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.

Market Commentary for the week of May 11, 2009

Not too early.
Early signs point to a “beginning of the beginning” continuum in stock price rebounds. Although it is too soon to pinpoint, in hindsight, where we “hit bottom,” actions in sector trends and equity pricing seem to indicate a widening of participation in short upside cycles. Clearly, the magnitude of downside velocity is abating, while the uptrend breadth of participation is magnifying. As I have previously cautioned, bottom-fishing is dangerous. But value exists in almost every region, every sector, all equities. Adherence to price/earnings metrics as a barometer of future performance, particularly where earnings are accelerating, is solid early-evaluation technique.

Within the framework of long-term secular motion, we are starting to see upside momentum confirmed in Biotech, Technology, Telecom, and Consumer Staples. Each of these uptrends is the “initiation of an uptrend,” not necessarily the trend itself. But in a market replete with bad news, even the origins of uptrends are positive news.

It might still be too soon to allocate a “full position” to any equity or to round-out a total asset allocation program, but I am starting to see the potential for moving cash or fixed income assets into larger capital gains potential in equities.

One positive we glean from our data is the March-April period during which prices, news, and psychology bottomed-out. Since that time, upside magnitude has been strong.

Use your science.
In the world of quantitative statistics, these upside magnitudes create inverse probabilities of performance. Therefore, as each short cycle matures, the potential for profit-taking and pullbacks increases. I would be careful about chasing equities here, and prefer, instead, to enter the market at an appropriate accumulation juncture on the next go around. The good news? I expect the lows within the bear trend to begin rising, indicating a turnaround into “bull” territory.

Clients may have recognized a significant reduction in equity exposure during the past two years. This has enabled us to mitigate the impact of an “equity-only” bear market. Fixed income performance has been somewhat disappointing, not so much because of credit risk or maturity scales, but because the liquidity/credit crisis sapped all buyers out of the market, leaving no one on the other side of the trade to make a bid. Prices seemed to fall through the floor as a result, but have rebounded recently as stimulus and enthusiasm have returned, if even modestly.

Fish in a barrel?
Global trends mirror the U.S., reversing sizeable deterioration into something akin to a broader early-stage accumulation pattern. In fact, our quarterly equity research contained more non-U.S. companies for review than any quarter in the last 3 years. I expect those quotients of distribution to remain constant for several years.

Infrastructure, Pharmaceuticals, and Basic Materials lead the global charge, currently. I expect energy companies to join in soon.

Going forward, my efforts will be to rebalance portfolio potential without increasing any appreciable risk. Our objectives are to mirror leading trends, avoid laggards, and to broaden upside possibilities through prudent use of our momentum models.

Market Commentary for the week of May 4, 2009

The markets suspended the "blame game" last week, just long enough for the markets to go up. Subliminally suppressed for now are any recriminations about the Fed, the banking system, one's broker, or any other targets previously the domain of investor's anger.

Could it be that all the market's ills have been solved simply because of an "up" week? It can't be that easy.

Client's portfolio problems never were Fed related, or the result of Congress. No, portfolio problems are the offshoot of poor portfolio planning and methodology. Anyone stubborn enough not to have seen the potential pitfalls of excess leverage or unduly high valuations has only himself to blame. Simply, the failure to plan, or to restructure one's asset allocation, is the investor's fault. One must be nimble in down and up markets, alike.

The enormity of the economic collapse leaves no one blameless, and has wreaked destruction upon all asset classes. But the severity of the decline might have been mitigated by having a fluid methodology, rather than a static insistence upon one strategy only. In all markets, one needs to adapt to the changing environment and data.

This is not to suggest that traditional "buy and hold" methods are antiquated. Nor would one presuppose that day-trading is an antidote to failing economic statistics. But if one is sitting with losses of 40% or more (consistent with the return from most global bourses) then he has violated his mandate for capital preservation, and must hold himself, or his financial representative, culpable.

Last year, for example, I wrote extensively about rebalancing requirements for our accounts as a result of highly leveraged equity returns and fixed income pricing. In fact, as far back as 2007, we were making the necessary accommodations to rebalance account asset allocation from risky to risk-averse. Because of the change in momentum indices, our data mandated a change in asset allocation. Our clients were protected from the ravages of 2008 because of a fluid adoption of the principles of earnings-driven and momentum-based analysis.

To be fair, we were accused of "bailing out" on equities too soon, and today of not participating on the "value hunt" that has driven the bear rallies recently. Our rejoinder is that historically we have outperformed the averages by better than two-to-one. I will pick my spots for re-entry carefully.

Too much of today's investing is driven by the television pundits that proliferate our media. My best advice is to turn the darn thing off and focus upon long term fundamentals. Daily news is merely a "snapshot" of what is happening today. These events are not indicative, or accurate, representations of the longer term secular trend that truly drives fundamental investing. Nor is a fixation upon the calendar, which by practice has become a new benchmark for performance returns. Market cycles are not sensitive to the calendar, or today's date. Such exogenous noise is anathema to quantitative science.

Trends, and their quantitative calibration, are long term phenomena. As such, a good money manager is governed by demographic data, not emotion. Today, in fact, is one of the best investment and capital gains opportunities of our investment lifetime.

Although hardly anyone is ready to lay down all their bets today, historical perspective tells us that the landscape is quite compelling. Think of it this way: would you be willing to invest when the market was at the top, or at the "bottom"? Well, we are closer to the bottom than we were when the decline began nearly two years ago. My concern is that the same architect who got you into this mess is now the salesman trying to convince you to stay the course and to "trust" that he/she knows how to generate portfolio returns. Believe me, dart-throwing is not an investment methodology.

I would no more expect you to recover from a 50% decline than suggest you even try. If you find yourself in that situation, your expectations for breakeven are unrealistic. The blame lies, as I suggested, with a failure to plan and your investment methodology. Trying to recover through a series of one-off "hot ideas" is a syndrome, not a cure, for portfolio ills. More than anything else I know, that is more true today than anytime you might have known previously.