Friday, June 23, 2006

Current Equity Market Performance

I had a long meeting with my partner this week, and the topic of our portfolio strategy's performance arose. The strategy now trails the index by some 10 percentage points.

Earlier in the year, I was more perplexed and concerned by the portfolio's lackluster performance relative to the index. Now, however, it's clearer to me what is occurring.

Beginning with May's negative index return, the first this year, and continuing with a nearly equal performance so far in June, the S&P is now hovering at a 0% return for the year. Evidently, many investors have become so paralyzed and confused by various confusing signals regarding global economic activity and US inflation, that they are just treading water. They feel no compelling directional push from the mass of data.

As my partner and I discussed this, he asked if it were not true that, essentially, our position is, "we are right, and the market will come around sooner or later." Is this not rather arrogant, he thought? "Arrogant" may not have been the word he used- but his point was similar. Are we not "blaming" the market for our being behind, and accusing other investors of "getting it wrong" on equity valuations.

This led me to another application of my insight on mediocrity. If you search this blog for the term "mediocrity," or "mediocre," you will find several past blog posts which explain my thoughts on this important concept.

In the equity market, I believe that the vast preponderance of investors, institutional included, are mediocre, and, at times such as these, spend most of their energy being scared, trading aimlessly, and generally emitting no directional signal whatsoever.

We have a lot of apparently mixed signals in the market right now, if you aren't very savvy. There is the bugaboo of high energy prices. Then there's the Mideast situation overlay- Iran, Iraq, and even Nigerian supply issues. Commodity prices have been high, gold rose, and, in the US, the Fed is worried about the current rate of inflation.

Yet, US corporate performance is good, and commodity prices and demand signal continued healthy global growth.

My contention is that the "average" investor is now like a deer caught in the headlights of an oncoming car. S/he is frozen.

Taking a look at my portfolio selection process' recent results, I am struck by the continued significant presence of energy companies. Homebuilding fueled the portfolio's outstanding performance for some 18 months over the past two years. As the sector cooled, though, the companies in the sector that had been selected for the portfolio were gradually dropped by the process. Not so with energy. Something else is going on here. Despite this year's choppy return performance by many energy companies, they remain prominent in the model's selections.

My thinking is that this represents the system's reaction to a strong, if confusing, equity market situation. The portfolio strategy does worst with a near-zero index return. In times like these, growth equities are punished, but not so emphatically, for so long, as to justify shorting them.

Instead, we are in the position of remaining long prior to what I believe will be an awareness on the part of many market investors, later this year, that things are really quite attractive and healthy in the equity markets. Since our model is designed to be invested, and not in cash, we are now long, and, thus, behind a wavering market.

The recent occurrence of days of sharp gains and losses by the index and the portfolio, some approaching 4% daily, suggest to me that we are near a "bottom" of uncertainty-related trading. I expect that by summer's end, either the market will plunge, and our strategy will go short, or investors will realize that there is healthy fundamental global economic growth, and the equity market will advance sharply for several months.

Thursday, June 22, 2006

Boeing v. Airbus: The Value of Executing Fundamentals

The Wall Street Journal has recently run several pieces on Boeing's resurgence at the expense of Airbus. Last Thursday, the article provided details of Airbus' sizable gamble on the A380.

What is very comforting to read is that Boeing learned what customers were doing- going for niche direct routes- and designed a plane for that. The 787 "Dreamliner."

Airbus, in contrast, continued to 'serve' the failed hub-spoke system, and launched an expensive program to produce the A380. As it turns out, there is little demand for the plane, even if it were not behind schedule and over budget.

Sometimes, success is just getting the fundamentals right when the other guy doesn't. Boeing excelled at the simple "blocking and tackling" of asking customers what they needed, what they were doing, and then provided a produce, the 787, tailored to those needs. Airbus did not.

As a result, Boeing's fortunes have steadily improved over the past several years (click on the chart above to see the larger version). Despite
McNerney's recent arrival, and Boeing's past military program management/ethics problems, the commercial aircraft division seems to have done things right, and already begun to put Boeing on a path of consistent returns.

