Monday, December 31, 2007


excerpts from this week's report:

"In what might be viewed as the alter ego version of the Oscar winning movie of a few years ago, “As Good As It Gets”, it does seem advisable that investors appreciate that, when it comes to the credit derivative-inspired credit squeeze, things appears to be As Bad As It Gets.

As noted back on November 13th, companies involved in the reality pricing game are “Clearing the Decks” as they work to deal with “the impact that Sarbanes-Oxley will have on the reporting of the sub prime and other credit derivative problems lurking on the books.”

Therefore, logic dictates that “When it comes to potentially hidden credit-related bombs what CEO is going to..."

Investment Strategy Implications

"The year ahead looks interestingly like a mirror image of 2007 as 1H08 looks like 2H07 with the second half of the year looking brighter as the effects of the credit squeeze fade and the positive impacts of the global growth story, strong money growth, continued new capital flowing into the New Power Brokers (see blog posting of December 27: “Reflecting Times – Day Two”), and..."

also in this week's report:

* Expected Return Valuation Model
* Moving Averages Scorecard
* Model Growth Portfolio
* Sectors and Styles Market Monitor
* Key US Economic Indicators

To gain access to this week's report (and all reports), click on the subscription info link to your left.

Friday, December 28, 2007

Quotable Quotes: Resolved

The New Year. A time for resolutions, promises, and intentions.

“Good resolutions are simply checks that men draw on a bank where they have no account”
Oscar Wilde

“An ounce of performance is worth pounds of promises.”
Mae West

“The woods are lovely, dark and deep. But I have promises to keep, and miles to go before I sleep.”
Robert Frost

“A Native American elder once described his own inner struggles in this manner: Inside of me there are two dogs. One of the dogs is mean and evil. The other dog is good. The mean dog fights the good dog all the time. When asked which dog wins, he reflected for a moment and replied, The one I feed the most."
George Bernard Shaw

Best wishes this holiday season and in the New Year.

Thursday, December 27, 2007

Reflecting Times – Day Two

The investment landscape has changed. Only a hermit or one stranded on a deserted island would think otherwise. Years of capital flows out of the US via its current account deficit have resulted in a wealth transfer of enormous proportions. Moreover, financial innovation has produced a nearly equal rise in not only new financial instruments, but the players that utilize them.

In a recent report titled “The New Power Brokers”, consultancy McKinsey & Co. describe the rising importance and influence of Petrodollars, Asian central banks, Hedge funds, and Private equity.

As the table above shows*, these new financial actors have large and growing clout that will not go away anytime soon. In fact, according to the McKinsey report, “Under current growth trends, MGI research finds that their assets will reach $20.7 trillion by 2012, 70 percent of the size of global pension funds. But even if oil prices were to fall, China’s current-account declines, and growth in hedge funds and private equity slowed, our analysis shows that the assets of these four players would nearly double over the next five years, increasing to as much as $15.2 trillion by 2012.”

Investment Strategy Implications

There are many implications that result from our new financial world order. For example, understanding the investment styles, risk tolerances, and time horizons of the new power brokers is very important. Moreover, the interplay between these new actors on the financial scene and the existing major players is also a dynamic that requires a deeper understanding.

Whatever the larger implications are (and they are many), one thing is certain - the power and clout of the new power brokers is here to stay.

*click on image to enlarge

Wednesday, December 26, 2007

Reflecting Times – Day One

(Note: This week is one of those two weeks per year when the Sectors and Styles Strategy Report is not produced. There are no changes to the Model Growth Portfolio. The next report will be published Monday, December 31st.)

This holiday shortened week presents a good time to reflect and review some of the key principles of investment decision making. Accordingly, with the Sage of Omaha in the news today, the following thoughts from Warren Buffet on risk (as expressed in the single factor – beta) are worth considering:

“In assessing risk, a beta purist will disdain examining what a company produces, what its competitors are doing, or how much borrowed money the company employs. He may even prefer not to know the company’s name. What he treasures is the price history of its stock. In contrast, we’ll happily forgo knowing the price history of its stock and instead will seek whatever information will further our understanding of a company’s business. …

The theoretician bred on beta has no mechanism for differentiating the risk in, say, a single-product toy company selling pet rocks or hula hoops from that of another toy company whose sole product is Monopoly or Barbie. But it’s quite possible for ordinary investors to make that distinction if they have a reasonable understanding of consumer behavior and the factors that create long-term competitive strength or weakness. Obviously, every investor will make mistakes. But by confining himself to a relatively few, easy-to-understand cases, a reasonably intelligent, informed and diligent person can judge investment risks with a useful degree of accuracy.”

