Bye, Bye Greenspan Put. Hello Market Discipline.

You may recall that the Greenspan Fed had the tendency of acting preemptively, seemingly at the first sign of danger. Moreover, the Greenspan Fed was far more inclined to view nearly all difficulties experienced by financial institutions as a reason to step in and provide whatever liquidity was needed to avoid contagion from erupting. Both facets gave the impression that the actions of the Greenspan Fed relied heavily on the artistic judgment of the Fed chairman.

Contrast that with the Bernanke Fed, which appears to take a more deliberative and detached approach to action preferring collegial confirmation to prescient preemption. This is not to say that the Bernanke Fed will not act preemptively if it has to. No doubt it will. However, preemption does not appear to be first option taken. Then there is perhaps the single most significant difference of the Bernanke Fed versus the Greenspan Fed: it’s reliance on the principle of the “market discipline”.

Time and again, the market discipline mantra has been espoused. By Fed heads and Treasury Secretary Paulson. However, the implications of this point are often ignored by equity investors possessed with animal spirits, too much liquidity, and the pressure to perform (see prior comments on the issue of hedge fund and traditional equity managers and the pressure to perform).

Investment Strategy Implications

There is a two-fold difference between the Greenspan era and the current one under Bernanke. First, unless the circumstances warrant it, the Bernanke Fed is far less likely to act preemptively. Second, the Bernanke Fed is more likely to let the markets exercise a market discipline, which has been defined as the first line of defense against excess risk. In other words, there is no Bernanke put. You play, you pay.

The larger issue that remains to be learned is just how effective the new regime (both meanings) will work out when (not if) a major financial or economic crisis hits. Put differently, can the Bernanke Fed manage a crisis without resorting to a flood of liquidity, which has the unintended consequence of generating the next bubble? And that will be the mother of all tests for the professor turned Fed chairman.

Shifting Gears

excerpts from this week's report:

"If it isn’t obvious by now, it should be.

A key characteristic of this bull market (yes, it’s still a bull market) that began in the spring of 2003 has been its tendency to climb in a steady manner, with low volatility on the way up, and then to experience sharp, seemingly out-of-the- blue corrections such as the one we are now having. In other words, a bull market punctuated by sharp, sudden corrections..."

"As for the bull market corrections experienced thus far, they can be described as a mini-Me version of a real correction: <10%. Will the current correction finally revert to the mean, if you will, and push the correction into the 10%+ range? For that answer, let’s consider the following six factors that are weighing on this market:..."

"Questions:

• Is this still a bull market? If so, then what we are experiencing is a correction.
• Is a leadership change underway? If so, what should be the portfolio mix once the correction is over and the bull market resumes?
• What should be the timing factors as the correction evolves?

Answers..."

also in this week's report
• Current Blue Marble Research Fed Valuation Model
• 2Q07 Earnings Update
• Model Growth Portfolio
• Key Economic Indicators

Note: To gain access to this week's report (and all previous reports), please click on the Blue Marble Research Services link to your left for info.

Quotable Quotes: Disappointment

As the bears (prematurely) whoop it up, it might behoove them to consider the emotion of disappointment.




“We must accept finite disappointment, but never lose infinite hope.”
Martin Luther King, Jr.

“If we will be quiet and ready enough, we shall find compensation in every disappointment.”
Henry David Thoreau

“But O! as to embrace me she inclin'd
I wak'd, she fled, and day brought back my night.”
John Milton

“You're always a little disappointing in person because you can't be the edited essence of yourself.”
Mel Brooks

Have a good weekend.

Technical Thursdays: Hedge Funds and Downside Correlations

Exactly two weeks from today, my next Market Forecast event for the New York Society of Security Analysts will feature a keynote address by Dr. Tobias Adrian of the New York Fed. The title of his speech is “Hedge Fund Tail Risk.” After reviewing an advanced copy of his presentation, I want to share with you a few thoughts on one of the issues that Dr. Adrian will address on August 9th that has a high application to today’s market: “Does tail risk of hedge funds increase in time of stress?”

