Market Commentary for the week of July 26, 2010

Hopscotch.

As earnings are reported, the most obvious accelerator of profitability is pricing power.  Nowhere is the evidence of the laws of supply/demand more obvious than in tangible assets, such as metals, oil and paper.  For many years previously, investors were buying-up real estate in anticipation of reaping easy reward.  In hindsight, the plethora of cash and low borrowing rates at that time magnified the potential for opportunity in the sector.  Now, money seeks new opportunity in other “depleting” natural resources.

This near-manic search derives not only from the scarce nature of the resource itself, but also from its application as tools of industrial development.  Minerals used in technology (copper, eg.) energy components, and foodstuffs (agriculture) are the next best tangible resources to own after the real estate collapse.

Despite rhetoric about “value” during a market collapse, there is always a counter-cyclical opportunity elsewhere, outside the primary focus of our vision.  Besides, instead of profitability through layoffs and “efficiencies,” demand in these sectors provides room to grow, along with potential increases in prices.  In that context, real earnings acceleration is quite probable.  And the opportunities are borderless, lying in regions that are yet to be cultivated.

Macro equals micro.

Not only are the locations of these “commodities” global, but the potential demand is, as well.  The population of these regions needs homes, technology, food, and energy.  Global data confirms that a large portion of our unmet demand is within the next two decades, a factor that equates to a rebalance in our asset allocation for many years hence.

An additional benefit from this data, too, is that the market’s response thus far has been muted.  Predictably, analyst’s focus has been on highly visible underperforming sectors like banks and retail.  At present, negative psychology is more influential on market performance than fundamentals or future projections.  Stock picking and capital preservation is a stronger driver of market activity than any other influence.  Thus, fear trumps idealism, and long-term forecasting goes unheeded.

Cycles.

To be sure, current cycle measures within the economy and markets are abysmal.  Large downdrafts have wiped out a serious portion of discretionary cash and portfolio valuation.  No one is sitting and waiting for the “next best thing,” anymore. 

Rendering traditional fundamental analysis invalid, investors are guided by fear, safety of principal, and boredom.

I would hasten to note that cycles do end, they do reverse.  The tech upside explosion in 2000 reversed precipitously downward.  Sometimes bear markets reverse course in similar fashion.  Usually, I can see early signs of accumulation in certain demographics that have longer-term implications.  Following the demand side, there are nascent indications of countercyclical strength in those sectors discussed herein.

The key is to know where the cycle originates, have a “good idea” where and when it might end, and to be judicious with one’s asset allocation.

Market Commentary for the week of July 19, 2010

Which do you choose?

Earnings season, such as it is, has begun, and the most significant dichotomy we are witnessing is between companies that must reduce prices to incent consumption versus those that must raise prices to cover costs and remain in business.  Neither scenario is very good for earnings-driven investors, only one works to the benefit of the corporation, both might accrue, ultimately, to the consumer.  None of them, however, drive confidence and stock activity.

If you must choose sides, (and that ultimately is what business I’m in), the right outcome for equity performance is to select companies that are raising prices.  That, at the very least, indicates a modicum of pent-up consumer demand, and answers many demographic questions about a corporation’s relevance within a hierarchy of business needs.

It also becomes inflationary, which underscores a host of other factors regarding viability, borrowing expenses, and profitability.

Portfolio process.

Although our mandate is to make the correct bet on earnings outcomes, suffice it to say that individual equity outcomes mean far less than does the prevailing secular trend within which they exist.  On a general level, we know that demand is down, production values are stretched as tightly as they can get, and corporate cash levels are less than abundant.  Recognizing the current limitations of the global economy, we have to build both portfolios and portfolio expectations that accurately reflect the prospects for debt-ridden economic development in the future.

This sets up a tug of war between deflation (a reduction in all costs and expenses) and inflation.  The headwinds facing an economic rejuvenation are quite strong.  We are clearly in transition from unabated spending and consumption towards what pundits call a “new behavioral paradigm.”  The progress we make will be the direct result of recognizing a new normalcy, a financial upheaval that yields results and profits for corporations and citizens, alike.

As a result, I have significantly rebalanced portfolios to look more short-term oriented.  Maturity scales in our bond portfolios are between 1-3 years in most cases, while stock trading has supplanted buy-and-hold.  My metrics have become more staccato in the short-term, while longer term secularity has turned decidedly more bearish.  Volatility and diversification are two hallmarks of equity trading right now.

We all pay.

It is unlikely that my inflation scenario will manifest anytime soon in conventional reports.  But each of us has anecdotal experience with the dry cleaner, movie theatre, university, insurance company, transit authority, electric utility, telephone provider, luncheonette, and pharmacy to indicate that prices are not declining when it matters most.  To be sure, the “discounters” might be trying to incentivize our spending by lowering costs, but it’s not working anyway, at least to the degree in which economic stimulus ripples past their front door.

