Market Commentary for the week of April 30, 2012

Trust.
Machines talking to machines.  That is how some describe the machinations of Wall Street currently.  Clearly, as volatility dissipates, the balance of orders becomes driven by execution “systems” and tonality that looks to outsiders as more artificial than negotiated between two parties.

Thus, a chain reaction a decade in the making has supplanted the human factor, opening up new avenues for greed and opportunity.  All the while, obstacles and inefficiencies are being manipulated out of financial trading.

Of course, this is not an American phenomenon, it is a global one.  The strengths, and weaknesses, of a local economy or currency are being exploited today more “efficiently” by technology over which even its designers can’t control.  Remember the 1000 point Dow decline aberration a few months back?

The markets need, no require, the human effect in order to succeed or fail.  We must reward ingenuity and bargaining acumen to make good, and bad, decisions.  Failure is, and should be, an option.  Otherwise, a sterility is introduced into the trading environment that robs capitalism of its primary component, risk.

Technology, or more clearly its overuse, has robbed the perception that the opportunity to make money is fair.  By holding a machine, or theory, responsible for maintaining good faith, we punish the subjective thinkers and rob them of an accountability which, for generations, lay with the brightest amongst us.

Globalization and systemization have expanded the reach of money, but not necessarily its virtue.  What is to distinguish one region from another if all regions become homogenized by 24 hour day-trading?

Credence.

There is a choice.  Vitality in capitalism is a human condition, not technological.  One cannot manufacture entrepreneurship and innovation.  While technology hastens the flow of money, it can also impede studied thought and deliberation.  Crises expand too rapidly today, as do sustained upside bubbles.

Science teaches us about equilibrium, what I call the Zed-line, a point above which, or below, your odds are exactly even.  Computer geeks call this “rebooting.”  But rebooting is not the same as equal odds.  If a machine is turned off at night, and on again each day, one does not enter the arena with the same probabilities as leaving the cycle to run over months and years.

Unchecked, rebooting implies that all cyclicality is also turned off and we simply “start again tomorrow.”  I believe this robs markets of vitality, dynamism, sustainability, and confidence.

Most of the time we can see value in innovation.  I am not an old fool.  I like computers and modern times.  I also like to have some risk in the game, risk which makes the discipline of analysis and sustainability more fun than just flipping a switch.

Market Commentary for the week of April 23, 2012

Focus.
As markets regroup from their phenomenal start to the year, certain groups have transformed the conversational dynamic.  Focusing as I do upon longer term demographics, I have noticed a shift from traditional consumer cyclical brands toward epic “population issue” sectors, such as agriculture, healthcare, energy and infrastructure.

Beyond the obvious significance of these topics, trading machinations within those secular themes have transformed during the last year.  While traditional trading for opportunity still permeates, one notices a steadier stochastic pulse to equities within these sectors, emblematic of a longer attention span.  It is possible that these themes represent more than just prudent asset allocation potential, but also socio-economic dynamics that might capture our imagination for profitability, innovation, and forecasting for decades going forward.

There is no question that austerity is the name of the (current) game.  No longer a victim of profligate spending, businesses are now (as they always were) beholden to the bottom line and to building equity for their stakeholders.  Nevertheless, certain companies, certain sectors, do this much better.  Without being susceptible to 24 hour news cycles, some industries can simply manage the durability of earnings based upon real demand, real margins and real socio-economic benefits.

Creativity.

My expectation for rebound in these “secular duration” sectors keeps my interest high that despite operating within a secular bear, certain brands might aggressively deliver capital gains in the next year.  Although it is difficult to “time” the market’s turns, one might expect that a modicum of attention paid to these focal issues could yield attractive percentage increases in their shares.

It would be foolish to wait for one hero stock to emerge.  I recommend, therefore, a prudent asset allocation strategy amongst those sectors which represent new initiatives within an old space.  Obviously, one must also be reasonably circumspect about investing either in a declining cycle, or within companies whose rate of earnings acceleration is dissipating.  When planning for the best result, we must also be cognizant of a worst case scenario, too.  As a top down investor, I try to be patient about allocating funds as well as my expectations for immediate gratification.  Both disciplines are slow, deliberate, and cautious.  In any event, one cannot focus upon capricious, opportunistic risk-taking as a surrogate for scientific method and discipline.

We apply a strategic macro overlay to all our asset distribution.  While bond yields are at historically low levels, we have nevertheless found good opportunity in intermediate maturity scales.  This is not to suggest that the fixed income landscape resembles the halcyon years of the mid 1990’s, but valuation, dividends and yield can be found with the right mix of research and ingenuity.  Creating value is always a matter of where you find it.  Reducing volatility risk is as important as monetizing upside potential.

Resolve.

Oftentimes, so many investment decisions are driven by an emotional appeal, sometimes to greed, other times to evangelical purpose.  Neither of these values, alone, is sufficient, in my opinion, without a strong methodological overlay.  I am also committed, as best I am able, to decisions whose long term impact is couched in a sense of social responsibility.

