Thursday, July 31, 2008

No End In Sight meets Mr. Alpha and Regression to the Mean

“U.S. bank stocks may be staging another suckers' rally.”
Reuters, July 31, 2008

From time immemorial the four most dangerous words in the investment language has been “This time is different”. Today, however, a new phrase seems destined to join the dreaded phrase group – “No end in sight”.

If an investor assumes that the IMF is correct, then the bank loss write-downs could reach $945 billion. If hedge fund investor extraordinaire John Paulson is correct, the number increases to $1.3 trillion. If Bridgewater Associates is correct, the number rises further to $1.6 trillion. And the top end of Nouriel Roubini’s disaster scenario range is a cool $2 trillion.

At under $500 billion in losses taken thus far, “no end in sight” is an apt phrase.

But, to quote the Joker, “Why so serious?”

Investment Strategy Implications

While the relief certain investors may feel due to Merrill’s actions may be premature, investment strategy considerations drive the current portfolio decision-making process. For, if an investor has been fortunate enough to have produced alpha thus far this year – for example, portfolio and investment strategy decisions made in the Model Growth Portfolio (MGP) have yielded over 300 basis points of alpha thus far this year – then the real risk may not be the next plunge in equities (that’s coming) but the danger in not exploiting the near-term momentum game courtesy hedge fund momentum players and thereby losing valuable alpha in any short-term bear market rally.

Therefore, the appropriate current investment strategy appears to be largely a market neutral one. With an undervalued market and no sustainable and exploitable trends or themes at work, being fully invested – yet with no particular tilt from a sector perspective* – seems most appropriate. It’s only from a style and size perspective that a modest tilt toward the Smids and growth (as opposed to value) remains advisable**.

So, when Warren Buffett declares that the financial crisis due to “financial weapons of mass destruction” is “far from over”, investors should heed the warning. For those who are paid to exploit near term market moves, however, an undervalued market dominated by hedge fund momentum players is too hard to ignore and an investor stands to lose a considerable amount of hard won alpha***.

No end in sight is real. However, regression to the mean in an undervalued market may take precedence for the time being.

*The MGP is strongly underweight Energy. This will change shortly pending their 2Q08 earnings reports, the potential of negative political influences therefrom, and technical analysis considerations.

**This, however, would change should the recent weak relative performance of the Smid growth styles continue.

***If wrong, then the absolute performance will suffer, no doubt, but the alpha remains largely unchanged.

Wednesday, July 30, 2008

Beyond the Sound Bite: An Interview with Steve Forbes

Steve Forbes, in his capacity as economic advisor to John McCain, shares his perspective on the Senator's positions re tax policy, the federal budget (including entitlement programs), regulatory issues, and working with a Democratic Congress.

Beyond the Sound Bite postings can be found at
To listen to this week's podcast interview, click here

Tuesday, July 29, 2008

Sell Boardwalk. Buy Water Works.

commentary from this week’s “Sectors and Styles Strategy Report”*:

In economic life as in the game of Monopoly, what you buy determines how large your pool of assets will be. If the Republicans are advocates of the high life, then the Democrats are more pedestrian in their interests. Consider the need for public works programs in the US.

Regardless who wins the White House, the crumbling infrastructure in the US will almost certainly receive considerable focus and funds beginning next year.

There are two reasons that should drive this initiative. First, the need is clearly there. Years of neglect and priorities elsewhere (Iraq, for example) have produced a pent up need to fix bridges, roads, and water facilities (see today’s C-Span program on water infrastructure issues). The second reason for the initiative will likely come from the need to offset the second down wave in the US economy with bank losses exacerbating the circumstances. Moreover, should such a second down leg occur, it is highly likely that the global economy will get sucked along in the slide as emerging market economies must begin to come to terms with their own inflationary difficulties thereby necessitating a serious increase in monetary restraint.

Investment Strategy Implications

The US Congress is likely to push through another consumer-focused rebate before election time this year. However, past that point the need to address the neglected infrastructure will be both necessary and politically useful.

