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.