Two weeks ago I discussed contrarian thinking.  Most investors agree that the path to profits is achieved by taking an approach that differs from others.  For this reason, most consider themselves contrarian by nature.  However, taking a different approach does not make one a contrarian investor.  The key is to take an approach that is both different and correct.  Only when doing so can one expect to profit while others suffer.

                Knowing there is a subtle difference, I will use an example to illustrate the point.  Imagine we are sitting inside our homes during a blizzard.  As the snow stops falling, we decide to go outside.  Most people would wear layers of warm clothes to protect themselves from the harsh weather.  Even though this would be the consensus view, it would be the correct approach.  Someone trying to be different and viewing themselves as a contrarian thinker would go outside in sandals and a bathing suit.  Obviously, this person is not an individualistic, contrarian thinker, but a stubborn person making unwise decisions.  Being exposed to harsh weather with little protection results in discomfort, sickness or worse.  The same logic can be applied to the financial markets.  Taking a stance that is wrong and maintaining that stance against all odds is foolhardy and stubborn.  All that can be expected from such action is swift and frequent losses.

                Considering the slight subtlety above, we must understand what the group consensus is, how groupthink could be wrong and what the potential profit actions would be.  Along those lines, I would like to discuss two major topics, what the consensus opinion represents and how a contrarian investor would position and profit from them.

                The first area to discuss is commodity prices.  Beginning in 2004, I took a 20% portfolio allocation in commodities.  My investment decision focused on both the future expected gains in commodities themselves as well as the diversification benefit received from a commodity investment.  In January 2004, the CRB Commodity Index stood at 258.  Today it trades at 455 - a gain of 76%.  My view has always been that the increase in prices reflects the supply and demand of the world’s markets.  As emerging economies industrialize, the need for commodities increases.  China has shown that building booms drive the need for iron ore and coal.  Populations who had lived in poverty begin to acquire wealth and want to upgrade their lifestyles.  Among the first goals for this group of people is better quality food.  This desire increases the cost of wheat, soybeans and other foodstuffs.  The dynamic of commodity demand continues as oil is needed to for transportation and precious metals are acquired as a symbol and store of wealth. 

                Seeing China, India, Brazil and numerous countries grow rapidly; the demand side of this equation is large and growing.  Unfortunately, supply has not kept pace.  Worldwide, oil is becoming harder to find and more difficult to extract.  Droughts in Australia and floods in the United States have shown the fragile nature of agriculture markets.  Despite high gold prices, producers have not brought much supply to market.  Limited supply coupled with rising demand drives higher prices.  Until the laws of economics are invalidated, this relationship will hold.

                As we all know, prices can rise and fall beyond the true value of any good.  The consensus opinion on commodities is that the current price rise has outstripped the supply/demand relationship and that current prices represent a bubble.  The bubble view has gained such prominence that Barron’s has published two cover stories in the last three months (March 31^st and June 23^rd) describing how we have reached bubble status and must prepare for the bubble to burst. 

                Knowing that most are calling this price increase a bubble that will collapse, what should a contrarian investor do?  I remain a believer in the long-term fundamentals of the commodity markets.  While the increase in prices has accelerated lately, the story is intact.  Demand is growing and supply is limited.  As the emerging markets grow, they will demand fuel and food to satisfy their populations.  The demand pressures create inelasticity where prices can remain high even after supply grows. 

                As I learned years ago, the best way to invest in a bull market is to maintain your position.  Recently, I have used the Powershares DB Commodity Index ETF (DBC) as my commodity investment vehicle.  Looking at a chart, we see many instances of quick, painful declines.  Had an investor panicked at each decline, they would have surrendered their position and missed the next move higher.  A better approach is to live with some volatility, hold your position and let the fundamentals works in your favor.  Having said that, it is also prudent to maintain your position in a size that confirms with your portfolio goals and risk tolerance.  Starting with a 20% portfolio allocation to commodities in 2004, I have scaled that back to a current weighting of 10%.  As commodity prices have risen, I have consistently sold pieces of my position to maintain a risk profile that I am comfortable with while still benefiting from the increase in prices.

               A second topic of key interest is the ability of the Federal Reserve (Fed) to manage the economy.  During the tenure of Alan Greenspan, investors became enamored with the ability of the Fed to cure all economic ills.  Inflation was low, productivity was growing and asset markets behaved well.  Whenever turmoil occurred, the Fed would devise a way to quickly cure the pain and allow investors to prosper.  Over nearly 20 years of consistent medicine, the investment community became convinced that central planners can adequately manage a capitalistic economy.

               As Greenspan passed his role to Ben Bernanke, investor faith remained largely intact.  When the credit crisis began unfolding during the summer of 2007, Fed interest rate reductions led to stock market rallies that allowed the Dow Jones Industrial Average (DJIA) to reach an all-time high of 14,164 on October 9^th, 2007.  Even though that peak was short lived, the Fed has taken increasingly aggressive and creative actions to bolster the stock market and the economy.  Recent proclamations from various Fed governors indicate that they are now focusing on the value of the dollar.  From there, many are pushing for greater influence for the Fed to oversee investment banks.  It seems that faith has been put in one central organization to increase its grasp over all aspects of the economy and financial markets.  Sadly, few have questioned this expanded mandate and continue pushing for more intrusive regulation.

