Market Commentary for the week of December 20, 2010

Pedal to the metal.

It should be a wake up call to the markets if, despite global monetary initiatives to the contrary, interest rates accelerate their rise.  While the debates rage on about stimulus versus tightening, recent trends indicate that the innate mechanisms of economics are at work, most notably the reversal of a twenty eight year disinflationary cycle in asset valuations and interest rates.

While the hope is to create jobs by freeing-up the cost of money, recent history indicates that the policy itself is either uncertain at best, or a total failure at worst.  So far the impact of global easing is to see an increase in capital values (stocks, commodities, interest rates) not a decrease, thereby making these items less affordable to consumers.  This is quite a sobering impact upon emotions as well as pocketbooks.  No matter how hard our institutions try to manufacture strength out of weakness, their machinations are thus far unable to influence immutable physics of economics and market cycles.

Officially, federal treasuries worldwide haven’t had sufficient time to evaluate these policies.  By trying to make money inexpensive they hope to move the needle forward.  The effort unfortunately looks more like pushing a boulder up a steep hill.

To make a further dent upon an immovable obstruction, bond buying sprees and printing presses have been implemented to “speed-up” the process.  Once again, not an inkling of success in creating jobs or stimulating corporate expenditures.  One might even suggest the policies are having the opposite effect than what was intended.  Higher valuations in tangible assets (food, oil,) are rendering many items too expensive to produce or consume.

Another practical joke.

Some might suggest that rising prices indicate an improving economy.  I might agree, except that in definitional economics demand drives prices and of course growing demand is a pre-indicator of economic expansion.  In today’s case, however, rising prices are preempting demand and making expansion less likely.  By putting the cart before the horse our policy-makers have encouraged dissuasion and dissatisfaction with our economic landscape.

My preference would be to see debt levels diminished.  The cause of our recent bear cycle (2007) was an inordinate amount of debt and leverage synthesized by a few in the hands of many.  Growth forecasts would be greatly upgraded if we could get expectations and policy “in-synch,” and drive liquidity into the hands of those who might confidently use it.  Bankers might complain that “it doesn’t work that way,” but what way has it worked where the bulk of the money is currently aggregated by tight-fisted corporations and greedy financial institutions?  For the second consecutive year lending has decreased, not grown, despite an ever larger pile of money in the pipeline.

Eating away at the market’s capital gains potential is the erosion of confidence in our financial institutions.  The amount of wealth in the hands of a few has increased to its largest value since the 1950’s.  Unfortunately, that wealth has not trickled down to the underclass, thus creating the widest divergence of have’s versus have nots in recorded history.

Equity in transactional assets is not a right, it is a hobby.  Whatever allows that hobby to be successful for some but unattainable for others is an impediment to the fair-play provisions that should govern the financial marketplace.  So far, it doesn’t look too fair or appealing enough to create a rally we all wish would come.

Today’s Weekly Outlook is the last for this year.  The next publication will be the Quarterly Overview,

dated January 1, 2011.  Have a happy, healthy holiday season!!

Market Commentary for the week of December 13, 2010

Loyal opposition.

Each of the recent “relief rallies” draws many into thinking that the worst is over, at least for equities.  I believe, however, that investors are putting too much emphasis upon short-term consequences to the exclusion of looking through the wider aperture.  Of course, during the holiday season we are all searching for “good cheer,” but market cycles that are unsupported by fundamentals are not “rallies,” but bear traps.

Besides, a follow-the-herd mentality about investing isn’t always rewarding.  It might be comfortable to join into the mania of others, but who do you blame if it goes wrong?  I’ve always believed that having a discipline, and sticking with it, mitigates the effect of hyperbole or guesswork, and makes me responsible for the net result of portfolio performance.  Don’t blame the crises upon some exogenous event, take responsibility for reading the data as they are, not as you wish them to be.

In fact, from a quantitative perspective, asset prices are sharply disconnected from upside probabilities, and likely to revert back to nominal levels during the next few months.

All this means, simply, is that an allocation of new monies to the equity markets today would be done at less than optimal timing.  I am not implying that one could not achieve capital gains currently, just that to do so one must be exceedingly careful or lucky.

There are several reasons for my concern, not the least of which is a global synchronicity with which budget problems and market valuations seem to gyrate.  Fiscal problems in Asia migrate to the United States.  Currency and monetary issues in middle Europe spread to the Ukraine.  Crop harvests in South America impact pricing power in Canada.  To this extent, valuations are becoming inextricably linked, and causing stresses of unintended consequences.

There are no empirical data to suggest the “sky is falling,” nor are there any to refute the impact of rising bond yields, a depressed housing market, low employment, and treasury budget deficits worldwide.  Further, even if the globe’s monetary ills were to be solved today, this afternoon, the response time before which consumer solvency and confidence could return would be months, if not years.  It appears, at a minimum, that we are in a vortex of underperformance and low expectations for the foreseeable future.  All of today’s risk is a definitional by-product of the breadth and duration of the bull cycle we were in during the preceding decade. 

Buy the cycle.

I believe that politicians must address issues of confidence as well as competence, although the two are inevitably linked.  Does job creation precede investor allocation, or must there be an era of confidence-building before the capital markets respond?  The correlation between “feeling rich” and “being rich” is a measure of tiny proportion, but massive in terms of asset allocation and moving the probabilities of capital gains statistically forward.

Unfortunately, as bank profits soar but many feel disenfranchised, the gap between words and action widens.  Perceived risk is a good thing; actual risk just keeps people at home.

