Market Commentary for the week of December 22, 2014

Whiplash
The exhilaration of watching your portfolio rise in value mid week last week pales in comparison to the depths of anguish and despair you felt when five to seven percent of your market value was erased such as in the weeks prior.  Because zenith valuations are not finite, but fluid, one rationalizes that he hasn't really  lost anything when the account value goes "down"....it always "comes back" over time.  But seriously, who swallows that sort of justification when the monthly statement comes in the mail showing portfolio valuations minus several tens of thousands of dollars?

For that reason alone, I am loathe to accede to client demands that we go "all in",  or "stop playing it so cautiously".   As I said last week, recovering from portfolio draw down is a most difficult task statistically and psychologically.  I must never forget that these are my clients' monies, not mine, and that I serve as steward to their financial objectives.  The markets are a tough place, and not for the faint of heart.

Uppermost, we must remember that investing involves time, process, methodology, risk, and patience.  There are no guarantees about return on equity, but there are rewards usually for those who don't panic.

Thus, a steady deterioration during the past several weeks in portfolio values, and the global bourses themselves, should not have been unexpected.  A decline in energy prices might have caught the "experts" off guard, but the potential for a market capitulation, even a big one, has been something my quantitative integers have been indicating for several months.  October's decline was swift and difficult to take.  December seems to have its own agenda for swoons and gains.

One reason why sector allocation is more important than stock picking is that indiscriminate  over weighted concentrations of underperforming stocks can have a deleterious impact upon portfolios,  whereas, in the right proportions, even bad stocks within specific groups might not have a correlated impact upon portfolio performance relative to the benchmarks.

In addition, one's timeline of expectations is critical to the analysis.  We should know by now that it is impossible to guess correctly every short term swing in prices of stocks and bonds.  Instead, rather than "timing" trades, it is better to focus upon demographics and secular shifts in culture, population, social trends, geography, politics, and money flow (fiscal and monetary policy).  From there, it is more likely to make educated decisions, even if they are unique to each investor, about how money can be put to work to achieve your growth aspirations for the longer term.  I favor Technology, Industrials, Cyclicals, Alternative Energy, Biosciences, Agriculture, and Basic Materials for those tasks.

While I view economic data as becoming decidedly more positive, my concern is the unusual volatility of short cycles and emotional responses which can interrupt the strength of our portfolio building.  Indeed, as mentioned earlier, it is no fun seeing five percent or more in portfolio losses in one month through no "fault" of our own, except for manic mood and price swings in one or two sectors.

Support

Do we thus conclude that investing is all for naught, a big waste of time?  Absolutely not.  Our discipline and processes are oriented specifically towards balancing risk during the kind of volatility that we are experiencing now.  For example, prior to the dot.com debacle in 1999-2000 clients may recall that we had begun to shift our asset allocation away from technology shares because (1) valuations had become unsustainable and excessive and (2) there were few real earnings-driven companies in that space at that time. In 2008, as the run up in credit deconstruction was occurring, we were devoid of any Financial shares and had already pared down our exposures to lengthy bond maturities in our balanced portfolios  because our screening tools had flashed warning signs about excessive borrowing in the global marketplace.  While I might be sitting with "too much" cash today, the parallels to an unsustainable valuation rally and a decline in relative strength integers is uncanny, a situation which has persisted since April of 2013!!

If we wind up missing the targeted benchmark return, so be it.  The reward is avoidance of a flash-point decline that can do serious harm.

We will continue to be invested, in the proportions we deem appropriate to our client's risk/reward tolerances, and to do so with a respect for our client's families and long term objectives.

(Our next posting will be the Quarterly Commentary:  January 1,  2015)

Happy Holidays!!

Market Commentary for the week of December 15, 2014

Home stretch
As we approach knocking on the door of the new year, we reflect that what sometimes precedes  the year end is often an indicator of what follows  after the page turns.  While the broad averages flirt repetitively with new highs, the make-up of those landmark breakthroughs really are not necessarily a mirror image of what's occurring in the economy, but simply pretence, taking you and your money for a glorious ride devoid of any real meaning...other than to increase or decrease with extreme volatility your brokerage and 401-k valuations.  The last three days of last week were 200 point Dow Jones "E ticket rides"!!  Along those lines, I would caution that 2015 cannot reasonably be a carbon copy of this year's upside achievements.....or 2013 for that matter.

Why?  Well, the simple answer is that the obvious divergences and disconnects between the stock market and the global economy are too wide to sustain one, the other, or both for any duration.  While I continue to support the view that the long term prospects for equity performance and economic growth are good, the stresses being placed on both by their performance in this post-recovery phase are vast.

The market continues to curry favor with investors simply by refusing to succumb to the weight of its own advance.  And yet, relative strength quotients....a measure of duration and acceleration of current trends.... have been sustaining at unreasonably high levels, setting up an inverse probability of direction.  While it is far more sexy to respond to "trend"  rather than "objective data",  we have to be able to distinguish between a mirage and a building, and to know the difference between the two.

Anyone who still believes that 20%-plus equity returns are the norm, not an aberration, is fooling himself.

"Yes, but everyone is winning and benefitting from the rally.  It's indelible", the proponents say.

 

Indeed, that is exactly how we should have felt during the recovery rally.  My client's portfolios have prospered in the last year, the last two years, and the past several decades thanks to a discipline of prudent asset allocation and sector rotation.  The difference in philosophy, however, is that we attempt not   to be swept down by the unforeseen capitulations of exogenous mania.  And for the most part, we have not.

