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%
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