Market Commentary for the week of June 23, 2008

In the imaginary “race to the finish line” that is stock and bond investing, it is important to prioritize the metrics by which one might measure success. For some, the finish line is just a short sprint from the starting gun, for others the finish line keeps moving and the game is simply to keep pace with that forward momentum. Finally, and obviously, no one is looking to fall behind the pack.

No matter which barometer is yours, a steady upside progression is the result of methodological consistency.

Are we bottoming?

As the markets contract, more concerns arise about the state of underlying fundamentals whose authenticity is the backbone of traditional fundamental analysis and economic theory. For example, I am concerned about the deceleration in corporate earnings caused by a manic spike in commodities costs. A heavy price is borne by those in manufacturing, as well as a reduction in discretionary capital by the product’s end-user, the consumer. Surging prices have caused not only a debilitating economic landscape, but have cast a psychological pall over the whole proceedings.

Clearly, the variables which impact economic and market prosperity have lost momentum during the past year, and trace their (negative) origins even further back in time. Whether or not a panic is the right response is debatable. My work indicates that we are within an economic contraction, but closer to the end than the beginning. Those prescient enough to have seen the beginning of the reversal had already taken sufficient action to mitigate its effects. For instance, our clients had reduced equity-only exposure by 25-30% as far back as last October.

Going forward, the issues revolve around the magnitude of negative performance and the duration of capitulation cycles.

It’s about the money.

Primarily, markets must deal with psychological and fiscal liquidity. During various cycles each of these requires stimulus of varying degrees. Currently both factors are quite barren, and causing the kind of manic upswing/downswing patterns we are experiencing today. It means that we have a harder time defining the prevailing bias towards or against financial instruments. As long as ambivalence rules, markets (and economies) will stagnate.

It is exceedingly difficult to quantify the “choke-point” in the market. Looking ahead, I believe a seminal moment might be the Presidential election in the U.S. We need questions answered about fuel (energy) policy, jobs growth, war and peace, economic development, and fiscal policy. The reverberations of this election might spread beyond our borders to influence attitudes and policies elsewhere. Linking nations together is part of the global flow of capital, and likely a way to stimulate industrial expenditures.

In the meantime, I am encouraged that some sectors are showing a resilience that belies talk about gloom and doom. In fact, I see a healthier, “value-type” landscape for the next few months. Maybe even some opportunity to “buy low, sell high” once again.

Market Commentary for the week of June 16, 2008

Real returns, as well as relative ones, took a huge beating last week as concerns about earnings sustainability in the face of rising costs caused a pause in positive sentiment. So far this year energy prices have risen at a double digit rate.

A common theme amongst all global exchanges is a reduction in momentum, cash, and sentiment. As evidenced by the flattening of the advance/decline ratio, most markets look ready to take a long summer hiatus.

While those who do own stocks are experiencing frustration, not all are leaving for the exits. Fundamental long-term projections are for solid growth in the coming years, just not right now. After a near-linear ascent earlier in the year, the equities markets are in a nominal retracement that might bring valuations into a more suitable equilibrium from where they can resume bullish direction. That, too, is my expectation for the latter part of the year.

After all, those who predicate their earnings analysis upon retail sales and demand are missing the bigger picture. Discretionary capital is now going to pay non-discretionary expenses, and, besides, there is too much negativity to sustain a consumer-led economic expansion. The relentless advance in prices has many believing that margins will not expand significantly this year.

Globalization is proving a boon to dormant sales categories as China and India take their place amongst the globe’s consumer leaders.

However, the commodities markets still command the most attention because it influences so much of the economic price scale worldwide. This category affects profit potential more than any other. Irrespective of geography or ideology, oil, food and other raw materials are influencing a decline in economic affluence.

As an earnings-driven specialist, I find fewer companies that are creating counter-cyclical profit expansion. With no bias towards any discipline, region, or sector, I see the landscape of earnings candidates dwindling slowly. This is a cyclical, short-term phenomenon, but real and pervasive currently, nonetheless.

To me the most compelling statistic to watch is not the fundamental data, but the ethereal psychological components. Generally speaking, this type of data is difficult to quantify, and has little to do with underlying fundamentals. But this is a different time, following on the heels of a record run in many sectors, that is defined by expectations about lifestyle and security. Without discounting the significance of my own research, and the larger macro picture, personal margins are suffering disproportionately to the economy as a whole.

At a time in the market’s cycle when optimism and liquidity are so badly needed to sustain capital gains, neither is in large supply. The most formidable task in front of us is to weather the short-term and to hold out for a better equilibrium in the not-too-distant future. As we near the official start of Summer, I look for the markets to quiet down and await a “start over” in the Fall.

Market Commentary for the week of June 9, 2008

Global inflation risks are strengthening, and not simply limited to the U.S. and our “pain at the pump” refrain. Indeed, as the rest of the world modernizes and integrates into industrial production, the demand for natural resources, wage increases, and a heightened standard of living will put a strain upon barriers and price points that heretofore had kept a lid on runaway excesses.

