Market Commentary for the week of August 31, 2015

Parallel Disconnect, redux
The middle of a battle is no place for philosophy or moralizing....and believe me, we are in the midst of a financial "battle"...but suffice it to say that one must define one's self either as an investor  or a trader,  and in times like this that distinction is more than just conversation.

Stocks had gotten so expensive, and run for so long, that the quandary of if/when a correction was going to occur became quantifiably absolute.  The only problem was that in practical terms no one was addressing the issue, satisfied instead that portfolio gains during the past 5 years were at least double, and that 2015 was shaping up at least as a "nominal" type year.

Most investor's field of vision was so far downfield that they only focused on the promise of future returns rather than the science of statistical probabilities which posited that you can't fill a vessel "fuller than full".   And who’s to blame them really?  The media and the "experts" didn't see the need to warn anyone about quotients, leverage, or risk while things were good....they just kept producing "fast money" television programs, instead.

However, there are indelible truths which must be acknowledged.  Chasing valuation is not exactly the same thing as strategic asset allocation.  Particularly for investors whose mandate combines preservation of principal with growth, they must rely upon duration, fundamental research, and sector rotation.  That discipline is totally unlike the speculator's ploy of throwing money into big gamble piles which may or may not pay off.  One simply has to decide where they are on the risk paradigm and favor, on a sliding scale, return or stability...not both....to understand what is happening (and will happen) in the financial markets.

Yes, I hear you (even as I am writing this), "Why not both?"

To be sure, we all seek both, but with the latter comes the former, not necessarily the other way around.  Therefore one either accepts the vagaries and intense volatility of the past few trading sessions or one becomes unnerved by the magnitude of the "integers".

Change of heart

With dramatic effect, those who chase alpha (return) faced the biggest obstacle when the market fell.  They lost all of this year's gains and more, not to mention the discouragement of starting over. Some investors just threw up their hands and shook their head over the magnitude of it all.  Quick trade retail-type speculators are faced with the notion that they either change their goals and tactics, or they will face the prospect of losing yet again.  Or not.  After all, there is room on the playing field for a variety of disciplines.  Concentrated investing can, and often does, pay off.  It's simply not for everyone.

Steadier hands recognize that markets are parabolic, there really are no benchmark thresholds, investing is not the same as saving, and that the angle of ascent remains upwards in spite of recent capitulations.

So what caused all the turmoil?  Because what should have been the last parabolic  upleg became instead a linear  (straight line) advance, without pause.  Those kinds of surges are mathematically impossible to sustain.

If you're not a mathematics devotee, know this: global earnings acceleration requires consumer demand and robust economies.  China may be number 2 in the global financial hierarchy, and unquestionably significant to integrated trade, but the inference that they alone caused the crash is specious, at best.  Nor were the warnings sudden or unexpected.  If the marketplace had been paying attention, it would have noticed signposts all along that global consumer demand was tepid, at best.....flat-lining, at worst.  In addition, the entire pan-Asian region (most notably China) was exploding in credit-driven economic infrastructure development

There is no question that we will recover from this current cycle decline, but I hope that we will pay closer attention to fiscal and long-term monetary policy on the next go around.  You cannot grow an economy by flooding the marketplace with cheap money and using stocks as candy to lure investors into thinking that all is right with the world.  Several decades ago I coined the phrase "parallel disconnect"  to edify  the difference between the markets and the economy.  Simply because two "related" phenomena move on parallel tracks does not, by definition, link them as one and the same. Even now, as global bourses retreat, we find improvements in fundamental macro economic data.

And as for those single-space traders, one hears that they've taken their money to Atlantic City, Las Vegas, and Monte Carlo while the market chills out from indigestion.

Market Commentary for the week of August 24, 2015

Top, or not?
A devastating sequence of sequential triple-digit down days in the Dow last week illustrates emerging trends that are becoming more clear,            as business indicators from China, and around the globe, imply that a lackluster period of moderate-to-shallow growth is the best we might hope for. Without question, a dissipation in market confidence is the end result of a slowdown in global earnings acceleration. Valuations of stock prices simply don’t have much room for expansion to the upside.  Many analysts are looking at the S&P as a time bomb waiting to go off. 

Our work also indicates the probability of continued weakness, like the kind of sell-offs we had last week, but not a full bore reversal, or a repudiation of any data that are confirming economic recovery.  One must be careful to separate the markets  from the economy-at-large,  and realize that they sometimes execute in tandem, but sometimes not.  In other words, the upside magnitude of stock and asset expansion might have hit a temporary lull, while significant economic measurements, overall, are showing improvements.
 
It's the short term market performance, however, to which we need to pay attention.

