Saturday, July 8, 2006

June 2006 Review and Inflation Concerns


Cervino Capital Management is pleased to announce June 2006 performance returns for our Diversified Option Strategy program, which operates under our Commodity Trading Adviser (CTA) registration. This month was the program's best month yet with a positive return of 1.68% for June 2006 at a time when equities showed continued uncertainty from the prior month. So far year-to-date we've return a composite 3.98% in this program versus the S&P 500 Index (GSPC) up 1.76% as of June 30th. The non-correlated performance between our program and the stock market is not by chance, but by design—consequence of a multifaceted approach based on selection of markets, flexible instruments and a variety of decision inputs. For more information, please visit our website at

While satisfied with this past month’s accomplishment, our focus remains on evolving macroeconomic trends and prospective trading opportunities. That said, much of the recent global market turmoil has been linked to market participants’ perception of inflation pressures going forward, which in turn effects interest rates, fiscal policy and consequently asset prices. But in order to envisage how such percpetions may influence investors' future actions, we need to first cover what's happened in the last couple months. Here’s a play-by-play of the recent market correction:

At the beginning of May the DJIA was nearing its January 2000 all-time high of 11,723 on expectations that the Fed would stop raising the Federal Funds rate. Then on May 11th, a day after the Fed raised rates by a quarter point to 5%, market sentiment “suddenly” shifted to the threat of inflation in response to the FOMC policy statement which indicated the potential for further Fed tightening. The market corroborated its fear on May 17th with the Core-CPI number coming in at 0.3%, “significantly?” over market expectations of 0.2%. Since the bottom (closing price) on June 13th, the market has posted two strong up days with consensus saying it was due to short covering.

The lack of clarity in communiqués from a transformed Fed council (not only is Bernanke new to the Fed Chief role but there are also a number of new board members) added to the confusion. A cynic would suggest that for the Fed... “to decide is to succumb to the preponderance of one set of influences over another set.” Yet it is no surprise that the Fed has been leaving its options open. The same uncertainties exist today as after the Fed meeting in May with respect to the intensity of inflationary pressures versus the robustness of the economy. This is reflected in how different markets are saying different things or the same thing differently.

The stock market vacillates between bear and bull concerned about whether we’re in for a “soft” versus a “hard landing” with the bulls arguing continued strong productivity and corporate earnings. The U.S. yield curve is shifting between flat and inverted projecting a recession, but remaining vigilant on the inflation front due to 'many years in the making' excess global liquidity. All the while speculation in certain commodities markets (also reflected in certain emerging markets) is creating a frothy trading environment—but this time, unlike the late 1990’s technology stock era, what is good for producers comes at a cost for consumers. And let us not forget the ongoing fiscal concerns about the U.S. current account deficit underlying the decline in the dollar. There has even been some suggestion of a 1970’s economic redux coined “stagflation-lite.”

All this uncertainty reflects a potentially more complex set of factors underlying current inflationary concerns as opposed to economic cycles in the collective past memory. There is in fact a battle between assets and goods that are under strong inflationary influences versus services and wage costs that are still under deflationary pressures. Labor and the service sector has been and continues to be under downward pressure largely due to the power of technological improvements that came with the internet. This situation has created what is referred to as the ‘global labor arbitrage’ which, while helping corporate margins in the short term, over the long term has depressed U.S. workers’ income and therefore the disposable income of the world’s biggest consumer economy.

Meanwhile, consumer staples and other items of necessity are rapidly increasing in cost (e.g., energy, food, health care, rent). For many years the U.S. consumer has benefited from globalization and the importing of low priced goods. But now, a developing shortage of key raw materials as the world’s economy grows is creating an economic environment in which raw materials prices are rising faster than finished goods prices. This trend is likely to continue and as a result certain countries, specifically China and Russia, may find it in their best interests to allow their currencies to appreciate against the dollar. An appreciating currency will cause a country’s finished goods export prices to rise, but it will also lower that same country’s respective import costs of raw materials. Assuming the ongoing trade deficit, this means U.S. consumers end up importing inflation from abroad. The logic follows that if inflationary pressures are felt most on necessities the resulting impact on consumer spending behavior will ultimately be reflected in corporate earnings.

At the same time, assets such as real estate and stocks, which have greatly benefited from a “goldilocks” environment of strong growth and low inflation, have reached valuation levels that are subject to rational scepticism. Housing-rent parity, proliferation of sub-prime and adjustable rate mortgages, tapping out of home equity lines of credit, consumer debt levels, and historically low household savings underlies our concern about real estate. If a bearish housing market evolves, consumer discretionary spending will come under even more pressure, as in the past few years much of this spending was subsidized by the home equity extraction strategy.

As for equities—yes, productivity and earnings have been persistently strong, and the balance sheets of corporations for the most part are solid. However, deeper analysis shows that we are, at the moment, in a period of unusually high earnings—which does not bode well for future returns. Further, the graying of baby boomers is expected to have broad economic impact. Not only will this population shift encumber public entitlements such as Social Security and Medicare, the burden is already being felt on private and state pensions’ as they struggle to match future liabilities. As this generation’s age accelerates past 65, it may spark an asset meltdown affecting equity returns just when increasing numbers begin to tap their investments.

