Growth Scares

We didn't expect yesterday's comment regarding synchronization of markets during swoons to be so timely with most stock markets around the world down 3-10% today. We'll claim the "shark-in-the-water" syndrome where one often doesn't see anything but there is an uncomfortable feeling that perhaps prudence would dictate some time on the beach.

Today's decline was precipitated by subprime loan problems, housing worries and a slowing consumer but the final straw, so to speak, was the reported weakness in durable goods (down -7.8% versus the consensus down only -3.0%). Most economists have expected some drag on the economy from the consumer, but weakness on the business side colors the current environment different. UBS comments that the "data are only for one month of the quarter but they even weaker than the recent trend in orders growth in the manufacturing ISM index. More broadly, our forecast for sub-par growth mainly reflects weakening in household spending, so weakening in business investment would be significant."

In addition, with regard to housing, UBS mentions that "with a glut of vacant unsold homes still for sale, we expect prices to fall further, holding down consumer spending growth. We expect prices will fall by as much as 10% by late 2007." I don't think you'll see that on the housing side this year - our take is that it will be a more methodical slide. We once heard a commentator say they thought housing could underperform inflation by 50% over 10 years. At first glance that seemed extreme but if you experienced inflation at 3% per year for 10 years and house declines of 2% percent for 10 years you arrive at the 50% underperformance on the raw numbers. On a compounded basis you would only need a 1.68% decline in housing along with a 3% rise in inflation over 10 years to result in 50% underperformance. We see that as very doable.

Strategy Update: Our long US treasury exposure continues to benefit a number of strategies with yields on 30-year treasuries dropping over 10 basis points today. It is now within 10 basis points of the recent bottom in rates put in during the first week of December. We'll begin tempering our long duration bet at these levels. The 1-year chart shown here is of the Dynamic High Yield Strategy (dark line) versus the Lehman Aggregate Bond Index (gray line). The strategy has partially benefited from having a long duration bet (though not reflecting today's strong move). Visit our website for more information.

Treasury Bonds and Market Correlations

Most investors occasionally need reminding that most markets move in the same direction in times of stress. Asset allocation and diversification is based on the idea of markets moving in different directions, for example, Japanese stocks rising while the US stock market drops or visa-versa. This was more the case in the 1970's and earlier; it is less true in the last several decades. Yet most asset allocation models are based on long time series that include pre-1980 data. Today's WSJ discusses Friday's rally in Treasury bond prices, "pushed higher by continued worries in the subprime-mortgage sector . . . after a benchmark credit-derivative index for risky mortgage loans hit record levels in the midmorning." John Spinello, Treasurys strategist at Jefferies & Co. followed by saying, "the subprime-mortgage market led the way with respect to a flight to quality," and Carl Lantz, fixed income strategist at Credit Suisse Group said that the weakness in subprime mortgages is starting to "leak into higher-rated credits."

What all this means is that the primary beneficiary during times of stress is US Treasury notes. After dropping 5 basis points on Friday, the 10-year treasury index interest rate is down another 5 basis points today to 4.63%. It has now retraced more than 50% of the rise from early December to late January. Looking back at extreme stress in the markets, such as October 1987, 1997, and 1998, treasury yields declined in each of those periods. We continue to feel that market developments favor a continued rally in quality fixed income, even while lower quality fades.

CPI and Bonds

Strategists in the Global Fixed Income Research Division of UBS comment that, "Fed officials (Poole and Yellen) used yesterday's slightly higher than expected Core CPI print to remind the investing public how pleased they are to have maintained their tightening bias in the face of a housing recession. We think that the drag from . . . housing will ultimately translate into weaker US employment conditions -- spurring a series of rate cuts that will begin in May. For the near term, however, the Fed has the upper hand which means that rangebound conditions in bonds are likely to persist for a while longer. Sadly."

We suspect that yesterday's news of additional subprime lending problems, this time at Novastar Financial, emboldens strategists to predict a near-term rate cut. We doubt it will occur this soon unless the mortgage market really begins to unravel. While that is possible (see today's WSJ article on C1 that reports that as of the third quarter 2006 there were $1.28 trillion in subprime mortgages outstanding, which represents about 13% of the $10.0 trillion mortgage market), we believe global liquidity will delay rate cuts til later in the year. However, we continue to believe that longer-term rates will continue to dial down in a slow fashion. Contrary to UBS, we are "saddened" by lower long-term rates because it makes it that much more difficult for retirees and investors to capture an adequate cash flow on investments. We would much prefer a gradually rising rate environment that permits more attractive reinvestment options even if it means slightly less-than-coupon total return to get the higher rates. We just don't see that happening. As such, we find it increasingly important to have value-added solutions such as our Dynamic Fx Strategy. This strategy overlays a long or short US dollar bet on a generally intermediate-term bond portfolio. The chart on the right shows the favorable performance relative to the Lehman Aggregate Bond Index (as usual, past performance is no guarantee of future performance). See our website for more information on managed accounts.