The art of portfolio management, versus oblique stock-picking, is to manage trends unemotionally and objectively, and to perform in all economic climates to achieve positive alpha throughout.  Draw downs are not a viable option when seeking portfolio equilibrium for the long-term, and in many cases too disastrous from which to recover.

Despite the fact that global equity valuations and cycle stochastics remain extended, we favor equities as an appropriate vehicle to achieve portfolio capital gains for the next year.  We are not caught up in the definition of "bullish"  or "bearish"  because every sector has an appropriate role to play in our overall asset allocation process.  I consider the distribution and weighting of those sector allocations to be more significant to portfolio performance than any particular winners or losers we might own.  That having been said, note how many (or few) equities actually are leading the rally during the recovery.  A shallow breadth to be sure.

Critical

After we dig below the surface of what we know and what is obvious, the popular, easiest notion is not always a direct route to portfolio success.  Most indicators are suggesting implicitly that 2015 might not measure up to the past two years' recovery pace.  If we do see improvements in the economy, I suspect that they will come slower than we hope, and actually look more like historical norms in terms of rate and magnitude.

The financial markets should complement those improvements in the economy with performance of their own...if we, as investors,  can only come to understand the importance of realistic timelines and expectations, and stop trying to hit "the home run" every time.  

Market Commentary for the week of December 8, 2014

Excess
As energy prices continue to fall, many analysts are predicting dire straits for the entire energy complex going forward, particularly the fossil fuels and other ground-based sources.  However, there is another school of thought that thinks the impact of falling energy prices might just be the panacea for cash-strapped consumers that years of stimulus have failed to provide.  While I see no windfall effect from an annual $310 per family "tax break" that falling gasoline prices might provide, the net savings in the short-run seems to be creating a temporary boon to their pocketbooks.  Economists are anxiously waiting to see if/how that money gets put to use.  Bear in mind, though, that the savings "at the pump" are being offset by severe portfolio declines for those who own an evenly diversified portfolio that includes energy equities.

Despite a steady drumbeat of new highs in the market averages, it doesn't seem to be enough to quell investor apprehension about the overall strength and sustainability of the current recovery.

Witness the lackluster start to the holiday buying season.  The numbers are incomplete, obviously at this juncture, but point to a lack of enthusiasm in traditional brick and mortar store sales as well as in internet purchasing.  If you're looking for portfolio conclusions to draw from these data, and you are the kind of investor who dreads news-driven intraday volatility, avoid the retailers, cyclicals, and energy stocks.  I would favor biotech and healthcare, traditional non-cyclicals, and global industrials at this point in the sales cycle.

More significant than foot traffic at the mall and energy stock price declines, however, is the potential for a global slowdown in industrial production and capital spending.  European Central Banks are giving conflicting guidance about sustaining, or cutting, their monetary policies relating to interest rate accommodation and financial consolidation.  We know that interest rates are low because of years of austerity packages, but within those same governments, politicians seem more intent on spending and investment cuts  than on stimulus.  The recent US mid-term elections were a mirror of governmental inefficiencies worldwide which confirm a political landscape of antagonism and gridlock rather than cooperation and problem-solving about infrastructure, business spending, full employment, and citizen participation.  Right now, no politician wants to be perceived as a big spender.  Thus, the global economic recovery has to carry on "on the cheap".  Clearly, without consumer buy-in and corporate spending the recovery is stuck in neutral.  Nevertheless, "safe money" is betting on a haven in the US.

This new era trend towards a more "efficient" business model foretells a social paradigm in which there will probably be a permanent underclass of non-participants.  Even though smaller, more nimble business yields greater profitability, that same model prohibits an equivalent engine of consumer demand.  It might indeed be easier today for corporations to meet profit projections of Wall Street analysts, but we are also witnessing an inadvertent side effect: public inertia and mistrust.  This will perpetuate a decline  in prices, not an increase, and further exacerbate the disinflationary effect that lower oil prices are having on the economy. 

While it might make sense based upon the data that energy prices should decline, a paradigm in which consumers sit out or are excluded from the recovery is likely to do more harm than good in the long run.

Problem?

With one sector (energy) under such particularly stifling pressure, the broader market performance is left to struggle for gains minus a significant component.  A capitulation in the energy sector does not specifically represent a death knell for all stocks, but its significance cannot be discounted.  As stated above, broad repercussions about consumer confidence, discretionary spending, corporate profitability, and federal capital expenditures are all tied to the production, distribution, and consumption of energy products.

We shouldn't become accustomed to the temporary efficiencies of lower energy prices.  It is a bait and switch game we ultimately cannot afford.  We have seen how business is reinventing itself by doing more with less, spending less in the process.  Weakness in the energy sector, and pressure on prices to stay low, might help in the current recovery cycle, but it places the bar too low for sustainability down the line.  I perceive a potential vulnerability in the financial markets as a result of becoming "hooked on" cheap goods and services.  There is nothing inherently wrong with an "affordable" economy, but I would prefer a scenario in which the glut in oil is eradicated, and higher prices ensue.  Hard to do, since oil reserves are hitting 30 year highs.  But the laws of supply and demand have not been rewritten, simply modified to fit our economic condition.  Oil is cheap, that's a fact.  But depleting resources hardly ever stay inexpensive unless manipulated to do so.  This is not a negative sentiment about stocks and bonds, but a baseline assessment about the sustainability of artificially created gluts or shortages.

