This column was originally published on RealMoney on Jan. 12 at 9:58 a.m. EST. It's being republished as a bonus for TheStreet.com readers.
It's not too late to reflect on the past year and plan for the one ahead.
I'm going forward in 2006 overweight in consumer staples, energy and basic materials, and underweight in everything else. Consumer staples cover the bear case; energy and materials cover the bull case. Financials, which are dependent on interest rate margins, will have a hard time.
In insurance, I think that large-cap life names such as
will pack a punch. Scale is an advantage in the life insurance business.
is undervalued, and its pricing model is more powerful than the market thinks.
is one of those companies that everyone will wish they bought at the IPO. It is a very good capital allocator. Beyond that, the property and casualty reinsurers in Bermuda are undervalued, but who can tell how bad the catastrophes will be this year? I am getting more hesitant about the group.
In bonds, I think the yield curve will be flat to inverted for a longer time than most anticipate. In general, short rates will rise, and long rates will stay pretty stable. The federal funds rate should top out at 5%, give or take 25 basis points. Credit spreads will remain tight for most of the year and widen a little toward the end of 2006 on fears of recession and consumer credit problems.
There won't be stagflation in 2006, but growth in real GDP will slow, and inflation should rise a little. Toward the end of the year, news stories about a likely recession will proliferate, partly due to a weakening of the residential real estate market.
My guess is that on the whole, the stock market won't perform too badly, but the indices will only see single-digit gains. It won't make either the bulls or the bears happy.
That's my forecast for 2006, but the future is difficult to predict. My investing is conservative, and I don't take my macroeconomic views to their maximum, because macro views sometimes fail. Good investing takes the likelihood of error into account.
Looking Back at 2005
Humility is a huge plus in managing money, because it keeps us from becoming wedded to ideas that have lost their punch. For that reason, I find it instructive to reflect on my failures last year.
In the insurance sector, I was bearish on
St. Paul Travelers
( STA), and I was too bullish on
There's no common factor here -- I simply misunderstood the fundamental cases, at least in the short run.
I was also wrong about auto-parts maker
( DCN). I broke my own rule by buying a company of medium-to-low credit quality when the industry as a whole was under stress.
Along with all of that, my commentary was too bearish on equities, too bearish on the dollar and too bullish on the 10-year note. Regarding currencies, read the work of Marc Chandler. He clearly has a firmer view of relative value in currencies than I do.
Best of 2005
On insurance, I was in the money with MetLife, Prudential, Assurant and Montpelier. There are three ideas here. First, scale is an advantage in insurance, and that helps Met and Pru. Second, Assurant is a well-run corporation. It is my hedge fund's largest holding.
I shorted Montpelier after Hurricane Katrina (along with other property-exposed reinsurers), and recouped my losses. (I try to report all of my significant trades on
, but my agreement with my legal department precludes reporting companies that I am short, unless they allow my disclosure.) I also got
( FNM) right, and I am no longer short.
I had the auto sector right, where I like
. I feel sorry for Kirk Kerkorian, but it's foolish to follow the actions of wealthy people simply because they are wealthy. The stock market doesn't care who owns a stock, but it sometimes cares why large investors buy and sell. Unless GM can figure out a clever way to legally spin out GMAC, I can't see how GM is buyable.
I predicted the yield curve inversion well in advance of most commentators. My strategy of barbelling fixed-income investments for 2005 worked very well. The long end rallied, and the short end fell.
My trading of the
iShares Lehman 20+ Year Treasury Bond
also worked out in 2005. I made money in each trade. What is gratifying here is making money in an unusual environment. Long rates were low due to foreign investment.
I was ahead of the curve on:
Pensions: The situation is bad and getting worse. Pension reform, when it passes, will cause many plans to be frozen or terminated. Those that survive will be very secure.
The FOMC: The Fed tightened more than the consensus at the beginning of the year, and more than I thought while I was on the bearish side of the consensus. At least I wasn't with most commentators with the rolling "one or two more and they're done."
Credit derivatives mess: The blowup in the credit derivative market in mid-May was caught by me before most of the press, and explained in greater detail.
Yuan: I caught on earlier than most that the Chinese were not really running a fair-though-undisclosed currency basket. They are running a crawling peg, but not calling it that.
Eliot Spitzer: I expressed skepticism regarding his ability to genuinely try cases, except through public embarrassment through the media. As I thought, his case against Hank Greenberg was a tough one, and he did not pursue it, because Hank fought back.
Quant hedge funds: I suggested that they were in oversupply, and that judgment proved right, as they underperformed.
My year contained: 114 trades; 61 names; 35 positions (on average); 35 wins; 26 losses (wins bigger than losses on average); and 13 positions held from the beginning to the end of 2005.
Though I can't promise to find the bull market for you (that's Cramer's job), I can help you understand how to control your risks better. Here's to a profitable 2006, with risks under control.
Please note that due to factors including low market capitalization and/or insufficient public float, we consider Neenah Paper and the Japan Smaller Capitalization Fund to be small-cap issues. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
At the time of publication, Merkel and/or his fund was long MetLife, Assurant, Prudential, Sappi, Dorel, Gold Kist, Fresh Del Monte Produce, Neenah, Cemex, Anglo-American, Apache, Japan Smaller Capitalization Fund, Toyota and Allstate, and was short Ford, though positions may change at any time.
David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he appreciates your feedback;
to send him an email.
Analyst Certification: All of the views expressed in the report accurately reflect the personal views of the research analyst about any and all of the subject securities or issuers. No part of the compensation of the research analyst named herein was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research analyst in this report.
Merkel is employed by Hovde Capital Advisors LLC (the "firm"), a registered investment advisor with its principal office located in Washington, D.C. The Firm and/or its affiliates have or may have a long or short position or holding in the securities, options on securities, or other related investments of the issuers mentioned herein.