As the charts above show and has been stated numerous times before, correlations are very high between and among sectors, styles, regions, countries, and, to some degree, other asset classes. What needs to be appreciated and what the above charts imply highlights a key aspect of Dr. Adrian’s speech: during times of stress, downside volatility accelerates in higher risk (but not necessarily higher beta) sectors*. This is precisely the risk that Dr. Adrian’s boss, NY Fed President, Timothy Geithner, worries about - When the brake becomes the accelerator. According to Dr. Adrian, the role hedge funds play in exerting downward pressure during times of stress is significant**.

Investment Strategy Implications

If technical analysis is worth its salt, then the current market decline will not metastasize into a contagion rout, which will trigger the tail risk (high downside volatility) event referred to by Adrain and Geithner. As noted in yesterday’s blog entry, the current correction got its start at an insignificant price point, thereby implying that the equity markets in the midst of yet another short and nasty correction. Moreover, as long as liquidity remains abundant, large and sustained market corrections tend to be mitigated.

It is advisable, however, that investors become keenly attuned to the risks of highly correlated markets that end up nearly eliminating the benefits of diversification and reducing downside risk minimization to the asset allocation decision. For there will come a day when the technicals are set up more completely than they are today for a major market decline. And liquidity may not be as abundant to save the day.

*For the styles in the left chart, the beta for the mid caps (MDY) is .98 and for the small caps (IJR) it's .95.
**Average hedge fund correlations are 32%; during time of stress the number jumps to 53%. In a related fact, Dr. Adrian points out that the correlations between hedge funds and investment banks are very high during times of stress (see third chart for a clear example of this point (IAI - broker/dealer ETF)

To view a larger version of the above charts, simply click on the images.

When a Flood Isn’t a Tsunami

Yesterday’s decline, while dramatic and will almost certainly require time to repair the damage done, contained little in the way of new news. The catalyst for the plunge, courtesy Bill Gross and Countrywide Financial, centered on the recurring fears of contagion spreading from housing and opaque exotic credit instruments. Yet, while the technical damage of such a large plunge will likely take time to repair (9 to 1 down days generally do), there is a secular trend that continues to mitigate any sustained decline – money creation.

As the charts above make quite clear, money creation continues to be very robust. What is important to remember re the data is that it does not include the money creation that has occurred in the world of exotic credit instruments invented by the financial engineers of Wall Street. And, at $400 trillion, that is where the real danger lies.

Investment Strategy Implications

As I will point out in tomorrow’s blog, market declines, no matter how dramatic or severe, that take place in the middle of trading ranges and not at major inflection points are largely meaningless beyond the very near term. Therefore, in a world of abundant capital, it is advisable to think of market declines such as yesterday's as damaging floods that take time to repair but not quite the equivalent of a tsunami, which remains somewhere in our future.

To view a larger version of the above charts, simply click on the images.
Chart sources: Strategas, Federal Reserve Bank of Saint Louis, respectively.

The New PE Ratio Revisited

Back on June 5th, I posted the following comment: "It can be heard with increasing frequency that your standard P/E (price to earnings) ratio should be replaced with a new PE (private equity) ratio. As the chart to your left shows (see June 5th posting), the combination of stock buybacks and PE deals is reducing the supply of equities and, thereby, adding fuel to the bull market fire. At around $2 trillion and counting, corporate cash and PE deal money (not to mention the $1.5 trillion in cash plus the 4 to 8 times leverage from the hedgies) are clearly having a profound impact on many areas of the investment landscape.


Equity valuation 101 teaches us that private market values are always higher than public market values. Accordingly, investor expectations can be reset to a higher level if enough investors believe more deals are on the way. A price to deal ratio, if you will. As with all new era talk, however, it is advisable to temper the enthusiasm as expectations based upon a continuation of the extraordinary stock buyback + PE driven deals at the current pace may not be sustainable resulting in PEs reverting back to P/Es."

Since that posting, a whole raft of issues have arisen in the private equity space the result of which is an increasing concern that the equity markets in the US may be losing a main engine of stock market appreciation - the private equity machine.

