Jerry Jordan Commentary | Third Quarter 2008 Investment Outlook
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The capital markets witnessed slightly less drama in the quarter ending June 30 than in the first quarter, although the trends that unfolded in the beginning of the year persisted through the first half. Global stock indices trended lower, but only some of the emerging markets, like India and China, posted significant double-digit decline. For the first quarter ending March 31, India’s Bombay Sensitive 30 Index was down 14% in the first quarter and China’s Shanghai A Share Index was down 21%. The credit crisis has lingered on, but without the dramatic collapses, like Bear Stearns, that characterized the first quarter. The excitement in the second quarter occurred in the surge in oil, natural gas, and grain prices, which, in turn, caused headline inflation throughout the world to expand rapidly.
The U.S. stock market performed poorly as the second quarter progressed, ending with the Dow Jones Industrial Average (DJIA) closing at a lower low for the year (2008). Nevertheless, the damage was not severe, as the S&P 500 Index declined only 3% during the quarter, and the Russell 2000 Index and the Nasdaq Composite Index even posted marginal advances. But many foreign markets continued to suffer, especially those economies that lack raw materials, such as India and China. It is noteworthy that the U.S. stock market continues to outperform most foreign markets, due to the lower energy dependence of the U.S. economy and a more accommodative Federal Reserve.
Our holdings gained ground in the second quarter, as our emphasis on energy, power supply, and strong demand for industrial commodities worked well as the world began to recognize the scarcity of energy supplies and raw materials. In our last Outlook, we signaled our increasingly optimistic view for U.S. equities this year. We still maintain this view, but recognize that rising oil and gas prices have, at least temporarily, offset some of the stimulative effect of lower interest rates.
The Economy & Interest Rates
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"Valuations for many equities appear attractive." |
Technically, the U.S. economy did not decline into recession in the first half of this year. As we noted in our previous Outlooks, we expected the economy to “brush with recession,” meaning experience between -1.5% and +1.5% GDP (gross domestic product) growth throughout the year. We still maintain this view. But many segments of the economy, most notably the consumer, are in recession, and the recent spike in oil prices has been especially punishing. In aggregate, the economy has “muddled along” at a slow pace, but the actual output numbers have not been as bad as feared. In fact, negative expectations regarding economic prospects ended the second quarter at multi-decade lows, judged by various consumer confidence surveys, despite the fact the economy likely continued to expand modestly.
Regarding economic prospects for the second half of the year, the critical issues are interest rates and oil prices. If oil prices continue to “shock on the upside,” or if the Federal Reserve Bank is forced to tighten to curb rampant headline inflation, the economy and stocks will suffer further, as investors become more pessimistic regarding stagflation. We believe that, despite recent central bank hawkish rhetoric, the probability of the Federal Reserve raising short-term interest rates in 2008 remains very small, and that there is growing recognition that high oil prices are already dampening many aspects of consumption. In May, the unemployment rate in the U.S. rose 50 basis points (0.50%) to 5.5% and consumer confidence dropped to a 28-year low. The Federal Reserve will not likely raise rates until these economic indicators have been rising for many months.
While consumer spending has been weak due to both declining home prices and rising fuel prices, much of the U.S. economy remains relatively healthy due to the depressed dollar and robust foreign demand. We expect this to continue, and potentially be augmented by stronger consumer spending in the second half of the year. It is critical, however, that the developing economies, like Brazil, China, India, and Russia, continue to prosper. In fact, some meaningful deceleration in the overheated economies should be welcome news to mitigate excessive demand for raw materials. In summary, we expect the U.S. economy to improve slightly in the months ahead, and the foreign economies to slow down to more moderate and sustainable levels. We remain alert to the potential of a more significant slowdown in the second half, but feel such an outcome is unlikely given the magnitude of U.S. central bank easing.
