Market Commentary for the week of March 5, 2007

With the dust having settled from last week’s near-record market decline, I am obliged to ask my readers if they really believe that the pullback was unexpected? Archives of previous weekly commentaries indicate that I have been warning about the peril of unbridled speculation and its impact upon the quantitative statistics that I use as the basis of my market allocation processes. What had only previously been a possibility became reality as investors stampeded for the exists on Tuesday, only to return with a “big-toe” curiosity on Wednesday.

But this decline wasn’t a one-off occurrence. As early as January, the economic statistics failed to keep pace with market performance essentially paving the way for a decoupling of fact and expectation. Indeed, the damage wasn’t local, but global, as well. The huge recent allocations of speculative money into the world’s bourses was exacerbated by low interest rates and a lack of any competitive alternatives to equities.

The higher the markets went, the more cash came in, particularly from fringe speculators who felt passed-by if they weren’t “in it”.

Fueling the delirium (both on the way up and on the way out) was an absence of liquidity in equities caused by share buy-backs and merger activity depleting the percentage float in the markets. Some might argue, and have, that liquidity is higher today than ever owing to lower interest rates. I would posit that while there may, indeed, be more cash, it is nevertheless chasing after fewer shares, causing the stampede effect we witnessed last week.

The Fed has the power and the responsibility to inhibit such negative characteristics, but chooses to remain a marginal player in assuming any real responsibility for regulating money supply and the incumbent speculation which accompanies the current situation. In fact, if the Fed has any culpability in this matter, it is the excessively low “relative” rate of interest which fueled equity speculation in the first place.

Instead, when a panic ensues, investors have no safety net and little guidance. Unless, or course, you are a student of my methodologies. While the market wiped out its annual gain, moving to negative territory for the first time this year, our clients maintained both absolute and relative positive outperformance, year-to-date.

While it is true that certain geopolitical and/or exogenous events exert leverage over the sequence of events in the financial markets, it is unfair to ascribe any one of these as the catalyst to last week’s tumultuousness. Taken in sum, influences such as commodities inflation, global terror, an aging demographic, failed fiscal policy, industrial and technological revolution, etc. take their turn as centers of influence. I have been writing about these factors for decades and rare it is when one of these events “causes” the financial markets to respond intraday. As I recently wrote, trends take decades to develop, not hours. A legitimate portfolio strategist focuses upon the secular, enduring trends, and does not become fixated upon television-driven mania or hyped-up business news programming.

However, it does bear repeating that my data strongly indicates the reemergence of inflation pressure upon global business. Combined with relatively lower interest rates, the two factors coalesce to create a speculative mania typified, for example, by real estate speculation, mergers and acquisitions, buying stocks “on margin”, and Federal budget deficits. The unraveling of the market last week was a linear response downwards to a near-linear, excessively speculative market trend upwards. It matters not what the trigger, or how the morning news characterized the aftermath. The trends are in place to continue this pattern of speculation/regression. The leverage and borrowing issue is within that hierarchy of fundamentals to which I alluded in the previous paragraph.

The big question in the wake of Tuesday’s collapse is the measure of vulnerability (quantified) of the markets and the psychological impact it might create. It now becomes a chicken-or-egg conundrum. Can the market pull sentiment up with it, or does sentiment drag the market? Obviously, this is not an either/or scenario but, rather a matter of degree.

My advice is to pare exposure to non-accelerating earnings equities. They have shown an inability to keep pace with cost pressure or profitability. Return, instead to prudent asset allocation strategies that mitigate the influence of daily volatility and add resiliency to portfolio return.