Quarterly Commentary:
January 2008

Housekeeping

The Prassas Capital website has been a disappointment.  There is a lot of information embedded throughout the site, but it has been a struggle to properly convey the scope and diversity of our practice in an easy-to-navigate fashion. And while the blog format is a wonderful tool for regular communication, it is only effective if occasionally I actually write something.

Part of the solution appears to be the need for a second site, dedicated to our institutional not-for-profit work.  Beyond Hand to Mouth:  Independent Financial Advice for Independent Schools should launch about February 15th as an interactive site for K-12 private school board members, headmasters, and business officers.  Most of the institutional material from Prassas Capital will be transferred to the new site, with the hope that both sites subsequently become more focused and easily navigated.

I have pledged to update the blog on a regular basis.  I will also experiment with the format of the Quarterly Commentary, as I search for the right balance of detail and brevity.  Hopefully, the periodic blogs will support and help explain the Quarterly Commentary.  Please let me know if you have any comments.

Ruminations on 2007

The fourth quarter rally did not materialize as the markets come to terms with the meaning and extent of the credit crisis.  Many of the same investment themes of 2006 continued to play out again this year.  Energy, metals, and foreign markets were certainly the strongest sectors in which to concentrate.   The subprime crisis in August ended the fantasy of a quick real estate rebound, and clearly identified the problem sectors.  As in the past, the best strategy has been to buy heavily on the few big dips of the year, with the expectation that the market would always rally back.  However, fourth quarter volatility foreshadows a market that is beginning to realize that our economic problems are not contained, or at least not fully understood. 

Our Hits and Misses for the Year

Hits were concentrated in the usual suspects:  yield-bearing energy, agriculture and metals, and foreign emerging market stocks as the safest risk/reward path.  The August crisis was of particular concern because I have anticipated it for so long, and thus had somewhat dire expectations.  However, the bond market reaction was selective:  interest rates largely stayed low, or even fell, for creditworthy borrowers.  As such, I bought the dips, or at least sat tight during the rough patches, which turned out to be the right thing to do.

Misses were largely in the fourth quarter.  I expected the Federal Reserve’s rate cuts to at least support the market until year-end.  As such, I held on to October profits too long and sold my short hedges too early, and had an inadequate fourth quarter performance. 

Countrywide was my other mistake.  Countrywide is the country’s largest mortgage originator, with a valuable mortgage servicing business.  The stock fell in the August crisis from mid-$40’s to $15, in a panic selling fear of bankruptcy.  Buying a stock in the midst of such hysteria is generally a smart tactic, as the bad news is usually overestimated.  Then again, sometimes not.  I piggybacked on the investments of Bank of America and other value-oriented mutual fund managers.  In retrospect, the investment was not a mistake, but rather I should have placed a tight stop-loss against such a high risk position.  Countrywide cost about 2% performance on the overall portfolio.

Observations and Comments

• By now, the investment community is, en mass, avoiding the problem sectors and piling into the bullish markets.  Such a lopsided market often argues for a contrarian approach; i.e. buy what everyone is selling, and sell what everyone is buying.  The problem, in my view, is that the herd is currently correct.  The problem sectors (mortgages, homebuilders, financials, etc.) are really bad, and the bullish sectors (oil, agriculture, metals) are really good.  As such, I think the big moves (in the short term) have been made, and the overall market is now likely to churn around in big volatile fluctuations.
• Many oil and commodity stocks (at least many of the ones I own) have not appreciated as much as the price of the commodity itself.  The stocks seem to rise slowly and fall fast.  I continue to trade many of these positions (other than the yield-bearing stocks), as I am concerned about price support in the absence of constantly rising commodity prices.
• If the credit crisis was limited to the subprime market, it would be over by now.  Clearly it is not, and in fact is spreading to other forms of securitized debt.  Such banking problems are long in developing, and are not solved overnight.  The crisis is real.
• Rising inflation, mounting loan defaults and a collapsing dollar should unavoidably lead to skyrocketing interest rates.  As rates have steadied, or actually fallen, for creditworthy borrowers, it is hard to argue that there is a liquidity crisis.
• Low interest rates, combined with the Fed’s predisposition to cut rates further, should provide some price floor for most assets.  And yet cheap money has not prevented a real estate crash.
• Foreign (commodity-based) securities did not again always correlate with underlying commodity.  The few foreign stocks I owned all did extremely well, independently and with less volatility than the underlying commodity.

