Quarterly Commentary April 2009

First Quarter Review

The market bounce off the November lows lasted until about mid-January, and then began another dreadful quarter of volatile decline.  The S&P 500 fell almost 24% until a late March rally cut that loss to 11.7%.  The markets were, again, largely uninvestable.  Most securities on my watch list were generally too low to sell, but not low enough to buy.  Asset class behavior was inconsistent.  Many agricultural stocks did well, for example, but the agricultural index hardly budged.   I sold a few winners early in the quarter, but mostly sat tight with 25-30% cash, and still lost money.

My oil positions are down a little, natural gas holdings are down much more, agriculture and foreign investments relatively steady.  Overall, I focused on royalty trusts and other yield-bearing securities, with mixed success.

The Stimulus Package is a theoretical concept.  There is no historical evidence to suggest it will work.  During the Great Depression, we only know what did not work.  The fiscal spending for World War II is ultimately credited with ending the Depression; but then again, no one is sure, since at that point the Depression was in its 14th year (economic downturns are a bit like a cold; they end on their own at some point.)  Japan tried a stimulus plan and fell into a two decade (and counting) economic coma.  George Bush tried it, and merely substituted the dot.com bubble with a real estate and credit bubble.  The only arguably successful application was Reaganomics; but again, such spending occurred nineteen years after Lyndon Johnson’s attempt at guns and butter ignited nineteen years of stagflation.

What is certain are significant unintended consequences.  The spending is too vast, too ham-handed, too partisan, too poll-driven and politically gutless to achieve any deliberate objective without a lot of collateral damage.  

Ironically, we have a pretty good idea of what to expect… we’re just not sure when.  We know that vast government borrowing, coupled with the Treasury’s need to purchase bonds to keep interest rates low, will cause the dollar to fall.  And it is the falling dollar that will be the catalyst for the other market movement we’re watching for.  A falling dollar will trigger inflation and ultimately cause interest rates to rise.  A falling dollar, in the short run, is terrific for the stock and commodity markets.  The problem is timing.  At the moment, we are in a period of deflation, which will contain interest rates and commodity prices.  And governmental intervention will continue in the quest for an instant solution.  But once deflation ends, the degree of fiscal spending by every major central bank and developed country will likely result in a tremendous counter reaction.  And that is what every money manager is watching for.

Perspective for the Second Quarter

I think this worst is likely over.  Enough bad news has come forward, and has been discounted, to suggest that some sort of intermediary bottom is in place.  That is not necessarily good.  The markets can still flop around like a dying fish and go nowhere.  But I reinvested most of the cash balances at the end of the quarter, and while I expect a continued degree of volatility, I suspect the S&P 500 will end the year higher.

The first attached article is interesting, in that it suggests that now is the time many investors make their greatest mistakes, as they take inappropriate chances in an attempt to recoup their investment losses.  Tremendous opportunities will arise.  But as I can certainly attest, it is very difficult to sit tight and wait for the right trading environment, instead of day trading to make up lost ground.

The deadly trio

Banks and financial institutions are where the daytraders and bottom feeders play for fast money.  While I suspect the worst of the news is out, frankly I have no idea.  I don’t understand the degree and extent of the bad assets.  I don’t understand the degree and extent of the government’s intervention.  I suspect default rates will continue to rise, but the current interest rate spread does ensure a certain degree of profitability for the banks.  Financial service stocks have a casino-like quality, which makes it extremely hard to invest intelligently.  I am avoiding the sector entirely. 

Bonds and other fixed income:  Again, there may be tremendous opportunity, but only for others much smarter than I.  At the moment, I see little reward, tremendous risk, and am avoiding the sector.

Real estate runs in long cycles and can easily take five years to bottom.  It does not take an investment genius to see that there are far too many houses for sale at ridiculous prices.  There is no bottom at the moment.  Commercial real estate is earlier in the cycle, but vacancies are rising in every sector and the lending environment continues to become more restrictive.  The REIT market has all but collapsed.  Short of a need for a 1031 exchange, there is no point to watching real estate.

Opportunities

Commodities are the only sector in which the fundamentals steadily improve.  All investment and exploration in new mines and new energy sources has ceased.  China is in the midst of a fifty-year drought.  Argentina, the soybean capital of the world, is in the midst of a seventy-year drought.  At the moment, all commodities are in a severe slump.  But prices appear stabilized, and the upside reward looks promising.

• Energy:  Oil appears steady above $50.  I continue to hold the Prudhoe Bay Royalty Trust.  Natural gas has been weaker, and my position in the San Juan Royalty Trust is among my weakest holdings.  However, as discussed in the attached article, all exploration has stopped, and supply has steadily declined.
• Metals:  I am holding some copper and zinc.  Prices still tend to bobble without a defined upward trend, but little downward price risk seems evident.  I continue to wait.
• Agriculture:  I am holding and watching several names and indices.  Agriculture stocks continue to trade in a fairly narrow range.

Global markets.   Asian markets, in the aftermath of China’s own stimulus package, look better, as well as Latin America and other commodity-producing country indices.  I held these indices through the downturn, and am optimistic that Asia will emerge first from the recession.