It supplements yesterday’s comments on market technicals. Here’s the link–or just click the tab at the top of the page.
Monthly Archives: May 2010
I’ve updated Current Market Tactics
Here’s the link–or you can just click the tab at the top of the page. A discussion, voodoo-ish as it may be, of market technicals today. The fundamentals tomorrow.
Should you “buy when there’s blood in the streets”? … or “not try to catch a falling knife”?
Wall Street has spawned millions of clichés. They run from capturing the essence of stock investing, “Buy low; sell high” to not-so-useful chatter (for investors) from traders, like “Wait for a pullback,” to the inane natterings of cable TV show personalities.
Market truisms are often mutually contradictory. But, excepting the ones from TV, they often outline possible approaches to important investment issues. That’s certainly the case with the two I’ve cited in the title for this post, which talk about how to deal with sharp drops in the market in general, and how to play a possible upturn in the business cycle (and therefore in the market cycle as well) in particular.
the big middle
In the old days–meaning pre-Eighties, professional investors in the US customarily talked about working the “big middle.” The idea was to avoid undue risk at potential cyclical turning points in the market. A manager would do this by becoming more defensive as he saw three signs: the economy beginning to expand at an unsustainably high rate, the market becoming fully valued and the Fed about to shift money policy from expansive to restrictive.
He might miss the actual market peak by months. But he was prepared to profit from the subsequent downturn. As he sensed the opposite signs, however–the economy flagging, the market cheap and the Fed about to reverse course–he would do nothing. He would wait for the market to clearly turn upward again before becoming more aggressive. Again, he might miss the absolute bottom by months, but he would avoid coming out of his defensive position too soon and he would gain performance for a year or more after he turned his portfolio more positive.
No one talks about this overall strategy anymore. Why not?
–For one thing, as a result of deliberate policy decisions by the major governments of the world over at least the past quarter-century, individual country economies are much more closely linked in a global network than they were. The closed economy model is a thing of the past. Markets are affected, sometimes profoundly, by events that take place elsewhere and over which the local government has only limited control.
–The investment business is much more competitive today than it was then. Underperforming for six months or a year may be enough to get a manager fired before the “big middle” strategy allows him to catch up. His clients may say they’re ok with the risk mitigation his approach provides, but when the numbers fall behind the peer group, memories can be very short. And it’s always the customer’s right to take his business elsewhere if e chooses.
–For thirty years, we’ve been seeing the creation of ever newer derivatives tools that allow the manager to change portfolio composition much more quickly than before. In addition, volumes in the physical market have been steadily increasing as well, allowing managers whose contracts with customers bar the use of derivatives to act swiftly, too. Maybe we’re now seeing the limits to this speed, even large market participants have the flexibility to alter their portfolio structure in a matter of a few weeks if they choose to.
To sum up, linkages with the rest of the globe mean more chances for sharp short-term market movements, which new tools and increased competition have professionals increasingly focused on. Also, as the recent “Crash of 2:45” shows, the new tools themselves may be another source of temporary market instability.
the falling knife
Opinion is divided on how to approach sharp market declines. “Don’t try to catch a falling knife” expresses one technique. I’m not sure what the origin is. I’ve only begun recently to hear it in the US, although it was already very common among British investors when I began to look carefully at foreign markets in the mid-Eighties.
The “falling knife” idea is a variation on the “big middle” theme. The thought is that when investors are selling aggressively and stocks are dropping sharply, it’s better to wait until this energy has exhausted itself before going in to pick up the pieces. See the bottom and watch the turn happening before entering the market.
blood in the streets
The “blood in the streets” approach is to some degree the opposite idea. Buy when everyone else is selling, when the predominant emotion in the market is fear, and when stocks are cheap. Don’t wait for the turn. By the time you’ve convinced yourself that the worst is over, the best buying opportunity is long gone.
more professionals are embracing the “blood” idea…
…in my opinion, anyway, for two reasons. The opportunity to profit from market disruptions, and by doing so to perform better than one’s peers, is too great to ignore. Increasingly, the time period over which clients are judging professionals’ performance is shrinking. Hedge funds, where returns may be scrutinized and evaluated on a month by month basis, are the limiting case. But this performance pressure is also being felt by long-only managers.
What should individuals do?
The most important thing is to ask yourself two related questions:
–Are you willing to accept the extra risk of trying to trade a downdraft in the market?
–Is your financial situation strong enough that you can absorb possible losses if you turn out to be wrong?
Assuming the answer to both questions is “yes,” these are my thoughts:
1. Ask yourself what the primary trend in the market is. Are stocks generally going up or generally doing down? Are we in a bull market or a bear market?
In my opinion, you should only be interested in counter-trend movements. Only think about buying, or about replacing defensive stocks with more aggressive ones, during a decline that happens in a bull market. Conversely, only use a sharp upturn to become more defensive during a bear market. Otherwise, do nothing. During the past twenty years, the lows have typically been much lower, and the highs higher, than anyone would have predicted. Welcome to a world with derivatives trading.