                 Considering that the DJIA has retreated 16% over the last nine months, you would expect investors to question the Fed’s ability to cure all ills.  Investors have not taken that step.  Having seen the Fed avert the financial meltdown that would have accompanied the collapse of Bear Stearns, many believe it is a matter of time until growth resumes and the markets push higher.  The relative strength of the NASDAQ and the particular strength of some high profile technology companies (i.e. - Amazon.com, Research in Motion) over the past few weeks show that investors are not prepared to abandon high beta, volatile stocks.  If investors truly believed bleaker times were ahead, they would abandon high beta stocks for the safety of diversified, strong dividend paying companies.  Instead, risk profiles remain high as investors buy what is working instead of what is cheap.  If the Fed does anything to stabilize the markets, these risk seeking investors are looking to position themselves for the eventual rebound. 

                 As a contrarian, we must ask ourselves what would happen if the consensus’ faith in the Fed is incorrect.  Personally, I see very little the Fed can do.  They have expended a great deal of their ammunition in reducing their overnight lending rate to 2%.  With future interest rate reductions unlikely, a different path would be to raise interest rates to boost the dollar, deflate commodity markets and make US assets more attractive.  In an election year with a weak economy, this approach is unlikely as well.  Instead, the Fed will maintain the current level of interest rates, provide liquidity to financial firms and help avert any further disasters.  What we are left with is an economy that struggles for growth while dealing with persistently high inflation.  From an investment perspective, I expect strong companies to get stronger, innovation to decline and marginal competitors to be merged out of existence.

                In the two examples above, I have illustrated how a contrarian can develop a non-consensus view and apply that thinking to investment decisions.  When investing, innovative thinking is needed to develop profitable ideas.  Look at what most think, consider contrary views and determine ways to profit.  However, you must also remain flexible in your thinking.  Maintaining a losing position because you want to be different is a path to ruin.  Giving up a losing position because the market disagrees with your logic leads to frustration.  Instead, develop a thesis, constantly reassess conflicting data and adapt as needed.  The nimble, flexible investor will be the one who can let correct, contrarian views grow into profitable positions.

                 Where do we go from here?  That has always been the most important question that any investor can ask.  As a person who reads volumes of research each day, I see that most commentators focus on what events have occurred in the past and how those events can be used to determine where we head in the future.  After all if we know where stock prices will be tomorrow, it becomes very easy to earn money today.  Unfortunately foreseeing the future is neither easy nor precise.

                Most investors receive information from a few different sources.  Whether it is television, newsletters or some other medium, knowledgeable investors seek information that will allow them to prosper.  With many different ideas swirling in the air, you can always find someone who has an idea that resonates with your thought process.  Think housing has bottomed?   A professional investor can supply reams of data to justify your view.  Think the economy is headed for a depression?  A different investor can share information to support your thesis.  As ideas conflict, people enter into investment transactions that reflect these various views.  In theory, the mass conflict of ideas arrives at a point where stock prices are efficient and reflect all known information.

                So what happened last week?  To review, the Dow Jones Industrial Average (DJIA) dropped 429 points (3.4%) on the week.  Within that drop we saw a 101 point decline, a 214 point rally and a 395 point decline.  During this process, positive information on retail sales and the Federal Reserve’s (Fed) decision to defend the dollar offered reasons to drift higher while an increase in the unemployment rate and an $8 spike in oil justified the decline.  While the explanation for the price swings is simple, it is more difficult to determine if enough had changed in the underlying economy and business fundamentals to justify such swings.

                As one who never put much faith in the idea of efficient markets, I will leave it to others to determine if last week’s increased volatility is justified.  For me, I am more interested in determining what we have learned from the events and how to profit in the future.  With lower stock prices, a few things are clear.  The first is that investors are feeling less optimistic than a week ago.  The second thing we know is that the cost of buying ownership positions is lower now than it was a week ago.  Both of these facts are key in creating a long term strategy to create wealth.

                Whether or not you believe in market efficiency, the presence of millions of profit seeking investors makes following consensus views a difficult approach to achieve success.  The best opportunities arise when you can develop an idea that is contrary to the majority yet is also correct.  The need to take a contrarian view is essential to profit.  This is where a lower market helps.  As investors were throwing stocks out the door, an opportunity arose for a contrarian to step into the void and buy companies others did not want. 

                To buy when others are selling sounds simple, but there are a few nuances that most be noticed.  At times, investors are justified for selling.  An example would be if the markets have experienced an increase in value that is not justified by the fundamentals, you do not want to buy on dips.  In this case, the drop is justified and buying it will results in losses.  A generation of investors during the 1990s was taught to buy every dip and sell every rally.  As a bull market moved higher, this strategy produced predictable profits.  However, as the bull turned into a bear buying dips led to large losses and investor frustration.

                Therefore, you do not buy when others sell, but buy when the selling is not justified by the market environment.  So was Friday’s selling justified and should we be buying at these levels?  For me, this answer is less clear.  As I have written over the prior weeks, the rally off the April lows were based on the hope that the Fed would save the economy, housing would soon bottom and that escalating commodity prices would either stop rising or not harm the economy.  Never believing any of these arguments, the recent drop in the DJIA looks more like justified selling than a contrarian buying opportunity.  Also, not all dips are the same.  As the DJIA peaked above 13,000 in mid-May we saw many drops followed by rallies.  During this time, price drops were occurring as stocks were consolidating gains.  In that environment, buying dips led to profits.  Recent market information indicates that the current declines have accompanied stocks that are breaking down.  Buying these dips will often lead to losses.

