Market Commentary for the week of January 27, 2014

Stocks are the new Bonds

Despite projections that interest rates might enter a secular upswing if the economy continues to improve, the inescapable fact is that bonds, and other fixed-income securities, are not the place for investors to generate yield, stocks are.  The way to improve upon dwindling dividend and interest investment objectives is to build a portfolio of high yield equities, and to protect against downside market volatility with select stop-loss support.  While yield and dividends are typically expressed as a finite integer, risk is not often as quantifiable, unless one applies certain metrics for cycle magnitude and expectations for cycle amplitude (duration).

Equity dividend portfolios require certain assumptions and forecasts.  Using historical dividend acceleration patterns can mitigate against macro exogenous events which might affect stock selection, overall.

At the end of the day, yield (interest) is simply a payment to the security holder.  We can get yield from bonds, ETF's, partnerships, or options.  Looking at equities as an income source is not a "trick" to divert attention from traditional methods, but rather a way of expressing a new reality of cycle phase evaluation as it relates to the evolution of asset allocation and dividend studies.

Over the past year, as the equity markets have gained greater momentum, the risk in substituting stocks for bonds as an income source has diminished.  Starting with the aggregate yield on a basket of stocks versus the current high yield return on bonds, one must conclude that projected returns might be higher in the former versus the latter.  Last year, for example, our equity portfolios approximated a dividend interest return at a multiple of several times the fixed income benchmark we established.  Combining Utility stocks with income producing growth stocks, our objective was to mesh the allocation totals with cash reserves to meet client expectations for capital preservation, capital gains, and competitive returns.  For the most part this evolution away from bonds was caused by maturing securities and short duration objectives.

Dividend stocks with specifically measureable volatility quotients have a much higher probability of generating "income" in 2014 than is attainable in the fixed income markets.

While there are always risks associated with yield optimization using equities, one cannot forget that the "credit crisis" of 2007-08 successfully dispelled the notion for many investors that bonds are "always more secure than buying equities".  However, irrespective of the  strategic methodology selected, one must still apply prudent discipline and asset allocation principles.

Bear in mind, too, that "high dividend paying" stocks are not interchangeable, nor can one just "throw darts" to build a portfolio.  My metrics, for example, optimize the selection process by quantifying the relative strength of each security under review.  Applying a proprietary quotient to risk factors enables us to group time-weighted calculations so that risk to the portfolio as a whole is significantly less than that of each of the members within that portfolio.  These rankings relate to current and past trend analysis, helping to minimize any prospective risk to future performance.

Stay calm

The market is no doubt looking for guidance from "experts" regarding these seismic shifts in asset balances.  On the heels of last year's remarkable recovery rally many are wondering what the second act might bring.  Amid this dilemma, I find that clients/prospects are measuring risk not so much by an implied improbability of another record-breaking year, but by their desire not to be left behind if, in fact, it were to happen again!!  They seem to forget that, over time, the measure of portfolio success comes from minimizing the effect of downside risk (drawdown), not by how much one meets or exceeds common short-term benchmarks.

Volatility is a given.  At the valuation levels we find ourselves currently, the probability is greater that we recede than advance.  Of course, no one knows that for sure.  What we do know is that violent or unexpected turnarounds are always likely, and can undermine investor confidence more swiftly than it takes to build that confidence in the first place.  Being fixated, as many are, by the "short-term" is divisive and counter-productive to strategic asset allocation methodologies.

It appears, unfortunately, that high anxiety is here to stay.

Market Commentary for the week of January 20, 2014

Sustainable trends
One of the most common themes we hear from political pundits and market observers these days is about either the demise or rise of the middle class, an amorphous, non-homogeneous group of people not quite rich but also not too poor.  This class is often cited as the reason either to be for or against legislation, fiscal policy, social norms, or the price of a gallon of gasoline at the pump!

But few attempt to define just who these people are, or how/ where they live.  In the context of the financial markets, for example, what does it mean to be "middle class"?  What are the implications to a nascent economy to have a decreasing/rising middle class?

