Market Commentary for the week of May 18, 2009

Calm down.
Recent market volatility is causing investors to panic over “direction fatigue,” not knowing from day-to-day whether they are winning or losing. That kind of distress is exactly why our methodology is oriented around longer-term secular themes. To wit, any disruptions in performance we might have experienced during the last 18 months, have been flattened by recent intermediate rallies.

Although no one can fully prepare for short-term gyrations in market activity (beta), we can try to avoid the need to keep pace with benchmark indices by ignoring them and allocating to a model that reflects secular demographics and longer term probabilities of performance.

We have seen this kind of beta before, in the 90’s, ‘80’s and in this decade after the Tech wreck. We have also successfully avoided its corrosion, as our clients know.

The anxiety such volatility causes, however, is real. Fear of having enough for retirement, declining home values, job insecurity, economic disruption, etc., cause a “what have you done for me lately” consternation about one’s money manager. Feeling emboldened on the days the market goes up, and defeated on the days it doesn’t, is no way to view the practice of portfolio allocation and investing.

Similarly, if you are doing well, one shouldn’t feel as if they are “cheating” disaster and just waiting for the other shoe to fall. Our discipline tells us to avoid, or mitigate, the impact of falling (low momentum) financial securities, and to “overweight” positive momentum. Rising, then falling, consistent with industry benchmarks nets you a “flat” portfolio, and is not the objective we seek.

It’s global.
In general, I am becoming more positive, but still cautious, about the upside probability of global equity investing. Broader participation within sectors, and amongst them, along with “rising lows,” tells me that investors have the appetite to test the lows within the bear, and plant the seeds for a longer-term “accumulation.” That doesn’t mean short-cycle performance might not be poor. Considering all the economic obstacles the markets have to hurdle it is likely that exogenous negative influences could frighten the markets yet again. But relative strength data is gathering at significant inflection points sufficient to allow that the damage might be minimal.

I have to pause when I hear of the “value” players making remarkable returns this quarter. Bear in mind that depressed stocks got that way for a reason. Percentage gains, therefore, from a low cost-basis are opportunities, not trends. Recovery in Financials, for instance, is not yet confirmation of a change in lending, profit, or business models in that sector, but more a function of alpha (capital gains) from a laggard’s starting point. Those equities are looking up at the wake created by Basic Materials, Energy, Technology (Bio-Tech), and Non-Cyclicals. High risk/high reward is a lifestyle from which our clients try mostly to avoid.

Nevertheless, bottom-fishing has been successful for many, recently. But think of it this way: If you had owned these laggards one year ago it would have been a disaster to one’s alpha. This is why I believe so strongly in sector rotation and asset allocation. Relative strength quotients (RSI) can be a handy tool for risk avoidance or for exploiting momentum on the way up.

Get ready.
Current RSI are maturing during this second intermediate upleg within the bear. The rallies have been “good” for portfolio recovery, but so, too, has bond performance. Upticks in fixed income prices during the first two quarters has added about 3% to our portfolio performance, year to date.

While “short term risk” might be increasing as the markets get overbought, I continue to see an upside bias returning to stocks. More entry points are showing than any time in the last 2 years. I will avoid laggards, if I can, and focus upon earnings and price accelerators in Telecom, Energy, Materials, Technology, and Industrials.