“Inflection Day” Rally: Progress Report and Forecast

Since “inflection day”*, the equity markets have witnessed a modest increase in risk appetite. This is evidenced by several indicators (credit spreads, TAF and TSL auctions, for example) as well as by the trading action between and among various market indices.

To illustrate, the charts to your left show the risk appetite increase but it is not as uniform as one might suspect. And a few surprises are found.





Chart 1** (upper left) shows the performance from a size and style perspective. Note that the top performer is the Mid Cap group (overall - MDY, value - IJJ, growth - IJK). In the number four performance slot is Small Cap Growth (IJT). The rest (Small Cap, Small Cap Value, Large Cap, Large Cap Value, Large Cap Growth, and Micro Cap) are bunched fairly closely together with Micro Cap (IWC) at the bottom of the list.

Chart 2 (upper right) looks at the data from a US economic sector perspective. Here, Energy and Basic Materials assume their global growth story lead position. And “defensive issues” such as Healthcare and Consumer Staples are at the bottom of the list. The remaining sectors are bunched together. However, it is interesting to note who is in the number three performance slot – Consumer Discretionary.

Chart 3 (lower left) takes us to the global markets with the lead country/region held by China (FXI). The second cluster contains Japan (EWJ), Latin America 40 (ILF), and Emerging Markets (EEM). The bottom grouping is anchored at the bottom by the United Kingdom (EWU).

Chart 4 (lower right) provides a look at the BRICs. Once again, China (FXI) heads the group with Brazil (EWZ) in second place. Russia (RSX) is third. And the S&P 500 (SPX) just ahead of highly volatile India (INP)

So, what does this all mean?

Investment Strategy Implications

The above charts provide equity market performance evidence of a return to risk among investors. Higher risk styles, countries, and regions have generally produced the best “inflection day” rally results thus far. There is also performance evidence that US investors believe economically sensitive sectors such as Consumer Discretionary are likely to be near term beneficiaries of the rebate checks in the mail.

From a macro strategy perspective, however, there is much to be concerned about re the sustainability of the “inflection day” rally beyond the end of the summer.

For example, it has been argued on this blog and in my reports that the equity markets are a touch ahead of themselves, that the return of investor risk appetite (including a higher degree of comfort re earnings) is premature at best. The pain to be experienced - economic, financial, and political – going into 2009 may surprise many ready-to-return-to-risk investors. The same goes for those who seem ready to resurrect the Goldilocks scenario (is Kudlow listening?).

That said, it has also been argued here that in the very short term (as in this month), valuation levels and certain technical analysis data suggests the “inflection day” rally may fade a bit before resuming after Memorial Day (US).

Again, so what does this all mean?

I may be wrong but here goes:

Flat to down in the very short term; up through the end of summer; possible mega market top within the next six months; investor hell on earth in 2009.

*So declared by many market mavens as being March 17 – Bear Stearns bailout day.
**click on images to enlarge.
Note: All dates are from March 17 (“inflection day”) through the close yesterday.

“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.

Technical Thursdays: The Quality Migration Cycle

The Quality Migration Cycle is a very useful tool that no investor should be without. It provides the mega trend context by applying the Divergences Principle to the five size (market cap) categories – mega, large, mid, small, and micro - to give to perspective on the breadth of the mega trend in force. It assumes that size = quality, which is affirmed as such by the performance history of other quality metrics such as S&P quality ratings for stocks.

The application of QMC can be seen by looking at the first chart above*.

As the chart makes clear, the current market conditions show the beginnings of a breakdown in relative performance of the Small (IJR) and Micro (IWC) cap ETF index trackers. Lower lows for each while the remaining three size groupings have not made such a move during the recent phase of the current market correction.

