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“In theory there is no difference between theory and practice. In practice there is.” – Yogi Berra Yogi Berra passed away last week. He was a writer’s dream, providing me with great quotes over the years. Plus he was my grandma’s favorite player, so that counts for a lot. He will be missed. This week’s letter is a little late due to some outside events. Literally outside. It’s grape harvest time in the Columbia River Gorge and as the owner of a vineyard, it’s all hands on deck over here. The kids are taken out of school, given clippers and a bucket, and get to learn what it means to do real work. Then last night we spent a few hours watching the lunar eclipse from the Rose Garden in Washington Square Park in Portland under a cloudless sky. I hear it was cloudy in a lot of the country, but at this time of the year in the Pacific Northwest it’s usually crystal clear, and last night was no exception. Family first… I had a plan all week to write about actual stocks. Not the Fed, not interest rates, not macro stuff. Just a few stocks. And then the market fell 2.5% today and I had to scrap that plan, but I’m still going to talk stocks, just different ones than initially planned. The others are getting moved to our StockPicker newsletter instead. Email me for a free trial. In theory, issues affecting other markets, or sectors that are peripheral to our markets, shouldn’t knock down the whole U.S. stock market 2.5% in a day. But they did. And I think they will continue to have an impact for a little while longer for a few reasons. Right now, cars, credit, and commodities are creating some more of those nasty correlations we have been talking about lately. The cars in the title are Volkswagen. VW isn’t a part of U.S. indices, but it is a huge part of the German market, and along with other German carmakers (Daimler, BMW) and their suppliers accounts for nearly 775,000 jobs and 20% of all German exports. VW is the new Greece for the German economy. One company’s scandal won’t cause a recession, but the issues dogging the company have made the DAX fairly uninvestable at the moment. This isn’t good for global funds that thought Germany was the safe haven in Europe. And we know what happens when global macro funds get hit in one market – they sell in all of them. "A nickel ain't worth a dime anymore." – Yogi Berra Credit and commodities are linked. Oil and copper and other commodities are in a free-fall, creating problems for companies that borrowed a lot to build the capacity to mine or drill for them. High yield spreads (see the chart below) are widening out. This creates problems for investors who lent at very low spreads last year, when a record amount of debt was issued. Now add in the unfolding saga at Glencore. The correlation here is from potential counterparty risk if Glencore gets downgraded to junk. Risk resides somewhere – but the question is where and in what form. Glencore is a big borrower ($26 billion comes due in the first half of 2016) and its credit default swaps are blowing out to extreme levels. My inbox has a number of reports on what banks have exposure to Glencore debt, which is never a good sign for the company in question. However, this is not just a Glencore problem -- high yield spreads overall are widening (albeit from very low levels), and new deals are coming below par with higher-than-marketed spreads. As usual, high yield was the canary in the coal mine for the stock market – spreads started widening in late June. The new capital given to the oil industry earlier this year was banking on a recovery in oil prices – and when oil prices fell over the summer instead of sustaining their rebound, credit markets got more realistic about the industry’s prospects.  "Nobody goes there anymore. It's too crowded." – Yogi Berra So what is different today that hasn’t been known to the markets for a few months? Commodities have been terrible for awhile. Glencore has been in the news for weeks. Energy is about 7% of the S&P 500 and Materials are under 3%. Well, today the markets got word that Hilary Clinton’s tweet from last week about price-gouging in drug prices (after Turing’s CEO did a star turn as the douche-bag CEO of the year), which wrecked biotech stocks, has now gone viral, as House Democrats asked to subpoena Valeant for documents related to drug price increases. Valeant was off over 12% today, and 4 other pharma companies stocks fell more than 10%. This healthcare selloff is what caused the most pain in the markets today, as U.S. stock fund managers have more exposure to healthcare than to materials and energy combined. Pharma was the place fund managers could hide – there was a lot of M&A, companies had activists backing them, borrowing for deals was cheap. Now M&A is in doubt, as the industry has apparently become the new whipping boy for Congress. (Does this mean the banks are now finally out of the hot seat? If so, they’re cheap…). Healthcare is a very crowded trade. Suddenly, with all this risk, nobody goes