Market Commentary for the week of January 29, 2018

Full plate

A decade of capital gains should be good enough for most anybody, shouldn't it?  As the global economy starts to shift into higher gears, the Great Recession is becoming a distant memory.  The message coming out of the global economic summit in Davos, Switzerland last week was cautiously optimistic.  So, will the good times keep rolling forward?  It all depends on how your aperture of expectations is calibrated.

The contrast, however, between Wall Street and Main Street is striking.  While one (the former) moves effortlessly like a jaguar, the other (the latter) moves at a snail's pace.  The political "populism movement" has evolved out of this dichotomy, and is alchemically rejuvenated with each quarter of growing corporate profitability.  Despairingly for some, the recent good fortune of corporate commerce has become a sore spot, where they look up at the fortunate and ask, "where's my piece of the pie?".

By recent historical standards, the gap between the affluent and the poor has become excessively discomfiting.  Depending upon which side of the paradigm you lie, things are either alright or downright unfair.

Even if you feel as if you're on the wrong end of the scale, empirical evidence suggests, however, that the tides are rising for all ships in the harbor.  The level of economic expansion supports current equity price increases, no doubt.  The question, as I've suggested in the past, is whether the rate of appreciation  in stock market valuation is sustainable and/or realistic.

The global economy is now creating more jobs, profits are rising, and US output (GDP) has risen above 3% for the first time since the early part of this millennium.  We expect a continuation for each of these factors for the foreseeable future.

But I caution, once again, that the stock markets and the economy are only linked congruently (parallel disconnect) in a partnership that is highly fragmented by sectors of varying performance.  Technology and Cyclicals have done exceedingly well, but as stock prices rise in these successful areas it is likely that a more defensive allocation shift might occur.  Money is always in fluid transition from one prosperous sector to another.  While I am not forecasting a cessation of the bull, nor an economic recession, the potential for higher inflation and interest rates is definitely a factor in our future projections.  Those, by themselves, will not erode an economic expansion, but they do signal the potential for seismic shifts in economic advances and the areas (both by sector and geography) in which they might reside.

Nevertheless, despite my confidence in the bull market overall, I will safely assert that the current rate of stock price accretion will not continue indefinitely and might abate significantly, if these benevolent circumstances don't permeate down to the "average" consumer.

In other words, everything must continue to improve, beyond today's levels, with or without Federal intervention, or we are in jeopardy of changing our economic and market forecasts.

As it appears now, consumer purchasing power has not proven to be sufficient to keep the expansion going.  Somewhere, somehow, this year (2018) will be critical in finding the source of "fuel" to power the economy's engine.

Pay attention

Growth is a factor of two things: demand and production.  Both elements must be increasing if the market and the economy are to power forward.  To be sure, we have seen productivity increases for the last half-decade at least.  Thanks to technology, accounting, and prudent fiduciary stewardship, corporations have wrung about as much as they can from their part of the equation.  Now it's time to incentivize the buyer.  I have always believed in a "better mousetrap" theory of economics.  Secular social issues are the nexus for the "next big things", for example, in areas such as water and food development, biotech and medical research, alternative energy, and physical plant (infrastructure).

It is entirely possible that the markets are  "different this time".....but I doubt it.  On a scale of probabilities ranging from zero to one hundred, there might be infinite scale, but only a limited number of possibilities.  How we address the issues of economic and social equanimity, as well as the moral peril inherent in that discussion, will determine the opportunity investors have for cashing in on the next bonanza and keeping the party going for years ahead. 

Market Commentary for the week of January 22, 2018

Fair exchange?

Many of you are wrestling with the conundrum the market is presenting.....how much is enough, how high is high?

This raises a very relevant question for you to understand what kind of investor are you: would you willingly today cash in all your current extraordinary portfolio gains from the stock market during the past 2 years in exchange for a base floor rate of return of 3 percent annually from fixed income investments for the next 15 years?

Knowing that it is impossible to "time" the market and still be a successful investor, you nevertheless have to look at your current "gamble" as if it were a poker game in which your chips keep growing and you have to assess the table and ponder when the luck might run out.  Could it keep going?  Of course, as might the incredible "linear" run in equities prices.  But when does it end and, more importantly, what is your level for risk-taking (how much can you afford to give back) and what is your time horizon for waiting out these probabilities?  Think of it this way:  these annualized numbers are simply unsustainable, and you have to recognize that.

