Portfolio Update - 10/31/2007
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What if, on New Year’s Eve of last year, you knew the following would take place by the end of October…
- New Home Starts would be down by over 30%…
- New Home Sales would be down by over 34%…
- Existing Home Sales down by nearly 20%…
- We’d have the first significant decline in home sales prices since 1930…
- Oil would be over $94/barrel…
- YOY gasoline prices up would be up 31%…
- Commodity inflation would be in excess of 15%…
- Food prices would be up over 17%…
- The US$ would be down over 9%…
- Earnings growth for the S&P 500 would be flat to down in Q3…
- And Consumer Confidence and Sentiment would be down 14 & 12 points, respectively…
What would you have predicted for equity prices?
But wait, there’s more…
What if you knew that a hand full of prominent hedge funds would implode by mid-year?
And that our nation’s biggest banks would have created these neat little entities called SIVs (Structured Investment Vehicles) for the purpose of taking advantage of mark-to-market accounting for pricing assets of questionable value - just the way Enron did a half a decade ago. And as an additional bonus, these SIVs allowed banks to move undesirable assets off their balance sheets to help improve financial ratios to meet reserve requirements – and when news of this broke, the equity markets saw it as a good thing and financial stocks rallied!
If you knew all of this at the beginning of the year, would you have predicted that by October, the Dow and S&P 500 would be trading at historical highs and the NASDAQ 100 would be up nearly 30% YTD. I certainly know I would not – which is why I’ve felt compelled to be out of the equity markets - which is a strategy this is finally paying off.
Here is how my performance measured up to the averages on a YTD basis through October:
| PORTFOLIO | |
| The MAC’s Core Portfolio | |
| The MAC’s Focus Portfolio | |
| S&P 500 (VFINX) | |
| NASDAQ 100 (QQQQ) | |
| Benchmark |
When I first sat down to write this update on Thursday, I wrote the following: “The last few months have been profitable for your portfolios as the market begins to price in inflation and credit risks but we still have a little catching up to do before I reach parity with my benchmark. But as I sat down to finish my market outlook over the weekend, I downloaded updated account information to find that we have finally caught up to our benchmark after a strong showing in the first couple of days in November. As of the close of business on Friday, my “Core Portfolio” was up 8.7%, just a 1/10th of a percent below my benchmark which is up 8.8%.
While I’m certainly not satisfied with my performance on a YTD basis, the returns in your account for the second half of the year are fairly impressive thus far. I appreciate your patience with my investment strategy and I’m glad that you are finally enjoying some appreciable gains.
The capital markets are starting to price in the possibility of Stagflation, which is why my strategy is working so well. Fundamentally, we know that this undesirable outcome for Wall Street is becoming more and more probable. (For an update look at the Stagflation picture, click here.)
However, there are still some severe short-term disconnects between certain asset classes that do not make any rational sense. The most prominent disconnect is between bond yields and precious metals. Since the beginning of July, Gold has increased over 20%, while yields on 10-year treasury notes have declined over 13%. Over the long-term, this relationship should never exist. Rising gold and falling bond prices are fundamentally opposed to one another.
There are two plausible explanations for why these trends can coexist on a short-term basis and the good news for your portfolio is that both support my investment strategy. The first explanation is that the market is being torn between higher inflation and a slowing economy (i.e. Stagflation). The gold market realizes that inflation pressures are mounting and will not subside anytime in the near future unless the Fed does a “complete 180” which is unlikely. The bond market, being controlled primarily by Wall Street’s minions who are in denial about inflation, see weakening economic data and are convinced that bonds are the only way to hedge the risk of falling equity prices.
The second explanation is the liquidity story. There is so much excessive liquidity in the markets that it is driving up the demand and therefore prices of all securities, including bonds and gold. Excessive liquidity or monetary inflation always leads to price inflation. While both themes are likely playing a role in the abnormal behavior of bonds relative to gold, I would contend that the liquidity situation is more responsible for the divergence than any other factor. Just last week, the Fed injected $41B into the markets which is the largest injection since 9/11/01. Excess liquidity always leads to price inflation and we’re positioned to take advantage of any further inflationary pressures.
It will be interesting to see how the market digests a YOY CPI figure north of 3.5% that will be reported by the middle of the month, well above the Fed’s “comfort zone” of 2%. While some will point to a lower “core” figure, eventually the Fed has to acknowledge that inflation in food and energy impacts our economy and that food and energy prices are increasing at a far faster rate then products that make up the “core” number.
The justification for excluding food and energy is that it is too volatile to use as a measurement on a month to month basis, but when price increases for “necessary” goods outstrips “hedonically-adjusted” prices for “core” goods several years running, it is time to face facts. Real inflation pressures are robbing our nation’s citizens, especially its retirees, of their purchasing power.
Market internals are a mixed bag of bearish and neutral indicators that are not giving a clear indicator of market direction. As I’ve stated in previous updates, I am cautious about the validity of some of these indicators for various reasons but they should never be ignored. In the bullish or neutral camp is breadth and a more favorable bond market environment. On the bearish side, leadership is weak and the US$ and Consumer Sentiment have declined significantly. I have a theory that weakness in the US$ is disguising weakness in market internals as most analysts measure technical indicators in US$’s rather than in a trade-weighted currency index.
Also in the bullish camp is the idea that we are entering a seasonally strong period for equities and commodities. Historically, the majority of equity gains have taken place from November through April, which is the impetus for the “Sell in May and go away” investment strategy. However, the worst two bear markets in the last 40 years (’73 & 2000) both started during this seasonally strong period for stocks.
We know that fundamentally stocks and bonds are expensive by all historical standards, especially in light of the inflation picture. What I don’t know is when the market will reprice stocks and bonds in line with their intrinsic value, or even better, below their intrinsic value. Due to the seasonality of equities, it could be next year before the equity bear market really takes hold. On the contrary, given the monumental weakness in the US$, inflation pressures and the issues with the credit markets, the equity market may turn down before year-end as the cracks in the fundamental foundation for equities and bonds finally give way.
The fundamental data is increasingly building the case for Stagflation. I haven’t seen anything in the past couple of months to suggest otherwise. I will continue to invest your portfolio to take advantage of this theme to the best of my ability.
If the equity markets rally or trade sideways through the end of the year, I expect the strongest sectors will be those that are already up for the year such as Energy and Tech. Investors won’t want to create a tax liability by selling assets with unrecognized gains. Weak sectors should continue to show weakness as investment advisors won’t want to jeopardize YTD returns by adding vulnerable assets. If there is another liquidity event, everything will likely sell-off just as it did in August, but I’m confident that the precious metals will perform better on a relative basis than they did in August.
As always, please do not hesitate to contact me if you have any questions or concerns about your account.
All the best,
Matt McCracken
