Market Commentary for the week of April 28, 2014

How much would you spend?

In recent weeks, I have been writing about pundits' concerns about the depletion of our natural resources, not necessarily during our generation (although it is certainly a factor) but for generations to come.  If we don't start thinking about how to replenish diminishing sources of potable water, food, wood and metals, energy, arable land, and clean oceans then the solutions might be too late in coming for our heirs.

But think for a minute about what you would do if you were faced with a situation in which you had to choose between food or medicine, housing or transportation, security or survival.  Believe it or not, there are millions of our fellow citizens on this planet who must do exactly that every day.  And as, or if, those numbers might increase, those factors, and those citizens, will impinge more greatly upon the natural order of things for the rest of society.

What would you do if your "soylent green"  was no longer available or affordable.  Indeed, the stuff of movie fantasy and science fiction thirty years ago might become the reality for others thirty years hence.

How much would you spend if your survival depended upon it?

I suspect that the will to survive is so great that even the wealthiest amongst us would pay anything not to be destitute, hungry, or ill.  How much pain, how much hunger is too much for some of us?

Today, for example, medical diagnostics and pharmaceuticals exist which can bring  a healthy life back to those severely afflicted by disease.  But those cures cost money, not to mention that our pharmaceutical and medical infrastructure operates as a "for profit" business.  It is mostly the poor and indigent who have to make life or death choices, or who have no choice whatsoever.  What we once experienced as premeditation and constructive consultation with our medical practitioner is being replaced by raw survival instinct.

In a culture where acquisition and "having things" becomes the standard by which we live, how much of those things (money, home, family, health) become expendable if the choices were dire.  We are becoming a marketplace of profitability at the risk of sacrificing social responsibility and empathy.

To be sure, there will always be sickness, poverty, affluence, haves and have-nots.  What seems to be receding, though, is compassion and moral obligation.

Greed: 1, Business Morals: 0

To that point, the markets last week had a schizophrenic week trying to interpret earnings reports.  Question: if a company reports higher revenue and greater profits...but starts at a lower basis, at a "deficit" from previous high-water marks...is it really a profit, or simply an improvement over the previous reporting period?

Fed Chair Yellen said last week that the Board would spend most of its efforts trying to focus upon employment within the recovery rather than its inflation-fighting biases of previous years.  You and I know from anecdotal experience, however, that prices are not going down, they are going up.  Tuition, energy, food, recreation, travel, commutation and housing are not less expensive than five years ago, they are more expensive.  It is surprising that the Fed would fail to discuss at length the "impoverished" condition of its constituents and focus instead upon a more ethereal "jobs market", a factor best left to the private marketplace.  Yes, it is difficult to balance several balls in the air at the same time, but the reality on the ground is that many households are hurt by the concentration of wealth by a few and the failure of our banks to lend money willingly.  In fact,  financial institutions are already in recovery, flush with cash.  They choose instead not to lend because they still see too much risk in the economy, and because of their fear of repeating the last greed-driven cycle they helped to create.

The general fallout from this past Great Recession is far from over.  Despite falling consumer demand, global credit confidence crises, and a market which cannot determine if we're in a "bear bounce" or a "bull recovery", the stresses upon our global ecosystem and social institutions continues to exacerbate.    

Market Commentary for the week of April 14, 2014

Overestimation

Weather conditions and natural disasters worldwide have us wondering about the security of our natural resources infrastructure.  Farmers look to the skies hoping for rain; rain-soaked hillsides collapse, causing unfathomable carnage.  Certain geographies are rich with energy deposits, while other places lack the resources for sustainable economic activity.  The limits of plentitude are being stretched by a planet under constant duress.

The problem of natural resource allocation is made all that much worse by the disparate nature of politics, economics, and geography.

Predicting the future is obviously never easy.  But it seems we are paying the price, if not today perhaps in the future, for a false sense of security about a never-ending supply of natural resources and commodities.  If forecasting is designed to tackle these issues head-on, the forecasters are being a little too cavalier with the data and not acknowledging  pockets of poverty, inequitable distribution, or diminishing supply.  The worst thing that scientists and politicians might do is to underestimate the needs of their constituents for the decades ahead.

Production forecasts are also obviously impacted by the weather.  There was no equivocation when, during this past Winter, the United States was broadsided by a particularly difficult stretch of cold weather.  The effects have yet to be fully calculated, but we know that food prices have risen due to weaker harvests, while consumer retailing, already suffering from lack of foot traffic in stores, has seen higher prices owing to delivery delays, fuel price increases, and cost pressure at their manufacturers.

Natural resource access is a pandemic concern.  We are already seeing political effects upon heads of state in countries depleted of, or hoarding in, necessities for their population's basic existence.  Citizens' revolution in  areas ravaged by climate or political disequilibrium are warnings that this issue must be addressed before it's too late to remediate the imbalances.

