So Many Worries, So Little Concern.
Riddle: What do volcanoes, Government bureaucrats, oil rigs, nuclear terrorist attacks, Chinese inflation, Greek tragedies and dead comedians all have in common? Hint: they’re all related to the US equity markets. Give up? Answer: despite massive negative headlines regarding the first six items the US equity markets have taken very little notice in the way of profit taking, continuing their slow upward trend and earning a nickname from the seventh: the “Rodney Dangerfield” rally. After a brief sell-off following the news of the SEC fraud case against Goldman Sachs for some probably legal but seemingly unethical behavior just prior to the Financial Meltdown of 2008, which took more in market cap off the US equity markets than the entire value of Goldman itself, the Markets resumed their climb and the S&P 500 and Dow gained 2.1% and 2.5% respectively for the week. The so called “risk trade” was back in fashion as evidenced by the small-cap Russell 2000’s corresponding strong 3.8% gain. Even a 6% slide in the Shanghai Composite on further Chinese Government tightening, it biggest since January, couldn’t pour cold water on the US markets for long. After spiking to near 20 on the Goldman fraud case news, the VIX fell back and remained below 17 for the week.
So with a stock market rally amidst all the negative headlines, a rally that is almost universally proclaimed as “having no respect,” it seems we are climbing the so called “Wall of Worry,” that quaint old Wall Street term for a rising stock market in the face of general pessimism about the economy and Market itself. Well, maybe. According to the Investment Company Institute last month, equity mutual funds consumed their excess cash at the fastest rate in 18 years, leaving them with the smallest reserves since 2007. Cash as a percentage of holdings dropped to 3.6% of assets in March, down from 5.7% in January 2009, the quickest decline since 1991. According to the ICI the last time equity managers held such a small proportion was in September of 2007, a month before the S&P 500 began its 57% drop. This would signal that investors are already fully invested, a sign that optimism, rather than a wall of worry, prevails on Wall Street. However, this ICI data point just measures cash on hand within equity mutual funds, whose mandate is to spend their available cash in the stock market anyhow. Looking at other, non ear-marked, sources of cash, more recent data shows that investors have still have nearly $3 trillion in money-market funds as of the end of last week and although this number is down 25% from a year ago, the year ago number represented the peak in money fund assets during the Financial Crisis. The current money market balance is roughly the same as it was at the beginning of 2008, after the equity markets had already experienced a full quarter of fund redemptions from the markets’ peak in October 2007. In addition to the money market data, ICI shows that flows into equity funds through the end of last week slowed significantly while flows into bond funds continued strong and outpaced that into equity funds at almost a 3:1 rate, in line with its average this year. All this signals that if the markets are rallying due to complacency, euphoria and the so-called “dumb money” rushing in, it sure isn’t supported by the data. The Wall of Worry, then, just might be intact and growing.
A word on Goldman Sachs. We aren’t securities attorneys (thank God!) and so will not pass judgment on the culpability of Goldman vis-à-vis its purported actions. We are, however, market watchers with a background in the analysis of financial services firms. Our only comment on this whole controversy is a reminder that the tangible assets of financial services firms go up and down the elevators each day—that would be the employees—and that the intangible assets are written on air—that would be their reputations. Merrill Lynch, Bear Stearns and Lehman Brothers failed due to leverage and the failure to manage the risk thereof. That isn’t the case here so we look further back in history for guidance on the possible fate of Goldman. Unfortunately, we are old enough to recall Drexel Burnham Lambert, E.F. Hutton and Kidder, Peabody as potential examples. These brokerage firms failed not due to excess leverage or bad financial management, but due to the rapid loss of market reputation and, thus, market clout. In all cases it was the actions of certain employees who set the cataclysmic chain reaction in motion. Whether or not Management was involved was irrelevant as the questionable behavior was seen as symptomatic of the corporate culture of each firm. However it began, the reputational impact was the beginning of the end. We don’t suggest that this fate awaits Goldman but, perhaps more likely, it does await its current Management.