there anymore… "The future ain't what it used to be." – Yogi Berra This is where those nasty correlations come into play again. High yield has always been a leading indicator for equity markets for me – high yield spreads widening imply that equity risk premiums are also likely to increase. High yield spreads widened on energy worries late last year, but then tightened again as companies issued equity and refinanced debt. However, the most recent spread increase has coincided with bigger worries about global financial markets overall. If you were a simple stock fund that sensibly avoided all this mess by staying away from energy and commodities, you may well have been hiding in the “safe” auto and healthcare industries. Which is what makes the car problem and Clinton problem big problems – they are hitting stock investors where it hurts. J.P. Morgan said it well in a note today: “HC isn’t just big (~15% of the SPX) but has also been a massive contributor to fund performance over the last 1-2 years (thus the HC stock plunge has inflicted enormous amounts of P&L pain throughout the fund community and that is only adding to the broader risk-off trend).” "If people don't want to come out to the park, nobody's going to stop them." – Yogi Berra I think investors feel under siege. Global macro players have been hit by emerging market and currency volatility, global bond investors have been hit by credit spreads widening, and now stock investors are being hit in what they thought were their safe havens too. Buyers who were patient and added to their favorite stocks on the recent pullbacks are now sitting on losses on almost all of those buys. If you had a plan to buy a position in thirds, and you bought your first third on the first drop and the second third last week, well, now you’re looking at your book and thinking “do I really need to buy those last shares here? Why not wait a few days and see what happens?” Buying the dips, unless you were really good on August 24th, means you’re starting to feel some pain. (See the SPY chart below). And the thing about the stock market is, if you don’t want to come out to the park, nobody is going to stop you.  This week’s Trading Rules:
Resistance: 192, 195, a lot at 197/199, then 201 and 205. Positions: Long and short U.S. stocks and options, Long SPY Puts. For more ideas, charts, and market information, Email me for a free trial of my bi-weekly StockPicker newsletter. No credit card or other financial information is required. Mad Hatter: “Why is a raven like a writing-desk?” “Have you guessed the riddle yet?” the Hatter said, turning to Alice again. “No, I give it up,” Alice replied: “What’s the answer?” “I haven’t the slightest idea,” said the Hatter. - Alice in Wonderland A lot of investors are feeling like Alice in Wonderland, trying to figure out the riddle that is the Federal Reserve’s thought process. Investors are trying to understand why the Federal Reserve is so reticent to raise its target for the federal funds from its current 0 to ¼%. Its press release is fairly concise and offers quite a bit of insight into their thinking – I highly recommend actually reading it, not just a newspaper summary of it. As someone who thinks that rates should be higher, and banking regulation lower, because that is what will drive our economy upward, I’m trying to see what the Fed sees. What matters in investing is not what you think things should be but instead understanding what things are. And what things “are” today is lower rates for longer. So why are things the way they are? What does the Fed see that the rest of us don’t? Taking the press release as a guide, the Fed is focused on the following areas of the economy: Household Spending Business Fixed Investment Housing Sector Exports Labor Market From the release, they state that all of these areas are “improving” or “increasing moderately”, with the exception of exports, which have been “soft.” While they are worried about “global economic and financial developments” restraining economic activity, they believe that “with appropriate policy accommodation” (ie, lower-than-normal Fed Funds rates) that “economic activity will expand at a moderate pace.” “Take some more tea,” the March Hare said to Alice, very earnestly. “I've had nothing yet,” Alice replied in an offended tone, “so I can't take more.” “You mean you can't take LESS,” said the Hatter: “it's very easy to take MORE than nothing.” - Alice in Wonderland Implied in the release is that each of these areas, absent the magical interventions of the Fed, would not be expanding at a moderate pace. It also implies that these areas of the economy are helped by low rates – in fact, that these areas need rates at zero to improve even moderately. That is not a very bullish outlook for the state of the economy years after Lehman imploded. Seven years later and we still are barely expanding, and the Fed thinks that MORE of the same, more of nothing, is the answer. But if, seven years on, more of nothing isn’t really working, according to your own