Update

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

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

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

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

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

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

Signs of Recession?

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

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

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

Mortgage Applications

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

Bond and Currency Comment

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

April Performance for Strategies

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

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

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

Large-Cap versus Small-Cap

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

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

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

Tax Rates and Revenues

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

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

Rate Cuts This Year?

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

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

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

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

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

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

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


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

Bond Rally

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

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

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

More Subprime Fallout

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

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

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


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

The Bernanke Fed

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

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

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

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

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

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

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

Reversal Day

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

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

Consistent Returns

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

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

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

Employment Data

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

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

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

February Performance

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

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

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

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

Growth Scares

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

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

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

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

Treasury Bonds and Market Correlations

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

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

CPI and Bonds

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

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

Silver Demand

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

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

Interest Rates

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

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

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

Ruminations on Space Travel

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

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

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

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

Oil musings

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

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

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