Market Commentary for the week of July 2, 2007

The next twelve months, until the middle of next year, should be critical in defining the key inflection points which, thus far, are nascent trends for equities and bonds. From the makeup of this quarter’s equity recommended list, the coming three months should say a lot about the asset allocation and sector breakdowns of our investment portfolios.

More specifically, the secular rise in inflation and interest rates is making me sour on the bond market. Not only is the current crop of new issues uninspiring, but rising rates are diminishing portfolio valuations amongst existing holdings. Irrespective of the higher coupons I might own, I am not keen on having a falling segment in my portfolios.

The bond market is in such disrepair, in fact, that tumbling prices also affect credit rating and future promises to pay. This phenomenon is not restricted to US companies, alone. Shrinking profit margins, caused by inflation and higher borrowing costs, are reducing credit structure, globally, and negatively impacting upon what once was a vibrant trading market in fixed income securities.

I can envision that through attrition, redemptions, and early sales to avoid declining market value, that my portfolios might fall as low as ten percent allocation in fixed income, not including cash, within the next twelve months.

The problem is structural, and negatively gestating throughout many segments of the marketplace, most notably housing (real estate), financial companies, and industrial equities.

However those same secular trends which adversely affect bonds are brightening the possibilities for equities. Although margins are squeezed, pricing power is the corporate equivalent of usury. Whomever controls the commodity, controls the ability to price it in the open market.

Consider that milk now costs more per gallon than gasoline. This price trend is permeating throughout all agricultural sectors, making food the “next dot.com sector” for investor’s consideration.

By the way, my regular readers know that nearly two years ago I had previously highlighted this trend in agriculture!!

The case for equities is further bolstered by the “alternative investment scenario”. Although higher, and stable, bond yields might ultimately be the goal for investors who wish to “lock in” high coupons, this particular phase in the bond market, during which yields redirect, in either direction, is a dangerous inflection point.

The macro trends in my work clearly indicate a redirection upwards in interest rates and inflation. As stated, this is manifest in declining bond prices, and also in sector and secular rotation of earnings acceleration patterns in equities.

Additionally, the dollar’s decline means that higher yields must happen in order to attract buyers to the bond market. When the US economy stagnates the direction of money flow is out, not in. Therefore companies that benefit the most from economic inertia are the multinational conglomerates that report earnings from all global quarters, and whose product demand is stable and enduring. Indeed, that is where I am seeing the greatest shift in focus and buying patterns

At some point, and in the not too distant future, the markets must start to unwind the monstrous amounts of debt and leverage that it has accumulated. The level of avarice and greed that built the foundation of the current economic bull cycle has exacerbated the inherent risk in owning financial instruments.

The recent hedge-fund debacle, (which fell subsequent to the 1990’s dot.com debacle, and the most recent real estate bubble, etc.) is no joke. These events are the result of borrowing and lending gone awry, and a symptom of fad investing at its worst.