InnerHarbor Advisors Logo (Black Background)
 IHA Monthly   March 2011 
In This Issue
Market Commentary
February 2011 Asset Class Returns
Investing in Oil
Quick Links
Join Our Mailing List 

Watch Video 

History Speaks
The last few weeks have seen numerous calls for U.S. military intervention in Libya. The history of American involvement in Northern Africa stretches back to our first days of independence. At that time the areas from Morocco to Libya were known Barbary Piratesas the "Barbary" states, home to pirates who preyed on merchant ships. As a colony the American states were under the protection of the British navy but upon gaining freedom the Barbary pirates began seizing U.S. ships and holding sailors for ransom. Congress at first appropriated monies each year as tribute to the pirates in order to protect the vital shipping industry of New York and New England. Eventually the bribe money amounted to 20% of the federal government's total revenues. In 1801 the pasha of Tripoli upped his demands and President Jefferson refused to pay, instead sending military frigates to the region to confront the Barbary pirates (basis of the "to the shores of Tripoli" line in the Marines' Hymn). Eventually a peace treaty was signed in 1805 but there was a second Barbary War in 1815 and the Barbary piracy issue was not really solved until the British and Dutch jointly bombed Algiers in 1816.

Market Commentary

InnerHarbor Advisors, LLC is a Manhattan based financial planning firm catering to market professionals. The firm's co-founders, John O'Meara and Michael Keating, are both CERTIFIED FINANCIAL PLANNER™  professionals. If you would like to speak with a financial planning expert - or if you are currently working with someone and would like a fresh perspective, please contact them at 212.949.0494 ...or simply 'reply' to this email.

Let's get started...

Markets generally shrugged off the unrest spreading across northern Africa to post solid returns in February. In the U.S. there has been a definite uptick in the labor data as weekly unemployment claims and the national unemployment rate are at multiyear lows and the January employment report showed a gain of 192,000 jobs. The slow recovery in the labor market has distinguished this recession from the 12 others in the post-WWII era. It has been 37 months since we last posted a peak in non-farm employment and we are still 5% below that level. In the 12 previous recessions we had surpassed or were within 1% of the previous high by this time.

Non-Farm Payroll

We think the optimism displayed in market indexes just might be the result of investors factoring in what a recovery in jobs would mean to corporate profits.  

A jobs recovery would certainly be threatened by high oil prices. Oil has topped $105 a barrel in the U.S., higher in Europe. U.S. recessions are often associated with oil shocks. Our most recent downturn was undoubtedly made worse by the record oil prices in 2008. Please look at the chart below because we want to point out that while overall use of oil  has increased, the efficiency of the U.S. economy has grown to a much greater extent. We get far greater 'output per barrel' now than we did in the 1970's- the start of the oil shocks.   

Oil Consumptions 

In theory this should make us more resistant to the ill effects of higher oil prices than we were in the 1970s. The unknown factor here is how much higher oil prices (and other commodity prices) affect emerging markets around the globe as they have been the source of much of corporate America's growth since 2009. The entire Mideast region is in such flux that it defies any accurate predictions. Our best guess is that if the unrest is limited to Libya, oil prices will not have a significant effect on global growth but if it spreads to Saudi Arabia or Kuwait then all bets are off as oil prices could really go higher. 

One of the more remarkable divergences from our point of view has been the relative strength in European markets even as its most fiscally vulnerable members are under more and more strain. Gaddafi dominates the news cycle, but yields on the government bonds of Ireland, Portugal and Greece have all reached their highest levels in a decade. It was questionable whether any of these countries could ever repay their debts a few months ago but at current rates it now seems impossible. Yet stock indices are within a few percentage points of their 52 week highs all across Europe. Either the markets think default by one of these countries would not have a significant economic effect (hard to imagine) or they feel the more stable Euro countries will ride to the rescue. Stay tuned- we expect the answer sometime in the next quarter.

That time-line coincides with the planned end of the Federal Reserve's QEII program. The Fed took a lot of political heat for this round of quantitative easing and unless there is some real weakness in the data we do not think they will launch directly into another round. Whatever you think of the probity or soundness of government's influx of liquidity and spending (whether through the Federal Reserve or the federal budget) there is little doubt that it has helped push financial markets up these last two years. That wind behind the sails is scheduled to die down in the second and third quarter of 2011 as the Fed winds down its liquidity programs and many U.S. states struggle to balance budgets without the benefit of federal handouts. Bill Gross, manager of the worlds largest bond fund at Pimco, is vastly dialing back on exposure to government securities in fear of what this withdrawal of liquidity will do to yields.

We have been generally cautious on equities as we feel current prices don't really reflect the risks inherent in an economy that is still in a deleveraging mode. It may well be we are a brick in the proverbial wall of worry that bull markets have to climb but at this time we are willing to have less risk exposure as governments around the world start removing some of the bandages they used to prop up financial markets over the last two years.

Asset Class Returns

Through February 28, 2011
Monthly and 52 week returns for major asset classes. Performance information is for total return assuming reinvestment of interest and dividends. It excludes management fees, transaction costs and expenses.