For one, being in the middle class is not as important as either aspiring to, escaping from, or falling back into that classification.  For some reason, the middle is never where we want to be.

More compelling, though, is that the global "middle" is growing smaller relative to the number of people who are either above it or below it.  The gap is inexorably widening.

We must conclude, therefore, that based strictly upon wealth, the financial markets are attainable by a smaller percentage of persons, the most affluent, who can truly benefit from taking discretionary risks with their money.  As defined by aspirations and expectations, my job is either easier (because the rich have more money to play with) or harder (because the less affluent have less).  If managing money is really about the management of client expectations, then aspirations today fall clearly on two sides of the bell-curve and are not necessarily compatible with the principles of economics.  Two distinct classes of investors define the equities' markets today, while the "middle" is, indeed, shrinking.

So?

So why even write about this?  Because the investment implications are enormous.  We know, for example, that stocks trade up or down predicated in part upon earnings projections.  In regions where the middle class flourishes, discretionary income and spending patterns sustain a host of industrial and consumer companies that might not do as well in less diverse jurisdictions.  Sounds like common sense, right? In countries with a growing consumer base, factors such as supply, cost, and manufacturing are vitally important to political governance and moral equity.  Measured correctly, these data can sustain economic vitality indefinitely.  Longer term, the sustainability of regional growth trends mitigates against political and economic risk.

Innovation and entrepreneurship also need capital and an educated citizenry.  The ratio of schools, symphonies, libraries, sporting fields, and theatres within a region is also as significant as its access to potable water, inexpensive and plentiful energy sources, transportation infrastructure, natural resources, and agricultural products.

In other words, the markets work best where long term economic and political durability offers a chance at "making it" to the greatest number of its peoples.  Demographics, including capital reserves, vibrant and healthy citizens, competitive schools, low production costs, and social respect drive markets higher.  Speculation works best not when it's hoarded by a few, but available to many.

My analytics are also designed to evaluate macro trends such as the magnitude and sustainability of resource allocation within sectors, and whether or not the valuation expansion of equities within those sectors might outpace the ability to sustain such price levels.  How symbiotic we find the relationship between cost, capital, manufacturing, and demand is the very nature of quantitative market analysis.

 

From a societal perspective, equality is a matter of trust.  Trust that business, government, and our social institutions play a congruent role in expressing the values which make capital markets efficient and fair.   

Market Commentary for the week of January 13, 2014

Rarin' to go....nowhere

The stock market's valuation expansion has left a bittersweet taste in the mouths of some who believe that this historic sequence of "new highs" is simply smoke and mirrors and accelerated expectations.  Indeed, while the wealth effect is improving the lot of many, it is also exacerbating the gap between "reality" and "perceived-reality".

 

It doesn't feel like a bull market to everybody.

 

To be fair, the economy is much improved from its cataclysmic bottom in 2009, but even the gains we have made are narrow and gradual.  Until we see an uptick in people's mood about the economy, no amount of data shifts can remake our perceptions that the pace of growth is arduously slow.  Confirming that fact is the outgoing Federal Reserve Chairman himself, who noted that the economy has "much farther to traverse before conditions can be judged as normal."

 

So, while the policy-makers jiggle on the throttle a little bit, consumers are holding on tightly to their wallets pending any new

(negative) occurrences.

 

Spinning wheels

Traditional capitalists argue that jobs are created from the ground up, neighborhood by neighborhood.  In fact, small jobs' growth is happening at a rate far slower than in the economy at-large.  That's mostly because small businesses are more susceptible to permutations in borrowing costs, wage expectations, and local tax initiatives.  The ongoing wave of newly unemployed or underemployed affects local communities and municipalities far heavier than its impact upon larger corporations, many of which have been preparing for an economic downshift by hoarding cash reserves and laying-off those very workers who populate the local unemployment lines.

 

As a result, any discouragement about economic stagnation is felt mostly by the "average Joe", while big businesses try to bide their time and ride out the down-cycles.