Investment Strategy Implications

Stocks are rising in emerging markets and for the companies that serve those markets due to the extraordinary growth rates there and the assumption that there is more to come. In the US, however, a great deal (some say too much) of the equity price appreciation is due to the power of financial innovation, with private equity and hedge funds at the forefront. Should the PEs and hedgies' difficulties not only persist but expand, stocks will likely slip back to their pre PE valuation days. Moreover, should the earnings outlook change, then a much more substantial decline in stocks would occur in which both the multiples would contract (from PE to P/E) and as the E itself drops. This scenario is most definitely not what the current market level is priced for.

"Still Time to BelIEVe in IEV?

excerpts from this week's report:

"Over the past year, the big stocks of “Old Europe” have made the big (mid - MDY - and small - IJR) stocks of Uncle Sam looked rather old and tired. At 17x current earnings (versus 18.5 for the S&P 500) and a beta of .74, the companies comprising the Europe 350 (IEV) are both cheaper and less volatile than their US counterparts. The reasons are several as IEV companies benefit from a resurgent European economy as well as its trading position with the extra hot Asian economies.

Moreover, as “New Europe” continues to join the fold, a ready pool of low cost labor and potential growth market sits within the overall European border. Finally, as a competitive and geo-political force vis-à-vis the US, European countries and economies benefit from the weakness in both the US economy and dollar, not to mention its standing in the world community (thanks to the Bush Administration’s disastrous foreign policy).

Now that the market has clearly looked past the rhetoric of “Old Europe” and come to appreciate its growth potential, both domestically and globally, should investors still belIEVe in IEV? The answer from this desk is yes, but. Here are a few reasons why, beginning with the composition of the portfolio..."

also in this week's report

* Current Blue Marble Research Fed Valuation Model
* 2Q07 Earnings Update
* Model Growth Portfolio
* Key Economic Indicators

Note: To gain access to this week's report, please click on the Services link to your left for info.

Also, to view a larger version of the above chart, simply click on the image.

Quotable Quotes: Skeptical Thinking

At the heart of the sub prime problems is the failure of far too many savvy investors to view the investments with less than a prudentially skeptical eye. Given the fact that approximately $400 trillion (face value) of OTC credit derivatives exist, just how deep and wide the problems are is the great unknown. Therefore, perhaps a few sage words on skeptical thinking might help.



“Skepticism is a discipline fit to purify the mind of prejudice and render it all the more apt, when the time comes, to believe and to act wisely.”
George Santayana

“It is unwise to be too sure of one's own wisdom. It is healthy to be reminded that the strongest might weaken and the wisest might err.”
Mahatma Gandhi

“There are all kinds of devices invented for the protection and preservation of countries: defensive barriers, forts, trenches, and the like... But prudent minds have as a natural gift one safeguard, which is the common possession of all, and this applies especially to the dealings of democracies. What is this safeguard? Skepticism. This you must preserve. This you must retain. If you can keep this, you need fear no harm.”
Demosthenes

"Belief in the truth commences with the doubting of all those 'truths' we once believed."

Friedrich Nietzsche

“Precaution is better than cure.”
Cicero

Have a good weekend.

Technical Thursdays: Money Growth and the Stock Market

In a prelude to next Monday’s weekly report on money growth, productivity, and equity values (rescheduled for July 30th), I want to share with you today two aspects of that report – money growth and the stock market.



A technical indicator that several astute market technicians point to is the growth of money, specifically MZM (money with zero maturity). The argument made is that money growth has provided the necessary liquidity to maintain ever-higher stock values. This is true. As long as liquidity* remains abundant, equities have an upward bias.

As the above charts show**, since 1980 the S&P 500 and MZM have trended higher at a compound annual growth rate of 10.2% and 8.5%, respectively. Obviously, stocks have fluctuated getting over and undervalued along the way. But the trend is undeniable.

Now, one might ask, is there a factor that helps explain the difference between money growth and equity value increases. The answer is none other than productivity. The compound annual growth rate of US productivity since 1980 is 1.6%. I think you can do the math: money growth at 8.5% + productivity growth at 1.6% = equity growth at 10.1%, a tenth of a percent off the actual growth rate.

Investment Strategy Implications

In next Monday’s weekly report, I will provide the details and data of these three factors – money growth, productivity, and equity values – along with the fair value levels they predict as well as a commentary on how to use the data. Until then, let me leave you with this thought – according to the data and given expectations for money growth and productivity, fair value for the S&P 500 for 2007 is 1569.67.