Equities, and the economy, are at a critical spot.  Already in a secular downleg, equities are failing to gain traction on the way down sufficient to reverse the trend in the near-term.  Therefore, I would expect relative underperformance from stocks for the foreseeable future.

In the absence of any real catalysts otherwise, my enthusiasm is restrained by persistent and contagious corrections within the cycle that we simply have to endure before we might expect any meaningful upside reversals.

Market Commentary for the week of July 12, 2010

Wimbledon or Wall Street?

Is your neck tired from snapping back and forth, witnessing the daily “ping pong-ing” of the stock market, first up and down then left and right?  Well, don’t get used to it because as in any racket sport rallies come to an end and a winner emerges from one side or the other.

In this case, it appears the winner, with the strongest serve, is the downside.

Be specific.

Global economic and fundamental seams are fraying slightly around the edges.  Brought about by credit and currency concerns, equity futures are giving enough indication about trader’s confidence (or lack thereof) levels, that gaps are being created through which traditional support is eroding.  The pain of lower stock prices is likely to intensify before it gets better.

Some see these concerns as “opportunity.”  After all, the cheaper a share of stock becomes the more attractive it is, right?  Not always the case.  The reasons for an equity price decline are always more significant to me than the price itself.  Additionally the magnitude and velocity, as well as its duration, of the existing trend can tell you a lot more about the probability of a company’s performance than fundamentals, alone.  Coupled with an overly or exceedingly poor psychological malaise, the overall prognosis is not great.

To be sure, investing involves risk.  My job is to balance the expectations of my clients with the realities of market fundamentals, to navigate through all channels of risk.  Every market experiences bull and bear cycles.  Our pessimism about world events today is distinct counterpoint to our optimism during the last bull run.  I expect the bear to reverse course, I just don’t know the exact date.  However, during any cycle, I expect to find “counter-cyclical” opportunity from amongst various sectors.

What is clear is that the consumer is hunkering down, changing habits, and no longer the single engine that can reverse an economic slide.  Interest rate patterns, stimulus incentives, market manipulation cannot provide sufficient momentum to change psychological mistrust and fear.

It now appears that a synchronized global decline is forcing the consumer into hiding, waiting for policymakers and market makers to come to their rescue.  It’s not a good idea to flood the market with cash and “easy” borrowing, but it seems like all they’ve got to offer.

The long haul.

There are clues, however, that private capital is awakening.  Biotech research is expanding.  Alternative energy confabs are popping up all round the world.  Technology and internet are developing more rapidly than we can absorb.  Telecommunications, traditional and otherwise, is making yesterday’s devices obsolete.  Lastly, cultivation of food and water crops is essential to sustain life and prosperity for underdeveloped nations.

What government can, and cannot, do is irrelevant to these processes, but to provide the right landscape and moral persuasion for these endeavors to succeed.  Financial markets must provide the stimulus, momentum, and psychological will to invest beyond their singular best interest and to venture into capital expenditures that “make-it-right” for all of us.

These lofty goals notwithstanding, markets are collectively sending out bad news on a daily basis.  Our vulnerabilities are showing.  To focus simply upon intraday price movement is a misplaced endeavor.  It’s tough to escape from within a circle.

 

These problems didn’t occur overnight, nor will they resolve conveniently much quicker.

Market Commentary for the week of July 1, 2010

Ready.  Set.  Set.

 

Momentum is turning against our expectations for market appreciation and economic relief.  By trading in such a narrow, but volatile, range my relative strength quotients have tipped into “negative” territory.  The threat to the markets, however, doesn’t come from stochastic integers, but rather from a steady drip of fundamental flaws which leave the investing public dispirited.

During the last quarter, which I described as being the most difficult to perform in the past half-decade, the panic widened and the reality shifted from intermediate recovery upleg to secular bear.  The constant resonance of bad news from Afghanistan, Greece, the Gulf of Mexico, corporate greed, and one’s neighborhood, resulted in the erosion of market potential in the near-term and psychological malaise in the long-term.

Our focus, too, has shifted during the past few months from goal setting to surviving.  Despite all best efforts by our political and moral leaders, there is a general sense of negativity amongst the least well-off.  This underlying disconnect from hopes and goals casts doubts on whether our common fabric is woven tight enough to sustain and support all but the uber-rich.  Rhetoric is “me-too” and self-directed, dealing a serious blow to the science of civics and the philosophy of cultural inclusion.

In fact, the dogma of self-reliance could push policy and rhetoric into a full blown cascade of survival of the fittest.

Markets.

Fiscal and monetary policy is not helping the situation, either.  Without discretionary cash, the consumer is simply not predisposed to spend money on items that might suffocate his budget.  Unfortunately in today’s climate of low employment many/some of those items are necessities such as medical care, food, transportation, and housing.  What once was thought to be academic is now becoming a devastating choice.