As the market breaks for its fourth month pause I am neither distraught nor worried about a bear market completion.  It is the logical order of things that nothing goes straight up.  Therefore, we need to take advantage of cyclical upswings and avoid at all costs the catastrophe of being unprepared for times when opportunity disintegrates.

Market Commentary for the week of April 16, 2012

Your choice.
Investors often confuse profitability with competition, overlooking the fact that you can manipulate profits, but it’s harder to concoct demands for one’s better mousetrap where none currently exists.

Thus the markets were dealt a dose of reality last week by focusing upon inflated valuations with unsustainable “profit” margins, simply reflecting better year-over-year accounting statistics, not real growth in top-line demand.

Even if a company experienced technology efficiencies, one must consider the social impact of its products and practices to consider how, and who, their impact most affects within the landscape in which they operate.

Everyone admires the bottom line.  Sometimes, however, suspicions arise about the organic mechanism by which “the black” is created.  In riskier markets, for example, it is often times the risk-taker who winds up on top.  Think about how many dollars must be allocated to risk before a big bet pays off.  We cannot discount the complicitness of those who simply play to put up big numbers versus those who steadily push forward a solid agenda.

The single biggest trouble we manifested during the last, and previous, market crisis was a sense of exuberance about bigger and bigger rewards, manufactured and synthesized by unnatural greed and avarice.

What’s appropriate?

So why are the markets seemingly “stuck in neutral” even thought first quarter valuation increases might be so compelling?  A good part of the answer lies in the difficulty of overcoming negative connotations about what spurs market growth in the first place.  More trading is done by computers for computers.  Much of the toxicity and malevolence is still in the pipeline.  Despite technological efficiencies developed during previous decades, it takes longer to eradicate negative psychological residue.  Unemployment, war, politics, and business-as-usual permeate client’s thoughts and cause behavior to recoil with mistrust. 

If you’re looking for solutions that capture above average potential with limited volatility, it’s imperative to create asset allocation models that correlate benefits with positive alpha, and which diminish the risk of concentrated positions and/or high risk leveraging.

This is important because today’s investors have become one-stop shoppers, looking for an “all-in” strategy that yields big rewards.  The majority of all-in strategies fail, and are usually implemented to generate above average returns.

I find this pattern quite disturbing because new relative strength data is again confirming the unsustainability of cyclical (short-term) patterns of aggression begun last October.  Despite the first quarter’s siren song of re-entry, more equities worldwide are either topping or entering into a pattern of distribution that confirms a migration from “no risk” to “higher risk” in equity selection.

Thin ice.

As if on cue, the second quarter of the year has started to mitigate the annual bull effect, providing remediation from historical excess.  Because the markets seem so fragile, the slightest deceleration rekindles a panic which destabilizes our psyche.  That’s what last week’s market resembled.

The fundamentals don’t really change that much, only our perception of their meaning and significance.

Market Commentary for the week of April 1, 2012

How high is up?

Not long after the remarkable global credit collapse of 2008-2009, the landscape was replete with strategists and naysayers who were predicting the demise of our financial systems.  The markets had seen historic depreciation, in bonds and stocks, amidst a dizzying panoply of bad news.  No one was quite willing to bet it all that a turnaround was imminent.  Except, of course, the speculators and value hunters, whose usual mantra that nothing is ever “too cheap” was put to the test with great prejudice.

The elasticity of this negative frontier was being highly tested.  Valuations were pushing the envelope of stochastic tolerance.  These were times exactly when quantitative statistics were supposed to kick in and define “a bottom.”

Pure mathematics is never a match for gunslingers and gamblers.

The counterpart to purely objective scientific dynamics is hunch, innuendo and a machismo that is unusual for the average investor who is usually governed by a herd mentality that makes managing emotions as important as managing his portfolio.

It was rational to assume that markets had broken a new barrier, downwards, and that they were likely to languish there for awhile.  It was, however, wrong.

In one of their most remarkable recoveries, the global equity bourses produced a near-linear recovery, in price mind you, that left traditional parabolic thinkers in its wake.  The problem, though, is that it was only a price/valuation rally whose repudiation of fundamental, earnings-based analysis was equally as historic, and stupid, as the data and events which spawned the decline in the first place.

A greed-only rationale for capital gains, or capital depreciation, is a misuse of the capital market’s responsibility to build something that contributes to the society, mores, and culture in which it operates.  Madoff-like greed screwed up the markets then; speculator-type gambling is skewing the odds, today.

Markets.

As the market’s positive response expands, so too does a concern that valuations and fundamentals have disconnected.  Although earnings reports indicate better year-over-year patterns, the number of companies that actually beat analyst’s estimates is at its lowest since before the credit crisis in 2008.  If, in fact, stocks trade based upon earnings, and earnings acceleration projections, we are likely to see a slowdown in fundamental asset allocation into equities.

The most significant effect of a 6 month “linear” valuation spike is that it shortens the timeline of equity analysis from long-term to short term, month-by-month to minute-by-minute.

The dominant, secular, trend of the global equity bourses is still down, despite the precipitous short cycle advance of the last half-year.

