Arlington Econometrics First Quarter Commentary

….not a drop to drink.


Just about everyone’s worst case scenario unfolded last year, following on the heels of large-scale deleveraging in the financial and housing markets. Who might have imagined the demise or acquisition of some of Wall Street’s most revered names?

In simple terms, the world got greedy, lazy and superficial about basic financial assumptions, such as the sustainability of heroic capital gains projections for tangible assets and financial securities. The most improbable scenario became highly probable, and unfortunately very costly for investors.

With market data such as employment, savings, corporate earnings, and equity valuations reaching historically dismal levels, the expectation is that economic recovery is further down the road and not immediately likely.

What makes the global conflagration so unique is the congruence with which all global bourses, all global economies, declined. Typically, powerhouse nations might be immune to the “trivialities” of emerging market problems. Perhaps, as well, regional problems could have been mitigated continent to continent by immunity provided from disparate natural resource bases, or population (workforce) disproportions. Not in this case, however. There was simply no place to hide last year, no sector leadership, no country any more likely than any other to work through the tumultuousness of poor credit, low demand, systemic greed and non-transparent financial institutions.

We expected more from those in the know, and we didn’t get it.

Markets
We are, though, sitting on the cusp of the greatest capital gains opportunity in the last 50 years. Resources, and political will, are there to provide a new generation of taxation, monetary, and moral codes that might indeed rescue the bear market’s capitulation from oblivion. Whereas, the “cure” might not be in the first quarter or first half of this year, the essential tools for economic renaissance are still in place. The problems are not new, but the solutions might be.

My forecasts for earnings acceleration rates for 2009 are modest. Quite simply there isn’t enough capital or pent-up demand to resuscitate industrial production or new hiring. If growth is measured by output, revenue and profitability, then the numbers are not there in denominations sufficient to move markets early on.

When positive sentiment returns, a nascent climate of opportunistic commerce will respond.

Standing in the way of immediate response is the enormous debt load the globe is carrying. Savings rates worldwide are at historically low levels. No matter how low interest rates go, you cannot incentivize capital to be spent where it doesn’t already exist. National debt and personal debt are the single largest impediment to sustained economic growth. The coordination and conjunction of global markets make this problem more severe. Whereas we once spoke of “globalization” as the salvation to regional and country malaise, the opposite has become true. If Japan sneezes, the United States catches cold…while China suffers from an ensuing headache.

It seems that a classic age of consumer-led prosperity is another paradigm to have lost its luster as a result of the recent past. Productivity is a misnomer, representing, as my data sees it, higher levels of output on the backs of fewer employees in a declining real wage environment. If you take away such draconian measures, market share isn’t growing at all for most companies. We should be mindful, too, that pricing pressure is abating, taking away another definitional tool of business to maintain profit margins.

Expectations must be shifted from traditional models to a more innovative method of attracting capital. This is where moral persuasion and societal altruism become important. The globe requires an “all for one” concept that enhances the lives of its constituents with better healthcare, cleaner water, more efficient and replenishable energy, abundant agricultural resources, scientific discovery, biotech research, infrastructure development, and long term prospects for peace. Does this sound like a laundry list of market sectors ripe for capital expenditures?

Similarly, there must be a rejuvenation in conversation between nations about the perception of transparency and morals in the financial markets. Without this, jingoism and protectionism might rip apart the common themes identified above and contribute to a “what’s in it for us” mentality similar to the political climate in the middle of the last century. I have difficulty trying to imagine a network of unilateral economies and economic resurgence at the same time.

Strategy
My mantra of asset allocation is going to be tested this year. We are nowhere near a “model portfolio” allocation, choosing instead to be over-weighted in cash and short term fixed income. It is more difficult to position oneself to take advantage of potential capital gains in a climate of fear, mistrust, and disgust. Whereas our goal is to correlate risk/reward probabilities to favor lower-risk scenarios, returns are already paltry and non competitive. Given the need to be “in it” to prosper, timing the inflection point from the bear to a potential bull will be critical in the next few months. Market timing? Not really. Just the realization that we must return to nominal asset allocation levels to meet our client’s expectations for performance.

It also wouldn’t be prudent to place any long-term bets either in bonds or stocks. Owing to the rapid change in sentiment that pervades the markets, I believe that volatility and uncertainty will characterize the early stages of any turnaround. Because of currency volatility and a widening of bid/offer spreads for financial instruments, long term market gambits are too risky. To be sure, we will evolve from this landscape, but knowing its early-stage characteristics is paramount when evaluating risk parameters.

However these systemic “risks’ make the case for casting a wider net and to consider more markets than the United States, only. Some of the emerging markets offer meaningful potential, along with risk, for capital gains in agriculture, technology, energy, and basic material shares. As the global perspective widens, the need for careful discrimination narrows.

Bear in mind that no economic renaissance can be complete without consumer demand. Despite efforts to recapitalize banks and global treasuries, you cannot stimulate spending by adding cash, alone. There must be a psychological will to spend, indeed a need to spend which heretofore has laid dormant. To undo the psychological damage inflicted upon consumers by the market bear, we must enter a world of drastically different norms. Under historically “normal” terms, inexpensive cash would be incentive enough to prime the spending pump. Not today, however. I question the motivation and efficiency of today’s global response, but remain hopeful that we can turn the page on mistrust and suspicion of financial institutions.

Conclusion
Over the long term, we will emerge successfully from this malaise. There isn’t an option not to. The consensus view is that it might take more time, but that selected response to certain stimuli will work. I am emboldened by private sector research in agri-business, biotech and life sciences, alternative energy, water purification and ecology, technology, and infra structure. It makes no sense to look backwards with recrimination or remorse. Indeed it is a “new paradigm”, perhaps the one envisioned by our dot.com friends, but ten years later than imagined.

Portfolio decisions are more global than ever before. After overcoming regional, territorial, or jingoistic postulates, no nation has a monopoly on good ideas. The applications of global solutions are cross-border and multi-dimensional. It is not simply a corporate response which is needed, but a nationwide solution.

Despite the distortions that have occurred in the financial markets, it should be noted that the will is there to support a market/economic renaissance. From rich to poor, it serves no purpose or constituency for the globe to plummet into inertia. As the New Year unfolds, cycle rhythms seem to be “gathering at the bottom” with greater frequency, perhaps indicating that the same commonality of negative investment sentiment that took the market down might be extinguishing, or at least slowing down, towards a confluence whose redirection upwards could be a powerful capital gains opportunity during 2009.

The paradigm, indeed, will shift. Leverage is yesterday’s game. Responsible balance sheets and transparency are the new norms. As a consequence, it is hoped that confidence can be restored in common values. Central banks have little wiggle room right now. The burden falls on consumers. If valuations stabilize, it might represent the first step this year towards establishing an equilibrium from which regeneration might occur.

Who will take the first sip?



Asset Allocation:
Equity 30%/Fixed Income 40%/Cash 30%