Market Commentary for the week of September 24, 2012

It’s Your Fault.
Isn’t it absurd:

·         if your auto mechanic were to blame you for your car’s broken gaskets?

·         if your doctor were to blame you for having an arthritic hip?

·         if Wall Street were to conclude that your ignorance causes them to feast at the trough of greed?

And yet, certain studies commissioned by the securities industries governing bodies have recently concluded that terrible things happen to people who are too ignorant to know better.  It’s amazing that your confidence and trust could be so obfuscated as to propose that an economic tailspin was your fault.

While there is no doubt that most consumers have limited, or less, knowledge of the subject matter than the experts to which they turn, it is blatantly false to blame the uninitiated for what they don’t know.  The findings of these surveys contain self-serving, yet unsustainable, conclusions which serve only to absolve the wrong-doers of blame.

A frightening picture begins to emerge about why, and with what degree of frequency, these cataclysmic events occur.

Given the rather hefty return of the financial markets this summer, most all discussion has dried-up about who was/is to blame for what ails the economy.  Let’s consider ourselves lucky that the psychological damage wasn’t too severe.  However, we must be mindful that portfolio performance and economic fundamentals are not always synchronized, nor necessarily one and the same.  Thus far, annualized performance has exceeded our expectations, but was limited in its breadth of participation.  Do we therefore expect the laggards to catch-up, or the leaders to retreat?

Stay Cautious.

My overall investment process emanates from an earnings-driven, success-driven, methodology.  We cannot, nor should not, try to reveal an undisclosed secret to a company’s failure to perform, but rather just move on to one which does.  The current climate of earnings accelerators derives less from unit volume increases (demand) than from efficiencies created through layoffs and technology, and from extremely low bases of comparison from one year ago.  Therefore I might conclude that demand is not as critical for near-term valuation expansion as speculation and psychological enhancements.  If, in fact, we were to get a global equity expansion it would be fed by a reversal of negative sentiment as much by a reversal of negative fundamentals.

Currently, corporations are playing coy with their capital.  Buoyed by aggressive speculation in their shares, some corporate boards see little reason to deploy cash for new hiring.  As much about good governance as disdain for social or moral compass, these executives are likely to stand pat and allow cyclical swings in pricing, as opposed to seizing upon this moment as the turnaround inflection point for their growth.  Like it or not, they too hold you accountable for what ails them.

The empirical evidence for buying stocks is quite compelling, however.  Despite a level of mistrust which exists between you and corporations/corporations and you, we are significantly nearer a time when a reversal is anticipated.  Short cycle concerns are less significant to our evaluation than the broader secular (generational) themes.  Today, we are indeed at a political, financial, psychological, geographical, and moral inflection point.  Quite simply the needs of all citizens rest upon a coalition of opportunistic leaders who strive to “get it right.”

Market Commentary for the week of September 17, 2012

What’s next?
Liquidity injection from both European and American treasuries would precipitate a short-term rally in financial instruments, but would not, however, provide that magic panacea to what ails the world’s markets.  Therefore, while I expect a continuation of a test/re-test rally into the autumn, it is too early to call for the end of bear market circumstances.

To think that one decision, or one derivation of previously tried economic theory, might reverse the balance of trend magnitude would be disingenuous.  Before I would change implementation of conservative asset allocation policy, I must see a consolidation of patterns and trends that indicate the risk of losing money is less than the risk of growing it.  That seems simple, but is mighty in its execution.

The problem, then, is to define risk into prudent timelines whereby it becomes clearer when short term cyclicality has begun to rise, and secondarily, when intermediate trends at least appear to have stabilized from a five year decline.

To test these theories, it becomes absolutely critical to see an uptick in relative strength within consumer and business sentiment indicators.  Do we need another false trap that suckers us in?  I doubt it.

Rally.

In the longer term, I must see a renaissance in the world’s banking/financing structure.  The markets desperately need new capital for jobs creation, research, and capacity expansion.  Obviously, the paragraph above references a psychological change in expectations.  Thus, the two notions, taken together, are critical to changing a multi-year pattern of deficits (psychological and remunerative) that deleveraged hope from the world’s financial markets.  Without capital, and goals, the problem remains complex and compounded.

The viability of portfolio performance, while hinging upon these data, is not as crucial because asset allocation can be framed to reflect the changing times.  But it is critical to note that expectations and performance need to be adjusted down when confidence and capital are in limited supply.

