Market Commentary for the week of January 26, 2015

Revolution
To many outside observers the fabric of the European Union is fraying at the edges, if not culturally then certainly economically.  The concept of "one Europe" is coming under intense pressure from within.  It is more clear than ever before that wealth, resources and abundance in one country or region is not necessarily wealth, resources and abundance for all.  This disparity of riches is putting enormous stresses upon the currency and the patience of those who have the responsibility to do something about it.  Last week's announcement in which the Union plans to try "spending" its way out of stagnant growth elicited both skepticism and hope about whether or not a corner might have been turned in monetary policy for the region.  

While Europe digests the diverse strengths and weaknesses of its member states, the US is becoming (if it wasn't already) a "go to" alternative for serious investment capital from abroad.  The one cloud hanging over both continental models, however, is the potential impact upon the markets of a fossil fuel price decline.  This variable has economic, philosophical, regional, social and psychological significance of historic proportions.  While we're waiting for the effects of a "consumer tax cut” to flow into the economy, it hasn't played out that way just yet.

Throw into this mix the fact that the S&P and Dow Jones Industrial Average are still trading at rarified multiples, and one might begin to have concerns about whether consumer sentiment (measured at better levels from a year ago) can actually sustain purchasing and economic recovery.  The markets are at phases that inspire more fear and trepidation than commitment to go "all in".  It looks to this observer that terrorism and geopolitics occupy a greater importance in the mindset of most investors than does profit-making and portfolio allocation, thus putting the brakes on "new cycle highs” and double digit performance expectations.

As with all investment endeavors, the probability of capital gains rests as much with fundamentals  as with a stability and consistency  of market factors.  The more unpredictable and inconsistent the playing field, the greater the cost for the end result.  Fear and terror might be emotions dealt with on battle fields, but they create overwhelming inertia for the financial markets.

Go big

Geopolitical uncertainty combined with the advanced "age" of the markets' rally are aggregating to create enormous confusion and intraday volatility, resulting in percentage daily swings that expose long-standing psychological wounds.  No one wants to be caught in another dot.com- style capitulation.  It's disturbing that many were swept down yet again by the next crisis after that, in housing and credit.  Now, many are petrified that we are on the brink of an energy crisis, or, at the very least, a regional hotspot event which might permeate into Western economies.   

As a result, portfolio creation is becoming an inexact science and starting to look more like an exercise in stock picking rather than asset allocation modeling and fundamental analysis.  Client's selectivity is becoming more acute, as is their focus upon monthly and weekly "net returns".  Investing is, and should always be, about the allocation of financial resources to those assets which provide the highest probability of long-term growth and moral/social contribution to the society at large.  Is that what you see happening currently at the close of each market session?  I think not.

But the reality to be drawn from all this confusion is that there is tremendous reward to be derived from finding that needle in the haystack.  Important demographic shifts are taking place right now in medicine, energy, farming, waste management and technology.  Individual stocks, as well as sectors, traverse a broad secular (generational) pattern of cycles, sometimes as leaders, sometimes lagging.  The quantification of those cycle movements is the nuance that allows us to build positions from inflection point gatherings irrespective of capitalization, geography, or asset class.

With relative strength integers (RSI) now trading at exceedingly high valuations, the balance of this year should be a process of redistributing sector weightings according to leadership.  If the first few weeks of the year are any indication, expect accelerating momentum in biosciences and non-cyclicals, while (traditional) energy and basic materials might recede slightly.

Placing all of our focus upon short term posturing is just fruitless conjecture and hypothesis.  By working from the "bottom up" and minimizing the width of one's analysis, it becomes too simplistic, and potentially too dangerous, to create a well balanced portfolio.  Instead, try focusing upon those major demographic shifts to which I alluded in an earlier paragraph.  They are the signposts and benchmarks that should guide the probability of the market's next capital gains expansion.    

Market Commentary for the week of January 20, 2015

Shock and awe
We remain hopeful about equities in 2015, but remind readers that the linearity of the market's upside trajectory in recent months was susceptible to a similar linear (straight line) downside response, as occurred last week.  In fact, all the way up the ladder of capital gains during the past two years we had been exceedingly careful about jumping in with the herd mentality because relative strength integers were bumping up against and testing the boundaries of probabilities and potential.  Sure enough, the wave of panic which overtook the markets last week was one part fundamental excess, two parts psychological panic.

