Thursday, May 31, 2007

V - TV just posted their video interview with me. The MoneyMasters' interview was excellently conducted by Vahan Janjigian, CFA, editor Forbes Growth Investor.

Vahan and I discuss emerging markets, valuation (my modified Fed Model), technical conditions for the markets, and the Model Growth Portfolio.

To view the interview, click on the above title ("V - TV") and enjoy the webcast.

Technical Thursdays: Deceleration

It isn’t just the economy that has decelerated, the market’s momentum has as well.

As the updated and longer-term four-year chart to your left shows*, yesterday’s all-time highs were not accompanied by confirming momentum. In fact, at no time over the past four years has the deceleration in momentum been this pronounced.

Investment Strategy Implications

Needless to say, nothing is for certain. Markets can reaccelerate, with momentum reemerging taking prices to higher highs. However, the pattern of decelerating momentum PLUS a negatively tilted MACD has been fairly consistent in forecasting market stagnation at best with corrections being the most common outcome. Both decelerating momentum conditions must exist, however. At present, they do.

Of course, then there is always “this time is different”.

*See May 24 entry below for a more clear, shorter-term chart.

Tuesday, May 29, 2007

Valuation Analysis: Why Multiples May Not Expand

Since September of last year, I have posted numerous comments re why stocks are and will remain undervalued. The central point of my argument deals with risk. The valuation tools used are forward looking and are best and simply viewed in a modified Fed Model (see May 23 posting below). There is another aspect of valuation, however, that bears noting (or is it what the bears are noting?): Is the current and expected level of various valuation metrics above, at, or below their respective long term averages? To shed some light on the subject, an interesting piece of valuation work has been produced by sector expert, Merrill's Brian Belski.

From an historical perspective (which is not always the best way to make valuation decisions), an argument can be made that stocks are not undervalued. Using the average of the past 16 years as the centerpoint, the two above charts (Brian Belski, Merrill Lynch, May 9, 2007) paint a picture of a market that is already more than fairly valued.

The first chart makes it clear that on a P/E basis, stocks are just slightly undervalued. However, on a Price to Cash Flow basis (second chart), stocks are actually quite overvalued.

Investment Strategy Implications

Using such historical data neglects other important valuation inputs, most notable of which is interest rates*. Nevertheless, the past can be a useful guide, particularly as an indicator of cycle ranges. In the current cycle, a US market that trades at or below fair value is appropriate.

While more than a handful of investment strategists believe multiples can and should expand, I beg to differ. Considering risk in all its forms (geo political, liquidity induced bubbles, over extended US consumer, untested decoupling, profits deceleration, high global growth dependence on immature emerging countries, etc.), the above noted historical data for the current market cycle suggests multiples may not expand.

*The charts also invite other questions and further analysis, such as: for the current market cycle, why has the price to cash flow levels consistently been above their long term average?

Note: Conclusions reached on this blog entry are solely those of Vinny Catalano and should not be construed as being those of Mr. Belski or Merrill Lynch. Additionally, Belski employs different methods for determining the long term average for each indicator. For a further description of the methodologies used, please see the Belski report "Sector Valuations - May 2007"

Just How Smart is the “Smart Money”?

“The availability heuristic is a rule of thumb, heuristic, or cognitive bias, where people base their prediction of an outcome on the vividness and emotional impact rather than on actual probability.”*

"Are US individual investors more cautious in this bull market due to their recent experience with the bursting of the tech bubble? Does that help explain why individual investors appear to be less ebullient than the “smart money”?

Behavioral finance teaches us that investors tend to overweight those events that are most vivid over events that are less so. This is known as the “availability heuristic” (defined above). Events that are most vivid tend to be those that are (a) most dramatic and (b) most recent. The more dramatic and recent the event, the more vivid in the mind it will be and, therefore, the more likely it will overweighted in the minds of investors.

One current application of this behavioral tendency is the aforementioned US individual investor who experienced the tech bubble bursting, and appears to be more cautious than they might otherwise be. In this regard, two questions come to mind:

1. Will individual investors stand their ground and, due to their absence from the bull market party, cause an eventual (and substantial) contraction in equity prices? Or

2. Will their resolve to not join the bull market party eventually give way (capitulation) and, therefore, become the necessary final push of liquidity for the “smart money” to sell to?

In other words, just who is the smart money?..."

