Arlington Econometrics First Quarter Commentary January 1, 2010

The Last Apocalypse?


My work has always been predicated upon using quantitative modifiers to enhance portfolio value through greater efficiency of information processing and the creation of momentum-driven asset allocation models. As a result client accounts didn’t suffer to the extremes of others during the past 2 years, and rebounded with greater aplomb as the markets gained their footing once again. Our methodology and its consistent point of view has enabled clients to benefit without compromising investment expectations. The underpinnings of Arlington Econometrics’ objective data analysis is to sift through exogenous noise, and unnecessary emotion, to provide modest, if not superior, enhancements to net performance over time.

Markets.
Market crashes are inevitable. Last year was not the first such crisis I have seen. While most indices collapsed mightily in the past 18 months, history has shown that, after the dust settles, those same indices go on to make new highs. Thus, any rational methodology should be designed to mitigate the severity of downside risk when crisis occurs, and to maximize upside leverage during a period of rebound. Unfortunately, most don’t and investors pay an ultimate emotional and fiscal price.

We continue to have a stagnant global economy. There are, to be sure, pockets of strength geographically. Where imbalances occur, markets seek equilibrium. Any problems that persist are embedded in the infrastructure of government, finance, and markets. To wit: Deficits create a weight around our financial systems; currencies are “uneven” and vex global trading patterns; historical demographics are changing, necessitating a new orientation towards healthcare, agriculture, natural resources, energy, and national defense. We cannot ignore these problems, but we might also be able to capitalize from them as nations and as investors. In spite of those data, macroeconomic forecasts are noticeably stronger today than one year ago.

In short, we don’t have to have all the answers today. We might not even know the names of companies that could become market titans in the future. We need only to apply our metrics of evaluation and consistency to come up with the right decisions for a longer view to become successful.

For example, I believe, that successful investments take time to gain traction. Unfortunately, I am usually not “first on the scene.” A more plausible scenario for me would be to identify the macro-opportunity, and to let a company fill the void over time with repetitive earnings. That provides me an outcome that is rational, time-tested, and less panic-driven. It also removes the pain and anxiety of being wrong, like the dot.com enthusiasts who followed the crowd a little early.

The most important questions for investors in the period ahead revolve around how the current climate of fundamentals meld with the psychological climate of mistrust which, I believe, is stronger globally than any set of representative data we have analyzed so far. Although markets have shown a moderate rate of acceleration from their lows, nothing has yet moved the meter in changing the appetite for risk or the divide that exists between sophisticated investors and the average citizen. That worries me enormously.

The long view of investing, as I previously alluded, is cyclically positive. The effectiveness of that data, however, is rooted in the stability of the financial system. We not only have to battle shifts in traditional demographic themes, historical metrics, and market fundamentals, but we need to assuage a global populace that is disinterested in our rhetoric, and still suffering from the effects of the apocalypse they endured during the last year. The public’s rage directed at global financial institutions has reached disproportional levels. Until we in the industry address that disapproval no fancy television commercials or hyped-up advertising will be sufficient to coerce their dollars, or their trust, back.

Strategy.
As the global credit crisis slowly recedes, our focus shifts from brinksmanship to profit-making. We are impeded somewhat by lower flows of investment capital at the Federal, corporate, and personal level. To be sure, we are “awash” in stimulus packages targeted at one sector or another. But the cascade of stimulus money is no replacement for moral leadership in areas such as public health, renewable energy, infrastructure, bio-sciences, technology and national defense, nor for a renaissance in consumer confidence which, up until now, has been sorely lacking.

Globally, it is inconceivable that nations “can go it alone” in this internet society. Remediation is borderless. Going to bed hungry and impoverished are not viable options for citizens of this planet. If mere survival is the highest aspiration of a nation, their sights are set too low, or we have failed to provide the resources for them to dream bigger. The gap between rich and poor is widening. Some countries do not experience these disparities, others do to the extreme.

Solutions are not quarterly by nature, nor do they respond to anniversary dates on the calendar. Instead, they are cyclical, generational, and need a generational mindset to transact.

It is true that norms are changing. Our rational approach to yesterday’s problems might not work today or tomorrow. But logic and common sense never become antiquated. That is why everyone intuitively acknowledges the problems, but becomes immobilized by the Herculean effort required to address them. The last market catastrophe was exacerbated by a failure to address these breakdowns, while remaining dispassionate and inert as long as things kept going our way in the short term. Burying our heads this time around is not an option.

The creation of moral imperatives is not the “other guy’s” responsibility. Each member of society is part of the fabric of his culture. Whatever fears might hold you back also hold back progress in addressing cultural dynamism. While we expect bankers and monetarists to exert wholesale influence over financial matters, core moral values reach us in many other ways, and ultimately resonate more deeply than government dogma.

