Monday, April 30, 2007

Speed Kills

excerpts from this week's report

Friday’s blog commentary on “Decoupling”– will the world economy find other sustainable sources of consumption demand as US consumer spending slows? – puts the global growth story in the right context. And, should the global growth baton pass from the US consumer to the rest of the world and if goods and services that are designed for US consumption can transition effortlessly (not an easy task) to other sources of consumption with the same profitability dynamics, then the forecasts of nearly 5% global growth for this and next year are reasonably assured.

No doubt, the markets will like that scenario as it is being baked into the equity cake via higher market caps. However, there is another dynamic that is a part of the world economy that investors would be wise to heed. A dynamic that is one of those hard to quantify factors that bedevil traditional thinking investors - Speed.

There are three defining aspects to the two mini corrections of this current bull rally – the synchronized rally, little to no technical warning signals, and the speed with which the decline erupted. The first two points have been addressed many times in previous Blue Marble Research reports and blog postings. Now, let’s take a moment to appreciate the speed aspect...

Note: To read this week's complete report, which includes the ETF Model Growth Portfolio and other features, a subscription is required. For details, click on the Blue Marble Reseach services link to the left.

Friday, April 27, 2007

Decoupling: An Economic Cacophony

Someone please help me out with this one.

If other emerging market countries depend on trade with China and China depends on the US (specifically, the US consumer) for much of its growth then, by default, don’t other emerging market economies depend on the US consumer as well? If so, then please advise how decoupling occurs if the ultimate demand source is the US consumer?

Much of the good earnings data discussed (and the supposed source for new highs) centers on global growth originating in other parts of the world as US growth is clearly slowing. In other words, decoupling. This view is gaining among investors. However, there’s a point to consider:

If a major root source of demand is the US consumer and US consumer spending still shows little to no effects of the broad economic slowdown, then has decoupling really been put to the test*?

There are two economic issues that will determine the direction of earnings growth – the US economy and decoupling. If the former turns out to be worse than expected or if the latter falters, then the markets may be in for a surprise as the year progresses. Given the rising degree of investor expectations that the US is in the midst of a soft landing, that 2H07 earnings will rebound substantially, and that the valuation gap has closed substantially, the risk of disappointment is on the rise.

But there is also the related, and larger, issue at work here – interconnectiveness.

Investment Strategy Implications

It has been argued on this blog and in my reports that a feedback loop exists today the likes of which the world has never seen. Globalization has produced great economic benefits at a price – we are all in it together. Growth depends on markets that are developing (many of which are quite immature on multiple levels). And as long as economic progress continues in a benign fashion, the extraordinary growth of the past several years stands an excellent chance of enduring.

However, to use a musical metaphor, that presupposes that the global economic symphony will continue to make sweet music. And, should decoupling occur, synchronized economic growth must give way to a harmonized tune of disparate ensembles, each making their own sweet music**.

Decoupling may accept the musical baton and harmony may emerge. However, while that musical test has yet to happen, the markets are acting as if it is a done deal. Beethoven gives way to Duke Ellington and Eminem.

I wonder how many investors are prepared for the cacophony that decoupling will produce?

Have a good weekend.

*This point was recently raised by Steve Roach and in the IMF World Economic Outlook report.

**The trade version of this is the Doha round is replaced with numerous bilateral agreements. The risk is trade factions can form resulting in, what in effect are, economic tribes.

Thursday, April 26, 2007

The Difference Between Traditional and Thematic Analysis

The problems in the sub prime mortgage area provide a perfect example to illustrate the difference between traditional investment strategy analysis (practiced everywhere) and thematic analysis (practiced here).

Traditional analysis takes what in effect is a vertical approach, a silo view, if you will, and bases its investment decisions on the traditional components of equity analysis – cash flows (or earnings), growth, and risk. Traditional analysis looks for the impacts that can be felt within an economic sector or industry and seeks to identify its top and bottom line effects to the investment in question.

Thematic analysis, on the other hand, takes a horizontal approach and looks for the trends and themes that cut across the industry and economic verticals. Thematic analysis looks for the mega trends and themes that can alter the direction of whole economies, sectors, industries, and companies.

Let’s use the sub prime mortgage problems as an example of the difference between the two analytical approaches.

Sub Prime Contagion

From a traditional analysis perspective, the main concern re sub prime is contagion*. Will the weakness in the housing market caused by the sub prime problems extend beyond the housing market and affect other parts of the US economy? Moreover, will this contagion extend beyond the US borders by depressing US consumer spending that then results in reduced global growth from the world’s leading source of demand thereby producing a global contagion**? Thus far, this fear seems to be unfounded.

Relief has swept over many investors as the sub prime problems have shown little effect beyond the immediacy of the housing market. Earnings and economic reports provide the proof that so far corporate profits and consumer spending have not been meaningfully impacted by sub prime’s problems. In other words, no contagion.

Now, let’s view this thematically.

Sub Prime as a Thematic Metaphor

From a thematic perspective, the sub prime problems appear to be symptomatic of a larger issue – liquidity.

Liquidity is a thematic driver that cuts across all verticals, both economically and financially. Liquidity is the cross beam that provides the floor below the market that everyone points to as a reason why stocks will not decline. It is also the root cause for the sub prime problems for, were it not for excess amounts of capital, loans that should not have been made would not have been made. Or, would have been made with less gusto.

If we were to stop with liquidity, the story would be obvious and over and of limited value. It would be said that bad real estate related decisions were made, liquidity was the culprit, but that’s all been fixed. The end.

But that’s not the end as there is another mega theme that plays a role in the sub prime story - Financial Innovation.

Financial Innovation as Theme

Financial innovation is the manufacturing process of money. It is the innovative blend of structure and talent to create new financial machines and systems that capitalize on opportunities through financial engineering. Instruments and process systems are created that leverage talent and capital to satisfy the needs of globalization (a theme in its own right).

Thanks to the ingenuity of asset managers and their financial services' compatriots, financial innovation has produced two such structures – the unregulated money machines of hedge funds and private equity.