Silver Demand

The silver ETF (SLV) briefly punched through $140 one day last week after hitting lows just under $96 last June. The quantity of silver backing the ETF (the metal to back the ETF is put into storage, thus creating physical demand) has been rising steadily and now exceeds 125 million ounces, according to Jeff Christian of CPM Group, a commodities research firm. The Silver Users Association reports that worldwide demand for silver in 2004 was 367 Moz for industrial uses, 181 Moz for photography, 247 Moz for jewelry and silverware and 41 Moz for coins. These numbers predate the silver ETF which is now a major competitor for available silver. Interestingly, the total demand in 2004 was 836 Moz yet the amount of newly mined silver was only 634 Moz, with the balance made up from scrap metal. We view this shortfall of production, combined with increased ETF demand as reasons to think that silver (and gold) prices will continue to rise in a sawtooth pattern. The silver ETF is currently somewhat overbought but look for the next run later this year to take it over $150. The 2/20 edition of The Wall Street Journal reports that "any continuation of inflows into the silver ETF eventually could result in 'critical supply' tightness. This may result in gold and silver taking a turn in the rotating manias of the last 6-8 years.

Strategy Update: The Dynamic Global Macro Strategy continues to have a commodities emphasis with 45% of the strategy in commodity ETF investments. Performance YTD (right) compared to the S&P 500 has been favorable. The strategy has outperformed by a wider margin its stated benchmark: the balanced index.

Interest Rates

The recent declines in interest rates have come in spurts - note the chart on the right that shows rates declining from around 4.9% on the 10-year treasury index to just under 4.7% today. Yet it was really only 2 or 3 days that were responsible for the decline. Various commentators have complained about the lack of follow-through. Perhaps that is because they only notice rates on the bigger decline days, then the immediate follow-through seems weak. Yet it has retraced 40% of the rise off the 4.4% bottom in early December. That's not bad.

Contributing to the decline in interest rates has been a spate of recent articles on the state of the lower grade mortgage market. Increased defaults could directly affect bank loan portfolios and consumers ability or willingness to spend. But higher defaults could also jeopardize some of the speculative-grade tranches of Collaterallized Debt Obligations (CDO), which in turn could begin to impact bank earnings. In addition to mortgage loans in inventory that begin to be non-performers, many banks actually invested a significant portion of the bank's investments in CDO paper. We know of one bank that had a substantial portion of its investment portfolio in CDO's made up of loans to smaller community banks. It works while it works, but when these things stop working the wheels usually fall off in dramatic fashion. This represents a sizeable risk below the surface to the economy and bank profits. As it continues to play out we would anticipate more declines in treasury interest rates within the current trading range: 4.55% seems doable over the next few months. Corporate and mortgage credit spreads could widen under such circumstances.

Strategy Update: we continue to be long duration in our aggressive active fixed income models. Dynamic Duration Select strategy (dark line on the right chart since the peak in rates versus the Lehman Aggregate Bond Index) is hitting new highs. Visit our website for more infomation on strategies management.

Ruminations on Space Travel

Today's Wall Street Journal aired a spat between Burt Rutan and Jim Benson, former partners who are now "sparring over who deserves credit for various aspects of SpaceShipOne," the first private suborbital craft to fly two consecutive flights to space in less than two weeks during the fall of 2004. We like the idea of entrepreneurs pushing the space boundaries like modern-day Wright Brothers and suspect that we'll see success in the next few years. (As an aside, we would ask if Lincoln had been alive today, would he have chosen to be a pioneer in a different sort of way?)

One of the biggest myths is that discovery and the advance of science was strictly a European/Western phenomenon. Supposedly when Columbus and others were exploring the globe, other people were just waiting around ready to be "discovered". In fact, in the early 1400's, the Chinese navy of the imperial Ming dynasty was not only equal to anything the Europeans had, but was in many ways technologically superior. Such inventions as gunpowder, printing and the compass were commonplace in China hundreds of years before they reached Europe. Beginning in the 500's, the Chinese sailed to East Asia and by 1420 the Chinese had sailed down the coast of East Africa, in the process bringing back a giraffe to Peking. Some of these ships displaced 1500 tons and carried a crew of 500.

What happened? as author-physicist Arthur Kantrowitz has pointed out, "In 1436, when the Cheng-t'ung emperor came to the throne, an edict was issued which not only forbade the building of ships for overseas voyages, but also cut down the construction of warships and armaments." By 1575, an imperial edict ordered any leftover ships destroyed and the mariners who used them arrested. Why? Historian Joseph Needham writes, "the Grand Fleet of Treasure Ships swallowed up funds which, in the view of all right-thinking bureaucrats, would be much better spent on water-conservancy projects for the farmers' needs, or in agrarian financing, granaries and the like." According to Jack Kirwan, "Chinese science ossified and, even worse, became divorced from technology. And this, the ongoing partnership of science and nuts-and-bolds technology, was what gave Western civilization the edge it has kept to the present day." There are similar parallels in our country. Politicians continually rail against spending money on space or other technologies at the expense of social programs. In Mr. Kantrowitz's words: "To the argument that we can no longer afford large-scale exploration of space, I would respond that hindsight makes it clear that the destruction of the Ming navy was the real extravagance . . . As in Ming China, there are those among us who profit from adventurous technology and there are those who have gained center stage by its suppression. The suppressors in both cases claim moral superiority and have too often been able to conceal the magnificent role of creative technology in liberating and elevating mankind."

