Monday, October 23, 2006

Commodity Debate

The latest issue of Forbes has an interesting article highlighting the debate about the future course of commodity prices between Jim Rogers and Stephen Roach:

While the Dow Jones booms, commodities like oil and gas swoon. Jim Rogers, the man who called the raw materials rise years ago, is upping his bets. Economist Stephen Roach thinks that's nuts.

We have been underweight commodities recently and in our latest tactical update to be published this week, we maintain that position. However, Jim Rogers makes a good case for a long term commodity bull market. Stephen Roach always seems dour about something - he's known as a permabear on Wall Street - but he was right about stocks a few months ago. He was ridiculed at the time because he got more bullish right before the correction, but I'd say he's been vindicated.

I tend to think commodities are reflecting the general view that the economy is slowing. If that proves short lived, commodities could add some return to your portfolio. We'll be watching closely.

They Couldn't Hang Him

Jeffrey Skilling, former Enron CEO was sentenced today:

HOUSTON (AP) -- Former Enron Chief Executive Officer Jeffrey Skilling, the most vilified figure from the financial scandal of the decade, was sentenced Monday to 24 years and four months in the harshest sentence yet in the case that arose from the energy trading giant's collapse.

I don't think this requires further comment.

Barron's on the Election

This past weekend's Barron's cover article makes the prediction that the Republican's will hold their majority in the House and the Senate:

JUBILANT DEMOCRATS SHOULD RECONSIDER their order for confetti and noisemakers. The Democrats, as widely reported, are expecting GOP-weary voters to flock to the polls in two weeks and hand them control of the House for the first time in 12 years -- and perhaps the Senate, as well. Even some Republicans privately confess that they are anticipating the election-day equivalent of Little Big Horn. Pardon our hubris, but we just don't see it.

The writers base this on the amount of money available to the candidates which has been a good predictor in the past. Interestingly, the last time it didn't work that well was 1994 when the Republicans took control. I place more faith in the futures markets which are predicting that the Democrats will take the House while the Republicans will retain the Senate.

Friday, October 13, 2006

Divided Government

MSN Money has an article today called "An investment Guide to the MidTerm Elections" which addresses my comment from a recent post that investors were probably hoping for a Democratic takeover of Congress because they perceive divided government as good for the market:

Forget politics. Before you cast your ballot in November, think how it will affect your portfolio.

Some on Wall Street expect the stock market to benefit if the Democrats gain enough seats to take control of the House of Representatives. The linchpin of this idea is that political gridlock is good for stocks. A Congress divided between a Democrat-controlled House and a Republican-run Senate and White House reduces the chance that lawmakers will upset the legal and regulatory status quo.

I don't really agree with the analysis, but I do believe that a lot of people think this way. The idea seems to be that gridlock reduces the chances of legislation passing and therefore spending may be brought under some kind of control:

But if bonds make up a big part of your portfolio, you may want to support Democrats this year, the study suggests. It shows that during periods of divided government, bonds generally beat stocks. Johnson and his colleagues conclude that gridlock does lead to a slowdown in legislation and to slower growth in spending. That should mean smaller budget deficits, which means the government needs to issue less debt. That could lead to lower interest rates, and since bond prices move inversely with yields, bond holders tend to benefit.

My fear is that divided government at this time in history will just result in the same spending from Republicans on defense and increased spending on domestic programs from Democrats. Discretionary spending growth under Republican control has already been growing at rates faster than inflation. Luckily, it has grown slower than the rate of increase in tax revenues and that coupled with above trend GDP growth has reduced the deficit as a percentage of GDP. However, with the Baby Boomers starting to retire, the current deficit pales in comparison with the long run budget problems created by Social Security and Medicare. Divided government will certainly make it less likely that Congress will address those issues.

Tuesday, October 10, 2006

Bad News? No Problem

The resiliency of the stock market has been amazing. The yield curve is inverted, bonds are rallying even as inflation and wages rise at 4% per year. House prices show the first price fall in over 10 years and housing stocks outperform. Oil, even after a 25% correction, is around $60/barrel. Republicans lag badly in the mid term election polls. North Korea tests a nuclear weapon (maybe). Iran defies the world in continuing nuclear research (well most of the world anyway). And the Dow makes a new all time high. What gives?