Despite Wall Street being labeled as monopolists by the current Administration, its bread and butter business is, in fact, largely a commodity. This has two implications of which to be mindful: First, if you operate in a commodity business, your only edge is your reputation and that can be fleeting. Goldman Management--and investors in its stock--beware. Secondly, for all other investors, know that in a commodity market, no one firm is indispensable and many participants can come and go without causing harm to the health of the overall market. Despite what they would have you believe, Goldman doesn’t have a monopoly on brains, creativity, innovation or market influence. When Drexel folded the junk bond market remained healthy and vibrant. BBB or lower companies could still access the capital markets and the existing “junk” in investor hands could still be traded. Other firms quickly sprung up to fill the void, many with ex-Drexel employees at the helm. Yes, a Goldman failure (and we aren’t suggesting this) would send ripples through the financial markets but just as ripples in a pond, these will fade with time reestablishing the earlier relative calm. Should Goldman fold or exit certain markets the capital markets will remain liquid, strong and healthy and other firms will emerge to fill whatever void might be created. And if all Wall Street firms are restricted in how they do business in certain products or markets, remember the Wall Street is all about innovation…there is no way a bunch of bureaucrats and regulators can keep up with the new products that will be created. So our word to investors is that while Goldman Sachs stock itself is probably not worth the risk of committing more money at this time, the overall market, should it sell off on any negative news regarding Goldman, certainly is. Just maybe avoid investing in Hamptons’ and Upper East Side pre-War real estate for the time being…
Monday, April 26, 2010
Monday, April 19, 2010
Monday, April 12, 2010
Ramblings of a Portfolio Manager
The VIX and the “Smart Money Index”
The VIX, or CBOE Market Volatility Index, is an index created in 1993 by the Chicago Board Options Exchange to track market volatility as an independent value, which can be traded on major exchanges. The VIX is calculated based on options prices and activity in the S&P 500 and measures the Market’s expectations of near-term volatility and, thus, many market watchers use it as an indicator of investor sentiment, with high values implying pessimism and low values implying optimism. The VIX itself has been a quite volatile security in recent years, hitting an all-time low of 9.39 in December, 2006 and spiking to 89.53 in October, 2008 at the height of the global financial crisis. Currently, the VIX is trading around 15 meaning that, because mathematically the VIX is expressed as an annual percentage, the market is expecting a 15% change in price (plus or minus) over the next year.
The market has developed a great deal of lore regarding the VIX over the years and it is now often referred to as the "investor fear gauge" because it has a tendency to rise sharply when markets are under stress. Investors, however, tend to be divided over the meaning of the VIX with some seeing it as an indicator of investor confidence and, thus, higher stock prices ahead, while others view it as a contrary indicator of euphoria and complacency implying risk to stock prices going forward. In reality, the VIX is not a measurement of sentiment at all but of implied volatility. Since implied volatility is highly correlated to actual volatility, the rise in the VIX during periods of market turmoil is the result of the increase of volatility itself rather than a change in investor sentiment. Further weakening the VIX usefulness as a sentiment indicator is all the available synthetic methods of hedging risk that have been created over the last decade, which essentially have disenfranchised the S&P options market as the primary source of hedging for many investors.
So what can we make of the fact that the VIX is currently trading at a 52-week low? Well, taking the strict definition of the index, the implication is that investors are not expecting a great deal of market volatility in the near to medium term. Taking the looser “fear” gauge definition, it means that investors are getting comfortable with the levels of the market. By either definition that’s probably good news for individual investors but not so for the “sophisticated” crowd, who make their living hedging and trading off of volatility. This group includes day traders, high frequency traders and hedge funds. In fact, the numbers are starting to bear this out. Through Friday the S&P 500 index was up 7.7% year to date and the Russell 2000 index of small cap stocks was up a whopping 12.8%. With the expectation of volatility along with the “fear” gauge so low, investors are willing to “put on the risk trade,” meaning they are eschewing safer investments for risky assets like small cap stocks. The hedge funds, however, have missed this trade and are showing the impact of the lack of volatility on their returns. Through Friday the HFR Equity Hedge Index was up 1.52%. A more aggressive hedge fund index, the Greenwich Alternative Investments Index, is up only 2.9% year to date. Hedge funds only make the real money for themselves if they make money for their clients and so far that isn’t happening in a big way. So for the hedge funds to have another good year, they need to cover their short positions in hopes the market continues to go up or stay short and pray for a correction. In the first case, that implies further fuel for the “melt up;” in the latter it implies buying support in any pullback. Either way, for individual investors, barring some exogenous event, the VIX is likely to remain low and the slow grind up the “wall of worry” is likely to continue. By the way, has anyone noticed that we stealthily creeped through Dow 11,000?
The VIX, or CBOE Market Volatility Index, is an index created in 1993 by the Chicago Board Options Exchange to track market volatility as an independent value, which can be traded on major exchanges. The VIX is calculated based on options prices and activity in the S&P 500 and measures the Market’s expectations of near-term volatility and, thus, many market watchers use it as an indicator of investor sentiment, with high values implying pessimism and low values implying optimism. The VIX itself has been a quite volatile security in recent years, hitting an all-time low of 9.39 in December, 2006 and spiking to 89.53 in October, 2008 at the height of the global financial crisis. Currently, the VIX is trading around 15 meaning that, because mathematically the VIX is expressed as an annual percentage, the market is expecting a 15% change in price (plus or minus) over the next year.