As investors, we need to be cautious about overweighting the rumors, to the exclusion of solid fundamental analysis and prudent methodology. This coming year we just might see a diminution in returns, an increase in hysteria/disbelief, and greater volatility in trading of financial instruments before patterns return to more nominal levels. Finding the right equilibrium from amongst the chaos will be the investment goal for 2010.

The trading markets and the economy are not necessarily functioning in lock-step synchronicity while we attempt to reverse course from the global recession. In the past I have referred to this decoupling as a “parallel disconnect,” a period during which the economy and the markets only appear to be moving congruently, but in fact are accelerating at different rates of speed, altogether. Right now, the financial market’s recovery is obviously happening at greater pace than the rest of the economy.

Conclusions.
My raw data is not altogether positive in the short term. Already we have rebounded from valuation lows in a near-linear fashion, making any additional upleg extensions hazardous for late-entry. As the national debt expands it raises the spectre of higher interest rates to finance our obligations from within and abroad. The alternative, allowing the economy to flatline, would be calamitous. The question is “How long can the market sustain an intermediate, unabated advance in the face of imposing economic circumstances?”

My vision (and my numbers bear this out) is for the market (and the economy) to focus upon secular themes that offer the highest probability of earnings growth and sustained capital gains. We have seen an acceleration in the price of health sciences equities, but not yet matched by a consistency in earnings acceleration patterns across the board.

As money seeks new breadth of opportunity, those sectors which offer the next generational upleg are: Alternative Energy; Agriculture; Water Filtration; Biotech; Brick and Mortar Infrastructure; Technology; Aerospace; and Pharmaceutical Research. The bond market has temporarily lost relevance to long-term portfolio allocation strategies, as interest rates transition from lower to higher.

History tells us that there is always an upwards bias in the stock market. It is the nature of man to be “greedy.” As the fictional character Gordon Gekko once said “Greed is good,” I agree. But I would add that capitalism has an inherent “morality clause” which can drive greed to be the engine of constructive profit-making, and not the apocalyptic mess we just fashioned.






Asset Allocation:
Equity 50%/Fixed Income 30%/Cash 20%

Market Commentary for the week of December 21, 2009

Don’t be foolish.
Who do you trust more?
(1) Gene Hackman
(2) Sam Waterston
(3) Willem Dafoe

Ah yes, a cop, a district attorney, or the son of God.

You may not know it, but these three actors, and others, are the “voices” of today’s financial institutions on television and radio. Which begs the question: “Does the subliminal intonation of financial-speak really influence where you’ll go with your money or who you trust more?” Can the media actually influence the purchase/sale decision-making of the public?

Hey, they can if it’s automobiles, whiskey, vacation spots, clothing, and toothpaste. Why not investing?

Throughout the fiscal crisis of 2008-2009 all the networks seemed consumed by the gravity of the subject matter, not the least of them being business networks like CNBC, Fox, MSNBC, CNN and others. (Under full disclosure, let it be noted that I am a contributor to some of those outlets listed above.) Seemingly, minute by minute, coverage of the financial crisis pelted you with fact, opinion, and rhetoric. In days gone by, we used to wait until the next day’s newspaper to know what happened yesterday. Today, the proliferation of instant access, instant opinion, provides the means for hasty decision-making and incomplete vetting of the subject matter.

“What?” you say. “Incomplete analysis?” “Yes” I respond.

Motivation.
The media, indeed, adds a sense of immediacy to our news, but it can also turn a cyclical situation into a frenzy, resulting in more hysteria and unnecessary volatility. Adding fear to an already frightful situation exacerbates the cauldron of doubt, skepticism and mania.

Consider that more people are now “plugged in” to news through internet and instant media access, adding to the ingredients for mass hysteria. When conditions are good, the media can fuel an upswing; when things go badly, the networks are jumping over each for “ratings first,” telling us how much worse it’s going to get, and stoking the fire of negativity.

It is probably naïve for me to hope that financial media might actually serve the public’s needs by answering basic questions, and making the hard look easy. But consider there’s danger in serving its own needs first, playing on the vulnerability of listeners and giving them advice which might not be appropriate to their unique situation.

Value.
While it is also presumptuous of me to assume that all media are bad, or that all viewers are gullible, it is safer to harken back to an era when investing was a noble undertaking, a means between you and your ultimate goals, rather than a pitch-box through which all kinds of junk is thrown at you without empathy or consideration.

Commercials and opinion will always be with us. Not long ago we heard how “When one company speaks, people listen,” or that they “Earned it” (who better than John Houseman?).

My contention, though, is that the sheer enormity of financial coverage and commercials can also lead to a sense of helplessness and a feeling of being overwhelmed. Losing control of information is as bad as too much information.

(There will be no commentary published next week. Our next contribution will be the Quarterly Market Outlook, January 1, 2010. Happy Holidays!!)