 

Make no mistake, fiscal belt tightening is felt by everyone, but to a much larger degree by those who can least afford to absorb it.

 

Gross versus net

This year, as investors perceive that their portfolios are larger and their home values are increasing, they are choosing to "hold on" to their recovery gains rather than to spend that money flagrantly.  And, the government has been no help to them.  Locked in a  political stalemate, our legislators have imposed the biggest "phantom tax" upon its citizenry in decades by shutting down the government for political spite and by allowing sequestration to rob the programs (and pocketbooks) of badly needed funds to our Federal safety net.

 

To make matters worse,  the Fed is "taking its foot off the spending pedal" while the government rejoices over interim compromise spending cuts.  The net effect is to shift the social burden to cities and states which, as mentioned, have a shrinking tax base from which to address these local issues.  You can see why some feel like the recovery never really happened for them, and the recession is still their reality.

 

The bottom line both for the economy and the financial markets is that confidence and demand move the needle.  Protestations to the contrary, you can lead a horse to water but you can't make him spend.  While I am forecasting higher market valuations for year-end 2014, and a stronger economic landscape globally, it would be improbable to predict percentage gains equal to last year.

 

All equity, fixed income, and cash allocation decisions going forward must be scrutinized in the context of each client's unique risk/reward tolerances.  There is no "one size fits all" response to a market which many experts believe is a crude amalgamation of exuberantly excessive asset valuation expansion, political risk, and fiscal confusion.

Market Commentary for the week of January 1, 2014

Glass Half Full.


Against the backdrop of a renewed sense of economic optimism brought on by a remarkable 2013 equity market rally and a five year, steady upside climb from the depths of a generational global recession, there is an eerie calm of unresolved issues which permeates the psyche of the marketplace.  In many ways, and for whatever reasons, it feels less like a rebirth and more like "we've been here before."  Rather than issues being resolved by the rebound, continued uncertainty confuses the outlook for prospects going forward.

A year ago, we rolled hesitantly into a new year with a vast majority of investors quite skeptical about fundamentals, technicals, and personal particulars.  For the most part, portfolios were aligned around risk aversion and the hope that equities could continue their marginal, yet steady, ascension off of their lows.  Bonds has lost their luster by failing to compete with equities, either for coupon yield or capital gains potential.  For the fourth consecutive year, net bond yields failing to compete with equities, either for coupon yield or capital gains potential.  For the fourth consecutive year, net bond yields failed to deliver a competive alternative to stocks.  With interest rates being held low by intervention and low credit demands, investors only hoped that risk/reward paradigms favored their equity-biased portfolio allocation.  Without skipping a beat, the equity markets powered through 2013 and rewarded the bold, the meek, and the in-between.

The biggest issue going forward is what might derail, or encourage, this remarkable expansion of portfolio valuation and risk-taking?

Markets
I see the greatest mitigating factor to extraordinary portfolio returns in 2014 is the lack of breadth in participation here at the top...not only in the types of sectors which took fight in 2013 but also in the types and numbers of investors who completely benefited from the rally.  Statistics show that only a handful of already-wealthy investors outperformed the rest, while the number of securities investors either diminished or remained the same.  The flaws in the data indicate, moreover, that this was a wealth rally ostensibly for the wealthy, while a large percentage of the population remained financially inert.  In five years time the gap between rich and poor widened.

Part of that problem is attributable to how governments chose to solve the recession.  One negative view concludes that keeping interest rates low hurt traditional conservative investors who typically bought bonds as a hedge against the market risk.  Without this "alternative investment strategy" those investors were forced to the sidelines with cash reserves in low yielding money market accounts, or to participate minimally in stock speculation.  The return spreads also widened, but for the most part only for hose who chose the risk side of the equation.

Several possible solutions to this competitive gap might have been available if government hadn't sat on its hands debating on a dizzy-ing array of do nothing strategies.  On the one hand government action might have precipitated the wealth gap, while at the same time government inaction also perpetuated it.

