Sectors and Styles Strategy Report: June 30, 2008

excerpts from this week’s report:

Model Growth Portfolio (MGP)
"A moderately rough week with a negative 28 basis points of relative performance resulting in a dropping of the year to date outperformance to just under 3% at 299 basis points. All in all, a very good relative performance for the first half of the year…”

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

ETF Market Monitor
Econ. Sectors & Industries: Energy did well but so did Heathcare. Networking and Aerospace and Defense were to weakest.
Size & Styles: Given the carnage, the Smids hung in there, particularly Mid Cap. Growth continued to best value across all size categories.
Global: India continues its terrible absolute and relative performance.
Other: Blackstone had a surprisingly strong week.

Expected Return Valuation Model
“Fearful expectations (thanks to lower equity prices this past month) have driven the ERVM back into attractive return territory. That is if one believes that global recession is not just around the corner. According to the most recent bottom-up analyst expectations at S&P, such a dire scenario is not foreseen even if one were adjust for the still overly optimistic, which are very much in the process of decline to sanity…”

Moving Averages Scorecard
“Another big down week has turned the data decidedly to the downside and reaffirmed the negative meag trends that appeared to be in process of some repair. All that is gone for the time being with a 33.33% aggregate reading. And the need for more time to repair before any upside can be reliably forecast…”

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Quotable Quotes: Oil Vey!

As the price of oil bubbles ahead, a few words on the crude stuff.



“The stars, that nature hung in heaven, and filled their lamps with everlasting oil, give due light to the misled and lonely traveler.”
John Milton

“The use of solar energy has not been opened up because the oil industry does not own the sun.”
Ralph Nadar

“It is clear our nation is reliant upon big foreign oil. More and more of our imports come from overseas.”
George W. Bush

“Let me tell you something that we Israelis have against Moses. He took us 40 years through the desert in order to bring us to the one spot in the Middle East that has no oil!”
Golda Meir

Have a good weekend.

It's All About the Price of Oil

Does Oil Price Speculation = Manipulation?

The US stock market could not have sent a clearer signal these past two days as to what it is obsessing on – the price of oil. For as important as the Fed’s actions are (with the same opinion being applied to the Financials and their prospective economically destructive write-downs and write-offs), the price of oil is numero uno in the mind of Mr. Market.

And in this regard, the debate rages over just what explains the high price of oil. For example, today Libya , in contemplating cutting production, joined Saudi Arabia in declaring that the physical demand for oil is being more than met by existing supply. Yet, free market ideologues continue to rant that it’s all about the physical supply/demand equation with references to the oil output crisis du jour be it Nigeria or questions re the true reserves in Saudi Arabia or impending hurricane season in the US or failure to build and update adequate refinery capacity or….well you get the picture.

The center of the oil price storm appears to rest with the battle between the US politicians and the free market ideologues. In this regard, it seems that both the politicians and the free market ideologues have got it partly right, but wrong in key aspects.

The politicians are right to focus on the speculators as they have tilted the supply/demand equation via speculative positions. Moreover, in a world where positions established cannot be determined (dark markets, OTC index and derivative related trading), it is anybody’s guess as to just how strong the demand is and to what end such demand is being established.

Where the US politicians have gotten wrong, however, is their implied (and often stated) conclusion that speculation = manipulation. In this regard, it is hard to support the view that speculation = manipulation if large asset managers (e.g. pension plans) move large sums of their investment capital into what they have come to accept as an attractive asset class – commodities. Moreover, it is hard to support the speculation = manipulation thesis when true speculators (versus large asset managers) piggyback on the speculative (not physical) supply/demand imbalance pushing prices higher. That is, of course, assuming that collusion is not occurring.

As for the free market ideologues, they are right to argue that markets tend to function best when regulation is minimized. Moreover, free market activities by speculators provide desirable liquidity, which reduces the cost of investing via smaller price spreads.

Where free market ideologues get wrong, however, is to argue that free markets are efficient markets. If anything behavioral finance has proven wrong is the unfettered markets = efficient markets thesis. In this regard, it is advisable to remember that not all speculators are price efficiency arbitrage operators. Many are momentum players joining the parade for the ride and tending to exacerbate an existing trend. Therefore, unfettered free markets influenced by large shifts of capital from major asset managers enhanced by momentum speculators allowed to establish undisclosed positions is rife for price exploitation.

Investment Strategy Implications

When it comes to today's stock market, it’s all about the price of oil. The economic havoc due to soaring energy costs has many parallels to the destruction of the credit creation process and broken business models of financial services firms and their effect on economic growth. If the US politicians and various experts are correct, the price of oil will decline once both regulatory (CFTC) and legislative action (closing the Enron and London Loopholes) take effect.

On the other hand, if the free market ideologues are correct, then demand destruction is the sole path to end of the current oil price crisis. However, that path will produce broad economic pain (how does a global recession sound?) and, therefore, significant and more onerous regulatory and legislative action, made more likely in a US election year.

On this last point: Investors operating under the assumption that the Democrats in charge of the US Congress will operate in manner similar to the way the Republicans have acted for a dozen years are sorely mistaken. Should the free market ideologues prove correct, investors will learn the real meaning of the slogan “change”.

