Market Commentary for the week of May 27, 2008

Leadership remains focused in those sectors that are immune from shortages, lower demand, or labor cost increases. Leadership slowly ekes out profitability and price performance from a quagmire of low expectations and bear market statistics. Give wide berth to an economy and stock market in transition. Selectivity is the watch-word of the day. Government and central banks are irrelevant to the equation, now. Stocks move either because investors perceive value or money is being put to work out of necessity. In large measure, leadership is working in spite of underlying fundamentals.

Market crawl.

Right now, any bullish scenario for equities is independent from cyclical economic reality. Globalization has, indeed, leveled the magnitude of downside erosion in some sectors, but has not significantly shortened the duration of historically normal capitulations. If given some breathing room, the market might correct less disastrously than anticipated, but not any sooner than most would like.

The key to any turnaround would be a protracted period of earnings acceleration surprises and a consumer willing to suspend disbelief or fear that he won’t get burned a second time around. I would argue that such a time is not the present.

The data indicates, in fact, that inflation and pricing power cannot be contained but, rather, sweeps most equities into a broad network of coincidental and laggard performance. Margins are shrinking because of these expenses, and only those companies in protected strata are marginally growing their bottom line. In fact, a good percentage of earnings performers are doing so not by increasing unit volume growth, but by raising prices to their end-users, the consumer.

My data indicates that, even for the most successful stocks, the gap is widening between multiple expansion and book value, heightening the potential for a reversal in equity price advances.

The most exposed to these reversals are Consumer Cyclicals, Financials, and Industrials.

From a contrarian’s perspective, some sectors have not yet reversed their secular (generational) advance. There is no doubt that Energy (in all its forms) remains the most dominant sector of our decade. If one can remove focus from fossil fuels and terrestrial stockpiles of coal and gas, one might imagine a new generation of power sources, some of which we can’t even identify today. In that sense, Energy is the New Paradigm that many thought would be the dot.com revolution of the new millennium. You see, it takes years to develop “paradigms”, not simply a pronouncement by marketing departments, ad agencies, or “talking heads” on business television.

A page from my book.

Our portfolios are heavily weighted in earnings performance, and solid dividends from bonds and growth equities. I make no distinction by capitalization, geography, or sector. Starting at an equal basis, all financial instruments are screened for price momentum and relative strength (RSI), while fundamentals are monitored closely for sustainability and profitability over the long-term.

The market is fragmenting into daily upswings and downswings of various magnitude. It is a seductive siren song which, if played incorrectly, might lead to overweighting in the wrong sectors, or disappointment about anticipated momentum not materializing.

Market Commentary for the week of May 19, 2008

Financial markets by their very nature are always going to be volatile. The key to understanding that volatility is to define the location, phase, and duration of the current cycle. Comprehending the psychology of those responses is what defines a bull or bear.

My less-than optimistic viewpoint is defined purely by the data, not my hopes or expectations. As an earnings-driven investor I begin my analysis with prevailing magnitude and duration of earnings acceleration patterns. When working well, markets expand because of an increase in share price, or earnings.

In today’s climate, the correlation I seek is limited to very few sectors.

Upside down fundamentals.

Earnings are rising but in equities and sectors whose pricing power creates hardship for the rest of the economy. It is clearly no secret that energy, basic materials, and agriculture (Consumer Non-Cyclicals) are performing well. And although their shares are not performing well, pricing power is moving pharmaceuticals, utilities, technology, and infrastructure (Industrials).

So why all the negativity?

Firstly, I am not negative, I’m practical. We had been in a bull market since late 2002, and if you missed it because the Tech-bear frightened you away, it is already gone. Five years, that’s it. Today, on the back side of the parabolic upswing, I see a lot of “stock-picking” but few strategists who are able to define an enduring bull leg without first allowing for a definitional pullback in excessively priced shares. In other words, be patient the next bull leg is developing, but presently doing so “under the radar”.

The long view.

The market’s bigger problems emanate from fiscal and monetary policies which I deem to be very limited in scope and not creative enough.

Monetary policy, the sequential lowering of interest rates, has created enormous speculation and inflation in tangible assets. By any measure, real estate speculators drove prices into prohibitively high ranges, causing what now has become a punitive cycle for owners and investors. Similarly, energy, food, tuition and healthcare cost more and represent a bigger percentage of budget expenses than ever.

Banks need to reconstitute their lending practices and, in some cases, their management. Excesses in greed and product-origination contributed to the last cycle’s misplaced and misguided expansion. Today, financial shares are the worst performing group, and the least likely to turnaround first.

The emergence of strong sector leadership abroad also dilutes the success of fiscal policy at home. It cannot be taken for granted that U.S. leadership in industrial and technology shares will go unchallenged. And without an energy policy resulting in self-sufficiency our budget will be stalled economically, militarily, and creatively.

Bring it home.

The tip of this economic iceberg is only what we know and see today. Weather related challenges around the globe point out how precarious life and money really are. If we are to measure the quantity and quality of market potential, I believe it requires a recalibration of thought and imagination.

Benchmarks are simply guideposts, not absolutes. We need to customize our approach to investing in order to reach quantifiable, and achievable, goals.

