Market Commentary for the week of July 30, 2007

Well, that was quite a ride the markets took last week. As the swings become more pronounced, and the volatility more staccato, investor’s fear and paralysis becomes more overt.

As I have written, the credit crunch is decimating more portfolios than previously thought, while stocks continue to meander then tumble. It’s not out of control, yet, but it does inflict pain in greater and greater numbers than earlier in the year. Arguing against hypothesis or theory, the unraveling of leveraged securities’ transactions leaves little satisfaction in its wake.

I have also previously stated that earnings are specious, seemingly supported by anecdote or hyperbole. Certainly there is less discretionary demand built into the economy, and now it appears that capital expenditures are being monitored quite closely. Some worry about cash flow altogether, in a market devoid of incentive-style lending rates.

The pain is not restricted to the United States, either. Across nearly every industrialized global bourse, the leverage is unwinding.

The problem, as I see it, is that investors are trying to be too perfect. They tend to measure their performance, and satisfaction, against an artificial legend, such as the Dow, or S&P. By comparing themselves to these standards their emotions, rise and fall like the barometer itself. Their pension assets, IRA accounts, personal portfolios and mutual funds are “tied” to these indices, so, therefore, is their security and emotional well-being.

In fact, those indices are not a measure of perfection, but rather marketing. Investing is not, nor should be, anything but the gamble and selection upon trends that endure as opportunities to make money from global (secular) phenomenon. We should hail the scientists and strategic thinkers of our era, the political statesman, the capitalists and industrialists who put social and societal development ahead of personal gain. Don’t you hate it when executives “cash out” with a golden parachute?

The concept of investing “perfectly” ruins many opportunities for diversification because too often we focus upon hot trends and overweight the odds. By losing sight of the meaning of investing, one places at risk the very security and safety he wished to achieve. The dot.com phenomenon was the last/best test of this theory. Greed is good, diversification is better.

Investing is better if unimpeded by emotion or fantasy. However hard it might be to divorce subjective review from the process, it is necessary, nonetheless.

The rally of April (2007) is fast unwinding. Nothing goes straight up. But all is not lost amidst the chaos.

If indeed the task is to find and isolate secular pockets of upside momentum, then it is important to step back and widen the aperture of analysis.

We need fuel to power-up industrial development. We need a healthy populace to come to work every day. We need institutions which perpetuate morality and responsibility. We need businesses that provide service, satisfaction, and comfort to its’ end-users. We need natural resources and food to sustain the people, and we need technological and brick-and-mortar infrastructure to provide for the execution of society’s mission.

As an economic scientist, the key for me is to develop a top-down landscape that supports my investment hypotheses. The data must support that theory, and the results must prove it to be compatible with the climate in which it operates. Based upon current assessment, the margins are shrinking and the road of accelerating probabilities is narrowing.

I would be cautious about which sectors I add to my accounts, and very careful to underweight the laggard stocks that, thus far, have contributed very little to total performance.

Market Commentary for the week of July 23, 2007

It’s probably a safe bet that last week’s hiccup, following an all-time high close, will be repeated several more times. Typically, nothing goes straight up with the velocity the Dow Jones has showed without taking time to digest, look around, and backslide just a little.

In fact, the most recent Dow rally (begun in 2006) has been on a near linear collision course with upside resistance values since April of this year.

Too much, too soon.

All the while, valuations, which traditionally traverse a parabolic cycle, have been expanding well beyond “nominal valuation” levels, and doing so more on hype than science.

Traditional U.S. and global brand names have shown remarkable staying power in the face of shrinking profit margins. This year, for example, is targeted to be the slowest earnings growth accelerator quotient than any in the last decade. Even though the mean integer is still in the plus-side, its rate of annual returns is diminishing.

Why? Because discretionary capital is eroding and being eroded further by the stealth tax imposed upon it by rising core costs, particularly energy costs. There is nowhere to hide from these rising prices, either. Emerging markets are exposed to the fastest price-hike accelerator, while the “mature” markets simply try to divert the pain by passing along their inflation costs to their end user. To that extent, it is nearly impossible to build sales or profit margins and to be responsible for share valuations at the same time.

Traders simply bid-up the value of stocks, ignoring the eroding fundamentals of many underlying securities. As wonderful as it is to reach record new highs, it is highly suspicious when correlated to the facts.

I would characterize the recent new high rally as an attempt by the tail to wag the body of the dog.

Corporations (and market valuations) have little room to maneuver right now.

Smoke and mirrors.

