Arlington Econometrics Second Quarter Commentary

Kaleidoscope


Key economic factors, (such as interest rates, leverage, speculation, valuation expansion, e.g.) got terribly out of balance in the last decade, exacerbated by personalities and felons whose charisma helped fuel the calamity. Indeed, the secular boom/bust cycle would have played out with or without their help, but the erosion of “principled investing” accelerated the negative influences that eventually led to a magnitudinal failure in the markets and the economy.

At a time when markets are gyrating, seemingly without purpose or direction, I get the perception that the economic landscape is woven together by parts that don’t necessarily fit together, some which don’t even belong. As politicians, analysts, and investors seek comprehensive solutions to far-reaching problems, does it not seem that the dynamics are unsynchronized? Policy goals and monetary efforts aside, the bigger issue is the notion that we need to feel connected to rational data, and be unwavering in our conviction to invest money for the long term.

In other words, sometimes the solution to economic matters is not economic responses, but rather a feeling of innate comfort and optimism.

In a climate of disequilibrium and lawlessness, the natural instinct is first to withdraw, as the market clearly has done, then to go after the miscreants who caused the systemic breakdown in the first place, (somehow ignoring that our participation in the greed-driven excess might also be blame-worthy).

Markets
Globalization and the synchronicity of interdependent commerce drove the same factors around the world as those which affected the United States. Technology played its role, too. Our dot.com forebears probably could not have foreseen how instantaneous communication might have exacerbated the negative influences of trading, exogenous news, and a constant background “chatter” from business news channels. The multiplier effect of push-button technology exceeded our ability to process the data. Leverage built into our financial system was simply an annotation within computer programs, not necessarily a well thought out plan for long-term investing.

The post script to our actions/reactions is now being written in the second leg of the parabolic secular trend, and in legislation/policy designed to ameliorate the impact of bad news, as well as to redirect the focus from the short-term pain to the longer-term opportunity before us.

With yields having fallen to record levels in the past year, and incentivized by monetary policy to remain there, some have questioned why we can’t achieve a sustainable rally in the economy or stocks? An unusual mosaic of housing, portfolio declines, greed, negative psychology, and unemployment are providing sufficient impediment to a turnaround, that favors inertia over speculation or rebound. These data exert an onerous influence upon the markets.

Perhaps we need more punitive monetary policy, such as a rise in interest rates. While the current bias “makes sense” to many, it has become an unwitting culprit in encouraging a depletion in the savings rate. There is no incentive to park long-term money in low-yielding time deposits. Additionally, the traditional alternative investment strategy, in which equities provide an outlet for capital-gains-seeking investors, doesn’t exist either. In times when equities project danger, or lower capital gains probabilities, high yield bonds have usually provided safe-haven alternative. Today, no such alternative parking-place exists, thus the markets stagnate.
Thanks to stimulative global monetary policy of the last decade, we have painted the world economy into a corner.

Capacity, productivity, profitability, and innovation are combining for a kaleidoscopic cacophony of historic proportions. As a result I had grudgingly reduced equity risk exposure in our portfolios to its lowest level in a decade. The probability of secular long term gains might be rising as stocks slide lower, but I didn’t want to be out in front of a bear market tsunami without protection. Indeed, equities appear to be decelerating their downside momentum, making for a potential turnaround by mid-Fall. (This contrasts with the mini-bull short-cycles we have seen during the past year which deviously sucked investors into a no-win game of “guessing where the bottom might be.”) Stocks are undervalued, globally. But their potential can only be fulfilled with a vibrant fixed income marketplace alongside.

Bonds today offer no compelling relative value, other than their appropriate weighting representation within a broader asset allocation plan. The yield curve does not favor long-term investments. The probability that rates might rise, concomitant to a rise in economic activity, is quite high. Despite potential for periodic fluctuations in interest rates and currency values, the capital gains opportunity in the fixed income market died at the end of the last decade.

With stocks crashing through one “bottom” after another, it is tempting to throw up one’s hands and to park money in short-term time deposits. Unfortunately, the price to be paid for permanently waiting on the sidelines is net return. More than in the recent past, the probability of equities outperforming bonds on an annualized basis is growing. Said another way, if you commit to inactivity or cash, a rise in interest rates will hurt you in fixed income more than any other financial security.

Strategy
It was over three years ago when I argued that the bull market in stocks was expanding precipitously and with too much leverage (margin). I further stated that low interest rates were contributing to the disequilibrium by flooding the market with cash and by removing an appropriate investment surrogate for stocks, mainly bonds, from investment consideration. The cycles progressed at such a rapid rate that the confluence of all factors magnified the collision at the top, and drove markets down linearly rather than in an orderly parabolic flow.

Heavily leveraged bets in real estate, equities, employment, production capacity, retail sales, and exports imploded, with the net result being a near-zero growth rate in all of those bets for the last two years. That is not an outcome, or bet, I am comfortable making.

Today we are attempting to breakout through resistance barriers whose markings are traditional indicators and normally cyclical in their behavior. Any manipulation by our legislators upon upwards data might be as volatile as manipulation was downwards. But I do expect a recalibration of indicators associated with turning around our moribund economy, what many have referred to as “hitting the reset button.” Examples of these stimuli might include letting interest rates rise rather than holding them down artificially. If “growth” does occur, raising rates would achieve a more neutral bias in monetary policy. How high to go, and at what velocity, could be problematic, but consistent with a secular trend away from disinflation.

We must not confuse short-term market cycles with secular trends. Bond yields will reverse course and rise to a sustainable level as moderate economic growth returns, and as real rates of return expand. Progress on the fiscal/legislative front has the potential to accelerate growth industries for decades, and to build strategic synergies in energy, infrastructure, education, science, and national defense. Employment should rise as a result. Rather than a deconstruction of our industrial models, we hope for structural improvements.

The deficits are, indeed, a problem. The overhang of long term liabilities can quickly destimulate any progress made. But if the last decade was built upon leverage that caused the problem, perhaps a prudent allocation of public/private capital might start the painstaking progress of reversing the immoral excess and paying back the ills of misplaced consumption?

The irony of these questions is a focus upon short-term responses by Wall Street and Main Street, even as we try to widen the aperture of perspective to longer-term solutions. I blame the problems, themselves, on day-to-day greed. Why, then, do we magnify the problem by looking at solutions through the same prism?

As the potential grows for capital gains expansion and legislative initiatives, it is critical to set out with a methodological advantage. Schemes and trading strategies quell our short-term instincts for success but do little to solve systemic ills. Indeed, the landscape of investment opportunity is much broader in “value” (depressed) stocks than it is in growth equities. Buy, if you must, for maximum capital gain potential, but I prefer to remain in leading sectors rather than to “bottom fish” amongst the laggards. Those depressed stocks are down there for a reason. If necessary, rather, let’s start with a five year estimate and build our portfolio accordingly.

Feeling “secure” tomorrow will reflect how well the other things have been done first.






Asset Allocation:
Equity 35%/Fixed Income 30%/Cash 35%