Portfolio Update - 05/29/08
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Dear Clients,
The following is my Performance Update and Outlook for May. All prices and returns are as of 05/29/08.
Inflation’s back…
Cover of the May 24th Economist
Just as the smoke has cleared from Act I of the credit crunch, everyone is now up in arms about inflation. While the threat of inflation is real and growing, unfortunately, the credit crunch has not played itself out. In fact, the curtain maybe just going up on Act II which I’ll discuss in Part IIIb of this update.
I’ve started to find myself in pretty good company as more and more investing legends are coming around to the probability of Stagflation. On May 20th, Yahoo Finance wrote the following regarding Warren Buffet’s and George Soros’ views on the economy, inflation and the credit crunch.
Soros was particularly concerned about inflation, which is front and center today as crude prices surge toward $130 and core PPI was higher than expected…While the less dramatic than the uber-skeptical Soros, Buffett was certainly direct in his assessment that the credit crunch is not over, contrary to popular belief on Wall Street. “I don’t think the effects of the credit crunch are far from over at all,” Buffett said during a presentation in Europe, according to wire reports. “I think there will be rippling, tertiary effects.”
Bill Gross, CIO of PIMCO Funds and manager of the world’s largest bond fund, is the latest guru to throw himself into the inflation camp which I find odd since he was a proponent of lower rates last year which would have resulted in more inflation. He says in his June Investment Outlook, “…we’ve been foolin’ ourselves [believing] that inflation is under control.” (when he says “ourselves” he is making a general reference to US citizens – not to himself.)
Of course, the continuing inflation in our economy is not surprising as it is a necessary evil. Our government must continue with its inflationary policy to finance trade and budget deficits. They are seeking to repay our debt to foreigners with a discounted currency. Its not an ideal situation but it is likely better than the alternative. Until the US becomes more fiscally responsible with individuals becoming net-savers, industry becoming net producers and government maintaining balanced budgets, inflation is imperative.
Here is how my performance measured up to the averages for the first five months of 2008:
| PORTFOLIO | ||
| The MAC’s Core Portfolio | ||
| The MAC’s Focus Portfolio | ||
| S&P 500 (VFINX) | ||
| NASDAQ 100 (QQQQ) | ||
| Benchmark |
Nothing in the portfolio earned remarkable gains for the month but on average we came out ahead of both the equity markets and my benchmark. And for the year, we are still far ahead of the major indexes. I track about a half-dozen of the best performing Market Neutral mutual funds and none of them are within 4% of my YTD performance in my Core Portfolio.
The most encouraging development in May was the relative performance of the mining stocks. I bought into these shares far too early and while averaging down has softened the blow, there are some fairly significant unrealized losses in these positions. They represent a small portion of your account so the losses in these shares have had a nominal impact compared to the gains we’ve made in the rest of our portfolio. The performance of the mining shares has baffled many of the analysts that I follow but as I’ve contended for six months now, I think they are due to outperform the actual metals.
I have rebuilt all of the commodity exposure that I had liquidated early in the year. These positions are down since I repurchased them this month which hurt May’s performance, but the repurchase price was far below what I liquidated them for back in late February. Our YTD gains in these funds is still very positive.
I believe the pieces are continuing to fall into place for an incredibly strong performance in Q3. The current equity rally may or may not have some legs so it will be interesting to see how it plays out in June. When the countertrend rally in equities is exhausted and the bear market trend resumes, I think we’ll see impressive gains.
Given that the financial crisis is far from over, that corporate profits will unlikely rebound strongly for the foreseeable future and that the outlook for inflation is unfavorable (higher interest rates), we remain extremely defensive.
- Marc Faber, June Market Commentary -
The fundamental picture for domestic bonds and equities continues to deteriorate. The odds of a Stagflation economy are increasing which will have serious implications for the capital markets. While there are a few hurdles that this bear market needs to get over before continuing in earnest, the long-term outlook for equities is miserable.
There are few significant developments this month that I’d like to address. And I just updated my
Stagflation Alert post if you would like to check it out.
Technical strength
There is not much to update here, which is news in and of itself. Despite the uptrend in equities, there is still no leadership in the equity markets. In the last week in May, more stocks hit 52 week lows than highs, even though the Wilshire 5000 index advanced every day last week and is less than 10% off of its 52 week high. This is not the type of leadership we should be seeing if we were truly entering a bull market.
Breadth is flat which typically signals no immediate move one way or the other. The relative strength of the market does suggest weakness over the next few weeks but this indicator could easily turn bullish.
Perceived Market Risk (aka. the ^VIX Index)
The CBOE Volatility Index or the ^VIX is a measure of option activity in the marketplace. It is generally assumed that the lower the ^VIX index the less perceived risk there is by market participants. This index serves as a valuable contrarian indicator as when perceived risk is low, market participants are overly confident in equities.
The ^VIX index hit a historical low in early 2007 before shooting up when whispers of the credit crunch began working their way through the markets. The index peaked in March of this year just before the BSC bailout and has fallen precipitously since then. The index has formed a double bottom which may or may not hold. If the double bottom holds, it means the index is headed higher which is not good for stocks.
