Wednesday, July 09, 2008

Three Scenarios For The Economy

As I posted in Consider More Than One Scenario When Making A Decision, "Financial decisions based on a single scenario can sometimes be disastrous if the assumed scenario proves incorrect." In my opinion, the stock market direction is currently being driven by the price of oil. As oil goes up, the stock market goes down, and vice versa. So here are three possible scenarios for oil prices, and what I plan to do in the stock market.

  • Oil prices rise to $200 or more. This is the worst case scenario. I believe the economy would definitely go into a deep recession. The price of all goods would increase, creating the worst inflation in years. The stock market would dive. This would be a very bad scenario. I estimate a 25% chance of this scenario happening.

    Personally, I would need to reverse my early retirement which I took in 2007, and take a new job. Although I have put near term expense needs in safe investments (e.g. CDs and bonds), my stock portfolio has declined significantly, to the extent that five years may not be enough to recover.

    As for stock investments, I would hold most of my current holdings and sell small portions that are profitable into rallies. I would continue to look for opportunities to sell stocks short.

  • Oil stays in the $130 to $170 range. A short recession will likely happen. Weak companies will go out of business. However, consumers will be able to adjust and use less oil, keeping demand relatively stable. I estimate a 40% chance of this scenario.

    For this case, I would expect the stock market to be very choppy for a few years, moving within a channel. I would be a trader of stocks, attempting to buy as stocks near the bottom of the channel and selling near the top. I would use the modified Unemotional Investor growth system for choosing stocks.

  • Oil declines to around $100. Either demand declines, productions increases, or speculators exit the market. As a result, oil prices decline to a manageable level. Business profits rise, the recession ends sooner, and the bull market resumes. I estimate a 35% chance of this scenario.

    I would increase our allocation of stock in our long term savings. However, I would still not be fully invested in stocks unless oil prices would decline further.
  • At this point, I betting on either the second or third scenario. However, I am also getting prepared for the possibility of the first scenario.

    For more on The Practice of Personal Finance, check back every Wednesday for a new segment.

    This is not financial or investment advice. Please consult a professional advisor.

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