Market Commentary for the week of July 28, 2014

Too little....
We are in the heart of the current earnings season and it's interesting to observe, as one of our recent US presidential candidates once opined, that "corporations are people, too".   That remark has never been more typified than by what we see coming out of analyst's reports and forecasts today.  Like you, corporations are in pare-down mode, hoarding more cash, and loathe to spend indiscriminately.

Not that the opposite has always been true.  In fact, corporations, just like you, try to live within their means; deliver an on-time profitable budget; and have an obligation to invest wisely on behalf of their stakeholders, hopefully to deliver even more value.

But the comparisons end there when assessing the current spate of data.  Indeed, while one must concede that the engine of commerce is beginning to ignite, the changes in how business is being done have serious and long-lasting consequences for how the economy and the financial markets are to be quantified in the future. 

One important distinction is that the primary nexus of capital savings is not in consumer's hands, but in treasuries, banks, and corporate coffers.  This would imply that what you or I do, what you and I might spend, pales in comparison to the significance of institutional capital expenditures and their impact upon sustaining future economic development.  Gross Domestic Product (GDP) now emanates from a substantially different source than in the past.

This sits in diametric opposition to a consumer-led expansion in which business takes its direction from demand we, the people, might create.  Instead, capital today sits, figuratively, in drawers and vaults that, at the end of the day, are micro-managed with potentially self destructive implications, over which the consumer markets have relatively little control.

The second example of a new paradigm in earnings emerges from the centralization of natural resources into fewer and fewer global sources.   If, for example, there were to be an interruption in the flow of vital commodities (food, water, energy, e.g.), the global economy would respond immediately with a high velocity inflation in prices which remarkably today sit pent-up, in abeyance.  The potential impact of sudden commodities price spikes upon corporate profitability and consumer savings would be catastrophic, many might speculate.

The good news is that we do not expect a material disruption at this juncture, although current events in the Middle East and Ukraine bring the sensitivity of these facts into clearer focus.  However, earnings reports, and market behavior, seem to anticipate the potential for price increases "at the source" and are making the necessary adjustments with savings and cut backs as a part of the nomenclature, just in case.

Too late....

From an investment standpoint, these data force us to look at commodities prices, basic materials, utilities, and price sensitive equities as direct beneficiaries of this uncertainty.

Another effect I see coming out of the current releases is a stagnation both in breadth and enthusiasm for financial securities.  To be sure, the markets are toying with making "new highs" and investors are eager to speculate in future price advances, but while global economic activity is accelerating, it certainly doesn't feel like it in many homes.  The most compelling argument for consumer disassociation from the financial markets is that the downside seems more scary than the upside seems enticing.   While Friday's volatility was disconcerting, it doesn't appear to have stopped the risk-takers who chase after a 5 year recovery with great zeal.  Even if investors haven’t yet lowered their threshold about hoping for the best, their tolerance for yet another market collapse has nearly evaporated.  Not a good combination of odds, in this reviewer's opinion.  Markets work best when risk and reward are evenly correlated, and work even better when risk is at "absolute zero".  Present conditions are nowhere near approximating either the former or the latter. 

The data is good, the forecasts are better, but the emotional conviction has justifiably been tame.

We need to ratchet down the "chase instinct"  just a notch and realize that contractions are part of growing,  growth implies future revision,  and planning for those ebbs and flows is instrumental in helping to reduce the effect of risk upon portfolio allocation strategies.

Demand generates income and profitability for corporations.  That is the sequence I believe in, and upon which I predicate my market analysis. Therefore, the wealth centers have to step up, participate more aggressively, and allow that potential to be released.

Market Commentary for the week of July 21, 2014

Under the radar
In stealth fashion, consumer prices are surging at their fastest pace in almost a decade.  Although energy is the most visible culprit, gains in food, retail, transportation, and leisure products cut deeply into our standard of living.  As previously noted in other missives, just about the only things not going up due to inflation are wages and savings, both of which have experienced slight declines in the past couple of years.

The news on inflation, however, has not kept a lid on stock market activity, which again had a muddled path last week.  Thanks to comments made by Fed Chair Janet Yellen, investors found themselves caught in a squeeze between limited economic expansion and the promise of monetary policy designed both to stimulate and protect concurrently.   No wonder we got bounced around during the week.