2. Calculate probabilities as best you can. The point is that you don’t need to find the absolute bottom in order to act. For me, if I can satisfy myself that a stock might go down 10% but has an equal chance of going up 30%, I’m happy to buy. Your own risk tolerances will determine what the appropriate ratio is for you.
3. Separate market events from stock-specific ones. In a temporary downturn, more economically sensitive stocks will typically decline more than defensive ones. Similar stocks in the same industry should show roughly similar volume and percentage change patterns. These patterns should also be similar to the stocks’ behavior during past declines. An individual stock decline that is, say, twice what one should expect and that happens on much higher than expected volume can be a warning sign that sellers are acting on newly developed negative information that you may not be aware of. In such a case, discretion is the better part of valor. Choose a different stock to buy, or don’t transact at all.
4. Don’t force yourself to do anything you don’t feel comfortable with. I think it’s a characteristic of today’s market environment that if you miss an opportunity today, another one will likely occur in a month or two.
Waddell & Reed and the crash of 2:45
the Ivy Asset Strategy Fund
Government investigators have been tracking the sell orders that were executed in Chicago on the afternoon of May 6 betweeen 2:30pm and 3:00pm, the period when the S&P 500 plummeted by 5%–and just as quickly rebounded.
According the Financial Times, they’ve discovered that a mid-Western investment firm, Waddell & Reed (ticker: WDR), was a significant seller of stock index futures during that period. At one point, 2:32pm, WDR constituted 9% of the total volume of one specific stock index futures contract, the “e-mini”. WDR has issued a press release (not so easy to find on its website, but it’s there) confirming the press stories and stressing it was just doing normal hedging transactions for its $22 billion flexible fund.
The prospectus of the fund in question, the Ivy Asset Strategy Fund, says it can invest in stocks, bonds, precious metals and currencies around the world. It can also use derivatives to hedge its exposures. In other words, the customer gives WDR enormous freedom in how to invest his funds.
Neither the WRD press release nor the fund prospectus spells out what the fund might have been doing on the afternoon of May 6th. The only clues we have are that the WRD selling seems to have been triggered by the declining market (rather than vice versa) and that the selling continued even as the market was rebounding.
This suggests, to me anyway, that the selling was done in accordance with mechanical rules that were set in advance, and were to be carried out without any human intervention. The idea would be to remove human subjectivity–feelings of greed or fear–that might lead to impulsive (and thereby usually money-losing) on-the-spot action.
dynamic hedging
the investment manager
The simplest explanation of the activity is that the managers were using a plain-vanilla technique for hedging portfolio value where the short derivatives position shrinks as the S&P rises and increases as the S&P falls (it was called portfolio insurance when it became popular about a quarter-century ago).
There’s nothing “wrong” with this technique or exotic about it–in fact, it’s ubiquitous in the hedging world–other than that it was invented by academics. An underlying assumption is that there’ll always be someone (you can call him the “dumb money,” if you want, because that’s the idea) who will willy-nilly take the other side of the trade. And, I suspect, when the WDR computer/trading room entered its sell orders, along with about 250 other firms who were using similar techniques and wanted to do the same thing, there weren’t enough buyers to go around.
Two points:
1. The investment manager sees the market declining and sells S&P index futures to hedge his position. The counterparty, who is likely the broker he is dealing with, takes the offsetting long position. If it’s the broker, he will try to balance ( or “flatten”) his books by selling stock short in the physical market, thereby creating further downward pressure on the S&P. In addition, if he already has a long futures position and is employing the same hedging technique for his own books as the investment manager is, he wants to sell more physical stock short to restore the level of hedging he wants against any long futures position he already had.
This means the market declines further, the investment manager wants to hedge more … The investment manager hedging activity has a snowball effect.
2. This kind of hedging has been around for about 25 years. If it still works–it’s possible it doesn’t and that practitioners lost their shirts on the 6th (warning: my practical derivatives experience is limited to currencies and emerging markets stocks), it seems to me to depend on the assumption that the counterparty never catches on. He never alters his behavior He never reads the books his customer studied from. He never tries to hire away one of his traders to learn his secrets. He just continues to be the “dumb money” who racks up losses from this trading.
Not likely, though. It’s possible that the counterparty makes so much money from his customers’ other, losing, trades that he writes this off as a cost of doing business. More probable, I think the counterparties model their customers’ actions very closely–after all, everyone is doing basically the same dynamic hedging trading–and can predict with a high degree of accuracy when they will act and what they’ll do.
The counterparty has three responses that I can see. He can charge more for trades done at times he identifies as risky. He can begin his own hedging activity in anticipation of his customers’ acting (in effect triggering their trades). Or he can drag his feet in executing them so that he ends up not doing them at all, or not doing as many as he would otherwise do.
the counterparties
I think there should be a debate about what obligations, if any, an exchange, or a broker who is a member of an exchange, have in a situation like this. This is particularly so, since we are enacting legislation to force most derivatives trading out of the shadowy over-the-counter world and onto exchanges.
We do know that the NYSE partially withdrew from making markets during the decline on May 6th. Members did so by unhooking their computers as the market was falling and starting to process trades manually. They certainly avoided losses by doing so. Given how they are connected to the stock index futures markets, this short-circuited the derivatives world, as well. Should they be allowed to?
