Market Commentary for the week of October 27, 2014

Utility or discretionary?
It used to be that analysts had a consistent way to evaluate corporate earnings, how they were derived, and how likely it was for those bottom-line dollars to continue to be produced.  Increasingly, however, we have to be careful to distinguish between earnings and earnings.

Things may look the same as before (after all, profits are profits) but the origin of earnings growth today is far from the pattern we would like to see happening as a norm.

A loss of general accounting and ethics uniformity during the past decade or so underscores the fact that companies have fallen into the bad habit of manipulating balance sheets, playing with their product lines, cutting their workforce, and shading their conversations with the media in order to conform to a set of Wall Street-led expectations about what it means to be a profitable corporation and how their share price should be reflected by those expectations.  While it is true, mathematically speaking, that a profit is good for shareholders, I believe that those which derive from alchemy and manipulation, and not an increase in consumer demand, set up a false calculus about the fundamentals of economics and the framework upon which this bull recovery has been built.   The moniker "too big to fail"  no longer applies only to financial institutions.  Tech stocks, traditional household brands, and energy conglomerates are like big battle ships stuck in the water searching for an escape lane. Simply raising prices, or reducing packaging size, is not doing anyone any good when it comes to public relations or economic sustainability.

Opinion polling tells us that business is held in low esteem (along with politicians and banks) which diminishes its prospects for the future, and heightens a distaste for the fortunes of those who run them.  Market activity last week typified this point. There was a wide mix of companies that reported reasonably good earnings whose share price paid the ultimate penalty because shareholders just couldn't see how much longer the largesse might continue.  Earnings acceleration is not always rewarded by share price appreciation.

Tell me, when you open a box of your favorite snack food do you notice that net weight and product portions are shrinking?

Isn’t it annoying, too, when companies raise prices just because they can?  Clearly, we've turned the corner on compassion and restraint.  Discounting and customer incentives are so last year!!

Unnecessary and indiscriminate price increases are harmful to the economy, the consumer, and corporate public relations.  There is always a danger that consumers might "tune out" the message if they feel as if they are being taken advantage of.  In a world where demand  should drive sales and pricing power, business is putting the cart before the horse, focusing more on profits to the exclusion of customer satisfaction.  It is more productive to respond to a broader macro secular evolution slowly than to try to milk performance out of a dry stone for the benefit of financial analysts.

Does money equal loyalty?

Are core costs rising?  Yes they are.  And yet, this anecdotal information is contrary to what published statistics are telling us about inflation.  Certainly, statistics can't always be believed nor are they applied unvaryingly across the board for all cases.  But if, in fact, there is no/low inflation, how do you account for an increase in airfares, or tuition, or movie tickets, or hamburgers, or bridge tolls, or new clothing, or that "shrinking bag" of potato chips?  You get the point.

Instead of holding fast on prices as they did during the recession, many companies are forecasting an increase for the next year.  While no one begrudges the right for business to make money, they sometimes pander to the need for Wall Street to make money off of them.

At a time when competition for consumer's dollars is increasingly ferocious, sales growth could be reaching an exhaustion point.  Manufacturers last week reported slower growth for the quarter, while new orders are stagnating from the weight of world tensions.  It just might be that we are reaching a temporary apex in the recovery.  The best way to bridge the gap from recession to global boom is to be mindful of political, social, and moral necessities for all market constituents.  Even corporate presidents need to avoid the appearance of greed and hoarding, or risk the wrath of disgruntled consumers.

The thought that they are driving customers into the arms of a competitive vendor would be abhorrent to any executive.  However, walking on "thin Ice" is not a successful business strategy, either.

Market Commentary for the week of October 20, 2014

Betting  it  all on black
The market's near-term sell-off and subsequent volatility are obviously indicative of the precariousness of buying/selling stocks in a world economy that is burdened with so many fundamental variables.  We came out of last week confirming an underlying suspicion about the strength of various global geographic regions and an overall skepticism about the exuberance of stock performance of the last 12 months.  We did, however, hold certain support levels which confirm the existence of a bottom-left/top-right configuration in equity markets.

It should come as no surprise, though, that a struggle is still being waged between near-term  versus longer-term  expectations, and just what might happen to capital spending and consumer wealth as a result of each time frame.

In fact, corporate profit growth has been accelerating, even as employee wages have remained stagnant.  So, depending upon your point of view, either stocks should have deservedly been advancing.....or stocks were building equity for their shareholders upon the backs of those with less bargaining power.  This argument embellishes upon the debate between the "haves" and the "have-nots" by exacerbating the psychological rift between old fashioned economics and modern civics.  In any other time, the debate itself would be marginalized by the hyper-success of stock valuations rising for the past five years.  But because it was the corporate and institutional financial difficulties of the last decade that led to the economic depression of many, even "good" isn't "good enough".