Market Commentary for the week of December 14, 2009

Crossroads.
Ultimately, we’re going to have to come to grips with whether or not we are in a bull leg within a secular bear or a renaissance cycle signifying the first upleg in a new bull. All semantics aside, it does matter how we define these trends because asset allocation, sector allocation, and investor expectations depend upon a “correct” assessment.

Fortunately, we can sit and allow today’s remarkable upside capitulation to continue, and count the benefits that accrue to our retirement accounts. But, at some point, if we don’t get the definition, the moment, correct we might be destined to repeat an ugly lesson of jumping into the pool too soon, with disastrous results as a consequence. (As a matter of comparison, for example, Japan has been digging out from an abysmal bear market since 1988).

This year’s capital gains have come quickly and without interruption. Under typical metrics that type of cycle is impossible to sustain. For that reason, some are looking for an identical down-leg to follow. Additionally, the magnitude of this upswing has been so significant that we have eradicated the losses of the previous bear leg. Some might conclude from that data that we need only to “breakout” to new highs to confirm a new bull market.

So which way to go?

Just the facts.
I believe portfolio allocation decisions must be made upon the existing trend data not the expected, or anticipated, direction of the trend. Therefore, I consider us to be in a secular bear market, and the beneficiaries of a remarkable upleg within that trend. Additionally, the current relative strength quotients of today’s bull cycle are unsustainable in the near term and potentially high risk entry opportunities. These data are true for the majority of global baskets that have experienced a bull cycle since March, 2009.

Further corroborating my conclusion is the secular bull cycle in defensive sectors such as Utilities, Basic Materials, and Fixed Income.

In the short-term, these defensive secular trends offer significant counter-cyclical balance to the secular downtrend in earnings growth and traditional “front-end of the market” sectors. In sum, global synchronicity has the financial markets on the cusp of something positive, but not quite there, yet.

Up or down?
One might conclude, then, that I am bearish about investing. Quite the contrary. Rather than parking money in a tin can in the backyard, I see a tapestry of fundamental and quantitative needs that are ripe for harvesting. This is where the market has become more subjective and more individualized in its opportunity. We are past the point of preserving net worth against decline. Our mission is to find strategic ways to make money grow.

As with most things, it is smart to look at the alternative case scenario. With money trading at cheap levels (low interest rates), the best game in town is growth stocks. In spite of the perceived risk in owning equities, the best way to obtain anticipated nominal rates of return is to balance sector and equity selection so as to overweight upside probabilities of performance, and to underweight downside probabilities of performance, based upon continued decline in earnings.

In a few weeks, I will publish the 2010 first-quarter commentary in which those opportunities will be discussed. Hang in there.

Market Commentary for the week of December 7, 2009

What we see.
While the stock market continues to surge, economic news has concurrently been surprisingly good. An increase of corporate expenditures in recent months has been a hopeful sign that investor psychology might have changed and that employment might reverse its current downtrend. Few think we have definitively turned a corner, but many are curious about what positives might lie ahead.

One potential source of good news is a series of reports that currencies are stabilizing and that interest rates are finally catching up to economic assessments. In other words, the age of expansive borrowing and speculation is being replaced by fundamental valuations and a “cash is king” mindset.

Of course, subtle changes become amplified over time by momentum shifts, and the hope here is that secular growth patterns emerge that might lead the way to better portfolio balance. For a time, stock-picking was a better tool than market analysis, but that time might be coming to an end.

What we think.
The bears need not be humbled, however. With the near-linear explosion in equities since last March, the market could be subject to a correction, one for which many have been already waiting months.

The good news is that there is enough money on the sidelines that any meltdown might only be temporary, and certainly a new buying opportunity.

There is also a growing appetite for non-U.S. equities. Emerging markets, commodities-driven regions, and fresh intellectual capital are all hot spots for money seeking new opportunity. As well, returns are likely to be compound-multiples of those obtained in traditional Western markets.

Obviously the only factors that could change the global appetite are war, and political instability. Although those are unlikely, investor skittishness is not something we can predict at this time.

Nevertheless, the coming year holds more promise than last year when the general consensus was quite poor. Despite that, the year turned out quite nicely.

What we hope.
Another factor influencing my attitude about stocks is the dearth of quality bond purchases available. Last year at this time the credit crisis pulled the rug out from under any credit certificates and caused prices to drop precipitously. Despite, or perhaps because of, the recovery in price and credit this year, there just aren’t enough good issuers at sufficient yield to make the trade worthwhile.

Therefore the equity markets become, de-facto, the only game in town.

This double-edged sword takes the alternative investment scenario out of play and limits the flexibility of portfolio managers to diversify adequately in the event of a turnaround in sentiment. While I am loathe to be a one-trick-pony, the market is shaping up as my only source of asset balance. I will carefully monitor our equity sector allocation as well as our cash reserves so as not to be too overexposed to risk next year.

The last time money was this cheap a speculative crisis emerged. We can only wait to see whether responsible fundamentalists or trader-savvy speculators define the next market cycle.