The balance of this year is likely to be a struggle between hope and forecasting versus empirical data and market standards.  I anticipate that empirical data will supersede hope, likely moving the global markets into technical disarray for the short-term.

Market Commentary for the week of December 6, 2010

Splitting hairs.

There’s a fine line between suggesting that “economic data appears to be turning around” and stating “the economy is good.”  Similarly, while any short-term day rallies and interday price advances in the global bourses are always preferable than the alternative, it is far from true to suggest that the markets have bottomed and are poised to reverse course, upwards.

The theory that we have hit bottom is simply not supported by my data, economic or financial.

It would be wrong, then, to bet otherwise and risk the possibility of capital deterioration.  In fact, by my readings, any conclusions to be drawn as to fiscal, economic, or monetary successes might extend into mid-summer of 2011, at best, and could (as I recently wrote) marginalize 2011 altogether.

Federal debt, personal debt, political gridlock and global currency imbalances are systemic problems.  It was difficult and time-consuming getting into these predicaments, and will be equally as difficult from which to extract.  I am seeing indications in my quantitative database that we are in the early stages of cyclic deterioration, a period during which the rate of capital gains probabilities declines and market valuations perform indiscriminately in a non-correlated way.  We should be prepared for the opposite of what we expect or want.

You say potato…

What if I’m wrong?  What if a concerted, cohesive global effort to revitalize capital production succeeds?  In that case, then, we simply rebalance our asset allocation to allow for, not only, the possibility of these things occurring, but also to profit from it.  I’m not in this business simply to hypothesize, but to benefit from the validity and science of the hypothesis.

In the absence of good science, the worst thing you can do is to guess, or to chase fads.

While sentiment and hope are not sufficient market tools, without them we have little in the way of creating the very theories we wish to prove or disprove, profit from or avoid altogether.  The problem, really, is when “conventional wisdom” or “mania” guide one’s theoretical decision.  From a scientific point of view, it is always those theses that are loosely followed that might bear the most fruit.  Follow the gold hordes?  Certainly.  But not at the expense of knowing when to get out and rotate into better opportunity.

Notably, the current configuration of relative strength data shows me that this market cycle is overdone, long-in-the-tooth, and susceptible to a pullback of significant proportion.  In the aggregate, despite news stories that indicate otherwise, economic activity is not picking up, earnings are not accelerating, and confidence (indicated by hiring, savings, and capital expenditures) is not robust.

What we are seeing are year-over-year comparisons to figures which were dire, morbid, and cyclically negligible, thus creating the perception that improvements are in the offing.

Bottom line is the bottom line.

Clients and prospects have commented to me that I’m “getting negative.”  You think?  Check back to my writings in 2006 and 2007.  At that time I began to lay out the scenarios for trend dissolution in which we currently find ourselves.  The mania of real estate and asset speculation was then at its peak, capping off a decade of low interest rates, indiscriminate borrowing and “dart-throwing” investing.

If anything, I am now cautious about our current trend, but cognizant that, ultimately, we are closer to the end of the decline than we were two years ago.  While I remain tactically defensive, I anticipate continuing to outperform the benchmarks through prudent asset allocation.  No single stock, or sector, is going to account for wholesale changes in our portfolio probabilities.  Rather, we can buttress against heightened volatility and still deliver positive “alpha” by planning for the best, expecting the worst.

Market Commentary for the week of November 22, 2010

The science of risk.

We’re in a particularly vulnerable time in world financial markets.  Having just completed a significant 2 year market response (upwards) to the global credit crisis, the question of whether or not we can sustain similar economic magnitude has everyone’s attention.  Although financial data seems more or less in line with a nascent recovery, investor confidence and activity are still less than robust.

The absence of empirical consumer spending and corporate capital expenditures becomes the basis of a self fulfilling prophecy.

By no means am I suggesting that all economic activity has come to a grinding halt.  Aggressive deal-making has benefited from low cost of cash, and currency revaluation has boosted foreign trade.  Indeed, some emerging markets have raised prospects for growth due to accommodative monetary policy and concentrations of natural resources.  While these isolated portfolios have raised their probabilities of outperformance, outright global bullishness remains an unattainable afterthought for now.

Thus, the name of the game is still “risk management.”  More dangerous, though, are the players who fail to heed these data, choosing instead to speculate, without science, on half-truths or rumors.  Wise decisions derive from a strict adherence to methodology and discipline.  Our thesis begins by worrying about consequences now, not later.

For these reasons alone, I am worried about bond speculators, gold speculators, oil speculators, investment banking and merger transactions, or any other financial transaction that smells of “fad” or “immediacy.”

Take, for instance, the sudden and recent rise in commodity prices.  While I have written for several years about burgeoning inflation forces within the economic landscape, it has only been in the last 6 months that investing and relative strength activity in commodities has taken off.  What had been in hibernation for years suddenly became the “sector-du-jour.”  As if by accident, investors (speculators) stumbled into the world of fundamental analytics and made a mockery out of it by riding a trend, then looking to cash out.

It may sound like it, but I do not begrudge these “faddists” their profits.  What I do object to are the latecomers who accelerate fundamental demographic economic shifts by injecting speculative capital, then leave as if the party might migrate elsewhere.  As a youngster, I was taught to leave my “play area” exactly as it was when I arrived.  The vigilantes who abuse the markets for avarice and quick gain have failed to do the same, thus exacerbating the feelings, by some, that the markets are unfair and that true economic cycles of recovery don’t really relate to their lives.

Finding confidence.