*Note: For the purposes of this commentary, I will limit the definition of liquidity to MZM and not include the unknowable – liquidity from non-bank lenders and leverage upon leverage in the form of instruments such as credit derivatives.

** To view a larger version of the above charts, simply click on the image

What to Listen for in Bernanke’s Testimony Today

No doubt today’s testimony by Ben Bernanke before Congress will focus on his views on inflation, including the debate re headline versus core inflation. A careful reading of his speech of last week provides the answer. Based on his comments, the debate of headline versus core inflation appears to be quite resolved in the Fed chairman’s mind. Here are a few observations:

For Ben Bernanke, it is core inflation that matters most. To the extent that headline inflation comes into the mix, his comments re the sustainability of “changes in oil prices and other supply shocks” are not likely to effect the public’s expectations of inflation as the data shows that their expectations are “anchored”, meaning that the public’s inflationary expectations are “relatively insensitive to incoming data”. This view is significant in that Bernanke apparently believes that, to the extent that components in headline inflation are impacted by supply shocks, the likelihood that they will result in a more serious and sustainable rise in core inflation are limited.

For example, in referring to research on anchoring, Bernanke notes, “Changes in the trend component are highly persistent whereas shocks to the cyclical component are temporary”. He, therefore, goes on to note that “unexpected changes in inflation are today much more likely to be transitory than they were before the early 1980s”.

There is one important additional factor to note re his comments of last week that is quite telling. While data, research studies, and econometric models may point to a conclusion, it is judgment, by him, his fellow Governors, and the Fed staff, that is the most crucial component in the Fed’s decision process. In other words, the Bernanke Fed is not dogmatic in either its process or views.

Investment Strategy Implications

The subject of Bernanke’s speech last week was “Inflation Expectations and Inflation Forecasting”. It could have just as easily been titled “Why I Believe Core Inflation Matters Most”. Therefore, I am fairly certain that his comments today will reinforce that view. If so, one might assume that, with core inflation moderating of late, interest rate increases are not likely. This would be a mistake. For while the subject of last week’s speech dealt with inflation expectations and behavioral science issues like anchoring, the unmistakable gist of both last week’s speech and other comments by the chairman and other key members of the Fed is that judgment is central to the Fed’s monetary decision-making process. Therefore, when it comes to this Fed, all the talk about inflation targeting is nonsense.

In Case You Missed It

As the equity markets flirt with new all-time highs and most US investors focus on earnings season, today's FT Alphaville has a noteworthy posting titled, "Subprime sell-off rattles credit derivative markets". Here is an excerpt from that posting along with three charts showing the plunge in value for key credit derivatives indices:

"The cost of insuring European corporate debt against default spiked sharply on Tuesday, after an index of securities linked to US subprime mortgages fell to a record low.

ING was downbeat about the outlook for the rest of the week, saying in a note: "The week ahead looks set to be fraught with volatility in an illiquid market, which is a very dangerous cocktail considering that the Crossover has already retraced 40 bps off its highs last week."

The iTraxx Crossover index of 50 mostly junk-rated European names jumped 19.5bp to 287bp after a sell-off in the ABX index.

The ABX is an index of credit-default swaps on subprime mortgage bonds and is used by investors to hedge subprime mortgage exposure. Overnight, the lowest-rated portion of the most recent ABX index, which is based on bonds sold in the second half of 2006, slipped 7.5 per cent to 45.28, according to derivatives data provider Markit."

Investment Strategy Implications

For those investors who are getting increasingly comfortable with the idea that we are climbing a wall of meaningless worry and that today's problems are quite manageable, acknowledging that contagion risk still exists seems warranted for a little margin for error, fully valued equity market.

Note: To view a larger version of the above charts, click on each image

A Two-Legged Stool

excerpts from this week's report

"Throughout its entire run, the bull market that began in the spring of 2003 is like a stool that has had three legs supporting it – valuation, liquidity, and market metrics. Yet, while both liquidity and the technical aspects of the market remain firmly in place, valuation, perhaps the most important of the three, has now broken down and no longer provides a justification for higher prices. And, in the process, the stock market has now become a two-legged stool.

