Market Commentary for the week of January 22, 2008

In case you’ve been too busy to notice, investing is “going global”. As borders become obsolete, theme driven investments carry greater impact upon portfolio success than does a jingoistic location from which the idea emanates. Today, issues like natural resources, pharmacology, energy, and technology have their solutions in factories, boardrooms, and playing fields as diverse as the globe itself.

That is why Arlington Econometrics’ portfolio products have been so successful. Irrespective of capitalization or geographic location, my database serves up vigorous strategies and solutions which capture the essence of capital gains and price momentum worldwide. It is another reason why I am averse to using standardized benchmarks such as S&P or Dow Jones as a means of comparison for performance.

Instead, Arlington Econometrics applies proprietary calibration to financial products to sift efficiently through the noise and hype to arrive at characteristics that give my clients a better probability of portfolio performance over the long term.

Bought and paid for.

Interestingly, a confluence of sector analysis and globalism coalesced this past week with the announcement of an infusion of foreign cash into the U.S. financial services sector. From sources as diverse as the Middle East and Asia, money was used to bail-out catastrophic losses in mortgage-related and other synthetic financially-driven faux pas of many financial megaliths in the United States. To be sure, the collapses are not limited to the United States, but do seem, oddly, to have U.S. corporate interests behind their folly.

As I said in last week’s missive, terms like “efficiency” and “productivity” are buzz words coded to signify lay-offs and unemployment. Right on cue, job cuts in the U.S. banking and brokerage universe topped out over 40,000 during the past six months, alone.

In world news…..

But the reverberations of negative data are far-reaching. Rising energy costs, as well as the increasing costs for food, pharmaceuticals and education may mean layoffs in healthcare, business, transportation, publishing, etc. Last week the Beige Book reported the largest year-over-year inflation rate than any in nearly two decades. If investing is, indeed, global, then no border or country of origin can protect the innocent from the tidal wave of economic deconstruction. As with everything else, there are two sides to the sword and at least one of them cuts quite deeply.

I also found it amusing that President Bush chided his Arab counterparts while in the Middle East last week by saying that “rising energy prices hurt the average (American) family”. His responsibility is to provide policy and strategies to his constituents that mitigate the negative consequences of secular themes whose devolution could be harmful, not to beg others to do it for him. In other words, his plea fell on deaf ears. If it weren’t true that he said it, I don’t believe I could have made it up and been believed.

Consumers and businesses had to reach deeper into their pocketbook to pay for goods and services during the past year. Price push inhibits industrial production. Global output and inflation data hit decades-long negative thresholds. It seems that the market is only now willing to acknowledge what had been discussed anecdotally in kitchens, hallways, and meeting places for the past two years: something is amiss, and someone needs to do something about it. Unfortunately, a short term “stimulus package” is not a long term solution to inflation or natural resource depletion.

So it’s pointless, right?

While it is increasingly more difficult to isolate market baskets that seem poised for upward movement, it is not as difficult to find individual one-off circumstances in equities or bonds that might offer capital gains potential. The key to such an endeavor is to work, top-down, from an idea and then eliminate capitalization biases from one’s research. Today’s successful portfolio looks like an emerging-market basket of varying probabilities in sectors whose actualization might be found first in the imagination, and secondly on the balance sheet. Price and location are secondary considerations.

(Note: There will be no Market Outlook next week. The next scheduled publication will be Monday February 4^th.)

Market Commentary for the week of January 14, 2008

It is doubtful that the roller-coaster effect of the first two week’s trading is likely to end anytime soon. Anticipating results for the upcoming earnings season, I would expect to see more disappointments than upside surprises. Further, it seems probable that we will not be making new highs in the averages for the foreseeable future.

It is early, or late?

With just a few trading days having passed by, patterns are already emerging that represent a continuation of cyclical trends begun last year. In most cases, and with only a few significant exceptions, sector strength throughout my database is topping or has already begun a bear-type consolidation. The most notable exception to that pattern is the Basic Material sector, more specifically precious metals and gold.

Considering the turmoil in earnings acceleration patterns, it is no wonder many are forecasting a market and economic slowdown.

