2008 Second Quarter in Review

Well. That wasn't pleasant. The market (as measured by the S&P500) extended its losses for the year, down about 3% for Q208. We are now at 1280 in the S&P500, roughly the same level as January 2006. A 10,000 foot view of the market isn't encouraging......with the gasoline prices exorbitantly high, home prices still falling, and the credit markets showing no signs of recovery. To make matters worse the Fed is stuck between a rock and a hard place (slow growth vs. inflation), and they seem to be "screwed" if they cut interest rates and screwed if they don't (more on the Fed later). Further, we still haven't seen a major black swan for some time (e.g. hurricane Katrina, September 11th). With all the "blood in the streets" is now the time to buy?

The good news is now is a better time to buy than it was last quarter, but the bad news is we could be saying the exact same thing next quarter. My portfolio beat the S&P500 and was up for the second quarter of 2008, but like most people I'm still a little beat up after the horrible first quarter of 2008. I feel strongly that certain investments are better than others right now, and I'll provide more detail on that at the end of this article, but first I'd like to reflect on the second quarter market performance and specifically what has been working and what hasn't.

What's Been Working:Energy stocks have been working. According to this Morningstar link, Energy has been the best performing sector for the quarter (and over the last year). This isn't surprising with names like Massey Energy (MEE) up 144% for the quarter, Petrohawk Energy (HK) up 130%, and Alpha Natural Resources (ANR) up 140%. Considering the ever weakening US dollar and increasing emerging market demand for energy, this trend may well continue.Agricultural commodities have also been working well. For example grains (e.g. corn, soybeans, and wheat) continue to reach amazing new highs, and agricultural stocks like Potash (POT) and Agrium (AGU) are up approximately 42% and 67% for the quarter, respectively. Similar to energy names, agricultural commodity gains have also been fueled largely by the weak US dollar and increasing emerging market demand. Additionally, recent rain damage to US crops may cause the rapid price increases to continue.Bets against the US Dollar have still been working. For example, the dollar has steadily declined against the Euro over the last 3 years, and it made up no ground over the last quarter.

Some short term trading strategies have been working. Specifically, all the market noise and volatility we've been experiencing this year has created opportunity. For example, I was able to complete a handful of successful short-term options trades during the bear market rally during the first half of last quarter.

What Hasn't Been Working:

Basically, everything else. The worst-performing sector for the quarter was Financials (down around 8% for the quarter). This is no surprise as investment banks continue to write down securities, and the credit markets show no signs of returning to their former glory. I still believe there is more significant downside risk for these stocks.

Another interesting type of stock that has performed particularly poorly are the stocks that were considered by many to be buyout targets over the last year. In stiff credit, poor performing markets, less M&A deals get done. This creates some very obvious short sales opportunities that I'm kicking myself for not recognizing over the last year. Specifically, many stock prices were bid up last summer in anticipation of potential buyout announcements, and then as the market has deteriorated the likelihood of these buyouts getting done has decreased and the value of these stocks has also decreased strongly.

I'm sure there are some astute investors out there who recognized this by shorting these stocks. Considering history almost always repeats itself, I'll be keeping this in the back of my mind for many years to come as the business cycle will eventually come full circle and these types of opportunities will arise again.

One other obvious negative signal that many investors overlooked over the last year and a half was the IPOs by Fortress Investment Group (FIG) and Blackstone (BX). The leaders of these organizations are by far some of the smartest investment people in the World, and that fact that they were IPO'ing should have been a signal that their companies (and the overall market) were overvalued. Companies don't have public offerings when the market is bad because they won't be able to issue their stock at a good price (thus the very low amount of IPOs over the last year), and companies do have public offerings when their companies will be overvalued.

Since their IPOs in late 2006 and early 2007, both BX and FIG have performed miserably, so it looks like guys like Stephen Schwarzman and Wesley Edens cashed out with IPOs at the exact right time... congrats guys, you outsmarted the market... again!

What are the Regulators Going to Do? What are the Fed, the Treasury, and Congress going to do to improve our current horrible market? There isn't much they haven't already tried, and our market is still struggling. They've lowered interest rates drastically, they've changed reserve requirements, they opened the discount window to brokers, they bailed out Bear Stearns, and they mailed out stimulus checks, all to very little avail. Even Democratic talks of carried interest tax reform on hedge funds and private equity firms has died down in recent months because they know it's not good for the economy right now.

Now the Federal Reserve is facing a steep inflation problem, and can't raise rates to fight it because it would likely push our slow growth economy over the edge and into recession. To make matters worse, other central banks around the world are raising rates, which seems to undermine the efforts of the U.S. Central Bank. In my opinion, inflation and a weak dollar will continue to be a major problem for the United States for many months into the future because there is no quick way to solve the problem. In fact, continuing inflation is one of the main tenants upon which I have positioned my personal investment portfolio for the upcoming third quarter of 2008.

How I'm positioning my portfolio for Next Quarter: I am overweight select energy stocks (mainly oil and coal) because I believe the weak US dollar and growth in emerging market demand will continue. The Fed can't effectively fight inflation right now because they are in between a rock and a hard place with inflation and slow growth. Also, there is a strong correlation between energy prices and certain types of energy stocks, and I've positioned my personal portfolio to take advantage. I'll be looking for more bear market rallies to make some shorter term trades. I think we'll see continued high noise and volatility in the market, and I think these conditions create some interesting shorter term trading opportunities. However, until underlying market conditions improve (e.g. strength in housing, financial stocks, and the U.S. dollar), I don't anticipate any major new uptrends in the overall market.

I'm not going to try to call bottoms in Financials. Too many people have attempted and failed. In fact, I think there is still more downside risk in these stocks. I continue to like low "Bernanke-Beta" stocks (i.e.select large-cap, non-cyclical, dividend-paying stocks, that are under-valued). Procter & Gamble (PG), and Raytheon (RTN) are two of my favorites. I believe these types of stocks can be successful no matter what Bernanke does with monetary policy. Overall I think the market is not in great shape. It's possible we have an amazing third quarter market rally, but I'm certainly not betting on it.