                Before we reject this selloff as an opportunity to buy stocks, we must also examine the values the market presents us.  As mentioned above, stocks are clearly cheaper now than they were a week ago.  If we want to buy long term positions in strong companies, is now the time to do so?  Again, this answer is unclear.  Looking at my research universe, nearly 15% of all stocks I follow are selling at prices where investors are being compensated for the risks they take.  This is the highest number of cheap stocks I have seen in almost 5 years.  Unfortunately, most of these companies have exposure to the credit crisis.  One thing we have learned during the credit crisis is most banks do not have an accurate view of what they hold on their balance sheet or the true value of those assets.  Therefore, we must ask ourselves at what point financial stocks evolve from investments to speculation.

                So as I asked at the beginning of this article, where do we go from here?  Despite last week’s large drop I am not convinced we have reached bottom.  Over the past two days, the market foundation has started eroding as price declines are met with higher volume, more stocks breaking to new lows and negative breadth.  A market that had shown signs of consolidating gains is now showing signs of breaking down.  Without compelling values to justify increasing my equity exposure, I would rather rent stocks than own them.  Eventually, this market will offer an excellent opportunity to buy strong companies at low prices.  We are not there yet.

                Eleven weeks ago (March 18^th), I wrote an article decrying the Federal Reserve’s (Fed) handling of the economic crisis.  My argument was that although the Fed had taken every step imagined to unlock the credit market and bolster the stock market, little had been accomplished.  Having just reduced their overnight lending rate 75 basis points (bp), the Dow Jones Industrial Average (DJIA) staged a 420 point rally.  However, my concerns were that the Fed was running out of options to revive the equity markets, had destroyed the dollar and bolstered commodity prices with their constant intervention.  At that time, I asked why the current monetary stimulus would save the stock market and why was not anyone concerned with the havoc higher commodity prices and a weaker dollar would have on the average American.

                At the time, my concerns seemed unfounded.  The DJIA closed that day at 12,392.  Over the next seven weeks, the Fed would reduce interest rates an additional 25bp and the DJIA would close above 13,000.  Most continued to ignore escalating commodity prices and a weakening dollar.  After all, the Fed had managed to boost the DJIA nearly 5%, prevented a market meltdown by arranging for JPMorgan to acquire Bear Sterns and taken increasingly creative actions to unlock the credit markets.  Having accomplished these goals, why worry that oil prices had increased 25%?

                As I have identified many times, the key when evaluating any investment decision is to look at things over proper time periods.  What initially seemed like an unnecessary concern was actually a prudent assessment of the risks in the marketplace.  The Fed’s easy money policy had increased inflation risk.  Eventually the market realized this risk and began pricing in the possibility.  As a result, the DJIA currently trades at a price below where it closed 11 weeks ago.  Despite a break in prices, oil is still 15% higher and the dollar remains relatively unchanged versus other currencies.  More worrisome, the KBW Bank Index is 11% lower and the Dow Jones Broker Dealer Index is unchanged.  Further, if we look back to when the Fed began reducing interest rates in response to the credit crisis (9/17/07), the DJIA has dropped 8%, the Broker Dealer index has lost 23%, the Bank index has declined 31% and the CRB commodity index has risen 28%.

                Having pushed their overnight lending rate to 2%, we are now in the position I feared.  The Fed has expelled a great deal of ammunition and creativity in addressing the financial crisis, yet has accomplished little.  The US economy is reliant on borrowed money to grow yet credit is unavailable to most borrowers.  Further, the weak dollar and higher commodity prices that have gnawed at consumers have finally drawn the attention of Fed chairman Ben Bernanke.  With yesterday’s acknowledgement that a weak dollar is leading to inflationary pressures, the likelihood of further interest rate reductions has diminished.  One must remember that the value of the dollar is under the leadership of the US Treasury, not the Fed.  Bernanke, by mentioning his concern over the dollar, has injected himself into a discussion that prior Fed chairman avoided.  It is hard to imagine how Bernanke could have made these comments and still plan to reduce interest rates in the future.  The logical assumption is that further rate reductions will not be forthcoming and that the next move from the Fed will be to push rates higher.

                As I asked in my article on March 18^th, the key question is, “where we go from here?”  The immediate reaction to Bernanke’s comments has been a stronger dollar and weaker commodity prices.  While short term volatility will remain in those markets that have become most reliant on easy money (i.e. - the banks and brokers which continue to selloff), we must also consider the long term ramifications of the Fed’s actions.  Personally, I have never been comfortable or advocated the current approach to managing interest rates.  By constantly reducing interest rates in the wake of every financial crisis, the Fed has prevented the economy and asset markets from ever reaching equilibrium.  The result has been one bubble after another.  As we are now learning, when the bubbles stop blowing the cleanup can be painful.