The Stock Market
As of the end of June, the stock market has been declining for nine months. According to Ned Davis Research, the average duration of bear market declines since 1980 has been 201 days. Additionally, by the standard of the last 30 years, this has already been a long bear market, with the S&P 500 declining 19% from its peak on October 11, 2007, through June 30, 2008. We believe that the current decline is close to ending because of 1) significant pent-up demand to buy stocks; 2) very attractive equity valuations, especially relative to interest rates; and 3) an abundance of attractive growth opportunities.
There is significant pent-up demand for equities because shorter-term equity investors have become excessively defensive, especially in light of the dearth of attractive investment alternatives. Namely, investors are confronted with the choices of equities, bonds, real estate, and cash, among the major asset classes. Bonds appear unattractive due to low yields and rising inflation. Real estate remains unattractive at present due to excessive debt loads preventing valuation expansion. Cash appears attractive when equities are actually declining, but otherwise, at 2% or less, provides a negative return after inflation. And while equity returns have been negative year-to-date, equities can prosper while inflation is elevated, provided that corporate profits are growing sufficiently to compensate for inflation. Thanks to the low, but competitive, dollar, corporate profits continue to be strong, excluding the financial sector.
Pent-up demand for equities is visible in many ways: 1) Nasdaq short-interest ratios are at record highs as of 6/30/08; 2) money pouring into low-yielding money market funds, which potentially will return to equities when the stock market starts to rise again; 3) foreigners have been aggressively liquidating U.S. stocks, which has historically been associated with stock market bottoms; 4) surveys indicate that hedge funds generally have low net exposure to equities; and 5) large speculators are heavily short the U.S. major stock indices. The majority of these constituencies will need to buy stocks when they start to rise again. An excellent summary of these aggregate liquidity factors is reflected in the all-time record high levels in Ned Davis Research’s 2/29/08 Available Liquidity Forecast, (ALF) which measures the combination of mutual fund cash, credit balances of cash, and margin accounts and NYSE (New York Stock Exchange) short interest in dollars. Extremely high ALF levels historically coincided with major market bottoms in 1962, 1974, 1987, and 2002.
Valuations for many equities appear attractive, especially adjusted for interest rates. The earnings yield for stocks is currently over 5%, while short-term interest rates are at 2% (as of 6/30/08). Dividend yields for the S&P 500 and the DJIA exceed the T-bill rates. Stocks generally yield less than T-bills because stocks provide long-term earnings growth potential, and a hedge against inflation. Many of the equities that we own have price-to-earnings multiples of less than 12.
There are many attractive investment opportunities emerging in this environment. Investors fret because of the perception that many traditional growth areas have exhibited disappointing prospects over the intermediate horizon. Our view is that the very definition of growth stocks is evolving, as traditional growth areas are confronting overcapacity and stagnant markets. The economy is changing, and the global appetite to satisfy energy and material needs is escalating sharply. We expect the orientation of growth investors to shift from catchy electronic gadgets to industrial and technological solutions to our declining resources. Infrastructure spending will likely increase dramatically in the years ahead, along with compelling solutions to energy, water, and other resource shortages.
Strategy
We continue to regard energy-related companies, especially oil service, as having the strongest fundamentals in the market. The outlook for the service industry seems much more bullish today than even a few months ago. Higher oil and natural gas prices have provided producers with the cash needed to increase drilling activity domestically and internationally. Recent surveys indicate that worldwide exploration and production expenditures are forecast to grow 20% in 2008, with continued growth in spending in 2009 and 2010. The North American and international drilling rig counts are up 5.3% and 6.7%, respectively, since June 2007, and those numbers are likely to accelerate as drilling permit applications are growing even faster. Also, recent congressional debates on offshore drilling are highlighting the need for the U.S. to boost oil production, and pressure is intensifying for the producers to drill on leased (but currently idle) acreage. Finally, global oil-supply growth continues to surprise to the downside, as many of the largest fields are now in decline. Additionally, countries still experiencing production growth (i.e., the Middle East) are seeing their internal oil demand grow rapidly, reducing net supplies available for export. All of these developments are extremely bullish for oil service fundamentals.