Austerity and budget cuts depress entrepreneurialism, competition, social fairness, and capital deployment.  In the meantime, valuation bubbles in equity shares exacerbate the problem for those who don't have the capital to invest in the first place.  As the bubble mushrooms, the potential for complications intensifies.  Globally, the argument for or against, for and against valuation expansion, begins to pit region against region, citizen against citizen.  The Middle East conflict is a prime example of rich versus poor, nation versus nation, social beliefs against religious fanaticism.

How do we go about building portfolio strategy for the coming year, responding to a perpetual cycle of greed versus social consciousness?  An appropriate answer begins by defining a strategic macro overview.  Rather than focusing solely upon economic or political flaws, we must find instead areas where the imbalances actually create unique investment inflection points.  Rather than worrying about low bond yields, for example, we might devote our resources to consistent earners and high dividend payers in the Utility Sector.

The market's aren't collapsing, they are rebalancing.  Very little is said about cycle phase methodology, but the fluid nature of commerce and capitalism is that something is always going right even if it's not apparent to all at the same time.  In fact, those cycles on the periphery are usually the hardest to quantify but ultimately the most lucrative in the long run.  Focusing where everyone already is does not yield the same probability for upside gain as being unique and diligent in finding the next big upcycle.

Further, I would postulate that when the balances are as asymmetrical as they are today, the opportunity to position portfolios for any corrective opportunity is at its greatest.  with so many compelling economic and social issues still unresolved the potential for finding the next "better mousetrap" is distinct.  ultimately, it might take years to actualize gains in alternative energy; biotech and lifesciences; infrastructure redevelopment; aerospace research; food and agriculture, but the opportunity is there nonetheless.  In the meantime, patience, methodology, and discipline are necessary components to successful portfolio modeling.

Crises do abate over time.  It is our job to navigate through the interim while the noise intensifies.

Strategy.
The outlook for the markets this year remains strong.  Despite starkly diametric opinions within the investment community, I believe the factors that govern risk and speculation can be sustained if we understand the inevitable cycle capitulations and potholes that invariably occur.

The primary engine of investment opportunity is to address the equality/equity gap that persists worldwide.  The individual is the engine of economic expansion, not the corporation, and everything must be done to address demographic shifts that effect productivity, sustainability, and moral security of the household's integrity.  Governments and corporations must begin to address their consumers with respect, and develop policies which have direct impact upon purchasing power and net income.  Wall Street must also see that market valuation is more sustainable when earnings emanate from consumer, not accounting alchemy.

The classic bubble we are in now is nothing new.  In fact, today's returns are negligible and  marginal when taken in context of what could be if mechanisms were in place to create a sharp increase in breadth of participation and wealth transfer to a larger majority.  This might cause a major bull to erupt with more realistic probabilities of sustainability.  In addition, policies which enhance innovation and initiative give the public/private sectors rooms to cultivate capital deployment, and transition for more equal distribution of opportunity.

"Business as usual" is not friendly for investors.  While many despite inconclusiveness and chaos, consensus is not always conducive to market expansion.  Failure to compromise and political gridlock have actually hurt the markets by making choices too tribal, too territorial.  Instead of breeding euphoria, political deadlocks drag down our collective psyche.  In short, we need to return to five year plans and traditional fundamental long-term analytics.

Conclusion.
While the current bubble represents a potential short-term threat to the markets, I remain extremely optimistic about the financial markets, themselves.  Recent systemic remediation, along with momentum in the data, represents a more permanent chance to engage successfully in portfolio rebuilding.  The sensible thing to do is to recognize that nothing can go straight up forever.  But we are better off than a half-decade ago, and likely to be better still five years from now.  The worse outcome would be to ignore the problems and opportunities we confront and to let other factors, out of our control, dictate the risk.  Markets always gyrate, that we should acknowledge.  The opportunity we get from those gyrations is why we enjoy the science so much.





Asset Allocation:
Equity 42%/Fixed Income 20%/Cash 38%