Quarterly Commentary:
January 2007
Last quarter I boldly wrote, without equivocation, that the recent stock market rally was a head fake not worthy of notice or consideration. As the year ends, I now feel like the mathematician in Las Vegas, frustrated at the black jack table while the drunk with all the chips keeps hitting on 18.
The general market indices once again crammed a year’s performance in the last few months. The conventionally-diversified, fully-invested-at-all-times investor ultimately did fine. Hedge funds and other serious-money investors (who are also paid not to lose), on average, made money but under-performed the indices. As did I. So I suppose I’m in good company.
Ruminations on 2006
1. The Viagra of easy money is losing potency. Even the tease of extra dosage is failing to elicit more excitement (housing’s stall in spite of a re-decline in mortgage rates). The price of almost every asset class is now disproportionately influenced by, and vulnerable to, interest rates.
2. Commodity prices are volatile and certainly not immune to interest rate risk and global demand. But they are also fundamentally affected by long-neglected supply conditions. The respective companies have tremendous earnings and can pay handsome dividends or expand operations. Oil and gas also offer a geopolitical hedge.
The complacency of conventional wisdom is often useless to the advisor who must simultaneously identify, anticipate, and address risk, reward, liquidity, volatility, and tax consequences of every trade.
1. I am completely uncomfortable constructing anything resembling a conventional portfolio. At this point, too many interest rate-sensitive assets uniformly bear too great an interest rate risk. And diversification is pointless if the entire asset class is held aloft by that single thread. As markets tend to fall much faster than they rise, I am not confident I can dance in and out without excessive risk.
2. Dividends and interest income enhance total return and smooth volatility, with one critical caveat: no risk to principle. Anything yielding less than 5% is not considered, since a CD yields as much with absolute safety. Bonds are limited to short maturities; stocks limited to superior payout and bullish underlying asset. Our choices have been bank loan funds, and royalty trusts for various commodities.
3. Oil, natural gas, copper, and other commodity stocks bought cheaply have favorable supply/demand characteristics, often high cash yield, and generally trade contrary to the general stock market.
4. Foreign and emerging stocks tend to have a commodity-based economy, and exaggerate a commodity-heavy exposure.
5. Taxes should have little or no influence on portfolio strategy, but obviously they do. Dividends are preferred due to 15% tax rate. Royalty trust distributions have a depletion allowance. One-year holdings are taxed at 15% capital gains rates. As we have significant taxable accounts, I tried to limit portfolio turnover this year.
Hits and Misses for the Year
I ran a concentrated portfolio of largely yield-bearing oil, gas, and other commodity stocks as the safest risk/reward path, and also to avoid the pervasive interest rate risk inherent in so many other asset classes.
We had a good first six months, and a flat second half as interest rates again fell and speculative mania returned. Stocks, bonds, and real estate – all pretty dreadful until about July, roared back again on cheap money.
Observations:
1. As long as current liquidity conditions remain, money will continue to slosh toward leveraged assets. Nothing succeeds like excess.
2. The tax tail wagging the dog. I had tremendous capital gains in May, but held for capital gains treatment, collecting those dividends along the way. Time will tell…
3. I bought natural gas cheap – and it stayed cheap. I concentrated my oil royalty trust holdings into the Prudhoe Bay field, to avoid Canadian foreign taxes, and then the damn pipeline corrodes. A few plays just didn’t live up to their full potential in 2006.
4. Volatility in my portfolio was greater than anticipated, although I have been highly tolerant with dividend-paying stocks. A 10%-14% cash yield (in a 4.5% Treasury market) should have smoothed the ride.
5. Foreign stocks did not always correlate with underlying commodity. The few foreign stocks I owned all did extremely well, independently and with less volatility than the underlying commodity.
As We Anticipate 2007…
Wall Street ended the year on a high note, and the prognosticators have declared fair skies, a soft landing, and new global prosperity. However:
• Commodity stocks plunged recently on concerns of less demand from a slowing economy – but then;
• Stocks fell on concerns that a favorable jobs report suggests a strong economy, extinguishing any chance of an early Fed rate cut – because;
• Both stock and bond markets require low and lower interest rates to perpetuate the liquidity orgy propping up asset values– but then;
• Long and short rates are already extremely low, containing virtually no risk premium in spite of the debt bubble permeating every corner of the financial market – and of course;
• A slowing economy flames hope of a Fed rate cut- but then;
• A slowing economy will struggle to service that debt bubble. and then;
• The bond market will re-price as default premiums return, and interest rates will explode upward.
My favorite example: economists declare the bottom of the housing market, while mortgage companies anticipate defaults to skyrocket, and class action lawsuits from adjustable-rate mortgage holders claiming misrepresentation.
Piece of cake.
Strategy for the First Quarter
Equities overall look pretty bad as the quarter begins, particularly after the unbridled run of the fourth quarter, and the continued complacency of the investment community. Last year’s winners have every probability of becoming this years losers. Other than a continuing love for dividend-bearing stocks, I genuinely start the year with an open mind. I am most watchful of technology and certain healthcare sectors, but only after a general market shake-out.
Emerging foreign equity favorites may not fare as well this year. I am more interested in the mature markets of the EU, and possibly markets in South Africa and the Middle East.
The dollar, widely reported to be in freefall, rallied strongly on the recent jobs report, proving how difficult that trade can be. The trend is still down, particularly as other global central banks raise rates. I prefer oil to gold as a dollar hedge, as oil has more definable intrinsic value and often pays a dividend, but I suspect gold is a better hedge right now.
Hedge funds with assets over $100 million must disclose holdings every quarter. Recent filings from prominent investors such as George Soros show a substantial shift into oil and gas holdings. I believe demand is inelastic at much higher prices, at least in the short run, and that prices still have plenty of room to run. Oil and gas may also become a better hedge against the dollar, as oil producing countries in the Middle East and Venezuela increasingly hold euros instead of dollars.
The only Bonds to consider at this point are adjustable rate bank loan funds. We have a few that have appreciated in price, while also paying 8-9% yield.
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.
The residential real estate downturn has not even started yet. Mortgage rates are too low. In fact, mortgage rates can rise by 200 basis points and would still be low by historical standards.
Commercial real estate cap rates continue to fall, although more slowly.
Apartment REITS have had a very good year as rents increased. However, a noted money manger has begun shorting apartment REITS. His theory is that single-family speculators, unable to flip their property, will soon start pouring into the rental market, and that flood of new supply will pressure all rental rates.