We should look at this price displacement as a transient condition, and an opportunity for cogent discussion about alternative energy, and other product sources, for future consumers.

Market Commentary for the week of November 24, 2014

Perception
A few weeks ago, a colleague stopped into my office, a copy of my current market commentary in his hand, and said to me, eyeing the piece of paper, "oh, so I see you're now getting bullish on the market".   Evidently my penchant for conservative asset allocation investing preceded me, because I wasn't aware that I had previously been negative or positive, or that it is possible to turn on a dime and be either bullish or bearish only.

The point of telling you this anecdote is that I truly consider myself to be "market agnostic" , preferring mostly to read the tea leaves of my proprietary stochastic integers, invest in leading cycles, and to avoid laggard sectors at all cost.

In other words, my  focus is not so much on the Dow, or energy, or the Euro, or the Federal Reserve, or any one factor in particular to determine the optimal opportunity potential of financial instruments, but rather the preponderance of all evidence, all factors, taken in sum which determines whether I am a net buyer or seller.

I believe clients expect prudent asset allocation in their portfolios which accurately reflects their individual risk tolerances relative to the opportunity/probability of capital gains for the long-term.

In general, I find it hard to get enthused daily by short term cycles in the market.  When one considers where wealth really comes from, it's not usually in one  stock's performance in the portfolio, but from the proper balance of risk, and risk aversion, within the overall execution of portfolio strategy.

Nor should one discount the significance of strategy and methodology to the success of an investment program.  Success does not derive from bouncing around from style to style, nor does that kind of investing yield consistent results.  You only have to ask "sector specific" investors about their rise ...and fall...in tech stocks and dot.com IPO's in the late 1990's.  Stories abound about squandered opportunity and wealth, betting it all on one company or grouping of shares, and failure to recognize when greed becomes excessively penal.  At best, as an earnings-driven investor, I might have allocated a small portion of "special situation" cash to these ideas, cognizant that they neither fit the profile of my ideal investment parameters nor satisfied the criteria for long-term sustainability.  "Buy them later, after the winners and losers have been determined”, I argued at the time.

Perhaps my colleague ascribes too conservative a bias to me and my work, but my track record of delivering capital gains and risk aversion is quite good.  By concentrating on consistency of application of my methodology, as opposed to news-driven current events, I find it easier not to get suckered in by hyperbole or rumor.

Lay-up?

So, given the details laid out above, I would hardly say that I am ecstatically bullish right now...simply aware of the current uptrend in stocks, but cautious about the risks inherent in valuation expansion spiraling onward without pause or consequence.  We saw examples of this skittishness in last week's market activity.

One of the most compelling risks to future equity performance (or, more specifically, the rate of acceleration of price performance) is the issue of profits and profit margins.  While gains in equity share prices and earnings have been fast-tracking during the market's rebound rally from 2008, it appears quite obvious that many of those same companies currently benefitting from deflated costs and consumer recession are contemplating being done laying off employees, holding down competitive wages, manipulating balance sheets, or holding back on research and inventory expansion.  If, in fact, we have turned the corner in the rebound/recovery cycle, cost increases and inventory growth must, at some point, eat into those expanding margins.

At what point does the recovery become all-inclusive?  Regarding profits and the hoarding of corporate cash, "how much is too much?"  is a question for CEO's, economists, politicians, and social ethicists.

My optimism about equity price performance is based upon objective cycle measurements and statistics.  Conversely, though, my pessimism about global commerce in general stems from the fact that no nuance seemingly can dictate to business what is the "right thing to do" concurrently to sustain both their bottom line and the consumers they are supposed to serve.  That moral dilemma between profits at all cost and socially responsible allocation of resources is the elephant in the room the financial markets are waiting to see addressed.

Market Commentary for the week of November 17, 2014

Trickle down, up, and sideways
While the US stock markets are bounding, seemingly endlessly, towards new highs, many of my clients express acknowledgement  that real portfolio investing is not quite as simple as buying an S&P tracking ETF or simply tagging along with the Dow Jones Industrial Average.  In real life, portfolio strategies must take into account the often wild and sometimes precipitous downside possibilities of owning stocks in general, and benchmark indices in particular.  In other words, not every "new high" is really such a unique opportunity or anticipated goal.  As one might sometimes wonder with the old fairy tales, what exactly happens after "happily ever after"?

More specifically, it is the potential for cycle reversion, profit taking, or manic panic through which a real portfolio manager must navigate, not some fantasy of chasing every new high sequentially.

Psychologically, it still looks to me as if market trading patterns are suffering from the double collapse of dot.com and real estate in the past decade and a half.  Not that everyone is afraid, but enough of our contemporaries have been touched by the corrosiveness of those declines that its effects are showing up in the diminution of breadth and depth of equity participation from pension funds, institutions, and "average" retail customers.

The elevation in stock prices during the past fifteen years has not benefitted everyone, just those with the mental fortitude, resources, and nerves of steel to withstand crashes and calamities.  Unfortunately, those are the unwelcome companions to the occasional upside boomlets.

One could cynically make the case that a concentration of wealth amongst the already-wealthy harms the economy by forcing the markets to wait for a "trickle-down" of investment capital into the broader community.  To that point alone, a residential migration of the affluent into conclaves specifically designed for similar affluence and homogeneity siphons money out of other less well-to-do communities, causing taxes to diminish and services to slide into a steady regression.   For example, we witnessed Detroit forced into bankruptcy for these same reasons despite the rebound in the auto industry, a robust stock market, and an infusion of Federal cash.

