Market Commentary for the week of April 19, 2010

Risk/reward game.

Risk appetites abated last week as investors digested early profit and earnings data and came away less-than-sated.  In addition, the Dow hitting 11,000 was a wake up call for anyone who wasn’t paying attention in the last year.  We’ve come too far, too quickly for many people’s tastes.  That prices are this high magnifies the risk quotients in equities, and could quell any interest some might have for putting money to work in the short-term.

My cycle screens are giving way too many caution signals for me to run through or ignore.

For the long haul.

Nonetheless, it is critical to widen the aperture on our perspective and recognize that we are in a secular bear, both in the economy and in the financial markets.  Very little investment capital is flowing into the markets even though the rebound in prices has been resounding.

While we may be on track to expect good news, no good news is forthcoming.  In fact, in today’s climate of inertia and skepticism, most news has already been discounted for its impact upon upside momentum.  As the markets top out, they build a higher probability that the next short cycle is down, making it harder for even the smallest bits of good news to stem the tide.  This headwind is immutable and, on balance, unyielding.

Bottom-up analysts stand to suffer the most.  Their insistence upon one dimension means that they have no more than a 50-50 prospect for performance.  Owing to the year-long rise in nearly all sectors, a measure of certainty has fallen over the probability of performance in equities, and it’s not good.  To be sure, there are always “pockets of performance” and individual aberrations to the norm.  But by historical standards this current upleg is quite mature and not likely to remain intact nor reverse the broader secular bear cycle.

I suspect that this season’s earnings reports will be better than last year, but historically tame by traditional benchmark standards.

Few indicators, in fact, are exceeding historical norms.  While some look like “improvements,” it is through the wider aperture that we can really see the lack of confidence and momentum in economic data.  Costs are simply too high, profits not high enough.

Low expectations.

I expect that this quarter will be more difficult than most in generating absolute and relative beta.  Considering the starting point for this quarter, following 12 months of near-linear growth, it is likely to be a muted opportunity at best.  Until we drain some money out of the markets, or unless the average investor jumps in, the cyclical bull we all hope for is somewhere down the road.

What will be the catalyst for a reversal of this secular bear trend?  First, we could try turning off the torrent of negative “exogenous noise” about immorality and greed on Wall Street and start sending a positive message about zero-tolerance for miscreants and synthetically fabricated investments.

But that’s not likely to occur by next Friday, is it?

Market Commentary for the week of April 12, 2010

Who’s right?

An intimidating debate is currently taking place between and amongst investment advisors, strategists, and media pundits.  It has to do with the role of debt, interest rates, and equity markets forecasting.  On the one hand, there are a number of factors which keep downward pressure on interest rates, such as a benign inflation picture and high consumer indebtedness.  On the other, there are forces which limit borrowing costs and the cost of money, like a wavering global economy, scarce natural resources, and a rising stock market.

Can you have both, or a little of each?  Certainly.  And today might be the confluence of both influences.

Netting the data out, however, draws some incontrovertible facts about rising inflation, rising rates, and a cessation in immediate upside gratification from stocks.

Interest rate debate.

As the benchmark 10 year yield hit 4% last week many investors became fearful that a continuation in the bond market’s bear phase was confirmed.  My bond market data has been turning negative since 2002, well before the credit collapse occurred in 2008.  A persistent bull phase in bonds had grown “long in the tooth,” and had already seen a cessation in momentum.  The credit scare was an exaggeration brought about, in part, by the excess influence of low rates and cheap money.  It was prudent for bonds to retreat and it is proper that a secular wave of reflation/reversal is beginning.  I continue to underweight the long end of the yield curve.

Around the globe there has been a congruence in the portfolio performance of sovereign bonds.  For most countries their bonds have seen the last, best sell opportunity of a generation.  The next leg in fixed income is likely to be a slight adjustment upwards in money costs around the globe.

This also presents the likelihood of a currency redistribution.  As all countries presently seem to be mired in a sea of debt, the dollar is likely to advance against most currencies.  Although some take the easy path of attacking the dollar (because of root economic factors in the U.S.), when all is discounted, the relative strength of the U.S. economy might bode well for the dollar’s position.  Conversely, one might conclude that the yen, yuan, and euro are vulnerable.  Deflation, trade imbalances, and debt put additional pressure on those non-dollar denominated nations.  This is an opportunity for the U.S. to expand its economic influence, if handled adroitly.