Undeniably, valuation is a highly subjective measurement tool. What’s one person’s fair value level is another’s over or undervalued level. Regardless of one’s fair value point, however, it is becoming increasingly more difficult to make the valuation argument..."

"With earnings growth slowing and interest rates rising, a stock market that has risen to record highs reduces if not eliminates the margin for error. Hence, the equity bulls are now resorting to the age-old Wall Street axiom of a market climbing a wall of worry..."

"As the data on page three shows quite clearly (see report), individual investors are anything but concerned as their bullish levels have reached multi-month highs. Moreover, numerous surveys of professional investors are equally optimistic..."

also in this week's report

* Current Blue Marble Research Fed Model
* Model Growth Portfolio
* Key Economic Indicators

Note: To learn how to view this week's report, please click on the Blue Marble Research services link to your left.

Quotable Quotes: Optimism

Yesterday’s equity blast off implies an economic glass more than half full. Yeah, baby!

Therefore, a few quotes re optimism seem fitting.




"Man's real life is happy, chiefly because he is ever expecting that it soon will be so."
Edgar Allan Poe

"If you see ten troubles coming down the road, you can be sure that nine will run into the ditch before they reach you."
Calvin Coolidge

"Optimist: A man who gets treed by a lion but enjoys the scenery."
Walter Winchell

"The nice part about being a pessimist is that you are constantly being either proven right or pleasantly surprised."
George Will

"Those who wish to sing always find a song."
Swedish proverb

Happy Friday the 13th and have a good weekend.

Technical Thursdays: Forget Goldilocks, Think Gold

On April 24, 2007, I wrote about Gold and its prospects for a run to $1,000 an ounce. In that blog posting, I referenced the special nature of Gold as an investment vehicle, how precious little of its value resides in its industrial use, and that the primary value in Gold is as a hedge against instability and as an alternative to the US dollar. Given the fact that the geo-political climate has remained quite unstable (see yesterday's intelligence report re Al Qaeda, for example) as well as the prospective further weakness in the greenback (not to mention the white hot growth in Asia that has helped fuel demand), Gold's role as an attractive investment seems assured.



One concern that I hear pertains to the potential supply coming from Aunt Tilly and Uncle Willie as they cash in their jewelry and coins. While this may be a factor to be mindful of, the larger concern resides in the bullion holdings of central banks, as they dwarf the current demand/supply equation. At 9x the current supply rate, central banks could easily flood the market and depress the price of Gold in a heartbeat. While this risk exists, the likelihood of such an act seems quite remote as a catalyst for such action appears to be fairly non existent.

Investment Strategy Implications

Since the ETF tracker began trading in January of 2005, Gold has outperformed the market by a wide margin (see above chart). Over the past year, however, Gold has been locked in a trading range that has all the hallmarks of a high end consolidation. And, in the process, has enabled the 200 day moving average to approach its current price.

For both fundamental and technical reasons, Gold continues to be an excellent asset to own with qualities befitting the uncertain times ahead. The terrorist and other threats are with us for the foreseeable future. Coupled with the dismal performance of the US dollar and a domestic political climate that is both locked in gridlock and likely to become more cantankerous the closer we get to 2008, the prospects of an upside breakout and run to $1,000 is not unrealistic.

Note: To view a larger image of the chart, click on the image.

Synchronized Markets: Nowhere To Run

The highly synchronized nature of the US equity markets has become common knowledge to most investors. The same is true for global markets. What is interesting, however, is that comparing the last 100 days of the current bull market with its first 100, US economic sectors have become somewhat less correlated with the broad market (save Utilities) while most global markets have become more so (save Japan).

Investment Strategy Implications

Highly synchronized markets make it harder to diversify away risk resulting in a default to riskier positions (the beta trade) and/or leverage to generate excess returns. This is also true within most domestic markets. Therefore, it should come as no surprise that, given the plethora of investors and the abundance of capital, competing for alpha has become largely a leveraged play and/or the beta trade (see May 1, 2007 blog posting, "The Bubble Machine of Liquidity and Leverage"). Thus far, the apparent market consequences are long periods of tranquility (low volatility, consistent gains) interrupted by moments of financial angst.