It's almost as if the goalposts keep being moved further back, even as we drive successfully downfield.

My forecasts for equity capital appreciation remain unvarying despite the recent roadblocks of price resistance/overhead supply, earnings weakness, and psychological discomfort.  A further reversion to the mean would not necessarily suggest, at least not yet, a failure of the market to follow through on its bull run.

The world's epicenter has been moving from West to East.  Even though we spent much of the early summer fixating upon Greece and the      Eurozone, the past few weeks have morphed into a cacophony of Asian statistics.  A global recovery keeps advancing even as equity market softness results in portfolio distribution and decline.  We are monitoring closely to see if a disruption/slowdown in Chinese capital markets, or debt issues on the European continent, potentially pose enduringly negative spillover consequences for stock price movement.

Typically, data are strong at market peaks.....until they are not any longer!!  Therefore, it is not always possible to discern the difference between a market top  and a correction.   Although the terms are similar, what matters most is gauging the probability of the severity (magnitude) of any capitulation.

Patterns

The markets have been trading "in neutral" for several months, neither helped nor hurt by global exogenous noise or current events.  Were a correction to occur, we do not believe it would represent the end of a bull rally, but rather an opportunity to buy shares at a more attractive price than when they were trading at their pinnacle.

In fact, our portfolios have maintained roughly a 25-30 percent allocation to cash during the quarter as a buttress for just such an occasion.  Remarkably, the pattern of new highs followed by trading selloffs has netted zero return in the S&P as well as most global bourses for the year, despite an improvement in most fundamental measurements.

What I find most interesting is the flight from commodities shares during the cyclic advance.  There is a strong probability of a rebound in those equities during the next few years.  I am always reminding clients that the markets are "fluid", parabolic in nature, and not, by definition, linear.  One can be "long" stocks in a down market and still make money.  Outperformance  is simply overweighting those sectors which are working while underweighting the laggards.

Critical fundamentals still align to the plus-side, in particular a low level of interest rates as well as overall strength of the US dollar.  Those factors alone should enhance performance in Utilities, Consumer Cyclicals, Financials, Technology, and Industrials...roughly 75 percent of the global sectors we review.

Whereas we acknowledge that profits are tough to come by, the real key to growing share price valuations is consumer demand.  The elements which most predict demand are wage growth  and job satisfaction/security.   Neither element is in large supply right now, or likely to improve dramatically in the next few months despite modest, "tip-toe”  improvements in consumer confidence.  Right now, though, we continue to favor equity participation.  But one must recognize that traditions, like trends, are parabolic and are frequently influenced by events outside of our control.  It is much too early to predict a bear market, but not too early to recognize factors which might help to push aside confidence and resolve.

An old golfer's pre-shot maxim states: "hope for the best; prepare for the worst". 

Market Commentary for the week of August 17, 2015

Casino Royale
There's that climactic moment in every card game when you have to turn over the last card, resulting either in a win or a loss.  Last week, that momentous card was played by China, and it definitely was not a win for the global financial markets.

In a surprise move, the People's Bank of China (their equivalent to the Federal Reserve) depreciated their currency, the Renminbi, twice, by nearly 4 percent total.  The reasons given were self-serving: the world's second largest economy took measures to devalue (decrease) the cost of their goods and services so that their exports might be more affordable for the rest of the globe, thereby assuring , at least by their thinking,    a revitalization for their stagnating economy.

As a result, however, the world financial markets dropped precipitously, concerned that these monetary measures might create headwinds to the global recovery.

Whereas China implies that this move might be simply a one-off occasion,  the market's interpretation of their intent only added to nervousness about the strength of future earnings and stock valuations across a spectrum of sectors.

Indeed, if the US dollar strengthens as a result of China's currency devaluation, America's own exports become higher-priced and less competitive.  It is my belief that once we get past the initial knee-jerk reactions and finger-pointing jingoism, fundamentals which underpin our markets will become clearer and stronger.

China made this move now because of their desire to be a consistent "player" in the global arena.  Usually, currency exchange rates happen in fractions, not full percentage points.  The very magnitude and timing of this transaction shows how much the Chinese want to be taken seriously as a preeminent member of financial intercourse.  Because they perceive a downshifting in organic economic momentum, their bold move was meant not only as a monetary statement but a geopolitical one, as well.  And yet, the dollar/yuan equivalency rate now approximates the same value as last year.  Clearly, this decision was made to make a declaration, and based upon the negative reaction of the markets, it was unwelcome and perhaps burdensome.  Nevertheless, the card has been played and the winners and losers are being sorted out.

Did it work?