Rising.

Going forward, nothing is certain of course.  But the falling fortunes of the Euro markets, and significant Asian weakness, could yield significant upside pressure on U.S., and all, interest rates.  Most importantly, the likelihood of anticipated expectations will certainly change the global secular pattern of low rates and expansive borrowing.

I alluded also to the potential for higher inflation because of depleting natural resources.  The market’s recent anxiety has reflated gold and energy prices.  An increase in exports and inventories might raise the price of a basket of other commodities as well, forcing interest rates to rise.  A self-fulfilling evolution is likely.

All in all, one can argue that inertia, anxiety, valuation, secular and demographic trends and fundamentals are conspiring to create a tug of war which might truly lead to a “new paradigm economy” like the kind we may have envisioned a decade ago.

Market Commentary for the week of April 1, 2010

Square Three

Over the next few months analysts and economic theorists will no doubt have their hands full dissecting the net effects of the last bear market and financial meltdown.  Although the markets performed proficiently during the first quarter, the best that can be said is that performance was “good.”  One cannot close one’s eyes to the systemic flaws, however, that have been the reasons why.  By ignoring the history of personal suffering during the last bear, and its causes, we essentially are starting again from a tepid and insufficient starting point.  My job as a portfolio manager is to modulate a credible plan for the medium-term and to reconcile fairly disparate data into an actionable portfolio strategy.  Without knowledge of what transpired, and why, it becomes difficult to avoid the same pitfalls should they occur.

Remediation begins with identifying and sticking with a discipline, an overview if you will, about investing.  Ultimately, the goal is to build capital gains for the next decade which emanate from earnings performance and relative price out-performance.  No doubt for many this too will be a period of psychological transition.  Our collective bad mood about being manipulated by the system needs to be diffused before an era of trust can manifest again.

Markets.

In reality, this most recent period of market decline and malfeasance did no more damage (on a percentage basis) than other previous bear markets we have experienced.  But it did cut more deeply than most into our psyche and sense of well-being.  The popular sentiment today is to trust no one and to start anew with a continuing sense of skepticism.  If this attitude persists, it could be several years before the market recovers.

One might argue that this decline was an aberration, caused by a few, and not sufficient to wreck an entire system.  But I contend that the damage done to our global financial institutions was so pervasive that a congruence of negative factors seems to have overridden common sense, altruism, and reasonable expectations.  This recovery, when it occurs, will be one of the most watched financial cycles in memory, and worthy of atypical praise if it succeeds.

Historically recoveries have been led by demonstrable upswings in consumer consumption.  Thus far, I see little evidence that this is occurring now.  Corporate and personal expenditures have contracted significantly in the past 2 years, and are likely to remain subdued commensurate with the climate of psychological malaise.  Similarly, job destruction during this period has been significant.  Recovery in the jobs market has been subtle and slow to reflect a turnaround.  Further, global commerce is receding, in part due to these personnel issues, but aided also by turmoil in the currency markets, as well as social unrest in regions of the globe that control natural resources and production schedules.  All of this suggests that peeling the layers back to find answers will not yield a sweet smell.  In the meantime interest rates commence a secular upleg, the credit markets decide which way to go, and nobody knows who is a suitable risk anymore.

All in all, an immediate global economic recovery does not seem imminent, at least with the robust nature many would like to see. 

This is not to suggest however that the market lacks sector leadership.  In general, while the more visible businesses lie dormant, there exist patterns of nascent influence that replace the more permanent infrastructure.  In the last few quarters, during the consumer meltdown, natural resource equities have been the strongest capital gains generators.  Once one of the more depressed categories, the rise of these equities foretell a major change in the transfer of wealth, expectations, and profit potential.  Entrepreneurship and risk capital in areas such as water filtration, ecology, alternative and solar energy, agribusiness, and biotechnology are vanguards for a new era in portfolio modeling.   Indeed, while the mighty financial institutions now resemble a shell of their former selves, tangible assets (metals, timber, coal, chemicals) and demographic enhancements have gained valuation and capitalization intensity.

