WRA Strategies & Observations

Update

2007-08-30T12:36:00.000-07:00

Our firm is now managing key client relationships and acting as a sub-advisor on various investment strategies for other investment managers. As such, we are placing less emphasis on indirect communication with our clients and potential clients, such as with this blog. Should you have an interest in becoming a client, please visit our website at www.windriveradvisors.com. Thank you for your past interest in our commentary and insights. All the best to you in your trading and investing.

Sub-Prime to Sink More

2007-07-10T11:50:00.000-07:00

This morning, S&P placed 612 U.S. subprime RMBS classes on Watch Neg and announced methodology revisions. A teleconference was to be held by S&P at 10am. According to UBS, "The vast majority of the issues put on Watch Neg are in the triple-B category, although Watch listings extend even into some double-A tranches."

This could partially explain the huge rally in treasuries today while spread product, such as corporate issues, have faded and spreads widened. Look for more fallout in the months to come.

Strategy Update. We have partially reversed our bullish commodity bet at the close today in the Dynamic Commodity Strategy. Performance has been solid over the past year up +13.5% versus a decline of the Rydex Commodity of -15.0% for a positive spread of 28.5% (see chart).

Equity Linked Note Problems

2007-07-06T15:35:00.001-07:00

One of the fads in the current market are Equity-Linked Notes (ELN's). These securities provide investors with fixed income-like principal protection together with equity market upside exposure. According to Lehman Brothers, the "instrument is appropriate for conservative equity investors or fixed income investors who desire equity exposure with controlled risk." They also state that the "the structure generally provides 100% principal protection. The coupon or final payment at maturity is determined by the appreciation of the underlying equity."

These are sold on the basis of buying them and forgetting them, without regard to market valuation. We think there are significant risks with this position:

1. Compounding and opportunity cost. We have previously discussed the idea that if you have a goal of earning 12% per year for 3 years and you actually lose 12% the first year it will require a return of 26.4% for each of the remaining 2 years to reach the 12% annual goal. A 12% return is a doable objective; a 26.4% return is considerably more challenging. In the case of the equity-linked notes, just because you avoided the 12% drawdown does not mean your investment is "flat". The reality is that if the underlying index declined 12%, you will need it to rise back to the starting level before you will be able to earn any positive return. In addition, the underlying index will still need to return 26.5% in each of the final 2 years to realize a 12% annual return over 3 years. If an investor had a better sense of when the values were advantageous and invested accordingly, the returns would improve despite the marketing pitch that ELN's represent a free lunch. During the initial period when the ELN index is declining and then rebounding back to break-even, the opportunity cost of not being invested in an investment that is rising is a significant detractor to long-term returns.

2. Buy and forget. At the other end of the spectrum is the case of purchasing an ELN and then experiencing good returns in the early years. These are sold on the basis that the principal is assured so they can be tucked away and forgotten about. But if the ELN rises, say 20% in the first year you now no longer are in a position that the principal is assured. Why? Because a decline the following year will wipe out the gains. Effectively we are marking-to-market the principal value. As such, gains are not locked in and an investor is never in a position to walk away and forget the investment.

Bottom line: losses early cause the investment to potentially be "dead money" for an extended period of time. Gains early still require a decision about whether or not to continue to hold. Perhaps the investors that should consider ELN's are those that have no inclination or interest in analyzing value in the marketplace or investors who have found themselves chasing markets in the past and need an investment to save them from themselves (buying an overvalued ELN and having a flat return over a period of years is preferable to buying high and selling low).

Strategy Update: Performance for the first 6 months will be available soon at the Wind River Advisors website. The best performing strategy continues to be Focused 13D, up +27.6% year-to-date, followed by Select Equity up +16.0% YTD versus the S&P up 6.9%. We're also particularly pleased by the Dynamic Bond/FX Strategy up 11.8% YTD versus the Lehman Aggregate Bond Index up less than 1% YTD. Performance was driven by tactical weighting of bonds (long or short) and the US dollar (long or short). Please note that past performance is no guarantee of future performance. See the performance PDF for the full disclosure.

Time Away

2007-06-19T09:49:00.000-07:00

I spent an amazing three weeks travelling through primarily France, Italy and Slovenia. Perhaps the most impressive city visited was Ljubljana, the capital city of Slovenia. The town was full of energy and anxious anticipation of full participation in the world economy after decades of being torn apart by dictators and wars. Absolutely beautiful town - perhaps one of the benefits of being left behind by decades of growth in other parts of Europe is that the city seems to have fewer tacky buildings thrown up in the 50's, 60's and 70's like other cities. Great food, clean streets, good night-life, classic European old-town feel and beautiful setting.

Strategy Update: The Dynamic Bond/FX Strategy rocked over the past month or so (see chart). Shown here outperforming the Lehman Aggregate Bond Index by 19% to 4% since the end of 2005. The latest outperformance was driven by a short US dollar position with a long US dollar overlay. We've since flattened the dollar bet and reduced by 2/3 the short bond bet.

Seasonal Tendencies

2007-05-25T13:21:00.000-07:00

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?

2007-05-23T08:33:00.000-07:00

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

2007-05-15T14:45:00.000-07:00

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

2007-05-15T07:11:00.000-07:00

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

2007-05-04T13:37:00.000-07:00

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

2007-05-02T07:53:00.000-07:00

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

2007-05-01T10:31:00.000-07:00

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.

Rate Cuts This Year?

2007-04-19T20:26:00.000-07:00

Dr. Ronald Ratajczak of Morgan Keegan & Co. states that he believes "there is virtually no likelihood that rates will be cut this year. Only a recession would do that, and even if one develops, the need for response at the expense of rising core inflation will not be accepted until next year. As I do not have a recession, I also have no need to lower rates. (The argument for a rate decline is that the adjustable rate mortgages are creating so much trouble that relief must come from lower rates. However, the adjustable rate problem is one of availability rather than price and cannot be solved without dramatic reductions in short-term rates, which are inappropriate with core inflation rates pressing higher. There will be no rate reductions.)"

"Can there be a rate increase? Of course!! Increased import prices induced by a weak dollar could add to inflation. Higher earnings abroad also could shift more of our capacity to meeting the needs of export markets, leading to price pressures at home. Even if these do not develop strongly, higher energy and food prices could raise wage pressures, which will be successful because of the tight labor markets. In other words, the odds are shifting towards a possible rate increase, although I still believe holding the line is the most likely outcome."

Strategy update: short-term overbought conditions have taken us out of commodity funds at the moment in the Dynamic Global Macro Strategy and the Dynamic Commodity Strategy. However, we continue to believe longer-term pressures on resource usage will provide positive trading opportunities for commodities and commodity-related stocks.

Credit Card Delinquencies

2007-04-18T07:22:00.000-07:00

In the press, Moody’s reported yesterday that credit card delinquencies continued to rise through February. Additionally, UBS reports that "the repayment rate on credit card balances fell to 17.27% in February from 20.03% in January—the lowest repayment rate in over a year and a sign that financial stress is building at the household level." UBS also mentions today’s Wall Street Journal (Pg. A8) discussing "how the Option ARMs market may be the next headline-maker in mortgage space." and how in today’s NY Times, "how China is becoming 'less' reliant on US exports as the value of the Dollar falls. The article highlights the imbalances that could further heat up trade frictions between the two countries. As they say, 'China is still nearly 25 times as dependent on exports to the United States as a percentage of total economic output as the United States is on exports to China. Given that the Chinese economy is less that a quarter of the size of the American economy, it is all the more striking that Chinese exports to the United States are worth more than six times American exports to China.' ”

Fed Meeting Comments

2007-04-14T13:08:00.000-07:00

The FOMC minutes continued to state that inflation is the Committee’s “predominant concern.” However, they also emphasized that with “increased uncertainty about the outlook for both growth and inflation, the Committee also agreed that the statement should no longer cite only the possibility of further firming.” According to UBS, the "minutes continued to highlight that Fed officials expect that the economy is likely to expand at a 'moderate pace in coming quarters' but noted: 'additional evidence of sluggish business investment and recent developments in the subprime mortgage market suggested that the downside risks relative to the expectation of moderate growth had increased in the weeks since the January FOMC meeting. At the same time, the prevailing level of inflation remained uncomfortably high, and the latest information cast some doubt on whether core inflation was on the expected downward path. Most participants continued to expect that core inflation would slow gradually, but the recent readings on inflation and productivity growth, along with higher energy prices, had increased the odds that inflation would fail to moderate as expected.' In the end, the minutes reiterated that future policy adjustments will depend on the incoming data. We expect risk perceptions will continue to evolve in coming months as growth data continue to weaken, ultimately leading to Fed easing."

