Q2 2008 Notes on the Quarter

Q2 2008 Notes on the Quarter

Overview of the Quarter:

  1. The indexes all ended the quarter lower than they started: the Dow Jones Industrials DJIA) -14.4%, Nasdaq Composite (CCMP) -12.9%, S&P 500 (SPX) -12.8%. Most of the international markets faired ever worse: China -46.4%, India -33.6%, Japan: -11.9%, Germany: -20.4%.But things are not that simple; with remarkable volatility, the U.S. indexes rose dramatically during the quarter before giving it all back. The DJIA rose 11.2% from early March to near the end of May, the CCMP rose 17.1% and the SPX gained 12.0%! This volatility made investing very difficult, hedging extremely problematic and only day-traders made any money.
  2. Commodity prices soared. Oil topped $140/barrel; grains were higher, as were most metals. Gold showed a little weakness, but still ended at $928.40/troy oz.
  3. Financial and housing stocks got even weaker. Nobody believes management or can figure what fair value should be. These stocks are at or near 10 year lows.

Portfolio Specifics:

  1. The only sectors that worked were energy and commodities this quarter. We believe that short-term, this area is overdone. We want to wait for a pullback to add to these positions and to date, we have taken partial profits. Every other sector and industry was negative this quarter.
  2. We are adding covered call writing to our positions to reduce volatility and add some protection. We also have added short positions as hedges. These hedges worked extremely well in the first quarter, and until recently, extremely poorly in the second quarter. The key to hedging has been to focus very short term. Long term hedging resulted in losses as the markets were so volatile.
  3. Economic weakness due to inflation and a slowdown in the U.S. seems to be affecting the emerging markets. We are going to remain cautious and defensive.

Looking Ahead:

The Big Picture

Last quarter we postulated that the financial crisis was near the end even though financial stocks could fall further and that stocks in general had yet to price in the impending economic weakness. “…the markets do not seem to have adjusted for an actual economic slowdown. Earnings expectations and valuations still seem high to us… We are adding stocks as we get the opportunities, but think we will have even better opportunities within a few months.”

I continue to believe the financial crisis is near its end. This does not mean banks will start to lend soon, or that they will not have to cut dividends and raise addition capital. However prices seem to be getting hysterically low. Price to book on many banks is trading at close to half their normal levels. However, discretion is the better part of valor, and for the time being cash is king. We continue to look at names, but until we see more dividends cuts, risks are still a little higher than we would like.

Outside of the financial sector, some stocks are certainly attractive and we have been buying them, albeit in small amounts. We have started utilizing a covered call writing strategy and it seems to be adding a great deal of value now thanks to increased volatility. We expect to discuss this strategy with all of clients in the coming months and urge clients to call us with any questions.

While inflation has been rising and this is hard on fixed income, we also expect to add to fixed income portfolios in shorter maturities. A weak stock market will benefit fixed income as investors flee for a save haven, but inflation, when the Fed starts to raise rates (probably after the election) will hurt. While there are a number of possibilities over the next two quarters, the longer term result will be higher inflation.

The Bottom Line

We will buy commodities and industrials on pullbacks. We will utilize covered call writing strategies to reduce volatility and add to returns. We will also utilize short fixed income securities of high quality. The key is to keep losses low, keep plenty of powder dry and ride out the rough patch we are in. We will persevere!

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