Excess liquidity is being used to buy back shares, giving the appearance of stability and growth. In the past two years nearly 60% of S&P companies have taken “float” out of the marketplace by buying their shares in the open market. A review of my data shows that earnings revisions are moderating downward in a majority of sectors that I follow. I have a great deal of difficulty identifying groups in which core inflation and cost pressures do not negatively impact upon margin acceleration coefficients.

Many of the data one reads in the news lag the actual statistics. The digestion of wages, benefits, commodity costs, barriers of entry, currency exchange rates and gross sales figures are not reflected in real-time data, but they are going to have an effect down the road.

It is this transition that I believe will sideswipe the current rally in equities.

Look overseas.

However, it looks as if a new prototype might be developing. Given that Arlington Econometrics uses earnings acceleration patterns as indication of sector rotation, a new leadership is in the offing. Growth can be found in global interconnectedness, ranging from telecom to computer periphery. It is finally time for the “Tech-heads” to emerge from their bunkers.

The potential growth rate in earnings per share (EPS) within the developing nations is staggering compared with the anemic former dominance of the more mature world bourses. Regional dominance is shifting and creating a potential new home-base of fast growing equities in commodities-related countries.

While brick and mortar companies will remain the mainstay of investor interest, I see a new wealth-building opportunity in energy exploration sciences, biotech, telecommunications, technology, and nascent product development and marketing in the emerging and small cap markets, such as South America and the Southern Asian Rim.

You can’t ride one pony to exhaustion without stopping to change horses. I’ve got a fresh saddle ready, just in case.

Arlington Econometrics 3rd Quarter Commentary

Last Call

Without equivocation, equity market risk is rising, while equity market acceleration is slowing. The domino effect that inflation and core costs are inflicting upon stocks is shaking any equilibrium that might have been achieved in the previous two years. At mid-year, enthusiasm for owning stocks is waning, as focus shifts to anemic economic statistics.

Amongst the risks that my work quantifies as most potentially damaging to stocks and the economy is the tremendous leverage built into stock and bond valuations from “borrowed” money. Someone owes on this debt, and the markers must be called at some point.

Despite a mid-Spring surge, the market is bound by an upside resistance which bends but can’t be broken. While concerns about falling profits permeate the data, most analysts are focusing instead upon declining top-line revenue. Most of the evidence shows that discretionary spending is slowing. Demand simply is not the engine of stimulus it once was.

Instead, the global markets are held hostage by exogenous influences, like oil costs and terrorism. Too large a percentage of the world’s supply of fossil fuels rests in regions of instability. The cost of replenishing those resources is more often paid for in blood than in currency. The prospects for economic revitalization lies in a more cost-efficient delivery and source of energy.

Unfortunately, these global imbalances are tilting towards inertia. Growth, demand, peace, and profits are all debilitated by a lack of focus and/or consensus about solving core rate inflation in energy and other commodities. Instead, the tail is wagging the dog. “Back-end” commodities sectors are leading portfolio valuation increases, rather than the other way around. Rather than the consumer driving the economy, the cost of goods produced sometimes determines whether or not they are necessarily affordable.

Ultimately, the demand for fuel will put unreasonable upward pressure on interest rates. To that extent, equity market expansion will depend upon the duration and magnitude of regional risk, sector rotation, and available capital. Already, the U.S. dollar decline has created an enormous expansion in our trade gap. There is currently no greater global demand to offset this imbalance, which means the deficit will continue to expand. Realistically, unabated Federal spending for war should project to an even larger multiplication of debt levels within this country.

(Interestingly, my earliest projections about inflation led me to overweight the “tangible” commodities sectors as far back as 1999. During that period, and since, both the markets and my portfolios greatest increases have occurred in Energy, Basic Materials, Agriculture, and Industrials. This historical time-frame coincides with the dot.com fiasco during which hyperbole, not earnings, drove equities up and, calamitously, down. Fortunately for my readers, we did not succumb to any breach in our discipline.)

Overview

Today, my models are indicating some trouble spots ahead. Despite anecdotal statistics to the contrary, my work shows a slowdown in jobs growth along with a commensurate shrinking in savings and wage rates. This represents the seed capital for the next wave of economic demand, and indications are not good that those monies will be plentiful.

Price increases in technology, medicines, energy (fuel), and utilities might drive those costs to unattainable levels or, at best, shift the emphasis from bother to burden. Were this to occur, pockets of earnings patterns would shift dramatically and impact equity market performance and expectations. Certainly, fighting these price trends is counter-productive. The most successful strategy today is to work diligently at finding earnings acceleration patterns that are socially responsible and economically sustainable.