The necessary part is self-evident. The political dynamic is also apparent when you consider that the longer lead time for infrastructure spending programs (versus consumer directed initiatives) dovetails perfectly into the election cycle as the benefits for programs begun in 2009 will begin to be felt most strongly in 2010 – a mid term election year.

As noted a few reports ago, infrastructure spending worldwide is projected to be $41 trillion (2005 to 2030). Added to this is the vision put forth by Al Gore re renewable energy and the companies playing in the infrastructure space are in the secular sweet spot.

As for the MGP, in addition to building on the modest position established in ..., I am considering the .... Will advise on this shortly.

*subscription required. see link to your left.

Monday, July 28, 2008

Sectors and Styles Strategy Report: July 28, 2008

excerpts from this week’s report:

Model Growth Portfolio (MGP)
“Last week’s modest decline in relative performance moved the year-to-date results off its high to 346 basis points over the S&P 500…”

Expected Return Valuation Model
“While risk expectations declined last week with the VIX dropping below 23, it does seem more realistic to consider the prospects of a P/E ratio around 17 versus the BMR forecasted 19.2. Given the likelihood that a further weakening global economy, uncomfortably high inflation, and the prospects for the second wave of bank losses, a move toward…”

Moving Averages Scorecard
“While last week’s market action produced a standoff in the bottom line mega trend reading at the still fairly bleak at 29.17%, most indices moved more toward the negative side of the equation. Notably is the drop to bearish for Emerging Markets (EEM). Moreover, unless markets rally quite significantly or at least stabilize, the negative readings will likely increase pushing nearly all indices into bearish territory…”

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

Friday, July 25, 2008

Quotable Quotes: The Joker

Without question, Heath Ledger created the most memorable villain since Hannibal Lechter.

The Joker: Do I look like a guy with a plan??

The Joker: The only sensible way to live in this world is without rules!

The Joker: See, I'm not a monster...I'm just ahead of the curve.

The Joker: See, I'm a man of simple tastes. I like gunpowder...and dynamite...and gasoline! Do you know what all of these things have in common? They're cheap!

The Joker: [to criminal] Why don't we cut you up into little pieces and feed you to your pooches? Hmm? Then we'll see, how loyal, a hungry dog really is. It's not about the money... it's about... sending a message. Everything burns.

Criminal: [to The Joker] Give me one reason why I shouldn't have my boy here rip your head off.
The Joker: How about a magic trick?
[pulls out a pencil and sticks it upright into the table]
The Joker: I'm gonna make this pencil... disappear.
[Criminal’s thug walks over to kill The Joker, who pushes his face into the pencil and kills him]
The Joker: Ta-daa! It's... gone!

The Joker: [looks directly at Dinner Guest] You know, you remind of my father.
[takes a knife to dinner guest's neck]
The Joker: ... I hated my father!

The Joker: [to Batman] You have nothing to threaten me with. Nothing to do with all your strength.

The Joker: [to Batman] We really should stop fighting, we'll miss the fireworks!

Batman: Why do you want to kill me?
The Joker: [laughs] Kill you? I don't want to kill you! What would I do without you? Go back to ripping off mob dealers? No, no, you... you complete me.

The Joker: What does not kill you, makes you stranger!

Have a good weekend.

Thursday, July 24, 2008

The (Mega) Trend is Your Friend

Bottom fishers, short term traders, and market timers aside, some investors might be tempted to conclude that the sell oil/buy bank stocks trade is a sustainable trend. If, however, an investor takes a step back and utilizes one of the most consistent longer term technical analysis tools a decidedly different conclusion would be reached.

To illustrate, take a look at the accompanying chart for Financials (XLF)*.

The technical analysis tool I am referring to is called the Mega Trend. The Mega Trend (as I define it) is a multi-year stock price trend analysis where price and two moving averages (50 day and 200 day) are measured. In well-established Mega Trends, price is above (or below) its moving averages, the shorter term (50 day) Moving Average is above (or below) the longer term 200 day, and both moving averages are pointing in the same direction, either up or down.