                Assuming the Fed leaves interest rates constant, we should see a steep yield curve and slower growth.  Banks will have the ability to lend money at larger spreads which allows them to rebuild their balance sheets.  Capital will begin flowing to the businesses that are strong and produce returns for shareholders.  Marginal players in weak industries will see their access to funds diminished and will be merged with stronger partners.  Dominant players in strong industries will grow the value of their franchise as barriers to entry increase.  Consumers will begin focusing on restoring their creditworthiness and strengthening their personal wealth.  All in, a movement away from slashing interest rates to prop up the stock market will result in a stronger economy that will create wealth and efficiently allocate capital in the future. 

                 Unfortunately, the transition in that direction will be painful.  Even if the recession is over and the worst behind us, the lack of lending will result in subpar growth over the next few quarters.   This lack of growth with no true catalyst will make it difficult for the markets to move higher.  When this transpires, expect the calls for Fed action to be loud and constant.  From there, we will see if Bernanke has the persistence to create an economic environment where risk is priced and returns are reasonable or if he will bow to the pressure, follow Alan Greenspan’s lead and provide a short term solution with serious long term consequences.

                 I am always interested in what can be learned from reading financial statements.  At their core, certain information must be discussed.  A company will provide their financial results, accounting assumptions and various details about how their core business is operating.  Outside of those numbers, management is given great latitude.  Management is given the ability to present information in a fashion that tells their story and persuades current and prospective owners to buy the stock.  A clear example of how information can be framed is when the strengths of the business are discussed and the order in which each of the three key financial statements is presented (Balance Sheet, Income Statement and Statement of Cash flows).  Generally, the management discussion will focus upon what makes a company better than its peers and the first financial statement provided will attempt to direct an investor’s attention away from areas in which management would rather not discuss.

                When interpreting information, many people use mental short cuts.  Doing so allows us to process vast amounts of data quickly and arrive at informed decisions in short periods of time.  Knowing this, people who present information often frame it in a way to influence the recipient.  By influencing a person’s perception of information, the conclusion reached will support the message being delivered.

                For years I have believed that companies use their financial reports to frame a story they would like to present to the investing public.  To most people a company’s annual financial statements are bland documents filled with facts and figures.  Since a company presents hard data, there must not be any latitude in what we see.  After all, facts are facts, right?  The question is straightforward yet the answer is a more nuanced yes and no.

                As an example of how different companies frame their finical results, examine the annual reports from Amazon.com (Ticker: AMZN) and Whole Foods Markets (Ticker: WFMI).  AMZN offers us an in-depth look at their operating business, many non-GAAP metrics they use to manage and evaluate their business performance and a thoughtful discussion of the risks they face.  Turning to the financial statements, AMZN starts with the Statement of Cash flows.  Since the entire report has discussed how cash flow is a better measurement than earnings, the financial statements are consistent with the message that has been delivered.  While I am not in favor of AMZN’s reliance upon non-GAAP financial performance, I can appreciate the fact that their message focuses upon their operating business and is consistent throughout the report.

                 So what do we find with WFMI?  Within the management discussion, little attention is given to their operating business and why shopping in their store is better than buying organic food from a larger supermarket.  Instead, we are treated to pages of descriptions detailing how they have shaped the organic industry, benefited local farmers and created a positive environment for their employees.  Far less attention is given to how 67% of all inventories are perishable, their prices are higher than competitors and how a slowing economy may alter consumer behavior.

                 Turning to the financial statements, WFMI leads with the balance sheet.  This is an interesting choice.  When you bring off-balance sheet liabilities into the equation, WFMI has a negative book value.  Also, as a growth stock most of their investor base would rather look at an income statement or cash flow statement to discern future growth and the ultimate stock price.  Could it be that management would rather not have us look upon diminishing growth prospects?

                 Given the mixed message in the report, what are the investment implications?  Looking at the numbers, WFMI has some great attributes.  Cash earnings have outperformed GAAP earnings the last 3 years and the cash conversion ratio has remained steady.  Operating margins have been improving and turnover metrics remain strong.  All together, the business is well run and efficient.

                  Now we turn to the negatives.  By financing the purchase of Wild Oats with cash as opposed to stock, interest expense is set to increase from $4mm to $35-40mm.  At the same time, growth is slowing as consumers have less discretionary income to purchase expensive, prepared organic food.  Since 67% of WFMI’s merchandise is perishable, any fall in sales caused by an over strapped consumer will lead to increasing shrinkage and lower margins. 

                  The market has started to recognize this fact as the shares have dropped from a high of over $74 in late 2005 to the current price of $27.62.  While this decline has been brutal, the shares are still priced for perfection.  If you assume WFMI can maintain operating profits of 4% during 2008 and then steadily expand those margins over the next 5 years, you can make an argument that the shares are fairly valued.  All in, you would be assuming 30% earnings growth over the next 5 years with a terminal growth rate of 26%.  While possible, I find this scenario unlikely.  More realistic would be a slight compression in margins during 2008 followed by a five year growth rate of 15%.  Under this assumption, the shares are worth $15 - a number that is in line with both a P/E model and a dividend discount model.

                  From a technical perspective, the shares are weak with no discernable support in place.  Having recently traded below $30, a price last seen in 2003, we must watch for consolidation.  Guessing where that may occur is futile at this point, but the charts indicate the stock may trade down toward $20 in the future.