Finally, credit experts agree that some turn in the credit cycle seems overdue—leverage multiples are sky high, banking covenants have been relaxed, and as we write this, a growth slowdown is being instigated by the co-ordinated removal of liquidity by the world’s central banks. This is occurring at a time when the credit spreads between high yield and investment grade debt are at cyclical lows. Between 2000-2002 the spread on corporate high yield bonds over US Treasuries was 6-11 points versus 3 points at present. Any renewed market turbulence could reduce risk appetite further, just as credit fundamentals start to weaken. Unfortunately, many investors have grown so unhealthily used to chasing returns at almost any price that any slight up-tick in spreads will be seen as a buying opportunity.

This line of reasoning causes us to conclude that a 2007 recession should be almost unavoidable. In light of expected actions by the Bank of Japan (“Tokyo’s revised growth forecasts point to rate rise” Financial Times, July 8, 2006) and European Central Bank (“ECB signals likelihood of interest rate rise early next month” Financial Times, July 7, 2006), their actions at this juncture seems to be far more important to the macroeconomic picture than Fed actions now and even after its next meeting August 2006. With this perspective in mind we will try to navigate the seas of global investing as profitably as possible in full recognition that the assets you have entrusted to us were earned with hard work.

- Davide Accomazzo, Managing Director

Saturday, July 1, 2006

Ways to Diversify Your Investment Portfolio

"Behold, the fool saith, 'Put not all thine eggs in the one basket' which is but a manner of saying, 'Scatter your money and your attention' but the wise man saith, 'Put all your eggs in the one
basket and... watch that basket.'"

- Mark Twain, Pudd'nhead Wilson, 1894

A well embraced tenant of prudent investing is to diversify your investment portfolio among different types of assets which may respond differently to various economic conditions. Diversification is an effective risk management tool in helping reduce investors’ exposure to a downturn in any one sector.

Notwithstanding the spirit of truth in Pudd'nhead's maxim, a sentiment echoed by Warren Buffet who once said "Wide diversification is only required when investors do not understand what they are doing," proper diversification is a proven method to improve the long-term probability of upside performance as well as downside risk exposure. The key is knowing how to diversify properly. In this blog we delve deeper into the concept of diversification to present the importance of allocation among uncorrelated assets as well as investment strategies.

The term “asset class” describes a group of securities that shares similar risk and return characteristics such as: cash equivalents, fixed income, and equities. Additional diversification can be achieved by blending different categories contained within each asset class. For example, equities can be divided into large-, mid- and small- market capitalization stocks; economic sectors such as energy, healthcare or technology; geographic regions (domestic vs. international); or investment styles (growth vs. value). Fixed income is typically separated into groups designated by the type of issuer, credit quality and maturity.

Beyond asset class distinctions there are several approaches to investing which require differing levels of active management based on assumptions about the investor’s risk tolerance and changes in market expectations. Popular forms include the “buy and hold” strategy in which an investor determines an initial allocation and then holds this portfolio throughout market fluctuations without making adjustments. Another approach is “strategic asset allocation” which requires the investor to make periodic adjustments to restore the portfolio to the targeted mix. And then there is “tactical investing” where the investor actively changes investments to reflect his or her own shorter-term capital market expectations.

An ongoing debate among investors is the extent to which asset class exposure is the primary driver of risk and return, versus to what extent does an active/tactical approach to investing play a positive, negative or neutral role in managing risk and return.

The demise of the unprecedented 1980s/1990s bull market in equities left many sophisticated investors disputing the case for a pure “buy and hold” strategy. Based on institutional demand for hedge funds, these investors have established their growing interest in investment alternatives, particularly “absolute return” programs that generate “alpha” or skilled-based returns that exceed the performance of the financial markets.

Since the late 1970s certain savvx investors have taken advantage of an array of alternative investment approaches vis-à-vis a niche strategy called “managed futures.” These sophisticated investors realize that superior traders operating in this specialized universe offer an outstanding tradeoff between risk and return. They are attracted to the incremental and often non-correlated returns that such investment can provide beyond exposure to traditional asset classes or investment strategies.

Academic research and a growing body of investment theory has shown that assets should be compared on a risk-adjusted basis (e.g., mean return/standard deviation) and that the potential benefit of adding an asset to an existing portfolio may be measured by an asset’s excess breakeven return. Because the correlation between managed futures and most traditional investments is extremely low, when portfolios of traditional assets are combined with managed futures, the result is a reduction of risk (i.e., standard deviation) to the overall portfolio.

Growth in investor demand for managed futures products indicates appreciation of the benefits this strategy can add to a diversified investment portfolio. However, it should also be noted that there is a high degree of leverage that is often obtainable in futures trading that can work against you as well as for you. Because the risk of loss in futures can be substantial, you should carefully consider whether such trading is suitable for you in light of your financial condition.

- Mack Frankfurter, Managing Director