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%