analysis of the situation, then maybe the right thing to do is to try something different. That would be the logical approach in my mind. Zero rates did not jump start Japan – in fact, they have had zero rates for 20 years without inflation, and their economy has been stuck in a rut the whole time. Here in the U.S. we have had zero rates for seven years and inflation is going down, not up, and the Fed thinks our expansion basically stinks. At what point will the Fed realize that setting interest rates really low doesn’t help the real economy much? It did help avoid an apocalypse in financial markets in 2009/2010, but those risks are behind us (at least here in the U.S.). But now, what is holding back our economy is not the level of rates but the level of regulation and bureaucracy in our economy. If you are GE or Coca-Cola, you have refinanced your debt and lengthened your maturities a number of times in the past seven years. Slightly higher (say 200 basis points) rates aren’t going to hurt you. If you are a home buyer, unless you have pristine credit, lower rates haven’t really helped you because you can’t get a mortgage without herculean efforts – the paperwork, the regulations put in place by the Consumer Finance Protection Bureau (CFPB), make lending very onerous for community banks and borrowers. All the fines and penalties the Justice Department has been imposing on the banking industry have made bankers question whether mortgage lending is worth the risks. It was already a marginal business pre-2008. Now, its fraught with risk – if you lend someone money and they do pay you back, you make say 3.5% to 4%. If they don’t, you have a hard time collecting because of all the processes and legal maneuvering that needs to take place. It’s basically a lose-lose proposition for the banks today. If the Fed really wants to move the economy into a higher gear, it should remove the barriers to lending it has put in place in the past seven years, it should work with the regional and community banks it regulates as partners, not as adversaries, and it should make it profitable for these banks to make loans again by raising the level of interest rates so that they can make some money from their lending. “But I don’t want to go among mad people," Alice remarked. "Oh, you can’t help that," said the Cat: "we’re all mad here. I’m mad. You’re mad." "How do you know I’m mad?" said Alice. "You must be," said the Cat, "or you wouldn’t have come here.” - Alice in Wonderland I wonder what it must be like to live in your own dreamworld, divorced from reality, where you actually believe that what you do matters so much to the world’s economy that you must be extremely careful with what you say and do, otherwise people will stop working, companies will stop producing, whole economies will come screeching to a halt with rioting in the streets and starvation everywhere. It must be so strange to believe that raising the Fed Funds target rate a mere 25 basis points will cause all this havoc, so strange to believe that you have this magical power over people’s decision making as to whether or not to start a company, expand one, sell one, or close one. Personally, I don’t know how they sleep at night, thinking that by making this momentous decision that they will unleash these catastrophic forces that they will be unable to stop. But what if.. instead of unleashing hell, a strange thing happened. Nothing. The economy didn’t stop, kids still went to school, people still went to work, and life went on. What if the only thing that happened is that a few emerging markets currencies depreciated, and a few macro funds took some losses, and maybe in a worst case, our stock market went down a bit. Would that end the world as we know it? Would we be in a recession again? I seriously doubt it. It used to be that market declines of 10-20% happened fairly regularly, a normal ebb and flow as markets adjusted to earnings and changes in the real economy. Stocks are not being so finely modeled that 25 basis points changes the NPV calculation (or at least they shouldn’t be if you have any common sense). “It’s no use going back to yesterday, because I was a different person then.” – Alice, Alice in Wonderland I’m not saying that interest rates play no role in the real economy. What I am saying is that the Fed has gotten so caught in its own world that it thinks that every little move it makes matters. Volcker used a sledgehammer to stop inflation. Greenspan used a fire house to jumpstart our economy in 2002. Big moves in rates do matter, and do impact things like lending and banking and investment decisions. But small ones don’t. The Fed has gotten caught in a weird dream world where it thinks that it is like Jacques Seurat, where every fine detail in their painting matters, when instead they should be thinking like Jackson Pollock, where the broad, dramatic movements are what creates the masterpiece. We’re very far from yesterday, where the Fed made big moves in rates to have a real impact on the economy. Today, we’re in a world where rates will be lower for longer than they should be, and that is the reality we have to live with and adjust to. What we think rates “should be” is irrelevant – you can’t invest on “should be”, you have to invest on what will be. And after Thursday’s statement, it’s clear that this Fed is definitely led by a different person than in the past. ______________________________________________________________________________ This week’s Trading Rules:
Support: 194.5, 192, 188/189, then not much. Resistance: a lot at 197/199, then 201 and 205. Positions: Long and short U.S. stocks and options, Long SPY Puts. For more ideas, charts, and market information, Email me for a free trial of my bi-weekly StockPicker newsletter. No credit card or other financial information is required. Miller’s Market Musings is a free weekly market commentary written by Jeffrey Miller, who has been managing money through various market environments for over 20 years. You can subscribe here. Millers Market Musings and StockResearch.net are not making an offering for any investment. It represents only the opinions of Jeffrey Miller and those that he interviews. Any views expressed are provided for informational and entertainment purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony for Miller's other firms. Jeffrey Miller is a Partner at Eight Bridges Capital Management and a Member of Eight Bridges Partners, LLC. Eight Bridges Capital Management, LLC is an exempt reporting advisor with the SEC. Eight Bridges Capital Management solely manages the Eight Bridges Partners, LP investment fund and does not provide any advice to individual investors in any capacity. This message is intended only for informational purposes, and does not constitute an offer for or advice about any alternative investment product. Past performance is not indicative of future performance.
Any views expressed herein are provided for informational purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any manager, fund, or program mentioned here or elsewhere. Any opinions about any individual stocks, commodities, or other securities expressed in this article or any linked articles or websites are solely for informational purposes only and are not an offer or inducement to buy or sell any securities. The author and/or funds he manages may hold positions in the securities mentioned and his positions may change at any time without an obligation to update this disclosure. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. Jeffrey Miller and/or funds he manages may or may not have investments in any securities cited above as well as economic interest. Jeffrey Miller can be reached at 503-333-9725 or [email protected]. First, a note about 9/11. It appeared to me that the press seemed to ignore it this year. The Wall Street Journal ran one small article on Saturday. That’s it. This is a big deal, a seismic event in our nation, and we get, just 14 years later, almost nothing on it. The New York Times continues to make its rememberances available online, which is very nice. I’m sure next year, being the 15th anniversary, there will be more coverage, but I for one was very disappointed that it appears that the events of that day seem to already be fading away. That’s just wrong. Now, as someone that used to work in the World Trade Center and lost many friends that day, I’m sensitive to the issue. But still, I think the dearth of coverage in the press was pretty sad. If you want to read some of the profiles of my former co-workers at KBW who died that day, you can go to their website here. On to the markets… It vexes me. I'm terribly vexed. – Commodus, Gladiator This is Fed week. As much as I want to talk about stocks and what is going right or wrong for individual companies, the reality is that right now, most of that doesn’t really matter. What will be moving stock prices for the next few weeks is all macro. The Fed, and how the rest of the world reacts to its actions, is what matters unfortunately. David Tepper gave a very lengthy and interesting interview on CNBC last week. I highly recommend looking it up online and watching it. Mr. Tepper has an excellent long-term track record, and he’s also able to communicate simply and clearly. A few of his comments captured the angst many investors are feeling today. Teppper said “there are times to make money and times to not lose money. Which one do you think we are in now?... Right, don’t lose money times.” He mentioned he has a fairly low net exposure to stocks, which is the same position my fund is in – we have longs and shorts, but our hedged net is zero. Indexers and mutual fund relative-performance-game players don’t really care about making money or losing money – they just want to beat their peer group, or more cynically, just be in the middle of the pack. Then they can let their marketing departments take over. But if you are in the business of thinking about capital preservation, in the business of generating absolute, not relative, performance, then you need to figure out