We do ourselves an injustice when the inflation discussion is limited to our shores, Western nations in general, or the English-speaking population.

Structural decomposition.

This past week the topic of global hunger and food shortages was addressed by the United Nations’ Secretary General. Right now he speaks with a voice more significant than any Central Bank representative, or Wall Street tycoon, because the issue is not solely about money greed or profit, but about equitable allocations of precious resources. Could potable water be the next black gold?

Thus far, titans of industry have steadfastly refused to acknowledge the inconsistencies of their rabid price increases, exorbitant profit margins and declining standards of living in the poorest parts of the world. Their approach is to view these “headlines” as arm’s-length events, when in fact their benign assessments are way off base. Structural price pressure has been building into global commerce since 1999 and skewing profit and industrial patterns worldwide since that time.

The difference for most observers is that inflation has been limited to highly visible and obvious sectors. But when the patterns of price increase (and profit erosion) spill over into everyday costs like food, medicine, education and transportation it has an effect upon psychology and spending patterns. What’s the old saying, “It’s a recession if it affects your neighbor; it’s a depression when it affects you.”

Like a wildfire.

The interesting thing about declining psychological exuberance is that it carries over into all facets of day-to-day life. No one likes to think that their standard of living is going down, nor do they want to be forced into either/or decisions about necessary and discretionary spending. But that’s exactly what the market (retailing) is observing. The data is understating the severity of the financial and moral crisis the economy is facing.

Among the most important macro trends my data has uncovered in the last decade is the decline of retail/consumer influence upon profits and the diminution of unit volume growth in industrial output. I was early with this message, writing about it as far back as 1998.

Dot.com, or dot.natural resources?

Looking ahead, my data is identifying a new paradigm, just not the one the dot.com generation envisioned a decade ago. Theirs was a nirvana of productivity borne out of technological innovation, a wristwatch that might control every facet of modern life. My data does, in fact, recognize the expediency of technology in medicine, communication, energy production, information processing but at what cost? If machines can produce more efficiently than humans, and more cheaply, then we could see the genesis of the demise of human production lines and capacity employment. Even Wall Street has begun the process of laying off floor traders, analysts, and portfolio managers, as machines systematize the delivery process of analysis and services.

My data is not conceived to predict future trends, simply to reflect and quantify the trends that are there. I am confident that the challenge of measuring the effect of inflation upon equity analysis and performance is in its infancy, and not yet fully developed. The key is to break through psychological rigidity to uncover new sector trends that might create capital gains opportunities where currently very few seem obvious.

Market Commentary for the week of June 2, 2008

Micro perspectives.

Market declines that are preceded by unusually large parabolic price expansion tend to look more benign than a definitional correction because the earlier magnitude takes longer to unwind and, numerically, still looks to be trading in a bullish pattern. For example, while S&P decline is measured at a paltry 6 percent year-to-date, its integer value of 1400 still looks to be “within range” of its all time high set last September. Given decent valuations, it becomes more seductive to investors to think about how far they are from the peak than to contemplate how much further to the bottom.

In terms of relative performance, however, it is far more likely to see the market consolidate downwards than to trek aggressively through previous upside resistance levels.

Earnings growth expectations continue to disappoint in nearly all sectors. While there are certainly individual exceptions within each category, I do not like to think about stock-picking when my purported expertise is really about asset and sector allocation. A far more objective review of the data leads me to conclude that more sectors warrant underweighting in our portfolios versus overweighting. While analysts reconfigure their numbers for the year with each new announcement about inflation-led concerns, I think that equity exposure should be modest relative to overall portfolio growth expectations.

Stocks last week completed an impressive week of capital advancements. While the rebound might look impressive, the bearish pattern begun last October remains quite rigid. I might look to sell into these rallies rather than to buy.

The big picture.

Most global bourses, in fact, have had muted responses to the global inflation scenario. Although somewhat correlated to each regions’ lack/plentitude of natural resources, most commerce has been somewhat immobilized by a steady increase in core wholesale costs and by currency irregularities that drastically impact upon imports/exports.

A majority of central banks are trying to deal with inflation and price-creep. In some instances interest rates are already rising, and in some others, currency is being mass produced to meet that country’s needs. In either case, monetary policy is clearly influenced by supply and demand not only for commodities and natural resources but by nominal demand for necessities and economic viability.

The biggest macro issue today is about an equitable distribution of available commodities (food, metals, water, wood, coal, gas, etc.). Where supplies are weak economies are “poor”. The fine line between abundance and shortage is more precarious today because of regional self-interest and jingoistic monetary implementation.

By definition, normal cyclical timelines are drawn-out longer during these periods of uncertainty. Psychological exuberance and capital flow are in short supply, which prolongs the duration (amplitude) and possibly the magnitude of any correction we might be experiencing. I am not expecting a market crisis, but, rather, a slower negative advance until the details correlate with fundamentals.