Bottoms Up!

Giving the devil his due, the bottom-up crowd has won this round, as earnings results are not disappointing as economists did for the third quarter. Therefore, in light of the recent market action, it seems more than productive to understand the nature of this important (but not dominant) segment of the market.

Most investors are bottom-up oriented. They buy and sell stocks with a passing reference to the sector and style tilt their portfolios produce. Like many sports teams, portfolios are populated with the best ideas. Sectors and styles are a by-product. Individual company earnings results, performance metrics (such as profit margins, growth rates, etc.), and valuation levels determine the buy/sell/hold decisions made. From that comes the action taken.

This situation is largely due to tradition and training: traditional among individual investors, training among the professional crowd (the CFA program, for example). It is what the financial media obsesses on while providing limited, yet sorely needed, education on what constitutes good portfolio management.

As one of the two essential elements that drive stock prices up or down (the other being financial market liquidity), earnings results can dominate the moment, as they appear to have done thus far this month. When good earnings results motivate investors to act positively, the momos (the real power in today’s market) join the party, as they are indifferent to the reasons that drive investors and are far more interested in an excuse to act. As long as money is abundant (financial market liquidity), the upside bias exists. Which brings us back to earnings results.

As long as companies deliver positive earnings results and financial market liquidity remains ample, the bottom-up crew can move markets (aided and abetted by the momos, of course) to a significant degree. Should earnings falter, however, then the dual impact of declining results and diminution of financial market liquidity (in the form of redemptions and withdrawals) can produce a negative feedback loop to the real economy (Soros’ “reflexivity”). Yet, more importantly, within this investing approach lie the seeds of its own destruction.

Bottom-up investing is aided and abetted by ivy tower fantasies about efficient markets, assisted with high-sounding phrases like “price discovery” and “capital asset pricing models”, and supported by economic methodologies that are anchored in traditional metric analyses. Such traditional economic methodologies do, however, come with two significant blind spots: the inability to forecast with any degree of accuracy and consistency (certainly commensurate with a practice that fancies itself as a “science”) and an inability to do global macro analysis particularly well.

The first point is self evident and saturated with historical fact. For example, one need only look at today’s consumer confidence miss to see just how off the mark these “social scientists” can be. The second point was made most evident in the debacle known as the Great Recession. Moreover, the inability to do global macro well also comes with an inability to incorporate contagion’s speed and source (real and/or financial economy).

This is a big part of how the world works in Wall Street. It is the dynamic reality that exists in the surreal world of finance. It is the state of denial that many who play the investing game occupy. And it is why it is so essential to step back and smell the global macro rose, which right now has a decidedly foul odor to it.

But, hey! “Who cares?”, say the bottom-up boys and girls. "Earnings are good and that’s all that matters to me."

Bernanke to Wall Street: More Cowbell

“I got a FEVER! And the only prescription...is MORE COWBELL!”
-Bruce Dickinson (Christopher Walken)

There are two reasons why the stock market is trading where it is. One deals with valuation levels. The other is liquidity. These factors are the most direct to stock market levels. From a stock market point of view, the larger macro economic, political, and societal (including cultural and demographic) issues matter only to the extent that they ultimately impact the inputs to the valuation levels – cash flows, growth of the cash flows, and the uncertainty (the risk) of receiving those cash flows – and liquidity, specifically liquidity to the financial system.

It is on this second factor, financial system liquidity, that many fast money professional investors (hedge funds, high frequency traders, prop desk traders) are paying the most attention to in today’s testimony by Fed Chairman Ben Bernanke. As the primary market forces that move markets at the margin, fast money types want to know that the Bernanke Put (rising prices of risky assets help produce the wealth effect, which helps the broad economic environment) is still operative.

Based on what they heard thus far, all is good. Or as the Saturday Night Live quote above suggests, the fast money crowd has a fever (they always have a fever) and generous Ben assures them that there will be more cowbell.

Investment Strategy Implications

Hang in there. A resolution to the sideways market is not far off. As noted on several recent blog postings, the clock is ticking and appears to be set to strike midnight very soon.

Will it ring a new day for the bulls or will investing Cinderellas themselves with pumpkins and not stagecoaches for transportation? Right now, it's anybody's guess.

9 ½ Weeks

For the bulls these past 9 ½ weeks were like the movie of same name – hot. However, the bulls (including many recent converts, especially from the land of momentum lemmings – the hedge fund world) should not forget that in the movie the lovers (Basinger and Rourke), drawn by the heat of the moment, have something as substantive and sustainable as a chimera. In a case where life imitates art, such may also be the story line with stocks.

Using the historical average P/E of 15 times and an optimistic $60 operating earnings number for the S&P 500 for 2009, stocks are projecting a robust earnings rebound into 2010 - a point made by my “Beyond the Sound Bite” guest from last week, Subodh Kumar, with a $75 call for next year. Only if that occurs AND/OR only if one accepts the talk I hear from some institutional investor circles that a P/E above its historical average is fitting for the times courtesy a low inflation rate (18 times is the number I hear), can an investor find fundamental support for the fragile technical analysis base stocks have built. However, it does give one pause when the leadership for this market is the same leadership that existed before the great tumble. Generally that is not how new bull markets get started and sustained, as the more common occurrence is for new leadership to take the helm. Rather, bear market parades are led by those who led before.