Tales of municipal woe abound, even in the face of new highs in the Dow.

Comeback?

I once coined the phrase "parallel disconnect" to convey the notion that two concurrent events, apparently moving in the same direction, may not necessarily be bound to one another, nor causal in the way that one might associate two directly correlated phenomena.  Nor could we draw inferences that the benefits accruing from one event might be the same for the other.  Therefore, I would argue that the bull market and new highs of 2013-2014 have had very little trickle-down impact upon the population-at-large....other than to reinforce a stereotype that all must be well with the economy since the market is doing so well!!  

Given this economic duality, it makes it easier to understand some of the stagnation and reticence of consumer spending, jobs and wage growth, and overall output.  Global wealth is being concentrated in certain geographic areas and within specific demographic strata, and not yet "trickling" into the general public.  In spite of improving statistics, it is often how we "feel" about growth and expansion (as well as available discretionary funds) that determines overall spending patterns.

Sustained slumps in the real estate market, municipal tax revenues, and public economic development projects have been impeding the financial health of many cities and the corporations which inhabit them.  This next political season should be about revitalizing and replenishing municipal cash and mislaid personal hope.

Market Commentary for the week of November 10, 2014

Rising  tide
With the US elections now completed, it is time for the "talking heads" to provide analysis and commentary...all the stuff of subjective conjecture and personal opinion, of course.  So, while this missive will not  attempt any in-depth political analysis (certainly not our forte) it would be logical to review current market activity to try and gauge investors' moods and to confirm or rebut the staying power of recently initiated sector trends.

As reviewed last week, the most notable of these trends is a consistent decline in energy prices worldwide, attributed to a slowdown in global economic activity in China and the United States.  It is strange that we are still talking about deflationary pricing pressure more than six years removed from this generation's worst economic recession.  Despite investor's expectations for a robust recovery, we are still victims of low interest rates, price allowances, and meager discretionary spending.  The timeline and magnitude of this rebound is lagging that of other recoveries at similar junctures.

Political discourse going forward should be about the effectiveness of prior austerity and stimulus packages being transacted concurrently, and which fiscal and policy initiatives generate positive results for the citizenry.  Ebola  and terrorism  have become the catchphrases of our day, while infrastructure, national defense, technology, healthcare and education have temporarily receded into the background.  Even the once-mighty real estate boom, a barometer of economic viability, has fallen upon hard times.

Our research is diligently reviewing sector allocation shifts and trend duration.  Despite a plethora of conflicting economic news (employment, GDP, savings, corporate earnings), none of these economic data has dissuaded investors from betting on the current uptrend, upon the Darwinian selection process of finding "survivors", and prospering from the advance in equity valuations.  The three days following last Tuesday's election, in fact, have been a confirmation of a major shift in psychology, from cautious to optimistic.  I believe we are likely to continue an upsurge in equities through the balance of the year.  Hopefully, a rebalancing of sector leadership from defense to offense will additionally confirm that political problem solving and cooperation can intensify the recovery.  Following a not-unexpected cycle of profit taking from the current valuation expansion, I anticipate aggressive accumulation in Technology, Industrial, and Financial shares as money flows into as-yet unmet potential.

Below the surface

There is a strong appetite for anything with a capital gains bias (equities, private placements, tangible assets).  Low interest rates have nearly eviscerated the bond market, so short-term trading looks more attractive today than long-term yield plays.  The question, though, is whether higher share valuations really satisfy our thirst, or heighten our anxiety.  Indeed, there is nothing like seeing one's portfolio expand in value.  But what seems to be missing from the equation is a sense of equanimity and opportunity for everyone in the game...the equivalence of a moral compass.  The market's remarkable rise hasn't really netted those fantastic gains for everybody, nor has it blanketed all financial strata or geographic regions.

Fiscal and monetary policy is being carried out as if no one wants to repeat the mistakes of the most recent, and other, booms of the past.  It is obviously uncomfortable for the Fed to announce an "unwinding" of their powers over the purse.  They face the prospect of reengineering the same conditions that brought us aggressive expansion earlier.  Obviously, bubbles and cycles often repeat themselves historically.  So the gamble now is whether worldwide output, and confidence levels, can sustain trade, savings, and commerce without intervention by "Big Brother" central banks.  For politicians, monetarists, and consumers the question is, "who do you believe?".   Additionally, these data are not always "empirical" in the strictest sense, but more a matter of how we "feel" about the data in our daily lives.  Given that that the market's focus has narrowed into a short-term aperture, I am anxious to see how our political leaders address the issues of fairness and inclusion.  While the next month might not be enough time to digest the messages and results of the election, our portfolio positioning will be oriented around a longer-term demographic, a set of sectors and policies which could net significant reward for the patient investor. 

It would take a major secular event to reverse the course of the current bull phase.  We shouldn't exaggerate the negatives at the risk of obscuring what is working.  The most likely scenario is for the market to "test" a post-electoral euphoria, then settle into a more extended upside pattern.  Collectively, we are desperate for political solutions and fiscal reward, and tired of blame laying and name calling.

Market Commentary for the week of November 3, 2014

Is it just about energy...?
Much is being written currently about energy: the glut in supply, and the decline in prices.  And while there is no denying the empirical facts about cost at the pump or barrels in storage, I would urge caution in attributing the market's recent performance solely to a global "tax cut" owing to energy prices, or the notion that a price decline is not only inevitable, but sustainable.

