Market Commentary for the week of October 18, 2010

Resource economics.

With a steady run-up in natural resources equities the past year, some are concerned that the progression might come to an end.  I am not one.

Although global indebtedness is still a primary concern, consumption of tangible assets moves on unabated, and with that the fundamentals for commodities’ price increases remains.  Clearly, the market’s obsession with natural resources is a two-edged sword.  But sentiment and relative strength indicators are sufficient not to expect a sudden reversal of trend in the near term.

Concomitant with a demand for basic materials is the expectation that price increases (inflation) in those commodities are also likely.  If it doesn’t get out of hand, a rise in prices might be a strong pre-indicator of a pickup in global industrial development.  Besides, we are far from a “hyper-inflationary” environment, as current asset price increases year-over-year hover around 4% across the board.

The intrinsic value of commodities heightens, too, as you move from highly industrialized Western economies towards emerging markets.  Today a “typical” basket of metals, timber, etc. might be more significant to GDP for emerging economies than for those with relatively low/stable demand.  Russia, Brazil, Chile, India, and China are all undergoing a wave of industrialization and modernization programs which require metals, lumber, rubber and energy sources.  Additionally, I have written prolifically about future land use for agriculture and potable, replenishable water supply.

Gold only?

While the market’s current focus seems to fixate upon gold, there are probably more geopolitical and psychological components to that metal’s rise than fundamental, industrial use and its effects.

Commodities are not a zero-sum game.  They are a depleting natural resource whose value can be measured based upon current supply/use and future expectations or alternatives.  Imagine if you will (and this is an extreme hypothetical) if the globe no longer needed fossil fuels.  How severely would production and price decrease?

The question at hand today is “to what degree should an asset allocator be committing to these sectors?”  Based upon improving policies and demand worldwide, it is entirely appropriate to reserve an “overweight” ranking for these equities.  As long as industry prudently manages inventory-versus-demand cycles, upward valuations might persist.

Recall, also, that during the dot.com boom, just a decade or so ago, one couldn’t give an industrial stock away!! Such is the nature of parabolic market continuums that decades elapse during which minor shifts in psychology, expectations, fiscal policy and politics, become tectonic secular themes for our time.

In other words, it is difficult to predict trends but easier to quantify them as we look back with the perspective of time.

Long-term, my thesis is that depleting resources (whose supply today is unquestioned) might provide the science and politics for an elongated trend whose capital gains potential could be significant.

If you simply like to bet on 24 hour trading cycles, please disregard the preceding text.  Mine is not a strategy of uncertainty and malaise, but rather a science of macro potential and cash flow.

Market Commentary for the week of October 11, 2010

Perfect investing.

Every morning of every day that the financial markets are trading, investors awake to the belief that “today might be the big score.”  Oh, come on and admit it, you’re hoping for that one big massive uptick that makes you fabulously rich, or, at the very least, validates your investment commitment.  By measuring your securities against a mythical benchmark, you’re either up or down at the end of the day, and today, by golly, might be the big one!!

This affliction sounds a lot like the psychosis which permeates Gambler’s Anonymous, but hey, that can’t be us because, after all, we wear suits and ties to work – we’re above gambling away the family mortgage, aren’t we?

This yearning is also hard to kick because of the immediacy of feedback we get through technology.  (I hate to admit it, but I come from a generation where we used to check the next day’s morning paper for stock prices from the previous day!!).  Today, investors trade by the minute, for the minute, hoping for an impressive uptick.

If the goal is to build portfolio net worth using a long term aperture and solid mechanics of portfolio management, then perhaps immediacy destroys the endeavor altogether.

Investing is not, nor should it be, “a big score” enterprise.  By working towards standards of achievement and perfection that are statistically improbable, most investors are setting themselves up for failure and disappointment.

My thoughts about this emanate from my observations of mood swings of colleagues and clients whose self worth seems so indelibly bound to their portfolio worth.  I think we need to divorce ourselves from subjective modeling and apply a different standard to our review.

