Market Commentary for the week of July 30, 2012

Terrifying.
Our collective mood is souring, particularly in light of falling wages, increased competition for jobs, portfolio (net worth) depreciation, and daily news about politics, terrorism, and business corruption.  Where’s the good news?

As a former professional athlete, I embrace the notion of competition, and all that it implies.  But I shudder to think that the feeling of disconnect we sometimes feel from others is borne from a struggle to maintain individuality.  At all costs, we are taught to succeed at the expense of others.  We feel threatened by those who have what we want, or wish to have what we have.  The benefits of our economy are bountiful, yet we feel averse to collaboration, sealing our destiny by our own efforts, not those of the team.

For what?  Respect, money, fame?  Is it better to be different, or difficult, than to cooperate?

Although each of us may have different empathies, different leanings, the variations don’t surpass the level of being human, the capacity to experience the same basic emotions and sensitivities.

In business, everyone searches for an advantage.  Not often enough, however, do they distinguish between projects that “get it right,” which devote resources to a common good.  Those who can sort out the complexities of tough issues are more likely to generate not only profit but good will, as well.  Those firms which understand the dynamics of inclusion and moral good leave a longer-lasting footprint on global business and society.

Quick, think of a name of a company that you believe leaves such a legacy.

Most positive moral qualities are also associated with good earnings and strong share valuation.  Although a “feel-good” test is not a strict investment methodology, it is a good adjunct to any science we might impose upon global markets.

Closing the gap.

Although corporate Darwinism is the essence of trial and error capitalism, there are no doubt other social imperatives which lead to success.  As I mentioned last week, demographic shifts create a needs-based capital structure that can cure diseases, build scientific advancements, educate a citizenry, remodel infrastructure, recreate technology for our times, and change a psychological dynamic of inertia to momentum.

Concomitant with such choices is a need for strong government, transacting fiscal policy to match the will of the common good.  The potential to shift a capital structure lies either with the willingness of the private sector to do so, or a politico that sees the financial and social benefits of making it so.  In either case, fostering political rivalry does little to achieve either goal.

As a portfolio manager, it is exciting to think of the potential in alternative energy, biosciences, hydroponics and agriculture, technology, etc.  We have the power to enter a world of plentitude and transformation.  The numbers can be either “smart” or despicable.  The benefits can be too numerous to quantify.

None of this means that the global marketplace is about to take off.  Granted, we are not nearing a global collapse, but neither are we laying the financial or psychological foundation for shared benevolence.  Dysfunction, and strife abound.  The sluggishness we feel is by our own making.

The world is rich, in culture, resources, talent and hope.  Unfortunately, we also have an abundance of predators building their own exit strategy.  I have hope that the reluctant become the strong, and embark on a collective hunt for prosperity whose psychic and remunerative reward generates the next secular bull upleg.

Market Commentary for the week of July 23, 2012

Asset relief.
I want to dispel the notion that I am an investment “bear.”  There is nothing wrong with expressing an opinion, bullish or bearish, particularly when the “consensus” says it’s alright.  Proof of one’s courage, though, lies at the margins, during undetectable inflection points, before the consensus has arrived.  My track record versus the benchmarks demonstrates a successful delineation between bearishness and being opportunistic.  However, I am a realist, and against the current global backdrop there is very little to suggest an earnings expansion or a worldwide economic recovery just yet.  As a result, my asset allocation models continue to be underweighted in stocks and favoring cash.

What makes the “risks” even more glaring is the lack of momentum from policymakers to create consensus about style or substance.  I am more neutral about fiscal policy than I am about self-sustaining economic cycles. 

Earnings patterns are decelerating because very few are willing, or able, to make capital expenditures when they are fearful about the economic climate in which they operate.

While monetarists, worldwide, have forced interest rates into a corner, I would posit that no matter how low interest rates go, or how inexpensive it might seem to be when borrowing money, that you can lead a horse to water but you can’t make him spend.  There is no indication in any sector I follow that inflation, or reflation, is a concern.

Besides, adjusting monetary policy has proven to be no match for intractable economic cycles that have boomed, then busted, in long secular durations.  Politicians can certainly adjust spending to match current conditions, but when everyone goes into hiding, as is the case now, traditional political solutions just won’t work.  The key to reigniting the economy lies in a shared sense of sacrifice, and creating a level playing field from where everyone “feels” as if they have an equal footing, an equal shot, and an equal stake.  No guarantees…just a sense of fair play and opportunity, win or lose.

Until, or unless, we find such adjustments, the market will remain tepid, at best.  In that climate, no manipulation, by government or the private sector, can jump-start a psychological sense of well-being which might aggressively increase the prospects for growth and, at the same time, limit the potential for downside deterioration.

Declining confidence.

People are fearful.  Employment statistics are stalling, paychecks are not keeping up with spending, and corporations are hoarding cash.  The message is clear:  you are in this alone, get used to it.  A downshift in expectations becomes a harbinger for negative portfolio results.  The paradigm is a self fulfilling prophecy.

