Market Commentary for the week of August 27, 2012

Smile.
For many weeks, I have received feedback from readers of my commentary that I am “too negative,” “too pessimistic” in my views about the markets.  While it is true that my objective quantitative science leaves little room for interpretation, let me dispel the notion that it is I, not my data, that is contemptuous of the “next move.”

In fact, I would argue that owing to the duration of our bear market (whose origins date back over 5 years), the necessary elements for a reversal in course are closer today than they were on day one of the bear’s initiation.  Both market valuation and sentiment indicators have taken precipitous falls from their highs.  A severe degree of pessimism is necessary for the seeds of a bull market upside reversal to occur.  Now that global policy makers are aware of the level of investor disinterest and mistrust, they are slowly acting upon policy which might reflate economies.  After all, how much lower can interest rates go before we consumers begin to “drink from the trough?”

While current demand for credit is slow, any increases in capital borrowings and expenditures going forward would be a welcome sign.

Although we are still waiting for policies to evolve, the potential now exists to push the trajectory of growth and spending higher.  Even the perception of movement becomes movement, boosting interest and perhaps confidence in the meantime.  As such, my overall view remains realistic, but cautiously optimistic, barring any exogenous turbulence.  I would rather act to increase portfolio valuations for my clients than to run and hide in a completely defensive posture.

Gauge the opportunity.

The biggest question, then, is the timing of more aggressive action, and from which sectors does money have the best probability of generating gains?  There is no doubt that we have seen a shift from purely defensive categories into more aggressive opportunities in Technology and Cyclicals.  Favoring a strategy of “cautious aggression” I have maintained a neutral weighting in Utilities, while increasing exposure to those companies that demonstrate consistent year-over-year earnings acceleration.  This would imply more mature companies that have non-cyclical market share.  I also see demographic, long-term shifts in agriculture, water, alternative energy and healthcare equities.

It is imprudent to load-up a portfolio on risk or hunch.  As such, I still hold to the belief that one’s asset allocation plays a greater role in the probability of portfolio capital gains than does any individual security within that portfolio.  Thus, at the appropriate time, I will rebalance sector weightings, asset allocation, and security selection to enhance portfolio performance.

On board.

The key macro factor that needs to reverse, or stabilize, is investor confidence.  For too long, many have felt that the game is played unfairly by those who control the capital.  A contagion of mistrust arose from that belief and paralyzed the financial markets for five years.  Relative and absolute performance diminished during that time and placed all market variables under suspicion.  These data interpretations can change, seemingly overnight, and are changing even now for the better.  But unless we buy-in to their favorability, the markets will remain inert and range-bound.

Global purchasing is attempting a comeback.  Inventories in select industries are expanding.  Prices are bullish (inexpensive) and ready for the taking.  If banks would start lending, there are dormant industries ready to expand.

The most appealing part of these conversations is that sentiment indicators show that people want to opt back in, not to melt away and forego the whole thing altogether.

That’s enough hopeful empirical evidence, right there.

Market Commentary for the week of August 20, 2012

Separate or equal?
In the common parlance of Wall Street, you’re either a bull or a bear.  It’s difficult to be both at the same time, yet this market has as many agnostics as it does true believers.  What you believe, however, is another story altogether.

Year to date, the market is higher than its January open.  Yet many skeptics hold to the notion that since 2009, the market has been in a recovery only, from the longer-term bear that started in 2006.  For them, a three-cycle intermediate recovery rally is just not enough to change the perception that things are still “not right” in the economy.  And for them, current longer-term secular cycles are the predominant trends dictating investment policy, asset allocation, and risk assessment.

Despite nascent signs of improvement in fundamentals, I, too, fail to see a resilience to the data sufficient to change the psychological, if not financial, dilemma of defining the current cycle’s theme.

It is for these reasons that investors find their convictions so contradictory.  Many feel caught between missing the next upleg or getting caught in a downdraft of unexpected consequences.  And, thus, the markets stay range-bound and mostly inconsequential to the day-to-day travails of most of us.  This is different from years back, when, knowing where their convictions lay, investors would tune into the business report, or check the stock pages, to confirm their inevitable wealth-building, sullied only occasionally by an off-day here or there.