The Essays of Warren Buffett: Lessons for Corporate America
(2001), pp. 77-79

Quote is contained within the Morgan Stanley "Investment Perspectives" report of December 12, 2007

Friday, December 21, 2007

Quotable Quotes: Peace on Earth

‘tis the season for wishes to come true. A few words on peace.

“When the power of love overcomes the love of power, the world will know peace.”
Jimi Hendrix

“Most people think of peace as a state of Nothing Bad Happening, or Nothing Much Happening. Yet if peace is to overtake us and make us the gift of serenity and well-being, it will have to be the state of Something Good Happening.”
E.B. White

“Christmas at my house is always at least six or seven times more pleasant than anywhere else. We start drinking early. And while everyone else is seeing only one Santa Claus, we'll be seeing six or seven.”
W.C. Fields

“I never believed in Santa Claus because I knew no white man would be coming into my neighborhood after dark.”
Dick Gregory

Best wishes this holiday season and in the New Year.

Thursday, December 20, 2007

Technical Thursdays: What a Decline to 1360 Means

In Tuesday’s blog posting, I provided a realistic worse case scenario for the S&P 500 – operating earnings for 2008 decline around 6% to $86 and longer term interest rates (10 year US Treasury) rise ½%. The combination of the two results in a decline in the S&P 500 to 1360, a level at which the potential return for large cap equities equals its historical long term average of 12%.

From a technical analysis perspective, what does it mean for the market to decline to 1360? Here are a few thoughts.

The above three charts* cover three distinct time frames that help shed some light on the characteristics of the current bull market current vis-à-vis the prior periods, one bull, one bear. In all cases, the application of the Moving Averages Principle (MAP) will be used.

Applying the moving averages principle to the first chart we see that the extended current bull market cycle (Jan. 1, 1995 to present) is in keeping with the global macro real economy trend of the Great Moderation. In three sustained cycles, the three components of MAP** are NEVER violated. Mega trends are sustained over several years with no whipsawing short term mega trend reversals. This, however, is not the case with the second chart.

Encompassing the period from August 1982 (the official start of the previous bullish supercycle) to Dec. 31, 1994, we see that there were three points at which MAP produced a mega trend reversal signal – Fall 1987, Fall 1990, and Spring 1994. In all three cases, the mega trend reasserted itself requiring investors to be flexible in their thinking and willing to reverse course as the bear signal produced was then reversed back to a bull signal. No doubt, there was some cost to the whipsaw nature of the times, selling when prices has already declined and buying back when they reverted to its prior bullish mega trend. However, that cost was miniscule compared to cost of missing the power of the reasserted bullish mega trend.

The third chart provides a view of much different time. Covering the time period of Jan. 1, 1970 right up to the start of the above noted bullish supercycle, the era of high volatility in the real economy (stagflation, extraordinarily high interest rates, etc.) was somewhat evident in the rocking and rolling of the market and the increased frequency of mega trend reversals – I count five – that took place, with a few additional very close calls.

Investment Strategy Implications

A break to 1360 will likely signal a change in the behavior of the market. A look back at the first chart shows that should such a break occur, not only will many market technicians (and no doubt numerous media mavens) point out that the prior lows have been violated (not to mention a more serious breach of the 200 day moving average) but, far more importantly, the MAP will signal a mega trend reversal.

For those adhering to the MAP, reducing their equity exposure will be required, despite whatever may be occurring in the real economy. However, as experience has shown, mega trend reversals can occur with greater frequency than many current bull market participants are accustomed to.

Should 1360 become a reality anytime soon, investors should be prepared for a period of whipsaw action in their asset allocation decision. This will then necessitate greater attention to the individual sectors and their mega trends. Moreover, a more thematic approach to investing might also be required to achieve alpha.