Investment Strategy Implications

9 ½ weeks ago I argued that stocks were grossly undervalued. Now, 9 ½ weeks later stocks, while not grossly overvalued, are more than fully valued. Built on the sand of a fragile technical analysis bottom led by those who led before make it more than justifiable to take some money off the table – most conservatively done by maintaining whatever the current equity percent of one's total investible assets at the current level, which in accounts that I manage is in the low 90% range.

In many respects the movie 9 ½ weeks was a study in extreme behavior devoid of real meaning and lasting substance. So, it is interesting to note that the stock market movie of these past 9 ½ weeks has brought out these qualities of extremes, including the expectations of more than a few investors with calls for more upside surges or great plunges. Therefore, allow me to offer an alternative view to this edgy thinking with a reference to another character from Tinseltown – George Costanza. Perhaps what investors will get in the coming months is a stock market movie not about heat but about nothing. A drifting, sideways, mini range-bound market where selectivity matters more than trend following, lemming-like momentum investing as investors digest what has occurred and guesstimate what 2010 has to offer and the appropriate P/E.

In such an environment, you can keep your (slightly bearish) hat on.

The Not-So-Smart Smart Money

It should be fairly evident by now that heavy redemptions at hedge funds over the past two months contributed significantly to the recent pounding in the one area where markets are liquid – stocks. Moreover, the deleveraging process continues to impact many hedgies as available capital (for leveraged strategies) has dried up*.

Accordingly and in anticipation of continuing redemption demands (many of which remain unsatisfied due to gating), many hedge funds have sold more than has been requested thus far. Lastly, there is some talk that private equity commitments of institutional investors are also forcing redemptions in their hedge fund holdings.

Investment Strategy Implications

With the market cap of the S&P 500 sitting at $7.4 trillion and money funds (institutional and retail) amounting to more that $3.3 trillion, the momentum nature of hedge funds and their high cash positions would only need a less bad environment (see Barton Biggs’ comments in yesterday’s Financial Times) to trigger a stampede back into equities.

With valuation currently at deep recession (bordering on depression/deflation) levels, any earnings surprises into 2009 (as in something north of $70) would be the justification for buying what was just sold.

*One wonders what has transpired behind closed doors between financial institutions and government re lending to the masters of the universe.

⇐ Only 5 days left to vote.

The Real Risks of Deleveraging

The deleveraging process that is dramatically impacting the economy and markets has two very serious consequences to it. One deals directly with the insane process of mark-to-market of illiquid, opaque assets. The other pertains to the effects deleveraging will have on the real economy. Allow me to highlight the key points of each.

In terms of the financial economy, the process of deleveraging can be characterized as feedback loops gone wild. Virtuous circles (and their accompanying animal spirits) give way to vicious cycles, in which lower prices beget write-downs, which beget lower prices. And on it goes. In the process, bad assets become toxic, especially for financial institutions who, unlike other entities, have capital requirements that must be met.

There is nothing new in all this. Bubbles and panics have been around for centuries. And bad behavior is always punished eventually. The larger macro economic issue is the fact that the global economy is in transition (listen to El-Erian’s comments below). The dominant question in such a macro economic environment is whether the transition will be an orderly or disorderly one (ex. a declining US dollar). What is new, however, is the impact that the rule change made last November that has turned a difficult situation into the disaster the financial markets are facing today.

Thanks to the well-intentioned actions of FASB last November and the updating of the accounting rule FAS 157, illiquid assets must now be marked to the current market price (mark-to-market) in an attempt to reflect the true value of the asset. This is all well and good were it not for the fact that marks in highly illiquid, opaque markets can produce a highly questionable reading as to what constitutes "fair value".

Moreover, when such marked-to-market assets are owned by financial institutions operating with high degrees of leverage often reliant on short-term financing with mandated capital requirements, you have a recipe for disaster. But don’t take my word for it. Listen to Paul Volker many months ago or Steve Forbes on Fox Business News last night*.

Lastly, so much of the current investment climate has been co-opted by short-term momentum players, many of which are aggressive short sellers. Does anyone seriously believe that these players are interested in what the "fair value" of an asset is?

All this creates a toxic climate for toxic assets.

The second risk re deleveraging is how it will impact the real economy. One effect is already being felt – fewer loans are being made. Gone are the days when credit cards, auto loans, and no-doc, no-income mortgages literally flew out the doors of financial institutions. Gone, also, are the very generous covenants attached to junk bonds. In their place is an austere environment where liquidity is abundant but the risk appetite in frozen with fear. This is all bad but what makes this situation highly dangerous is the state of the US consumer.

The US consumer, the spending workhorse of the world economy has a personal balance sheet that is in serious disrepair. In the current economic environment, the need to reduce debt and increase their personal equity will only come about through a process of savings out of income. Say goodbye to your personal (home) ATM. Say hello to a higher savings out-of-income rate.

But savings out of income coupled with extremely low levels of borrowing means that the US economy is on for a period of depressed economic activity. The shop-til-I-drop, I-must-sustain-my-unsustainable-lifestyle US consumer is toast. A weakened economic climate coupled with the negative wealth effect (from real and financial assets) and a looming retirement calendar will do that.

