Market Commentary for the week of April 28, 2008

It’s all in the name.

There have been several monikers used to describe the current state of economic malaise, the most common of which is “credit crisis”. Others have referred to a “housing” or “sub-prime mortgage” crisis. And some refer to a “liquidity” crisis.

Add to the list “commodities inflation” crisis or more specifically “agricultural harvest” crisis, as current events focus the spotlight on crop shortages and world hunger. As I identified last week, I began writing about the potential for these phenomena over five years ago in a quarterly missive entitled “Below the Fertile Fields” in which I posited the scenario of commodities (including food) inflation, while the discussion then was still on rescuing the ill-fated dot.com debacle.

After an invisible period of transition, we now see the outcome of those early phases during which low interest rates and rampant consumerism sowed the seeds of gluttony and greed for tangible assets (housing, energy, agriculture, basic materials). All of this taking place right under the noses of our “New Paradigm” techie brethren who single-mindedly took their eye off the macro-picture to focus instead on gimmicks, wizardry, and bottom-up methodology.

The equity markets have made a full transition in the last half-decade. While tech stocks have “matured” into a more traditional P and L evaluation, surging inflation has nearly eradicated the productivity boom and surplus of the last decade.

Current forecasts indicate that equity expansion might be below historical levels and shaky into the foreseeable future.

It’s all in the earnings.

However, as with all measurable data, there are leaders and laggards within any market cycle, irrespective of its direction and magnitude. Today those leaders are in equities (sectors) with pricing-power and the ability either to match production with demand, or to raise prices in the face of falling unit volume growth, and to do so responsibly and morally.

While Fed policy has made a mockery out of the dollar, the falling U.S. currency is offset by our ability to deliver cheaper exports to the rest of the world. This built-in buffer is an unintended benefit to the U.S. economy and serves as a buttress to mitigate the cost of falling domestic activity.

In fact, productivity and profit have rekindled a spark in agriculture companies and created a new leading market sector in U.S. equities.

Global spending on agriculture is relatively constant, showing a resilience that most industries would envy. Retail, wholesale, and international spending on food offers a long term buffer versus other sectors whose profitability is more cyclical and higher in volatility. It is important to see all quantifiable data as macro and global in order to reduce the effect of politics, currency, or cycle.

That same macro-resilience is still present in energy stocks. Exploration, development, and alternative sourcing are windows into the kind of capital gains boomlet that our dot.com friends thought might develop from their sector.

Despite recent cyclical strength in these sectors, I believe there is more to go as long as the secular trends remain intact.

Market Commentary for the week of April 21, 2008

Because of a run-up in energy and food prices, we are experiencing a rate of inflation not seen in the last two decades. Of course, statisticians like to talk about inflation without including these staples, but that seems foolish when faced with the realities of reconciling a balance sheet, or managing home finances. The rise in prices is causing a hoarding of natural resources, and a land grab worthy of the gold rush in the late 1890’s.

The battle between the “haves and the have-nots” is taking on epic proportion, favoring those who own the commodities versus those who consume them. As I have written many times before, agriculture and energy are the most significant components of economic development during the first half of this century.

Within this landscape, the opportunities for capital gains are actually magnifying the significance of global integrated commerce. We know, for example, about the rise of consumerism in China, the Middle East and Latin America. Political instability and the lack of true Western-style democracy dissuade venture capitalists from plowing money into these regions with abandon, or without iron-clad guarantees that their money will be safe. As always, if the payoff outweighs the potential risk, money flows into a vacuum of opportunity. Sometimes it’s all in the presentation.

At first blush, the potential for further development of natural resources tips the balance in favor of those regions with a plentiful bounty of product above and below ground. One might wonder why these wellsprings of opportunity haven’t already been mined. The answer usually lies either in political will or lack of resources. As one of the “youngest” democracies in the modern world, America has shown the fortitude to reward capitalist enterprise in areas of natural resource exploration. The rest of the world is now taking heed of its own potential for doing business ethically and profitably.

My data is indicating that these diverse global regions are catching on in developing regulatory guidelines that create an even playing field for the rest of the world to acknowledge the capitalist potential which abound. By cultivating an ethic of commerce and profit, countries can maintain their individuality but compete in a world of economic synergy.

In particular, the US market has been showing signs of maturity and slowing down. Investors are recognizing the allocation potential of the rest of the world. Our portfolios, for example, have increased asset allocation into non-domestic securities each year during the past three years.

It goes without saying that the best place to look for opportunity is in those companies with the highest rate of capital gains and earnings increases. Despite any question about political stability in these unexplored territories, our proof has been demonstrated in the meteoric rise of commodity and agriculture equities. Thus, I actually find the landscape of potential new investments to be rising, not falling, despite the lack of psychological exuberance about stocks.

I find this to be an especially creative time to be using my data analysis techniques. More and more we are demonstrating that the ability to navigate through difficult markets is a methodological conundrum, not an anecdotal exercise in speculation.

Sometimes the predictable path is not so predictable. Performance is the ultimate barometer.

The object is not always to act upon what is visible, but to seek out a methodological continuity that performs under any duress.

Food and oil.