Asset Class Returns 2/28/2011

Emerging markets continued to be the weak performer among equities, spooked by the dual specter of higher commodity prices as well as fears of political instability. Stock markets in the developed world were strong in February but have mostly pulled back in early March, as oil prices go over $100 a barrel. Fixed income markets were weak in early February but rallied throughout the second half of the month as the Mideast turmoil continued. Commodities, particularly energy and precious metals, remain strong.


Back to Top

Financial Planning Highlight 
Investing in Oil

'Rise early, work hard, strike oil' was J. Paul Getty's formula for success. As oil prices climb over $100 a barrel for the second time in the last three years you might be asking yourself if you should have some of your portfolio devoted to "black gold". In this month's newsletter we help you explore some of your options- and detail the the pitfalls- of investing in this volatile sector.

As a store of value oil is different from stocks or bonds. Besides the obvious difference- oil is a physical commodity and is smelly and flammable while stocks and bonds represent a claim on cash flows- the way oil is traded really sets it apart. Buying and selling of oil takes place on futures exchanges (the NYMEX for example) and the unit of exchange is a 'contract' (each contract represents 1000 barrels of oil). Therefore the way most of us can get direct exposure to oil is to trade using an account with a commodity broker who then directs orders to a futures exchange. A futures contract is an agreement today on price for a delivery of oil at a fixed date in the 'future'. This delay in delivery complicates the process of investing in oil in a few ways. First, most of us have no place to put this oil once the truck shows up in front of the house. We can't actually take delivery of the oil on settlement date. Because you will need to sell the contract to avoid delivery issues you are obviously no longer invested in oil. In buying it back you are following what most futures speculators do -roll their expiring contracts into new ones that expire at some later date. And right there is where the money leaks out. Futures contracts vary in price based on when the contract settles. This gives futures a price curve, similar to the yield curve on bonds.

Crude Oil Curve  
The chart above left shows the recent curve for the oil contract traded on the NYMEX. The price for the contracts expiring at a later date are more expensive than the contracts expiring sooner. This condition is known as 'contango' and means that if you own a contract expiring in the short term it will cost you money just to maintain your same size position in a contract that expires at a later date. The chart on the right shows the annualized cost of "rolling" over future contracts during the last year and as you can see it has ranged from 1%-5%. We want our readers to be aware that the cost of trading 'Texas Tea' includes more than daily price movements per barrel. So if you decide to invest in oil futures be sure to account for the transaction costs of trading the contracts as well as the cost dictated by the structure of the price curve at the time you roll over your contract.

The inherent expense and hassle of trading futures contracts opened the door to innovators, leading to a type of oil-linked exchange traded fund. These funds invest in oil futures but the actual fund shares trade on an exchange much like an equity share does, allowing investors to 'buy and sell oil' using a standard brokerage account. Sounds great, sign me up! (Please read further). Two of the largest oil ETF's are the U.S. Oil Fund (USO) and Powershares DB Oil Fund (DBO) with market values of $1.9 billion and $700 million respectively. Investing in these products does eliminate the need for a commodity broker and funds of this size certainly pay lower transaction costs than any individual would. However, these funds do not eliminate the cost that contango brings- in fact they institutionalize it. These funds must also roll over their contracts in the same way an individual does since they must stay fully invested in oil futures but don't take actual delivery of the oil. In fact, not only do they pay if markets are in contango but they also compete against oil traders who know the funds have to roll over the contracts. In recent years these funds have made efforts to minimize these costs (DBO in particular) but rolling the contract can still take a chunk out of their returns. The overall effect on you, the investor, is that the performance of these funds can be very different from the underlying commodity. This is a problem in commodity investing generally and not limited to oil; this Bloomberg Businessweek article explains the phenomenon in greater detail. The chart below shows the returns of the two funds over the last two years in comparison to crude oil  (Crude Oil blue, DBO green, USO red).


Oil ETF's
So what are the alternatives to investing in oil futures or oil-linked ETF's? Well you can always buy shares of oil companies like Exxon Mobil (XOM) or Chevron (CVX) in your brokerage account. This eliminates a few of the issues detailed above: the need to roll over contracts, remembering what exactly 'contango' means, and opening a new account to trade futures. Also, while these companies are sensitive to the overall price of oil, they are operating businesses and can be profitable even at low oil prices as opposed to a pure investment in oil, where lower oil prices mean only losses. Continuing on this idea- better than an investment in a single oil-related company would be a fund that invests in a basket of them - such as IXC (integrated multinationals) or IEZ (oil services). The chart below shows how these funds have actually done a better job of tracking the price of crude over the last three years than USO or DBO. (Crude oil blue, IEZ green, IXC red)
Oil Stocks
In general, we don't recommend investing in a single commodity such as oil. Unless your individual circumstances either gives you some insight into the supply and demand dynamics of the commodity in question or you have a need to hedge against that commodity, markets such as oil are even more volatile and unpredictable than equity markets. If you are going to make this type of investment make sure you have a good understanding of all the costs associated with your strategy as well as the products you will use to execute the strategy. As always we welcome your comments or suggestions. Stop in to see us at 420 Lexington Ave, Suite 2920, New York, NY... Call us at 212.949.0494 or simply 'reply' to this email.

Thank-you for reading,

John O'Meara, CFP
Michael Keating, CFP





Mike and John InnerHarbor Advisors

Contact Info:
InnerHarbor Advisors, LLC
212-949-0494 and