Portfolio Update - 07/31/07
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Well, that was abrupt
- Johh Hussman, Ph. D., 7/30/07 -
This is how Dr. Hussman started an article titled “Market Internals Go Negative”. I have theorized that the upcoming bear market would not only be more severe than average bear markets but that it would happen more abruptly as well. This theory, which I’ve discussed in great detail in prior updates, is based on the historical precedence set in previous Secular Bear Markets. The developments of the past week have lent considerable creditability to this theme.
I am reluctant to call the beginning of the bear market, but it is looking increasingly likely that the all-time highs reached by the broad markets in early July may very well be the highest levels the equity markets see for a few years. There are several things that need to occur to confirm the bear market, but if these events take place over the next few weeks, then I’ll tweak a few positions in your portfolio to better take advantage of a full-fledged bear market.
July was a good month for our portfolios as my Focus Strategy gained 4.2% and my Core Strategy gained 3.2% while the S&P 500 loss 3.2%. While one month’s performance is a relatively benign predictor of long-term results, the trends that have gained considerable traction over the past several months bode well for my long-term strategy. If these trends continue, I expect to see considerable appreciation in your account.
Here is how my performance measured up to the averages on a YTD basis through July:
| PORTFOLIO | |
| Core Portfolio | |
| Focus Portfolio | |
| S&P 500 (VFINX) | |
| NASDAQ 100 (QQQQ) | |
| Benchmark |
We did a fair amount of catching up but we still have more to do – and if the market trends continue, I think we could catch up quickly.
As I discussed in my previous update on July 24th, several trends have emerged that I have been anticipating. In addition to the themes I discussed in my last update (click here to read – or just scroll down as it’s the entry just prior to this one), several more developments have taken place in the short span of a week. I’ve added my editorial comments in italics.
- 7/31/07: American Home Mortgage – AHM - falls over 90% in one day. This trend will continue to have a devastating impact on financial stocks. IYR is now 18% below its February peak.
- 7/31/07: Sowood Capital Management liquated its two funds after suffering devastating losses in excess of 50%.(Read more below)
- 7/31/07: West Texas Intermediate Crude (CL) rose to an all-time record close of 78.21. The crude contract appreciated over 9% for the month. I’ve previously addressed the inevitable increase in Oil prices. (click here to read) I’ve positioned your portfolio to indirectly take advantage of energy prices by investing in Gold and Silver (PMs) but so far the PMs have shown a higher correlation to equities than they have to Oil and other commodities. This is highly unusual and at some point, the historical correlation between the PMs and other commodities will be reestablished.
- 7/31/07: The CBR Index increased 3.5% in July and is up 7.5% YTD. Obviously this is inflationary. The CRB index typcially appreciates more in the second half of the year than the first half. Currently, it wouldn’t be surprising to see the CRB index increase 10+% in 2007.
- 7/24/07: The US$ hit a new low on its trade weighted index, dancing with the critical support level of 80 before rallying at the end of the month. As of the close of business today, the US$ index is 1% from its critical support level of 80. The US$ was down 1.5% for the month. I keep hearing about market volatility, but what hasn’t got much media attention is the Yen volatility. 1% daily movements have become common in the last couple of weeks. If the Yen Carry Trade is wiped out – watch out!
- 7/30/07: Technical leadership in equity markets experienced a precipitous decline over the 5 previous days finally pushing this critical bear market indicator into positive territory. The extent of the decline has only been matched twice since the mid-1960’s. (Source: Investech) Seven of 11 indicators on my “Bear Market Hunter” are now signaling a bear market. The other four are neutral with a couple very close to being bearish.
- 7/31/07: Market volatility, measured by the VIX index, has more than doubled since Q2. An increase in volatility is typically a pre-cursor to a change in market direction. The DJI swung from a 100+ point gain to a 140 point loss in today’s trading action.
I came across an interesting article titled “The Crash that Could Come” which reinforces the themes I’ve positioned your account to take advantage of:
Investors and ordinary citizens have good reason to worry about a perfect economic storm: [1] A deepening loss of confidence in the dollar leading to higher interest rates, [2] the higher rates bringing a crashing end to a hedge-fund, private equity, and merger binge that has depended heavily on cheap borrowed money; [3] the boom in bait-and-switch mortgages ending in a morning-after of rising defaults and sinking housing values; [4] inflationary pressures in food, oil, and other commodities leading to still higher interest rates – all unsettingling stock and credit markets and putting a new squeeze on consumers borrowed to the hilt.(emphasis mine).
Robert Kuttner – Boston Globe, 7/30/07
In the movie A Perfect Storm, it was the confluence of 3 minor storms that created one devastating storm aptly called “The Perfect Storm”. Mr. Kuttner names four minor threats to our markets that when compounded could lead to devastating losses in equity and bond portfolios.
Another one bites the dust…
Strike up the Plano, Texas Senior High Band cause the school’s fight song is going to be the mantra for Wall Street and its Hedge Funds. Sowood joined the fray of Hedge Fund’s gone bad as it announced it is liquidating its two funds. (I’d provide a link to their website, but it would futile as it has already been taken down.)
Sowood, founded by a couple of smart guys from Harvard, liquidated itself after suffering 50% losses. Their portfolio primarily consisted of junk bonds. Not that CDO stuff that ravaged Bear Sterns but good ol’ run-of-the-mill junk bonds. What’s the difference? There is a liquid market for junk bonds where there is not one for CDO’s.
Bear Sterns pointed to the lack of liquidity as one of the primary reasons why their fund imploded. For the last 12 months, I’ve warned about a Hedge Fund Scandal and it is becoming increasingly apparent that one is inevitable.
The next few weeks and months will be interesting (and with a little bit of luck, profitable as well). If the bear market is upon us, it should be confirmed soon. The one concern I have is the behavior of the PMs. While inflation pressures persist, somehow inflation expectations are tepid. As soon as I see evidence that the PMs have shook off their correlation with equities, the trend reemerges. (Quite frankly, it’s becoming very annoying.)
This is not natural for PMs and at some point, they will reestablish their correlation with other commodities. When that occurs, we should do very well. Until then, I’m not exactly sure how our portfolios will perform. The impetus behind the equity sell-off has been a credit crunch and it’s taken the PMs with it.
I appreciate your patience and loyalty and I’m relatively certain that you’ll be rewarded over the next 12-24 months. As always, please do not hesitate to call me if you have questions or concerns about your account.
Matt
