du Pasquier Asset Management

Arlington Econometrics Market Commentary for the week of October 1, 2008

Rumpelstiltskin Economics

Some of the finest alchemy in the world is currently being transacted on Wall Street and in Congress, the Federal Reserve, and the banking system.  Some of us thought that turning straw into gold was simply the stuff of fairy tales.  Not any longer.

In distant times economists, politicians and capitalists argued that maintaining the purity of the capital markets was an empirical given, especially if trust and transparency were to be respected hallmarks of a free market.

The challenges within the credit markets today are the last gasp of that worthy goal.  Today’s failures are the result of a breakdown in trust and transparency.  And, evidently, professionalism, morals and competency.  It goes beyond the pale to envision nationalizing our capital markets and making the taxpayer responsible (twice) for the poor judgment of speculators and collaborators who brought down the system’s psyche by their wanton greed and disrespect.

I am truly alarmed, in particular, that the bond market (once viewed as a bastion of safety) has turned its IOU’s (promises of repayment) into near-worthless pieces of paper and left you holding the bag.  After all, weren’t bonds supposed to be a surrogate/alternative for the high risk equity markets?

When the Fed, or any government, injects itself into the bailout of risk markets they destroy a sense of equilibrium naturally found in uninterrupted markets.  Distortions occur in valuing securities (like mortgages or stocks) which leads to longer recovery time and potential negative fallout in the future.  This is not the first time an argument has been made for intervention.  And yet I would argue, each capital infusion heightens the level of uncertainty in the market, not quell it.  In addition, the agencies and officers responsible for the problem are deemed “blameless” because their money is not used to ameliorate the situation.  Setting up a model in which business can “tap into” the treasury is deceitful and probably illegal, if not certainly morally bereft.

Shareholders should seek redress from the agents of their disaffection, not from you and me.  And, indeed, they are “owed”, but perhaps only an explanation, not a full return of capital, for taking the risk in the first place.

Markets

Hybrid investments, synthetic alternatives, hedge funds and the like are concoctions designed to enrich their originators while promising to deliver returns to their investors.  But make no mistake, Wall Street is in the money-making business and the public is their vehicle.

I would argue, as well, that the influence of technology and 24 hour media contributes to a sense that markets cannot be destructive because “we know all there is to know”.  This sense of invulnerability permeates the investing public and makes them think that “it can’t happen to me”.  Unfortunately, when the market declines, or home values recede, or unemployment happens it’s only representative of the natural evolution of parabolic economic cycles.

I believe, for example, that technology, today, can be a double-edged sword in the financial world because while we now have access to methodologies and alternative strategies that expand the scope of capital gains potential beyond traditional investing, those options also deteriorate the fundamentals of valuation that govern the underpinnings of asset classes.  Additionally, the quality of humanism and morality cannot be replicated by black-box methodology or complex financial algorithms.

Finally, the problem with one-size-fits-all solutions is that they do not allow for regional or cultural nuance, or individual preference for risk/reward tolerance.

Wall Street has inflicted real losses in the last 6 months, some of which are financial, others are psychic and very painful.

The risk in financial markets is obviously not restricted to the United States.  Bankruptcies are pervasive in many global arenas.  The implication of further reverberation inhibits markets from raising capital or expanding their capital gains potential.

Balance sheets are suffering from lack of consumer demand and increased costs of raw materials, including energy.  No one believes that the ripple-effect of one depreciating economy can be held at the border, and not felt within.

Borrowers are cash-strapped and the crisis endures.  Regulators are either part of the problem or unsure about how to effect a solution.

Strategy

The difficulty of this whole mess is that it erodes investor confidence, the bulwark of any capital market.  With portfolio values declining, home values diminishing and earning power falling behind, many investors are overcome by hopelessness and distrust.  Goals and aspirations are becoming wiped out just like portfolios. 

People have a right to be angry.  But let’s realize that cycles are natural.  Prudent portfolio methodology might have mitigated the impact of risk-taking by balancing aggression with conservative asset allocation strategies.

