Market Commentary for the week of July 29, 2013

Hyperbole.
Throughout the 1980’s, we heard talk from the investment community to “go global”, invest worldwide, perhaps driven by true globalization of corporate exchange and balance sheets, and perhaps also by the need by firms to create “new” products for their consumers to devour.  Mutual funds, brokerages, and private equity companies alike saturated the media with product offerings from every corner of the globe and every possible market sector, including telecom, basic materials, energy and industrial development.  Nothing dampened consumer’s appetite for these various products…except lousy performance.

However, in light of a rapid price expansion in mature Western bourses, the public’s interest in these “undiscovered” regions has once again been piqued.  Given the nearly two decades of financial quandary overseas, it does finally seem appropriate to explore the potential for attractive entry points in non-U.S. markets.  The likelihood of gains in market valuation domestically has become more muted, while improvement in austerity programs overseas might lend itself to nominal gains in the next few years.

To be sure, I expect continuation in domestic equity growth as our own fundamentals improve, but one’s vision of corporate profitability cannot be limited to a specific continent or region.  The siren call of the 1980’s might finally be for real this time.

Relative to U.S. stock prices, foreign shares are trading at a more compelling valuation.  There is no way to know the future, but the fragmentation of regional interests might coalesce in the next decade truly to sustain the possibility of vigorous commerce and cultural exchange.  If the globe can withstand the recent financial crises in Greece, Ireland, Portugal, Japan, et al, it might suggest improved prospects for capital accumulation leading to consumerism.

Besides, these bourses have suffered mightily, and despite being diminished in consumer’s eyes, the true value in these regions lies in their potential not yet realized.  Just as it took a generation to turn “product-hype” into potential, perhaps we now need a generation forward to turn potential into cornucopia.

Fragile.

One still needs to hedge their bets, however.  These data may never actualize, or they may take decades to bear fruit.  Investing is always about assessing risk versus reward, and my proprietary systems are quite good at quantifying probabilities of risk/reward and sector/geography allocation.  Today, Federal policies that might have exacerbated risk a decade ago are abating, and volatility concerns are now at a minimum.

The time to look at opportunity is when no one else will.  While I am not advocating an “all-in” foreign market program, exposure to emerging markets warrants our attention in the long-term.  Like most defensive investors, I tend to look for confirmation of market entry points, earnings expansion, and little probability of exogenous disruptions impeding portfolio performance.  You can see, then, that we might feed into various sectors, like technology and energy, before we allocate to specific regions, entirely.

Don’t fret.  I am not abandoning traditional, U.S. investments.  There are still many opportunities to “catch the wave”, but one must be inclusive, and diverse, in one’s perception of opportunity and profitability in order to maximize gain and reduce risk.  Right now, I’m seeing miniscule, early blips on the radar screen.

At the risk of being early, like our brethren in the 80’s, this time might actually yield some potential.

Market Commentary for the week of July 22, 2013

Death of fundamentals?
Given the unconstrained nature of the equity market’s recent gains, I feel it is necessary to take a deep breath and reflect upon expectations, real and imagined.  It is fairly obvious that “benchmarks” are critically important when evaluating market and portfolio performance, but they are not the only criteria by which that assessment can be made.  Expectations, instead, must be reasonable, and consistent with appropriate market fundamentals.  To achieve one’s desired result you need an abundant data set, and a wide aperture for comparison amongst various sector and cyclic phenomena.

Unfortunately, within the current context of unbridled expectations, we are losing sight of what it means to be opportunistic and what it means to manage risk.

In my practice, you would assume that duration and tracking of certain benchmarks go hand in hand.  Ideally one would be looking for as close a correlation between the two as possible, and to arrive at a portfolio which is totally driven by risk assessment and return opportunity.

That being said, the market today, by its very nature, is creating a psychic de-coupling between return and risk evaluation, and setting up a wider beta that challenges some investors to stay patient.  Without benefit of time and cycle analysis, many investors are jumping on a train that has already left the station in an effort either to catch up for lost time or not to fall too far behind their neighbors.  This type of herd-mania can only increase the stress level and uncertainty for those who have no discipline or long-term plan.