Using Financials as an example, price has been below both of its moving averages AND the 50 day has crossed the 200 day (to the downside) and both moving averages are headed in the same direction (which is this case is down). For Financials, a bearish Mega Trend is well established. Now, let’s consider a few related points.

When price has rallied and touches one of its moving averages (which will be the 50 day), a potential Mega Trend reversal may be in the works. In the case of Financials, price has rallied to its 50 day. However, for a Mega Trend reversal to be complete, price must cross both moving averages AND the 50 day must cross the 200 day AND both must point in the same direction with price leading the way. Looking at the accompanying chart, this is precisely what occurred to the downside in mid 2007 after Financials had been (for the most part) in a bullish Mega Trend since the spring of 2003.

Investment Strategy Implications

The recent bounce in Financials is justified due its deep oversold condition and a degree of pessimism that was (and largely still is) so thick you could cut it with a knife. Short term sector allocation warranted (and rewarded) investors who increased their weighting in anticipation of and during the recent Financials rally within its bearish Mega Trend. It should not be construed, however, that deep oversold bounces signal sustainable trend reversals.

The Mega Trend tool is a simple, elegant, yet highly effective tool for investors (and traders) as it keeps the longer term picture firmly into view and helps place in context the shorter term wiggles and squiggles.

*click image to enlarge.

Wednesday, July 23, 2008

Beyond the Sound Bite: An Interview with Michael Greenberger

As the US Congress moves forward with its threat to force change upon energy speculators, my interview with the former Director, Division of Trading and Markets, Commodity Futures Trading Commission couldn't be more timely. Expanding upon his recent congressional testimony, our discussion focuses on

* Excesss speculation in commodity markets
* How futures do affect spot prices
* The role of financial innovation (notably swaps)
* Dark markets.

Beyond the Sound Bite postings can be found at
To listen to this week's podcast interview, click here

Tuesday, July 22, 2008

Jesus is Coming. Look Busy!

commentary from this week’s “Sectors and Styles Strategy Report”*:

The Democrats in Congress appear poised to exercise the political version of the second coming with a second coming of their own – a stimulus package targeted toward consumers for the last half of this year: the election half.

The number bandied about is $50 billion. Just enough to look busy, yet not quite enough to enhance the presidential chances of Senator McCain. After all, the Democratic equation is McCain = Bush third term. Certainly the Democrats can’t disrupt that math.

There are two aspects to this issue:

First, a clearly defined pattern has emerged, as stopgap measures seem to be rage in government. Be it the financial wildfire strategies of Paulson and Bernanke or the rebate checks or offshore drilling or ad hoc regulatory actions, seriously thought out solutions to long-term problems are clearly not a part of this most political of years.

Second, $50 billion, while hardly enough to be truly meaningful, will likely be just enough to help the US economy avoid a full blown recession this year. In the process, the full year operating earnings for corporations will likely be a touch higher than the top down projections of $82.

Investment Strategy Implications

If the operating earnings number for the S&P 500 for 2008 were moved up a touch from $82, and given the fact that the market is presently so sufficiently undervalued (assuming one does not buy into the stagflation lite scenario) then stocks should continue their summer rebound with or without Financials leading the parade.

In regards to Financials, it does seem that any economic performance that produces bad but not terrible results will be most welcome. Some semblance of stability may not produce much in way of stock gains for the group (contrary to what many bottom fishing investors might hope for), but it would go a long way toward to providing an overall sense of relief that the end of world is not just around the corner.

As for solutions to long-term problems, that clearly is not on the agenda for this year. Once it does become the focus of public policy, I would suspect issues like infrastructure building will take precedence over consumer demand stimulus packages. And in doing so, a secular uptrend in that area will produce very attractive investment opportunities for years to come.

While busy work is not truly productive work, a few sorely needed bucks (for consumers and investors) will not be rejected.