Discipline (the investment kind) can help to make sense out of these issues that are both complex and simple at the same time.  Obviously, the "simple" answer to our most recent avalanche is that sellers (profit takers, traders, and the anxious) became overwhelmed by the decline in energy and commodity prices, and the ubiquitous news coverage, and decided to cash in temporarily from the mini-boom that had been so good to them for months.  With indices approaching "saturation levels", technical deterioration was inevitable.  Thus, more sellers than buyers.

But as you know, that answer is far too simplistic when trying to weave together a combination of fundamental, technical, and psychological components that make up the markets.  Even if only one of those elements "caused" the panic selling, the accompanying constituent factors would be too diverse to be causal, alone.  What we know, now, is that earnings need to be revised downwards, and that sectors like banking, energy, and industrials might fall victim to a global slowdown in demand, if not uncertainty which seems to pervade the collective mindset of most traders.  Restricting our analytical focus to energy alone is not the answer, either.  We inhabit a complex "blue marble", and we need to be stewards of all things, big and small, to ensure that our planet's journey is bountiful for everyone.

Energy, food, and water

Besides, the energy price decline did not appear out of thin air, nor did it just materialize in the past week.  Indeed, the seeds of commodity price reversions had been gestating for several years.  As the global economy built traction while it climbed out of this generation's Great Recession, increasing demand for fuel and metals led to a rapid buildup in excess supply.  The integration of world financial markets, along with a globalization of commerce, produced the largest surplus of raw materials in a generation, trying to stay ahead of Western and emerging markets' demand for wood, metals and oil.  Producing nations competed ruthlessly for market share and market dominance.  Prices surged, and the advantage shifted to the owners of the commodities.

Thus, the price crisis today is born out of an insatiable appetite for fuel and materials that became overblown, and vulnerable to cyclical events and world politics.  Replacement reserves are so much more efficient today because of technology and the advent of alternative solutions.  In fact, alternative science such as wind, hydro, solar and geothermal now presents us with a unique, and historical, opportunity to create profits from sustainable and replenishing sources.  The same creative science should be applied to mankind's other pressing needs, including food and water.  Remember, the planet's resources are finite.  How we deploy them speaks volumes about who we are and in what condition we chose to leave this globe to our heirs.  The public has lost its appetite for oligarchs and current events to rule our access to life-sustaining supplies.

Under the current scenario, any scientists, engineers, industrialists, or capital sources that can figure out how to provide a dependable flow of social, economic, and moral resources, gains the upper hand in building political good will as well as financial profit for their stakeholders.

The horrific experience of the past few trading sessions nearly has eviscerated all the hope gained during the market's previous two year rally, and is a major reason we need to keep our head about us while ignoring a 24 hour news cycle and the pundits that offer quick fix answers to long-term portfolio management problems.  It's true that we have an earnings problem in the markets: the expansion of prices in the stock market is simply not able to support what is likely to be a reduction in the acceleration rate of earnings going forward.  That having been said,     I believe, in fact, that there is an ever widening corridor of opportunity in the equities markets, if we can just manage to navigate through the volatility and flotsam that causes near-term psychological distress.  Focus your resources on early stage research in biopharmaceutical sciences, agricultural breakthroughs, infrastructure development, and innovations in technology.  It requires a bit of work and study, yes, but that's why I'm here to do the heavy lifting.

The relevant numbers are found in the trendlines and the relative strength integers.  The former are improving; the latter are overbought.

Market Commentary for the week of January 12, 2015

Seriously?
It only took a few days...nay, hours...before the market's narrative quickly changed from "new year, new expectations, jobs growth, global economic expansion"  to "geo-financial stagnation, earnings regression, economic recession",  all driven by confusion and consternation about declining energy (fuel) prices and its impact upon commercial growth.

Despite what might ultimately prove to be an optimal outcome for the world's economy because of  cheaper energy costs, the markets became fixated last week upon the disruptive effects of lost profitability in the energy sector (and related geographies) and macro price deflation of the globe's most heavily traded commodity.

At the very least, reasonable perspective was severely clouded by the price slide, even though the longer term impact upon consumption and research into alternative sourcing will probably be a blessing in disguise.

Rather than rejoicing in the new year and looking ahead 18 months, jittery investors were looking back one quarter to the precipitous declines of this past October...and repeating the same effects in the process.

Despite the fact that most analysts predict a relatively consistent performance for equities in 2015, we nevertheless start out with one foot "stuck in cement", with a 3 percent decline in valuations right out of the box.  A catastrophic decline in consumer confidence this early in the year places in jeopardy the Fed's likelihood of letting interest rates float, a warning sign for disruption in the orderly flow of unwinding years of austerity packages and monetary manipulation.  With our euphoric perceptions in the rear view mirror, and danger signs in front of us, one feels surrounded on the left, surrounded on the right, and no Gunga Din to bail us out anywhere in sight.

