June 30, 2010

Market Summary – 2nd Quarter, 2010

The talk of the World Cup soccer (football) championships was not the action on the field as much as the buzz of vuvuzelas – the traditional African horn that fans have blown incessantly throughout each game. While vuvuzelas garnered much of the headlines, they were far from the only irritating noise we’ve been subjected to this summer:

• Publicized speculation by pundits warning of a “double-dip” recession.
• Claims of “stock market skeptics” (never in short supply during volatile times) that investors won’t be rewarded for the risk premium of equities. They suggest bonds can deliver sufficient returns in the future. This is a particularly bold statement given the current level of interest rates.
• Maybe most irritating of all, the never-ending whirr of computers, programmed by quantitative analysts (quants), trading on a high frequency basis, trying to find marginal profit opportunities. Their impact on the market, already felt in the financial crisis of 2008, was reborn during the second quarter of 2010.

The Runaway Quants
The quants are not new to Wall Street, but their power over the market has grown dramatically in recent years. They are the self-proclaimed “smartest guys in the room” who are convinced they can devise formulas to outsmart the market.

It was the quants who were behind the hedge fund Long Term Capital Management (LTCM). If you recall, LTCM nearly brought down the entire financial system in 1998 through over-leveraged bets that went wrong. One key premise behind LTCM’s philosophy was that they could quantify risk and figure out how to control it through effective hedging strategies. The brains behind LTCM were convinced they could outsmart the market with little threat of a downside. In the end, they collapsed when the market turned in unexpected ways that weren’t factored into their models.

Quants model their strategies on historical data. Unfortunately, the market keeps having what some would call “black swan” events (comes from the centuries-old belief that all swans were white, until it was discovered that there were in fact black swans). Black swans aren’t factored into their models. After all, there is no historical record of unprecedented events.

Another black swan event was the collapse of the subprime mortgage market in 2007. It had its origins in the work of quants. Their missteps led to the downfall of Bear Stearns and Lehman Brothers and threatened the very existence of the global financial system.

Leverage and Volume
Quantitative activity takes many forms in today’s markets. Hedge funds are the most visible example. Now there is the phenomenon of High Frequency Trading (HFT) that appears to be the dominant force in day-to-day trading activity in the markets.
HFTs are computerized trading systems that activate large volumes of trades, driven by computer programs, in a matter of seconds. Even the proximity of the trading firm’s computers to that of, say, the New York Stock Exchange, impacts the effectiveness of such trading, as two factors come into play:

• Speed in identifying rapid pricing discrepancies that, if all goes according to plan, creates a profitable trading opportunity. Speed of trade execution also matters. Talk about a short-term perspective – the difference between a winning and losing trade can be a matter of a second.
• Leverage to maximize the profit impact of the trade. Since the profit margins on most of these trades are minimal, due in part to the fact that so many different organizations are trying to capitalize on the same, short-term trading opportunity, leverage is used to make the trade truly worthwhile. As time goes on, more and more leverage is required to keep up with profit targets. If things go bad, it backfires and causes a rush to avoid significant losses.

Given their increasing dominance of the market, it seems that quantitative trading has probably generated much of the volatility we’ve experienced in the market on a day-to-day basis in recent times. Notably, volatility has been a virtual constant since 2007, when the “Uptick Rule,” which restricted short selling stocks that are going down in price, was revoked. We’ve noticed that since then that the incidence of the stock market (as measured by the S&P 500) changing value by at least 1% from the previous day’s close has become more common.

This was best exemplified by the startling events of May 6, 2010 – what was considered a fairly benign day in the market until mid-afternoon. Out of the blue, with no apparent triggering news, the Dow Jones Industrial Average plunged more than 7% in a 15-minute span. That represents $1 trillion worth of market value – gone in a quarter of an hour. Much of the loss was recovered before the market closed that day. Almost every explanation for this “flash crash” and its subsequent rebound relates to some form of program trading.

This was clearly an unsettling event for investors. It is troubling because the quants are not investors. They are traders looking for a quick profit. This is well explained in this year’s best-selling book The Quants by Scott Patterson. He writes that many of the big-name quants learned some of what they know by reading a book called Beating the Dealer: A Winning Strategy for the Game of 21. This guide to winning at the blackjack tables was written by a well-regarded mathematical mind named Ed Thorp who later became a hedge fund manager. Patterson makes it clear that many of the figures he writes about are geniuses in their own right, but also seemingly with a blind spot in terms of what potential “black swans” could suddenly sidetrack their strategies.

The traditional investor’s advantage
Are these quantitative geniuses killing the golden goose for the average investor? Hardly. The quants have no special access to proprietary information, and are no more aware of quality stocks available at fair prices than anybody else. They don’t look at the world in terms of fundamentals. They are playing a numbers game.

The upside for traditional investors is that inevitably, quants will overreach just like anybody who trades on a momentum basis. Momentum can drive stock prices of worthy companies down to extremely attractive levels. That creates value that offers a real opportunity for investors. It is important to remember that in the end, “Mr. Market” is not a voting machine (rewarding the most popular stocks or sectors or asset classes), but a weighing machine. Factors like the risk of a “double-dip” recession and valuation of a company are always being weighed by the market. Emotional factors are weighed as well, and emotion has swung considerably toward the psychology of fear. Yet Mr. Market has a Darwinian way of weeding out weaker investors, those driven by fear who bail out on stocks. This creates better opportunities for stronger investors who are able to capitalize on value opportunities.

