Saturday, August 13, 2005


Weekly summary

Although my portfolio succumbed to market weakness on Friday, I finished up $5,614 (1.1 percent) for the week, which compares favorably to the S&P 500 (up 0.3 percent), the NASDAQ (down 1.0 percent), and the Russell 2000 (down 0.4 percent). Like many other value investors, I am concerned that there is a dearth of undervalued companies out there. Although I believe that my core holdings (such as COBR, KTCC, OCCF) will continue to do well, the truth is that the market environment is considerably less favorable than in early 2003, when you couldn't sneeze without bumping into some stock that was trading below net asset value, had a great business model, and a share price stuck at a 52 week low.

There has been much discussion about the yield curve lately. Despite a steady stream of rate hikes, long term rates are lower than they were two years ago, and consequently, the yield curve has become increasingly flat, which historically has been a harbinger of recessions. I don't belong to the camp that puts too much weight on what the yield curve portends for the future. In the past, inverted yield curves have arisen when the Fed was aggressively raising rates to bring down inflation (the early 1980's is an obvious example). At that time, an inverted yield curve signaled that investors thought Fed policy was credible and would lead to lower inflation in the future (and hence, lower bond yields). A recession was the price we had to pay to bring down inflation.

I don't think the same dynamic applies today. Today's lower bond rates do not signal that investors expect economic activity to dampen, but rather reflect the steady stream of capital flowing into the country (much of it into the treasury market, and much of it from Asia). These capital inflows are the flipside of America's mammoth trade deficit, which is unlikely to decline dramatically any time soon. In short, while interest rates are low in America, they could get lower, and indeed are already much lower in countries like Germany and especially, Japan.

How is an investor to react to all this? My view is to sit back and keep doing what has worked in the past. For me, this means putting my money in small caps (which tend to prosper in an environment of easy credit). However, the economic environment may deteriorate more quickly than the pundits expect, especially if the housing market begins to crumble. In that case, I think most of the big profits will be made on the short side.

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