Arlington Econometrics Fourth Quarter Commentary

Manic Edge

The market completed its steady climb last quarter, up nearly 50 percent from its twelve-year-lows in early March. Unfortunately, opinion about its ability to sustain upside momentum falls on either end of a psychological paradigm. On a positive note, “everyone” is clamoring to get back in, but on the other side “many” have decided the game just isn’t worth playing anymore. Right now the sentiment data might be more significant than the economy’s underlying fundamentals.

However, fundamentals are improving. Employment data, while not satisfactory, have reversed months of declines. In the early stages of turnaround, modest reversals or declines in acceleration might be viewed as positives.

Risks, too, are more dispersed globally. Domestic commerce is global commerce, as well. It is conceivable, because of information technology, that your local retailer might be as well known in London as he is in your neighborhood. In the next decade, the definition of borders, ownership, and brand identity will evolve in ways that require adaptations to our thinking about what it means to own equities.

In fact, this quarter’s summary indicates a widening of global opportunity, and a shift in secular momentum trends away from the U.S. towards unit volume growth and pricing power from themes whose origins lie in diverse regions. As always, we try to vet opportunity for its intrinsic capital gains value and macro-modeling relevance. The data is now indicating greater capital gains and earnings potential in non-U.S. markets than at any time in the last decade.

Because investors are edgy about a sense of security when investing, I believe it is imperative to adhere to a methodology with which one feels comfortable. If trading is your forte, go with it. If balance and conservatism is to your liking, stay with that. The key, though, is not to deviate from what “feels right” and from what works on an absolute return basis.

I believe market cycles can be identified and quantified as to their location, duration, and magnitude. Indeed, cycles are “parabolic” not “linear.” They always offer entry and exit points, which I refer to as “inflection points.” These are not points at all, really, but periods during which characteristics of accumulation or distribution can be calibrated.

Therefore, investing in trends is not a day-trading profession, but rather a generational opportunity that endures. The direction of interest rates, the price of energy, demographic population shifts, are examples of trends that economists, sociologists, politicians and philosophers use to make learned discourse about the state of affairs. Limiting ones aperture to the “price of semiconductors”, or “when to buy XYZ co.” limits one’s capital gain potential, as well, and might result in negative performance during periods in which the focus is not on those bottom-up characteristics.

While I quickly acknowledge the myriad of diverse and successful investment philosophies, our metrics have worked well for our clients whose focus remains upon wealth preservation, risk aversion, balanced opportunity, and competitive absolute return.

Markets.
The global theme is fluid, not static. We are not suggesting that markets are abandoning the dollar or traditional non-cyclical U.S. companies. Instead, our metrics are showing areas of the globe that are rich with natural resources, labor, intellect, and solutions for macro problems that are devoid of borders or country identity. As this shift in opportunity takes place, we are suggesting one be ready for it and that the trend is already beginning.

Technology has already created a 24 hour marketplace. It also allows for greater transparency and uniformity of data analysis. These shifts have only occurred in the last two decades, during which contemporary data sharing has made global investing less adventurous. As traditional brick and mortar industries have evolved, so too have non-tangible “ether-net” businesses.

Many emerging market countries are learning not only how to produce but how to prosper. The “trickle-down effect” is less a political slogan than it is a reality of capitalism. Although many nations might suffer from a governmental comparison to the United States, they are nonetheless learning to cultivate their natural resources, entrepreneurial spirit, and a willing labor force to sustain economic viability. Whereas these nascent industries might be reliant upon the globe’s more mature market baskets into which to sell, they nevertheless represent a growing commercial challenge to less nimble industries.

Broadening competition from India, China, Germany, Greece, Brazil, Chile and South Africa accelerates the locomotion of secular trends and global problem-solving.

Meanwhile, here at home, growing budget deficits heighten inertia and constraints upon corporate capital expenditures. Our nation’s GDP is choking on a declining labor force, lower discretionary capital, and a psychologically debilitated consumer psychology. With or without Federal stimulus/bailout packages, a growing baby-boom generation is fearful whether their retirement savings will be sufficient or that their quality of life will be as robust as their predecessors.

Our global partners’ unwillingness to finance our largesse might come back to bite us. Friends, and adversaries, are aware of our internal political debate. They see that it might be cheaper to consume goods and services produced elsewhere. In spite of the dollar’s decline, domestic U.S. spending on war, social programs, and infrastructure might be sufficient disincentive for attracting foreign capital. Our trade deficit widens concurrently. Our consumption of exports is outpacing our ability to sell overseas.

Global quality, and competition, is a trend whose roots have already taken hold.

Strategy.
Arlington Econometrics is predicated upon the science that market events are not necessarily random. There are discernable, measurable statistics that can be quantified, secular trends that overlay all data, and cyclical patterns of advance/decline within those longer demographics.

The most significant secular evolution is occurring today in natural resources, particularly food and agricultural sciences. Whoever controls grain production and harvesting, water resources, meat and poultry production, corn, fertilizer and soybeans will be a profit beneficiary of the next secular wave.

While this may be a boon to emerging markets and fertile land resources, we also need to look at how these enterprises are financed in the public and private domain. No government should subsidize the destruction of crop harvests in order to maintain “equilibrium” in the supply chain. Further, no citizen should ever go to bed hungry. Lack of distribution, not production, is the bane of the agriculture industry.

Secondly, energy resources are the most inefficiently applied new science in our database. One of the most significant influences over economic and social policy is renewable energy production. The potential to match declining resources with alternative sourcing is not uniquely an American problem, it is a global problem. Expanding sources of energy production is a governmental responsibly, not just a profit incentive for the private sector. The solutions require technological sophistication and intellectual capital to achieve their ends.

And brain power might be the most important commodity export any nation has to offer. Investments in education, infrastructure, healthcare and security are requirements for emerging markets as well as our most sophisticated industrialized nations. To that extent, countries can provide the capital to each other for a renaissance in commerce as well as mutual protection.

Conclusion.
As the short cycle advance gathers at the top, risk heightens that those on the fence about investing will be dissuaded from jumping in with cash. Every downdraft creates more skeptics. Although the much larger bear correction is nearing its nadir, the recent monthly advance indeed has created a more risky entry inflection point.

I too am cautious about chasing short-cycle advances. However, with the multiplicity of longer-term, secular themes on the horizon I believe acceleration patterns in the market over the next few years will be upwards, not downwards, and will give our clients a chance to benefit from conditions that set the stage for an enduring bull phase.

Rather than living on the manic edge, I believe the science today quantifies fundamentals over fear, profit over hyperbole.





Asset Allocation:
Equity 40%/Fixed Income 25%/Cash 35%