MoneyNews
Saturday, Jan. 14, 2006

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Wilkinson's Edge
The Cutting Edge of Financial Analysis
 

Dear MoneyNews Reader,

There's a lady who's sure
all that glitters is gold,
and she's buying a stairway to heaven.
When she gets there she knows,
if the stores are all closed,
with a word she can get what she came for.

Stairway to Heaven, Led Zeppelin 1971

These famous lyrics rang loud in my head during the week as the Dow broke through 11,000 for the first time in four-and-a-half years.

Story Continues Below

The ascension of the American equity indices to new highs is something I have been waiting patiently to see for many months now.

The bigger question is: How will investors react to the bull run, and will they find the stock story equally appealing as valuations become naturally less attractive in the upswing?

Is there a glittering prize, or will the air get thinner?

During the week, I shot off a couple of e-mails to subscribers from our SectorTrade HQ here in South Florida, telling them to sell into the rally in order to bank gains of as much as 15% on last year's hot sector – semiconductors.

Semiconductor shares ended the year with a 9.8% gain, yet our nascent "hedge fund" (which focuses on superior sector selections) ripped almost TWICE as much in half the time – WITHOUT using leverage!

Hedge Funds

Making money in 2005 proved a hard game to play, as even the hedge funds found out.

If you have a cool million to invest, you qualify as an accredited investor. (OK, there are more requirements you must meet to get into the club, such as income, but let's overlook that for now.) Hedge funds invest a little differently than traditional mutual funds, since they will act upon a market direction allowing them to sell short as well as go long.

You could call hedge funds a playground for the rich since customarily they are exclusive and reward investors with above-average returns.

Their popularity has surged in recent years.

Hedge Fund Research Inc. recently announced that industry assets had swollen to $1.1 trillion by the end of 2005. That amount represents a doubling of managed assets in search of bigger returns.

However, it could be that the best returns are well and truly behind us.

The 16% average return experienced between 1990 and 1999 has tumbled to an average of 7.5% since 2000.

Last year the average hedge fund achieved a 9.2% return for the year. That's not bad, considering that the S&P 500 index put in a 5.8% total return (assuming dividends are reinvested).

2004 was not such a good year for the hedge funds, despite a similar 9% gain. That stacked up against a 10.9% return from the S&P 500 and again was a fall from 2003's 16.3% hedge fund return.

The rise in total assets clearly shows the appeal of the hedge fund industry. However, averages are just that, and to prove it competition is heating up as investors are quick to withdraw funds from money-losing managers who drag down the average return.

Through September 2005 some 484 funds shut down, representing one in twenty funds, according to Hedge Fund Research. That was the largest percentage since 1996. Today there are more than 8,000 funds.

The 2005 winners were stock funds, which climbed 10.7% compared to the macro-fund returns of 6%. Macro-funds focus on bonds, currencies, commodities and stocks.

2005 was a big year for the dollar, which rose almost 13%. That news hindered returns at currency hedge funds – in part since fund managers were not unexpecting it. The near-zero return is a big reason why funds are leaving that arena and heading back to stocks.

According to data from Deutsche Bank, 2003 saw foreign exchange-only funds return 12.9%, 3.7% in 2004 and only 2.7% in 2005.

Currency investors benefit from diversification representing simply another asset class. The trouble is that it seems difficult for portfolio managers to make consistent gains, because they fail to see the major trends unraveling throughout the year.

I've clarified my position here in my weekend column and stand by my view that the dollar will weaken this year.

Assets allocated to currency trading total $16.1 billion as represented by just 60 funds, according to measurements in the Parker FX index. Assets under management have tripled since 2002.

During the week I made room in the SectorTrade portfolio for the ideal sector fund to benefit from a resumption in the downtrend in the dollar.

Commodities Corner

During the week I alerted our SectorTrade service subscribers to take profits on their holdings in the basic-materials sector.

While commodities remain a hot property and possibly will be for a further several months, some fresh signs emerged concerning chemical and metal companies – ones we had feared in the aftermath of Hurricane Katrina.

Basically, surging demand for materials, while it continues to push up prices of metals and chemicals, is not helping basic-material companies as much as we'd hoped for.

Soaring energy costs are squeezing margins as these manufacturers are unable to pass on costs as rapidly as they'd like.

While energy prices are indirectly related to the hurricane season, plants at Du Pont remained shuttered far longer than expected, causing lower sales and therefore lower profits.

While we are walking away in the black from the basic-materials sector, we are suspicious of the bottlenecks emerging.

Take a look at the chart below depicting orange juice futures. This week the U.S. Department of Agriculture reduced its forecast for the Florida farmers' harvest for this season.

Florida growers will produce just 158 million boxes – four million less than forecast in December – this season.

They were battered by four hurricanes – the latest one being Wilma, which passed in October. The news of a lower crop forecast (accompanied by a shrinking orange size) sent orange juice futures up almost 1% on the NYBOT on Thursday.

Last season's crop was the smallest in 13 years and traders had hoped for an improvement. Had the weather been harsher right now, prices might have escalated even further.

The earliest projection from the Department of Agriculture this season was 190 million boxes.

The Valencia crop, the smaller variety of orange, is the fourth-smallest since 1960, while the early-season crop is the smallest in a decade, according to the report.

Earlier in the week the Commerce Department concluded that Brazilian orange juice producers had indeed dumped some product in the U.S.

If this ruling holds, there could be reprisals on future shipments, further restricting supply across the United States.

Orange Juice futures still look bullish.

The hurricanes and their aftermath

Have a great week! 

Andrew Wilkinson
Senior Newsletter Editor

P.S. Sign up for a risk-free trial to my SectorTrade service and save $400 today! SectorTrade subscribers have made nice profits in 8 out of 10 trades so far this year including an 8% gain in the semiconductor sector and over 70% returns shorting the oil sector. Our next Trade Alert goes out soon. Don't miss out. Go here now