The bottom line conclusion is simply this: If 1360 occurs in the first half of 2008, the potential of a more permanent bearish trend cannot be ignored. Accordingly, investors should then reduce their overall US equity exposure. However, should a whipsaw occur (from bearish back to bullish), that will certainly cut into an investor’s performance results for the year, for the reversal signals tend to occur after a period of some decline or advance.

Net, net: Whipsaw action may be the new reality. However, the cost of ignoring the mega trend reversals is far too great compared to the cost of being whipsawed.

*click images to enlarge
**price relative to the moving averages, moving averages relative to each other, slope of both moving averages (50 and 200 day)
charts courtesy

Wednesday, December 19, 2007

A Delicate Balance

To reiterate the point made on this blog one week ago today, “This Fed is attempting to walk that fine line between the real economy effects of the credit squeeze, the moral hazard consequences of a bailout, and the risks that inflation eminating from the global growth story poses.”

This is the essence of the debate investors are having.

The most vocal say the Fed is not acting with a sufficient sense of urgency, that the economy needs more liquidity to avoid what in their view will be a certain recession, that the Fed is taking a far too aloof ivory tower/academic view of the economy and, in the process, is far behind the curve.

Others, the less vocal minority, believe that the Fed should not bail out bad business practices, that the moral hazard consequences send precisely the wrong message, and that the economy will manage its way through a sharp slowdown but not a recession.

And even less vocal and smaller (but slowly growing) minority believe that global growth combined with a weak US dollar will push inflation higher here in the US, which, when combined with weak US domestic growth, produces a stagflationary scenario.

What tends to be lost in all this global macro debate is the calendar.

2008 is not just a US Presidential election year, it is also the year when all members (so, that's what they are called!) of the House of Representatives are up for reelection and many in the Senate are as well. The balance of power is at stake. Well, you tell me – Will the US Congress sit idly by while the US economy rolls over into a recession? Or will earmarks and other pork barrel projects inject a fair amount of stimulus into a moribund economy?

Now, let’s also consider this issue – China. Will China sit idly by as its moment in the global sun (Olympics) becomes clouded as its primary export market, the US, slips into a serious recession? Or will they take central bank and sovereign wealth fund action to provide the necessary liquidity to ensure that its primary customer remains in decent if not excellent shape?

Investment Strategy Implications

There is every reason to believe that the Fed’s balancing act will work. However, the innovative approach taken by the Fed and other central bankers may not sit well with certain market players who want the game that was to be reinstated*. Frankly, that won’t happen. That game is over. A new financial innovation game is being molded, with several of the key components from the old game, namely lots of liquidity, as an integral part of it. To the extent that this creates uncertainty, as all transitional phases do, so be it. Uncertainty produces opportunity - for those who can see through the fear.

Bottom line: Stay fully invested. And be on the lookout for Lunch Money** trades.

*see blog postings "Squealing Away", December 12; “Searching for the Magic Formula”, November 29
**see Topics Discussed "Lunch Money"

Tuesday, December 18, 2007

How Low Can We Go?

Depending on who you listen to, the reasonable analyst expectations for 2008 S&P 500 operating earnings range from a modest +6% (typically top down approaches) to a very optimistic +14% (the ever optimistic bottom up numbers). In either case, the stock market is severely undervalued. However, let’s assume for a moment that operating earnings for 2008 hit more than a few rough patches thereby pushing earnings down some. Moreover, let’s also assume that longer term rates rise due to inflationary concerns and/or an easing of the flight to quality. That produces two questions:

* What is the reasonable valuation level for the market?
* How much lower (if at all) must the current stock market correction go before it is done?

If operating earnings were more seriously impacted thereby producing an earnings recession, a reasonable worse case scenario for operating earnings in 2008 might be $86. This is not implausible as some operating earnings expectations for Consumer Discretionary are a very robust (insane might be a better term) +15 to 20%. Moreover, the effects of the housing bust and credit squeeze may impact sectors such Financials more dramatically than currently anticipated.

Now, let’s put a little more uncertainty into the mix and say that longer term rates, such as the 10 year US Treasury, rise, oh, ½%. The rate increase may be a result of inflationary concerns and/or an easing of the flight to quality as the global central actions to address the credit squeeze works to a degree thereby alleviating some of the fear built into the current flight to quality in the credit markets.

