Market Commentary for the week of February 15, 2010

Two sides of the curve.
Students of my quantitative investment disciplines are typically impressed during bull markets. We seem to be able to maximize efficiencies in up-markets by utilizing cycle phases and inflection points. Seemingly more impressive, and more useful today, is the use of these tools, and others, to leverage the other side of the parabola, the downlegs that occur after upcycles are completed.

Clients tend to look only at the “long” side of the markets. Their portfolios achieve an upside dollar value and, as if looking at a money market balance, they believe that having attained that valuation is the equivalent of locking-in that value. Despite repeated admonitions that “markets are cyclical,” it is nonetheless difficult for them to accept that portfolio valuations fluctuate.

It is important to recognize the prevailing secular theme and to be allocated so as best to maximize the upside probabilities of that trend. But it is nearly impossible to avoid up and down cycles that exist within those trends. Thus, one’s portfolio manager is a magician when riding the upleg of a parabolic curve, and a “bum” when the curve ends or reverses course.

Remember, asset allocation plays a more significant role in the probability of upside portfolio performance than does any individual security within that portfolio. Therefore, you only need to be “right” more often than wrong to achieve actual portfolio performance

Today’s market requires both magic and patience to be successful.

The right side of the curve.
As global markets transition from secular bull (1990-2007) to secular bear, I see a narrowing of opportunity in traditional assets, and a shift towards newer, more resilient business models that take advantage of pricing power, productivity, and thematic demographics. These industries, and their equities, underscore the staying power of international baskets whose underlying business activity remains upbeat and profitable.

I have previously identified these sectors as Agriculture, Life Sciences, Healthcare, Technology, Alternative (and Renewable) Energy, Telecom, Basic Materials, and select Infrastructure Industrials.

The dollar might be losing the short-term battles, but its base is too mighty to erode completely. Dire predictions to the contrary are premature. However, in a global economy, shifts in currency valuations and strengths are to be expected.

My current strategy is to continue expanding yield and dividend payouts within my portfolios, while using earnings accelerators to account for capital gains potential. The main risks to this long-only strategy is the current secular (bear) trend and the possibility of continued deterioration in equity support levels. This might worsen if earnings patterns and/or global demand further weaken.

The next left hand side of the curve.
There are, I believe, certain other immutable trends that are initiating. We know, for example, that interest rates had been in a decline since the mid-1980’s. Their decline, and prolonged period of “disinflation” which accompanied, produced the largest (magnitudinally) and longest bull market cycle in stocks and tangible assets in history. As with all trends, they expire. We have been at an inflection “point” since 1999-2002. (As you can see by my example, trends are not points on a calendar, but rather periods of time during which they are accumulating or distributing.)

Instead, owing to the expiration of the disinflationary curve and the current indebtedness of global nations from excessive over-borrowing, we are likely to see an upswing in the cost of money, savings rates, and prices, all of which could usher in a new cycle of economic phenomena.