March Performance

2007-04-03T14:33:00.000-07:00

All Dynamic Strategies and Equity Strategies were ahead of the 0.6% return of the S&P 500 Index YTD through March 31, paced by Focused 13D up +14.7%; Dynamic Global Macro up +12.7%; Dynamic Commodity up +8.9%; Select Equity up +7.3% and Dynamic U.S. Equity up 5.5%. The chart nearby shows Dynamic Global Macro over the last 6 months.

The best strategies over the past year were Focused International Equity up +22.9%; Select REIT up +21.6%; Dynamic High Yield up 20.8%; Focused Analyst Growth up +20.0%; and Dynamic Commodity up 19.9%. The S&P 500 returned 11.8% over the past year.

Please visit our website for more complete performance details at Wind River Advisors. As always, past returns are no guarantee of future returns. Please see the website for important performance disclaimers.

Business Spending

2007-04-02T19:37:00.000-07:00

Business spending on equipment and software continues to be sluggish. The fourth quarter saw its largest drop since 2002. One of the obvious conclusions is that corporations have opted to use to cash to fund stock buybacks. Why? most corporate managers are paid based on stock price performance. In an era of marginal investment options for corporate cash flow, CEO's have come to realize that over the short run the only way to meaningfully impact stock price is to shrink the float. Paying out higher dividends or investing in so-so projects will do little to increase the stock price over the short-term; so they buy-back shares. The WSJ reports that market float was reduced by $548 billion last year through a combination of stock buybacks and private equity deals.

This development has the potential to "surprise" the economy. Should business investment stay sluggish, consumer spending continue to moderate and housing decline much more, the Fed might find itself pushing on a string to rev the economy back up.

We think this provides a floor for bond prices and see longer US treasuries as attractive at these levels.

Commodity Inflection Point

2007-03-30T11:34:00.000-07:00

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

2007-03-26T08:38:00.000-07:00

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

2007-03-22T15:52:00.000-07:00

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

2007-03-16T07:15:00.000-07:00

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

2007-03-14T10:53:00.000-07:00

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

2007-03-12T13:37:00.000-07:00

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

2007-03-09T08:23:00.000-08:00

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

2007-03-07T21:10:00.000-08:00

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.

Growth Scares

2007-02-27T15:17:00.000-08:00

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

2007-02-26T11:51:00.000-08:00

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

2007-02-22T07:32:00.000-08:00

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

2007-02-21T08:08:00.000-08:00

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

2007-02-20T12:33:00.000-08:00

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

2007-02-13T11:29:00.000-08:00

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

2007-02-12T10:43:00.000-08:00

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

2007-02-06T09:52:00.000-08:00

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

2007-02-02T08:53:00.000-08:00

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.

Trading Range Economy & Markets

2007-01-31T15:47:00.000-08:00

We continue to believe that the economy and the markets are now entering a frustrating trading range condition. Frustrating anyway for investors looking for sustainable momentum - contrarian trading around the edges should be profitable. From an economic standpoint the following comment by UBS is typical for this environment: "somewhat mixed data, with greater than expected strength in real GDP growth (3.5%) but weaker than expected labor costs in Q4 (ECI up 0.8%) . . . excluding motor vehicles production, real GDP was up at a 4.8% annual rate in Q4 after 1.2% in Q3. However, we doubt the faster pace in the fourth quarter is likely to be sustained . . . other data continue to suggest that more slowing is underway than is evident in the Q4 GDP report."

The same trading range will likely be in place in the bond and equity markets. In a post several days ago we mentioned our belief that interest rates had then risen sufficiently to create a favorable environment for lengthening bond duration. Today, the iShares Lehman Treasury 20+ Year ETF rose nearly one percent. Stocks will also likely trend sideways to slightly higher from here within a broad trading range.

10 Steps to Retirement

2007-01-25T19:07:00.000-08:00

The Motley Fool lists "10 Steps to Ruling Your Retirement". They are:

1. Get your assets in gear
2. Practice smart "asset location"
3. Run your numbers (figure out how much you need to retire)
4. Make your portfolio last
5. Crack your nest egg (how and when to make withdrawals)
6. Make the most of Social Security
7. Prepare your estate
8. Extend the life of your IRA
9. Cash in your house
10. Decide what you want to do in the future.

Most of these points assume you have assets to begin with and that you have built up value in homes and social security. The Retirement Confidence Survey challenges some of these assumptions with its finding that only 19% of people over age 55 have accumulated more than $250,000 in retirement savings (total savings and investments, not including the value of the primary residence). And only 23% of this same age group have $100,000-$249,999. Even if an investor has just enough to get into this top category, they will find it difficult to withdraw more than $1,000 per month and not risk reducing the principal (a nearly 5% annual withdrawal rate). Additionally, we have seen many view their homes as their retirement. But people have to live somewhere - for a home to be a retirement source would require selling and moving to a cheaper location. Others short circuit Social Security by drawing on it sooner than is prudent, resulting in lower lifetime benefits. There will be increasing opportunities for retirees to work part-time in the early retirement years and thereby delay drawing on Social Security.

Point 2 regarding asset location: Most investment professionals will recommend covering the universe with assets: some large cap growth, some large cap value, small cap, international, some bonds, etc. Several problems with this: first, environments of market stress have tended to impact all markets together. In statistical terms, this means all investments merge toward a correlation coefficient of one in difficult times - US Government notes have been one of the few investments that have been a recipient of investment flows during these difficult periods. This means that to disaster-proof a portfolio would require a slug of 5-10 year treasuries, that unfortunately provide little extra return during the good times. The biggest problem actually isn't that investments converge in difficult times, it is that investors blow out of long-term financial plans. We've all read about how stocks do so well over a 20 or 30 year period, but how many investors couldn't stand the pain in 2001-2002 and blew out of stocks, only to miss the ensuing rebound? There isn't much value in a long-term financial plan if there is a pattern of selling at the bottom and gradually returning to the market at much higher prices. We mentioned in an earlier post that if an investor had a goal of 15% per year for three years, that a year-one drop of 15% would require a return of nearly 34% in each of the following two years to realize the average compounded return of 15%. The long-term average returns are dependent on being invested in the big up years. But many typical investors not only sell at the bottom but fail to capture the upside.

Our solution: investors should focus on where the values are at any time in the market. Even at the top of the market in 2000 there were many insurance stocks, home building companies, defense contractors and other stocks selling at single digit P/E ratios which subsequently rose 3-10 times in value over the next few years! We recommend that investors regularly review different segments of the market for value opportunities: Equities (large-cap, small-cap, value, growth, international, domestic, emerging markets, sectors, REITs, etc.), Bonds (long-term, short-term, TIPs, international, emerging markets, high-yield, municipal), Commodities (oil, industrial metals, agricultural, gold, commodity indexes) and currencies (strong or weak dollar). In addition to a wide variety of mutual funds, there are exchange-traded funds and closed-end funds covering all these sectors. An investor no longer needs to worry about individual securities with the proliferation of these vehicles. In fact, we would argue that for most part-time investors, owning and picking individual securities is a distraction that decreases returns. If your portfolio is always positioned in the value areas of the market, your need to worry decreases dramatically. Of course, cultivating a bit of a contrarian way of looking at markets is required. Instead of asking, "whats going up?", ask "where are the values and can I identify a catalyst that might resolve the values in my favor?"

We're skipping around, but MF's step 4 is to make your portfolio last. Two big points here: withdrawal rates and longevity insurance. Don't get caught up in the debate about whether you can withdraw 3%, 4%, 5% or 6% without risking your retirement. We find it best to determine your beginning level of investable assets, and add an inflation factor to determine your baseline portfolio. You can withdraw some percentage of the current value of the portfolio up to the amount that exceeds the baseline. If you started the year with $1,000,000 and inflation was 2%, the ending baseline is $1,020,000. If your actual portfolio grew to $1,150,000 you can withdraw some percentage of $130,000. We would suggest that you withdraw somewhere between 4% of the baseline or the current account value (whichever is less) and 50% of the amount the portfolio is above the baseline; in this case, withdraw somewhere between $40,800 and $65,000. Where does the remainder go? It provides a cushion in the event the following year is a negative return year: the 4% minimum withdrawal will mostly be from year one's gains. Plus you have compounding working for you in year two which may push the current value even higher above the baseline. Why do we like this plan? it provides "bonuses" in retirement in the good years. What do we do when we're working 9 to 5? We put off swapping out the cars and remodeling the kitchen until we receive some windfalls in the form of bonuses or overtime. Why not do the same in retirement?

