This Time IS Different

The bulls (not the bears) would have you believe that this time is different.

The root of this view in anchored in the dogma that the cyclical recovery cures all ills as follows:

The cyclical recovery evolves as increased corporate spending on wages and new hires which, along with an increase in emerging economies’ consumer spending, result in a consumer led demand driven sustainable cyclical expansion. Corporate profits rise further enabling the virtuous circle to become engaged.

The sustainable cyclical expansion then helps to alleviate the structural risks to the global economy – e.g. current account imbalances – thereby enabling the financial sector to recover further and move the global economy off government life support.

The financial markets respond with a move more toward normality as rates rise, the dollar stabilizes, gold loses its luster, and equity valuation levels return to above average (>15 times). The combination of higher corporate profits and above average P/E levels drives stock prices back to record highs, which for the S&P 500 means 1548 (18 x $86).

An era of growth and prosperity returns thereby proving that this time is not different; that there will be no new normal (i.e. below average growth and profitability).

Sounds good, doesn’t it? Even plausible, provided one thing – conventional thinking in unconventional times requires a belief that this time IS different.

The Burden of Proof

The bulls would have everyone believe that the burden of proof that this time is different falls on those who say what was no longer works (the old normal) and that the future is a place of great uncertainty (the new normal) with the road ahead a most bumpy one. There’s one problem with this thinking – evolutionary processes to new normals are normal. A purging of the old always occurs and it always leads to a new normal, whatever that new normal may be.

Extrapolating the recent past into the future often becomes a substitute for first order thinking. Be it fighting the last war or blindly accepting corporate earnings guidance, embedded interests conspire to preserve the status quo, which facilitates a blindness to change. And it is change that is normal, not what-worked-before-will-work-again-indefinitely thinking, made all the more illogical given the highly dynamic complex global macro environment the world finds itself in.

In evolution, those that are about to become extinct are the last to notice. The same is true in the social sciences of economics and the markets, where old rules in changed times demand the view that this time is different.

How to Beat the Market WITHOUT Even/Overweighting Financials

The stock market parade in the US has been led by Financials (see first chart). As a result, many investors with well-diversified portfolios may have struggled to produce alpha since the bull rally began in early March, especially if they were underweight Financials - as many no doubt were. In the process of the rally and in an effort not to fall too far beyond in relative performance, these same underweight Financials investors have been forced to plunge headlong into that sector to try and keep pace.

For investors (as opposed to traders), part of the problem with even or overweighting Financials is the high degree of uncertainty facing the sector. With the US government forging ahead with new legislation and regulation designed to steer the financial services industry toward a more managed future (see recent articles on the credit card legislation, executive pay caps, mortgage regulators, and Gillian Tett’s (Financial Times) excellent article on derivatives) no one can confidently predict the future shape of the sector, let alone its sustainable growth and profitability. Therefore, what investments should/could the well-diversified investor consider that can generate alpha AND avoid the issues and uncertainty even/overweighting Financials bring?

One approach would be to increase the equity exposure in those areas where sustainable growth and profitability appears to be more assured AND will benefit from themes that will likely play out for many years to come. Two such areas are emerging markets and global infrastructure.

As the second chart shows, while not matching Financials in the current rally, having a sufficient amount of money in several attractive emerging markets (EEM, EWZ, FXI) and global infrastructure sectors (IGF, PHO), as well putting some funds in the higher beta small cap growth area (IJT), a well diversified portfolio can produce alpha while simultaneously reducing the aggregate beta in a portfolio AND avoid investing in a sector (Financials) that is fraught with long-term uncertainty. Moreover, by doing so, less money is allocated to the underperforming sectors that drag down the aggregate portfolio performance (see first chart, again).

And Now, For Another Soapbox Moment

For well-diversified portfolios with a longer-term time horizon, it's a relative performance game. This is what "diversification with a tilt" portfolio strategy is all about. The underlying assumption is that stocks have a longer-term upward bias and investors should exercise sound asset allocation and modified market timing principles (along with a healthy dose of patience) to achieve alpha. If this stocks-have-an-upward-bias assumption is correct, even a modest 2% per year outperformance will produce exceptional long-term results.

Note: Walking the talk is what you see in the second chart as it represents most of the larger holdings in a small fund run my firm and in the Model Growth Portfolio, both of which have year to date alpha of 293 and 484 basis points, respectively. Needless to say, past performance is not a guarantee of future results.