*Subscription required. For more information, click here

Monday, July 21, 2008

Sectors and Styles Strategy Report: July 21, 2008

excerpts from this week’s report:

Model Growth Portfolio (MGP)
“Wow. A fantastic week as the strong underweight in Energy finally paid big dividends producing most of the relative performance gains at 63 basis points. Combined with a modest 13 basis points and no major negatives produced one of the best weekly performance for the MGP (+114 basis points) in its three year history…”

ETF Market Monitor
Econ. Sectors & Industries: “The collapse in Energy along with satisfactory results from key financial institutions generated a role reversal, at least for one week.
Size & Styles: Small caps, particularly Small Cap Value, Micro Cap, and Transports all had a stellar week.
Global: Most global markets did not join the US parade. Energy sensitive countries such as Canada and Brazil faltered.
Other: Along with Oil, Commodities were sharply lower.”

Expected Return Valuation Model
“The rise in the 10 year yield this past week coupled with the modest increase in equity levels reduced the severe undervalued readings. Nevertheless, stocks remain substantially undervalued. (It is also worth noting that the VIX dropped below 25, thereby justifying, for the moment, maintaining the 100 to 120 basis point risk premium – yellow zone.)…”

Moving Averages Scorecard
“Last week’s rally produced some relief for most indices as their near term direction improved. Most notable were the step up from extended (on the downside) to Intact for Consumer Discretionary, Financials, Industrials, Mega Cap, and Large Cap…”

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

Friday, July 18, 2008

Quotable Quotes: Investing 101

As equity investors in emerging markets get a taste of the bear (see yesterday’s image from the Pakistan stock market), the lessons of successful investing are learned the hard way.

“I am upset because I am constantly losing money and there is no one ready to help me.”
Naeem Jehandad, equity investor in Islamabad.

“For me, this is just a murder for my economic future.”
Usman Khan, a lift operator who returned from the Middle East last year and invested his savings of Rps350,000 ($5,000) in the KSE.

“I'm only rich because I know when I'm wrong.”
Goerge Soros

Have a good weekend.

Thursday, July 17, 2008


It hardly instills deep confidence in our government officials when, after nearly a year, its prime modus operandi is to react to the latest financial crisis with yet another 11th hour solution. This is one of the longer term implications of the bailout plan for Fannie and Freddie.

For all the near term good that could be construed from the latest financial wildfire containment, it is hard to understand why after nearly a year Messrs. Paulson and Bernanke are still in a reactive mode. Given all the resources at their disposal and all the warnings that are plain for everyone to see, it is most disturbing to hear the hurried pitch for unlimited back stop funds for the two GSEs.

Investment Strategy Implications

The Nouriel Roubini scenario where the write-down contagion spreads both up (the quality spectrum, which in the case of mortgages involves Alt-A’s, near prime, and prime) and out (to other categories, such as credit cards, auto loans, and corporate debt) is the nightmare scenario that is threatened by the reactionary mode of government. The economic dangers that $1 trillion (on up) in banking losses would produce cannot be fully measured. But what can be assumed with a fair degree of certainty is that the deleveraging process that such a credit creation contraction would generate will exacerbate an already fragile global economic and financial situation, if not tip the global economy into a depression.

Getting ahead of the curve, being proactive with a well thought out plan would go a long way toward instilling far more overall confidence in financial institutions and, thereby, likely result in stable if not higher asset values (not to mention a better level of consumer confidence).

Putting out wildfires is necessary and helpful but hardly sensible forest management.

Smokey the Bear would not be proud.

Wednesday, July 16, 2008

Beyond the Sound Bite: An Interview with John Augustine

My interview with the Chief Investment Strategist for Fifth Third Private Bank includes the three issues overhanging the equity markets, stagflation lite, value traps, and fixed income strategies.

Beyond the Sound Bite postings can be found at
To listen to this week's podcast interview, click here

Tuesday, July 15, 2008

Baby Steps

commentary from this week’s “Sectors and Styles Strategy Report”*:

Sunday evening’s US Treasury and Fed actions may seem bold to some. I beg to differ. Here are a few thoughts for your consideration:

A recent report from respected consultancy Bridgewater Associates upped the ante of banking losses to a whopping $1.6 trillion. In consideration of the fact that only ¼ of that number, $400 billion, has been write-off/down thus far was more than enough reason for investors to buy into the panicky feeling experienced these past weeks. For those who like I subscribe to Soros’ reflexivity thesis, the feedback loop to the real economy via a deleveraging contraction is the single most dangerous consequence of the credit crisis (even if the bank loss number is closer to IMF’s $945 billion figure).

