Archive for July, 2008

July Troubles

Friday, July 11th, 2008

I was in South Dakota last week at Mt. Rushmore for the 4th of July. Pretty spectacular Americana in spite of the ugliness that ensued in the financial markets. That ugliness continued through this week. We have uncertainty about the future of mortgage giants, Fannie Mae (FNM) and Freddie Mac (FRE), and uncertainty about oil supplies with Nigerian and Brazilian potential supply disruptions as well as news from Conoco that their production is down.

The government has been issuing news releases about the stability of FNM and FRE, but I believe they are referencing the ability of those organizations to continue to provide liquidity to borrowers. The investment markets have been realing because the likelihood is that people who own the common stock will see their investments negated because of losses on sub-prime mortgages. The government will likely recapitalize both entities in some manner that will cause entire or almost entire losses to the equity investors in those companies.

Additionally, we’ve seen oil move from $144 to $132 to $145 in just a few days. This pattern is a repeat of what we have seen multiple times in the current energy bull market. Some pundit will come out with a theory that oil is ready to drop 40% in value and it and energy stocks will sell off, only to be followed by news that supply cannot keep up with demand. The market is giving everyone a chance to own some great energy companies – particularly ones in the Natural Gas exploration field – before they make an assault on their all-time highs again. We’ve been buying EOG Resources, Devon, Chesapeak, El Paso, Southwestern, and Sandridge as the prices were dropping – some of them we own a couple points higher than current levels, but the current levels will be bargains when we look back at this period of time.

In terms of the broader market, from a technical standpoint we are severly oversold. You can see from the chart of the VIX above, that from a volatility standpoint, current readings are beginning to reach other turning points in the past year (Last August, November, January, and March). Each of these turning points has represented a significant move up in the market, but they were followed by an even bigger move back down. As an investment manager, you have to be nimble in a market like this, selling during the move up and buying during the move down. You have to protect your hard won gains with sales and use the cash to buy stocks in areas of the market that have strong fundamentals but that have sold off ( EOG Resources, Devon, Chesapeak, El Paso, Southwestern, and Sandridge ).

You also have to be aware of sectors with improving fundamentals, even on a relative basis – the one that comes to my mind is the Biotech sector. We have stressed the importance of Biotech in our investment strategy for some time now. Earlier this month, we started to overweight it as a potential opportunity to outperform the broader averages. Historically, Biotech has outperformed the rest of the market as the US economy grinds it way through economic turmoil. They are companies with improving fundamentals that are not impacted by rising interest rates or consumer recessions – the perfect prescription for our current economic situation. Fortunately, the market has recognized this and it is pushing Biotech, as well as broader medical stocks, higher. We’ve bought IMCL, XNPT, DNA to augment our core holdings of GILD and CELG.

The unfortunate thing is that an oversold market can remain that way for a long time. It can continue to grind lower before it rallies – and that rally may not be sufficient to bring your returns positive for the year. The market will turn at some point and we will sell into the rally to generate some cash so that we have liquidity available for the inevitable downturn.

There are just too many problems with financials and housing for the US economy and the financial markets to make a sustained advance higher and end the current bear market. Until then, we will continue to be nimble, book profits where we can and invest in under-appreciated companies with great fundamentals that inevitably will go up.

Have a nice weekend!

Mark