Market Commentary for the week of October 26, 2015

Mind reading
As markets have now evolved into trading violently up and down by hundreds of points, some are asking whether there are new forces, new rules, which appear to govern stock market behavior?

Obviously, it has become more possible for stock averages to appear to make "large" swings....what used to be 3 or 4 percentage points    thirty years ago was a number in the single digits.  At 17,000 on the Dow Jones today, one percent is already a three-digit integer.

The question is whether this volatility is a "problem" that frightens away investors, or simply an uncanny opportunity to profit from big swings.  Without implying that either scenario is good or bad, I do believe that we can ascribe a certain amount of stop-and-start behavior to the advent of technology and computerized trading programs.  Irrespective of fundamentals or long-term objectives, the machines are programmed to execute at valuation ranges which condense the aperture of analysis.  I know, because I am also the architect of such a data base.

The difference, though, between systematic "black box" investing and private client money management is that real  people have real tolerances for risk, and a set of expectations about normal market behavior and trend patterns, whereas computers don't....or don't need to...factor emotion into their models.  That's unfortunate

Since the onset of computer trading, the frequency of 4 percent (or more) moves in market averages has increased by several standard deviations above the frequency of their occurrence before the year 2000.

Regulators and legislators have noticed this change, and are highly curious, and critical, about computer's connections to market volatility.  It hasn't gone unnoticed that there is a more pronounced decoupling from long-term fundamentals in today's financial markets, even as the impact of directional changes wreaks havoc upon the psyche and confidence of retail market players.  The past decade and a half has been one of the most volatile in market history, while the aggregation of the most severe of those percentage gains/losses has happened only in the last decade.

Recoil or attack?

The best thing the "average" investor can do is to ignore the haze of exogenous noise, because trend lines tend to even out the extremes.  As we have experienced with client portfolios, the numerical net-net of recent calamitous upside/downside volatility has only approximated "zero" change during a protracted period of time.  It happened previously during a half-decade of S&P performance (2003-2008), and it occurred again subsequent to this summer's downside capitulation followed by the past few weeks' bounce-back.  If you don't have a money manager who produces incremental upside gains during these fallow periods, you're not following the right disciple.  For example, buying an index tracking fund and expecting anything different from the net index performance is being unrealistic.   

Unfortunately, the drag on investor psychology and behavior caused by these sudden eruptions outweighs any euphemisms I might write about.  Once the markets lose investor's confidence and trust, it is tough to regain it.  Financial institutions and individuals have tested the patience of clients for too long.  "New normal"  or not, the markets have been alienating their target customer base with impunity, portfolio gains notwithstanding.

In a sense, this is a morality play at work....the struggle between moral persuasion versus technological efficiency.

But when the empirical laws of economics break the bond of trust and ethical behavior, one unfortunately runs out of fiscal or monetary solutions to repair the breach.  No doubt, profits are good.  But we have not really addressed the notion that some profits are more socially productive than others.  It's also time we look at how the trend of increasing profit margins has, or has not, improved our quality of life.

One is always aware of the influence of exogenous and non-numerical factors upon data and market analysis.  In like fashion, trying to manipulate vast secular (generational) momentum is analogous to turning a battleship in a bathtub...very difficult to do.  The most critical element to all portfolio and economic analysis is time...time to remediate and effect trends; time to mobilize computer data; time to strengthen moral values; time to skew the politics of power; time to scrutinize the influence of business ethics; time to sit back and put things into perspective.

But, hey, who's got time for anything nowadays?

Market Commentary for the week of October 19, 2015

Necessary evil
Once again, the topic of interest rates.....more specifically, when or if the Federal Reserve Board will move to raise interest rates....surfaced last week.  (Did the subject really ever go away?)  Interestingly, the conversation arose because of several economic reports emanating from China showing that key third quarter earnings reports from that region were "slowing".  Thus, the tone was set early last week for US stock investors to recoil in fear while the bond markets sat back on the sidelines paralyzed by inertia.

That any of these data would be a surprise to the market is baffling, considering most economists, analysts, and traders had already factored in China's slowdown, not to mention anticipating rate reversals suggested either by market forces or treasuries.  Either way, we know that a rate hike is coming. 

Following the patterns set in previous weeks, the equity markets then rallied after the "bad news" had been digested and deemed really to be of little consequence.  In fact, upon closer inspection, US Gross Domestic Product (GDP) and S&P equity earnings reports actually mirrored an improvement in retail conditions.  If the markets had been paying attention, we danced to this tune a mere five weeks ago with much the same level of turmoil.

While my research doesn't believe there is much to fear from a secular reversal (upwards) in interest rates, its occurrence is nevertheless revealing about other supplementary factors which either respond to, or cause, rate fluctuations.