The NYSE is a particularly interesting case. On the one hand, you could argue that they are a quasi-utility that can’t be allowed to in effect turn out the lights in tough times. Given that it has a history that I would characterize as one of high fees and shoddy service, it wouldn’t be surprising to learn it has few friends among professional investors.
On the other hand, the NYSE is by no means a monopoly. Professionals have been bypassing it for years, through electronic crossing networks, for instance, that offer lower costs and greater confidentiality. The issue with ECNs is that they aren’t that liquid.
the debate should be interesting to watch
How do you reconcile the interests of a derivatives community operating with tools that presuppose infinite liquidity at all times, with a creaky physical stock trading system where the taps can be turned off at a moment’s notice? We’ll see.
By the way, I don’t think the Ivy Asset Strategy Fund did anything wrong. Its only sin is that its performance, along with WDR’s marketing, have grown it to such a large size that its actions are more visible than its peers’.
Is it time to buy Euroland stocks? I think so.
the recent EMU numbers are ugly
The euro peaked against the $US on November 25, 2009 at a rate of 1€ = US$1.5139. It now stands at 1€ = $1.2464, which is a decline of 18%. Over that same time frame, the S&P 500 is up about 4%. In contrast, the MSCI EMU (= European Monetary Union) index is down about 2% in euros and just about 20% in dollars.
we all know why
In the simplest terms, the EU was created to give Europe the economic heft it needed to compete with the United States. A side benefit was that it raised Europe’s standard of living by breaking down the then-ubiquitous border controls that inhibited intra-European commerce.
One key feature of the EU is that it is a monetary union, but leaves the determination of the level of government spending to the individual member countries. The rules for attaining membership required that candidate countries display economic solvency and a minimum level of fiscal prudence in spending. The tacit assumption was that any country that made the effort to walk the straight and narrow path in order to get into the union would continue to do so afterward. That, of course, has turned out to be wrong.
This is not 100% the members’ fault. The EU got things off on the wrong foot by running a money policy that was too loose of the smaller countries. It did so to aid Germany, the union’s largest member, cope with a “lost decade” of economic performance as it dealt with the reintegration of East and West, as well as a chronic problem of too expensive labor. Then, of course, it bent the rules to let Greece in and, generally speaking, turned a blind eye to excesses in places like Ireland, Spain and Portugal.
The current crisis was sparked by revelations late last year that Greece had falsified its national accounts over an extended period, thereby allowing it to run up an amount of government debt so large that it’s hard to see how Greece could ever pay it back. EU rules said no bailouts allowed. Kicking Greece out wouldn’t solve anything either, since investors would start to worry that, say, Portugal might be next to be tossed overboard and the funding crisis would migrate there. In fact, markets quickly coined the acronym PIGS (Portugal, Ireland, Greece, Spain) to refer to the EU situation. Violent demonstrations in Greece to protest proposed cutbacks in Greek government spending also raised the worry that Greek citizens had no intention of trying to repay the bills they had run up.
where are we today?
Greece is being bailed out by the rest of the EU, with some help from the Federal Reserve in the US. Portugal and Spain have announced austerity measures. We’re probably on the road to greater fiscal integration in the EU as a way of preventing the Greek situation from occurring again elsewhere.
As the figures in the first paragraph above show, the euro has been crushed. And we should probably expect that economic growth in the EU will be sub-par as formerly profligate governments pare back their spending.
bonds vs stocks
This bad news has expressed itself almost entirely in weakness in the euro and falls in government bond prices. Other than the fact that all the negatives appear to be out on the table now–and therefore one would think that they’re to a great extent already factored into today’s securities prices–this is a real disaster for foreign holders of EU government bonds.
It hasn’t been fun for holders of EU stocks, either. But for the latter, there’s a potential silver lining. About half the earnings of publicly traded EU stocks come from subsidiaries located outside Europe. For those firms, profit growth is going to be surprisingly strong over the coming year. So, too, will gains for export-oriented and import-competing businesses within the EU. On top of that, a currency drop acts somewhat like a decline in interest rates–not only rearranging the composition of domestic growth but adding to it for a while.
Typically, in a case like this the currency moves first and stocks only begin to discount the new realities a month or two later. I haven’t done an exhaustive check, but from the names I’ve looked at, it seems to me that stock market investors are still in shock from recent events and haven’t done much work in figuring out the plusses of the new reality.
Now is the time to do so, in my opinion.
There is a risk to this idea, however–apart from the normal uncertainties surrounding any investment in equities. I think the big political and emotional crisis over the stability of the EU structure is pretty much over as far as the financial markets are concerned. So it’s safe to go in and pick up the pieces. In this regard, I see Euroland now as in somewhat the same position today as the US was a year ago. Valuations are, of course, much higher, so the absolute returns won’t be as great if I’m correct. The point of comparison is the different pattern of stock performance for domestic-only (= bad) and multinational/export-oriented (= good) that the US has shown since march 2009.
If, on the other hand, if you think we’re only in the eye of the storm, it’s much too soon to act.