My analysis concludes that these ambiguous data could spell trouble for our expectations of unabated capital gains.  The elements are in place for a more conservative orientation in our balanced accounts management.  Even as the economy continues to show improvement, investors are skeptical about their institutions and their lack of initiative in dealing with fiscal, social, and moral issues. 

To be sure, there is earnings growth, valuation expansion, and economic revival.  There is also geo-political uncertainty and commodities volatility driven by world trouble spots. Ukraine is dominating the news, as well as the violent clashes between Israel and militants in Gaza.   Determining how long  divergent pieces of news might coexist without exploding into" something else" is the essence of the art of managing our client's portfolio risk.  For the moment, I perceive upside market expansion as possible, but tightly range-bound.  Current events are the wildcard.

Your choice

Stocks played a game of one step forward, two steps back  last week, as concerns over regional war, poor consumer confidence, and light summertime trading suspended market direction and exuberance.  As I have written previously, stretched valuations in many sectors only made the declines that much more predictable and, perhaps, less onerous psychologically because they were expected.

It is important to pay attention at this juncture because any news or exogenous event might be a strong catalyst for severe magnitudinal response.  Irrespective of capitalization or geography, global bourses are quite vulnerable to a pullback at these levels, and certainly much less likely to show any significant upside acceleration.

We have witnessed how low interest rates can spur stock purchases, and how a constant flow of mundane economic data has yet to dampen investor's appetite for risk-taking.  However, despite a strong first half, major indices are still susceptible to valuation risk if the slightest hint of economic regression or global conflagration is perceived.  Complacency is simply not an option for portfolio managers at this juncture... and neither is an unabated all-in asset allocation.

No doubt, there are improvements in the data.  But I believe that expansions (recoveries) are typically measured in years, generations even, and not the stuff of 24 hour news-cycle responses.  It is no surprise, then, that market participants seem to be divided into two camps: (1)those with wealth who wish to avoid catastrophic valuation declines and (2)those who seek to maximize short-term opportunity to bank (or make) their fortune while the getting is good...quickly!!

It also divides market metrics into two additional boxes: (1)how much is enough or (2)how fast do you need to "make up" your perceived shortfall?

Unfortunately, the reality of simply surviving today is becoming more expensive and forcing those in box 2, of both subsets, to become more risk oriented.  If you think you're poor, or behind the curve, you are more likely to act aggressively financially to "recover" a status position.

As a result, a large percentage of market trading activity is now subject to a collectively shared volatility imposed upon us by a risk orientation, as opposed to a long-term investment philosophy.  A certain measure of gratuitous greed has accelerated our expectation timeline from "a lifetime of good deeds" to "I want it ...yesterday!!"

Market Commentary for the week of July 14, 2014

Uncomfortable
A bit of nerves struck the market like a lightning bolt last week in response to a reprise of a potential credit and banking crisis in Europe and obviously extended domestic (US) equity valuations.  Yet, while the fundamentals are in place for continued modest expansion in cyclical economic growth, one still has to ask why we feel  so ambiguous about our personal prospects for participating in what the "experts" tell us is a renaissance in financial opportunity?  It seems to me that the most important piece of data we need to consider when evaluating sustainable activity in the market/economy is whether or not citizens feel connected (or not) to the consequences of this cyclical resurgence.  There is no classic definition of what it means to be rich or poor, it's more a matter of our perspective about our place in the world.  Unfortunately, owing to human nature, whether you’re rich or poor, there is always someone who appears better off financially against whom we might compare ourselves.  For that reason, and others, more than a few of you feel perfectly comfortable leaving the Wall Street casino to the speculators and well-heeled traders.

Believe me, there are no personal windfalls emanating out of this market upswing.

Instead, prices for goods and services are rising....yet no serious inflation is indicated by "the data".   Household  savings are down;  wages are stagnant, relative to the increase in jobs' numbers;  and despite an uptick in business capital expenditures, their (business) sole hope is for demand dramatically to increase to support their spending in new equipment, inventories and personnel.

Thus far, the equity markets are doing it with smoke and mirrors, engaging every nuance to make earnings  look like top line revenue growth.  However, most earnings expansion is actually coming from a refusal  to spend money, and an accounting system that impacts positively upon expenses, taxes, and amortization.

The sole engine to equity price expansion, according to my metrics, is an insistently low level of interest rates and a lack of alternative investment options.  If interest rates ever do go up, as the Fed indicated last week they will, the headwind against which the markets will travel could be significant.  This time around, I would caution against being seduced by a seemingly self-sustaining, linear bull recovery that, ultimately, will abate.