Practice Changes

I am unhappy with our performance.  Our correct appraisal of economic and market conditions is not reflected in our aggregate investment returns.  As such, I am making changes to our investment and risk management criteria, such as:

• Volatility in the portfolio is too high.  Certainly this is a concern of every money manager, and is unavoidable to a large extent if absolute returns are the objective.  However, a low turnover, tax-wise approach brings an unanticipated opportunity cost that I no longer find acceptable.  As such, I will manage all funds for absolute return without regard (well, with less regard) to taxes, which is frankly consistent with other successful money managers.  Of course, this is only relevant in our taxable accounts.
• It is impossible to adequately diversify smaller accounts with purchases of individual securities, as evidenced by the inconsistent performance and excessive volatility in the smaller retirement accounts.  As such, all accounts under $250,000 will be invested solely in a portfolio of exchange traded funds.
• Risk and money management tactics are paramount in this changing and volatile market.  I have purchased new software to help automatic certain decision processes for more consistent results.  I hope to have this system in place by the end of the quarter.

Strategy for 2008

I will not enumerate all the problems in the economy, as these can be read daily in any newspaper.  Credit expansion played a pivotal role in the last twenty five years of economic prosperity; credit contraction unfortunately signals the end of a very long party.  I believe that, at best, there will be a short and severe recession; at worst, there will be a twilight zone of stagflation similar to the mess of the Japanese economy of the last seventeen years.

In the checks and balances of a “normal” business cycle, rising demand and rising inflation are tempered and ultimately offset by rising interest rates.  However, over the past seven years, the interest rate “brakes” were disengaged by the Federal Reserve, hoping to avoid a recession after the dot.com bubble.   As such, the unpleasantness of a recession was delayed, but the asset bubble problem has compounded.

Lowering interest rates and providing liquidity is the Federal Reserve’s primary tool to soften a recession.  However, interest rates are already low and the world is awash in money.  Bond markets have been willing to follow the Fed’s lead to date, but rising loan defaults, a falling dollar, and other factors will ultimately end this cooperation, and interest rates will rise.  A lot.  And asset prices are already starting to collapse under their own weight, in spite of massive stimulus.

The Federal Reserve has clearly chosen inflation over recession, as they have cut the discount rate in the past five months, and indicated a continued willingness to continue.  So, while the long-term currently looks bleak, lower interest rates in the short term argue for some sense of floor under certain assets.  As such, the ugly start of 2008 strikes me as a normal (albeit rather harsh) correction, rather than a fundamental downturn.

One critical caveat:  the other shoe is higher interest rates.  If the bond market breaks from the Fed and demands a risk premium for rising loan defaults and the falling dollar, all bets are off.

Tactics for the First Quarter

Betting on Inflation

I suspect that most market sectors are now in a big, volatile trading range.  The inflationary assets – gold, precious metals, commodities, emerging markets, will continue to have a bullish bias.  Certain currency trades, through the use of exchange traded funds, make sense.  Real estate and mortgage asset, and most U.S. equities, will have a bearish bias.

We continue to have almost no exposure to U.S. Equities. I cannot think of a single scenario that will bode well for the S&P 500.  There is a new category of exchange traded funds, designed to increase in value upon the fall of various U.S. equity indices.  These are useful to short the market during more enthusiastic rallies. 

Emerging foreign equity favorites will be volatile, but I still think it is the smart play, provided purchases are made wisely.  I am more interested in the markets in South Africa and the Middle East.

I consider oil to be a better overall play than gold, particularly since there are dividend-yielding oil stocks. Natural gas is a strong substitute for oil (much better than ethanol) and those royalty trusts continue to be a long-term hold.

Bonds, other than short-term Treasuries, are perhaps the most risky investments of all.  I have been using the Rydex Juno inverse fund as a hedge against rising long-term treasuries.

Residential real estate:  To my astonishment, several friends have recently taken out jumbo mortgages to buy second or third homes.  They expect to make big money when the market comes back.  In money management, this classic mistake is called “trying to catch a falling knife.”  Sometimes you catch the handle, sometimes you catch the blade.

In the five years ending in 2006, aggregate incomes rose 15%, while residential real estate prices rose almost 80%.  Popped speculative bubbles do not re-bubble.  In fact, I have argued that the downturn has not even started yet.  Mortgage rates are still quite low.  Real estate can take ten years to “come back” and may decline 40%-50% in the meantime.  Really.

Commercial real estate is the next casualty.  Cap rates simply cannot stay low while the economy slows and lending rates continue to rise.    I have advised many clients on tenant-in-common private placements.  While the tax advantages of a 1031 exchange are compelling, I will only recommend recession-resistant projects such as assisted living facilities.