All is not lost. There are pockets of strength that can help alleviate the financial crisis and perhaps help avoid a worsening contagion to the real economy. For example, there is a segment of the world economy that appears to be poised to emerge as the source of demand – the emerging middle class of emerging economies. Growth in their economies should remain positive and, given their generally solid balance sheets (not to mention fairly good policy processes), should make a positive contribution to global growth and stability. Not quite 100% decoupling but more than the pessimists believe.

By the way, speaking of solid balance sheets, most investment grade corporations have very solid balance sheets. The ability to weather a financially-inspired storm is quite favorable.

Then there are the large pools of capital around the world that sit waiting for the crisis to resolve itself. From sovereign wealth funds to money market accounts to central banks, liquidity is more than ample.

Lastly, Americans have a great capacity to adapt, to innovate, and come together in common cause**. All these factors should not be ignored as they represent a path out of the credit crisis quicksand.

There is one final point that I wish to make.

Rule changes matter. FAS 157 is a well-intentioned rule that is rooted in an antiquated principle known as the Efficient Market Hypothesis. For while investors in the long run are rational and risk averse, in the short run they are anything but. Modifying FAS 157 would one very easy way to reduce the vicious cycle of mark-to-market.

Investment Strategy Implications

The technical damage done to the equity market is sufficiently bad (but interestingly not terrible) that aggressively adding to positions should be done with great care. However, a prudent portfolio management policy of sector tilting coupled with a mindful regard that stocks have an upward bias (see prior blog posting on this point) is always appropriate, made even more so when panicky selling rules the day.

*FYI - Little ole me has written on this topic on several occasions on this blog and in reports. I encourage you to use the topics link for credit related issues to your left to explore the writings further.

**This point is contingent on a less divisive political climate. Therefore: Memo to McCain’s advisors – cool it with the Karl Rove tactics. You may win the election just like W did, but you will cause severe damage to the country in the process, just like W did.)

It's All About the Price of Oil

Does Oil Price Speculation = Manipulation?

The US stock market could not have sent a clearer signal these past two days as to what it is obsessing on – the price of oil. For as important as the Fed’s actions are (with the same opinion being applied to the Financials and their prospective economically destructive write-downs and write-offs), the price of oil is numero uno in the mind of Mr. Market.

And in this regard, the debate rages over just what explains the high price of oil. For example, today Libya , in contemplating cutting production, joined Saudi Arabia in declaring that the physical demand for oil is being more than met by existing supply. Yet, free market ideologues continue to rant that it’s all about the physical supply/demand equation with references to the oil output crisis du jour be it Nigeria or questions re the true reserves in Saudi Arabia or impending hurricane season in the US or failure to build and update adequate refinery capacity or….well you get the picture.

The center of the oil price storm appears to rest with the battle between the US politicians and the free market ideologues. In this regard, it seems that both the politicians and the free market ideologues have got it partly right, but wrong in key aspects.

The politicians are right to focus on the speculators as they have tilted the supply/demand equation via speculative positions. Moreover, in a world where positions established cannot be determined (dark markets, OTC index and derivative related trading), it is anybody’s guess as to just how strong the demand is and to what end such demand is being established.

Where the US politicians have gotten wrong, however, is their implied (and often stated) conclusion that speculation = manipulation. In this regard, it is hard to support the view that speculation = manipulation if large asset managers (e.g. pension plans) move large sums of their investment capital into what they have come to accept as an attractive asset class – commodities. Moreover, it is hard to support the speculation = manipulation thesis when true speculators (versus large asset managers) piggyback on the speculative (not physical) supply/demand imbalance pushing prices higher. That is, of course, assuming that collusion is not occurring.

As for the free market ideologues, they are right to argue that markets tend to function best when regulation is minimized. Moreover, free market activities by speculators provide desirable liquidity, which reduces the cost of investing via smaller price spreads.

Where free market ideologues get wrong, however, is to argue that free markets are efficient markets. If anything behavioral finance has proven wrong is the unfettered markets = efficient markets thesis. In this regard, it is advisable to remember that not all speculators are price efficiency arbitrage operators. Many are momentum players joining the parade for the ride and tending to exacerbate an existing trend. Therefore, unfettered free markets influenced by large shifts of capital from major asset managers enhanced by momentum speculators allowed to establish undisclosed positions is rife for price exploitation.

Investment Strategy Implications

When it comes to today's stock market, it’s all about the price of oil. The economic havoc due to soaring energy costs has many parallels to the destruction of the credit creation process and broken business models of financial services firms and their effect on economic growth. If the US politicians and various experts are correct, the price of oil will decline once both regulatory (CFTC) and legislative action (closing the Enron and London Loopholes) take effect.

On the other hand, if the free market ideologues are correct, then demand destruction is the sole path to end of the current oil price crisis. However, that path will produce broad economic pain (how does a global recession sound?) and, therefore, significant and more onerous regulatory and legislative action, made more likely in a US election year.

On this last point: Investors operating under the assumption that the Democrats in charge of the US Congress will operate in manner similar to the way the Republicans have acted for a dozen years are sorely mistaken. Should the free market ideologues prove correct, investors will learn the real meaning of the slogan “change”.