Still gambling

The markets are only one barometer of economic prosperity.  It certainly is nice to see portfolio valuations rising.  The lure of chasing after even higher growth possibilities, more aggressive "indexing", is a difficult siren call to try and ignore.  The fact that one's 401-k and retirement plans have gone up in value is good for you, your children, your portfolio manager, and Wall Street.  But it doesn't remediate the problems which still plague the economy, worldwide, in general.

The bottom line: consumers need help in catching up financially, emotionally, and spiritually to a runaway train that looks like it has left them behind.  There exists a powerful disconnect between the hallowed halls of finance and the kitchen table dialogue of most average consumers.

Fewer people of their generation are working at jobs that befit their credentials (education, experience, objectives, etc.) than at any time in the past 40 years.  Wages, as a result, are lower comparatively.  Everyday costs are rising, pushing more young people to the brink of "subsistence" rather than "affluence".  Food is expensive, discretionary spending is non-existent.

Friends I know refute my analysis as "doom-and-gloom",  citing more millionaires, more corporate capital expansion, more mergers and acquisitions, higher portfolio valuations, more home sales.  They are indeed correct with their observations.  The data of the past 5 years shows a remarkable expansion in economic activity.

But the  span and scope of their analysis is shortsighted.  The past five years only represents a rebound from this generation's  worst financial recession, and one of the worst global regressions (in peace, prosperity, business ethics, and economic development) in memory.  Gross returns may be up, but net profitability is being beaten to a pulp.

Dow 17,000 is not just a number or another benchmark.  It is a representation of a major sea-change in economic theory whereby the integers get larger at the same time as the public's confidence and opportunity diverges wider from the events on the ground.

Market Commentary for the week of July 1, 2014

Ice Cube

 

Because the markets continue to make new highs, and have seemingly stabilized around a new normal, investors find themselves with the unenviable dilemma of trying to decide whether the market is about to "melt up", as some have called it, or melt down.  Obviously, the answers are critical not only to your net-worth, but also to your emotional well being, as well.

Granted, there are credentialed scholars and pundits on either side of these issues....that's what makes markets, after all.  But one's intent, on both sides, should be to develop and master a set of rules, a discipline, by which one can improve the probabilities of portfolio success under all market conditions.

No doubt the range of possible scenarios for this market, at this time, is vast.  My approach is to combine traditional fundamental analytics along with proprietary quantitative statistics to arrive at a set of variables which narrow the possibilities, and probabilities, of these factors negatively influencing my outcomes.

Since all investing involves risk, let's start with the thesis that current market valuations are already at magnitudes which defy traditional cyclical gravity.  That is not to suggest that it can't go higher, or that there is something "wrong", or not quite right, with the equity market's recovery.  Instead, we need to apply a wisdom that comes from experience, along with empirical metrics, to identify what signals are being given by the markets, and what restrictions the secular/macro overlay might impose upon them.

It seems that, this time around, some analysts are only focusing upon the "improvements" they see in areas such as housing starts, unemployment, corporate earnings, etc. to justify their scenario that the economy, and therefore the stock market, is, and should be, accelerating.  While I have no specific quarrel with those who espouse that point of view, I would point out that the improvements they cite represent either a return from the depths of the recent recession to levels previously achieved, or an alchemic corporate accounting which creates and encourages large hordes of cash in corporate treasuries, even as the average investor struggles to gain any foothold in his savings levels.

We should also acknowledge that without those average citizens and their discretionary savings/dollars, economic acceleration would come to a screeching halt.  How could it be possible to sustain the stock market's earnings gains without a vibrant and stable consumer base?

My proprietary analytics draw the following macro conclusions:

*Inflation and higher interest rates are definitional components of any economic renaissance, even if temporarily (artificially) suppressed.

*The depletion of natural resources is an ongoing global crisis.

*Earnings and productivity are shifting from West to East, changing the balance of economic and political influence.

*The globe's population, infrastructure, and climate is getting "older".

*Austerity, as a response to previous excesses, is causing economic contraction and hardship for the less affluent.

