Quarterly Commentary October 2008

Third Quarter in Review

I usually start with a quarterly market overview, for those clients who may not have kept abreast of current events.  This time, I’m pretty sure that will be unnecessary.

I saw the oil market topping out, and appropriately hedged our position.  There are inverse exchange traded funds that profit when a commodity such as oil falls in price.  And the hedge worked as expected, rising by about 40% as oil prices fell.

I did not expect a full counter-trend rally, but sometimes the markets temporarily switch directions when too many investors buy and sell the same stuff at the same time.  However, I had no intention of selling our commodity positions, which are profitable companies and/or paying a great yield, and reinvesting in real estate or consumer discretionary stocks, which merely paused in their plunge downward, and would have been too tricky to try and cleverly buy and sell.

And then came the credit crisis.

I must admit a certain surprise at the intensity of the market’s reaction.  After all, there has been a collective awareness of the problem for over a year now, and as a discounting mechanism, the market should not have reacted so violently.  And the true problem is not that a trillion mortgages have gone bad, but that the bad ones have been bundled with the good ones in such a manner that no one knows what is what.  Without such knowledge, the worst is assumed, and violated covenants require more collateral that the lenders do not have.

And so, the losses I so adroitly sidestepped all year caught me in the third quarter.  I took some tax loses for our taxable accounts, but once the slide commenced, there was very little to do but sit tight.  Bear markets do not start with a bang, but with a whimper, and to sell amidst the selling would have simply exaggerated the mess.  The only thing to do is ride out the storm.

Perspective for the Fourth Quarter

I find a certain amusement on the debate over who is at fault, what could happen, what should happen, what is supposed to happen.

Who cares.  We have no control or influence over unfolding events.  All we are concerned with is making money on what does happen. Here is what I anticipate will happen:

• Congress will enact an enormous bailout that will be matched by comparable packages from central banks all over the world.  It is our misfortunate that this crisis had to occur so close to the presidential election, inciting our politicians’ worst instincts for melodrama and over-reaction.
• Markets will rally hugely for some period of time – how long, I do not know. And then the stimulus will wear off, and even greater government intervention will be necessary to forestall the inevitable.
• Just as the dot.com bubble could not be re-bubbled, the housing market cannot be propped up.  But all that government money has to show up somewhere.  I believe the unintended consequences will be once again a plunging dollar, oil back up to $150+ per barrel, and soaring emerging markets.

Tactics

As I write this Commentary, an article popped up on the internet entitled “How to prepare for the coming financial apocalypse.”  So much for a calm reaction.  As is customary in such times, advisors and commentators flood the media with often extreme recommendations.    Perhaps I am insane, but I am not nearly as concerned about the credit crisis as the media portrays:

1. Loans and mortgages are still available, at attractive rates and terms, for rational, credit-worthy borrowers. 
2. Financial services are not like the auto industry.  It’s not going anywhere.  Bad loans will be written off, and the industry will reinvent itself.  Even the Goldman Sachs and Morgan Stanley conversion to bank holding companies is not particularly relevant.  They’re just accessing cheaper capital.
3. Outside of real estate and financial services, the real economy appears to be doing fine.  I have a friend, a very senior recruiter at Korn/Ferry, the prominent executive recruiting firm, who tells me business is exploding.  Corporate America’s willingness to pay their fees is one sign of a confident business community. 

While it was a very rough quarter, I think the hysteria is largely over, and I’m largely happy with our positions.  Some pay very high dividends, while others will rebound nicely once the immediate crisis has passed.If there truly is a credit bubble, then the price of most consumer or leveraged-based investments will fall. In fact, credit does not have to evaporate – it just has to expand at a lower rate, which at this point is a certainty.  A traditionally diversified portfolio has a long bias and will lose money.  Successful portfolios will incorporate inverse ETFs that profit from falling prices.  Blending a long-short portfolio will be the challenge.

• Treasury bonds – are recommended for diversification, and have certainly saved a few portfolios this year.  However, Treasuries are the new bubble.  Prices are too high, yields are too low.  At some point the credit crisis will manifest itself in much higher interest rates and this “conservative” investment will plunge in value.  No thanks.
• No banks, no real estate, no retail or other discretionary consumer consumption.  There is a lot of volatility in this area, and potentially a lot of money to be made for short-term traders.  Fundamentally, it’s a horrible area, one in which I may not be swift enough to play successfully.
• Real estate has not only not bottomed, the fall continues to accelerate.  And I believe this is only the first leg down.  Once mortgage trend up, and stay up, there will be another dramatic leg down.  I am regularly asked if now is the time to buy.  NO.  It could take a decade.
• Oil and natural gas have, in my opinion, largely bottomed, and pending Congressional action will only act as a catalyst higher.  I particularly like royalty trusts, as they pay high dividends and have held up nicely in the recent downdraft.  These are currently the safest play in the market.
• Domestic index funds do not interest me at all.  Many are heavily weighted toward financial stocks, or smaller growth stocks positioned for a growing economy.  Given our current state of economic affairs, I believe there may be trading opportunities, but otherwise will sink overall with the looming recession.
• Emerging markets will come back.  This is where the growth is, the trade and current account surpluses.  These markets are by nature volatile, and every time they fall, the media declares the end.  Far from it.  Asian banks are in great shape, and the Chinese economy is addicted to high growth, which the government will attempt to ensure.
• There will be opportunities in gold and silver, but I’m not sure I really understand these markets.  They will do well in a falling dollar/inflationary environment – as will oil.  Oil is a better play.
• We own a few other commodity stocks that are very profitable companies.  If the stocks do not rise on their own volition, I believe there will be merger and acquisitions activity by larger companies that recognize value.  So we sit tight.