Playing their increasingly activist roles, hedgies and PE have helped provide some of the fuel to the sub prime fire. Investments in companies that leant the sub prime money made capital more available than otherwise would be the case. But, there is a back end to this part of the story. And H&R Block provides a very good example.

The H&R Block Sub Prime Example

H&R Block’s announcement last week that it will sell its sub prime unit Option One Mortgage Corp to the private equity firm Cerberus Capital Management reveals both the activist role that liquidity and financial innovation plays in the form of a private equity firm cleaning up a piece of the sub prime mess and, importantly, the willingness, even eagerness, of corporate management to unbundled itself of its mistakes***.

Investment Strategy Implications

Traditional analysis looks for interconnections between economic and industry silos. It seeks to identify the valuation drivers within its defined space and any outside forces that might impact that space. In the case of negative impacts, contagion is its prime fear. Think contagion as virus.

A thematic perspective, however, looks for the conditions that enable a contagion virus to breed. It looks for the mega trends that have the wherewithal to impact the valuation drivers in multiple silos.

In the case of the sub prime problems, the contagion fears have been alleviated for now. And this has added strength to the current bull rally, especially in conjunction with the large cap 1Q07 results. Understanding its thematic nature is a value-add to any investor’s analytical approach.

*Contagion is not considered a theme as it is an effect and not a causative agent.

**Decoupling, global growth ex US, is A related theme. See my weekly report of April 23, 2007 (subscription required) and the IMF World Economic Outlook report.

***The nexus between corporate management, activist investors, and unregulated money is at the core of McVey’s “Misalignment Triangle”. See blog posting of March 30, 2007.

Wednesday, April 25, 2007

When the Generals Move Out…

…but the infantry doesn’t follow.

The classic major market top is made when the big names lead and the rest of the pack sort of stands around watching. Or in words of the old Wall Street axiom, “the Generals move out but the infantry doesn’t follow”.

Some signs are beginning to emerge that the hoopla surrounding Dow 13k may be evolving into a predominantly big name event. The data shows that on a very short-term basis (less than 2 weeks) and on a one-year basis large and mega cap issues have taken the lead and pushed the Smids into the second and third place performance rung (see chart). This has implications on several levels.

First, the underperformance by the Smids on a one-year basis has gone largely unnoticed by most (except those who read this blog, of course). Yet, it does suggest that last spring’s decline combined with the late winter decline of this year has shifted the focus from the Smids to the large and mega cap group, which can be interpreted one of two ways: either it is the start of new major bull cycle in which large cap leadership shows the way or it is the beginning of the end as large cap leadership is not supported by the rest of the market.

Second, and perhaps more importantly, the hot money hedge fund crowd may be forced out of their comfort zone in the Smids and into the big boys domain as they seek to minimize the underperformance damage a large and mega cap over Smids performance implies. This has many implications, not the least of which is the potential for an overheating of the big cap sector and a further gap between the big names (the generals) and the second and third tier (the infantry). And in the process, such a move would ring the technical analysis bells of many technicians.

Investment Strategy Implications

I am deeply suspicious of multi-year bull markets that rise under the guise of climbing a wall of worry and, in the process, produce a shift of leadership from the broad market to the big boys. I guess one would have to call me a mid cycle skeptic, which is the foundation for this bull rally. Accordingly, the very near term and one year data showing a shift in leadership to the generals must be supported by the troops. Any deterioration resulting in divergences is unsustainable and threatens to produce a major market top. We are not there yet, but it does bears watching.

Note: Despite all the cautionary implications you are reading on this blog (see all postings), the undeniable fact remains: no major market top has been made. And until such time, the current lean against the wind/regression to the mean investment strategy espoused here is most appropriate.

Tuesday, April 24, 2007

Gold: The $1,000 Investment

Just over two years ago (March 4, 2005), I authored and published a report titled “Gold Outlook: Buy”. The thrust of the report centered on the view that Gold was an attractive investment as it provided a necessary hedge against global uncertainty and US dollar weakness and that it had a zero correlation with equities and bonds. Since that report, little has changed to alter the view that Gold is a secular buy and the rationale for owning a position remains intact.

Gold is a special type of investment vehicle. Precious little of its value resides in its industrial use. And while most of what is produced ends up in non productive assets such as jewelry, the primary value in Gold is its standing as an alternative reserve currency to the US dollar. Given the sustained and projected US dollar weakness (not to mention an unforeseen exogenous event), Gold role as an attractive investment seems assured.

An investment in Gold is, of course, not without risk. However, the primary risk with Gold is not the production supply/demand equation but the official reserves. As noted in the report, “Perhaps the single biggest risk to Gold is the potential of an added supply hitting the market – particularly from the central banks of the world. As the aforementioned data from the February 28, 2005 Economist Intelligence Unit report on Gold show, the supply available from central banks dwarfs the supply/demand equation. At ten times the supply or demand levels, government and government organizational sales of Gold could have a serious negative effect its price.” The charts and tables in the report illustrate this and other points.

Investment Strategy Implications

Gold represents a 5% position in my Model Growth Portfolio (MGP) and has been a consistent provider of positive returns for the MGP. As a hedge against uncertainty and instability (and the weak US dollar), it is, in my opinion, an investment for the times. Moreover, as a zero correlated asset to equities and bonds, Gold is an excellent complement to anyone’s portfolio.

The only investment decision-making issue I see with Gold is when to increase or decrease the position. The recent increase in the MGP (from 3 to 5%) was made on March 26, 2007 when it was trading at just under $66. At 5%, it is currently at the maximum level allowed in the MGP.

In the coming weeks, I will update the report incorporating new data. Until then, you are welcome to consider viewing the 2005 report.

Note: Access to the report is available only to subscribers. To learn more about our subscription service, please click on the title of this posting or the services link to the left.

Monday, April 23, 2007

Baloney Ain’t Steak

Question: What do you get when you take out Energy and Financials from 1Q07 earnings?
Answer: -3.59%.

In the midst of the all the new-high excitement, a little piece of data seems to have slipped under the radar screen of many investors: mega cap has begun outperforming all other capitalization groups.