Much to the dismay of many, a consensus still exists that the financial markets are not “real” for them, other than the occasional winner they might uncover in their portfolio.  The hubris exhibited by the dot.com legions, the credit mavens, and the commodities speculators serves to lay the groundwork for investors to abandon their curiosity and withdraw from the game, altogether.

I don’t share that negativity.  First and foremost, confidence comes from process.  Acting in good faith and with prudent scientific methodology is a start.  Regaining, or building, trust is a solemn duty and begins with self awareness.  If one’s motives and methodology are legitimate, then control and results are likely to follow.  It is not sufficient to be part of a manic herd that follows rumor or mania.  Instead, we might try substituting scientific observation and common sense for hyperbole.

Today’s global marketplace, while hampered by negative fundamentals that we all acknowledge, is fertile ground for discovery in biosciences, agriculture, healthcare, infrastructure, technology, telecommunications, alternative energy, and consumer product innovation.

No amount of speculation can change the lifecycle of human ingenuity.

Market Commentary for the week of November 8, 2010

Gridlock, inertia, or hope?

Now that the U.S. election cycle is over, the most frequent question I am being asked is “how will the election results impact upon the markets and my portfolio during the next year?”

Firstly, let me dispel any notion that I am a political analyst, so my instinct when responding to that question is always to evaluate the data scientifically and unemotionally.  Besides, we are less than one week removed from the elections and it is yet to be determined how intentions might translate into actions.

But I can’t stress more strongly that my mandate is to respond to uncertainty with empirical know-how, to make discipline from events which seemingly are uncorrelated.  My thesis has always derived from the supposition that behavior and events are not random, that they can be quantified as to duration, magnitude, and sustainability of trend.  Further, I believe that these data can be organized, asset allocated, to create a macro, top-down landscape that is emblematic of broader generational themes.  In this regard, empirical or anecdotal events are neither Republican or Democrat, young or old, Western or Eastern, small cap or large cap.

Allowing for individual nuance of risk/reward tolerance, asset allocation plays a greater role in the probability of a portfolio’s capital gains performance than does any individual security within that portfolio.  Therefore, elections, Fed announcements, politics, or fiscal policy plays less of a role upon systemic long term secular themes than we would like to believe or are told we should believe.

Just facts.

What we do know is that the population of the globe is getting “older”; the infrastructure of many countries is either underbuilt or too archaic; that global debt is a burden upon economic revitalization; arable land is diminishing; potable water is a depleting natural resource; technology and innovation are bellweathers of a culture’s sustainability; confidence in traditional financial markets and delivery systems is at its lowest ebb in decades.

Before you indict me as being too negative, let me state that each of these “knowable data” are also potential opportunities for capital gains, investment generation, and economic renaissance.

Investors may differ about whether “stimulus provides jobs or tax cuts provide capital” but there is no doubt about confirmation of the problems, themselves.

Interestingly, the wider variance of opinion is about whether we define the time frame for solution-making as “long term generational” or “short term remediative.”  The wave of political aspirants in our current/next Congress would clearly be identified as the latter.

Forward, not backward.

My readers know that I am mostly “long-biased” and enthusiastic, despite my current readings of empirical data.  I am strongly in favor of innovation and research and development as engines of economic stimulus.  Real demand derives from building a better mousetrap, from which flows job creation, capital investment, inventory and sales expansion, revenue, and margin growth (profits).  Earnings drive stock performance.  It would follow that abundance of demand for new products drives earnings.

Markets depend upon the perception of fair play, confidence, and capital.  Bubbles of excess speculation or stimulus-driven valuations do not create sustainable earnings landscapes.  I would thus be looking at long-term themes as probable long term solutions to a dearth of current opportunity and confidence.

Market Commentary for the week of November 1, 2010

Looking past the graveyard.

We are two months removed from the end of this year, 2010, and already investors are bracing themselves for 2012 (more than one year from now), as if next year doesn’t, and won’t, count.  With unemployment widening and portfolio values simply treading water, many have their sights set on a “rebound year” (2012) that they think has more promise than next (2011).  In fact, informal opinion polling suggests that many see 2011 as nothing more than a postscript to a miserable three year cycle begun when the global credit crisis erupted.

Further, any optimism about next year is muted, and spoken about softly as if not to exacerbate an already chaotic situation.

Indeed, there are as many reasons to be pessimistic about 2011 as there are to be encouraged, which doesn’t embolden even the most bullish amongst us.  We have yet to complete the crises which put us on a bear cycle, so it is illogical, and against the odds, to consider that a turnaround might be quick, linear, or extreme.  One doesn’t unravel a half-decade or more of fiscal problems by fiat alone.

The solution to systemic inertia lies first in reversing the crisis of confidence by the public.  Along with consumer demand and discretionary spending there must be a reversal of debt expansion too.

There will be a 2011.

Today, the “confidence crisis” spills over into the home, the workplace, and the shopping mall.  We are worried about spending for goods and services, and those which we do buy are going up drastically in price.  A pyramid of hierarchical needs is rising to the top, as corporations recoup their losses, thus costing everyone much needed liquidity.  It’s not fair, but true nonetheless.

And yet, throughout these turbulent times, certain pockets of financial opportunity remain.  Basic Materials and Technology stocks are in a bull cycle.  For the most part, confusion about economics and statistics has been supplanted by a love/hate relationship with 24 hour trading platforms.  In a market of stocks, not fundamentals, some can win quite handsomely by engaging in “trading” daily.  On the other hand, this strategy is no place for the novice or the traditional “buy and hold” investor.