Strategy.

The key to capital gains is sustainability, viability, demand, and plentitude.  Structural characteristics in these “tangible assets” create opportunity for valuation gains later on, through sell-through demand and pricing power.  It is encouraging for these “tangible sectors” that as the market receded, they stood resilient.

Fiscal and monetary policy can only create the rules of the road for capital, they cannot demand consumption. 

Without credibility and stability, the financial markets stand ineffective.  Volatility levels indicate to me that the average investor is choosing to sit on the sidelines no matter how compelling the opportunities are brought before him.  But as I stated earlier, trends do end, cyclicality is parabolic not linear.  More often than not throughout history when everyone else throws in the towel, the opportunity is at its greatest.  I categorize these trends as “leading, lagging, or coincidental” cycles.  Remarkably, while it is always best to be invested in upwardly leading sectors, many also see opportunity in the laggards and their potential for capital gains.  In either case, my metrics can reasonably quantify the timing of these cycles and create asset allocation paradigms for all circumstances.  The bottom line is to select one’s methodology, stick with it, and not to be dissuaded from that style.  Otherwise you are mixing opportunity scales and coming out with negative-to-normal probabilities in the end.

Currently the best sectors for capital gains potential are Utilities, Technology, Basic Materials and Non-Cyclicals, while the laggards are Financials and Consumer Cyclicals.

All of these data not withstanding, the markets are still a reflection of investor sentiment about the potential for making money, and, more broadly, their attitude about the condition of the world and their place in it.  Right now, this uncertainty represents the most volatile statistic in my measurements.  Without disposable liquidity, no one feels compelled to gamble on financial alchemy for their future. 

Reluctance to stand behind one’s neighbors is fraying the social compact.  Last month’s healthcare debate was fractious.  I sense that civil discourse and altruism are ideals, but not applicable right now.  The viability of one’s family, one’s social network, is mankind’s strongest motivation.  When lack of clarity hangs over our heads, it is an unrelenting adversary.  This is hardly a climate for inclusion or interlopers.

The trouble with that attitude, of course, is that it, too, is linear thinking.  How long any cycle lasts and what will emerge are the unknowns for our time now.  Investing will probably be uncomfortable for a while.  I advocate moving to a more conservative and defensive portfolio in the short-term.  The one thing we know about contentious debate is that its impact on the markets is usually negative.  The beneficiaries of political flux might ultimately be revealed, but ours is not to predict, per se, but to navigate using a steady mindset.

Conclusion.

Profitability is the engine of portfolio capital gains.  Unlike the theorists who posture or cajole with nothing at risk, we who represent our clients are measured by performance, relative and absolute.  Over the next quarter it appears quite treacherous to balance the secular risks with short-term opportunities.  The world’s focus upon remediating monetary flaws, coupled with our nation’s own introspective social debate create a top-down landscape that is fraught with potholes.  Psychological momentum is probably not going to happen, either.  The first baby steps towards reigniting investment opportunity lies in jobs creation, budget cutting, and a strong mission statement.

The constituency of a market turnaround will be different, too.  Slowly, we are morphing from a consumer-led economy to an inflationary market of commodities.  Whereas a climate of low interest rates might have created the consumer boom of the last two decades, a sea change in monetary decision-making will frame a new context in the next secular upleg.  As if fearful of the effects of these new trends, the global financial markets ran headfirst into a brick wall of resistance last quarter, creating a linear price spike that, in my view, is unsustainable.  The nature of cyclical patterns is that they sometimes exceed their own boundaries only to fall mightily as a consequence.  Remember the Tech decline 10 years ago?  The flip-side of unmet expectations is potential for the next cycle.  Global decline ultimately might lead to global advance.  But it’s going to take patience before these needs are met.

The next upleg will put a period to the end of a long sentence, a sentence that was interrupted much too abruptly by aberrant behavior and excesses of an immoral kind.

Asset Allocation:

Equity 38%/Fixed Income 45%/Cash 17%