Portfolio Update - 5/19/06
Dear Clients,
It has been a tough month for the stock market but fortunately not for our portfolios. As of Thursday’s close (5/19), we were up just marginally month-to-date and up around 5% for the year. I don’t see anything happening today that will have a serious impact on our portfolio in either direction. This quick consolidation has been beneficial as it has allowed us to see how our portfolio will react to pullbacks. Having a relatively neutral market position has proven to be prudent, at least for the last two weeks, and we’ve identified some vulnerable positions that we’ll likely liquidate during the next rally.
In my April Market update, I stated that 5 dominos would fall in connection with the ensuing bear market and I looked to profit from the “falling dominos” rather than seek risky gains in an aging bull market. I’d like to address the first 4 which are as follows:
1. Sell Off in Bonds.
2. US$ Depreciates Significantly
3. Consumer Credit Contraction slows the Economy
4. Inflation erodes Consumer Sentiment
Domino #1: Sell off in Bonds: Despite the rally bonds have made the last few days, the 10-Year treasury has lost over 6% this year. This is a significant move to the downside, the largest such move since the Fed began raising rates in ’03. We have profited nicely from this and I locked in a 17% gain in our short bond position. (I liquidated this position this week as I see bonds continuing to rally. Even at current levels, investors will start to shift assets from stocks to bonds.)
Domino #2: US$ Depreciates Significantly: In 2004, the US$ reversed its’ long trip down versus foreign currencies. However, it renewed its descent this year and it will likely continue. The US$ has rallied a bit this week, but it is down in the 10% range against the euro and yen YTD. A foreign investor owning 10-year treasuries has seen his investment depreciate over 16% this year. Whether the continued fall of the US$ is either a cause or a result of the coming bear market, I don’t care as long as our portfolios profit from it. Our foreign bond positions have profited nicely from this move.
Domino #3: Consumer Credit Contraction slows the Economy: While there are signs of this starting to take place as the housing market cools off, I’m not prepared to say that this domino is falling, maybe teetering, but not falling. The coming months will be telling. Being short home builders in our taxable accounts hasn’t hurt us at all as these positions are up substantially.
Domino #4: Inflation erodes Consumer Sentiment: Here’s the biggy! I was shocked by last month’s consumer sentiment numbers. The University of Michigan’s numbers fell precipitously from 87.4 to 79. Currently, sentiment is below post 9/11 figures. The trend is even more discouraging as Sentiment gradually fell from the beginning of ’04 through the early this year and then dropped off the table this past month. Inflation fears including rising gas prices are the primary driver behind the drop in sentiment. We’ve profited by being long commodities which are the underlying cause of inflation.
I could live with the other factors, but the erosion in sentiment has me convinced that the bear market is coming sooner rather than later. The market could and should rally a few more times especially if the fed backs down. There is excess liquidity in the global markets which should keep pushing asset prices up but eventually something will give. Expect a substantial increase in volatility in the market and don’t get caught up in the swings.
Matt