The proportion of assets allocated to equities is diminishing in most traditional long-term portfolios, owing to the increase in volatility and risk in the markets.

Investors, thus, are stepping back from the exercise altogether, preferring to try to reduce personal indebtedness, increase savings, and build peace of mind.  Those of us in the industry, and those outside, feel a palpable distrust about the systemic failings that caused this last panic.  Our efforts might better be focused upon remediating the public, perfecting our disciplines, and abstaining from artificial derivatives and 24 hour investment cycles.

In this climate of reticence it matters little whether 2011 is a boom or bust year because its context will only be judged by what happens afterwards.

Maybe 2012 isn’t really that far off, after all?

Market Commentary for the week of October 18, 2010

Resource economics.

With a steady run-up in natural resources equities the past year, some are concerned that the progression might come to an end.  I am not one.

Although global indebtedness is still a primary concern, consumption of tangible assets moves on unabated, and with that the fundamentals for commodities’ price increases remains.  Clearly, the market’s obsession with natural resources is a two-edged sword.  But sentiment and relative strength indicators are sufficient not to expect a sudden reversal of trend in the near term.

Concomitant with a demand for basic materials is the expectation that price increases (inflation) in those commodities are also likely.  If it doesn’t get out of hand, a rise in prices might be a strong pre-indicator of a pickup in global industrial development.  Besides, we are far from a “hyper-inflationary” environment, as current asset price increases year-over-year hover around 4% across the board.

The intrinsic value of commodities heightens, too, as you move from highly industrialized Western economies towards emerging markets.  Today a “typical” basket of metals, timber, etc. might be more significant to GDP for emerging economies than for those with relatively low/stable demand.  Russia, Brazil, Chile, India, and China are all undergoing a wave of industrialization and modernization programs which require metals, lumber, rubber and energy sources.  Additionally, I have written prolifically about future land use for agriculture and potable, replenishable water supply.

Gold only?

While the market’s current focus seems to fixate upon gold, there are probably more geopolitical and psychological components to that metal’s rise than fundamental, industrial use and its effects.

Commodities are not a zero-sum game.  They are a depleting natural resource whose value can be measured based upon current supply/use and future expectations or alternatives.  Imagine if you will (and this is an extreme hypothetical) if the globe no longer needed fossil fuels.  How severely would production and price decrease?

The question at hand today is “to what degree should an asset allocator be committing to these sectors?”  Based upon improving policies and demand worldwide, it is entirely appropriate to reserve an “overweight” ranking for these equities.  As long as industry prudently manages inventory-versus-demand cycles, upward valuations might persist.

Recall, also, that during the dot.com boom, just a decade or so ago, one couldn’t give an industrial stock away!! Such is the nature of parabolic market continuums that decades elapse during which minor shifts in psychology, expectations, fiscal policy and politics, become tectonic secular themes for our time.

In other words, it is difficult to predict trends but easier to quantify them as we look back with the perspective of time.

Long-term, my thesis is that depleting resources (whose supply today is unquestioned) might provide the science and politics for an elongated trend whose capital gains potential could be significant.

If you simply like to bet on 24 hour trading cycles, please disregard the preceding text.  Mine is not a strategy of uncertainty and malaise, but rather a science of macro potential and cash flow.

Market Commentary for the week of October 11, 2010

Perfect investing.

Every morning of every day that the financial markets are trading, investors awake to the belief that “today might be the big score.”  Oh, come on and admit it, you’re hoping for that one big massive uptick that makes you fabulously rich, or, at the very least, validates your investment commitment.  By measuring your securities against a mythical benchmark, you’re either up or down at the end of the day, and today, by golly, might be the big one!!

This affliction sounds a lot like the psychosis which permeates Gambler’s Anonymous, but hey, that can’t be us because, after all, we wear suits and ties to work – we’re above gambling away the family mortgage, aren’t we?

This yearning is also hard to kick because of the immediacy of feedback we get through technology.  (I hate to admit it, but I come from a generation where we used to check the next day’s morning paper for stock prices from the previous day!!).  Today, investors trade by the minute, for the minute, hoping for an impressive uptick.

If the goal is to build portfolio net worth using a long term aperture and solid mechanics of portfolio management, then perhaps immediacy destroys the endeavor altogether.

Investing is not, nor should it be, “a big score” enterprise.  By working towards standards of achievement and perfection that are statistically improbable, most investors are setting themselves up for failure and disappointment.

My thoughts about this emanate from my observations of mood swings of colleagues and clients whose self worth seems so indelibly bound to their portfolio worth.  I think we need to divorce ourselves from subjective modeling and apply a different standard to our review.

When watching a great athlete or performer, one is struck by the ease and grace, the simplicity, with which they execute their craft.  What we don’t see are the fits and starts, the failures, that embody their practice in preparation for that one moment of grace.  It doesn’t just happen, and it’s never perfect, but it does occur, not because they wish it to happen, but because they work, prepare, and plan to execute.

Investing is no different.  Discipline and methodology are the forebears of success, not the goals or end product.

So?

Global equity markets are doing a poor job of mirroring the fundamentals of our time.  Simply because we wish stocks to go up is not sufficient justification for them to do so, particularly as economic fundamentals fail to keep pace with our accelerating desires.

Unfortunately, my work is forecasting a “resistance line” for the equity markets above which it might be difficult to go in the short-term.  For me the key to equity performance is earnings acceleration.  Despite year-over-year improvements from their depths one year ago, real integers are still down from their highs, and not likely to show any improvement without marked top-line demand.

I am, therefore, continuing to underweight equity exposure even as certain individual companies become more attractive from a valuation standpoint.

