Arlington Econometrics Third Quarter Commentary

Not Just Yet

It’s normal to question one’s whereabouts when in uncharted territory or halfway between “here and there”. “Are we there yet?” isn’t only a refrain heard from young children from the back seat of the car.

The financial markets are shockingly unnerved by anxiety caused by inflation fears and capital losses. Monetary policy is increasingly less relevant, while consumer confidence diminishes in concert with housing values. There is no “safe” place to hide. Bond yields are anemic and cash totals are dwindling. The only trend I qualify as an uptrend is inflation.

In addition, despite losses during the first quarter, equities are categorically mispriced and out of sync with their prevailing fundamentals.

It’s no wonder the markets lost steam during the first half of this year.


Markets

While most of the blame for inflation has been placed on energy prices, parallel influences exist in agriculture (food), pharmaceuticals, transportation, and non-discretionary purchases. The only correlation between fuel costs and stock prices is that all these factors in sum influence profit margins negatively, and diminish earnings potential.

What has been most surprising is the muted response from legislators and monetarists who seem to have bungled the responsibility they have to level the playing field. Prior and current Federal Reserve chairmen have lowered interest rates so much so that they encouraged speculative bubbles with “cheap” money. Tax and incentive programs have unduly influenced spending to the point that savings are depleted and deficits are the norm. I expect deficits to follow us for at least the next half-decade. Underlying economic fundamentals become irrelevant in such a scenario. Price-push permeates all strata of research, adjusting all the numbers upwards. The net effect is that results will be muted and therefore so too should expectations.

The most recent data supports the notion that consumers are experiencing the sharpest effects of inflation. Relative price trends confirm a macro trend leading to a reduction in personal wealth. Likewise, demand is decreasing and negatively influencing capital expenditures, hiring, inventory, and profits in the corporate sector. On the margins, only a few businesses are able to sustain any long-term planning.

These data affect my portfolio strategies by forcing me to hold more cash, limit the scope of equity allocation, find “less-liquid” equities in which to invest, and to downsize my expectations for performance against negative benchmarks.

To be sure, the market has given back any early-season gains and finds itself down by more than ten percent year-to-date. By comparison, our portfolios show relative and absolute performance, finishing the first half with low single digit advances. It brings to mind that a lowering tide brings down all ships in the harbor. Therefore, simply to advance is a testament to our asset allocation modeling, vigilance to finding earnings accelerators, and unwillingness to hold losers.


Strategy

The landscape is fragile owing to an inordinately high level of debt and leverage. Growth will be sluggish until the credit crisis is resolved and an equilibrium point is reestablished. For the short-term, however, I expect the markets to remain volatile and unstable. No doubt this might have an adverse effect upon client expectations for “absolute” return. Whereas I am more comfortable looking out over a macro longer-term horizon, the next quarter might probably be as unfulfilling as the last two.

The outcome of these diverse vectors’ unpredictability is to reduce global commerce below historical acceleration rates. When someone sneezes in China, the rest of the globe catches cold. The rising economic, political, and military pressures in the world mute the strategy of globalism without quelling it, altogether.

There is no doubt that we are in a “bear market” for equities, because earnings are dissipating and valuations had been so high that they became unsustainable. I conclude that this bear is normal, definitional and like all others which preceded it, quantifiable and cyclical. I’m not suggesting it isn’t a big deal, but, rather, not the beginning of a calamity or global meltdown.

The globe, and the U.S. in particular, can weather this crisis. Perhaps, too, it might create an opportunity to level the playing field and give stocks and financial markets a starting point from which to accelerate much higher.
This is not the first global slowdown, it is simply our time for a slowdown. One’s focal point is always personal and local. When it’s your neighbor it’s an oddity; when it’s you it’s a disaster. The triggers might be the same but when and where the crisis hits determines its impact upon one’s behavior. Natural disasters in far away places are “curiosities” to some. When they hit your home, your family, its cause for alarm.


Conclusion

I believe this, too, will dissipate. Depending upon the response in the next few months, we will either dig out of a morass, or sink deeper into a downtrend. On the whole, the environment exists for the negativity to abate, for the markets to get stronger.

The markets and the economy have definitely been “out of sync” during the past nine months. Fundamentals have actually hindered any expectations for growth. I believe that the excessive speculation in real estate and commodities (typically two “safe-haven” investments) has exacerbated the problem, making its unwinding that much more problematic. I expect interest rates to reverse their 18 year disinflationary cycle and to turn around (upwards) dramatically in response.

Although higher interest rates are not an optimal environment for equities, they will, however, punctuate a higher savings potential and mitigate the effect of inflation. In that sense, equities just might take their cue to perform as a leading indicator of economic growth. A stronger market might definitely send a signal to investors to come back.

I am always aware of asset allocation models that offer me the best probability of absolute return with limited downside risk. Therefore I continue to overweight tangible assets (Basic Materials, Energy) while looking for opportunities in Biotech, Utilities and Financials.

While there is no way to predict the impact of global fundamentals upon equity bourses, we can use history as a guide to our response. Presently we are responding cautiously, raising cash and reducing exposure to risk. This is a short-term response because I remain quite upbeat about the longer term. During a bottoming phase, one should stay out of the way of the wave, but look for opportunity to accumulate value. The overriding theme is to reduce risk. Market cycles are always quantifiable. That is the origin of Arlington Econometrics’ research. Despite the short cycle naysayers, I believe that the maximum fallout from this current capitulation is limited by valuation and sentiment. Therefore my adjustments are oriented around looking for opportunities without blindly standing in the way of a bear phase.

Despite a slowdown in acceleration, the market is still always upwardly biased. Have we hit the bottom? Not just yet.

Will opportunity return? Absolutely.







Asset Allocation:
Equity 48%/Fixed Income 30%/Cash 22%