Since the start of earnings season, the mega cap S&P 100 is at the top of the performance food chain. In fact, the performance record since April 4th shows exactly the high to low quality performance one would expect in changing times: mega over large over mid over small over micro (see chart to the left and in report).

What could possibly explain this occurrence? Perhaps the answer lies in the information noted at the top of this report: when one widens the lens to the much larger market and breaks down the data into its component pieces, the 1Q07 earnings performance data paints a very different picture.

Let’s look at the facts.

Mega over large over mid over small over micro. (see chart to the left and in report)

Interestingly, this now matches the one-year performance data noted in last Thursday’s Special Report. (see chart in report)

I suspect the answer to this shift lies in the data compiled by the Wall Street Journal on the much larger and broader 769 companies that have reported thus far. As the tables and analysis on the next page show (see report), the broad market has produced the following data:

769 companies reported
Net on Continuing Operations +7.21%
Net Income +3.96%

Now, if one excludes two sectors – Financials and Energy – to get a better picture of economic performance, the results are as follows:

769 companies reported ex Financials & Energy
Net on Continuing Operations +0.55%
Net Income -3.59%

In regards to the Financials sector, a breakdown of the very solid numbers produced thus far shows that when you exclude the results from Wall Street oriented firms, the 15 - 16% growth in earnings is cut in half.

(To view all tables and charts, please see report)

Investment Strategy Implications

There are many reasons to explain why the equity markets around the world are making new highs, but an across the board strong 1Q07 earnings season is not one of them.

If mega and large cap represents the higher quality end of the food chain, then the lower end is producing a much less tasty meal. In other words, baloney ain’t steak.

(Note: To obtain access to all Blue Marble Research reports, please click on the Blue Marble Research Services to the left.)

Friday, April 20, 2007

Surge, Then Purge

If there is one constant, one consistent characteristic to the current bull market, it is its propensity to surge, then purge. And many of the tools an investor might use have been rendered less effective (even useless) in a fully synchronized market such as this. So, what advice can an investor rely on? How does leaning against the wind sound?

To be sure, there are some signs that the latest surge, as impressive as it is, is not as robust as the major indices would suggest. Momentum is showing signs of deterioration. And, bullish sentiment is certain to be even more widespread (especially among the pundentry and strategistas). However, there is a piece of data that bears (are?) noting: the advance/decline line.

Much is made of the advance/decline line and how it is confirming the surge. This is true is one looks only at the NYSE. However, as the chart to the left makes clear, the NASDAQ a/d line is going in exactly the opposite direction. Higher highs in price, lower lows in the a/d line. This is a divergence of major proportions and the single largest weak link in the technical chain.

As for the NYSE a/d line, there is the issue of truly economically sensitive stocks versus funds and financials. According to the NYSE, there are “more than 480 closed-end funds with a total market value of approximately $114 billion.” The total number of listed companies on the NYSE is just over 2,700. That means that just under 18% of companies listed on the NYSE are not economically-oriented operating companies. And subject to double couting in the a/d data. Then we have the Financials group.

Everyone knows that Financials constitute the largest market cap component of the S&P 500. What needs to be added to the investment strategy equation is their composition in the NYSE mix. There are 429 companies classified in the Financial sector that are listed on the NYSE. That makes for another 16% of non operating companies in the NYSE a/d mix bringing the total of non economically-oriented operating companies to approximately 34%, or 1/3 of the total stocks listed on the NYSE that are counted in the a/d figures for that exchange.

Note: With so many trades now being conducted away from listed exchanges, it is hard to get an exact read. But, if the data noted above is close to accurate, the hoopla surrounding new highs needs to be tempered just a bit.

Also, note: I am gathering data on the NYSE a/d ex funds and Financials and will post that info next week.

Investment Strategy Implications

Whether the data and divergences re the a/d lines bears out, regression to the mean is always the most prudent principle in parabolic/melt-up market moves. Leaning against the wind and taking some chips off the table may be intolerable for some as it will diminish the short-term performance of a portfolio and make an Alberto Gonzales-like interrogation by others more likely. (Imagine a client, associate, or boss with a strong resemblance to Senator Ted Kennedy. Can you say "regret aversion"?.) However, if I am correct re the basic characteristics of this market, purges always follow surges. The problem is their unpredictable nature. And that argues even more for leaning against the wind, especially when that wind likely contains a fair amount of hot air.

Have a good weekend.

Thursday, April 19, 2007

Technical Thursdays: Divergences and Moving Averages

As a strong advocate of technical analysis, I have found certain tools to be superior to others. One such tool that has been written about several times on these pages and in my reports is Divergences.

Divergences come in two forms. One deals with the divergence between two indices. The other is the divergence of an index with its key indicators. In this week edition of Technical Thursdays, we look at a few charts that illustrate the first form, index to index. The other tool of great use is the Moving Averages.

As most investors know, moving averages smooth out the day to day fluctuations (some say noise) and help put a market trend into some longer term perspective.

On page 3 of this report (see link below), we look at the three primary moving averages (10, 50, and 200 day) and analyze the relationship between them and the current price of an index.

Dow Theory: Measuring one index against another helps to confirm a market trend. The granddaddy of index comparisons is the Dow Theory: Matching the Dow Industrials against the Dow Transports.

The first chart shows the current bull market and one can see that while there have been a few points in time when the one failed to confirm the other’s new high, those periods were brief and the confirmation gap to close was fairly small. (Example: late 2006. Dow Industrials makes new highs, Dow Transports do not.) Now, consider the difference between the above chart and the following: the period between 1998 and 2000.

Here one can see that the gap is quite substantial. (Industrials make new all-time high in early 2000, Transports are close to 50% away from confirming.)

Moving Averages: This long-term chart of the S&P 500 shows very clearly the mega trend value in the 200-day moving average. Throughout the 1990’s bull market, the slope of the 200-day moving average was always up. It wasn’t until price and the two shorter-term moving averages (10 and 50-day) crossed the 200-day that its slope pointed downward. That downward slope remained intact until early 2003, when, once again, price and the shorter-term moving averages crossed, this time to the upside.

Another, more near term, facet of the moving averages is the price of an index (or stock), the relationship between the three moving averages, and their slope. To illustrate, let’s view the past 4 years.