                   In summary, WFMI is a trend setting company that is adjusting to a period of lower growth.  To me, it is reminiscent of where Starbucks has been over the last few years.  As the price drops and multiples contract, sell side analysts race to say how cheap the stock is relative to where it has traded in the past.  While this statement is true, the shares become cheaper as the business struggles and the market reacts.  Instead of trying to catch the bottom, I would rather wait to see if the price reaches a level I find attractive.  Were the shares to trade to $15, I would be a buyer under the belief that I am finally being compensated for the risks I have taken.   Since I have taken the time to understand the company, model various valuation ranges and indentify the drivers of future stock prices, I am content with knowing that any decision to buy the shares will be informed and disciplined.  As the stock price then moves, I will not be forced to question my analysis or beliefs.  Instead, I can wait for their business to evolve and then determine how to best profit from my investment. 

                 At times, investing is easy.  Identify the primary trend, position your portfolio and wait for the returns to flow.  Other times, we are left with many unanswered questions that only resolve themselves over long periods of time.  While I prefer a simple, trending market, that is not what we are facing.  Instead, investors are left trying to determine if this most recent rally is real or a large bounce in a longer downtrend.

                My long-term concerns about this market are many.  For weeks, I have expressed concern that increasing commodity costs combined with limited availability of credit would eventually crimp consumer spending.  As oil races toward $130/barrel, agricultural commodities continue pushing higher.  At the same time, the precious metals have rallied with gold nearing $920/ounce.  Combined, rallying commodity markets foretell two problems for the equity markets.  The first is in the real economy and the other in the financial markets.

                In the economy, rising commodity cost will limit the amount of disposable income.  While temporary relief measures (i.e. - tax rebate checks) can stall the effect, ultimately consumers are left with less ability to spend.  Less spending equals lower growth.  Lower growth will cause company profits to shrink and expansion plans to be delayed.  Eventually, companies will act to reduce costs and eliminate portions of their workforce.  The net effect will be further pressure on spending that leads to more job losses.  As this vicious cycle repeats, our economy loses potency.

                The effect of inflation on financial markets is also severe.  With inflation increasing, bond investors will demand higher interest rates to compensate for the additional risk.  Higher interest rates will increase the discount rate equity investors require and lead to lower multiples.  As people are willing to pay less for each unit of profit, stocks will drop.  When you factor in a deceleration of earnings, the drop in the major stock indices could be deep and troubling.

                So if the future is so bleak, how has the Dow Jones Industrial Average (Dow) rallied 9% since early March?  This is the question I have wrestled with for some time.  After all, markets are known for their ability to look past the current environment and discount the future.  Isn’t it possible that as the Federal Reserve (Fed) takes action to rejuvenate the economy and increase liquidity, we will start to see growth resume?  While I hope this is the ultimate outcome, I fear it will not be.

                If we examine the bullish argument for the market, it rests on a few key assumptions.  They are the belief that the Fed will cause the recession to be mild and short-lived, that commodity markets are experiencing an irrational bubble that will soon deflate and that all the excess liquidity created by central banks around the world will search for a home and find its way into the equity markets.  While past experience justifies this outlook, I question the logic.

                Looking at each assumption, I am wary that the process will develop as hoped.  Concerning the recession, all agree that the housing and credit markets have experienced severe damage that is without modern precedent.  With a miniscule savings rate, our economy has morphed into a mechanism that relies upon credit and borrowing to drive consumption.  During the late 1990s, an escalating stock market provided the capital to fund one’s lifestyle.  As the dot-com bubble burst, housing became a key source of disposable funds.  From cash-out refis to home equity lines, millions of Americans used their home as an ATM to fund consumption.  As housing cooled during 2006, many turned to credit cards with low teaser rates to continue spending.  If there was a source of borrowing, the consumer could continue this game of musical chairs of borrow to consume.  This game is ending.  As banks realize their credit losses and race to strengthen their balance sheets, lending has slowed.  Banks are now more cautious and less willing to extend credit to all who desire it.  With this source of funds gone, Americans now must rely upon savings and income to drive consumption.  Over long periods, the return of financial discipline will be better for all.  Over the coming quarters, the negative effect on economic growth will be sharp.

                The commodity bubble argument is one that has existed for years.  Whenever commodity prices increase, arguments quickly begin that the price is unsustainable and destined to correct.  Is it?  Commodity price increases can be tied to two key events.  As ETFs and mutual funds have made commodities available to new investors, demand increases.  Since commodities are negatively correlated with equity markets, a commodity position offers diversification and reduces risk.  At the same time, emerging markets need raw materials to develop.  As India, China and the rest of the world develop, we witness an unprecedented level of demand.  This demand has not been with enough supply.  As demand grows from both investors and emerging markets, supply remains stagnate and prices escalate.  While I will not argue over whether $130 oil is too high or too low, the long term trend of commodity prices is higher.

                The final argument is that excess cash will be used to buy equities and drive prices higher.  Perhaps it will.  Or it could be used to drive commodity prices higher.  Or it could be used to reduce debt.  Or it could remain risk averse and stay on the sidelines.  Simply, we do not know where it will go.  What we do know is that excess cash eventually increases prices.  Another name for this is inflation.  As mentioned earlier, increased inflation wreaks havoc on the economy and financial markets.  Excess cash in the world economy guarantees it occurs.

