Quarterly Commentary:
July 2005

The Forest and the Trees

It is our observation that most people understand risk, and understand reward, but not at the same time. Market dynamics suggest that investors currently have little appreciation for risk, and far greater concern of not catching a few points of meager gain. We are afraid. We are very afraid and, with apologies for repetition, argue our perspective:

• Excessively low interest rates, initially intended to cushion the bursting of the dot.com bubble, facilitated new asset bubbles in stocks, bonds and real estate.
• The stimulus of cheap money is now largely over. We are left with a marketplace of overleveraged or cyclically exhausted assets, disproportionately vulnerability to rising interest rates. Little potential reward, great risk.
• In spite of nine federal funds rate increases, interest rates still provide enough liquidity for a temporary stay of execution.
• Since almost every asset class overreacts to even the perception of the direction of interest rates, it is difficult to construct a diversified portfolio which is not unacceptably vulnerable to interest rate risk.
• Those securities exhibiting a bullish trend and are not directly rate sensitive, (oil, other commodities, and real estate at the moment) are volatile and few in number. Such a portfolio would be too concentrated and too volatile.

The Quarter in Review	2nd Q	YTD
Goldman Sachs Natural Resource Index (oil-weighted)	5.8%	19.0%
REITs	14.0	6.0
Foreign Equites (EFA)	0.0	0.0
S&P 500	0.8	-0.2
Nasdaq 100 (QQQQ)	2.5	-4.8
Gold	2.0	1.0
Lehman Aggregate Bond Index (AGG)	2.2	1.0

 

Aside from the occasional melodrama, most market sectors have essentially done nothing this year. There has been no trend and few themes, with the exception of oil and Google.

Volatility has been astonishing, as managed money whirls through markets looking for quarterly performance. For example, Southern Peru Copper, the second largest copper producer in the world, shot up almost 40% in less than six weeks… and then fell almost 45%, in spite of record earnings and 16-year high copper prices.

The prevailing style is to trade more frequently, to anticipate changing sentiment and the next momentum investment. Such strategy is as likely to fail as make money. The alternative is to stay our course and manage our risk, as the economic and interest rate cycle continues to unfold.

The Conundrum – Our Perspective

The markets are in an odd battle over the direction of the economy; and quite a bit of smart money is lining up on either side. The catalyst is the direction of interest rates, which is reflected in the current behavior of the bond market. Interest rate relationships are illustrated by the yield curve: short-term rates should be relatively low and long-term rates should be relatively high. The imbalance in the yield curve, and all the guessing about what will happen next, explains much of turmoil in the stock and bond markets.

The Federal Reserve (which controls short-term rates) believes inflation must be contained in our growing economy, and has increased the federal funds rate nine times in the past year. As short-term rates are pushed higher, so should all rates along the yield curve. However, long-term rates (determined by the bond market) have declined over the same time-frame, implying that the economy is faltering. This contradiction should have been temporary, as unfolding economic statistics eventually support just one scenario, but the statistics continue to be contradictory or inconclusive. The yield curve, meanwhile, continues to flatten as short-term rates climb and long-term rates continue to fall. If neither the Fed nor the bond market will blink, the fear is that the yield curve will invert (short-term rates higher than long-term rates), which almost always forecasts an impending recession.

A market axiom is to never fight the Fed; and in the first quarter, the growth scenario held sway. Long-term rates climbed, interest rate sensitive assets like real estate declined, the overall stock market fell, and commodity prices skyrocketed

In the second quarter, sentiment changed as the price of oil became an economic burden, Fed language became ambiguous, and other data suggested that the economy was indeed slowing. Hope grew that the Fed would have to relent, or risk initiating a recession. Money flowed from commodities and other growth stocks, and into defensive securities, interest rate-sensitive stocks and real estate, as the cost of money was believed to stop rising. As the second quarter came to an end, the Federal Reserve’s language again made clear that interest rate hikes would continue throughout the year, and possibly into 2006.

2nd Quarter Tactics

Equities

We never believed the Federal Reserve would soon stop raising short-term rates. As such, it seemed absurd to invest in anything sensitive to rising interest rates, as most asset classes are quite vulnerable to interest rate shock. The S&P 500 fell about 3% by mid-quarter, but then reversed and rallied on hopeful interest rate expectations, to finish the quarter ahead by 3%. It’s hard not to interpret this activity as just trading noise.