Clearly, one cannot argue against the facts.  Slowing global growth is affecting oil supplies.  As a result, the behemoth integrated oil services companies are doing poorer in the equity markets.  But bear in mind, as I have stated frequently, that natural resource equities, particularly energy companies (oil, natural gas, coal) are "depleting natural resources"  equities, not "replenishing resource"  equities.  At some point, irrespective of consumer demand, and probably not in our lifetimes, prices for these scarce commodities will have to  rise and the world will have to find ways of cultivating alternative fuel sources, not from the ground, that create geopolitical independence, sustainable growth, and globally (socially) responsible outcomes.  In the meantime, and currently, the markets are rejoicing in the misfortune of the energy complex.

Beware of the euphoric hangover, however.  The glut is manmade, and the undoing of our "over supply" can similarly be undone by a stroke of the pen or fiat decree.

The current pause in energy price increases, and a concurrent financial boon to taxpayers, provides legislators and governors an opportunity to rethink economic and fiscal policies, hopefully expanding the possibilities for economic expansion to take root.  Rather than spending any net cash "reward", as some analysts predict consumers might do for the holidays, might it not be prudent to put away those currencies for a "rainy day" contingency, or perhaps to reinvest any cost savings into global energy R&D?

I believe the markets are overly obsessed with short-term features and fundamentals and less interested in long-term macroeconomic policies that inform the public about future investment and capital gains opportunities.  As a result, not only are the markets gyrating to an uneven pulse, but consumers' pocketbooks and their governments are, as well.

There are reasons we get the outcomes we do.  To be begin with, analytical focus is too much oriented towards the "next quarter".  When the attention span is that acute, businesses and governments fail to plan, believing deep down that "moment to moment" is a more palatable solution than any temporary pain with a more positive outcome might procure.  Fluctuation becomes the enemy.  Thus we inadvertently stumble into crises like the dot.com debacle, credit crunch, and global financial recession.

Obviously, there is no consensus about how to solve all of our ills, nor should there be.  At the same time, though, there seems to be very little compromise or political calculus applied to theoretical thinking or practical solution-making to get things done.

Or interest rates..?
With the Fed's announcement last week about finally winding down monetary intervention, of course the market's focus also turns to interest rates, inflation (pricing power) and economic growth.  Here again, it is incumbent upon politicians to step in and create fiscal policy which assuages any fear about hyper-expansion (not likely to occur), or the inverse, no growth at all.  The world financial markets are likely to take a "wait and see" attitude during the next several months, hoping that years of financial stimulus packages here and abroad have accomplished their goals of reengaging  public and private consumers.   No one wants to be buried by an inadvertent avalanche, yet everyone wants to be ahead of the capital appreciation wave!!

As with the energy price narrative, we need to change our focus from effective current cash flow to efficient longer term global outcomes.

It's not a secret.  The markets are always giving us clues about how to invest, and since quantitative science is a reactive discipline, it, too, is telling us that perhaps it is time we, the public, impose greater influence upon the creation of our own fiscal and monetary policies which thus far seem to have neglected social conscience and morally responsible long term investing.

To reach a goal, one needs to map out the course, and the context, of their actions, and to have sufficient emotional staying power to stick with the program even when it meets obstacles.

 

I'm hoping to see evidence in my research of that kind of strategic thought in areas like healthcare, aerospace, technology, infrastructure, renewable energy resources, and finance.

Market Commentary for the week of October 27, 2014

Utility or discretionary?
It used to be that analysts had a consistent way to evaluate corporate earnings, how they were derived, and how likely it was for those bottom-line dollars to continue to be produced.  Increasingly, however, we have to be careful to distinguish between earnings and earnings.

Things may look the same as before (after all, profits are profits) but the origin of earnings growth today is far from the pattern we would like to see happening as a norm.

A loss of general accounting and ethics uniformity during the past decade or so underscores the fact that companies have fallen into the bad habit of manipulating balance sheets, playing with their product lines, cutting their workforce, and shading their conversations with the media in order to conform to a set of Wall Street-led expectations about what it means to be a profitable corporation and how their share price should be reflected by those expectations.  While it is true, mathematically speaking, that a profit is good for shareholders, I believe that those which derive from alchemy and manipulation, and not an increase in consumer demand, set up a false calculus about the fundamentals of economics and the framework upon which this bull recovery has been built.   The moniker "too big to fail"  no longer applies only to financial institutions.  Tech stocks, traditional household brands, and energy conglomerates are like big battle ships stuck in the water searching for an escape lane. Simply raising prices, or reducing packaging size, is not doing anyone any good when it comes to public relations or economic sustainability.

Opinion polling tells us that business is held in low esteem (along with politicians and banks) which diminishes its prospects for the future, and heightens a distaste for the fortunes of those who run them.  Market activity last week typified this point. There was a wide mix of companies that reported reasonably good earnings whose share price paid the ultimate penalty because shareholders just couldn't see how much longer the largesse might continue.  Earnings acceleration is not always rewarded by share price appreciation.

Tell me, when you open a box of your favorite snack food do you notice that net weight and product portions are shrinking?

Isn’t it annoying, too, when companies raise prices just because they can?  Clearly, we've turned the corner on compassion and restraint.  Discounting and customer incentives are so last year!!

Unnecessary and indiscriminate price increases are harmful to the economy, the consumer, and corporate public relations.  There is always a danger that consumers might "tune out" the message if they feel as if they are being taken advantage of.  In a world where demand  should drive sales and pricing power, business is putting the cart before the horse, focusing more on profits to the exclusion of customer satisfaction.  It is more productive to respond to a broader macro secular evolution slowly than to try to milk performance out of a dry stone for the benefit of financial analysts.

