When Fundamentals Don't Pay

Sometimes being fundamentally correct can be monetarily wrong.

This was the title of an article that I wrote in July of 2005. My argument was that even though the fundamentals might be correct in the long-term, investors can lose tons of money if they stubbornly hold on to their views. I thought it would be interesting and educational to repost some of the comments that I made in the article, especially in light of the current market environment. Remember, this is July of 2005:

“The most glaring example of this has occurred most recently with the US real estate market. First, I believe that real estate prices should not rise in a recessionary environment. Furthermore, with the burst of the dotcom/tech bubble, one would assume that investors would not have the excess equity to upgrade to a bigger home or buy a second home. Nonetheless, the obvious boom in real estate has resulted in tremendous capital appreciation for many real estate investors. This trend has lasted for several years, soaring in the face of fundamental reasoning.

Of course, some would argue that home prices have risen because of artificially low interest rates and interest only loans. I do not disagree with this analysis. In fact, I believe that the real estate market is indeed overvalued. However, I also believe that trends often follow the demand of the investor. In this case, investors decided to take advantage of the low interest rates and "special" mortgage programs. This demand has ultimately led to an increase in home sales, and subsequently a rise in home values.

This idea that trends often ignore fundamental reasoning can be found throughout the markets. The US dollar index is another example of this. I consider myself bearish when it comes to the US dollar. I cannot easily disregard our twin deficits and a slew of other fundamental reasons on why the dollar is overvalued. However, since about June 2003, the dollar has experienced three relatively substantial counter rallies. In fact, we are in the midst of the most prominent of these rallies. Take a look at the below dollar index chart.” (Emanuel Balarie, 2005)

Several years later, it is clear that my fundamental analysis was correct. The real-estate market burst and the US dollar (trading at the time at 90) eventually broke down to new lows. However, it is important to note that investors still had a couple more years to profit from the growing real-estate market even though the fundamentals did not make sense.

What about today?

My office is located at the Chicago Board of Trade and I often get the opportunity to interact with several different types of traders. While these traders have one common goal- to make money- they differ in terms of the markets they trade, their trading style, and their overall outlook on the markets and the economy.

Having talked to these traders, it is also clear that they share my sentiment that having a solely fundamental focus on the markets is not really working today. Indeed, many “value” or “contrarian” traders who look to buy undervalued (or sell overvalued) positions have had a tough time reacting to the recent characteristics of this commodity markets. Momentum and trend-following traders, however, have been able to profit from these prolonged market trends.

By the way, you can log on and access some of the performance for these Commodity Trading Advisors.

This makes perfect sense. Take oil, for example. Several months ago, when oil was at $110/ounce, I wrote an article titled “Oil Bull Turns Bearish”.Oil prices, of course, continued their march towards $150/barrel. In the article, I stated the following:

“In fact, I want to let you know that I am as big of long-term commodity bull as they come. I understand the fundamentals that are driving this commodity bull market...I have even written a Commodities book about it! However, I also understand the speculative froth that often enters the markets...and the trend following approaches that hedge funds and other traders implement. The leverage aspect of the futures markets also allows for a lot of money to come in( and go out) in a quick period of time. The end result, of course, is that while the oil bull market will continue to climb higher for the next 7-10 years, it will also experience extreme volatility as prices will often get ahead of themselves.

In my opinion, we are now in the oil pullback mode. The move to $110/barrel was largely based on speculation and hedge fund interests. Fundamentals did not warrant such a rapid move up. Currently, energy supplies are showing a buildup and a slowdown in the US economy (the largest oil consumer) will have an impact on oil demand.”

Was I wrong in my fundamental analysis? I don’t think so. Prices have eventually sold off, and I think we will see a further sell-off in the oil market. However, it is pretty clear, that markets contradicted the fundamentals and moved substantially higher. The traders and investors who were able to make money in this market environment were those that simply continued following the trend.

Last week, I also mentioned that the fundamentals dictate higher gold prices moving in to the gold buying season and that the rally in the US dollar was short-lived. My reasons were based on the fundamental factors that I outlined. Was I correct? Not in the short-term. The US dollar has continued to rally (in the midst of dismal economic data) and gold prices have sold off even more. Does this mean that this recent gold-sell off should signal an end to the gold bull market? No. It just simply means that the trend is currently contradicting fundamentals.

What’s an Investor To Do?

But what’s an investor to do? While this logic makes perfect sense, it doesn’t take away from the fact that many investor portfolios have declined significantly due to the recent commodity sell-off. Should you hold steadfast to your long-term commodity bull market view point? Or should you sell all your commodity investments all-together? I think the answer lies somewhere in between.

First, it is important to realize that panicking and selling all of your commodity investments due to the current correction is not necessarily the answers. The fundamentals warrant higher commodity highs, and these type of drastic sell-offs can often provide great buying opportunities. You need only to look at a chart of the CRB index over the last 7 years to see why this is the case.

But beyond holding on to your commodity investments, it is important to note that simply having a “buy and hold” and “fundamentally-focused” investment philosophy is not optimal for an investment portfolio. You need only to look at the recent sell-off and volatility in the markets to understand why this is the case.

So while the trends have contradicted fundamentals over the past year, it is important to now take time to re-evaluate your portfolio. We are living in the midst of changing times and changing markets. While having some “buy and hold” assets in your portfolio makes sense, you should also con also consider diversifying your portfolio among other type of investments, trading managers, and trading strategies. To find out more, I encourage you to read my article from a couple months ago “ Managing Wealth in a Bear Market”.

If you would like to find out more about the managed futures products and strategies that can help diversify your "fundamentally focused" portfolio, please visit: ( http://www.balariecapital.com/ )

You can also sign up for a CNC weekly commodity newsletter.

Emanuel Balarie

Jabez Capital Management

www.commoditynewscenter.com