I believe there are no empirical answers to these questions.  Each investor is different, everyone's time line is different, and each has his own built-in clock to assess when the odds are dissipating.  The only thing we can  know is the science and study of economics and what makes for a fair, zero-sum trade in the financial marketplace.

The typical market "player" is bullish when he should have been bearish, and bearish when he should have been bullish!

While I have said repeatedly that there are no warning signs on the immediate horizon which might cause us to abandon stocks altogether, it is always helpful to have a contingency plan and to have learned from the lessons of calamities past. 

I would caution that it is a matter of monitoring cycle events and cycle shifts in order to optimize asset distribution by risk rather than betting all those poker chips on one hand of the cards.  If it's a bear market you fear, rest assured it will  come.  History, common sense, and quantitative analysis tells us so.  So it would be far better at least to prepare for one than to ignore its likelihood altogether.

Believe your eyes

It could be that positive reaction to the US tax cut legislation might provide additional stimulus to the stock market rally.  The economy is accelerating and likely will show improvement in wages, manufacturing, and profitability.  We feel that a secular rise in interest rates and/or inflation could also be positive for the stock market in that they represent the underpinnings of rising savings rates and competitive pricing which leads to innovation and research.

I am also extremely excited about my Arlington Econometrics' proprietary database focus for the longer term in areas such as healthcare, global agriculture, water, alternative energy, infrastructure, biotech, and technology.  These "socially responsible" themes resonate as global topics of discussion, as well as sectors from which a plethora of capital gains are most possible.

However, as we have noted previously, nothing goes straight up...neither the economy nor the financial markets.  As long as investors are realistic in their expectations about capital appreciation, their judgment about the question I posed at the beginning of this missive will be logical, as well.  The biggest mistake I have seen in my 40 years on Wall Street is that most investors, professional and retail alike, believe that this is a get-rich-quick playing field, an all-or-none proposition in which one has a limited amount of time and opportunities.... one shot perhaps (?)..... to make it big.

To the contrary, investing.....true investing.....is a matter of time, patience, methodology, execution, and fluidity.  Prepare for cyclicality and shifts in money flow where they exist and be deliberately strategic in modeling those shifts in your portfolio as you go.

The party is always going on.  You just need to know where to look.

Market Commentary for the week of January 15, 2018

Conflation

I think it's high time that we all acknowledge how drastic a departure this past decade has been from "conventional" market analytics.  Sometimes, investors take for granted the large tectonic shifts that naturally occur....in nature as well as in markets.  And while I previously have said that I am loathe to verbalize that "it's different this time", there are things which just don't add up or meet the "smell test".  Let me explain....

First, I believe we should agree that the stock market is not  the same thing as the economy.  Yes, there are convergences that meld the two nicely together.  I even coined the term parallel disconnect  years ago to describe two distinct phenomena (in this case stock markets and economies) moving in congruent directions but not necessarily items that are one and the same.

At the moment, they appear to be the same.  The economy is growing, creating jobs and new investment capital.  Similarly, the financial markets are rebounding off the lows of the Great Recession and are making sequentially higher-highs in the averages.  A lot is good for each, and the consensus is not to rock the boat or over analyze but simply to bank the profits and hope for a perpetuation of these parallel vectors.

However, just as it is difficult to imagine rain when it is sunny, investors are pretending not to think about any decoupling between the market's steady linear progress and the inevitable cyclic phases of economic growth.  Yet, every bear market, every "October surprise" has come without warning, even though quantitative signals may have indicated their evidence.

Investors only agree to acknowledge a shift in cycles after  they have been in them awhile.

Agility

The art of prudent asset management, however, is to identify trends, whether rising or falling, as much before they occur....and the reasons for their occurrence...as possible.  In other words, it is my job to worry for you.

Indeed, we are grateful for the past decade's portfolio performance and our stewardship of things such as asset allocation, sector rotation, security selection, and asset distribution.  Our returns have been commensurate with or better than our client's risk tolerances and market benchmark's progress. We are sometimes chided for our vigilant levels of concern.

But giddy traders are the worst kind of investors.  They bound along unwittingly and, oftentimes, un-scientifically.  When, or if, market capitulations occur, these players act baffled when they have to absorb portfolio losses of 25 or 30 percent.