Why wait?
By definition, money must flow somewhere.  When the economy is growing, as we are doing today, surplus cash chases after goods and services.  Obviously, if demand is sufficient, then prices for those services would begin to rise, precipitating the possibility of inflation.  Last week's economic and earnings releases reinforced a steady drumbeat of positive news, both for retail and corporate investors, modest inflation notwithstanding.  What we did notice, though, is that spending patterns in discretionary trophy items like artwork, boats, cars, and jewelry are robust in the province of the ultra-wealthy.  They have the funds, and the desire to deploy them.

But we cannot ignore seemingly "hidden" price creep in day-to-day items that are also in high demand.  Pharmaceuticals, clothing, commutation (bridges and tolls), foodstuffs, education.......even an all-day Disney theme park pass..... are all rising in price at a rate which seems to confound the inflation naysayers.  The latest Consumer Price Index (CPI) data shows that both input costs (core commodities) and output (retail price) costs are rising consistently, albeit not irrationally, in tandem.  The great equilibrium trade-off is that wages, too, are rising for the first time in a decade.

Thus, the Fed's worry will be that if these expenses appear to be mounting indiscriminately and with an unrestrained trajectory, then the market might be caught in a price spiral that could derail the recovery.  Which is also why the market obsesses and responds with such fervor whenever this subject matter is brought up.

The Fed would like to nip these frenzied debates in the bud, but worries at the same time that the consequences of early action might be worse than the consequences of action at a later date.  Indeed, they do not want to prevent  people from borrowing and spending, nor to inhibit capital flow.  Rather, and to their credit, they remain diligent about the psychological impact of any action they might take.

The correct decision, I believe, is to initiate a rate hike sooner rather than later, and to eliminate the "noise" that is dominating the conversation.  The truth is, as stated earlier, we all know what's coming.  The false perception under which the financial markets are operating is that money will forever remain "free", and that negative consequences would never occur, because the Fed stands ready to deploy its tools as a safety net when called upon.

Despite interest rates being very low currently, global stock markets have shown that they are susceptible to panic attacks and extreme negative reactions.  By allowing that psychological insecurity to build up, without providing for a suitable fixed income alternative to buying stocks, the Fed only increases  the likelihood that they might be called upon to act as a pre-emptive policeman at some point in the future.  They need to do now  what is necessary, and anticipated, and to remind all of us...as well as themselves...that you cannot control the future, but you can control the measures one takes which impact upon it.

Market Commentary for the week of October 12, 2015

What would you  do...?
What would you do if someone dumped a huge amount of money in front of you and told you to invest it for the next five years?  Would you put it into stocks?  Bonds?  Art work?  Real estate?  Gold?

With the volatility, and occasional corporate malfeasance, experienced by the financial markets during the last decade the conundrum of "what to do"  has only gotten more complex.  All to the good that 2013-2014 were banner years for stocks....but where do we go from here?

For some, the game just isn't worth playing anymore.  Yes, really!!  Certainly, last early week's remarkable surge in stock prices helped to dispel some anxieties, while also bringing portfolio valuations back from annual low points, but equally for some it only heightened their level of frustration about whether the markets are really working on their behalf or against their interests altogether.  While withdrawing from the "game" certainly wouldn't be my choice, it is understandable that one might just want to lower the decibel levels on noise and consternation related to "traditional" investing and retreat into cash or bank savings accounts.  By the way, what's the current return rate on T-bills and CD's.....1.2%?

In the end, though, we have to accept an uncomfortable truth that expectations need to be tamped down and that investing  is a long-term process of methodological evaluation.  We simply have to back off the integer tracking and focus more upon intrinsic value and scientific discipline.

Over time, I believe investment returns always are biased towards the upside if we widen the timeline of measurement and accept that investing is a relative risk endeavor.

For example, what if we were offered to accept only half of our expectations  for portfolio return in exchange for peace of mind and lower volatility?  Fair?  I don't know...you must decide.

Acknowledging historical rates of return, while at the same time elongating our timeline, might condense many of the causes of financial collapse and manic volatility.

However, this type of hypothesis requires a presumption of patience and elimination of any comparisons to traditional or manufactured benchmarks, our neighbor's hot stock tips, our brother-in-law's boasting, his dentist's nephew's new car, or any of a plethora of television "talking heads" and commentators who profess to know everything about our unique personal situation.  In fact, it would also require an intense self awareness, personal perspective, and inner calm....certainly a calm that avoids running after boom-and-bust fads, flavors of the month, or packaged "deals" offered by financial institutions.

