Commodity Inflection Point

As can be seen in the nearby graph (click to enlarge), commodities are nearing what appears to us to be the top of the recent range. The dark line represents the Powershares DB Commodity Index (DBC) while the brown line represents the US Oil Index (USO). Both indexes have declined moderately today despite several stronger-than-expected economic reports. Reuters reports that "personal income rose 0.6 percent in February, below the unrevised 1.0 percent gain for January but double the 0.3 percent increase forecast by analysts in a Reuters poll. February consumer spending also rose 0.6 percent, outpacing forecasts for a 0.3 percent gain after an unrevised 0.5 percent increase in January". In addition, "construction spending also defied forecasts for a decline as gains in nonresidential building overcame drops in home and federal construction, and a Chicago purchasing managers report showed a huge pick-up in Midwest manufacturing."

Reports like this would normally cause a spurt in commodity indexes and a drop in bond prices. The fact that they haven't leads us to conclude that the top of the range will stay intact and commodity prices will drift lower in the next few weeks as news reverts to some of the slowing economy reports. It can't help that Democrats are constantly in the press lately with a slew of anti-growth proposals.


Strategy Update: The Dynamic Commodity Strategy has increased 17.4% since the beginning of 2006 (see chart) versus the Rydex Commodity Index Fund (gray line) of minus -13.5% for a positive spread of 30.9%. It also has a positive spread of 12.0% over the Lehman Aggregate Bond Index for the same time period. The fund is moderately short at this time. More information.

Bond Rally

This morning saw the bond market rally in response to the weak housing data report. As such, we think it is appropriate to reverse our inverse bond position after realizing moderate profits. According to Reuters: "Sales of new U.S. homes unexpectedly fell 3.9 percent in February to the lowest rate in nearly seven years while the number of new homes on the market grew, according to a government report on Monday that showed more signs of weakness in the housing sector. The monthly decline was the second straight and the volume of sales fell to their lowest level since June 2000, when they hit 793,000. The struggling housing market also weighed on investors' confidence in the U.S. economy, according to a survey released on Monday. The UBS/Gallup Index of Investor Optimism fell to 78 in March from 90 in February, the lowest reading since 74 in September."

At the margin, we think this is also a positive for the US Dollar Index.

Strategy Update: The Dynamic Duration Select and Dynamic FX Plus strategies have each had excellent performance versus the Lehman Aggregate Index over the last 6 and 12 months (see charts: Duration Select has been slightly stronger over 6-9 months while Dynamic FX has been stronger over 12 months). There are some crossover aspects to these strategies (primarily bond exposure). In addition, we have determined that the goal of each strategy can be pursued in a combined context. As such we have merged the Duration Select Strategy into the Dynamic FX Plus Strategy and are calling the new strategy Dynamic Bond/FX.

More Subprime Fallout

Most of the national press reports on the big picture but it was interesting to note the local spin placed on the subprime mortgage mess by the local paper, the Contra Costa Times. It seems one home seller had seen his home "in escrow five times in the past three months after lenders canceled the subprime loans of four would-be buyers. . . Most of the people, except the last buyer, had 100 percent financing . . . They had a pre-approved letter, but when they went back to the lender, they were told, 'We're not doing those anymore.' "

The article also mentions that California holds 22% of the national sub-prime debt. "In a study by First American CoreLogic, economist Christopher Cagan projected that about a third of all 'teaser rate' loans originating from 2004 to 2006 will default because of reset, and an estimated 1.1 million homeowners will lose their first homes to foreclosure." Ed Leamer of the UCLA Anderson Forecast says "What drove the California marketplace wasn't foreign borrowers but entry-level buyers helped into the market by exotic loans." He believes "it will take four years before there is significant appreciation in the housing market, and subprime loans won't be given sparingly." A loan consultant mentions that "subprime salespeople would come daily to their four-person office, bearing gifts and hoping to get [them] to put their clients in their subprime loans . . . they would ask what loan they were working on and say they could cut a better rate without any documentation or credit history." Around January, the traffic abruptly stopped. Amazing!

