A Tale of Two Septembers

Here are the stock market performance facts re September, courtesy Wall Street’s keeper of the historical keys, Sam Stovall:

“Investors may have a reason to fear a set-back in September. No matter if you look back to 1990, 1970, 1945 or 1929, the S&P 500 posted its worst monthly performance in September, losing 1.3% on average since 1929 versus an average monthly advance of 0.54%. What’s more, the “500” has declined an average 56% of the time, versus only 42% for all months, making September the worst month for frequencies of declines. However, during the 14 Septembers immediately following the end of bear markets since 1932, instead of posting the average 1.3% decline, the S&P 500 gained a median 2.0%. What’s more, the frequency of declines – at 36% following the end of bear markets – was substantially better than the average 56% for all years. Yet history should always be looked upon as a guide, not gospel.”*

While nearly every investor knows the first fact cited by Sam – that September tends to be one nasty month for equities – what many may not know is the second point he makes: how September tends to perform AFTER the end of the bear. And therein lies the decision-making rub – especially for those of us who don’t buy into the Barton Biggs’ strongly bullish argument** that above historical average P/Es are appropriate in the current climate AND earnings are likely to surprise to the upside – the combination sweet spot for equities.

Investment Strategy Implications

When markets reach the outer band of their valuation range, crosscurrents are more likely. Additionally, given the highly correlated nature of the markets (thanks to the dominance of momentum investing among professional investors), sharp swings at market extremes become more common. Moreover, after months of progressively higher highs, with virtually no correction along the way, one could and should assume that such a relatively low volatility environment will come to an end.

And in that end, September may turn out to be as changeable as the season it ushers in: putting in a bullish first half followed by a sharp move to the downside to end the month. Head fakes abound as a tale of two Septembers unfolds.

*Sector Watch, August 31, 2009
**Bloomberg Surveillance, August 28, 2009

Advice to Obama Administration – Less Pro-cyclicality, More Contrarian Behavior

Contrarians are a lonely lot. They sell when others buy and buy when others sell. They are not the run with the herd type.

In the world of investing, herd-like behavior is the dominant form of action and can be seen in many forms – high correlations and animal spirits, for example. A pro-cyclical force that leads to bubbles and busts, in the extreme. And a high degree of mediocre investment performance (often via closet indexing).

Yet, pro-cyclical forces are not limited to the animal spirits of Wall Street. Main Street has its own version, one being played out in the form of layoffs and capex cutbacks as the business cycle runs roughshod over the longer-term secular trends. Understandable but very short sighted. Kind of like the preoccupation with quarterly earnings results.

Even in banking, pro-cyclicality is the way business is usually conducted. Consider the accompanying chart from the Economist re lending standards. Easy money when times are good, tight money when times are tough. More often than not, exactly the opposite of what the economy needs.

Now, easy money during good times is a good thing in the early to mid stages of an economic recovery, however it becomes highly destructive in the latter stages of an economic expansion as dubious projects get funded when a more appropriate approach would be toward prudence. The music is playing and everyone has to dance.

Sadly, as we are all learning with great pain, in the extreme, in all facets of the real and financial economy, privatizing gains and socializing losses becomes the end result.

Investment Strategy Implications

President-elect Obama wants to bring change to Washington. Being forced upon his administration and the global economy as a whole is change across all facets of the financial and economic spectrum. A new financial model needs to be constructed as does a new economic order.

One hoped for addition to the change mantra would be finding ways to encourage less pro-cyclical and more contrarian behavior. Perhaps, then the bubbles and busts will be less pronounced and the socialization of losses less costly.

Patience, The Lost Virtue

As the alternate universe of derivatives continues their great detoxification unwind, financial assets struggle to comprehend a world in transition to a new financial and economic order. In the process, fixed income markets remain frozen while equity markets lurch from one end of the prospective economic spectrum to the other in near 1.0 correlation.

Investment Strategy Implications

The derivatives tail continues to wag the cash market dog. For traditional investors (those who still believe in things like earnings, P/E ratios, and Discounted Cash Flow models), the only path through this chaotic, cold-turkey transition from an economically juiced, over leveraged, structurally imbalanced world to a less leveraged, more balanced one (e.g., global growth being less dependent on the US consumer) is patience. The alternative is to sell everything and hope that one is smart and quick enough to time their re-entry point.

