August 4, 2008

Investment Strategy Report

Market Tries to Stabilize After Early July Drop

After a miserable June, stock prices continued to drop in July, culminating in another panicky sell-off day on July 15th before they staged another dramatic recovery.  Since then, prices have meandered higher and now seem to be leveling off, at least for now.  In the week following the rebound off the July 15th lows, the hardest hit sectors experienced the biggest recoveries.  The shares of financial stocks climbed 20 to 30% in just a few days.  Conversely, those stocks that had been holding up the best up until then, suffered the most damage.  Energy and commodity stocks dropped sharply as the price of oil, which came close to hitting $150 per barrel, has now seen its price drop to the low 120’s.  This sector rotation has caused those mutual funds which had held up pretty well during the first half of the year to suffer the most last month. 

As often happens in this business, those clients who wondered why during the big commodities and energy run up, we didn’t have more exposure in those areas, are now wondering why we have as much exposure as we do.  For the most part, I avoid sector investing because I don’t like to invest in funds in which the manager has no choice in the stocks he or she invests in.  I rather invest in diversified funds in which the manager has the ability to adjust the amounts allocated to the various sectors.  The fact does remain, though, that certain diversified funds do have higher exposure to certain sectors.  For example, many so-called “value” funds had large exposure to financial stocks and suffered the most during the past year.  Growth funds tend to have a higher exposure to technology and other fast growing companies.  During the past few months, I have trimmed our value holdings and have added more growth funds.  Our funds don’t have a large exposure to the energy and commodities sectors nor the financial sector.  During periods of sector rotation like we’re going through now, I always feel “on heightened alert”, i.e., I need to determine which sectors are doing best and do adjust portfolios accordingly.  However, I do need to be careful.  While commodity stocks are currently correcting, the fact remains that their earnings are very strong and are projected to remain strong.  Their valuations are still very reasonable, and after the recent pullback, are even more reasonable.  At the same time, financial stocks are still losing money and still face a tremendous amount of uncertainty.  If I do decide to make any rebalancing moves,  I will move gradually to avoid being whipsawed (selling low and buying high).  I will also keep my eye out for new trends developing, such as the recent outperformance of biotech stocks.  Due to the problems that big pharma has been having, many of these large companies have begun buying up smaller biotech firms to gain access to new drugs and technologies.  After several years of mediocre returns, it appears that biotech may be in a new up cycle.

Many investors have once again proclaimed that a bottom has been established.  That July 15th was the panic selloff that saw mortgage giants Fannie Mae and Freddie Mac face imminent collapse until a government bailout plan was put in place.  That brokerage firm Lehman Brothers was teetering on the edge until it recovered about 80% in a week.  We never know when a bottom has been put in until months later.  An argument in favor of “the worst is over” is that the brokerage houses finally seem to be writing down the toxic waste in their portfolios.  Merrill Lynch sold a good deal of its mortgage debt for 22 cents on the dollar, finally getting rid of much of the unknown quantities that were on its books.  Those arguing that more pain is yet to come, point out that the housing crisis still has many more months to go and the pain inflicted on the consumer will spread throughout the economy.  I would make the case that hopefully, no bad loans have been made in over 12 months now.  We have had that much time for those toxic loans to make their way through the system.  At some point, they will come out the other side.  Financial institutions will return to profitability (albeit after losing billions of dollars until then).  The credit markets will return to some sense of normalcy, allowing interest rates for borrowers to decline to more reasonable levels. There is no question that the US consumer is hurting and that economic growth will slow.  But as I mentioned to my clients who I sent out invoices to this month, we have been through this before and have gotten through it, and we will get through it this time too.    Jeff Feldman

Market Data - 8/4/2008