Consumer Strength
Consumer Confidence and Sentiment are at 16 and 27 year lows, respectively. The S&P Retail index is nearly 25% off its 52 week high. GM is at a 27-year low and GE hit it’s 52 week low in May which suggests that that the weakness in the stock market is not isolated to just the banks.
Probably the most disturbing development for me personally has been the number of my young clients dipping into their savings to meet daily expenses. Over half of my clients under the age of 40 have inquired about liquidating their IRA accounts and about a quarter have actually withdrawn money from their IRA’s despite the steep penalties and my verbal berating. What is most discouraging is that in every single case, with one exception, the individual has not suffered any hardship (i.e. loss of job or medical emergency). They are dipping into savings purely to finance daily living expenses. The Housing ATM is shut down, credit cards are maxed out and the only thing left is 401k and IRA savings. Eventually, consumers are going to have to curb discretionary spending.
Bond Yields
Treasury bond yields increased substantially in May as investors looked past the credit crunch and focused on inflation. The 10-year US Treasury bond rate increased from 3.75% to 4.05%. This is a critical development as higher treasury rates lead to higher borrowing costs for consumers and businesses alike.
The relative strength in bonds is weak meaning bonds should continue depreciating resulting in increasing yields. This development is the lynchpin in my Stagflation strategy. I’ve been saying for some time, that in order for your account to appreciate substantially, we need to see bonds and equities fall in unison. (For more about this subject, please read Part IV of my January 2008 Update.)
Rising interest rates as a result of inflation wreaks havoc on equity markets for two reasons. First, and most obvious, is that inflation impacts company earnings in two ways. Either rising input costs puts a squeeze on margins or if companies pass rising costs on to their customers, higher prices reduces the demand for end products. For example, Dow Chemical announced on May 28th, that they would raise prices up to 20% to offset the soaring costs of raw materials. (source: Associated Press)
But the other impact is that rising interest rates results in equity valuation contraction. According to the Dow Theory, the foundation for valuating equities is in part based on the opportunity costs of owning risk-free treasuries (and by risk-free, they mean default free as inflation is a big risk to “risk-free” treasuries.) So, as inflation discounts future income streams, risk-free treasuries must provide a higher yield. Consequently, if bonds are providing a higher yield, then the yield one receives from owning equities must appreciate as well. But if earnings are falling, the only means of achieving a higher yield on equities, or you could say lower equity valuations, is for prices to fall.
Energy Prices
The big news from capital markets this month was the precipitous increase in energy prices. Oil hit $130+/bbl and gasoline is near the $4/gln mark. The rise in crude prices over the past year is truly remarkable.
In my Market Outlook which I posted last July, I state that the next surge in energy prices will be supply driven rather than demand driven. There is several pieces of evidence that supports this hypothesis and I’ll like to address two of them.
First, refinery utilization is down considerably from the last few years. In May of ’07, Capacity Utilization was over 90% where as it was under 87% this past month. With today’s gasoline prices, refiners would be running all out if there was ample supplies of crude.
Second, the disparity between diesel and gasoline prices suggests that the current energy crunch is due to falling supply. Our nation’s refiners are set up to make a certain ratio of gasoline, diesel, jet fuel, ect. Diesel demand is more inelastic than gasoline because it is an industrial fuel while gasoline is largely a consumer fuel. It is easier for individuals to curb gasoline consumption by carpooling, limiting trips to the store, ect. But is it difficult for rigs pulling a full load to consume any less diesel. When total demand for fuel falls, the demand for gas will fall faster than the demand for diesel because it is more elastic. Therefore, as the price of gasoline decreases relative to diesel, it suggests that overall fuel demand is falling. And if demand is falling, the only explanation for higher prices is declining supplies.
Before continuing, I would like to address the issue of the impact that speculators have on the price of energy. The claim made by our government and the media that speculators are partially to blame for the run-up in energy prices is utter nonsense. While speculators may have a short-term impact on the price of any consumable commodity (i.e. all commodities except Precious Metals), the long-term price is set purely by supply and demand. The derivatives market for commodities is a zero-sum game that in the long-term has absolutely no impact on the price of any commodity. The following quote appeared in last week’s Economist regarding this issue.
Stuck for answers [regarding the rise in energy prices], politicians have been looking for scapegoats. Top of the list are the speculators profiting from other people’s hardship…But that is plain wrong. Such speculators do not own real oil. Every barrel they buy in the futures markets they sell back again before the contract ends. That may raise the price of “paper barrels”, but not of the black stuff refiners turn into petrol. It is true that high futures prices could lead someone to hoard oil today in the hope of a higher price tomorrow. But inventories are not especially full just now and there are few signs of hoarding.
All futures contracts have to eventually be delivered at the spot price so if speculators were driving up the price of futures, they would get cleaned out at physical delivery. Other ways to play movements in the price of energy commodities is swaps and options which are both purely paper bets and a zero-sum game. For every winner in these markets there is a loser.