Beyond the Sound Bite: An Interview with Jason DeSena Trennert

My interview with the Chief Investment Strategist of Strategas Research Partners includes his short term bullish/long term bearish outlook for equities, the economic growth versus valuation conundrum facing various emerging markets, and the limited political wiggle room a new US President will have.

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

The Death of Market Fundamentalism

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

The US Congress was never been known for getting things done speedily. And for many years, under Republican rule, neither was it known for aggressive supervisory action. However, a decidedly more activist tone and tempo have emerged from the Democrats in charge. And the ramifications are likely to be quite significant.

The opening battleground centers on the speed and aggressiveness of the congressional Democrats (Senate and House) versus Wall Street, the futures industry, and the energy industry. Activist Democrats are on the move calling before congressional committees a steady stream of experts to testify on oil price speculation. Pressure has been brought to bear on regulatory bodies such as the CFTC. And laws are being submitted to pressure groups such as the energy companies to start drilling on the nearly 4,900 leases already granted of which less than 1,900 are in production (“Use It or Lose It”).

And it isn’t just the volume of action taken, but also the speed and a certain sense of media savvy that seems to be a part of the activist Democrats agenda. With Internet distribution of their message via organizations such as Move On and People for the American Way as well as mainstream media channels such as the “Countdown” program on MSNBC, mobilization of public opinion is moving with greater speed and power than ever before. And in the process the agenda for discussion is being set.

Republicans, in the meantime, reduced to a limited number of talk radio advocates operate in reactionary mode. The consequences of a decade of squandered opportunity.

Investment Strategy Implications

The investment implications of political matters fall into two categories: regulatory and legislative change, and public opinion. Both are being impacted by the activist Democrats. As noted above, the initial battleground centers on the price of oil. If the price of oil declines, the activist Democrats will feel emboldened as their first foray into a new era of power (speed, knowledge, informed spokespersons, and media savvy) will likely emerge. One near certain outcome will be a more aggressive regulatory regime. For free market fundamentalists, this will produce a fate worse than death.

The multi-decade era of market fundamentalism** is on the verge of ending. A more activist government appears almost certain to emerge. Bye bye laissez-faire, hello Mr. Regulator. After many years of detached government management, the pendulum appears to have swung. However, this may not be all that bad, as the detached government management style of the Bush Administration has produced poor administrative execution (e.g. Katrina) and more extreme developments in the markets (e.g. subprime). Of course, such a regulatory shift may be taken to an extreme. But that is not likely to occur for several years as political corruption takes time.

That said, it does seem probable that the death of market fundamentalism has arrived.

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**A belief that markets are best suited to handle the trading and value of assets with as little regulatory intervention as possible.

Sectors and Styles Strategy Report: June 23, 2008

excerpts from this week’s report:

Model Growth Portfolio (MGP)
“An excellent relative performance week as the MGP beat the S&P 500 by a solid 53 basis points pushing the year to date results to their highest level at 327 basis points over the S&P 500…”

Model Growth Portfolio (MGP) Re-balancing
“Many of the position changes noted are designed to move some of the portfolio’s assets toward a growth tilt. Also, given the valuation numbers noted in the ERVM along with certain technical indicators (Smids strong, Dow Transports not confirming Dow Industrials weakness), it seems prudent to increase the overall equity exposure to...”

ETF Market Monitor
Econ. Sectors & Industries: A bit of mixed bag with Energy (all subsets) doing relatively well but so did Biotech and Steel. Consumer Discretionary was hit hard but so was Healthcare Providers.
Size & Styles: The Smids and even Micro Cap put in a solid relative performance week. Transports were up in absolute terms.
Global: Other than India (down big) only the energy resource countries (Russia, Canada) moved.
Other: Gold had a strong recovery week.

Expected Return Valuation Model
“As noted above, valuation levels improved to the point where an increase in equity exposure is warranted with a potential total return from current levels of approximately 18% (dark blue zone).

FYI - While bottom-up analyst operating earnings forecasts remain overly optimistic (see table below), the expected return estimate noted above is based on the much more conservative full year operating earnings for the S&P 500 of $82. Therefore, ample room is left for any earnings disappointment or…”

Moving Averages Scorecard
The big down week in the US produced a number of downward ticks in the Scorecard. Most notable were several US sectors that had begun to form potential trends only to slide back to neutral even deteriorating near term direction. The net effect was to push the cumulative mega trend number down to nearly 40%. Most notable re the Global markets is the sharp decline in the two Asian giants – China and India. Both are solidly in negative…”

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

Quotable Quotes: Ideas

Be it bull or bear market, good investment ideas are rare occurrences. Therefore, a few words on ideas.

“Catastrophes come when some dominant institution, swollen like a soap-bubble and still standing without foundations, suddenly crumbles at the touch of what may seem a word or an idea, but is really some stronger material force.”
George Santayana

“Great ideas often receive violent opposition from mediocre minds.”
Albert Einstein

“A man is not idle because he is absorbed in thought. There is a visible labor and there is an invisible labor.”
Victor Hugo

“It is not once nor twice but times without number that the same ideas make their appearance in the world.” 