                So the question remains, with such a terrible outlook how has the market rallied over the last two months?  Even more important, can it continue?  As history has taught us, markets can act in unpredictable, irrational ways.  I continue to view the most recent move as a sharp, bear market rally.  Weeks ago I expressed my view that the markets could push higher in coming weeks.  Since then, we saw a series of small rallies that stalled near the 200 day moving average.  Within this price action, my timing model remained 65% long.  Knowing that we have not reached extreme euphoria during this move, I remain optimistic that prices can push higher in coming weeks. 

                At the same moment, we need to address today’s 200 point drop of the Dow and what I may tell us about the future.  With this drop, the Dow quickly approaches 12,800.  For months, the Dow traded in a range of 12,000-12,800.  For this market to remain short term bullish, we need to avoid falling back into that range.  Doing so would provide investors a reason to take profits and push us yet lower.  Therefore, while one day means little in the scope of the markets, today’s price movement pulls us closer to a key technical level. 

                Given the uncertainty over the short-term movement and my dire long-term view, what does one do?  From a trading perspective, I do not think this rally has exhausted itself.  For an aggressive trader, today provides an opportunity to buy stocks for a quick recovery.  If you do so, watch 12,800 on the Dow.  If we close below that level, expect more downside and quickly exit your position.  Personally, I would use the Ultra Dow30 Proshares (DDM) as my trading vehicle.  If I am correct and we quickly rebound, gains will be swift and meaningful.  If I am wrong, your stop loss is close and the damage will be limited.

               For long-term investors, little change is needed.  By committing your capital, you should have a view about the companies you own and why you own them.  Unless the specific story has changed, there is no need to alter your view.  No one can anticipate each market movement and profit.  Those with a long time horizon are best suited to allocate capital in the direction of companies whose stocks are cheap and prospects are bright.  Doing so ensures success over time.

                Life is complex.  From the moment we awaken each morning, a never ending cycle of decisions appears.  For most people, preparing for work, getting children off to school and enduring a morning commute offer increased stress levels.  By the time their workday begins, stress has become elevated, fatigue encroaches and then we realize our day has just begun.  To combat this repeating cycle, we simplify.  Taking mental short cuts that allow our choices to become easier and our stress level lower, we can better cope with life’s complexities.

                The average person’s morning rush serves as a microcosm of the financial markets.  When considering how international trade and monetary policy will affect the economy and markets, most people look for simple answers to complex problems.  While deciding to eat the same cereal each morning may simplify our daily lives, the financial markets do not provide the same ease.   As investors, mental laziness leads to quick, sudden losses.

                So how does one cope with the myriad complexities an investor faces?  Over the years, I have seen that Wall Street tends to accept some information while rejecting other.  This filter creates an environment where certain data does not matter.  However, it will matter in the future.  Within this shift is where a forward thinking investor can profit from pending market change.              

                As an example, consider the price of oil.  Five years ago, oil traded near $30/barrel.  Today, oil trades above $120/barrel.  During this price increase, various forecasters described how the price was disconnected from market fundamentals and would eventually return to prior levels.  It never did.  The next approach was to stress how higher oil costs would lead to inflation and constrict the economy.  While oil continued marching higher, these economic bears abandoned their viewpoint and adopted a stance that increasing oil prices would not matter.  But will they?

                When we consider the role that oil plays in our economy, escalating prices will eventually have a negative effect.  Rising energy cost directly impact all people who drive to work and heat their homes.  Further, energy is a key component in chemicals and plastics.  As input and transportation costs rise on goods we purchase, financial stress quickly spreads.  With a tank of gas costing almost $80, we have less disposable income and flexibility.  Since the consumer represents the majority of economic growth, it is clear the shrinking disposable income will translate to shrinking economic growth.  As always, the true question is when this shift occurs.  Eventually the high cost of oil will matter.

                Picking these turning points is always difficult.  After all, rising oil prices leading to constrained economic growth is a rational, straight-forward argument.  However, anyone investing on this thesis has done poorly.  As oil has increased 4-fold over the last five years, we have not seen the direct impact one would expect.  Does this mean the thesis is incorrect or that the market has not realized economic reality?  Unfortunately, the definitive answer will be provided after the profit opportunity has passed.

                The tendency of markets to act independent of visible facts leads some to believe that the market knows best.  Since many profit seeking investors spend their time and money attempting to determine the proper price of an asset, many people believe this collective wisdom offers the best prediction of the future.  In the current environment, bulls are seizing on the market’s discounting ability to determine that the future will be better and prices are going higher.  After all, the signs of economic malaise are clear.  Housing remains weak, credit remains tight and inflation pressure remain high.   The Federal Reserve (Fed) has indicated that they are finished reducing interest rate and that the next move in interest rates will be higher.  Banks continue to report massive credit losses that will continue into 2009 and actively seek expensive, dilutive capital.  The consumer is showing signs of fatigue as higher commodity costs reduce disposable income and the employment picture remains unsettled.  Despite all these facts, the markets push higher.

                Recognizing that the short-term trend of this market is higher, we must ask ourselves if the collective wisdom of the market has seen through a shallow recession, a brief bear market and is now ready to head higher.  While the argument is possible, I do not find it plausible.  As the past has taught us, markets can discount the future, but they can also disconnect from reality.