Note: To view a larger image of the tables, click on the image.

What to Listen for When Bernanke Speaks Today

Today’s 1 PM speech by Fed Chairman Bernanke will be closely watched by most investors for what he says about the direction of interest rates. It may, however, be a more fruitful exercise to listen to what the Chairman says about key issues such as non-bank lenders than the likely non-statement re his views on rate changes. For example, in his last speech given on June 15th, he stated the following:

“Endogenous changes in creditworthiness may increase the persistence and amplitude of business cycles (the financial accelerator) and strengthen the influence of monetary policy (the credit channel). As I have noted today, what has been called the bank-lending channel--the idea that banks play a special role in the transmission of monetary policy--can be integrated into this same broad logical framework, if we focus on the link between the bank's financial condition and its cost of capital. Nonbank lenders may well be subject to the same forces.”

Where Alan Greenspan was noted for his opaqueness (to put it generously), Ben Bernanke, on the other hand, assumed his position as Fed chair promising a more candid and clear spoken view of his positions. Unfortunately, he learned early on that being too candid can produce more problems than benefits. Therefore, being a good student, the professor is a quick study and adjusted his pronouncements accordingly. But to what level of candor has he moved to in his commentaries?

Having read his (and other Fed head) speeches, the sense I get it that Mr. Bernanke likes to frame his views in larger thematic concepts rooted in his theoretical views on how monetary policy should function. For example, in the June 15th speech referenced above, a careful reading reveals that he is keenly aware of the psychological dynamic of investor, corporate, and consumer sentiment and the impact it has on the real and financial economy. In other words, he tempers his ivory tower views with a real world recognition of how markets and economies work.

As I said, when it comes to matters pertaining to interest rate changes, today’s speech will likely be a non-event. Therefore, what should be a more productive use of time is to listen for the larger thematic issues, such as his views on non-bank lenders and unregulated money.

And read between the lines. He may not be Greenspan but he is certainly not loose-lips Ben. There’s lots of info and insight there.

The Fed’s Delicate Balancing Act

excerpts from this week's report

"One year and counting.

Time flies when you are having fun as the economy marks the one year anniversary since the Fed set its funds rate at the 5 ¼% level.

So, it seems worthwhile to compare the FOMC statement from a year ago (June 29, 2006) with the one issued last week (June 28, 2007). Yet, it is also worthwhile to consider factors outside the FOMC decision and statement to help get a more complete picture of the balancing act that the Fed is faced with..."

"Gone are such phrases as a “cooling of the housing market” and the “lagged effects of increases in interest rates and energy prices”, despite the fact that all these issues remain very much on the minds of investors and many economists. However, relying solely (or even predominantly) on the FOMC statement and actions leaves an investor with a very incomplete picture.

To round out the Fed’s view of the world, it is advisable to..."

Investment Strategy Implications

"Contrary to the more traditionally thinking economic advisors, it does seem fairly clear that living in the era of globalization and financial innovation warrants a more comprehensive and even out-of-the-box perspective on economic conditions. Accordingly, as long as the Fed remains vigilant to the non-traditional aspects of a transitional world economy, the odds of a fat tail episode and a financially-induced downward spiral are diminished. However, the odds are not zero. Whether they can pull this off while sustaining global growth with moderate inflation remains to be seen."

also in this week's report

* Current Blue Marble Research Fed Model
* Model Growth Portfolio
* Key Economic Indicators

Note: To view this week's report, please click on the Blue Marble Research services link to your left.

Quotable Quotes: Expectations

As the 2Q07 earnings season gets underway, a little expectational thinking appears to be in order.




“There is no terror in the bang, only in the anticipation of it.”
Alfred Hitchcock

“Climate is what we expect, weather is what we get.”
Mark Twain

“If one does not know to which port is sailing, no wind is favorable.”
Seneca

“You got to be careful if you don't know where you're going, because you might not get there.”
Yogi Berra

Have a good weekend.

V - TV Alert

It seems that Friday, July 6 is V -TV day.

Canada: 9:50 AM - BNN TV "Market Morning"
Global: 10:05 AM - CNBC "Morning Call"
India: 12:45 PM - New Delhi TV "NDTV Profit"


Happy viewing.

