FIRST QUARTER 2007 COMMENTARY
By Richard L. Kesner, President
The CommonWealth Group
May 2007
As I write this the doldrums of the first quarter are far behind everyone’s thoughts as the markets continue their upward movements setting records almost on a daily basis.
However, despite the fabulous six week upward run, it is important to understand that markets usually go up when most investors believe in doom and gloom. Remember, you cannot time the market.
Managers Commentary
It is always interesting to look at the manager’s reactions to the quarterly movements of the markets and to see why things performed as they did. Of course, it would be helpful if they told us these things before the quarter started so we would be more informed, and prepared. It is like looking at the Wall Street Journal on a daily basis to find out why something happened to the market in retrospect. “Oil prices increased so the market went up 100 points today. Energy increases cause market slowdown. I sure get confused by this noise.
One manager attributed the market’s underperformance to the problems in the “subprime” mortgage area. Why this is a surprise to anyone should really be the surprise, as the mortgage bubble (not housing but mortgage) has caused a lot of properties to go into foreclosure. When you lend to nonqualified buyers should it be a surprise that the loans don’t get paid back? The problem is that in addition to the “subprime” lenders, other lenders were also sold off, causing these companies to become value purchases.
GE, which was down -4.2% for the quarter, was affected because it owns WMC, a subprime lender. “WMC is one of the leading subprime lenders, however, it sells the entire loan, and has no recourse,” stated the manager. The subprime subsidiary was responsible for 1 cent of earnings per share of GE in 2006. Is GE now on sale?
Another manager also mentioned the subprime category as a cause for the market’s poor performance and stressed that “the housing market decline has not fully run its course, as low rate adjustable mortgages have been increasing resulting in higher monthly mortgage obligations.” In addition, he continued, “While the economy was already perceived as weakening, the additional negative economic news has caused a significant increase in stock market volatility.”
We have two managers, both in the large value area, giving reasons for why they had poor or slightly positive performance for the first quarter, warning us that the volatility was a cause for concern and that the economy was slowing. Six weeks later the markets (the three major indexes) are all up over 6% for the year and 6% for the past six weeks.
Once again, I stress that no one knows what is going to happen in the markets.
The European Markets
In addition to the above, we have clients who are now asking about investing in international stocks. While we agree that diversification is an excellent idea, and that some international investing is probably good for your asset allocation, the international markets have been achieving very strong results. According to Nick Murry, of the $180 billion invested in equity mutual funds in 2006, $150 billion went into international funds. This caused a disparity in returns between large cap international funds at 24.3% vs. the average large cap domestic fund with returns of 12.4%. So is now the time to move money into the international arena? It is our opinion that chasing returns is exactly the wrong thing to do and yet this is what the traditional investor does year after year.
Where do we go from here?
At Commonwealth we continue to look for managers who (a) manage risk, (b) perform well in down markets as well as up markets, and (c) do their own research. We like smaller and emerging managers who tend to move quickly, often before the vast researchers on Wall Street catch on to their ideas. Most of all, we want managers who protect principle.
We are looking to rebalance portfolios in the near future to take advantage of situations which have not appreciated as well as others. Our hedging strategies are designed to limit volatility, but with no guarantee. Hopefully, they will work and not affect upside performance in a dramatic way.
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