Almost all analysts agree that real growth has occurred in the first half of 2012.  But the rate of change (magnitude) and its duration (amplitude) fall well below historical benchmarks.  Also, it is not hard to show year-over-year growth when originating from such anemic low levels.

I worry that once we reach a stochastic (relative strength) saturation point, that the rally will end, a point referred to in last week’s piece.

The fact that we are near those upward relative strength levels now means that the next few weeks are going to make changes to portfolio outcomes.  Employment, interest rates, corporate earnings, and equity valuation might all contribute to the mix when evaluating the prospect for sustained portfolio expansion.  To that extent, the breakdown in sector participation will also be significant.  Over the past six months nearly all capital appreciation has been centralized in Technology, Non-Cyclicals, Energy, and Basic Materials, all “speculative” categories unlikely to maintain their short-term momentum.  While year-over-year performance in those equities has been good, the underlying fundamentals that support them have been specious, at best.

Wag the tail.

Bottom-up analysts may be jubilant over their short-term performance in financials (banking stocks) for example, but macro strategists, like me, are concerned about excessive speculation in low/depressed priced stocks and a global backdrop of poor consumer demand.

At a cyclical peak, profit margins have a way of showing their true value.  While I do not see a precipitous drop in earnings expansion velocity, I do see a flatter continuum ahead.  Above all, an impervious ceiling of expectations could be the next barrier to fall, if we only can muster the patience to wait. 

Market Commentary for the week of September 10, 2012

Does a powerful upcycle necessarily have to be followed by a downcycle?  Well, yes, if one believes in the notion of parabolic quantitative market theory.  Given that you can’t fill up a phenomenon greater than 100%, nor empty it more than zero, what happens when you reach a statistical “saturation point”, when the laws of probability no longer engender positive outcomes?

Economists and historians have long understood the necessity of balance.  In order to assess the probability of a trajectory, you have to be closer to the “zed-line”, that point where, minimally, one’s odds of success are 50/50, than closer to the end-point of a parabolic ascent/descent.  For example, as we near the end of a recession there is more reason for hope than when the initial storm clouds of trouble were brewing.

For practical reasons, nothing lasts forever.  Managing change, and risk, is more effective than waiting for change to occur.  When it comes to market theory, there is a big difference between strict fundamentals, versus quantifying the likelihood that those fundamentals generate positive alpha for portfolios.

One runs into trouble, for example, thinking that strict diversification is same thing as market weighting leaders and laggards in a portfolio.  On its own, diversification is a scatter-shot, rough balance approach.  The prospect of measuring which companies might succeed makes more sense.

Many portfolios have been crushed by the impact that one or more stocks might impose upon an outcome.  In today’s market, buying gold, technology, basic materials, or cyclicals in large quantities might yield the inverse of what the speculators intended.  While it’s not sexy, picking your battles in modulation can be particularly more effective than an all-or-none approach.  The tech wreck (2000) and the global credit crisis (2007) are two recent examples of seriously overestimating the chances for portfolio aggrandizement from what, on their own, are more serious threats when taken in improper allocations.  It is the portfolio manager’s responsibility to look for the next bubble before it occurs, and not to underestimate the statistical probabilities that are staring him/her in the face.

While it appears that the pieces are beginning to fit together in solving some global debt matters, we know that the solutions are not achieved in the short run.  Market rallies which emanate from news-driven events are not cycles in the purest sense.  The real strength of conviction and belief lies in seeing several short cycle events strung together to build a longer trend.

Adjustments must always be made and anticipated.  The tough decisions from the Euro zone have been unable, as yet, to sway long-term confidence.  Obviously, the markets are waiting for solutions that stress a palatability of alleviating the crises.  Since there is little “wiggle room”, there is less time and patience that the public, and markets, can muster when waiting.  In a global sense, it must be necessary to convince disparate geographies that the benefit accrues equally to all regions and all interests.

While there is no sweeping, single solution to the global debt/credit crisis, it is critical to see an outcome which promotes growth, trade, expansion….and inclusion.  At this juncture, withdrawing from the process is not an option.  The risks of inertia are overwhelming.  Coming at a time when confidence is waning, it might be that perception of an effort to build consensus could be as significant as the overall details of an agreement itself.

The most pleasant surprise of this summer’s rally is that we have reasonably held off a traditional “summer swoon” which might have exacerbated the calamity had it occurred.  Although the data are not significantly better, really, the general panic and exasperation have abated somewhat.

Statistically, big upward pushes must be followed by declines.  As we near the fourth quarter we are holding our collective breath to see if statistics trump hope, or if the mathematical headwinds are simply too great at this time.