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Adrian Day Portfolio Review 2Q11

Adrian Day Portfolio Review 2Q11

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Published by Jae Jun
Becoming my new favorite portfolio manager. Adrian Day's quarterly letter to investors discussing the economy, commodities and expectations.
Becoming my new favorite portfolio manager. Adrian Day's quarterly letter to investors discussing the economy, commodities and expectations.

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Published by: Jae Jun on Jul 12, 2011
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08/15/2011

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P.O. Box 6643, Annapolis, MD 21401
410.224.2037 Second Quarter July 2011
This has not been a happy period for investors, with May and June seeing many marketsand sectors collapse by 10% or more, wiping out first quarter gains. The reasons for thisspring collapse—well rehearsed in the media—have not gone away, and with valuationsneither particularly compelling nor overly stretched, we are neither aggressive bulls norbears for the next several months. We see a sideways market, with mini peaks and troughsalong the way, for the next several months (or longer), in what the Financial Times’columnist John Authers has called “The Age of the Crab”. We do, however, see some verysolid companies selling at good prices, particularly (though not only) in the resourcesector, on which we continue to be long-term bulls.
Sideways markets make stock selection key
Indeed, this sideways action is really what we have already experienced this year. It is similar to the patternfrequently seen after a major market decline; an impressive rally back towards old levels, followed by a long,broadly sideways movement (as per the Dow after 1929 or Tokyo after 1990). Of course, the peaks andtroughs along the way seem significant at the time. In this kind of market—a trading market not aninvestment one—there will be two general ways to profit: attempting to time the ups and downs—difficult atbest—or increasingly focused stock selection.Though ever-mindful of whether the market is overbought or oversold at any given time, we will emphasizethe second strategy, buying good quality companies, preferably those with appreciable dividends, when theyrepresent good value. Thus in June, after seven losing weeks that took the market to what appeared oversoldlevels, we bought fairly aggressively, topping up accounts with solid values in the broad U.S. and globalmarkets as well as in resources. We will be seeking to capture some gains in coming weeks and months.
The markets giveth, the markets taketh away
Given the declines in May and June, however, it is not surprising that the quarter was a poor one for mostmarkets and sectors, erasing most of the gains earlier in the year. The broad U.S. market fell (though theDow was up, less than 1%), and the majority of overseas markets were also down. For the year to date,European stocks have been the strongest, Asia the weakest; the world index (ex-U.S.) is up just 1.1%.The reasons for the market’s weakness are well known, but the rally of the last few weeks should not foolus. The problems have not been solved. The European debt issue remains and will eventually weigh on theEuro; the downgrade of Portuguese debt to “junk” exacerbates and will accelerate the decline. Chinacontinues to tighten in the face of a speculative real estate bubble. And here at home, “Quantitative Easing2” (QE2) has ended without a new stimulus program being announced, while the debt deadline looms, allamid a sputtering economic recovery. Despite all this, however, 2011 is not 2008; the excesses in the marketsare not as great, and May’s declines were mild compared with 2008’s.As for the commodities, their declines in the second quarter were worse than other sectors, driven by fearsover China’s economy, moving most into negative territory for the year. Though gold itself was up 6% forthe first half, gold stocks (as per the XAU index) fell over 10%, and the juniors even more. The broadcommodities index (Dow Jones UBS Index) was down 2.6%.
 
