A Colossal Mistake

My goal is to post one comment per day. However, today's trade sanctions against China cannot go without a response.

Let me join those condemning today's reckless act of political expediency.

Whatever the US government thinks will be the benefits of its actions are far outweighed by the downside consequences of this regrettable step toward protectionism. Clearly, this is precisely one of the key risk factors that has been noted in prior comments made here and elsewhere.

Investment Strategy Implications

The initial knee jerk reaction by the equity markets was the correct one - down in a heartbeat. With next week being a shortened trading week and the start of an uncertain earnings season, the odds of the equity markets making a new low have increased significantly.

Today's political decision and others to follow in the form of protectionistic legislation have added to the already high degree of uncertainty that far too many investors so sanguinely dismiss. However, if, for liquidity reasons and the noted "Misalignment Triangle", investors choose to ignore this real economy disaster in the making, then I believe they will join the politicians in making a truly colossal mistake.

Try to have a good weekend. Going forward, it may not be pretty.

Weekend Reading: McVey’s “Misalignment Triangle”

In a very insightful analysis, Morgan Stanley’s Chief Investment Strategist, Henry McVey, has connected the dots between private equity’s low hurdle rates versus corporate America’s high hurdle rates and the big long-only mutual fund managers’ need for performance.

Henry sees “a perverse set of incentives…afflicting the capital markets”. He goes on as follows:

“...(the) lack of corporate oversight at the company level as well as portfolio managers’ mandates to beat their benchmarks, not necessarily maximize value, is allowing private equity firms to ‘steal’ trophy properties at less than fair value.”

“…CFOs still believe that the risk premium associated with their businesses is around 9.0%.” “…our work shows that the equity risk premium on the S&P 500 is currently around 3.75%.”

“The problem, or the disconnect, lies in the misalignment of incentives throughout the system, and in three areas in particular. Whereas private equity firms are paid to use leverage to recoup cash flow as soon as possible, corporate executives are ‘safest’ in a post-Sarbanes-Oxley environment if they run their businesses with high cash balances and lower-than-average risk profiles. The final piece of the Misalignment Triangle centers on the big long-only, buy-side shops, many of whom are willing to sell shares at less than fair value because the ‘pop’ from the deal announcement is more than enough to help them beat their near-term benchmarks.”

Investment Strategy Implications

While many investors tend to get tangled up in their underwear over cyclical issues, I try to identify the more significant thematic issues that cross boundaries and have larger secular impacts on the markets. McVey’s “Misalignment Triangle” joins Rich Bernstein’s correlation analysis as thematic perspectives well worth your time exploring and understanding.

Have a good weekend.

Quotes are from Morgan Stanley Strategy and Economics, “Revisiting the Misalignment Triangle”, March 16, 2007.

“…no one knows which war the Fed is fighting.*”

Chairman Bernanke's performance yesterday may have earned him a passing grade but it was no A+ in my book.

First, kudos to the staffer for Republican congressman Jim Saxton for asking what I thought were the best questions. Probing into hedge funds, liquidity, leverage, and the economy, Bernanke’s replies were very telling.

On the downside of the Chairman’s testimony were his replies to the issue of hedge funds. In my opinion, Mr. Bernanke was way off the mark re the risks they pose. Moreover, he failed to acknowledge the interconnected nature of money. Is it realistic to believe that financial capital has no role in the real economy? Is it realistic to assume that the risks of liquidity and leverage are contained to the sub prime mortgage market only? Time will tell if his sanguine response is correct.

The upside to the Bernanke’s testimony was the Fed’s balanced approach to the risks of slow growth and inflation. Here he is right on the mark. Investors may clamor for lower short-term rates. However, excess liquidity and leverage, globalization, strong global economic growth, a weak US dollar, and rising US domestic inflation argue against cutting rates at this time.

Investment Strategy Implications

The sub prime mortgage fiasco has made clear to the Fed that unchecked liquidity and leverage has consequences. The balanced concerns of the Fed reflect the incredibly complex globalized world we live in. The narrow, self interests of some investors may support higher equity prices. But the larger, macro strategy concerns remain with the complex web of unintended consequences.

And now on to 1Q07 earnings results.

* London School of Economics professor William Buiter in his reply to Larry Summers’ Financial Times commentary “As America Falters, Policymakers Must Look Ahead”.

http://profile.typekey.com/WillemBuiter/
http://www.ft.com/comment/columnists/lawrencesummers

Faith in the Fed

It is remarkable just how strong faith in the Fed is. The belief that the Fed will work its magic under all economic circumstances is so ingrained in investors that it borders on the mythical. This is a mistake.

This is not to say that central bankers haven’t become more proficient in managing the world’s capital resources. They have. However, the fact that all economies function within the framework of a global economy raises the stakes considerably. And makes managing such an entity that much more difficult. Consider the issue of coordination.