The market has developed a great deal of lore regarding the VIX over the years and it is now often referred to as the "investor fear gauge" because it has a tendency to rise sharply when markets are under stress. Investors, however, tend to be divided over the meaning of the VIX with some seeing it as an indicator of investor confidence and, thus, higher stock prices ahead, while others view it as a contrary indicator of euphoria and complacency implying risk to stock prices going forward. In reality, the VIX is not a measurement of sentiment at all but of implied volatility. Since implied volatility is highly correlated to actual volatility, the rise in the VIX during periods of market turmoil is the result of the increase of volatility itself rather than a change in investor sentiment. Further weakening the VIX usefulness as a sentiment indicator is all the available synthetic methods of hedging risk that have been created over the last decade, which essentially have disenfranchised the S&P options market as the primary source of hedging for many investors.
So what can we make of the fact that the VIX is currently trading at a 52-week low? Well, taking the strict definition of the index, the implication is that investors are not expecting a great deal of market volatility in the near to medium term. Taking the looser “fear” gauge definition, it means that investors are getting comfortable with the levels of the market. By either definition that’s probably good news for individual investors but not so for the “sophisticated” crowd, who make their living hedging and trading off of volatility. This group includes day traders, high frequency traders and hedge funds. In fact, the numbers are starting to bear this out. Through Friday the S&P 500 index was up 7.7% year to date and the Russell 2000 index of small cap stocks was up a whopping 12.8%. With the expectation of volatility along with the “fear” gauge so low, investors are willing to “put on the risk trade,” meaning they are eschewing safer investments for risky assets like small cap stocks. The hedge funds, however, have missed this trade and are showing the impact of the lack of volatility on their returns. Through Friday the HFR Equity Hedge Index was up 1.52%. A more aggressive hedge fund index, the Greenwich Alternative Investments Index, is up only 2.9% year to date. Hedge funds only make the real money for themselves if they make money for their clients and so far that isn’t happening in a big way. So for the hedge funds to have another good year, they need to cover their short positions in hopes the market continues to go up or stay short and pray for a correction. In the first case, that implies further fuel for the “melt up;” in the latter it implies buying support in any pullback. Either way, for individual investors, barring some exogenous event, the VIX is likely to remain low and the slow grind up the “wall of worry” is likely to continue. By the way, has anyone noticed that we stealthily creeped through Dow 11,000?
Tuesday, April 6, 2010
Ramblings of a Portfolio Manager
When Will The Individual Investor Return To The Stock Market?
Market strategists like to look at dollar flows into and out of mutual funds as a sentiment indicator for the overall health of the Markets. The Investment Company Institute (ICI), a non-profit organization whose members are the majority of investment companies registered with the Securities and Exchange Commission, publishes a monthly report detailing net flows into domestic and international stock funds, bond funds and money markets. ICI is seen as the Industry standard source of mutual fund trends and tends to be the most reliable. In its monthly report new sales, redemptions and exchanges are netted out to show a "net new cash flow" figure, which can be positive or negative for a given period. Average cash levels at stock funds are also shown in the report. The ICI data is often looked at as a guide to retail investor behavior as institutional money and individual shareholders are excluded from the ICI report.
Many strategists believe that strong flows into stock mutual funds indicate that retail investors have become more confident in the Markets signaling further gains ahead. Some economists, however, view fund flows as indeterminate at best with some seeing them as a contrarian indicator or false positive on the future direction of the markets. In their view, individual investors are always “late to the party,” committing more money to the stock market after it has already run up and has received a lot of positive press and mainstream news coverage. In their view the behavior of the so called “dumb money” should be looked at as a negative sign. They often cite as an example the behavior that occurred in the last few months of the stock market peak back in early 2000. At that time, equity fund flows were at record levels those first few months and, of course, the stock market began a steady decline soon after, with the major indexes dropping more than 50% in the next year.
So what is the individual investor doing with his or her money these days? According to ICI equity funds had estimated inflows of $3.23 billion for the week ending March 24th. This is slightly down from the estimated inflows of $3.51 billion in the previous week. Domestic equity funds had estimated inflows of $1.55 billion, while estimated inflows to foreign equity funds were $1.68 billion. Hybrid funds, which can invest in equities and fixed income securities, had estimated inflows of $990 million for the week, compared to estimated inflows of $1.07 billion in the previous week. While inflows into equity funds slowed week over week, bond funds continued their trend of strong investor appetite with estimated inflows of $9.24 billion, up from their estimated inflows of $8.85 billion during the previous week. Taxable bond funds saw estimated inflows of $8.16 billion, while municipal bond funds had estimated inflows of $1.08 billion.
This fund flow data suggest that mutual fund investors remain in defensive mode, preferring bonds over stocks. The trend is similar to what was seen in early 2009, just after the financial crisis began, and suggests that investors who were burned during the Market downturn of 2008 and early 2009 remain wary about joining this bull market. For the contrarian crowd, this is good news for the equity markets going forward.