Second point: longevity insurance. People joke about spending their assets down to zero, then dying. Why not do it since there is a great way to accomplish this without risking getting to zero before getting to the end of your life? If investors purchase longevity insurance - insurance that pays out in the event the insured lives past a certain age - cash flow is assured. Purchasing a $10,000 policy at age 60 can provide as much as $700-$1,000 per month for life, once age 80 is reached. Putting $50,000 to $100,000 in such a policy can provide considerable piece of mind that the cash flow will be available later. The second great benefit is that one can spend much more up to age 80. If you know you are going to have several insurance policies kick in at age 80 it makes it much easier to spend down to zero through age 79 (although we wouldn't advise it). We suggest using several insurance companies to spread the company risk. Retirement can be fun (with such things as paying yourself bonuses) and worry free (longevity insurance). Why stress?

The WRA Strategies & Observations blog is written by officers of Wind River Advisors LLC, an SEC Registered Investment Advisor. See our web site for more information on strategies and account management: Wind River Advisors.

Raining Cash

2007-01-22T08:13:00.000-08:00

If you haven't seen this "commentary" on global liquidity yet, it would be worth your time: Sam Zell. Cash continues to spur increases in many markets. However, today's WSJ mentions in column one of the Money & Investment section that perhaps "Investors might not be pushing up prices for assets like art or high-yield bonds because they have so much cash. They might be seeking out more and more cash so they can push up prices while the going is good. Once they lose faith in an asset class they'll turn tail and all of that so-called liquidity will turn with them. That's what happened in the copper market . . . [with] the price of copper [falling] 39% since May."

"By the same token, all that cash doesn't seem to be pushing up prices for Florida condos or oil anymore. 'Liquidity is an ex-post justification for why markets are going up,' says Dresdner Kleinwort's strategist Albert Edwards. 'There's lots of liquidity around -- well, there always is until there isn't, and then it just disappears.'"

Bond Strategy

2007-01-20T12:22:00.000-08:00

Over the past two years bonds have provided good opportunities to adjust average maturity and pick up some incremental return. Note the fairly consistent moves in 10-year interest rates in the 2-year chart at the right (the yield is currently 4.77%). It has required some willingness to lean into the wind to see the real benefits of portfolio adjustments. We envision a continued trading range on bonds that will reward contrarian investment commitments.

In the second chart, you can see our Dynamic Duration Select Strategy is up 10% since the end of the second quarter of 2006 (6 2/3 months). Early outperformance was driven by aggressively positioning the portfolio to the decline in interest rates during the second half of 2006. This involved using long US treasury exchange-traded funds. In November and early December, performance was about even with the index due to a tempering of the interest rate bet. Finally, over the last month, performance diverged to the upside relative to the index as the strategy had a slight inverse exposure to interest rates. In the past several days we removed the inverse exposure and returned to a neutral interest rate posture.

Our Dynamic Fx Plus Strategy has a little different objective: to outperform the Lehman Aggregate Bond Index using a core position in US treasury ETFs and adding value through selective investments in strong or weak dollar investments. Interestingly, this strategy was up nearly the same amount as Dynamic Duration Select but with different investments. Recent outperformance is due almost entirely to a long US dollar position over the past several months. We reversed this last week and now have a moderate short dollar position. We continue to believe that, short of terrorist acts or some such thing, the dollar will remain in a fairly tight trading range. Investing around the edges has proven to be a value-added tactic.

Emerging Market Equity

2007-01-16T08:59:00.000-08:00

After rallying for 3 1/2 months with barely a correction along the way, emerging market equities have corrected since January 3rd. Even with the rally of the last couple of days, most emerging markets are well off their highs.

We've noted in the past that many emerging markets have a high correlation to commodity prices, which have tumbled over the past several months. But why the delayed reaction by emerging markets? According to Justin Lahart in today's WSJ, "one possibility is that the emerging-market selloff was simply a delayed reaction to what happened in December. The rally in emerging-markets stocks - the emerging-markets index rose 29.2% last year - may have prompted some investors to delay selling until this year in order to avoid a big tax hit. At the same time, some fund managers may have been pouring money into emerging-market stocks in the last part of the year in a bid to improve their 2006 performance. Once the New Year started, that bid went away."

Sounds reasonable to us. Justin's follow-on reason is that as a result of December's strong jobs reports, investors are now projecting a rise in interest rates rather than a fall, and as such, emerging market selling reflected a "worry that monetary policy . . . was getting overly tight." This reason is too large of a reach. Money supply has actually trended strongly up recently - not down, even though fed funds rates remain unchanged.

While it is true emerging-markets are not as commodity sensitive as they once were (partially because of their large trade surplus' built up over the last decade), commodity price correlation remains strong. We believe any meaningful decline in emerging markets should be bought. Consider that the USA uses 25.0 barrels/year of oil per capita. Japan is at 15.0 and Mexico at 7.0. Yet Latin America uses 4.5 and China 1.7 barrels (source: The Economist). Per capita usage of Copper in lbs./annum is 4.7 in China versus 15.8 in the USA; Aluminum is 4.0 for China versus 21.0 in the USA; and Autos per 1000 people are 6.0 in China versus 475 in the USA. This lull in the economy has produced a narrow surplus in oil production versus demand. Yet per capita commodity consumption demonstrates that developing market demand is still at an early industrialization stage. If some economists are right that we've turned the corner on the housing slump, contributing to improved world GDP in 2007, it is unlikely that commodities will experience much of a decline from these levels. This bodes well for commodities and emerging markets.

Contrarian Commodity Note

2007-01-11T10:43:00.000-08:00

A recent post by BCA Research mentions the structural demand support for oil: "Crude oil prices have fallen roughly 10% in the past month, reflecting plentiful crude inventories and warmer-than-usual weather in the northern hemisphere. We doubt there is sustainable downside from here. From a cyclical standpoint, the slowdown in the global economy should prove shallow and short-lived, so any demand softness will be limited. Longer-term, the emerging world’s thirst for oil will only increase. On the supply side, OPEC is trying to establish US$60 as a floor, and the lack of spare capacity among cartel members other than Saudi Arabia suggests it will ultimately succeed. Finally, while geopolitical strains are well known, they will keep oil price risks to the upside. Bottom line: we think the correction in oil prices is well advanced and look for prices to trend higher."

Seasonally, oil investments typically do well from February through late Spring as expectations begin to build for the summer driving and air conditioning demand. We view the current lull in pricing as a solid contrarian entry point.

Strategy Update: our Dynamic Commodity Strategy has dramatically outperformed the Rydex Commodity Fund over the past year at much lower volatility (see chart). Part of the reason for this is our flexibility to adjust absolute commodity exposure. We are now fully invested in commodity ETFs in this strategy. With equity markets at highs, interest rates range bound and specialty areas such as REITs overbought, we view commodities as an emerging attractive investment for the next several quarters.

2006 Performance Recap

2007-01-03T13:30:00.000-08:00

We closed out 2006 with solid performance across most Strategies. See the attached for a complete recap (click to enlarge). A few highlights:

The following equity strategies outperformed the 13.6% return for the S&P 500 Index for 2006: Select REIT (+32.5%), Focused International Equity (+27.9%), Focused Analyst Growth (+24.3%), Focused Analyst Upgrade (+19.1%), Equity Opportunity (+17.3%), and Select Equity (+14.0%).

The following fixed income based strategies outperformed the 3.9% return of the Lehman Aggregate Bond Index for 2006: Dynamic High Yield (+19.9%), Dynamic Bond Plus (+16.5%), Dynamic Tax-Exempt Plus (+10.9%), Dynamic Fx Plus (+8.8%), Dynamic Duration Select (+5.7%), and Individual Muni Bond (+5.5%).

Additionally, the Dynamic Commodity Strategy was noteworthy with a +8.5% return, outperforming virtually all commodity mutual funds anywhere from 7 to 26 percentage points!

Asset Allocation Models also enjoyed a great year. Absolute Return Income had a return of +10.8%, well above it's benchmark of 8%. Absolute Return Growth has a target of 10% per year and came in slightly under at +9.4%. The Growth Model returned +12.9%, just under the S&P with considerably less volatility. Other models with double-digit returns were Moderate, Conservative and Conservative Tax-Advantaged. The Current Income models returned +8.0% and +6.8%, well above the Lehman Aggregate Index of 3.9%.

As always, note the performance disclosures that state that past returns are not necessarily indicative of future returns, etc.

For more information on becoming a client of our firm, see our website. Here's to a profitable 2007!

Inflation Notes

2006-12-28T09:30:00.000-08:00

Put us on the side expecting inflation to moderate over the next several quarters. We were interested to read a few comments from Dr. Donald Ratajczak, Morgan Keegan's Consulting Economist:

"I guess we all could get upset by that gargantuan price gain for finished goods and for the core in the PPI. Frankly, I prefer to look at the changes from a year ago. Thus, the 2% monthly gain in finished goods is only 0.9% for the year. That 1.3% surge in the core is only 1.8% over the year. Of course, we should not talk so lightly about producer prices, but who seriously believes that SUV prices plunged 9.7% last month only to surge 13.7% this month. I even doubt that they are up the 0.7% from the previous year that the tables indicate. Certainly, a 2.2% gain in passenger car prices is suspicious when it follows a 2.3% drop the previous month. I certainly am not going to get upset by the surge in vehicle prices, which I doubt you will discover at the dealer's."