Slamming the Door on the Enron Loophole

The US Congress is on a rampage. And the oil speculators (who have inflated the price of oil by anywhere between 30 to $50 a barrel) are on the run. Perhaps the most extreme proposal by a legislator or regulator to reign in energy speculation comes from Senator Joe Lieberman. Consider his comments of yesterday:

"We are not, as some continue to argue, witnessing the ebb and flow of natural market forces at work. We are instead seeing excessive market speculation at work and that is why our government must step in with new laws to protect our economy and our consumers,"


With yesterday’s override of President Bush’s veto of the Farm Bill, the first of many steps taken and to be taken to put a serious crimp in energy speculation are well underway. And with each new effort to tamp down on unlimited and undisclosed oil futures’ positions, be it closing key aspects of the Enron Loophole as in the Farm Bill* or the proposals to close the “London Loophole”, or the Lieberman effort to “prohibit private and public pension funds with more than $500 million in assets from investing in agricultural and energy commodities traded on a U.S. futures exchange, foreign exchange or over the counter”, the debate over whether the high price of oil is due strictly to supply and demand in the real economy versus supply and demand of speculators will soon be resolved.

Investment Strategy Implications

I believe the catalyst for higher stock prices this summer will be a sustained and possibly sharp drop in the price of oil for all the reasons (and then some) noted above. With valuation at reasonable levels and professional investor pessimism as high as the recent Merrill Lynch survey states, room for higher equity prices appears more than justified.

Moreover, from both a fundamental and technical analysis perspective, it is hard to understand how stocks will head lower when Mid Cap and Small Cap Growth issues (IJK and IJT, respectively)** are outperforming the broad market and, in the process, signaling that 2Q08 earnings (which are not so inflated as 4Q08 numbers are) are likely to be more than acceptable. Strength in second and third tier issues is usually not the precondition for lower prices.

Beta bets plus a tilt toward growth appears to be advisable. For the truly adventuresome, Consumer Discretionary (XLY), Double Long Financials (UYG), and the Broker/Dealers (IAI) should react positively to any summer rally.

*However, not enough according to Michael Greenberger (see blog posting below re The Enron Loophole), as the process by which the CFTC can act requires too many steps.
**See above chart. Click on image to enlarge.

"We are in uncharted territory."

excerpts from this week's report:
Gary Crittenden
Chief Financial Officer, Citigroup

"For those who may be inclined to go along with the recent optimistic comments from the heads of several major investment banks (see last Thursday’s blog posting, “News Flash: Credit Crisis End in Sight”) and for those who might construe that last week’s impressive counter rally in the equity markets signals an end to the credit crisis and a resumption of the bull, the quote by Mr. Crittenden should put some real world perspective on the current situation. For the credit crisis and economy are intertwined a far greater degree than many investors may appreciate."

Investment Strategy Implications

"An undervalued market rally is one matter (see Expected Return Value Model in the report for more commentary on this point). But when it is accompanied by a return to complacency in the form of a lower VIX**, it behooves investors to take note, particularly when so much remains unclear.

Mr. Crittenden is right. And his comments are not exclusively related to Citigroup. The transformation of the credit creation machine at the core of the financial system (commercial and investment banks), within the “shadow” banking system (nonbank financial institutions, such as insurance companies, hedge funds and private equity), and the originate-to-distribute business model (not to mention the degree to which other securitized instruments..."

also in this week's report:

* Expected Return Valuation Model
* Moving Averages Scorecard
* Model Growth Portfolio
* Sectors and Styles Market Monitor
* Key US Economic Indicators

*To gain access to this week's report (and all reports), click on the newsletter subscription information link to your left.
**click on image to enlarge.

V - TV: BNN Interview

Last Thursday, I had the pleasure of once again appearing on the Business News Network (BNN), the leading business network in Canada. The interview covered a wide range of issues, including the US GDP, consumer spending, hedge funds, Brazil, Chindia, Gold, Defense/Aerospace, and more.

The interview will remain posted on the BNN website for the next few days.

To view the six minute segment, click here, select Thursday, then scroll down to the Market Movers segment.

All Bad is Not Good

“At the moment the media remains firmly on gloomwatch, which is mildly encouraging. The credit crunch will be over long before the press has finished dissecting it.”
Jonathan Davis
“How investable knowledge got scarce”
Financial Times, February 10, 2008


The flip side of early 2007 is in full force in early 2008. A year ago, goldilocks was all the media rage. Now her evil sister, gloomdilocks is running amuck in media land. Yet, as Mr. Davis implies in his recent excellent FT commentary, a little objectivity wouldn’t hurt. Take for example, the credit crisis.

I recently noted two separate pieces of information from two distinct and unrelated sources re the current credit crisis that should help put things in some perspective.

First, the remainder of the credit crisis is likely to be more of a slow rolling event. This point was noted by two of my Market Forecast panelists in Denver (see blog posting, “Wait ‘til Next Year, Feb. 1, 2008). Why? The answer to this question comes from my interview with S&P’s Chief Economist, David Wyss (see blog posting, “Beyond the Sound Bite: An Interview with David Wyss”, Feb. 6, 2008). In the interview, David points out that most of the must be published data re credit related losses (by the banks and other publicly traded entities) has already been done. One third of the write-offs by his reckoning. However, and this is key, the remaining two thirds sits with those entities who do not have to mark to market every credit derivative product they have on the books as their reporting requirements are significantly different from the high profile, publicly traded ones*.

Who are these entities? The very same ones that are providing liquidity to the high profile, publicly traded entities; the ones that have lots of cash to on hand – foreign entities (including sovereign wealth funds), hedge funds, and private equity.