The most bullish mix is price above moving averages, moving averages above each in time (10-day above 50-day above 200-day), and each moving average upwardly sloped. As the chart below makes clear, it is easy to see why a number of market technicians state that the current bull rally is the start of a new major uptrend. (see 2003 versus 2006).

A normal corrective phase occurs when price and the shorter-term moving averages turn sideways to down. Here, too, many bullish technicians point to the normal corrective phases of such shorter-term market action. Note: while price and shorter-term moving averages have crossed the 200-day, at no time does the 200-day turn down.

Investment Strategy Implications

Using just these two valuable technical tools, the current bull rally shows no signs of a major trend reversal. The only risk to the current bull market suggested by the two tools is exactly what we have experienced: sudden, sharp pullbacks in a fully synchronized, highly correlated market (spring 06, late winter 07). Unfortunately, the nature of the sudden, sharp corrections in a fully synchronized (both domestically and globally) is very unpredictable. The two nasty declines recently experienced burst on the scene with little to no advance technical warning*.

*Note: Sentiment did become overly bullish and certain other indicators did flash modest warning signs. However, there were no major market signals that would have warned of the severity and suddenness of the decline.

The overall recommended investment strategy is to lean against the wind. As the equity markets surge ahead, take some money off the table (and selectively short vulnerable countries, regions, sectors and styles). During market corrections, reduce the underweighting and rebalance the portfolio as needed.

Accordingly, the Model Growth Portfolio is presently less than fully invested, as noted in the report.

To download the report, please click here

Wednesday, April 18, 2007

…Becomes the Vicious Cycle

What goes up, must come down. And what goes up in unison, will go down in unison (relative performance, notwithstanding).

Since the new millennium began, the power of the virtuous circle has enabled equities to overcome an extraordinarily number of adverse developments. However, it should be appreciated where this strength comes from. And should not be ignored that all juggernauts have a weakness(es), an Achilles heel that could bring to an end (more likely, severely limit) the benefits enjoyed by many.

In cases involving self-reinforcing features, such as the current virtuous circle, strength begets more strength. Each aspect reinforcing the other to greater heights. Like a well-oiled machine with many interlocking moving parts, motion generates movement and forward progress is the result. But, the interconnected dynamics of our well-oiled machine can shift into reverse gear and all the parts can then work together producing a negative and most unwanted result - a vicious cycle.

A disruption to the virtuous circle can occur at any point. This is a testament to the dynamics of an interconnected, interdependent world. For example, an exogenous event can alter sentiment which tip the balance the other way. However, at this time and given the abundant liquidity in the system, there are two links in the virtuous circle chain that stand out above all – the US consumer and Decoupling.

It’s easy to see how a serious contraction of US consumer spending can break the virtuous circle – lower US consumer spending begets lower capital flows to emerging economies and oil-exporting countries which lead to fewer recycled capital into debt instruments which puts upward pressure on rates which impacts the borrowing availability to US consumers. And so it goes.

The offset to this is, of course, lower US consumer spending will reduce debt demand pressures and enable the Fed to mount its white horse and come to rescue yet again. That is all possible so long as inflation does its part and moderates. And in a moderate fashion.

The other offset is Decoupling – the ability of other regions of the world economy to pick up the growth slack of a slowing US economy. However, as Steve Roach has pointed out, the real test for decoupling has not made. It is only when the US consumer and, thereby, the US economy slows substantially that the decoupling scenario will be put to the test.

An additional risk to decoupling is if growth in the US does not moderate producing a sustained global boom that overheats and results in inflationary pressures worldwide. Concurrent with that is the financial markets and its overheated potential pushing all assets to extraordinary levels, while central bankers seek to offset extreme speculation and shut down the prime engine of global growth – liquidity. (This is, by far, the greatest risk to sustainable global growth and stability as it could precipitate a vicious cycle of historic proportions.)

Investment Strategy Implications

The current bull market’s greatest strength is also its greatest weakness – interdependency. The manifestations of this interdependency can be seen on multiple levels – highly synchronized economies, markets, sectors, etc. producing high correlations and low risk aversion. The interdependency has also produced a virtuous circle of self-reinforcing positives. But, self-reinforcing trends can work in reverse. And with great suddenness.

The world has become one economy and one market with highly interdependent qualities and exponential performance features. Yet, risk exists. And some are quite substantial. To dismiss them and genuflect at the altar of market fundamentalism is to advocate the end of human nature. Greed always gives way to fear.

The best investment advice I can think of in such an environment is simply this: Don’t Drink the Kool-aid.

Nothing is forever. And when the end comes, the characteristics that drove the run-up are usually the same characteristics that drive the decline.

An appreciation of timeless principles, such as regression to the mean, may limit the upside benefits of a bull rally, but will more than offset the inevitable plunge circles and cycles generate.

Tuesday, April 17, 2007

How the Virtuous Circle…

Support for higher equity values is anchored in the belief that we are in a virtuous circle: a Goldilocks version of money, economies, government policy, central bank accomodation, corporate management and profitability, and the markets.

Here’s how the virtuous circle works:

The US consumer buys what emerging economies and oil-exporting countries sell, and capital flows to the emerging economies and oil-exporting countries rise. The emerging economies and oil exporting countries recycle the capital back into financial assets, primarily debt. This lowers rates (producing the so-called “conundrum”), which help provide the wherewithal for US consumers to borrow at very attractive rates to support their lifestyles. Lower rates also help support higher asset values (equities and real estate), which further helps the US consumer to spend through the wealth effect (including MEW – mortgage equity withdrawals).

Products sold by emerging economies generate internal growth, which produces demand for raw materials and infrastructure builds that help fuel global consumption and generate incremental profits for global corporations. The resultant global growth and expanded markets coupled with globalization, technological innovation, and advanced management techniques help corporations generate above average top and bottom line growth.

Corporate leaders, by “creating value” through profitability and growth above the cost of capital, are kept in check via private equity and activist investors (including hedge funds) and the threat of M&A. Traditional long-only portfolio managers and their need for short-term performance support this environment when they willingly sell their shares to the highest corporate buyer. In the absence of a hot new issues market, the equity pop they receive from an M&A deal helps goose up their performance numbers.