As has been proven many times over, the “big score” is elusive and untrustworthy.

Market Commentary for the week of October 1, 2010

Take Two Aspirin

Almost out of nowhere, the markets are looking more and more imposing, and less attractive, to professional and non-professional investors.  The reasons lie less in the analysis of fundamentals but more in a deteriorating trust of systems, players, and motives in the financial community.

Natural risk takers, and the risk averse, are leaning more towards “stuffing money in the mattress” than they are towards complicated derivatives.  Wild gyrations in stocks and bonds heightens the fear and skepticism within investors that this is a game they wish to play.

A majority of poll services indicate that many think investing is “not fair.” 

In a climate in which concern is growing about performance and ethics in financial matters how, and why, does confidence dissipate so rapidly?

Markets.

The psychological shift has been imperceptible to some, tectonic to others.  My data indicates that despite rising prices during the last decade, relative strength integers (a measure of velocity, momentum, and magnitude) were declining as far back as 2006.  Thus, equity valuation increases were being built upon false bases.  Indeed, when the credit crisis hit in 2008, money was already looking for safe-haven escape routes.  Unfortunately, even bonds failed to offer the requisite alternative investment scenario.

During the next two years, cash was seeking a safe place to park.

Although wealthier investors were “less affected” by portfolio declines, high-net-worth players were, in part, more responsible for the permutations in product construction and use than the less affluent, thus the  perception that markets were “unfair.”

Downside collapses are “bothersome” to the wealthy, catastrophic to the poor.

As I have stated before, one’s tolerance for risk is mirrored in their asset allocation.  And asset allocation, itself, plays a greater role in the probability of portfolio capital gains than any individual security within that portfolio.  Thus, heavily concentrated portfolios, such as real estate portfolios or technology-only portfolios for example, showed poorer performance than more-diversified portfolios during the same period.

One’s willingness to absorb risk, and expose assets to specific sector volatility, is the great conundrum of investing.

But risk-taking is not only about objective data and portfolio modeling.  It is also about perception.  If the perception is that all risks are equal, or none are fair, then investors will be unwilling to balance risk against risk-tolerance.  Such is the case today.  The markets are delivering the opposite of what is expected (based upon theories of standard risk evaluation) and, thus, no one perceives a fair opportunity to win.

It is extremely difficult to keep from getting negative.  Markets are cyclical.  In fact, this period is not the most egregiously woeful period in the market’s history.  We have been here before (1929, 1987, 1993, 1999, etc.).  Fear is not an effective portfolio management tool.  In the long run, an effective discipline and methodology is preferred to an emotional or irrational response. 

Strategy.

The most remarkable thing about my proprietary Arlington Econometrics methodology is how quantitative statistics can improve upon intuitive return expectations by focusing upon correlated and volatility variances between asset categories.  The extent to which we can measure performance and location of a financial security helps us to identify the magnitude, velocity, and direction of its trend and to offer probabilities of its risk-adjusted return.

This is lofty stuff for many investors and often eschewed in favor of hot trends or recommendations from television personalities.  Unfortunately, these people are no different than you and sometimes have difficulty quantifying their own hunches within a global spectrum.  Most importantly, hunches tend to be quite volatile (beta), indeed just what the aggressive investor is looking for!!

Incorporating stochastic integers, analogous to a GPS system, into investing diminishes beta while enhancing return probabilities (alpha).  During the pre-crash period, most investors lost their focus about risk management, instead focusing upon less diversification and lower correlated probabilities to generate alpha.  Thus, crashes and mini-crises affected them more severely than most.

Diversification and asset allocation also exposes an investor to a global panoply of assets and potential for capital gain from a variety of geographies, capitalizations and sectors.  Indeed, my client’s accounts have shifted from high concentrations in equities, to sector rebalancing globally, and ultimately to cash and yield during the past three years.  As a result, our drawdown has been smaller, while our returns have been superior.

Conclusion.

Real or perceived, we are in a new dynamic of financial fundamentalism:  Earnings around the globe are shrinking as consumer demand declines; stochastic measurements are less aggressive than the previous decade; the secular bull is now a secular bear; capital formation is less aggressive and more biased towards traditional products; global employment patterns are reconfiguring towards energy, technology, bio-sciences and away from traditional retail, consumer-led brands; politics and terrorism are upfront and real in our internet-connected universe.

It would be disingenuous to deny the macro patterns described above.  It would also be calamitous to ascribe these trends as anything more than a general pattern of reshifting fundamentals that occurs on the “back-leg” of any market’s parabolic duration.  Simply, we are in a normal, albeit painful, response to the previous generational cornucopia, and a requisite recalibration of policies, data, and psychology.

I believe that we are also experiencing an excess of “manual stimulation” to, what should be, a normal measured time series during which (as has happened historically) there is a gradual shift from boom to bust, then boom again.  All the stimuli, all the political rhetoric, all the sustained partisanship is indicative of another type of fundamental dialogue, but not necessarily the science of economics and market statistics.  To that extent, the global financial markets are disassociated from politics and influenced only at arm’s-length from what occurs in political capitals around the world.

The markets tell us something when they react “positively” to negative political or economic data. In some cases, unrealistic expectations about the relationship between data and market performance can send investor psychology sky-high or down-in-the-depths on an hourly basis.  Such is the impact of expectations and internet upon market volatility over a 24 hour cycle.

Imagine, if you will, that you wake up one year from today to review market performance, the political landscape, and your portfolio.  How much, based upon what you know today, would have changed?  Then, do it again one more year later.  Now you can begin to understand how trends develop and how one either becomes right or wrong in the long run.  Those are the bets that real investors make.