Investment Strategy Implications

My bet is that three months from now, the media focus will shift from the gloom watch it is currently obsessing on to how resilient the US (and global) economy is turning out be as tax rebates, rate cuts, and a more robust global growth story help bring equities back to some semblance of fair value. Moreover, the credit lock up at the core of the banking system will likely begin to loosen up thereby producing some semblance of a return to credit generating normalcy enabling corporations to function more normally.

With a stock market that is in undervalued and oversold territory, the downside from the low 1300’s appears limited. Should the environment look brighter this spring (as I suspect it will), investors may regret getting too swept up in the media moment of extreme pessimism.

*Moreover, for those private entities who do experience credit related blow ups, the odds that their pain will extend to the larger financial and real economy is significantly less likely than in the banking and publicly traded company domain.

Where Are the Bodies Buried?

Whatever your views on yesterday’s Fed action might be, a disturbing question is emerging that few seem to be paying much attention to – How long does it take for the financial system to identify who owes what to whom?

CDOs of CDOs of CDOs of CDOs cannot stand unaccounted for indefinitely. Knowing where the bodies are buried is a vital component to putting an end to the uncertainty risk premium that has elevated the fear factor among many investors, which, in the process, has sucked the Fed into reverting to the Greenspan playbook of more liquidity. But will more liquidity alone do the trick?

The Bank Credit Analyst’s thesis, “The Debt Supercycle”, says liquidity will work its magic, provided inflation remains relatively tame. Massive amounts of money can be pumped into the system to help reflate assets and preemptively avoid a severe economic downturn. All well and good, but a reflating system that contains untold amounts of hidden toxic paper may end up producing unintended and unforeseen consequences. A true manifestation of the expression, “You don’t know what you don’t know”.

Therefore, as we approach the six-month anniversary of the great awakening, the moment when complacent investors woke up from their Goldilocks stupor and came to recognize that all was not kosher, the question of who owes what to whom still remains unresolved.

The longer it takes bankers to identify the toxic paper on and off the books, the more damage to the global economy they will incur as trust erodes both within and without the core of the financial system thereby exacerbating an already tenuous credit situation.

With bankers still unable (unwilling?) to identify where the bodies lie and horde their precious capital, the far less than transparent New Power Brokers (Petrodollars, Asian Central Banks and their Sovereign Wealth Funds, Hedge Funds, and Private Equity) have stepped into the breach to save the day. However, their rescue efforts come with a price – opacity. And opacity is precisely what is not needed at a time when so much remains unknown and trust hangs in the balance.

Investment Strategy Implications

Equities are undervalued and yesterday’s Fed action certainly helps improve everyone’s valuation model. Equities are undervalued in a scenario that overstates the downside risks to global growth and corporate profitability (see “Here Comes the Global Depression”). Equities are not undervalued, however, in a world of endless undisclosed toxic paper and new capital opacity.

It’s high time we all learned where the bodies are buried.

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.

“Get Busy Living or Get Busy Dying”

This famous line from the great movie, “The Shawshank Redemption”, seems apropos to the current mood of many investors. Locked in their prison of investment doom and gloom, the glass half empty crowd seem to becoming “institutionalized” in their fear of unknown, as well as the possible and the maybe.

*click on image to enlarge.



For those who are not so frozen in their fear of the unknown, the possible, and the maybe, I have an actionable idea that may make sweet music like Le Nozze di Figaro. My long idea is rooted in three strong current market trends:

* Hedge Funds, Low Redemptions, and the Quality Migration Cycle
* Mid Cap issues and the January Effect
* Growth over Value

The actionable idea is the Mid Cap Growth ETF – IJK.

IJK is a unique position to consider as it benefits from each of the three above noted items for the following reasons:

1 - A source of strength for our aged bull has been the fact that equity hedge funds have not experienced mass redemptions. Quite the contrary, new money continues to flow into the category requiring capital to put to work to earn those fat performance fees. If money is both staying and flowing in, where is likely to be put to work?

One place is where the equity hedgies have been all along – in the Smids, as this is where the bulk of their equity capital is deployed. However, the hedgies are not unaware of the risks facing the markets and the economy, which may explain why a quality migration from Small to Mid has resulted in the Small cap sector faltering while the Mid caps have not (see blog posting of last Thursday, December 6th).

Moreover, as also noted last Thursday, the Mid cap group has yet to trigger a sell signal, as the Small and Micro group has.

2 – The second driver for IJK is the historical ritual of the renewed flow of funds into 401ks and other retirement vehicles known as the “January Effect”.

Where the January Effect is felt most dramatically is in, you guessed it, the Smids. Therefore, it is quite reasonable to assume that as 2008 gets underway, the January Effect will join the funds already at work by the flushed with capital hedgies to help get the New Year off to a good start for the Mid caps.

Now that we know the who and the when, let’s fine-tune our work to identify the where.

3 – The third driver for IJK is what is known as the growth scarcity factor.

Most of the time, value outperforms growth. However, as Rich Bernstein at Merrill has noted numerous times before, when growth becomes scarce, growth tends to outperform value. Since growth rates for corporate earnings are expected to decline for the next several quarters, the growth scarcity factor suggests that the outperformance by growth over value that has emerged these past four months (across all size classes, I might add) has a good chance of continuing for a while longer.

