Third Quarter Outlook
Insight NewsletterIssue #03
As an independent money manager, we watched in amazement earlier this year as prices for all different kinds of securities seemed to just elevate. For more than six months all asset classes rose in concert. From our point of view, this seemed too good to be true… and it turned out to be exactly that. Fund managers and individual investors were reintroduced to risk in the 2nd Quarter of 2006.
In April and the first half of May, common stocks in markets around the world rose steadily. The largest gains were in commodities, precious metals and industrial cyclical stocks. We suspect many of the 8,000 hedge funds participated fully in this trend. The first six weeks of the quarter saw Gold rise from $582 to $738 per ounce while industrial stocks like Boeing rose from $78-$89 and oil stocks like ConocoPhillips went from $63 to $72. Then something changed.
…On May 10th the Federal Reserve increased short-term rates for the 16th time in two years. Almost like clockwork, the stocks in the hottest sectors started to fall. At the same time, economic data began to show that credit and monetary supply was also contracting in Japan, Europe and Asia. The reduction in credit and the money supply set off a cascade of selling.
In June the selling continued. It has been reminiscent of 1998 when Long-Term Capital Management came unglued and was forced to sell billions of dollars of stocks and bonds in August and September of that year. The recent indiscriminate selling, particularly in the hottest sectors including energy and commodities, indicates that either large funds are liquidating large positions or the cyclical bull market is ending or both. Either way, we are pretty certain that the economy is slowing down.
3rd Quarter Outlook
The 2006 slowdown might turn into a recession. We continue to reserve judgment on that score. But clearly, the concept of risk has returned to investors. Some good news for value investors is that price-earnings ratios and other valuations are nearing their historical averages. But if inflation or interest rates continue to rise, or a recession commences, common stock prices are pretty likely to drop quite a bit further.
Is this a bear market? Maybe. Is it a bull market? It doesn’t seem likely. In any case, we are positioning portfolios more defensively. We are increasing cash and short-term fixed income positions. Timing and extreme patience is required in order to keep our heads clear and be in position to take advantage of a nasty market correction. Some of the sectors we are currently researching include: Biotech, Oil & Gas, Gold & Silver, municipal bonds, and large cap value stocks.
We believe that later this year there will be opportunities to buy common stocks at some very good prices. For now, we are content to increase our cash positions, exercise patience, focus on research, and protect capital.
Daniel Barnes, CFA