Zero Beta

Is this Selloff Too Scripted?

This morning I woke up to the futures rallying like crazy and said to myself - this is just a headfake - I expect a selloff midday as those who are bidding up the futures sell their positions.  Just as AHM started trading - 9 bucks below its last appearance on the tape, my morning thought came to fruition.  This made me think. The last week has been basically what myself and many other bloggers have basically been writing about for some time. 

I don't mention this to boast or brag but instead for the complete opposite reason.  It seems like we are watching some bad movie that we figured out halfway through.  We all know that art imitates life, but for something to be artistic it must feel like it is real and not scripted.  Is it just me but for the last week has life imitated art?  We all have written this script months prior - some even for years.  Speaking only for myself - the script that I had written was always something that I thought would never occur.  At best I figured it would be like a novel that was adapted for TV - with plot changes and characters added and removed.  I anticipated some "ad-libbing" by the market and some "creative" revisions but up until now have not been surprised one bit. In fact, the only surprise has been that there hasn't been one.   

Some people would take this moment and boast and brag.  They would make up for the numerous times they were told that they were crazy and silly to be bearish by all their friends and colleagues.  I know, however, that life can rarely be scripted and those who believe they can are soon proven wrong.  If I was the only one who had thought this I would feel more comfortable in the "randomness" of such an occurrence - but many others have felt this way and are a very active voice in financial media. These same people (myself included) share a belief that the crowd is usually wrong at times like these.  Are we not the crowd now?

Robert Burns wrote, "The best laid schemes o’ mice an’ men / Gang aft a-gley.”  This week has shown that the the bankers, hedgies, and PEons have had plans that have failed, but we must think how our own plans have come to fruition and remember the same quote. 

Most market collapses and great transitions are not as predictable.  One can say that the Tech Bubble burst was to some - but 9/11 caused them to take a red marker to their script.  These leaves me with one question... 

If we all have had it figured out, then what are we missing?  What do we have wrong?

Comparing Today’s Market Selloff to February’s Correction

Today's selloff was only a fraction of the selloff that we experience back on February 27^th.  In fact in the book of market selloffs today is merely a footnote when evaluating severity.  But I think it is important to look at these lower probability events – whether it be a huge rally or ugly selloff – as it can give us clues to the evolving market psyche.  Let's see how today compares to the February's panic.

1. Internally vs. Externally Driven – The selloff in February followed a enormous selloff in China.  This time, the Chinese Markets have been on fire and gave no "signal" to the US markets about impending doom.  Many people tried to blame the plunge in China for February's selloff but the same blame can not be assessed this time.  While February's selloff opened the door for terms such as "sub-prime" to be added to the mainstream media lexicon in the days following, today's selloff was dominated by the terms.  I know in reality, things are much more complex, but it seems to me that the fear that drove the selloff in February was viewed through a window looking out on China and the global economy, whereas the fear today was viewed through a mirror looking at ourselves and our domestic economy.  This selloff was primarily a secular one, driven by internal factors.  Whether the effects spread globally will remain to be seen.
   
2. Deleveraging – February's correction involved a deleveraging abroad – China raising margin requirements.  Today's involved another type of deleveraging – the realization of subprime spreading and more importantly, the death of CDO's.  Leverage has produced liquidity which has driven markets.  When that is taken away the markets appear to get cranky. 
   
3. Indicators – In February, the selloff came on a day where durable goods orders came in awful.  This is a leading economic indicator.  Today's selloff came without any major economic indicators but alongside weak lagging indicators – corporate earnings.  An optimistic bull market sometimes shrugs off leading indicators and waits for lagging confirmation to selloff.   The selloff in February was quickly forgotten as the earnings season began and the lagging indicators eschewed away and fears.  It will be interesting to see how the rest of earnings season plays out and how it coincides with many leading economic numbers coming out such as Durable Goods orders. 
   
4. Technically Speaking – Technically, the selloff in February seriously broke trend.  It came at a time of very low volatility and as a serious technical breakdown – which has since proved to be relatively insignificant.  Today's selloff came during a time of considerably higher volatility and could possibly noise in a three month trading range.  It will be interesting to see whether this move – which at the time seems technically insignificant – will actually prove to be the beginning of a downward trend or just a sign of more volatile times. 
   
5. Market Identity – In February, nobody really understood the selloff.  Many blamed China, some blamed weak economic numbers, others blamed subprime, some even blamed "technical glitches".  No matter where blame was assessed the underlying theme was a lack of understanding and that resulted in a lack of significance.  Today's decline is much clear in terms of why.  There are no real debates going on or pondering.  The credit markets are scared and corporate earnings are not weak.  The opacity as to the reason behind the February drop resulted in a period of "ignorance is bliss".  What will such a strong correlation between the facts and the outcome do this time?  Will it usher in panic as the market comes to a self-realization or it will it usher in extended euphoria as it feels that the reasons for the decline have been priced in and the sky is the limit?

