Arlington Econometrics Second Quarter Commentary

The Long Way There

Global central banks as well as the U.S. Federal Reserve stepped in last quarter to provide billions in capital, buying time in the process, but, perhaps, exacerbating the problem of leverage and speculation that brought the crisis on in the first place.

As the economy slows, and the likelihood of aggressive capital gains opportunities from equities markets diminishes, it is stubbornly apparent that global problems are raising the fear factor within the investment community. A persistent drumbeat of negative news is weighing upon millions of investors, corporate and individual alike. The unofficial arbiter of a market downturn is when one believes there is no place to hide from the expanse of a bad-news tidal wave.

Markets

The severe global credit crisis has claimed victims large and small. It resonates all the way from the hierarchy of Wall Street to the humble abode on Main Street. It stresses the seams of our financial system by bringing valuations down, seemingly with no net or support.

Doubt and uncertainty produced wild short-term swings in global equity markets last quarter as analysts digested the symptoms and cures amidst renewed worries about the economy and inflation fears. To a large extent, those conclusions have not yet been drawn, and could produce more volatility in the interim.

In the meantime, and for the foreseeable future, the markets are likely to underperform everyone’s hopes for recovery. Because profits are so closely linked to expenditures, sectors like Consumers, Financials, and Cyclicals are likely to remain stagnant, while Energy, Basic Materials and Biotechnology have some staying power and reliability.

I believe current monetary policies are insufficient because the public has lost confidence in government and its solutions. If acted upon earlier, issues such as the mortgage crisis might have been averted by prudent fiscal initiatives. Instead, it seems as if leaders are out of touch with their constituents, particularly as large sums of bail-out capital flow from institution to institution. There is plenty of money on the balance sheet to fund mergers and acquisitions of the weak by the strong. So it seems less as if we have a “credit crisis”, but more as if we have a morality crisis about how and where our money is to be spent, and to what use it is best directed.

When government is seen as the impediment to the solution, the public loses its intrinsic altruistic trust. When that happens, spending stops and personal security takes precedence over monetary influences.

Because of this breakdown in confidence, my models have shown a distinct negative bias about earnings acceleration trends in the next quarter. We can no longer expect the kind of year-over-year jump in earnings expansion as we had in the last five years.

The consumer sector is subject to market forces, such as higher commodity prices and tighter credit, that are typical of late stage declines and economic slowdown. The cost of filling a gas tank has nearly crippled several industries (such as transportation and airlines) and, certainly, many households. History has shown that recovery from acceleration in core inflation is a lengthy process, measured in years, not days or quarters.

Further, the amount of leverage built into the global financial network is staggering. The recent Bear Stearns debacle is only emblematic of a flagrant use of margin, speculation, and hyperbole that permeates many industries. Imagine a valuation built layer-upon-layer of fabricated values or synthetic derivation. Stock prices, home values and corporate valuations that are expanded by a multiple of twenty or more have become commonplace, and cause concern about their unraveling. We have seen and heard how some bankers did not know, or could not compute, the magnitude of their leveraged products.

Today’s situation, however, is not unlike the excesses of speculation that occurred prior to our last bear in Technology. Although the industry groups are different, the profit squeeze is the same. Quality companies will outperform, laggards will trail badly, just as before.

Strategy

But it is more important as we embark upon the next quarter’s adventure to focus upon the bigger picture which supports a cyclical, not catastrophic, view of today’s data. While sentiment is important, statistical science is better at identifying how to commit capital.

Obviously, diversification of risk is an important component to the correct solution to our dilemma. Although it is more difficult to find momentum-driven and earnings-based equities, it is not impossible to do so. Every market has an inflection point that offers an ideal entry-point. My data download is giving positive indications, albeit modestly, for capital gains in specific biotechnology, energy, basic materials, and industrials. These models are useful because they sift through the “noise” of politics and economic discussion to find real, quantifiable cycles and location of opportunity irrespective of geography, capitalization, or currency.

These data also dispel the notion that gloominess and panic are ruling the landscape. Although there are certain troubles, like inflation and liquidity, that exert influence over monetary and fiscal policy my research seeks to minimize the significance of their influence by isolating a “standardization” of components that lead equity performance.

Therefore, contrary to typical prognostication, we are probably closer to seeing the end of an economic downturn than we were when the markets were initiating the downturn in 2006. This can be qualified by the sectors that are leading and some relative strength data that are nearing cyclical resolution.

I would hasten to add, though, that buying laggard stocks “on the way down” is not a good strategy nor the position I am presently advocating. Instead, I prefer to own leadership and ride its crest rather than to “value fish” with no bottom or end in sight.