Thus, our portfolio asset allocation had assumed a more defensive posture towards stocks for quite some time.  It isn't that the numbers weren't to be believed.  It's simply that the numbers reflected a reality that wasn't shared top-to-bottom by all of its constituents.  Financial leadership should, in reality, raise all the ships in the harbor.

But the fact is that we don't deal in an altruistic world.  My modeling is built upon objective data, cognizant of its effects upon a subjective universe.  Right now, published economic data is as positive as it's been in quite some time, having slowly built momentum from the depths of the recession.  That gradual improvement has led to a climb in equity prices and trendline acceleration.  While the rally has been punctuated by several remarkable upsurges, it is the ability of stock markets to hold support in the face of ambiguous global fundamentals that impresses us the most at this juncture.  As you are aware from my writings, quantitative science presents us with an "inverse relationship" to probabilities.  The higher the market goes, as it did in July of this year, the greater the probability that it might succumb to negative influences.  On the other hand, as the markets fall, the cyclical probability of an upside response increases.  Difficult to understand?  Not really.  You can't fill a glass fuller than "full", and you can't empty it more than "empty".  Somewhere in between exists the laws of physics and momentum.  As we "empty" valuation in the market today, we heighten the odds of an influx of buying power later on.

The market built up to a crescendo, held ground, fell hard last week, tenuously held once again, emphasizing that there is sufficient cash on the sidelines looking to sweep in and buy long term expectations at discounted prices.

My data indicates support in the averages within a tolerable 6-8% range from here.  In the long run, the downside probabilities are starting to look less menacing.

Firing on all cylinders

Oftentimes, the markets move in variance to the news.  This observer believes the markets exuberantly moved up during the past few years in contrast to what was commonly believed about the economy.  Curiously, as a positive consensus is forming about an economic recovery, we had the market reacting in contradiction to that premise.  Even with a possible fourth quarter swoon, the data now suggests nominal risk which we believe might become more palatable by the beginning of 2015.  Bear in mind that any corrosive exogenous events (war/terror/politics) might change the nature of our forecasts, or the patience of investors to bear the heavy load.  But, as has already occurred, any significant downside capitulation most likely will be met by aggressive buying.

The United States is fast approaching an election season.  Winners and losers are more than just political candidates.  The markets are highly synchronized with political persuasion, which can affect sector leadership and trend velocity in the coming months.

If you are worried about protecting your near-term valuation gains, sell into the rallies, or give up investing altogether.  If, on the other hand, your horizon extends well beyond the next three months, I believe the risks will lessen as the reward potential increases.

Market Commentary for the week of October 13, 2014

Data undressed
Score this round for the negativists.

As investors lick their wounds over some heavy volatility and precipitous price declines last week, reports on economic data and fundamental market analytics also regressed just enough to take a little steam out of the bull rally.  We witnessed some serious earnings disappointments, there is still terrorism in the Mid East, a regional outbreak of the ebola virus shook the global medical community, European growth prospects suddenly turned sour, and domestic housing starts slowed.  There is obviously enough concern built-in to equity price advances that negative news, or even inferences  about negative news, can disrupt momentum, confidence, and valuations.

And there is more to go around.  Is the real estate/housing boom sustainable?  Can we build earnings growth across the board in a low wage environment?  Is energy really  in plentiful supply as the experts tell us...enough so that prices for this depleting natural resource should regress to levels of five years ago?  Will the Fed ever get around to releasing interest rates?

 And who is watching suppressed inflation data on food and discretionary spending costs?

I believe the build-up in pricing pressure for agriculture, energy, healthcare, and housing is much underestimated in the current data, and will become an economic sticking point, particularly if employment data continue to do better but wages are not commensurately rising.

In that vein, all sectors in recent weeks have been impacted by a rush out the door of investment capital.  While it is generally accepted that the cyclicals and industrials are more immediately affected by nuance in the short-term, even the most strongly performing sectors (non-cyclicals, utilities) witnessed capital losses in the past few weeks.

Hold the fort

An interesting confusion will arise for equity investors if/when interest rates do  begin to rise.  Whether or not to retreat from hard-won gains and to redeploy wealth into more secure/less volatile instruments is a difficult reality to confront.  One cannot, of course, try to "time" the market, but we know intuitively what's coming.  The question is whether the stock markets not only do now,  but will in the future, offer an appealing blend of capital gains exposure along with balanced risk aversion.  I believe the fourth quarter will offer a glimpse into how that question will be answered.  Thus far, it appears that investor's appetite for risk exposure is waning, as more money seems to coming out of stock funds than going in.  Last week was a kaleidoscope of emotions, cash flow, capital gains and losses, and portfolio angst.