Without espousing any particular political ideology, many agriculturalists bemoan the deterioration of soil content, the lack of plentiful access to water, and the net output declines per acre from once bountiful lands.  In its stead, scientists are working hard to "engineer" agricultural solutions, gradually exacerbating the economic and social vacuum that these crises have created.

Meanwhile, one might argue as with all other socio-economic endeavors that quality is being replaced by quantity, but not necessarily improving the lot of those who depend upon a big-picture outcome.  In a world of plentitude, no one should be living a bare subsistence, without adequate food supply, drinking water, energy, or housing.

Paying the price

As a result of "horizontal political diatribe"....a kind of status quo complacency in which nothing changes ...costs are rising steadily.  As supplies diminish, how are we to decide which commodities we can best afford and which to sacrifice?  The negative effects of political inertia, industrialization, and climate change are diminishing economic momentum for some countries, creating winners and losers within every strata of their social and economic continuum.  While the wealthy can clearly afford rapid price hikes in basic commodities, the gap keeps widening between "affluent citizen" and "impoverished neighbor".

The markets, though, are reacting to these inequities with a shrug of the shoulders.  Valuations are breaking out above resistance levels during this quarter but, in my analysis, are showing signs of "breakout fatigue".  At some point the divergence between investor's greed and their empathy for other's reality might cause capital investments to redirect into more altruistic endeavors and to create a "new normal" type of profit.  For a while, this investment fatigue might be expressed as temporary intraday volatility.  But we know that deep cyclical trends must emerge in order to differentiate between long-term demographic leadership and those short-term trends which are fad-driven only.  Look for secular investment opportunities coming from agriculture, commodities, and water resourcing.

As stocks challenge historic new highs, buyers must be cautious about getting out in front of the wave and being carried away by the exuberance.  Enthusiasm sometimes tends to wane when ample justification for negativity overwhelms the conversation.  Unintended consequences, in life as in investing, are the kind which take too much effort and pain to fix.  

Market Commentary for the week of April 1, 2014

Fundamental Tango

The economy and financial markets are forever sending out mixed, parallel, or confusing messages.  Inflation or stagflation?  Buy now, or take your profits?  Proceed slowly, or go home?  At this moment, the signals are hardly synchronized.

There are just as many observers who could make the case for a "bull run"  as those who favor the opposite point of view, a "bear in hiding".  Obviously, any disjointedness of the message being conveyed could perplex the financial system or those who participate in it.

Like most of us, you, the client, want concrete answers as to what to do next, or what to do now.  In the absence of substantive answers to those queries, some (many) choose to do nothing at all.

Signs of that insecurity abound.  Despite new highs in a few of the averages during the last quarter, the breadth of participation, (the total number of stocks and sectors), actually diminished slightly.  Money flowed out of financial instruments during the quarter, either from profit-taking or "fear of the top".  Consumer sentiment, a measure of likely future participation in equity and discretionary spending, also fell from its peak of last year.  More stocks are in a cyclical bear than are in a cyclical bull.

Most investors hope to re-engage in the market... it's the only game in town.  When  is a different matter, altogether.

Market experts always say that it is impossible to "time" the market.  Because so many of my measurements are actually undervalued relative to their nominal values, I would argue it's a great time to hold, buy on dips, or to "nibble" around the fringes.

Underlying those data, however, is a troubling statistic:  the alarming diminution in earnings acceleration patterns. Whether it be downsizing or accounting alchemy, most businesses have wrung about as much profitability out of their balance sheet as possible.  As a result, the rate of earnings expansion is actually shrinking for the first time in decades.  With consumer demand lagging expectations, it is highly unlikely that the stock markets will offer you the returns you had last year.  Get over it....and get used to it.

Markets

Because there are fewer compelling storylines to attract investment capital, clients are becoming skeptical about good fundamentals and are loathe to commit any new capital, even if on a short term basis.

But even more problematic is that so many more are looking for that golden goose, those returns of a halcyon period, which makes one prone to a "sucker punch", a foolhardy aggressiveness subject to whatever "cool story" might cause them to abandon logic and conservative biases in order to make up for perceived lost opportunity.  These "faddists" didn't learn their lesson with dot.com, or gold, or leveraged mortgage securities.  No, they seek profit above methodology, and, I believe, are doomed to fail yet again.

So, with "long-term" being  too "out there in the future, someplace", and "short-term" construed as  too "choppy and risky",  what is one to do?  The best thing is always to revert back to investment basics.  Just like the golfer who must stretch his/her brittle bones first, and start the season with "short shots" (like most of us in the Northeast!!),  it is always best to start with sound principles that enable the first step to be successful.  Shrinking the margin for error is always a good starting point when investing.