Lastly, central bankers stand at the ready to provide liquidity as needed so that global growth remains sustainable and consistent.

Investment Strategy Implications

Of course, there is more complexity to the story, but I think you get the picture.

The virtuous circle is a stool that stands on many interconnected legs and requires many things to go right and few to go wrong to sustain itself. Yet, despite investors' persistent low regard for what could wrong, nothing is without risk.

Tomorrow, I will describe how the virtuous circle can become the vicious cycle.

Monday, April 16, 2007

Thematic Perspectives

“The typical long/short hedge fund has about 67% of its assets in small and medium capitalization stocks, according to a study by Morgan Stanley. A long-only institution has only 35% in these stocks. Most brokerage firm strategists believe that larger-capitalization stocks are undervalued today. If they start to outperform, hedge funds will either have to change their exposure to large-cap issues or risk lagging in relative performance.”

Byron Wien
“There is No Hedge Fund Bubble”

As noted on my blog last Thursday, mega and large cap have outperformed the Smids on a one-year basis. Moreover, as the chart on page 2 shows (see report), Large Cap Value tops the size and style performance list. However, as also noted last Thursday, the Smids have resumed their leadership roles over the most recent periods and are on the verge of making up the ground lost to their large and mega cap brethren due to last spring’s mini market meltdown.

As Byron’s comments note, the Smids are the main beneficiary of unregulated hedge fund money as performance pressures drive their investment decision-making. As I pointed out several weeks ago, much of this has to do with an increase in risk appetites. And so long as performance justifies actions, I would expect nothing to change. Until it changes on a more sustainable level.

Therefore, as with many comments made in early March, the demise of the Smids seems premature. Risk aversion had returned for the briefest of periods (a few weeks) and then it was back to business as usual.

Investment Strategy Implications

This market has parabolic melt-up written all over it. And a key driver is the liquidity flows that are so abundant around the world. Globalization has wrought money flows that find their way into many assets (financial and real) in our borderless world. While Financial Innovation has produced new, powerful instruments, such as hedge funds and private equity, that utilizes the highly liquid fund flows.

Byron’s views help put things in perspective. As he states in his commentary, “hedge funds represent an evolutionary step in money management. They are here to stay and the funds under management are likely to continue to grow larger over time.” When coupled with that other juggernaut of unregulated money, Private Equity, the game has most definitely changed.

As long as liquidity remains abundant and valuation justifications can be found, performance pressures and competition will likely drive financial assets higher. However, make no mistake: the liquidity game can turn on a dime. Put differently, downside volatility can alter the market’s direction fairly quickly, as the largely unforeseen market drops of last May/June and late February/early March demonstrate.

The dynamics of the markets have changed. And unregulated money is at the forefront of that change.

GEM (government, economy and the markets) Implications

The impact of unregulated money on the real economy and the markets are strong and obvious. Tied in with liquidity and leverage, the impact has and will continue to be felt for the foreseeable future. In both directions. When, not if, the political dimension comes into play will depend on when, not if, a major financial crisis erupts.

Friday, April 13, 2007

Weekend Reading: No Place for Ostriches

For those investors who still believe that the Fed’s next move is to lower rates, perhaps it’s time to take their heads out of the domestic economy sand and get a more complete global picture as to what’s really going on with growth and inflation. As the just issued IMF World Economic Outlook report along with today’s PPI data make abundantly clear, demand for goods and services are driven by global, not US, forces.

As the chart to the left shows, expectations for global growth for both this year and next remain robust. This despite an expected slowdown (not recession) in the US. Which brings us to one of the risks to this scenario: decoupling.

As the IMF report references, one of the uncertainties is whether other regions of the world economy can grow at the projected rates in the event of a US recession. In this regard, as the demand source of last resort the capacity of the American consumer to shop ‘til he/she drops is a vital factor to be decided on (capex, notwithstanding). And, one that makes metrics on the consumers’ well being (such as today’s consumer sentiment report) so important.

Investment Strategy Implications

Given the added fact that capital is abundant, liquidity and leverage (along with my other four thematic forces – McVey’s “Misalignment Triangle, unregulated money, innovation (technological and financial) and Globalization) stand at the ready to sustain world growth. And, to step into the markets and buy the dips. This is the so-called “floor under the market”. But what should not be forgotten, however, is the fact that this floor is not made of concrete, nor wood, but of sand. Ever shifting with the relative performance wind.

The delicate balance that is the current world economy should be understood by all investors. Issues, such as decoupling (the world economy grows while the US drifts, slows, or declines), should be appreciated for they impact not only global growth but capital flows and valuation inputs – most notably interest rates.

The world economy and markets, driven by the five forces noted above, are a complex, interactive, highly dynamic set of conditions that far outstrip the domestic-only debate. For those investors who wish to grasp this reality, I believe the just issued IMF report makes for a productive read.

Have a good weekend.

Thursday, April 12, 2007

Technical Thursdays: Time Travels

There is much talk regarding the failure of large cap to assume the mantle of leadership from its smaller cap brethren. This is true only if an investor looks at the most recent price performance. However, if an investor takes a step back and sees the market cap categories from a one-year time frame, a different picture emerges.

As the charts on the following page show (see report, link to Blue Marble Research services on left side of page), large and mega cap has outperformed the Smids on a one-year basis. Moreover, the relationship is in the exact order one would assume if the environment has become more uncertain (mega over large over mid over small over micro). However, from a global perspective, things are unchanged. And that’s where things get a bit more complicated.

(Chart comments. See report, link to Blue Marble Research services on left side of page.)

Year To Date: While Large and Mega cap trail, a pattern divergence is evident – Mid over both Small and Micro. This is contrary to the past several years but is less meaningful as Large and Mega trail.

One Year: A different picture emerges when you widen the view. Here, the impact of last spring’s mini correction can be more clearly seen. Mega (OEF) over Large (SPX) over Mid (MDY) over Small (IJR) over Micro (IWC).

From a global perspective, however, things are unchanged.