"Even with a near doubling of natural gas prices for the month (reflecting the unwinding of large hedge bets by one trader), they are down 35% from the previous year. . . Metal prices have reversed [gains] in recent weeks. Indeed, while my leading inflation indicators increased modestly in November, they already appear to be falling in December."

We would suggest that the interest rate markets also make a strong case for moderating inflation. A significant number of economists and investment strategists got burned throughout 2006 with their repetitive and wrong forecasts of rising intermediate/long-term interest rates.

Consensus Review

2006-12-26T08:52:00.000-08:00

Ticker Sense recently published a 3-part year-end poll of financial blog writers (including WRA Strategies & Observations) on a variety of investment topics. A couple of area where we think it makes some sense to be contrarian to the consensus:

US Dollar: 62% are bearish. We'd take the contrarian bet on that one and opt for a flat to up dollar.

Gold: only 26% bearish. With inflation likely to surprise on the downside a short gold position seems to make some sense here.

Sector bet: bullish on technology. At best, technology will probably be a middle of the pack performer. The 6-0 bet against consumer discretionary is interesting and causes us to wonder if we should reconsider our negative bet there.

58% of participants believed that Growth will be the better investment style in 2007. We think that even though growth is a slightly cheaper than value currently, that the huge amount private equity cash sloshing through the system will continue to give the performance nod to value.

The most obvious stock pair to bet against is the consensus pick of AAPL over MSFT. Fundamentals would suggest that AAPL could see some multiple compression as growth momentum slows. Microsoft has a number of new product launches in 2007 and a much lower P/E ratio. Regarding GOOG, those predicting $700 are smoking something. The stock will come down to earth in 2007.

More on the equity market, interest rates, the housing market, recession probabilities and some individual equity picks on TickerSense. Check it out.

Tax-loss Selling

2006-12-23T08:06:00.000-08:00

We think it is important to note that the Nasdaq Composite versus NYSE relative strength broke below the early November lows with last week's trading. This has usually been accompanied by weakness in the market as a whole.

Having said that, the week between Christmas and the New Year has usually been a favorable period for stocks - - particularly those stocks that have had difficult years and have been the brunt of tax loss selling by individuals (mutual funds generally sell losers in advance of the end of fiscal years which typically end in October). There are many years when it make sense to buy a basket of stocks during the several days before Christmas that the small investors are throwing away in the small/mid-capitalization segment.

We like to apply some fundamental analysis to these names and come up with a list of companies where various catalysts may occur to augment the returns from a simple bounce off the cessation of tax-loss selling. Stocks are only purchased where a 50% move over the following 3-4 months seems possible based on this combination of fundamentals and bounce capability. Of course, not every name will rise 50%, but a sufficiently large sample will, that in many years it is possible to average 20-25%. Since this has been a relatively solid year for stocks, the strategy of buying the dogs for a bounce doesn't have the same attraction as in other years. Still, this has always been the safest time of year to step up and catch falling knives if there are any that catch your interest.

Money Supply

2006-12-21T12:21:00.000-08:00

Money supply has seen huge jump since early October with adjusted reserves rising at an annual rate of change of 16.1%! This has been a major contributor to the more than 600 points added on to the Dow Industrials. Another major factor has been the private equity cash sloshing around. Anecdotally we hear of many large funds needing to put cash to work. This likely puts a floor on the stock market over the next several months.

Nevertheless, the market is currently overbought and looking somewhat tired. As evidence of the deterioration, the Nasdaq has underperformed the S&P and NYSE indexes since Thanksgiving. In addition, many individual stocks have begun experiencing breakdowns (see SNDK, MOT, GOOG, GLW, BBY, INTU, NDAQ, etc.)

Strategy Update: As evidence of the narrower market, the Select Equity Strategy has seen quarter-to-date lead on the S&P 500 Index narrowed over the past several weeks.

Housing Bottom?

2006-12-14T12:51:00.000-08:00

Today's Wall Street Journal discusses whether or not we have hit bottom in the housing market and how that affects the recession outlook. The article states "the U.S. central bank and much of Wall Street are now betting that the old rules don't apply, and that a recession next year, while possible, is unlikely." However, analysts at UBS Financial produced the chart here (click to enlarge) and ask if "This is what a housing bottom looks like?" They comment, "that if we've learned anything in our decades in this business it is this: it is almost NEVER different this time. . . these charts show that housing prices are still historically out-of-reach while inventories of unsold homes remain historically bloated. The bottom in housing will come when inventories normalize and/or prices become more affordable. The spurs will be: more time, higher incomes, lower rates, further declines in home prices -- or, most likely, some mix of all these. Remember that in the last housing bust in the US (late 1980's), housing peaked in June of 1986 and did not find a bottom until January 1991 . . . Also, the 5+ year boom in the housing market that ended just last summer was, by many measures, "more frothy" than what was experienced in the 1980's . . ."

Global Growth

2006-12-13T09:25:00.000-08:00

BCA Research comments that the Global Leading Economic indicators are looking up. They say that, "while global industrial production growth is set to slow in the months ahead, these leading indicators imply that downside risks to growth are limited and that a renewed bout of strength is likely in the second-half of 2007."

This makes sense given a lack of significant pull-back in the US economy and a world economy that is increasingly less dependent on the U.S. In a addition, many countries of the world are in much better financial and political shape than they were in the mid/late 1990's. If the world economy grows from here, we would not expect oil to decline much beyond current levels, which is perhaps a contrarian viewpoint these days.

Employment Report

2006-12-08T13:16:00.000-08:00

The bond market has priced in a reduction in interest rates but if the employment report does not begin cooperating, don't look for the Fed to accommodate anytime soon. Today's employment report was stronger than expected with a 132k rise in payrolls and previous months revised up, as well. We still expect payrolls to weaken in coming months. The weakness beginning to show up in manufacturing and construction is a harbinger of change in the balance of the economy.

This expected weakness has yet show up in the latest unemployment rate, which reversed only a part of the prior months decline. Yet, UBS says, "The share of consumers perceiving that jobs are hard to get has risen a little in recent months, while the share saying jobs are plentiful has edged down. That pattern is typically associated with a rising unemployment rate."

The employment report smacked bonds with 10-year treasuries rising 7 basis points on the news today and up 15 basis points since the lows of last week.

Strategy Update: We recently moved to a defensive posture in the Dynamic Duration Select Strategy, which should benefit the strategy in the event of continued increase in interest rates. The Strategy has seen solid outperformance, nearly doubling the return of the Lehman Aggregate Index (shown here as AGG) since the bottom of the bond market in May.

Global Equity Markets

2006-12-07T09:03:00.000-08:00

Birinyi's Ticker Sense shows a great table of overbought/oversold ranges for global ETFs today. In almost all cases the equity markets are at the high end of the range or within one or two points of the high. We mentioned BCA's concurrent opinion in another post. International markets may go up more over the short-run but we doubt the gains can be held. Book some profits.

Strategy Update: There was a bit too much self-congratulation and back-slapping on the part of dollar bears after the recent weakness. We viewed this development as a contrarian opportunity to remove and partially reverse our short dollar position in the Dynamic FX Strategy. The largest position in the strategy is currently intermediate US treasury securities. Dynamic FX is up over 8.5% YTD and 4% ahead of the benchmark Lehman Aggregate Index (see inset). Past performance is not indicative of future results. For more information on opening a managed account, visit our website. We are an SEC registered investment advisor with more than $40 million in assets under management.

Long-term Return Outlook

2006-12-05T09:39:00.000-08:00

John Hussman's November 27 review of some of Ben Graham's sayings was interesting from a value methodology point of view. However, we think the chart that was included is particularly relevant to investors who want some guidelines for 20-year returns. Bottom line: the model is predicting 5% per year for the S&P 500 over the next 20 years.

The S&P 500 has returned 84% on a price-only basis since the lows of October 2002; nearly 100% if you count dividends. Good market performance brings out the Ibbotson "buy-and-holders" who say never sell. Ibbotson: "Markets go up over the long-term." (link) Sure, they go up over the long-term, but sometimes it takes 20 years to get back to breakeven after substantial losses. Sometimes, if you happen to live in the wrong country or the wrong century it never happens. In contrast, long-term wealth is created by analyzing where the values reside and investing accordingly.

Strategy Update: since the bottom of the international equity market in June our Focused International Strategy has outperformed the EAFE Index by 10 percentage points through overweights in emerging and asian markets as well as specific country weights in Australia and Brazil. Our manager has elected to move out of some of the asian exposure and create a 20% cash reserve in the Strategy.

