Quarterly Commentary:
July 2007

The Quarter in Review

Stocks steadily drifted about 6% throughout the quarter, apparently unconcerned over $70 oil, several huge hedge funds busting on subprime loans, and rising long-term interest rates.  Much of that drift can be attributed to oil, commodities, and overseas markets.

In spite of the media’s attention, I am not sure last quarter’s performance is particularly relevant.  The markets feel trendless as money continues to slosh about looking for return.  I started the quarter with roughly 20% cash, and sold more in May, mostly for tax gain/loss matching.

Strategy for the Third Quarter

Markets must inevitably react to the widening cracks in the economic foundation.  The stock market feels a little like the residential housing market, resilient until suddenly the legs are kicked out from underneath.

In some regard, our job is made easy through process of elimination.  Credit problems in subprime mortgages and collateralized debt obligations are not isolated nuisances, and I believe foreshadow lending problems to come.  Overpriced and interest rate-sensitive securities such as REITS, homebuilders, banks, brokerage firms, and almost all categories of bonds, should be avoided due to substantial interest rate risk.  

Albert Edwards, Dresdner Kleinwort’s well-known global equity strategist, describes interest rates set by the bond market as the “cornerstone” for valuing equities and other securities.  He cautions that if the bond market has truly entered a new era of steadily rising long-term rates, “all investment portfolios will be shredded to ribbons”.

Studies also show that stocks decline during both very weak and very strong inflationary periods.  As oil and commodity prices continue to rise, inflation risk increases.  And the cure for rising inflation:  higher interest rates.  Or else the dollar collapses.  So, as we consider various economic scenarios, many asset classes are becoming boxed in, with little probability for gain and substantial probability for loss.

The problem:  Everyone else knows this.  As such, short interest (betting on a fall) is at record levels. Energy, metals, and other agriculture commodities have the best profitability characteristics, and are the most logical bull market asset class.  

The problem:  Everyone else knows this.  Too much money is chasing too few opportunities.

Tactics for the Third Quarter

Stocks have done a little too well, given the mounting economic problems.  I have been selling into rallies to avoid giving back gains in the inevitable pullbacks.  Most markets seem to be bobbling, with the exception of oil.  And frankly, oil could just as easily fall to $60 as rise to $80.  I have kept about half of our oil positions in an attempt to straddle the fence a bit.

Commodities are strong, but then again, they are a bit too strong to buy back into right now.  I have picked up positions as opportunities arise, but I do not have conviction that a substantial new bull market is about to begin.

I have sold all natural gas positions except for the San Juan Royalty Trust, which pays a dividend.  I probably have too big a percentage of assets in this position, which has been sleepy now for almost a year.  I see little downside risk, as the natural gas market has even better fundamentals than oil.  But patience has certainly been a requirement with this position.

About 5% of our assets are in Rydex inverse funds, which appreciate in value as markets fall.  These funds hedge our long positions, and offer a direct profit opportunity in a falling stock market.  I have also recently added the Rydex Juno fund, which appreciates as long-term interest rates rise.  I am happy with our cost basis, although this too is a hedge and not a long-term holding.  

Our adjustable rate bank loan fund positions are up about 10%, while also paying 8+% interest.  This income is taxed as ordinary income, so I am not inclined to add to these positions.  While this funds do not have interest rate risk, they do bear credit risk, particularly if corporate bond defaults accelerate.  I have stop loss orders on these positions.