Investors (in the true sense of the word) will follow the former while traders will choose the latter.

A Matter of Degree

One of the attributes of the past decade has been the increase in correlation between and among sectors, size, styles, regions, countries, and even across many asset classes. Given the turmoil that has erupted in the financial markets, an investor might have assumed that the synchronized investment swimming might diminish as alpha starved investors gravitate toward winners and away from the losers. As the two accompanying charts show, however, that does not seem to be the case thus far this year.

From a size and style perspective, for example, the first chart* shows the high degree of correlation among the three major size categories – large, mid, and small – and the two major style categories – growth and value. This same is the case from a global markets perspective (chart 2*).

The only apparent performance difference is the degree to which a sector of the equity markets moves, with little to no signs of diminishing correlations. In other words, despite the disruption and the incentive for money to gravitate more clearly toward winners and away from losers, markets remained fully synchronized.

Investment Strategy Implications

Perhaps it is the credit related risks to hedge funds and the strong momentum (some might argue the lemming-like) aspects of many professional investors that explains why alpha starved performance has not produced a move away from high correlations. Or maybe it is the strong influence of quant models. Whatever the underlying reasons might be, it would behoove investors to keep a close watch on this aspect of the equity markets as signs of divergence in synchronization can yield excess return rewards – something that I would suspect will emerge as the year progresses.

*click on images to enlarge

2008 Themes: A Less Correlated World Part II – Sector Divergences

In 2008, decoupling will likely apply not only to the global economy picture (as noted in yesterday’s blog posting) but also to the recent high correlations between and among asset classes. Until recently, some of the most notable examples of high correlations have been in the economic sectors (see blog postings for previous correlations, particularly the July 11, 2007 posting).

This year, however, there’s a very good chance that correlations will diminish.




As the above chart from investment strategist extraordinaire, Tom McManus, shows the variance between sectors has begun to rise.

Investment Strategy Implications

Since starting this blog back in March of last year, I have noted correlations 10 times. Each time, the references have been toward the trend that was in place – higher correlations. With the advent of the credit crisis last summer, the trend toward lower correlations has become apparent. Gold, for example, was once highly correlated to the equity markets, even though logic dictates it shouldn’t be. Clearly, something has changed and that change is producing a divergence that has already manifested itself in not only Gold but also in weak trending economic sectors such as Financials and Consumer Discretionary.

Hedge funds and 130/30 managers will likely contribute to the trend toward lower correlations. Alpha seeking among a more seasoned and aggressive growth of credit fiasco survivors coupled with momentum investing should be key factors in bringing about a greater divergence between and among asset classes and sectors.

As a result, momentum investing, a key component of many investment professionals preferences, will likely, in 2008, become more concentrated as hedge fund managers as well as more aggressive 130/30 mutual fund managers seek to segment the sectors and styles, the regions and countries that the global growth story provides.

So, here’s a little investment rhyme that should play out this year:

The strong get stronger,
The weak will fade.
All gets overdone,
There’s money to be made.

The Rip Van Winkle Correction

excerpts from this week's report

"Ever so slowly but no less dramatically, investors are coming to appreciate what readers of this newsletter and blog have known for well over a year – risk has been grossly underestimated and correlations among assets are very high. And, in the process, a very healthy, and long overdue, correction is underway.

From an investment strategy perspectives, two issues appear to be worth noting:

• The magnitude of the correction
• The meaning of the correction

Here are a few thoughts on each..."

"The magnitude of the correction depends on your perspective on the driver of the correction – risk adjustment due to credit related problems. For this, an opinion needs to be rendered as to whether we are experiencing a financial crisis comparable to the Long Term Capital debacle of nearly ten years ago? Or is the crisis more like the one-off Amaranth blow up of last year? In other words, contagion or no contagion? That is the first question..."

Investment Strategy Implications

"The world’s financial markets are going through a grand transition from Greenspan’s bubblenomics to Bernanke's professorial sensibilities. If I am correct in this view, then the risks, opportunities, and implications are both more complex and more substantial than many investors appear to realize.

It is good that the discussion has finally moved to where I have been harping about for well over a year – risk. However, it is far more productive if a better understanding of the nature of change the world economy and financial markets have been undergoing these past few years took hold.

