The market and the economy have given investors much to think about since my last writing. With good reason, many have concerns about both the US and global economic picture. True value and bargains never appear so when presented, but in hindsight seem blatant. Bubbles in asset prices also tend to obfuscate themselves at tops. Historically, bottoms in markets are created around troughs in sentiment while peaks are marked by exceptionally high ebullience. Based on the level of anxiety surrounding equity markets today and the irrational exuberance of commodity markets I expect both may reverse course in the not too distant future. Of course short term commentary is just that, and our investment decisions are made with long term perspective. Consistently however, the near term will test one’s resolve. The successful investor is one that can avoid the innate urge to react on either fear or greed.
During the course of the second quarter, first quarter GDP was revised upward twice to leave us with final growth of 1%. The surprising growth in the economy has been driven by surging exports. Goods sold to foreign buyers have been turbo-charged by the declining dollar and strong economic growth throughout the world. Real income increased in the second quarter as did the all important consumer and service sectors of the economy. Unfortunately for investors, markets don’t trade so much on what has happened as what is expected to happen. The parabolic rise in oil and other commodity prices coupled with devastation in the banking, brokerage, and housing sectors have sent confused investors to the sidelines. With little visibility about the ultimate macro-economic consequence of the financial and energy crisis on the economy, buyers have gone on strike.
Through June 30th 2008, the Dow Jones Industrial Average (DIA) is down 13.4%, the S&P500 (SPY) is down 11.9% and the Russell200 (IWM) Index of small companies is down 9.4%. Holding the broader markets hostage was the KBW Bank Index (KBE) down -32.8% and Crude Oil (OIL) +50.7%. Volatility in financial markets remains elevated as sentiment shifts rapidly with each new economic or earnings report.
Expectations of an energy induced rise in real inflation may prove to be a bit too pessimistic. While prices of high frequency consumer items such as gasoline, eggs, and bread have surged, other prices have shown relevant declines. Important for inflation calculations are the cost of housing and the level of wages both of which have declined of late. Energy prices could decline sharply and rapidly on increased supplies, profit taking, trading regulations, or slowing demand from an anemic world economy. Of much greater relevance to the inflation debate is the supply of currency. The year over year growth in the Fed’s balance sheet is barely 1% while the annual growth of currency in circulation has dropped to its lowest level in 47 years. Both of these metrics suggest inflation readings will moderate in the second half.
Market volatility brings opportunity and we found no shortage of either in the second quarter. We have continued to take profits in commodities ETFs (DBC). In addition, we have been and will continue to take advantage of tax swap opportunities as they present themselves.
Looking forward, I expect second quarter economic growth to be supported by the effects of the Economic Stimulus Act of 2008 and continued strength in exports. The headwinds of energy prices, bank woes, and employment should contain both growth and inflation. The net effect should be GDP reports in a tight range around very low or zero growth. Longer term I see exceptional value in equity prices and decent visibility in all sectors other than financials (XLF). I still expect better earnings reports near the end of 2008 and early 2009 as the economy recovers and companies look back to favorable prior year comparisons.