Subprime-Loans Getting Ugly

The August 30 edition of the WSJ discusses "the first glimmerings of problems among customers with poor credit." H&R Block has "set aside about $60 million because borrowers were falling behind on their payments. Customers of Countrywide Financial are paying loans off more slowly, as are those at subprime companies Impac Mortgage and Accredited Home Lenders." Mortgage origination volume is also significantly off earlier levels: "First Horizon National said yesterday that mortgage volume was falling so rapidly that it would miss earnings estimates the current quarter."

Another development is that "with the mortgage market slowing and the secondary market for mortgage-related securities faring modestly worse than in the past, investment banks are scrutinizing the loans that come in more carefully." Another problem on the horizon is the rising unpaid balances on Option ARM loans. Investors may need to start worrying about bank's balance sheets and "the industry's lending standards as a whole."

Here's a chart from an article by Robert J. Shiller, an economist at Yale. After the last two peaks in the housing market, prices subsequently went sideways or down for 50 years, adjusted for inflation. This story isn't over - stay tuned.Strategy Update: We've stuck with our long maturity treasury exposure. The treasury market has repeatedly been the investment of choice in times of stress. We see nothing on the short-term horizon to indicate a bottom in the economy or an end to increasing credit worries. Since the interest rate peak in early May our Dynamic Duration Select Strategy is up 7.6% versus the Lehman Aggregate index of 3.1%.

Return on Investments Expectations

UBS reported that the median expected 12-month return on investments fell in August to 6.0% from 7.0% in July. The mean (average) expected return fell to 8.6% from 11.1%. The mean expected return was close to 19% at the peak near the end of 1999 and was as high as 14% in early 2006. The next few months will likely see it drop further but it serves as an early contrarian signal that the it may make sense to go back in to equities for the seasonally strong November to April period.

Strategy Update: We went from 0% to 20% commodity funds in the Dynamic Commodity Strategy; it is still a bit early to play commodities in big way again, what with the global economy slowing down, but with the recent selloff in crude, natural gas and other commodities it made sense to start looking again. The Strategy continues to outperform general commodity mutual funds YTD. Bloomberg News reports that the average commodity hedge fund posted a loss of 11.8% in July. Our Dynamic Commodity Strategy was up 2.42% over the same period.

Housing Slumping

Another chart on the housing situation - this time from David Rosenberg of Merrill Lynch. Note the S&P 500 is 12-month lagged. We're more constructive on the stock market for 2007 than this implies; but it provides more evidence that some caution is warranted on this intermediate-term overbought equity market. The buyers strike in housing likely has further to run.











Strategy Update: Given the above, our timing may not be ideal but we have recently added a REIT offering to our stable of managed strategies. The model has a combination backtested and real-time performance of 20.04% YTD; we do not expect a repeat of this over the next period of the same duration and would wait for a pullback before recommending. The Strategy uses REIT closed-end funds when the discount to Net Asset Value is attractive, and when it isn't, the Strategy utilizes the REIT exchange-traded fund or individual REITs. Our individual REITs are currently concentrated in the Office and Industrial sector.

Equity Update

Equity markets typically struggle in the September to early October time frame. And with an overbought market that has some indicators like the equity put/call ratios flashing negative signs, we think some caution is in order. Still, the bond market has rallied well in recent weeks and inflation pressures appear to be moderating. Any pullback in equities is likely to be mild unless the economy flames out.
Strategy Update: After a great 10 weeks, we've lowered our equity exposure in Dynamic strategies that invest with an equity focus.

PIMCO and Market Timing

We noted in today's Wall Street that PIMCO's flagship bond fund is up 1.55% this year, better than 74% of all comparable bond funds. But here is our Dynamic Bond Strategy - up 10.21% for the year through August 22 (AGG is the Lehman Aggregate Bond Index ETF).

In Bill Gross' defense, he has recommended doing what we've done: buying closed-end bond funds. It's just that with his fund at $94 Billion in assets he doesn't have much flexibility to do the things that a smaller, more nimble competitor can do. He would drive up the discounts on closed-end bond funds without even being able to spend 1/2 of 1% of his fund's assets. As the article says, he is mostly relegated to being a market timer by making large interest rate bets on liquid securities (US Treasuries). There are those who do this well but it is more difficult to be consistently right than with a "value" approach to investing.

Strategy update: though we've had a great run on bonds with the 40-basis point drop in rates on 10-year treasuries since the end of June we think there is more to come. The rate decline appears to coincide with the acceleration in the nation's housing slump. Discounts to NAV on closed-end bond funds have narrowed some but are not yet at levels that would concern us. We continue to be long maturity on all our fixed income portfolios.