The correction underway is both healthy and long overdue. Rip Van Winkle would be proud."

also in this week's report

• Current Blue Marble Research Fed Valuation Model
• 2Q07 Earnings Update
• Model Growth Portfolio
• Key Economic Indicators

Note: To gain access to this week's report (and all previous reports), please click on the Blue Marble Research Services link to your left for info.

Cool Headed Opportunism

"The selling was so aggressive on Tuesday because this was another reminder of the great unknown," said Vinny Catalano, chief global strategist at Blue Marble Research. "There appears to be no clear understanding of how deep the credit-derivative problem is and how long it will take to be resolved."
Wall Street Journal, Abreast of the Market, August 1, 2007



”Markets do not always trade in line with fundamentals. All asset classes show inefficiencies, and much money is made exploiting them. But this latest spasm raises questions about the vast and unruly market for credit derivatives. How does it operate, and how to gauge fundamental value?” John Authers, FT, July 31, 2007

Perhaps the most unnerving aspects of the present financial market meltdown is the magnitude of the hits taken and fear of the great unknown. For, every bad news story seems to involve not your garden-variety decline, say, 10 – 15%. Rather, the damage is in the mega category, >50%. Moreover, today’s news that investors who want out of the latest Bear Stearns debacle can’t get their money only adds to the concern. And, if recent history is any guide, when they can get their money, it will likely be in that mega loss category. Yet, it is the ignorance re just how deep the rabbit hole goes that remains the most dangerous part of the current financial market meltdown.

Frankly, none of what is occurring is news to the readers of this blog and my weekly reports. For well over a year, the risk factors pertaining to the black hole of knowledge re credit derivatives and hedge funds has been noted. So, as the rest of investment world finally acknowledges the risks that existed all along, the appropriate current investment strategy requires a little Joe cool (see image above - the pass that became "The Catch")*.

Investment Strategy Implications

With correlations so high (and even higher in market declines – see blog entry July 26, 2007), the potential for the brake to become the accelerator is possible but not highly probable. That’s another way of saying that the contagion the markets are experiencing is likely to fall somewhere between the systemic dangers prevalent during the LTCM crisis and the isolated Amaranth blow up. If so, then a buying opportunity is unfolding with leadership change underway. As noted in this week’s Weekly Report, the investment strategy course of action is to answer the three questions posed (see Monday’s, July 30th blog below).

*It seems only fitting to use the image above as a very small tribute to Bill Walsh, a true innovative genius.

Technical Thursdays: Hedge Funds and Downside Correlations

Exactly two weeks from today, my next Market Forecast event for the New York Society of Security Analysts will feature a keynote address by Dr. Tobias Adrian of the New York Fed. The title of his speech is “Hedge Fund Tail Risk.” After reviewing an advanced copy of his presentation, I want to share with you a few thoughts on one of the issues that Dr. Adrian will address on August 9th that has a high application to today’s market: “Does tail risk of hedge funds increase in time of stress?”

As the charts above show and has been stated numerous times before, correlations are very high between and among sectors, styles, regions, countries, and, to some degree, other asset classes. What needs to be appreciated and what the above charts imply highlights a key aspect of Dr. Adrian’s speech: during times of stress, downside volatility accelerates in higher risk (but not necessarily higher beta) sectors*. This is precisely the risk that Dr. Adrian’s boss, NY Fed President, Timothy Geithner, worries about - When the brake becomes the accelerator. According to Dr. Adrian, the role hedge funds play in exerting downward pressure during times of stress is significant**.

Investment Strategy Implications

If technical analysis is worth its salt, then the current market decline will not metastasize into a contagion rout, which will trigger the tail risk (high downside volatility) event referred to by Adrain and Geithner. As noted in yesterday’s blog entry, the current correction got its start at an insignificant price point, thereby implying that the equity markets in the midst of yet another short and nasty correction. Moreover, as long as liquidity remains abundant, large and sustained market corrections tend to be mitigated.

It is advisable, however, that investors become keenly attuned to the risks of highly correlated markets that end up nearly eliminating the benefits of diversification and reducing downside risk minimization to the asset allocation decision. For there will come a day when the technicals are set up more completely than they are today for a major market decline. And liquidity may not be as abundant to save the day.