Not one week, one quarter, nor even one year can markedly change the momentum of political inertia.  However, the pulse of secular cycle, quantitative macroeconomics tells us that cycles, themselves, do not necessarily rely upon politics but, rather, a social dynamic that has a life of its own.  Elements such as healthcare, energy, technology are not beholden to a Congress or Parliament, or even a dictator, but to the evolution of social consciousness and need.

Banks need to “let go” of capital to help the entrepreneur.

As investors, we are “in it” either to make a profit, or to inspire social and moral good.  They are not mutually exclusive goals, however, but they have just recently become an either/or dilemma for the current times.  In my opinion, that juxtaposition is the biggest investment hazard we face.

Market Commentary for the week of July 16, 2012

Watching and waiting.
In order to achieve optimal portfolio returns, particularly in “un-optimal” market periods, it is vital to adopt an ongoing strategy/methodology that is consistent.  Attention to details, without capitulation, is the hallmark of a professional portfolio manager.  Ideally, one is seeking durable results over the course of a long-term, and not a reflex change to short cycle events.

This is not to suggest a stubbornness about one’s endeavor, a kind-of intransigence that a child might exhibit when denied a cookie, but rather a calculated comprehension of the details of one’s science which confidently produces consistent outcomes.

If this goal is met, one has a repeatable set of prescriptions which can be applied to all geographies of the financial landscape.

Not only should these “laws” be understood by the tactician, but it helps if a client can, within reason, marginally regurgitate the concept of these laws for his own comprehension.  As market conditions change, precipitating portfolio allocation changes, what might seem random becomes the basis for successful decision-making and a greater appreciation between client and manager.

The essence of that relationship relies not only upon a highly desired positive alpha for the portfolio but upon the consistency and proficiency of the manager’s stated discipline.

In my relationships with clients we hold to the notion, unique to each account’s risk/reward tolerance, that asset allocation plays a greater role in the probability of portfolio capital appreciation than does any individual security within that portfolio.  In other words, there are no heroes or villains, only groupings which heighten the possibility of the portfolio achieving its stated objectives.

Uniquely, my discipline has outperformed its “benchmarks” by two-to-one for nearly three decades by minimizing drawdown (the big error) in allocation combinations.

It is impossible to avoid any mistakes within the security selection process, but it is possible to aggregate the preponderance of positive outcomes in your favor.

Mammoth jump.

Today’s marketplace is a series of negative probabilities wrapped by insufficient psychological expectations.  Given the heightened state of insecurity, most investors will do whatever it takes to avoid another dot.com collapse in their portfolios, including doing nothing.

That is not a plan.  Market cycles ebb and flow and we must be responsive to those cyclical events.  Focusing upon the minutae, however, diverts your attention from the secular themes that resonate most strongly, and which ultimately impact upon raising valuations.

So far 2012 has been what I had forecasted:  a global economy with significant risk.  Individually, countries, sectors, and equities are doing their best to gain earnings traction.  Collectively, they are fighting against psychological disruption like none we have witnessed in the last decade.

Until, or unless, wealth perception changes significantly, wealth collection will continue to deleverage.

Equity prices will continue to rise and fall depending upon news events and a steady drip of data from local television and government sources.  But don’t expect the net effect seriously to alter the secular paradigm that earnings drive prices in the long run.  We are less about managing money than we are about managing one’s expectations about money.

Market Commentary for the week of July 1, 2012

This film is rated “R.”

This is not your father’s stock market.  Nor really is it “yours,” the one you envisioned two decades ago.  Instead we may have leveraged, in a literal sense, all the financial details to our heirs.  The bad news is that we have become marginalized.  Our goals and expectations have been sequestered, postponed, for another time.  Fed Chairman Ben Bernanke testified last month that we have “lost a generation,” twenty years, of investors because of the foibles and failures of our financial institutions.  Some might say our bankers were reckless and irresponsible.  Others, being more generous, have concluded that an era of greed motivated both bankers and investors to execute beyond their means.  Either way, its manifestation has been ugly.  The last decade yielded 0% return on equities worldwide.

Thus, the critical question going forward is whether or not a psychological recovery is possible, even as financial assets might rebound, or rebuild, into an impactful upside reversal.

In fact, recent economic data might suggest that the economy has “bottomed,” that many of the excesses have been wrung out.  Why, then, do we “feel” as if things aren’t quite right?  Changing that perception is, in my view, the first step in evaluating any fundamental data analysis, because without a context into which to place our economics there is no landscape definition.  Truly, to be a good economist one must first be a good political scientist.  Absent a context into which these data can be evaluated, it’s all abstract integers to most.

Underscoring the magnitude of the psychological disruption caused by the recession/bear is the erosion of the relative sense of net-worth that most companies/individuals feel.  The dislocation of one’s relative value is the largest in 25 years.  Debt as a percentage of assets owned hasn’t been this severe in decades, driven mostly by the decline in portfolio assets, real estate valuations, and excess inventory.  While the overall effort to save more/spend less is pervasive, it is the proportion of gain in our standard of living which has most decoupled.  We try harder, but achieve significantly less than our forbears.

Markets.

