Reversion to the Mean?

Today's Ticker Sense looks at sector performance over the past year. A couple of thoughts: First, we note that 9 of 12 respected Wall Street strategists named health care as one of their favorite sectors in the Sept 4 issue of Barron's. It looks to be one of the worst performers since then (along with consumer staples). Is defensive out and Aggressive in again?

Second, this brings up a behavioral bias point. In the March-April 2006 issue of CFA magazine, Roger Mitchell states, ". . . whereas most people are prone to hot-hand fallacy (undue confidence that a recent trend will continue), professional investors are prone to gambler's fallacy (undue confidence that a trend will revert to the mean). It seems that specialized training can alter people's tendencies." In our experience, there are at least as many, and probably more professionals who fall into the hot-hand fallacy category, but the point is taken. We at times have been too early as contrarians and have had to suffer through some troughs that turned out to be longer and wider than originally anticipated. Still - we continue to believe that if you are not willing to be contrarian, or more specifically, contrarian with a catalyst scenario, you ought not to be trying to adjust sector weights in a portfolio. It won't work in the long run.

Baltic Dry Index

The Baltic Dry Freight Index have risen substantially in the past several quarters (see chart). Charlie Maxwell, the highly-regarded energy analyst at Weeden & Co. has often said this, along with a rise in Tanker rates, has been a harbinger of higher crude prices in the past.

In recent years China has altered this relationship. In the Capital Chronicle , written from Grenoble, France by RH Adams they ask if this is still a good proxy for global economic activity. They state, "As China moves in 2006 to being a consistent net exporter of steel its influence over an important driver of the Baltic Dry Index (BDI) - iron ore for steel production - grows. But China's massive growth in steel output has come in large part though government intervention. This, to some degree, is distorting the underlying freight rate picture. . ."

"China's imports of iron ore represented 13% of total dry bulk trade in 2005. Given that in the half year 2006 Chinese iron ore imports jumped 23% that share has at least held steady and probably risen. Chinese steel production has correspondingly accelerated. To June 2006 it churned out 35% of global output and has become a consistent net exporter of steel since the start of the year. Which is essentially the same time period over which the BDI has counterintuitively taken flight. . . China is in effect artificially boosting freight rates on an unprecedented scale (by having become the largest iron ore consumer and steel producer)."

This should sort itself out over the next several quarters with the BDI declining from recent peaks. In the meantime, we think a contratrend rally in crude is likely from these levels as we enter the fall season. Global economic slowing had a hand in the recent decline, but we suspect hedge fund capitulation and over-leverage contributed, as well.

Strategy Update: The stock market has entered one of those occasional odd periods where certain sectors have had radically different performance. Technology stocks are overbought and energy and material stocks are at oversold levels, reversing what was the case in July (when stocks like NVDA, ADBE and AMD couldn't seem to find a bottom). Our strategy managers have taken the opportunity to increase positions in energy and materials in several strategies, including Dynamic Beta and Equity Opportunity. Commodity exposure has increased in Dynamic Commodity and Dynamic Global Macro. For more information on Strategy Investing with up to 10 strategies per account, visit www.windriveradvisors.com/strategies.

Energy Sell-Off

The UBS energy team suggests there was a "perfect storm" responsible for the $17/bbl drop in the oil price since August:
1) "the U.N. failing to press Iran with sanctions following the Aug 31 deadline passing without the country committing to halt nuclear enrichment programs;
2) "the 38% collapse in gasoline prices (since late July) from the combination
of the liquidation of the contract by the Goldman Sachs Commodity Index
(GSCI), onset of more plentiful winter grade gasoline, and the seasonal
downturn in demand;
3) "the flurry of hurricane downgrade forecasts post-Labor Day removing a
significant supply risk; and
4) the somewhat normal decline in prices on a seasonal basis.

We would add short-covering and a fading world economy to the list of reasons.

Strategy Update: Our Dynamic Commodity Strategy didn't entirely side-step the decline in commodity prices but has done much better year-to-date than commodity mutual funds, including the Rydex Commodity Fund, shown here versus our Dynamic Commodity Strategy:











The Dynamic Commodity Strategy is up 2.89% YTD versus a decline of 15.42% in Rydex for a positive performance spread of over 18.3 percentage points! Other than not being aggressive enough in the spring, we like how the year has played out in the Strategy. We stepped up our commodity exposure today and have only 20% remaining in short US treasury notes.

On the bond side, we pulled back maturities again in the Dynamic Duration Select Strategy and Core Fixed Income Strategies and now are closely invested to the intermediate-term benchmark. We still believe the economy is weakening enough to warrant further interest rate declines but think it makes sense to ease back on duration in the face of this short-covering rally. Performance of Dynamic Duration Select since the May 12 peak in rates has significantly exceeded the Lehman Aggregate Bond Index (AGG), 10.50% versus 4.40% for a plus 6.1% margin.

Bond Notes

The last week's 20 basis point move in the 10-year treasury from 4.80% to 4.60% indicates the economy continues to weaken. This speed of the drop suggests some panic short covering from hedge funds and others who were betting on much higher inflation. We would take a little off the table on the longest maturity positions.