Year To Date: On a global basis, we see the same year-to-date relationship as in the US, with one twist. Higher growth/higher risk regions such as Asia-Pacific ex Japan (EPP) and Latin American 40 (ILF) top the list while the US (SPX) is at the bottom. The twist is the higher quality Europe 350 (IEV) which is edging out the broad Emerging Markets (EEM) group.

One Year: Unlike the one-year data for the US, however, most of the same year-to-date relationships exist on a one-year basis. It should be noted that Japan trails the pack by a wide margin.

Investment Strategy Implications

On a domestic level, I lean toward the one-year chart as it supports my fundamental views and suggest that we are in a transitional period where risk is not being rewarded as in the past. The counter argument is on a global basis where both the very short and near term trends (year-to-date and one year) are nearly identical. The question then becomes is the US leading or will the year-to-date US performance evolve and bring the one year size performance back in line with the rest of the world?

Beyond the potential breakdown of correlations this earnings season, there is no clear answer just yet. I do believe, however, that change is in the air and caution (higher quality, lower equity exposure) is justified.

Wednesday, April 11, 2007

V – TV (Take Two)

Wha Happened?

In case you were wondering, yesterday’s story regarding North Korea and its nuclear program preempted my scheduled appearance on CNBC, which has been rescheduled to today – same time 11 AM (ish). The focus once again will be on the upcoming earnings season and the market’s likely reaction.

What makes appearing on CNBC and other media channels special is the opportunity to encapsulate a point of view that adds value to the discussion already taking place. This is the challenge for the guests. So, what has already been said re earnings season and what can I add to the conversation?

First let’s begin with what we know.

The earnings data points that will come spewing out these next weeks will help describe the state of the US economy and individual sectors and industry economic performance. This we know. We also know that expectations for the first and second quarter have been ratcheted down to the low single digit levels. Many investment strategists and commentators have come forth to proclaim that the markets have already baked into the stock price these lowered expectations. In other words, it’s old news and any bad news is likely not to have much of an impact. This I cannot argue with mainly due to last week’s market performance.

As noted in Monday’s blog (see below) and report (see link to your left), the market had every reason to decline last week or at least post little to no change. It didn’t. When a market rises more than 1 ½% during a week that included a key economic report that came out on a day when the market would be closed and before an earnings season that could easily surprise to the downside, the message is fairly loud and clear – the markets have once again returned to their sanguine mode.

Investment Strategy Implications

Bad earnings news will likely be greeted with a large yawn. And only really bad earnings news and/or guidance, individually or collectively, will cause stocks to pause or decline. However, given the fact that we have come off a small correction base, that many technical cross currents are active (see tomorrow’s blog for one aspect of this point), and that liquidity and leverage remain high (see Bank of Japan’s rate decision today), I would expect stock selectivity will rise these coming weeks as correlations decline (for the moment). Overall, I would also expect that individual stories and circumstances cumulatively produce a ragged market with an upward bias. This fragmentation should, however, reveal the true strength and sustainability of the current rally off the weak correction base.

This will be my contribution to today’s “Morning Call” segment. Hope you get a chance to catch it.

Tuesday, April 10, 2007

V - TV

Today’s appearance on “Morning Call” (CNBC, 11 AM eastern) presents an opportunity to discuss the potential for stock selectivity as earnings season kicks off. My argument will center on the unpredictability factor due to the complex nature of the world’s markets and economies. Moreover, given the persistent slide in earnings expectations for the first two quarters of this year, it will be interesting to hear if my fellow guest posits how 2H07 will rescue the near zero growth rates of the first half of this year.

Yesterday’s appearance on Business News Network (formerly ROBTV) should be of interest to some, particularly those in the private client area as I fielded questions from callers on a wide range of subjects. All ETF investment ideas and strategies. Was great fun and always informative when real people pose questions.

Note: The BNN segment is available on the web at
(See 2:35 PM segment.)

Happy viewing.

Monday, April 9, 2007

Are We In Shangri-la or Sangui-la?

Last week’s market action was most telling. For here was a shortened week with a key economic report due out on a day when the markets were closed and just before earnings season begins – an earnings season that by all accounts could easily disappoint to the downside. Yet, despite all this, and despite the fact that the recent failure of predictions to get it even close to right (up or down - Goldman’s earnings, jobs report, for example), the markets still staged a solid performance.

Either the bulls have it right and we are in Shangri-la. Or the bears will be borne out and that we are in Sangui-la.

One thing is for sure: we aren’t in Kansas anymore.

Liquidity, leverage, the forces of the “Misalignment Triangle”, unregulated money, innovation (financial and technological) and Globalization have altered the traditional dynamics of the market. This helps explain, in part, why so many predictions are off the mark. For example, some experts remain stuck in the dogma of a domestic economy, failing to appreciate how the world has changed due to Globalization. Others insist that traditional monetary measures capture the level of liquidity. Yet, they ignore the factors of unregulated money. And so it goes.

All this should argue for greater caution among investors. But bubbles are not periods where caution is the modus operandi for many investors. The greater fool theory is. Buy high to sell higher. And, most definitely, buy the dips.

And who can criticize investors who adhere to such thinking? After all, since early 2003 what has worked better than this? In fact, this morning on CNBC there was a strategist who advocated exactly that – buy the dips. And that seems to be the mantra. It is certainly the mantra of the newly minted “masters of the universe”, a/k/a 20-something hedge funds managers.

What is forgotten and/or ignored is the fact that our world is a highly dynamic place. It is a multi-faceted Hydra whose behavior is erratic and most unpredictable. Yet, too many still believe the past, particularly the recent past, is the best tool to predict the future. And that certainty is the norm. Risk appetites have returned to pre mini correction levels. And credit spreads have barely budged off their historically low levels.

I believe, however, that some investors have been seduced by the elixir of liquidity and leverage and mistake high times for good times. Good times that are both predictable and sustainable. An other-worldly quality to it. Kind of like, well, Shangri-la.

Investment Strategy Implications

Shangri-la is a fictional place described in the 1933 novel "Lost Horizon". It is a book about a mystical, harmonious valley. An earthly paradise where all is good and life exists without consequences.