November Performance Recap

2006-12-02T09:03:00.000-08:00

Once again, the markets were favorable in November with stocks, bonds and commodities seeing solid gains. A few highlights from our managed Strategies program:

Equity Strategies
Focused Analyst Growth +5.91%; +28.90% 1-year
Select REIT +4.12%; +33.79% 1-year
Equity Opportunity +5.00%; +20.20% 1-year
Focused International Equity +3.50%; +28.46% 1-year

Dynamic Strategies
Dynamic Bond Plus +2.08%; +19.51% 1-year
Dynamic High Yield +0.97%; +18.82% 1-year
Dynamic Fx Plus +1.42%; +11.03% 1-year
Dynamic Commodity +3.41%; +10.72% 1-year
Dynamic Tax-Exempt Plus +1.26%; 11.86% 1-year
Dynamic Beta +0.84%; +11.48% 1-year

Asset Allocation Portfolios
We have eight Asset Allocation Models that combine up to 10 strategies to create a diversified portfolio. The Absolute Return Growth Portfolio has a goal of a consistent 2.5% per quarter and 10% per year. It is currently meeting this goal with a 3-month return of 4.18% and a 1-year return of 10.87%.

The Absolute Return Income Portfolio has a goal of a consistent 2.0% per quarter and 8% per year. It currently far exceeds benchmark with a 3-month return of 4.59% and a 1-year return of 12.61%. Click on the image below for returns for other Strategies and Asset Allocation Portfolios. A pdf file will follow shortly on the website.

Strategies and models are managed by WindRiver Advisors LLC, an SEC registered investment advisor with $40 million in assets under management. Visit our website for more information on investment management and how to establish an account.

Nasdaq Relative Strength Update

2006-12-01T23:27:00.000-08:00

In an earlier post we mentioned one of our favorite intermediate-term indicators for the equity market: the relative strength of Nasdaq Composite versus NYSE Composite. As can be seen here, it turned up in August and since then has seen higher highs and higher lows. But now the relative strength has faded for 10 days and is in danger of hitting a lower low, possibly resulting in a sell signal for this indicator.

We also note that individuals usually start hunting for tax losses about this time and continue selling small/mid-cap dogs into Christmas Eve. The last market day before Christmas this year is the 22nd. We've found that if you're thinking of buying small/mid-cap dogs on tax-loss selling the two trading days prior to Christmas generally offer the best prices. This year should be no different.

FRODOR

2006-11-30T10:21:00.000-08:00

One of Ed Yardeni's great contributions to financial discussions has been his analysis and use of Foreign Official Dollar Reserves (FRODOR). This is defined as US marketable securities held in custody for foreign official and international accounts at the Fed. We've always been impressed with FRODOR's forecasting ability. Visit here to view the correlation between FRODOR and various indexes.

A couple of comments: FRODOR momentum has been declining since 2004. After reaching a cyclical peak of near 35% it has backed off to under 15%. In the past, this decline in momentum has generally coincided with a decline in the US Federal Deficit and an easing in the rate of growth in the US Merchandise Trade Deficit. It has frequently preceded declines in the CRB Raw Industrials Spot Price Index, the CRB Metals Spot Price Index and crude oil demand. With regard to equities, a drop in the FRODOR rate of change typically precedes a drop in S&P 500 forward earnings momentum. Finally, FRODOR seems to have a fairly reliable inverse correlation to the Trade weighted dollar.

Our take: after backing off in 2004 and 2005 from a decade long high, the annual rate of change for FRODOR has churned sideways for a year at a still relatively high level. We think there is a high probability of the decline reasserting itself until it reaches flat year-over-year growth. If so, this would suggest a strong dollar, weak earnings, falling commodity prices and crude oil demand, and falling trade and budget deficits. For more commentary from Yardeni, see this older analysis.

Strategy Update: Equity Opportunity Strategy is a value-based portfolio that is currently up 19.7% YTD through 11/29. The best performers in the Strategy since purchase have been ECA, PRAA, THE, TRX and USG. We continue to think a value strategy makes sense in this environment of private equity capital looking for deals. As always, past performance is not indicative of future results.

Market Undervalued?

2006-11-29T19:09:00.000-08:00

The CXO Advisory Group LLC produces an interesting value analysis of the markets with their Real Earnings Yield Model and their Reversion to Value Model. Currently, the models indicate the S&P 500 is 8-26% undervalued. The models appear to have reasonably strong predictive value over longer periods of time.

Trucking Volume

2006-11-29T18:52:00.000-08:00

An interesting post from the MarketBeat Blog regarding recent trucking volumes. They mention "volume fell 1.8% in October, putting the index at its lowest level since the end of the first quarter . . . The news prompted David Rosenberg, chief North American economist at Merrill Lynch, to note that it is extremely rare to have truck tonnage go down in October ahead of the holiday shopping season — declines of the likes we saw last month took place in 1981, 1982, 2001 and 2002, and these proved to be disappointing sales periods.”

Money Supply and Equities

2006-11-28T19:52:00.000-08:00

Dr. Marc Faber comments at AME Info that "the notion among investors has again arisen that the Fed will soon cut interest rates and support the economy and asset markets with monetary policy measures. I believe that, sooner or later, this scenario is very likely, but instead of boosting the real economy and asset prices in the US, it will lift precious metals, commodities and foreign assets further." This is a provocative call - why would this be the case?

Faber continues: "In the monetary philosophy of Mr. Greenspan and Mr. Bernanke, a bubble is never a problem. However, if the bubble bursts, a problem might arise - as was the case in Japan in the 1990s and in the US in 1929/32. So, the central bank must immediately provide enough liquidity to the system in order to prevent the bursting of the bubble having a negative impact on the economy!"

"In the long run [this is] a suicidal monetary policy because it leads to one asset bubble after another. So, after the NASDAQ in 2000 and housing in 2005/2006, where is the next big bubble going to occur? In my opinion, two asset classes stand out as asset bubble candidates: grains and Asian assets. Wheat and corn have led the grain and agricultural commodities price advance over the last two months. But now, it is very likely that the entire sector including especially soybeans, sugar, coffee, and cattle, will follow. Other 'bubble candidates', are Asian currencies, stocks, and real estate prices."

Given these factors and the belief that the US equity market is overbought, investors are complacent, bullish sentiment is high and volatility is low, Faber leans to a short the S&P position rather than long.

Strategy Update: Focused Analyst Growth started the quarter weak but since then has exceeded the S&P 500 by over 10 percentage points quarter-to-date even though it has held 10% cash for the last month. Performance year-to-date is a positive 27.7%. The best performing stocks held in the strategy are LSI Logic and Allegheny Technologies, although we would not be buyers of these two at today's prices. On Wednesday, our manager moves to a 20% cash position. Visit our website for more information on how we can bring you investment solutions that work.

Petrodollars and the Urge to Merge

2006-11-28T15:58:00.000-08:00

We think one of the reasons we were wrong (early?) on expecting a correction in the equity market is the huge interest in doing deals. According to Ritholtz Research & Analytics the total value of 2006 deals announced through November 17 "had reached a record $3.368 trillion. . . the surge is being driven by companies which, after years of big stock buybacks and dividend increases, still have large amounts of cash. The flood of money into private equity funds also needs to be put to work." An added factor is that of corporations and countries trying to secure sources of supply of raw materials and energy through the equity markets.

Another spin on this comes from Peter Thiel in the 11/27 issue of Barron's. His contention is "that volatility has been suppressed across all global markets as a result of the flow of petrodollars into the world economy. Basically, there was a $1 trillion dollar tax increase on oil, and while that's bad for consumers, its actually been very good for financial markets because the money has been reinvested in financial markets: gold, real estate, tech stocks, emerging markets and equities."

We think this increases the attractiveness of companies trading at cheap ratios of Enterprise Value to EBITDA. Prior to the announced merger, Phelps Dodge Corp was trading under 5x. This could result in value continuing to play better than growth in the equity market.

Strategy Update: The Dynamic Fx Plus Strategy's goal has been to add 2-4% each year over the Lehman Aggregate Bond Index (AGG). As can be seen here it has outperformed the index by nearly 4% year-to-date. So far so good. We have decided to slightly broaden the Strategy's security selection universe to include some new currency-related exchange-traded funds (ETFs), as well as various existing foreign closed-end bond funds. These will provide the Strategy with improved income and appreciation potential, as well as enhanced FX flexibility, as its name implies. Visit our website for more information on strategies investing.

Equity Return Outlook and Cash As Trash

2006-11-22T15:00:00.000-08:00

A recent research publication from Crestmont Research, reprinted in Mauldin's E-Letter (see 11/20/06 Outside the Box archive), a detailed analysis of future stock returns provides a good baseline for understanding what challenges investors face in overcoming a long-term lackluster market.