As if that weren’t enough, the oil price crisis, with its worldwide inflationary consequences for all countries, is generating demand destruction in developed countries. Here, too, a feedback loop to developing countries presents yet another dangerous outcome to the world economy. Decoupling goes only so far.

These past few weeks, the twin negative forces are being manifested in fear among investors as the valuation inputs from declining earnings and high inflation are producing a dangerous cocktail of lower P/Es and declining earnings that may bring about a stock market decline befitting a super bear.

Investment Strategy Implications

Incrementalism is a product of a belief that what is in place will work. Yes, there may be pain but the tools at hand are the tools that will produce the good result in the end. In the case of the governmental powers that be, that belief is market fundamentalism. This is at the heart of the problem and difficulty in reaching sustainable financial and economic solutions. As long as the Treasury, the Fed, the Administration, and the Congress operate under the rules of market fundamentalism, the actions taken will be like baby steps (such as the Bear Stearns and now the Fannie and Freddie bailouts as well as the Term Facilities to commercial and investment banks) when more serious, more comprehensive, more activist solutions are required.

But let me not restate last Thursday’s blog posting and point to the general market consequences that declining earnings and high inflation will produce.

The following rather simple table provides the P/E levels investors might contemplate should earnings experience even a moderately bad decline from last year’s $82.54:

Does the market fully understand and anticipate such a scenario? I doubt it. More likely shorter-term factors are moving the markets as the dominance by momentum-playing hedge funds produce surges and plunges (mostly the latter of late). Nevertheless, the numbers noted in the above table must not be ignored as its outcome seems more likely the longer market fundamentalism ideology results in baby steps.

*subscription required
For more information, see newsletter subscription link to your left

Monday, July 14, 2008

Sectors and Styles Strategy Report: July 14, 2008

excerpts from this week’s report:

Model Growth Portfolio (MGP)
“A strong relative performance recovery due to the aforementioned strong underweight in Energy and moderate underweight in Financials along with the absolute positive performance in the Smid growth positions lifted the year to date results to a positive 257 basis points…”

Model Growth Portfolio (MGP) Re-balancing
“One minor portfolio change and one reclassification are being recommended...”

ETF Market Monitor
Econ. Sectors & Industries: Financials were hammered while Healthcare and domestic Consumer Staples and Utilities excelled. Steel also rebounded strongly.
Size & Styles: The Smids (including Micro Cap) and Dow Transports painted a much brighter picture than the S&P 500.
Global: Many global markets tracked the dismal US. However, China, Malaysia, and Singapore did not.
Other: : Commodities did not follow Gold’s good performance.

Expected Return Valuation Model
“A justifiable argument can be made to raise the risk adjustment factor (concurrently lowering the projected P/E ranges) as the real risk of declining earnings occurring next year are now being heard with greater intensity. The stagflation lite scenario. I will hold back on making this change for the moment pending the US government’s action…”

Moving Averages Scorecard
“Further deterioration pushing the total mega trend number to its lowest reading thus far. The one bright spot is the improving near term trend in China…”

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

Friday, July 11, 2008

Quotable Quotes: A Conversation in Tehran

Tuesday, July 8, 2008

Iranian Oil Minister: Mr. President. The price of oil has declined the past two days by nearly $10 a barrel.

Iranian President: Launch a few missiles tomorrow.

Wednesday, July 9, 2008

Iranian Oil Minister: Mr. President. The price of oil has barely moved today.

Iranian President: Launch a few more missiles tomorrow.

Have a bombastically good weekend.

Thursday, July 10, 2008

Where’s John Maynard Keynes When You Need Him?

This morning’s testimony before Congress affords US Treasury Secretary Paulson and Fed Chairman Bernanke yet another opportunity to allay the fears of all parties interested in the health and wellbeing of the world’s economies and markets. Unfortunately, however, what is likely to be heard is more dogmatic drivel regarding the magic of the markets as the elixir that cures all ills.

