Portfolio Update - 01/31/08

By proceeding, I acknowledge that I have read and understood the Disclaimer, Performance Reporting Disclosure and Copyright Statements . Dear Clients, The following is my Performance Update for January. All prices and returns are as of 1/31/08.

If this old adage has any validity, than equity investors are in for one hell of a time in 2008; conversely, we could see spectacular appreciation in your accounts this year. Over the past several months, my strategy has gained considerable momentum and your accounts have profited substantially. While the large-cap indexes (S&P 500 and DJI) have not technically reached bear market territory, it is essentially a foregone conclusion that they will in the near future. For the first time ever, equities fell over 10% in January. The market volatility has been “gut-wrenching”. After falling nearly 11% in the first 14 days of the year, the S&P 500 rallied 5.2% in the last seven days of the month, but only after the Fed took drastic actions in cutting the Fed Funds rate 1.25%. The average intraday movement in the S&P 500 for the month of January was just over 2.4%!

Despite the recent rally, the stock market has never faired so poorly during a Fed cutting campaign. The S&P 500 is down nearly 10% since the Fed started cutting rates in August. We are in unprecedented territory. Furthermore, the actions by the Fed given the astounding inflation picture, which I’ll cover later, are a sure sign that they are panicking. It is uncertain whether the Fed can bail out the credit and equity markets, but if they do, it will mean a lot of money creation which always leads to even more inflation. The book has been closed on Goldilocks.

Here is how my performance measured up to the averages for the first month of 2008:

On an absolute basis, we had a fairly amazing month and on a relative basis, we had a spectacular month. My Core Portfolio beat the S&P 500 (VFINX) by 15.3% and the Scott Burn’s Couch Potato Portfolio by 10.4%. If the current investment trends continue, your account should continue to perform well – but I would not get used to 9+% returns every month. Nearly 80% of your account’s allocation did very well and 20% was flat to down. I invested the portfolio to be more balanced and I expect it to act accordingly going forward. Nearly everything went our way in January and we shouldn’t count on that to continue but I think we can count on beating the market by a considerable margin for the next couple of quarters. I’m certain that my “swing” position will not perform as well in the coming months as it did in January. If you recall from past updates, I’ve allocated a portion of your portfolio to Direxion Funds to adjust my equity long and short bias in your account. In early January, I also added a Proshares ETF to further tilt my equity bias short. For the month, I played the volatility almost perfectly and if you’ve followed my performance over the past year, you’re aware that this hasn’t exactly been the case in the past and may not necessarily be the case in the future. Furthermore, I don’t expect there to be any significant upside volatility for the next few months to play. While I believe that the current market cycle could be one of the most profitable opportunities we will see for many years, my returns this month are likely to be at the high end of range. My primary goal is to protect your accounts from losses in what will prove to be a significant bear market correction. My secondary goal is to profit from the trends in the market which I’m confident that I can continue to do for the foreseeable future. However, I’m placing a higher emphasis on protection than accumulation so I’ll be locking in profits if I become uncertain about future market activity.

I’ve used the word “warning” far more than I would like in recent months. For an investment manager who tries to maintain a fair amount of equanimity about market direction, I don’t take this lightly…Still, I am emphatic that investors should evaluate their risk exposure and tolerance now, in order to allow for substantial further market weakness. (emphasis mine)

I believe that we are entering the “middle innings” of a significant correction that will defined by Stagflation. The S&P is now 4 or 7 months into its correction phase that should last 9-15 additional months. (I say 4 or 7 months because it depends on how you measure the S&P 500. In US$, the bear market started in October but in the US$ trade-weighted index, it started in July.) Historically, inflationary bear markets have lasted 13-20 months, but since there have only been three in the last 100 years, it’s difficult to create an accurate expectation for how long this one will last. Unfortunately for equity investors, the losses accelerate in the latter stages of a bear market correction. As for the technical strength of equities, Steve Saville has provided another nail in the coffin for the equity markets. He writes:

There were more than 1100 new lows on the NYSE on Tuesday [1/22/08], which is something that has only happened on four prior occasions over the past 40 years. It happened in May of 1973; it happened on the day of the 1987 stock market crash; it happened on August 31, 1998 (the day of the US stock market’s bottom during the 1998 financial crisis); and it happened at the peak of last August’s financial market panic.

A few of the worst times to be in the market! I’d like to add that the 1987 and 1998 episodes came at the bottom of the bear, not at the top. 1973 was the only time leadership was so dismal at the beginning of a bear market. And it has happened twice in the current cycle while it only happened once in each of the others. The odds of stagflation are continually increasing and the Fed seems more than willing to keep pushing our economy in that inevitable direction. In interview with CNNMoney.com, Jim Rogers discusses the Stagflation outcome. The article says, “Rogers looks at the Fed’s willingness to add liquidity to an already inflationary environment and sees the history of the 1970’s repeating itself.” And then the author asks Rogers if that means Stagflation and he responds, “It is a real danger and, in fact, a probability.”