"There is another aspect to consider, however, one that involves the subject being described in this report – the behavioral tendencies of investors. And for that, it's worthwhile to take a look back at the last period investors had to deal with the aftermath of a real bear market – the mid to late 1970s.

The bear market of 1973-74 had its roots in..."

Investment Strategy Implications

"This bull market may not experience the “dumb money” bailing out the so-called smart money crowd. The experience of the last US equity bubble is still vivid in the minds of many investors. Whether this results in a capitulation or not remains to be seen. Nevertheless, it is advisable to remember that stocks can remain undervalued for an extended period of time. Particularly when risk is as abundant as liquidity.

If the “smart money” is waiting for the “dumb dough” to show up, they may be disappointed. Investor behavior is a sticky tendency. Besides, if the “smart money” wants to find where the “dumb money” is, perhaps a trip across the Pacific is a better place to look. Can you translate this?: 泡影"

Note: To view the entire report (including the all-ETF Model Growth Portfolio) and for information regarding our subscription service, please click on the Blue Marble Research services link to your left.

* Wikipedia

Friday, May 25, 2007

Quotable Quotes

on a lighter note:

"When I was young I used to think that money was the most important thing in life. Now that I am old, I know it is."
Oscar Wilde

"Gentlemen prefer bonds."
Andrew Mellon.

"Don't gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it."
Will Rogers

"When shit becomes valuable, the poor will be born without assholes."
Henry Miller.

"We have two classes of forecasters: Those who don't know--and those who don't know they don't know."
John Kenneth Galbraith

Have a good weekend.

Thursday, May 24, 2007

Technical Thursdays: 4 Reasons Why a Market Correction is Imminent

Setting aside seasonal factors (sell in May and go away; the long Memorial Day weekend ahead), I have identified four reasons why a market correction of some consequence is imminent. The four reasons noted are encapsulated in the chart to your left and are all of a technical analysis nature.

They are as follows:

1 – Rising Wedge – while a rare occurrence, chartists will tell you that a rising wedge is a bearish pattern. History shows that the narrowing of the spread between the highs and lows of the trend lines, with the lower end rising dramatically (the rising wedge), usually results in a serious reversal.

2 – Momentum Divergence – one of the most reliable short term trading indicators I have found is when price advances are not matched by momentum. The second area of the chart to your left shows an unmistakable decline in momentum as the market marched ahead to new highs.

3 – MACD – moving average divergence is another area of concern. Here MACD (third area of the chart) has gone flat, confirming momentum’s weakening of market strength.

4 – Price to 200-day Moving Average – at 9%, the gap between the current level of the S&P 500 and its 200-day moving average (arrow) matches the most recent gap (end of February) that preceded a minor (yet dramatic) market correction.

Investment Strategy Implications

Common sense dictates that market corrections are a normal, healthy aspect of a bull market. And, while it is risky business to try and be so precise in calling market turns, when equities run up in nearly a straight line, it is not exactly a low risk environment.

Note: This call is strictly in a market correction vein and not a major market top call. For that to occur, other, more substantial factors must come into play. Despite clear signs of market bubbles and highly risky this-time-is-different new era thinking, a major market top has still not been formed.

Wednesday, May 23, 2007

Fed Model - Fair Value Update

As of today's close, the concurrent rise in stocks and interest rates has lowered the Blue Marble Research Fed Model expected return for US equities (S&P 500) to 4.98%*.

*average of 6.80% and 3.15%

Tuesday, May 22, 2007

What to do, what to do?

“…with almost 100 million stock accounts now open -- including 310,000 opened just this past Friday -- any panic selling might test the limits of the system.”

"China's Bubble is Defying Beijing"
Wall Street Journal
May 22, 2007

To the Chinese leaders meeting with their US counterparts I say: Welcome to world of capitalism.

The Chinese economic model threatens to spin out of control, a nightmare scenario if there ever was one for a communist country trying to transition to a free market-based economy and not experience the chaos of the pre-Putin Russian model nor the near global financial debacle of the Asian contagion of the late 1990’s. Yet, the baby steps taken thus far by the Chinese government toward cooling an overheated and increasingly speculative economy and stock market are clearly not working. What to do, what to do?

