Market Commentary for the week of July 25, 2016

Theory versus practice
Last week, we began by asking , "did the recovery pass you by...?"
This week, we examine exactly "what recovery"  we were referring to.

There is no question that both the stock market and the global economy have shown significant improvement since the commencement, and darkest hours, of the financial crisis in 2008.  But those improvements are somewhat mitigated by structural and operational complexities that still linger for various industry groups, regions, and individuals that are still trying to gain financial traction.

This current earnings season is already punctuated by acceleration "slowdowns" and uncertainties about a reluctant public that just can't seem to muster the courage to spend money without justification.  Those disinclined buyers are not being helped by the failure of corporate leaders who have chosen a bunker mentality over innovation, capital investment, or designing a "better mousetrap".  This complex political, financial, and moral state of affairs might be summarized best by whomever blinks first....but that's hardly the vibrancy of a 1950's-style economic juggernaut.

There is no denying that digging out from the credit collapse has been a complex, time consuming process.  Facing the impediments it did, the market responded aggressively, with stimulus and belt tightening.  But still we face the most persistent of all obstacles: the failure to rebuild confidence in the very institutions that took us down the primrose path in the first place.  While no one hopes these bastions fail (?), there is a feeling that no one yet has been held accountable for naive or, even worse, nefarious behavior.

Last week, European central bankers announced that they would leave interest rates unchanged...at historically low levels. Continued monetary easing has not succeeded, however, in producing the desired result.  "You can lead a horse to water, but you can't make him spend"  is a phrase I coined recently to describe the unfortunate situation that currently engulfs us.  Without security and confidence, corporations and citizens will simply sit back and hoard money until they feel justified in changing course. We now concede that the Fed, the ECB, and other nations' monetary boards will likely continue to prime the pump with additional stimulus and accommodative monetary policy.  What else could they do to encourage spending and capital investment?

A potentially disquieting geographic reallocation is going to occur as a result of the Brexit vote, further exacerbating the competitive imbalance and currency disorder of the European markets.  Politics seems to be driving the continent's monetary policies, not fundamentals.  This could have onerous consequences for global commerce in the next few months as the negotiations for Britain's pullout settle in.

A new/old  prototype

Despite this potential global disequilibrium, we still believe that selective opportunity in "secular-themed" equities exists.  Even though the markets are making "new highs", this is likely not  to be the last time we reach a new valuation apex.  Demographic themes such as ecology, alternative energy, biotech and pharmaceutical research, water purification, infrastructure renewal, agriculture (food distribution and supply), and technology innovation are resistant to short term schematics.  By their very "moral" and socially reaffirming nature, they provide innumerable response...and capital gains potential....to what ails a directionless financial landscape.  Companies that respond to the halcyon call will be duly rewarded.

Our mission...my mission...is to navigate through the exogenous noise and "ice floes" of conversational and current events obstruction to arrive at a capital gains destination without unnecessary divergence or interruption.  It matters not whether the instrument is cash, bonds or stocks....valuation appreciation with minimal drawdown is the ultimate objective.

Imbalances and distractions aside, I believe the goal is attainable.  The value of our unique quantitative screening and portfolio management process is that we are able to analyze and construct solutions to a myriad number of issues more efficiently using integers and probabilities which complement traditional fundamental analysis as a stand-alone discipline.  There is no doubt that our product correlates more closely to the "action on the ground" while also creating the longer term, top-down perspective that high net worth investors require to smooth out the inevitable news-driven bumps in the road.

Market Commentary for the week of July 18, 2016

Did the recovery just pass you by?
It goes without saying that as the global market averages roar into "new high" territory, relative strength integers are indicating the probability of disintegration of momentum at the top.  Thus, the question for many has become "did we just miss the optimal entry point for stocks?"

But the question of "if" is not as significant as the fear, exuberance, trepidation, and expectation with which it is posed.  A sense of uncertainty that investors feel about entering/exiting the risk markets is analogous to the heart-stopping angst that NASA engineers feel as they await communications from a spacecraft that hurtles through space during second stage propulsion.  While they may suspect that everything will be alright, they nevertheless sit anxiously at their workstations waiting for certainty of that fact.

Similarly (and I know the metaphor is a poor one), the disparity between market chaos versus metaphysical certitude is what allows for a Brexit-type inverted market response followed by manic buying sprees....just the pattern we have seen in the past two weeks.