what kind of time it is. And right now, I think we’re in a don’t lose money time. Tepper also commented on the market’s recent increase in volatility. Volatility was very low for a very long time because the flow of money was moving in one direction (lower rates, lots of global liquidity), and now that river is going to run into resistance, some flows heading into the other direction (higher rates, capital outflow from emerging markets). When you get flows that run into each other, like a river entering the ocean, you get waves. That’s what we’re getting now. His conclusion: this volatility is normal, to be expected, and will be here for awhile, so get used to it. That conclusion seemed fine when I listened to it – it made sense, and didn’t seem like a big deal. I personally like higher volatility, as it creates more opportunities for mis-priced stocks. But then the Bank for International Settlements (BIS) released its quarterly review. It was pretty eye-opening, and made this recent volatility sound like a precursor to something much bigger. There was a dream that was Rome. You could only whisper it. Anything more than a whisper and it would vanish, it was so fragile. Marcus Aurelius, Gladiator The BIS is basically the central bank of central banks, and Claudio Borio, head of its Monetary and Economic Department, said the following in a presentation on the latest review: “This is…a world in which interest rates have been extraordinarily low for exceptionally long and in which financial markets have worryingly come to depend on central banks’ every word and deed, in turn complicating the needed policy normalization.” “It is unrealistic and dangerous to expect that monetary policy can cure all the global economy’s ills.” “We are not seeing isolated tremors, but the release of pressure that has gradually accumulated over the years along major faultlines.” Source: Financial Times That got my attention. In a recent letter we mentioned that the U.S. economy is clearly strong enough to handle higher rates, so why is the Fed so afraid to do so? What do they know that we don’t? Apparently, they are worried about their tiny, irrelevant 25 basis point hike triggering an earthquake, that the pressures and imbalances in emerging markets will unleash a disaster that it can’t contain. And if, as BIS states above, we are seeing “the release of pressure” in an increasingly interconnected world, does delaying this release help anything? Will these pressures dissipate with time, or will they just remain hidden below the surface, ready to rear their ugly heads any time the Fed tries to raise rates in the future? I think that time will not help, that the dollar denominated loans that companies in emerging markets are holding will not become easier to pay back later. The odds of the currencies of these countries meaningfully appreciating against the dollar long-term are low, so the repayment burden will continue to increase over time. Which is why I think it’s better we raise rates here in the U.S. while our economy is still relatively strong – waiting is only likely to lead to bigger problems for emerging markets down the road. "They lied when they told me he was dead. If they lied, how can they respect me. If they don't respect me, how can they love me?" Commodus, Gladiator The Fed wants to be loved. And that is a problem. Personally, I’d be much more comfortable with a Fed that didn’t so obviously care about being loved. It wants to be loved by everyone - by our bond markets, stock markets, foreign markets, and everyone else. The Fed should do what it thinks is right, not what it thinks will be popular. Then it would earn our respect. This is a weird moment in time we find ourselves in, a time when the Fed focuses more on investor expectations and financial market reactions then on the impact of their actions on the real economy. We need to get past this desire to be loved that seems to be driving the Fed’s decision making so that the real economy can expand at a brisker pace. Velocity of money is at all-time lows, and the only thing that is going to get it moving again is higher rates, which will make banks much more willing to lend. Until then, we’ll be stuck in this “ok” economy, where things are neither really bad nor really good, and everyone genuflects before the almighty central banks, who in turn genuflect before financial markets. This is a weird time, and it’s a time to focus on not losing money. This week’s Trading Rules:
