Quarterly Commentary July 2008

Second Quarter in Review

It was the worst first six months in 38 years.  Markets bounced from the March lows, but the S&P 500 ended the quarter down by 2.64%.  Many mutual funds and professional investors have significant losses.  Bill Miller, the legendary manager of Legg Mason, is down 22% for the year.  Other than energy and mining, every sector, in every country throughout the world, is down.  I caught some of the bounces…  and rode a few back down.  I am now largely invested as the quarter ends, with perhaps 10% cash.

It has been a day trader’s market, as securities continue to fluctuate in a big, volatile range, with a downward bias.  Stocks will double in a few weeks… and then melt right back down.  Conventionally-invested, long-only, fully diversified portfolios are losing money.  Ironically, the only result of broad diversification has been to limit upside gains while offering no protection against market losses.

"Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom." — David Swensen, Yale University

The most difficult aspect of running money is addressing client preconceptions.  Investing is the ultimate armchair spectator sport, and everyone has an opinion – or an argument (which is why we carefully choose our client relationships).  My father made a little money in the late 1970’s in gold and silver, and then waited for twenty-five years for lightening to strike again (he recently sold out to buy real estate because “I’m a long-term investor.”  At seventy-five years old, I’m not sure what he has in mind).  Another 70-year old (successful) businessman I know will never sell his blue chip stocks because his now-dead mother told him not to.  In my experience, successful professional men tend to be the most self-directed (“nobody touches my money”) and the most unwilling to listen to anyone else.  Some are such consistently bad investors that I use them as a contrary indicator – I do the opposite of anything they do.  

Far worse are the hordes of financial advisors and commentators who, while perhaps well-meaning, simply have no idea what they are doing.  In particular, I find it astonishing that banks and brokerage firms, having just lost tens of billions of dollars of their own money, have the audacity to advise anyone on anything.  The new fashion among independent planners is to charge for creating a passive index fund because “no one can predict the market” (and which, incidentally, anyone can do for free with exchange traded funds) and charge additionally for “life coaching.”  Wow.

The issue of investment advice often goes beyond style or difference of opinion: a client who fails to make money may grumble, but a client who loses money may join a class-action lawsuit.  And the courts openly favor the client.  So advisors counsel that prudent, long-term investing requires a broadly diversified, long-only portfolio.  Selling short or commodities (merely other investment tools) are inherently foolhardy (proclaiming any tool as inherently good or bad is like claiming a hammer is inherently better than a wrench). And of course, the safest investments by far are bonds.  These “rules” have been repeated so often that an advisor who deviates can be accused of breaching their fiduciary duty.

Oddly enough, in the decade ending on June 30 (which includes the height of the dot.com bubble), the S&P 500, adjusted for dividends and inflation, had a negative return.  Holding cash for the past ten years was a better investment than a low-cost index fund routinely touted as the appropriate retirement vehicle.   And in a high-inflation economy, selling short and commodities have been the only consistent tools, while bonds can be categorized as among the most risky.  

Hedge fund assets have exploded in the past six years for a reason:  the old rules are inadequate.  A diversified portfolio is important – but you have to know how to do it.  Efficient, low-cost funds are terrific- as long as you choose the right asset classes.  Economic conditions have clearly and dramatically changed from the last 25 years, and will require a new investing mindset, with a broader array of tools.

Perspective for the Third Quarter

• The world economy has fundamentally changed, and great fortunes are about to be made and lost.  What is irrefutable is change.  Many old investment habits which have worked for the past 25 years are now unsuitable, or at least insufficient for the needs of our clients.
• Interest rates world-wide have been too low for too long, creating an inflationary mess that must ultimately be addressed.  The cure for high inflation is higher interest rates, and both are bad for both stocks and bonds.   However, sticking to cash and CDs bears significant risk to purchasing power, as the falling dollar and rising inflation currently demand returns of about 20% just to break even.  Loss of purchasing power is a risk every bit as real as investment risk.  There is simply no safe haven for investors.  We simply have to grind it out.
• The American public, and their choice of politicians, are petulant children who cannot tolerate a moment of economic inconvenience.  I believe the next round of elections will veer our country sharply toward socialism, as we demand the appearance of quick, effortless solutions.
• There are no quick, effortless solutions.  As surely as day follows night, there will be high inflation followed by high interest rates, if not initiated by the U.S., then by other foreign nations who will force our hand.  Current political solutions can only delay and exacerbate the inevitable.
• Investing for a decline in asset values will become an integral tool in a diversified portfolio.  In fact, selling short may offer the greatest opportunities.  I have been using inverse exchange traded funds to mimic these trades, but the tools are proving somewhat crude and inefficient.

Tactics

The first week of the third quarter has been brutal, and all of our accounts are down about 10%.  However, as I write this Commentary, there have been two pieces of encouraging news.  The Federal Reserve will extend its emergency loan program for investment banks through 2009.  Implicit is that the Fed will raise the discount rate during this time.  Also, Iran has declared it will avoid conflict with the U.S. and Israel.  Falling oil and steady rates should ease market conditions, at least throughout the summer.

In spite of the recent market volatility, for the most part I like our positions and our cost basis.  I am betting on a short-intermediate correction in oil prices.  I have nothing leveraged, or related to loans, real estate, or the American consumer.  I have investments in emerging markets, and have recently bought in China after a 50% decline.  The fundamental key here is interest rates.  Should the central banks of these countries begin to raise interests (as they ultimately must), the dynamics will change.

Is oil in a bubble?  The answer offers no guidance.  Oil can be in a bubble, and still double in price.  Or, the price may legitimately reflect supply and demand, and still fall by 40%.  It is the nature of markets.

I sold most of the oil/gas holdings throughout the rise in the spring, and am actually short oil as a hedge.  I hope to re-establish positions as the market corrects.

Has real estate bottomed?  Is it time to buy?  Not at all.  Banks are still lending, on reasonable terms and at reasonable rates.  The next shoe to drop will be higher mortgage rates, which are already trending upward.  I do not know what the tipping point will be, but the credit crisis (and real estate crash) will resume anew once rates increase.

Are bonds a safe haven?  Ten-year Treasuries are currently yielding 3.88%, arguably almost half the inflation rate.  Bonds are easily the riskiest investment category, and in fact are a logical short.  We own no bonds of any kind.Qua