Quarterly Commentary:
April 2006

Complacency

I recently met a potential client who made $700,000 from the sale of a San Francisco apartment.  We discussed several tax and investment strategies.  The client decided to buy another Bay area rental, so that when the investment doubled again next year, there would be twice as much money to invest with my firm.

A family friend asked for my opinion on his portfolio, diversified by a respected financial planning firm.  The firm had a system by which it ranked no-load mutual funds each quarter, selecting those funds in the upper quartile of performance.  The portfolio was designed to yield a long-term 8% return, as my friend’s goals and needs (per the planner’s software) demanded such performance.  The presentation booklet had color charts detailing the precision of its calculations, and the certainty of its outcome.

I am continually fascinated by two aspects of investment management:  first, the degree in which emotions often dominate our decisions; and second, fears of (or at least discomfort with) uncertainty is a great vulnerability we often seek to allay by embracing intellectual shortcuts or some other false promise of control.

We have to do the unthinkable:  we have to think. 

The Basis for our Fear

The following graph compares the S&P 500 (red line) to the ten-year Treasury yield (blue line) for the past forty-five years. 

The relationship between interest rates and stock prices is hardly coincidental.  1964-1981 can be economically defined by high and rising interest rates, high commodity prices, and high oil prices exacerbated by political instability.  A dollar invested in stocks during this period lost roughly 87% of its purchasing power.

The most recent twenty-five year period has been fueled by cheap and easy money, cheap materials, and relative political stability.  This long and glorious stretch has been the genesis for a number of investment fallacies, or at least false conclusions: 

1. Brains versus bull market.  Almost ANY investment strategy worked over the past twenty-five years, as long as one remained invested.  Buy-and-hold, indexes, mutual funds, real estate, diversified asset allocation – it all worked over time.
2. Illusion of control.  Most asset allocation strategies are based on Monte Carlo or other statistical analysis, which rely on databases rarely extending beyond 15-20 years.  As such, the data (and the analysis) is skewed or biased.  A portfolio designed to produce a target yield, popular among financial planners, likely under-estimates risk and over-estimates reward.  In fact, given recent market performance, most portfolios so designed are often over-weighted in the riskiest segments of the market, yet imply diversification has mitigated risk.
3. Most investment professionals (including your humble advisor) have spent their entire working careers in a bull market.  It is emotionally foreign to anticipate or even believe in a sustained bear market.

We are surprised by the duration of the current bull market.  But while the cheap money and cheap material fuel is diminishing, prices are still low and rising.  Systemic risk continues to build as interest rates, oil, and commodities rise while market indices flirt with multi-year highs.  We don’t know what the trigger will be.  But there always is one.  And the rug can be pulled from under almost every asset class.

The Quarter in Review

Domestic Equities:	1st Quarter	YTD
Russell 2000 Small Cap (IWM)	6.0%	6.0%
Russell Mid-Cap (IWR)	3.0	3.0
Russell 1000 Large Cap (IWB)	0.8	0.8
S&P 500	0.5	0.5
Nasdaq 100 (QQQQ)	0.8	0.8
International Equities
Global Equities (EFA)	6.0	6.0
Emerging Markets	7.2	7.2
Commodities:
Goldman Sachs Natural Resource Index (IGE)	4.5	4.5
Real Estate:
Cohen & Steers Realty Index (ICF)	4.0	4.0
Bonds:	-2.0	-2.0
Lehman Aggregate Bond Index (AGG)

The quarter was far more volatile and uncertain than the averages might imply.  Our oil, gas and commodity positions, established during the downdraft of the fourth quarter, rebounded nicely.  We sold gains in copper and silver.  Markets seemed to reach consensus by the end of the quarter that the Federal Reserve will continue to raise rates.  Oils and metals have been the beneficiary as inflation becomes the primary focus.  We end the quarter with about 20% cash.

Strategy for the Second Quarter

We believe the ‘supercycle’ theory of commodities, and that this bull market will last for some time.  We also believe oil will continue to climb, due to supply and demand, political instability, or both.  We tend to buy oil when the price appears to be headed toward $40/barrel, and sell when market fears $70/barrel.  Many commodities have raced ahead after reaching our target price.  We sold Peru Southern Copper at 60; it now trades at $92.  Better to lock in profits; reinvestment opportunities are rarely more than a few months away.

Money is flowing out of almost every other asset class and into oil and metals.  Our side of the boat is getting tipsy.  We are still developing a trading strategy to profit on this upward momentum while limiting the sickening ride back down as is characteristic with this asset class.

In addition to cash, our positions are divided among income-producing oil and gas royalty trusts, and significant natural gas positions.  Natural gas is 50% below its high, yet is subject to the same supply and demand dynamics as oil.

Oil and commodities are not a panacea.  The BRIC countries (Brazil, Russia, India, and China) are primarily responsible for the demand.  A short-term economic pause could plunge commodities for an extended period.  As more traders and investors begin to crowd commodities as one of the few sure trades, volatility is sure to increase. 

Tactics for Second Quarter

Equities

• Small and mid-cap stocks seem overbought, particularly in light of increasing cost pressure.  The risk does not justify the reward in our view.
• Foreign:  We are looking for an entry point in foreign and emerging markets.  We own Artisian International fund for a diversified overseas exposure in smaller accounts.  Our Malaysia and Japan ETF positions are doing well.  Many emerging countries such as Australia, Brazil, etc. are essentially a commodities play in which we already have direct exposure.  Further investment would create too great a concentration in our portfolios.
• Oil and gas:  We own several Canadian oil royalty trusts which pay (at our basis) about 13% annually, without sacrificing appreciation as oil prices rise.  We have traded Valero with success as it seems to fall/rise about 20% per quarter.  We own several natural gas plays.  Santa Fe Royalty Trust, the largest natural gas field in the continental US, pays about 10% dividend.
• A variety of commodities are traded as the opportunity presents itself.  Copper has raced ahead without us; we wait for a pullback to re-establish many positions.  A rule is to never overpay.  Commodities garnish a lot of attention as prices spike, and then sink back down.  A little observation goes a long way.

Fixed-income

• Intermediate and long-term bonds are clearly to be avoided as interest rates trend higher.  The Rydex Juno fund is a derivative fund that is one of the few vehicles for a rising long rate market.  We may take a small position to hedge the balance of the portfolio, if we can find comfort in an appropriate price.
• The dreaded adjustable-rate bank loan funds, those that have broken our heart in quarters past, are actually starting to look good again.  The oil/gas royalty trust is a better play right now, but as the yield in these funds increase, we may once again become a buyer.