When watching a great athlete or performer, one is struck by the ease and grace, the simplicity, with which they execute their craft.  What we don’t see are the fits and starts, the failures, that embody their practice in preparation for that one moment of grace.  It doesn’t just happen, and it’s never perfect, but it does occur, not because they wish it to happen, but because they work, prepare, and plan to execute.

Investing is no different.  Discipline and methodology are the forebears of success, not the goals or end product.

So?

Global equity markets are doing a poor job of mirroring the fundamentals of our time.  Simply because we wish stocks to go up is not sufficient justification for them to do so, particularly as economic fundamentals fail to keep pace with our accelerating desires.

Unfortunately, my work is forecasting a “resistance line” for the equity markets above which it might be difficult to go in the short-term.  For me the key to equity performance is earnings acceleration.  Despite year-over-year improvements from their depths one year ago, real integers are still down from their highs, and not likely to show any improvement without marked top-line demand.

I am, therefore, continuing to underweight equity exposure even as certain individual companies become more attractive from a valuation standpoint.

As has been proven many times over, the “big score” is elusive and untrustworthy.

Market Commentary for the week of October 1, 2010

Take Two Aspirin

Almost out of nowhere, the markets are looking more and more imposing, and less attractive, to professional and non-professional investors.  The reasons lie less in the analysis of fundamentals but more in a deteriorating trust of systems, players, and motives in the financial community.

Natural risk takers, and the risk averse, are leaning more towards “stuffing money in the mattress” than they are towards complicated derivatives.  Wild gyrations in stocks and bonds heightens the fear and skepticism within investors that this is a game they wish to play.

A majority of poll services indicate that many think investing is “not fair.” 

In a climate in which concern is growing about performance and ethics in financial matters how, and why, does confidence dissipate so rapidly?

Markets.

The psychological shift has been imperceptible to some, tectonic to others.  My data indicates that despite rising prices during the last decade, relative strength integers (a measure of velocity, momentum, and magnitude) were declining as far back as 2006.  Thus, equity valuation increases were being built upon false bases.  Indeed, when the credit crisis hit in 2008, money was already looking for safe-haven escape routes.  Unfortunately, even bonds failed to offer the requisite alternative investment scenario.

During the next two years, cash was seeking a safe place to park.

Although wealthier investors were “less affected” by portfolio declines, high-net-worth players were, in part, more responsible for the permutations in product construction and use than the less affluent, thus the  perception that markets were “unfair.”

Downside collapses are “bothersome” to the wealthy, catastrophic to the poor.

As I have stated before, one’s tolerance for risk is mirrored in their asset allocation.  And asset allocation, itself, plays a greater role in the probability of portfolio capital gains than any individual security within that portfolio.  Thus, heavily concentrated portfolios, such as real estate portfolios or technology-only portfolios for example, showed poorer performance than more-diversified portfolios during the same period.

One’s willingness to absorb risk, and expose assets to specific sector volatility, is the great conundrum of investing.

But risk-taking is not only about objective data and portfolio modeling.  It is also about perception.  If the perception is that all risks are equal, or none are fair, then investors will be unwilling to balance risk against risk-tolerance.  Such is the case today.  The markets are delivering the opposite of what is expected (based upon theories of standard risk evaluation) and, thus, no one perceives a fair opportunity to win.

It is extremely difficult to keep from getting negative.  Markets are cyclical.  In fact, this period is not the most egregiously woeful period in the market’s history.  We have been here before (1929, 1987, 1993, 1999, etc.).  Fear is not an effective portfolio management tool.  In the long run, an effective discipline and methodology is preferred to an emotional or irrational response. 

Strategy.

The most remarkable thing about my proprietary Arlington Econometrics methodology is how quantitative statistics can improve upon intuitive return expectations by focusing upon correlated and volatility variances between asset categories.  The extent to which we can measure performance and location of a financial security helps us to identify the magnitude, velocity, and direction of its trend and to offer probabilities of its risk-adjusted return.