Calm after the storm

I believe, as I have stated before, that we must return to basics of fundamental analysis coupled with numerical quantitative approbation to release the tension in the room, both in good times and bad.  Empirical data says that fundamentals are improving and creating secular shifts in wages, employment, spending, inventory expansion, and bottom-line profitability.  Take it with a grain of salt, or cynicism if you may, but the markets are responding to a new post-credit-crisis continuum.

Mind you, these changes are not heroic nor are they something we haven't experienced before, but their staying power has nevertheless fueled a market expansion that has lengthened the amplitude of this current bull cycle.

Interestingly, it is just as confusing that what we think of as "traditional" engines of economic recovery, such as consumer spending  and confidence levels,  have been lagging other factors which have, in fact, contributed to significant economic  sustainability.  Last week we highlighted what we believe to be the single most important factor to that sustainability: low interest rates.  A decline in rates, while temporarily a boon for borrowers, is the equivalent of "losing money" and opportunity, while undermining wealth appreciation for a generation of savers.  Global austerity programs and steady-handed managed capital allocations have accounted for capital formation in the private and public markets at an alarmingly accelerated pace, replacing the traditional middle-man lending function of the banks.

Breaking those gains down by category, two of the more noteworthy appreciation patterns have occurred in the financial sector and utilities.  Of course, those groupings were also hit the hardest by the credit crisis, so they had the most distance from which to recover.  We must be on our guard, though, that these companies not only service the needs and objectives of their shareholders  as they generate capital gains and new sales, but that they are also paying homage to the desires of their customers,  too.

Climbing out

Allowing for a few exceptions, my overall bias is still to be "long" stocks.  But because tensions are running so high...and stochastic integers are rising so rapidly...we must be aware of fundamental and quantitative factors that could change our macro outlook.  Right now, absent any suitable alternatives in the fixed income markets, we have to make do with prudent asset allocation, careful equity selection, and a healthy (realistic) skepticism about the sustainability of purely news-driven rallies.

Being critical of events emanating from Britain is counterproductive. Everyone knew the brew was stewing long before the vote occurred.  Becoming agitated or overly aggressive as a result, creates a false equivalency.

We are certainly not naive about long term demographic issues, or how the global commercial situation might play out.   Acts of terrorism and random violence like the kind we saw last week in France should make us stop and think about how we value the little things, and where, exactly, portfolio issues fall within that hierarchy of priorities.  Yet, to expect all positive trade and industry news suddenly to become polluted by current events outside of our span of control is also just as reactionary.

There continues to be every possibility for investors to build wealth and security if they only have the patience...and discipline...to look in the right spaces.

Market Commentary for the week of July 11, 2016

Boom or bust...hide or engage?
Now that the financial markets have had a few weeks to digest the Brexit vote and the resulting volatility left in its wake, let us add our voice to those who urge caution about drawing immediate conclusions from the plebiscite, or changing the course of behavior because of perceived detours in fundamentals.  Excluding the vote itself, we see little significant falloff from the trajectory and magnitude of fundamental, technical, or quantitative information that manifested before  the British population had their say.

In fact, there are several more issue oriented votes that will take place around the globe this year, not the least of which will be the US Presidential election.

Within that backdrop we strongly suggest that global economic data are, and should remain, relatively robust and on an upwards trajectory.

We further offer that even if these situations were to change, there would be significant lag between any precipitating event and a compelling case for enduring secular shift in business and/or personal capital spending.  More importantly, in the absence of such an event, we are seeing that the indecision being fueled by exogenous proceedings and rumor are doing no one any good.  We will concede that rates of change  could be affected by current events or lack of clarity, but the drivers of economic recovery are nevertheless significant and sturdy.  One only need look at historical comparisons of past recoveries to conclude that we are sitting in a "sweet spot" inflection point within the timeline.

Credit

One of the reasons for our current (guarded) optimism has to do with the global interest rate scenario.  While low interest rates, alone, do not guarantee economic growth (Japan), the uniqueness of our current cycle position is that we haven't yet fully tapped into a wellspring of available capital for future economic projects.  Rather than fearing inflation borne from too much spending, we are actually experiencing deflationary pressures (and inert fiscal policy) that have kept the recovery from harvesting its best rewards.  Our previous, and erroneous, consensus forecast for the US Federal Reserve to raise rates and for higher fixed income yields globally has proven untimely at this juncture, as economic growth remains range-bound because of political and currency concerns...even after years of austerity plans and monetary stimulus.  The financial markets, despite the "risk", must simply learn to evolve in a world of highly unpalatable alternatives.