Incorporating the $86 number and a 10 year US Treasury rate of 4.75% into my Expected Return Valuation Model* produces a potential low point for the S&P 500 of 1360. That said, the final question becomes when?

Investment Strategy Implications

Given the high degree of current market pessimism and the fact that we are just weeks away from the January effect, the likelihood is that the market might begin its slump to 1360 (7.4% decline from yesterday’s close) sometime around mid January. Until then, staying fully invested seems prudent. Moreover, during the next four weeks, trading opportunities (Lunch Money) should present themselves.

Note: The above worse case scenario produces a target range for the S&P 500 of 1496 to 1550. At those levels, the minimum market return from yesterday’s close is an average +1.88 to 5.56%.

*subscription required
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Monday, December 17, 2007

Don’t Get Scrooged

excerpts from this week's report:*

"The spirit of Christmas is one of hope, charity, and good will to all. However, the tone of many in the equity markets of late appear to be consumed by their loss aversion fears as opposed to viewing current circumstances with their more objective, less emotionally driven valuation assessors in risk aversion mode. A most Scrooge-like psychology.

Of course, many would argue that they are being risk and not loss averse. That the real economy will suffer the fate of the credit derivative fools guided by the blind men at the world’s central banks. (e.g. Wolfgang Munchau’s commentary in today’s FT “Hold tight, the central banks have no plan.”)

To be clear, there is a real economy risk to all this Bah Humbugging. However, it lies not in the “predictive” nature of the equity markets, but in George Soros’ reflexivity principle – the feedback loop from the financial markets to the real economy. For should the fear of a Christmas Yet to Come prove true it likely will be due less to the so-called “wisdom of the market” and more to the self fulfilling prophecy nature..."

"Last Tuesday, I posted on this blog “A Simple Stock Market Balance Sheet”. As listed, there are many strong components on the asset side of the ledger. Yet, Mr. Market seems intent on focusing on the liabilities side, with all its potential real economy..."

also in this week's report:

* Expected Return Valuation Model
* Moving Averages Scorecard
* Model Growth Portfolio
* Investor Sentiment Data
* Chart Focus: Consumer Confidence
* Sectors and Styles Market Monitor
* Key US Economic Indicators

To gain access to this and all reports, click on the subscription info link to your left.
*requires subscription

Friday, December 14, 2007

Quotable Quotes: Performance Enhancing Substances

Athletes have steroids and human growth hormones. Portfolio managers have IPOs. A few words about performance enhancing substances.

“Why is there so much controversy about drug testing? I know plenty of guys who would be willing to test any drug they could come up with”
George Carlin

“I've tried everything. I can say to you with confidence, I know a fair amount about LSD. I've never been a social user of any of these things, but my curiosity has carried me into a lot of interesting areas.”
Dan Rather

“The best pitch I ever heard about cocaine was back in the early eighties when a street dealer followed me down the sidewalk going: I got some great blow man. I got the stuff that killed Belushi.”
Denis Leary

“Drugs have taught an entire generation of American kids the metric system.”
P.J. O'Rourke

“I tried marijuana once. I did not inhale.”
Slick Willie

Thursday, December 13, 2007

“Get Busy Living or Get Busy Dying”

This famous line from the great movie, “The Shawshank Redemption”, seems apropos to the current mood of many investors. Locked in their prison of investment doom and gloom, the glass half empty crowd seem to becoming “institutionalized” in their fear of unknown, as well as the possible and the maybe.

*click on image to enlarge.

For those who are not so frozen in their fear of the unknown, the possible, and the maybe, I have an actionable idea that may make sweet music like Le Nozze di Figaro. My long idea is rooted in three strong current market trends:

* Hedge Funds, Low Redemptions, and the Quality Migration Cycle
* Mid Cap issues and the January Effect
* Growth over Value

The actionable idea is the Mid Cap Growth ETF – IJK.

IJK is a unique position to consider as it benefits from each of the three above noted items for the following reasons:

1 - A source of strength for our aged bull has been the fact that equity hedge funds have not experienced mass redemptions. Quite the contrary, new money continues to flow into the category requiring capital to put to work to earn those fat performance fees. If money is both staying and flowing in, where is likely to be put to work?