While it's not my particular methodology simply to "park" money in a buy and hold strategy (without applying measurements to cycles and trends), I do believe that the market's obsession with short term performance statistics is a bit misguided, and potentially quite dangerous...not to mention counterproductive to the true spirit of what "investing" really means.

Master the game

Some speculators are so willing to chase fads and "rate of return" data that they place bets on the riskiest scenarios, most vulnerable geographies, and, sometimes, the most questionable market trends.  On the other hand, I will concede that the most aggressive bets oftentimes pay off the most handsomely.  Such is the nature of investing.

The thing to remember is that markets are cyclic...parabolic...and that today's up can become tomorrow's down.  Conversely, what's lagging today might also become tomorrow's biggest portfolio winner.

So, in answer to the question "what to do from here?",  I will continue to advise clients to allocate assets amongst sectors with fluidity, using quantitative integers to establish risk probabilities, and to diversify within those sectors to hedge individual security risk.  Even the best in our profession have occasional losers in their portfolios.  In spite of a tumultuous third quarter, there are still long term sector opportunities in which to make profits, such as Technology (including biotech), Cyclicals, Utilities, and Energy.

But rather than adopting a lopsided mindset that chases elusive integers, I would advise anyone with "new money" to invest in the process rather than the result.  Sometimes, you just might surprise yourself with the reward.

Market Commentary for the week of October 1, 2015

Awkward Aftershocks

 

Although the market's third quarter performance was nearly cataclysmic, its gyrations had very little to do with burgeoning fundamentals in the global economic recovery.  Or did it?

Equivocation?  Contradiction?  Not really. Television talking heads and market pundits use a kind-of "grey speech" to voice their opinions about a variety of data.  It's commonplace to conflate two situations and call them "causal".  Right now, it's popular to attribute market volatility to global economic instability  and suggest they are the same.  Obviously, these issues are much more complex than slogans.

It goes without saying that since mid-summer (S&P 2120) we have been in a rather strident market correction.  Ascribing that correction to specific factors (Greece, China, The Federal Reserve Board) is analogous to looking for causality for any  cyclical event without first looking at quantification corroboration.  In our judgment the markets rose too far and for too long, and too excessively, during the final phase of this rally. 

The reasons for the 5 year rally, and the extraordinary "upside linear spike" which punctuated it, are many, not the least of which facilitated by accommodative monetary policy that allowed hoarding of corporate cash, then to be used for share buybacks and additional non jobs-related endeavors on behalf of their stakeholders.  I have argued enduringly that corporate profits and share price capital appreciation which derive from accounting manipulation or anything but consumer demand (building a better mousetrap) are specious at best and untenable at worst.  Thus, portfolios are now paying the piper for all those excesses of greed.  It's as if we created a mini "housing bubble" all over again, except with stocks as the culprit this time.  All along,  the "wall of worry" we climbed created a schizophrenic sense of anxiety about when it might end juxtaposed against euphoria over an increase in our net worth.... none of  which was greeted well when the predictable catalysts came along to bring valuations back to reality.

 While metaphysical certitude is never assured, most everyone knew instinctively that the other shoe was going to drop at some point.  This is why I cautioned clients that "benchmark high water marks" achieved in their portfolios earlier in the year were not permanent.  It is fascinating to observe what we know in hindsight, and what we choose to ignore in the moment.

As an earnings driven investor, I reaffirm our belief that the economy is getting better, selectively, but that those improvements are not widespread amongst all publicly traded equities...nor are they distributed equally amongst all sectors and geographies.  In fact, the recovery is quite youthful from a quantitative point of view, and still looking for solid footing after a tumultuous credit crash and commodities-led capitulation.  We know, for example, that manufacturing activity and inventory expansion during robust periods tends to mirror public confidence (purchasing), and by that standard alone we are still in for a long slog trying to build top-line revenues and bottom line profitability.  We are still waiting for consumers to pick up the slack and "do their part".

In fact, were the market to continue its sell-off, it would only postpone assumptions about a turnaround in consumer confidence.  I would not be surprised if this coming holiday shopping season was tepid.

Overview

The Federal Reserve has also been making news recently, saying it will do its best with monetary policy to mirror economic development while also being sensitive to anecdotal emotional constraints.  It is a fine tightrope to walk between ensuring growth while maintaining monetary compassion for political and fiscal trends that have been punitive for the less fortunate.  Being at the bottom of the interest rate trend line leaves the Fed no choice but to accept that the parabolic curve will migrate upwards whether they like it or not.  By their own words in speeches given towards the end of September, the Fed governors are saying this and preparing us for that inevitability.  As soon as the market acknowledges that premise, also, I believe some of the volatility in trading will abate.