The underlying principle of QMC is to help determine who is leading the mega trend parade at any given point in time. If all are marching in sync AND the mega trend parade is being led by the Smids and Micro, then the mega trend is intact. The logic being that lower quality issues should reward investors for the greater risk of owning them. However, when the mega trend parade is being led by the big boys AND the lower quality issues not only trail in relative performance but exhibit signs of breakdown (such as lower lows unconfirmed by the larger indices), then the prospects for a market topping process must be put into a potential bearish mix.

The fly in the bearish mix currently is the strength in Mid cap. It has not confirmed with a lower low but may do so in the near future. This cannot be determined beforehand. Nor should it, as indicators such as QMC are mega trend indicators helpful in making longer term market calls.

The Quality Migration Cycle helps an investor determine the market ending process of improving relative performance of the higher quality/larger issues as the lower quality sectors underperform in sequence. That appears to be the case currently. Micro failed first, followed by Small. Is Mid cap next? For that answer, see the second chart above* and the application of the long term Moving Averages Principle.

Here we see MDY on the verge of rolling over. Price is at its moving averages and the moving averages are close to crossing (50 below 200 day). However, unlike the Small cap (see third chart), MDY’s moving averages have not crossed nor are they trending down, a condition of a mega trend change as required by the Moving Averages Principle (MAP).

(see prior blog postings under the Topics Discussed category - scroll down, left side - for more on the MAP.)

Investment Strategy Implications

The QMC’s usefulness rests in providing the mega trend context as to where we are in a bull market cycle. At present, the cycle suggests that a market topping process is underway. However, a misapplication of the QMC would be anticipatory. The full cycle must be allowed to play out as what appears to be a market top may actually turn out to be a consolidation range, launch pad for the next up phase.

Context, yes. Tactical decisions (sector and style allocation), yes. Anticipatory, not advisable.

*click on the image to enlarge
Charts sourced from Bigcharts.com

Expected Return Valuation Models

excerpts from this week's report:

"For the most part, market prognosticators start with a point of view and then declare the market to be in or out of synch with that view. What happens less often is when an investment strategist starts first with what the market says is the expected return (based on variety of inputs) and then asks the question, "Do these scenarios make sense?"


On the following pages (see report) you have exactly this second approach described in the form of two valuation models – adjusted Fed Model and the Discounted Cash Flow Model.

Beginning with the assumption that the market return over any given twelve month period for large cap issues such as the S&P 500 approximates its historical long-term rate of 12%, the earnings and interest rate assumptions produce that expected return of 12% in a range of scenarios. This is expressed in the adjusted Fed Model.

From this point, we now have an easy-to-view framework from which such assumptions can now be compared with the assumed growth rate in earnings beyond the next twelve months and the implied Return on Equity that such an assumed sustainable growth would infer. This is noted in the Discounted Cash Flow Model.

As you will note, in both cases the current level of the S&P 500 assumes earnings growth, interest rates, sustainable growth, and return on equity that is at odds with most recessionary forecasts and more in line with the doomsday scenarios of deflation and depression..."

also in this week's report:

* Valuation Models
* Model Growth Portfolio
* Investor Sentiment Data
* Chart Focus: Styles
* Sectors and Styles Market Monitor
* Key Economic Indicators

To gain access to this and all reports, click on the subscription info link to your left.

Technical Thursdays: This Thing Called Moving Averages

click on images to enlarge







To paraphrase Ronald Reagan: "There they go again."

Every time the stock market’s major indices slump to their 200-day moving average, the bears come out of their caves to announce the end of the bull. As interesting as a price trade below the 200-day might be, it is a misuse and misunderstanding of how to read such trading action.

As noted numerous times before, it is far less important when the current price trades below its 200-day moving average than it is if the 50-day moving average crosses the 200-day. And even that is not as important than if both the 50 and 200 day point in the opposite direction of the established trend, which in this case is up.

Then, and only then (price below moving averages, 50 day below 200 day, both 50 and 200 day pointing downward), do you have a trend reversal.