This kind of slippage in credit-driven activity is the one variable I fear most could contribute to stifling market and economic success rates.  Nevertheless, consumers and businesses have the upper hand at present, if only they choose to increase their negotiating leverage with the credit markets over the next few years.  Millions of consumers are itching to start spending if only given the right opportunity and a climate absent economic ambiguity.

Even though we are constantly confronted by vagaries and mania in the financial markets, we still believe the equity markets hold more potential upside in the long run than has currently been shown.  Arguably, stocks are the "only game in town" (other than putting cash into tin cans buried in the backyard) for investors looking for capital appreciation and diversification of risk.  No.... equities are not "cheap" following a seven year bull run, but they are less expensive now than several months ago (because of the Brexit selloff) and that type of cycle driven/event driven unpredictability only enhances valuation entry inflection point opportunity.  For those who seek the safe-haven of cash or bonds as a distraction from stock volatility, the pain of discounted rates is just too much to accept.

As quantitative strategists we routinely compile cycle information which we believe makes every effort to minimize portfolio drawdown while seeking to maximize both short and long-term secular potential.  There is no doubt that recent events have shifted the dynamic of investing.  Logically, we too could make the case to cut and run.  However, the integers, while evolving, are not tipping over into bear territory just yet, so we persevere as long-only practitioners. 

This quarter will undoubtedly be difficult to assimilate.  However, we see important prospects for Financials, Basic Materials, Technology, Biotech, and Non-Cyclicals for clients who have the patience not to run away from relative indicators.  As the "glass half full" parable tells us, there are always two sides to every story.  In this instance, while recognizing the potential risks inherent in investing generally, we choose to focus on what got us here, and to tune out most of the negative exogenous noise.

Market Commentary for the week of July 1, 2016

Cool Head.  Steady Hands.

 

Overall, investor anxiety about stocks is intensifying.  There appears to be strong momentum in the wake of the Brexit vote to "dump everything", to get out of the way of a snowball rolling downhill.  What might have been a "normal" response, a more measured tightening of share prices within a cycle decline, has turned into a catastrophe for some, resulting in a total state of disequilibrium.

However, amongst the variables that changed last quarter, last week,  for the financial markets, only investor perception and confidence  exaggerated the downward velocity of the sell-off with any degree of conviction.  The facts of the economy remain relatively the same as the week before.

Despite astonishing monetary and fiscal efforts that elevated us out of the recession, financial global bourses have become a victim of their own pecuniary success.  They became too expensive, too speculative to sustain those five-year highs...Brexit or not.

Add to this mix the upcoming US Presidential election, and you concoct a host of unknowns that everyone is pointing towards to justify a    "sell" bias.

Thus far, however, I see no particular data which lead me to change our perspective about secular trends, earnings patterns, sector weightings, or moral imperatives.  Our expectations for a sturdy-but-slow climb from recession-driven lows outweigh any sense of panic.  We are not going to be oblivious to the impending obstacles in front of us (terrorism, regional discord, economic uncertainty, etc)  but, equally so, we are not going to punish ourselves for an optimistic, glass-half-full orientation, either.

Markets

The markets are being held hostage by financial uncertainty that trails the Brexit decision.  But, as alluded to above, we do not see a direct correlation between those fears and fundamental or quantitative analysis of  the investment landscape.  It is not the stock market that governs our everyday lives, it is economic kitchen-table facts and our social customs.  One's children's education, plentiful food and water, our jobs and hobbies, physical surroundings, health and well-being are those ethereal factors whose "happiness quotient" hopefully does not equate to the Brexit vote in a straight line, nor which determine our personal Price/Earnings ratio.  While the cost of "things" changes constantly, our personal quotients are more grounded, and do not rise and fall with the Dow Jones Industrial Average...nor should they.