Strategy update: We are still long maturity relative to benchmarks in the Dynamic Duration Select and Core Fixed Income Strategies but are tempering the bet today by selling approximately one-third of the long-term security position and redeploying to intermediate term.

High Yield Investing

Investors in corporate high yield often simply compare the total income from a high yield investment to total income from other investments. By definition, high yield usually compares favorably. We think it warrants more attention than this and find that analyzing a variety of factors can improve total return considerably. In taxable fixed income, high yield bonds are debt obligations of below investment grade corporations. Typical issuers include General Motors Acceptance Corp., Sprint Capital, Lucent Technologies, Quest, Rogers Wireless, Boyd Gaming, AES Corp., and Williams Cos., etc. Historically, some of these companies disappear and as a result, the total return (principal plus interest) is often less than the amount of income generated. As such, it is critical to evaluate is the credit spread, or the amount of interest generated relative to a risk-free investment (US treasuries), to determine if you are being adequately compensated for the extra risk. If the additional income is too small it does not provide a good risk/reward profile and it makes sense to step aside. Generally credit spreads are narrow when few defaults have surfaced in a moderate to low interest rate environment. Under these conditions, investors chase yield and bid up the prices of high yield bonds to unreasonable levels. In recent years hedge funds have been a factor, as well. They leverage up their funds through borrowed money from Japan and other places and purchase high yield securities. This leverage swings both ways and has exacerbated trends in high yield.

Another consideration is the projected direction of interest rates. Rising interest rates are usually a response to a strong economy and anxiety over future inflation rates and result in declining bond prices.

Our high yield strategy has made extensive use of closed-end bond funds. This adds another component to returns - the discount to Net Asset Value. In closed-end funds this variation from NAV can swing from a premium to a sizable discount. As can be expected, this discount is often the widest in times of stress (rising interest rates and increasing defaults) creating contrarian opportunities for opportunistic investors. Spreads can swing from 10-20% discounts to premiums and then back to discounts over time.

Simply comparing income misses much of the profit opportunity.

Strategy Update: Our Dynamic High Yield Strategy has had solid performance YTD, up 13.72% and significantly over the Lehman Aggregate Bond Index, seen here up 1.77%. Discount to NAV continues to be wider than normal on funds held in the strategy yet narrower by 4-5% versus earlier in the year. Combined with the recent moderate decline in interest rates we have chosen to take a bit off the table and are now at 32% in the Lehman 1-3 year treasury exchange traded fund. Should either rates decline more (as we expect) or spread to NAV narrow more we would anticipate further profit-taking.

Fed Meeting

We think the Fed is done raising rates. As such, this next meeting on September 20 will be a non-event with rates remaining unchanged at 5.25%. Oil prices have come down significantly but probably too recently to have much impact on near-term inflation reports. Economic growth has slowed, which will start to show up in reports. Housing starts should continue to taper off and once builders finish some recently started homes, construction industry employment should begin to recede. The Homebuilders Survey has declined from 42 in June and a revised 33 in August to 30 in September.

Strategy Update: today we added another 20% to an inverse S&P 500 Fund in the Dynamic US Equity Strategy. This brings the total to 40%, our maximum allowed for this strategy. Performance has compared favorably to the Balanced Index Benchmark over the last 2 months (see chart). For more information on strategy investing visit www.windriveradvisors.com/strategies.

Optimism Index Fades

The National Federation of Independent Business (NFIB) Index declined from 98.1 to 95.9, which is consistent with GDP growth around 1%. The net percent expecting higher sales fell to 10% from 18%. After making a double peak in July/August near $80 per barrel, crude oil prices appear to be making a short-term bottom at late winter support levels around $64. We think a bounce is likely here but would not be surprised to eventually reach the 4Q05 support level below $60.












Strategy Update: We bottom-fished a few names in the energy and materials sectors in the Dynamic Beta Strategy, but continue to be cautious on the overall market. We would note that this is options expiration week. In most months this year, the trend of options expiration week seems to be reversed the following week.

Up Now, Weaker Later

The following chart from sentimentrader.com shows September's average performance, 1950-2003. It shows a generally weaker market as we move through the month and today was the 7th trading day (with the S&P up nearly 1%). Mid-term election years are weaker than average over this stretch.

John Hussman (hussmanfunds.com) notes in this week's letter that we are in one of "the longest stretches the S&P 500 has ever gone without a 10% correction." The early summer swoon was only 7.1%. In terms of corrections, the oddest year we ever experienced was 1995: only two corrections greater than 3% the entire year. One in July lasted a day and a half with a 3.6% decline while the other reached 4 days and 3.1% in October. Compare that to the 16 corrections greater than 3% in 2000 and 14 in 1999. Even 2003, which was a great year for the market, had eight 3% corrections.

Hussman continues, "as of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action. Stock valuations remain extremely elevated on the basis of nearly every historically reliable fundamental, including normalized earnings (price/peak, price/earnings normalizing profit margins, etc). The only fundamental that suggests stocks are reasonably valued is the price/forward operating earnings ratio. While this, of course, is the only valuation measure that's widely quoted by analysts here, the price/forward operating earnings ratio has a very limited historical record, much less any proven reliability. Even here, the assertion that the current multiple is “reasonable” is based on an apples-to-oranges comparison with the historical average of 15 for price/ trailing net earnings."