The rules of the game quantify slightly differently right now.  Stocks are not as isolated from the potential for reversal as some would like you to believe.  We are aware of the hiccups that can occur on an intraday basis, like the kind that happened mid-week last week, but don't believe that they are the initiation of a significant cyclical trend reversal.  That also does not mean that the economy will violently cease its rebound, either.  In fact, in a low interest rate marketplace, we still believe that there are sectors in the economy that will outperform our expectations (biotech, alternative energy, agriculture, water, technology, basic materials).  We have to concede, however, that interest rates will begin to trend upwards, inflation will most likely begin to appear (if not clinically then at least anecdotally), and the rate of appreciation  in corporate profits must at some point abate.  We just want to avoid the kind of hubris and mental complacency in our asset allocation processes that sometimes accompanies success.

We are not bearish, nor contrarians.  Any inference that we are is a misunderstanding of this tome.  We remain fully allocated and will continue to do so until indicators direct us otherwise. 

The landscape has shifted favorably for investors in the past half-decade.  But the primary surge in prices has already occurred.  Now it is incumbent on investors to know the difference between cautious optimism and awkward aggressiveness that leads to falling into an abyss.

There is plenty of the latter, and not enough of the former. 

Market Commentary for the week of January 1, 2018

It's a lovely  view up here...

"Oh, the view is tremendous",  said one of America's astronauts as his space capsule rocketed out of Earth's gravitational pull for the first time.  And as physics tells us it is so, at some point his spaceship returned from its apogee and fell unfailingly back to land.

So, do the laws of physics apply to all moving objects....such as the parabolic, sometimes linear, trajectory of stock prices?

Financial markets are not specifically governed by physics, but by the laws of economics.  And yet, the discipline of quantitative statistics and algorithmic equations are themselves interlinked with physics and all other sciences, if truth be told.  Thus, "what goes up must come down"  is at the core of the lexicon of physics, financial markets, sports, life, and a whole panoply of other common sense endeavors.

What many find almost surreal about the current bull market is the number of times it keeps making new highs without significant capitulation.  Who knows, maybe the laws of all sciences no longer apply?  How many times in your investment lifetime have you heard the phrases "it's different this time"  or "it's a New Paradigm"?  While this author doesn't disparage those who subscribe to the notion that it is  different this time, I am stressed, nevertheless, by the pervasiveness of such belief.

Strategy

The thesis which governs my interpretations is predicated upon the ability to quantify factors that define the movement of financial phenomena, like stocks, bonds, interest rates, earnings acceleration patterns, consumer confidence, sector rotation, global trade, etc.  Those data if understood properly can leverage the probabilities of capital gains in our favor, and allows the user to intercede in, or avoid altogether, any catastrophic "right side of the parabola" disasters.  Sometimes price compressions take generations to occur.  Other times, they may occur in a 24 hour span. I'm sure you've seen examples of both.  They are a fact of life.  History has shown us so, and so too do the laws of mathematics.  It is the ability to stave off the unforeseen consequences of a failure to plan that makes my profession so interesting and so valuable to clients.

The bright lights and fancy bells of 24 hour business news coverage feed a vicious narrative of unrelenting success that too many unsuspicious investors buy into, thus creating a parallel landscape of impractical expectations.

I ask you to reflect back to the humbling and disastrous portfolio experiences of the dot.com crash and this past Great Recession/credit crisis as examples of something to which your euphoria blinded you, and the panic they created in boardrooms and kitchens worldwide.

Investing requires strategy, methodology, diligence, and patience.  One cannot ignore the existence of obstacles, just be nimble enough to navigate them when they arise.  Whether passive or active with your portfolio you must be aware of history and certain flash points that inevitably occur and which might have significant corrosive effects upon asset valuations.

Markets

Despite any misgivings I have about the linear nature of the market's recent phase, we have nevertheless been a full participant in the investment landscape within the limits of our client's stated risk tolerances and their longer term expectations for performance.  When moving from zero probabilities....as in the post recession doldrums....to nearly full stochastic integers of present valuations, one must always be prepared for negative catalysts.

One of those catalysts is the growing global divide between the wealthy and the impoverished.  If economic growth is to be engendered worldwide and domestically we have to find a way to breathe new life into the less affluent and their access to healthcare, education, transit and infrastructure, homeland security, banking and commerce, and institutions of faith.  The big X-factor is that a preponderance of the concentration of money in today's world accrue to a very small percentage of the populace even as more around them degrade financially.  The clock is ticking for those at both ends of the economic paradigm.