My commitment is to quantify those bets, and to allocate client’s resources so as to mitigate downside risk and to maximize sector opportunity.  Within that context I see several categories of opportunity, irrespective of 24-7 internet proponents who proclaim otherwise.  I see significant quantifiable momentum in agriculture (foodstuffs, grains, arable land); biosciences; biopharmaceuticals; alternative (replenishable) energy; technology; industrial infrastructure (rail, highway, air); basic materials (tangible assets); and consumer cyclicals (innovative product development).

Interest rates cannot stay this low indefinitely, nor can global treasuries continue to be as accommodative as they have been since the credit slide began.  I believe we are likely to enter a period of tighter money and higher inflation in the next decade, particularly if a hoped-for economic recovery is to succeed.

Every investor’s dream is for 20% returns with no risk…at least that’s what is frequently requested of me.  But our emphasis should be on maintaining a prudent discipline about investing, and mitigating any turbulence whose volatility might cause significant risk. 

While it appears as if the “little things” are of greater significance, my belief is that we can improve performance by focusing upon those activities that generate positive macro performance for the duration.

As the title infers, “Take two aspirin and call back next October.”

 

Asset Allocation:

Equity 28%/Fixed Income 42%/Cash 30%

Market Commentary for the week of September 27, 2010

Inertia.

One of the most hotly contested debates within the financial markets is whether data “supports or refutes” current actions of stock and bond performance.  One of my colleagues strongly suggests that the disconnect between equity direction and news releases is nearly correlated.  While I agree that there is a high inverse correlation between daily stock prices and long-term fundamentals, I am not yet willing to throw in the towel about equity ownership.

In fact, with bond yields as low as they are, there is seemingly no other choice but stocks with which to ride out this storm.

In addition, there are significantly more options to own than just classical “blue chips.”  Uptrend cycles in agriculture, basic materials, utilities and technology are forming in my long-term analytics, even though the short-term is sympathetically volatile with current statistics.  In other words, depending upon one’s aperture or perspective, the long term prospects for industrial development, technological innovation, and infrastructure looks much rosier than what knee-jerk traders would have you believe.

I hasten to caution that short-term cycles, whose performance since July has been impressive, are near expiration and likely to turn down in the near term.

As always, these issues translate into one’s time horizon and tolerance for risk.  Versus the broader global averages, it is quite possible to isolate situations and sectors whose upside probabilities are more optimistic.  The only hurdle to this exercise is to remain confident in one’s discipline and not to get dissuaded by “exogenous noise.”  Usually, the more obstacles placed in your way, the more difficult it is to find good investments, but the more likely it might be to reap positive rewards.  My philosophy of prudent asset and sector allocation has been important to my clients during this navigation.

Forecast.

When comparing groups to the rest of the market, I prefer to look for earnings acceleration patterns and relative strength indices whose values give me a higher probability of outperformance against a general benchmark.  I am noticing a gradual shift (despite non-confirmation from public data) into tangible assets, inflation plays, and yield oriented securities in my RSI components, and a decidedly anti-consumer bias in those rankings.

Although the past two months have been heroic, the achievements are less-than substantial.  The most we have gotten from those indices is “new annual highs,” while valuations remain at least 15-30% below previous all-time highs, a mighty struggle to maintain relevance, at best.

The next short cycle direction is likely to be down and likely to break all the support bases built during the summer.  Signs are building that my colleague might get what he wishes for, a full-bore, year-end confluence of negative global economic statistics along with a market bear.

Overall, investors are looking for confirmation of the direction of their choice, higher or lower.  It is, in fact, this uncertainty about such confirmation that keeps any rallies from emerging strongly, and holds at bay any commitment to deploy cash into financial securities.

Market Commentary for the week of September 13, 2010

Perception.

At a time when the financial services industry is reeling from uncertainty following valuation collapses unseen in recent history, we should be aware that peaks and valleys, twists and turns, are part of the investment process.  For those who might have been lured into believing that home values, portfolio values, and altruism provided external support for their needs, welcome to the reality of risk management.

Does is really make sense believing that “nothing goes down?”

Indeed, the disruption caused during the last two years has changed the landscape and mindset of investing for decades to come.

Reality.

What becomes fascinating about the current chain of events is the global synchronicity with which all measures fell.  Typically there are leaders and laggards in the market.  But when the credit crisis hit in late 2008 it seemed as if the floor fell out on all measurable statistics.  Now, we are left to make sense of the carnage and to figure out a “new” way to reevaluate financial data transparently and accurately.

For some, the burden of solving economic stagnation lies with government.  For others, that burden falls upon the private sector.  For both, issues like taxation, stimulation, regulation, and moral authority are paramount.

The risk, however, is believing that exogenous “stronger hands” play a greater role in narrating the result than does the inevitable push/pull of time in a parabolic, cyclical world.  Sometimes it just takes time for cycles to evolve and for problems to go away.

Execution.

Am I advocating a hands-off approach to market strategy?  Absolutely not.  As a quantitative scientist it is my duty only to measure the events before me, not to ameliorate them.  However, as a social scientist I can look back over statistics and glean that this is not the first market collapse, nor is it inherently different from those which preceded it.