Again:

* Price below moving averages
* 50 day below 200 day
* 50 AND 200 day pointing down

Now to take this one step further, when seeking to identify a mega trend reversal, it would help if other key indices were also experiencing a similar such episode. For example, if the twins of the Dow Theory (Industrials and Transports) or the NASDAQ and the NASDAQ 100 or the Russell 2000 were in synch with the angst perhaps then an investor might suspect a mega trend reversal was in the works.

At present, aside from the Dow Transports (second chart), the other indices noted are either at a similar juncture (Dow Industrials, Russell 2000) or nowhere near such a potential turning point (NASDAQ (third chart) and NASDAQ 100).

One additional way to evaluate the potential of mega trend reversal is to view the three market cap segments – mega, mid, and small – to see if a mega trend reversal is at hand. Once again, the data says no trend reversal has occurred, although the small cap style is in the worse shape with the price 4% below its 200 day.

Lastly, let’s go global. Here’s a short list:

EAFE (EFA) – nowhere near
Europe 350 (IEV) – nowhere near
Emerging Markets (EEM) – nowhere near
Latin America 40 (ILF) – nowhere near
Japan (EWJ) – on the verge

Naturally, other reasons to be concerned exist in some of the above noted markets, specifically overbought levels in highly speculative markets like the emerging markets. However, overbought conditions in speculative, smaller markets, while likely to experience substantial market corrections, are not systemic threats to the global mega trends in place. Only a massive plunge in concert with a breakdown in developed markets would give cause for serious concern. That is not the case thus far.

Investment Strategy Implications

For the umpteenth time: It’s a bull market ‘til it ain’t.

The momentum lemmings may scare the bejesus out of some investors with days like yesterday. However, it is advisable to keep in mind that as swiftly as the pack runs for the hills so, too, do they race right back in the game when the money flows in an upward direction. (See yesterday’s blog for the latest comment re our little furry friends.)

My advice: Never lose sight of the fact that mega trends are what matters most first, foremost, and always. The call re a mega trend drives the single most important decision any investor needs to make: the Asset Allocation decision. From that point of view come the strategic and tactical decisions of where to allocate one’s assets and when to expand or contract current and prospective positions (what I call modified market timing).

The great value in technical analysis is keeping one in or out of the game when emotion, personal circumstances (a/k/a loss aversion), or fundamental logic dictate otherwise.

Investing is a dynamic, perpetual social science experiment that is both rational and irrational. Therefore, to the best of one's ability - Identify then Exploit the behavior.

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.

Info Tech, Growth Investing, and the Crowded Trade

“…every monetary tightening cycle has almost always produced a financial or economic crisis, which in turn has marked the beginning of a new reflation cycle.”

Bank Credit Analyst
Strategy Outlook Part 1 – Fourth Quarter 2007, September 14, 2007

The reflation cycle is well underway. The Debt Supercycle (see report October 15, 2007) underpins the perpetual rise in assets, rolling from one to the next, producing bubble after bubble only to have the bursting bubble be resolved with more liquidity. And so the story goes.

Accompanying the Debt Supercycle is the tendency of sectors to get overowned producing a crowded trade. And an opportunity for keen-eyed investors to exploit.

I made this point several times before but it bears noting again, particularly in light of the very solid earnings news eminating out of one of my favored areas – Info Tech: Growth investors need to find growth issues to own. One of their favored areas, Financials, is now toxic. Yet, the money allocated to growth not only remains but is actually increasing as investors shift money from value to growth plays. So, what do growth money managers do when one area goes from favored to toxic? They find another area to overown. Enter Info Tech.

Investment Strategy Implications

With an end of year rally setting up nicely, the momentum lemmings are poised to act like Santa’s little helpers and get busy, busy, busy driving prices higher once we get the spookiness that is October out of the way and 2007 comes to a close. In the process, Info Tech (and Industrials) should remain very solidly in the upper quartile of performers.

