Market Commentary for the week of December 17, 2007

Even veteran Wall Street observers had to be scratching their heads in bemusement over the market’s strange twists and turns last week. The much anticipated Federal Reserve Board (FOMC) meeting produced a lot of fireworks but ultimately netted no change in the averages following a calamitous downdraft responded to by an ebullient upswing in two successive days following the Tuesday release.

Intraday fared no better, as stock averages surged out of the gate early in the day, retreated late, and closed flat at the closing bell.

If, at this point, you don’t need an aspirin for migraines or whipsaw, then you aren’t paying attention.

Don’t confuse the trees for the forest.

Despite the emotional responses to the Fed’s meager pronouncement, there continues to be troubling data which overhangs the probable performance of stocks, globally. Currency imbalances, poor credit, low consumer demand, diminishing earnings rates, and the threat of terrorism and war pale in comparison to rising energy costs, inflationary pressure upon raw commodities’ prices, and the aging of the globe’s infrastructure. To be sure, confidence is low and the appetite for stocks and speculation is waning, with the exception of day traders and professional profiteers who make their living off of the imbalances in valuation.

I should note that all market sectors in my universe of evaluation have either begun topping or are preparing for a reversal of existing short-term uptrends.

Before you read doom and gloom into the preceding five paragraphs let me add that cyclicality in markets/sectors is a normal thing. It represents a quantifiable build-up and breakdown in valuation that enables sectors to gain leadership over the long-term without exhausting any linear potential. Rather than using a “cherry-picking” approach to equity evaluation, I feel more comfortable relying upon leadership sectors to play out their long term secular processes, while still recognizing a natural cyclicality of capital gains/capital losses that evolves over shorter duration. Simply stated, “play the long themes; trade the short-term”.

Despite the nuance I describe above, last week’s news did little to quell concerns that the mortgage crisis in the U.S. and credit crunch globally would be sufficiently addressed. Indeed, in their own words, the Board members left open the possibility that fighting inflation (raising interest rates) is a more significant project in the future than releasing liquidity on a temporary basis.

Liquidity isn’t the problem, prices are the problem.

I think that inflation and its impact upon profit margins is the greatest threat to equity expansion, currently. But “inflation” is not simply cost creep. It is a morality play that relates to feeding the hungry, healing the sick, housing the needy, spreading the wealth, and maintaining a globe with clean and abundant natural resources for its citizenry.

With a load like that to worry about, it’s no wonder the markets can’t get out of their own way.

Market Commentary for the week of December 10, 2007

More of the same last week, as global markets get used to 1 and 2 percentage point up and down days in succession. Either it’s oil supplies, consumer spending, earnings disappointments, or credit disasters, but it always involves the same four “players”. Remember when product innovation and net sales moved markets?

Optimism vs. pessimism.

The current panic/mania revolves around the psychological knee-jerk responses to news and the failure to isolate fundamentals from perception. Although debt levels are high and savings are poor, the optimists search for reasons to drive equities higher. Similarly, although earnings still remain positive and recession is at arm’s length, the pessimists use any news as a reason to take profits or sell altogether.

This modern confluence of good and bad perceptions is eerily similar to the “he said, she said” of the dot.com era a decade ago. The old geezers, like me, said “no” to the “New Paradigmers” who claimed that “it was different this time”, while the young bucks bid up stocks with unabated, and nearly unintelligible, vitality.

Of course, since markets are cyclical, no one is ever entirely right or wrong. Every technology, every subtlety of change has its day in the sun. The key to the whole endeavor, however, is to quantify and to isolate the right time for those events to be occurring, and to be on the right side of the surge when it occurs.

Market history, and the redundancy of cycles, is the best model for understanding these strategies. Episodes occur with regularity. We know that. Once in awhile, when excesses occur, there is a juncture of greed and ego during which the advocates for both sides disagree, setting up a conflict between fundamentals and perception.