Electricity generation is another area facing critical shortages both in the U.S. and abroad. Decades of underinvestment in power-plant construction and grid improvements have decreased the stability of many transmission corridors and left regions susceptible to power shortages. One domestic example occurred in Texas earlier this year (before peak summer temperatures), when wholesale electricity pricing jumped 10-20 times normal levels, for brief periods, and have remained 50% higher since April. South Africa is only one of the developing regions to experience more severe shortages; the government has instituted a power rationing program to keep blackouts to a minimum. We expect more incidents to follow this summer, as well as significantly higher electricity prices backed by elevated natural gas and coal costs for electric utilities. Our portfolio holdings include companies that provide equipment for upgrading and expanding power generation facilities, as well as independent power producers who we presume may raise prices materially in the coming months.
The aforementioned power shortages are one factor contributing to continuing shortfalls in the production of many commodities, which is being exacerbated by the consistently strong demand growth in developing nations. Inputs for steel production, such as metallurgical coal and iron ore, have become supply-constrained and have tightened the supply/demand balance in steel markets. Consequently, steel pricing has doubled this year, while still allowing the producers further pricing power. International coal production is being constrained by flooding and power shortages, causing the U.S. market to increase export levels 49% year-to-date. This has allowed domestic pricing to more closely track foreign levels, which is up over 88% since January. Copper is another raw material seeing repeated supply disruptions, where global inventory levels are just above multi-year lows, as well as sustained demand growth from emerging economies such as China. We believe our investments in industrial resources will continue to prosper because these companies will maintain pricing power in the tight supply environment, and that consensus estimates remain far too low.
While many of our investments have benefited from higher oil prices, our thesis is predicated upon commodity prices remaining at relatively high levels, not necessarily continued record highs. Given the significant increases in oil prices this year, we acknowledge that a short-term correction may be possible. However, we believe any such decline will be moderate in duration and intensity. The companies in our portfolio will probably not see their long-term outlook change materially in the event of such a temporary pullback in oil pricing.
Traditional growth companies still have a place in our portfolios, albeit on a more selective basis. We remain focused on companies that will be able to grow in a sluggish economic environment. Examples include beneficiaries of increased Internet advertising and healthcare segments such as biotechnology and high-tech medical devices. As always, we will continue to search for other opportunities with improving long-term fundamentals potential and reasonable valuations.
The S&P 500 Index is a broad-based unmanaged index representing the performance of 500 widely held common stocks. The Nasdaq Composite Index is an unmanaged index representing the market cap weighted performance of approximately 5,000 domestic common stocks traded on the Nasdaq exchange. The Dow Jones Industrial Average (DJIA) consists of 30 stocks that are considered to be major factors in their industries and that are widely held by individuals and institutional investors. Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index. India’s Bombay Sensitive 30 Index is a value-weighted index composed of the 30 largest and most actively traded stocks, representative of various sectors, on the Bombay Stock Exchange. China’s Shanghai A-Share Index is a capitalization-weighted index which tracks the daily price performance of all A-shares listed on the Shanghai Stock Exchange that are restricted to local investors and qualified institutional foreign investors. One cannot invest directly in an index or average. Price- to-earnings ratio is the value of a company’s stock price relative to company earnings. This indicator is calculated by dividing the monthly short interest figure by the average volume of trading per day.
Before investing you should carefully consider the Jordan Opportunity Fund's investment objectives, risks, charges and expenses. This and other information is in the prospectus, a copy of which may be obtained by calling 1-888-314-9048 or visiting the Fund's website. Please read the prospectus carefully before you invest.
The Fund's investment parameters are diverse and as such may be subject to different forms of investment risk such as non- diversification risk, concentration risk, small- and medium- sized company risk, interest rate risk, high yield bond and foreign securities risk, and lastly, the Fund may use derivatives such as options to increase its exposure to certain securities. Please see the prospectus for a more detailed discussion of the risks that may be associated with the Fund.
The views in this newsletter were those of the Fund manager as of June 30, 2008 and may not reflect his views on the date this report is first published or anytime thereafter. These views are intended to assist shareholders in understanding their investments in the Fund and do not constitute investment advice.
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