Market Commentary for the week of September 22, 2014

The conclusions of the Federal Reserve Board's meeting last week remained virtually unchanged from their previous bias, setting off a knee-jerk chain reaction in the stock market, pushing yet again to new highs in the Dow.  As expected, the governors chose to acknowledge improvement in the economy but do nothing in the short-term about the direction of interest rates or the cost of money.  Their rationale made sense, at least to them and certain market traders, not to impose too big a change or burden upon borrowing costs within the capital markets.  The "sameness" is boring even if the resulting market effects are anything but.

So, money is still inexpensive to borrow, but seemingly hard to come by from stingy and twice-bitten banks.

However, the operative details of the Fed's lack of initiative were to confirm to the outside observer that their biggest fear is snuffing out a recovery by taking early or preemptive action.  As evidenced by all the "QE's" of the previous few years, they still maintain a healthy appetite for growth and stimulating the flow of money.  We know that this becomes a double-edged sword, and no Board member wishes to impale himself upon it.

Intuitively, though, we know that low interest rates are not likely to persist indefinitely.  Prosperity is abundant for those who have or have access to capital.  Conversely, census data now tells us that the gap between those with and without capital is widening, so most of "the rest of us" are tightening our belts, spending less and trying to save more.  For those people their reward is pittance.

This reality is reflected now in next year's corporate earnings projections.  The market offers a better valuation to those companies that reflect higher customer demand and cost pressure.  Those unfortunately at the other end of the consumer spectrum...poor demand....are seeing their share prices stagnate or tumble.

Remember, the stock market and the economy are not lock-step cousins.  While some data either enhances or debilitates share valuation, in the end all companies need clients, innovation, and sales revenue.

To that extent, the markets could be susceptible to more of a pause than the broader economy.  My job is to play off of those imperfect correlations to maximize earnings progression and portfolio capital gains potential.  The wrong question to ask is "which stock(s) will do well?"  The proper question, in my view, is "in what proportion and what balance will sector allocation complement the potential for overall portfolio appreciation?"

Regress or progress?

The fundamental story of 2014 has been a "repudiation" of traditional fundamental (long-term) analysis in exchange for the continuation of a robust speculator's-driven bull market.  It looks more and more as if the traders  are winning while the investors  lag behind.  Nonetheless, I prefer a house of stone to a house of straw, anytime.  Continuing to follow a (true) earnings trail and creating the proper balance of risk is my mandate from clients.

One of the great fallacies of "chasing"  the Dow Jones is that no one knows when the end will occur.  It is impossible to "time" the peaks and valleys of portfolio performance.  It is far better to plan for the unexpected but hope for the best.  Phases ebb and flow, and history has shown  us that managing draw-down is a far more efficient predictor of portfolio success than trying to recover from cataclysmic disaster.  Rather than waiting for events to unfold, it is better, I believe, to balance sector weightings and long-term demographics to optimize portfolio alpha.

Despite my short-term misgivings, the landscape is awash with intuitive opportunity in alternative energy, biotech, agriculture, infrastructure, telecommunications, and technology.  That's a handful enough for any prudent investor.

Market Commentary for the week of September 15, 2014

Transition

I've been writing for quite some time that the stock markets are being propelled by a lack of suitable alternatives in fixed income, more so than by simple fundamentals alone.  As we discussed last week, the more "good news" we hear about the economy (housing starts, earnings, employment data), the greater the risk that "bad things" (price erosion, momentum dissipation) might happen to financial markets.  For sure, the fear that the Fed might abruptly reverse course and start to tighten money rates had a major impact upon stock trading last week.

While no one wants to see another recession, neither do we welcome the thought of a major downside capitulation in market valuation.  And if the market continues on a pattern of uninterrupted new highs, the latter is likely to occur.  Quite simply, valuation expansion is nearing a point of exhaustion.

Gauging the strength and sustainability of the economic recovery is, after all, at the heart of each investor's monetary gamble.

Is all the short-term posturing really of any significance?  To be honest, no.  It is the stuff of interesting conversation by television "talking heads", and too often the focus of traders and speculators.  It is far more important to recognize that interest rate trends will  redirect upwards, equity performance will  ultimately revert to historical norms, and long term demographics demand  allocation into:  aging infrastructure; healthcare for citizens (biotech, pharmaceuticals, life sciences); depleting energy and natural resources; technology; and civil defense.  In the end, objective intelligence and intuition will own the lion's share of future capital gains opportunity.

Response

A concern about inflation is nothing new.  The previous five years' unbridled digestion of equities as a surrogate for just about any other investment is as much a psychological compulsion as a fundamental one.  As economic data improves, it would only be logical for "price creep" to manifest as well.  Inflation is a secular/generational phenomenon.  While we may find it difficult to quantify at its inception, we obviously know it when it happens.  And once its roots take hold, it spreads into the market in more prolific ways, such as higher energy costs, food costs, wage spikes, and other cost-of-living data. 

