Monday, July 16, 2007

Shift In The Force

"To death and taxes you can add this to your list of inevitabilities: the subprime crisis is not an isolated event and it won’t be contained by a few days of headlines in The New York Times. And it will not remain confined to a neat little Petri dish in some mad financial derivative scientist’s laboratory. Ultimately through capital market arbitrage it will affect risk spreads in markets completely divorced from U.S. housing."

Bill Gross - July Investment Outlook

This is a chart comparing the S&P 500 Index to the Broker/Dealer Index. The broker dealers are the ones who own the laboratories that many of these toxic petri dishes are kept. If they don't have first hand exposure to them, the have second hand exposure to them. Bill Gross' July Investment Outlook makes a very plain case for the trouble, caused by leverage in relation to the mortgage market, not being over and will effect other sectors because there will be a restriction to extend credit in other areas.

"Importantly, as well, and this point is neglected by most pundits, the willingness to extend credit in other areas – high yield, bank loans, and even certain segments of the AAA asset-backed commercial paper market should feel the cooling Arctic winds of a liquidity constriction. If not taken too far – and there is no hint yet of a true “crisis” – these developments may be just what the Fed has been looking for: easy credit becoming less easy; excessive liquidity returning to more rational levels." - Bill Gross

In a somewhat unrelated topic, the chart below is of the S&P 500 Index, with the bottom pane showing the percentage of stocks trading above their 40 period moving average. This shows that as we have made these new highs and headlines, fewer and fewer stocks are carrying the load. This does not mean the rally is invalid by any means, it just means that stock selection is important.

This compared to the broker/dealer index not making a new high with the market, could mean it's time to tighten stops and/or re-balance holdings to reduce risk by ensuring that concentrations in a few outperforming assets are not out of balance.

Below is a graph showing the returns of Stanford's Endowment over the past year, along with a graph showing the 10 year averages.

As can be see everything pretty much followed the benchmarks until you see the 61.2% gain in their exposure to natural resources. According to there asset allocation, they have a 7% exposure to natural resources in their endowment. Without going into the individual holdings they might have, the make up of the endowment at the end of June would have a greater than 7% exposure to natural resources because of its tremendous gain. This requires the endowment to enact the discipline to trim out of some of its great winners and re-balance to the original asset allocation model.

This re-establishing of the original asset allocations might seem like a small thing, but it is what makes the difference in the long run to outstanding out-performance. It is not rocket science, but it does take discipline to sell winners and buy into lagging areas. This is best done when you are selling high and buying low, rather than being forced to do the re-allocation in times of adverse moves when you are forced to sell lower and buy higher. David Swensen's, who runs Yale's endowment, book was mentioned in the previous post is a great source of information on this topic.

Below is a chart comparing the CRB Index(commodities), S&P 500 Index, and the U.S.Dollar Index from 1992 to current.

It clearly shows the inverse relationship between the U.S Dollar Index and commodities. Supply and demand aside, if the dollar loses 30% of its value, a commodity would gain in dollar terms to just account for the currency it is traded in. The demand for commodities is shown in the growth of economies which translate to the growth in equity earnings, which show up in the prices of stocks. It then makes sense that commodities would have a lead in appreciation before this growth might show up in improved stock earnings. This can be seen in 1993 and in 2002 in the chart above. The next few weeks should hold for some interesting times. The U.S.Dollar index is testing an important low, commodities seem to be at an inflection point. Some are coming off great runs and could be due for consolidation. Oil still makes new 11month highs as we come into hurricane season. Boring is the one things it shouldn't be over the next few weeks. Below are some commodity charts along with one of China's exchange.

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