Seasonal Tendencies

The market has now rocked for nearly a year causing some observers to recall the adage "Sell in May, then walk away". According to Sam Stoval, Chief Investment Strategist for Rydex Funds, "since 1945, the S&P 500 posted an average price gain of 7.1% during the November through April (N-A) period, versus a rise of only 1.6% from May through October (M-O), implying that greater profits could be made elsewhere. What's more, the performance during N-A outperformed M-O 69% of the time, as was the case in the last 12 months." He continues, saying "investors may be focusing more on their tans than their portfolios. Also, analysts may be more inclined to reduce their full-year earnings estimates late in third quarter than they would have been in the first or second, thus helping make September the worst performing month of the year. What’s more, October is historically a month in which the market establishes a bottom, so the S&P 500 enters November at a fairly low level compared to other months. This gives the N-A period the advantage of starting at a lower base."

This all makes sense. However, we've often thought the more important reason is performance driven. Nearly all professional investment managers start the year with a clean performance slate. This encourages more speculation than would otherwise be the case. As such, the more aggressive, higher-beta stocks often do better. Later in the year (around now), managers start getting ready for vacations and taking more time off. If they bet on stocks that subsequently became winners they have a tendency to not want to risk their good fortune during a period when they may not be able to pay as much attention. They'll move closer to an S&P 500 portfolio weight or move to more stable stocks, such as utilities or consumer staples. On the other hand, if they bet poorly they may be more concerned about being fired by a big client. In this case, they may go more conservative simply to avoid being the bottom manager. Early in the fourth quarter managers will realize they are nearing a new year (with a clean slate again) and increase the aggressiveness of the portfolio. In years when the market has done poorly, the bottoms are often reached in August and the period of aggressiveness begins sooner - in this case, it is more of a situation where managers are simply afraid of being left out of the fun during lift-off. Because of the prior poor market they often positioned their portfolios to conserve assets (or perhaps they capitulated) and now find they must play catch-up not only with the market but by increasing portfolio beta.

Signs of Recession?

The economy is growing the slowest it has grown in 4 years. Most economists expect continued deceleration in the 2nd quarter but then a pick up later in the year. This sounds great, but the present environment reminds us a bit of the 2000-2001 period in the sense that there is considerable hope that this happens but it is backed more by enthusiastic finger-crossing than it is by hard data. We recall companies, and Corning Glass (GLW) comes first to mind, that one month were saying everything was rosy and a short 2 months later were projecting huge (40-50%) declines in revenues.

Consider now that retail sales abruptly halted in April, housing construction plunged, the government raised more in revenues (big capital gains haul) than it spent, business spending was sluggish, semiconductor memory prices are dropping double-digit rates monthly, mortgage cash-outs have ground to a halt, auto sales have been tepid with even Toyota and Honda reporting slow sales, housing and semiconductor inventories are soaring, and new federal rules for 2007 limiting diesel emissions probably front-end loaded heavy truck sales in 2006. In addition, much of the rebound case rests on exports - yet many European and Asian central banks are raising their interest rates.

Fred Hickey points out in his recent issue of The High-Tech Strategist (PO Box 3133, Nashua NH 03061-3133 $140), "in this manic, seemingly one-way market, all problems are overlooked by investors as long as there is something, anything, positive to grasp onto; whether it is an upbeat second half outlook from Intel or Texas Instruments, a debt-driven buyback announcement from IBM or Linear Tech, or a rumor of a merger or private-equity buyout (and nearly every stock has been the subject of at least one of these types of rumors). I don't know when this insanity will end, but I do know that it well end very badly. Every day that goes by, the U.S. Economy sinks further into recession. At some point, investors will wake up to that reality. maybe an external event will blow it all up - such as a collapse in the insanely overpriced Chinese stock market, or a break in the sinking U.S. dollar, or a messy unwinding of the yen-carry trade. Maybe the incredibly over-levered debt market will blow up or maybe one of the gigantic private equity deals will implode. There are innumerable potential catalysts."

Mortgage Applications

We heard an interesting take on the recent rise in the mortgage applications index: "We suspect the purchase index has been boosted by tighter lending standards (with applicants rejected and reapplying)." (source: UBS Securities) Nevertheless, the housing market index and housing starts continue to weaken.