Investment Strategy Implications

IJK is a good actionable idea for anyone seeking to get busy living at a time when others are “institutionalized” in their fear of the unknown, the possible, and the maybe. See you Zihuatanejo.

Note: The above is strictly for informational purposes and should not be construed as a recommendation to buy or sell any securities. Please consult your financial advisor. Neither Vinny Catalano nor any member of his family owns the above referenced securities. Accounts managed by Blue Marble Research do have positions in the above referenced securities.

The Enduring Bull Market

excerpts from this week's report:

“Quite a few people have been asking lately why on earth the equity market is so high, but I make no apology for joining them. If the Dow can rise 540 points in two days - as it did last week - something rather odd is going on.”

So writes Tony Jackson in today’s FT commentary, “Glum conclusion is equity investors are still in denial”. And herein lies the problem with viewing the equity markets solely through the prism of the real economy.

For while nearly all the references in Mr. Jackson’s commentary today cannot be disputed, one can be correct in factors pertaining to the real economy yet wrong when factors pertaining to the financial economy (the markets) are at odds with or offsetting the real economy issues noted.

Yes, there are ample reasons to be concerned re the credit crunch. Yes, there are many causes for concern re the credit crunch and its potential effect on emerging markets and the damage that can be done to the decoupling argument. And, yes, the markets may be foolish to be “starting to price in a return to more normal profitability after a long and exceptional bonanza.”

All true, all logical, and all flawed if one chooses to ignore the counterbalancing factors of valuation, equity market liquidity (as in the hands of hedge funds and private equity players), and the conditions favorable for decoupling.

Moreover, while fundamentally oriented investors may choose to, I believe that ignoring the technical analysis factors is done at one’s own financial peril.

Here are a few comments on each of the positive points noted..."

also in this week's report:

* Expected Return Valuation Model
* Model Growth Portfolio
* Investor Sentiment Data
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Searching For The Magic Formula

To some, the powerful two-day stock market rally was all about the prospects of the Fed cutting rates. While this no doubt was a contributing factor, the larger issue that may have been lost in the noise of rate cuts is the attempt by the Fed and other interested parties to secure the core of the financial system (i.e. big banks). Those at the periphery of the system can break down (hedgies, private equity, mortgage bankers and brokers, even investment banks), provided their problems do not metastasize inward toward the core of the system.


What seems to also be lost in all the noise re rate cuts and traditional real economy stuff is the concurrent effort of the Fed and other interested parties in fixing what got broke. Specifically, the financial model that gave us the Great Moderation (lower rates, low inflation) and all the wonderful real economy benefits complements of Globalization.

Perhaps it is the street kid in me but I find it rather curious that earlier this week the Fed pumped $8 billion into the system followed by ADIA (Abu Dhabi Investment Authority) pumping $7.5 billion into Citigroup (a core of the system entity) at the same time Fed Vice Chairman Kohn gives a speech widely interpreted as communicating the Fed’s intention to do whatever it takes to maintain the monetary boat. Random events? Reactionary decision-making? Maybe not.

In my view, what is happening is an attempt by the Fed and other interested parties to find that magic formula that can both secure the core of the system and invent a new and improved financial model, one that will enable the Great Moderation to live another day.

The core of the system cannot break down. The Fed has stated as such many times over (read just about any speech by Bernanke and other important Fed heads and you will hear this theme stated explicitly or implicitly). Now, this is not to say too big to fail is part of the policy solution currently being orchestrated the Fed and other interested parties with its attendant moral hazard implications. However, failure in the core of the system has very different meaning as in a managed transition to another entity that can ensure the system functions effectively. Think ADIA and Citigroup.

Investment Strategy Implications

The big equity markets' hurrah of the previous two days was about more than a simple rate cut. It was about the perception that the Fed and other interested parties seem to be making progress toward reestablishing a secure core of the financial system and reinventing the magic formula of economic peace and stability to the system, the markets, and the real economy.

To be sure, more pain is headed the markets way. Yet, unless one believes that the mark-to-market pain will aid and abet a US recession, which will precipitate a global slowdown or worse, which will thereby produce a double-digit decline in corporate earnings (see the Expected Return Valuation Model in my reports*) while at the same time the Fed and other interested parties are too dumb and lack the innovative wherewithal to work their way out of this mess, the credit derivatives problems of yesterday and today are fast becoming old news. And old news does not move markets. New news does. And the new news is the progress made toward reinventing the magic formula.

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Here Come the Vultures

Dinnertime!



At my last hedge fund/alternative investments seminar in Austin on October 25th, I sought the views of my expert panelists re the current credit crunch and what they thought the severity of the damage would be. The response by two of my panelists was most interesting, to say the least.

The two panelists, both credit experts, were nearly beside themselves with joyful anticipation. Why? Because they planned to exploit the situation by scooping up bargains from the chaos and fire sales unfolding.

So, when we hear stories re the hedgies and private equity boys and girls working overtime to reallocate their assets to join the bargain hunters seeking to benefit from the pain caused by the credit squeeze, we should not be surprised. Thanks to abundant liquidity, the hedgies, private equity, and asset managers with similar interests and abilities as my two panelists are forming a floor under the current credit debris and, in the process, are helping to bring to it to closure.

