Market Commentary for the week of February 25, 2008

Here is the thing about trends: they are not points in time, they are not isolated moments of upheaval or unrest. Instead, trends are elongated patterns of characteristics which taken in sum are the embodiment of a theme with enduring qualities.

For example, the identification of higher gasoline prices at the pump today is not, in and of itself, a trend. The depletion of our natural resources, the increased usage of fossil fuels, the industrialization of emerging markets…those are all factors which contribute to, and are trends themselves.

So, when the market recoils because of an announcement, I tend to dismiss its significance. When my data reverses direction and sustains the reversal, I take notice.

When is “too late”?

I am dismayed that only recently has come the halcyon call about global inflation. Inflation is one of those trends that, indeed, is not a point in time, but a grouping of related characteristics that had its origins as far back as 1998. At the conclusion of the dot.com expansion in the late 1990’s I started to observe the seeds of inflation in higher raw materials costs for computer hardware manufacturers. Despite the erosion of Technology shares subsequent to their capital gains explosion, a new generation of price push took hold in Industrials and Energy stocks. As a classically definitional market/economic resurgence took hold in 2002, one only needed to pay attention to commodities, earnings, and prices to realize that an inflationary trend had firmly arrived.

And yet, monetary and fiscal policy was slow to awaken to the data around us. In fact, I would surmise that our leaders were downright dismissive about inflation, or else highly unintelligent about reading the tea leaves.

Last week, the government’s own statistics measured year-over-year inflation as increasing at a faster pace than anytime in the last 16 years. Forecasts for 2008 inflation could be as high as 5 percent across the board.

Just around the corner, part two.

As yet, the full story is yet to be written. We know that as the Spring driving season arrives, gasoline at the pump might increase by another 10 percent, after an annual (12 month) increase of 75 percent, already.

Medicine and pharmaceutical costs rose globally last year by almost 24 percent. Grains, milk, soy, sugar and other agricultural products have risen in price by 25 percent in 2008, alone.

The downside risk to economic expansion is greater than its upside probabilities, currently.

Further exacerbating the economic dilemma is the focus upon “bailing-out” or “writing-off” the real estate credit issue. Because of the aggressive tone of conciliating the problem, it might be that an inadvertent consequence of lower interest rates might be to accelerate the inflation problem by making money too plentiful for the speculators and traders. Lower interest rates also weigh on that country’s currency by reducing the return on assets of products denominated in the currency.

No one is suggesting that there are simple or expedient solutions to these problems. But the psychological doldrums that accompany them are nevertheless exacerbating the duration and magnitude of the trends, themselves.

Market Commentary for the week of February 18, 2008

Market sleight-of-hand.

Watch closely, because what you think you’re seeing might not be as it appears. Euphoria last week about intraday gains in the Dow, Hang Seng, or Tokyo markets mask an unseen coalescence of negative economic statistics already in the public domain during the previous six months. While central banks wrestle with deteriorating economic statistics by lowering interest rates, other data suggests that more enduring negative trends exist that cannot be solved with short-term stimuli.

Thus it is that I caution investors not to link the activities of the economy with the activities of the equities’ markets. In prior writings I have referenced this as a “Parallel Disconnect”, a mirage by which two events, seemingly linked by parallel directional vectors are not really correlated at all.

In today’s terms the disconnect exists when news broadcasts and other media inflate the significance of large intraday upside price momentum in the face of declining or fragile momentum data. While a baseline comparison between stocks and the economy might seem to be moving in concert, they are in fact intersecting at one point while losing vector connectivity. Over time, the difference becomes more pronounced, but by then it is too late to avert portfolio decline.

For example, the mortgage crisis might seem to be a situation ameliorated by bail-outs, write-offs or low interest rates. But in the face of these short term solutions we run the risk of exacerbating lower profit projections in the Financials, layoffs and wage stagnation, inflation creep, deficit spending, inflation, and lower consumer savings rates. Clearly, the intersection at which the solution meets the problem might seem like a parallel connection, but, in truth, the solution’s vector rips apart any benign connection and ultimately creates more problems.

Just the facts.