Wednesday, June 21, 2006

Cell Phone Video Content Provider Troubles

Last November, I wrote a piece about the likelihood that a lot of people will want to view video content over ipods and cell phones.

Yesterday's Wall Street Journal featured a piece that described the troubles of several new mobile media companies, including one involving ESPN.

While I continue to believe that an insufficient number of people will pay to watch large amounts of content on cell phones, I did not realize there is an additional wrinkle to these companies.

They are forming new mobile networks, using leased lines, to market their content. This seems incredibly risky. No wonder Mobile ESPN is having trouble.

These start-ups are betting they can lure users from current calling plans of Verizon or Cingular, for example, just to get the video content on the start-up network. I would have expected these firms to license their content to existing providers. Maybe, if they fail at their own networks, that's what they will revert to doing.

I have a feeling that the coming wave of mobile video is going to look an awfully lot like the first wave of internet retailing did in the late 1990s.

Monday, June 19, 2006

Oil's New Rules: Sovereign Producers Change The Game

I read last week's Wall Street Journal article on the changing nature of oil supply and demand with great interest, and I am sure I am not alone in that regard.

The picture painted by the piece is quite dark. America experiencing both the loss of substantial, easily-accessible quantities of oil, while also remaining a major consumer of oil, though by no means now necessarily the only large one. Add to this the knowledge that several other major consumers, India and China, are also paying up for access to, or ownership of, oil reserves, and the picture gets almost totally black.

Or does it?

Back in the 1960s and before, the era with which the article contrasts the present situation, the phrase "global economy" had nowhere near the same meaning it does today. Without repeating a lot of economic history which can be found elsewhere, suffice to say that the world's major economies are far, far more intertwined today than they were even 30 years ago, let alone 40+ years ago.

I suspect this matters in the case of oil supply and demand. Oil is an industrial input, as well as a consumer good. Suppose China gained ownership of most of the oil reserves needed to slake its thirst, to the exclusion of America. What then? Would not the corresponding slowdown in US industrial production and consumer consumption boomerang right back onto the very China which had caused the shortage? And would this not ratchet down their own economic activity level, wealth, standards of living, etc?

When the Saudis had that kind of power, all they would lose was money they didn't really need to spend. The Saudi economy didn't so much depend upon selling non-energy goods to the Americans, as the Indian and Chinese economies currently do. Now, the Saudis want to develop energy-related industries, but here, too, it's not clear they will benefit from this in the long term. The Chinese and Indians are different. If their exploitation of the ownership of oil reserves gets too draconian, the global economy will come crashing down on everyone's head, not just the the victim countries who don't own sufficient oil reserves.

Furthermore, those countries paying for long term oil supplies at nearly $70/bbl are now locked into those energy costs. So are their petrochemicals, and other goods and services downstream which require the oil feedstock or refined petroleum. Doesn't that mean that, if oil were to decline just to, say, $60/bbl, those countries are now at a $70/60 price disadvantage? Are not the sectors of their economies which used oil all going to be overpriced, relative to those countries acquiring supply on the spot or more near term forward markets?

How is locking in oil reserves at a high price different from: S&L's locking in deposits with high long term rates on the liabilities, or; insurance companies locking in investment product customers with unsustainable rates on GIC (guaranteed investment contracts), or; utilities securing long term natural gas supplies at historically high prices? Haven't we seen each of these three scenarios wreck a sector or some companies in the US sometime in the last 30 years?

If so, why shouldn't China and India meet similar fates if their recent acquisition of oil supplies prove to be at historically unsustainably high prices?

I may be wrong, and the US may truly be on the economic skids, thanks simply to its dependence on oil which it does not own nor to which it is not buying access. But something about the interlocking nature of the current global economy leads me to suspect that the end game is not as simple as the WSJ article makes it out to be.

For everyone's welfare, let's hope I'm onto something, and that the article's author overlooked some key differences between the 1960s' and today's global economy.