Market Commentary for the week of July 25, 2011

Brand new.

It’s painfully obvious from consumer sentiment data and market statistics that a new normal is coming into focus which has the effect of recalibrating everything financial, from earnings patterns to capital gains expectations.  Curious that back in the late 1990’s our dot.com brethren spoke of a New Paradigm.  I don’t think this is the schematic they envisioned, though.

As a result, I have to prepare both my clients and their portfolios for a new calibration of return on equity.  It stands to reason that as earnings acceleration patterns diminish, so too does the prospect for equity price appreciation.  Higher volatility, shorter amplitudes for price cycles, and declining sector allocations are likely to be our basis for the next few decades.

Method shift.

What should we do to prepare for, and hopefully profit from, these new dynamics?  For one, we must recognize that active, customized portfolio management always trumps static, non-managed accounts.  High cost mutual funds have always been suspect for generating returns, in part because of their size, but also because they lose the flexibility of maneuvering within cycles.  Today, the markets have taken on a trading configuration which, unfortunately, dictates a shorter time-line even within a longer term arc of secular demographics.  Beta is increasing as alpha is diminishing.

Secondly, it is more important than ever before to define the secular themes, map out a topography, and remain consistent in one’s exposure to highly successful market cycles.  In the broadest sense, methodology and process are more important than return.

We need to keep in mind that investing is a journey, a process itself, which means ups and downs, detours, and sometimes some stress.  To achieve a “guaranteed” return means you are not investing, you are simply giving up or giving in.

Analysis shifts, too.

The most important function I provide to my clients is the mitigation of downside risk through the use of quantitative tools that measure cycle persistence, magnitude, and probability.  As my accounts have demonstrated, we have had remarkably low drawdown even during periods of severe financial rupture.  This has allowed us to outperform most benchmarks and to avoid the pitfall of hitting home runs to recoup severe losses.  In a low-to-static growth market these asset allocation cycles will play an even more important role in managing both return and client expectations.

We must also recognize that assets are becoming less correlated, not more.  Despite the fact that it appears as if everything is going down in value, the pockets of non-correlated phenomena are becoming more diverse.  The challenge, then, is to find those pockets and to capitalize upon them without shifting into intolerable asset allocation patterns.

The new normal is still consistent with prudent portfolio management theory.  There is really not a lot that is “new.”  Quality securities in the right risk tolerance profile should always be our objective.  While the baseline is being recalibrated based upon today’s current events, we want our actions to be consistently justified and standardized for the long haul.  Accept that history is still on our side, and patience is also a portfolio tool.

Market Commentary for the week of July 18, 2011

The long road.

Technology has indelibly changed our lives, and the pulses within, from longer-term to short term solution-making.  One sees this evolution, particularly in hindsight, in the way we process information and the multitude and complexity of decisions we are called upon to make.  The younger-set calls this “multi-tasking,” while others of us refer to it as brain “overload.”

But the overriding issue to me is not whether we have the technology, sophistication and panache to execute complex decisions, but whether or not there is an imperative to do so.  In other words, simply because we have it does not necessarily (definitionally) mean we have to use it.

This is particularly relevant to the financial industry because the complexity of market derivates, multiplied by infinite factors, has created a system that cannot support its own weight.  Just because we can, does not mean we have to.

Witness the convergence of market algorithms and trading systems, many of which you can buy at a discount brokerage house.  In the wrong hands… heck, in the right hands… these systems can be bastardized into producing high speed trading models designed to make the user more facile at trading market inefficiencies.  They also confuse trading with investing, dissecting the orderly flow of capital into staccato eighth-notes of turbulence.

Finish line.

Assume for the moment that you and I start out with the same objectives, to make money, but your engine is revving at 120 miles per hour (along with your pulse) while mine putters along much more slowly.  Without making any judgment calls about which disciplines are “better” (they’re all good), the efficiency you create is offset by a narrower margin for error and a shorter time line.  Further, assuming we arrive at the finish line together think of all the unnecessary layering and machinations you have imposed upon your system.

Think, too, of the recent mortgage debacle and all the vice-presidents it took to composite a derivative CMO or some other such product simply to layer up, and add fees to, a simple transaction at its core.

Somewhere in-between.

The key input to profit-making is energy and expense.  To make serious headway, I believe we need to simplify market techniques rather than to complicate them.

