Back to Quarterly Letters

Back to Quarterly Letters || Previous Letter || Next Letter

Quarterly Letter to Clients

July, 2007

Indices at quarter-end (June 31, 2007):

Dow Jones Industrials: 13,408.62 2Q'07 +8.91% YTD +7.96%

Standard & Poor's 500: 1,503.45 2Q'07 +5.81% YTD +6.00%

You needed to have your seatbelt fastened for the second quarter. The bumps of the first quarter were only a small hint of the powerful moves that marked this latest period. New all-time highs were put in by the major stock averages during April and May.

Recently some friends invited me to join their poker game. While I enjoy their company, I do not really play the game, and this led to my answer: “I’d like to play, but I know I would be the pigeon, so prudence dictates that I sit out.”

By June everyone was afraid of being the pigeon, and the markets sold off sharply. It’s the same old economist’s thesis: greed vs. fear. This is an adult swim, after all. So when the Dow retreated some 600 points, greed became the overwhelming sentiment, and the markets rebounded. By late June, at around a hundred points below the high, the rally again stalled.

We shouldn’t be surprised; the market went up 1700 (Dow) points from early March to the end of May. Did you actually think it wouldn’t stop for a rest? And it has been a pretty good six months for stocks nonetheless.

Buyouts (also referred to as private equity) have undoubtedly been the driving force behind the market, and have made for very exciting financial news, indeed. It looks like any company, no matter how large, is vulnerable to a takeover bid. The reason for this goes directly to the level of interest rates and the ready availability of money.

When borrowing costs as little as it does today, large investors look for methods to employ funds. And what better way to use capital than by buying companies? You borrow at cheap rates, using only a minimum of your own capital, lever up the balance sheet to the maximum, lay off extraneous workers, reduce overhead, take out all of the available cash, and then sell the company back to the public.

And to top it off, you can retain control of the company. Is it any mystery as to why private equity is so popular today? Even China is getting into the act, handing $3 billion to Blackstone.

This is an operation that has been ongoing for much longer than the 40 years that I have worked in the industry, and is only making headlines because of the extreme size of the deals being created today. Now it seems that bond investors are resisting buying the junk bonds that make these deals possible, and this may be the factor that precipitates the end of the current buyout mania, but one should not ever expect it to disappear.

Interest rates have been rising, and this has led to the poor performance of bonds this year.

The yield curve has finally righted itself, after an unprecedented two years of inversion. The cause has been fear of inflation, leading to a sharp rise in longer-dated bond yields, something I have been anticipating for almost three years now. This translates to lower bond prices, and as the uptick in rates continues you can expect to see the prices of your bond holdings marked down.

Remember that we had a bull market for bonds (declining yields) from roughly 1981to 2005. What you may not remember is that the thirty years leading up to 1981 saw a steady bear market in bonds.

If, as I suspect, we are indeed entering another long-term bear market in bonds, then my bond clients will eventually be very pleased at holding such large cash balances. I reiterate that, for fixed income investors, the money market is still the best place to be; the bottom line is that cash, represented by money market holdings, is an investment decision, equal to any security purchase; please do not view it as inertia on the part of the manager.

For if the bond market has truly turned bearish, we will have to re-think our investment strategies in order to protect principal while maximizing yield. This is an extraordinarily difficult problem and one I have been wrestling with for a couple of years.

Bonds and rates affect stocks: higher rates lead to lower price-earnings ratios; higher borrowing costs lead to lower earnings; and these factors negatively influence stock prices.

So I have my work cut out in both areas, stocks and bonds. I expect the summer months to be more difficult than the first two quarters, but I remain reasonably optimistic on this year as a whole.

Jim Pappas