The Fed really has no choice at this point but to abide by the weight of the statistical, quantitative, fundamental, and market evidence which suggest that the trend is ripe for reversal, and must, in fact, do so to complete a long gestation at the bottom.  While it won't be until 2016 that the effects of a rate rise might be felt, any action taken now should have immediate impact to decrease uncertainty within the financial markets.  An uptick in interest rates would be a logical, consistent effort towards normalizing the phases of market cyclicality and performance.

It has been a long road back from the aftermath of 2008's credit collapse. The market's third quarter meanderings and volatility have been a good indication of fundamental, technical and psychological discomfort.  Negative perceptions drawn from a constant barrage of 24 hour news cycles are morphing market trading sessions into a self fulfilling prophecy of indiscriminate fear and panic.  The recovery has been restricted to only a select few categories and sectors.  In that regard, the stock markets have become a parable of the distinctions between the "haves" and the "have-nots", underscoring the gap between the two.  History tells us that when a climate of optimism abounds, the prospects for economic sustainability improve.  We are not there yet.

Much of the criticism for the market's commotion last quarter was attributed to the term "globalization", more specifically difficulties in Greece and China.  No doubt that geopolitical disarray certainly contributed to a school of thought that holds "if China sneezes, the rest of the world catches a cold".   But our analysis subscribes to another way of looking at this chain of events, one which widens the aperture of perception:

We view globalization... the integration of political, monetary , and cultural processes around the globe... as a means to providing commercial solutions and capital gains opportunities for individual investors, corporations, and governments, contributing to capital flow and capital formation during times of insecurity or destabilization. For example, the recognition of South America and Latin America not only as traditional natural resource economies, but as technical leaders in telecommunications, merchant and commercial banking, and manufacturing, positions that region as a logical consideration for our investment allocation.  I also expect to see our portfolios overweighted this quarter in Utility and Technology shares on a global scale. 

Any aspirational commonalities amongst the globe's diverse economies are more compelling than their differences, and form the basis for profit opportunity and cultural cooperation in finance, infrastructure, natural resources, medicine, agriculture, and ecology.

There is indeed a difference between managing micro and macro investment particulars.  But our belief is that, barring war or other exogenous unforeseen influences, there will be profit and growth for equities during the next quarter.  Even if wages, core costs, and interest rates were to rise, industrial activity should keep pace with modest demand.  We are not naive about the obstacles already in front of us, but will be measuring key components, like jobs growth and credit applications, to confirm our expectations for a market push.  As always, consumer activity and confidence holds the key to untangling the market from the vagaries of disruptive unpredictability.

Conclusion

It will take awhile before the after-effects of a wild third quarter are digested and understood.  Unfortunately, total return has always been a "what have you done for me lately"  competition, rather than a more subdued approach of reviewing security of principal, asset allocation, vector direction and long-term macro cycles.  There are good people on both sides of that issue, and good reasons, both short term and long term, about why the markets did...and should have....pulled back.  However, those explanations don't assuage clients who see their monthly valuation statements decline in consecutive months.  As a client myself, I am sympathetic to those anxieties, but must add that global and regional current events over which we have no control play a key role in determining the rising and lowering of the tide.  We know unequivocally, however, and I had been writing prolifically, that our proprietary quantitative statistics were indicating an apex of this trend, and that capitulation (decline) was most likely.

I alluded earlier in this missive to the unusually large disparity between sectors that are doing well and those that are struggling to gain traction.  An even bigger breach also lies between those investors who feel "successful" and those who feel left behind by the swirl of Wall Street.  Our reactions and responses to those two dilemmas might be quite different in the abstract, but frame the essence of the most significant political and moral discussion of our time.  While we on Wall Street, those in the corporate sector, and politicians may spend a lot of time debating integers and X's and O's, let's not forget that there are real people with real issues on the other end of our statistics.

Even though "speculators" appear overly obsessed by market mini-cycles, it's pretty clear that recovery is a long process (never steady, straight-line, or consistent), and typically requires significant buy-in from political, monetary, corporate, and spiritual quarters.

Zero-sum economics is not  the key to sustaining the markets.  No, this is a game that requires patience and capital commitment.  If we can withstand some near-term vulnerability while remaining prudently invested, I have every reason to believe the data is moving in the right direction, towards improvements in wages and standard of living, economic and ecological sustainability, and long term capital gains in the financial markets.

In fact, I would have been more worried had we not  had the shock of last quarter's demise.

I expect global bourses to continue testing, then re-testing, technical supports during this next quarter while they search for a price and psychological equilibrium which brings into harmony current conditions that mirror both the constraints and the opportunity of the current secular advance.  An unusually sharp disparity between what's real  and what we perceive  is causing market tension, and only one of these characteristics can be "true" at any given point.

 

Suggested Balanced Account Asset Allocation Q4, 2015

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