Market Commentary for the week of August 27, 2007

Asian and other global benchmarks moved up modestly last week, in part because short-term valuations became extremely cheap and also because a macro assessment of the globe’s economies looks stronger than the individual credit crises which threaten them.

However, for a near-record consecutive months, output and profitability remain subdued.

The markets by my calculation are not about to slip into a long-term bear phase, but we are nevertheless well into a consolidation from the record high bull which just preceded. Going forward, it will be much more difficult to generate equity gains if interest rates, leverage, and liquidity keep moving in a restrictive direction.

Short-term disconnect.

What seems to be at play here is the divide between what some might perceive during a two week span, and what others can truly quantify over the long-term. Traders get excited easily, whereas the longer term looks less uncertain. Volatility, by itself, is not necessarily bad, but panic is certainly not an investment methodology, the last time I looked.

As an earnings driven investor, I follow the profit trail. As discretionary funds diminish, so too does the potential for traditional consumer-led equities or fundamental supply/demand economics. Instead, the models are supplanted by a tangible asset, price-driven alternative, with inflation as the driver. Hence, energy (not just fossil fuels), raw materials, agriculture and technology are leading today, and have been leading for several quarters.

The problem with earnings, though, is that there are both organic and exogenous reasons for success. In today’s market, liquidity is important in order to create demand. Tighter money, on the other hand, can stifle home-building, capital investment and Christmas toy sales.

But equally as punitive is the psychological landscape of global terror, joblessness, political inertia, and old age.

The factors that impact the psychological landscape depend less upon economic modeling and more upon confidence. Deficits matter. By all objective measures investors are less willing to finance someone else’s deficiencies without first addressing themselves.

One of my clients called me last week to state, in essence, that it doesn’t matter if we outperform the indices on a relative or absolute basis. It matters that she achieve a benchmark consistent with her risk/reward tolerances and her need for capital at retirement.

In other words, theory is fine when the markets are going up. Today, however, “I can’t afford to sacrifice any gains”.

Method trumps panic.

As I’ve said before, investing is risky and not anything like a bank statement. The key is to select prudent methodology and asset allocation modeling so as best to mitigate against the effects of volatility and inevitable changes in pulse and direction.

How ironic that the factors which move markets are so capricious.

Reflecting upon the rest of the year, I am confident that we will find an equilibrium within this consolidation. It might shallow-out the current, and unsustainable, rate of ascent we have previously experienced and come to expect, but I do not believe the secular trend will go negative.

Today, interest rates are trending higher and have not yet achieved the level toward which they are charging. Tighter money might have the potential to kill speculation, but also to build a more solid base for growth in the next intermediate upleg. Considering the difficulty speculation has created thus far, the contrast could be a good thing.

Market Commentary for the week of August 20, 2007

The reaction to U.S. market’s capitulation resonated last week throughout the globe as, among others, Asian and European markets fell to their lowest levels in months. Clearly, the reactions reflected both fundamental weakness surrounding what is now becoming a global credit crunch, as well as a psychological desire to “get out of the way” of a falling boulder.

Suddenly, everyone is tracking the performance of equities.

While the crisis cannot yet be characterized as a stampede, it does have the makings for a free-for-all if the news worsens and if the effect is to take down the innocent as well as the guilty.

From my data measurement, the most sinister component we need to watch-out for is persistent negativity. As I have written previously, I saw early on the menace of “profits” built upon specious data, such as layoffs, price increases and leveraged borrowing. I expected the damage which has thus far come.

But it is more difficult to quantify the impact of mass selling and reverberating effects of a herd mentality upon valuations, trend lines, and volatility. This entire affair is unfolding against a backdrop devoid of stock buyers, low savings rates, poor earnings, inflation, and priorities so skewed from center that domestic politics has become an “either/or” proposition.

As is the case with most bear cycles, the whole matter can sometimes be blown out of proportion. Pundits go on television to tell us about “fast money” but are unprepared, methodologically, to address the normal parabolic course of investing. Just like the last great psychological and valuation bear (1999-2002), talking heads go blank when trying to find reasons not to hype the market.

Even the names of investments seem to glamorize the upside tendencies of equities: “hedge funds”, “derivatives”, “mortgage-backed”. Incredibly, investors flocked to risky transactions without “reading the fine print”.

As with all cycles, they can be measured for intensity and duration. Fortunately, I do not believe the data supports a long bear cycle, but keep in mind that this bull leg has persisted for nearly 5 years without a serious interruption. Although the net gain for 2007 has been wiped-out, the real asset class deterioration has been minor. Those sectors that led the macro expansion are still leading. Those which lagged, continue to do so. I have avoided overweighting (or even neutral-weighting) the Financial and Consumer Cyclical sectors for over one year, with just cause based upon their fundamentals.

While spreads between buyers and sellers widen, the emotional gap between “feeling safe” and “feeling unsure” widens, as well. Private wealth management requires perspective and perseverance. Further, it requires a complete understanding of one’s life risk/reward tolerances, and an acknowledgement that asset allocation investing involves patience for cycles. Lastly, it absolutely requires an understanding of the methodology one employs to aggregate wealth to the next level. The most disastrous combination is to put an aggressive investor with a conservative client.

Two things are occurring which I believe are changing the dynamic of my quantitative statistics. First, fewer buyers are entering the market (while so, too, is an increase in selling pressure). Secondly, bonds are losing luster as a suitable investment alternative to stocks, particularly against the backdrop of inflation and higher interest rates.