There are many more similarities and differences that I have not mentioned and feel free to post your own.  As to where we go from here - to be honest I have no idea and would be foolish and irresponsible to say one way or another.  The only thing that I can say is today, although much less severe seemed much more real and indicative of impending doom but at the same time less scary as all the usual suspects were expected and known.  What I can say with some confidence is of those two feelings, the one the market subscribes to will most likely dictate our path for some time. 

The NYC Steam Pipe Explosion: Some Thoughts

First off I would like to extend my sympathy to the family of individual killed in today's incident  and my thoughts are with those who have been injured. 

To all of the skeptics and conspiracy theorists, who are beginning to shout "terrorism" due to the coincidence of this event with the bleak words of encouragement coming from our leaders and all the terrorist warnings that have begun to resurface - I am 99% this was not a terrorist incident. 

My confidence stems from the fact that I live and work in the neighborhood.  I work on 41st and park and walk by "ground zero" every day.  Abnormal amounts of steam and unusually foul odors have protruded from the manholes and sewers on 41st street for quite some time.  About a month ago a Con Ed truck was parked on the corner of 41st and Lexington for about a week working down there with loads of steam coming out. 

I do not mention this to lay blame or suggest incompetence - as I am pretty sure they knew things were pretty shaky down there.  Rather, I mention it to illustrate inevitability.  Something such as this was probably known about before, attempted to be fixed, but most likely unable to fix without spending billions of dollars, suspending the most popular subway line, and tearing up Midtown. They probably had no idea of the magnitude of what would happen, where, but probably knew that something like this would.  The pipes are from 1920 and things break.  It is inevitable.  Unfortunately some people were on the wrong street at the wrong time and were forced to absorb the risk that we all share living and working in Manhattan.  It may have very well have been me, as I usually leave work around that time - but randomly I left Manhattan around 5:00 pm today. 

Now, lets turn to terrorism.  This was not a terrorist event, but are events like this any different?  They both are expected to occur in New York, but very unpredictable as to when and how.  However, unlike the steam pipes, we have voted to restrict great amounts of freedom and allocated enormous amounts of money to fighting something that we will never win, because we will never eliminate the risk and probably ever really reduce it - and when it is realized it will be by the unfortunate few who fell victim to randomness.

I guarantee that tomorrow morning people will get up and walk on the street of Manhattan as if today did not happen.  For the most part their behavior will not be affected by the new information that there are steam pipes from the 20's under the streets growing older by the day.  They believe that this is random (which is pretty much is to the person on the street) and can hardly be anticipated or prevented.  If legislation came out tomorrow to go to war on the steam pipes - most would not really care and would be very upset when it interfered with their freedom roaming around New York, as well as the taxes.  that they pay.  They will do this and I will applaud them because they are winning the war on steam pipes already - to lose would be to fight it.

So, why then when terrorism is involved are we so quick to return fire with fire?  Is it because we see the randomness and "bad luck" involved with today's event and overlook it when examining the acts of 9/11. We instead believe that the individuals involved plotted to hunt out those unfortunate people and take it personal .  I want the evil remaining plotters behind the acts of 9/11 to be castrated just as much as the next guy, but more so I want our country to win.  Fighting the war on terror is essentially surrendering and paying to take risks that we will experience regardless all along eliminating freedom.  Spending somethign and getting virtually nothing in return is not a smart financial decision.

Today, unfortunately, someone had to bear all our risk of walking in the city and the steam pipes won.  That risk is the cost of living in the greatest city in the greatest and most prosperous country of the world. This risk may be different for terrorism but will is be a cost that everyone pays and only a small fraction feel.  Why pay extra for the same?

A Dream Deferred: The Housing Meltdown and an Extended Bull Market

What happens to a dream deferred?

Does it dry up
like a raisin in the sun?
Or fester like a sore--
And then run?
Does it stink like rotten meat?
Or crust and sugar over--
like a syrupy sweet?

Maybe it just sags
like a heavy load.

Or does it explode?

-Langston Hughes, "A Dream Deferred"

Many people (including myself) have long believed the housing decline will weigh down on stocks.  The common belief is that the easy money of the last few years has fueled the consumer spending which has stimulated the economy and the stock market.  Take that money away and the cards begin to fall.

What if that did not happen?