Amidst the joy, however, there is one style area that certain investors still remain confused with – The Smids

Yes, large cap and specifically large cap growth appears to be the better place to invest. However, converting an underperforming Smid group into a negative return group is a mistake and runs the risk of leaving lots of money in selected areas on the table.

For reasons stated previously (including what is noted above), excess liquidity, decent earnings growth, reasonable valuation levels, and the pressure to perform will continue to help drive prices higher in the Smids. Therefore, don’t overlook the opportunities that may be buried in the Smids, particularly in the Info Tech and Industrials sectors.

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.

The Return of the Momentum Lemmings

click on images for larger view

It’s hard to make the large cap argument out of yesterday’s liquidity driven rally by the momentum lemmings. As the one-day chart of the size indices above show (first chart), the Small and Micro styles did best, while the Mid caps held their own. There are two thoughts that come out of yesterday’s hoopla.

To begin, one day does not a trend make. The recent relative performance weakness in the Smids since the S&P 500 made its high on July 19th has produced a non-confirmation similar to what the Dow Theory is now indicating (see second and third charts above). The problem with making too strong of a case for the non-confirm call is the fact that (a) only the gap between the Dow Transports high and current price is wide enough to seriously suggest that the current non-confirmation will hold* and (b) global markets range from acceptable (Japan) to strong (EAFE) to white hot (emerging markets). And that takes us right back to the Fed and excess liquidity, which is the second point.

From an equity market's perspective, yesterday’s run to new highs makes clear the folly of the Bernanke Fed’s rate cut decision as the liquidity game is (mostly) back on and, with it, is the return of the momentum lemming trade. With money still very, very abundant and the pressure to perform always on maximum, the momentum lemmings have no choice but to stampede in when the markets are hot, tending to make them even hotter and, thereby, making excess the rule of the investment land.

Investment Strategy Implications

When the Fed signaled that it was abandoning its liquidity draining efforts with the speculative guess that the US economy might be headed for a recession and, therefore, reinstituted the principles of the Greenspan era – preemption and the moral hazard risks of the Greenspan put – it, to a large extent, turned back the clock to the liquidity game that had reached excessive levels. And, in doing so, unleashed the momentum lemmings to reassert their liquidity game. (Or what Morgan Stanley's former chief investment strategist, Henry McVie, described as the "Misalignment Triangle".)

What yesterday’s action suggests is a return to the kind of bull market the momentum lemmings know and love. And with it the return of liquidity-driven speculation. There is, however, a soft underbelly to the lemmings' enthusiasm as I stand by my concerns re this month (see yesterday’s blog excerpts and report) and would lighten equity holdings into this rally. While it’s still a bull market ‘til it ain’t, I am a buy low, sell high type of guy (the antithesis of the momentum lemming).

*However, that was also the case in late 2006, only to have the Transports stage a powerful rally into early 2007 and confirm the highs. In other words, Dow Theory seems to work only if other indices are also not confirming the highs made by the Dow Industrials.

The fundamental justification supporting this technical approach to market predictions is the signal that other segments of the economy are sending via their stock representatives. In other words, if the Transports are not confirming the Industrials new highs, it is signaling that economic conditions of the companies that comprise the Transports index are experiencing earnings growth or other fundamentally oriented difficulties.

Exploiting the Growth Investor

Growth investors invest in growth stories. Therefore, when the growth story of financial innovation dropped from favor, the growth investor had a choice – stick with the losing position or seek out alternative growth opportunities.

The chart* to your left highlights the performance change that taken place over the past several months (since the credit squeeze took center stage) for two growth stories: financial innovation and technology.

We all know the individual stories each sector has experienced. What may have gone unnoticed by some, however, is the shift forced upon growth investors as many such oriented investors abandon the financial innovation growth story and, out of mandated necessity, seek out other, more reliable growth opportunities. In other words, out of Financials (XLF and the broker/dealers, IAI) and into Tech and Telecom (XLK).