*For the styles in the left chart, the beta for the mid caps (MDY) is .98 and for the small caps (IJR) it's .95.
**Average hedge fund correlations are 32%; during time of stress the number jumps to 53%. In a related fact, Dr. Adrian points out that the correlations between hedge funds and investment banks are very high during times of stress (see third chart for a clear example of this point (IAI - broker/dealer ETF)

To view a larger version of the above charts, simply click on the images.

Synchronized Markets: Nowhere To Run

The highly synchronized nature of the US equity markets has become common knowledge to most investors. The same is true for global markets. What is interesting, however, is that comparing the last 100 days of the current bull market with its first 100, US economic sectors have become somewhat less correlated with the broad market (save Utilities) while most global markets have become more so (save Japan).

Investment Strategy Implications

Highly synchronized markets make it harder to diversify away risk resulting in a default to riskier positions (the beta trade) and/or leverage to generate excess returns. This is also true within most domestic markets. Therefore, it should come as no surprise that, given the plethora of investors and the abundance of capital, competing for alpha has become largely a leveraged play and/or the beta trade (see May 1, 2007 blog posting, "The Bubble Machine of Liquidity and Leverage"). Thus far, the apparent market consequences are long periods of tranquility (low volatility, consistent gains) interrupted by moments of financial angst.

Note: To view a larger image of the tables, click on the image.

An Orderly Decline

As investors await the FOMC’s rate decision, the focus of many will be on whether a rate cut is in the near future. However important such information is, the focus on these pages will be in the area of the balancing act the Fed must play between weak domestic growth, strong global growth, and fat tails and other uncertainties that financial innovation has wrought.

As the two month chart to your left shows, the equity markets seem to have settled into an orderly decline over the past month (note the tighter fit among the four major market cap sectors – large, mid, small, and micro). Its continued progress is dependent on the ability of the Fed to manage the delicate balance.

Investment Strategy Implicatins

It should be apparent by now that central banks around the world are seeking to deflate the liquidity bubble without bursting it. Call it a global soft landing, the aggregate concerns are centered on demand push inflation emanating from non US growth. The Fed has to strike the delicate balance between weak domestic demand and rising cost pressures from global growth, all the while being mindful of the risks presented by financial innovation. Based on the equity market’s behavior these past two months, investors seem comfortable with the economic environment. The consequences of failure will, however, produce a far more dramatic decline than most investors are prepared for.

Hedge Fund Seminar Observations: A Soprano-like Ending

One of the major benefits that come with conducting events over a given period of time on an important topic such as hedge funds, it helps to provide a unique perspective. As a result, yesterday’s Hedge Fund seminar produced here in San Diego was remarkable on several levels. Most notable was the degree of sanguineness regarding certain risks that was at odds with the sentiments that were raised at the previous such seminars that I have conducted over the past four years. Perhaps it had to do with the specific work performed by the four panelists. Or, perhaps, it is a reflection of the comfort bull markets generate. Hard to say but certainly not hard to notice.

One of the risks that I am referring to is the risk management capabilities of hedge funds in general: the ability of hedge funds to manage the downside risks that are inherent in leveraged strategies. Blowups may be inevitable but none of my four panelists seem to be particularly concerned with a systemic contagion. This was surprising to me considering the fact that both the nominal and leveraged amount of money in the alternative investments world (hedge fund/private equity) has grown considerably over the past four years.

Another risk that I raised that did not seem to produce much in the way of a concern was the issue of correlations, within and across markets. A point made by one of my panelists was a belief that, while the markets may be highly correlated, the world’s economies are less so. This is the decoupling story, one that in my opinion has not been tested.

Investment Strategy Implications

As informative as yesterday’s event was (they always are), the standout item was the degree of sanguineness of my expert panelists. Fear and concern was fairly absent. As I stated above, perhaps this was a reflection of the unique markets or experiences that my panelists operate in. Or it is a sign of a broader investor sentiment. Hard to say, but definitely not hard to notice. In this case, I will take a page from the final episode of The Sopranos and let you decide what the outcome will be.

Time for a Little “What If”

excerpts from this week's report

In light of last week’s upside breakout of the 10 year Treasury rate complete with confirming momentum and MACD (see chart in this week's report*), perhaps it’s time to play a little “What if” with our modified Fed Model.