On the other hand,

Sangui-la is a place where certain investors reside. It is a place where they smoke their liquidity-drenched doobies, listen to Pink Floyd, and get comfortably numb. It is a place where some investors mistake higher prices due to liquidity and leverage with unrequited value.

And a place where some investors mistake for Shangri-la.

Thursday, April 5, 2007

The Equity Conundrum Part IV: Liquidity and Leverage – How Deep Does the Rabbit Hole Go?

“As I see it, disintermediation, securitization, and globalization have rendered the monetary aggregates — which largely represent the liabilities of depository institutions — less useful measures of overall financial liquidity than in the past. I’m sympathetic to the idea that with Japanese rates at just 50 basis points, the yen remains the funding currency of choice for global carry trades — but I have no idea how to gauge their importance.”

Richard Berner, Morgan Stanley, March 5, 2007


When one of Wall Street’s premier economists has “no idea how to gauge (the) importance” of just one aspect of liquidity (the Yen carry trade), then one has to wonder if anyone has a clue as to just how wide and deep the liquidity rabbit hole goes. Based on the dozens of programs that I have conducted for numerous analyst societies, the answer is NO ONE KNOWS just how levered global liquidity is. Take, for example, the fountains of unregulated money: hedge funds and private equity.

It is estimated (again, no one knows for sure) that hedge fund capital is in the $1.5 trillion range. Private equity is guesstimated at around $1 trillion. The guesstimates on leverage of these pools of capital is anywhere between 4 to 8 times. That interprets into $10 to 20 trillion of hot-to-trot money. Now, add to this equation the fact that NO ONE KNOWS just how extensive derivatives are levered off these numbers. And this is just about hedge fund and private equity capital.

Then there are the burgeoning capital reserves of central banks, the cash hordes of corporations, and ever-gushing capital flows into oil exporting countries. To this we can add the monetary policies of the world’s central banks, banks, non-banks, and other financial institutions. Now plug in the multiplier effect.

So, when it comes to getting a handle on liquidity and leverage, Richard Berner is not alone. In fact, despite conducting dozens of seminars involving more than 50 experts and spending countless hours researching the subject, I have yet to meet, hear, or read about anyone who has more than a general clue as to just how extensive the liquidity and leverage binge is. Have you?

Investment Strategy Implications

In and of itself, liquidity isn’t a bad thing. Nor is leverage. In fact, they are necessary components of properly functioning economies and markets. But there is an Alice in Wonderland quality to those who sanguinely dismiss any and all concerns over this mountain of money, its application, and its opaqueness. More dangerous, however, is the fact that the people who should have a handle on the subject, such as Ben Bernanke, don’t. (And, if Gentle Ben and others do know, they aren’t saying beyond “trust me”.)

There is a Greek proverb, “All things in moderation”. It is hard to imagine that liquidity and leverage today is being used in moderation. Deals abound. And risk premiums and credit spreads remain low - despite predictions of mean reversion, an increase in volatility, and a reduction in the correlation between asset classes and their components.

If the wheels come off the global bull market train, look to liquidity and leverage (and the failure of the world’s policy leaders to act when they could) for the answer to the train wreck.

How deep does the rabbit hole go, Alice?

(Note: Liquidity and leverage, along with Globalization and market fundamentalism, are themes that I will return to regularly. Have a good weekend.)

Wednesday, April 4, 2007

The Equity Conundrum Part III: When Analysts Become Analists

“If you do what you’ve always done, you’ll get what you’ve always got”

Context is king.

Studies show that in well-diversified portfolios the asset allocation decision constitutes 85 to 90% of investment performance. Yet, it has been my experience that 85 to 90% of most investors’ time is spent on the 10 – 15% of individual issue analysis and not on the more significant larger context that is the asset allocation decision domain. Why do most investors, professional and non, spend the vast majority of their time digging into the details of individual companies and not on larger, more significant portfolio-wide decision process?

Studies also show that the vast majority of investors do not beat the market. This is true for traditional portfolio management types (mutual fund managers, for example) and the unregulated money types, specifically hedge funds. Call it the “losers game” if you wish, but it is a fact.

Why is this? Why do so many smart people spend so much of their time with such little results? Perhaps, they were trained to do so. Trained in a methodology of a bygone era. Consider the following:

It’s a market of stocks and not a stock market. Or so the saying goes. However, if the asset allocation trumps the individual stock selection process, then doesn’t it behoove investors to spend more time on identifying and understand the macro than dwelling on the details of individual issues? Moreover, isn’t it fair to say that far too many resources are expended in the area of the specific and too few resources are spent on the more significant macro environment?

For investment strategy purposes, the value in focusing on individual issues rests in the insights they can provide to the larger context. To be sure, there is value in getting down in the trenches. But when trench warfare is the dominant focus of investors, then getting lost in the forest for the trees is the more apt phrase. And that, unfortunately, is where many investors find themselves.

Investment Strategy Implications

The impacts from mega trends and themes such as those exemplified in the sub prime mortgage problem, the consequences of globalization and market fundamentalism, the opaqueness of unregulated money (just how deep does the credit derivatives rabbit hole go?), the effects of electronic traders, systems, and exchanges, the hard to quantify aspects of geo political risks, McVey’s “Misalignment Triangle”, and innovation (both technological and financial), among others, need to appreciated at worst and understood at best.

In a globalized world, an opportunity exists for those who can widen the lens and understand the larger context. This is a world where context is king and analysts are not analists.

Note: Tomorrow's fourth and final installment touches on one such mega trend and a key driver in today's equity markets - liquidity and leverage.

Tuesday, April 3, 2007

The Equity Conundrum Part II: Climbing a Wall of Worry

There are those bullish investors who would argue that the current rally is actually the start of a new, major bull market cycle and not a continuation of the bull that began in the fall of 02, and certainly not the final stages of that 4 ½ year bull. These bullish investors cite the lingering concerns of many investors and the fact that investor sentiment is somewhat cautious. As the market rises, this caution is viewed by the bulls as “climbing a wall of worry”. To understand whether this view has any validity, let’s first look at when and where climbing a wall of worry typically occurs.