It is, therefore, reasonable to assume that the primary point made in yesterday blog posting re Sarbanes-Oxley and the cleaning up of the books before the year is out will likely become some of the prime assets the bargain hunting hedgies and company will be interested in. The CEOs get what they want – clean books and no personal lawsuits – and the hedgies and company get what they want – great bargains. A win win. As for the investors in the affected companies and the sub prime and other credit borrowers, however, one can only say, “You’re din din.”

Investment Strategy Implications

Winston Churchill, a man well acquainted with times of stress, once said, “The pessimist sees difficulty in every opportunity. The optimist sees the opportunity in every difficulty.” I think it is fair to say that, despite their unsavory reputation, vultures are opportunistic.

So, equity investors should rest assured that these scavengers will help facilitate the end of the current credit crunch thereby enabling all to rejoin the liquidity party.

Come and get it!

The Dog Days of Contrarian Investing

In his soon to be published quarterly report, legendary value investor, Bill Miller, makes the following observations:

“This market has been remarkably serially correlated. In plain talk, what has gone up keeps going up, and what has not, does not. Valuation has not mattered at all. What has mattered is price momentum. This is very similar to what we saw with tech, telecom, and internet names in 1999. It is not yet that extreme, but it is pretty extreme.

The best quintile of stocks based on traditional valuation factors such as price to earnings, price to book, price to sales, and dividend yield, has underperformed the market by over 1000 basis points this year. The best quintile on price momentum alone, using 3 and 9 month price trends, has outperformed by 1400 basis points.”

Mr. Miller’s comments highlight several points that have been repeatedly raised on this blog and in my reports – namely the highly correlated nature of the equity markets. Two questions are related to this point: Why are markets so highly correlated and how should an investor exploit the situation?

As noted many times before, the highly correlated nature of the equity markets is due in large part to the enormous sums of actively-traded money that is in the hands of the hedge fund and other momentum lemmings. Bereft of original ideas, many hedge fund managers have little recourse than to chase the trades that ensure their relative performance record does not fall so far behind their counterparts (code for keeping my house in Greenwich).

Naturally, it should be assumed that these very same hedge fund managers believe that they have systems and investment strategies designed to gain alpha. At least that’s what the marketing material says. The sad fact is, however, the results are just not there. Since the proliferation of hedge funds, the performance results has regressed to the mean, so much so that there is little to no difference between the on average underperforming hedge fund manager and the on average underperforming mutual fund manager. (The only real difference is the compensation scheme.)

Moreover, logic dictates that there are only so many truly original strategies thereby limiting the arbitrage and other alpha generating strategies available. Put another way, how many brilliant 20-something money managers can there be? Hence, lemming-like momentum investing.

If this be the case, how does an investor exploit the situation?

Investment Strategy Implications

There is every reason to believe that hedge fund managers pressured to justify their high fees will be even doubly pressured these last two months to produce as much alpha as conceivably possible. Therefore, if price momentum investing is the dominant approach taken by many such market players, the odds are that, from now until December 31st, what has worked will continue to work meaning that bottom fishing and contrarian plays will likely underperform and the winners of 2007 will remain so, if not accelerate until the books close for the year.

The momentum game is here to stay. At least through the end of this year and likely into the early part of next year. Contrarian strategies, like the kind that Bill Miller advocates, will likely remain the least attractive approach to investing for some time.

No doubt, the day will come when being a contrarian will pay. However, for the reasons stated above (and others noted in prior blog posting and reports), I don’t believe that day is today.

Actionable steps: For predominantly US investors stay overweight the weak US dollar and global growth story of Info Tech, Industrials, Energy, Gold, and Large Cap Growth. Stay underweight the US consumer related themes of Financials and Consumer Discretionary. For global players sell China into strength, stay long Europe large and mega cap (Europe 350 – IEV) and a proportionally balanced mix of emerging market issues.

Specific investment recommendations can be found in the Model Growth Portfolio (MGP), which is available only to subscribers. MGP performance results are noted on the upper left portion of this blog.

SMIDs: Not Dead Yet

Of late, there has been much talk heralding the death of the SMIDs. Based on the following, such talk is premature.

As the first chart above shows, beginning in the spring of last year the US equity markets have experienced three corrections – two minis (< 10%) and one that briefly exceeded the fabled > 10% level (this summer). Over the course of the three corrections, the SMIDs have trailed the large and mega cap styles by a fair amount leading some to conclude that the SMIDs era of outperformance is over. I say, not so fast.

Without a doubt, the fundamental argument for underperformance is a strong one. SMIDs are largely domestic US companies and, therefore, will suffer the consequences of a weakening US economy to a greater degree than the large and mega cap companies who receive a greater portion of their revenues and profits from the global growth story than do the SMIDs. Adding to this argument is the forecast for a weak US dollar, which helps US export companies, the same large and mega cap group.

While I do not disagree with the fundamental reasoning, the technicals of the SMIDs are only one half as bad. Specifically, the deteriorating relative strength shown in the first chart is fairly clear and makes plain that the quality migration cycle is well underway as money moves from lower to higher quality issues*. However, applying the longer term moving averages principle (see second chart**) argues that whatever problems do and might afflict the SMIDs, it hasn’t shown up in a violation of its longer term mega trend.