No Such Thing As Conservation

We don't believe there is such a thing as conservation of resources. Why? Leakage. Any savings in one area leaks out into spending in another area. One example is fuel efficiency on cars. My first car was a 1972 Ford Gran Torino Sport with a 351ci engine that got about 15 miles per gallon. A lot of people at the time had cars that got 10-15 miles per gallon but who cared; gas was 30 cents a gallon. Consumers allocate a certain portion of their after-tax income to transportation, so when OPEC decided to reduce our oil supply and gas prices rose threefold on two separate occasions consumers initially purchased more fuel efficient cars. But engineers soon designed more fuel efficient engines and allowed consumers to return to even larger cars (SUV's in the 80's and 90's). As such, any fuel savings "leaked" out into bigger and faster cars and trucks.

Consumers also learned you could save on gas by flying to vacation destinations rather than driving. Thank you Southwest Airlines for bringing cheap fares to anyone willing to fly. Several years ago our family did a road trip from the west, through the middle part of the country to Virginia, up to Boston and back across the top. Many people commented on how unusual that was yet these same people remember doing such trips in the 50's and 60's. Now they fly; and flying assists them in keeping the big SUV in the garage back home.

Another example of leakage: the cost of energy for home heating and air conditioning has risen. Solution: put in double and triple pane windows, use 2 by 6 framing and insulate every square inch of the top, sides and bottom. Result: costs to heat went down on smaller homes which allowed consumers to purchase McMansions with 6-10,000 square feet of floor space. Again, consumers are going to allocate a certain portion of their income to housing. If you drop interest rates and build homes with greater energy efficiency the "savings" will leak out into larger homes.

What does this mean going forward? The move to hybrid cars and alternative fuels is great but once consumers get through the adjustment period, they will just leak the savings back into larger, more powerful vehicles. It would take significantly higher energy costs along with long-term stagnant wages to change behavior in any meaningful way. Flat, and possibly rising interest rates in the face of higher fuel costs over the next 15-20 years may contribute to a change in attitude. A possible leakage is that consumers will continue the trend of moving to urban high rises and flying to vacation destinations. A value premium will be placed on vehicles that are well made and last more years driving fewer miles.

Strategy Update: after the last runup in commodity prices in June/July we transitioned the Dynamic Commodity Strategy to short/intermediate US Treasury ETF's. With a slowing economy this seems the right thing to do. But if prices keep dropping (oil has dropped from $80 to $71 per barrel) at some point we'll begin building positions back up. We think oil can drop into the upper-50's sometime before the end of the year before rising substantially on the next upswing in the world economy ('07-'08). YTD performance of Dynamic Commodity is 8.72%. PIMCO's commodity fund is up 3.69% over the same period.

US Dollar Thoughts

The consensus seems to be that investors should be short the US Dollar. Earlier in the year we agreed but without strong conviction, particularly in the face of such pervasive consensus. We now think it prudent to take a bit different view. In brief, we think the recent slowdown in the US economy, particularly the rollover in housing will result in higher savings rates and lower consumer spending. In turn, this will result in a narrower trade gap. Perhaps more importantly, foreign manufacturers will see lower sales and profits.

Why is this important? With the consensus forecasting a lower dollar, these foreign producers have often used borrowed dollars to pay for high priced oil and industrial materials. When sales come in less than anticipated there will be a scramble to find dollars to repay the loans. This will result in an economic crisis somewhere, but more importantly, a rise in the dollar. For more information see the article by GaveKal Research at http://drewbbc.wordpress.com/files/2006/06/gavkal-6-26.pdf

Strategy Update: The US Dollar recently double bottomed. In the Dynamic Fx Strategy, we added some value in mid-July with the last mini run up in the dollar (see chart below). We closed that position and left the portfolio mostly in intermediate bonds, which have continued to have a nice run.

We're now once again rebuilding a long US Dollar position with a portion of the portfolio. (the index is represented by AGG - the Lehman Aggregate Bond Index)

Positive Psychology

The American Association of Individual Investor's (AAII) survey has recently posted a reading above 150% (bears/bulls). This bullish signal has only occurred 10 times since the start of the survey in 1987. On average, these 10 signals produced a return of 7% in the market over the subsequent 13 weeks.

Strategy Update: The Dynamic Beta strategy has had a nice run relative to the Russell 1000 Growth Index since the market bottom of June 13.












We like this strategy going forward - both for its flexibility in capturing rising markets and for its return potential. For more information visit www.windriveradvisors.com/strategies