Obviously, stronger action needs to be taken by the Chinese central authorities. The problem lies, however, in the fact that the Chinese economic and banking system is not like the US and other developed countries. As noted in yesterday’s Financial Times, “It might be more accurate to liken the Chinese economy to a flotilla of large and small boats, all steaming ahead at full bore, with little regard to the direction of the fleet or the diktats of its commanding officers in Beijing.*” No central control is evident here. What to do, what to do?

Well, if the central authorities can’t get the job done, then the market will do the dirty work for them – and let the consequences fall where they may. Ironically, should such a development happen, it may occur during the tenure of Mr. Market Discipline himself, Henry Paulson – the host of the current round of meetings here in the US.

Investment Strategy Implications

The nightmare scenario for stock market bulls and advocates of laissez-faire/cowboy/American-style capitalism is to have both ends of the global growth train – the US and China – go off the rails simultaneously. While this is a low probability, either event occurring is not. Nevertheless, given the interconnected nature of our globalized world, the odds of a negative feedback loop are not zero either. What to do, what to do?

Wait. I know. More liquidity!!!

*China’s Unbalanced Economy
Richard McGregor

Monday, May 21, 2007

MTA Market Forecast Notes: Liquidity Risks and Connecting the Dots

excerpts from this week's report.

“It is now the consensus of most practicing central bankers that monetary policy can’t do much preemptively to correct an existing substantial asset price misalignment. But if monetary policy is calibrated appropriately to keep aggregate demand growing roughly in balance with aggregate supply and to keep inflation low and stable, this reduces the risk that such misalignments will emerge and expand.”

Timothy Geithner
“Liquidity Risk and the Global Economy”
May 15, 2007
Remarks at the Federal Reserve Bank of Atlanta's 2007 Financial Markets Conference—Credit Derivatives, Sea Island, Georgia

Having moderated more than a half dozen Market Technicians Association (MTA) events over the past five years, I have noticed two distinctive features – market technicians tend to have a nearly unanimous perspective on the overall market (there were some differences around the edges) and audience participation is very lively.

Unlike fundamental analysts, market technicians utilize similar tools in their craft and, therefore, often end up coming to largely the same conclusions – at least at it pertains to the overall market. In the current case, the four panelists on last Friday’s panel – Acampora, Bartels, deGraaf, and Roque – were firmly in the bullish camp. However, the topic of liquidity came up during the audience Q&A segment and, in my opinion, it stood out on two levels – one in the form of question posed by Phil Roth, the other in form of an insightful observation made by Merrill’s Chief Market Analyst, Mary Ann Bartels.

Phil essentially raised the question, “When isn’t a bull market the product of ample liquidity?” This self-evident question is both simple and profound. And it cuts to the heart of all bull markets. Earnings can be as terrific as one could hope for. But without liquidity flowing through the bloodstream of the economy and markets, stocks can easily fail to produce favorable returns - which brings us to Mary Ann’s comment on a measure of liquidity – MZM – and how it connects to the above quote by NY Fed President Geithner.

Merrill’s Chief Market Analyst, Mary Ann Bartels, provided her usual terrific points on hedge funds. But it was her comment on MZM (money supply) that I found especially insightful. Mary Ann stated that the high growth in MZM was attributable in part to...

...The recent comments by Fed speakers make it crystal clear that financial shocks cannot be anticipated and a market discipline is the “first line of defense”. The Fed will play its liquidity supportive role proactively and preemptively...

...In my opinion, stocks should always reflect this uncertainty and not be priced to fair value (1650 for the S&P 500). Things are much too dynamic for such complacency. To help punctuate this point, Mr. Geithner states,“…we do not have the capacity...

Note: Access to Blue Marble Research reports (which includes our all-ETF Model Growth Portfolio) require a modest subscription. To view the entire report and for information regarding our subscription service, please click on the Blue Marble Research services link to your left.

Friday, May 18, 2007

Wrath of God

Due to a storm related two-day power outage plus out of office events (moderated the Market Technicians Association "Market Forecast" and New Delhi TV appearance) as well as several client meetings, no posts were made for Thursday and Friday.

Will be back on track on Monday.

Wednesday, May 16, 2007

Why Stocks Are (And Will Remain) Undervalued

“Risk can now be sliced and diced, moved off the balance sheet, and hedged by derivative instruments.”