One place is where the equity hedgies have been all along – in the Smids, as this is where the bulk of their equity capital is deployed. However, the hedgies are not unaware of the risks facing the markets and the economy, which may explain why a quality migration from Small to Mid has resulted in the Small cap sector faltering while the Mid caps have not (see blog posting of last Thursday, December 6th).

Moreover, as also noted last Thursday, the Mid cap group has yet to trigger a sell signal, as the Small and Micro group has.

2 – The second driver for IJK is the historical ritual of the renewed flow of funds into 401ks and other retirement vehicles known as the “January Effect”.

Where the January Effect is felt most dramatically is in, you guessed it, the Smids. Therefore, it is quite reasonable to assume that as 2008 gets underway, the January Effect will join the funds already at work by the flushed with capital hedgies to help get the New Year off to a good start for the Mid caps.

Now that we know the who and the when, let’s fine-tune our work to identify the where.

3 – The third driver for IJK is what is known as the growth scarcity factor.

Most of the time, value outperforms growth. However, as Rich Bernstein at Merrill has noted numerous times before, when growth becomes scarce, growth tends to outperform value. Since growth rates for corporate earnings are expected to decline for the next several quarters, the growth scarcity factor suggests that the outperformance by growth over value that has emerged these past four months (across all size classes, I might add) has a good chance of continuing for a while longer.

Investment Strategy Implications

IJK is a good actionable idea for anyone seeking to get busy living at a time when others are “institutionalized” in their fear of the unknown, the possible, and the maybe. See you Zihuatanejo.

Note: The above is strictly for informational purposes and should not be construed as a recommendation to buy or sell any securities. Please consult your financial advisor. Neither Vinny Catalano nor any member of his family owns the above referenced securities. Accounts managed by Blue Marble Research do have positions in the above referenced securities.

Wednesday, December 12, 2007

Squealing Away

This morning's bold central bank announcement will be seen by some as a capitulation, by the Fed and its counterparts, to yesterday’s negative knee jerk reaction to the Fed’s ¼ point rate cut decision. To see the announcement as such is naïve. Picture the scene: the Fed members sat around last night wringing their hands in woeful lamentation wondering why Wall Street just doesn’t understand us? Nonsense.

The decision this morning is part of the next phase, a series of steps designed to create the game that will be, the Magic Formula*. Like a pig stuck in an investment fence, however, some “investors” want the game that was to be restored asap while this Fed wants the game that will be to emerge*. To understand the difference between the two is to understand the tug of war that erupts every time this Fed chooses not to go back to the game that was via a bailout of bad behavior.

The principal reason why certain “investors” want to reestablish the game that was has much less to do with their crocodile-tear concerns re the real economy and the threat of a recession and much more to do with one simple, logical fact of human nature: When many have made a fortune playing the game a certain way, when their trading systems and information networks have generated seven, eight, even nine-figured incomes, they will do everything in their power to restore what was using any and all means possible, including those like-minded shills in the media.

Investment Strategy Implications

This Fed is attempting to walk that fine line between the real economy effects of the credit squeeze, the moral hazard consequences of a bailout, and the risks that inflation eminating from the global growth story poses. Therefore, it is advisable that real investors, those interested in making investment decisions with a time horizon beyond the next media sound bite, try to best understand the global macro context that policy decisions are being made in. It is also advisable not to become consumed in the moment (what behavioral finance experts call the “availability heuristic”, also known as “recentness”**) at the expense of the larger context as noted in yesterday’s simple stock market balance sheet.

It may be upsetting for some to hear but this far from perfect Fed does know something.

*see blog posting “Searching for the Magic Formula”, November 29
**see blog posting “Just How Smart is the “Smart Money”, May 29

Tuesday, December 11, 2007

A Simple Stock Market Balance Sheet

Lost in the daily angst is the fact that there are counterbalancing forces pushing and pulling stocks up and down. Yet, many investors often get consumed in the single-issue story and forget to take a step back and compile the pluses and minuses that tilt the market up and down.

To help frame the subject, applying a simple balance sheet approach to the market should help identify those factors that matter most and, thereby, put the current fear in perspective.

