Portfolio Update - 05/31/2007

By proceeding, I acknowledge that I have read and understood the Disclaimer, Performance Reporting Disclosure and Copyright Statements . Dear Clients, As I was putting notes together for this month’s update, I came across an interesting piece from Ed Easterling of Crestmont Research. It’s titled “Capture: Less Ups Needed if You Avoid Downs”. The purpose of his research was to answer the following question:

What percent of the gains during positive months is needed to match a buy and hold strategy if an investor avoids the declines?...The answer: if an investor can avoid the losses, it takes only 28% of the positive gains to match the market! (emphasis mine)

Easterling used the S&P 500 Benchmark index from 1956 – 2005 for his data. (I’ll send you a hard copy of Easterling’s work in my written update next month. In the interim, you can check it out by http://www.crestmontresearch.com/pdfs/Stock%20Capture.pdf ">Clicking here.) Easterling’s study does exclude dividends from his data, but if you assume that the interest you earn in cash while out of the market is equal to the dividend yield, then the two would wash out. (In 2000, the yield on cash would have been much more than the dividend yield of the market but by 2002, dividends would have exceeded earnings in a cash account. Currently, the money market account I use for your account is paying approximately 3% more than the dividend yield on the S&P.)

If you recall, I sent you a similar piece in my January, Quarterly update. (I also posted my work on this website which you can view by http://www.investorsadv.com/personal/by-matt/financial_planning_03/ ">Clicking here). The primary difference in my research and Easterling’s is that he used the S&P ex-dividends from 1956 to present while I used the Dow Jones Industrial Index (DJI) and included Dividends from 1920 to present. Also, he did his calculations on a monthly basis where as I calculated it on a yearly basis. (I originally got the idea from another piece that Easterling did.) My figures showed that you needed to participate in approximately 70% of the up years of the market in order to breakeven with a buy and hold strategy. Since the DJI is not as volatile as the S&P, the impact of volatility is more muted. This partially explains why Easterling’s research came up with a much lower figure. (The other predominate reason for the discrepancy in our work is that he uses monthly data and I used annual data.) I reran the numbers on my spreadsheet to include a 3% yield on cash during periods when the account was not invested in the market and determined that if a person participated in 61.5% of the up years and missed all the down years, then they would have matched a buy and hold strategy in the DJI. (Earning 0% in cash, you would have capture 68.5% of the up years which I rounded up to 70% and that is the figure I used in my January update.) Regardless if you use my data or Easterling’s, the conclusion is the same. Missing out on some gains is certainly worthwhile if you can miss out on all the downs. And this doesn’t account for the psychological toll of losing money in a bear market. Losing out on gains in an ageing bull market can be frustrating but losing money in bear market can be heartbreaking. If the market continues to appreciate, there are a few key ideas to keep in mind.

1. Stocks will be much, much cheaper at some point in the next 24 months than they are today.
2. The market is still in the midst of its 2^nd longest run without a 10% correction. This is the 4^th longest equity bull market in the last 100 hundred years.
3. Markets go down much faster than they go up so any gradual gains that we are currently missing out on will get wiped out relatively quickly.

With all that said, let’s take a look at how my portfolio’s stack up against the market indexes and my benchmark:

So what has happened in the last few months to cause my portfolios to down while the markets continue to go up. As you know, my portfolios are positioned to profit in an inflationary/stagflationary environment. Quite frankly, the market is ignoring the reality of inflation which has impeded my investment strategy. If inflation was a concern for the market, yields on everything would be increasing, not decreasing. Inflation discounts future income streams provided by income producing investments such as bonds, REITs and Dividend paying stocks (i.e. Utility and Financial stocks). Here is substantial support for the idea that the market is ignoring inflationary pressures by keeping investment yields at historic lows.