The other day I was speaking with someone who, at 57, is actually is much better prepared for retirement than most (and then he believes), not really feeling the effects of the housing slump, and collecting a regular retirement.  He was worried that he would not have as much money than he thought he would need to live how we wants to live in retirement.  He then asked me a question - "If I give you X amount of money, could you double it in the next 5 years?" 

Besides saying, "Absolutely not", I thought a lot about this question and its meaning on an individual scale.  Drawing back to high school English class I thought of a poem I once read by Langston Hughes, "A Dream Deferred" (posted above).   This person was not upset or worried about living in retirement, rather he was worried about living the way he had dreamed.  An American and his dreams are not easily parted and Americans are willing to put it all on the line to live out what they dreamed.  In a country that coined the phrases "American Dream", "I'm living the dream", "Make your dreams come", and "Follow your dreams" not realizing a dream is the ultimate failure and the biggest risk is the risk not taken. 

As housing prices are plummeting and retirement nest eggs scrambled, the inaudible roar of dreams crashing has never been so loud.  In his poem  Langston Hughes poses the question, "What happens to a dream deferred?"  Many people believe it will "sag like a heavy load" and drag the markets down with it. They believe many people will be risk averse after being burned in the 1990's and now again and will become an economic hermit. 

I have a feeling that over the past year as their housing prices have dropped and the price of everythign else risen, many peoples dreams have, up until now, "festered and boiled".  The fact that the stock market has gone up like crazy during this same time period leads me to believe that they are "about to explode". 

Are we seeing a Flight to Quality in Equity Markets?

After Mr. Market's wild ride last week, today we saw something, in my opinion, that was more interesting.  We have what I believe may have been an equity flight to quality.  The market opened up down but then rose up midday in which the Dow, S&P, and the Nazz all had modest gains.  The Quote screen was green and things looked cheery - however by the end of the day both the S&P and Nazz had dents in the latest "wax job" put on them and the Dow got taken down a notch on its march towards 14,000. 

In a time of asset allocation models and money mangers not having to keep cash because it is in the client's overall model already, when I see a divergence between indices, such as the one Dow (+0.31%) and Nasdaq (-0.30)%, I look to see what is up and what is down.  My theory being, in the old days when a mutual fund manager would sell positions he sometimes would place it into cash until he found something compelling to buy.  These days as everyone is fighting for return - he or she is not really rewarded for staying in cash, nor hired to do so - therefore he puts any proceeds into stocks that he or she would think are either the safest alternative or should outperform cash on a risk adjusted basis. This is the difference of being responsible for managing a piece of clients portfolio over a entire portfolio.  Therefore on days of divergence such as today, I believe that this is what is going on causing market breadth to be so high.

Today, I believe the divergence we saw in the equity markets was due to managers selling riskier stocks or stocks that did not offer growth at the most valuable price and buying safer stocks. 

Let's look at a few themes that stuck out today, which will help us see what defined "quality":

 

Underperformers

One way to look at quality is "value".  A commonsense place to look for value (whether it really exists or not) is see what has underperformed the last few years.  A popular strategy known as the "Dogs of the Dow" focuses on this.  If you go to WSJ Online and look at their Industry Group Tracker, you can compare how different sectors and industries have done over different time frames and compare relative performance.  Since the data for today will only be available today I have posted screenshots below.

The first is the leaders and laggard industries in today's market. 

 

Now lets look at the same chart but on a 4 year basis:

 

Notice the similarities between what is on what performed well today but poorly over the past few years, and vice versa.  It has been well told for quite some time that the rally the past few years has been somewhat narrow - with energy and materials leading the way and the second chart confirms that as many industries in that sector lost ground.  Although some of the particular industries are different - they are connected via related industries or broader sectors (i.e. Soft Drinks - Brewers, or Automobiles - Auto Parts). 

Multinational over Domestic

This may have been caused by the increasing anticipation of a slowdown in the US.  To see this let's examine the Dow components for simplicity sake.  Below I have posted a chart with the performance of the Dow components today:

Although most companies in the Dow are large multinationals, the companies that do a good amount of business overseas seriously outperformed those who did not.  Some examples of the advancers who displayed this are UTX, GE, KO, CAT, DD, PG, MMM, JNJ, and MCD.  The decliners included T, GM, HD, AXP, WMT, and JPM. 

 

Big over Small

Large Caps outpaced their smaller counterparts as the S&P 100 beat the S&P Small Cap 600 and S&P Midcap 400 by about 60 bps and 63 bps, respectively, and the Russell 1000 over the Russell 2000 by 50 bps. 

 

Growth over Value

Growth trumped Value - as the Russell 3000 Growth outpaced Russell 3000 Value by about 15 bps - as seen below. 