To do this we must first elongate the time line of discovery and execution, as well as the evaluation of what makes a successful investment.  It seems simple to say, but the fact that we have technology and multi-tasking at our disposal has not yet proven, in the last decade at least, that it has made the end result any more proficient or successful at generating alpha than not to have had them.

What millions of high-tech, turned-on, investors haven’t come to realize, yet, is that their personal receptivity to things “old fashioned” isn’t as advanced as their gizmos and gadgets.

Market Commentary for the week of July 1, 2011

The Ultimate Shell Game

For centuries, carnival barkers have astounded us by “hiding the pea” under a shell.  We wonder how and why we get fooled so often, yet return again and again believing that we have the eyesight, intellect, and instinct to outwit their sleight-of-hand. 

Our reaction to the financial markets today is this decade’s attempt to outplay the barker.

History tells us that markets and economic growth are parabolic, not linear.  Nothing in life goes perpetually straight up or straight down.  That’s why there’s always hope at the bottom, or anxiety at the top.  The lessons of professional sports tell us that the game is never won even if you’re ahead, or that you’re never defeated until the final seconds have lapsed.  To be sure, these parabolic ascents/descents occur on an axis which can either be advancing, declining, or stuck in neutral.  But never assume that you can take a straight line to the top or bottom.

Unfortunately, today’s bargain hunters think “enough is enough” (decline) and weigh into a parabolic cycle of decline skewed from “top left to bottom right,” only to find that secular momentum is against them.  Their vulnerabilities and instincts don’t work, and they retreat, wounded again by the ugly carnival barker (Wall Street).

Today’s market condition is a crisis for investors who see the impact of the secular economic and market decline upon their pocketbook, jobs, and psyche.

Whether due to fundamental or psychological factors, the synthesis of the global market bear is instantaneous and pervasive.  With few exceptions, earnings acceleration patterns are declining worldwide. Those companies that do have growth in earnings are doing so absent robust demand, and mostly attributed to “efficiencies” such as worker layoffs, price increases, or strategic mergers.  I believe that earnings growth absent a social or moral imperative is specious, in the sense that it serves to enhance shareholder equity first but not necessarily a societal need.  If any part of that thesis is wrong, then why do people feel so disconnected from corporations and the avarice they have shown?  A corollary also might be that if a corporation’s underlying societal obligations are fulfilled why shouldn’t they also make money as well?

Markets.

The past half-decade has been one of the worst event-driven reactions to the market in nearly 80 years.  What worries investors the most is a sense of disconnect from what happens to money at the institutional level.  Surprisingly, there have been no riots or contagion, just a feeling that “the other guys have won.”  Even if a dramatic sea-change in global fundamentals were to occur, it might take decades before a confidence in our financial institutions themselves could take root.  Contrast investor disdain today with the feeling of ebullience in the “get-rich” 1980’s and you can see, again, that you’re never as well off as you feel in good times, nor as impoverished as we might feel in the moment today.

But we’re close.

With price inflation rising during the past decade, joblessness increasing since 2004, portfolio and home values calamitously falling since 2007, global conflict and terrorism spreading, and political discourse sinking, it is no wonder that markets can’t get out of their own way.  The impact first and foremost of rising energy costs upon industrial production and consumer travel has made immediate course corrections necessary.  The globe is going to have to deal with this new reality of supply/demand, nation states, and terrorism impacting upon cost, profitability, access, and lifestyle for decades to come.

Even if a new, replenishable source of energy were found today, it might take years of development and distribution before an economic market system morphed into existence, eliminating ambiguities about profitability, equitable access, and sustainability.

No, today we are reacting to the realities on the ground, and those realities are tense.

Investors, and markets, disdain “all-or-nothing” situations.  When a disconnect exists between measurable risk and opportunity, inertia takes hold until the stalemate can be broken.  In that sense, today’s bear market is far worse than any of the recent past because the “gaps” are not being filled.  Clearly, many perceive that underlying fundamentals are unique to our time and affecting the public square differently than one might expect.  Rising commodity prices, falling home values, tenuous employment, uncivil discourse in government and between nations may seem excessive to some, but nominally influence whether the shock and awe of our current crisis is business-as-usual or an aberrant reflection of some other confluence.

Strategy.

While every generation must deal with problems of its time, typical intergenerational rules apply which govern the process of solution-making.  In today’s digital age, historical values are changing in milliseconds, and impacting upon the dynamic of conversation and methodologies.  To wit, when was the last time most families sat around the dinner table discussing current events?