The problem with most equities today is that their share prices had expanded so greatly that it became unlikely for their linear uptrends to maintain. Balance sheet analysis shows me that expenses are increasing at rates faster than sales or unit volume production, which squeezes margins and makes earnings per share analyses less attractive.

Similarly, those companies that inflate simply because of rumor or hyperbole are destined for the same fall that previously took down technology shares. To deny that “fluff” is to doom one’s portfolio to failure.

The data points to a conclusion that too much expansion (in inventory, in share price, in exuberance) has led to a disconnect from the rhythm of economic patterns and created a dislocation in equities that is difficult from which to dig out. The sheer magnitude of leverage, greed, and speculation that sustained the market has carved out a chasm that is too deep.

The global markets are under tremendous strain right now. The influences of terrorism, monetary policy, psychological reticence, and corporate chicanery have essentially cashed-in all available chips for compromise or wiggle-room. The longest global expansion in equities history is getting tired, and unable to find new tricks to rescue its malaise.

Conclusion

My work is based upon credible, quantitative measuring sticks. I would be exaggerating if I predicted large double-digit returns for 2008. The cost of inflation creep and negative psychology is extracting a huge toll on earnings potential. Most feel as if the markets are controlling them, rather than vice versa.

As I wrote in my January quarterly, monetary capitalists “set the stage for ineffectual lending and the crisis which now surrounds us”. We now find ourselves illiquid and incapable of responding to global crises, whether they are man-made or natural disasters.

It would be simple if we could re-set the clock, take a time-out, and recalibrate wealth back to a more benign time. The most obvious salve to our situation is time.

Money seeks an equilibrium, always. Although we are currently out of balance, we will reverse the course of negative psychology, negative earnings patterns, and negative performance. I don’t look for failure, I use these reversals as a means of finding opportunity.

Balance, asset allocation, earnings growth, generational opportunity, and moral science are the buzzwords for successful portfolio performance in the coming months.

Asset Allocation:

Equity 40%/Fixed Income 25%/Cash 35%

Market Commentary for the week of March 24, 2008

There is room for cordial disagreement about the impact of global Central Bank’s capital infusion into the marketplace and, more specifically, the rescue of Bear Stearns by one of its competitors and the Federal Reserve. Ben Bernanke likes low interest rates. But consider yourself in the minority if you believe that those monies did anything but postpone the inevitable disposition of the financial sector, the stock market, or the negative fundamentals which underpin the U.S. and global economy.

Indeed, it is ignorant to conjoin the activity of the equities market to any similar evaluation about the condition of the economy, fiscally or psychologically.

After one of the most emboldened acts executed by the Federal Reserve in years, to bail out an incompetent management hierarchy at a prestigious investment bank, the markets on Tuesday jumped for joy over the infusion of “cheap” money, then came crashing back to reality on day-two after realizing that the fundamentals are simply not there to support euphoria about earnings potential in a highly inflationary and volatile economy.

As if in concert with that thought, commodities prices (on a nearly linear and unsustainable upside swing) lost valuation and momentum, too, lending further credence to this sobering plot which is unfolding.

Bad diagnosis; bad cure.

Combine fiscal irresponsibility along with imprudent monetary policy and you brew a recipe of suspicion and fear. No amount of “pump-priming” can assuage consumer despondency that their government doesn’t care about the right moral solutions, only the most expedient financial ones. No matter how cheap the acquisition price, those several hundred millions of dollars of bailout money might have defrayed medical expenses, rising energy costs, tuition credits, bridge-building or deficit spending.

It’s not the reality about whether the deal makes sense, but, rather, the perception that money exchanges hands at an upper echelon of white collar business, but never touches the lives of real people who reside below the hierarchy. Even with the rescue, thousands of workers lost their pension and hope for the future because their management committees weren’t honest with them about their firm’s fiscal solvency.

It seems as if earnings and profits are being squeezed by higher costs or lower unit volume growth. In some cases we are seeing the next wave of mergers and acquisitions of depressed companies by larger sharks. There is enough money to finance these distressed buyouts. We are not in the middle of a global credit crisis as some might suggest, but, rather, a global morality crisis in which greedy corporations leverage themselves beyond their ability to pay. If leaders would lead rather than trying to dupe the public, they could mobilize capital to solve problems which ultimately would be remunerative to the bottom line.

Who cares about Main Street?

CEO’s who command failing corporations or who steward impolitic mission statements need to be held accountable for their poor governance. While write-downs and losses are part of the standard operating procedure for hedge funds, banks and brokerages that take unnecessary gambles with your money, you and I are not as “privileged” to walk away from inaccurate accounting or poor investments. Households go “bankrupt”, corporations “write it off”.