Whatever the talking points might be, the permanence of the trend could last for years.

The legacy of inflation further permeates into corporate profitability and, thus, market sustainability.  In that scenario,  unless top line demand were to expand, commensurate with or in excess of cost pressures, the global equity markets would be held hostage by a consumer that is "stuck in neutral" and lacking confidence.

When looking to create above average portfolio alpha with diminished volatility it is imperative to build asset allocation models that limit concentrated risk positions and which correlate earnings acceleration patterns with long-term price performance.

Whereas the first three quarters of this year have been more than sufficient for our investment objectives, they are prototypically way above average in expanding risk tolerance levels.  Prices versus earnings are too expensive, as measured by RSI (relative strength) valuations.  It would be difficult to propose an "all-in" strategy at this juncture as we enter the final quarter of the year.

As alluded to earlier, it is highly more likely that the S&P begins a "distribution" phase as a result of price fatigue than it begins a new period of accumulation and price mark-up.  This is not to suggest a new bear, simply the beginning of a cycle reboot.

That having been said, it appears as if fundamentals don't really matter...just our perception of them!! 

Full steam ahead.  Keep your powder dry.

Market Commentary for the week of September 8, 2014

Vertigo
In the strangely perverse world of quantitative statistics, "what's up"  is usually bad news for equities, while "what's down"  has the potential for tremendous rebound.  In principle, here "at the  top",  a security that has maximized its turnaround from a dramatic fall in valuation likely should experience difficulty sustaining its momentum because relative strength is a finite integer.

The presumption that the root causes of the 2008 capitulation have been forgotten, and that the prescription for capital gains is amnesia, may be the legacy of this bull recovery.

As the US economy continues its resurrection, the commonly shared belief is that any peripheral or exogenous noise is simply a distraction, not a deterrent, to markets climbing even higher.  Thus, equity valuations are continuing higher, seemingly oblivious to "minor" corrective data.  The first 8 months of this year have not been the same juggernaut as last year, but the incremental gains are founded upon the same principle: share buybacks, low interest rates, expanding productivity, and boatloads of cash sitting on the sidelines.

Underwhelming consumer participation is the drop-anchor that keeps this ship from sailing out more aggressively.

Despite federal and corporate austerity attempts and large stimulus programs, the prospect of unleashing the savings stashes of many savers seems highly unlikely.  As the Fed said last week, money is being "hoarded" at record levels and nothing seems able to pry the cash loose.

Markets are following the lead of interest rates and politics.  Low interest rates are a blessing for investors, but still reflective of the need to maintain huge incentives for corporate and personal borrowing in order to propel the economy forward.  Thankfully, with a few exceptions, not many are taking the bait.  Here again, in that "inverse world" of statistical probabilities, if the economy really were to heat up, interest rates would have to go up to stave off inflation and prolific borrowing.....and stocks would likely stall their unparalleled surge.

So, we're doing alright today, but stuck in an "accelerating neutral", waiting for something else to happen that might (negatively) influence market performance.

All aboard?

Ultimately, every cycle has its ebb and flow.  It should not come as a surprise if there were to be a "right side"  to this "left-sided"  parabola.  Markets just don't die off without warning, but the warnings are usually after-thoughts, post-mortems, for the overly rambunctious.

I currently don't see any catalyst for a "right side effect" just yet, but geopolitics certainly has the power to influence those data.  Rampaging conflicts across the Middle East and Eastern Europe have already impacted upon energy and commercial prices in that region, and obviously might spill over with deeper ramifications elsewhere in the world.  However, my readings on sentiment  and consumer enthusiasm  reveal an extraordinary paradox: although the desire for capital gains and portfolio recovery is strong, there is a much greater aversion away from  the specter of portfolio losses and catastrophic news events.  Thus, market activity has a kind-of "gunslinger" look, with short strokes of capital commitment, and even quicker triggers on the way out.  This is a far cry from traditional buy-and-hold fundamental investing.

It's a good idea always to manage one's asset allocation with one eye on the trend, and the other on the anti-trend.  This means having the discipline not to follow a benchmark indiscriminately, but to identify the ingredients that might curtail the benchmark's advance.  Too cautious?  Remember the market's angst following the dot.com craze and collapse, or the most recent housing bubble?

We have had success this year with a more modest allocation into Utilities, both as a surrogate for yield and as a capital gains provider, as well as Technology, Consumer Non-Cyclicals, and Basic Materials.  We have also been pioneers in quantitative research in longer -term demographic themes such as agriculture, biosciences, and alternative energy.

In my world, if you see the markets advance unabated, you see the return of risk accompanying your largesse.