Words such as “market discipline” will almost certainly be uttered by Messrs. Paulson and Bernanke today, as they cling to an ideology, “market fundamentalism” (laissez-faire or neo liberalism, if you prefer), whose time has passed. For with their adherence to “market discipline” comes the front line, the first wave of economic chaos in the form of a rolling destruction of major chunks of the financial services industry (not wholly undeserved) and the multi-dimensional feedback loop that the resulting deleveraging and radical shrinkage of the credit creation process will produce on the US (and ultimately world) economy.

Perhaps one might wonder if those on the other side of today's testimony table might provide some philosophical leadership in this highly charged political year. Guess again.

The Republicans find themselves locked in a defensive mode attempting to preserve their market fundamentalism ideology. (Supply side voodoo economics still rules this roost.) And where they are proactive is in areas that are tied to the ole timey magic of the “invisible hand” such as oil crisis = more land for drilling. No real solutions. No real comprehensive energy policy. More of the same animal spirits, magic-of-the-markets thinking.

As for the Democrats, their agenda is fairly obvious – look busy! As they appear to “fight” for the US consumer against the dark forces of cowboy capitalism and market fundamentalism their real end game is more power via a landslide victory this fall. Until then, why take more than band-aid economic action that will result in any form of a rebounding US economy when the more advantageous political objective is to pin the McCain tail on the Bush donkey?

Investment Strategy Implications

Cowboy capitalism expressed in the financial markets is market fundamentalism. They are rooted in the same philosophical thinking that has wrecked havoc on the world’s economies and markets via fat tail economic and financial crises that mega trends such as globalization, technological innovation, and financial innovation have only exacerbated.

What is needed, and getting more desperately so with each passing month, is new thinking and a new intellectual philosophy regarding government, the economy, and the markets. A good start would be a clear recognition that the philosophical underpinnings of the past two decades, the market ideology known as market fundamentalism and its economic counterpart, cowboy capitalism (replete with trickle down economics and ever resetting stock options for corporate executives), has produced radicalized results for the interconnected world economy and markets. What is needed is fresh thinking and a willingness to transform a broken system rooted in a defunct ideology. But that is not what you and I will hear today.

What you will hear is regulation and half measures. But neither is a real, sustainable solution. Therefore, the only remaining question is what will it take for transformative action that will produce less radical economic and financial results? The answer might lie in a global recession to rival the one some 70 years ago. Then we may see who emerges as this century’s John Maynard Keynes.

Wednesday, July 9, 2008

Beyond the Sound Bite: An Interview with Dr. Peter Hooper

My interview with the Managing Director and Chief Economist for Deutsche Bank Securities includes the state of the global economy, prospects for stagflation in the US, the expanded role of the Fed, and the US consumer.

Beyond the Sound Bite postings can be found at
To listen to this week's podcast interview, click here

Tuesday, July 8, 2008

The Bear Market Labeling Myth

commentary from this week’s “Sectors and Styles Strategy Report”*:

“So let it be written. So let it be done.”
The Ten Commandments

Labeling, such as equities are now in a bear market, seems to have taken on a meaning that transcends reasoning and analysis and has settled into the domain of dogma. In other words, is there any real, analytical significance to the fact that certain indices have declined to such a point that they have produced a decline of 20% or more?

To some, the bear market bell has rung and, therefore, stocks are now banished to a land of expanding declines to all segments and sectors, as evidenced by last week’s thrashing of the leadership issues. Stocks destined for more losses is the given. But is it so that because some arbitrary line in the sand (down 20%) has been breached further and more extensive declines are a fait accompli?

Moreover, is it a done deal that equities are headed for sustained bad times when other important indices, such as the Dow Transports or the S&P 400 Mid Cap have declined to a meaningfully lesser degree?

To be sure, there are those who would argue that the all-knowing market has a "wisdom" that mere mortal investors would be reckless to challenge. Yet, here too, dogma supplants analysis and reasoning. For example, as noted in previous reports and blog postings, the current equity market climate is dominated by the shorter-term players (hedgies), whose time horizon ranges between milliseconds and weeks. Therefore, can it be assumed that the "wisdom" of the market resides with those whose interests are less oriented toward fair value analysis and more oriented toward what will produce the best short term results?