Last week the market rose the most in 6 months, which was surprising not because it rose, but because a 2.3% increase was the largest in 6 months. We really were in a low vol world… The market’s been coloring within the lines. This week’s trading levels for the SPY are: Support: 192, 188/189, then 183.50/184. Resistance: a lot at 197, 198, then 201 and 205.  Positions: Long and short U.S. stocks and options, Long SPY Puts. Robert Baron at BTIG has been spot on with his trading calls lately. He has been sending a regular chart that I am copying below. It overlays today’s market with the fall of 2011, when the U.S.’s debt was (foolishly) downgraded. That was also a time of concern about linkages, pressures in markets, and how these macro factors would impact the real economy. The correlation is fairly amazing. Check it out:  For more ideas, charts, and market information, Email me for a free trial of my weekly StockPicker newsletter. No credit card or other financial information is required. Miller’s Market Musings is a free weekly market commentary written by Jeffrey Miller, who has been managing money through various market environments for over 20 years. You can subscribe here. Whenever people agree with me I always feel I must be wrong. - Oscar Wilde
A few weeks ago we highlighted how Value-at-risk models can exacerbate movements in various markets, even ones seemingly unrelated. Since then, this has become the topic du jour, as different pundits catch on to the fact that something is not quite right in today’s financial markets. It’s not that stocks are going down – stocks have been going up and down for hundreds of years. Going down is good. It resolves periodic overvaluations, and creates opportunities for those that have cash or new money to invest. It cleanses the markets of its occasional excesses, and there will always be excesses. But smart investors, who have been around for awhile, are sensing that something is amiss. When Art Cashin, one of the best writers on markets I’ve read, is worried about “another Lehman event,” as he stated on TV last week, I pay attention. So why all the angst? This is a complicated question. As I set out to write this week’s Miller’s Market Musings, I kept getting dragged down different paths, all of them legitimate, and all of them somewhat inter-related. But writing about them all would make this piece a lot longer than I like these Musings to be, so I will explore them in more depth in this week’s Stockpicker newsletter. You can get a copy of it for free by emailing me at [email protected]. Some cause happiness wherever they go; others whenever they go. - Oscar Wilde A proximate cause of the recent volatility according to a subset of the financial press, particularly the talking heads on CNBC, is that a large part of the Street is out on vacation. I’ve heard this explanation for market drops many times in the well over 20 years I have been working on Wall Street, and I am convinced that this is simply not true. I’ve worked on the sell-side and the buy-side, and only once have I walked into the office or the trading floor and been like man, where is everybody? The one time I can recall this happening was the Blizzard of 1996, when New York was basically shut down. I was young and dumb and figured eh, I’ll go in, what’s a little snow? I lived in the West Village, and when I finally made it to our offices in the World Trade Center, I was literally one of about 6 people there. So I can see why volume was low that day. But who are these people that are a) so powerful that they move markets all by themselves – or, thought of differently, are so powerful that they calm markets by their mere presence and b) why are they on vacation all the time. I mean, I go on vacation occasionally, but even then I check the markets at both the open and the close and am able to monitor all my positions, in real time, from my Ipad and phone. If I was “the” person moving markets, the person able to arbitrage away the market mispricings and provide liquidity and dampen volatility, I’d like to think that not only would I be diligent and pay attention to markets, even from the Hamptons or St. Tropez, but that I’d have a few employees whom I trusted watching after things for me. You know, in case things happen that provide us the chance to make some money. Like a market selloff. And if things got interesting, and I do think the markets are quite interesting at the moment, and I was the person responsible for moving markets, I’m pretty sure I’d have spent the money on a nice computer and internet connection at my house in the Hampton of my choosing and be able to do the things that I do from there. So I’m not buying the vacation argument. The U.S. isn’t Europe. We don’t go away and do nothing for a month. We take a long weekend, we go away for a week, but if you go to the places where people like to vacation, you’ll see lots of people still on their computers and their phones. Is this healthy? I don’t know, probably not, but that’s how Wall Street works, and you don’t get to be the man behind the curtain by leading a healthy and balanced life. You get to be the man behind the curtain because you’re willing to work harder and longer and sacrifice things, like your vacations. Sure, at the end of the movie the Wizard is revealed to be old and sad and not that powerful, but for the time he’s the Wizard, he’s the man, and he likes it, so he does it. And the Wizard of the market has a good internet connection on vacation. To understand the driver of the recent market volatility, I think we need to understand the cast of characters in this