Quarterly Commentary:
July 2006

Holding Steady

Nothing tests an investment theory quite like a sudden and violent downdraft.  The relentless rise in energy, material, and interest costs continues to confound the markets as to whether the economy is still strong, or weakening to the point of recession.

It was an ugly quarter.  Only a rally in the very last days mitigated a complete rout.  Recession fears undermined the most dynamic sectors, as emerging markets, metals, small cap and technology stocks suffered from relentless selling.

The Quarter in Review

Domestic Equities:	2nd Quarter	YTD
Russell 2000 Small Cap (IWM)	-5.8%	5.5%
Russell Mid-Cap (IWR)	-3.0	2.7
Russell 1000 Large Cap (IWB)	-2.0	0.2
S&P 500 (SPY)	-2.0	0.5
Nasdaq 100 (QQQQ)	-7.0	-3.0
International Equities
Global Equities (EFA)	1.0	6.5
Emerging Markets (EEM)	-5.0	2.7
Commodities:
Goldman Sachs Natural Resource Index (IGE)	4.0	8.5
Real Estate
Cohen & Steers Realty Index (ICF)	-2.5	10.0
Bonds:
Lehman Aggregate Bond Index (AGG)	-2.0	-3.0

 

Strategy for the Third Quarter

It is obvious to anyone objectively observing the markets that there is a bull market in energy and commodities, and a bear market, or at least a downward drift, in almost every other sector. 

• Energy and natural resource companies have record earnings almost every quarter.  While analysts argue whether other market sectors are about to improve, these companies are making money right now.
• Record earnings are and will manifest themselves in increased merger activity, as natural resource companies make all-cash offers to buy capacity.  This activity argues for a share price floor for many companies.
• Bull markets climb a wall of worry.  Commodities are innately volatile and yes, a sustained increase will someday kill the goose, as higher material costs precipitate a recession.  But not yet.

We have lightened up on our natural gas exposure, as our portfolio had collectively too great an allocation.  But otherwise our outlook and equities selections have not materially changed.

Tactics for Third Quarter

Equities

We will establish core positions in several energy/natural resources companies, which share several characteristics:  they are dominant stocks in key sectors, have demonstrated sustained capital appreciation, and most importantly, pay a relatively high (10%-12%) dividend.  These dividends protect our downside in the event of certain future volatility.   We will occasionally buy and sell to improve our lie, but will otherwise maintain a relatively constant position.

• Prudhoe Bay Royalty Trust (BPT) – 10-20% target allocation.  A buyer when the price is in the mid-$60’s, seller over $80.  BPT pays approximately 12% dividend and is an excellent barometer of crude oil prices.  As a U.S. company, there are no foreign taxes such as those associated with Canadian royalty trusts (we sold all Canadian trusts as the foreign tax unacceptably cut into yield).
• San Juan Royalty Trust (SJT).  Largest natural gas field in the continental U.S, SJT pays about 10-11% yield.  Natural gas is the most undervalued of the energy plays. 
• Southern Peru Copper (PCU).  We sold PCU too early in light of local political uncertainties.  Recent elections have allayed our concerns and we were able to re-establish 10% positions during the most recent decline.  PCU is among the world’s dominant copper producers, and pays approximately 12% dividend.

There are a smattering of other companies we will trade as the opportunity presents itself:  Valero (U.S. oil refiner), Peabody Coal, Chesapeake Energy (natural gas), others.

Foreign equities (especially emerging markets) fell significantly last quarter, but we are still bullish.  The most dynamic foreign equities are also natural resource plays, so we must choose wisely to avoid inadvertent overexposure to the same market risk.  Malaysia and Japan exchange traded funds are currently our only positions.  We may add the emerging markets EFT if we like the price.  Australia, Brazil, and Canada are also on our watch list. 

U.S equities.  We see current market dynamics as zero-sum:  higher energy/natural resource prices will eat into mainstream business earnings and are, by definition, bad for the economy.  As we are optimistic for energy and metal prices, we must avoid the general market in accordance with our own theory.  In fact, every time we stray and buy a domestic company (such as a recent purchase of United Health), we invariably regret it. 

Fixed-income

• The Rydex Juno fund is a derivative fund that is one of the few vehicles for a rising long interest rate market.  We may take a small position to hedge the balance of the portfolio, if we can find comfort in an appropriate price.  It is a viable tool, but much more of a speculative vehicle than we are often comfortable using.
• Adjustable-rate bank loan funds are the only logical fixed income investment in a rising interest rate market.  Yields are currently about 8.5%, and prices are generally stable.  These funds are not as attractive as the royalty trusts, which pay better and have better capital appreciation potential.  However, at times we will sell our core holdings if prices rally too high, too quickly.  These bank loan funds are an appropriate parking place for idle funds, or during periods of market uncertainty.