This “new paradigm” gives me pause about going all-in today as valuations continue to decline.  Both macro and micro would suggest that global bourses might contract another 5-10% during the next two quarters (S&P 1210).  Certainly, if we’re not contracting downwards, we are likely to contract laterally for the next quarter.  In either case, the sectors and equities which account for market leadership are fighting the larger, secular forces of decline.  Thus, I am building more defense, than offense, into client portfolios.

Global monetary policy has nowhere to go since the stimulus of 2008.  While low interest rates might be a boon to the markets in affluent times, they seem only to have painted economic probabilities “into a corner” temporarily.  From a strategic perspective, maintaining low interest rates, while sounding good to the borrowing public, fails to provide the impetus for savings and growth which I believe to be the wellspring of new capital expenditures.  The net effect of today’s yield curve is to suppress confidence and borrowing.

So how have governments attempted to ameliorate their condition?  Mostly by keeping interest rates low and by advocating “stimulus” packages that leverage fiscal and monetary objectives.  Couple these tasks with robust “austerity” rhetoric and one can see how two diametrically opposed forces might collide.  While acknowledging weakness in most global economies, prime ministers and financial chieftains are trying to fight back with the only weapons they have:  tax policy, printing money, and low interest rates.  The reality is that an extended period of problem solving is likely before we see clues about whether these packages are working.  In reality, irrespective of benefits and incentives offered to business, until or unless the consumer feels flush no amount of cajoling will improve either the markets or global economies.  The U.S. Federal Reserve Chairman as much as admitted this in his address at the end of June.

It seems unlikely that, in the short-run, asset prices are likely to increase.

Interestingly, these issues are being addressed with the same solutions and by the same cast of characters that got us here in the first place.  Profligate spending, excessive greed and the need to stimulate asset valuations produced the vexing predicament of our time.  If low interest rates couldn’t create jobs and economic growth the first time, from what perspective does one believe it might today?  Slow, steady, sustainable growth is the objective.  Broad economic expansion, full participation, and an equitable playing field are the pillars of that objective.  My belief is that we might probably not see a resumption in earnings acceleration patterns until 2012 at a minimum.

Those who argue for more of the same believe that low interest rates stimulate stock rallies, consumer purchasing incentives, and business capital expenditures.  While there might be a temporary boost to the economy as a direct result of cheap money, the short-sighted easing has actually driven down investment spending.  Additionally, despite best expectations to the contrary, global equities remain in a secular bear and have fallen this year.  Indeed, much of the benefit of easing was the psychological boost given to the markets before its results were fully understood.  There is a lack of energy, enthusiasm, in today’s global equity landscape which has muted the effects of the early bubble.

We are also aware that the U.S. dollar’s decline should be a net positive for exports, but thus far has not provided the needed incentive, or GDP expansion, that warrants calibration.  Is America’s plight bringing down the global markets or are global instabilities washing up on our shores?  My view is that dollar parity creates a level playing field which might help ameliorate industrial instability.

Conclusion.

Decades of decadence gratifies everybody, most notably the “already wealth.”  The objective, of course, is always to provide for the many.  However, watching our disjointed global economy apparently modifies the failure of monetary and fiscal policy to provide such a safety net.  Major secular upheavals in sector leadership gives rise to another decade of consequences from which it takes time to recover.  As governments are forced to shift policy from spending to saving, the instruments they have at their disposal become obsolete without consumer support and/or confidence.  The acquisition of “things” paid for by leverage, margin, and debt is a fruitless endeavor in today’s climate.  As a result a truer “new paradigm” must develop which:

·          Shifts the focus from hard asset leverage to savings and cash

·          Raises secular interest rates

·          Globalizes investment capital, trade, and profitability

·          Provides for a fairer, equal playing field in financial assets.

Ironically, the secular themes which most resonate with these solutions are those which provide capital gains and aggressive capital expenditures for investors and speculators alike, namely biopharmaceuticals, alternative energy, industrial infrastructure, agriculture, and natural resources.

Profound change is necessary to rejuvenate the inertia of investing and especially to raise the confidence level of those who currently occupy the sidelines.  The goal, after all, is fair access to capital gains for all who wish to participate, and not to “hide the pea” unfairly.

 

Asset Allocation:

Equity 30%/Fixed Income 32%/Cash 38%