Assuming heady assumptions on ending earnings per share ($116) and P/E ratios (23) they project annual returns of 6.9% through 2016 (from a 1375 base in the S&P 500 Index versus today's close of 1406). This does not include dividends, so figure 8.9% with dividends. If the P/E ratio fades to 15 times in 2016, the average return is 2.4%. They also make a case for earnings of $81 in 2016 which means an annual return of 3.1% at 23x PE and -1.2% at 15x PE. Of course, if PE's revert to levels seen in prior bear markets of 10x, the annual return could be between -5.2% and -1.7%.

Cash isn't Trash: As they point out in the article, about the only way to exceed these returns is to focus on absolute return strategies. Some time ago we realized a couple of things about absolute return strategies:

First, it only takes a compounded return of 1.17% per month to reach an annual return of 15%. If you assume that, on average, half your portfolio was invested in cash equivalent earning 4.5% with the rest of the portfolio invested in stocks paying dividends of 1.5%, your average return from income would 3.0%, or 0.25% compounded monthly.

Second, subtracting 0.25% from the goal of 1.17% leaves 0.92% per month needed from appreciation to make the 15% annual return. There are several ways to get to a 0.92% monthly return: One could put 10% of the portfolio in an investment that rises 9.2% over the course of a month. Or maybe put 50% in a few securities that experience an average appreciation of 1.84%. Or maybe for a short period of time place the entire portfolio in securities that appreciate an average of 0.92%. This is the equivalent of riding a stock from $27 to 27.25!

What can we learn from this? Cash isn't trash if you invest in the right securities when opportunities are present! Even with a large-cap index like the S&P 500 there are multiple opportunities to make 5-15% every year. So why don't more investors invest this way? We can think of several reasons: First, the advisory business tells investors to stick with the mutual funds they're currently invested in (if they don't own the funds, the funds can't earn the management fee). Second, they chase fund performance; a "cash isn't trash" investment philosophy usually requires a bit of contrarian resolve (going against the herd) that sometimes means you are on the sidelines watching as markets continue to rise. Third, they don't understand the impact of negative returns and the importance of avoiding them: let's say you wish to average 15% per year over a 3-year period for a total compounded return of 52%. If you lose 15% in the initial year it will require nearly 34% in each of the next 2 years to capture the average return of 15% - not an easy task. Finally, they just don't have the time, experience or interest in pursuing this approach. A "swing only at fat pitches" philosophy requires some on-going decision-making. Take a look at some of our strategies that utilize some of these philosophies.

Housing Sentiment and Inventories

2006-11-20T10:54:00.000-08:00

Housing continues to weigh on the economy. Gary Shilling's recent article (see archive for 11/17) on housing that is reprinted in John Maldin's Weekly E-Letter is an interesting read.

Of the many charts in the article, we think these two are the most interesting. The first shows how real consumer spending follows homebuilders' sentiment but typically with a small lag. The potential for a meaningful slowdown in consumer spending is real. The second chart shows that inventories of existing homes for sale have a long ways to go up before they approach earlier peaks. Shilling's conclusion is that the housing price decline will exceed 25% and hit bottom no sooner than the first quarter of 2008. That should make for an interesting political campaign, particularly if Iraq is off the radar screen.

Strategy Update: The Select REIT Strategy benefited from its ownership of Equity Office Properties Trust (EOP), which is up substantially (over 13% from month-end) on a takeover announcement. Dynamic Beta Strategy is currently at a minimal equity exposure after experiencing a rise of over 23% from the June low in the equity market.

International Equity Overbought

2006-11-17T13:52:00.000-08:00

BCA Research reports that "Global equities are due for a breather".

According to BCA, they have "gained 16% since mid-June, and are now well above their May high. Stocks have benefited from a stream of positive economic surprises, including the sharp fall in oil prices and bond yields, among other things. It will be increasingly difficult to sustain this positive news flow in the short term. Moreover, this latest surge in stock prices is already comparable to the past three rally phases during the bull run that began in 2003, indicating that stocks are more vulnerable to any “bad” news. Bottom line: although market fundamentals on a 6-12 month horizon are still favorable, stocks look stretched from a short-term perspective."

Median Net Worth

2006-11-11T00:10:00.000-08:00

From Freemoney Finance, we note the median net worth as well as the net worth for the top 25% and top 10% of people in the U.S. for various age categories:

Age 20-29 Median Net Worth: $7,900 Top 25%: $36,000 Top 10%: $119,300
Age 30-39 Median Net Worth: $44,200 Top 25%: $128,100 Top 10%: $317,800
Age 40-49 Median Net Worth: $117,800 Top 25%: $338,100 Top 10%: $719,800
Age 50-59 Median Net Worth: $182,300 Top 25%: $563,800 Top 10%: $1,187,600
Age 60-69 Median Net Worth: $209,200 Top 25%: $647,200 Top 10%: $1,429,500
Source: Federal Reserve Board's 2004 Survey of Consumer Finances

This doesn't say much for people's commitment to saving. Let's say you started saving at age 20 and you put your savings into a small-cap index fund that returned 11% per year (this has been very achievable). To have the Median Age 59 Net Worth of $182,300 would require a monthly savings of a little over $23, or a dollar and a dime a day for each work day. You get more than that in change each day. A related rule-of-thumb is that saving $100 each month in a small-cap (preferably value) fund over a 40 year career is usually enough to put you close to a million dollars.

October Strategies Performance

2006-11-09T08:58:00.000-08:00

Strategies performance for October and year-to-date is now available. Returns significantly beat the S&P 500 for most of the equity-based strategies, paced by Focused Analyst Growth up 10.21% for the month and 22.07% year-to-date. On the fixed-income side, strategies utilizing closed-end funds or Fx overlays performed best, with Dynamic High Yield leading the way up 16.42% year-to-date. As always, see the disclaimers on past performance. Visit our website for more information on investing with us.

Sub-Prime Mortgages Start to Bite

2006-11-07T15:50:00.000-08:00

The November 13 issue of Forbes takes a look at the trends in sub-prime mortgages. They note that "lenders did a lively business issuing mortgages in amounts perilously close to the full value of the home being bought or refinanced," and now Christopher Cagan of First American Real Estate Solutions calculates that 29% "of homeowners who closed mortgages in the first nine months of 2005 were sitting, as of February, on zero or negative equity. . . he also calculated that a further decline of 5% in home prices would jack that fraction up to 38%."

Strategy Update: Little change in strategies recently. Fixed-income (bond) strategies are fairly neutral duration relative to benchmark. Equity strategies generally have some cash cushion due to the overbought technical position of the market.

Employment Trends

2006-11-06T06:58:00.000-08:00

Last week the unemployment rate unexpectedly dropped to 4.4% from 4.6%. Many economists were expecting a rise to 4.7%. Overall employment data has also been strong in recent months (primarily due to strong upward revisions to August and September data). The Fed is unlikely to begin dropping interest rates until they see job growth slow and the unemployment rate rise.

In our opinion, the 4.4% unemployment rate is probably wrong and we'll see reversal of that begin next month. Evidence for that includes very weak housing-related employment and various diffusion indexes that show a slowing in employment. Also, the initial jobless claims jumped in the latest week from 309,000 to 327,000. These patterns should eventually be reflected in the unemployment rate. Housing related employment usually follows housing starts with a lag. Starts rolled over in April but housing units under construction only rolled over in August. This suggests housing employment is poised to slow significantly in the next several months.

Vacant Housing Inventory For Sale on the Rise

2006-10-31T13:58:00.000-08:00

In an interesting development, UBS reports that in the third quarter vacant housing units for sale have surged to new highs, at over 1.5% of total housing stock (the 36 year low was approximately 0.5% in 1970). Vacant housing for sale plus new single-family homes for sale under construction as a percentage of total housing stock has increased to nearly 1.8%. The prior peaks in 1984 and 1988 were at 1.3%. The 30-year low was in 1977 at just under 0.9%. Current dollar as well as real home prices are now falling. The rental equivalent price index has trended up lately, reflecting the move of former homeowners back to rental markets. Yet the rental vacancy rate is still a relatively high 9.9% nationally.

Strategy Update: The Dynamic High Yield Strategy is up over 16% year-to-date versus the Lehman Aggregate Bond index of about 3% (see chart). The strategy's main focus is to profit from movements in the discount to NAV of closed-end bond funds. We continue to take profits in this sector and move to US treasury ETFs, now currently at about 50% of the strategy. For more information on strategies management, visit our website.

New Highs Rolling Over

2006-10-30T19:23:00.000-08:00

Net new highs have rolled over recently as can be seen on this chart from Don Hays. This trend change is even more evident on the Nasdaq index. With the end of the quarter tomorrow, followed by elections next week we think this makes the case for some caution here.

