I can still remember
How that music used to make me smile.
And I knew if I had my chance
That I could make those people dance
And, maybe, they’d be happy for a while.
American Pie by Don McLean
For most of my 25 year career as a professional money manager I practiced various forms of fundamental analysis. You know, picking stocks based on "fundamentals," such as; sales growth, earnings growth, balance sheet strength, management quality, and valuation. Variations of this fundamental approach to stock picking has served many managers very well over the last seventy years, but in the last decade it was often lacking, "Now for 10 years we've been on our own". There were always periods where fundamentals didn't work, generally when one sector or another was experiencing a bubble (think, nifty fifty in the '60's, energy in the '70's, or technology in the '90's), but since the early 2000's something has clearly changed.
Over the years I've had many frustrating conversations with my peers trying to figure out why being a fundamental analyst was failing us. We never had a precise answer, but we did have some theories. One was the advent of sector funds and sector ETF's. With the advent of sector funds we noticed a marked increase in the correlation amongst stocks in that sector. When Pepsi moved up or down, Coke was most likely moving in tandem. The correlation among stocks in specific sectors grew closer and closer to 1.00. It often didn't matter if the fundamentals or valuations were better at Pepsi or Coke, they both moved in tandem.
Now clearly there were outliers. There are always company specific events that may separate one company from another (i.e. BP with the rig explosion, or on the positive side Apple with the iEverything), but these are becoming rarer and rarer to find.
What this means for fundamental portfolio managers is that the opportunities to add value (or Alpha in quant speak) are becoming fewer and fewer. This fact can be readily observed by looking at the performance convergence among active managers. "I can't remember if I cried..."
Another area of concern was the massive increase in trading being done by Quant shops, or High-frequency Trading (HFT) operations. Ten years ago we were aware that trading based on computer algorithms accounted for nearly 50% of daily trading volume in US markets. Since then the technology has accelerated to the point where HFT platforms have ramped up speeds from trades per second, to trades per millisecond, to trades per microsecond (that's one-millionth of a second). These trades now account for more than 80% of daily total trading volume. "Oh, and while the King was looking down, the Jester stole his thorny crown." One CEO of a High-frequency trading firm stated that their longest duration holding period for a stock was eleven seconds, and he considered that rare and unacceptably long. These trades have absolutely nothing to do with corporate fundamentals. Go back to May 6, how can Procter & Gamble be trading at $62 one minute and $39 the next? It wasn't fundamentals. Attached is an excellent article from International Economy magazine by Harald Malmgren and Mark Stys on HFT and "The Marginalizing of the Individual Investor." http://www.international-economy.com/TIE_Su10_MalmgrenStys.pdf
This divergence between fundamentals and reality is one of the main reasons I set up Rockhaven Capital Management the way I did, "singin' bye-bye Miss American Pie". At Rockhaven our goal is to preserve and grow our assets, it's not to try and find an undervalued stock and hope that someday it may trade to our perceived fair value (the deck is stacked against you if that's your game). Our job is to allocate assets broadly around the globe and be in harmony with what is working. The most important part of the job is the protection part, constantly monitoring risks and managing them.
I believe that High-frequency Trading is a risk, potentially a very large risk, that is undermining what markets were traditionally designed to do...allow companies to raise capital and allow investors to participate in a companies potential growth, the proverbial "American Pie". Hopefully the exchanges and regulators will be able to mitigate this risk, but we as investors must remain constantly vigilant, or "this will be the day that I die."
Investment Considerations:
After a tough August (S&P 500 down 4.50%) we've seen a very strong bounce in the first couple of days of September (S&P 500 up 5%+). Trends, momentum, and seasonality all point to lower equity prices, but maybe the short-term bearish sentiment had run a bit too far. The economic numbers out this week were not rosy, but they were better than the dire expectations. The real wildcard for September and October is how aggressive the Fed will be with Quantitative Easing II (QEII), and more importantly what may come out of a very panicked White House prior to the elections. With the administration facing third and very long, with the clock rapidly ticking towards November, it would not be surprising to see a hail Mary proposal to extend the Bush tax cuts, or implement some type of payroll tax relief.
Even though we are firmly in a secular bear market, there can be some very strong cyclical bounces, especially of the government engineered type.
Where do we stand?
US Equities -- Neutral, but very close to moving into Bearish territory
Int'l Equities -- Neutral for EAFE and Bullish for emerging markets
US REITs -- Bullish
Int'l REITs -- Neutral, and moving towards Bullish
Gold -- Bullish
Commodities -- Neutral, but moving towards Bullish
US Fixed Income -- Bullish, record highs and overbought
Int'l Fixed Income -- Bullish, and emerging market debt Bullish
Cash Equivalents -- At 16.5%.
A Fair Tax Plan:
Wayne Angell, former Governor of the Federal Reserve Board, in conjunction with several dozen economists have put together a very compelling plan to get this country on the right track. They call it a Fair Tax Plan, and all it does is eliminate all personal taxes, corporate taxes, and the IRS, and replaces them with a national sales tax (also known as a consumption tax).
It may be wishful thinking, but its at least nice to see something like this proposed by some very respected thinkers.
The Student Loan Scheme:
For those of you with college students heading back to school please take a look at this excellent graphic from Jess Bachman.
Student loans have now taken over the number two spot in Americas debt bubble (behind mortgages but ahead of credit cards).
Be careful out there,
Chris Wiles
For prior Rockhaven Views visit:
This article contains the current opinions of the author but not necessarily those of the Rockhaven Capital Management. The author’s opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
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