Last week, however, we posited that a hiccup in the bond markets, resulting from rising interest rates, would drive investors out of bond funds and into equity funds and clearly that has not yet happened. A possible reason is that “retail investors” are not a uniform class of individuals. They are made up of people from multiple age, ethnic and socio-economic groups all with different investment horizons and risk tolerances. One very prominent investor sub-group comprises the “baby boomers.” The oldest baby boomer is just now retiring while the youngest is half way toward saving for that day. The stock market downturn of 2008 hurt many of these boomers very badly, some just at the exact wrong time. While we question why an individual close to retirement would have a significant portion of his or her net worth in volatile stocks, still even those invested in the relative “safety” of corporate bond funds were hurt in 2008. These near-retirees may now be too scared to ever return to equities or corporate bonds under the philosophy that it is better to have half a slice of pie than none. That’s a big group of retail investors to leave permanently out of the market. The $64,000 question, in our view, is will further market gains entice even these gun shy investors back in with hopes of recouping some of their losses? We think so. Dow 11,000 just may be a headline magnet to this last group of hold-outs, driving fund flows into equities and out of fixed income.
Market strategists like to look at dollar flows into and out of mutual funds as a sentiment indicator for the overall health of the Markets. The Investment Company Institute (ICI), a non-profit organization whose members are the majority of investment companies registered with the Securities and Exchange Commission, publishes a monthly report detailing net flows into domestic and international stock funds, bond funds and money markets. ICI is seen as the Industry standard source of mutual fund trends and tends to be the most reliable. In its monthly report new sales, redemptions and exchanges are netted out to show a "net new cash flow" figure, which can be positive or negative for a given period. Average cash levels at stock funds are also shown in the report. The ICI data is often looked at as a guide to retail investor behavior as institutional money and individual shareholders are excluded from the ICI report.
Many strategists believe that strong flows into stock mutual funds indicate that retail investors have become more confident in the Markets signaling further gains ahead. Some economists, however, view fund flows as indeterminate at best with some seeing them as a contrarian indicator or false positive on the future direction of the markets. In their view, individual investors are always “late to the party,” committing more money to the stock market after it has already run up and has received a lot of positive press and mainstream news coverage. In their view the behavior of the so called “dumb money” should be looked at as a negative sign. They often cite as an example the behavior that occurred in the last few months of the stock market peak back in early 2000. At that time, equity fund flows were at record levels those first few months and, of course, the stock market began a steady decline soon after, with the major indexes dropping more than 50% in the next year.
So what is the individual investor doing with his or her money these days? According to ICI equity funds had estimated inflows of $3.23 billion for the week ending March 24th. This is slightly down from the estimated inflows of $3.51 billion in the previous week. Domestic equity funds had estimated inflows of $1.55 billion, while estimated inflows to foreign equity funds were $1.68 billion. Hybrid funds, which can invest in equities and fixed income securities, had estimated inflows of $990 million for the week, compared to estimated inflows of $1.07 billion in the previous week. While inflows into equity funds slowed week over week, bond funds continued their trend of strong investor appetite with estimated inflows of $9.24 billion, up from their estimated inflows of $8.85 billion during the previous week. Taxable bond funds saw estimated inflows of $8.16 billion, while municipal bond funds had estimated inflows of $1.08 billion.
This fund flow data suggest that mutual fund investors remain in defensive mode, preferring bonds over stocks. The trend is similar to what was seen in early 2009, just after the financial crisis began, and suggests that investors who were burned during the Market downturn of 2008 and early 2009 remain wary about joining this bull market. For the contrarian crowd, this is good news for the equity markets going forward.
Last week, however, we posited that a hiccup in the bond markets, resulting from rising interest rates, would drive investors out of bond funds and into equity funds and clearly that has not yet happened. A possible reason is that “retail investors” are not a uniform class of individuals. They are made up of people from multiple age, ethnic and socio-economic groups all with different investment horizons and risk tolerances. One very prominent investor sub-group comprises the “baby boomers.” The oldest baby boomer is just now retiring while the youngest is half way toward saving for that day. The stock market downturn of 2008 hurt many of these boomers very badly, some just at the exact wrong time. While we question why an individual close to retirement would have a significant portion of his or her net worth in volatile stocks, still even those invested in the relative “safety” of corporate bond funds were hurt in 2008. These near-retirees may now be too scared to ever return to equities or corporate bonds under the philosophy that it is better to have half a slice of pie than none. That’s a big group of retail investors to leave permanently out of the market. The $64,000 question, in our view, is will further market gains entice even these gun shy investors back in with hopes of recouping some of their losses? We think so. Dow 11,000 just may be a headline magnet to this last group of hold-outs, driving fund flows into equities and out of fixed income.
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