Brexit produced a classic psychological dislocation in which "what is"  and "what it feels like"  tilted our collective psyche so much that we  lurched either towards panic or inertia, debilitating the normal order of things.  The debate about what comes next is important, but the search for personal and market equilibrium is much more difficult to accomplish.  Two bogeys in the first three holes  does not constitute the whole story, nor is it an accurate depiction of the final score.  However, for many of us in this particular instance, it seems like the tail is wagging the dog.

Unfortunately, a relatively low global interest rate scenario has made stocks the only game in town.  But despite the inherent risks of owning equities we still see opportunity in biotech, healthcare and life sciences, alternative energy, infrastructure, agribusiness, and utilities.  We are also keen on maximizing our interest in our Water Stock concept as a socially responsible tool for generating both conversation and profit from an issue that has generational significance.

My recurrent readers might recall that we had identified several factors in the past few months that might have predicted just such a manic, right-side-of-the -parabola  reaction in the stock markets.  Depending upon the magnitude of the decline in valuation in the coming weeks, we know that the timeline of recovery has definitely been elongated by several standard deviations.  Only when we look back might we fully understand the severity...and reasons...for the market's Brexit capitulation.  However, it will not only be by the magnitude of the financial market's decline that we will measure the fallout, but by any changes that take place in consumer sentiment, spending, and behavior. 

Nearly everyone is captivated by the outcome of the Brexit vote, but for a variety of different reasons.....

Most notably for the amazement that many feel by the duration of the equity markets' remarkable 8 year recovery, and disgust with no appreciable effect upon their own financial circumstance.  This is a tale of the divide between the rich and poor, one which widens with each quarterly earnings season.  Now that the vote is over, pundits are left to digest this phenomenon that is taking root all over the globe.  Fears of a "domino effect" from other nations are worrisome.  But I would quickly add that wherever citizens go to bed hungry, dislocated, impoverished, and without hope, Brexit is the last thing on their minds.

To be sure, this is a complicated, multi-tiered political/financial issue.  Free trade, globalization, currency exchange, and multi-cultural integration are factors that affect us all...even the impoverished and disinterested.  But "who wins" and "who loses" cannot be determined today, and will take time to evaluate.  As is its custom, the financial market is positioning for trading advantage during this time of crisis, leaving in abeyance other real-life issues that have little to do with "the Street".

This is why citizens turn off to the machinations of Wall Street to focus instead upon what matters to them with immediacy.

All those trillions of dollars...and Euros....tied up by the Brexit uncertainty are being left unproductive while market-makers see how/when they gain clarity again.  The fallout from the debate has already begun.  Sudden swings in valuations always produce ups and downs, winners and losers...and, of course, tremendous volatility.  Moreover, the anger that many feel about the disparity between "the haves"  and "the have-nots"  becomes a potent political weapon not to be dismissed.

Even amongst those who keep an even keel about such things, emotions are running raw and powerfully.  It is incumbent on those in the business of money management and finance, for example, to lead with a steady hand, using methodology and discipline...not emotion...to guide their clients.  Complex tasks sometimes must be broken down into smaller steps.  Evaluating one's overall asset allocation and risk tolerances is an excellent way to mitigate any potential financial or emotional damage.  As you will see below, we are taking a more cautious approach this quarter with our overall balanced asset allocation, believing that bargains are to be had, but security of principal outweighs any desire to go bargain hunting.

 

Conclusion

Distrust of our political and social institutions everywhere around the globe cannot be overstated.  The debate is raging with good reason.  Consequences be damned, citizens are resolved to gaining equal access to their personal pot-of-gold.  This is the social and economic movement that created the underpinnings for Brexit to occur.

These issues of fairness and access are not easy to grapple with.  The same sense of unease and mistrust inhabits rich and poor alike, just in different ways.  While the visuals are sometimes different, the grievances are interestingly quite common.  By and large, human beings crave certainty, comfort, and security.  Despite geography, age, race, or wealth, those are life's most powerful forces.

Psychologists and sociologists agree that there are more emotions and features that unite people than which divide them.  Both Wall Street and Main Street can play a role in governing the shifts that are inevitably going to occur.  More importantly, our leaders should demonstrate a willingness to coalesce around common goals and socially responsible solutions to real life problems.  That would be a powerful rejoinder to the anxiety of Brexit for future stories to be told.

 

 

Suggested Balanced Account Asset Allocation, Q3, 2016

 
Equities:             50%
Fixed Income:   20%
Cash:                   30%