We can also glean a little about the rally by the composition of sectors participating.  Immediately before, and just after, the “credit bear,” much of the blame for our economic condition was laid at the footsteps of the banking industry.  Today, one of the largest sector capital appreciation values comes from bank stocks.  This is not difficult to understand.  Beaten down during the crisis, these equities, at their nadir, represented the deepest discount, best value, purchase opportunity.  This also explains the difference between fundamental investing and value investing.  To the value players “the cheaper the better.”  To others, there must be a reason for significant price erosion attributable to a company’s poor standing.

Over time these variables “even out,” as one man’s value stock becomes another’s growth stock.  But historically these variables may take years to develop.  Under today’s conditions, price rhythms expand or contract under a shorter timeline.  Generational growth is now referred to in months, not decades.  Japan’s 20 year bear market would be an anomaly in today’s terms, likely to exist only if structural, fundamental, and technical factors erode coincidentally and with extreme prejudice.

We know that debt restructuring and fundamental monetary rebuilding will not happen overnight, or in a vacuum.  What we cannot predict is the level of speculation that takes place within a 24 hour news cycle in response to, or in anticipation of, these potential changes.  While having lost a measure of respect for, and confidence in, our financial institutions, investors are much more likely to affect a knee-jerk trader’s mentality to risk.

There is no doubt that a short-term acceleration in valuation has developed because of the perception of global central banking intervention.  Although the fundamental situation remains uncertain, the markets have gained new vigor, and confidence, since last October.  After underperforming for the previous 6 quarters, the last two have been historically dynamic.  One looks at a technical graph of the market’s response and is reminded of a contrail produced by launching a spacecraft into orbit.  The only question is to what degree the acceleration can be maintained and how high is up?

During the past quarter, risk aversion gave way to a kind of aggression usually reserved for last-gasp phases of cyclical upswings.  This was evidenced by strong returns in sectors, such as Financials and Cyclicals, that usually lie fallow when fundamentals rule the landscape.  I do not think that the annual (2012) returns for these sectors will be quite as strong.

Strategy.

My quantitative processes place great emphasis upon momentum, velocity and duration of cycles.  In that regard, building a portfolio involves the maintenance and attention of the whole product, versus any particular element within that portfolio specifically, and a careful adherence to risk/reward guidelines that focus not only upon current return but the probability of expected return, with moderate risk, going forward.  Each element must be carefully matched to the others so as not to overemphasize the contribution (positive/negative) of each unit’s profile.

A systematic process also allows for a reduction in stress or pessimism.  That’s not easy to do in this environment.  Despite stock price increases, fundamentals hit home in a visceral way.  It is often said “it’s a recession if your neighbor is out of work; a depression if you are.”  Although exogenous events might seem a world away, their impact is being felt in every community here at home.

A rise in volatility and trading ramps up the expectation that if you’re not in there “swinging for the fences” you’re falling behind everybody else.  The pressures mount to take more risk, or to correlate to what you think others are doing.  It makes the task of managing risk more difficult because everything is now being measured against a subjective profile, losing perspective and intuitive science in the process.

As is my custom, I review all macro events from a “secular,” long-term, structure.  Looking at the story in years, decades even, provides a beneficial focus from which sector rotation and longer trends take on a more dramatic effect.  From this perspective, false echoes and exogenous noise degrade the data to a lesser degree.  Recovery rallies take their place within a broader context.  Similarly, today’s vulnerabilities might take on a mini-structural identity whose cumulative effect might impact intermediate trends.

Since 2009 we have experienced only two intermediate relief rallies within the context of a persistent secular bear.  This bodes poorly for our current short-term rally (begun last October) because there is neither a fundamental nor historical context in which its continued ascent can be justified.  While price momentum might be increasing, relative strength integers do not confirm the probability of a continued extension.  As well, volatility spiked “at the top,” confirming a likely distribution or sell-off is likely.

Globally, the advance required to sustain price momentum is waning in a majority of sectors and regions I review.

My conclusion is that real stochastic integers (proprietary relative strength data) have a high probability of reversing, and could become the downtrends which re-set the matrix of values for the second quarter.

Conclusion.

Although performance in our portfolios was good during the first quarter, it is likely that my defensiveness might be costing us during the current rally.  Right now, my allocations reflect a lack of conviction that the rally can sustain, so while “cash is king” is a handy catchphrase, in our case it is our best defense against the kind of draw-down that ruins portfolios.  The calling card of our methodology is not to have one or more security rupture the probability of continued portfolio progress, point A to point B.  In that sense, we successfully continued our steady climb in valuation appreciation.

The game going forward is not to succumb to false pressures by announcing an end to the secular bear.  Avoiding significant drawdown is not cowardice, it is good money management.  One might conclude that subscribing to reasonable methodology is an attribute that manages downside risk while allocating to upside probabilities.

No one likes, or wishes for, portfolio pain.  Complicating matters for the sake of bravado is irrational behavior.  The rankings suggest that these short term rallies are helpful, but not sufficient to ameliorate our crisis in fundamentals, valuation, or confidence.

 

 

Asset Allocation:

Equity 35%/Fixed Income 45%/Cash 20%