Markets

With the massive amount of deleveraging that has been taking place globally, I can envision several scenarios which might carry enormous risk for future equity performance.  Bear in mind, though, that absent a suitable alternative, stocks are still the best game in town. While global central banks try their best to keep interest rates down, the influences of their monetary policy are confirming the theory for those who subscribe to the "melt up" philosophy of market inevitability.  "Why not go up?", they ask.  "There are no other options for investing, at present".

These theories, however, are not effectively looking at probabilities, science, or recent history.  They calibrate only one side of the equation: the current "improvement" in economic statistics.  While it is possible for the markets to continue making new highs, advancing in an almost linear fashion, satisfying our obsession with stock performance, it is also highly improbable for it to do so.  Whenever a bull market surges, investors forget that each upcycle also implies a regressive downcycle response.  There are two sides to a parabola.  I will acknowledge that we are in a remarkable secular turnaround, a new bull phase emerging from economic collapse, but those resounding rhythms have become excessive and overvalued in the short-term according to my analysis.

There's nothing wrong with being defensive, awaiting the "next shoe to drop".   As the old parable tells it, better to be prepared with a brick house than to be blown away by a capricious, unexpected wind.  Asset allocation is our brick house.

Economic and demographic realities demand that we focus upon and overweight in emerging markets, telecom, infrastructure, banking, utilities, alternative energy, healthcare/pharmaceuticals, technology, and agriculture.  Demand in these categories is certain to increase in underdeveloped regions and investors need to stay ahead of the curve, not rejoicing for too long in their current success at the risk of being run over by the next cyclical undertow.  The global economy is not yet under such intense pressure that inflation has taken hold, but it is a likely cyclical/secular possibility.  Nor do these data exist in a vacuum.  The moral, societal, and lifestyle needs of the unfortunate amongst us are inexorably interconnected to the aspirations of those who are well-off and in need for very little more.

It's  also important not to conflate the market  with the economy.  While many fortunes are being multiplied, or created for the first time, by the market's five-year recovery, many more people are not quite as fortunate.  Whereas the technology and desire to address many of our social inequities might exist, we have yet to capture completely the attention of the financial and political gurus who wield the power and control the economic resources to do so.  Government and Wall Street might not be the answer to all that ails us, but they certainly shouldn't be part of exacerbating the problems, either.

Strategy

During the halcyon age of consumerism in the 1980's-90's, our collective cultural psyche evolved from our parent's Depression Era mentality to a "Gordon Gekko-like" aggressiveness.  That kind of thinking was sustained, and even encouraged, as long as people had good jobs, the world was not at war, and asset valuations were rising.  Unfortunately, the recent recession wiped out a generation's worth of net worth, as well as the all-consuming enthusiasm we might have had for playing the casino game of "capital appreciation".  The market's collapse took all the wind out of our sails, even as it may have recalibrated the opportunity for wealth building and starting over.  I have seen firsthand that some just prefer not to play in the markets any longer, believing the game is rigged or unfair, serving as a playground only for those who can already afford to take the financial risks.

We are rapidly moving into a bifurcated structure in which some pontificate about, and dabble in, the economy and financial markets, and others whose reality is far from the canyons of Wall Street.  We need to develop a sense of empathy for both points of view, but not to be so consumed by the 24 hour ups and downs of equity trading that we lose a sense of compassion and perspective.  The run-up to the last market crash was gradual, but fueled by excessive speculation.  Leverage, in the form of bigger houses, more margin on securities transactions, increased fees on bank products, indiscriminate consumer borrowing, might have increased valuations, but it also increased the sheer number of "things" that saturated our landscape.

It all seemed so good as long as the pile of "things" continued to appreciate in value.  Once it all started to unwind, the creditors had to be paid. Resale values fell, collateral fell, enthusiasm fell.  In short, the whole thing collapsed upon itself.

Leverage is good if used wisely.  My fear is that those who espouse the never-ending bull theory of this current recovery are only looking at valuation expansion, again, as the barometer of perpetual success.  The public is skeptical that there might not be a second or third economic collapse in the offing within their brief lifetime.  By compromising its integrity to create the bubble, Wall Street is contributing to that sense of uneasiness.  "Melt up" or "melt down" is not the issue; cooking the golden goose and forever ruining opportunity for everyone else is the issue.

 New highs?   Old news.

New paradigm?   Try "old paradigm redux".

 

  

 

Suggested Balanced Asset Allocation, Q3 2014:

Equity 55%/ Fixed Income 25%/ Cash 20%