The Oil Factor: Protect Yourself and Profit from the Coming Energycrisis [Englisch] [Gebundene Ausgabe]

"The Oil Factor" is a comprehensive and practical investing book disguised in a misleading title. The book is best described as a very lengthy investment newsletter that describes how to use the price of oil to time major investment decisions.

For a book with the word "oil" in the title, you expect discussion of concepts such as Hubbert's Peak and the state of current oil production. Mr. and Mrs. Leeb do not disappoint and present these topics in a way that is palatable to the uninitiated. However, this is not the main focus of the book.

The main focus of the book is the use of a market timing indicator that they call "the Oil Factor". They describe a way to use the price of oil to predict the direction of the US economy and thus the direction of US stocks. The premise is that all economic activity in the US involves energy and the principle energy source is oil. It is an interesting idea and they have a decent amount of back-tested results to show how utilizing the Oil Factor to switch between the S&P 500 index and Treasuries would have resulted in a doubling of your returns in the tested time period. This indicator is surprisingly simple and can be easily calculated and monitored by anyone. It is so simple, that it occupies only a single chapter to describe in full.

The bulk of the book is subsequently used to present the case that the economy is in for hard times and investing strategies that will help you prosper. A surprisingly thorough treatment of the entire US Economy is presented. The book is an unexpectedly excellent summary of the bear's case for the next decade. The recommendations are surprisingly specific. Mr. and Mrs. Leeb name specific companies, believing strongly that their recommendations will stand the test of time that is demanded of books but not demanded of magazines and newsletters. Complete model portfolios are presented. They describe a model inflation portfolio for when the Oil Factor swings in one direction and a model deflation portfolio for when the Oil Factor swings in the opposite direction.

The highly specific and pragmatic nature of the book will surely be a breath of fresh air for those accustomed to theoretical treatments, but very serious flaws of construction undermine the main thesis of the book.

The first is that the Oil Factor is yet another simple mechanical method perfected through data mining. That is, they found something that correlates with market performance and have made the assumption that what worked over the past 30 years should work into the next decade. Suffice to say that out of countless models invented over the past century that utilize simple rules to outperform the market, none has ever stood the test of time. Some may remember the once popular "Dogs of the Dow", one of the more recent demonstrations of such a failure. I see no reason why the Oil Factor should survive and in fact see many reasons why it should fail. For example, the back-tested strategy uses only the past 30 years. The past 30 years excludes an enormously crucial factor clearly visible into the future: China. Strangely enough, Mr. and Mrs. Leeb discuss the enormous impact that industrializing China will have on the world's oil supplies, but neglect to discuss how this might influence the reliability of the Oil Factor, which has never seen a nation of 1 billion people pushing into the industrial age.

A second serious flaw is that even if you accept the premise of the Oil Factor as a method of switching between stocks and cash, the authors then go on to argue that you should not use the Oil Factor to switch between stocks and cash, but rather to switch between an inflation portfolio and a deflation portfolio. They do not bother to backtest this strategy, but present only forward-looking fundamental arguments of why this should work in the future. It is a flaw stacked on top of a flaw.

In summary the book is a poorly unified in concept. It should be noted, however, that the proposed deflation portfolio and inflation portfolio are excellent. Few people have arranged diverse asset classes under these banners. This alone makes the book worthwhile. If you believe that we are headed for inflationary or deflationary times, you may want to buy this book and skip to the last few chapters to find out what to buy.

This is an unusually lucid guide for investors with the focus on the price of oil as the key economic indicator.

Stephen and Donna Leeb argue rather convincingly that oil has been and will continue to be the big moose that moves the financial markets one way or the other. They show how sharp jumps in the price of oil in the past have triggered market downturns, and how falling, moderate or stable prices have led to bull markets. With oil at or near its so-called Hubbert's peak (one trillion barrels used; one trillion still left in the ground), and with rising demand from an increasingly industrialized world, especially from a voracious China, the authors see oil ratcheting up to record highs in the near future and more or less staying there. They see this as leading to inflation and negative real interest rates--although in some scenarios (hedging their bets, as all wise prognosticators do), the authors warn about periods of deflation. Consequently, investors need to pick investments that protect them against the erosion of their dollars, while hedging against intermittent economic slowdowns.

The authors have a table on page 202 that uses what they call the "oil indicator" to tell you which investments are best for inflationary periods (the coming norm) and deflationary. For example, when the oil indicator is positive (that is, oil is rising only modestly) you should buy energy stocks, gold, and a few hand-picked others, like Real Estate Investment Trusts. But when the oil indicator is negative (when the price of oil is skyrocketing) the danger of an economic slowdown looms because the price of doing business becomes more expensive for just about everybody in our oil-dependant economy. In such times, deflation is the danger. Therefore, your portfolio should be heavy into things like zero coupon bonds and "cash"--cash being treasuries, triple A corporate bonds, or other super safe instruments.

