Market Commentary for the week of May 21, 2007

The parallel disconnect between negative economic data and positive equity market performance is setting up an uncomfortable scenario in which one of those two has to reverse direction in order to achieve parity. Obviously, negative jobs growth, wage stagnation, low savings rates, tepid capital expenditures, etc., cannot turn on a dime since these data are trends not phenomena. So it seems likely that with short-term relative strength numbers at high value the equity markets have a higher probability of reversing course than do the economic numbers. But simply to ignore the disparity is the most foolish course of all. There’s simply too much cash in stocks quantitatively to support a high probability upleg.

By denying these valuation discrepancies investors might impose a self fulfilling death wish upon their portfolios. Using one’s emotions as justification for portfolio modeling is just plain foolish. However, that seems to be the only dynamic at work right now.

As an earnings driven investor, I count fewer and fewer stocks that qualify for recommendation if one considers three year accrual patterns. But if you look at the activity within the market, the tide is raising (nearly) all ships in the harbor. Over time, there is nothing wrong with valuation acceleration. But within short cyclic outbursts, these levels are excessive.

Good news, or high expectations, are not viable, methodological, justifications for moving markets to record highs, in the face of declining economic statistics and high inflation in commodities and core costs. In fact, expectations are irrelevant statistically to the relative strength (RSI) data which refute the current short term trend.

When the “consensus” is that markets cannot go down, there is usually an implicit threat to stock ownership.

The obvious herd mentality is negative for long term equity patterns because linear trends unwind too quickly and do too much damage psychologically and financially.

The last time the markets were confronted with the parallel disconnect was just prior to the “tech-wreck” in 2000. In that case companies without earnings were being accorded exorbitant valuations because the emotion and justification of the New Paradigm in technological development was being hailed as the changing of the guard, “new this time”.

But cycles are parabolic, not linear. The spike in prices might have been justified over time, as some of today’s winners were born of that era, but not immediately nor so quickly. Without suitable gestation, no new industry can sustain lofty expectations or high prices. Emotion took over from methodology and investors paid the price.

Not my investors. We held firm to our earnings driven selection criteria and chose to avoid the mess entirely.

Today, the fantasy of valuation explosion and record highs flies in the face of market fundamentals and quantitative statistics.

On a price-to-sales level most companies are way overpriced. Capacity is nowhere near full. Instead, the “productivity” catch phrase is lauded as proof that companies can do more with less. Margins are being pumped at the expense of workers who are, in fact, these company’s consumers. As costs for materials rise look for these inflated valuations to come back to Earth.

The data is incontrovertible. Too few consumers are in a mindset to spend money they don’t have, eroded by taxes, declining real estate values, high margin expenses, rising costs of energy, and nonexistent savings.

The subtlety of my discipline is that it cannot predict deadlines or barriers, only quantify them. Therefore I am not trying to be negative about stock ownership, only realistic. With imposed criteria (such as earnings patterns, sector allocation, and relative strength ratios) it is possible to observe the lunacy without succumbing to it.