Aristotle

“I can't understand why people are frightened of new ideas. I'm frightened of the old ones.”
John Cage

“Man's mind, once stretched by a new idea, never regains its original dimensions.”
Oliver Wendell Holmes

“You do things when the opportunities come along. I've had periods in my life when I've had a bundle of ideas come along, and I've had long dry spells. If I get an idea next week, I'll do something. If not, I won't do a damn thing.”
Warren Buffett

Have a good weekend.

Slamming the Door on the Enron Loophole

The US Congress is on a rampage. And the oil speculators (who have inflated the price of oil by anywhere between 30 to $50 a barrel) are on the run. Perhaps the most extreme proposal by a legislator or regulator to reign in energy speculation comes from Senator Joe Lieberman. Consider his comments of yesterday:

"We are not, as some continue to argue, witnessing the ebb and flow of natural market forces at work. We are instead seeing excessive market speculation at work and that is why our government must step in with new laws to protect our economy and our consumers,"


With yesterday’s override of President Bush’s veto of the Farm Bill, the first of many steps taken and to be taken to put a serious crimp in energy speculation are well underway. And with each new effort to tamp down on unlimited and undisclosed oil futures’ positions, be it closing key aspects of the Enron Loophole as in the Farm Bill* or the proposals to close the “London Loophole”, or the Lieberman effort to “prohibit private and public pension funds with more than $500 million in assets from investing in agricultural and energy commodities traded on a U.S. futures exchange, foreign exchange or over the counter”, the debate over whether the high price of oil is due strictly to supply and demand in the real economy versus supply and demand of speculators will soon be resolved.

Investment Strategy Implications

I believe the catalyst for higher stock prices this summer will be a sustained and possibly sharp drop in the price of oil for all the reasons (and then some) noted above. With valuation at reasonable levels and professional investor pessimism as high as the recent Merrill Lynch survey states, room for higher equity prices appears more than justified.

Moreover, from both a fundamental and technical analysis perspective, it is hard to understand how stocks will head lower when Mid Cap and Small Cap Growth issues (IJK and IJT, respectively)** are outperforming the broad market and, in the process, signaling that 2Q08 earnings (which are not so inflated as 4Q08 numbers are) are likely to be more than acceptable. Strength in second and third tier issues is usually not the precondition for lower prices.

Beta bets plus a tilt toward growth appears to be advisable. For the truly adventuresome, Consumer Discretionary (XLY), Double Long Financials (UYG), and the Broker/Dealers (IAI) should react positively to any summer rally.

*However, not enough according to Michael Greenberger (see blog posting below re The Enron Loophole), as the process by which the CFTC can act requires too many steps.
**See above chart. Click on image to enlarge.

Beyond the Sound Bite: An Interview with Marty Fridson, CFA

My interview with the CEO and CIO of Fridson Investment Advisors explored the fault line in credit instruments - high yield bonds. Related to this we discussed credit default swaps, the potential for rising corporate default rates, and the changing investor environment for high yield instruments, among others.

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

Summer Breeze

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

The past several weeks have witnessed the equity markets filled with many crosscurrents. As noted in the various portions of this week’s report, strength has emerged side by side with new and renewed weakness. And it isn’t just the US. Take, for example, certain global markets.

With the unexpected rise in the ECB’s rate coupled with Ireland’s rejection of the EU’s Lisbon treaty, pressure on the EU’s ability to compete, despite many advantages, has emerged. And the equity markets of the EU have taken notice, as evidenced by poor relative and absolute performance of the Europe 350 (IEV).

Then you have various emerging markets, particularly the Asian variety, that have pushed strongly to the downside of late, which requires an investor to decide if a bubble has burst or is it a healthy bull market correction? Sensitivity to the US consumer and inflationary induced riots are two of several areas of concern for investors.

On the more positive side is a likely modest US economic rebound (or at least not falling off the cliff) driven by the stimulus efforts (fiscal and monetary) of the US government. GDP reports and corporate profits for 2Q08 will likely be a touch better than consensus enabling equity investors to benefit from any upside surprises. That said, however, it cannot be assumed that the US consumer will be able to continue his/her profligate ways indefinitely. No matter, for as noted by Phil Roth in a recent Beyond the Sound Bite interview (June 4, 2008), the equity markets are dominated by short term momentum hedge fund players as never before. And the very short term momentum action is about all that will be the primary focus for equities in the US this summer.

Investment Strategy Implications

Given so many crosscurrents, where would one find the drivers for higher equity prices? Let me offer the closing of the Enron and “London” Loopholes as the potential catalysts for much lower oil prices and, therefore, a justification for a summer stock market rally. If so, then the likely bigger winners should be US consumer sensitive sectors and the higher volatility regions that are also highly sensitive to US consumer spending, such as the recently beaten down equity markets in China (FXI).

The legislative action re the loopholes this summer coupled with better than expected 2Q08 US economic activity and corporate profitability should provide enough fuel for a reasonable summer rally. However, from a longer term perspective, it will be the quality of that summer rally that determines whether the fall of this year will be the opening act for the second wave of credit related problems and the associated second leg of the bear.

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