Does money equal loyalty?

Are core costs rising?  Yes they are.  And yet, this anecdotal information is contrary to what published statistics are telling us about inflation.  Certainly, statistics can't always be believed nor are they applied unvaryingly across the board for all cases.  But if, in fact, there is no/low inflation, how do you account for an increase in airfares, or tuition, or movie tickets, or hamburgers, or bridge tolls, or new clothing, or that "shrinking bag" of potato chips?  You get the point.

Instead of holding fast on prices as they did during the recession, many companies are forecasting an increase for the next year.  While no one begrudges the right for business to make money, they sometimes pander to the need for Wall Street to make money off of them.

At a time when competition for consumer's dollars is increasingly ferocious, sales growth could be reaching an exhaustion point.  Manufacturers last week reported slower growth for the quarter, while new orders are stagnating from the weight of world tensions.  It just might be that we are reaching a temporary apex in the recovery.  The best way to bridge the gap from recession to global boom is to be mindful of political, social, and moral necessities for all market constituents.  Even corporate presidents need to avoid the appearance of greed and hoarding, or risk the wrath of disgruntled consumers.

The thought that they are driving customers into the arms of a competitive vendor would be abhorrent to any executive.  However, walking on "thin Ice" is not a successful business strategy, either.

Market Commentary for the week of October 20, 2014

Betting  it  all on black
The market's near-term sell-off and subsequent volatility are obviously indicative of the precariousness of buying/selling stocks in a world economy that is burdened with so many fundamental variables.  We came out of last week confirming an underlying suspicion about the strength of various global geographic regions and an overall skepticism about the exuberance of stock performance of the last 12 months.  We did, however, hold certain support levels which confirm the existence of a bottom-left/top-right configuration in equity markets.

It should come as no surprise, though, that a struggle is still being waged between near-term  versus longer-term  expectations, and just what might happen to capital spending and consumer wealth as a result of each time frame.

In fact, corporate profit growth has been accelerating, even as employee wages have remained stagnant.  So, depending upon your point of view, either stocks should have deservedly been advancing.....or stocks were building equity for their shareholders upon the backs of those with less bargaining power.  This argument embellishes upon the debate between the "haves" and the "have-nots" by exacerbating the psychological rift between old fashioned economics and modern civics.  In any other time, the debate itself would be marginalized by the hyper-success of stock valuations rising for the past five years.  But because it was the corporate and institutional financial difficulties of the last decade that led to the economic depression of many, even "good" isn't "good enough".

Thus, our portfolio asset allocation had assumed a more defensive posture towards stocks for quite some time.  It isn't that the numbers weren't to be believed.  It's simply that the numbers reflected a reality that wasn't shared top-to-bottom by all of its constituents.  Financial leadership should, in reality, raise all the ships in the harbor.

But the fact is that we don't deal in an altruistic world.  My modeling is built upon objective data, cognizant of its effects upon a subjective universe.  Right now, published economic data is as positive as it's been in quite some time, having slowly built momentum from the depths of the recession.  That gradual improvement has led to a climb in equity prices and trendline acceleration.  While the rally has been punctuated by several remarkable upsurges, it is the ability of stock markets to hold support in the face of ambiguous global fundamentals that impresses us the most at this juncture.  As you are aware from my writings, quantitative science presents us with an "inverse relationship" to probabilities.  The higher the market goes, as it did in July of this year, the greater the probability that it might succumb to negative influences.  On the other hand, as the markets fall, the cyclical probability of an upside response increases.  Difficult to understand?  Not really.  You can't fill a glass fuller than "full", and you can't empty it more than "empty".  Somewhere in between exists the laws of physics and momentum.  As we "empty" valuation in the market today, we heighten the odds of an influx of buying power later on.

The market built up to a crescendo, held ground, fell hard last week, tenuously held once again, emphasizing that there is sufficient cash on the sidelines looking to sweep in and buy long term expectations at discounted prices.

My data indicates support in the averages within a tolerable 6-8% range from here.  In the long run, the downside probabilities are starting to look less menacing.

Firing on all cylinders

Oftentimes, the markets move in variance to the news.  This observer believes the markets exuberantly moved up during the past few years in contrast to what was commonly believed about the economy.  Curiously, as a positive consensus is forming about an economic recovery, we had the market reacting in contradiction to that premise.  Even with a possible fourth quarter swoon, the data now suggests nominal risk which we believe might become more palatable by the beginning of 2015.  Bear in mind that any corrosive exogenous events (war/terror/politics) might change the nature of our forecasts, or the patience of investors to bear the heavy load.  But, as has already occurred, any significant downside capitulation most likely will be met by aggressive buying.

The United States is fast approaching an election season.  Winners and losers are more than just political candidates.  The markets are highly synchronized with political persuasion, which can affect sector leadership and trend velocity in the coming months.

If you are worried about protecting your near-term valuation gains, sell into the rallies, or give up investing altogether.  If, on the other hand, your horizon extends well beyond the next three months, I believe the risks will lessen as the reward potential increases.

Market Commentary for the week of October 13, 2014

Data undressed
Score this round for the negativists.