movie. Markets have changed, and what we used to think of as the “investor” really has changed. In the 1800s, markets were dominated by syndicates of related investors who would sometimes corner markets, manipulate them, and profit from them at the expense of somewhat less sophisticated “punters”. In the 1920s, markets became dominated by speculators trading on extremely thin margins who resembled the momentum investors of the late 1990s. They mostly disappeared in the Crash of 1929, to be replaced by more sober investors like the great Paul Cabot, who founded State Street. As the markets churned through the aftermath of the Great Depression, they became slightly more institutionalized, and a diligent and smart investor like John Neff or a young Warren Buffett could thrive on the inefficiencies. A little sincerity is a dangerous thing, and a great deal of it is absolutely fatal. - Oscar Wilde The institutionalization of the stock market in the U.S. in the 1980s was initially a good thing, as an element of the guesswork involved in picking winners and losers was squeezed out. Peter Lynch and other star stock pickers became as well known to the investing public as sports figures were to sports fans. The lingering inefficiencies in the market, mainly due to a lack of easy access to data and information, were mostly removed with the advent of the internet and the widespread availability of financial data. Now, a database of comparable company data that used to take reams of analysts month to build can now be bought for a few hundred dollars, and be searchable and screenable in ways that were literally unimaginable 25 years ago. Today’s active stock picker has more fundamental data available to her than the head of research at a large investment management did at a fraction of the cost. This should have created greater understanding about the true value of a business, as estimating current and future cash flows becomes easier and more widely dispersed. But a funny thing happened along the way. This dispersed information and computing power led to the rise of a two parallel universes of investors who do not make judgments about the value of companies and their securities, but instead simply use the prices of those securities and/or the variability of those prices to judge their value and riskiness. Here is where the market’s structural weakness resides, in funds that have gotten too large relative to their strategy’s capacity. A parasite only survives so long as it doesn’t kill its host. A man who does not think for himself does not think at all. - Oscar Wilde The “Chicago School” refers to a group of professors that came up with the Efficient Market Hypothosis and effectively set in motion the odd market movements we are seeing today and will continue to see in the future. These professors basically stated that all information is immediately reflected in security prices, so there is no advantage to be gained from studying companies or markets. One can simply take a security’s price, at face value, as being correct at all times. This has generally been proven to not be the case, as all information isn’t generally known, some information is hard to ascertain, and some information requires judgement and experience (along with investors willing to give the manager sufficient time and variability in returns to extract this return – but that is a story for another letter) to understand. But unfortunately this idea, however misguided it may be, found a champion in Vanguard, which built one of the largest investment firms in the world based on this idea. Vanguard’s simplistic notion is that since the average investor can’t beat “the market” (whatever that may be defined as), then the average investor shouldn’t try. The only differentiator is cost in the Vanguard world. This is based on some really shoddy statistics (of course the average investor can’t beat the average investor by definition, just like the average person can’t outlive the average person, but that doesn’t mean that eating well and getting some exercise are fruitless endeavors either) and lazy thinking (why use market capitalization except that it is easy?), but nonetheless it has come to define a world called Index investing that has come to increasingly drive markets. Index investors don’t think. They take perverse pride in not thinking. Thinking is bad, it leads to bad decisions, and anyway, it’s not necessary – just define a “market” and then replicate that market. Simple, easy, done. One of the many lessons that one learns in prison is, that things are what they are and will be what they will be. - Oscar Wilde Except that there is a problem. When the parasite, aka, the world of index investors, was small, it didn’t really matter that it was relying on a flawed Efficient Market Hypothesis because it was “good enough” and the money invested in related strategies was small enough to not really matter. It was truly a parasite along for the ride. But the index fund industry forgot that eventually it will kill its host if it