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2006-06-13 :: Strategic Overview

It’s easy to get shaken by the events in the market over the last month – yes, we’ve been suffering through this nonsense since May 10th.  Even I get to doubting myself and my investment thesis when I wake up to find that the Japanese market was down 4% overnight.  So, based upon that, I thought it would be a good point to give an update/overview of where we are and where we are going.  In times like these, I always like to refer to Don Coxe of BMO/Harris, whose writings and discussions help me to clarify my thoughts.

First, let me state up front that in spite of the gyrations in the market, I think that this is simply an overdue correction and not some major systemic market downturn.  The stocks in the areas we emphasize, those with growing earnings and reasonable valuations – particularly the energy, metals and infrastructure stocks – are cheap and should be bought.  They may continue to go down some until the short-term players are all out of the sectors, but ultimately the fundamentals will shine through and these companies will lead us higher.

In order to have something more than a correction, there are certain indicators in the market that tell you there is something systemic wrong with the market (big thanks to Don Coxe for teaching me these indicators over the years):

  • You need to see a severe drain on liquidity, to the point where corporations are having issues borrowing funds to support ongoing operations –  we do not have that at this point nor is it anticipated that we will have it.
    • Yes, the Fed has raised rates to 5% and are likley to go to 5.25% or 5.5% before they are finished, but by historical standards this is not a high level of interest rates designed to choke off economic activity and curtail borrowing
    • Yes, the Bank of Japan has announced that it will beging to raise rates from its current 0% level and it has been reducing cash in its banking system.  But they have shown that they will not destroy the economic activity in the Japanese economy that is finally starting to revive.  They have already eased up on their cash reduction strategy when they noted that the rates being charged on interbank borrowings had reached the lofty heights of 0.75%.
  • You need a big jump in the price of gold as it becomes a safe haven for investors afraid of fiat currencies
    • What happened in this stock market sell off?  Gold FELL $100 per ounce
  • You need a big sell off in the dollar
    • What happened in this stock market sell off?  The dollar has actually strengthened some against the Yen and Euro
  • You need to have major problems with the US banking system, as we saw witht he collapse of Continental Illinois Bank in the 80’s
    • What happened in this stock market sell off?  The money center banks have actually performed better than the broader market

These are the indicators that I watch to make sure that we are simply in correction territory and not in crash territory.

What we’ve seen in the commodity markets – energy and metals – is an unwinding of short-term positions by hedge funds in both the futures markets and in the stocks themselves.  What we saw prior to Chairman Bernanke’s famous speach was that copper, for example, soared from $2 to $4, then when the hedge funds started to interpret Bernanke’s speach to mean that he would raise interest rates significantly higher in coming months, they anticipated a worldwide recession and began to sell copper.  This drove the price down 95 cents in three hours, an unheardof event caused by fear and program trading.  As the futures sold off, the shares of the underlying companies soldoff in tandem, and have fallen further than the futures have.  Phelps Dodge is trading at 4X cashflows at this point; how can you lose if you are an investor and not a gambler like the hedge funds.

Taking a step back and looking at what I believe the various central banks are trying to accomplish, none of them desire to throw the entire world into recession.  Higher interest rates and slightly reduced liquidity are designed to ease inflationary pressures caused by too much demand (see my blog post from last week where this is discussed).  If inflation is kept in check, global growth can continue steadily upward, making an even more bullish case for energy and metals than we had prior to May 10th.  That’s because these stocks are downright cheap and need to be bought.

Nearterm, we will continue to see problems and volatility in the market as we bounce along this bottom.  Investors are waiting for a sign that the Fed is at or near the end of their tightening phase.  Once that is in place, and absent any negativity in the four indicators listed above, we will see the commodity stocks once again lead the market higher as the fundamental investors add shares at these bargain basement prices.

So, hang in there.  Its a bumpy ride, but ultimately we will see strong investment returns in client portfolios once we get past this soft spot.

More later!