“Buy America” = Protectionism

If you are looking for one subject that will tilt an already precarious world economy toward a very bleak future, it is the "Buy America" provision of the stimulus bill currently under negotiation. For nothing in the stimulus bill – not the ill-advised earmark pork of the power starved liberal Democrats, not certain suspect components of the business tax cuts favored by Republicans, not the not-shovel-ready infrastructure spending – is more threatening to the global economy than the “Buy America” provision.

But don’t just take my word for it. Consider the warning from the EU today. Or British Prime Minister Brown when he “warned gravely against "deglobalisation" and denounced trade and financial protectionism.”

* What signal does “Buy America” send?
* How are other countries faced with economically-derived internal strife likely to respond?
* What are other countries that provide capital to the US likely to do?

While not exactly Smoot-Hawley, it is a big step toward closing the door on the prosperity that trade and globalization facilitates. Moreover, it generates more issues and problems precisely at a time when cooperation and communication matter most. And, in the process, how Mr. Obama handles this issue will speak volumes as to his governing style.

Investment Strategy Implications

At my first five Market Forecast events conducted thus far this year and on these pages*, I have raised the larger economic question, “What will be the economic philosophy that follows the death of laissez-faire, American-style cowboy capitalism?” Heaven help us if the answer includes protectionistic measures like “Buy America.”

*see Jan. 13 & 17 postings

“Inflection Day” Rally: Progress Report and Forecast

Since “inflection day”*, the equity markets have witnessed a modest increase in risk appetite. This is evidenced by several indicators (credit spreads, TAF and TSL auctions, for example) as well as by the trading action between and among various market indices.

To illustrate, the charts to your left show the risk appetite increase but it is not as uniform as one might suspect. And a few surprises are found.





Chart 1** (upper left) shows the performance from a size and style perspective. Note that the top performer is the Mid Cap group (overall - MDY, value - IJJ, growth - IJK). In the number four performance slot is Small Cap Growth (IJT). The rest (Small Cap, Small Cap Value, Large Cap, Large Cap Value, Large Cap Growth, and Micro Cap) are bunched fairly closely together with Micro Cap (IWC) at the bottom of the list.

Chart 2 (upper right) looks at the data from a US economic sector perspective. Here, Energy and Basic Materials assume their global growth story lead position. And “defensive issues” such as Healthcare and Consumer Staples are at the bottom of the list. The remaining sectors are bunched together. However, it is interesting to note who is in the number three performance slot – Consumer Discretionary.

Chart 3 (lower left) takes us to the global markets with the lead country/region held by China (FXI). The second cluster contains Japan (EWJ), Latin America 40 (ILF), and Emerging Markets (EEM). The bottom grouping is anchored at the bottom by the United Kingdom (EWU).

Chart 4 (lower right) provides a look at the BRICs. Once again, China (FXI) heads the group with Brazil (EWZ) in second place. Russia (RSX) is third. And the S&P 500 (SPX) just ahead of highly volatile India (INP)

So, what does this all mean?

Investment Strategy Implications

The above charts provide equity market performance evidence of a return to risk among investors. Higher risk styles, countries, and regions have generally produced the best “inflection day” rally results thus far. There is also performance evidence that US investors believe economically sensitive sectors such as Consumer Discretionary are likely to be near term beneficiaries of the rebate checks in the mail.

From a macro strategy perspective, however, there is much to be concerned about re the sustainability of the “inflection day” rally beyond the end of the summer.

For example, it has been argued on this blog and in my reports that the equity markets are a touch ahead of themselves, that the return of investor risk appetite (including a higher degree of comfort re earnings) is premature at best. The pain to be experienced - economic, financial, and political – going into 2009 may surprise many ready-to-return-to-risk investors. The same goes for those who seem ready to resurrect the Goldilocks scenario (is Kudlow listening?).

That said, it has also been argued here that in the very short term (as in this month), valuation levels and certain technical analysis data suggests the “inflection day” rally may fade a bit before resuming after Memorial Day (US).

Again, so what does this all mean?

I may be wrong but here goes:

Flat to down in the very short term; up through the end of summer; possible mega market top within the next six months; investor hell on earth in 2009.

