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
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%
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