Investment Strategy Implications

There appears to be two ways to interpret current equity market sentiment. One is to say that stocks have crossed a line that now dooms future market action to much lower levels, with a broadening out of the pain to all sectors, styles, and regions. No place to hide. The current decline is the second leg of the bear and any near term rallies should be treated as selling opportunities.

The real economy underpinnings to this conclusion are numerous, everything from stagflation to $1.6 trillion in bank losses to $200 a barrel for oil and a global recession. Of course, such serious economic problems assume a static rather than dynamic environment. A cause and effect that lacks responses and their feedback effects that could alter the pre-destined outcome.

There is a real danger in buying into the dogma of benchmarks. As someone who believes more economic and investment pain lies ahead, it is hard to agree, however, with the thinking that it will all come to pass now that we have passed some magical, yet dreadful, line. Therefore, an alternate conclusion might be that the aforementioned real economy horrors will be forestalled for a variety of reasons, such as the $1.6 trillion bank losses is shrunk thanks to intellectual sanity rebuffing FAS 157 and the fair value doctrine. Or that $200 oil does not occur as the demand destruction that $140 oil produces caps further rises. Or perhaps oil declines to $100 as regulatory and legislative action force full disclosure of ownership interests in commodities (see yesterday's WSJ online article re pressure on the CFTC).

Timing is everything, it is said. And the timing of a large drop in equities seems more appropriate for a later date, more like the first half of 2009.

*subscription required

Monday, July 7, 2008

Sectors and Styles Strategy Report: July 7, 2008

excerpts from this week’s report:

Model Growth Portfolio (MGP)
“Not even the strong underweight in Energy (producing a positive 28 basis points could offset the combination of poor results in the size & styles and global markets plus the occasional pricing distortion between the S&P 500 (-1.21%) and the economic sectors (-1.67%)…”

Model Growth Portfolio (MGP) Re-balancing
“No position changes are being recommended at this time...”

ETF Market Monitor
Econ. Sectors & Industries: The strong performers were finally hit big with Steel the biggest weekly loser tracked followed by Homebuilders. Biotech stood out on the plus side.
Size & Styles: The same story, strong giving way, was evident in this grouping as the Smids declined dramatically.
Global: Heavy losses across the entire spectrum (except the UK, which came off a very low prior week ending number).
Other: Gold and Commodities produced solid weekly results.

Expected Return Valuation Model
“One the significant values in running a valuation model is that it forces you into challenging the assumptions built into the model. In the case of the ERVM, some of the issues that must be resolved us whether projected operating earnings are accurate? In this regard, the much more conservative number reached via a top down scenario method does not appear to be out of line, especially when compared to the bottom up numbers forecast by…”

Moving Averages Scorecard
“Most of the damage was done in the prior week with last week’s action merely producing some near term deteriorating but no changes in the mega trends. Basic Materials, a market leader for several years, gave up considerable ground these past few weeks but has not produced a mega trend change thus far, as the following chart shows…”

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

Thursday, July 3, 2008

Not So Fine at $4.09

“She’s real fine my 409”
Beach Boys

When the price of gas in the US hit $4.09 a gallon, the song that many consumers began singing was decidedly out of tune from the one the Beach Boys sang many decades ago.

Back in the day, 409 had a different, simpler meaning. Summertime, hot rods, muscle cars, and cheap gas. Today’s tune is, unfortunately, more about demand destruction than it is about how to pick up chicks.

Demand destruction is underway on several levels with high energy prices the central part of the scene. Deleveraging is also playing a major role in demand destruction via credit contraction. Then there is threat of greater regulation and more activist governments.

I have noted this more activist role several times before. And, while the US Congress is in recess this week, recent developments show the increased regulatory threat continues and is broadening. Take for example, the recent surprise announcements re CFDs.