My data definitely reveals a dichotomy between  the way we perceive the economy and how those perceptions translate into real execution.  Despite some remarkable government statistics suggesting improvements in the country's gross domestic product (GDP), the markets appear to me to be worried that we might barrel headfirst into another brick wall of unmitigated disastrous consequences.  To wit:

...price increases in natural resources, particularly heating oil and energy, have cut into household and corporate budgets; Congressional studies recently reported that over 80% of our roads and bridges are in a state of disrepair; our population is aging, putting pressure on services and retirement benefits; a large percentage of the population is migrating to warmer climes, placing more pressure upon the housing market, transportation infrastructure, and healthcare services; interest rates have been historically too low, and, yet, fewer businesses are allocating precious resources back into R&D.

At the same time, Federal tax revenues are being squeezed by a smaller, less affluent workforce, while spending is being cut in areas like defense, education, agriculture, and healthcare research.  The adrenaline that could have stimulated capital growth in the economy is now just a trickle.

While there is no way to document people's suffering on a "pain meter",  we know that  the after-effects of the recession have caused a huge shift in sentiment about how each of us manages expectations for the future.  There might, indeed, be new jobs in the pipeline, but wages are at pre-recession levels and not sufficient in many cases to lift a family out of poverty.  Here again, the dichotomy persists between commonly acknowledged good news and the perception by some that we are simply maintaining in order to get by.  Economic parity is a fallacy for many.  Optimism is an illusion to some.

Strategy

The foundation of my "parallel disconnect" theory is that these disaffections stem in part from  systemic weaknesses in our institutions that have been masked by complacence and mostly forgotten because of the concerted efforts by us all to remediate the effects of the financial crisis.  We know that cycles will forever come and go, patterns of inordinate joy followed by unflinching despair.  When each cycle is done it becomes forgotten.  But the obligation of government is to prevent the crises from ruining the most vulnerable amongst us.  The wealthy benefit from the same rules that govern everybody else....we would hope.   It's only right that we should all be mindful of which of our peers goes to bed hungry, impoverished, homeless, helpless, or in need.

In light of these societal imbalances, our portfolios favor defensive sector allocation, such as utilities, technology, and basic materials.  We all expect and hope for an economic turnaround, but at the same time we recognize the reality that stock and bond investments are only moderately attractive right now after having experienced a five year recovery. It would be imprudent to jump on the train after it has already left the station.   When the economy improves (and I believe the balance of the year should prove that to be the case), I also expect that interest rates might start to migrate up, reflective of an increase in business activity.

As noted above, the first principle of investing is to moderate downside risk through prudent allocation and diversification strategies.  Trying to recover from catastrophic drawdown can be lengthy, painful, and fraught with volatility trying to catch up with the markets and friends.  I believe that managing strategic probabilities is a function of good discipline and it always outperforms traditional benchmarks.

As an earnings driven investor, I always find it useful to look, first, at companies that manage their own cash flow well.  That means that , year-over-year, they not only pay dividends but increase those payouts at a rate in excess of their competitors in the same space.  Because of foresight and strategic planning, these businesses dominate their  niche and deliver quality products to their consumers.  While many investors like to dabble in the "new issue" markets for aggressive returns, I believe that risk is managed better, and portfolio returns generated more consistently, through a disciplined approach of selecting the "best of the best" in each category ranking.  I also think that the market is focusing, slowly, upon those disciplines which grow the "P" along with the "E" consistently.  At these valuation levels today, conservative investment objectives are outweighing people's need for greed and aggressiveness.  Until, or unless, confidence levels improve, trying to hit "home runs" is probably a minority endeavor.

Conclusion

The simplicity of using one comprehensive methodology is to allow for monitoring factors on a consistent basis over a longer period of time.  Quantitative analysis, for example, enables those statistical redundancies to be calibrated and measured for probability of future performance, duration and magnitude both.  When these factors coalesce around certain "inflection points" the predictability of perpetuating that trend is optimized.  The result is to eliminate subjective, or emotional, responses and to focus more acutely upon those factors which magnify trend and cycle duration.  In effect, we not only manage the "upside" of portfolio analysis, we quantify and adapt to any "downside" modifiers which might impede cycle advances.

We know that there is always something which is worthy of investment today, and likely to be worth more twenty years from now.  We also are always searching for the reasons why something happens...that's what it means to be human in a world of uncorrelated cosmic events.  But, more importantly, it is crucial to avoid the "what have you done for me lately"  syndrome, or to chase "hot tips" indiscriminately.  As complex as we are, us humans, we are subject to immediate mood swings that mirror the trajectory of market benchmarks on a daily basis.  Therefore, we should probably affix a more noble cause to our investing and build our asset allocation to reflect more than "how did the Dow close last night?"

  

 

Suggested balanced account asset allocation, Q2, 2014:

Equity:                55%

Fixed Income:  15%

Cash:                   30%