Monday, July 7, 2008

To say the second quarter entered like a lion and left like a lamb would be half right. April saw broad market gains of 5.33% in a single month after a particularly weak first quarter. However the fundamental problems I've spoken about previously reasserted themselves and June registered a loss or 8.43% as measuredby the S&P 500. It was the worst June performance since 1930, less than a year after the infamous October 1929 crash.

We continue to focus on capital preservation and our goal of equity like returns with lower risk. Given the depth of the economic problems focused on the financial sector a more opportunistic approach is likely needed not only to expand our outperformance but quickly regain positive year over year results. While clients are doing significantly better than their appropriate benchmarks many are now in negative return territory for the trailing twelve months. Relative performance is the measurement that investors use and all clients are outperforming the broad market although all too often in slightly negative territory. I expect the remainder of the year to be challenging as well as markets react to perceived crisis followed by perceived solution.

We are always looking for underappreciated assets to add to portfolios and although the market is technically oversold and likely to find a bounce, the bearish fundamentals are still in control. Visibility in financial industry assets remains murky, commodities are now extended, corporate earnings under pressure and interest rates are thrashing around in the midst of an inflation vs deflation debate. The market is officially in bear territory as it has fallen from October highs by more than 20% which is generally accepted as the defining trait of a bear market. The money center banks and investment banks have created their own demise by retaining highly leveraged, illiquid low quality assets from the subprime mortgage market boom. Even worse, these investments are often off balance sheet and provide shareholders very little in the way of visibility regarding their value. As far as I am concerned these assets are marked to myth. In other words the banks are still unwilling write off the assets to the full extent necessary to reflect an accurate market valuation. This head in the sand approach is understandable. It is likely that if the valuations were accurate, a number of large and important banks could fail.

There are various signs that the stock market is entering a bottoming phase, but how long it will take is anyone's guess. I believe that a 50% retracement of the past five year bull market will be a technical support level worth considering. We are seeing even shares of companies in leading sectors such as steel, coal and materials being sold agressively. Bear markets begin to find their bottoms when, "they start shooting the generals." The erosion of leading sectors is indicative of market capitulation when nothing is immune to sale. Unfortunately, the fundamental seeds of the next bull market such as seen in July 2002 are not yet apparent.

I note clients are also not emotionally immune to the constant barrage of negative news about the economy. I have had more than one call expressing fear that the latest headline in the media directly translates to despairing losses in their portfolios. This is simply not the case. While the market went into "official bear" territory this week, defensive and diversified portfolios have performed as intended in difficult conditions. Taking moderate sized aggressive trades has been a successful tactic when technically oversold conditions warrant. In general however, we maintain a patient posture. The average bear market typically ends with a significant strong upward response. The 20% loss can very quickly become a 30% gain so we are watching closely for countercyclical trading opportunities.

The fundamental reasons to look for the next long, extended bull market are not in place and as such investors should use the time to harvest tax losses. In those assets which are integral to our long term models but have taxable losses, we are selling and replacing with similar holdings to remain invested while avoiding wash sale regulations. Portfolios held elsewhere should be reviewed by clients and viewed with a dispassionate eye. The opportunities of the past can often become the albatrosses of the future and a reason why performance suffers. It is unlikely investors are going to miss anything important in the next few months and should use this time for housekeeping. For the second quarter while the S&P Total Return was a negative 2.74%. Our clients were evenly divided between modest postive quarterly returns and losses ranging to 1.60%. In no case have clients had long term prospects for wealth accumulation and preservation disrupted.

John F. Barnyak AIFA® 7/6/08
PresidentStonehouse Asset Management