Regular readers of my commentary know, however, that these reversals are not new. While I appreciate the validation of “recession-speak” by some of my Wall Street market strategist compatriots, take note that I discussed these factors early last year, particularly when addressing productivity reports. You see, I believe “productivity” is code-speak for unemployment. Making fewer workers do more, and paying them the same or less, is not productive. It is psychologically destructive to those left behind who carry on, while “empty lockers” remain a constant reminder of the threat to “do more or you’re next”. Therefore, today’s unemployment numbers took root in last year’s productivity reports.

A slippery slope.

The market cannot hype its way out of a downturn. Stocks trade on the expectation of future earnings growth. Consumers will not flock to your storefront unless you build them a better mousetrap. I believe it is imperative for corporate planners, politicians, and philosophers to weave a fabric of goals and expectations which might lay the groundwork for global work projects that motivate creative thinking and consumer spending.

In the face of mounting debt and declining portfolio valuations in the U.S., tax cuts and interest rate reductions fail to solve the problem. Thursday’s announcement by Fed Chairman Bernanke strongly hinted that he was voting to lower interest rates significantly, in order to quell an economic slowdown. By freeing up the money supply he hopes to make expenditures less costly. I have said many times that “you can lead a horse to water, but you can’t make him spend”.

Working in the market’s favor, though, is the intricate tapestry of global commerce. It is easier to make up for sales lost in the domestic market by crediting more sales to overseas partners. Real-time technological connectivity has created a 24 hour marketplace. In a very real sense, this is the New Paradigm spoken about during the technological revolution. These tapestries now allow for sales and efficiencies to manifest without borders by eradicating seasonal variances, the time clock, and cultural disagreements. The dollar’s decline, borne out of domestic inefficiencies and poor policy, has proven to be a boon for commerce.

It’s not local, anymore.

In a global market, there is little time to bemoan local problems. A dramatic shift is developing, which is reorienting the balance of power from government statehouses to financial boardrooms. Because of this, bear market cycles are isolated to an industry, a company, a region, rather than taking down an entire market basket or economy.

During the coming year, I believe my work will identify pockets of sector and regional acceleration, as I have done successfully before, and make investing more practical and efficient for my readers. In the past, the consumer drove the economy. Today, I believe that nations must drive the consumer by creating conditions that posit a strong moral and economic dynamic.

Market Commentary for the week of January 7, 2008

For your consideration:

“While lower interest rates might stimulate spending and borrowing, they really precipitate more speculation rather than greater investment. Lower interest rates have created the home building surge.” (February 5, 2007)

“The biggest threat to stock prices is the mania and greed that pervades Wall Street caused by abnormally low interest rates, high levels of speculation, and eroding profit margins caused by rising core and commodities costs.” (March 19, 2007)

“In spite of all the mania, rising commodities prices, including gasoline and food, give rise to a scenario in which earnings acceleration patterns are contracting.” (April 23, 2007)

“Oil has already begun its climb towards $100-a-barrel. For the past week, fuel oil has closed at record levels and held firmly. Only five years ago, crude oil was priced in the spot market at $22 a barrel.” (September 24, 2007)

“Our “integer obsession” about $100 per barrel masks the bigger picture that the trend in energy prices has been rising steadily since the late 1990’s and has triggered a price pressure/inflation-driven economic expansion. It is no accident that real estate and other tangible assets have risen sympathetically during an era in which portfolio price expansion was at its greatest.” (December 3, 2007)

The preceding excerpts were contained within the past year’s Market Outlooks. They are significant as benchmarks against which asset allocation and market prognostication might be measured, and further enhanced by the market’s disjointed activity in the opening week of 2008. Crude oil prices finally soared above the $100 milestone.

Surging economic development in India and China lent credence to the belief that global demand for petroleum products might one day outstrip supply. Further “exogenous noise” was provided by politically inspired violence in Nigeria, export tensions from Iran, and bad weather in Mexico.

As if world events were not sufficient cause for concern, the U.S. reported its own strategic petroleum reserve is significantly below capacity. Traders used these data to bid-up energy shares on exaggerated speculative buying. Fundamentals were thrown out the window, along with any sector not already “nailed to the floor”. Primary attention is focused upon any disruptions in the supply of oil from global sources.