Our financial drift didn’t happen overnight.  At the peak of the last bull leg (2006), relative strength integers began to reverse.  These data foretold a reversal in the probability of the maintenance of financial trends.  Keep in mind that while we are programmed to believe that “good times never end,” real science teaches us that events are probability-driven.  Hence, nothing goes straight up.  And when a cycle reaches its apex, it is expressing, quantitatively, that the glass is full and that there is no more room for inevitable trend sustainability.

Why is this significant today?  Because the deceleration in wage growth, earnings expansion, and portfolio accretion became a fundamental and quantitative “given” that insured the expiration of a monetary and fiscal expansion that couldn’t persist.  Despite political or economic window-dressing, all trends ebb and flow according to scientific measurability, not just our desire to hype and hope for the best.

Of course, policy makers can exert influence, particularly of the psychological kind.  A perception that our needs, present and future, are being met can hold much significance over how corporations, governments, and individuals spend their money.

With the European debt crisis piggybacking on our own, there is a consensus that markets are painted into a corner.  Alternative solutions, such as austerity packages or spending packages, have not been agreed upon or adopted, which elongates the timeline of our current bear cycle.  It is likely that these trends become self-fulfilling prophecies, as spending cuts and non-discretionary purchases also elongate their cycles.  This leaves a real possibility that despite any monetary or fiscal measures, the world’s stock markets are trapped by their own velocity for the foreseeable future.  Thus, forcing our leaders to act might prove to be in vain.

There is no question in my mind that this quarter will ultimately be a statistical draw, with a heavy bias to the downside.

Strategy.

Some have labeled my analytics as permanently bearish.  They forget that my mood was positively giddy after the dot.com collapse (1999) when our asset allocation models became as bullish as they had been since 1987.  In fact, by following my models my clients outperformed their benchmarks by 2 to 1 during the last decade, something very few can claim with a buy-and-hold discipline.  Given that my metrics apexed twice in the last 5 years, I am now focusing on ways to generate positive alpha in a zero interest rate market and a vacant earnings acceleration period.

The global markets face more obstacles ahead.  Money is scarce, except for the trillions held by those who choose not to participate in the exercise altogether.  Paradoxically, that’s part of the problem.  Without printing more money, or relying upon government to bail out the economic crises, there is still enough corporate cash to fix our factories, hire workers, invest in research and development, do good socially, and turn around a moribund psychological mindset.  But they can’t, and they won’t, because:  (1) there is no demand for new products; (2) it’s not profitable to their stakeholders to spend money; and (3) the government won’t assure that they get additional tax incentives to be “socially and morally responsible” citizens.

That makes the economy hostage to fiscal policy, leaving the monetarists impotent and irrelevant to the profit discussion.  The more business says “no” to their social responsibility, the closer we get to a standoff without end.  As a result, the markets are in reverse and spasming mightily.

I am painfully aware that financial models are not surrogates for good old-fashioned common sense.  All the algorithms put together cannot outsmart ingenuity and entrepreneurship.  However, we must also be cognizant of the laws of model-making and how, through trial and error, laws become “hard data” responses to exogenous, anecdotal, or ambivalent phenomena.  Models make the interpretation of data “easier”, and create more efficiency in data assembly.  Finally, my models have been consistent in addressing, identifying and reducing risk, which enhances portfolio returns over time.

Assuming a normal timeline (lifeline) for certain market phenomena, it is very helpful to know where you are within the secular trend and how to quantify both the magnitude and amplitude of trend characteristics.  Markets are not inert.  The value of quantitative statistics is that they can offer a snapshot of three dimensional systems as they are happening, helping us to exploit inefficiencies where they exist, or correlations when they occur.  It is not an exercise in hindsight, only, but also a predictive methodology when expressing probabilities of future events unfolding.

Portfolio execution involves the optimization of expectations, methodology, and market volatility.  Whether one uses math or intuition, the best problems are usually solved by asset allocation and risk management.  Long-term buy and hold, as well as short-term stock trading, are approximations of science but not fully representative.

Markets sometimes exceed boundaries of upside/downside measurements, such as occurred most recently in the dot.com mania and global credit crisis.  It is helpful to know how to measure these trends so as not to expose one’s portfolio to extraordinary risk, up or down.  The impact of risk affects all securities, all regions, all capitalizations, all sectors.  While it is no surprise that all securities can fluctuate in value, it is usually problematic for clients when it does occur, particularly on the downside.  That is why statistics, methodology, and asset allocation can limit “drawdown” and/or excessive upside maniacal peaks.  Is this the discipline for all investors?  Of course not.  It simply works for me and the profile of investor I attract.

Conclusion.

The most constructive thing we can do for portfolios is to “do no harm.”  That doesn’t mean we can avoid volatility at all costs.  Jumping in an out of the market is not investing, it’s gambling and timing.  But with a disappointing set of data with which to work, asset allocation is crucial to averting an “all eggs in one basket” catastrophe.

There are few scenarios in which market activity or political intervention might have immediate results in the third quarter.  Perception, in this case, is reality.  On an ongoing basis, we are fighting on multiple fronts, and it should continue for the balance for the year.

 

 

Asset Allocation:

Equity 31%/Fixed Income 44%/Cash 25%