The article goes on to say that "some areas of the country, such as the Midwest, are considering foreclosure moratoriums." This is supposed to help? It would be like Nixon's price controls. The problems will leak out in other ways: if a bank can't foreclose, do you think they will be able to make other loans? Do you think a bank will loan money the next time around to lower income buyers if they don't think they'll be able foreclose if they need to? How could a moratorium possibly help? This problem is not near the end.


Strategy Update: The Dynamic Beta Strategy has shown solid out performance relative to the S&P 500 since the June 2006 bottom, rising 27.9% versus the S&P's 19.0% and has tacked on big returns this week rising 5.8% in the last 9 market days. Visit our website for more information.

The Bernanke Fed

In a recent speech by Charles Plosser, President of the Federal Reserve Bank of Philadelphia he discusses policy saying, "many of people’s economic decisions are affected by their expectations about the future course of monetary policy. As a result, the central bank faces a time-inconsistency problem. That is, it will be tempted to pursue policies that deliver temporary economic benefits that may be inconsistent with longer-term goals. And realizing that the central bank will have the latitude to give into this temptation, people will make decisions today that drive the economy to a suboptimal outcome. [As an example,] it is widely acknowledged that in the long run, monetary policy cannot raise the level of output or employment. However, due to various rigidities in the economy, the monetary authority may face a short-run tradeoff: by generating unexpectedly high inflation it may be able to temporarily boost output and employment. By like token, unexpectedly low inflation may temporarily reduce output and employment."

"Economic analysis tells us that as long as the prospect of exploiting this short-run tradeoff exists, a central bank conducting a discretionary monetary policy will not be able to achieve its desired rate of inflation. To see the reason why, imagine the monetary authority announces it is going to maintain average inflation at some desired level. If policy successfully maintains that desired inflation rate, then output would grow at trend. But at some point the monetary authority will be tempted to exercise its discretion to generate a bit more inflation, which may not be very costly, in exchange for the benefit of more output in the short run. However, once the higher inflation is recognized, the public will revise its expectations of future inflation and push wages and prices up. Consequently, the monetary authority will see higher inflation, but no higher output. It might be tempted to try the same experiment again, but it will generate the same outcome. Thus, the monetary authority’s attempt to increase public welfare will be thwarted by the behavior of forward-looking individuals and will end up producing more inflation with no added output. The monetary authority now faces a dilemma: if it seeks to re-establish its desired inflation rate, it must generate unexpectedly low inflation, risking a temporary decline in output. The loss of output would diminish public welfare; thus it seems unlikely that policymakers will undertake such action, and so the economy gets stuck with a permanently higher inflation rate than it desires. Thus, discretionary monetary policy proves to be time inconsistent and so fails to deliver on the desired inflation objective."

"Now, what if the monetary authority could commit itself, in some way, to producing the desired inflation rate that it had announced? The answer is clear. The public would expect that inflation rate would be maintained, there would be no unanticipated inflation, and output would grow at trend. So a monetary authority that could commit to its desired inflation policy would outperform a monetary authority that is free to exercise discretion—that is, it would deliver the same output growth, but lower inflation rate. Some people may find this result counterintuitive . . . People often think that keeping monetary policy from deviating from a desired inflation goal is like tying the policymaker’s hands and, therefore, should yield worse outcomes. But in fact, doing so gives a better outcome."

Why the long quote here? We think the Bernanke Fed, through its actions and statements intends to operate in a way that is fundamentely different than experienced under the Greenspan Fed. Under Greenspan, the Fed reacted to virtually every wiggle in the domestic and international economy. As a consequence, it was largely responsible for the dot-com bubble, the commodities bubble and the housing bubble. We believe the Bernanke Fed intends to reestablish the Fed as a stable institution that lays out clear expectations - and in the process, tamps down some of the wild speculation and volatility in asset classes. As a starting point, the Bernanke Fed seems willing to let the sub-prime loan and housing problems run their course.

