Market Commentary for the week of September 24, 2007

The Fed, redux.

Prepare for a second, and probably more powerful, inflation upleg, now that the Fed has taken steps to lower lending rates. Although largely ignored, inflation during the current bull leg is gaining at greater than 3% per year and expected to grow at almost 4% this year, all inclusive. Of course, we all know anecdotally that some household and business costs are gaining at more than 15-20% per year (can you say “milk, bread, pharmaceuticals, and raw materials?”).

The Fed’s move last week might initiate a new round of financial speculation, but not necessarily in the industry which spawned the credit crisis in the first place, housing. My data already is exposing the beginning of stock and futures speculation in tangible assets such as gold and fuel oil. The engine that drives economic growth is fuel (energy) reserves. With global reserves being depleted at an alarming rate because of war, terror concerns, and Pan Asian economic development, the safe bet is to wager that energy prices might skyrocket in the future. Further, gold and other metals become a tangible hedge against inflation or equity devaluation in the financial markets.

Oil has already begun its climb towards $100-a-barrel. For the past week, fuel oil has closed at record levels over $80 and held firmly at that mark. Only five years ago, crude oil was priced in the spot market at $22 a barrel.

While some may disagree that inflation is the bogey, none can dispute that the data is troubling. Global reserves are stretched, and production is dropping. Weather conditions in the U.S. have stretched our refining and exploration capacity.

I wrote about this crisis nearly three years ago in my missive entitled “The Other Color of Money”, (1/1/05), in which I posited that oil black is the new green. To that extent it is shocking to see the Fed address a parochial issue with such global disdain.

Fiscal troubles, too.

The dollar is also going to take a hit by the Fed’s move. It certainly hasn’t gone unnoticed that the dollar doesn’t buy what it used to. Last week, too, the dollar hit its lowest level in eight years versus the Euro.

While this might affect the cost of the average tourist’s vacation to Paris, it has even deeper reverberations worldwide. Confidence in the U.S. monetarily, fiscally, and politically is evaporating. It is not good when those who might invest in Treasuries feel compelled to think twice about the value or merit of such an investment.

The impact of the inflation wave might not immediately be felt. All phenomena are cyclical, meaning that a sudden spike up could be met by a precipitous sell off, or profit taking. But there is no denying that the first cycle occurred, that a second cycle is initiating, or that the trend is in the “wrong” direction to avert an inflation threat.

I urge caution when digesting the monthly data announcements about prices, wages, productivity, GDP, etc. August numbers might be strong but lag, in real time, the effects of seasonal changes, current events, or long term expectations.

Real life response.

The key to prudent portfolio management are the secular trends. Despite the explosive response to the Fed’s announcement last week, the upswing in equities is exogenous noise and short cycle gain within, what has been, and intermediate contraction in equity valuations following a five year bull phase. Think of the gain as “letting off steam” from the severe compression of bad news within the credit markets.

Pockets of equity deceleration continue in discretionary Cyclicals, Financials (housing) and Industrials. If you must buy, wait until key entry points are indicated in Energy and Basic Materials following the fallout from last week’s explosive gains.

Fed Fund Rate Cut - Special Report September 19, 2007

*** SPECIAL NOTICE ***

The Fed made a bold, but poorly conceived, move yesterday by lowering its main benchmark interest rate by half-percentage point, and by inference, lowering borrowing costs throughout the economy.

Although the action was designed to forestall some of the adverse effects of the global/domestic credit crunch, it had just the opposite effect immediately as stocks surged over 300 points, the largest one-day gain in years.

This was the first time the Fed had lowered interest rates in more than four years. Indeed, we have a very soft economy right now, but the question is whether or not this move, or others to come, accurately enact the right solution for the “right” problem.

The Fed didn’t lower the price of tuition for schools. Indeed, it can’t.
The Fed didn’t lower the cost of a gallon of milk. Indeed, it can’t.
The Fed didn’t lower the cost of prescription drugs or healthcare services. Indeed, it can’t.
The Fed didn’t lower the cost of grains, metals, or other raw materials. Indeed it can’t.

No, the Fed chose to bail out the financial speculators who, by using easy money and “cheap” credit, gambled and lost in hedge funds, equities, and real estate. By the way, not all of the speculators were Wall Street sharks in pin-striped suits and ties. Many “average people” used come-on schemes and cheap money to buy things they couldn’t afford, and later defaulted as the leverage unwound.