Contracts for difference (CFDs) is a swap instrument that many hedge funds (and no doubt other institutional investors) use to establish positions without disclosing the true nature of the ownership. Within the past few days, however, certain rules changes have been instituted by the Financial Services Authority (FSA) that took most professional investors by surprise. Below are a few links re this story.

Investment Strategy Implications

The world economy is experiencing the dark side of both globalization and financial innovation.

Developing economies, led by China with its policies of excess money creation and subsidies along with hot money flows, continue to provide the demand fodder for high commodities prices, most notably oil. Coupled with capital market flows by major institutional investors away from equities and into commodities (as an asset class, often satisfied via swaps like CFDs), the unsustainably high price of oil will produce one of two high probability outcomes – stagflation (the lite version, most likely) in developed countries or a global recession.

The contraction of financial innovation is also underway as write downs and bail outs force business model changes for financial firms while the consequences of deleveraging produce a substantial cutback in credit creation.

Gas at $4.09 or higher is unsustainable to the world economy. Developed countries can attest to that. So will developing countries, many of whom are heavily dependent on exports to developed countries’ consumers.

The Bank for International Settlements is correct when it declared that the world economy is near a tipping point. For the equity markets, the relevant primary investment question might seem to be “Have the equity markets come to fully appreciate the danger?” In other words, have prices discounted the risks?

I would propose, however, the more relevant question to ask is “Do investors correctly see the complete picture?” In this regard, the answer is more likely no.

409 was in a simpler time. $4.09 is much more complex.

Enjoy the weekend and a happy fourth.

CFD related links:
Article 1
Article 2
Article 3

Wednesday, July 2, 2008

Beyond the Sound Bite: An Interview with Alec Young

My interview with the International Equity Strategist for Standard and Poors includes a tilt toward to US equities, the concept of a "home bias" in investing, and attractive and unattractive economic sectors.

Beyond the Sound Bite postings can be found at
To listen to this week's podcast interview, click here

Tuesday, July 1, 2008

Not That 70s Show

commentary from this week’s “Sectors and Styles Strategy Report”*:

Recently. there has been a fair amount of talk re stagflation and its consequences, both economic and equity valuation. Should the experience in the coming years resemble the stagflationary era of the 1970s, then P/E levels are more than justified to crumble to single digit levels, as they did then.

Dismissing the stagflation threat entirely would be a mistake. Yet, buying into the idea that a 1970s style stagflation environment is in the current economic cards appears to be equally suspect as the world economy are clearly changed considerably since then. There is, however, a stagflationary scenario that does bear serious consideration – stagflation lite.

In a stagflation lite environment, growth stalls like it did in the 1970s but inflation rises at a much more modest degree. In such an environment, the economic impact is obviously more muted, this thanks to a more globalized climate.

From a valuation perspective, P/Es, for example, would be lower than they would in otherwise less stressed times. But not quite to the degree that they were in the 70s.

Investment Strategy Implications

The broad market investment implications of any version of stagflation are rather straightforward – lower valuation levels. Any time quality of earnings is affected, valuation levels must go down.

In a stagflation lite environment, an investor could kiss the current reasonable S&P 500 P/E level of 19 – 20 times (with the 10 year US Treasury at approx. 4%) goodbye. Nor would its historical level of 15 times earnings hold. However, only a stagflation period comparable to the 1970s would produce single digit P/E levels as it did then. Hence the higher P/E probability in a stagflation lite world would be somewhere around 12 times earnings.

If that were the case, then an $82 operating earnings forecast would put the fair value target for the S&P 500 at 984, a full 23% below current levels. Interestingly, 984 brings the S&P 500 down 36% from its high of 1550. In the process, the drop of 554 points from the high achieved in October 2007 would match against the 770 point increase from the low reached in October 2002 (to the high of October 2007) and, therefore, would produce a decline of approximately 75% (from peak to trough). Such a drop would result in a slightly greater than your standard major bull market correction of 2/3s.

Be it stagflation or stagflation lite, it does appear to be a touch premature to make such a call. Nevertheless, the market may be taking some of this thinking into consideration, and so should we. More on this prospect in the coming weeks.

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