Commentary For December 2007

“Both optimists and pessimists contribute to our society. The optimist invents the airplane and the pessimist the parachute.” G. B. Stern, a British novelist

The financial media gets the luxury of being both, so no matter the subject, they are “right.” We are taking the role of the optimist in this commentary (as has been our nature). Time will tell.

Sure sub-prime mortgages have negatively impacted housing sales and construction and that will continue to be the case for the future.  If you assume the sub-prime mortgage market to be $1.3 trillion and that 20% are foreclosed and written-off to zero that would amount to $260 billion. Our GDP for 2007 is projected to be north of $13.89 trillion and if we assume real growth (after inflation) was 3.25% this would translate into a gain of $451 billion. After taking a worst-case scenario hit to the economy, we would still have real growth. But that is only part of the picture. In the first quarter of 2006, the combined non-residential and residential construction was $1.225 trillion.  As of June 30, 2007, the aggregate had declined $50 billion to $1.175 trillion so it is not quite as gloomy as it initially appeared.

Much has been made of our budget deficit and its absolute value, but we believe it needs to be viewed in the context of historical data. For the period 1960-2006, we ran deficits 43 of 47 periods. No deficit is good but unfortunately it not something that just started happening in the last 20 years. The highest deficit as a percentage of GDP was 5.77% (1992). In 2003, our budget deficit exceeded $529 billion or 4.83% of our GDP of $10.96 trillion.  It is projected for 2007 that our deficit will shrink to $165 billion, or 1.2% of our 2007 projected GDP of $13.89 trillion.  The use of scale shows that it is less than the long-term average of 2.51% (1960-2006).

From a relative valuation standpoint, according to Goldman Sachs, they put a current valuation on the S&P 500 of 14.5 times 2008 estimated earnings. From a historical perspective, assuming a 2.5% inflation rate and an interest rate of 5.25% on 5-year treasury notes, this would translate into an 18.6 P/E, so the market is still very attractive.  There has been a noticeable increase in volatility.  Since 2002 through the mid part of this year there was very little volatility compared to historical norms. During this period, much of this was attributable to a decreasing interest rate environment, but with the “credit crunch” we have experienced recently, volatility is back to its normal level.  It was during these periods of volatility where stocks performed their best so even though it may feel that way, it should not be viewed as a “sky is falling” scenario. Since July 19th, when the S&P peaked at 1553.08, it fell to 1406.70 on August 15th for a decline of 9.43%. Technically, a correction is a period when the market declines 10%.  Since then it has advanced 8.53%, as of September 28th.  If history is any indicator, the third year of a president’s term is  the best year for stocks. We continue to believe that we will end 2007 in double digits.

For the quarter just ended, year to date returns for the S&P, NASDAQ, Russell 2000, MCSI EAFE and Lehman Brothers Aggregate Bond indexes were 9.13%, 11.85%, 3.16%, 15.15% and 3.85%, respectively.  For the same period, our Stock, Aggressive Stock, Balanced and Fixed account returns were 10.56%, 11.56%, 7.42% and 4.27%, respectively.

“Self-conceit may lead to self-destruction.” Aesop. Iranian President Mahmoud Ahmadinejad recently spoke at Columbia University & the United Nations much to the outrage of the U.S. and it was a great propaganda moment for him to show his country how they were able to snub their nose at the United States.  In John Mauldin’s June 29, 2007 weekly column, “Thoughts From the Front Line”, he shares some interesting insights.  The economic power that Iran carries, having the 3rd highest proven oil reserves in the world, appears unlimited. Oil revenues provide upwards of 70% of  Iran’s government revenues. With that said, it is interesting to note that Iran’s annual oil production before 1979 to 2006 fell from 6 billion barrels to 4 billion barrels. This doesn’t make sense because they should be cranking it out in light of the historical high price for a barrel of oil and  sticking it to the American “ infidels.” Iran’s problem is that they do not have the refining capacity to be able to process the oil. It is akin to fighting a house fire, but rather than having a fire hose (refinery capacity) to connect to the hydrant (oil reserves) they only have a garden hose to fight it. No matter how much water is available to fight the fire, the garden hose severely limits the firemen’s ability to put it out and in all likelihood your house will be a total loss. You just hope that you have paid your homeowners insurance because that is the only way you are going  to survive economically.  The long-term implication of a lack of refining capacity could be devastating to Iran economically.

For all that capitalism is maligned, one truth remains that free enterprise works well, especially when the government isn’t involved. Mauldin lays much of the blame for the lack of refining capacity at the feet of the government and the constitution that it operates under. A major cause for this shortage is a result of their constitution; they do not allow foreign ownership of oil reserves or fields. Why do they need to have foreign investors to build refining capacity when they are sitting on all this oil? Iran’s problem is similar to winning the lottery (huge oil reserves) and having more money than they know what to do with so the government began giving money to all their citizens in the form of government subsidies. For example, in June 2007 the price of gas in Iran was $0.34 per gallon which could fill up a Honda Civic for $4.49 versus costing a U. S. citizen $31.42 to fill up. Unlike Americans, with their insatiable demand for gas at any price, Iranians have never had to worry about the cost of having a full tank of gas for their Honda Civic. In reality, that cheap gas cost a lot more than they could ever imagine because the government subsidized the price of gasoline to the tune of 38% of their government expenditures. Yes, 38% of their government expenditures.

Rather, Iran should have been reinvesting part of their winnings back in to increasing their reserves and refining capacity. Iran and its leaders and government now realize that their unabated spending has put them at a huge economic and political risk because they don’t have the financial capacity to fund it on their own. It is like they are on a moving train with a high probability of a train wreck, and the only outcome in question is the magnitude of the wreck and whether there will be any survivors. Now you can understand why they need foreign investments to increase their refining capacity.

Iran is between a rock and a hard place. Their income is significantly restricted because they don’t have the assets to expand their refining capacity and if they did, it wouldn’t come online for several years. On the expense side of the ledger, the consumer demand for gas is growing at least 10% per year and so is the gas subsidy. The mathematics doesn’t favor them.  This is a dangerous scenario for the current regime, since the Iranian population is growing younger and has been more vocal on the poor fiscal policies being carried out by the government and their lack of adoption for innovation through technology. The cleric leadership and the officials they appoint must be keenly aware that to ignore this constituency puts them a great risk. Contrary to what we see on nightly television, the current regime is not one that is popular with a significant part of the citizens and at some point will be susceptible to being overthrown, much like we saw in Russia.

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