Part of the answer for this persistent strength resides in the hedge fund world and the need for alpha via higher risk bets. With liquidity still very high and the pressure to perform always on very high, hedgies have little choice but to find the bets that generate whatever alpha they can get their hands on. Another supportive argument is the fact that valuation of the SMIDs versus the large and mega group is not excessive. P/Es and PEG ratios are right around the large and mega cap rates. Lastly, part of the argument for a SMID underperformance or even negative return rests with weakness in the US dollar. Now, while there is little disagreement re the long term direction of the US dollar (down and dirty), over the very near term the large speculator bets have become so lopsided to the short side (third chart) that what is known as a crowded trade has developed which presents the potential for a counter rally in the dollar over the near term. Such a rally would help allay some of the dollar related fears for the SMIDs.

Investment Strategy Implications

Without question, where you want to be is in the big boys' space. However, there remains many SMID bets that can work and, while the bulk of an investor’s assets belong in the large and mega cap space, investors should not shy away from selective opportunities in the SMIDs.

*Smaller cap = lower quality, large cap = higher quality.
**The small cap ETF, IJR, is illustrated. The same picture is seen using the Mid Cap ETF, MDY.

Note: to view a larger version of the above charts, click on the image.

Hedge Fund Seminar Data Points - Day 2: The Power to Exploit

Sometimes the deeper you dig the more you get to appreciate the many nuances and special wrinkles that make up a given complex subject such as alternative investments. Such is the case with yesterday's hedge fund seminars that I conducted. To my ear, two points among the many superb and often insightful comments made by my excellent expert panelists stood out and I share them with you here.

At my luncheon session, Rob Blabey with Jim Hedges' firm noted that there are no secrets among hedge fund players, particularly the equity players who are reasonably well informed. As with traditional positions (say long only) taken by your typical portfolio manager, the positions taken by most hedgies are fairly well known among those who make it point to know their markets. This occurs despite the opacity that is part and parcel of a largely unregulated business because the information network can be rather porous in areas. Nothing new here. However, where this gets most interesting is when things go wrong.

During such times, the Darwinian approach to money management kicks in and those that are in difficulties are left to twist in the wind until the pain can be taken no more. The pack then swoops in and makes the most hay out from the residue of the bad bet made.

I suppose none of the above should come as a surprise. It is, after all, the nature of the free market system. You place your bets, you take your chances. I guess I just never gave it much thought as to how ruthlessly it all plays out, especially during times of market stress.

The dinner session produced a piece of actionable information for all investors.

As this year wraps up in a couple of months, there is likely to much window dressing conducted by the hedgies. Given the summer experience of the pre Bernanke put era ("we didn't bail anyone out", wink, wink) and the fact that so much remains to be uncovered (including the real value of the assets on the books), it is quite reasonable to assume that many market-related cross currents will continue to occur and will likely intensify as the year comes to a close. For with the end of the year comes the auditors and audited investor reports as well as the performance fees "earned". Since mark to the market is still absent from many alternative investment instruments, alternative pricing methods (mark to model, to ratings, to marketing, and/or to myth) set the stage for a number of potentially suspect "transactions". With so much money (and careers) at stake, the free market system operating in a largely unregulated space could produce a number of, shall we say, interesting "transactions".

Investment Strategy Implications

There will be additional points in next Monday's weekly report (subscription required). For now, the central issue is the exploitative mindset that the rest of us, the more traditionally-oriented investor should develop. When it comes to thinking about the alternative investments space, much like the Darwinian example above, it is what an investor can do to exploit the situation that matters most.

With knowledge comes power. From an investment perpsective, that power is expressed in the ability to exploit the situation.

For despite the once in a century storm that actually occurs every five years*, alternative investments (hedge funds, private equity, structured products, etc.) are here to stay. An investor's mission, therefore, is not to bemoan the situation but to exploit it. The power to exploit is in the ears and minds of all investors attuned to changed game of investing.

*With the implications for equity valuation models via the destruction of the normative bell curve distribution of returns. A point made before and one that I will return to in future reports and blog entries.

Hedge Fund Seminar Data Points - Day 1

Every Hedge Fund/Alternative Investments seminar I conduct produces a wealth of useful and insightful information. Last night’s kick-off event in Tampa was no exception.

The first points of value I wish to share comes via Tim Hayes the highly regarded Chief Investment Strategist from the equally highly independent research firm, Ned Davis Research. In Tim’s excellent handout are three data points (among many) that I found particularly interesting:

* Of 7,300 hedge funds, the largest 200 account for 75% of hedge fund assets. 40% of hedge funds don’t last five years. (source McKinsey & Company)
* A Greenwich Associates survey indicates that during the next three years, 34% of U.S. institutional investors plan to increase their investments in private equity, 22% to increase investments in hedge funds.
* At the end of September 2007, monthly dollar flows into Exchange Traded Funds by hedge funds reached a record $19.9 billion, eclipsing August’s record at just over $14 billion.

Three initial conclusions reached by all three of my seasoned and well experienced expert panelists (which included D. Scott Luttrell of LCM Group and Daniel O'Conner of M&I Investment Management) is that high end, high quality hedge funds will weather the storm quite well, with many exploitig the misfortunes of their lesser talented peers; for most investors, sticking with the better run, better disciplined fund of funds managers is superior to selecting individual hedge fund managers (the data supports this view); and that the effects of the recent credit crunch will be felt more on existing deals and private equity.

I will provide today's two events and their insights and comments in tomorrow's blog entry.