But the recent volatility in stocks, although troublesome to the uninitiated, is not without its benefits and advantages.

Stay the course

Let's begin by acknowledging that investing is not the same as burying money in a tin can in the backyard, nor is it even the equivalent of putting cash in a bank savings account.  It's investing,  for goodness  sakes, with all the incumbent implications of risk, volatility, and potential reward that investors seek.

The early collapse of equity valuations last week (and preceded earlier in October last) allows the market to create and traverse a cycle pattern of measurable duration and magnitude, unlike the near-linear, and highly unrealistic, pattern of its straight line advance most recently.

In effect, equities recalibrate around nominal "zed-lines", a quotient that levels the playing field of quantification for stocks and which, in effect, re-boots the cycle phase phenomenon.

For stocks to push forward, they must be "pushed back" as well.  The decline in energy prices, for example, while unfortunate for energy producers, creates a redistribution of wealth, by sector and by geography, that normalizes the flow of capital in a Darwinian-like economic recovery.

The end result of this dislocation may not look like a traditional landscape as we want it, but perhaps it creates a more realistic tapestry of opportunity by bringing traditional research and fundamentals back into play.  This is an excellent time for creative solutions, in alternative energy as well as agriculture and biosciences, to flourish.

Stocks are still the most prudent investment vehicle for clients seeking capital gains in their portfolios.  There is no doubt that we are in a post-recession recovery, labor markets are improving (as evidenced by Friday's report), and businesses have slowly begun increasing their capital outlays.  I believe the market bourses have turned a corner, even if a bit overextended presently.  Interestingly, whether you are a value seeker, growth investor, or low risk/balanced investor, we are at an inflection point amongst a variety of sectors, geographies, and capitalizations that makes for a unique blend of potential, a point we made in our recent Q1 report.

Market Commentary for the week of January 1, 2015

Power Shift

When 2014 began, few thought that the markets had the ability or the urgency to achieve yet another year of record high valuations.  Overall, however, most investors would agree that their expectations have been more than fully realized.  My research sees stronger fundamental underpinnings for market performance, even acknowledging any potential economic risks on the horizon.  This generation's "Great Recession" has slowly become a financial rebound of historical proportions.  Never mind that the "net return" on equities during the past six years has been less than five percent...peak to peak...clients are jumping in full bore, or so it seems.

So what could possibly be the problem? 

Two things stand out immediately.  First, the percentage of persons who actually own stocks has dropped precipitously over the past decade.  Burned by crises in dot.com and the housing/credit markets, investors are loathe to play the game.  In effect, the greed and recklessness of Wall Street has single-handedly managed to alienate a large percentage of its current and potential constituents, such that many would rather leave altogether than try to compete with computers, traders, or worse, crooks.

Secondly, geopolitical unrest and domestic political inertia have depressed investor's psyche and flow of capital sufficient to shut off a major source of innovation and ideas that once galvanized great societies to create scientific wonders, brick and mortar infrastructure, social institutions, and moral goodness.

All is not lost, however.  We simply need to re-boot political and social willpower to create a fair and equitable playing field for commerce.  A classic imbalance between "what is"  and "what it should be"  is tilting the landscape towards inertia, in spite of the fact that the stock market is making record highs.  If we are to believe the widely held theory of "trickle down" economics, then those who benefit most from the market's largesse must step up their activities in and contributions towards education, energy, economics, ethics, and charity.  One should not be surprised to hear that, for the disaffected, they feel the tail is wagging them!!  Look, no one begrudges the markets doing well.  But if we look back on the previous two years (post recession) and realize that all we did was to widen the gap between the affluent and the poor, and then the market's recovery might have been for naught.  For too long , we have equated the success of the financial bourses and our own economic well-being with how many things we acquire, a limitless demand for disposable consumption.

Markets

The flight away from  consumption might be this bull market's greatest legacy.  Today, greater efficiency and cost savings punctuate the culture of a larger percentage of companies that trade on global exchanges.  One might correctly posit the notion that there is a direct correlation between the advent of computers and a steady decline in the cost of doing business.  The erosion in energy prices worldwide, for example, is not an inadvertent event, but rather amongst other factors a direct link between a shift from heavy machinery, exclusively, to computing power.  In this regard, we observe that access to wealth and power within the citizenry is getting broader, not shallower.  The migration of technological efficiency into business is this generation's hyperlink for social and economic change.