This is lofty stuff for many investors and often eschewed in favor of hot trends or recommendations from television personalities.  Unfortunately, these people are no different than you and sometimes have difficulty quantifying their own hunches within a global spectrum.  Most importantly, hunches tend to be quite volatile (beta), indeed just what the aggressive investor is looking for!!

Incorporating stochastic integers, analogous to a GPS system, into investing diminishes beta while enhancing return probabilities (alpha).  During the pre-crash period, most investors lost their focus about risk management, instead focusing upon less diversification and lower correlated probabilities to generate alpha.  Thus, crashes and mini-crises affected them more severely than most.

Diversification and asset allocation also exposes an investor to a global panoply of assets and potential for capital gain from a variety of geographies, capitalizations and sectors.  Indeed, my client’s accounts have shifted from high concentrations in equities, to sector rebalancing globally, and ultimately to cash and yield during the past three years.  As a result, our drawdown has been smaller, while our returns have been superior.

Conclusion.

Real or perceived, we are in a new dynamic of financial fundamentalism:  Earnings around the globe are shrinking as consumer demand declines; stochastic measurements are less aggressive than the previous decade; the secular bull is now a secular bear; capital formation is less aggressive and more biased towards traditional products; global employment patterns are reconfiguring towards energy, technology, bio-sciences and away from traditional retail, consumer-led brands; politics and terrorism are upfront and real in our internet-connected universe.

It would be disingenuous to deny the macro patterns described above.  It would also be calamitous to ascribe these trends as anything more than a general pattern of reshifting fundamentals that occurs on the “back-leg” of any market’s parabolic duration.  Simply, we are in a normal, albeit painful, response to the previous generational cornucopia, and a requisite recalibration of policies, data, and psychology.

I believe that we are also experiencing an excess of “manual stimulation” to, what should be, a normal measured time series during which (as has happened historically) there is a gradual shift from boom to bust, then boom again.  All the stimuli, all the political rhetoric, all the sustained partisanship is indicative of another type of fundamental dialogue, but not necessarily the science of economics and market statistics.  To that extent, the global financial markets are disassociated from politics and influenced only at arm’s-length from what occurs in political capitals around the world.

The markets tell us something when they react “positively” to negative political or economic data. In some cases, unrealistic expectations about the relationship between data and market performance can send investor psychology sky-high or down-in-the-depths on an hourly basis.  Such is the impact of expectations and internet upon market volatility over a 24 hour cycle.

Imagine, if you will, that you wake up one year from today to review market performance, the political landscape, and your portfolio.  How much, based upon what you know today, would have changed?  Then, do it again one more year later.  Now you can begin to understand how trends develop and how one either becomes right or wrong in the long run.  Those are the bets that real investors make.

My commitment is to quantify those bets, and to allocate client’s resources so as to mitigate downside risk and to maximize sector opportunity.  Within that context I see several categories of opportunity, irrespective of 24-7 internet proponents who proclaim otherwise.  I see significant quantifiable momentum in agriculture (foodstuffs, grains, arable land); biosciences; biopharmaceuticals; alternative (replenishable) energy; technology; industrial infrastructure (rail, highway, air); basic materials (tangible assets); and consumer cyclicals (innovative product development).

Interest rates cannot stay this low indefinitely, nor can global treasuries continue to be as accommodative as they have been since the credit slide began.  I believe we are likely to enter a period of tighter money and higher inflation in the next decade, particularly if a hoped-for economic recovery is to succeed.

Every investor’s dream is for 20% returns with no risk…at least that’s what is frequently requested of me.  But our emphasis should be on maintaining a prudent discipline about investing, and mitigating any turbulence whose volatility might cause significant risk. 

While it appears as if the “little things” are of greater significance, my belief is that we can improve performance by focusing upon those activities that generate positive macro performance for the duration.

As the title infers, “Take two aspirin and call back next October.”

 

Asset Allocation:

Equity 28%/Fixed Income 42%/Cash 30%