More likely is that we are witnessing the origins of a new cycle calibration, one in which sector rebalancing and portfolio allocation takes on a more conservative bias.  Our asset allocation models are becoming more skewed towards resetting the stronger/fewer earnings performers against a backdrop of disappointing expectations.  Besides, two weeks doesn't make a trend.  There is still the completion of this right half of the parabola to experience.  Traders call this "backing and filling"; clients call it a "slow water torture".

Is there really any relevance to this capitulation?   That answer depends upon your preparedness.  We knew it was coming....just not when.  One should have already positioned for its eventual occurrence.  A careful re-read of my previous missives will show that I have been describing this distribution pattern for several months, but by no means is this a repeat of 2008.  We are still solidly in a bull expansion, both for stocks and the economy-at-large.  The problem is that everyone is impatient for something extraordinary to happen, that magic moment, even though the markets are travelling at their own pace.

 Pullbacks make great drama, but it takes a more sustained period of time to wreck a secular uptrend.  That kind of full-bore erosion is not happening now, despite the fact that pullbacks are so darned frightful, so we suggest to clients that they refrain from the hourly log-in price checks, the daily market stock quotes, and monthly statement perusals, and rely on the fact that money generally follows the longer term trend. 

In which case, the longer term uptrend is still intact.

Market Commentary for the week of October 1, 2014

Altitudinal Indigestion

As the US markets made multiple consecutive new highs last quarter, less overhead resistance meant greater unlimited upside potential, even as the "air supply" became less plentiful.  But untapped potential also raises concerns about whether economic  fundamentals are really strong enough to keep stock rallies going.  To do so, there needs to be a clearer picture about what default options are available to investors if equities' prices continue to rise, or if events on the ground dictate a contraction.  Despite staggering to a jittery ending in the past few weeks, benchmarks are indicating that the markets have a bias to continue rising.

Depending upon one's tolerance for volatility, financial indices are either recovering their true potential, or leaning towards excessive valuation.  Thus far, the relationship between corporate profits, consumer spending, lower interest rates and GDP has shown a remarkable equilibrium, even in the face of variables which have the capacity to destabilize them.

While being held psychological hostage to exogenous current events (terrorism, Mid East tension, airstrikes in Syria and Iraq), investor's commitment to financial instruments is actually picking up steam.  The classic  pull between speculators and fundamentalists is  tilting towards staccato trading, which helps further the debate about whether the current sequence of new highs is reality-based or merely a fiction of grandiose proportion.  Nevertheless, one cannot argue that this year's portfolio appreciation has been good for the psyche.

The only difficulty I see with these patterns is that the sector weightings of today's portfolio bull are narrowly defined , and that the breadth of participation is likely to stay quite shallow in the next few quarters.  In fact, if economic recovery were to become more inclusive, those most likely to do well would be cost-push sensitive companies (commodities, non-cyclicals) and harbingers of inflation, the one stealth tax we all wish to avoid.

Ultimately, we surmise one of two things will happen, neither of which is promising for the high-wire gamblers out there.  Either the market accepts that "fundamentals matter less"  and continues to push forward,  or the economy actually does  improve beyond current constraints so much so that interest rates start to rise leading to the onset of higher prices for goods and services. 

At present, my models favor the "improving economy" scenario, and a likelihood of higher interest rates, higher economic output, and (modestly) higher equity prices.  One shouldn't find it strange, though, that this "good news" overlay might be  negative for stock performance in the short term as we grow accustomed to a new normal in pocket-book economics:  a strengthening in employment, wages, and, of course, prices.  Additionally, I would expect sector allocation in portfolios to migrate towards tangible assets and industrials in that scenario.  We might also be mindful that a rise in interest rates sets up an alternative investment scenario away from stocks and into bonds, a balance which I think investors would welcome.

The one thing we must be careful about in this "good news" panorama is how rising prices might impact upon corporate profitability.  Those businesses which rely upon customer foot traffic could be vulnerable to a slowdown in discretionary spending if consumers decide to "bank" their new-found largesse.  The ability to pass-along core costs to the end-user is vital if corporations are to maintain profitability and sustainability.  When the demand pipeline contracts, business loses its most valuable means of generating profits and share price appreciation.

One reason why I might expect investment banking activity to increase in the next few quarters is that it is cheaper to acquire profits than to build them from scratch.