It always pays to remember that markets are discounting mechanisms. What markets do today reflects investors view of the future, not the present. Yes, current inflation is too high, but commodity markets are signaling that the peak is past, so stock market investors believe inflation is under control. Yes, the housing market is weak, but with interest rates falling, refinancing activity picking up and homebuilders in good financial shape, investors believe the downturn will be over fairly quickly. And if history is any guide, they are probably right. Yes, oil is high by historical standards, but its falling, OPEC is talking about production cuts and there have been some major new finds recently. OPEC doesn't have a good track record when it comes to controlling prices either so even the threat of production cuts is having little impact. Investors are looking past the current price and factoring in the increased cash flow of consumers as gas prices fall.

North Korea and Iran certainly seem scary, but the paucity of yield in the North Korea test signals either a lack of fissionable material or maybe even an outright hoax. Iran, while acting obstinate, is probably further away from a bomb than the doomsayers think (but probably closer than we would like). They may be a problem down the road, but that assumes that the current regime survives. With a restive, young population that is probably a longer shot than the mullahs think. Did anyone notice the confrontation between Iranian citizens protecting a dissident ayatollah (who thinks that clerics should stay out of government) and government goons? Read about it here.

As for the midterm elections, apparently investors have adopted our view that it makes little difference who controls Congress. Will Republicans lose control of the House and Senate? Futures markets are currently predicting a 36% chance they will retain control of the House and a 63% chance they will retain the Senate. Frankly, with the advantages of incumbency I think the odds of a Democratic takeover of the House are somewhat lower than that, but then I'm not betting on the outcome. Investors seem to be saying that it doesn't matter. In fact, I believe a lot of investors are thinking that divided government would be better than one party control. And they are probably right.

Another factor to consider in the recent runup is sentiment. We typically like to bet against the crowd and this rally has plenty of sceptics. The latest AAII (American Association of Individual Investors) poll still shows more bears than bulls (46.7% to 37.8%) so the little investor is still scared of the market. He's probably thinking about the spring when a run at new highs was turned back by a nasty correction. That's okay; when the bulls start running we'll be looking to cut back, but for now the wall of worry is still fairly tall.

Predicting the future is always a tricky business, but especially when it seems there are so many potential problems. Are investors too optimistic about the outcome of all these things? Maybe, but for now, there aren't enough optimists to make us worry. When the small investor starts to jump on the bandwagon, we'll start to worry. For now the small investor is still chasing last year's returns - inflows to international funds are swamping inflows to US funds even as the US outperforms. It seems dangerous to us to invest (or drive) by looking in the rear view mirror.

Thursday, October 05, 2006

New High for the Dow

There has been much ink spilled this week about the Dow Jones Industrial Average making a new all time high. Frankly, it's just a number and it doesn't mean all that much. The components of the Dow have changed pretty dramatically since 2000 so the average making a new high now is not comparing apples to apples. More like apples to kiwi.

More important to us is the relative performance of the various asset classes in which we invest our clients assets. Our large cap emphasis has paid off recently and we expect that to continue. We have also been underweight the commodity indexes and that has certainly turned out to be a good move with the GSCI taking a pounding over the last couple of months. Unfortunately, our crystal ball isn't perfect so we do have exposure to commodities and that has hurt our performance somewhat during this time, but overall we've had a good 3rd quarter.

The market is starting to anticipate a rate cut by the Fed and that has been the driving force behind this stock rally. The economy is slowing with housing leading the downturn. No surprise there; we've been talking about that for a while too. However, we still believe the housing market will not take the whole economy down for the count. Just this week, the Mortgage Bankers Association reported that mortgage applications jumped impressively over the last month. Refinance applications were up more the 17% and purchase applications were up about 7%. Lower rates are having the expected effect. There's probably some more pain to be seen in the housing market, but so far the correction has been rather orderly.

As for the Fed, we don't expect them to cut rates anytime soon. The yield curve is still inverted and all Treasury rates are less than the Federal Funds rate, but with the way the banking system works today, we don't think that means as much as it once did. The market is setting rates and the Fed, while not irrelevant, is certainly less important than it once was.

We continue to see a lot of positives about the stock market. Sentiment is still pretty negative and valuations, while not cheap, are certainly reasonable. And large cap stocks are still the cheapest part of the market. Falling commodity prices seem to be saying that inflation is moderating and that should be positive for stocks and interest rates.

We'll be publishing our Tactical Update next week.