What if rates continue to rise by another 50 basis points? What if earnings growth disappoints over the next twelve months producing a modest decline to, say, $88 operating earnings for the S&P 500? What might be the likely market impact?

As our modified Fed Model shows (see table in this week's report*), a market decline of approximately 10% from current levels is not out of the question (and some might say long overdue)...

Investment Strategy Implications

Given the highly correlated nature of ALL equity markets, a self reinforcing downward spiral could easily develop, particularly if weakness continues into the end of the current quarter and portfolio managers...

*subscription required. For more info, click on Blue Marble Research services link to your left.

The Complacent Correction

Perhaps my May 24th forecast of a market correction (see blog posting, “4 Reasons Why a Market Correction is Imminent”) is now underway. If so, the issue then becomes just what type of a correction will this be?

I submit to you the following three versions of a market correction that US stocks are likely to experience:

1 – The Alfred E. Newman Correction

This version is more anecdotal than quantitative and easily fits in magnitude with version #2 below although less violent, a relatively tranquil-like downward float. The strategist and pundit talk should center on the “healthiness” of a correction - which is a true statement but of concern when accompanied by a sanguine tone. The quantitative manifestation of this version follows.

2 – Painfully Short and Sweet (scare the bejesus out of ‘em) Correction

In 2005, 2006, and early 2007, this version (<10%) has been the correction du jour. Sharp down, seemingly out of the blue, yet, when completed, not all that bad. Kind of like some nasty tasting medicine – bitter but brief. Final damage is in the 5 to 8% range.

3 – The Real Deal

The US equity markets have not experienced this version at any point during this entire multi-year bull market. I am speaking of the >10% variety. A steady corrosive decline down (versus the sharp, sweet #2 version) that, after a while, shifts sentiment from complacency to concern to capitulation.

Investment Strategy Implications

Regardless of which version you think will occur (I suspect most will opt for versions 1 or 2, which means the contrarian in me says to lean toward version #3), the issue of what to do comes to the fore. If you believe in version 1 or 2, then you’re a buy-the-dip investor. After all, that’s what has paid off recently*. If you’re a version 3 person, however, then the issue of correlations becomes a consideration.

Given the high degree of correlations among and within markets, the ability to “bury the money in defensive issues” is taken somewhat off the table. Granted, there is some comfort in the lower beta aspects of certain sectors and styles, but in fully synchronized, highly correlated markets, across the board losses tend to be more certain. Accordingly, non-correlated assets are nearly impossible to find, which leaves only the asset allocation decision as a tactical course of action for most investors. And that may a problem for some, as it is a market timing approach that many investors (as opposed to speculators) are not completely comfortable with.

Note: Going into this week, the Model Growth Portfolio (MGP) is currently 86% in equities with several hedged positions, including a short in long term US Treasuries (TLT) and a long position in the Ultra Short QQQQ (QID). To learn more about the strategies employed and MGP, click on the Blue Marble Research services link to your left. A modest subscription is required.

*see May 29 blog posting "Just How Smart is the Smart Money" re the behavioral finance tendency of recentness.

…Becomes the Vicious Cycle

What goes up, must come down. And what goes up in unison, will go down in unison (relative performance, notwithstanding).

Since the new millennium began, the power of the virtuous circle has enabled equities to overcome an extraordinarily number of adverse developments. However, it should be appreciated where this strength comes from. And should not be ignored that all juggernauts have a weakness(es), an Achilles heel that could bring to an end (more likely, severely limit) the benefits enjoyed by many.

In cases involving self-reinforcing features, such as the current virtuous circle, strength begets more strength. Each aspect reinforcing the other to greater heights. Like a well-oiled machine with many interlocking moving parts, motion generates movement and forward progress is the result. But, the interconnected dynamics of our well-oiled machine can shift into reverse gear and all the parts can then work together producing a negative and most unwanted result - a vicious cycle.

A disruption to the virtuous circle can occur at any point. This is a testament to the dynamics of an interconnected, interdependent world. For example, an exogenous event can alter sentiment which tip the balance the other way. However, at this time and given the abundant liquidity in the system, there are two links in the virtuous circle chain that stand out above all – the US consumer and Decoupling.