On the asset side of the ledger:

  • High Levels of Investment Liquidity
  •                  Hedge Funds, Sovereign Wealth Funds, Private Equity, Mutual Fund
                              Low Redemptions, Net Cash Infusions
  • High Corporate Cash Levels
                       Strong profitability
                              Technological Benefits
  • Valuation
  •                   Expected Returns, P/E
  • Technicals
  •                  Mega Trend
                              Moving Average Scorecard
  • US Elections, Olympics in China
  • Global Growth Story
  •                  Globalization

    On the liability side:
  • Slowing US Economy
                    US Consumer Under Pressure
  • Credit Freeze
                    Black Hole
                            More Shoes to Drop
  • Weak US Dollar
  • Emerging Markets Bubble
  • Inflation

    Unresolved issues include:
  • Geopolitical Risks
                    Pakistan, for example; Terrorism always
  • Decoupling

  • Investment Strategy Implications

    It appears that we are now in the worst phase of the credit derivatives debacle. For this is the time, before the bean counters close the books and senior management has to sign on the personally liable line, when all that needs to be known will be revealed.

    Interestingly, however, the big shoes are dropping but, beyond the very near term, the stocks aren’t. That should tell you something about the strength of the market and its near term direction.

    Moreover, it’s also worth noting that the two ultimate measures of the market – valuation and the mega trend (as measured by the technicals) – are currently on the asset side of the ledger.

    Finally, only if you believe in the deep recession scenario, which produces a substantial impact to the global growth story, as decoupling proves to be a myth, which in sum produces a large hit to corporate profits (>10%) should you chose to undervalue the asset side of our simple balance sheet. If, however, you are not in that camp, then fear should be tempered as there are many sectors and industries to stay invested in.

    Monday, December 10, 2007

    Your Move, Mr. Market

    excerpts from this week's report:

    This week I am pleased to provide a new weekly market-tracking service based on a very reliable tool – the Moving Averages Principle.

    The Moving Averages Principle (MAP) is an excellent guide to determining the state of the mega trend in any one sector, industry, country, region, or stock. MAP minimizes the noise of the market and helps keep our eye on the most important investment ball – the mega trend.

    The Moving Averages Scorecard noted in the table on the next page (see report*) applies the MAP and measures the mega trend for each of the ten economic sectors tracked by the S&P 500 in the first grouping. The second grouping applies the MAP to the five size metrics of the market – mega, large, mid, small, and micro. Lastly, the third grouping applies the MAP to selected global markets.

    As above table (see report*) shows rather clearly, the mega trends for 15 out of the total of 20 individual sectors, styles, and global markets are bullish. At present, with 75% of the key metrics for the US and global markets on the bullish side of the MAP ledger, the only investment strategy question to answer is tactical. For that, we look at my Expected Return Valuation Model (see report*)..."

    Chart Focus: Mortgage Tranches

    "The first chart above (see report) is from today’s Wall Street Journal. The second is the S&P 500 over the same period. It is interesting to note how investors chose to ignore the warnings signs as prices deteriorated in early 2007, yet equities moved to all-time highs, which takes me back to the follow excerpt from my August 6, 2007 weekly report:

    "Ever so slowly but no less dramatically, investors are coming to appreciate what readers of this newsletter and blog have known for well over a year – risk has been grossly underestimated and correlations among assets are..."

    also in this week's report:

    * Expected Return Valuation Model
    * Model Growth Portfolio
    * Investor Sentiment Data
    * Chart Focus: Mortgage Tranches
    * Sectors and Styles Market Monitor
    * Key US Economic Indicators

    To gain access to this and all reports, click on the subscription info link to your left.
    *requires subscription

    Friday, December 7, 2007

    Quotable Quotes: Direction

    As the stock market crisscrosses its way in a range bound manner, perhaps a few words on direction would help.

    “We live in an age disturbed, confused, bewildered, afraid of its own forces, in search not merely of its road but even of its direction”
    Woodrow Wilson

    “There is nothing wrong with change, if it is in the right direction”
    Winston Churchill

    “One day Alice came to a fork in the road and saw a Cheshire cat in a tree. Which road do I take? she asked. Where do you want to go? was his response. I don't know, Alice answered. Then, said the cat, it doesn't matter.”
    Lewis Carroll

    “Maybe I'm lucky to be going so slowly, because I may be going in the wrong direction”
    Ashleigh Brilliant

    “When you come to the fork in the road, take it”
    Yogi Berra

    Have a good weekend.