Remarks by Chairman Ben S. Bernanke
May 15, 2007: Regulation and Financial Innovation

Chairman Bernanke’s remarks yesterday to the Federal Reserve Bank of Atlanta's 2007 Financial Markets Conference highlight an issue that I have written about on numerous occasions – the degree of uncertainty brought about by financial innovation. As with Globalization, financial innovation has produced many benefits. However, what is often ignored is the downside, the risks that accompany our brave new world. As Mr. Bernanks goes on to say:

“Indeed, the need for better risk sharing and risk management has been a primary driving force behind the recent wave of innovation. But in some respects, new instruments and trading strategies make risk measurement and management more difficult. Notably, risk-management challenges are associated with the complexity of contemporary instruments and trading strategies; the potential for market illiquidity to magnify the riskiness of those instruments and strategies; and the greater leverage that their use can entail.”

A major component of the Fed’s plan to deal with this complexity is a reliance on what is known as market discipline. Harry Paulson cites it often and Mr. Bernanke referred to it in yesterday’s speech as follows:

“…part of an effective risk-focused approach is the promotion of market discipline as the first line of defense (emphasis added) whenever possible.”

Investment Strategy Implications

Isn’t the first line of defense the one that bears the greatest risk? If credit derivatives and other financial innovations that have sprung up over the past years have become so complex that most professional investors have little full knowledge of their consequences (a point referenced time and again at the hedge fund seminars that I have conducted), then shouldn’t stocks always reflect that enhanced risk* and, therefore, never close the valuation gap to fair value (see Fed Model to your left) thereby remaining undervalued for the foreseeable future? I think so.

*Along with other macro risk factors such as the unknown consequences of Globalization as well as geo political issues.

Note: Chairman Bernanke’s remarks can be found at

Tuesday, May 15, 2007

IVE – An ETF for a Contagious Market

As the US equity markets struggle to keep pace with their Asian bubble counterparts, concerns of an overheating appear to be justified. Yet, M&A activity has never been frothier. A market melt-up can just as easily develop (as if China wasn’t already there) as yet another seemingly out-of-the-blue nasty correction. For reasons noted in yesterday’s weekly report (modest subscription required), Large Cap Value (IVE) appears to be very well suited for either occurrence.

In the melt-up scenario, hedge funds may be pressured into shifting more funds out of the underperforming Smids and into the better performing large cap value sector (see 1 year chart above). Contrarily, in a meltdown environment, the lower beta/higher quality sectors (IVE’s beta is .93) should weather the storm better than higher risk issues (again, see chart).

Investment Strategy Implications

Whether there is a market melt-up or another spring market swoon, IVE appears to have the odds tilted in its favor regardless of which contagion sweeps over the markets.

Disclosure note: IVE is owned in accounts under Blue Marble Research management. No shares are owned by Vinny Catalano nor any members of his family.

Monday, May 14, 2007

IEV and IVE: Two ETF Winners

excerpts from this week's report.

"As the chart on the next page shows (see report), two positions held by the Model Growth Portfolio have produced above market returns over the past twelve months: Europe 350 and Large Cap Value. The Europe 350 is benefiting from a confluence of developments (dollar weakness, growth in Asia, modest resurgence in European..."

Investment Strategy Implications

"It is likely that the outperformance of the two sectors will continue for the foreseeable future and may even accelerate, particularly for Large Cap Value, as private equity..."

Note: All research reports (which includes our all-ETF Model Growth Portfolio) require a modest subscription. For information about our subscription service, please click on the Blue Marble Research services link to your left.

Friday, May 11, 2007

Uncertainty – The One Constant in a Global Environment

What does it say when a gaggle of economists can’t get a monthly domestic number correct like the April retail sales? When you combine this morning’s April retail sales number with the just concluded 1Q07 earnings season, the issue that leaps out is unpredictability. This unpredictability factor is key to valuation models as the Fed Model shows on today’s blog.

Investment Strategy Implications

The Fed Model (see updated model on May 23rd blog entry) illustrates the risk adjustment process that reflects uncertainty. As noted earlier this week, an 80 to 100 basis point upward adjustment to the capitalization rate of the 10-year US Treasury (which equals the downward adjustment to the P/E ratio) has been the average risk premium throughout most of this bull market. A reduction of that premium implies an increase in risk taking.

As much as bullish investors would wish otherwise, today’s world is a highly uncertain one. So, when forecasts go awry with such regularity, a substantial reduction in the risk premium seems most unwarranted.

Have a good weekend.