Fixed Income – Safe and still Sorry

It is very difficult to hedge both stocks and bonds against rising interest rates. While the interest rate ambiguity sorts itself out, we employed a portfolio of bank loan funds as our primary fixed income vehicle, and also as our overall default position (see accompanying article). Bank loan funds currently pay an interest rate of about 6.5-7.0%, which adjusts once a month. This adjustment feature virtually eliminates capital risk due to rising interest rates. The funds have a diversified portfolio of corporate loans, which are either secured, or unsecured but investment grade. As such, bank loan funds overall exhibit perfect investment characteristics for the current climate.

Bank loan fund prices fell about 5-8% in the second quarter.

Why? The collapse of GM and Ford debt into the junk bond category fueled the perception of an economic slowdown, and cast a pale over the entire junk bond market. And while bank loan funds are emphatically not junk bonds (see article), investors did not differentiate, on fear of more debt downgrades and defaults.

The basic characteristics of these funds have not changed. Interest payments have increased each month. No borrowers are in risk of default. But, as our portfolios carried a disproportionate percentage of bank loan funds this quarter, our performance has correspondently suffered.

Commodities

Commodities shifted from a top-performing asset category in the first quarter, to one of the worst performers in the second quarter. Oil, copper, and other commodities have record profits on record material costs, yet their stocks suffered from fear of a slowing economy. We did well in oil, taking profits in San Juan Basin Royalty Trust (SJT) about mid-quarter, although oil surged again by June. Our copper position, Southern Peru Copper (PCU), pays a 7% dividend, but did poorly with copper market overall. Alcoa never caught the market’s attention. We are breaking even on a small position.

Strategy for Third Quarter

We think the yield curve will likely invert, as the Federal Reserve and the bond market both refuse to alter course. But, in our view, either interest rate scenario is foreboding. Either the Fed ceases due to an imminent recession, or long-term rates rise and topple our overleveraged economy. Neither is optimistic for stocks.

Under any scenario, we believe the economy will eventually lapse into recession, but not until sometime in 2006 (assuming no oil or interest rate catalyst). We also believe the stock market may experience one last rally before resuming a downward trend. That ugly second quarter would have set the stage for a second-half rally; but the market, in anticipation, truncated the correction. Prices overall just seem too high in light of rising rates. We will watch and wait.

We are highly predisposed to invest in yield-bearing securities. That way, if our timing is off, our money is not sterile.

Equities

If the market sells off enough over the summer to justify the risk/reward, we will commit maybe 25% of our assets. Yield curve behavior will preclude any interest rate sensitive stocks, including financial companies. Since 60% of the S&P 500 is represented by financial services, our equity index exposure will focus on mid and small cap funds. Otherwise, we will pick and choose among individual stocks.

Real Estate

By now, even the Aborigines in New Guinea are studying for their realtor’s license. There may still be money to be made in real estate. But at this point, we just don’t think we are smart enough, or nimble enough, to navigate such an anticipatory market without enormous risk to our clients.

International markets fall into several categories: European markets are mature economies that appear to be faltering as their central banks cut interest rates. European bond funds should profit in such an environment. Much of the active South American and Asian markets are an emerging growth or commodities play. We are neutral.

Commodities have had a volatile year. While we still believe that commodities are in a secular bull market, at this point in the cycle, we are unwilling to buy and hold. We will instead trade them as opportunity presents itself.

We will focus on oil and copper in the third quarter. Copper did poorly in the second quarter, even though prices reached a 16-year high, but began to rebound as the quarter ended. Our copper exposure is Southern Peru Copper (PCU), the world’s second largest copper producer, which pays a dividend of about 7%. PCU suffered as ownership partners restructured and sold a secondary class of stock. We expect this stock to rebound nicely next quarter, and UBS recently issued a buy recommendation, with a target price of 55.

Oil is the new asset bubble. Many mutual funds and money managers hold as much as 25% of assets in oil related stocks, although we think that is too risky for such a volatile commodity. We took profits about mid-quarter, and will re-establish our position.

Our attention is on San Juan Basin Royalty Trust (SJT), the largest natural gas field in the U.S, paying about 7.5% dividend; and Prudhoe Bay Royalty Trust (BPT) paying about 6.5%. We expect increased volatility and will not chase these stocks, but will take a longer time horizon than perhaps any of our other holdings.

Fixed-income: We expect our bank loan funds to recover this quarter, now that GM and Ford have demonstrated that fears of default were overblown. We will reduce our exposure as these funds rebound, but a target allocation has not been determined.