Commodity Watch

Commodities are telling us something here with the Reuters Commodity index down 12.4% from the July highs. It is not just energy, which accounts for 33% of the index, that has declined. Precious metals, which account for 7% of the index, as well as other commodities (lumber, corn, wheat, soybeans) are also down in recent weeks. This is saying something about the economy that we suspect is not good.

Dollar Bounce

While everyone discusses why the dollar should decline it has managed to put in a quiet bottom since the mid-May interest rate peak in longer maturity bonds. There has also been a series of rising bottoms over this time period and it has the potential to breakout of a triangle formation to the upside. We continue to feel the consensus is too complacent about dollar weakness and think it could continue to surprise by climbing higher.













Why? As we pointed out in an earlier post, with the US economy rapidly slowing, the US consumer has greater incentive to temper spending and increase saving. This leaves goods suppliers, such as China, short the dollars needed to import oil, basic materials and technology products that are often priced in US dollars.

Strategy Update: The Dynamic Fx Plus Strategy continues to be long the US dollar with a portion of the portfolio. Performance has benefited from strong bond momentum and a moderately rising dollar. As can be seen from the following chart, Dynamic Fx has had nearly a 1% advantage over the Lehman Aggregate Bond Index since the end of June.

Muni Bond Investors Win One

A Kentucky couple recently won a lawsuit challenging the state's authority to tax them on earnings from out-of-state municipal bonds. If the ruling holds up, it would be good news for all municipal bond investors. Similar suits are winding their way through courts in Arizona and North Carolina with other states expected to follow.

Even without tax on out-of-state bonds, we've always thought investors were over sensitive to not owning out-of-state bonds. Consider the difference between owning a 10-year California insured bond compared with a 10-year Texas AAA rated bond. The Cal bond yields 3.80% while the Texas bond yields 3.97%. If a California investor purchased the Texas bond the current effective return would be 3.97% less the California tax adjusted for the federal marginal tax rate (because any additional California tax is deductible for federal tax). At a 35% marginal tax rate the effective return on the Texas bond is 3.73% (or 3.97% - (9.3% - 35%)). In this case, the return difference is 0.07% (3.73% - 3.80%). Hardly enough to justify a geographically non-diversified portfolio. Additionally, there are a lot of interesting opportunities available in municipal bonds that a single state investor foregoes.

We also never understood the rationale for taxing out-of-state bonds from the perspective of the issuer. Our studies indicate that the yield difference on issuance is at most 0.01% and once you condition your state's residents to purchase in-state, the incremental income tax revenue is negligible. Hardly enough reason to antagonize your wealthiest constituents.

Equity Comment

The third trading day in September turned down - about on schedule.











This puts in a double top for the S&P after a trough to peak move since October 2005 of over 13%. This wasn't a large move relative to the 51% move from October 2002 to March 2004, but it was nevertheless significant. Other indexes captured investor's focus more over this recent 10 month period and experienced better returns: the Russell 2000 Index was up 27%, MSCI EAFE Index up 29% and the Emerging Market Index up 48% trough to peak. These three are well below the May highs - so some negative divergence is apparent. Sure, equities may reverse and head higher again but the risk/reward favors some caution.

Strategy Update: Dynamic US Equity added a small position in an inverse S&P Fund (about half of what is permitted) on yesterday's close and eliminated long positions in Biotech and a couple of small-cap ETFs. We continue to nibble at oil and commodities in the Dynamic Global Macro and Dynamic Commodity Strategies, but overall commodities exposure remains low/moderate.

September Trends

We're now into September and typically only the few days leading up to Labor Day experience positive returns in the equity markets - the balance of the month tends to be poor performing.










There are a lot of reasons for this. We think one of the main reasons is that most mutual fund's fiscal years end at the end of October. The stock market often trades in a seasonal pattern where the best returns occur from mid/late October through April of the following year. The past year was no exception, with the S&P 500 hitting a low on October 13th, 2005 and reached its 2006 intraday peak on May 8th. Imagine mutual funds receiving inflows in conjunction with the rise in the market and since most equity mutual funds trade in and out of positions frequently they may realize a large amount of capital gains in the first 6 months of the fiscal year (November-April).

After the market trails off in the summer months (as it did this year) they realize that many investors that purchased shares near the peak now have losses on their position yet will be required to receive a capital gains distribution from the fund. A related point is that funds don't like to make distributions, preferring to keep the asset base intact for fee generation. Bottom line: fund managers spend much of September digging through their portfolios looking for losses to offset earlier gains. Because they tend to think well in advance on this (unlike individual investors who may wait until Christmas hoping their losers turn around), the fund managers are generally finished culling portfolios by early October and the market can be free to run up again. This was not as much of a factor in 2003 or 2004 due to the tax-loss carryforwards in the funds from 2000-2002 but should be more of a factor going forward.