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%
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