Perhaps geopolitics is contributing to the problem?  Foreign markets are experiencing their own mini-depression.  A similar climate of easy money sickened the Asian and Euro zones.  Their meltdown was as inevitable as ours, and largely caused by the same symptoms of excess.  Last quarter, no nation gained traction in my research.  Most lost momentum.  Nearly all are in down cycles with no immediate termination likely.

The key to any turnaround henceforth will be a psychological migration from fear and skepticism towards optimism.  Otherwise, an economic and financial markets breakdown will persist.

Recent deceleration in earnings performance translates into decelerating equity prices.  We seem to be entering a “quicksand zone” in which global markets get mired down simultaneously, adding additional negative momentum to our probabilities.  Whereas we once thought of certain geo-zones as being immune from market swings, we know that that is not currently the case.  Even mighty China has fallen during the last quarter.  Whether this reflects growing risk to the global economy is not quite clear, but it is emblematic of a slowdown in end-user demand and cheap money being spent to excess.

Some other geographic regions are also losing relative strength.  We know that the Euro-zone closely mirrors the West, but consumer demand is slowing in the Pan Asian region, as well as some countries in South America.

The bottom line is that my metrics are gradually in transition from acceleration to deceleration.  Relative strength indices are topping in all but a few sectors.

Coupled with a slowdown in equities is the probability of a rise in global interest rates and, therefore, a secular decline in the bond market.  These shifts are inevitable because of the long period the markets spent with “inexpensive” money.  Just the slightest hint of a rise in the cost of money might represent a severe magnitudinal change (on a percentage basis) in the direction of interest rates.  As we all know, rising rates adversely affect the valuation of bond portfolios, which is why my clients might have noticed our maturity scales are on the very short end of the curve.

We need to keep in mind that the framework for finding high yield bonds or strongly accelerating equities with earnings performance is narrowing.

I would caution, however, not to confuse a diminution in the scope of opportunity as a lack of opportunity altogether.  Because of a bias to expand growth; add jobs; search for alternative fuel sources; remediate illness through research and development; rebuild brick and mortar surfaces; diversify the globe’s internet infrastructure; replenish our food and water supply; and explore space and seas; scientists, politicians, and market theorists have a very full plate, indeed.

Business and market cycles evolve, parabolically, and react to the excesses imposed upon them.  Ratios are constantly changing for the long, intermediate, and short-term duration.  When this market shakeout is completed a new secular upswing will emerge.

So the question remains, “Are we in a bull or bear market?”

Without being evasive, I would define our times as a bear cycle response to the excesses of the long bull market which preceded it.  At present, we are experiencing several unsuccessful bull rallies within that bear whose significance and strength is more durable than any short-cycle efforts to reverse it.  There is little evidence to suggest this is the beginning of a market cataclysm, but neither should we take lightly the significance of a bear response to the greed, growth, and excess of our last economic surge.

Conclusion.

How will we know if/when the secular risk is over?

Economic cycles always inspire the best/worst reactions at critical end-of-phase cycle inflection points.  When the economy accelerates unabated, there gathers a near-unanimous shakeout of all doubters.  Similarly, when all hope is lost and economic activity contracts to historic proportions, one might quantify (in hindsight, of course) a very high probability of upside rejuvenation.

We are nowhere near a magnitudinal turnaround upwards, and several cycles removed from the market’s last apex.

Corporate earnings worldwide are inhibited by low consumer demand, but “spreads” on equity valuations are far from historically low levels.  Relative to forward earnings projections, P/E multiples are not “cheap,” but neither are they reflective of the vast “high” spreads of the late 1980’s.  One might anticipate that absent a renaissance in positive consumer sentiment we could shave a few more points off P/E levels which could bring equity prices lower still.  Besides, I see no other suitable alternative for owning stocks at this juncture.

Following last month’s G-20 conference it is important to remember that in a globally integrated marketplace the activity of others is equally as important as any unilateral actions one nation might take.  To rebalance negative effects, there needs to be a coordinated systematic step-up in fiscal and monetary policy that assumes shared risk without endangering proprietary needs of any single member.  This is a fragile ballet that is far from over, nor easily accomplished.

Finally, we are dealing with, and seeing the results of, severe psychological trauma wrought upon the public by institutional corruption, greed, and malfeasance.  Frightened consumers do not spend.  Nor do they learn to trust easily again.  This means that financial institutions, policy-makers, and governments must assuage those doubts and the insidious lack of trust we all feel about giving our money to “those people,” whomever “they” might be.

The ongoing secular bear is a fact.  Sufficient data suggests that until or unless circumstances change, its impact will continue to be felt, in higher prices, fewer jobs, declining home and portfolio valuations, higher taxation, political and social alienation and global economic stagnation.

Such is the residue of the “glory days.”  It seemed like a good idea at the time.

 

Asset Allocation:

Equity 30%/Fixed Income 40%/Cash 30%