s-style inflation? My guess is “neither,” but investors still need to be prepared for both. No one taking over for Federal Reserve Chairman Alan Greenspan would have had an easy transition. But current Fed head Ben Bernanke has been a decided bust thus far in assuring the markets that the same middle course--not a swerve to some extreme--is what lies ahead.

There’s no better proof of the lack of faith than the market’s continued wild gyrations. On Wednesday, for example, the Dow Jones Industrial Average jumped more than 200 points as investors took the chairman’s remarks to Congress to mean the Fed was through raising interest rates. But the very next day, the Dow slid 83 points and the Nasdaq did even worse with a 41 point cave-in, essentially going back to its level after Monday’s jagged but directionless trading. 

One reason for the reversal was likely Bernanke’s Thursday comments that high energy prices “are clearly making the economy worse off in terms of real activity and in terms of inflation.” That much is plain to any casual observer of the economy and markets. Also clear to market participants is the fact that the Fed has basically no control over the level of oil prices. 

Mentioning the risk of energy prices today not only contradicts the impression that inflation is at bay and the economy is slowing enough for the Fed to stop raising rates. It gets to the issue that the Fed is basically impotent to do anything about the central problem for the US economy. And, unlike the always-circumspect Greenspan, Bernanke is admitting it to the world.

As for world oil markets, there seems to be more than ever to worry about. Contrary to earlier reports, the attack of Nigerian rebels or a CHEVRON (NYSE: CVX) oil convoy and pipelines in the country did interrupt production. The US government’s company newspaper, The Washington Post, reports bomb attacks in Iraq are increasingly frequent and deadly, despite the steady refrain from the US military and the government there that the situation is in hand. And it looks like Israel’s aerial attack on Lebanon could well become a ground offensive, raising the risk of even further carnage and a wider war.

True, recent oil inventory numbers came in a percent above last year’s levels. The chart for natural gas still looks very bearish, despite hot summer temperatures across the country. Many believe the Israel/Lebanon conflict will not spread, as Arab governments across the region show restraint and the Bush administration rallies support against Hezbollah. And oil prices have again retreated from their upper 70s highs to the low 70s.

Even if tensions cool in the near term, it’s difficult to imagine a real meltdown in oil, given the political risk in most nations and the sheer supply/demand dynamics. Chinese economic growth, for example, actually accelerated last quarter, defying forecasts. And US demand for big cars is apparently undimmed, despite abysmal earnings at FORD (NYSE: F). 

My contention remains that energy prices will remain a major factor overhanging both the market and the economy until we see some combination of the same forces that ended oil’s 1970s’ bull market. These are: conservation on the scale of the move to small cars from gas guzzlers in the late ‘70s and early ‘80s; adoption of real alternative energies on the scale of nuclear plants replacing oil-fired power in the ‘70s and ‘80s; a discovery of conventional oil and gas reserves of the magnitude of the North Sea during the ‘70s; and a real, demand-killing global recession. 

Until these things happen, the balance of power in the energy market will be squarely in the hands of the producing nations. And since they’ll try to maximize their advantage, there will also be a substantial political premium in the price of oil, and natural gas as more comes to be imported to the US via liquefied natural gas (LNG). More expensive non-conventional resources like Canada’s oil sands or ethanol will not break this power, since they’re more expensive and will rapidly become uneconomic on any real dip in energy prices. 

These are the facts of life for the US and for the world economy. Energy prices will wax and wane in coming years, and will push and pull economic growth and inflation as they move. Eventually, they’ll lose their clout, as every commodity does at the end of its price cycle. But until major demand-killing/supply-enhancing events occur, we can look forward to more volatile markets and the Fed will have the same bleak choice: Restrict inflation at the risk of slowing growth, or else keep growth pumped up at the risk of faster inflation.

PLAYING IT SAFE

What this really means to investors is a return to explosive ‘90s growth in the economy and markets are still some years off. I’m also not forecasting another bear market of the magnitude of 2000-02, at least until we see a lot more bad news and horrible mistakes by policymakers. Rather, what we’re likely to see is a continuation of the chop that began when the Great Bull Market ended in early 2000. 

Occasionally, the stock market will produce big-time capital gains. But these will invariably peter out as the economy overheats and commodity prices rise too dramatically, in turn short-circuiting growth. Those who time the cycles well can still make money. Those who count on a buy and hold strategy to produce growth will basically run in place, but with a lot of heartache in between. 

As long as we’re in this environment, only one thing will continue to grow wealth: cash distributions. Better, companies able to grow distributions will steadily trend higher to reflect their higher payouts. Their investors will get both regular income and capital appreciation, and they’ll be in the market/economy’s steadiest sectors as well. 

This spring--for the fourth year in a row--interest rates spiked, raising the specter of stagflation and triggering a selloff in income investments across the board. This time around, the selling was scarier than in 2003, 2004 and 2005, since the benchmark 10-year Treasury note finally broke above 5 percent and at one point the betting was it was headed for 5.5 percent and higher, as reflected in the fed funds futures. 