grows too large relative to the host. Trillions of dollars now reside in index funds and their related products, Exchanged Traded Funds (ETFs). ETFs are index funds on steroids, because while an index fund only needs to worry about inflows and outflows once a day, ETFs are constantly adjusting their holdings based on supply and demand during trading hours. Again, when the parasite was relatively new and small, the host market didn’t really notice them. They added volume but, critically, not much volatility. But as ETFs have come to be an asset class in and of themselves, somewhat removed from the underlying assets, the feedback loop has been reversed. Whereas once upon a time, the value of the underlying companies determined the price of the ETF, increasingly today it is the trading supply and demand for a particular ETF that is moving the underlying securities. I see it all the time – all the components of say, the Alerian MLP ETF (AMLP) or the KBW Regional Bank ETF (KRE) will rise or fall together. A change in an investment firms’ allocation to an “asset class” will immediately ripple across all the stocks or bonds in the ETF, regardless of whether or not all the stocks and bonds deserve to be treated the same. The defining characteristic of how their securities will behave in the short-term is now almost always their sector and their market cap, not their product or prospect for future success or failure. Absent the 4 times a year when companies report their earnings (in which case fundamentals do determine the near-term stock movements), the day-to-day movements in stocks have become more synchronized. Correlations are up because the driver of prices over short periods of time is simply money flows into an ETF. As index funds and ETFs have become the investment of choice for many investors, price movements within sectors have become more homogenous, and securities in them are more correlated to one another. However, I believe that the weird feedback loops markets are experiencing lately is because all financial markets are now tied to one another as a second parallel universe of investor – the “risk-parity” investor, has garnered more assets under management. These investors look at asset classes, like foreign bonds or emerging market equities or currencies, as just things to be modeled and leverage applied to based on expectations for future returns and volatility. I read an article last week where the head of a firm with hundreds of billions of dollars in risk-parity investments said, effectively, that his firm doesn’t make judgments about securities individually, but only about asset classes and their theoretical returns and the variability of those returns. They then lever up the asset classes with lower expected volatility to get to a “market” level of volatility, and they then do this across asset classes globally. Which led me to ask myself – if everyone is now an indexer, or a derivative of an indexer (ETF) who assumes that the prices being generated by the other indexers, none of whom actually thinks about things like the businesses these companies are in, or their values, or what the possibility of disruption to the business is, then who is driving the bus? In other words, who’s deciding what these companies are worth now that the parasites have taken over their hosts? Consistency is the last refuge of the unimaginative. - Oscar Wilde After initially being alternately annoyed and scared by the realization that multi-billion dollar businesses have been built on top of a faulty foundation and then new, even more fragile businesses have been built on top of them, I’m now quite happy that this has happened, because while it has made my job much more frustrating on a day-to-day basis (“Why is that stock down 4% on no news?), it is also creating many more opportunities for intelligent, rational, and most important, active fundamental investors to make money over time. I believe that we are nearing, if we haven’t already reached, a tipping point in markets in which the parasites have become the hosts, and the prior hosts can now become the parasites (in a good way of course, because I’m one of them), feasting off of the market disturbances that are occasionally created by these feedback loops and VAR model driven selloffs. Index investors and their risk-parity cousins have become the hosts for a new version of parasite (fundamental, active investors who are not benchmark huggers) that takes advantage of these dislocations to buy great companies at distressed prices. The opportunities that await those that are flexible enough to take advantage of them will be tremendous. This week’s Trading Rules:
Support: 191, 188/189, then 183.50/184. Resistance: a lot at 197.50/199, then 201 and 205. Positions: Long and short U.S. stocks and options, Long SPY Puts. For more ideas, charts, and market information, Email me for a free trial of my weekly StockPicker newsletter. No credit card or other financial information is required. |
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