Climbing a wall of worry (CWW) typically occurs in the early denial phase of a bull market. The denial phase is one of eight phases of the greed/fear cycle.

The eight stages of the greed/fear cycle are:

1. Denial
2. Capitulation
3. Doubt (corrections)
4. Euphoria
5. Denial
6. Capitulation
7. Hope (rallies)
8. Extreme Pessimism

Stages 1 through 4 occur during a bull market. Stages 5 through 8 happen in a bear market. As you can see, they mirror image each other. Each phase starts with doubt and disbelief, which gives way to acceptance, experiencing periods of doubt (or hope), and culminating in extreme sentiment. (Note: the doubt and hope phases interact with the capitulation phase as corrections or rallies lower or raise investor sentiment.)

It is in stage 1 that CWW occurs. As a new bull market gets underway, hold over thinking from the extreme pessimism phase persists. Many investors find it hard to believe that good times really are just around the corner. And this skepticism adds fuel to the emerging bull fire, sustaining it as early believers feel confident that doubting investors will eventually join the party to take prices even higher.

The real economy counterpart to CWW typically involves an economic environment that is going or has gone from bad to worse. This becomes the economic justification for the skeptics as they hold onto their prior cycle beliefs. Also, during this period, central bankers have begun or are leaning against the wind and providing liquidity to the system that finds its way into both the financial and real economy.

Investment Strategy Implications

Given this brief history lesson, the question becomes “Does today’s bull market and economic environment resemble the above?” If the answer is yes, then you are a bullish CWW advocate. If not, then cause for concern over acceptance of this argument must enter into your thinking.

This is one overriding reason why I find it hard to believe that the markets are climbing a wall of worry.

As I have noted in yesterday’s installment, the deterioration of the fundamental underpinnings for higher stock prices gives me serious pause. In the context of the greed/fear cycle, the economy is not going from bad to worse but from good to okay. I would argue that okay is likely to be followed by bad, not good again. But that’s the essential economic argument, isn’t it? Or we in or did we just experience the pause that refreshes? Or are we in a way station, that calm before the storm really hits? Put me in the latter category.

If this market is climbing any wall it is not one of worry but of a liquidity-juiced enthusiasm.

But what about individual issues? After all, it is a market of stocks and not a stock market? Or so the saying goes. The subject of bottoms up investment decision-making is the focus for tomorrow’s installment.

Monday, April 2, 2007

The Equity Conundrum: Part I

Nothing exemplifies the equity conundrum (yes, there is one here, too) than the dichotomy between the deteriorating fundamental reasons for higher stock prices and the liquidity and leverage machines of unregulated money.

This week, I will touch on four aspects of the equity conundrum beginning today with a look into the deteriorating fundamentals supporting the argument for higher stock prices.

Tuesday will explore the technical analysis justifications of climbing a wall of worry. Wednesday will cover the bottom up approach to investment decision-making and why I believe it is flawed. On Thursday, I conclude with a look at the powerful forces of liquidity and leverage and unregulated money.

Deteriorating Fundamentals


With each passing week, the data makes clear that the economic climate in the spring of 07 is quite different from that of the fall of 06.

Last fall, inflation was a nagging problem but it was believed by many (not the least of which was the Fed) that it was headed lower. Energy prices had moderated and productivity remained strong. Corporate earnings expectations for 2007 were in the low double digits. The US housing slowdown had begun but there were few signs that it would spread to the overall economy in a serious manner.

Global growth was strong and expectations for the coming year were in the mid single digits, with all of the higher growth coming from emerging market economies. China was showing signs of overheating, but government policies were deemed appropriate and would have the desired effect of reducing excess speculation.

Monetary policies around the world were in a tightening mode. But long rates were showing no signs of concern of inflation.

The geo political environment was in flux, however, as the Republicans lost the Congress and protectionism was a concern but it was mostly talk. Iraq and other regions were in bad shape. Aside from the political consequences in the US, little had changed over the past several years.

And Now…

Contrast each of the above items with where things are today.

Inflation remains stubbornly above acceptable levels. Energy prices are headed higher. Corporate earnings growth have been adjusted downward to single digits, with 1Q07 being set below 4%. Productivity growth has slipped considerably and wage pressures are rising.

Perhaps, the biggest change is in housing, with the sub prime problems and its potential ripple effects on consumer spending. This is a story that has legs.

Monetary policies remain unchanged – tightening even further. Long rates, however, continue their liquidity-induced conundrum suggesting to some that either (a) economic weakness is headed or (b) inflationary concerns are unfounded. Neither is correct for reasons that I will elaborate on in Thursday’s installment.

A careful reading of the Fed suggest that concerns over slow growth and persistent inflation (mild stagflation) are justified and troublesome.

The already poor geo political environment has worsened, most notably with the rise of protectionist actions in the US. If left unchanged, retaliation is certain. And the likelihood is that things will actually get worse. Moreover, the nexus of global growth, monetary policies, interest rates, and geo political risks occurs here. Finally, the recent comments by Chinese Premiere, Wen Jiabao, regarding the “unstable, unbalanced, uncoordinated, and unsustainable” condition of the Chinese economy just adds to uncertainty factor of the emerging market growth phenomenon.

Other geo political risks are also in worse shape with the Middle East tensions threatening to widen as Iran ups the ante.

Finally, back in the US, Republican-minded investors can find little comfort in the chaos that is their party and the mountain of cash being raised by leading Democrats, most notably Darth Vader herself, Hillary Clinton.

Investment Strategy Implications

The fundamental justification for higher stock prices rests in a belief that the overall economic conditions conducive for growth and stability are present and likely to remain so for the foreseeable future. It could be argued that this was the case last fall but not today. The deterioration that has occurred since then is now so severe that, at a very minimum, investors should demand an appropriately higher risk premium for stocks. To accept any fair value arguments is inappropriate and far too risky for my thinking.

Note: Many bulls (both fundamental and technical) would argue that we are in a new phase of the bull market and investment principles like climbing a “wall of worry” are fitting. I disagree and will expand on this in tomorrow’s blog entry.