My market data, in fact, shows that negative momentum permeates the equities market, globally. Rising commodities and energy costs have ripped apart the potential for profit margins to expand in nearly every sector I have reviewed. In fact, intermediate cycle price gains in Basic Materials and Energy stocks leave them vulnerable to profit-taking even as their fundamentals position them for secular long-term profit appreciation.

In other words, global equities baskets are susceptible to a disconnect of their own, even from local or regional good news, because of the duration and magnitude of the bull cycle during the last five years.

Many analysts believe that solutions to an economic disconnect rests in short-term manipulation of the market. From week to week downside risk can be avoided, they believe, by cutting interest rates, incentivizing value-oriented purchases of stock, or by packaging product into synthetic solutions.

Focus on the long term.

However, I believe that the best research is framed by the big picture and more enduring themes. Analysis and transaction should be predicated upon fundamental research and longer term forecasts. Ultimately what is “timely” should also be what is measurable, in order to capitalize upon major thematic moves in both the economy and the market during the short and long-term.

I do believe that despite the pervasive negativity in thought and data, that there is always something to own for the long term. Despite price fluctuation in those sectors, I believe that Basic Materials and Energy offer a strong potential for capital gains in the near and longer-term. Biotech stocks represent cutting edge thought towards solutions in healthcare and disease prevention. Agricultural companies (Consumer Non Cyclicals) have yet to actualize their dominance in world commerce by their penetration into the economic development of emerging markets. Finally, Utilities represent yield and capital gains potential in a world seeking not only new sources of energy, but competent delivery systems, as well.

With a shortened work week on Wall Street, look for the compression of five fun-filled days into four, and perhaps more volatility than normal. I see no cause for alarm, but remain cautious about any short-term projections of capital gains for global bourses.

Market Commentary for the week of February 11, 2008

“Reality versus perception.”

“Absolute versus relative.”

These are the two phrases most often used to describe portfolio allocation and performance. In the first, one encounters a host of variables, from interest rates, credit crunches, deficits, retail sales, manufacturing, unemployment, wages, etc. In the second, we deal with real live integers versus today’s declining portfolio balances.

Throughout it all, however, I prefer to focus upon the cyclicality of all phases of investing, and the very dynamic of change itself. There is always an opportunity to buy. There is always something falling out of favor.

Such is the nature of algorithmic studies of market phenomena. Recall in 2001 that tech stocks were falling while industrials were gaining steam. Recently, strong consumer brands began a contraction (in price and margin) while gold skyrocketed.

Thus, it is with a parabolic perspective that we need to weigh the relative ups and downs of equities today. My conclusion is that equities need a rest, a contraction, from their expansive bull cycle begun in 2002. Therefore, any upticks within the prevailing downtrend are opportunities, but aberrations nonetheless. Profit margins are expanding in one global category only, tangible assets. Meanwhile, sales and manufacturing numbers are constrained to a small width, and unlikely to accelerate during this cycle.

I have been commenting recently about productivity data, a key factor in determining economic reality from perception. I advocate that “productivity” is a colloquialism for “employment”. Corporations try to extract the most output-per-worker, at the lowest cost. Failing that, unemployment begins to creep up. It is often said that a recession is when your neighbor is out of work; a depression is when you are out of work. Given the laconic growth in jobs, it is not surprising that both employment and productivity figures were weak last week, far below their record levels nearly a decade ago.

What’s the Fed to do? It is possible that they will take their eye off of the inflation statistics to focus upon investment stimulus by lowering interest rates yet again. However, their dalliances notwithstanding, the market’s performance has been negatively influenced by rising costs and shrinking profit margins as much as it has by a slowdown in confidence and spending.

It is too late for blame-laying, but it is noteworthy that my statistics started to turn negative almost two years ago as deficit spending and the dollar’s decline began to extract a heavy toll upon exports and manufacturing data. While this occurred, Wall Street fiddled while the economy burned (oil) and exacerbated the situation by peddling “concocted leverage” and “synthetic hope” in their packaged product offerings.

And now, the repercussions of the U.S. economic slowdown are being felt overseas, including China and India. Tech stocks and investments are weaker, as are clothing, automobiles, and financials.

