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.