When one considers the fact that there is not a world central banker, coordination between domestically oriented (and politically influenced) central banks cannot falter. Yet, central bankers are near autonomous entities*. They are subjected to the political dynamics of their respective countries. Moreover, there are diverse interests and needs within each economy that influence domestic monetary policy. Lastly, their individual missions are not exactly identical to each other. For example, the Fed’s dual mission of growth and stability is not the mandate of most central bankers. And all this doesn’t take into account the core of their capabilities – monetary policy.

There is a danger in a near blind faith in their powers. Forgotten is the fact that central bankers are limited in the tools at their disposal. The Keynesian levers of demand management have been replaced by a strong belief in market fundamentalism, globalization, and the capital management skills of the world’s central bankers. How long this trio can maintain global growth and stability remains to be seen.

Investment Strategy Implications

It is worth remembering that there was a time when economic downturns, absent fiscal deficit spending policies, revealed a key weakness in a central banker’s monetary powers. It was during the first globalization and it was called “pushing on a string”.

Faith in the Fed may be high among market participants. But it should not be a blind faith.

We know that the market hates negative surprises. With faith and expectations in the Fed so high (and risk premiums still so low), just how strong should faith in the Fed be?

A little something to think about as Bernanke speaks today.

*I say near autonomous as the power of persuasion from the Fed to other central bankers is considerable (Bank of Japan, for example), although not absolute. Nor permanent.

Technical Tuesdays: Failing Rallies

For the most part, I find chart patterns interesting but often have a low predictive value. There is, however, considerable contextual value to them.

The current pattern for most stocks and indices are such a case as they strongly suggest one of the infrequent but useful patterns - the failing rally.

The sequence goes like this: Market makes a new high; market experiences a correction phase but does not complete that correction phase (neither in time nor in depth); market rallies back toward the highs but falls short. (Market then goes back down to (or below) the correction lows.)

Using SPY as our market proxy, the chart on the left shows that we may be experiencing just such a pattern.

Investment Strategy Implications

Failing rallies are born out of unresolved market corrections. Failing rallies have two characteristics: they come off weak bottoms and they are accompanied by weak breadth and strength. The first part of that equation is true, the second is not (at least not completely).

However, on this second point, I think it is fair to argue that we are in changed times (see yesterday's entry below). And that liquidity and leverage in the hands of the numerous new players in the game (hedge funds, in particular) have distorted many traditional analytical tools as correlations and momentum have gone to extremes. In other words, synchronicity is the current market order.

If last week was a failing rally (and I would put the odds on it), then the second down wave is the likely next move.

The Times They Have a-Changed

Change, the one constant in life, has impacted the investing world in ways that many may not fully appreciate.

The primary source of change today is Globalization.

Globalization, in its full manifestation, reflects the free flow of goods, services, and capital. When coupled with the emerging dominant economic ideology - market fundamentalism - a world of change is the dynamic, the effects of which are yet to be truly understood.

Innovation, technological and financial, is the other element in the change equation. Technological innovation is the great enabler of Globalization. And financial innovation plays a vital role in capital – sources and flows.

An expression of change that should be of great interest to investors is the players now inhabiting the markets.

Hedge funds, private equity, and millisecond traders have moved in alongside the more traditionally oriented investors. Yet, the goals and interests of the relatively new kids on the block, not to mention their diverse valuation methodologies, must be a part of the investment decision-making equation for the larger, more traditional investor types. If not, for anything else than to exploit opportunities as they are presented.

When markets are moved by such players, relying on traditional analytical approaches is insufficient for today’s dynamic global markets. This is not to say that traditional valuation approaches do not play an important role. They do. But to ignore the new players, with their trillions of dollars at work, is to deny the change and its impact on markets.

Investment Strategy Implications

The danger for investors is in not appreciating that we are living in changed times. And not just from a geo political perspective. Market participants with trillions of very active dollars cannot help but alter the investment landscape. Investors who fail to add this to their valuation tools do so at their own investment peril. Conversely, those that do appreciate the change that has taken place will find themselves in an enhanced competitive advantage.

Market Forecast notes from the field: Austin, TX

Follow the money. Expect the unexpected.

Last evening, I had the privilege of moderating my ninth and final early 2007 Market Forecast event. And the comments and conclusions from my panel – Bartels, Roth, Freeman, and Bovino – reflected many of the same sentiments heard in the previous eight events – and a few new ones. Here are some quick notes from last night’s event:

• Volatility is here to stay (Bartels)
• It’s an aging bull and is showing it (Roth)
• We have entered a new leg of the bull (Bartels)
• US growth will slow but pick up in 2H07 (Bovino)
• Long-term Bonds are the most overpriced asset class (Freeman and Roth)
• Forget Large cap, the Smids remain the place to be (Bartels and Roth)
• Liquidity is abundant and a key driver to the markets (Bartels, Roth, and Freeman)
• Correlated market moves are a problem for alpha production (Freeman and Bartels)

Investment Strategy Implications

Areas of disagreement were heard and many insights were shared. However, the expression “The more things change, the more they remain the same” seems to apply, particularly in the areas of liquidity and unknown risks (credit derivatives, for example). This is to be expected, despite major and minor market moves. But, new and integrated thinking was also part of last night's event. For example:

• Market moves will tend to remain synchronized (and perhaps highly correlated)
• Most of the action by hedge funds is market following
• Hedge fund behavior is a reliable contrary indicator
• Sudden and largely unpredictable sharp market corrections are now the norm.