Yes, the Great Recession is in the rearview mirror.  But even as the economy has raced back from its depths, it has taken on disparate meaning for different parts of the market.  Will recent US tax legislation, for example, really unleash greater prosperity, or might it exacerbate an economic chasm that has already alienated a significant segment of the population?  Can the short term good-will created by a legislative accomplishment be sustained into legitimate long term investment and bounty?

Soaring stock markets only fuel so much of the recovery...and only for those fortunate few, as mentioned above, who have the resources to be playing in that arena.  Who's paying attention to and voicing solutions about areas of social need such as eradicating hunger and poverty; clean water access; cures for medical pandemics; computer and bioscience research and development; geriatric care; crime prevention; affordable education?  

In the end, a misplaced social trend which exclusively covets capital gains and corporate profits could wind up squeezing dry the goose that lays the golden eggs.  Excessive social inequality erodes public cohesion, consumer confidence, and ultimately growth itself.

The more we are surrounded by exogenous noise, the less attention we are willing to pay to anyone else.  Failure to focus upon others is not, by itself, a cause of financial crisis, but it is reasonable to assert that apathy has the ability slowly to unwind progress that has already been made.  Accounts have shown us that periods of financial instability or inequality always follow epochs in times past where excessive asset growth, corporate greed, wage imbalances, and euphoric passion have been disproportionate to underlying principles of fairness and distribution of opportunity.

Low interest rates, for example, are creating a climate in which prices of stocks have been driven up simply because of a scarcity of alternative choices, thereby fostering a riskier playing field while accommodating investor's hunt for absolute return on assets.  Global central banks, including the US Federal Reserve, have left themselves painted into a corner with no choice but to adjust interest rates higher while they ballyhoo the data indicating higher consumption, price pressure, and lower unemployment.  Curiously, our analytics observes very little evidence of rampant inflation or price pressures that might typically define an excessively out-of-control economy.  We do see, however, that anecdotal cost-push pressures are slowly eating away at household take home pay and exacerbating the anxieties that the “average citizen” feels in trying to succeed in the global economy.

Our asset allocation for the coming quarter will be much more selective based upon our interpretation of  the facts.  Because of pervasive bullishness about financial market's performance, our goal now is to identify those financial instruments that are quick to respond to a volatile US dollar; rising interest rates; slower earnings acceleration patterns; secular changes in energy, healthcare, housing, productivity; and a world in flux because of regional disputes and terrorism.  Indeed, the range of probable performers is a smaller list.  The task, obviously, is to winnow out plausible winners from those securities that we deem untouchable.  Therefore, we begin the year as we ended it: taking profits when available, selectively adding short-term time deposits to lessen portfolio volatility risk, and rebalancing into emerging markets and opportunities whose downside risk is diminished by early stage, left -side-of-the-parabola cyclical nexus.

Conclusion

The seeds of change require a long gestation.  There is still abundant opportunity to participate in the flow forward of stocks and other financial instruments.  Irrespective of the Fed, global central banks, the US Congress or other social domains, there is always a bias to improve one's lot in life....financially, educationally, spiritually.  It is how we perceive  financial trends, however, that makes those struggles more identifiable.  "Fairer trade", "increasing GDP"," declining unemployment"  are abstract concepts to anyone working paycheck to paycheck, burdened by illness, poor education, hunger, thirst, or lack of hope.

Our portfolio strategies for the next quarter will reflect a broader secular redirection and rebalancing away from consumer-driven (consumption) sectors towards tangible assets, pricing power, production and manufacturing sectors, and inflation oriented developments.  This month, we also introduce our Agriculture and Food investment strategies to couple with our earlier initiatives in Global Water, Alternative Energy, and Health and Life Sciences.  We believe these concept investments resonate well with our operational mandate of risk protection and strategic asset allocation.  A solid base of earnings acceleration and dividend investments will do more potentially to offset risk posed by excessively high valuations across the current continuum than speculative one-off investments or misplaced hyperbole.

 

Suggested balanced account asset allocation, Q1, 2018

Equity:                60%

Fixed Income:  24%

Cash:                  16%