                Over the past twenty years, the US economy has morphed into a system that relies upon debt to fuel consumption.  During the past five years, easy credit was the jet fuel that allowed our economy to recover from the tech bear market.   However, the credit crunch has altered the landscape.  Prior credit cycles were characterized by an environment where counterparties where uncertain if they would be paid.  If broker A sold you a stock, he expects to receive cash in return.  If that cash is not delivered, broker A will be reluctant to offer his service to you in the future.  This counterparty risk has always been addressed by the Fed pouring money into the banking system.  The arranged buyout of Bear Stearns is an excellent example of how a compliant Fed will help prevent a counterpart default from rattling the system.

               Unfortunately, the current credit crisis is much different.  During the housing boom, banks made many loans that would have been deemed too risky in the past.  By requiring lower down payments and providing teaser interest rates, housing becomes affordable to a group who had been locked out of the market.  The result was higher demand leading to higher housing prices.  Banks felt the virtuous cycle of home price appreciation could continue indefinitely and therefore relaxed underwriting standards.  As the culture of securitization took hold, banks made poor loans, sold them to an outside party and then created more bad loans.  As these loans turned bad, banks are left with large losses, depleted capital base and less willingness to extend new loans.  The lack of new lending will make it difficult for consumers to increase their spending.  Lack of new spending will ultimately yield lower economic growth.

                 Given these mixed signals from a market believing the worst is behind us and economic environment that remains fragile, who do we believe?  As mentioned earlier, the battle between the market and the economy will eventually resolve itself with a definitive action.  Until then, we must invest in an uncertain environment and profit accordingly. 

                 Over the short-term, the trend is higher.  The markets have bounced sharply from the lows recorded in early March with the Dow Jones Industrial Average (DJIA) rallying 10% in two months.  Normally, I would consider such a move as a sure signal that we have come too far too fast and need to pause.  However, my timing model is 69% long (a relatively neutral reading) and other sentiment indicators do not show the markets to be overbought.  While this does not guarantee we move higher, it shows that a fair amount of strength remains.  Further, the markets have begun to ignore bad news and move higher on good news.  The ability to selectively filter news flow is another sign that the next move may be higher.

                Given the ability to head higher over the coming weeks, investors need to be disciplined.  Shorting stocks into a market pushing higher can eventually turn profitable, but may increase volatility and test your emotions over shorter periods.  Similarly, chasing a rally by buying stocks you are not willing to own for long periods increases the chance for loss if markets reverse.  Therefore, the best approach is to maintain your investing style, gain more exposure to the market to benefit from strength, yet own a portfolio of solid companies who you would be willing to hold through an uncertain economic future.  Simplification may work in our normal lives, but financial markets require we pay acute attention to all details.

                 One of life’s never ending debates concerns what makes people who they are.  As each individual has a different genetic background and an infinite number of unique life experiences, pinpointing what causes people to act as they do is difficult.  To simplify, many have focused on two distinct events - nature versus nurture.  Those who espouse the power of nature believe an individual’s unique innate qualities dominate.  Therefore, the DNA within your being is the dominant characteristic.  Those favoring nurture, feel that our experiences dictate who we are.  They view us as a blank slate that relies upon life events to determine our personality.  With such a large gap between the two camps, it is not surprising that everyone from 19^th century poets to modern psychologists have voiced opinions about whether the answer lies in the nature-nurture extremes or somewhere in the middle.

                As investors, it is important to consider what drives our decisions.  Virtually all of modern financial theory relies upon the assumption that rationale, profit-seeking individuals enter into transactions hoping to minimize risk and increase return.  Within this rationale framework, viewpoints are combined with the net effect being an efficient market where current price equals fair value.  Unfortunately, few purely rationale investors exist.  All of us are composites that at times exhibit rationale decisions and at other times exhibit emotional decisions.  The drift from rationality causes markets to move beyond fair value and offers opportunity for profit.

                If we return to the nature versus nurture debate, what qualities are needed to be an excellent investor?  While I would love to offer a clear, decisive answer, reality is harder to discern.  Since investing is a process that is both mechanical and intellectual, nature and nurture can both claim superiority.

                When looking at our investment performance, virtually everyone focuses on how their investments have changed in value.  If your account increases in value you are happy and if it decreases in value you are upset.  This is a natural reaction as good investments will ultimately be profitable while poor decisions will be unprofitable.  What makes this evaluation much more difficult is how often the analysis is performed and what caused the performance to occur.

                We invest in stocks because they offer superior risk adjusted returns over time.  From 1926 through 2005, equities had an annual geometric mean return of 10% with a standard deviation of 20.5%.  Assuming that performance is similar over the next 80 years and that prices move in random patterns, the probability of positive return over various time periods is as follows:

As shown in this chart, increasing the time horizon increases the probability of positive return.  However, most investors focus on short term results with the belief that every piece of data yields significant information.  Unfortunately, increasing data often results in excessive noise with little incremental value.  So should we simply invest, relax and wait for positive results?  No.  Knowing that anyone who bought the S&P 500 in March 2000 and sat tight has lost money over the last eight years, sporadic review is no better.  The trick lies in determining both the proper review timeframe and review process.

                When making an investment, many factors drive our process.  Momentum investors may look for chart patterns while a value investor examines the balance sheet.  Regardless of your approach, a process dictates how you make decisions.   The following diagram shows a matrix of process versus outcome with the four possible combinations we can observe:

Knowing that a good process can yield a bad outcome while a bad process can yield a good outcome, we must resist the temptation to assume all positive investment derive from excellent decision making. 