Plosser goes on to say, "a policy governed by commitment dominates one of discretion. The question now is: How do we get commitment?" It is interesting to note that throughout the speech he tried defending the Greenspan speech yet his question implies a lack of commitment evident in the past Fed. He says, "we are very fortunate to have in Ben Bernanke another Chairman whose commitment is equally as strong." This is putting lipstick on a pig. Greenspan was the ultimate user of discretion - commitment was not in his vocabulary. Yet Plosser makes it clear that the current Fed intends to honor commitment and provide consistent messages: "there is a realization in monetary policy-making circles that maintaining credibility for low inflation is an important aspect of good monetary policy. Furthermore, it is important to be transparent so that the public’s expectations and the objectives of monetary policy are better aligned. Achieving this alignment ultimately furthers the central bank’s objective of maintaining stable prices while fostering full employment."

This is a new world in Fed policy. Look for lower volatility in asset classes as this message begins to sink in over the next several years.

Strategy Update: Our Dynamic Commodity Strategy is up +17.3% (dark line) over the past year versus a decline of -15.8% in the Rydex Commodity Fund (light line). We have an underweighted position in commodities at the moment, with a 15% weight in silver and 20% in general commodity funds. We're pleased to continue to deliver higher highs while the indexes experience lower lows. Visit our website for more information.

Reversal Day

Still two hours to go but it looks like the makings of a reversal day in the market, which can be a strong buy signal, particularly from oversold levels. Reversal days represent capitulation and a washing out of the weak players. Don Hays mentions in his wonderful market letter today that put/call ratios and the Rydex bullish/bearish index are flashing psychological buy signals here. The speed at which each of these indicators has declined recently has been impressive (see chart on the right by Hays).

We continue to view the market now trading in a broad range. As it nears the low of the range, commentators will focus on sub-prime mortgages or some weak economic indicator. Near the top of the range, they will focus on private equity and corporate buybacks. Until Fed policy changes or something dramatic changes in the economy or the world, we view this trading range staying in place for several quarters.

Consistent Returns

Many investors get sidetracked into large bets on single companies or equity sectors. These bets often come with significant volatility and drawdowns. If you are trying to average 12% per year for 3 years (40.5% total compounded return) a single misstep can make it challenging to reach the goal. As an example, a 7% decline in year 1 requires a 22.9% return in each of years 2 and 3 to reach the average compounded return of 12% for the entire period. This is not impossible but it is certainly more difficult. A 15% decline in year 1 requires a 28.6% return in year 2 and year 3.

With the S&P 500 Index likely returning mid/high single digit returns over the next half dozen years a simpler approach to outperformance would be to make some broad bets on diversified indexes when the opportunities favor investment. First, identify a half dozen or so broad asset classes to track. The general categories could be stocks, bonds, commodities and currencies. Within the stock arena one could consider general indexes such as the S&P 500, Russell 2000, an international index, REITs, or specific sectors such as energy, technology, finance, etc. With bonds you generally only want a long bond fund to invest in when interest rates appear poised to drop or track a few closed-end funds closely monitoring their discount to NAV for opportunities to benefit from a combination of interest rate movements and spread narrowing. We recommend investing in commodities using general commodity mutual funds and ETFs as well as specific sector funds such as gold and oil & gas. Currencies can be easily invested in using a variety of ETFs and mutual funds (such as the Rydex funds). There are ETFs and mutual funds that provide opportunities to profit from inverse movements of the above asset classes if you are so inclined.