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It was a disappointing period for us, with May and June’s declines wiping out all gains for the year. Thoughour gold accounts beat the index in the first half, losing only half as much, our resource accounts fell around5%. Similarly, our global accounts lost some ground over the period, with the mid-risk growth accountdown, though less than 0.5%; our conservative accounts rose just 1.6%, while our aggressive accounts weredown (though largely due to one anomalous account).*Although we mostly underperformed the indices in this period, we are comfortable with the value in what weown. The high allocation in our global accounts to resources, which were among the hardest hit sectors, isthe primary reason for this relative performance, while the juniors, which dominate our gold and resourceaccounts, fell more than the big caps this quarter. Many of these juniors, however, are selling at compellingvalue and we expect them to rebound quickly when the resource sector recovers before the end of the year.Similarly, many of the other stocks that have fallen more than the broad market in the last couple of monthsalso represent good value at these levels. I suspect that precisely these stocks will rebound the most.
Economy stumbling as easy money continues
Given the economy, it’s not surprising that the market fell in the last couple of months. QE2 clearly did notwork. Ben Bernanke finally seems to comprehend this, though he has no idea why. So even as the economicrecovery seems to be stalling, with jobs growth changing from tepid to abysmal and house prices downagain, the Federal Reserve failed to announce a QE3 as the previous program came to an end.Although the Fed did not announce a new program to follow the end of QE2, it is clear that monetary policyremains loose. The Fed has stated that interest rates will stay low for an extended period and made clear thatalthough it would not (for now) introduce a new stimulus program, it would make ongoing purchases fromprincipal repayments. So there has been no “exit”, and the Fed’s balance sheet will remain large.Federal Reserve credit has grown at over 45% the past three months; that is not being withdrawn. And whileit’s a political assessment as much as an economic one, I am guessing that, given Uncle Ben’s puzzlement asto why the Fed’s textbook prescriptions have not worked, and his obsession to avoid a depression, not tomention an election little more than a year away, the Fed will institute a QE3 at some point in the future(although perhaps called something different). Once economic reports deteriorate sufficiently, the Fed willtry to stimulate again.
Banks, employment and housing: all hurting
Surprising to some on Main Street, the bank and financial sector is hurting, hit with staff layoffs and otherexpense cuts; Goldman Sachs expects to lay off almost 2,000 employees by the end of the year. No wondersales at the Manhattan Maserati dealership have dropped by a third just in the last month!More importantly, the housing market remains in very poor shape in most parts of the country. Prices aredown again, as are sales. Significantly, of the mortgages in default (two months or more in arrears), fully30% have not made a payment in over two years. These are not people who are trying to keep up and with a
* Please note:
Past performance is no guarantee of future results.
For complete information on our past performance, including factors tobe considered in viewing past performance and other disclosures, please contact our office. Specific stocks mentioned herein are intendedsolely as illustrative of strategies and types of stocks we are buying or selling, and are not intended as indicative of entire portfolios or of anyindividual client’s portfolio. The numbers mentioned represent our composite averages. They represent all accounts that fall within the statedobjectives which have the ability to buy and sell options; they exclude accounts under $200,000 and accounts with significant limitations orrestrictions that would make them unrepresentative of the account type. Performance figures for composites referred to herein reflect thededuction of administrative fees, but may not take into account all performance fees attributable to the specific period. The performance of any individual stock or stocks does not take into account fees. Performance numbers include dividends; dividends are not reinvested.Commissions charged may vary depending on the brokerage firm at which an individual account is held. All accounts are managedindividually and are therefore different, even within the same broad objective. Factors such as an individual’s circumstances, the size of theportfolio, and the time the account opened can affect specific buy and sell decisions. Factors such as price movements and security liquiditycan affect whether any trade is made for all accounts. Global Strategic Management, an SEC-registered investment advisor, does business asAdrian Day Asset Management.
 
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bit of luck will be able to. These are people who, for the most part, could not afford the house they boughtand never will. So for all the houses currently in foreclosure, there are more lining up behind them ready forforeclosure if the backlog clears at all. Worse, there are eight million mortgages with a long-to-value of 95%or more, on top of the 12 million already “under water”. They may be current now, but if prices decline, theymight think twice. This is why Fed and Administration policies are aimed at boosting housing prices, andwhy the Fed will keep interest rates low.But with the unemployment rate stubborn at over 9%, many people will find it increasingly difficult to keeptheir mortgage payments current, and a mortgage holder who gets behind, is underwater on his mortgage,and sees no near-term prospect of improvement, is more likely to stop making payments altogether.Despite the stalling economic recovery, inflation is inching up; the latest CPI report showed prices up 3.6%year-on-year, up from a CPI of 2% a year ago. Measures to restrain inflation growth will equally hurt theeconomy.
Europe’s debt and China’s bubble hurt global prospects
The same concerns exist in global economies, with their well-publicized problems, especially the Europeandebt crisis and economic slowdown in China. The recent downgrade of Portuguese bonds to “junk” clearlyillustrates that the debt problem is by no means resolved. The debt problems in the periphery compared withthe relative stability in the core makes European monetary policy all the more a juggling act.The European Central Bank has been tightening in order to stop inflation in its tracks, but only moderately. Itmay be enough to keep a bid under the Euro, but possibly not sufficient to stop inflation, yet enough tohamper the efforts of the peripheral countries to bring their debt under control. Despite these rate increases,in Europe as elsewhere, real interest rates remain negative.
Is China’s tightening phase coming to an end?
Likewise, China has been tightening, with five rate hikes since last October, in a bid to dampen inflation anddeflate a real estate bubble. There are certainly risks: higher rates are pushing up the
yuan
and therebynarrowing the cost differential between manufacturing in China and in home countries (including the U.S.),and leading to some reduction in outsourcing to China.Thus, manufacturing output is beginning to decline. There is also the ever-present risk that tightening getsout of control and social tensions increase, due to reduced work and higher prices. But inflation continues tomove up—latest numbers show a consumer inflation rate of 6.4%--suggesting pressure to continue tight.Yet there is strong real growth, rising consumer spending, and, despite the latest numbers, signs that themonetary tightening is beginning to have an effect on inflation. Many local analysts expect the governmentto hold off additional rate hikes for the near term as inflation peaks and speculation is dampened.What happens in China is critical as it has been the engine of global growth for the last several years. Yet if there is a slowdown in growth—on track for around 9.5% growth this year—the economy will still grow atlevels of which the U.S., Europe, and Japan can only dream. So we see a moderation in growth but not acollapse for the foreseeable future.
Emerging economies will rebound sooner
The U.S., China and Europe are not the only ones where inflation has picked up. Indeed, the emergingeconomies have imported inflation, primarily from the U.S., while many, particularly in Asia and thecommodity exporters, have felt the brunt of China’s tightening with lower imports. But as we have discussedbefore, by and large these countries have stronger balance sheets at the government and private level than the

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