For the fourth year in a row, however, the jump in rates appears to have sputtered out. And while the 10-year note yield is still slightly above 5 percent, the trend has clearly turned. Technicians will argue whether the current chart resembles a double top, a potential head-and-shoulders top or simply a continuing rising trend. But with utilities and other income-oriented, supposedly interest rate-sensitive stocks now leading the market, a drop in the 10-year yield back below 5 percent should come as no surprise. 

Should that happen, income-oriented investments would pick up still more ground. Even if it doesn’t, a disciplined strategy of buying and holding quality income investments--i.e., those backed by businesses that are becoming more valuable--will pay off, simply by gradually appreciating over time as dividends are raised. 

The necessary caveat here is that we’ll need to sell any security backed by a business that’s stumbling, rather than holding and hoping for a turnaround. That will sometimes mean letting go of a stock held profitably for a long time, and it may mean paying taxes. And it may even mean unloading something after a steep drop, swallowing an unwelcome loss. 

Ultimately, in directionless markets like this one, stocks, bonds or preferred shares of weak companies are poison to any portfolio. You won’t do yourself any favors by being sentimental. That said, here’s a brief look at the various income-producing sectors here in late July 2006. Utility Forecaster and Personal Finance subscribers will see updates on specific recommendations in the Roundup section that follows.

UTILITIES: These have been the real bright spot for income portfolios this year. The reason is simply improving fundamentals. As I pointed out in last week’s U&I, we’re now four years-plus past the ENRON debacle and the carnage it wrought in the industry. Companies are still cutting debt and operating risk, relations with regulators are improving, credit ratings are firming and markets are tightening. And it’s all showing up in earnings. The only stocks I’d avoid now are those being negatively impacted by regulators, which at this point are few and far between beyond those identified in Utility Forecaster. Accordingly, I’d continue to stick with most utilities at this time.

FIXED INCOME: As noted above, bonds, preferred stocks and fixed income mutual funds appear to have turned the corner from the spring carnage. My inclination here is still to stay conservative. That means open-end bond funds should have duration of 5 years or so and closed-end funds should be trading at discounts to net asset value. Any individual bond you own should be of a company that is getting stronger, rather than one that’s already strong. That way, declining credit risk over time will offset higher interest rate risk. Convertibility to common stock is a major plus for preferred stocks. REAL ESTATE INVESTMENT TRUSTS: After six years of virtually uninterrupted gains, the key with REITs is picking the right sectors. Specifically, the best sector now is apartment REITs, which are gaining from rising occupancy and higher rents. Beware of any REIT yielding less than 4 percent.

BIG OILS: These appear to be pricing in a drop in the price of oil to $40 per barrel or lower. Since that’s unlikely, their next significant move is likely to be significantly higher. By and large, these companies are literally too big to fail. But individual selection is still important. We still like our picks in Utility Forecaster and Personal Finance.

BANKS AND FINANCIALS: These are historically big yielders. But the large money center banks also tend to be big losers when the economy weakens, as they’ve historically bet unerringly on the wrong leveraged trend. In stark contrast are smaller regional banks that have stuck to their core businesses and eschewed risk like REGIONS

FINANCIAL (NYSE: RF).

CANADIAN TRUSTS (NOT INCLUDING OIL AND GAS PRODUCERS): The Canadian dollar has appreciated rapidly versus the US dollar during the past two years, as that country has enjoyed big trade and budget surpluses versus big deficits in the US. The Canadian dollar has weakened slightly in the last month or so, due to some concern about commodity prices. And that’s hurt the prices of all Canadian trusts, even those not involved with energy. But trusts like YELLOW PAGES (TSX: YLO.UN, OTC: YLWPF) continue to operate healthy businesses that are increasing cash flows and dividends. As a result, lower prices are simply an opportunity to earn bigger returns.

ANADIAN OIL AND GAS TRUSTS: By definition, dividend levels for these trusts are set by two things: output and energy prices. The big trusts with balanced production between oil and gas are capable of weathering the downs of commodity prices, and in fact will use them to their advantage by buying up the weak. In contrast, most of the smaller, gas-weighted trusts have already cut dividends once this year and may have to cut again as the impact of lower gas prices filters through completely to cash flow. More than any other group of income investments, it’s critical to be selective here.

All in all, if you’ve been buying securities of companies with healthy and growing businesses, you have little to worry about, as long as they stay healthy. The key is to keep tabs on performance, and second quarter earnings are the ideal opportunity for a check up.

As was the case with first quarter earnings season, I’m confident all of our Utility Forecaster, Personal Finance and Canadian Edge holdings will meet the test. That’s why, despite the current chop in the market--and regardless of whether the market is up 100 points one day and down an equal measure the next--I’m comfortable holding them as they’re reported in coming weeks.

© 2006 Roger Conrad
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