August 08, 2008 Options Success Market Commentary

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The story of the quarter remains the shakeout in commodities, which posted their biggest monthly drop since March 1980. Consensus opinion is that the bubble has burst, but we beg to differ. The CRB index is down about 15 percent from its all-time high reached in early July, which is not unheard of when it comes to leveraged investments in the futures markets. When commodity futures prices go parabolic, futures traders tend to pyramid their positions as they chase momentum. At the same time, these same traders tend to tighten their stops/loss orders to protect their gains. Declines trigger stops, causing more selling, making the correction even more pronounced.


Keep in mind, too, that the CRB Index was up more than 50 percent in the past year and it is absolutely normal to give up part of that to work off some of the excess. Bull market corrections can surrender one-third to one-half of the preceding rally. It's also worth nothing that when the bull market in commodities kicked off in 2001, it began from all-time lows in inflation-adjusted terms. Even after making nominal new all-time highs, the CRB is still 50 percent below its inflation-adjusted high reached in 1974. In other words, the run-up we've seen in recent years does not look like a bubble to us.


Still, the case that commodities needed to correct can easily be made. It's also true that they had become a very crowded trade. In July hedge funds posted their worst month in five years, only because the Global Hedge Fund Index has been in existence for that long. The most popular hedge fund trade was long commodities/short financials, and that one has backfired on both sides. The unwinding of leveraged positions may have pushed both commodities and financials further than what fair value would imply.


The stock market liked the Federal Reserve's policy statement on Wednesday, rallying strongly on the news. The statement was very short and a part of it was very interesting:


This seems like an admission that stagflation is the problem, which should be supportive of natural resources markets, and particularly gold, after this correction runs it course.

One of the biggest obstacles to understanding the action in both the economy and the stock market is the human tendency to stereotype.  As we sail into the uncharted waters known as the future, we look for things that resemble what we have encountered in the past, because they make the dark and foreboding waves feel more familiar. 

Unfortunately, it is all too easy to spot a fish and say, "Oh yes, that's a salmon.  A funny looking salmon, but a salmon all the same."  It is comforting to put labels on things.  Later on, however, we may realize that we actually discovered a brand new species.

So we use the word "recession" as if it is one type of event, even though the term can encompass everything from a mild slowdown to the Great Depression.  Because the term is imprecise it can be more harmful than helpful.  How we should respond as investors is very different depending on what end of the continuum a recession is closer to.  (If we are in a recession at the moment, for instance, it is far more like a protracted decline rather than a full-fledged economic collapse.)

Similarly, we think in terms of either "bull market" or "bear market," as if they are the only two possibilities, which they aren't.  Consequently, everyone today is looking hopefully for some sign that the bear market is over -- some climactic action, such as a day in which upside volume exceeds downside volume by a 10:1 ratio.

But what if we aren't in a bear market?  What if we are simply in a down leg of a long-term horizontal trading range?  In that case, market action will continue to frustrate both bulls and bears alike.

It appears that both the economy and the stock market are in uncharted waters.  However, this is nothing to be alarmed about.  The market is always in uncharted waters, history never repeats itself exactly. 

For instance, we have never been in a situation in the past where resource supplies have been so constrained at the same time as the economy has slowed.  We have never before had a U.S. slowdown while worldwide growth remained strong.  Yet this year, the world economy is expected to grow by 3.7%, which is slightly above average for this decade so far, despite the economic slowdown in the developed world.  We are in new territory.

Also unprecedented is the immense level of complexity in today's world, which is one reason the U.S. housing crisis has caused so much trouble worldwide.  And these are just two of the unique factors affecting the world economy.

Nonetheless, as the saying goes, if history doesn't repeat, it occasionally rhymes...



Despite the uniqueness of the times, we continue to see more parallels between today's economy and that of the 1970s than any other previous decade.  For example, after adjusting for inflation, the S&P 500 has actually produced a negative annual rate of return since the start of the 2000s.  If you bought the S&P in 2000 (say via an index fund), you've been losing money in real terms by about 3% a year (including dividends).  Plus, you will have paid out an additional amount in fees and expenses.  That's no way to get rich.

Then again, simply stuffing money under your mattress would not have been a good choice either -- or even keeping your savings in cash investments such as T-bills.  The return on cash has also been negative, after taking inflation into account.  The 1970s also was a decade in which stocks and cash lost money.  Plus, then, as now, commodities have been the best performing sector.

However, there have been some big differences between the two eras, one of which has been the performance of bonds.  In the 1970s, bonds were the worst performing asset class, whereas they have been producing positive real returns this decade.  Also different this time around is that government bonds have been outperforming corporate bonds -- the reverse of what happened in the 1970s.

The reason bonds have done so well in the 2000s is that investors are far more afraid of deflation -- some sort of calamity that would turn the current recession into an outright collapse or depression.

This fear is legitimate since, unlike in the 1970s, our economy is far more leveraged and complex today.  An accident today can have much larger consequences.  Both the subprime crisis and the blow-up of Long Term Capital Management in the late 1990s are examples of how fragile our economy has become.

We believe the Federal Reserve has for some time been in the process of deciding that rising inflation will do less damage than a repression.  In fact, with inflation now at close to 5%, we could argue the decision has been made.  But not quite.

What has to happen, and what did happen in the 1970s that made that decade safe from risk of depression, is that inflation must start to drive wages higher.  In the 1970s, we become locked into the so-called wage-price spiral.  This protected workers against increases in the cost of living. 

So far in this decade, companies have been cautious about handing out wage increases.  American workers have also had to compete with very cheap Chinese labor.  However, now that wages are rising in China, we suspect the Fed will hold back on any interest rate hikes until wages in the U.S. begin to rise. 

There really is no alternative.  For if wages do not start keeping pace with inflation, consumer spending will decline.  And that would put very serious deflationary pressure on the economy.  So the Fed continues to walk a fine line between inflation and deflation, while leaning a little more heavily towards the inflation side.

Here's how to invest in such a market...



For the shorter term, we see little change ahead.  Stocks will likely remain in a trading range -- neither a bull nor a bear market.    We expect no decisive rebound in the market anytime soon.  Nor do we expect a major decline from here.

What we do expect is for commodity-related investments to be the market leaders, far more than financial stocks.  Keep in mind that financial stocks such as Wells Fargo and US Bancorp, both recommended in TCI, are close to their all-time highs.  They have certainly outperformed both the financial sector by a huge amount and also the market itself.

For this reason, we don't see much more upside in the financial sector, at least not until the direction of the economy becomes clearer, and that could take quite a while. 

We could see gold and oil prices retreating a little more.  But if oil retreats to below $120, we will consider it a buy.  We also think that oil prices below $120 would be self-limiting.  They would encourage demand to increase and possibly force OPEC to cut back on production.  Oil at $110 would still promote very strong growth for our oil service companies, and would imply that the oil sector (which seems to be trading as if oil were selling for $90) was very undervalued.  So despite the recent dip, oil stocks continue to be excellent long-term investments.

We are also convinced that the turmoil in the financial world will eventually make its way into the gold sector.  When that day comes, hold onto your hat, because you will see a bull market like you have never seen before.  Unfortunately, gold is subject to the Uncertainty Principle:  the more certain we are that gold will rise, the less able we are to predict when.  On the day gold truly makes its spectacular gain -- which it will -- it will catch everyone off guard.

Meanwhile, hold onto your gold investments along with your oil and commodity stocks.  They are the most likely winners in the months ahead.  At the same time, the bond market is saying you should have some insurance against something going wrong.  The best insurance policies are gold, once again, and zero coupon bonds.

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