Oil & Water, Politics & Markets, Euro & Dollar

David R. Kotok, Cumberland Advisors
May 19, 2010

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Like oil and water, politics and markets do not mix well. And politics are driving worldwide markets.

In the US the FINRA debate intensifies and the uncertainty rises. Financial institutions and individual investors are unsure of the rules that will be in effect when Congress is done and this legislation becomes law. This item should be resolved within weeks but the ride will be rocky until a final text is known.

In Europe, the German government is in the midst of approving the financial stability fund package. There is debate in one of Germany’s Houses of Parliament with a vote scheduled for Friday. Furthermore, Germany imposed certain trading restrictions in a unilateral move that appears to be inconsistent with the French position. So the two largest economic and financial blocks in the Eurozone are opposed on financial issues at the very moment that the stability fund is being officially approved. In the Eurozone and European Union, the confederation structure means that it takes all the countries to agree to get this fund to implementation. If Germany and France do not agree, there will be no deal. Also we must remember that Germany and France together comprise about half the capital structure of the European Central Bank.

The euro broke lower against the dollar and the yen on a trading plunge. That triggered uncertainty premiums to run higher. We may have seen an actual trading bottom in the euro as it touched the “teens” before rebounding. We do not know if this “was” the bottom; it is way too soon to buy the euro. On a purchasing power parity basis the euro is nearly fully corrected from excess. However we must remember that trading to the mean is often not the event. Markets tend to overshoot and that means trading through the mean. A euro as low as the 1.00 to 1.15 range is possible even though that would be a very cheap price. We are waiting for the buying opportunity. Right now the Cumberland global multi-asset class portfolio is long the US dollar, the Loonie and the Aussie. We worry about the impact of the Australian mining tax but that was not enough for us to trigger a position change. Yet?

In the Gulf of Mexico the continuing revelations about BP and its partners and the emerging and damaging oil slick are starting to weigh more heavily on the US outlook. Florida is now threatened. The slick size is up to 19% of the US federal waters in the Gulf according to the latest NOAA fishing ban. It appears that the Florida coastline will be reached soon and the damage to the fisheries and the tourism business mounts daily.

The two financially-focused political issues will be resolved soon enough because both Europe and the US are on a fixed political timetable. The oil issue may go on for many months. Our three scenarios outlined in Oil Slickonomics Parts 1-2-3-3a ( www.cumber.com ) are sadly and sequentially unfolding. We have moved from “bad” to “worse.” Damages will certainly be in the tens of billions.

Political forces in the US will shut down new deep water drilling for years. Costs and penalties for the oil industry and the drilling and servicing sectors are assuredly going to rise. The population blames BP and wants retribution. If negligence can be proven in the strictly legal sense of the term, the costs to BP and it partners are going to be staggering and may impair the companies. We would not own them; the liabilities are potentially huge. One of the re-insurers has just raised its internal exposure estimate from $200 to $300 million to $3.5 billion as its expected liability cost. This is only one insurer. Investors should not underestimate the eventual dollar cost of this oil slick.

So far the proposals to raise the environmental protection oil tax by a single penny are met with laughter. From 8 cents to 9 cents is a joke. Some of our US Senators just don’t get it. That is why they are getting kicked out of office. One contractor client whose business is directly tied to the oil price is also livid at BP and disgusted with our energy policy. In our meeting yesterday he clearly said that “gas taxes must go up.” He claims to represent his industry. I believe him. If Congress were to raise the oil tax to 9 dollars a barrel instead of 9 cents, it would likely get public approval in this climate. We expect that the higher energy tax movement will evolve as a political force. Madam “drill, baby, drill” is drilling a hole in her political head.

In the US the political disgust is evidenced in more and more elections. It started in the governors races in New Jersey and Virginia, it spread to the special senate race in Massachusetts. Last night we saw it in Kentucky and Pennsylvania. The “ins” are being thrown “out.” This applies to both political parties.

Markets do not like uncertainty. They can rise with bad news or good news but no resolution and lack of clarity is the worst case for markets. That is the condition we are in today in Europe and in the US. Scared markets are those which present opportunities. Calm markets are usually fully priced and are riskier. We maintain our invested positions. We believe that the short-term worldwide interest rate in the G4 currencies is likely to average below 1% for at least another year or longer. G4 is yen, dollar, euro and pound.

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David R. Kotok, Chairman & Chief Investment Officer, Cumberland Advisors, www.cumber.com

David R. Kotok, Chairman and Chief Investment Officer

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