Arlington Econometrics 1st Quarter Commentary

Just Around the Corner


· Going global means expanding the capital gains horizon.

· Focus upon enduring, secular trends, not themes or fads.

· Asset allocation opportunity is shifting from consumer-led to tangible assets, from unit volume to pricing power.


Information, and access to it, is shrinking the perspective investors have about how and where to allocate their resources. It is now possible to see real time geopolitical and economic events unfold at our desktop. Events in Tokyo, Basel, New York, Caracas, Miami, and Moscow are available and digested instantaneously, and their effects are immediate, as well. Ubiquitous information is changing the meaning of the word “neighbor”.

This means that risks and rewards are more easily analyzed and that global strategies are domestic strategies, too. No longer does the professional or part time investor feel disassociated from the events which interconnect to form his landscape or methodology.

Many companies are “world-class” even though they may be local, because the end use of their product might have far-reaching consequences in the scheme of global commerce. It is possible for your neighborhood baker to be as well known in London as he is down the street. In the next decade, the definition of global investing will change and we need to adapt to those changes.

Arlington Econometrics, my proprietary quantification and analytical product, has proven to be an excellent resource for market timing and distribution of assets. All signals seem to be pointing towards a shift in commerce from unit volume increases to pricing power, from neighborhood/regional to continental/global. The value of my tools and models is that they can distill markets from their regional barriers by focusing on earnings acceleration patterns and sector momentum irrespective of location or capitalization.

To whit, it can help us focus upon companies that are participating in the kind of capital gains momentum which positions investors away from high risk speculation and towards themes which have been vetted for their intrinsic and potential value.

By asking the model the key question about perpetuating earnings and price acceleration patterns, one can eliminate at least one element of “hope and pray” investing that can ruin portfolios.

Without prejudice going in, Arlington Econometrics can find opportunity that represents better-than-average potential for achieving desired portfolio performance. That is why I believe the data to be correct that earnings potential and capital gains opportunity is more global than at any time in our professional lifetime.


Markets

What seems to permeate the landscape right now is a sense that if you’re not in the market you might miss the opportunity, altogether. I believe differently. Since markets are cyclical, not linear, in their development, they always offer reflexive entry and exit points, which I refer to as “inflection points”. These are periods, not points, during which one can calibrate the level of accumulation going in, or distribution coming out.

Therefore, trends are not points but generational opportunities which endure. For example, if one looks at the current Energy sector performance, one might focus solely upon the price-at-the-pump surge in equity prices from July through the end of December. But behind the diminished aperture of that perspective is the notion that as far back as 1998, just prior to the Tech stock run-up and subsequent disastrous fall, Energy stocks (in fact, commodities of all type) were gestating and reversing a negative secular trend which had lasted nearly 15 years prior.

Whether one focuses upon the 13% price performance increase of the sector in 2006 or the nearly 1000% performance of the group during its nascent 2002-2006 bull cycle is reflective of the perspective one brings to solving difficult portfolio allocation questions. As my metrics have shown, our performance and ability to adapt to the changing climate of earnings derivation makes the issue moot in the long term.

Obviously, there are no guarantees about the future. However, cyclical phase methodology and sector momentum analysis trumps bottom-up, or wishful thinking, analytics.

The dollar’s continued decline diminishes the U.S. market’s value both financially and psychologically. When the U.S. fails to compete successfully, it impacts upon our share of market capitalization as well as upon the psychological influence our markets and product wield.

It is quite clear that world market shares are shifting. Whether influenced by finances or psychology is a question for others to ponder. As an analyst, my choice is only to follow the methodological purity of my data. Fighting the trend is not an option for a quantitative market scientist.

The shift from U.S. to global is fluid, not static. As with all trends, it will be possible to maximize these trends over time rather than by erroneously jumping into one market basket or another. For example, quantitative metrics allow us to measure and define the relationship shifts over time between two disparate continents. By triangulating the correlation between earnings and price performance data to the markets themselves and to each other we can measure the shifting value of the opportunity and its cost over time.

In this way we determine a gradual shift in asset allocation that would be expected to yield portfolio performance and diversification of risk at the same time.

My data is incontrovertible today that earnings acceleration is shifting to many shores and that a jingoistic approach to portfolio building is past tense. Foreign (non U.S.) markets offer greater diversification and opportunity by combining emerging market potential with mature industry problem solving. Additionally, the timeliness and transparency of data makes the analytics more “contemporary” and not seem so much as it did two decades ago, namely unsafe and adventurous.

Contemporary investing is all about old-fashioned analytics. The most obvious form of corporate analysis is still the balance sheet. What a company makes, how successfully they market and sell it, and whether they create equity for their shareholders is not unique to the United States. If you were to ask many international analysts today, they would conclude that standards and reporting practices have leveled the playing field. Additionally, industrial development of the global infrastructure is the halcyon call of government and its citizenry, alike. To complete the mission our tech friends and dot.com advocates suggested a decade ago, we need to complete a universal overhaul of brick and mortar institutions as well as non-tangible “ether-net” applications worldwide.

This, then, is the promise of our “New Paradigm” advocates, although not as ethereal as they might have thought a decade ago.

Lumber, cement, steel, coal, gas, water, food are the fuel sources for global industrial development as much as semiconductors and microchips.

