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Economics, Oil and Butterflies
- August 2007

You may have heard the saying from Edward Lorenz and Chaos Theory that when a butterfly flutters its wings in one part of the world it can eventually cause a hurricane in another. This seems especially appropriate given that the dominant stories of recent years have been the rash of hurricanes that have battered the Gulf Coast and the rising price of oil. In an economic system like ours, everything affects the economy in some way, which in turn affects the capital markets. Trying to make sense of these cause and effect relationships can be daunting. As we experience yet another hurricane season, it makes sense to look at the impact of certain events and how they affect your investments.

Investors become conditioned to seeing everything from the perspective of investing consequences. It is difficult to watch the news or read the newspaper without wondering "How's that going to affect my stocks?" With hurricanes, two major concerns are their effect on economic growth and their effect on the insurance industry. Katrina, in addition to the devastating loss of life, caused an estimated $81 billion in damages. Interestingly, due to industry reforms after Hurricane Andrew in 1992, the insurance industry as a whole has emerged in fine shape after the past few years. In fact, some in the industry believe it will benefit from these hurricanes as more people are likely to buy hurricane insurance and because insurance companies can likely pass along much of the costs to the consumer through higher premiums.

From an economic viewpoint, in the short run, hurricanes are normally an economic drag, with unemployment rising and lower retail sales resulting from long-lasting power outages and a general lack of consumer buying. In the longer run, however, we often see increased economic output as rebuilding leads to increased employment and construction-related spending.

Another hurricane-related effect comes from the disruption in oil supplies due to the storms. As if the world of oil did not have enough going against it, hurricanes have added to the upward pressure on the price of oil by slowing the important Gulf of Mexico transportation routes and shutting down refineries. As we have seen over the past 30 years or so, periods of rising oil prices lead to a host of problems ranging from upward inflation pressure, drop-offs in consumer confidence, and lowered consumer spending. All of these things affect the U.S. economy, causing increased volatility in the capital markets.

Hurricanes and oil, as well as the difficulties in Iraq, the sub prime mortgage problems, and other geopolitical issues in the world right now make it seem like there are hundreds of butterflies fluttering their wings all around us. Developing a sound investment plan can help investors navigate through these rough waters.

History tells us that long-term investors can weather these storms by maintaining their plan through good times and bad. A study from the University of Michigan reveals that in the last 30 years, the average annual return for the market has been 11.83 percent. However, take out the 90 best days and the average annual return drops to just 3.28 percent, a figure comparable to the return you would get on money market funds.

The lesson is clear. No one can predict when those "best days" will occur. To reap the advantage, you must be invested on those days, and having a sound, long-term investment plan can assure you of that advantage.

For assistance in investment planning, contact Chris Doll.