Quarterly Commentary:
October 2005
Flight to Risk
We have been openly cranky for the past 18 months, ever since the Federal Reserve began to increase the Federal Funds Rate. As interest rates rise, particularly in light of the valuation excesses cheap money has created, it is only logical to adopt a conservative outlook and flee to safety. Investors, in contrast, have apparently abandoned any fear of risk in search of the most meager increment of additional absolute return.
We don’t like to cry wolf, but we can only conclude that select market sectors are temporarily insane. We have no intention of joining them.
The Quarter in Review
Equities: |
3rd Quarter |
YTD |
| Russell 2000 Small Cap (IWM) | 2.1% | 4.0% |
| Russell Mid-Cap (IWR) | 4.0 | 11.0 |
| S&P 500 | 2.0 | 0.2 |
| Nasdaq 100 (QQQQ) | 6.5 | 0.0 |
| Foreign Equities (EFA) | 11.0 | 11.0 |
| Commodities: | ||
| Goldman Sachs Natural Resource Index | 15.0 | 45.0 |
| Real Estate: | ||
| Cohen & Steers Realty Index | 1.0 | 9.0 |
| Bonds: | ||
| Lehman Aggregate Bond Index (AGG) | 2.2 | 1.0 |
| Lehman 20+ Year Treasury Index (TLT) | -2.3 | 4.0 |
| Lehman 1-3 Year Treasury Index (SHY) | -0.75 | -1.0 |
| Floating-Rate Bank Loan Funds (average) | - 5% | -7-12% |
3rd Quarter Tactics: What’s working, what’s not
The most consistent action this quarter, and year-to-date, has been in natural resources stocks. Almost all gains in the stock indices can be attributed to their proportional allocation in natural resource stocks. Foreign equities have done well this quarter due to natural resource-exporting countries such as Australia, Canada, Latin America.
Bonds have been utterly counterintuitive. In a rising interest rate market, long-term bonds are most risky, while short-term bonds are a safe haven. Adjustable rate bank-loan funds, yielding about 7%, are arguable the most desirable vehicle for any investor.
And yet, as the chart illustrates, long term bonds have performed most favorably. Short-term bonds are down slightly, and adjustable rate bank loan funds, bearing absolutely no interest rate risk and a favorable yield, significantly declined.
Real estate faltered this quarter, as rising interest rates and material costs threaten the profitability of REITs and major home builders.
Equities
Hurricane Katrina and exploding commodities prices dispelled any notion that the Federal Reserve would pause in its campaign. Equities rallied through most of the summer, then sank back down in the aftermath of the hurricanes. Equity indices, absent commodities, are flat for the year.
Fixed Income – Safe has been risky
We have employed two strategies for the fixed income portion of our portfolio. The Templeton Global Income mutual fund is denominated in Eurodollars, and (in our opinion) is a better hedge than gold against a falling dollar. However, the dollar has strengthened during the Fed’s campaign, and this fund is down about 10%. It pays a dividend of about 5.5%, but the price behavior has been disappointing.
By far our biggest fixed income position has been in adjustable rate bank loan funds. These funds have declined in price on average about 10% year-to-date. We are dumbfounded.
Bank loan funds carry no interest rate risk, and interest payments have climbed with the interest rate market. Why any rational investor would decline a secured, fixed income instrument yielding 7%, in favor of bearing stock market risk for a smaller return, is beyond us. We can only assume that investors, seeking greater absolute return, are still hopeful that the stock market will reward their loyalty.
Commodities
Commodities, one of the worst performers in the second quarter, clearly dominated in the third quarter. But not every commodity. Oil, natural gas, and copper. Nickel, necessary for the manufacture of stainless steel, finally rose this quarter. Hurricane Katrina and the prospect of heightened inflation fueled the commodities boom.
Risk Capital
A money manger diversifies based on a calculated perception of future risk and reward. As we construct a portfolio, some of our money is in “safe” investments and some is put at risk in an attempt to earn above-market yields.
Every manager has their own rule of thumb, but we will generally not put funds at risk unless we perceive a 25% or more return. Otherwise, the risk is not justified. As such, most of the U.S equity market has not made much sense to us this year. The only sector that has met our parameters is commodities. Southern Peru Copper is up 30% for the quarter, 22% for the year. San Juan Basin Royalty Trust (natural gas) is up 70% for the year. Excluding dividends. Oil, copper, and natural gas stocks have paid a competitive dividend, and also increased significantly in price. Our “risk” capital has not been particularly at risk.
Our safe money has been in adjustable rate bank loan funds. As we have highlighted, yields each month have increased, but the price of these funds has declined. Our “safe” money has been a disproportionate drag on our overall performance.
Strategy for Fourth Quarter
There is some market expectation of a fourth quarter rally, comparable to 2004. However, the presidential election was the catalyst last year. This year, the only possible catalyst may be falling oil/commodity prices.
We suspect oil and commodities may have a weak quarter and indeed accommodate the stock market. Or, they may not. At current price levels, we do not believe it is particularly appropriate to buy or sell anything until the market reveals its hand.
Under any scenario, long-term we are still downbeat on the overall stock market. Rising long-term interest rates, the cooling of the housing bubble, and rising commodities will ultimately push the economy into recession.
Equities
We may increase our foreign equity exposure if a buying opportunity presents itself. Other than a nominal equity index position, our bearish disposition remains.
Real Estate
Contrary to our horror at real estate prices in the last Quarterly Commentary, several homebuilders have declined significantly due to rising commodity prices and the perception that third quarter earnings will be disastrous. We have taken several small positions, but do not expect to hold them beyond the fourth quarter.
Commodities behave differently than stocks and bonds; spiking up in great leaps, and often collapsing back down. While we still believe commodities are in a secular bull market, at this point in the cycle, we will wait again for a buying opportunity.
We will focus on oil, natural gas, and copper. Our copper exposure is Southern Peru Copper (PCU), the world’s second largest copper producer, which pays a dividend of about 7%; and Phelps Dodge (PD).
Oil and natural gas are 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 have bought and sold positions throughout the quarter, and will again wait for a pull-back.
Our attention is on the Canadian royalty trusts that pay substantial dividends. 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 are disgusted with our bank loan funds and will reduce our exposure, but they are still the most logical fixed income play at the moment.