The mutual fund research company Dalbar, Inc. regularly conducts studies to determine how the portfolios of actual investors are performing compared to the typical market measures we follow, such as the S&P 500 Index. Over the past 20 years (through the end of 2009), Dalbar has calculated the following return comparison:

• Average Equity Mutual Fund Investor 3.17%
• Broad Stock Market (S&P 500) 8.20%
• Inflation Rate (Consumer Price Index) 2.80%

Stock fund investors are failing to grow their assets at the market’s pace, and are barely earning more than the rate of inflation. Why is that? Because, often driven by emotions, investors are “guessing” wrong about when to be in and out of the market.

Today, investors continue to favor bonds over stocks, a trend that probably won’t serve their long-term interests. In previous newsletters, we mentioned the rapid flow of money into bond funds. Here’s the latest – the Investment Company Institute reports that year-to-date through May, $118 billion of new money has flowed into bond funds, while stock funds garnered just $14 billion of new money over the same period. In fact, stock mutual funds suffered a $24 billion net outflow in May. Yet, as reported in Barron’s (“Beware Bond Funds,” July 12, 2010), buying into bond mutual funds today comes with an added risk beyond that of rising interest rates. If bond fund investors begin to sell their positions, bond fund managers will be forced to do the same. The remaining investors in the funds will suffer even more. In this instance, rather than the weak investors creating opportunities for stronger investors, their actions actually do more harm.

The problem with concentrating assets in bonds today is not just the immediate risk inherent in doing so when rates are near historic lows. It is also the tepid long-term outlook. You can tie up money in a 30-year U.S. Treasury bond and earn less than 4% – but that’s a hard way to accumulate wealth or even generate income that can keep pace with higher living costs.

It is notable that in his company’s annual meeting five years ago, Warren Buffet said “If you had to make a choice between long-term bonds and equities for the next 20 years, I would certainly prefer equities.”

That was five years ago. The stock market today is close to the same level it was at that time. 30-year U.S. Treasury bonds are actually yielding 14% less today than they were when Buffet made that statement. Stocks are no more risky today than they were five years ago, while the risk in bonds has decidedly risen.

What investor psychology tells us about the market
The popularity of bonds today is clearly a reflection of investors seeking comfort. Yet the same potential bubble is brewing in bonds as was the case with technology stocks around the turn of the millennium, financial stocks in the 2005-2007 era and real estate in the past decade.

The stock market seems stuck in a trading range as investors try to figure out where they stand. Yet the point of maximum risk in the stock market is clearly when investors are euphoric at the market’s strength or complacent that a rally will continue. That usually occurs near the point when stocks have reached a peak at the end of a long bull market run, according to a chart on investor psychology published by the website “Wall St. Cheat Sheet.”

Today’s psychology is far from complacent. Investor emotions seem to range from anxiety to denial to depression to disbelief that any rally could be sustained. These emotions tend to occur at the point of maximum opportunity in the market, when stocks are well below their highs. Emotionally speaking, the market is clearly closer to a period of peak opportunity than one of peak risk.

Future value – what investing is all about
The main reason to invest, more than anything else, is to protect the future economic value of your assets. If this could be accomplished by simply leaving your money in a bank account or CDs, investors would have settled for that long ago (especially when bank accounts and CDs paid something above 0.5% interest). But it became evident to most of us that the best way to accumulate wealth and therefore, protect future economic security, is to hold hard assets or take ownership positions in corporations that create wealth.

Protecting future economic value is becoming an even more significant challenge in light of a dominant issue confronting the market today. Government spending and the resulting debt are well beyond a reasonable level of comfort. How is this being paid for? One way is to print more money. Think of it in these terms. What if a company paid for its expenses by issuing new stock? It would dilute the value of existing shareholders’ equity. So what happens to the value of your money when the government prints more of it? Existing dollars lose their value as more currency is put into circulation.

Deflation risk – not on the Fed’s agenda
What about deflation fears? Despite repeated concerns that government debt will result in an inflationary spiral, high unemployment and other factors like the depressed housing market have made inflation a non-issue for the moment. While deflation is a higher risk today than at anytime in memory, it is fair to say that the Federal Reserve is committed to preventing that from happening.

Look no further than a speech delivered on Nov. 21, 2002 by then Federal Reserve Governor and now Fed Chairman Ben Bernanke for assurance. He stated, “a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation.” He went on to say “deflation is always reversible under a fiat money system.” Bernanke pointed out “U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or today its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.” Bernanke suggested that even the threat of increasing the number of dollars in circulation could cause prices to rise, and avert a deflation threat. His conclusion, which we assume Bernanke still subscribes to, is “under a paper money system, a determined government can always generate higher spending and hence positive inflation.”

If and when that occurs, investors can best prepare themselves by owning assets that can hold their value when purchasing power is at risk, such as gold and other hard assets. Rather than flee to the perceived safety of bonds in pursuit of short-term comfort, investors need to focus on their long-term economic well being. Owning assets is a more favorable position when living costs are rising, rather than putting money to work in lending instruments such as bonds and other fixed income vehicles.

Overestimating the “right time”
Today, with the Dow Jones Industrial Average hovering around 10,000, stocks seem like they are standing still and clearly, with so much cash on the sidelines or in bonds, investors are waiting for the “right time” to return to the market. Keep in mind that a century ago, the Dow Jones Industrial Average stood at 81.18. Even with the latest pullback from the Dow’s peak of 14,000 (in 2007), those who were along for the ride have enjoyed a prosperous journey – even through a century of wars, various economic upheavals and political uncertainty.

Despite all of the fear and loathing about the state of the economy, global debt crises, frustratingly slow growth in job creation, pending tax hikes and any number of other issues highlighted daily in the media, opportunity in the stock market today is better than was the case even a few months ago. Strong investors who capitalize on those opportunities can lay the groundwork for their future economic security.

~MPMG

Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.

The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.