                The focus upon process and methodology speak to skills that are acquired over many years.   Reliance on experience would strengthen the argument of those who feel nurture dominates nature.  While I understand that line of thinking, it is too simplistic.  If process alone could guarantee results, the use of black-box, quantitative methods would.  However, virtually every financial crisis over the past twenty years has the reliance of quantitative methods at its core.

                Obviously some investors are better than others.  From Warren Buffet’s remarkable track record to Bill Miller’s streak of beating the S&P 500, certain individuals and groups have performed better than others.  Since every transaction requires two participants, any investor beating the market must be offset by an investor underperforming the market.  Combine enough people and we will see that roughly 50% outperform with the other 50% underperforming.  Given this 50/50 split, the statistical probability of one investor continually outperforming over many years is low.  While this thought process is understandable, I believe it is wrong.

                Leaning toward the nature camp, inherent skills allow certain investors to think through issues more clearly and make better decisions.  The result is that the likelihood of sustained outperformance increases.  As an example, assume you have two basketball players shooting foul shots.  The first is a 90% shooter and the second is a 60% shooter.  If they decide to see who can make 5 shots in a row, there is a 59% probability that the first shooter will win and an 8% probability that the second shooter will win.  A higher level of skill alters the equation to favor the first player.

                So where does all this leave us?  In the end, a good investor must increase the value of their portfolio over time.  Eventually, skill and a good process will yield positive returns that allow you to achieve your goals.  However, interim results often dictate investment action and may cause poor decisions.  The key is to determine whether you are executing a good process in a disciplined manner.  Over time, the adherence to this process will allow you to make more good decisions than bad and to see your wealth grow.  By finding the mid-point of the nature versus nurture debate, you can pick positive aspects from each discipline and develop an investment thesis that allows you to leverage your innate skills, combine them with a good process, determine the proper review timeline and let the positive results take care of themselves.

“There are only two emotions in the market, hope and fear. The only problem is you hope when you should fear and fear when you should hope” -Jesse Livermore

I wrote my last market commentary on April 8^th. On that day, the Dow Jones Industrial Average (DJIA) closed at 12,576. Yesterday the DJIA closed at 12,825. The net result is a two week gain of just under 2%. However, the underlying story of this 2% move tells more about how an investor’s emotions can overwhelm logic and lead to inopportune decisions.

From the April 8^th close, we saw the DJIA dive over 250 points lower, briefly flirt with 12,300 and then stage two different gains of over 200 points that pushed the index above the top of a 4-month trading range. Within this violent action, breadth began deteriorating, my timing model has been breaking down and volume has remained light. Given the variety of warning signs, most investors were not prepared for the dramatic moves and are now left questioning what the next step will be.

This brings us to investor’s emotions and the effect they have on decision making. As the quote above describes, fear and hope are two competing factors that drive our thought process. Unfortunately, most fail to apply these emotions correctly and make inopportune decisions. As the market approached 12,300 last week, many investors went to cash and began increasing short positions. Since these actions had been successful over the prior days, the decision appeared reasonable. However, as the market rallied, fear that we have moved too far too quickly prevents these same people from increasing their exposure. At some point, this fear will evaporate, the hope of catching a rally will emerge and sidelined investors will pour into this market. From there, we will hit a peak and begin selling lower. It is a matter of when, not if.

Knowing that emotion can lead to faulty decisions, what can we do to protect ourselves? As always, we must think of both the long-term future of the market and what opportunities short-term volatility provides. My approach has been to combine the two time periods to develop a portfolio of strong companies as long-term holdings and then to adjust my net equity exposure for short-term movements. Within a well diversified portfolio of excellent companies, I seek limited downside risk, strong profit potential and an above average dividend yield. By spending the time needed to fully understand each company and the value placed upon it by the market, I have strong conviction about what I own and why I own it. Doing so eliminates the daily noise the market produces and allows me to focus on the business prospects of the companies I own. As mentioned earlier, the 2% move over the past few weeks would not cause anyone to alter their long-term investment stance while the massive volatility that drove us to this point left many behind.

On a short-term basis, I maintain a net equity exposure that ranges between 50-120% long. When I think markets are in for trouble, I gravitate to the lower end of the range. If I think we are heading higher, I buy more stock and approach the higher end of that range. For the past few months I have been between 60-75% long. For me, this represents a neutral stance. By being short of weak companies and long of strong companies, I participated in rallies and profited during downturns. As this market has moved higher, I will begin to drift longer and expect my accounts to approach an 80-85% long exposure. While there are many factors that worry me about the current market environment, I am inclined to become longer in order to profit from any future rallies.

For the past few months I have stated that we are long-term investors who pick stocks to own. This allowed me to remain invested as the market bounced. Knowing that certain sectors of the market will always be out of favor, I focus upon companies who are mispriced and build my portfolio accordingly. Since my job is to help my clients compound wealth over time, we stay invested, diversify our risk and look for opportunities. While this approach does not allow us to maximize every sharp market rally, it achieves our objective of profiting when markets go up, down or sideways. The ability to generate positive return regardless of market direction will allow us to steadily increase wealth over long periods of time.