Quacks Like a Top

The Dow Jones Industrial Average closed at 12,867 today, 3.3% below the level of one year ago. The performance of various components, however, varied significantly. If we take three companies in the Dow as representative of their sectors—Exxon-Mobil (energy), Bank of America (financials), and Intel(technology)—we see that the major divergence began last fall when the magnitude of the subprime crisis began to be apparent. The deterioration in the assets of financial companies soon leaked out to the wider economy and pulled down tech, energy, consumer products, autos, durable goods, and other sectors.

Blue--Exxon, Green--Intel, Yellow--Dow, Red--Bank of America.

In March we faced more than a mere dip in the business cycle; there was a full-blown crisis of confidence in which large international institutions refused to take each others’ IOUs. The Federal Reserve ladled out liquidity by lending on and guaranteeing assets that the private sector refused to accept, and the immediate crisis was averted. The world was awash in dollars (although it doesn’t seem that way to individuals with foreclosed homes) that chased a fixed amount of goods, and the price of oil and other commodities exploded. Of the three stocks (none of which I own or short) on the chart, Exxon is the top performer, Intel is slightly higher than one year ago, and Bank of America is 25% lower. All well and good with the history, but where do we go from here?

Now that oil has doubled in price in one year to $124 per barrel, there’s talk from reputable sources that we could see $150 - $200 oil by the end of 2008, a so-called “super-spike”. To those of us who bought real estate three years ago, joined in the Dow-30,000 and Internet hype of the late 1990’s, or who were gold bugs in the late 1970’s, the oil markets look, feel, and quack like a classic top. So I’m staying away from energy. [Update - May 9: Trying to pick a “top” to this market is the surest way to the unemployment line,” writes Steven Schork, who writes an oil-and-gas newsletter out of Villanova, Pa.]

You may be tempted to nibble at the beaten-down financials, but I think you really have to be careful. The worst of the writedowns may be behind them, but some banks have to issue capital---and dilute existing shareholders—in order to shore up their balance sheets. Layoffs are coming, and it’s hard to expand the business when the organization is in turmoil. Also, leverage won’t be as powerful a tool to grow earnings because their own lenders haven’t quieted their nerves.

Storing euros over 1 year would have exceeded the return on Exxon.

If oil prices come down, the rest of the economy will benefit. A strengthening economy and higher U.S. interest rates should also reverse the fortunes of the dollar, although no one expects 1:1 parity with the euro any time soon. So I would direct investment monies into non-energy, non-financial U.S. stocks, especially those with an export book. Bonne chance!