All times listed are US Eastern times.

Technical Thursdays: Rates Matter

As the chart to your left shows quite clearly, when the 10-year Treasury recently broke out of its multi-year downtrend, the move was more dramatic than your standard upward blip. In fact, I am fairly certain that most market technicians would argue that the breakout was more than a mere coincidence as the sharp upward move occurred right at that multi-year downtrend line and after an extensive multi-year base building process.

So, what are fundamentally oriented investors to make of this?

The fundamental connection lies in the attempts of central bankers to address the issue of excess global liquidity. As central banks do their best to drain excess liquidity without precipitating a financial meltdown, the logical result is rising rates. Thus far, the carry-trade enabled “conundrum” appears to be slowly unwinding. And reality appears to be returning to the fixed income world.

Therefore, if you believe as I do that rates should be higher, the question is not whether rates are going higher. Rather, can rates go up without producing (or at least facilitating) an out-of-control financial meltdown (a/k/a contagion)? In other words, what central banks are trying to do is ease off the liquidity gas pedal without causing the brake to become the accelerator.

Investment Strategy Implications

The technicals strongly suggest that the rate increase is here to stay, the magnitude of which is hard to say. What is not hard to say is the direction, which is up. And the equity valuation impacts are obvious.

When Complex Markets Are Not Transparent

The complexity issues described in yesterday’s weekly report are amplified by the fact that so much that occurs in the financial world today is hidden from view. This is especially true for the multi-trillion dollar unregulated money worlds of hedge funds and private equity. For competitive and other reasons, full transparency does not exist and a “trust the experts” mentality rules. I suppose, as long as the results are there, who is to question the 21st century’s version of masters of the universe?

The point of this falls back to one of the three valuation inputs – the discount rate. One might suspect that astute investors would consider adjusting the traditional discount factor for a world so complex and opaque. Yet, most investors, particularly professional investors appear to be content and accept conventional valuation inputs in a most unconventional time.

Investment Strategy Implications

When complex environments are not as transparent as they should be, risk should be higher and, therefore, valuation lower. A further point for my primary argument that stocks should remain undervalued*.

*Note: Undervalued does not mean down. It simply means that wherever fair value is, stocks should not reach that level. For example, if fair value were determined to be 1700 in the S&P 500, equities could rise from present levels. However, my research argues that they should not reach fair value.

Welcome to The New Era of Complexity

excerpts from this week's report

"Entering the year, the three components of valuation – earnings/cash flows, growth rates, and discount factors – were fully supportive of higher prices. Moreover, the lifeblood of higher values - liquidity – was abundant. Therefore, the potential for a closing of the valuation gap was very good. The primary caveat expressed on these pages stemmed from a concern re the high degree of complacency among the majority of professional investors. As I conducted my early 2007 Market Forecast events, I was surprised by the degree of the sanguine certainty of so many in a world rife with uncertainty.

The primary concern I expressed at the start of the year was centered not on traditional economic issues..."

"Risk in a complex, interdependent world is different from risk in the traditional sense. It is comparable to the difference between a closed economic system and one that more globalized. More moving parts mean more potential for both reward and risk. Thus far, all that has been seen is the good stuff. The Great Moderation, as it is called, is cited as..."

"I became aware of issues like fat tails thanks their constant references in speeches by Ben Bernanke and NY Fed President Timothy Geithner, among others. Naturally, whenever a phrase that key Fed officials and other learned thinkers appears with a fair degree of frequency, I want to..."

"Fat tails are high volatility occurrences that are several standard deviations away from the norm. Such low probability events using Gaussian distribution principles are so rare as to render them irrelevant. But using a distribution rule such as Power Laws, the probability of such occurrences increases exponentially..."

"According various research reports, the more networked the world becomes, the more interdependent it becomes. And a more interdependent world adheres more to Power Law distributions than Bell Curve ones..."

"The implications for valuation under a Power Law versus a Bell Curve are significant..."

also in this week's report

* Current Blue Marble Research Fed Model
* Model Growth Portfolio
* Key Economic Indicators

Note: To view this week's report, please click on the Blue Marble Research services link to your left.