As processes and technology improve, not just in energy production but across a spectrum of businesses, so too will the probability of capital gains and profitability.  Signs are already there that the recession has bottomed out.  Our best economic, scientific, and political minds are now searching for creative alternatives to finding and building wealth.  Changing demographics are altering the landscape in profound ways.  The world's aging population is a factor in the creation of life saving medicines, and the growth in pharmaceutical and healthcare industries.  Residential migration to the cities imposes a declining burden upon rural communities, while placing more emphasis upon urban matters such as efficient automobiles,  modern transportation, newer schools, and energy efficient buildings.  The "new economy" will need civil engineers and financial accountants.  The cost of retraining and educating the workforce is an issue our political leaders must address and finance.  Gridlock is no longer an option.

Anecdotal evidence suggests that the public and its leaders are starting to "get it".  There is momentum in certain market sectors that is having a spillover effect upon other sectors.  Beyond the statistics and data, the conversation is getting more positive. 

For example, while we know that the current decline in energy prices is having a positive effect upon corporate profitability and trade data, its anecdotal impact also can be felt in households and boardrooms as spending in retail and other discretionary activities accelerates.  Pricing, which has always had an influence upon gross domestic product (GDP), is moving in favor of consumers.  Last year's retail sales and durable goods orders (inventory growth) slowly improved from the year prior.  Thus, more aggressive market sectors are seeing a greater influx of investment capital.

Most of the market's attention is focused upon equities, but we also have a keen interest in the bond market and the future direction of interest rates.  While it may be a "foregone conclusion" that austerity packages must unwind at some point, it is our particular concern the manner and rate of monetary tightening.  The fundamentals are in place to support a 3% ten year Treasury bond yield, but it is the journey getting there that has my attention the most.  Letting interest rates float is a delicate undertaking, and we must trust that the Federal Reserve has its finger on the pulse of the economy with great care.  To reduce portfolio volatility, we have already begun to shorten portfolio bond maturities or to sell appreciated bond positions and to redeploy assets into other asset classes.

Strategy
One of the ways my proprietary tools are able to isolate economic changes is by quantifying money flow from source to target.  We anticipate this quarter to be heavy with activity in Industrials, Basic Materials, and Technology.  In addition, those sectors in which efficiencies are creating capital gains, like alternative energy and biotech, have a strong bias in our models.  As funny as it may sound, an odd coupling between raw materials and computers now fit together like hand-in-glove!!

Volatility is part of the investment game.  The VIX (volatility) index had been especially active at the end of last year.  October's market swoon was a bit of a jolt to those who thought the bull market would never go down.  But interestingly enough, the psychological transition that lower equity prices afforded them was a boon for stock performance at the end of the year and going into 2015.  We see enough of a combination of conservative and speculative money going into selected sectors to justify our expectation for a continuation of the current short cycle advance into the first quarter of the year.

This is what markets and economies do.  They go from up to down, and down to back up again, sometimes in a linear (straight line) fashion, more often parabolic.  What we see is that declines tend to inspire new generations of solutions.  Usually, during those declines, societies adapt by doing more with less, creating technology and inspiration in the process.  Then, after a few decades of growth, markets fall back down again from the weight of the excesses, greed and neglect that have been created.  When the headwinds are at their greatest, the pack separates into the haves and the have-nots.

It is at our most bountiful times that we need to pay attention to our social conscience.  If not, when the bad times inevitably occur, we could wind up with a moral and financial deficit, a time of extreme recalibration...that curiously looks a lot like the precipice that is January, 2015.

Conclusion
Current trends, although slightly exaggerated, are confirming the likelihood for a continuation in the bull market, but certainly with a "duller edge" than in the previous two years.  Earnings that derive from consumer demand are becoming more sustainable than those which are crafted from accounting alchemy.  Consumers are emerging from their shell, but slowly and cautiously.  This, while still reeling from the after- effects of a decade and a half of Wall Street's bad habits.

Our work focuses not so much on the day-to-day gyrations of market mania, but on a quantification of cycle movements within a longer macro demographic.  As a result, we feel safe in predicting that 2015 will see a steady migration from laggards to leaders and that sentiment will improve for the future.  Every asset class and sector has its individual merits, but the rest of the year should be a rebalancing of leadership from defensive equities to aggressive and innovative opportunities in Biotech, Energy, Food and Agriculture, Ecology, and Infrastructure.

The remaining questions to be answered for 2015 are whether higher stock prices place too great a burden upon historical earnings acceleration patterns (P/E) for markets to continue to perform, and whether higher interest rates might wreck the magnitude of the gains we already have achieved.

 

Suggested Balanced Account Asset Allocation Q1, 2015:

Equity 65%/ Fixed Income 15%/ Cash 20%