Investment Strategy Implications

With earnings season upon us and as the macro story on credit problems and the Fed’s rate action fades from the front page (and most investors’ minds), the focus will now shift to the micro stories of individual economic sectors and investment styles. One aspect of this shift is the growth part of the style equation.

There are several economic reasons to overweight Tech and Telecom, especially the big cap issues. Global growth and a weak US dollar are two. Then there is the above noted style factors: A pattern that is likely to remain intact, particularly through the upcoming earnings season.

*To view a larger version of the chart, click on the image.

Technical Thursdays: Lowering the Noise Level, Focusing the Mind

The recent questionable rate cut decision by the Fed has sparked numerous speculative comments re the implications of their actions.
• Does the Fed know something re the economy that is far worse than we mere mortals are clued into?
• Has the risk of inflation increased?
• Has the risk of stagflation increased?
• Has the Fed reinstated the Greenspan put and, thereby, moral hazard?

And on it goes. Sadly, the only clear result that came out of this Tuesday’s Fed meeting is that the investor noise level has gone up exponentially. And with it so has the tendency for confusion via the mental gymnastics investors tend to go through when the applecart gets upset. So, let’s try to cut through the clutter and chatter and “keep the main thing the main thing”, as Jim Barksdale would say.

The mega investment strategy question to be answered is, “Are US equities in the process of producing a major market top?”

Last Thursday’s “It’s a Bull Market ‘til it Ain’t” blog entry (S&P at 1485) describes why stocks must be assumed to be in a bull market until the technical conditions dictate otherwise. Despite the justifiable concerns re the Fed’s recent actions noted here and elsewhere, nothing can alter the fundamental technical analysis principle that a bull market is a bull market until it forms a major market top. Since that has not occurred, the relevant question becomes, “Is it in the process of doing so?” The answer (as it was last fall) is maybe. And here is where anticipation is most essential to successful investment strategy decision-making.

There are two primary* technical analysis conditions that would signify a major market top: Divergences (Size, Dow Theory, and other key indices) and Moving Averages. I have described divergences re Dow Theory last Thursday and moving averages on August 2nd (see prior blog entries). I have also touched on key aspects of divergences re Size (market cap) on August 23rd. Let me elaborate and update the Size issue today.

The above chart** shows the four major cap sizes (OEF, mega; SPX, large; MDY, mid, IJR, small) and the micro cap group, IWC. From a size divergences perspective, the key issue to focus on is whether new highs in the closely watched large cap SPX is confirmed by the SMIDS (small and mid). If yes, then higher highs are in store for investors. The bull is intact. If not, then a warning bell has to be rung.

As you can see, no such event has occurred, mainly because no new highs have been made in any index, most notably SPX. That’s where anticipation comes into play.

Investment Strategy Implications

If, in the coming weeks, SPX makes a new high and if it is not accompanied by new highs in the other size metrics, then you have one piece of the major market top puzzle in place. And that’s where anticipation can help focus the mind on what to look and listen for and diminish the noise emanating from the market.

*Supporting technical analysis conditions would include investor sentiment and divergences with other indices.

**To view a larger version of the chart, simply click on the image.

Technical Thursdays: Style Investing – Momentum versus Contrarian

"Bernanke says nothing new, stocks soar!"

That easily could have been the headline explaining yesterday’s lemming-like, momentum driven stampede back into stocks. Which raises the issue just what is the investment style of most professional investors?


I don’t know if anyone has the data on this, but the past two days of market action – plunge then surge – sure looks like most professional investors, particularly the very short term hedge fund variety, are little more than momentum players. And while this may have always been the case, perhaps it has gone to another level: Momentum players on steroids. (Note to Barry Bonds: I see a hedge fund manager position in your future.)

Now, it is a fact that correlations between, among, and within asset classes are at their highest levels ever. And knowing this fact is helpful in planning and executing exploitative investment strategies and tactics (which is what I and other good contrarian investors try to do). But what struck me about Tuesday’s plunge and Wednesday’s surge is how stocks ended each day at their respective lows and highs (see chart above).

