Boo!
10/30/07
John Riley
Chief Strategist

What scares you? What are you worried about? Scary stuff has been in the headlines for months. Huge earnings losses - Sub-prime mortgage mess - Dollar collapse - Commodity spike up – Gold’s spike – Stock Market spike - Bond market decline – Oil nearing $100/bbl – Housing market collapse… and on and on.

We at Cornerstone see the headlines too, but instead of being scared, we see the opportunities. We have been adjusting portfolios to take advantage of many of the problems. Below is a recap of many of the problems and what we are doing about it.

The Dollar is collapsing because of low interest rates in the US, too much debt and too much currency floating around the globe. We use foreign investments like foreign bonds and stocks to benefit from a declining Dollar.

The bond market topped out in 2003 and has been sideways to declining since then because of the fear of rising inflation. This is because of the Fed lowering rates and the rise in commodity prices.

The Long Bond yield bottomed in 2005 and looks like it is turning the corner to head higher. Higher long term rates will stifle the economy and housing especially. It is a result of foreign sellers of Treasuries and the Fed lowering rates.

We have reduced exposure to Treasury bonds and use only Treasury Inflation Protection bonds. (If the Fed is going to let inflation run, these should not be hurt the way traditional bonds would be.)

Commodities are rising because global demand is pushing prices higher. There is nothing the Fed can do about that. They can raise rates, lower rates or change them to blue, and it won’t make any difference to how much oil China or India consume.

If the CRB were to pull back 10% to 20% we wouldn’t be surprised. But since the economics of hard assets is very strong, we would view it as a buying opportunity. For that reason, we are reducing the exposure in some portfolios with the anticipation of increasing exposure after a pullback.

Gold is up for two reasons. The first is inflation and the second is the declining Dollar. Or maybe it is the other way around. It doesn’t matter. (For those of you that care which is first, I don’t.) A drop of $100 would put it at major support. We wouldn’t be surprised by this, but are not reducing allocation, yet.

Oil has had a nice run this year, almost doubling from the low of 52/bbl in January. A pullback in oil should happen only because it has gone up so far so fast. I would expect 81 – 82 for initial support. The bullish trendline is down at 73, so a big drop could be in the offing. Does this mean oil is a bad investment? No. But we have reduced exposure to oil for some portfolios and will probably reduce even further.

Our expectation is that we will increase our allocation after a significant correction. A pull back in oil will also affect the CRB and gold, giving them buying opportunities also.

The stock market is up because…

Earnings are great? No.

The economy is humming? No.

The real estate debacle is over? Ha! Hardly!

No, the stock market is flirting with new highs because….

I can tell you the simple answer is that there are more buyers than sellers. That is true. Understanding why they are buying is like trying to figure out why a kid puts his hand on a hot stove after you have warned them not to.

All the other markets are acting like a recession, (with inflation), is coming like a freight train. Yet the stock market seems not to notice.

Or better, what does the stock market see that the other markets are missing? The other markets are pretty well linked together. The Dollar’s decline is irrefutable. The advance of Gold and other commodities is obvious. These occurrences lead to higher inflation and economic slowdown.

The average stock market bull will tell you the market is going up in response to the Fed’s lowering rates. Excellent. A well thought out answer. Wrong and uninformed, but exactly what Wall Street wants you to believe.

Before we explain why the answer is wrong, a few more questions to ponder. Do lower rates help or hurt a declining dollar? (Hurt) Do lower rates stifle inflation or ignite it? (Ignite) Do lower rates help cool off the foreign demand for commodities? (No) Do lower rates increase the money supply and debt outstanding or decrease it? (Increase)

So if lowering rates hurts the economy in so many long term ways, why is the stock market going up? Wall Street and the market are populated with monatarists that believe lower rates are a cure-all for everything. They are wrong. (See our article “Money, Money Everywhere” for more info on this.)

It is our belief that the Fed is acting very short term. They are only looking out for the next few months, trying to put a band-aid on a very serious problem. “So what if lowering rates today hurts the economy long term, let that be the next guys problem.” we believe is the Fed’s attitude.

But too many of the variables are out of the Fed’s control. We think the danger is now and the Fed has little they can do to prevent the inevitable economic and market declines.

Wall Street got it wrong by ignoring the warnings of 1999, should we expect anything different this time?

Because of this, we have increased our hedge position allocation (hedge positions are not hedge funds). Hedge positions are designed to take advantage of a declining market.

The International stock markets are still scary. After having a significant correction from 2000 – 2002, they have gone almost straight up. While I’m glad we benefited from the rise, we have reduced our International Equity position in anticipation of a major pullback. Since the bullish trendline is down at about 152 and the Dow Jones World Index is about 317, an implied 50% correction could be ahead. While I’m not that pessimistic, a good sized correction is expected. The main difference between the a decline in US equities and International stocks is that we believe the US economy is in worse shape than many foreign countries and will not be able to recover as quickly.

While we do not guarantee against loss, our strategy is designed to take advantage of many of the things that may concern you about today’s very scary headlines. Yes, our portfolios will have some ups and downs, but our strategy of using inversely correlated assets is designed to mitigate much of the volatility while not giving up the performance.

You can rest easy, because we already have a plan in place for much of what may worry you.

If you have any questions, comments or observations, please contact your Cornerstone representative or John Riley at johnr@cornerstoneri.com

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