This market is proving one of the most fascinating and difficult to call that I can recall. Opinion remains as deeply polarised as I can remember, and volatility is high.

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The autumn of 2007 was only the second time in 15 years of writing a regular commentary about the markets that I have found it impossible to generate a strong instinct or conviction about the underlying direction of the market - positive or negative. The irony of course is that everybody else seems to be finding it very easy, being either ultra-bearish or still very positive. Opinion remains as deeply polarised as I can remember, and volatility is high.
 
My instinct all last year was that the year would end just about okay, which is what broadly happened, but recent market action has been so choppy that caution is beginning to get the better of me. Despite my earlier more optimistic view, it is clearly not impossible that we have seen the start of a new bear market that will severely test the resilience of investors. Given the general nervousness of the seasoned investors that I talk to, it would be foolish to discount the possibility.

When bear markets do start, I pointed out early last year, investors typically get two or three chances to change their mind and get out before the decline becomes catastrophic. We certainly had one such chance, with the rebound from the August lows (subsequently given back in November). For those convinced about a bear market, there was another mild opportunity in the run-up to the end of the year. The major indices all fell 10% or so in November's correction and were due a rebound even before the modest interest rate cut by the Federal Reserve.

While I don't think that technical analysis can tell you directly what is going to happen next to markets, experience has taught me to respect what the charts are saying about the pattern of recent investor behaviour, which often does provide some clues to where markets may be heading. At the moment the charts are saying don't get carried away by the bullish story, which has been that we are going to sail through the current credit crisis relatively unscathed.

As a result I am becoming progressively more cautious. The golden rule in the punditry business is to look carefully at what any market forecaster is doing, not what they are saying they intend to do. The two are rarely the same. My own portfolio is becoming more defensive in nature. In other words, while my head says I should be adding risk to what I own, my actions are pointing in the opposite direction. The underlying problem is that it is difficult to take a brave or contrarian view without a higher degree of conviction than I currently possess.
 
Many of those I speak to on a regular basis are also cautious. Anthony Bolton at Fidelity, for example, has talked about the possibility of a 6-9 month bear market in the UK. "The impact from the financial crisis will not disappear quickly", he said the other day, although "the worst will be over next year". Derek Stuart at Artemis, another professional investor for whom I have a lot of time, is also cautious. His Special Situations fund remains heavily - and unusually for him - over-represented in the large cap space for that reason. The only problem with the view that large cap is where you want to be is that everyone already seems to think that this is the case.

Sandy Nairn at Edinburgh Partners recently completed an interview with me that explains in detail why he thinks we are heading for a new bear market. You can download a copy from the website, or click the link at the side of this letter. As a former Research Director for Sir John Templeton, with a five-year time horizon, Sandy knows from first hand experience the need to endure relative underperformance (which all his funds are currently experiencing) in order to benefit from the rebound when valuations become more compelling and certain than they are now.

Even Ken Fisher, who with Bill Miller have been strongly bullish since the start of the year, has admitted to doubts whether his stance is still the right one. In a recent email he told me "It is either a second correction because the first one was too brief and didn't freak enough folks out, or there is something bad down the pike that I can't see and isn't the stuff everyone is fomenting about.  I'm rather inclined toward the former view for now and simply see it as completing a full freak out factor before I higher market.  But maybe there is something I'm not seeing.  Wouldn't be the first time".

That is pretty much how I see it too, for now - you can see how negativity is spreading. Investor sentiment meanwhile seems to be deteriorating quite fast, which is potentially a positive signal, but as I see it is only now that fear is beginning to surface in earnest. Don't be kidded into thinking that this could be as bad as it gets if it does turn out that we are in for a real bear market. For some time now I have been shifting the balance of my own funds away from conventional equities into more specialist areas, such as gold, soft commodities and selected emerging markets (nothing original there). A recent meeting with Jim Rogers, the one-time partner of George Soros, did nothing to dissuade me that this general approach was right, popular though it is undoubtedly starting to become.

Jim is now in his mid 60s, but still running hard - so hard indeed that my conversation with him was held in the gym of his London hotel, where he was busy working out. Between exertions, his line was that the dollar was on a hiding to nothing; and that there was little that a conventional bear market would not now put right. In his view, the Fed's obsession with saving Wall Street from its own excesses by cutting rates and printing yet more money will do nothing but build up problems for the future. "I have a lot of friends on Wall Street, but why they should be bailed out when the cost to the economy is potentially so serious?" he wanted to know. (The Fed, it now seems, takes a different view). 

Jim was expecting a correction in many stock markets, but remains a long term bull of soft commodities, for the reasons that he has laid out convincingly on many occasions over the past few years. It is worth noting that the commodity index he created nine years ago has risen three times as fast as the S&P 500 since then.
 

What is noticeable in the last few days is how a number of experienced fund managers, while cautious about the markets as a whole, are starting to buy back into the most beaten up sectors of the market, including banking, property and housebuilders. Two examples are given in the link besides this letter.  If you are a fund manager, you are automatically in the relative performance business, so it is not impossible to be generally bearish and yet find some good bargains at the same time. The positive way to look at the markets is to note how surprisingly resilient they have been, given how much bad news has been thrown at them. So far it is still mostly bankers rather than investors who seem to be keenest on talking down the economy. It is proving contagious.

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On the subject of commodities, I promised to give a few more details on the new venture in which I am now a principal. This is a new Cayman company called Agrifirma Ltd. My role is Director of Research and Business Development for the investment advisory subsidiary that seeks to guide the board in its investment decisions. The company's focus is on investing in farmland, initially in Brazil, where the potential for gains on the back of strengthening world prices for agricultural commodities looks to be very favourable. 
 
The principals behind the advisory firm, one of whom I have known for many years, are the same as those who have had great success with Galahad Gold, a mining venture company that has been listed on AIM since 2003. Galahad has this year sold all its positions in mining projects, having achieved an annualised rate of return of 66% per annum over the last four or so years. It is in the process of returning all the gains to shareholders. The two main principals, Ian Watson and Jim Slater, will also be the main shareholders in Agrifirma, the new company. Their view is that the "low hanging fruit" in mining has now been picked, and that farmland/grains now offer potentially more attractive returns.

One consequence of joining this new venture is that I have spent a good deal of time over the last six months researching the market dynamics of both agriculture and farmland. (Despite a largely blameless life, I discover that I have a bit of catching up to do on Jim Rogers in this respect). The arguments are compelling enough to have convinced me to put a significant amount of my own money into the new venture. Time will tell whether this conviction is well-founded, but the omens to date - against a background of a deteriorating stock market and a widespread retreat from paper assets - seem good.  No doubt you will hear more about this from this source in due course.

Agrifirma is an unlisted company. It is in the process of recruiting a high calibre specialist team in South America to oversee the investment programme as it unfolds. In due course, once the deals start to flow, the board expects to opt for a market listing. The company doesn't yet have a proper website, but as more details become available, I would be happy to share what I am learning with anyone who is interested. The grains and soft commodity story is one that is going to run and run, and has some interesting features.

In view of these new commitments, my plan is to write a monthly review of the markets from now on, with links to my newspaper columns and links to the most interesting pieces of research that have caught my eye as being particularly interesting. I have cut back on some of the other features on the website for now, but hope to introduce new writers shortly. There will also be reports on the website of the meetings of the Alpha Society, the monthly seminar series that will kick off in the New Year. Less experience investors can also hear three podcasts in which I discuss the merits of investing in funds online.



Jonathan Davis
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