These data, along with the scenario I previously addressed (diminishing margins, price pressure, labor “efficiencies”, declining relative strength acceleration (RSI), and “backend” sector rotation away from Consumer Cyclicals) portends a period (45-days-3 months) during which relative and absolute equity performance should be quite muted.

Finally, I urge all investors to step back, take a deep breath, and widen the aperture of their objectivity. No one called the TV networks to say the market was “too high” in July. Similarly, recognizing that peaks and valleys are part of the process, don’t jump ship during the pullbacks.

Invest in what works, from a macro-economic perspective. Then relax and go play golf. It’ll all be fine tomorrow.

Market Commentary for the week of August 13, 2007

Something’s obviously not quite right.

As the market weakens, it begins to expose the ugly underbelly of exactly how all those “new highs” were achieved. And despite the fact that smoke and mirrors work well enough, those rallies were executed with debt and leverage. The pullback has gotten everyone’s attention.

However, revealing the ugly secret of credit-driven-rallies is not altogether a bad thing. I have written extensively this year about the misallocation of priorities, and how phantom earnings are not really earnings, at all.

Let’s bring this to a human level.

The terrible bridge collapse tragedy in Minnesota, for example, is not only a human event. Its consequences resound loudly throughout politics, economics, and sociology. Why, for example, are there such deficiencies in our brick and mortar infrastructure? Resources are only part of the problem. Priorities are skewed when we have a generation of dot.com theorists who believe, nay worship, that the power of technology trumps the well being of social institutions or the values of social studies.

I believe the same type of decay and collapse is happening in medicine and other institutions, for example, but the warning signs are going unheeded.

Forgive the editorial, but…

My missives are certainly not political polemics, but it does strike me as odd when “technology” and “efficiency” are verbal surrogates for morality and civility. Billions of dollars that might be used for one purpose are substituted for another. Those decisions affect my ability to quantify investment opportunity and sector allocation. Frequently, because quantitative methodology is reactive to events not predictive, I must throw up my hands and go with “what’s there” on paper, rather than what should be there.

This matters because patterns are redundant. Free money caused this predicament and is part of the problem globally as well as within the U.S.

As the fantasy of leveraged growth unwinds, we will be forced to deal with the consequences of the massacre, and the decisions that follow about restructuring economic priorities. Ultimately, as the lenders dry up, so too will the hyperbole.

Methodology and discipline matter.

It is also important to realize that trends, no matter in which direction, take time to manifest. Who knew that a majority of investors might get burned again within one decade after the last bear folly? Sometimes, in the middle of a trend evolving we can’t see it. I hope that we aren’t chiding ourselves in the future for the same fantasy-chase that took down our expectations once before.

Politically, our institutions need to address the allocation of resources and tax strategies and incentives. In order to achieve successful economic modeling, we need good political science. One must first be a citizen of the globe, before making decisions about asset allocation, investing, greed, and the need for profits.

Living on the edge is fine, as long as we contain the risk to ourselves.

Market Commentary for the week of August 6, 2007

The short-term view.

Overall, market performance is disquieting. Depending upon one’s tolerance for risk, the past few weeks have been either an interruption or a disaster. The domino effect of global leverage unwinding is not a near-term, or short cycle, phenomenon, but, rather, likely to be a systemic characteristic for months to come. Judging by the economic statistics, capital expenditures are likely to remain close to the vest, while consumer’s demand (and their desire to dabble in stocks) is disappearing from the radar screen.

I have written profusely about the parallel disconnect between the markets (Wall Street) and the economy (Main Street). In spite of lower accelerating values, share prices had expanded to near unsustainable levels. New high, followed by another new high, and yet another, set up the reaction we are experiencing today. The numbers didn’t add up.

Despite working at the outer fringes of its technical barriers, the market, nonetheless, seemed convinced of its own public relations, that things were ok and we were in “bull-mode”.

But exogenous influences, such as a secular reversal in the yield curve and softer sales data, exerted a stronger pull downwards in stocks than did any upside influence supported by hyperbole.

Thus, the classical push/pull dynamic that all cyclic phenomena experience lost this round to the realities of uber-valuation and linear short term advances.

Intermediate factors.

Ultimately, the credit and leverage bubble built into financial assets will unwind and put severe pressure upon both Wall Street and Main Street.

Throw in the nascent seeds of inflation, and you are looking at a pretty severe set of obstacles to overcome.

GDP, globally and in the United States, is severely impeded by cost increases and higher interest rates. I expect the accelerant to slow down by year-end.

Interestingly, my models show no significant deceleration in those sectors that have led the market’s performance for the past three years, Energy and Basic Materials. Despite the leverage and valuation problems facing the market, neither of those sectors is adversely affected by inflation or low demand. Commodity price increases seem to be the one constant in the “back end” of the market.

For example, most of the global bourses that are direct beneficiaries of tangible asset demand (Canada, Russia, South Africa, etc.) are holding their own, currently. The globe needs these products, therefore those markets are prospering.

Longer-term factors.

The problem, though, is that many “mature” Western-ized markets are suffering from old-age and slowing production. Many of these markets (Japan, Germany, U.S., etc.) are punctuated by limited natural resources and low investor confidence. One can no longer assume that “brand names” will bail out a floundering portfolio.

Price-to-earnings (P/E) levels, globally, are contracting, not because earnings are accelerating, but because the numerator (price) is coming back and reversing its momentum. In light of diminishing earnings expectations, I expect the contraction to continue.

Investors saw a chance to lock-in profits earlier this year. Absent a sudden redirection in current data, I believe that portfolios have, at least, a few months of pain before any new opportunities materialize.