No one was complaining when the markets were expanding.  Regulators looked the other way as long as the machine was functioning profitably.  We all know, however, even from most recent experiences with technology and dot.com equities, that no trend endures indefinitely.

Portfolio returns have a built-in relevant range, I believe.  No portfolio can exceed “maximum valuation’ or fall below “negative valuation”.  This means that historical norms are guidelines for understanding the realm of portfolio probability potential.  When tech stocks rose, then fell in the 1990’s, it was not the demise of technology as a fundamental tenet of secular growth.  Rather it was a reversion to mean valuation and an expression of the excesses of speculation which preceded.  In the 1980’s home values did the same thing, rising then falling, but eventually returned to a bull market status in subsequent decades.

Every asset class has a time, place, and quantifiable limit to its expansion.  How do we know when and how much?  I have tried, for example, by creating a proprietary tool to help answer these questions quantitatively, equating relationships between stocks sectors, regions, and macro events.

Conclusion

History helps determine the magnitude and amplitude of investment cycles, such that we might explain performance in terms of quotients and relative strength within these cycles.  Whereas cycles are not limited by psychology or methodology, we can quantify their movements to determine optimal entry or exit strategies.  Without attaching a value judgment to a stock or sector, we can measure the location of a financial security and its duration within its cycle.  One never wants to stay too long at the party, so we use excess valuation as a trigger to sell securities or to rebalance the portfolio.

Simply knowing the course you are on and its location is better than not knowing at all, and wishing you had known.  Reducing risk is sometimes a matter of having a science (methodology) and sticking to it.

As investors, we can choose either to be aggressive or risk averse. Those who understand the volatility involved with high risk investing accept those parameters.  Those who choose a more conservative approach are less willing to be subject to the whims of market contingencies.  In either case, though, returns are directly related to the type of risk one might be willing to take.  And since “return” is generally what most investors are about, it is necessary to accept some risk in order to achieve the desired performance.

We can, however, modify risk, and enhance returns, through prudent asset allocation methodology, diversification, and statistical quotients that allow us to balance internal portfolio relationships to the overall market’s probabilities.  In other words, we try to do more with less overall exposure to volatility.

In the context of today’s market, the lowering tide has taken down all boats in the harbor.  But the equilibrium point is not “equal” for all asset classes.  Out of the current mess, I believe a new secular bull in alternative energy, biopharmaceuticals, agriculture, environmental pollution control, infrastructure and technology (including telecommunications) will be the next areas of global opportunity, without borders and irrespective of market capitalization.

But I do caution that changing the discussion, the mindset of greed, and the culture will not be easy.  A generation of techno-savvy investors hold strongly to the belief of a “new paradigm”.  Consulting computers for solutions, and 24 hour business media for direction, they have lost a certain ability to authenticate their ideas with street-wise common sense.

I would argue, however, that machines infect the investment process by relying sometimes too much upon alchemy and synthetic solutions.  The process is corrupt, not the objectives.  Thus far, no one has sought to slow down the speeding train, or be the hero standing in front of it.

Market dysfunction sometimes creates a self-fulfilling prophecy.  As we all might agree, no other system can replace what we have, but the one we have needs fixing and a better moral compass.  I am confident that infusing our science with humanism is the correct first step towards dispelling the fairy tale whim of 2008.

Asset Allocation:

Equity 30%/Fixed Income 45%/Cash 25%

Scotty C. George

(212) 624-1147

www.dupasco.com

Arlington Econometrics is a quantitative market tool.  Utilizing proprietary algorithmic equations, Arlington offers solutions for market-timing, asset allocation, and macro economic analysis.  Arlington Econometrics’ database spans over forty market bourses, and includes over 70,000 financial and statistical instruments.  Using historical time-series measurements, Arlington Econometrics optimizes the analytical process and forecasting coefficients to make economic forecasting more objective. 

The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete and it accuracy cannot be guaranteed. It is intended for private informational purposes only. Any opinions expressed are subject to change without notice. Du Pasquier Asset Management and its affiliated companies and/or individuals may from time to time own or have positions in the securities or contrary to the recommendation discussed herein.

(c) du Pasquier Asset Management

www.dupasco.com