And this leads me to speculate that the vast majority of hot money traders (at least those who are active right now) must not only be momentum oriented speculators (maybe gamblers is a more apt word to use), but that have become so desperate for relative performance that they cannot afford to risk missing any move that has appears to pick up steam. If this is the case, when the rest of the gang returns from East Hampton volatility should rise even further to levels not seen in nearly a decade.

Investment Strategy Implications

For true investors, the noise factor from this whipsaw action is deafening. So, my advice is to put on your Bose noise cancellation headphones (earmuffs, if you prefer), tune out the noise, and pick your spots where prices get out of alignment with value. The momentum lemmings may be desperate for relative performance (their third yacht depends on it) and that presents opportunities for the rest of us.

In times like these, it takes conviction and commitment both by an investor and his/her clients to be a contrarian. But isn't that what buy low, sell high is all about?

Note: To view a larger version of the chart, simply click on the image.

Technical Thursdays: Size Matters

To help gain further market strategy insight, the time frame an investor uses will influence his/her conclusions. Take, for example, large cap versus the Smids.

If an investor takes the arbitrary and artificial time frames of year to date or one year perspective, there is no shift from the Smids and Micro cap to large cap. However, if an investor starts with the far more meaningful May/June 2006 correction, a very different picture emerges, as the first chart clearly shows.

Over this time frame, large and mega cap outperform the Smids and the Micro cap sectors. In fact, the performance order is mega (OEF) over large (SPX) over Smids (MDY and IJR) over Micro (IWC).

Why use May/June 2006 as the starting point? Primarily because that is when the market’s behavior changed. That correction was the first of three (and counting) sharp corrective shocks to the equity markets, which just happened to coincide with the beginning of the end of monetary ease that is now being manifested in a credit squeeze. Moreover, it is also the start of the rise in volatility (see second chart).

Investment Strategy Implications

The investment climate changed in the spring of ‘06. And, while it may have taken investors a good year to truly appreciate that change (old habits die hard), the investment strategy implications are fairly clear: a lower portfolio risk profile is warranted.

If size equates to quality (which it does), then mega and large cap are the preferred investment styles to employ.

Note: To view a larger version of the above charts, simply 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.

The Skeptic and the Cheerleader

excerpts from this week's report

"Investment styles boil down to whether an investor is a contrarian or a momentum player. Is an investor naturally skeptical and takes with a grain of salt every news story that describes how great things are and will be for the foreseeable future? Or is that investor emboldened to join the party and shout “Booya” with every market advance?..."

"Slow growth developed countries, most notably the US, have been on a high consumption binge with capital flows rushing out the export door at a fairly quick pace. At the other end of the capital flow channel, high growth, slow consumption emerging countries gladly accept the money flows, which they then export that capital right back to the slower growing, higher consumption developed countries in the form of..."

Investment Strategy Implications

"As noted many times before, financial innovation and globalization are two major themes that are altering the economic and financial landscape in an unprecedented manner. And on a scale and scope that dwarfs previous occurrences.

Perhaps all’s well that ends well. Perhaps the concerns..."

Note: To view this week's report, please click on the Blue Marble Research services link to your left.

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.

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.

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.

Baloney Ain’t Steak

Question: What do you get when you take out Energy and Financials from 1Q07 earnings?
Answer: -3.59%.

In the midst of the all the new-high excitement, a little piece of data seems to have slipped under the radar screen of many investors: mega cap has begun outperforming all other capitalization groups.

Since the start of earnings season, the mega cap S&P 100 is at the top of the performance food chain. In fact, the performance record since April 4th shows exactly the high to low quality performance one would expect in changing times: mega over large over mid over small over micro (see chart to the left and in report).

What could possibly explain this occurrence? Perhaps the answer lies in the information noted at the top of this report: when one widens the lens to the much larger market and breaks down the data into its component pieces, the 1Q07 earnings performance data paints a very different picture.