The goal, then, is to isolate those global pockets of earnings acceleration and to invest in them moderately and wisely. While my wish would be for those patterns to emanate from high consumer demand, such is not the case. Instead, most earnings acceleration rates derive from pricing power and a hope that demand will be sufficient to sustain price increases. Currently, the sectors which most typify that pattern are Technology, Biotech and Life Sciences, Utilities (particularly water companies) and, of course, Energy. In other words, the expansion potential in those sectors outweighs the relative potential of any others.

Markets

Although the second quarter surge in equity valuations was most welcome, it did not set in motion any significant relative strength (RSI) sustainability. The market’s fundamentals are no less poor than when the quarter began, but continue to look weak. Driven by low cost money, the second quarter was a story of “last best chances”. We are forced to accept that someone must pay for the unwinding of leverage, which, in turn, might mean tight money and higher interest rates in the foreseeable future.

Since my discipline is predicated upon earnings expansion patterns, these issues force a serious rebalancing away from bonds. While I believe that equities will finish the year in “positive territory”, I am nevertheless concerned that the process is tightening up and leaving less room for error than in other years. Remember when your cousin had the greatest stock tips? Those days are far behind us.

It also appears as if the breadth of potential gains might shallow. As investors sell gains, perhaps to pay off margin, fewer dollars might return to the market. The “drying-up” of the capital pool could trigger a reverse psychology that makes the game altogether too risky except for those with sufficient means to afford the gamble or the volatility. In either case, my work shows less pent-up demand for stocks today than at anytime since the last bull cycle began in 2006.

There are, however, themes which can trigger a stampede into equities. Strong fundamentals exist in global interconnectedness, such as computer periphery or telecommunications. Alternative energy sourcing is in its infancy, not unlike the pre-IPO days of dot.com stocks.

Conclusion

It doesn’t matter if one wishes to be contrarian, and fight the tape. Those stocks are down for a reason, and no amount of wishing will change their fundamental circumstance. The ideal scenario would be to underweight one’s negative potential and to overweight the RSI themes which currently resonate. I fear that many dismiss the significance of positive cyclical trends by claiming that those uptrends have too much risk. If this were so, why would they be rising in the first place, while laggards continue to lag?

For the past five years, the market has done a good job building out from a disastrous capitulation in Tech stocks. The bull cycle is not yet completed. But neither is it new and “shiny”. The winning edge is getting more tarnished. Upside momentum is still winning, but losing steam.

I believe the next cycle could be an interruption to upside momentum, although not debilitating to it.

I expect that corporate, as well as personal, capital expenditures will narrow, giving investors a chance to stand on the sidelines and digest realized and unrealized gains/losses. As with all market cycles, they go neither straight up nor straight down, usually. Given the rotation into “back-end” cyclicals, currently, I do not see any change in the condition of consumer stocks or industrials.

The market responds to objective data and psychology. Unfortunately, neither is providing the leadership necessary to keep the party going. I am afraid that both the gambler and the bank are “tapped out”.

It is rare to wish one’s life away, but I am more eager to see October than July. Overall, the third quarter looks to be “steadily neutral” until it can be punctuated later by cash reserves and a dose of fundamental optimism.

Asset Allocation:

Equity 50%/Fixed Income 25%/Cash 25%

Market Commentary for the week of July 9, 2007

Let’s try not to ascribe too great a significance to the market’s current rally since April. However, for all the right reasons, everyone loves an uptick and portfolio valuation increases. Bear in mind, though, that markets are cyclical, not linear, and nothing goes straight up without pause or capitulation.

The danger this time is not in the rise itself, but in the underlying fundamentals and justifications that are given for its occurrence.

To start, too much of these rallies are paid for with borrowed funds. And as we all know, but conveniently tend to forget, borrowed money needs to be paid back at some point. By avoiding any thought about payback, and hoping instead for the “big score”, individual investors and hedge funds, alike, are playing fast and loose with incontrovertible truths, and ruining the market in the process.

Secondly, if earnings are the lifeblood of economics, then there are too few success stories to support the kind of massive rotation of all stocks into a never-ending upswing. In truth, only two sectors (Technology and Consumer Non Cyclicals) have shown any kind of near-term staying power.

To be sure, the moves in Energy and Basic Materials can be justified on a secular (generational) basis. These two sectors have/have had the highest product demand and the greatest pricing power, which drives bottom-line profit margins. But even the strongest of secular trends experiences intermediate topping, and that is the case for commodities currently.