The timing and magnitude and congruence of this decline do look a little suspicious, though.  I suspect that this recent bear market is much more a function of us putting all our eggs in one basket without adhering to commonly-held tenets about diversification.  It’s more a generational thing, a belief that “it can’t happen to me in this internet, always-plugged-in world.”  Perhaps the “new paradigm” our dot.com forebears envisioned was really a pre-pubescent narcissism about infallibility and invulnerability.  Buy a house?  It’s always a “win.”  Stocks?  Never go down.  Merrill Lynch, Prudential, Goldman?  Steady as rocks.

Where were the adults while all this was going on?

Today, the market looks to be rallying from recent lows.  Some might think the danger has passed.  I see these mini-rallies, however, as reflex adjustments from within a continuing bear trend. 

Our financial issues are complex with no single answer.  Not one political party, not one financial institution, not one piece of data, alone, can resolve a cyclic, systemic progression from occurring.

The next wave, and the ones after that, will slowly reveal the timeline.

Market Commentary for the week of August 30, 2010

Are bonds alright?

With stocks offering very little in the way of a “sure thing” investment return lately, one might think that the bond market, traditionally an excellent alternative to the run-and-gun high risk platform of equities, could be a more sensible option for investors.

Such is not the case, however.

Although money flows do indicate that the last few years has seen a measurable uptick in assets in the bond market, today’s historically low interest rates have many wondering whether the relative security of fixed-income is worth the non-risk?  Indeed, in a climate of credit defaults, budget deficits, and the spectre of inflation and rising rates, this allocation choice might ultimately be the wrong gamble.

To be sure, today’s uncertain economy makes any long duration commitment, equity or fixed-income, a very high risk endeavor. 

In particular, price sensitivity in the bond market (that is, the inverse-relationship between price and the direction of rates) could adversely affect net-return for “safe haven” bonds, having exactly the opposite consequence than originally intended.

With rates near their long-term low inflection point, my work postulates that the only logical direction for rates in the next half-decade is “up.”  If that were the case, its impact upon retirement money, life style, and portfolio valuation could be disastrous, if not planned for in advance.

Execution strategy.

My clients might have noticed that our fixed income durations are quite short, unlike the last optimum yield opportunity we had for long-duration investing in the mid-90’s.

Because of the economic uncertainty of our time, it is easy to see why investors choose to avoid stocks.  But with the confluence of factors I briefly mentioned above, even that thought process might not be entirely correct.  The numbers do not quite yet indicate that equities are a safe bet, I concur.  The last two years of economic and political conflict have surely diminished enthusiasm for risk-taking, and rightly so.  Earnings, demand, and capital gains are all muted, at best.  Average annual returns in major global indices have been horrible since 2007, with last year being an exception, and not looking any better in 2010.

The symbolism of such under-performance might be a greater deterrent to new investable assets than the facts, but it’s tough to counter human nature.

As I scan available inventory and yield opportunities, I am struck by the dearth of potential in fixed income relative to equities.  This, I believe, will have deep reverberating consequences for our portfolio allocation models, as well as life style choices for clients looking at “safety of principal” as their primary objective.  It might be necessary to establish new chronological benchmarks, or valuation expectations, to attain personal goals or ideal return.

The best way to address today’s economic inefficiencies is to segment goals and assets into risk and risk averse execution strategies and to care less about 24 hour investment cycles in favor of longer-term, and more realistic, options.

Market Commentary for the week of August 23, 2010

Cash out?

Recent volatility in the financial markets has some speculating that we “throw out the old rules and find something different,” that, in effect, we are living through a new morality which requires a network of new assumptions.  The fact that existing correlations are still working, albeit not with the result we seek, is irrelevant.  Some are suggesting we “throw the baby out with the bathwater” and start remodeling our risk strategies.

The market’s lack of traction has, indeed, brought into question many of our fundamental underlying assumptions about economic forecasting.  Whether by asset class, sector allocation, or capitalization all financial instruments fell precipitously during the last two years.  Safe havens are no longer safe places to be.  Credit rating and quality are no longer to be trusted.

And that, my friends, is the essence of our near-panic search for new answers:  whom, or what, do you trust?

It has become apparent that “reliable” sources were not.  As a result, valuations became impractical.

But the key to portfolio structure is to acknowledge in advance that our data are not infallible and to prepare for that event, or sequence of events, which might precipitate a market capitulation like the kind we are now experiencing.  Applying those safeguards is, after all, the mantra of asset allocation.  To wit:  “asset allocation plays a greater role in the probability of portfolio capital gains than does any individual security within that portfolio.”

Sound familiar?  To my clients and protégés it has become regurgitation.

Innovation.

If asset allocation is key, then why does the market, or your portfolio, still go down?  Most importantly, asset allocation is a modification, based upon each investor’s risk tolerance, of standardized data.  For some, risk is acceptable.  For others, their time horizons or tolerance for market fluctuation is paramount.

There will always be market volatility.  Our goal is to mitigate the impact of that volatility upon each person’s individual response to that “normalcy.”

Some have gotten hurt by real estate price declines.  Others by the bond market and global credit crisis.  No one is immune from upside/downside price fluctuations.  How we manage its impact upon our finances, lives, psyches is the ultimate arbiter of today’s financial concerns.

Fundamentals.

Portfolio asset allocation is also a dynamic exercise.  Strategies and results are constantly in flux, never static, and require constant adjustment.  My clients may recognize, for example, that during the past 3 decades we have changed our allocations (macro and micro) continuously to adjust for sector opportunity, regional opportunity, or perceived risk.

There is no need to modify our tools at this time, but, rather, to change our mindset about putting square pegs in round holes.  Global markets are evolving.  We must adjust our expectations to the changing times.

The real risk would be to abandon ship while still on the journey.