Additionally, I am seeing some investors casting so large a net that their portfolio becomes an amalgamation of geographies, sectors, cap-weightings, and product offerings.  As a starting point alone, that should raise red flags about the prospect of portfolio performance.

Although some might claim that this “wide net” creates diversification and opportunity, it looks to me more like an act of desperation and unanticipated negative consequences.

Within the laws of prudent portfolio management theories is the need to stay focused, disciplined, and patient.

Too high?

So what is the market trying to tell us this early in the quarter?  I believe that whether your confidence allows you yet to commit fully to the market or not, the global financial bourses are trying to synchronize around longer term fundamentals and earnings patterns, and looking to “re-systematize” the approach to this equity selection process.  In other words, we are at a more opportune time than any in the last half-decade to return to pricing and market data which make for traditional valuation on a comparative basis within a coordinated universe of common assumptions.

While short-term volatility is always a trademark of this rebuilding process at the margins, we will eventually return to somewhat better correlation of global information that makes, by extension, broader market timing and asset selection more impactful for the longer term.

Historically, when opportunity lines up within a smaller ratio of beta and standard deviation, it may not guarantee successful portfolio outcomes, but it does improve the predictability of adding potential value to the portfolio.  Far less than we fear the sudden spurt of market gains this year, we hope for a greater equilibrium to our psyche so that we neither fear, nor chase, that train departing the station.

Market Commentary for the week of July 15, 2013

Hard to hold.
After having had a tremendous first half of the year, what direction might the market take into the next few quarters?  On the one hand, trend analysis has indeed turned “positive” and would suggest that the throttle is in full “go” mode.  However, we know from historical and economic analysis that markets cannot sustain linear acceleration indefinitely, and that even the most robust trend is susceptible either to linear reversion or cyclical unraveling.  Those of us old enough to remember also know that “black hole” events like October 1987 or flash trading collapses can unwind not only valuation but enthusiasm as well.

Much of the current rally, I believe, is driven by two factors.  First, the economy and valuations had become so depressed as a result of the previous decade’s recession that a response was not only warranted, but likely.  Prices became so attractive, and relative strength integers had dipped so low, that those with the right mental, and fiscal, makeup were seduced to come back in.  Secondly, and working in concert with the above, the cost of funds had become so incredibly attractive, in large part due to machinations by government treasuries, that speculation became more “valuable” than simply holding on to cash.

But news that the Federal Reserve might reverse its policy of holding down rates caused a near calamitous response in the latter half of last quarter that the vulnerability and reliability of fundamental economic data was now being called into question.  In other words, a “value-driven” rally, unsupported by consumer demand, manufacturing, and consumer confidence is a house of cards ready to collapse.

The factor which I hold most important to equity and economic vibrance is earnings, household and corporate, and today the evidence cannot conclude decisively that we are gaining in savings and sustainability.  Companies are indeed improving their earnings, but are doing so through accounting and manipulation moreso than growing demand for, and higher revenue from their product offerings.  Perhaps demand will pick up in the coming months, but evidence that it can sustain this equity rally beyond the speculators is still not confirmed.

Easy to lose.

The rally can sustain, but the speed at which it has been growing I might call into question.

While there has been economic improvement over the past year, the big question that might impede its pace is about the direction of interest rates.  Globally, nations must begin a conversion from austerity and building “profits” to loosening the reins and allowing economic demand to lead.  There is no story to be told if enthusiasm doesn’t transcend from corporate balance sheets to the consumer’s living room.  Demand (consumption) drives the engine, and today’s low savings and low interest rates inhibit that engine from revving up.  If rates don’t rise the trend for market performance will lapse into just another speculator’s game of cat and mouse.