Today, China, Greece, Portugal, Spain and other regions mean a great deal to our portfolios and the probabilities of wealth gains contained therein.  Influenced by fear of another catastrophe, and fewer options, investors are staying away in droves.  They don’t like what they are seeing, hearing, feeling, and they recognize that one event more might wipe out all their expectations, and cash, immediately.  The market is a game, and the consequences can be diabolical.

One step back…

And if the market is a game, some might say an “art form,” we also are losing our belief that the game is played fairly.  Fiscal and monetary policy is oriented around stabilizing and influencing the effects of exogenous news upon the data, not in letting an equitable response to those data play out.  By manipulating the duration and impact of cycles, legislators might also be creating unintended harmful consequences.

We are all hopeful that we might break the cycle of continuing disappointment.  The notion that someone, something, might come along to remediate our ills is a powerful fantasy.  Still, one must err on the side of caution and reality.  I choose, at least in the short-run, to underexpose portfolios to risk until quantitative confirmation of a reversal in declining momentum.

Both anecdotal and empirical analyses indicate a high correlation between economic uncertainly and the potential for market price reversion.  The majority of sectors in my universe are coincidental-to-laggard elements.  Many, if not most, are related to psychological expectations as well as fundamentals.  Sector sentiment, or lack thereof, is at its highest in the last 12 years.  Therefore, following a period of intermediate cycle recovery, we are not yet at the point where short cycle trends cross-over and “breakout” above the secular slide.  Nor do I see this changing during the next 6 months.

Sentiment (psychology) is relevant to these empirical data studies because it helps to define the probability of symmetry between what we read and what we do.  Right now, the divergence of correlation between the two would indicate that despite our best efforts, many are content to do nothing.  More importantly, reversing our negative psychology is perhaps a powerful precedent for future portfolio gains.

Market Commentary for the week of August 13, 2012

“De,” “In,” or “Stag?”
So far, key data has been unable to answer conclusively whether we are in deflation, stagflation, or targeted inflation.  I wrote several weeks ago that I saw no empirical statistics indicating inflation.  I was partly right…and partly wrong.  Indeed, I had been early in identifying targeted inflation in tuition, foodstuffs, energy and healthcare.  These demographic price hikes are systemic, and mostly driven by consumer demand or ecological/climatological influences.  On the other hand, where no demand exists, profits, and prices, have been falling.  Unfortunately, the drag on the economy outweighs any pockets of acceleration.  That is why the market doesn’t “believe” a recent rash of earnings successes and immediately reverse its bearish course.

The only hope, it would seem, would be a sea change in how the private sector chooses to deploy its trillions in capital reserves before the government steps in to tax it away from them or moves to “nationalize” the public’s psyche and chases big business into submission.  Many agree that immobilizing the wealthy only antagonates them.  The flip-side to that debate, however, is that coddling the “haves” also alienates the “99%” who are the “have less.”

In a sense, this is a struggle of moral persuasion versus bombastic super strength.

When economies break down into rioting and civil war, such as is the case in the Middle East, you have run out of fiscal and monetary solutions to the crises.

The other key element to this debate is the time horizon one applies to analyzing the causes and cures of a global recession.  It didn’t take one policy, one administration, or one nation to initiate the decline, nor might it take one person or theme to remediate it.  On the other hand, there doesn’t seem to be enough fiscal firepower in the arsenal that might represent a cause-and-effect immediate response to what ails us.

What is clear is that acts in the past are less relevant than future actions.  We used to talk in the 1980’s about global interdependence, globalism.  We now know how true that was.  Earnings from your local bakery today might be as much a function of nations thousands of miles away as they are from adjoining neighborhoods.

Not overnight.

There are still opportunities for the right businesses to succeed.  We are probably, and statistically, closer to the end point of a recession than its origins.  Expectations have diminished, and that’s usually when opportunity finds fertile ground.  It might be possible, from the depths, to reconcile opposing points of view to look at the longer-term, wider aperture of solutions.

