$90 oil won't kill the bull

(Money Magazine) -- As the price of crude oil broke $90 a barrel for the first time, investors worried that stocks were headed for a major downturn. But the odds are high that the bull market will survive.

First, though, let's face up to the bad news. The current oil price is high enough to threaten the economy. During the oil crisis of the late 1970s and early 1980s, the price of a barrel of crude peaked at between $75 and $80 in today's dollars. So we're well past that now.

Money Magazine editor at large Michael Sivy.

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In coming years, the oil price is likely to stay relatively high. After the last oil crisis ended, oil plummeted to less than $20 a barrel (in today's dollars) several times between 1986 and 1998. But when the current squeeze finally eases, we'll be lucky if oil dips below $50.

The problem is that all the cheap oil is being used up. Supplies can't be increased very fast, and new production is expensive.

Plus, globalization is producing phenomenal growth in China and other emerging countries, which are far thirstier for additional oil than more mature economies in the United States and Europe.

A lot of investors look at the prospect of permanently expensive oil and conclude that a replay of 1970s stagflation is inevitable, to be followed by something like the killer recession of 1982-83.

But here's some good news.

For starters, oil plays a smaller role in modern economies than it used to. Today, it takes about one-quarter as much energy for an additional unit of GDP as it took in the 1970s.

In fact, the economy seems to be shrugging off today's expensive oil. Earnings will be lousy for the quarter that just ended, but that's largely because of the subprime mortgage crisis. Moreover, forecasters project a return to double-digit earnings growth by year-end.

There's also the risk of inflation - there's no question that high oil prices put upward pressure on the cost of other goods. But so far, there's little evidence of big price increases. And globalization trends - competition, outsourcing and cheaper foreign labor costs - help keep a lid on inflation.

To some extent, peaking oil prices are the result of a weak dollar. Oil doesn't look nearly as expensive in euros, which are now worth 50 percent more than European currencies in 1981. So energy prices are less of a drag on economies outside the United States, which should help support growth in this country.

In a sense the current situation is self-correcting. If the U.S. economy weakened for any length of time, growth would slacken in China's export-oriented economy, which would reduce the total world demand for oil.

The real danger is military conflict of some sort that disrupts the supply of Middle Eastern oil for a protracted period. That can't be ignored. But we can gauge the chances of these risks. Some disruption of Middle Eastern oil supplies has already occurred and the risk of further problems is already reflected in stock prices.

There's a rule of thumb that the price/earnings ratio of the S&P 500, based on earnings for the coming year, should be 20 minus the inflation rate. With the consumer price index up 2.8 percent over the past 12 months, the market P/E should be over 17. But many top growth stocks are trading for less.

Your best investment strategy now is to recognize that there is a small but real risk of a bear market. That argues for diversifying as broadly as possible and favoring undervalued stocks and those with high dividends that would receive some support from their yields.

I gave some specific suggestions in "Profiting from subprime turmoil."

As for energy stocks, this is not the best time to buy them. An improvement in the global political situation or even a small slackening of demand, could force oil prices back down - as well as the stocks of major energy companies.

But at some point, certainly whenever the next recession does arrive, oil will pull back a lot. Then, you should make sure to add first-class energy stocks to your portfolio, including ExxonMobil (Charts, Fortune 500) and ConocoPhillips (Charts, Fortune 500).

Anadarko Petroleum (Charts, Fortune 500) and Apache (Charts, Fortune 500) are also interesting because they are producers with reserves mostly in politically stable regions, such as North America. The more-speculative stock to buy the next time oil prices retreat is Schlumberger (Charts), the leading oilfield services company. Its share price is up 92 percent over the past year.

Long-term, of course, it's essential for investors to include energy stocks in their portfolios, or to rely on an inflation-hedge mutual fund like T. Rowe Price New Era.

The damage done to your purchasing power over decades by even moderate inflation will always be the greatest threat to your financial well-being.

It's also the threat that investors are typically least prepared for. So keep an eye on the energy stocks. This may not be the moment to buy them, but they're a must for your portfolio when the time is right to scoop them up.