Liquidity and savings are soft, probably leading to a slower market for the second half of the year.  While there is no other game to play except stocks, that doesn’t always lead to an enthusiastic result.  We should not always evaluate things based upon a market outcome, but upon the right things being done to sustain people’s hopes and expectations about living a prosperous and meaningful life.

So, while I hope for the Fed to allow rates to drift upwards, I’m inclined to think their hand is firmly on the rudder for now.  Their margin for error is tighter in the short run as a result.  The window for stock speculation is still open.  Secular and demographic themes lay secondary to short-term cycles.  The “responsible” thing is not always the first thought for those looking to score big at the table.  But a durational approach most usually wins, thereby strengthening the notion that asset allocation isolates gains, and prevents losses, more effectively than jumping from theme to theme indiscriminately.

Market Commentary for the week of July 1, 2013

Seatbelts Fastened.

 

Somehow, we managed to tip-toe through the last quarter, walking right up to the edge of a precipice before all hell broke loose, valuations dropping because the Federal Reserve decided to “hint” at actions not yet taken.  Those most facile were able to dodge any serious catastrophe to portfolio net worth, while others unfortunately succumbed to a short-term “worst case scenario.”

All this conflict, however, doesn’t address underlying economic fundamentals whose collective sum is less than spectacular.  Being devoid of significant crisis is not a substitute for substantive fiscal policy and political will which might raise the economic expectations of investors.  In this period of multiple economic threats (wage stagnation, low interest rates, budget austerity, high unemployment) even the most vulnerable of us fears the one-off negative event like those of recent weeks which could spur a reversal of fortune.

In many ways, what it means to be an investor, a citizen, has changed dramatically during the past half-decade.  A series of monetary and fiscally ill-advised decisions brought this generation to a near catastrophe whose psychological impact was matched only by two generations prior during the 1929 market crash.  That long-ago period of calamity, illiquidity and psychological despair was felt anew by our generation during a total obliteration of the credit and equity markets in 2007.  Essentially, we were reliving a financial nightmare of epic proportions that most of us thought we might never see again.  In hindsight, and with a great deal of trepidation today, we know that, in this technological/digital age, ruin is a button switch away.

As we recover from such trauma, normalizing patterns of behavior becomes highly important.  Instead of fixating upon the problem, we must try to go to work, raise families, invest in our businesses, and strive to build attractive futures for ourselves and offspring.  More than ever, we have to be psychologically strong, and committed to a future, even while we harbor greater doubts and misgivings about the institutions in which we place our trust.

Based upon all that, it is remarkable that a global market rally can sustain against such strong odds.

Markets.

Among all the investment criteria we are asked to digest, the most critical is an effective and consistent discipline for managing risk and our expectations about generating alpha (upside return).  I find that average investors try too hard to benchmark their decisions against an elusive standard, whether it be their neighbor’s (apparent) affluence, a market index, or a set of expectations that are unreasonable.  Constrained by these exogenous influences, many are doomed to fail before they begin analysis or execution.  That said, there is no normal to investing, and many are flying blind from the outset without adequate professional help.

Suppose you uncovered a “hot” manager or strategy that held the market’s fancy.  How do you quantify the duration of success for that strategy?  Can one imply the same level of expectation for a strategy after the strategy has achieved its objectives?  Shooting at moving targets is difficult at best.  Driving your investment theories simply by emotion or fad is not an investment strategy.

I believe that all disciplines are cyclical.  They can be measured for duration and probability of risk, and some are more enduring than others.  For the most part, I try to manage portfolios to restrict downside risk while always assuming that I can outperform on the upside, a fact to which most clients can stipulate.  Because we are asking portfolios to do “less”, the potential for downside regression is smaller and upside momentum can be exploited more fully, more efficiently.  The challenge of reigning in the scope of our expectations is difficult to do if you’re always checking an elusive benchmark for confirmations.