Meanwhile, gasoline prices at the pump edged higher after holding steady during the always busy holiday driving season. A similar scenario as this past spring’s (2007) gasoline price hike might occur this year, too, causing prices to inflate well above $3.50 in the U.S. by springtime 2008. The rest of the globe already knows the burden of $6 per gallon gasoline.

Last year the stock market accelerated out of the gate early. I expect for that not to happen this year. Instead, I am expecting significant shift into longer-term demographic themes such as tangible assets, pharmaceuticals, food/agriculture, and, of course, energy, including alternative fuel sources. The cycle of capitulation is here, and more meaningful than any time in the last decade.

Relax, rebalance, be prudent.

Arlington Econometrics First Quarter Commentary

Who’ll Stop The Rain?

Even the most successful hot streaks are due an inevitable rest. Thus, because of an extended bull market phase, the markets are showing signs of directionless fatigue.

Compared with years past, last year was the least successful for finding global opportunity and earnings accelerators. In fact, commodities price push erased nearly one half of one percent from global output. The data clearly shows, even if analysts are loathe to accept, that inflation in core costs, goods and services, and currency imbalances are beginning to show an impact upon spending patterns.

Markets

As inflation creeps, the impact upon industrial research and development, discretionary spending, food, healthcare, and fiscal policy resonates even stronger. Consumers are not keeping pace with the stealth tax effect of diminished spending power.

In turn, the financial markets are affected in two ways. Obviously, the first effect of cost creep is the viability of earnings power. Given that market timing and asset allocation are determined, in part, by profit potential, the diminution of earnings velocity adversely effects the momentum of stocks as well as the breadth of equities participating in such growth. But the second, and more complex to evaluate, factor which limits equity acceleration is the psychological impact of feeling “poorer”, of not feeling as if one is keeping pace with savings and capital gains expectations. In all facets of life, failure to meet one’s expectations for performance can be a serious obstacle to overcome, even if the perceptions are misguided.

Real or not, the perceptions which overlay today’s trading landscape are nefariously doing more harm than good.

In my opening commentary last year (Jan. 1, 2007) and throughout the balance of the year, I warned against the devolution of trends that many perceived as immutable strengths. For example, in addition to my early warnings about pricing pressure, I warned against the insidious valuation explosion in stocks and real estate, that was leverage (margin) inspired and built upon unsustainable hyperbole. The most obvious threat to capital gains expansion is always the manic velocity of the latter-stages of a secular bull cycle. Sure enough, just as a generation of dot.com enthusiasts discovered a decade ago, foolishness coupled with leverage can bring a trend to a screeching halt. This time, the erosion of fundamentals, and the discarding of prudent portfolio methodology brought down the real estate markets and took stocks (as well as most financial instruments) down with it.

One difference between this decade’s collapse and last, however, is that more “grey-hairs” got caught in this downdraft. Unlike the twenty year old “nerds and geeks” who postulated that the technological new paradigm was for real (in 1997), this latest mess was built upon the naïvete and gullibility of pre-retirees and the nouveau-riche who had always thought that real estate was a “lay-up” investment. Many failed to remember the 1980’s, during which real estate values declined, causing similar pain.

The guilty also includes grey-hair culprits from the boardrooms of the globe’s financial services megaliths. Getting fat and wealthy off the backs of the uninformed is nothing new for Wall Street. This time, though, the composition of synthetically engineered products, highly leveraged and highly speculative, was too intricate even for the insiders. The golden goose was slain by its owners.

I also find fault with the custodians of fiscal and monetary policy. Politicians spent the previous decade with their eye on globalism, succeeding in principle to turn the global economy into a reality. However, at the risk of leveling the playing field, some of the “have-nots” became too emboldened, demanding their fair share at the table. In the process, equal access to capital eradicated territorial rights and borders, diminishing the impact of the superpowers.