As investors lick their wounds over some heavy volatility and precipitous price declines last week, reports on economic data and fundamental market analytics also regressed just enough to take a little steam out of the bull rally.  We witnessed some serious earnings disappointments, there is still terrorism in the Mid East, a regional outbreak of the ebola virus shook the global medical community, European growth prospects suddenly turned sour, and domestic housing starts slowed.  There is obviously enough concern built-in to equity price advances that negative news, or even inferences  about negative news, can disrupt momentum, confidence, and valuations.

And there is more to go around.  Is the real estate/housing boom sustainable?  Can we build earnings growth across the board in a low wage environment?  Is energy really  in plentiful supply as the experts tell us...enough so that prices for this depleting natural resource should regress to levels of five years ago?  Will the Fed ever get around to releasing interest rates?

 And who is watching suppressed inflation data on food and discretionary spending costs?

I believe the build-up in pricing pressure for agriculture, energy, healthcare, and housing is much underestimated in the current data, and will become an economic sticking point, particularly if employment data continue to do better but wages are not commensurately rising.

In that vein, all sectors in recent weeks have been impacted by a rush out the door of investment capital.  While it is generally accepted that the cyclicals and industrials are more immediately affected by nuance in the short-term, even the most strongly performing sectors (non-cyclicals, utilities) witnessed capital losses in the past few weeks.

Hold the fort

An interesting confusion will arise for equity investors if/when interest rates do  begin to rise.  Whether or not to retreat from hard-won gains and to redeploy wealth into more secure/less volatile instruments is a difficult reality to confront.  One cannot, of course, try to "time" the market, but we know intuitively what's coming.  The question is whether the stock markets not only do now,  but will in the future, offer an appealing blend of capital gains exposure along with balanced risk aversion.  I believe the fourth quarter will offer a glimpse into how that question will be answered.  Thus far, it appears that investor's appetite for risk exposure is waning, as more money seems to coming out of stock funds than going in.  Last week was a kaleidoscope of emotions, cash flow, capital gains and losses, and portfolio angst.

More likely is that we are witnessing the origins of a new cycle calibration, one in which sector rebalancing and portfolio allocation takes on a more conservative bias.  Our asset allocation models are becoming more skewed towards resetting the stronger/fewer earnings performers against a backdrop of disappointing expectations.  Besides, two weeks doesn't make a trend.  There is still the completion of this right half of the parabola to experience.  Traders call this "backing and filling"; clients call it a "slow water torture".

Is there really any relevance to this capitulation?   That answer depends upon your preparedness.  We knew it was coming....just not when.  One should have already positioned for its eventual occurrence.  A careful re-read of my previous missives will show that I have been describing this distribution pattern for several months, but by no means is this a repeat of 2008.  We are still solidly in a bull expansion, both for stocks and the economy-at-large.  The problem is that everyone is impatient for something extraordinary to happen, that magic moment, even though the markets are travelling at their own pace.

 Pullbacks make great drama, but it takes a more sustained period of time to wreck a secular uptrend.  That kind of full-bore erosion is not happening now, despite the fact that pullbacks are so darned frightful, so we suggest to clients that they refrain from the hourly log-in price checks, the daily market stock quotes, and monthly statement perusals, and rely on the fact that money generally follows the longer term trend. 

In which case, the longer term uptrend is still intact.

Market Commentary for the week of October 1, 2014

Altitudinal Indigestion

As the US markets made multiple consecutive new highs last quarter, less overhead resistance meant greater unlimited upside potential, even as the "air supply" became less plentiful.  But untapped potential also raises concerns about whether economic  fundamentals are really strong enough to keep stock rallies going.  To do so, there needs to be a clearer picture about what default options are available to investors if equities' prices continue to rise, or if events on the ground dictate a contraction.  Despite staggering to a jittery ending in the past few weeks, benchmarks are indicating that the markets have a bias to continue rising.

Depending upon one's tolerance for volatility, financial indices are either recovering their true potential, or leaning towards excessive valuation.  Thus far, the relationship between corporate profits, consumer spending, lower interest rates and GDP has shown a remarkable equilibrium, even in the face of variables which have the capacity to destabilize them.

While being held psychological hostage to exogenous current events (terrorism, Mid East tension, airstrikes in Syria and Iraq), investor's commitment to financial instruments is actually picking up steam.  The classic  pull between speculators and fundamentalists is  tilting towards staccato trading, which helps further the debate about whether the current sequence of new highs is reality-based or merely a fiction of grandiose proportion.  Nevertheless, one cannot argue that this year's portfolio appreciation has been good for the psyche.

The only difficulty I see with these patterns is that the sector weightings of today's portfolio bull are narrowly defined , and that the breadth of participation is likely to stay quite shallow in the next few quarters.  In fact, if economic recovery were to become more inclusive, those most likely to do well would be cost-push sensitive companies (commodities, non-cyclicals) and harbingers of inflation, the one stealth tax we all wish to avoid.

Ultimately, we surmise one of two things will happen, neither of which is promising for the high-wire gamblers out there.  Either the market accepts that "fundamentals matter less"  and continues to push forward,  or the economy actually does  improve beyond current constraints so much so that interest rates start to rise leading to the onset of higher prices for goods and services. 

At present, my models favor the "improving economy" scenario, and a likelihood of higher interest rates, higher economic output, and (modestly) higher equity prices.  One shouldn't find it strange, though, that this "good news" overlay might be  negative for stock performance in the short term as we grow accustomed to a new normal in pocket-book economics:  a strengthening in employment, wages, and, of course, prices.  Additionally, I would expect sector allocation in portfolios to migrate towards tangible assets and industrials in that scenario.  We might also be mindful that a rise in interest rates sets up an alternative investment scenario away from stocks and into bonds, a balance which I think investors would welcome.