It will be most interesting to see just how much changes and how much remains the same at my next Market Forecast events in May (MTA) and August (NYSSA).

Note: I will be on CNBC Morning Call on Monday (March 26) around 10 AM. Hope you get a chance to catch the segment.

Have a good weekend.

Melt-up!

To begin, kudos to the Bernanke Fed as it took an important step yesterday in decoupling itself from the Greenspan bubblenomics era by rightfully stressing the need to focus on inflation (and by default excess liquidity). And, in the process, the Fed continues the global central banker strategy of draining liquidity from the system.

However, given the likelihood that earnings growth will decelerate to low single digits, US real GDP growth seems heads to the sub 2% level, and inflationary pressures remain stubbornly sticky, it is remarkable, to say the least, that equity investors would celebrate such a scenario in the context of central bank tightening.

Investment Strategy Implications

If anyone needed proof that the equity markets are liquidity driven, yesterday provided it - in spades.

Maybe my good friend Jason Trennert is right. Maybe we will experience a market melt-up. And perhaps he has it correct to suggest that private equity capital will be a major player in the melt-up.

Yet, if investors acknowledge that this Fed is as data dependent as it says it is, and if one believes that the equity markets are an important source of information, then yesterday’s equity-booyah is unlikely to be ignored by Bernanke and Company. With the economy precariously balanced between the rock of stagflation and the hard place of excess liquidity, yesterday’s loud equity hurrah may be premature.

Will Bernanke Decouple From Greenspan?

With more than a year under his belt and his first crisis underway (sub prime), Ben Bernanke has arrived at that moment whereby he can separate from the Maestro and establish his central banker vision. Or he can follow the path of his predecessor, bail out yet another bubble-induced economic sector (housing), continue to flood the world with even more liquidity, and send a signal to the world markets and economies that his Fed supports Greenspan’s bubblenomics. My bet is that we will witness the beginnings of a clear break from such a policy. In this regard, Bernanke does have a precedent – Japan.

When the Bank of Japan recently raised rates, it sent a signal (albeit a modest one) that global liquidity via the carry trade took priority over domestic needs. Bernanke needs to send his own signal that his philosophy is truly his own, that it is different than Greenspan’s, and that the markets cannot rely on the Bernanke-put to rescue reckless economic decision-making. There is, however, a big risk that comes with being his own man. He may precipitate unintended (and unforeseen) consequences by exercising what Harry Paulson calls the “market discipline”.

Investment Strategy Implications

With the S&P 500 parked at the top end of the correction range (1410), the market has erased nearly all of its oversold condition and now stands poised at a key price point.

The FOMC decision today should set in motion the next steps for the market – either breakout of the range (and possibly make a run at a new all-time high) or trade down through it (and probably set a new correction low).

If the Fed makes the right call by not lowering rates, and, most importantly, does not change its language to neutral, the market may be disappointed and head south. While painful in the near term that, in my opinion, would be the right decision. And it would send a clear signal that Bernanke has begun to decouple from Greenspan and bubblenomics.

If, on the other hand (had to slip in an economist phrase), the FOMC does lower rates and/or change the language to something less hawkish, the markets may celebrate and conclude that the liquidity punch bowl is not going anywhere anytime soon.

Either way, today’s decision matters more than most.

Technical Tuesdays: Using Technical Analysis for Profit (and Fun)

As a big believer in the additive value of technical analysis (TA), I have found that many (not all) tools of TA have a useful predictive value. One such tool combines momentum, moving averages, and the concept of divergences.

As the chart on the left shows, momentum and MACD plunged in the early phases of the current correction. Now, here’s where the fun begins.

To begin, take a look at last spring’s correction and first focus on momentum (first chart lines beneath price chart) . Big plunge, rally to neutral, followed by a secondary drop. During that second drop, note how the market made a new low BUT momentum did not. Divergence #1.

Now, look at MACD (second chart lines beneath price chart). It, too, plunged, rallied to neutral, then dipped again. Also, not making a new reaction low. BUT, and this is most important, it wasn’t until the moving averages of MACD (the moving averages of the moving averages, if you will) crossed and trended upward that the market began to stabilize, build a base, then make a run to new highs.

Investment Strategy Implications

Thus far, the current correction has followed the above script fairly closely. The argument I have made, from a TA perspective, is that the extent of the damage done by the first wave is followed by a second wave during which divergences hopefully develop (between price and momentum and MACD) which sets the stage for the rally to new highs.

If the current correction does not unfold according to TA Hoyle, then the most dangerous words in the investment language are in effect – “This time is different.”