As complete as one might think the review, the very nature of investing is about taking risk. Admittedly, the goal is to assess risk and to identify pitfalls, but all investing is about risk. Prudent analytics (methodology) and good data are an investor’s best ally in the fight for risk reduction. It is not sufficient merely to say “this company looks less/more expensive than that one”.

It is important to have a universe large enough from which to make studied judgments. Arlington Econometrics employs key techniques that extend beyond price comparisons. Our data correlates based upon a proprietary relative strength quotient which ranks all stocks global and domestic based upon location and opportunity within its sector, country of origin, and globally, to achieve a universal dynamic that pinpoints financial risk/reward potential. Allowing for exogenous noise and data variations, our results convey the results which prioritize opportunity and potential according to our proprietary ranking system and asset modeling.

However, without a top-down landscape, not even good data can be properly analyzed or positioned.


Strategy

Whereas the United States had been the engine of global commerce for most of the last century, the millennium has seen a gradual shift in locomotion towards the Pacific Rim and Latin America. At best, that means that the U.S. is trying to keep up with itself formerly, and to maintain market share in a highly competitive, and less costly, world sphere.

Our competition comes not only from exogenous influences but also from within. Significant budget deficits do little to quell the inertia that constrains corporate expenditures. The nation’s GDP is choking on nascent inflation, a declining savings rate, falling wages, and a psychologically damaged consumer base. Rising interest rates, with or without the Fed, will squash any potential for discretionary debt in the foreseeable future.

The U.S. savings rate is at its lowest level in decades. As baby boomers reconnaissance the landscape as they near retirement, they see stagnating wage growth and falling real rates of return. Of course this scenario does not apply to the multimillionaires of Wall Street’s most prestigious investment banks but, then again, very little of Wall Street’s exclusive boardrooms really does apply to the average citizen.

Furthermore, concomitant with the declines at home, the U.S. trade deficit continues to expand. With the dollar in decline and Federal monies currently financing war, not domestic infrastructure, I forecast the deficit to expand next year as a percentage of the country’s national output. The primary impediment to this circumstance reversing is unwillingness of foreign partners and adversaries to finance the expense of producing our products. Gasoline, computers, steel, food and a host of other “staples” can be produced more cheaply overseas than here in the United States. Our consumption of alternatively priced products is outpacing our ability to sell them overseas.

Exacerbating the negative profit potential of U.S. markets is the broadening of competition around the globe. Greece, Russia, Sri Lanka, are examples of “furthermost” destinations and sources for commerce, adding to the regular litany of India, China, Japan and Germany.

Many of these countries are learning not only how to produce but how to prosper. The “trickle-down effect” is less a political slogan than it is a capitalist reality in developing countries. Although many of these emerging markets may suffer from a governmental comparison to the United States, many are nonetheless learning how to cultivate their natural resources and labor pool for a sustainable economy. Can these countries flourish without economic support from the globe’s superpowers? Perhaps not exclusively, but the effort is there and the “flea in the fur” analogy is nonetheless pesky for the middle class U.S. citizenry.

So, with growth being shared by a multitude of competitors, what will emerge as the major trend(s) for 2007?

Firstly, the breadth of opportunity globally is my main focus. In order to compete, countries and companies need a growing working class base and a consumer-led economy. When the labor force grows, unemployment declines, savings increases, and pressure subsides. Additionally, an expanding workforce “regulates” interest rates in a manner more effective than the machinations of government. Higher rates during an expansion, for example, are less punitive than a secular reversal (upwards) of rates when the economy is in a deficit.

Natural resources, particularly food and agricultural products, will develop as the next inflationary sensitive item to rule the economy. Whomever controls grain production and harvesting, water resources, meat production, and corn and soybeans will be profit beneficiary of the investment markets.

While this could be a plus for vast United States resources, we also need to change the way we finance agricultural harvesting, particularly the way the government pays to decrease production or destroy harvest in order to maintain “equilibrium”. No global citizen should go to bed hungry. It is lack of distribution, not production, that is creating this policy of government.

Energy resources will be the focus of my work, as well. The greatest influence upon economic and social policy is Energy. Declining resources and ineffective fiscal policy to develop alternatives is not a U.S. problem, it is a global problem. Maintaining and expanding sources of energy is a governmental and economic necessity. The situation requires sophistication and the help of technology to find solutions to this diminishing natural resource problem.

Many emerging market nations are decades behind the West in addressing these and other infrastructure issues. To that extent, there exists an opportunity for Western business to influence and exert a new spirit of renaissance at the opportunity to recreate their past successes. After all, we have faced-down and overcome many of the technological and industrial crises that now envelop the developing nations. Brain power and problem solving could become our best export.

The next year will be a rebuilding year: rebuilding alliances, infrastructure, attitudes and opportunity. Instead of squandering the potential, nations should convene an “Opportunity Conference” to define ways of looking around the corner for new themes and to atone for breakdowns in lost opportunity. Successful reforms would address debt, trade, healthcare, education, infrastructure, and energy.


Conclusion

Let me reaffirm that I am always looking to buy, not sell. Market patterns are not necessarily random. There are discernable, measurable statistics that can be quantified. Technology is important to the expansion of capitalism: biotech, energy technology, communication technology. This is the decade when Tech stocks mature from hype to reality. Who delivers and who fails is measured in profit and demand, not fluff any longer.

Who will be around the corner?



Asset Allocation:
Equity 51%/Fixed Income 34%/Cash 15%