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%
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