Q3 2007 Notes on the Quarter

Q3 2007 Notes on the Quarter

Overview of the Quarter:

  1. Even with the volatility in August, the major indices were up for the quarter. Year to date, the S&P 500 is up 7.65% and the Russell 2000 is up 2.26%.
  2. Interest rates are down across the curve, thanks to the Fed rate cut. While the curve still is inverted slightly on the short end, the curve is slowly returning to “normal” as spreads are increasing to account for risk.
  3. Real estate problems started to become apparent. Sub-prime issues led to liquidity problems, which forced the Fed to lower rates. This created massive volatility in most markets. Many securities and markets dropped 15% over the course of a month. Most of these have already fully recovered.
  4. Oil hit new highs, over $82/barrel. Gold hit a 20 year high of $737.75.

Portfolio Specifics:

  1. We started to see a few signs of the economy slowing, but it is too early to be sure. PPI and CPI have been under control (highly questionable since just about all commodities except for sugar are at new highs), but Consumer Confidence is below 100 (sign of contraction) and Jobs Growth showed some initial signs of slowing.
  2. Technology did better this quarter; energy continued its climb as did commodities and industrials in general.
  3. There are concerns about whether mergers will continue. Deal flow has slowed down, but they are getting done. Housing stocks continued to weaken, as did mass-consumer stocks like Wal-Mart.
  4. Small caps did the worst, large caps the best, and growth outperformed value; exactly what one would expect.
  5. The dollar continued to weaken, the Dollar Index hitting 50 year lows. This helps exports, aggravates inflation, and helps drive gold and commodity investments higher.

Looking Ahead:

A month after the credit scare and the markets seem to have already dismissed the issues. Risk is back with a vengeance. Everyone seems to feel the worst is over and the economy should reaccelerate. And while there is no question that economic cycles have moderated in depth and length due to technology and systems such as just-in-time inventory methods, economic cycles have not disappeared, debt problems and housing issues will take much longer to unwind.

But the Fed apparently is trying to eradicate recessions completely. They have kept interest rates low for an extraordinarily long time and pumped lots of money into the system, the effect of which is to provide speculators with a cheap source of capital to “invest” in almost every asset class possible. We note that stocks, bonds, commodities, art, real estate, almost all asset classes are at or near highs.

This cheap money phenomenon is global in nature and has affected much of the world market as can be seen by real estate prices in Spain, England, Ireland and Asia. But more recently, while the Fed dropped rates to settle the U.S. markets, the Bank of England did not. While our 3 month Treasuries yield 4.00%, the 3 month Libor is at 5.25%.

So what happens if interest rates stay low? The markets probably continue to slowly rise with short, sharp drops in between. Speculators will run from one investment to another. But this cannot go on indefinitely because cheap money leads to inflation which will eventually raise interest rates and slow the economy.

If the economy slows on its own (heaven forbid!) then the speculative money will run for the hills. The losses will appear extremely fast and there will be little time to react. “Diversity” will not help with most asset classes because correlations are quite high.

So what to do. First, since it could go either way for some time, we focus on the long term – where do we want to be in 5 years. And then we commit only part of the capital, leaving the rest in safer, and yes, lower returning securities like bonds. “He who invests only part of the way, lives to invest another day.” As we have said before, we want to focus on commodities, industrials and healthcare because of their demographic benefits. In addition, we will continue to find great companies that will continue to growth because of their special niches.

Second, find some alternatives to the asset classes most people focus on. What can we invest in that will have a close-to-zero correlation to stocks and bonds? Areas that could be of interest include certain types of real estate, premium finance and possibly hard money lending. As we find investments in these areas that offer good risk/reward opportunities we will add them as well.

The bottom line…

Plan to ride through some very volatile times. Have exposure to areas we want to be in over a number of years, but do not hold full positions now. Keep the rest in fixed income that earns a return and allows you to keep dry powder. As we get big drops, we will average down. Focus on areas that will benefit by demographic trends. And finally, invest in areas that have little correlation to stocks and interest rates.

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