Market Commentary for the week of May 12, 2008

Despite “breaking out” above recent resistance levels, stocks showed little breadth of participation during last week’s rally. Most importantly, sentiment remains unconvinced that either the economy or the stock market is all that strong. What we saw during the rally was a reflexive bounce off the severely depressed levels that we achieved in March/April.

I remain unconvinced that we are in anything more than defensive rallies within the existing secular downtrend.

The factors which drive the rallies are an abundance of cash by some speculators who need to put money to work, and extremely attractive prices on some companies whose name recognition and perceived “good will” in the public identity make them must-have investments in spite of their poor track records recently.

Which way now?

The Fed seems to have little wiggle room left, and becomes, therefore, more irrelevant. Despite the creation of liquidity from rate cuts, they seem to have very little significance to the performance of stocks. By their own doing, they created inertia and doubt about their role in monetary governance by losing their “arms-length” neutrality during the Bear Stearns bailout. Historically, rallies generated by Fed-buzz have had very little staying power. Any justification for equity rallies that are credited to the Fed are suspicious, at best.

My profit models continue to show diminishing acceleration patterns. I am not convinced that these numbers might turn around in the next quarter or two.

The lone positive trends continue to be in heavy demand commodities areas, such as Energy, Materials, and Agriculture. Risks of these secular trends evaporating are relatively low, and would require months (or years) during which any asset allocation remodeling might take place. These patterns hold true globally as well as within the U.S. market.

It is what you think it is.

There are precious few signs that psychological support will flow into equities. Until the stress factor of personal finance and corporate earnings subsides, there is little appetite for conjecture, speculation, risk, or hypotheses.

Let’s be clear about what factors are driving the economy:

· Inflation is the greatest threat to economic security, and the biggest impediment to corporate profits.

· The dollar’s historically low conversion rate has changed the political, economic, and psychological landscape for global and domestic commerce.

· Price-creep, as referenced earlier by inflation, is the largest stealth-tax invasion upon investors and is, by itself, a form of domestic terrorism. If fear and jingoism win, money flow stops.

· Monetary policy has lost significance by creating the conditions for commodities inflation and asset devaluation.

I am carefully marking time by positioning my client’s asset allocation to reflect secular earnings patterns, and by mitigating risk through administration of cyclic entry and exit opportunities when appropriate. Until or unless these persistent patterns give indication of reversing, my bias is to be conservatively opportunistic and cautious. In my world earnings are the key, and right now the opportunities are extremely narrow.

Market Commentary for the week of May 5, 2008

As we swing into May, heading for summer, we enter a critical inflection point for global equities. In particular, rising energy prices will take their greatest toll during the next six months, as driving, industrial production and capital expenditures increase more significantly than did the impact of winter heating expenses.

The growth rate for energy spending should have a negative impact upon profits, with the potential to overwhelm any pickup in consumer spending.

Look short, then look long.

As an earnings-driven methodologist, I believe the next six months are crucial in defining equity capital gains potential for this calendar year.

Given that equity vectors had already been quite depressed, and in a bear phase, the key question will be “how low can valuations go without rupturing significant historical support levels?” I believe the situation could become precarious in some sectors, such as Financials.

Of course, the unintended consequences of an “inflation-tax” upon the rest of the globe could create serious price pressure upon regions, sectors and particular equities. The current secular bear cycle is only mid-way to completion. Any “head-fakes”, in which spurts of upside momentum look like the “real-deal”, are not to be taken too seriously. With few exceptions, the market has settled into its leader/laggard paradigm quite nicely. Tangible and natural resource assets lead, while consumer sensitive equities lag.

Even in high demand emerging markets, shortages and price-creep quell any expansion of GDP. A common misperception is that regions are insulated from global events. However the delicate supply/demand balance in agriculture, energy, and materials creates synergy and codependence that is felt from Delhi to Kansas City. One should not imply that the energy-rich countries are immune from shortages in other assets simply because of their bounty in “black gold”.

What’s going on here?

Clients might have noticed that the bond market has been quite volatile, and negatively influencing portfolio performance. What is thought to be our “safe-haven” is actually the most disruptive part of our portfolios.

While casting no aspersions upon the potential maturity value of our issues, I do note that the credit crisis has negatively influenced all bonds by affecting their secondary market values. The bond market is not immune from psychological angst, and clearly the current demand for any long-term currency is diminishing during these periods of uncertainty. I believe this pattern, too, will continue, and we need patience to accept its short-term impact upon portfolio performance.

Broad momentum is not happening. As stated, leadership is centered in a few sectors, and quite defensive. I suggested in this quarter’s overview (The Long Way There, April 1, 2008) that we need a recalibration of baseline expectations in order to dig out of the morass. In the current environment, fundamentals and expectations need a reorganization towards a dynamic which changes the focus from “what went wrong” to “what’s going to happen now”.

I do see the potential for capital gains (fiscal and psychic) to occur in biotech and life sciences, energy sourcing, infrastructure, and telecommunications. At the risk of seeming unidimensional, I intend to follow the profit and earnings trail and to do so without prejudice for capital scale, region, or industry. However, profits without moral or social compass are hollow, indeed. Our evaluation needs to focus upon equal parts reward with equal parts responsibility.