This book is the trade paperback edition of the original hardcover book copyrighted in 2004. This is essentially the same book that Stephen and Donna Leeb wrote in 2002, but with a new introduction. The reason for this edition is that the Leebs were especially prescient in their predictions. Oil has shot up to over sixty dollars a barrel, and inflation is on the rise while the Fed has continued to raise interest rates in an attempt to slow things down. Prognosticators that are right tend to gain readers.

What sets this apart from many investor-guides that I have read over the years is the authors' lack of even the barest hint of political bias, and the fine justification and reasoning for their portfolio recommendations. The fact that they have been right so far is to their credit, but there are always prognosticators that are right and prognosticators that are wrong. The fact that someone is prescient a time or two or three means little in my opinion. It is the strength of their reasoning that counts, not their past record. To appreciate this point, consider that in any given year there are hundreds of books written that tell the investor where to put his or her money. Some turn out to be right, some wrong, and some in-between. Almost inevitably someone will get it right or nearly right by happenstance. If they really had a crystal ball they would not need to write books (although they might for the sheer joy of it). They could instead just put their money where their mouth is and make mass bucks, as does, say Warren Buffett.

A nice point made by the authors is that with so many Americans caught up in so much debt ("2.8 times the gross domestic product") "strong economic growth becomes essential, even at the price of high inflation." Furthermore, since so much of that debt is in the form of home mortgages, there is a limit to how high the Fed can raise interest rates since that would raise mortgage rates which would keep people from buying homes, which would result in falling home prices, which would "cause the economy to unravel." (From the summary of Chapter 5, "The Debt Burden" on p. 61)

Ergo, inflation is coming, and what the investor needs to do is invest in inflation hedges such as gold mining stocks, gold, art masterpieces, etc., but NOT in real estate (the usual best hedge against inflation) since there is that...uh, bubble.

The problem with all this--as I like to remind everyone--is that the future will be like the past, only different.

Let me repeat that: the future will be like the past, only different.

The "only different" is the important part. We should have had a deep recession when the tech bubble burst in 2000. That is what has typically happened in the past. But we only had a slowdown because what was different was that the value of our homes rocketed up allowing consumers to dip into their equity to buy stuff while interest rates fell and fell so that many more people could afford to buy homes which continued to lift home prices, which led to more equity spending which floated the economy.

What might happen that is different from the authors' scenario is that the home price bubble might burst despite the best efforts of the powers that be. Along with skyrocketing oil prices, this would cause the whole economy to come tumbling down. Such an economic catastrophe would usher in a recession with inflation just a fond fool's dream in the rearview mirror.

Bottom line: very much worth reading for the authors' lucid explanation of why they (and most other experts, by the way, that I have read) think will be the shape of our near-term economic future and what you the individual investor can do about it.

Lately I've been doing quite a bit of reading on Hubbert's Peak and our energy situation, the effects of mammoth US trade and federal budget deficits, as well as China's re-emergence on the world stage; and I can say that for the most part the Leebs do an admirable job of describing our coming economic environment in the broader strokes. More important, they discuss how to distinguish inflationary from delationary times through their oil-indicator and how to invest in each sitution.

The Leebs make a strong case for having oil stocks, gold and Berkshire Hathaway shares as core holdings in both an inflationary and deflationary portfolio. Aside from REITS, their case for holding defense stocks and particular tech and lifestyle stocks is much less convincing. In fact, their much touted tech stock has under performed the S&P index by 40% over the past year, and made the news last week losing 7% in one day. I am also very aware of one of their lifestyle stock picks and would never put my money there - an organization noted for its success in losing pounds, may also succeed in losing dollars. These are their recommendation sins with commissions.

There are sins of omission as well. There is no mention of TIPS - a surprising omission when discussing inflationary environments. And there is no mention of how or why to invest (or not invest) in China apart from PetroChina (whose ticker is PTR not PRT as printed in the book).

The authors include their results from their last portfolio recommendations from 1998. On the plus side, they honestly reproduce their portfolio warts and all. On the negative side, one of the warts is ENRON (listed as an environmental play) which they correctly report as having a return of exactly -100%. The silver lining is that their zero-coupon investment gained over 90%, so their overall return was above 39% over a 5 year period. Overall, pretty good, even with Enron. But what this underscores to me is how important and useful zeros are for investing in a deflationary time and just how wrong the Leebs can be with their individual stock picks.

All in all, though, I highly recommend this book for anyone wanting to protect their assets in the coming years.

PS: Regarding the status of our civilization vis-a-vis oil and energy, I'm of the same opinion as the May 31st review from "A Reader." We are, I believe, in a period of overshoot soon to be followed by war and/or collapse. So, in a way, reading this book was something of a pick-me-up -- for the Leebs presuppose that things will pretty much continue as before only with more expensive energy. I fervently hope they're right! We'll all find out soon enough. This is one wager I'd be happy to lose.