Markets

Equity prices are trading at P/E  levels well above historical norms as a result of the five year run we've been on.  Thus, most benchmarks look too expensive to this observer.  Fair market value would look more balanced at 13-15 times forward earnings projections.  In light of current earnings and price acceleration rates during 2014, it is dangerous to project too far out with so many variables as yet unanswered.  Do we consider double-digit equity returns to be logical for 2015?  Might earnings actually catch up to share price expansion?  And what if equities recede in the face of slower consumer demand, profit taking, higher interest rates, or some unknown global conflagration?  My work is indicating not more than historical rates of equity price appreciation for next year (6%), as the fourth quarter of this year becomes a staging area for necessary changes and rebalancing of portfolios.

We also have to consider the impact of psychological reticence even to bother with the stock market on the part of some investors,  having been burned at least twice already in the last 15 years (dot.com, credit crisis).  The impact of having a "dual" emotional connection to the financial markets (in or out) cannot be overstated.  Out of fear, confusion, or desperation, some have even expressed that they now prefer a return of  their assets, more than they are seeking  a return on  their assets!!

There is no doubt in my mind that the Fed will eventually abandon its bias to keep the cost of money low.  Global macro factors are too strong for the markets to be manipulated into an artificial condition of euphoria, even as we hold on to cash with a vice grip.  The influence of austerity programs and governors of money supply is beginning to wane.  In fact, I would argue that the policy combination of austerity and lowering interest rates has created a schizophrenic confusion within the financial markets at a time when absolute clarity was needed.  I have written repeatedly (and sarcastically) that "you can lead a horse to water, but you can't make him spend".  The Fed has diminished the capacity for recovery in the short term, I believe, by creating a population bifurcation as it relates to the allocation of spending and savings: those who have the resources are  spending, those who do not cannot.

Additionally, corporate expenditures have been subdued during the market's recovery.  Unless business can see a scenario in which they are rewarded for taking on new costs, they will be hesitant to do so.  As with all market barometers, these things are variable, cyclical, and unpredictable.  The one constant amongst all principles of business endeavors, however, is that demand drives revenue growth, which in turn drives asset expansion potential.

The financial markets are not entirely to blame for the volatility they sometimes exhibit.  Investors, themselves, manifest certain characteristics that lead to their emotional ambiguity.  Without  having a strict discipline, most people succumb to greed and emotionalism when it comes to portfolio structuring.  Just like "keeping up with the Jones'" , many follow the herd, jumping in too late and too enthusiastically.  Rather than subscribing to a prudent methodology, some buy in when the market confirms  momentum, and sell out when the indices retreat.   Greed guides them in, fear takes them out.  This is exactly the opposite of how opportunity should be uncovered.  We cannot forecast precisely when risk will occur.  We know only that risk is always a part of the investment equation.  Therefore when things are at their worst, opportunity for upside performance is usually at its greatest.  Conversely, with the averages trading at these levels today, it is incumbent upon us to play the trend but to prepare also for a potential reckoning.  That's just the nature of the beast, and what we saw in the past few days of trading activity.

Conclusions

The strongest performers for the first three quarters of the year are not likely to be the strongest performers into the balance of the year.  As mentioned, valuations and momentum are simply too high to be able to count on a continuation of price performance without some kind of pause or profit taking such as occurred at the end of last quarter.  However, the obvious place to look for performance and balance within one's sector allocation going forward is in those sectors, regions, and capitalizations which have not yet manifested full pricing potential, such as Basic Materials, Biotech, Energy (alternative sources, in particular), and Financials.  The cyclicals  should lag, until the consumer jumps in convincingly.  

The secular demographic themes that I believe will lead to near and long-term portfolio opportunity are in infrastructure development, agriculture, healthcare and life sciences, military/defense, ecology, and energy.  For example, my quantitative work confirms an increase in industrial activity globally, with commensurate demand for commodities and currency.  The valuation potential of these sectors when measured against current levels is compelling.  Ancillary businesses which could benefit from these demand shifts include internet, transportation, and real estate.  Earnings acceleration always drives valuation expansion.  We simply need consumers to step up to the plate with their money and spend convincingly, as we need business to demonstrate a commitment to capital expenditures without hesitation.

It would be foolish to say that we are at a critical inflection point in the markets right now, because in the world of parabolic sciences there really are no points, just periods  of accumulation or distribution.  Indeed, we are at levels sufficient to suggest it is appropriate for a distribution (downtrend) in equity valuations to occur, but given no empirical evidence to the contrary, I would prefer simply to abide the uptrend, and to be smart about balancing risk and current allocations.  In other words, the fourth quarter should be a parallel to what has already occurred this year.

 

 

Suggested balanced account asset allocation, Q4, 2014:

Equity:                65%

Fixed Income:  10%
Cash:                  25%