The solution is not to manipulate the ebb and flow of the capital markets but to rejoice in its efficient processing over time. As painful as it might be, it serves no interest to delay or interrupt the normal cyclical flow of economic and market destiny. You don’t agree? Try to jiggle money loose from a disbelieving public right now.

There is a true, quantifiable quotient that connects human emotion to the capital markets.

While a stimulus check might be nice, a hug and some reassurance might be nicer.

Market Commentary for the week of March 17, 2008

The tail that wags the dog….

The worst kind of redemption is an act or response that seemingly has no relationship to the act committed. Such was the case last week when global financial markets dramatically spiked upwards in reaction to moves by the Federal Reserve and other global central banks to infuse the money supply with billions of dollars (and other currency). The knee-jerk reactionary euphoria was typical of a parallel disconnect I had defined earlier in which the appearance of two unrelated phenomena moving in the same direction take on the appearance of being somehow inextricably linked. But, alas such is not the case. A reflexive bounce in equity prices does not represent a sea change from negative economic data, nor does an infusion of capital mean that investors are likely to spend their newly-found largesse. As I’ve said in the media on many occasions, “you can lead a horse to water, but you can’t make him spend”.

Especially non-redemptive about last week’s monetary response was the naïve belief that the solution lies in combating poor credit or spending inflexibility. I believe that the world would beat a path to a “better-mousetrap”, and is hungry for solutions to biochemical research, alternative energy, education, infrastructure redevelopment, agricultural research and availability, technology deployment, etc. In other words, irrespective of market cap or geographic location, the financial landscape is rife with possibilities, solutions and opportunity, right now. And there exists sufficient resources and capital to invest in these projects. Standing in the way are governments, jingoists, and ego-centric bankers who see solutions as personal money-making occasions, not altruistic opportunity to combine profit with the public good.

….but the dog won’t move.

Further exacerbating the disconnect surrounding last week’s market gyration is the systemic intransigence of the underlying problem, namely inflation. Until this headwind abates, the profit picture for equities looks sullen. Inflation is not a derivative of the global credit crisis, it is a casualty of it. Lower interest rates, and the insistence of monetarists worldwide to lower interest rates, have succeeded in creating a hoarding of money that punishes those who don’t have it, while rewarding those who accumulate.

This accumulation might be represented by “things” (real estate, commodities, businesses) or it can be cash, itself.

Witness how there was enough cash in abeyance to move the markets last week, simply by the suggestion of a global capital infusion, and enough credit to go around to allow leveraged financing of mergers and acquisitions, equities, real estate and other depressed financial instruments. One of my friends likened the effect to “giving alcohol to an alcoholic”.

The “five sisters”.

The bottom line is that there remain several intractable data that didn’t change last week, and won’t, irrespective of any announcements or news releases:

· Inflation is the most insidious tax upon spending patterns since the 1970’s.

· Most global equity bourses remain in a secular bear downtrend.

· Corporate earnings are slowing at a rate not seen in the last 16 years.

· Currency exchange patterns are causing a rebalance in political and economic influence

from West to East.

· The trigger to a reversal in the bear will not be an event or announcement, but time and

its palliative effect upon what ails the financial markets.

Given no further action by the Fed or its counterparts, cyclical patterns should emerge in the next few months that will redefine the capital-gains landscape. It’s that complex, and it’s that simple.

Market Commentary for the week of March 10, 2008

It’s time to rebalance.

Be prepared for additional market recoil as energy prices ease into the spring and summer driving season. Refineries began mixing their lighter “summer blend” of gasoline last week, one which requires a recomposition of the mixture used during the winter, and therefore more expensive to produce. The amount of damage inflicted upon the economy by rising gasoline and energy prices is unknown, but the evidence is clear its effect will not be positive for corporate earnings, or your pocketbook.

I also expect subtle shifts in other natural resource indices in the next months, particularly in agricultural products (foodstuffs) and metals. Without debate, the trends are inflationary and pointing towards higher thresholds. My long range forecast for tangible assets is solid, bullish, and consistent.

A little perspective.

Just one year ago, the market was on a precipice, but clearly not in decline. Consider that late in 2006 an energized equities market was rolling along in the fourth year of a post dot.com bull. Concerns about earnings abatements had not yet permeated our thought, and housing (as well as financial equities) was a boon to the economy.

Not so today, although predictably it was bound to happen.