• According to Robert Kessler of The Kessler Companies, the Yield on Utility stocks is at it’s lowest since 1930.
• Yield on Moody’s AAA bonds is 5.5%, the lowest since 1966. The average yield for these bonds from 1970 through 2000 was 9% - 65% above current levels.
• According to NAREIT, the average REIT Yield is around 3.5%. The average from 1988 (when REITs were first being tracked by NAREIT) through 2000 was 6.4%. The only time during this period that yields dropped below 4% was during the ’91 recession. (REIT yields are incredibly susceptible to economic slowdowns. http://www.investorsadv.com/market-commentary/by-matt/reit-yields-the-fr... "> Click here to read more.) If the payout on REITs doesn’t decline, as it has in every previous recession, REITs would have to suffer a 40% price depreciate to bring the yield in line with their historical average. If the next recession causes a decline in REIT payouts, they will have to fall much further to reach their historical averages.
• Inverted yield curve. I’ve beaten this subject to death. An inverted yield curve denotes the market’s anticipation of deflation, not inflation. If the market had high expectations of inflation, the yield curve would be steeply positive.
• The CRB Index hit another record high in May at 411.74. While inflation is caused by excessive liquidity, it is measured in prices and the CRB index is one of the most timely and effective means of measuring price inflation.

If the market was concerned with inflation, these yields would not be at historic lows. There are only two explanations why yields would remain this low given the increasing inflation pressures in the worldwide economy. First, despite true fundamentals, inflationary expectations are low on Wall Street due to the dip in energy prices and industrial metals last fall and the slowdown in housing. Second, excessive worldwide liquidity has led to too much money chasing too few investments resulting in price appreciation in everything including income-oriented investments. The popular term for such an event is a “credit bubble”. They’ve happened before and rarely do they end well. What I find most surprising is that even the Federal Reserve is acknowledging the inflation issue that Wall Street continues to ignore. The following was the Associated Press’ take on the May Fed Minutes:

Concerns about inflation trumped worries about the slumping housing market last month in the minds of Federal Researve officials who voted to hold interest rates steady…While Fed officials said the downturn in housing was turning out to be more severe than expected, worries about inflation continued to dominate the May 9 discussions among [the Fed]… “Nearly all participants viewed core inflation as remaining uncomfortably high and stressed the importance of further moderation,” the minutes said.

Fundamental economics states that excess liquidity always causes inflation. PERIOD! You cannot have excessive liquidity and low inflation. As long as central banks worldwide, most notably the US and Japan, keep pumping money into the financial system, inflation will persist. The following fundamental data provides a strong case for inflation.

• The CRB Index which measures the prices of all raw materials is up 4.3% YTD and 8.4% for the trailing 12 months. The index is up over 115% since 1/1/2002 which means the average price of all the stuff you buy at the gas station, grocery store, ect has more than doubled in the last 6+ years.
• According to AAA, the average tank of regular unleaded cost $3.22 last week, the highest ever and close to its inflation-adjusted high from 1980.
• The CRB Foodstuffs Sub-index and Energy Sub-index are up over 15% YTD. This is the stuff that we consume everyday. While the Fed can hedonically adjust the price of many items lower when calculating the CPI, it can’t adjust the cost of food and energy. (Which is why it promotes the figure that excludes these items)

I feel like I’m “preaching to the choir”. You’re certainly aware of the painful reality of inflation as you buy gas, groceries and utilities. But if you would like a some more information on the inflation picture, you can check out my Stagflation Alert that I originally posted in April but am updating each month. I will be posting an update to it in the next couple of days. http://www.investorsadv.com/market-commentary/by-matt/stagflation/ "> Click here for the original post..) So, here’s my conundrum and the basic root cause for my portfolio’s lousy short-term performance. If inflation is for real, which I am convinced that it is, Precious metals will outperform equities over the next couple of years. However, if there is a liquidity crunch, both equities and Precious Metals will decline precipitously. So my challenge is to take advantage of the long-term potential of precious metals while protecting your account against what could be a painful short-term liquidity squeeze. My solution was to take a significant long position in the I-shares Silver ETF (SLV) and Streetracks Gold ETF (GLD) plus a few Precious Metals mining shares while taking a mild short bias in US equities and treasuries. I increased my short equity position as the technical strength in market breadth and leadership deteriorated starting in April. In retrospect, it would have been wiser to allocate a larger portion to my short US treasuries position which has made some money. Despite the overwhelming fundamental evidence for higher inflation, the glut of worldwide liquidity has continued to push equity and bond prices up. While the fundamental case for Gold and Silver continues to improve (i.e. the price of commodities is increasing leading to more inflation), the price of Gold and Silver has declined over the last few months. Furthermore, while the fundamental case for equities continues to deteriorate, the price of equities continues to appreciate. Fortunately, I shorted Financials and Small-caps which have underperformed the broad market, but they have still appreciated causing my positions to lose money. Compound this will declining metals and my portfolios have taken a decent hit. I’m confident that one of two events will take place resulting in a major sell-off in the equity markets. Either the market will realize the mounting inflationary pressures in the economy combined with slow economic growth (Stagflation) or we’ll see a liquidity crunch which may be caused by one of the following stimulus:

• Unwinding of Yen Carry Trade: This is looking to be less and less likely to happen in the near term as Japan’s Central Bank remains dovish despite worldwide commodity inflation. Their continued dovish has resulted in the Yen being at all-time lows compared to the Euro and at multi-year lows compared to the US$. The Yen would have to experience a significant rally to choke off the carry-trade. It might happen so it’s worth watching.
• Hedge Fund Implosion: If Hedge Funds start falling apart, which they most likely will at some point, the velocity of money coming out of the market will be devastating. I’ve touched on this in past updates but it’s worth revisiting. Due to the excessive leverage used by Hedge Funds, every $1 investors pull out of hedge funds will result in these funds liquidating $5-$10 of market exposure. (According to Bloomberg, Goldman Sach’s largest hedge fund is down over 5% YTD.)
• The Fed raises rates further: Unlikely to happen as long as the housing slump is still taking its toll on the economy. Net of inflation, the economy barely grew in the first quarter. However the Fed is in a difficult spot since the only way for them to save the US$ is to keep rates high. It’s troubling that the US$ is near an all-time low and 14 consecutive rate hikes and no rate cuts in site.
• Continued deterioration in the Mortgage Industry. Recently, the media has been relatively quiet about the sub-prime mess that everyone was focusing on late last year, but foreclosures are still increasing significantly. If mortgage defaults continue, as they most likely will, it could have a significant domino effect on consumer spending and market liquidity. In case you’re wondering who owns all those mortgages that we created in the US, the answer might surprise you because it is not the mortgage companies. They are owned by investment banks, foreign central banks, hedge funds and individual investors. In the last 12 months, homebuilding stocks have languished at multi-year lows and over 80 mortgage lenders have closed their doors. However, the securities that investment bankers created from these mortgages have continued to appreciate. It doesn’t make sense housing and mortgage originators have taken it on the chin but the at-risk existing mortgages have escaped unfazed. For this reason I felt compelled to short the Financials who will take the biggest hit if the sub-prime mess isn’t “contained” as Wall Street repeatedly claims that it is.

Conclusion: On Sunday morning, our pastor used an analogy that is appropriate for investing as it is for living. He was discussing the importance of taking a long-term view of life and not getting distracted by the short-term swings. The analogy he used was driving through a “Texas Rainstorm” – the kind we have become all too familiar with over the past few weeks. He stated that it’s of critical importance that “you don’t watch the windshield wipers” when you’re driving through a “gullywasher”. In the short-term, I’ve been on the wrong side of the market but at some point, market fundamentals will take hold and overcome the emotional mania gripping Wall Street. As a prudent investment advisor, I have to stay focused on long-term fundamentals and not short-term market swings. I’m not sure when this ageing bull market will end but until then, you can expect my portfolio to continue sideways. But when the trends that I’m seeing start to take hold, I’m confident we’ll see some substantial profits in your accounts. An inflation-induced bear market is very rare. It’s only happened twice in the last 80+ years (’37 & ’73) so it’s understandable why Wall Street has been slow to recognize what is taking place in our economy. Typically, a bear market starts as a slowing economy preempts a recession. However, inflation in prices is masking economic weakness as measured by GDP. First quarter’s Real GDP was just revised downward to 0.6% primarily due to the GDP deflator which eliminates inflation from Nominal GDP to arrive at Real GDP. In ’37 and ’73 Equity prices fell 50% in less than 15 months. Because inflation induced bear markets are rare, it catches investors by surprise leading to a sharper and more significant sell-off than traditional bear markets. When I started studying these trends last year, I had a difficult time believing that equities could lose 50% in less than a year and half but now it’s becoming more evident how such a sell-off could happen. I’ll close this update with a well-known quote by the world’s most renown investor, Warren Buffett: Rule #1 in investing is “Don’t Lose Money.” Rule #2 is “Don’t Forget Rule #1”. While you’re account has suffered a minor setback so far this year, I’m confident that the gains we’ll make and the losses we’ll avoid in the next bear market will far outweigh any short-term setbacks we’ve experienced. “Keep you eyes on the road and don’t focus on the wipers.” As always, call me if you have any questions or concerns about your account. All the best, Matt