Strategy Update: The Dynamic Beta Strategy has returned 22.0% since the bottom in June, well ahead of its balanced benchmark of 9.2% and the S&P 500 Index return of 13.3%. Today, we reduced equity exposure to 24% and may reduce further if the individual stock holdings show signs of tiring. Several of the remaining positions are gold related and have recently shown positive performance and inverse correlation to the equity market.

GDP Comment

2006-10-27T12:11:00.000-07:00

Ten-year interest rates have declined 15 basis points, from 4.82% to 4.67%, on indications of weaker economic growth. This was capped off by the third quarter GDP report of 1.6% annualized growth. UBS comments that, "if anything, the details of Real GDP looked even weaker than 1.6%. The 1.6% figure was despite a reported 27.5% rate of increase in motor vehicles production . . . Excluding motor vehicles production, real GDP was up at just a 0.9% annual rate in Q3 after 3.0% in Q2."

The 4.67% ten-year rate is near recent lows of 4.55% in late-September. We think interest rates, stocks and the economy transition to a condition of "noise" versus trends for the balance of the year. Expect reports to continue to present a mixed picture.

Strategy Update: Below are charts of two strategies that have done well recently, Dynamic Beta and Focused Analyst Growth. In each case lately, our managers have elected to take partial profits on positions and attempt to moderate the bets. Analyst Growth powered through this recent period with high earnings growth companies. In contrast, Dynamic Beta suffered in late August and early September initially through holding too much cash, then later through too early of a bet on resource and materials stocks. The latter bet has paid off in recent weeks.

Confusion among the experts

2006-10-25T16:50:00.000-07:00

Richard Russell, the long-time writer of the Dow Theory Letters recently commented on the large divergence of opinion regarding the current state of the markets. He mentions several: "David Fuller writes, 'we have often said that Wall Street is in a secular bear market, which we define as a generational long period of P/E ratio contraction and rising dividend yields. The path that a bear market follows is dictated by the availability of liquidity. A Japanese style deflation has been averted because the Greenspan Fed eased aggressively and allowed the monetary base to expand. Barring a major central bank monetary policy blunder we can expect Wall Street's uptrend to continue. James Paulsen, a successful investment strategist is basically bullish although he believes somewhere ahead the dollar must fall . . . Noriel Roubini almost guarantees that the US is headed for a major recession that will hit in 2007 . . . Martin Barnes of the Bank Credit Analyst believes that 'the US economy remains on track for a housing and consumer-led mid-cycle slowdown' . . . but 'the grinding equity bull market should continue. Valuations are decent and market multiples should expand when it is clear that the Fed has finished tightening' . . . [yet] fund manager John Hussman writes: 'The current Market Climate in stocks is characterized by unfavorable valuations, but modestly favorable market action. Valuations are sufficiently high that we can already conclude that total returns on the S&P 500 over the coming 5-7 years will probably fall short of Treasury bill yields. The current bull market has already lasted beyond the historical norm, and though the S&P 500's percentage gains of the past several years haven't been spectacular from a historical perspective, this has been among the longest periods the market has ever gone without a 10% correction' . . . Lowry's thinks that what we're seeing now is an extension of the bull market that began at the 2002 lows."

As for Russell, he asks, "where's the decline associated with the 'six bad months' of May to October?" He also notes the market's current "remarkable complacency . . . Volatility, now below 11, is near a record low, this in the face of a failing war, huge deficits, and the possibility of a housing slide."

We believe the stock market is both overbought and overvalued yet find ourselves mostly content to earn profits as long as Hussman's "favorable market action" continues.

Strategy Comment: Month-to-date we have 7 strategies up 5%-10% (the Focused Analyst Growth strategy up 10% MTD and over 21% year-to-date). We find this to be incredible, particularly since the market never had the usual September/October correction. Our increasingly plausible rationale for this is the greater influence on the markets of trend following hedge funds. This makes it important to not be contrarian too early nor too anxious to exit profitable positions. It also increases the importance of analyzing inflection points.

Silly Season for Budget Deficit

2006-10-20T08:59:00.000-07:00

In our view, election time is always the silly season for the Federal budget deficit. This is because politicians like to rant and rave about the deficit. The fact is, it doesn't and never did have much impact one way or the other on interest rates or stock returns.

We've always thought the concern was misplaced, anyway. Shouldn't we be more focused on overall spending trends? Would you rather have a federal government that spends 18% of GDP but only confiscates 17% of GDP in receipts or a government that spends 22% of GDP but balances the budget? I'll take the former. In reality, congressman would prefer continual work on narrowing the deficit but only through increases in revenues. This provides more opportunity to run deficits and ramp up spending. It appears to make no difference if your congressman is a Republican or Democrat, the result is the same. Why are the Republicans in so much trouble this year? They were elected in 1994 on a platform of limited government. Spending is up 49% in the last 5 years. Voters figure that if Congress has no interest in spending constraint they might as well vote for the real champions of pork - Democrats.

How does this play into investments over the short-term? We think that as investors come to believe Congress may swing to the Democrats, that stocks will take a breather. Government spending won't be much different.

Help Wanted Index

2006-10-17T09:57:00.000-07:00

The Help Wanted Index has plunged since late winter. This appears to be solid evidence of slowing job growth, as well as slowing overall economic growth.

An additional sign of slowdown has begun to show up in state sales tax collections. The Liscio Report states that "just 37% of the states in our Survey met their forecasted sales tax collections, down from 51% in August," with the majority reporting, "wide misses, the worst of these coming in 2-8% below where they thought they would be."

US Dollar Confounding the Experts

2006-10-16T14:36:00.000-07:00

The stronger dollar has confounded the experts since the 2006 bottom in mid-May and the more recent bottom in August. Several items usually help predict the direction of the US Dollar. First, loose fiscal policy and tight monetary policy have often resulted in a stronger dollar. This was the case over the last year or so but a recent surge in tax receipts that results in a narrowing of the budget deficit could signal changing dynamics. Second, high consumer spending usually leads to lower savings rates and a lower dollar. Recent indications are that the consumer is beginning to back off slightly on spending and save more, again producing somewhat of a mixed message. Our forecast is for the US Dollar Index to continue to muddle along in a trading range of 84 to 88 for the next several months.

Strategy Update: We had a small long dollar position in the Dynamic Fx Strategy that we reversed on the close today. We think the dollar reverses within the trading range but have a weak enough conviction that our position size is small. The majority of the portfolio continues to be invested in intermediate treasuries. Dynamic Fx has outperformed the Lehman Aggregate Bond Index benchmark by 2.75 percentage points year-to-date. Visit our website for information on Strategies investing.

Nasdaq Strength

2006-10-13T08:01:00.000-07:00

One of the more reliable signals we have used for the market is the relative strength of the Nasdaq versus the NYSE Composite, seen below. You can see the relative strength bottomed in the first week of August and has risen steadily since. The market as a whole is severely overbought at these levels.

Interesting Times at OPEC

2006-10-12T11:32:00.000-07:00

OPEC produces about a third of the oil used worldwide and obviously enjoyed the higher prices that oil fetched earlier in the summer. Prices are now down over $20 from July highs (see the INO chart below).

The problem for OPEC is to decide who will help with production cuts. OPEC President Edmund Daukoru (aka The Little Red Hen) said this week that it was agreed they would cut production by one million barrels a day. It is difficult finding anyone who to admit they will contribute to the drop.

In prior times of declining prices, Saudi Arabia, by far the largest producer, at about 9.1 million barrels a day, has taken the brunt of the cut. In the late 80's it nearly bankrupted itself trying to put a floor on the market. We believe it has little interest this time around to be the sole swing producer simply because it has no interest in causing pain for itself while Iran remains unscathed. While they won't say it too loudly, the Saudi's might enjoy seeing Iran squirm a bit. In any event, we think the plunge in prices causes OPEC to finally grapple with this over the next couple of months. With the decline slowing in the last couple of weeks, this seems to be occurring.

Strategy Update: several strategies are now overweight economically cyclical sectors such as energy, basic materials and commodities. Reason: oversold technically, favorable seasonal factors, low P/E multiples and a belief that we are still in the middle innings of a commodity bull market.

Mortgage Problems

2006-10-09T17:13:00.000-07:00

We think it interesting to note that several financial firms have taken hits to earnings recently as mortgages they underwrote have come back to haunt them. The issue: mortgages are often booked, then sold to mortgage consolidators. If problems surface on repayment of the loan, the consolidators may come back to the originator and claim that there was inadequate due diligence or weak underwriting standards. They can demand compensation or they may push the non-performing mortgage back to the originator. This could be a sleeper issue for banks and other financial institutions if the real estate down cycle lasts much longer. Many regional bank's stocks are near all-time highs yet a high proportion of recent revenue increases were from mortgage originations and related interest income.