If this "flight to quality" is something permanent will be seen over the near future.  At a major market inflection point with many averages at or just above new highs it will be interesting to see just what type of inflection point this will be. 

Are Indices Actually Just Actively Managed Portfolios?

Lately, the topic d'jour in the ETF industry (aside from Vanguard's entrance) has been whether actively-managed indices and the ETF's that track them are viable products.  This is a very formidable debate to be had, but I beg the question - are our current indices not already actively managed? 

With the popularity of ETF's and its emergence as a competitor to mutual funds and separately managed accounts - the business of indexing has become a big one.  Standard and Poor's (a division of McGraw Hill) and many of the exchanges (which are now "for-profit" entities) make money of of leasing out their index to various asset management firms to use in their ETF's.  If you are a Barclays or Vanguard, tTo be able to sell an ETF mimicking the S&P 500 or the EAFE you must pay the maker or the index - if you want to advertise that it follows such an index.  The introduction of Powershares "Intellidex" indices creates a form of competition that was not there before.  If you are Standard and Poors, you now want to make sure that your index outperforms the Powershares Index or else you may lose the monopoly you have on "the market".  What is an index such as the S&P but a mutual fund of 500 stocks weighted by market cap (or more specifically, float), with discretion given essentially to sector weightings.  The S&P, therefore generates alpha by what sectors it chooses to overweight - which basically determines the stocks that will be included.  The weightings of the individual stocks are essentially independent of the entire process.  If Standard and Poors wants to go heavier on Energy, they add another oil name, and so on.   

It is difficult for S&P to generate that much alpha in their S&P 500 index, but for Barclays to generate alpha for their iShares Biotechnology index, they rely on NASDAQ's Biotechnology Index - very geared towards their top five holdings.  According the to NASDAQ website,

The NASDAQ Biotechnology Index contains securities of NASDAQ-listed companies classified according to the Industry Classification Benchmark as either Biotechnology or Pharmaceuticals which also meet other eligibility criteria. The NASDAQ Biotechnology Index is calculated under a modified capitalization-weighted methodology.

So, there is definitely a great deal of discretion over the contents of this index.  If this index begins out outperform other biotech indices, Barclays may want to change its index provider from NASDAQ to S&P or someone else - eliminating any royalties that NASDAQ receives as well as the commissions they earn from these stocks being traded on their index through the ETF.  It is therefore in their interest to create the best index possible.  Is that not active management?

This of course has some interesting implications.  First off, Index Providers, who in the past were more interested in presenting an informational product are now tied to an asset management investment product.  Therefore they are less inclined to present an accurate representation of the overall market and more inclined with outperforming the market.  Since the ETF business now creates even more net inflows into the stocks that they represent, it is a self fulfilling prophecy of sorts, which has implications all to itself.  For example if the Fidelity Contrafund was a readily available index to follow, and all of a sudden considered by the general public as the indicator of the markets as well as a benchmark for active managers to follow, the stocks that it owned in the fund would become more valuable. Many passive investors would try to invest alongside the index as well.  In reality, William Danoff is concerned (or should be concerned) solely with outperforming his competition - other equity funds or contrarian funds.  His investment strategy is to invest in stocks that are contrary to the general market opinion, but at the same time the market opinion is becoming his own - causing his contrarian style benefit from the money flowing into his contrarian ideas.  His fund will continue to grow and value of the stocks within it - as his opinion changes and he sells off some holdings for others the market moves with him as well.  Therefore the value of his fund goes up and up and up.  The belief that his "index" represents the market therefore inflates the value of the shares of his mutual fund, but the divergence between what his fund's holdings and performance and his funds holdings and performance become wildly different.  The Contrafund example is of course an extreme one, but illustrates how this divergence between what index providers are concerned with and what the investing public believes to be true can cause the indices that are provided to diverge from the reality of the market that it is supposed to follow. 

A secondary impact is on active managers.  If you are an Small Cap Value manager, using the S&P Small Cap 600 as your benchmark, you can not compete on price with the S&P, therefore as ETF popularity rises, the reward for following an index falls - since you are likely to get about the same return at more than double the expense ratio - and with tax concerns.  Therefore you must take much more risk NOT to mimic your benchmark. This will introduce a greater variability in performance in a Lipper Category.  The top Morningstar rating and the bottom Morningstar rating will vary wildly from the average percentile as more managers are out there taking larger tracking error risks.  This may cause a huge shakeout and then resurgence in Mutual Fund management as it will create both many more losers and winners alike, with losers losing more and winners winning more.  So, ETF's the "mutual-fund killer" of sorts may cause them to become more popular - as investors are searching for that 10 point alpha which now pays to take the risk over what used to "historically outperform active managers".
In addition, large investment banks may begin to create more indices in order to benefit from this boom.  In the past, they made money out of selling their in-house funds - which came with a lot of hair on them causing many to be skeptical.  Now, creating an index, that is largely thought to be "harmless" and selling it to an asset management company allows them to still get their share of this market as well add some value to the increasingly worthless sell-side research arms.  This may be one reason why Barclay's has been so heavily sought after as well as why the exchanges are a hot item on the auction block. 

