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Major Highlights of the Third Quarter
We entered 3rd quarter of 2006 with a very conservative portfolio, expecting serious market volatility over the course of summer. This proved to be the case (for example, Nasdaq 100 index returns varied from -4.8% in July to +4.6% in August), even though the market managed to finish the quarter in the green. The average performance in our equity accounts was +2.44% (net of all fees!).1
| 3rd Quarter
2006 | Year-to-date
2006 | Year
2005 | Year
2004 | Year
2003 | Annualized
Since Inception * |
|---|
| Vega Equity+™ | +2.49% | +8.1% | +7.7% | +12.00% | +40.00% | +19.0 |
| Vega Equity*™ | +2.42% | +7.2% | +8.90% | +17.60% | +42.70% | +22.1 |
| S&P 500 | +5.41% | +8.7% | +3.00% | +9.00% | +26.40% | +12.4 |
| NASDAQ | +4.90% | +0.8% | +1.40% | +8.60% | +50.00% | +15.1 |
| Dow Jones | +5.02% | +10.9% | -0.60% | +3.10% | +25.30% | +9.90 |
As we informed you in our last newsletter, we have established the Institutional Relationship with Schwab, and are in the process of transferring some of the accounts there. We are analyzing brokerage expenses and best execution practices account by account, and will be making the appropriate recommendations within the next few months to some of our clients. To those of you who already have suffered through the transfer, or are in the process - thanks.
Our Portfolio Management technology has added a new feature, Dynamic Portfolio Insurance, which allows us to better monitor specific parts of our portfolio, leading to more precise risk control and limiting potential losses.
Our assets under management have grown over 10% this quarter.
The main reason for our underperformance this quarter can be attributed to two factors: our significant overexposure to oil and oil-related companies, and a significant amount of cash, cash-related instruments and "conservative" stocks in our portfolio. We have not been convinced yet that this is a wrong position, and continue to play it safe. Of course, most of you still remember the "irrational exuberance" speech by good Dr. Greenspan. Talking heads on the screen are raising "their ugly heads" with a constant talk of new highs for the Dow, new levels for S&P. We will remain careful and see how the situation unfolds. Somehow, it just does not feel right. If, however, our models will continue to generate positive signals, and the earning season starting soon, will prove to be better than expected, we will make the appropriate adjustments to our portfolio.
The Mid East situation has eased a bit; there were no major hurricanes this season (so far); the oil prices are down; the interest rates are also down. Sounds like a recipe for the healthy stock market? Some analysts indeed see it this way, but our view is that much of the good news is already factored into the prices. Indeed, the general expectation that Mid East is calming can be upset in an instant; any disruption to the oil supply is bound to claim heavy toll on the oil and gas prices; and the interest rates seem to have found their bottom and are not going any lower. However, keep in mind that October is the worst month for oil - it is between the seasonal swings in demand and it comes at the end of a hurricane season.
Based on the above view, we kept our portfolio rather conservative (albeit slightly increasing our total market exposure), still keeping large portions of the portfolio in relatively safe positions, such as consumer staples, healthcare, large cap, utilities and fixed income-related instruments. The few changes to our portfolio this quarter were:
- Decreasing our exposure to Energy sector by selling XLE (Energy SPDR);
- Further hedging our exposure to oil prices via purchasing of additional airline shares (CAL, LCC, LUV). Airlines started to show some signs of life lately. While this might be the riskier bet than we usually take, we feel it fits well in our portfolio - we believe that the fundamentals of the airline sector are fully in place to have a reasonable capital appreciation of this sector. If, however, we are wrong, and something happens to the airline sector - oil stocks, which tend to anti-correlate with airlines, should compensate for that;
- Buying large cap conglomerate shares (DHR), a stable cash generating company;
- Liquidating one of our technology positions due to stop loss (WIND);
- General rebalancing of positions which weights in our portfolio fluctuated beyond our tolerance levels (BAB, CLB, ESV, IGN, IJR, MRK, ORB, T, USU, VPL);
- At the very end of the quarter, re-entering into the gold shares (GLD) at levels 10% below our QII exit point ($58.50).
Not all is gloomy on the stock market front, however. The corporate profits grew 13% in QII, and are expected to keep growing at over 10% for the next few quarters (analysts expect QIII earnings to be +14% and Q4 - +11% year-on-year). The long term interest rate indeed seem to have reached a low plateau, 10-year T-note yield decreasing from 5.1% in July to current 4.6%. So, barring major geopolitical events, we expect a quiet 4th quarter with risks and profits balancing each other.
There was a major rally in the fixed income market over the past few months, as long-term yields dropped and the market expectation of Fed's policy aggressiveness eased. The downside for the new fixed income investments is that the investment grade yields are low again, and the yield curve is still inverted giving no premium for longer-term investments. Thus, we will keep most of our new fixed income investments on the short side (appropriate for the client, of course). In addition, you might have noticed that CD rates are now sometimes better than long-term corporate rates. Most of the analysts agree that Federal Reserve is done with raising interest rates, and might indeed lower interest sometimes during the next year. We believe that the interest rate will be somewhat volatile in the next few quarters; therefore, you should not be surprised to see a lot of shorter-term instruments in your portfolios (7-days and 28-days auction preferreds). We are also buying some carefully selected closed end funds.
We remain neutral to slightly bullish on the market. This view is reflected in our cash position in the accounts, as well as strategic positioning of assets in more defensive securities (see the description of trades above). There is at least one major uncertainty about this market, and that is how the real estate weakness will ultimately play out. If it burst like a la high tech bubble burst of 2000, the ripple effects might propagate throughout the economy. If it fizzles slowly, it may just have an overall cooling effect that would be felt only in the specific area of stock market, such as real estate finance and construction. The market seem to show little reaction to news from the war on terrorism front, but this all may change on a dime if a major event strikes, or the market perception is changed.
We continue to exercise extreme caution in our equity portfolios, including a large percentage of cash- and cash-equivalent instruments, hedges, and tight stops for more aggressive positions. Of course, we already paid a small price for that in the QII, under performing S&P 500. We will remain, however, skeptical and careful about this market until convinced otherwise by the objective data. They are, simply, not there.
As always, we would appreciate the referrals from our loyal and satisfied clients.
1Vega Capital Group LLC ("Vega") is an independent adviser registered with the Securities & Exchange Commission. The performance shown reflects actual performance for representative accounts. One representative account is selected for each strategy. The selection of representative account is based on the following factors: cash flows into or out of account for the reporting period, size of account sufficient to be representative of the strategy, average trading expenses. Performance of other accounts managed under the same strategy may vary. The firm maintains a complete list of its' accounts performance, which is available upon request. Past performance is not indicative of future results. Accounts under Vega's management are not insured against loss of principal, and may loose value. The U.S. Dollar is the currency used to express performance. Returns are presented net of management fees and include the reinvestment of all income. In addition to an advisory fee, performance shown includes any additional custodial or service fees. The advisory fees are calculated as follows: for Vega Equity Plus accounts, the fee of 0.5% per quarter is charged quarterly, in advance, based on the closing balance on the last date of the previous quarter; for Vega Equity Star accounts the quarterly fees consists of management fee of 0.375% per quarter charged in advance, based on the closing balance on the last date of the previous quarter plus performance fee, charged in arrears equal to the 10% of investment gain for the quarter above all relevant watermarks and hurdle rates for the account. Vega's schedule of advisory fees vary based on product and type of client and is contained in Form ADV-II. Additional information regarding the policies for calculating and reporting returns is available upon request.
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