The one thing we must be careful about in this "good news" panorama is how rising prices might impact upon corporate profitability.  Those businesses which rely upon customer foot traffic could be vulnerable to a slowdown in discretionary spending if consumers decide to "bank" their new-found largesse.  The ability to pass-along core costs to the end-user is vital if corporations are to maintain profitability and sustainability.  When the demand pipeline contracts, business loses its most valuable means of generating profits and share price appreciation.

One reason why I might expect investment banking activity to increase in the next few quarters is that it is cheaper to acquire profits than to build them from scratch.

Markets

Equity prices are trading at P/E  levels well above historical norms as a result of the five year run we've been on.  Thus, most benchmarks look too expensive to this observer.  Fair market value would look more balanced at 13-15 times forward earnings projections.  In light of current earnings and price acceleration rates during 2014, it is dangerous to project too far out with so many variables as yet unanswered.  Do we consider double-digit equity returns to be logical for 2015?  Might earnings actually catch up to share price expansion?  And what if equities recede in the face of slower consumer demand, profit taking, higher interest rates, or some unknown global conflagration?  My work is indicating not more than historical rates of equity price appreciation for next year (6%), as the fourth quarter of this year becomes a staging area for necessary changes and rebalancing of portfolios.

We also have to consider the impact of psychological reticence even to bother with the stock market on the part of some investors,  having been burned at least twice already in the last 15 years (dot.com, credit crisis).  The impact of having a "dual" emotional connection to the financial markets (in or out) cannot be overstated.  Out of fear, confusion, or desperation, some have even expressed that they now prefer a return of  their assets, more than they are seeking  a return on  their assets!!

There is no doubt in my mind that the Fed will eventually abandon its bias to keep the cost of money low.  Global macro factors are too strong for the markets to be manipulated into an artificial condition of euphoria, even as we hold on to cash with a vice grip.  The influence of austerity programs and governors of money supply is beginning to wane.  In fact, I would argue that the policy combination of austerity and lowering interest rates has created a schizophrenic confusion within the financial markets at a time when absolute clarity was needed.  I have written repeatedly (and sarcastically) that "you can lead a horse to water, but you can't make him spend".  The Fed has diminished the capacity for recovery in the short term, I believe, by creating a population bifurcation as it relates to the allocation of spending and savings: those who have the resources are  spending, those who do not cannot.

Additionally, corporate expenditures have been subdued during the market's recovery.  Unless business can see a scenario in which they are rewarded for taking on new costs, they will be hesitant to do so.  As with all market barometers, these things are variable, cyclical, and unpredictable.  The one constant amongst all principles of business endeavors, however, is that demand drives revenue growth, which in turn drives asset expansion potential.

The financial markets are not entirely to blame for the volatility they sometimes exhibit.  Investors, themselves, manifest certain characteristics that lead to their emotional ambiguity.  Without  having a strict discipline, most people succumb to greed and emotionalism when it comes to portfolio structuring.  Just like "keeping up with the Jones'" , many follow the herd, jumping in too late and too enthusiastically.  Rather than subscribing to a prudent methodology, some buy in when the market confirms  momentum, and sell out when the indices retreat.   Greed guides them in, fear takes them out.  This is exactly the opposite of how opportunity should be uncovered.  We cannot forecast precisely when risk will occur.  We know only that risk is always a part of the investment equation.  Therefore when things are at their worst, opportunity for upside performance is usually at its greatest.  Conversely, with the averages trading at these levels today, it is incumbent upon us to play the trend but to prepare also for a potential reckoning.  That's just the nature of the beast, and what we saw in the past few days of trading activity.

Conclusions

The strongest performers for the first three quarters of the year are not likely to be the strongest performers into the balance of the year.  As mentioned, valuations and momentum are simply too high to be able to count on a continuation of price performance without some kind of pause or profit taking such as occurred at the end of last quarter.  However, the obvious place to look for performance and balance within one's sector allocation going forward is in those sectors, regions, and capitalizations which have not yet manifested full pricing potential, such as Basic Materials, Biotech, Energy (alternative sources, in particular), and Financials.  The cyclicals  should lag, until the consumer jumps in convincingly.  

The secular demographic themes that I believe will lead to near and long-term portfolio opportunity are in infrastructure development, agriculture, healthcare and life sciences, military/defense, ecology, and energy.  For example, my quantitative work confirms an increase in industrial activity globally, with commensurate demand for commodities and currency.  The valuation potential of these sectors when measured against current levels is compelling.  Ancillary businesses which could benefit from these demand shifts include internet, transportation, and real estate.  Earnings acceleration always drives valuation expansion.  We simply need consumers to step up to the plate with their money and spend convincingly, as we need business to demonstrate a commitment to capital expenditures without hesitation.

It would be foolish to say that we are at a critical inflection point in the markets right now, because in the world of parabolic sciences there really are no points, just periods  of accumulation or distribution.  Indeed, we are at levels sufficient to suggest it is appropriate for a distribution (downtrend) in equity valuations to occur, but given no empirical evidence to the contrary, I would prefer simply to abide the uptrend, and to be smart about balancing risk and current allocations.  In other words, the fourth quarter should be a parallel to what has already occurred this year.

 

 

Suggested balanced account asset allocation, Q4, 2014:

Equity:                65%

Fixed Income:  10%
Cash:                  25%