Quarterly Commentary:
January 2006

The Quarter in Review

It was a somewhat flat, uneventful, “good riddance” end to 2005. The equity markets tried to rally as energy and commodity stocks declined, giving false hope that inflation was tame and a new Federal Reserve Chairman would stop raising the discount rate. The bulk of equity market gains this year were in the second quarter, and the autumn rally merely offset third quarter malaise.

 

Equities:	4th Quarter	YTD
Russell 2000 Small Cap (IWM)	0.0%	4.5%
Russell Mid-Cap (IWR)	2.0%	12.5%
S&P 500	1.0%	4.0%
Nasdaq 100 (QQQQ)	2.5%	2.5%
Foreign Equities (EFA)	2.7%	13.0%
Commodities:
Goldman Sachs Natural Resource Index	-3.8	39.0
Real Estate:
Cohen & Steers Realty Index	2.0	11.0
Bonds:
Lehman Aggregate Bond Index (AGG)	-0.2	-2.0
Lehman 20+ Year Treasury Index (TLT)	1.0	4.0
Lehman 1-3 Year Treasury Index (SHY)	0.0	-1.5
Floating-Rate Bank Loan Funds (average)	- 7%	-17.0%

Ruminations on 2005

Comparable to 2004, the markets vacillated this year according to the hopes and fears of the Federal Reserve’s anticipated behavior.  An interesting observation: When the markets anticipated a continuation of rate increases, the dollar strengthened and gold declined. When inflation seemed in check and there was hope the tightening campaign might end, gold rallied and the dollar fell.  Maybe coincidental. But such market reaction suggests that current interest rate levels, despite almost two years of increases, are still too low to contain inflation.

The flat, sometimes inverted yield curve made a mess of the bond market.  Adjustable rate bank-loan funds should have had no reaction to rising interest rates, yet performed among the poorest of fixed rate instruments.  Long-term bonds actually did ok.

Real estate stocks virtually collapsed this quarter as fear of a slowdown led to panic, so much so that we dipped a toe in the water, adding St. Joe and Toll Bros to our holdings.  Despite a massive sell-off, and record earnings from both companies, the stocks have been lackluster.  We sold St. Joe at about break-even.  We sold Toll Bros. in our taxable accounts; in the tax-exempt accounts, we’re not quite ready to fold.

Reward once again trumped risk as investors, flush with liquidity, chased yield.  Every “safe” holding: defensive stocks, adjustable-rate bonds; all performed poorly.  Almost every “risky” investment: commodities, emerging markets; performed well.  During the fourth quarter we sold off all remaining adjustable rate bond funds and bought energy and commodity stocks throughout the downdraft.  The way to make money is to make it.

Hits and Misses for the Year

Our focus on energy and commodity stocks in 2005 was clearly successful.  Many of these securities increased 60-90% over 12-months.  As we believe there is a cyclical bull market in commodities, it is easy to buy with conviction during volatile periods.

We limited exposure to domestic equities, viewing any strength as a function of liquidity instead of genuine growth.  Mid-caps were the only sector with appreciable return.

Emerging foreign markets also performed well this year, although we held very little exposure.  Adding these commodity-based economies (Australia, Latin America, Mexico) would have further exaggerated our concentration in such sectors.

Gold was relatively flat for most of the year, but rallied in the fourth quarter.  We are ambivalent about gold, believing that other metals are a better hedge against inflation. 

The adjustable rate bond funds were a clear miss.  Normally, we would have been more vigilant and sold off such poor-performing investments.  However, given the lack of interest rate risk inherent in these securities, we held on longer than is our practice.

As We Anticipate 2006…

We are over-exposed to oil, natural gas, and other commodities.  The market is hopeful of a Cinderella economy:  low inflation and a Federal Reserve almost ready to stop raising rates, creating such benign conditions that argue for an equity bull market. 

However… any “externality” such as uncontained inflation, rising oil prices, or a Federal Reserve that is not quite done, could upset our fragile story.

Strategy for the First Quarter

We have significant cash reserves, and will maintain our commodity holdings until the market swings our way.  At the time of this writing, oil is again pushing $66 per barrel, the initial euphoria in the equity markets has clearly ended, and we are selling some holdings to lock in profits.

The direction of interest rates will again consume our attention.  Although it is difficult to predict the actions of a new Fed Chairman, rocketing oil and commodity prices do not effectively argue for contained inflation.  We may trade the market indices if our price parameters are met; however, we are still downbeat on the overall stock market.  We are still bullish on commodities, and will trade as market sentiment provides opportunity.

Equities

• Foreign:  If the Federal Reserve stops raising interest rates, we will watch for the dollar to fall and foreign equities to become correspondingly more attractive.  Emerging markets warrant the most attention.  We own Artisian International fund for a diversified overseas exposure in smaller accounts. 
• Domestic:  Higher interest rates argue for a poor stock market reaction, and yet, if the Federal Reserve adopts a neutral policy, foreign equities look more attractive.  Other than a mid-cap position, our bearish disposition remains.

As long as the yield curve remains flat or inverted, Bonds, individually or through funds, are unacceptably risky.  It is somewhat uncomfortable to have no exposure to fixed income securities, but it is also foolish to invest in an unattractive sector merely for the sake of diversification.  If adjustable rate bonds do not work, we are not confident that anything will work right now.

Our primary income-producing investments are oil and gas royalty trusts.  These trusts currently pay in excess of 10%.  While it is true these yields are not guaranteed and wholly dependent on oil and gas prices, we are bullish on those markets and are confident that yields will be maintained with minimal risk to capital.

Commodities are clearly in a bull market, due to a number of fundamental factors. We watch this market in many forms, from a variety of metals to individual stocks to exchange-traded and mutual funds. Commodities spike up in great leaps, and often collapse back down.  Much of the current pricing overall is attributable to demand from China and India, two overheated economies which can be a potential surprise disappointment.

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 will not chase these stocks, but will take a longer time horizon than perhaps any of our other holdings.