Market Commentary for the week of August 16, 2010

“What do we do?”

Whether long-term or short-term; large cap or small cap; value or growth; there is no methodology, no panacea, for altering the conditionality of a secular “life cycle.”  Try as we might to change them, generational themes play out with a predetermined sequence that is difficult to change with a wave of the wand.  Isn’t the essence of great literature, after all, the push/pull of preordination versus one’s power to change events?  While I am not suggesting that all themes are inexorably determined by fate, I believe that cycles need to complete before devolving, changing direction, or expiring.

Thus it is with financial trends that, despite the reasons being given on 24 hour cable business news, financial and certain demographic trends happen with or without the Fed’s assistance, trader’s intervention, earnings reports, business announcements, or analyst’s justification.

They occur because life happens, patterns evolve, and trends develop.

Science or mythology?

I am, similarly, not suggesting that there is “nothing we can do about it.”  The science of portfolio management (in particular my science of quantitative market analysis) is to analyze these trends, and those factors that comprise them, to determine influence, magnitude, velocity, duration and, ultimately, optimal asset allocation.  However, to imply that exogenous influences might be imposed upon these factors to change a trend is the great fallacy of politics, economics, and social studies.

To be sure, there are underlying factors which comprise the data of my science such as fiscal and monetary policy (interest rates), earnings, sales, consumer demand, geopolitics, microeconomics, etc.  None of these factors, alone or in sum, however, are stronger influences than the time in which they exist.

I’m sure you’re thinking “but the Fed said…” or “the Congress said…” or “housing starts were…” If so, then you fail to capture a larger imagination.  History has always been marked by great periods of famine, disease, art and literature, religion, agnosticism, war and peace.  Civilizations develop around great centers of culture, mighty rivers, strategic and polemic thought.  These are concepts of epic proportion, not just mundane day-to-day concern.

What time do we live in, and how can we use these cycles to maximize our place in the world?

Or as a client might posit “Yes, but what do we invest in today?”

Within or without?

These answers are not short-term oriented, nor are they simple.  What makes markets ‘go round is the diversity of aperture we each bring to finding solutions.  For some, it is trading; for others it’s longer-term.  For others still it’s the legacy of fine art, real estate, or other “treasures.”

It might also be a commitment to a higher order:  a connection to others, one’s health, or spiritual and psychic awareness.

The fascination I have for my work is that, looking from the top-down, the possibilities are endless, artistic, and never dogmatic.  Investing is understanding the needs of my clients and their attitudes about their place in the world.

Those answers are not on cable business news.

Market Commentary for the week of August 9, 2010

Volatile.

It could be that the markets are reacting so inconsistently because the data, itself, is so inconclusive.  On one day, inventories are increasing, thus the markets go up (industrial production).  On another day consumer confidence begins to wane, thus markets pull back (consumer demand).  In fact, almost literally, each day brings a new, and sometimes disparate, reason for markets to respond.

Examples of hyperventilated fundamentals include housing starts, home sales, savings rates, interest rates, currency equivalencies, terrorism, taxes, capital spending, unemployment, etc.  You get the picture.  For every uptick there is a reason.  For every downtick there is a reason.

Do you hear the Byrds intoning “Turn, Turn, Turn?”

As I have said before, the data is less significant than the implied symbolism (interpretation) of events and the secular trend within which those data occur.  You cannot change a generational trend overnight or with the announcement of a particular day’s data.  In fact, even the accumulation of “change of direction” data might only be a seasonal or short term aberration to the prevailing secular condition.  (Think Japan with its 20 year secular decline, accompanied by anecdotal occasional changes of direction within that bear).

Manic.

The spillover stress factor of 24 hour news incites anything from greedy mania on the upside to depression selling on the downside.  Or worse, as is the case today, news/data overload creates inertia, or “net-zero” performance.  Not only am I concerned that fundamentals are missing from the investment exercise, I am nearly convinced of it.

On balance, I interpret today’s financial market performance as “shared contagion,” in which a collective attitude gathers either to move markets up or down as emotions flow in reaction to data.  This occurs not monthly or weekly but hourly as markets around the globe move with such synchronicity that there is little distinction between sectors, regions, currencies, or national interest.

If you want to make money, and we all do, you cannot hang on the periphery, you must join in.  A “stronger core” is moving the markets indiscriminately, almost without strategy or methodology.  One cannot “time” entry or exit criteria, you just have to bear with it.

A legitimate case could be made to avoid the game altogether.  In some fashion, I am using my quantitative tools to define opportunity much more discreetly than in the past.  Core balanced accounts have less than 20% of resources allocated to the global equity markets right now.  Although I seek to have broader participation (owing to my philosophy of asset allocation and sector diversification), I find that the volatility factor day-in-and-day-out is more injurious to achieving steady performance than the risk of overexposure.

Potential.

There is a coincidental effect between the widening gap in fundamentals and the deterioration in quality portfolio management performance.  As the market nears key downside inflection points I see less enthusiasm for risk-taking.  Although I am disturbed by the acceleration in short-term volatility, my measurements have me on track for understanding the broader secular themes of our time.  My focus remains upon population demographics (life sciences, biotech); agriculture (food science, land use, farming); replenishable energy; natural resources (chemicals, metals, water, wood); and infrastructure (utilities, technology).

I believe, too, that there will be a lower entry point from which to make strategic allocation decisions during the next six months.  A market “meltdown” is unlikely, but a continuation of our current bear is likely to persist into the medium term.  I still believe that absent a suitable alternative in fixed income, equities are the best opportunity to achieve portfolio accretion.