Let’s look at the facts.

Mega over large over mid over small over micro. (see chart to the left and in report)

Interestingly, this now matches the one-year performance data noted in last Thursday’s Special Report. (see chart in report)

I suspect the answer to this shift lies in the data compiled by the Wall Street Journal on the much larger and broader 769 companies that have reported thus far. As the tables and analysis on the next page show (see report), the broad market has produced the following data:

769 companies reported
Net on Continuing Operations +7.21%
Net Income +3.96%

Now, if one excludes two sectors – Financials and Energy – to get a better picture of economic performance, the results are as follows:

769 companies reported ex Financials & Energy
Net on Continuing Operations +0.55%
Net Income -3.59%

In regards to the Financials sector, a breakdown of the very solid numbers produced thus far shows that when you exclude the results from Wall Street oriented firms, the 15 - 16% growth in earnings is cut in half.

(To view all tables and charts, please see report)

Investment Strategy Implications

There are many reasons to explain why the equity markets around the world are making new highs, but an across the board strong 1Q07 earnings season is not one of them.

If mega and large cap represents the higher quality end of the food chain, then the lower end is producing a much less tasty meal. In other words, baloney ain’t steak.

(Note: To obtain access to all Blue Marble Research reports, please click on the Blue Marble Research Services to the left.)

Thematic Perspectives

“The typical long/short hedge fund has about 67% of its assets in small and medium capitalization stocks, according to a study by Morgan Stanley. A long-only institution has only 35% in these stocks. Most brokerage firm strategists believe that larger-capitalization stocks are undervalued today. If they start to outperform, hedge funds will either have to change their exposure to large-cap issues or risk lagging in relative performance.”

Byron Wien
“There is No Hedge Fund Bubble”

As noted on my blog last Thursday, mega and large cap have outperformed the Smids on a one-year basis. Moreover, as the chart on page 2 shows (see report), Large Cap Value tops the size and style performance list. However, as also noted last Thursday, the Smids have resumed their leadership roles over the most recent periods and are on the verge of making up the ground lost to their large and mega cap brethren due to last spring’s mini market meltdown.

As Byron’s comments note, the Smids are the main beneficiary of unregulated hedge fund money as performance pressures drive their investment decision-making. As I pointed out several weeks ago, much of this has to do with an increase in risk appetites. And so long as performance justifies actions, I would expect nothing to change. Until it changes on a more sustainable level.

Therefore, as with many comments made in early March, the demise of the Smids seems premature. Risk aversion had returned for the briefest of periods (a few weeks) and then it was back to business as usual.

Investment Strategy Implications

This market has parabolic melt-up written all over it. And a key driver is the liquidity flows that are so abundant around the world. Globalization has wrought money flows that find their way into many assets (financial and real) in our borderless world. While Financial Innovation has produced new, powerful instruments, such as hedge funds and private equity, that utilizes the highly liquid fund flows.

Byron’s views help put things in perspective. As he states in his commentary, “hedge funds represent an evolutionary step in money management. They are here to stay and the funds under management are likely to continue to grow larger over time.” When coupled with that other juggernaut of unregulated money, Private Equity, the game has most definitely changed.

As long as liquidity remains abundant and valuation justifications can be found, performance pressures and competition will likely drive financial assets higher. However, make no mistake: the liquidity game can turn on a dime. Put differently, downside volatility can alter the market’s direction fairly quickly, as the largely unforeseen market drops of last May/June and late February/early March demonstrate.

The dynamics of the markets have changed. And unregulated money is at the forefront of that change.

GEM (government, economy and the markets) Implications

The impact of unregulated money on the real economy and the markets are strong and obvious. Tied in with liquidity and leverage, the impact has and will continue to be felt for the foreseeable future. In both directions. When, not if, the political dimension comes into play will depend on when, not if, a major financial crisis erupts.