One more fundamental change in the market needs to take place before my strategy “starts hitting on all cylinders” and I believe that we are the verge it happening. And more importantly, George Soros believes it on the verge of happening as well. The trend that is about to change is the direction of the bond prices. Since July, US treasuries have appreciated significantly in-spite of the heightened inflation pressures. Inflation typically leads to a discounting of bonds as investors need to be compensated for a loss in purchasing power. Soros says the following on the subject:

Because of the reluctance to hold US$’s and because of the inflationary threat, a point will come, when the lowering of the short-term rates will actually lead to long rates going up. I am actually surprised that interest rates have fallen as far as they have without a much more steepening of the yield curve. (source: Financial Times, Jan. 24, 2008)

(For those who unfamiliar with George Soros, he ran the Quantum Fund with Jim Rogers and has since managed his own Fund. Soros is known to be the man who “broke the Bank of England”. He is one of a handful of exceptionally successful investors whose opinion on economic matters should always be considered.) In addition to Soros, Nobel Prize winning economist Joseph Stiglitz agrees that long-rates will start moving up. In an interview at the Davos 2008 convention, he warned,

The biggest fear is that long-term bond rates won't come down in line with short-term rates. We'll have the reverse of what we've seen in recent years, and that is what is frightening the markets. The mechanism of monetary policy is ineffective in these circumstances. I'm not saying it won't work at all: it will help the banking system but the credit squeeze is going to go on because nobody trusts anybody else. The Fed is pushing on a string. (source: The Daily Telegraph)

I think the most compelling reason to believe that long-term rates will rise in-spite of falling short term rates is the sheer irony of it all. In 2004, then-current Fed Chairman Greenspan called it a “Conundrum” when long-term rates didn’t rise when he raised short-term rates. They didn’t rise because his policies resulted in such a substantial increase in the money supply that excess money flowed into treasuries driving up the demand for bonds which kept rates low. Currently, Soros and Stiglitz (and myself) are making the case that the Fed’s excessive money creation has lead to an increase in inflationary pressures and a weakened US$. Consequently, long-term rates must rise to compensate investors for inflation. And it gets worse, when more money is created by the current Fed by keeping short-term rates low it will invariably lead to even more upward pressure on long-term rates. In conclusion, the Fed inflated the money supply so much that it kept long-term rates from rising when they wanted them to rise and conversely will cause long-term rates to rise when they don’t want them to. The irony is that their “Conundrum” is of their own making. And this sums up why I have long argued that both equities and bonds would depreciate in the next cyclical bear market as inflationary pressures persisted in the face of a weakening economy leading to Stagflation. (You can read more in my Market Outlook) Obviously, we are well positioned to take advantage of these trends however the capital markets are having a difficult time accepting this outcome. The most compelling evidence of Wall Street’s denial of Stagflation is the recent reversal in the relationship between Gold and Bonds which I addressed in detail in my November Month-end Update (Portfolio Update for 11/30/07). Once treasuries start depreciating due to inflation concerns, the last bastion of safety will be the Precious Metals. Since May of 2005 through late 2007, there has been a strong positive correlation between equities and precious metals, which is contrary to the historical norm. The positive relationship between these two assets classes is beginning to break down. However, whenever there is a threat of a liquidity event, the PMs have sold off along with equities while treasuries have rallied. Once treasuries are no longer considered a safe-haven because of inflation and a depreciating US$, it will be time for Gold and Silver to rally during equity liquidations. And once this happens, get ready for fireworks in the PM space! (And maybe the mining stocks will come along for the party, which would be a nice change from the last several months!)

This market will provide some incredible opportunities for those who can position themselves to take advantage of the appropriate trends and not be thrown off by excessive market volatility. Unfortunately, most investment advisors have no idea how to profit from this opportunity and conversely will lose substantial amounts of their clients’ money holding onto ill-fated investment strategies from the 90’s. Equity investors will not be the only people who will find themselves short-changed by the current market cycle. The inflation created by the Fed is ravaging our nation’s retirees of their purchasing power. It pains me to hear my 89-year old grandmother tell me about how increasingly difficult it is for her to meet her basic financial needs as inflation has eroded her purchasing power. Utility bills shock her every month. Her monthly dues for her retirement community increase at a far faster rate than her social security income. I think it is tragic that the Fed is robbing our nation’s “Greatest Generation” of their purchasing power in order to bail out a bunch of unscrupulous banks, mortgage lenders and Wall Street firms. Since August, when the Fed went on their monetary inflation binge, there has been an unprecedented amount of commodity inflation. The CRB Commodity index has appreciated over 20%. The foodstuffs and grains indexes have gained 11.6% and 36.2% respectively while the energy index has increased 21.1% – in just five months! Over the past six years, the CRB index is up over 160%. Retirees have not been able to achieve adequate yields in fixed income instruments to offset inflation – of course, that is about to change. While social security benefits increase in line with the CPI, food and energy necessities only comprise one-third of the CPI index while the other two-thirds are comprised of non-essential items such as cars, computers, electronics, ect. The costs for these items are hedonically adjusted by the BLS to understate the reality of inflation. According to Shadowstats.com, if we calculated CPI today as we did prior to the Clinton administration, it would be in the 6-7% range with a significant uptick in late 2007. I’m optimistic about the returns I can generate in your account, but my enthusiasm is tempered when I think about the millions of retirees who can ill afford higher living expenses. Our profits, unfortunately, will be the result of many others’ hardships – but I can’t change the markets. I don’t understand why retirement advocacy groups, such as AARP, are not taking a stronger stance against inflation. The good news is that market volatility provides opportunity and I’ll do my best to take advantage of this volatility in whatever asset class I see provides the best opportunity on a risk-adjusted basis. As always, please do not hesitate to contact me if you have any questions or concerns regarding your account. All the best, Matt