    Thursday, December 6, 2007

    Technical Thursdays: The Quality Migration Cycle

    The Quality Migration Cycle is a very useful tool that no investor should be without. It provides the mega trend context by applying the Divergences Principle to the five size (market cap) categories – mega, large, mid, small, and micro - to give to perspective on the breadth of the mega trend in force. It assumes that size = quality, which is affirmed as such by the performance history of other quality metrics such as S&P quality ratings for stocks.

    The application of QMC can be seen by looking at the first chart above*.

    As the chart makes clear, the current market conditions show the beginnings of a breakdown in relative performance of the Small (IJR) and Micro (IWC) cap ETF index trackers. Lower lows for each while the remaining three size groupings have not made such a move during the recent phase of the current market correction.

    The underlying principle of QMC is to help determine who is leading the mega trend parade at any given point in time. If all are marching in sync AND the mega trend parade is being led by the Smids and Micro, then the mega trend is intact. The logic being that lower quality issues should reward investors for the greater risk of owning them. However, when the mega trend parade is being led by the big boys AND the lower quality issues not only trail in relative performance but exhibit signs of breakdown (such as lower lows unconfirmed by the larger indices), then the prospects for a market topping process must be put into a potential bearish mix.

    The fly in the bearish mix currently is the strength in Mid cap. It has not confirmed with a lower low but may do so in the near future. This cannot be determined beforehand. Nor should it, as indicators such as QMC are mega trend indicators helpful in making longer term market calls.

    The Quality Migration Cycle helps an investor determine the market ending process of improving relative performance of the higher quality/larger issues as the lower quality sectors underperform in sequence. That appears to be the case currently. Micro failed first, followed by Small. Is Mid cap next? For that answer, see the second chart above* and the application of the long term Moving Averages Principle.

    Here we see MDY on the verge of rolling over. Price is at its moving averages and the moving averages are close to crossing (50 below 200 day). However, unlike the Small cap (see third chart), MDY’s moving averages have not crossed nor are they trending down, a condition of a mega trend change as required by the Moving Averages Principle (MAP).

    (see prior blog postings under the Topics Discussed category - scroll down, left side - for more on the MAP.)

    Investment Strategy Implications

    The QMC’s usefulness rests in providing the mega trend context as to where we are in a bull market cycle. At present, the cycle suggests that a market topping process is underway. However, a misapplication of the QMC would be anticipatory. The full cycle must be allowed to play out as what appears to be a market top may actually turn out to be a consolidation range, launch pad for the next up phase.

    Context, yes. Tactical decisions (sector and style allocation), yes. Anticipatory, not advisable.

    *click on the image to enlarge
    Charts sourced from

    Wednesday, December 5, 2007

    Feed Me!

    Gone largely unnoticed, the Global Consumer Staples ETF (KXI) has been producing a very nice return to investors. Benefiting from the global growth story, KXI’s holdings are well positioned to provide the basics of modern life as the populations of the emerging economies gradually migrate to the middle-income strata of their respective societies.

    Since its introduction one year ago, KXI has outperformed the S&P 500 and the more domestically oriented Consumer Staples XLP (see chart above*). The standout reason for the outperformance vis-à-vis XLP is illustrated in the composition of their top ten holdings. As the table above* shows, XLP is much more heavily concentrated both in the top 10 holdings as a percent of the total portfolio as well as its two largest positions, PG and MO.

    Investment Strategy Implications

    KXI provides investors with a vehicle to play the rising middle-income classes of emerging countries. While the US economy may slump, the global growth story remains intact (unless, of course, you don’t buy the decoupling scenario). Additionally, anyone seeking to stay in the aged bull with a reduced level of risk, consumer staples as a group is a place to be. (It should be noted that the weak US dollar has aided the US oriented XLP as more issues in that portfolio are major global providers benefiting from the falling dollar, as evidenced by the fact of its near equal performance over the past several months.)

    With a P/E just a notch above XLP and a beta of .68, KXI should be on every moderate to conservative investor’s radar screen.