People have an innate desire to learn and grow. The benefits of such challenging of orthodoxy and the status-quo spins off exponential benefits. Recall the words of Waldemar Kaempfert, the Managing Editor of Scientific American and author of "The New Art of Flying", on June 28, 1913: "The aeroplane . . . is not capable of unlimited magnification. It is not likely that it will ever carry more than five or seven passengers. High-speed monoplanes will carry even less." We salute those who push the envelope!

Oil musings

Oil prices have seen a decent rally since mid-January (see chart at right). However, as they point out in the Hays Advisory Letter, "despite this latest increase in price off the bottom, not one trend line has been broken. The downward trend on the price of oil is still intact, despite this recent upward spike."

We believe that oil prices, like interest rates and stock prices, have entered a broad sideways trading range. Despite today's decline in oil we think it has a bit higher to go before it hits the top of the range. Longer-term we think once a synchronous expansion in the world economy gets underway it will put oil over $100/bbl. within 3 years.

Strategy Update: Our Dynamic Commodity Strategy is up 15.6% over the past year compared to the Rydex Commodity Fund down -15.8% (gray line) for an outperformance of 31.4%. The key to the outperformance has been to miss much of the downswings despite less than perfect participation on the upside. Visit our website: www.WindRiverAdvisors.com.

Recycling Petrodollars

Much of the rise in asset values in the past couple of years has been due to the massive flow of petrodollars into such assets as bonds, stocks, real estate, commodities and precious metals. While this may be good over the short run for holders of such assets, the long-term is more problematic. In a recent Barron's publication the governor of the Bank of England, Mervyn King was quoted as saying, "It is questionable whether such behavior can persist. At some point the ratio of asset prices to the prices of goods and services will revert to more normal levels. That could come about in one of two ways: either the prices for goods and services rise to catch up with asset prices as the increased money leads to higher inflation, or asset prices fall back as markets reassess the appropriate level of risk premia."

Barron's comments that the "prospects of a rate cut are growing more remote. The futures market is predicting only about a 50% chance of a quarter point cut in September; it had thought one was likely by spring." The article goes on to say that, "while observers and central bankers have come to recognize the impact of the massive petrodollar flows on the financial markets . . . the world as a whole cannot become wealthier if oil exporters do . . . Siphoning billions from strapped oil consumers to oil producers who have no other use for the money but to funnel it into the financial markets may benefit those markets, but not the economy as a whole."

In addition to the continued massive liquidity from oil producers markets have benefited from large pools of savings in emerging market resource countries and low interest rates in places such as Japan. Additionally, supply has been crimped in the US by private equity deals, corporate stock buy-backs and a fairly tepid domestic new issue calendar. Some of this is driven by such things as Sar-box and its regulatory reach. In the face of this, many observers have commented on the possibility of a melt-up in financial assets similar to what occurred in 1987, a year which saw an incredible rise in the first 9 months of the year only to followed by the collapse in October. It remains a possibility despite an overbought market over the short-term.

Strategy Update: We rolled out a new strategy recently: Focused 13D. This strategy actively purchases stocks that are the subject of SEC required 13D filings or other sources that indicate shares are under significant accumulation by knowledgeable investors. Presumably, it would be a beneficiary of continued private equity deal demand. We currently hold 22 stocks in the strategy, including yesterday's takeover announcement, Triad Hospitals. As can be seen in the graph, performance has been stellar, up +14% in the 2+ months since the end of November. We are an SEC Registered Investment Advisor. Visit our website for more information on our Strategies management program.

January Performance

We had a fabulous month of performance in January. Our objective continues to be to deliver aggregate returns that exceed the S&P 500 over full cycles at half the volatility.

The equity strategies were paced by Focused REIT up +7.8%, Focused 13D +7.3%, Focused Analyst Growth +6.7%, Select Equity +5.5%, versus the S&P 500 Index return of 1.5%. The International Strategy was up +1.5%, about 0.6% ahead of the MSCI EAFE Index.

Dynamic strategies (those with more hedge fund and absolute return characteristics) were led by Global Macro up +3.9%, High Yield +3.7%, and Commodity +2.8% (noteworthy since the prominent commodity mutual funds were negative performers). Versus a flat bond index, the Bond Plus strategy was up +1.1%, Fx Plus +1.2% and Tax-Exempt Plus +0.9%.

The asset allocation models were led by the +3.8% return of the Growth model. The Absolute Return Growth model has a quarterly return benchmark of 2.5% (10% per year) which was exceeded in the month with a return of +3.1%. Absolute Return Income has a quarterly benchmark of 2% (8% per year) and was exceeded in the month with a +2.1% return. Both strategies are well ahead of the 3, 6, 9, 12 and 24 month benchmark.

For more information on investing with us, visit our website, where you will also find the complete performance rundown. As usual, past performance is no guarantee of future performance. Please see the disclosures.