*So declared by many market mavens as being March 17 – Bear Stearns bailout day.
**click on images to enlarge.
Note: All dates are from March 17 (“inflection day”) through the close yesterday.

2008 Themes: A Less Correlated World Part I – Decoupling

The political scene today is littered with the word Change, as Barack Obama captures the high ground on this issue. So, too, have the markets embraced the C word. Unfortunately, it is in the form of an economic change for the worse.

Yet, there may be another way to view the changing economic and investment environment, one that investors can more profitably exploit if my following thesis turns out to be correct. The change I am speaking of is a change in the degree to which economies and markets are correlated.

Over the past decade, markets, sectors, and even styles have become more highly correlated. I have noted this issue in previous blog postings. However, high correlations are not just the domain of the investment markets. As economies have become more interconnected they have, as a result, become more highly correlated.

All this may change this year.

Correlations may diminish this year driven by two forces – one economic, the other financial. In the case of our globally interconnected world, a change from high correlation may occur in the form of decoupling: most notably a lessened economic effect emanating from the US.

Granted, decoupling may not result in a significantly lower correlation as economies are influenced by each other to a large degree. However, decoupling may prove to be more prevalent than many think as policy actions undertaken by various other global actors, such as China, will likely produce stronger domestic demand thereby delivering the sorely needed non-US consumer demand to sustain global growth.

If so, then a US recession (or, more likely, a growth recession – growth below potential) will not have the same effect on global growth as it has had in the past. In my opinion, decoupling is not just possible but probable for two primary reasons.

To begin, the financial health of most economies is quite strong. For example, the current account balances of nearly every emerging market economy is positive. In the past, such economies have been a source of economic global turmoil. That is not the case today. Moreover, Eurozone economies are, for the most part, also in good economic shape.

As a result, containment of the pain in the US will likely be limited to domestically oriented businesses while the more globally oriented will reap the fruits of globalization and the global growth story. In this regard, what may be lost to some is the fact that businesses that serve a true global audience via the Internet may also experience positive economic results which will help minimize the damage of a credit derivative inspired economic contraction.

A second factor that will likely play out this year is the Olympic games to be held in China this summer. It is hard to imagine that the leaders and policy makers will not pull out all the financial stops to ensure a rosy picture.

As for the US, the damage emanating out of the credit derivative fiasco will almost certainly run its course over the first half of this year. Yet, given the political realities of a major election year, it is hard to see our government exercising an electoral death wish and not act to assist the US economy work its way out of what amounts to a financial, not economic, crisis. To the naysayers I say, the policy tool kit contains many more instruments than you are giving it credit for.

Investment Strategy Implications

There is a considerable amount of skepticism regarding decoupling. And that skepticism is deserved. After all, the world has function a certain manner for just over a century. Yet, as is the case with the US political scene, meaningful change may be occurring below the radar of many investors. Globalization, the Internet, and financial innovation are just a few examples of a changing world.

Many are uncomfortable with change. For change means a disruption of the status quo. Ways of life are constructed around the status quo, as processes and systems enable the early adopters to gain competitive advantage and the spoils thereof.

Yet, change, for good or ill, is the one constant in life. Recognizing it can produce alpha.

Note: Tomorrow, in Part II, I will explore the issue of lower correlations between and among markets and sectors.

Pop Goes the Weasel

How about a little thematic thinking?

As everyone knows, investing, finance, and business rely on confidence. And confidence relies on trust. For example, if the pricing of assets cannot be determined, then trust is eroded and confidence is shaken. On a financial markets basis, solutions to such problems tend to be very disruptive yet solvable. Recent case in point, sub prime mortgages and credit derivatives. A work in progress, but progress is being made. It is, however, quite another story when it comes to world’s economic leader, the US.

If confidence in the world’s economic leader is brought into question, then investors start the process of self preservation of their assets. Such is the case with the weakness in the US dollar, the single one factor that strikes fear in the hearts of the superbulls.

With the US so far out of step with the rest of the world on so many levels (geo political and economic, for example), it is understandable that the US dollar should bear the brunt of any loss of confidence. What matters most is the fact that it won’t take much to tip the balance and require more than the usual stopgap, emergency words and actions to stem a tide of fear that results from a heightened case of a lack of confidence.