    *click on images to enlarge
    Note: The above is strictly for informational purposes and should not be construed as a recommendation to buy or sell any securities. Please consult your financial advisor. Neither Vinny Catalano nor any member of his family owns the above referenced securities. Accounts managed by Blue Marble Research do have positions in the above referenced securities.

    Tuesday, December 4, 2007

    Hurry Up, Hank!

    The search for the magic formula (see last Thursday’s blog posting) is running into serious roadblocks and the financial powers that be must resolve the re-engaged credit freeze asap. With each passing day, the failure to create the new financial order puts increasing strain on the core of the system – something that cannot be allowed to metastasize into the real economy. Dangerously, such a risk seems to be on the rise. Yet, at the same time, the excess liquidity sitting in the coffers of institutional investors (including hedgies) along with reasonable earnings growth suggests that the downside risk to equities is limited.

    The two above dichotomous points are captured quite clearly in the following three excerpts from the must read FT Alphaville:

    “The perceived riskiness of European corporate debt increased on Tuesday as traders in credit default swaps, worried the credit squeeze will ripple from banks to the wider economy, drove spreads wider. Concerns for banks’ balance-sheets were exacerbated yesterday when the one-month sterling Libor rate hit a nine-year high. There were growing signs that tightening credit was hitting consumer demand as restaurants, credit card businesses and property funds began to feel the strain.”

    “Five hedge fund managers at London’s Marble Bar Asset Management will share at least $400m after agreeing to sell their five-year-old firm to EFG International, the Swiss bank.”

    “Warren Buffett has rediscovered his appetite for junk bonds, buying $2.1bn in debt issued by the Texas utility TXU in a move that suggests value-seeking investors are prepared to step back into the troubled credit markets.”

    So, there you have it in a nutshell. The core of the system has reentered the deep freeze with the increasing risk of spillover to the real economy while investment capital remains abundant, and abundantly rewarded.

    Investment Strategy Implications

    One week from today, the Fed’s interest rate decision will be a no brainer – another ¼ point cut. That will put the Fed 2/3s of the way toward the normal rate cut response (1 ½%) to a potential domestic economic slowdown. However, rate cuts alone will not do the trick. The magic formula must be found - and quickly - as there is little about the current situation that is normal.

    As for equities, signs of a topping process increase. As noted in yesterday's weekly report (subscription required), the infantry is abandoning the effort as Small and Micro cap have significantly underperformed of late leaving only Mid cap standing. It is, however, far from being a done deal. Counterbalancing positive factors (valuation, global growth story, investment liquidity) provide support for higher equity prices, or at least limiting the downside risk. Yet, these positives can evaporate in short order if the magic formula cannot be found.

    Time is not on anyone’s side.

    Monday, December 3, 2007

    The Enduring Bull Market

    excerpts from this week's report:

    “Quite a few people have been asking lately why on earth the equity market is so high, but I make no apology for joining them. If the Dow can rise 540 points in two days - as it did last week - something rather odd is going on.”

    So writes Tony Jackson in today’s FT commentary, “Glum conclusion is equity investors are still in denial”. And herein lies the problem with viewing the equity markets solely through the prism of the real economy.

    For while nearly all the references in Mr. Jackson’s commentary today cannot be disputed, one can be correct in factors pertaining to the real economy yet wrong when factors pertaining to the financial economy (the markets) are at odds with or offsetting the real economy issues noted.

    Yes, there are ample reasons to be concerned re the credit crunch. Yes, there are many causes for concern re the credit crunch and its potential effect on emerging markets and the damage that can be done to the decoupling argument. And, yes, the markets may be foolish to be “starting to price in a return to more normal profitability after a long and exceptional bonanza.”

    All true, all logical, and all flawed if one chooses to ignore the counterbalancing factors of valuation, equity market liquidity (as in the hands of hedge funds and private equity players), and the conditions favorable for decoupling.

    Moreover, while fundamentally oriented investors may choose to, I believe that ignoring the technical analysis factors is done at one’s own financial peril.

    Here are a few comments on each of the positive points noted..."

    also in this week's report:

    * Expected Return Valuation Model
    * Model Growth Portfolio
    * Investor Sentiment Data
    * Chart Focus: ISM Indices
    * Sectors and Styles Market Monitor
    * Key US Economic Indicators

    To gain access to this and all reports, click on the subscription info link to your left.