It’s easy to see how a serious contraction of US consumer spending can break the virtuous circle – lower US consumer spending begets lower capital flows to emerging economies and oil-exporting countries which lead to fewer recycled capital into debt instruments which puts upward pressure on rates which impacts the borrowing availability to US consumers. And so it goes.

The offset to this is, of course, lower US consumer spending will reduce debt demand pressures and enable the Fed to mount its white horse and come to rescue yet again. That is all possible so long as inflation does its part and moderates. And in a moderate fashion.

The other offset is Decoupling – the ability of other regions of the world economy to pick up the growth slack of a slowing US economy. However, as Steve Roach has pointed out, the real test for decoupling has not made. It is only when the US consumer and, thereby, the US economy slows substantially that the decoupling scenario will be put to the test.

An additional risk to decoupling is if growth in the US does not moderate producing a sustained global boom that overheats and results in inflationary pressures worldwide. Concurrent with that is the financial markets and its overheated potential pushing all assets to extraordinary levels, while central bankers seek to offset extreme speculation and shut down the prime engine of global growth – liquidity. (This is, by far, the greatest risk to sustainable global growth and stability as it could precipitate a vicious cycle of historic proportions.)

Investment Strategy Implications

The current bull market’s greatest strength is also its greatest weakness – interdependency. The manifestations of this interdependency can be seen on multiple levels – highly synchronized economies, markets, sectors, etc. producing high correlations and low risk aversion. The interdependency has also produced a virtuous circle of self-reinforcing positives. But, self-reinforcing trends can work in reverse. And with great suddenness.

The world has become one economy and one market with highly interdependent qualities and exponential performance features. Yet, risk exists. And some are quite substantial. To dismiss them and genuflect at the altar of market fundamentalism is to advocate the end of human nature. Greed always gives way to fear.

The best investment advice I can think of in such an environment is simply this: Don’t Drink the Kool-aid.

Nothing is forever. And when the end comes, the characteristics that drove the run-up are usually the same characteristics that drive the decline.

An appreciation of timeless principles, such as regression to the mean, may limit the upside benefits of a bull rally, but will more than offset the inevitable plunge circles and cycles generate.

Technical Thursdays: Time Travels

There is much talk regarding the failure of large cap to assume the mantle of leadership from its smaller cap brethren. This is true only if an investor looks at the most recent price performance. However, if an investor takes a step back and sees the market cap categories from a one-year time frame, a different picture emerges.

As the charts on the following page show (see report, link to Blue Marble Research services on left side of page), large and mega cap has outperformed the Smids on a one-year basis. Moreover, the relationship is in the exact order one would assume if the environment has become more uncertain (mega over large over mid over small over micro). However, from a global perspective, things are unchanged. And that’s where things get a bit more complicated.

(Chart comments. See report, link to Blue Marble Research services on left side of page.)

Year To Date: While Large and Mega cap trail, a pattern divergence is evident – Mid over both Small and Micro. This is contrary to the past several years but is less meaningful as Large and Mega trail.

One Year: A different picture emerges when you widen the view. Here, the impact of last spring’s mini correction can be more clearly seen. Mega (OEF) over Large (SPX) over Mid (MDY) over Small (IJR) over Micro (IWC).

From a global perspective, however, things are unchanged.

Year To Date: On a global basis, we see the same year-to-date relationship as in the US, with one twist. Higher growth/higher risk regions such as Asia-Pacific ex Japan (EPP) and Latin American 40 (ILF) top the list while the US (SPX) is at the bottom. The twist is the higher quality Europe 350 (IEV) which is edging out the broad Emerging Markets (EEM) group.

One Year: Unlike the one-year data for the US, however, most of the same year-to-date relationships exist on a one-year basis. It should be noted that Japan trails the pack by a wide margin.

Investment Strategy Implications

On a domestic level, I lean toward the one-year chart as it supports my fundamental views and suggest that we are in a transitional period where risk is not being rewarded as in the past. The counter argument is on a global basis where both the very short and near term trends (year-to-date and one year) are nearly identical. The question then becomes is the US leading or will the year-to-date US performance evolve and bring the one year size performance back in line with the rest of the world?

Beyond the potential breakdown of correlations this earnings season, there is no clear answer just yet. I do believe, however, that change is in the air and caution (higher quality, lower equity exposure) is justified.