Typically, reactions become excessive, too. The Fed, for example, has abandoned its inflation-fighting bias for liquidity, thereby setting up a circuitous problem: more cash simply inflames the wound of depreciating portfolios, but spurs inflation in tangible assets. Instead of mediating the ego/greed conflict, the Fed has made it worse, and become an immediate part of the problem.

Nowhere to go but….(?)

The current liquidity versus inflation scenario is different this time because we start at such a lofty “baseline”, five years into a bull market for equities. Right or wrong, the markets simply can’t “afford” to go down much further. In addition, the artificial nature of the crisis, originating because of leveraged products and “synthetic” investments, undermines our ability to quantify the true value, fiscally, of the calamity. Subjectively, however, we know there is real pain to be endured.

My point is that this crisis is less about cyclicality and normalcy than it is about greed and excess. Globally, the complexity of manufactured financial products and services has failed to deliver to clients upon their expectations.

Market Commentary for the week of December 3, 2007

I am observing an almost mythical obsession with “$100 per barrel of oil”, as if the integer (100) itself holds sway over the outcome of many other events. And, indeed, while the achievement of such a milestone might have consequences of significant proportion, what seems lost is the journey to that milestone.

Like it or not, inflation.

Americans are paying nearly 87 cents more per gallon of gas at the pump this year than last, and the purchase price of fuel has doubled in the last three years. Unless your wages have increased at such an exponential rate, or your dentist, doctor, or restaurateur has lowered prices by thirty percent per year, you are falling behind.

Being held hostage to petroleum prices is not limited solely to transportation expenses. The cost of vinyl and other plastics found in computers, housewares, medical technology, and recreational equipment is tied to the price of finding, extracting, refining and delivering fossil fuels. In fact, the number of wage hours required to purchase consumer goods of all kind has increased in the last decade faster than wages themselves.

Consider that global savings rates are at their lowest level in a generation, and discretionary consumer spending (a measure of psychological and fiscal well-being) has decreased in each of the last three years.

Our “integer obsession” about $100 per barrel masks the bigger picture that the trend in energy prices (and costs in general) has been rising steadily since the late 1990’s and has triggered a price pressure/inflation-driven economic expansion. It’s no accident that real estate and other tangible assets have risen sympathetically during an era in which portfolio price expansion was at its greatest.

By widening the aperture of evaluation rather than focusing upon a magic number, it’s possible to understand that $93 is no better or worse than $96, except for the vector direction itself and the magnitude with which that trend is moving. That is why I recoil over business news analysis that a change of $1 in oil prices caused the markets to go up or down. In fact, it is the upward trend itself which is confronting this market, this economy, with an enormous obstacle from which to recover.

A growing number of companies are losing earnings momentum because they are unable to maintain profit margin in the face of increasing expenses. Still, others are recoiling from bad investments and write-offs related to the credit crunch worldwide. We know that declining portfolio balances affect capital expenditures in the boardroom and in the living room, without prejudice.

A shifting landscape.

There is such global malaise today, that psychology plays a greater role in portfolio performance than does fundamental analysis. Taking care of essentials is the first priority for today’s households, as well as the foundation for prudent corporate governance.

Overlaying these particular concerns (about energy and inflation), most of the markets’ sectors are responding uniformly negatively. Market indices have reached peaks and begun modest retracements. As I wrote last week, the most significant analysis going forward will be to determine if we can hold existing upside support levels, or whether the flood of bad news will cause the market, and the sectors within, to breach those support lines and reverse course towards a protracted bear phase.

There is no question that the markets were accelerating at an unsustainable pace. Low interest rates, and leveraged spending, caused a manic bubble whose progression made today’s inevitable fall more drastic. Whereas nominal fundamentals are indeed weakening, I see no cause for abandoning hope about global expansion and market rotation. But the fact that the excesses carried forth with such abandon previously is now the pill we are forced to swallow in response to that mania.

Ultimately, as my work has historically shown, cycles play out, both up and down. The time is now to recognize our fundamental difficulties and to prepare for the response that is most necessary and appropriate.