Bond and Currency Comment

Our model for bonds and the US dollar recently signaled a change in position to long the US dollar and short the US bond market. Per the chart alongside, you can see performance for the Dynamic Bond/FX Strategy relative to the Lehman Aggregate Bond Index since 12/31/05. We view current dollar and bond positions in the model as tenuous, particularly the long US Dollar bet but choose to stick with the model since it has added value over time. Fundamentally, continued unexpected strength in the economy (such as the Empire State index, which was reported this morning to have risen to 8.0 from 3.8 in April) should have negative implications for bonds as inflation rises (certainly not what was seen in this morning's report with April inflation rising 0.4% versus the consensus estimate of 0.6%, and core inflation up only 0.2%). Meanwhile, housing continues to play out on the downside. Over the short run, we would think this tug-of-war plays out in favor of stronger growth and higher inflation. Nevertheless, we'll stick with the model for our signals.

April Performance for Strategies

April was another strong month in the market. We would highlight 12 month performance for several strategies: Focused 13D +42.1%; Select REIT +31.8%; Dynamic High Yield +24.2%; Focused Analyst Growth +21.9%; Focused International Equity +18.5%; Dynamic Global Macro +17.9%; Dynamic Bond Plus +16.6%; and Dynamic Beta +15.4%. Full performance data can be viewed at the Wind River Advisors website. Contact us about managed account programs. Past performance is not a guarantee of future performance.

A comment is also appropriate for our asset allocation models. The Absolute Return Growth Model, which is a combination of mostly Dynamic Strategies, has a goal of 10% per year and 2.5% per quarter with moderate drawdown. Over the past 2 years, 1 year and 3 months it has returned 29.8%, 14.8% and 5.2%, respectively - well exceeding the benchmark. This was accomplished with a maximum month-end drawdown of only 2.2% since 12/31/04. Likewise the Absolute Return Income Model returned 24.9%, 15.6%, and 3.64% over the prior 2 years, 1 year and 3-month time frames, respectively, versus a benchmark return of 8% per year and 2% per quarter. Maximum drawdown was 2.8% since 12/31/04.

Strategy Update: Year-to-date, the Focused 13D Strategy has risen 23.4% through today's market close, making it our best performing strategy. Note the chart compares the Strategy return to the S&P 500 beginning at the end of November 2006 and does not reflect today's 0.63% return for the strategy.

Large-Cap versus Small-Cap

There has been considerable discussion in the financial press about whether a move back to large-cap stocks is imminent. Certainly P/E ratios are lower and earnings prospects in the face of a weak dollar make for the fundamental case for large cap stocks. This chart prepared by Rydex Funds shows small-cap outperformance since the market bottomed last summer. The trend continues to favor small-cap stocks but the line is nearing the 1-standard deviation point.

Rydex points out that "33% of all observations have fallen outside [the 1-standard deviation] lines. Thus, if you believe in 'reversion to the mean,' any point above/below one SD is relatively infrequent, and may represent a good trading opportunity."

We think a change to large-cap outperforming small-cap probably occurs coincidentally with a pullback in the market as a whole. This will make it problematic to actually make money on the large-cap outperformance.

Tax Rates and Revenues

The Treasury announced that it paid down $145 billion of debt in the second quarter versus only $92 billion last year. The budget outlook continues to improve as they estimate only needing to borrow $43 billion in the third quarter. This improvement in the budget deficit can be directly attributed to the huge influx of revenues from capital gains taxes; making it all the more amazing that Democrats in Congress appear serious about letting lower capital gains rates sunset after 2010, if not by active legislation before then. If the maximum capital gains tax rate of 15% on long-term capital gains expire at the end of 2010 we predict huge tax receipts for 2010. But 2011 will experience significant reductions in income taxes. But of course, state and federal government will continue to spend in 2011 like revenues will continue to rise at the 2010 pace. Unfortunately, they won't and deficits will explode. A related story that is likely to develop over the next several years is our government's reliance on upper wage earners for the majority of tax revenues and how that could mean significantly higher revenue volatility. This means that any recession will severely impact revenues. It could become a vicious circle.

The change in tax rates in 1986 are instructive as to what could happen in the equity markets in 2010 and 2011. Rates on capital gains rose after 1986, causing markets to drop nearly the entire fourth quarter of 1986 as investors sold stocks for the favorable tax treatment. Of course, stocks came out the gate strong in 1987, rising over 20% in the first few months. Look for 2010 and 2011 to show a repeat of this, only with a larger magnitude due to the 20+ additional years of accumulated capital gains.