A consensus seems to be building that, at the very least, we are coming to the end of the first growth cycle of the new millennium and that a natural regression/devolution is unfolding. This is not a doom and gloom analysis but rather a realistic review of the prospects for actual portfolio returns (as opposed to relative portfolio returns).

One of my colleagues brought me a remarkably ironic parody of my weekly missives the other day, saying that I promoted fear because it’s “easier to read”, and that my use of probabilities and statistics was analogous to scientists talking about a “meteor hitting the earth”. In a tongue-in-cheek way they expressed that the rule for good negative commentary takes its roots in raw, negative emotion. I mention this because I found the parody quite funny, but also to stress that all scientific methodology is based in hypothesis, good or bad. The underlying theory of quantitative market analysis is that patterns are neither random nor indeterminable. Rather, the extent to which we might “know” or anticipate quotients of behavior helps the investor to avoid emotional disasters, like holding onto a declining tech stock because its story sounds so good.

In either case, we all seek to limit “weeping” as a verb that creeps into the lexicon of portfolio management disciplines.

Market Commentary for the week of February 4, 2008

The Federal Reserve responded to Wall Street’s lament that lower interest rates were the solution to recession buildup by cutting interest rates again last week, the second time in two weeks. The reaction however was quite boring, if not downright negative. I guess giving away money is not the answer to failed corporate governance.

Coupled with the Fed’s monetary actions, the U.S. Congress is trying to craft a “stimulus package” designed to get money in the hands of citizens immediately, the expectation being that money will be spent on goods and services.

The conventional wisdom about the efficacy of giving away money is widely debated. Some might view give-backs as justification for the corporate sector to raise prices, reduce output and cut jobs to create bigger margins on their balance sheets. Playing to Wall Street is not always the panacea for what ails Main Street.

In addition, were these plans to work, stimulating the spending side might lead to debilitating inflation and financial instability later on by driving purchasing without increasing savings levels among the general populace.

Further, any spending would be designed to move existing inventories (cars, homes, apparel, etc.) without offering any incentives to the corporate sector to increase manufacturing.

As I have said many times earlier, I believe lower interest rates are anathema to economic growth because they create too much leverage and greed. Besides, “you can lead a horse to water but you can’t make him spend” is a favorite phrase I use to remind the supply siders that all ills are not cured by money.

Tax cuts, for example, in real and inflation adjusted terms have failed to reign in runaway cost increases and have mostly gone into savings for the rich, necessities for the poor. Their effect has been to pour gasoline on the fire. And while I’m not making light of a “found” allowance of $600, I do not believe it is sufficient to solve the problem. One car payment, one doctor’s visit, one basket of groceries? The problem lies deeper than a stimulus package. Simply throwing money against the wall to see what sticks is not the proper summation of an administration’s budget and economic policies during the past eight years.

I believe the problem rests in the inability to wean off of non-renewable energy supplies, such as fossil fuels. Wall Street would certainly be more highly motivated and energized if a mission statement clearly laid out policy and incentives for shaping the globe’s economic future, and a reliable alternative energy source for creating and sustaining that growth. This is not short-term speak, like the kind from Washington D.C., but a long term, viable investment and capital gains solution.

Consider that the last time the Fed Funds Rate was above 5% (1990’s) the economy was flourishing, the budget was balanced and our investment brethren were sky-high on the possibilities of a dot.com “New Paradigm”. One doesn’t need low interest rates to incentivize new investors, one needs new ideas.

I have just returned from a one week research trip, and find myself amazed by the difference between what motivates Wall Street and the average business on Main Street. Many are not directly affected by the upticks and downticks of the market. For some, intrinsic values such as community, charity, and employee welfare are uppermost in their minds. Analyst’s projections are out there on another strata, insignificant for many, and unrelated to generational themes.

To a certain extent “profit” is not always bottom line wealth, but rather bottom line quality of life.

My clients expect performance, indeed. But they also ask me to extend their vision to cross over beyond profit potential and to use methodology to discover capital gains potential along with value based objectives.