Arlington Econometrics 2nd Quarter Commentary

Crossfire


Although the market’s first quarter performance was nearly microscopic, broader and bigger themes materialized which overshadow the movement of stocks during just one quarter. Anecdotal and specific economic data confirm that the rate of acceleration in equity earnings patterns is dissipating, and that inflation is creating disorder within households and corporate boardrooms. It is becoming more likely that stock appreciation might be stopped by patterns of disinterest and fear.

The best that can be said about the first quarter is that no harm has been done if you own stocks. However, probabilities and potential are diminishing probably for the next several months.


Prices rise

To varying degrees, the influence of “price creep” upon corporate margins and household spending depends upon the industry or the level of discretionary decision making. Without a doubt, pharmaceutical/agricultural/energy price increases hurt the average consumer. Such a drain upon purchasing power transcends, therefore, into unit volume sales patterns and winds up hurting certain industries more than others. The depletion of capital worldwide for expenditure of energy is the most egregious of the trends which manifested during the last three months. The extent of these exogenous influences upon equity valuations is not going to go away. Export/import imbalances within energy, food, and consumer sectors is likely to render negative performance to earnings expectations and leave a psychological confidence gap in their wake.

In fact, the psychological legacy of the “news of the day” is becoming as important as the statistics and fundamentals proffered by professional analysts and pundits. The most significant price hikes upon consumers in areas like healthcare, energy, food, tuition, etc. resonate locally and globally, exacting a toll which I believe is in the equities pipeline but yet to be quantified. The enduring legacy of energy price increases, for example, is more significant than the dot.com mania of the late 1990’s.


Sectors are diverse

But anecdotal inflation is not restricted to energy prices. Agricultural development and processing is the next wave. The cost of producing a pound of food, worldwide, is rising faster than the cost of crude oil. Despite technological advances in planting and cultivating, the supply/demand curve is tipping perilously close to a danger zone. Like no other consumer-related product, food might represent the one commodity which influences humanity as much as the performance of stocks, bonds and portfolio performance.

And yet, in the face of these data, consumers ignore the warning signs. Household savings rates, globally, as a percentage of take-home pay are at historically low levels. Credit-driven spending is rising, bankruptcies are rising, and despair amongst the “have-nots” is rising.

My estimates of the impact of these data upon earnings forecasts is less than positive. Consumer spending is not without limits. The market’s first quarter meandering is an indication of fundamental and psychological discomfort. While the long-term prospect for stocks is “always” good, it is the tide of negative expectations which is preventing clarity from overcoming. The age of chasing anything indiscriminately is ending. Historically, equity performance depends upon unit volume growth and earnings expansion. But certain sea-changes are preventing most sectors from gaining traction.

A reduction in unit volume purchases is morphing into a self fulfilling prophecy and becoming a price-driven inflation trend. In spite of productivity gains derived from downsizing and outsourcing, multinational commerce is impacted more by a reduction in sales than by margin expansion from price maneuvers. Specific instances might refute this claim, but globally the trend is unmistakable. The sectors that show positive price performance in their stocks are emblematic of price pressure, and unit volume demand, like Energy, Basic Materials, Healthcare and Consumer Non-Cyclicals (food).


Markets

Although the subtlety of this argument might be lost on some, the market is an efficient barometer. Beset by knee-jerk responses to daily news events, the equity markets nevertheless react to long term trends. I urge caution in delineating the differences between bottom-fishing for good value and owning patterns which are orderly and quantifiable. Investors who deny the probability of trends, refute the possibility of longer term rewards.

The most effective way to quantify those probabilities is to separate patterns of price performance into leading, lagging, or coincidental geography. Recognizing that the market is cyclical, not unified, allows this analyst to create a probability scale which places patterns on earnings and price performance into an asset allocation model. Indeed, the nuance of price patterns is the heart of the matter. The characteristics which separate one energy stock from another, and one energy stock from other sector’s performance is the essence of Arlington Econometrics’ methodology.

Since earnings acceleration is the truest barometer of future performance, the measurement of a company’s fundamentals is part of the top-down science I bring to sector location and equity selection. No matter what stocks one might own, there is a measurement and locus of its current position and probability of future performance relative to other stocks within its grouping.


Strategy

While I expect only modest performance from equities during the next quarter, I see the make-up of price gains changing significantly. When measured by global demand scales, the markets will start to abandon cyclical companies in favor of tangible assets. A tidal wave of new demand is not in the offing. Whereas low interest rates might have spurred purchasing in the past, credit levels today are nearly exhausted and unsustainable. The incalculable effect of the cost of money upon capital expenditures is the next shoe to drop.

The effect of global military and political turmoil is also weighing heavily upon the geopolitical agenda. While it is difficult to quantify the impact of these events upon the financial markets, there is a noticeable inertia that sets in during periods of psychological uncertainty.

I believe the time to make up ground in stocks will be later in the year. Upon reflection, the markets might have time to sort out the influence of inflation and “price creep” upon spending patterns. Similarly, the global interconnectedness of regions, one to the other, will play out in a carefully crafted ballet between demand and politics. Worldwide, margins will be squeezed more tightly by cost pressure. The likelihood of earnings acceleration is dim. As if wishing might make it so, investors seem hopeful that we can resume forward momentum in stock prices. But methodologically I foresee a necessary stagnation in equity performance in order to buy time necessary to recalibrate the impact of inflationary trends upon sectors and leading stocks. Just as the catalysts for negative performance late in the 1990’s were set in motion before the bear market fall, so too must the germination of positive influences be taken into account before a bull market phase reemerges.

I remain suspicious of overnight trends or news-driven capital gains. I choose to focus upon the nature of long term cause and effect. If we can be patient through the next quarter, I could foresee a strong close to the year.

In review, the quarter’s most significant themes are:

· Expect a slowdown in earnings expansion/acceleration patterns.
· Reduced margins owing to inflation and price creep stagnate equity performance.
· Psychological influences are as significant as fundamental data.
· Sector rebalancing means that tangible assets will outperform cyclicals.
· Bond yields must continue their rise to quell unabated discretionary spending.





Asset Allocation:
Equity 50%/Fixed Income 25%/Cash 25%