So just what is the economy telling us about its ability to sustain, or engender, growth?  Even global policymakers admit that it requires more time to bridge the gap from austerity to solvency.  Their guidance would indicate that stimulus packages are mostly exhausted, and market traction has been woefully inadequate.

Update.

The bottom line is that global growth is slowing, on balance.  A lack of momentum and psychological conviction might keep us range-bound for the near future.  As an earnings-driven analyst, I see a preponderance of evidence indicating a slowdown in earnings acceleration patterns, a key statistic in my ratios of upside/downside probabilities.

One is always aware of exogenous influences upon one’s data, like the U.S. Presidential election for example.  Similarly, long term systemic pressures require huge secular shifts in momentum to make even the slightest computational adjustment.  I recommend underweighting risk for the time being, until I see momentum shift.

I am going to keep this missive in my desktop drawer and re-read it in two years to see how we have answered the “De,” In,” or “Stag” question.

Market Commentary for the week of August 6, 2012

Sensitive.
Markets are so fixated on anecdotal and factual imagery like jobs’ reports and sentiment meters that they are experiencing mania and panic over the least things.  While reaction to hype tends to lead to price exaggerations, I also see a “so what?” response to data that sometimes borders on boredom.  I prefer to believe that analytics can be useful in cutting through the ambient noise, to place an identity upon sectors’ trends and their probability of trend maintenance.

The most obvious, and effective, way to create capital gains probabilities is to correlate sentiment with price performance.  “Put your money where your mouth is” is a crass way of establishing workable, and predictable, hypotheses about market rhythms.  In bull markets, prices go up; in bears, they go down.  This type of correlation is known as coincidental sympathy, a phenomenon that moves equally as the silo in which it’s contained.  If we observe low correlation to the silo, there is a laggard effect.  Conversely, if a security exceeds the velocity of its benchmark, it is a leader.

Following a nearly 3 year period of inertia in the global financial markets, there are few market “leaders,” those which perform better and at a faster rate of appreciation than the market overall.  Rather, many are correcting from price highs they established before the crises hit.  Bear in mind that there are few linear (straight line) patterns in quantitative science.  Instead, many things, as in life, move in wavelength-type parabolas, edging forward, retreating, then edging up again.  The only thing that “moves” is the axis, and rate of speed, upon which they traverse.  So, it would be normal to expect 6 month cycles, decades-long holding periods, and secular (long-term) cycles before any significant changes in patterns occur.

Today’s conventional wisdom stipulates that we are in a global recession.  Earnings patterns are decelerating, if not reversing, on balance.  Some business cycles are stagnating.  The degree of psychological conviction about things is hugely negative, and highly sensitive to the perception of measured decline in the economy.  One is more likely to see negative responses to news than positive, higher negative volatility than buying pressure.

Rotation.

As mentioned, there are few sectors in my universe that show leadership separation from the overall benchmarks.  In fact, the highest psychological coefficient is in Consumer Non-Cyclicals, one of the most defensive plays an investor can make.  And even at that level of non-commitment, earnings patterns in consumer-led equities are diminishing marginally.

When you split the market into bulls and bears, you create a different dynamic.  Bears do more speculating than bulls in this climate, either “selling short,” or bottom-fishing for distressed equities.  For them, Financials are the most gamble-worthy.

In either case, diverging symmetry leads to a market flailing “in the margins” with no conviction or magnitudinal velocity.

Risk strategy.

I am comfortable building cash reserves for the time being.  Although current yields are quite poor, the upside horizon for equities is rich with candidates, but lacking in confidence.  Therefore, I see market cycles stuck in a period of insignificant valuation for the immediate future.  In this climate, my primary concern is not in missing the upside, but the potential for continued sensitivity/mania to the downside, by a measure of ranking I ascribe to laggard securities worldwide.

It is more likely that prices revert to a new normal rather than achieving a new platform of breakouts in the next 3 months.

To address those concerns, I am modifying asset allocation and holdings periods to reflect a more hyperbolic information cycle that has a bad habit of turning long cycles into staccato syllables.