Stewards of global monetary policy have been easing credit for years, setting the stage for ineffectual lending and the crisis which now surrounds us. Rather than anticipating third world demand, bankers found themselves responding to natural disasters, cyclical boom cycles, and legendary ego-driven capital expansion. Despite specific lessons of history, decentralized money supply accentuated the ideology of risk-based lending. Cheap money exacerbated the problem. To their credit, the French recently announced that they are going to forego micromanaging the spending/credit crisis and remain focused upon curbing the long term inflation impact of core cost price increases. We must respond to the crisis, yet our bankers are doing a very poor job sorting through the bubble’s collapse.

Strategy

Caught, as we are, in the midst of this downdraft, the application of methodology becomes the most crucial element of achieving investment success going forward. I still believe that pockets of earnings acceleration exist. However, my recent findings conclude that the number of global equities which qualify using this primary screening process is diminishing, the numbers of sectors to be included is narrowing, and the cause of earnings expansion lies more in pricing power than unit volume growth.

Applying specific criteria to equity analysis should also require a discussion of humanistic factors. Quantitative analysts, like me for example, are usually mathematicians or engineers who apply strict scientific analysis to our data. We must also learn to think beyond the science and add theories of psychology and the humanities to our physics.

An advantage of scientific analysis is its objectivity. By filling volumes with strict review and processes we create efficient patterns of execution. We are able to identify and measure technical and numerical imbalances in the markets, and to provide strategies and solutions at a faster, more determined, pace.

On the other hand, the disadvantage of our science is the quantification of impact these imbalances might yield to the end-user, the client. Therefore, it is not uncommon to see negative history repeat itself as each generation of “nouveau-tycoon” feels that they are different this time, and somehow immune from the fatal flaws of ego, greed, and hyperbole.

In this coming year the markets need somehow to recalibrate, as if the excesses and pain never happened, to create an equilibrium starting point from which to render a new ideology about risk and reward, just as a golfer “shakes off” a bogey and proceeds to the next tee. Banks need to reconstitute their lending practices to avoid the expansion of credit risk. Similarly, global monetary boards must adjust their perspective from growth to inflation, and worry about the devastating effect of the depletion of natural resources upon the planet.

Into the first part of this year, I believe we will see an overhang of the downtrends that started last summer in the world’s financial markets. Obviously, the workout is quite complex. Its effects will resonate upon the rich, the poor, east and west.

Higher inflation and interest rates are unwitting cousins in the next decade. Emergence of global pockets of industrial, scientific, and economic strength can be the surprise player of next season. The gestation period for a new globalization is unknown. We do know, however, that fiscal policy as well as cultural influences will play the most significant impact upon the flow of capital and the profit potential for regional equities. Whomever demonstrates the qualities of building for the future will attract the most capital and the most political goodwill. In particular, the United States has a unique burden to rebuild a moribund moral dynasty that could be capable of sustaining a new humanism as a beacon for capital, talent, and expectations.

Conclusion

The markets can sense fear as surely as one fighter can sense the weakness of his competitor. Unfortunately, the markets don’t perform well in a negative vacuum. They stop lending, speculating and improving when there is no optimism. The bigger problems overwhelm everything during a psychological retreat.

My clients will note that our cash levels grew from the beginning of the year to the year-end, as we secured profits and rebalanced into strong leadership sectors. Performance on accounts was, in most cases, higher than the benchmark S&P, with significantly fewer dollars allocated to equity ownership in our models. Therefore our story this year is that we “did more with less: less risk, less equity exposure”.

My work indicates that opportunities exist for markets to accelerate in agriculture, energy and health issues, but with the imperative for leaders of the political and capital markets to coalesce to create policies whose effect is to promote the quality of life.

Indeed, in the short term, we must acknowledge slowdowns in wages, jobs creation, and earnings acceleration. But fear is not an option. Not every stock will struggle in 2008 nor will the economy “fail”. As with all cyclic phenomena, bottoms will become staging areas for an acceleration into new tops. Look for capital gains potential in agriculture, healthcare, energy, industrials, and internet technologies. Keep your cash handy because liquidity, not leverage, will prove to be the factor that jump starts the next upward cycle in the financial markets later in the year.

Asset Allocation:

Equity 38%/Fixed Income 30%/Cash 32%