Thursday, May 10, 2007

Reading, Researching, and ‘riting – The 3Rs of the Independent Investor.

Capital isn’t the only thing that is very affordable and abundant these days. Information is as well.

Information availability has leveled the playing field for all investors. The investment implications are significant. Take, for example, the work that I do.

While I do benefit directly from my first hand experiences as a moderator of my events, from my access to investment opinions from various sources, and the occasional interaction with fellow investment professionals at selected functions, the vast majority of my research time is spent in quiet solitude at my desktop reading, researching, and ‘riting – the 3R’s of the independent investor.

The power of the Internet has made independent research possible. As has the financial innovation of ETFs, which has enabled me to perform investment strategy analysis on a sector and style basis, something not possible previously. The construction of the all-ETF Model Growth Portfolio is the investment strategy expression of my work.

So, if information is very affordable and abundant, what's left for an investor to gain a performance advantage? There appears to be four specific ways an investor can achieve a superior rate of return: non-public information, advanced trading systems, leverage, and insight

The first two are out of reach for most investors. One is illegal. The other is the domain of specialized trading firms. That leaves the last two –leverage and insight – as the sole areas where investors can hope to gain a performance advantage.

Leverage is the path that many investment professionals are either engaged in or headed toward – whether intentional or inadvertent. As I have noted numerous times before, liquidity is being aided and abetted by leverage (see May 1 blog entry for most recent comment in this regard). However, with leverage comes added risk. One example of added risk was noted in last Friday’s blog "Quotable Quotes" entry (BlackRock’s founder and CEO, Larry Fink – “…probably the greatest issue that’s confronting the world’s investors is we are trading liquidity for illiquidity.") And leverage is a major function of that trade.

As for insight, it is the only pure and unique element of investing. Everyone tries but few succeed at being insightful. However, it is important to note that insight is not the domain of the smart, nor the well connected. In fact, it could be argued that the further away one is from the mainstream thought process, the better the chances of operating in an environment that insight can flourish*.

Investment Strategy Implications

As the equity markets continue to set new highs and threaten to overheat, some professional investors might take solace in the fact that the individual investor, the so called little guy, has yet to join the party in earnest. Last week’s large jump in individual investor bearishness is one example. However, when information is both very affordable and abundant, I wonder just how uninformed that little guy actually is.

Investors live in an age of empowerment. The playing field has been leveled, at least in the legal areas. And insight is the greatest tool of the independent investor.

*Warren Buffet being the most prominent example, at least from a geographical perspective.

Wednesday, May 9, 2007

Keeping It Simple

The Fed Model referenced in the most recent Sectors and Styles weekly report described the closing of the valuation gap to the point where, based on one’s assumptions of risk, the market is either 24% undervalued or less than 6% undervalued (see updated model on May 23rd blog entry).

If an investor assumes that a 80 to 100 basis point premium is warranted (which has been the case for the past several years) and that $92 is the appropriate 2007 operating earnings number for the S&P 500, then the best case return potential for stocks is little more than that which one can receive owning a US Treasury.

Investment Strategy Implications

The analytical process may involve a very complex set of data, but the valuation process is quite simple. It’s the getting the inputs as well as investor perceptions and expectations correct that’s the hard part.

Tuesday, May 8, 2007

Technical Tuesdays: What’s With the VIX?

Under the radar and out of the discussion of late, but as noted in a prior comment, the VIX has settled into a trading range approximately 30% higher than previous bottoming levels (see 3 year chart to the left). What is the significance of its elevated trading range? One possible answer lies in the increased fragmentation of market size and styles.

An interesting pattern has emerged over the past year in which the performance of style segments within market caps are widening. For example, for several years small cap growth and small cap value have tracked very closely to one another (see chart to the left). However, beginning last spring, the performance patterns have changed with small cap growth outperforming small cap value. The same is true in the mid cap area – only the reverse is true: mid cap value has begun to outperform mid cap growth.

Investment Strategy Implications

I have argued in recent television appearances that we have likely entered a market period where size and style selection will matter more than it has in the recent past. The performance data bears that out. And with it is an elevated level of the VIX implying that the homogenization of market returns has ended and in its place is greater performance diversity, higher uncertainty, and, therefore, greater risk. Correlations are still high but I would suspect that they are about to change as well.