In its strict about-face from fighting inflation and the real ravages of cost creep upon corporate profits, household finances, and the economy, the Fed used the wrong tool, sent the wrong message, and, based upon the upsurge in the stock market, achieved the wrong result.

Much more to come….

Market Commentary for the week of September 17, 2007

The markets closed out a mostly successful week, the best since April, on speculation that the Fed might lower interest rates this week in response to the disastrous credit crunch and its reverberations throughout the rest of the economy.

If the index is any barometer, that hopefulness might be misplaced.

Caution is the name of the game. I urge investors to pay heed to the difference between reflexive giddiness and secular trends. To lose that distinction is to be caught up in the emotion of day-to-day volatility.

The contradiction that last week’s activity highlights is to forget that the Fed, or the President, or the local cleaner, has impact upon turning, or magnifying, the direction of more enduring trends.

For example, an infusion of bail-out capital into the markets might quell, in the short run, fears about illiquidity or bankruptcy. But to turn around and use that capital for speculation or leveraged gain would defeat the purpose of those “rescue” funds. Further, since inflation and price acceleration are the problem, short term capital, without strings attached, becomes an enabler to the problem, not a solution. Might not higher interest rates diminish the appetite for speculation and price-push faster than ready cash?

Investors, after all, are inspired by greed. Any “infusions” must be designed to diminish speculation, not to provide it.

Last week’s events feed into our innate need to see markets go up. I, too, would rather buy than sell, own rather than be in cash.

Yet, the significance of a strong week is overshadowed by the downtrend that developed earlier this year. The statistics bear out the fact that the aging bull market, begun in 2002-2003, needs a rest and more likely might test its current support than to break-out above its current resistance.

Borne out by the fact that earnings acceleration patterns are diminishing, and by the defensive leadership of the market’s sectors, it will require more than hope or hype to reverse the current intermediate consolidation.

I wrote back in March of this year that the biggest threat to market performance was the unusually low interest rate environment that contributed to price speculation in real estate and equities (March 19^th 2007). As profit and earnings patterns dissipate due to rising inflation and price creep, the likelihood of a market surge diminishes, too.

Perhaps overwhelmed by the lack of safe haven, investors might feel better off “selling it all”. That, too, would be an inappropriate response. Despite the negativity, I still see pockets of acceleration.

Basic Materials (commodities), Energy, and Bio-Sciences are performing well, if not relatively better than most. It is important to find trends which resonate cyclically to their time. In the long term it is most important to find those equities whose probability of outperformance is relatively and absolutely better than most.

With options expiring at the end of this week, and the potential for a Fed disappointment, I do not believe this week will mirror the success of last week.

Market Commentary for the week of September 10, 2007

In the next few weeks we face a crucial juncture as all global markets consolidate against strategic support levels after this summer’s disastrous sell off. Holding support becomes of utmost importance if we wish to keep crisis from becoming a catastrophe.

The data still looks menacing, as sentiment, purchasing, capital expenditures, and manufacturing cool off. According to statistics, the pace of advance is at its lowest level in months.

And yet pockets of economic strength continue to do well. Mining, Energy, Agriculture and Biotech have each receded less than the market, or not at all.

The key to a market reversal (upwards) still lies with the consumer. As the collective IQ of the investing populace diminishes, volatility expands. Ravaged by daily trading ranges that defy gravity, investors one day run in, and the next day withdraw just as quickly. Hardly the stuff of long-term methodology, traders defy logic by following 24 hour fads.

Altogether, the sequential movement of stock prices is not difficult to understand. The markets ran up on speculation and leverage, and as the hype and leverage unwind the corresponding drop takes on magnitudinally disproportionate effect. Short-term trend movements obviously look more severe, graphically, than larger movements within the context of accumulation, price mark-up, and distribution over the long term.

As uneasiness builds, investors seek short term safe haven, which only confirms the success of long term patterns in Energy, Basic Materials, and Non Cyclicals.

As news from around the globe continues to frighten or disappoint, it heightens the potential for a distribution (not yet a bear) cycle to widen and expand. Revised data from early quarters (2007) already shows economic stagnation worse than previously reported.