Just behind their exhaustion follows the always volatile Industrials, which has been in a short cycle advance for the past 3 months, but with little acceleration in earnings advances.

The least attractive, and worst performing sectors are the Cyclicals and Financials, for obvious reasons. The consumer is simply not in a position to boost discretionary spending, and those who are lending investment capital have the most to lose if demand does not pick up, as has happened to the once-burgeoning real estate market.

One might think from this diatribe that I don’t favor stocks, currently. I respond by saying that the subtlety of the message is more complex than that.

Stocks will do better than bonds because rising rates hurt bonds more than all sectors in the equity market. As I wrote last week, tumbling bond prices are certainly enough of a disincentive not to buy bonds. Although my work does indicate a rough road ahead for stocks (because of declining earnings acceleration patterns) there always is the opportunity to be properly “sector-allocated” and “sector weighted”.

Unfortunately the yield projections in my analysis do not lend the same type of buoyancy to the bond market. I predict more defaults on outstanding long term debt, and more portfolio devaluation in the face of rising interest rates.

The same macro fundamentals that drive the economy have negative influences upon categories of financial instruments. Many global banks and most consumer pocketbooks are two of those potential casualties of the current climate in world finance.

Couple the “cost of money” with the “cost of goods” (inflation) and you have a potential shift in economic momentum.

All is not doom and gloom. I see investment opportunity in the emerging markets, which require telecommunications and brick-and-mortar development, alternative fuel sources, bio-pharmaceuticals and healthcare, as well as computer periphery and software.

The question to ponder today is “where are we on the social and economic paradigm” and in which phase is the momentum moving?

Market Commentary for the week of July 2, 2007

The next twelve months, until the middle of next year, should be critical in defining the key inflection points which, thus far, are nascent trends for equities and bonds. From the makeup of this quarter’s equity recommended list, the coming three months should say a lot about the asset allocation and sector breakdowns of our investment portfolios.

More specifically, the secular rise in inflation and interest rates is making me sour on the bond market. Not only is the current crop of new issues uninspiring, but rising rates are diminishing portfolio valuations amongst existing holdings. Irrespective of the higher coupons I might own, I am not keen on having a falling segment in my portfolios.

The bond market is in such disrepair, in fact, that tumbling prices also affect credit rating and future promises to pay. This phenomenon is not restricted to US companies, alone. Shrinking profit margins, caused by inflation and higher borrowing costs, are reducing credit structure, globally, and negatively impacting upon what once was a vibrant trading market in fixed income securities.

I can envision that through attrition, redemptions, and early sales to avoid declining market value, that my portfolios might fall as low as ten percent allocation in fixed income, not including cash, within the next twelve months.

The problem is structural, and negatively gestating throughout many segments of the marketplace, most notably housing (real estate), financial companies, and industrial equities.

However those same secular trends which adversely affect bonds are brightening the possibilities for equities. Although margins are squeezed, pricing power is the corporate equivalent of usury. Whomever controls the commodity, controls the ability to price it in the open market.

Consider that milk now costs more per gallon than gasoline. This price trend is permeating throughout all agricultural sectors, making food the “next dot.com sector” for investor’s consideration.

By the way, my regular readers know that nearly two years ago I had previously highlighted this trend in agriculture!!

The case for equities is further bolstered by the “alternative investment scenario”. Although higher, and stable, bond yields might ultimately be the goal for investors who wish to “lock in” high coupons, this particular phase in the bond market, during which yields redirect, in either direction, is a dangerous inflection point.

The macro trends in my work clearly indicate a redirection upwards in interest rates and inflation. As stated, this is manifest in declining bond prices, and also in sector and secular rotation of earnings acceleration patterns in equities.

Additionally, the dollar’s decline means that higher yields must happen in order to attract buyers to the bond market. When the US economy stagnates the direction of money flow is out, not in. Therefore companies that benefit the most from economic inertia are the multinational conglomerates that report earnings from all global quarters, and whose product demand is stable and enduring. Indeed, that is where I am seeing the greatest shift in focus and buying patterns

At some point, and in the not too distant future, the markets must start to unwind the monstrous amounts of debt and leverage that it has accumulated. The level of avarice and greed that built the foundation of the current economic bull cycle has exacerbated the inherent risk in owning financial instruments.

The recent hedge-fund debacle, (which fell subsequent to the 1990’s dot.com debacle, and the most recent real estate bubble, etc.) is no joke. These events are the result of borrowing and lending gone awry, and a symptom of fad investing at its worst.