Inflation, Hourly Earnings and Housing

2006-10-06T12:38:00.000-07:00

Average hourly earnings rose 0.2% in September - a level hardly sufficient to spur new consumer spending. The unemployment rate also dropped to 4.6% from 4.7%. Recent reports also show a leveling off of inflation with the CPI growing only 0.2% in August, down from 0.4% in July. While all these reports are highly subject to revision, we think it means there is little chance of the Federal Reserve increasing short-term interest rates in the next few months.

Further evidence of benign inflation was the report of a drop in existing home prices of 1.7% over the last year, the first decline in eleven years. Anecdotally, we think the pain is greater than the indexes indicate. One analyst pointed out that if priced right, the homes in the best condition and the best locations will often sell close to asking price even in tough broad market environments. The homes in less desirable locations and poorer condition just don't sell - and therefore, don't contribute to the index. Past recoveries in housing covered up some of this behind the scenes pain. This time the decline may be longer and more widespread. Yesterday's Wall Street Journal reports on a Moody's survey that projects price declines for many cities, with some not expected to hit bottom until the second quarter of 2009 (Las Vegas, Fresno, Bakersfield, Saginaw, Portland OR).

The Economy and Interest Rates

2006-10-05T09:55:00.000-07:00

There continues to be significant discussion regarding the impact of slower auto sales and a housing market in near recession. Namely, can consumer spending hold up in the face of these headwinds. Recent oil price declines and to a lesser extent, natural gas price declines have helped consumer sentiment. However, we suspect this will not be enough to prevent the economy from slipping lower over the next several quarters. One confirmation of this was the recent dramatic reported drop in the business price index falling from 72.4 to 56.7. The Fed does not seem concerned about any pain currently being felt by house flippers or speculators. Don't look for short rates to drop over the next several months.

The above chart shows ten-year treasury rates over the past three years. In this context, the recent rally from 5.25% to 4.60% in yield has been typical. We think yields continue to trend lower but the easy money has been made here.

Strategy Update: We swapped another 10% out of high yield closed-end funds in the Dynamic High Yield Strategy. That brings us up to 42% treasuries. We continue to think this makes sense in light of not only the recent drop in interest rates but also the drop in credit spreads, as well. YTD performance through 9/30 is 14.22%, providing some room for profit-taking.

We moved to a fully invested position in the Dynamic Commodity Strategy adding a small position in silver and adding to a general commodity ETF. We think we are at the tail end of mutual fund realignment into finance and tech, etc. and away from commodity related stocks. As such, it looks like a solid contrarian bet for the next quarter or two. We also went to a barbell position in the Dynamic Global Macro Strategy, utilizing commodity and international equity exposure. Our international positions are focused on Asia, small-cap Japan, emerging markets and a little Latin America. In general, these have some correlation to rising commodity prices, but also think some of the U.S. market's recent strength will spill over into international markets.

Midterm Elections

2006-10-02T07:51:00.000-07:00

Since 1950, the stock market has had an average gain of 18.6% in the 12-month periods following mid-term elections. In four of the last six midterm votes the one-year gain following exceeded the average: 24.9% in 1998, 21.7% in 1994, 25.7% in 1990 and 23.5% in 1982. The other two were also positive: 16.7% in 2002 and 6.2% in 1986.

Most of these years saw a fairly strong decline in the market prior to the election, something we haven't seen yet. They also began at a much lower P/E than today's. To see the 18.6% average one-year gain coming out of this year's election would require a lower market over the next five weeks along with dramatically lower interest rates in 2007. We think the Fed will be lowing rates next year but doubt it will be enough to produce an above-average gain in the market, especially in light of the record high profit margins we are seeing this year and a clearly slowing economy.

It is interesting to note that the poorest performing post-election year was 1986 - another year with a second term Republican president experiencing significantly lower approval ratings than seen earlier in the presidency.

Reversion to the Mean?

2006-09-29T12:09:00.000-07:00

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

2006-09-28T10:44:00.000-07:00

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

2006-09-26T08:40:00.000-07:00

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

2006-09-22T10:37:00.000-07:00

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

2006-09-19T07:48:00.000-07:00

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

2006-09-18T07:58:00.000-07:00

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

2006-09-13T10:08:00.000-07:00

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

2006-09-12T15:17:00.000-07:00

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

2006-09-11T16:03:00.000-07:00

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

2006-09-09T20:47:00.000-07:00

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

2006-09-07T07:48:00.000-07:00

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

2006-09-06T14:41:00.000-07:00

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

2006-09-01T13:02:00.000-07:00

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.

Subprime-Loans Getting Ugly

2006-08-31T07:59:00.000-07:00

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

2006-08-30T12:39:00.000-07:00

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

2006-08-29T17:25:00.000-07:00

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

2006-08-28T20:17:00.000-07:00

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

2006-08-23T13:09:00.000-07:00

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

2006-08-17T07:09:00.000-07:00

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

2006-08-07T10:49:00.000-07:00

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

2006-08-05T13:13:00.000-07:00

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

Inflation Worries

2006-07-28T08:12:00.000-07:00

Disinflation - a moderating of the rate of increase in prices has characterized the U.S. for much of the last two decades and contributed to attractive stock and bond market returns. Lately, investors have worried about a return of inflation with the Consumer Price Index and the core Personal Consumption Expenditure deflator rising at levels above what Bernanke has stated to be price stability.

According to Van Hoisington and Dr. Lacy Hunt of Hoisington Investment Management Company, "a further pass-through of energy costs is likely to push the year over year rise upward over the next several months, such a development should not be taken as a sign that inflation is moving higher. Multi-year inflations take the character of what may be termed a money/price/wage spiral."

"To have a money/price/wage spiral develop and become entrenched in the economy, money growth must accelerate, be sustained, and lead to a speed-up of price increases across the board. Then the widespread rise in inflation must lead to faster wage increases that are validated by a further acceleration in money growth and inflation. This happened in the 1960s and 1970s when M2 growth was the highest for any two consecutive decades. M2 growth averaged 7% in the 1960s, and then accelerated to almost 10% in the 1970s. This was the fastest acceleration for any decade other than those containing World Wars I and II. In the 1970s the core PCE deflator increased by as much as 8% per annum, more than triple the average 135 year inflation rate. Wage costs accelerated steadily in those years. The Employment Cost Index registered its all time high of nearly 11% in 1980."

"The current situation is extremely different. In the past two years, M2 growth has averaged just 4.2% per annum, a far cry from the pattern in the 1960s and 1970s, and well below the 6.6% average increase in M2 since 1900. The Employment Cost Index was up just 2.6% in the latest four quarters, a record low increase. Hence, money growth is decelerating and so are wage costs. This is more likely to lead eventually to a downward money/price/wage spiral rather than to an upward one. "

This is further evidence of our belief that interest rates will decline in the second have of 2006.

Leading Economic Index

2006-07-26T11:57:00.000-07:00

We think the recent drop below zero of the Leading Economic Index (LEI) supports our view of lower interest rates on the near horizon. The thirteen times since the Korean War that the LEI has dropped below zero has a perfect record of declines in long and short term rates. In addition, recessions occurred in 9 of the cases and significant economic slowdowns in the other 4 periods.

If the Fed raises rates at the August Meeting it likely marks the last time this cycle they raise rates. On average, the Fed has started easing five months after the end of the prior tightening cycles. This ranges from one month in mid-1984 to eight months after the end of tightening in mid-2000. This suggests easing by late 2006 or the first few months of 2007.

Strategy Update: Our projection of lower interest rates over the balance of the year has us long maturity in most fixed income Strategies.

Slowing

2006-07-26T10:21:00.000-07:00

Several recent economic reports have confirmed the widespread slowdown currently unfolding. Last week saw declines in total retail sales and consumer confidence and a much bigger than expected rise in inventories. The inventories, in the face slowing sales, should continue to impact overall growth in coming months as end product users order less and attempt to work off backlog.

Existing home sales volumes dropped 1.3% in June versus May. Prices continued their steep momentum descent - slowing to just 0.9% year-over-year in June. It has only been eight months since the momentum peak of 16.8% y/y, quite a dramatic change. It seems likely that with existing higher interest rates and changes in federal mandated mortgage lending practices coming (tighter underwriting standards, improved portfolio management policy, and fuller consumer disclosure of risks) that y/y prices will go negative in the near term.

Strategy Update: Our strategy manager eliminated the long exposure to the US Dollar in the Dynamic Fx Strategy after a favorable two-month move. The strategy is now flat the dollar and invested primarly in intermediate-term bonds. We also booked profits (over 10% since mid-June) in gold and commodities in the Dynamic Commodity Strategy leaving it invested in short/intermediate treasuries. This makes sense in the context of a slowing economy. We continue to favor gold and commodities longer-term yet believe a better entry point will be evident in the next several months. (see BCA's comments on the long-term picture at http://www.bcaresearch.com/public/story.asp?pre=PRE-20060721.GIF