Market Commentary for the week of May 7, 2007

The banana peel.
I don’t know what others are seeing, but it makes me quite skeptical when I see the market averages explode upward because data indicates, as it did last week, that “productivity gains rose slightly, and per-worker costs remained within target ranges”. To me, that’s code which means that output per worker is rising without commensurate pay raises. It’s no wonder more jobs are being exported, or that unemployment stubbornly refuses to go down.

A typical scenario has a company piling on the debt, trying to use money at low cost, then telling its workers that it must lay people off (“downsize”) or raise sales prices to meet margin (profit) expectations. However, the data fails to support that theory, showing in fact that overall output is declining, not rising. In what looks more like recession era economics, the gross domestic product (GDP) has actually declined for two quarters. Adjusted for rising inflation in energy, the numbers have actually underperformed, looking more like 2005 than 2007.

Simply, consumers are running out of cash and out of steam. Automobile sales, discretionary household purchases, new home sales, magazine advertising, and retail stores all showed red ink in the last quarter. These declines are more than bumps, they are systemic.

Taking the long view.
The only industries that approximate cyclic growth are those which have high demand, limited supply, or pricing power. Look at the economic and equity performance of Energy, Telecom, Electric Utilities, Pharmaceuticals, and Basic Materials to realize that the sea-change from consumer spending to tangible assets/pricing pressure is built-in to our economy, and most of the globe, as well.

While quantitative oscillators might indicate temporary negative or positive impulses, the longer range cycle measures indicate that the “price-trend” continuum is a part of the fabric of the market’s landscape, in a way in which it hasn’t previously exerted such influence.

For the first time since the mid 1990’s the trend models are leaning towards the “back-end” of sector rotation. This means that analysts no longer look first at consumer spending patterns to determine future economic cycle direction. Rather, we now look at corporate borrowing, capital expenditures, wage data, employment, and price patterns as predictors of first resort. If the consumer market place spends, fine. So be it. But most businesses now look first at their costs, not your spending or demand habits.

Market sleight-of-hand.
In previous writings I have referred to the “Parallel Disconnect”. I define this phenomenon as the appearance of the market and the economy moving in lock-step synchronicity, when, in reality, their parallel appearance only masks a declining rate of acceleration in one, with an increasing rate of mania for the other. It doesn’t matter which is manic and which is accelerating. The de-coupling of their vectors makes it look synchronized and connected, but it is not actually so.

The slowdown in earnings, the rate of inflation, the depletion of savings and the intense borrowing for future gains is in direct opposition to a psychological equity hysteria that loves record highs and expanding price/earnings valuations. Somehow, leverage and debt keep finding their way into the economic psyche.

Couple that with the activity in mergers and acquisitions, and share buybacks, and you have more players for fewer equities….another recipe for price acceleration fervor.

I’m not mocking the market’s gains. I, and my clients, like gains. I want them to notice, however, that we’re making money with limited exposure to the hysteria. Current equity asset allocations are averaging less that 40%. I expect to remain prudently optimistic, but always cautious.