Q1 2008 Notes on the Quarter

Q1 2008 Notes on the Quarter

Overview of the Quarter:

  1. Dow Jones Industrials: -7.6% Nasdaq 100: -14.5% S&P 500: -9.9% The international markets were mostly worse. China was down 26.8% and India 29.2%.
  2. Commodity prices soared. Oil topped $110/barrel; grains were higher, as were most metals. Gold rose to an all time high of 1032.70 on 3/21/08.
  3. Massive write downs led to a liquidity crisis in the financial markets, culminating in the last minute buyout of Bear Stearns to avert its filing for bankruptcy. Just a few days ago, UBS wrote off another $19 billion but markets actually rallied on the news – go figure.
  4. Housing – still weakening. By the way, this is what started it all, but the financial issues have become more general issues of over-leverage in the financial system.

Portfolio Specifics:

  1. Stock picking continued to be the name of the game. By complimenting this with hedging portfolios, we were able to protect portfolios from the majority of the losses.
  2. Speculation in commodities and the dollar led to significant volatility throughout all markets. By the end of the quarter, prices sold off their highs (rather quickly) as a recession changed speculators minds about demand, and the dollar strengthened.
  3. Q1 earnings are going to be important to watch to see whether the financial crisis seems to be spreading to the broad markets. We also want to watch whether Europe and therefore Asia see an expansion of the financial problems we have experience in the U.S.

Looking Ahead:

The Big Picture

Back in late 2000 we opined that the markets move in cycles, and we were seeing a monumental cycle shift that would make commodities the most attractive asset class for the next decade and a half and that stocks would likely be flat for some time.

What is interesting is what the decade has produced. According to research done by the Wall Street Journal, an investment in the S&P 500 index made ten years ago has made a whopping 1.3% annual return. Over the past nine, you have lost 0.37% annually, and over the past eight, a loss of 1.4% annually. Treasuries are up 4.7% over the same nine year period and commodities have averaged almost 9.5%.

Two important points come out of this. First, the argument “you can’t beat the market” is not true. During the same time period, we have averaged for our clients close to 10 times on a risk adjusted basis. To the contrary, it confirms our belief of investing in companies, not in the stock market makes sense. Thus, while the overall market has been flat, not all companies and their stocks by extension, are stagnant. Second, that multi-asset class investing is a critical part of investor strategy. Investors need to make asset allocations based on risk/reward rates. Stocks are just one asset class and do not always offer the best opportunity for investors.

Now, while crowing is fun, it is not our purpose here (well, at least not the primary purpose). It is our belief that the stock markets have a ways to go before we enter another secular bull market. For a while, the ups will be offset by the downs until we have re-deflated expectations and returns. The key will be when no one is interested in stocks anymore and the lack of interest is reflected in valuations.

At the same time, we believe that while not straight up, commodities still have a ways to go. Not only do we have to continue to inflate to get to adjust for the prior almost 20 years of deflation in commodities, but because of the increased demand for commodities (both soft and hard) from developing countries.

Thus stock picking will continue to be very important, as will paying attention to valuations. The same will be true in the commodities markets. We will continue to ferret out values and position accounts to take advantage of the overlooked values.

Is the Worst Over?

We believe that the worst of the financial crisis is over. This does not mean there won’t be further write downs. We expect there will be. The question is whether the banks and investment banks can get capital to stabilize themselves. This is happening. Bear Stearns became the sacrificial lamb, but UBS was able to take another $19 billion write off and still raise another $15 billion in new capital. Lehman Brothers, even WaMu (Washington Mutual) – expected to go bankrupt by many – has just raised $5 billion in new capital. The money is out there and it is getting committed.

However, with that said, the markets do not seem to have adjusted for an actual economic slowdown. Earnings expectations and valuations still seem high to us. In addition, Europe is starting to admit to financial problems. Spain finally admitted they are having housing issues. The EU is now talking up coordinated action to protect liquidity; India, China and Australia are all admitting slowing growth.

The Bottom Line

We are still cautious. We are adding stocks as we get the opportunities, but think we will have even better opportunities within a few months. We like infrastructure stocks, which includes names in the technology, industrial and commodity spaces. We will also continue to use hedging techniques and alternative assets as ways to round out portfolios. Non-correlated investments continue to be critical.

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