Monday, May 7, 2007

Valuation: All in the Eye of the Beholder

excerpts from this week's report

Astute investors know that equity valuation is 2 parts science, 1 part art. The methodology used to derive the science part of the valuation equation is fairly well known – cash flows (or earnings, if you prefer), a projected growth rate, and a discount rate. The fabled discounted cash flow (DCF) model.

However, valuation isn’t all science. Numerous behavioral finance studies have made this quite clear and irrefutable. Loss aversion is as much a part of the valuation process as risk aversion is. And the regret factor plays a very large role in the investment decision-making process.

As equities move into new high territory, the fundamental anchor is valuation. It is the justifier for M&A, as well as the analytical support for equity positions taken and held. As long as there is a projected higher valuation level forecasted (based upon the mix of the three DCF inputs), investors are able to find reasons to remain long. Which brings us to a very reliable and effective valuation tool for the overall market – the Fed Model.

As shown on the following page (see report), the updated Fed Model shows a valuation gap still remains despite the current double-digit rally. The only question is just how wide is that gap?

As the model makes clear, if one uses the current 10-year Treasury as the discount factor, then stocks have a very long way to go to the upside. However, throughout this bull market, a risk premium has always been a part of the valuation equation, which has ranged from 80 to 100 basis points. (see table in report)

Using that discount benchmark, the valuation gap is right around the rate of return an investor can get in a US Treasury. (see table in report)

The risk adjustment I have used to reflect the numerous uncertainties investors face (from exogenous events to geo political risks to financial contagion) is made via the 10-year interest rate level. By adjusting upward the discount factor* to the level it has maintained for the past several years (80 to 100 basis points), the valuation gap has closed significantly. The only question now is has the relationship between risk and reward changed?

Investment Strategy Implications

If earnings growth remains on track and rates remain well behaved, then valuation support for the equity markets will remain intact. The only issue is the aforementioned risk/reward dynamic. If that has changed, then the valuation gap is sufficiently large enough to push equities meaningfully higher.

The concern expressed here, however, is that so much has work to work so well and little can go wrong. In other words, there is little margin for error.

Valuation, like beauty, is all in the eye of the beholder. Or as Lord Keynes once said:

“It is not a case of choosing those [faces] which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.”

In my opinion, it won’t take much to change perceptions.

*In the Fed Model case, the 10-year Treasury is used as a capitalizaton rate. Nevertheless, the effect is the same as a discount rate used in a DCF model.

Note: All research reports require a subscription. For information about our subscription service, please click on the Blue Marble Research services link to your left.

Friday, May 4, 2007

Quotable Quotes

"Bull markets are characterized by disbelief. Our sentiment work still shows extreme bullishness. In this respect, this market is in no way similar to that of the mid-cycle pause of 1995. At that time investors were immensely bearish. Keep in mind that Alan Greenspan's "Irrational Exuberance" speech was in 1996, and that he was not commenting on the yet-to-come Tech bubble."
Rich Bernstein

"The right response to current balmy economic conditions is not complacency, but to treat them as an opportunity for action. This is an ideal time to implement long-term reforms that will allow individual economies to grow faster and adapt better to change. This is, above all, the ideal opportunity to make the policy changes that will allow countries to exploit the opportunities provided by globalisation."
“Risks and rewards of the world economy’s golden era”
Martin Wolf
(see related chart to the left)

FT: "We’re seeing LBOs become more and more leveraged. We’re seeing covenants weaken. As a buyer of loans does that worry you?"
MR FINK: "Absolutely. I think we are going to look back two or three, four years, the same way we were looking at the subprime market where we saw standards and covenants deteriorated. We’re seeing the same thing in the credit markets. I believe if I was the chairman of the Federal Reserve I’d be paying more attention to that, because to me this is going to be tomorrow’s problems. The biggest reason for this, we’ve had just vast liquidity. The global capital markets have flourished so well, and there’s so much money sloshing throughout the world, people are looking for ways to invest. And so the risk we have throughout the world now is that not only are we trading credit, higher grade credits to lower grade credits with poor covenants; probably the greatest issue that’s confronting the world’s investors is we are trading liquidity for illiquidity."
FT interview with Blackrock’s Larry Fink

"Get your facts first, then you can distort them as you please"
Mark Twain

Have a good weekend.

Thursday, May 3, 2007

Technical Thursdays: Separation Anxiety

"In this week's edition of Technical Thursdays, we take a look at three charts - the VIX, Size and Styles, and selected global markets.