The truth is that reckless monetary policy by central banks worldwide coupled with massive trade deficits in the western world has created a surge in demand in emerging economies. And now that energy production and supplies are declining, these two trends are colliding resulting in a formidable impact on the price of energy products.
Over the next several weeks, I think it is probable that the Credit Crunch will rear its ugly head once again. I’ve said all along that the Financials will lead the market in which ever direction it is headed. They led the market down all of 2007 and conversely led it higher starting in the Feb/Mar timeframe this year. In the month of May, financials significantly underperformed the market. The I-shares Financial Sector ETF (IYF) lost over 8% since 5/3/08 while the S&P 500 index was essentially flat. The performance disparity between these two indexes in the month of May was comparable to July and November of last year.
The action in the Credit Default Swaps (CDSs) for some of the largest investment banks is providing the most acute evidence that the next wave of the Credit Crunch is upon us. Lehman Brothers and Merrill Lynch saw massive jumps in the price of their CDS’s over the past two weeks. The price to insure yourself against a default in Lehman’s bonds more than doubled in the span of 10 business days.
Many financial stocks are nearing their 52 week lows from early March. IYF is less than 7% from its 52 week low.
The write-downs from the credit crisis are far from over. It was just a few months ago that Jim Cramer on his infamous show Mad Money stated that “The Financials of the Financials cannot be trusted.” Warren Buffet said recently in a news conference that “You’ve got a lot of leeway in running a bank to not tell the truth for a quite a while.” The Enron-like accounting games played by the investment and traditional banks are not over. There will be even more write-downs over the next couple of years.
Supporting the idea of the continuing credit crunch is a report from Fitch’s. They state that bondholders for 1/3 of all junk bonds going into default will not receive more than 10 cents on the dollar. Another 1/5 will likely get no more than 30 cents on the dollar. This compares to a historical recovery rate in the range of 45 cents on the dollar. Global defaults in 2008 have already surpassed the total for all of last year by 25%. Standard and Poor’s “optimistic” estimate of 2008 defaults is three times last year’s level! (source: Bloomberg)
If these predictions by S&P and Fitch’s hold true, the owners of the collateral, primarily the large banks, will suffer catastrophic write-downs as many have yet to discount their junk bond holdings. Given the precariously overleveraged balance sheets of the banks, any significant writedowns could spell DISASTER.
The following quote comes from a RBC Capital analyst named Gerard Cassidy via Marc Faber’s most recent newsletter…
We continue to believe the biggest issue confronting the banking industry over the next 12-18 months will be credit deterioration. Residential mortgage delinquencies are at record levels, home equity loan defaults are steadily rising and residential construction and land loan nonperforming assets are skyrocketing for lenders with excess exposure to the weakest housing markets in the US. The “Next Shoes to Drop” for credit in conjunction with the slower economy will be in the commercial and industrial and commercial real estate loan areas.
The intermediate-term outlook for equities is poor and the short-term outlook is neutral at best. The next month will be interesting as equity markets could go in either direction. But when the more dominant bear market trend reestablishes itself, I think I have your account positioned to take advantage of it.
Q2 is a seasonally weak period for the non-cyclical commodity plays in my model portfolios. Conversely, Q3 has historically been a very strong period for these same commodities so while I’m not sure what June will hold for these positions, I’m confident that they should do well in the second half of the year.
However, I always try to maintain a healthy skepticism about my strategy. My biggest current concern is how a pullback in the energy space might impact our precious metal exposure. The Gold:Oil ratio is at its lowest level ever, except immediately after Hurricane Katrina, so I would expect that Gold and Silver would be partially insulated from falling energy prices but there are no guarantees. The precious metals have historically done well when there is negative real interest rates as there are now. (The “real interest rate” is simply the nominal rate minus inflation. When inflation is higher than nominal rates then you have negative real rates.)
I’m also leery of the changing relationship between equities and the precious metals. From the summer of 2005 through Q3 of last year, these asset classes were exhibiting a strong positive correlation which is not the historical norm. This was mainly a factor of large infusions of liquidity into the capital markets as a result from loose monetary policy by central banks. The Credit Crunch resulted in liquidity being squeezed from capital markets as banks, hedge funds and private equity groups start to deleverage. This deleveraging process resulted in all asset classes falling last August. In order to account for the deleveraging risk, I had implemented a long-short strategy which took advantage of the secular bull market in commodities but shorted equities to hedge a massive deleveraging scenario.
In Q4 2007, as the credit crunch began to unfold, it seems that equity and precious metals finally decoupled, meaning they were no longer positively correlated. Over the past couple of months, it appears that not only have these assets classes decoupled, but now there is actually a negative correlation between them. This resulted in terrific volatility in your account over the past several months. If these assets classes remain negatively correlated, my strategy will be highly profitable once the bear market reasserts itself. However, there is a concern that a massive deleveraging event could bring everything down as money managers have to liquidate anything with a bid on it. I think this is unlikely but not entirely out of the realm of possibility. So, I’ll be keeping a close eye on the liquidity issues in the market and the relationship between equities and the precious metals to determine if it would be prudent to liquidate some of your precious metal exposure.
As always, please call me if you have any questions or concerns about your account.
Matt
