DEAD BULLS AND CATS?

The stock market's sudden, sharp selloff is paralyzing investors with fear. Even the "perma-bulls" are terrified. The recent declines are breathtaking in speed, but not particularly large, as far as corrections go. At least not yet.

In the short term, the market's movements can be explained entirely by the collective appetite for risk. Up until a few weeks ago, this appetite was strong, but it has weakened significantly. The aggressive indiscriminate buying of everything from junk stocks to blue chips during the first half of 2007 is likely over.

In last Monday's update to the subscribers of Strategic Investment, I wrote: "The market is long overdue for a nasty correction, and you can hedge your overall position by buying a bit of UltraShort Financials ProShares (SKF), the August recommendation." SKF has performed brilliantly, thanks to the stock market's sharp selloff. Key Energy has performed less brilliant. But I emphasized that Key Energy was attractive for long-term investors at $17. So it's now a better value at $15, and I'm standing by both recommendations.

I expect that the price-discovery process currently underway in the CDO and leveraged loan markets will continue in the coming months, and perhaps lead to a few more high-profile hedge fund blowups.

But eventually, cooler heads will prevail. We must always keep in mind the global economy's highly inflationary monetary backdrop. If you look at out-of-control money and credit creation emanating from all parts of the globe, it's hard to believe that any asset price can decline in nominal value over the long term.

Sovereign wealth funds -- from Asia, the Middle East, and any country where exporters earn more U.S. dollars than they can handle -- will likely increase the buying pressure under U.S. assets. In a future environment in which the supply of paper money is virtually limitless, it makes sense for these funds to shift their focus away from bonds and toward stocks, especially stocks of companies that provide what they demand: energy, commodities, and other key components of infrastructure.

The Chinese government controls one of the largest sovereign wealth funds and has announced headline grabbing investments in Blackstone and Barclays, two firms heavily exposed to the financial economy. Odds are good that China will eventually announce investments in natural resource-related companies.

This week's issue of The Economist describes the recent shift in the behavior of sovereign wealth funds worldwide:"Many emerging markets, notably China, have built up vast reserves of foreign exchange. Such reserves are traditionally invested in liquid assets like Treasury bonds, which could be sold quickly if the central bank had to prop up the currency. But many countries have far more reserves than they need for this purpose...That leaves the government free to buy more exciting things where it might make a better return. Earlier this year, China decided to set up a sovereign fund.

"Most of the other funds get their money from oil exports. Such funds have been around for some time --Abu Dhabi, for example, started a fund in 1976 -- but have been multiplying recently. Russia intends to channel some of the money from its Oil Stabilization Fund, which invests in safe, liquid assets, into a more adventurous sovereign wealth fund. Kazakhstan, Azerbaijan, Venezuela, Bolivia, Nigeria, and Angola have all either set up funds recently or are looking at doing so."

The shift from bonds to stocks should only grow over time as these funds slowly realize that holding U.S. dollar-denominated bonds until maturity means holding the bag in the U.S. dollar's inflationary endgame. The rest of the world already has far too many U.S. dollars. They are constantly getting flooded with more of them, and they are certainly going to take action that's in their best interests.

Keep in mind that the stock market is first and foremost a "market of stocks." Rather than get distracted by the day-to-day movements in the Dow, concentrate on the sectors and stocks that remain entrenched in strategic positions.

Oil and oil services remains at the top of that list, and we were reminded of this industry's importance in Petroleos Mexicanos' (Pemex's) recently published 2006 annual report. If the status quo is maintained, Mexico will face a crisis, as all of its proved oil reserves will be exhausted within seven years.

Mainstream economists continue to focus almost entirely on the drivers of U.S. demand for oil, when the real factor at the margin is demand from rapidly growing Asian economies. China's oil imports are currently growing at a rate of 20% year over year.

Longer term, I expect that global oil demand will be constrained by global oil supply, and the key variable in the equation will be price (volatile, but upward-trending). Supply will go to the highest bidder, since the rest of the world is now on an equal playing field with the U.S. when it comes to bidding for shipments of oil on international markets.

Higher oil prices usually prompt producers to produce as much supply as possible. Yet we're not seeing this response. Last week's earnings report from Exxon clearly indicates that it is not investing enough in future production growth.

Also, looking at entire oil-producing regions shows that many are having a hard time maintaining production despite high prices. The Alaska Department of Revenue just published a report concluding that North Slope oil and gas production declined 12% last year.

The long-term investment picture for energy remains positive despite the credit market turmoil that's currently
rattling financial markets.

[Joel's Note: Dan Amoss has been guiding readers of his Strategic Investment newsletter through tough times in the markets, even in these volatile trading days. In this special report he outlines the case for an alarming new energy crisis that could seriously impact your investments.