Last but not least, if "passive" indices are actually actively managed, then the idea that they will move with the market may be unwarranted.  If they begin to vary wildly from the overall market, sector, industry, country, due to the competition between index providers, two people who invested in Energy ETF's could and should have entirely different results.  Therefore the results of the buy and hold approach in a diversified asset allocation usually applied to them may have no real groundings in historical data and may be heavily dependent on which ETF is chosen.

Regardless of its implications it is important to understand that the ETF industry and its rapid growth and source of profits have caused those who produce an index to be interested in its alpha over its beta (aka performance over market representation).  The effects of such an emphasis on performance should be used not only in evaluating the markets as whole but any portfolio being constructed. 

Private Equity Shunning the Public Spotlight

Bad news seems to be filtered through the media if at all possible on Friday afternoons or before big holidays.  The Bush Administration is genius at ushering through all the bad news on Fridays as are some public companies.  So, I found it somewhat peculiar that Blackstone Group's buyout of Hilton Hotels - a very big news item for Private Equity and Wall Street in general was released on Tuesday July 3rd. 

With Congress debating the validity of their tax structure and PE firms cashing out in the public marketplace it seems interesting that this week there were an usual amount of deals mentioned.  It is generally accepted that Private Equity has had an underlying "bid" on the market for the past few years.  They have enjoyed the press on the way in but shun any sort of public scrutiny thereafter.  Now that Blackstone is a public company, much more in the public eye than before, the timing of the Hilton deal signals a desire to stay out of the public spotlight as much as possible.  Other smaller deals such as Barney's and even the BCE acquisition (although not PE it was announced over the weekend), seem to be avoiding as much "publicness" as possible. 

The Hilton deal has very public connections as well - with Paris Hilton the main attraction of the circus that has been mainstream media of the past few years.  Maybe it is me reading too far into this or maybe they are trying to get business done in the public arena but at the same time avoiding public interaction as much as possible - akin to having a one-night stand with a coworker, then avoiding them at all costs around the water cooler because you know it's a one night stand - but your coworker has different ideas on your intentions. 

The Suburban Shopping Center Portfolio

A few weeks back, an associate and I were debating adding Bed, Bath, and Beyond (BBBY) to our buy list.   I remember telling him, “No way, I don’t want to own anything in a suburban strip mall alongside Home Depot.”  My comment, very biased and un-researched as it was – deserves some greater attention and begs the question.  How has the Suburban Shopping Center Portfolio done? 

In order to answer the question I put together a portfolio of seven stocks that remind me of the suburban shopping centers – many of which have propped up the last few years as a result of the suburban housing boom (and subsequent bust).  You know the shopping center I am talking about – it usually is anchored with a Wal-Mart and Best Buy (or Circuit City).  It is also quite likely to contain a Bed, Bath, and Beyond, Barnes and Noble, and of course an Applebee’s (for all the shoppers hungry after a long day of investing their home equity in flat screens, home appliances, DVD's, and other crap that adds no real value to a home).   These stocks have formed the basis of my portfolio.  I have graphed their performance against the S&P below: 

 

What immediately jumps out to me is how these stocks have underperformed the S&P YTD.  It appears that the more big ticket stores like BBY, CC, and BBBY are hurting big time – underperforming for the majority of the year.  The smaller ticket stores such as Barnes and Noble’s, and food-driven stores (Applebee’s and Wal-Mart), have held up and outperformed up until recently where they too have taken a dive.  All in all, an equally weighted portfolio would have lost money this year according to numbers above. 

What does this tell us?  The skeptic in me says, “Absolutely nothing, we already know this”, but I do think it is important to see how the market has already discounted the consumer a decent amount – and also how the ripples may play out into the broader economy.  As big ticket consumer electronics begin to pile up – the companies who make those products may start to take a hit, leading to the chip and parts makers, materials companies, and so on.  And if that does start to happen, it is all because Mr. and Mrs. Interest Only Loan couldn’t find time between paying off their bills and driving the kids to soccer practice in their Hummer to go Best Buy and eat at Applebee’s.