You won’t have to look far beyond the mortgage/credit crisis to find the next demand-driven economic problem areas. Market analysts and economic strategists have already begun to focus on agricultural and energy shortages as the next hotbed of activity. Indeed, I wrote a treatise about these topics in 1998 entitled “Below the Fertile Fields” in which I posited the potential for price hikes and pricing pressure within these sectors, as well as the ten year run-up in Energy stock’s prices and agricultural shares. Already, early within the trend, these equities are trading at historically high valuations.

In other commentary I have discussed at length my belief, drawn from my quantitative economic studies, that energy (in all its permutations) should be the “dot.com” sector of the next decade in this millennium. Companies whose names we do not know, as well as technologies not yet invented, will dot the landscape of capital gains opportunities for years to come. Only political wisdom and scientific ingenuity might limit the scope of a much needed global demand and solution for replenishable energy.

Only recently has our focus broadened to include agriculture as another high demand/short supply global problem, although its origins have been right in front of us for decades.

You’ll pay more.

Commodities prices have skyrocketed in the past decade meaning higher production costs at the “farm”, as well as higher retail prices at the store. Higher prices affect the average household budget by raising the cost of staples like bread, milk, eggs and poultry.

Government subsidies have contributed to shortages by reducing the incentive and payout for farmers and by encouraging dissolution of planting fields.

And yet, the decline in productive acreage is being replaced by alternative growing methods for different crops, altogether.

The American Farm Bureau reports that reduced planting might raise the price of global harvests by three times the amount paid in 2005. We just have to wait to see.

Steadily rising prices and occasional regional shortages are causing the worst inflation double-take in the last twenty years. While some go hungry, others have been forced to make conscious discretionary decisions to cut back. Record sticker-shock has me predicting that this sector is the next capital gains and investment opportunity.

I believe that agriculture is only superseded by energy as the most caustic socio-economic, macro-oriented, problem for the next decade. Many of these equities are in uptrends and struggling mightily to maintain valuation, even as the rest of the globe’s sectors are in decline. I would be a buyer of earnings-positive equities in that space.

Unintended valuations.

While these two sectors might take years to realize their potential, the rest of the market has been tempting the uninitiated to dabble “at the bottom”. The problem is this is not the bottom. My work indicates that recovery bounces within the prevailing bear-trend are intoxicating, but dangerous. The complexity of the problem is substantial. Global economies are interdependent and fragile. The demise of one region shakes the foundation of others. I have expressed that I wish that there had been better governance over these issues, but the horses have already left the barn. Any unwillingness to remediate the problem at this point only delays the normal, cyclical, course of events. That would be a compound manifestation of incompetence.

We are not at the bottom of this retrenchment, nor have we completed the cycle phase of recovery from the financial crisis that, only two weeks ago, was the topic du jour.

Market Commentary for the week of April 7, 2008

Besides the pain or suffering caused by the financial markets, it is worth noting two other culprits in the “profit gap”. The most obvious is inflation and its wide swath of price hikes and recessive spending patterns it causes. I have been writing for nearly a decade about the erosive effects of pricing power upon the economy. To be sure, the most lasting net-effect of the bull market begun in 1982, and perpetuated with a vengeance since 2002, is the rising cost of goods, services, and commodities caused by an aggressive economic expansion and equities’ market generational bull phase.

According to statistics the rate of inflation is at its highest in more than 16 years, even when factoring in the regression in real estate prices.

The problem is so pervasive that it affects retail, wholesale, institutional and individual consumption, without prejudice.

At the risk of repeating my often-written refrain, rising costs influence raw materials, tuition, pharmaceuticals, energy consumption, industrial output, household food purchases, military spending, global trade, travel & leisure, etc., etc. It also plays a role in skewing the value of stocks either by restricting share price appreciation because of declining earnings, or by inflating prices because of artificial hyperbole associated with puffery and pricing power.

Which brings me to culprit number two in the saga of decimated financial markets, ethics.

Since the beginning of industrialized society, commerce and trade has been based upon the stability of the currency and the ethics and morals of the counterparties involved in a business transaction. My industry has imposed layers of rules and regulations, laws and governance, to provide for the security and safekeeping of the public trust in its financial institutions. The decades of confidence it takes to uphold these values and safeguards can be wrecked in a moment if only one party to the transaction acts deviously, mischievously or with malice. Too often, and too recently, we have experienced acts of untoward corporate and personal greed which shake the very foundation of this business compact.

An entire network of global commerce is dependent upon an adherence to strict codes of ethics, and a sense of fair play and morality.

I contend that the recent disruption in the financial markets is caused in part by a natural progression/regression lifecycle in financial instruments, but exacerbated by a breakdown in ethical conduct by institutions, themselves, during which they endeavored to inflate profits by manufacturing information, products, and revenue with blatant disregard for the public.

Is it possible that the actions of a few might tarnish the reputation of many who act responsibly to uphold those standards and practices? Might the after-effects of this breakdown in confidence change the dynamic, or postpone the timeline, of a natural cyclical order?

Though the entire system is not to blame, those who were charged with its oversight and execution certainly are, and should pay any price, and bear all the burden for its remediation.