"VIX: It may have gone largely unnoticed but the VIX has settled into a higher trading range ... The implication is twofold – either bullishness is..."

"Size and Styles: The one-year performance gap between mega and large cap (which includes large cap value – IVE) continues to widen. If risk has returned..."

"Selected Global Markets: There are two interesting aspects to the global markets –one is the sustained strength in the Europe 350 (IEV) and the other is the sustained weakness in Japan (EWJ)..."

Note: To view today's report, a very modest subscription is required (less than 3 tanks of gas). To learn more about the benefits of subscribing, please click the Blue Marble Research services link to the left.

Wednesday, May 2, 2007

The Bull in the China Shop

“New accounts at brokers are being opened at a rate of more than 200,000 a day, touching a high of more than 310,000 on April 24th. The total so far this year is more than 8 million, which is around ten times as many as in the whole of 2005, when the market began to emerge from a four-year slump.”

from “It’s like a casino set up by the Communist Party”’s blog Alphaville*

“If the bubble were to pop, it could have a bigger impact on social stability than any previous downturn in the stockmarket’s 16-year history. There are now more than 91 million accounts held by individuals at brokers or in mutual funds. Estimates for the number of investors vary widely. At the height of the last market boom, in 2001, there were 60 million accounts but perhaps fewer than 10 million investors. There are certainly many millions more now."

from “The people's republic in the grip of popular capitalism”
The Economist**

Investment Strategy Implications

If words don’t move you, perhaps the two charts above might. The first one is the Shanghai market over the past two years. The second is the NASDAQ over a comparable two year period at the height of the tech bubble. Guess which one has risen at a faster rate? (Hint: It ain’t the NASDAQ.)



Tuesday, May 1, 2007

The Bubble Machine of Liquidity and Leverage

As someone who has conducted numerous hedge fund/alternative investment seminars over the past four years, I found yesterday’s front page article in the Wall Street Journal on leverage (“As Funds Leverage Up,
Fears of Reckoning Rise”) to be of great interest and a must read for all investors. Understanding the role leverage is playing on asset values and the actors involved is vital to a clear understanding of the real drivers of higher market values.

The issue of leverage was also succinctly addressed in my March 5, 2007 weekly report by the father of the Modern Portfolio Theory, Harry Markowitz:

“The unlevered investor cannot go any further than point (0,0), at which his return is maximized. If an unlevered investor tries to compete with a levered investor for returns, he can only access higher yielding, risky securities. As a consequence, the presence of leverage for some investors drives down the risk premium for ALL securities, including the riskiest securities with worse risk-reward profiles.”

As for liquidity, astute investors know that the global money supply growth shows no signs of abating. What is less appreciated is the role hedge funds are playing in the manufacturing of money. Here, Rich Bernstein’s comments on April 25, 2007 are most insightful:

“As we first wrote more than a year ago, the Fed and other central banks will effectively have to disintermediate hedge funds to curb inflation pressures. The unbridled credit creation outside the traditional banking system (i.e., from hedge funds, CDOs, CDSs, and the like) remains the key factor within the financial markets today. Monetarists, of whom we assume most central bankers are, would argue that the route to inflation is through credit creation. Inflation expectations, as measured by TIPs spreads, have been rising for five months. A manager at one of the world's largest hedge funds recently commented to us, "We aren't a hedge fund anymore, we're a bank." That is exactly our point. Interest rates may necessarily have to rise enough to disintermediate these new "banks" in order to slow credit creation.”

Investment Strategy Implications

Investors who insist that this bull market is all about earnings or some Goldilocks economic scenario are sorely mistaken. Granted, bull markets are a reflection of the real economy and earnings growth and profitability are a key component. As is low interest rates. But the lifeblood of this or any other bull market is liquidity. And when combined with leverage and the “genius” of financial engineering, capital is virtually unlimited.

As Milton Friedman would note, however, the problem develops when too much capital chases too few goods. In the real economy, capital is more than adequate. And certain economies (emerging markets) are threatening to overheat. In the financial economy, the sustained reduction in equity via M&A and buybacks is tilting the demand/supply equation strongly in the direction of over inflationing financial assets.

A valuable Greek expression sums it up, “All things in moderation.” However, moderation is the last attribute one equates with excess amounts of capital.