Quarterly Commentary July 2009

Second Quarter Review

The second quarter was a splendid example of the disparity between the market’s media coverage versus its actual performance.  Certainly, if one bought the S&P 500 at exactly the market low of March 6, and sold exactly at the high of June 12, it was possible to earn almost 37%.  That gain, however, would have been insufficient to cover the accumulated losses of trying, and failing, to catch the market bottom over the prior six months.  If one bought toward the end of March, when a rally appeared sustainable, and held throughout the quarter, a gain of about 17 % was more likely.  Hardly the roaring market of an imminent recovery.

About 40% of the S&P 500 is comprised of financial service stocks.  Consequently, a large percentage of the quarter’s gain can be attributed to an almost doubling of such securities… which is puzzling, since I work closely with commercial banks and mutual funds in various capacities, and know firsthand that the credit markets are getting worse.  Not better.  Not stabilizing.  Worse.

If there has been any logic or reason to the market this quarter, someone please explain it to me.  The Treasury is about to embark on a trillion dollar debt orgy and the dollar… rises.  Natural gas is clean, economical, easily accessible…and prices collapsed.  Coal and solar stocks, however, soared.  Argentina’s drought is so severe that the country will not export wheat for the first time in 100 years, and yet the agriculture index has hardly budged.  Junk bond prices rose in the face of record loan delinquencies and defaults.  The best performing sectors were financials, automotives, and small, vulnerable companies of the Russell 3,000, many with share prices under five dollars.  In other words, those same securities that dropped the hardest in the fourth quarter rose the most in the second quarter…  as if a massive economic recovery is imminent.  As if the credit crisis never happened.  I’m not following.

I did almost nothing this quarter.  Cash levels are about 50%.  My largest position is the Prudhoe Bay Royalty trust, which is the only remaining trust to still pay some semblance of a dividend.  I could not bear to chase the rising dreck, not without some logical underpinning, not after the losses of the last six months.

Something is Different this Time.  Ray Dalio of Bridgewater Associates calls it the D-process:  the point in which decades of accumulated debt eventually overwhelms the income base.  It is not just a concept.  We are seeing it live in the State of California:  perhaps the most fertile economic region in the world, destroyed by profligate spending, ironically just several years after the end of an extraordinary economic boom.  It is a scenario playing out in many, perhaps most regions, industries and asset classes.  The era of dependably rising asset prices, easy credit, and “costless” governmental remedies; the only era most of us have ever known, is over.

The rational, logical argument suggests that the stimulus packages enacted by virtually every developed world government will lead to inflation, perhaps even hyperinflation.  It has become almost a foregone conclusion.  It is why there is such a cry among some advisors to buy gold.   Entire hedge funds have been created to invest exclusively in the inflation trade.  The precursor of impending inflation will be a falling dollar, rising interest rates, and rising commodities prices.

Funny, though:  the dollar has not fallen, and in fact keeps rising.  Interest rates remain low and falling, in spite of massive treasury sales.   Energy and commodity prices have collapsed.  Manufacturing capacity utilization is at 60%.  All of which suggests deflation, not inflation.

At some point, it seems impossible that inflation will not come roaring back.  The current administration is now talking of a second trillion dollar stimulus package, in addition to the trillions necessary for universal health coverage.  But at the moment, the investing herd is leaning toward imminent inflation, or at least imminent economic recovery, but the data clearly suggests otherwise.  Something has to give.

Perspective for the Third Quarter

The rally of the second quarter is already rolling over, as the S&P 500 slips back into the red for the year.  While everyone expects the drama of volatile highs and lows, the most likely scenario is malaise:   perhaps a market drifting lower as an economic recovery is not immediately evident.  

Sector Thoughts

Other than the fleeting momentum of certain stocks and sub-sectors, the general stock market looks utterly uninspiring.  I have about 5% of assets in SPY, the S&P 500 index, which is probably flat at the moment.

Most of my core holdings:  commodities stocks and investment trusts with substantial dividends, have failed me after five years of faithful service, as one by one, dividend yields have fallen or been cut altogether.  Many strongly-held (and widely-held) beliefs about the world economies have, at best, been put on hold for the time being.   And without a strongly-held belief, cash looks like a compelling asset class at the moment.

The tight supply of commodities has apparently been offset by a strong dollar and an utter lack of demand.  In addition, China (a primary source of demand) has taken advantage of the current slump to lock in direct ownership of sources in Africa.  So I’m not sure what will ignite prices in the near term.  I have a smattering of positions that look to have bottomed, but see no bull market in the near term.

The decline of energy prices truly has me baffled.  Scarce supply, inelastic demand (we all thought) and the world is awash in oil.  Natural gas pricing has collapsed, as new fields and better transportation capacity has dramatically increased supply.  The disparity between oil and natural gas prices has prompted speculation that natural gas prices will eventually have to rise.  I suspect the disparity may eventually force oil prices back down.   

Global markets. 

China and the BRIC countries continue to be the global darlings.   However, China’s manufacturing industry, expanded to serve the insatiable American consumer (China has no middle class to speak of), now appears to have vast overcapacity, as Chinese factory owners disappear in the night to escape their debts.  Bulk shipping vessels are piling up, empty and unused, outside ports in China, India, Singapore, and the Philippines.   The decoupling theory does not appear to be valid in the short run.  I will be selling my foreign holdings into strength.

Agriculture strikes me as having the most promising fundamentals, but the stock prices remain suppressed.  I will look to add to my holdings, but I have done poorly to date.

Long-term Treasury bonds are utterly insane in an inflationary environment.  All reasoning and logic demand that rates rise and prices fall – profoundly.  But… they’re not.  Prices are down a bit in this last stock market rally, but are rising and yields falling; which makes absolutely no sense… unless we’re entering a period of significant deflation.  If the dollar stays strong, treasury prices should hold and may be an intelligent asset class to hold.  If the dollar starts to tumble, I don’t see how interest rates don’t rise – a lot.  I’m watching.

Real Estate:  It is exhausting to hear the pundits incessantly proclaim the bottom of the residential real estate market.  The bottom is nowhere in sight.  Historically, markets overshoot on the downside just as much as they overshoot on the upside.  As such, real estate will bottom when it gets downright cheap.  Until then, there are myriad variables that will knock the legs out of any signs of stabilization. 

The shoes are beginning to drop in commercial real estate as well.  I’m seeing rising vacancies in almost every market segment, as commercial loan defaults begin to skyrocket.  I work with several real estate companies in the 1031 arena, and it is very difficult to recommend a property to an investor that has no vacancy or yield risk.