Sustaining growth by lowering interest rates, and a decidedly greedy corporate body, exacerbated a normal growth cycle by “leveraging” average investments and encouraged “incentive pricing” in retail (autos, furniture, etc.) and housing. The net result of the expansion of this bubble was no different than the irrational exuberance of our dot.com friends ten years earlier.

In fact, it is curious to me that investors fail to acknowledge the excessive price spike which follows nearly all long-term bull phases. History has shown us time and again that you must capture the rally early to mid-stream, but avoid the greed of manufactured expectations at the back end. Instead of focusing upon the humanism and social responsibility of equities, the last stages of a bull market are about hoarding and collecting the most personal reward.

Arguably, it is not easy to dissuade the emotions of speculators during these volatile periods. But it is easy to quantify the excesses from an arm’s-length perspective. When the broader altruism of the equities market becomes subordinated to a short-term EPS (earning per share) perspective, it is time to rebalance one’s expectations.

Tectonic shifts.

The subtlety of this observation might be too overblown for some. But consider that monetary policy is sometimes predicated upon a herd mentality, not on a broader secular theme. If that were untrue, today we would be seeing higher interest rates, not lower.

As the dollar declines, psychological and fiscal damage widens. The punitive impact of a dollar decline is an unnecessary tax upon commerce and manufacturing. It is probably time to reign-in spending, not to encourage it with cheap money and lower interest rates.

In the meantime, commodities-rich emerging markets are leading an expansion in economic development, and laying the groundwork for supplanting the West as the engine of innovation and commerce.

The situation is quite complex, but not dire. Cycles expand and contract. We will see a reversal of the equity bear phase and we should prepare now to identify earnings leaders that will be remuneratively rewarding to our portfolios. Time is the ally of today’s negative expectations.

Market Commentary for the week of March 3, 2008

As we speak, a confluence of factors runs towards an inevitable result. Consider that meanderings of the market during the past week were less important than the data which caused them. And the data was not great.

The most significant of these is the velocity of price increases across the board, from commodities and tangible assets to tuition, pharmaceuticals, and healthcare. We knew that we were in a period of pricing power, but the impact of its cumulative effect hit like a freight train last week. Wholesale prices jumped more than 7 percent in the past twelve months, and that was the least amount of gain amongst a basket of staples reported. Wheat, gasoline, copper and sugar rose at year-over-year increases nearly double the core rate.

Indeed, the confluence is one of those trends about which I wrote last week. Once it hits, it’s difficult to turn around.

Economics is global, not local.

Mini-rallies in stocks worldwide are symptomatic of a hope that we are near the bottom. In fact, all trends do end at some point, so one might assume a bearish stance during a bull market, or a bullish stance during a bear. But the truth is that you never want to commit your money, your hopes or your expectations to stemming the tide unless indications warrant a change in direction. That’s not the case presently.

Global stewards of monetary and fiscal policy seem to believe that one can spend out of decline. Lowering interest rates to “motivate” spending is misguided, in my judgment. As corporate (and consumer) earnings decline, reducing the cost of money only encourages hoarding of money, not spending, especially when there is little to spend. Psychological uncertainty and lack of vision do more to disrupt the flow of capital than do ordinary cycles of economic patterns.

What perpetuates the tone and behavior of the market’s current decline is the failure of the response itself. Investors have tremendous resiliency and likely would be inclined to invest in science, technology, infrastructure, agriculture and energy if properly inspired or incentivized.

Compared to last year’s lackluster performance, this year could be worse. The impact of price creep means that wars might be fought over natural resources, or that economic development might be held in abeyance for matters of national security.

Lower interest rates are a threat to capital gains expansion by encouraging an unsustainable and unrealistic perspective about the more onerous threat of inflation and price pressure.

Double-edged sword.

In previous decades, politicians spoke about globalism as a noble construct. Today it seems as if regions have become pockets of opportunity or isolation based upon their indigenous share of natural resources or economic potential. Such characterization creates consumer panic and pits region against region. If you want to see commerce come to a screeching halt, start playing the game of “who’s ahead and who has the most chips”. Isolating the money supply issue to ego or jingoism is a recipe for short-term planning and global disequilibrium.

Caught as we are in this dilemma, the best result is to hope for less intervention in the cyclical impact of traditional economics and more humanism towards those most adversely affected by the cycle, itself. Medicine needs to reach the infirm, infrastructure is required to deliver the goods, resources need to touch the most vulnerable.

Both the objective and subjective conclusion of my research is a vision of global commerce that levels the playing field and opportunity to compete. To eradicate the devastation of hopelessness, a clearer perspective must be constituted, and an ideology of moral capitalism should be transacted by the public and private domain. Whomever demonstrates the qualities of building for the future will attract the most capital and the most political goodwill.