Our bottom line: keep it simple by focusing on less than 10 asset classes that resonate with your investment temperament. Follow them and learn about what drives the returns. Analyze if contrarian or trend following commitments seem to work best over time. Then commit 20-25% of your capital to a position that you think can generate a return of 10-15% over a 1-6 month period. If the S&P 500 returns 7% per year and cash returns 5% per year, it doesn't take many correct calls to exceed the market return. In the past year the following asset classes provided these opportunities: TLT (bonds) 4.3%, 11.2%, and 4.7% total return; DBC (commodities) 18.0%, 10.9%, 11.5% and 11.5%; IWM (small stocks) 7.9% and 22.1%; EEM (emerging markets equity) 19.0% and 45.9%; IYR (REIT ETF) 8.4% and 39.3%; RYWBX (weak dollar fund) 17.2%, 6.0% and 11.7%; AWF (international bond ETF) 20.0% total return; GLD (gold ETF) 33.5%, 17.9%, 13.5% and 12.8%; USO (oil ETF) 13.3% and 15.8%. Of course, this is catching the bottom and selling at the tops and we're not suggesting that is possible. But it IS possible to catch of 30-50% of many moves with reasonable consistency. The biggest impediment to success is usually your own lack of patience and/or discipline. Before you attempt this, we suggest you read Mark Douglas' book, "Trading in the Zone".

Employment Data

Today's report that the U.S. economy added 97,000 jobs in February led to a 7 basis point jump in yields of 10-year treasuries. This was the smallest employment gain in more than 2 years. The response by interest rates was partially due to the revisions to December and January employment data that increased employment by 55,000 jobs. Reuters predicts that "the weather effect suggests job gains will pick up when balmy weather returns," with February construction activity showing a big decline.

We're not so sure. Employment numbers will likely continue to come in under estimates, particularly as the year progresses. The latest round of tighter lending standards at many financial institutions, along with the implosion of the sub-prime lending community, is bound to have an effect on employment and economic growth later this year. As such, we think a short-term follow-through for rising interest rates is reasonable from the perspective of a bounce off oversold levels but longer-term, you will not have upward pressure on rates.

Strategy Update: The Dynamic Global Macro Strategy has had an impressive run over the last 9 months. The chart seen here shows performance since the end of the third quarter 2006: up nearly 16% versus the S&P 500 up 5% for an 11 point outperformance. The outperformance has come recently from a combination of bonds and commodity fund exposure in January and February followed by a swap to domestic and international equities after the recent market drop.

February Performance

We are pleased to report performance for our managed strategies. Though the S&P 500 was down 2% in February, we had 21 of 23 strategies posting positive returns. These were led by Dynamic Commodity up +5.3%, Focused 13D up +4.3%, Focused Analyst Growth up +3.3%, Dynamic Global Macro up +3.0% and Dynamic Duration Select up +2.8%.

On a longer term basis, the S&P increased 9.9% and the Lehman Aggregate Bond Index increased 5.4% for the year ending February 28. Over this same period strategy performance highlights include Select REIT up +31.5%, Focused International Equity up +22.2%, Focused Analyst Growth up +21.4%, Dynamic Commodity up +20.3% (over 30 percentage points over the Rydex Commodity Fund performance of minus -11.2%), Focused Analyst Upgrade up +19.9%, Dynamic High Yield up +18.3%, Equity Opportunity up +13.6%, Dynamic Bond Plus up 13.2%, and Dynamic Global Macro up +12.1%.

One other note: a fairly new strategy, Focused 13D was up +26.2% over the last 6 months, more than exceeding our initial expectations.

Regarding asset allocation models, Absolute Return Growth Portfolio has outperformed its 2.5% per quarter target (10% per year) for the trailing 3, 6, 12, and 24 month periods. Absolute Return Income Portfolio has outperformed the 2% per quarter target (8% per year) for the trailing 3, 6, 12, and 24 months. Growth Portfolio was up 15.0% over the last year and 28.6% for two years. As always, we are required to mention that past performance does not guarantee future performance. Visit our website for more complete information on performance and disclosures. We welcome any inquiries.