Asset diversification is essential to achieving high return/low risk portfolios.  While it is crucial to make well-informed decisions about which sectors or geographies might do well, strategies that concentrate upon trend duration introduce a level of risk reduction and alpha generation which, historically, outperform traditional fundamental analysis, alone.  The thing that most investors will tell you they most wish to avoid is “drawdown”, excessive losses without limits.  For me, liability is mitigated by prudent asset allocation, quantification of trend cycles, stop-loss execution, and specific risk tolerances established upon the initiation of any new portfolio relationship.  That is a far cry from traditional “index benchmarking” done by most mutual funds, bank trust departments, or fundamental strategies.  That said, there is room for all investment strategies in our vast universe.  It is necessary, however, to have a long-term commitment to your objectives and expectations without hesitation and without subtle influence from outside agents or events.

 

Once armed with those assumptions, the next logical step is not to deviate from them by following the latest fads, or hyperbole.  Jumping from gold stocks to tech, tech to utilities, utilities to private placements is not a portfolio strategy.  It is a sign of inevitable “type-A” anxiety which precipitates unwanted consequences.  Also, it is a “red-flag” to suggest that any manager might be a successful investor with such a bizarre array of choices.  Instead, consider the confidence you have in one strategy, one methodology, and attempt to stay with it.

Strategy.

We need to quantify the probability of our recent market implosion continuing for the foreseeable future.  Many believe that as austerity unwinds globally, so too will the markets.  I believe otherwise.

Current short-term interest rates and monetary policy is actually quite restrictive because the markets are transfixed by short-term results.  Managing a budget to make it through the next quarter demonstrates a lack of vision about the future.  Cutting costs is a necessary evil, yes, to ensure financial solvency, but we need to consider what events might have precipitated a business, or family, being in that situation in the first place?  In other words, good cash management begins during the good times, not after a crisis has erupted.

The markets unfortunately are fixated upon short-term phenomena to the exclusion of long-term data that widen the focus of aperture to appreciate earnings that sustain, and companies with high top-line revenue.  Far more than is currently considered, there is a panoply of financial instruments that do more than simply go up after being depressed, or go down because the markets do.  Ultimately, good investment timing has very little to do with a calendar, fad, or mania.

We should be able to turn seemingly irrational panic at present into persistent, long-term opportunity if we dig deep enough.  Irrespective of quarterly numbers, global demographics should lead our focus into areas like biomedical research, water purification and agricultural efficiency, telecommunications, alternative energy, infrastructure, and emerging markets.  All of this must be in a context of humanity, compassion, and morality so that we know what to do with our money and where.

I expect there to be more volatility in the second half of the year as we unwind a 6 month linear price expansion and revert back to an equilibrium from which to sustain the next uptrend.  Interest rates will play a part, but demographics cannot be manipulated by monetary policy.  It is what it is.  I expect confidence to wane as it usually does when market uncertainty is high.

Just prior to the cataclysm of stock valuations at the end of last quarter, equity prices were overvalued, although there was no other game to play but stocks.  Profit margins today are overvalued relative to real demand and sales, so I expect this quarter’s announcements to be less aggressive than last, perhaps leading to a slowdown in equity purchases.  In this fragile climate, it is hard to envision a continuation of growth in stocks at the rate of one percent per month.

Conclusion.

Details of the Fed’s reversal in policies will be problematic.  Despite the fact that I see interest rate trends rising for the long term, political and psychological response to taking the foot off the brake might weaken the appetite for stocks.  Investors are anxious to lock-in their gains for this year and secure some semblance of normalcy.

To be sure, there is still value in owning stocks.  Being defensive in the short-run does not imply a lack of optimism.  It is more difficult to advance in a headwind, but anyone can make money when the markets do well.  If the markets do “revert to the mean” during this quarter, insulate against risk by maintaining a strict, and reasonable, allocation model to reduce volatility.  Don’t confuse typical market volatility with a change in secular, long-term opportunity.  A strategic view determines the odds of success much more effectively than responding to an ever-changing landscape of news-driven events.

 

 

Asset Allocation:

Equity 38%/Fixed Income 21%/Cash 41%