An unintended consequence of the Chinese decision, however, might be to hyper stimulate their economy at a time when a necessary pause might have been more in order.  The last thing they want to do is to reignite a round of inflation, or worse, business failures, when they least can afford to have them.  By ceding power to the "demand economies" of other nations, they also cede authority over their ability to maintain order and control over their financial destiny.

Meanwhile, here at home, it is possible that the markets might have overreacted to the news.  For quite some time I have been writing about the anxiety investors have been feeling even as portfolio valuations continue to expand.  Trading around "resistance levels" has made the market susceptible to exogenous noise, and selling sprees which remind everyone of an "I told you so"  mentality.  I contend that once the dust settles from the Chinese devaluation and the market's response, investors will get back to the business of fundamental evaluation of the sustainability of our recovery.

That task implies a serious assessment of sector strength and balance in the wake of a seismic bull run which began in the wake of yet another consumer calamity, namely the debt market crisis.  Things are very different at the end of a bull phase than they are at the beginning, and our portfolio weightings need to reflect those differences.

Perhaps the "exogenous noise" to which we alluded did us a favor?  It simply is not possible for markets to go up perpetually...and linearly...without pause or consolidation.

Market Commentary for the week of August 3, 2015

Poised...but which way?
The employment and consumer spending data that the Federal Reserve says it uses to determine future interest rate policy is recovering so well, in all industries except for oil, that the FOMC interest rate committee last week deemed it probable that we will see an interest rate hike before the end of the year.  Although the energy space had accounted for a significant portion of jobs created early during the recovery, its current demise has been more than offset by jobs increases in healthcare, manufacturing and technology.

The one sticking point that might delay/prevent immediate monetary action is the unfortunate market deceleration (crash) in China.  Paper losses in Chinese companies and their resultant influences abroad are in the billions of dollars.  Continued financial disruption in the globe's second largest economy will surely have policymakers second-guessing about any net pain that might be inflicted worldwide.

But here at home, there is a strong shift from defensive investing towards accelerating trends in cyclical businesses, financials, industrials, and technology shares.  An interest rate rise seems already to have been factored into our thinking and trading patterns.

My biggest concern, at present, is that investor's expectations have become highly unrealistic because of the massive returns generated in the course of the current bull recovery.  We have become so accustomed to seeing consistent increases in our monthly account statements (as if they were passbook saving accounts) that when an inevitable cyclical market correction occurs, we act "shocked", "panicked", or "angry".

The truth is that we have been peaking in equity valuations for the past 7 months, traversing a zigzag pattern around a very inflexible upside resistance point, roughly 2100 on the S&P.  Despite a steady drumbeat of "new highs", each one of those has been swiftly offset by inter-day lows or selloffs that net zero sum return.  Patterns which used to take weeks are now transpiring over days with great regularity.  Obviously, the key to market performance in the long-term is to be allocated into sectors with high probability of earnings acceleration, and to underweight exposure to those sectors and stocks with negative trends.

Although that sounds simple, and highly logical, it is not how most retail investment portfolios look.  Typically, one finds portfolios constructed of one-off ideas, and highly concentrated in one sector that might happen to hold their attention.  Failure to diversify risk exacerbates the probability of something going wrong, and exaggerating emotional stress levels in the process.

Multiple choice
Even the most well balanced portfolios suffer setbacks during volatile times like this because of the staccato-like pace of peaks and troughs.  Our numbers indicate that we are close to exhausting the dramatic bottom-left to top-right configuration of the current uptrend, and settling more into a short range trend of lateral consolidation.  That does not imply that I think a "crash" is imminent.  To the contrary, as we reboot valuation expectations for the next quarter, the probabilities of sector shifts and price acceleration in specific sectors heightens.  But the laggards are more likely to recede at the same time.  That bears careful responsibility to watch out for any "accidents" or slips.

Any analysis is subject to healthy caveats, but those equities that indicate the highest probability of earnings acceleration and stochastic (relative strength) durability are likely to continue to offer capital gains opportunity despite the macro overlay or current events.

We will caution, however, that earnings patterns across the board  are likely not to increase at the same pace as in the past five years.  Corporations have mostly consolidated or merged, laid off employees, manipulated their accounting practices, or bought back sufficient quantities of their outstanding shares that their growth now depends upon good old-fashioned consumer demand for revenue and sales increases.  Examples of such shift include biotech and biopharmaceuticals, alternative energy, investment banking, industrial machinery, and computer technology.  Those who have built, or are in the process of building, a better mousetrap will flourish.  We are now at the cusp of an important inflection point in our analysis.  Demand-driven success  is the art of bringing customers into the store and having them leave happy, with a new purchase under their arm.

Be forewarned: the next decade in the stock market will not look like the go-go past half-decade.

But you already knew that, right?