I don’t believe that the sting from these data can get much worse, however. Compared with glorified expectations earlier in the year, it looks to me as if malaise and discontent with the market has hit home forcefully and enduringly. In much the same manner as the dot.com debacle, the unwinding of the global and domestic credit crunch hits with a one-two punch that stings, and takes all the fun out of owning stocks.

In response, cash, gold, oil and short-term time deposits replace real estate speculation, mergers and acquisitions, and IPO’s as the investment of choice. Using a conservative barometer as a benchmark, I would expect a period of uncertainty and fatigue to last a little bit longer. I will caution my clients that we are closer to the start of the downswing than to its conclusion. I urge the utmost discretion when trying to “buy” into a downside consolidation pattern, as upticks can be quite seductive.

On the other hand, I fear that interest rates are going to rise, as indicated by their secular long term direction from their lows in 2002-2003. As a result, I see continued price pressure and inflation patterns becoming part of the permanent landscape. It is very difficult to dispute the data and patterns of advancing inflation.

Unfortunately, the confluence of the sub-prime credit crunch and inflation will negatively influence real estate and housing prices in the short run, or until the damage can be assessed, before any bounceback in that sector.

Overshadowed by a cloud of uncertainty, the markets present more probability of downside risk and a trading range that keeps getting more challenging.

Market Commentary for the week of September 4, 2007

Raise your hand if you are waiting for the Federal Reserve to lower interest rates in order to diminish the impact, psychologically and fiscally, of the global credit crunch upon market bourses worldwide.

Now, go stand in a corner in the back of the room.

Look, the key to the entire market volatility predicament does not lie with the Fed or the regulators. It falls squarely at the feet of the speculators who, using borrowed money, rode up the ladder of capital gains and now are falling from their untenable perch. Just like the dot.com bunch that rode hyperbole and hope to the market summit, this crew took their greed into real estate speculation, stock-buying on margin, and hedge funds to accelerate a normal bull market cycle (2003) into something it wasn’t.

And like the group that preceded them, these ne’er-do-well investors might experience the same fate, with the same “what happened?” look on their face.

Without exaggerating the significance of these late-term aggressors, bear in mind that all markets are cyclical, all have ups and downs, and that this last bull phase was nearly five years old when the reversal began. Nothing goes straight up, and it surprises me that we can’t remember that. However, I will be the first to admit that the premise of quantitative market statistics and Arlington Econometrics is that events can be measured and phenomena have statistical and measurable probabilities of occurring and reoccurring.

In the aftermath of this decline we can look around and theorize, but now is the time to fall back on methodology and science.

Obviously, as “the market” weakens, certain sectors perform coincidentally to the market’s direction. I would avoid Consumer Cyclicals and Financials, as they are the primary negative beneficiaries of the current economic climate.

However, within the realm of counter intuition, I would overweight my portfolio today in cash, Utilities, and short-term fixed income securities, at least until we hit a measurable bottom in probability averages.

It is impossible to “sell everything” and sit on the sideline to ward off the negative influences of investing. Further, “market timing” is not what quantitative statistics is about. Rather, the goal of my theory is to calculate asset allocation strategies predicated upon probabilities of direction and magnitude of certain vectors, factors, and economic statistics.

I know, it all sounds so antiseptic. But would you rather measure your probabilities of performance, or guess based upon hope and hyperbole, as if walking in a dark room across to the kitchen?

Bear phases happen, and we must accept that. The current capitulation might destroy any forward progress made so far this year. That raises the old “why didn’t I just throw everything into Treasuries” argument. The answer, I believe is simple. At the beginning of the year (2007) your maximum expected return in treasuries was 2.5%. Today, that might seem attractive on a relative basis. Eight months ago you would have fired me for making such a suggestion.

The best one might do today is to weather the current predicament with solid asset allocation methodology and hands-on portfolio management practices, not something you will get in an impersonal mutual fund that “tracks” the direction of the market.

I am not always comfortable predicting downturns. They are never happy events. Buy my regular readers and clients know that by using my models we have already predicted these events well in advance of their occurrence and made the necessary rebalancing effort to mitigate the negative effects.

I am always looking to own rather than to sell. Our foresight will pay off when bottom junctures are indicated. If we can weather into the fourth quarter, most indications will be clearer regarding a plan of action for the next bull leg.