In a larger context, it is reasonable to assume that, in time, the current world economy and markets will be viewed as being in a transition phase. Like a first year college student, the body may be in college but the mind and heart are still stuck in high school. Such is the case with our 21st century world.

Economies and markets, made up of people, are products of their past. And that includes systems and processes that may not be best suited for new era, one wrought by globalization and innovation.

Now, what is most worrisome is when things go wrong, very wrong, say a precipitous decline in the dollar. Or some other unforeseen global macro event that requires a more comprehensive and coordinated solution. What then? Are the policy makers prepared to manage such a massive disruption? Or will the world accept the blended solution of the market discipline and individual country driven policy actions?

Investment Strategy Implications

A crisis looms in our future that liquidity, technological and financial innovation, strong corporate growth and profitability, globalization, and good old-fashioned animal spirits have thus far helped to forestall.

When, not if, that crisis emerges, a new world order will be called for in which economic, monetary, social, and cultural issues will have to be addressed in a more cohesive fashion. The fragmented nature of a market based global economy coupled with nation state agendas will prove to be unworkable when, not if, a global disruption emerges. And when, not if, that occurs, the pressure to resolve the issues that are truly global in nature will be enormous. Hopefully, the policy makers will be up to the task.

For investors, when the global crisis does occur, all the traditional tools of equity valuation analysis will go out the window as the crush to get out the door will put into motion George Soros’ “reflexivity”, with its feedback loop to the real economy will be felt, as animal spirits run wild (in reverse) and conventional thinkers do lots of head scratching.

Until that day, happy times will be punctuated by mini panics. The US yesterday, India today, somewhere else tomorrow.

The music will stop one day. It always does. Until then, it’s all around the Mulberry Bush, as the monkey chases the weasel.

Note: Click on the above blog title for a little musical treat.

Out with the Old, In with the Relevant: Sectors in the Thematic Spotlight

With 3Q07 earnings season about to unfold, perhaps a far more productive use of investor time is to turn away from the well known and the insignificant and focus instead on identifying the themes that are playing out in the market and their prospects of continuing. For the well documented and the largely irrelevant issues (credit squeeze and the GM strike, respectively) may be vital to media ratings but they have the effect of taking the investor eye off the more productive alpha ball when they have past their useful investment value. Like the shelf life of any product, when news is old and quite well known (or in the case of the GM strike, irrelevant), it’s time to shop elsewhere.

With that said, let's consider the year to date performance of the 10 economic sectors that comprise the S&P 500 and any investment insights we can glean.

What is noticeable in the above chart (click on image for larger view) is how neatly the performance of each sector is tracking various identifiable themes. For example, at the top of the performance list are Energy (XLE) and Basic Materials (XLB), both major beneficiaries of the global growth/Asian infrastructure build story.

Next are a trio of growth issues that are clustered very tightly around the +15% category: Tech (IYW), Telecom (IYZ), and Industrials (XLI). Tech and Industrials have both a touch of the global growth dynamic as well as the weak US dollar/export benefit, while Telecom remains in its long term, undervalued recovery mode.

In the middle of the pack, out on its own, is the Utilities (XLU) sector at +10%, staging a rebound from its recent interest rate/over valued driven correction and subject to its sector specific forces.

Then we have the two “defensive” plays – Consumer Staples (XLP) and Healthcare (XLV) – crawling along at the +5% level, with the Healthcare sector being dragged down by big Pharma’s woes (Hillarycare, depleting pipelines) while Consumer Staples is still unable to realize in the minds of investors its feed-the-world potential.

Finally, the bottom of the performance barrel is inhabited by the two toxic economic sectors – Consumer Discretionary (XLY) and Financials (XLF) – solidly in negative territory, both heavily impacted by US consumer issues with Financials getting the extra kick in pants from the aftermath of the excesses of financial innovation.

Investment Strategy Implications

Insights will be gained over the next month as the themes noted above and other important sector forces become revealed via 3Q07 earnings reports. Contrarily, insights will not be gained by a continued fixation on yesterday’s macro news. Out with the old, in with the relevant.

The Difference Between Traditional and Thematic Analysis

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

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

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

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

Sub Prime Contagion

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

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

Now, let’s view this thematically.

Sub Prime as a Thematic Metaphor

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

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

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

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

Financial Innovation as Theme

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

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

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

The H&R Block Sub Prime Example

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

Investment Strategy Implications

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

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

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


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

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

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