“Be careful about what you wish for. You might get it”.
Since the late 1980s the world’s financial markets have undergone a radical democratization, opening the door for retail investors even of modest means to access markets and assets previously the exclusive domain of the very wealthy, at a steadily decreasing cost. The twin facilitators of this financial mass marketing have been liberalization and technology. Liberalization – the break-up of old structural monopolies like the New York Stock Exchange into multiple trading exchanges, systems and platforms. Technology – the means by which information on prices and other raw data traverse the globe at light speed. But there is a dark side to this imagined financial utopia.
Lights Out, Nobody Home
When the NASDAQ exchange went dark, literally, for three hours on Thursday it was not something out of the blue but only the latest in a long string of technical “glitches” that have plagued markets with increasing, and worrying, frequency. We live in an era of glitches, from which nobody is immune. Just two days before connectivity problems with its main data feed brought the US’s second largest exchange to its knees, Wall Street behemoth Goldman Sachs disrupted markets during a 17 minute panic resulting from over 800,000 erroneously executed options contracts. Last year Knight Capital, a major market maker, nearly went out of business after a coding error dumped hundreds of millions of unwanted positions into their account. Then there was the Facebook IPO debacle and the flash crash of 2010, and these are just the ones that make the headlines.
Elusive Centers of Accountability
Part of the problem is that the decentralized structure that makes trading cheaper and more accessible also makes the system architecture more complex and the centers of accountability more diffuse. In the US alone there are 13 stock exchanges and some 40-odd “dark pools” that facilitate private trading between thousands of institutional market participants. When problems arise like the NASDAQ securities information processor (SIP) connectivity glitch, you can’t just call the IT guy and have him go into the server room and fix the problem. And that’s just the hardware side. On the software side securities markets are now dominated by algorithms programmed to make hair-trigger decisions on patterns and events. Behind every algorithm is someone’s computer code, and as examples like the flash crash and Knight Capital remind us, even the smartest programmer is prone to make mistakes.
Vigilance and Oversight Needed
There are no cure-alls for technology risk. But we need responsible oversight and a regulatory approach that anticipates the future rather than just cleaning up the mess after it happens. Much good has come of the democratization of markets, for many people. Their interests and financial well-being are second to none in importance, and need to be the sole concern of the market’s institutions and policy leaders.
The latest data points on US inflation trends reminds us once again that the much-anticipated road to rising interest rates is likely to not be anything resembling a predictable, linear trajectory. The July Producer Price Index, which measures price trends at the wholesale level, edged up 0.1% for a 1.2% year-on-year gain. The more closely watched Consumer Price Index came in at 0.2%, meeting consensus expectations and running at 2% year-on-year. As the Fed heads towards its first period of reckoning for the future of QE in September, the question of relatively low inflation hovers over the proceedings.
With regard to inflation and QE tapering, the concern is that if demand for credit is naturally soft – i.e. muted growth and modest price levels are keeping a lid on business and individual borrowing – then anything that has the effect of edging up interest rates could make a bad situation worse. There will be one more reading each of the PPI and CPI between now and the Fed’s September FOMC meeting when the world will be watching to see if the QE smoke is white or black. Arguably the September inflation readings will be the most influential in the year to date.
Meanwhile, At the Bull
Corporate earnings provide another aspect of the picture. The outlook as measured by analyst expectations has turned considerably less rosy. At the start of the year forecasts for 3Q and 4Q earnings growth for companies in the S&P 500 were 9.5% and 15.9% according to FactSet. With 2Q behind us those estimates have been pared back to 4.3% and 10.8% respectively. Meanwhile, the latest burst of the 2013 rally took prices on the S&P 500 to new record highs in early August. So…prices up, earnings down, and the result is higher P/E valuations. The current level of 16.1x (twelve trailing months) on the S&P 500 is not much above its most recent 10 year average annual rate of 15.8x, but the trend is moving higher.
Putting It All Together
Inflation and corporate earnings are both windows on growth, which continues to be the most vexing part of the equation. It is probably fair to say that the absence of a clear and compelling growth story is what makes the current stock market rally – which after all has been surging along practically unabated since the first trading day of 2012 – a sort of Rodney Dangerfield of bull markets, getting no respect. When you take financial companies out of the equation, earnings for the S&P 500 have actually declined through the second quarter. But that is still impressive compared to the even more growth-challenged rest of the world. Investors would seem, at this point, to be ready to trade their QE morphine for a compelling tale (with supporting data) of global growth. We’ll know more soon about how close we are to that trade.
The world’s second largest economy has influenced many asset markets beyond its own borders this year, from emerging markets equities to energy and industrial materials commodities. Much of that influence has been negative. The MSCI Emerging Markets index was down -8.4% for the year to date as of August 8, and continues to be the bane of any diversified equities portfolio manager. The Dow UBS Commodity index is off more than 10% for the same time period. But with record volumes of commodities imports by China in July, many investors are wondering if the turn is at hand.
Beware the False Turn
Those out of favor asset classes have come to life in the past week or so. The S&P Select Materials Sector has shifted from laggard to leader, and copper prices jumped nearly 3% yesterday as the July data points rolled in. Shares in emerging markets and China-correlated developed markets like Australia have also perked up. But a closer look at the latest data, while offering evidence that a major stall-out of the economy is likely not at hand, does not make for an open-and-shut case.
The 9.7% growth in industrial production, well in excess of expectations, comes at the same time that Chinese retail sales ticked down a notch. Long term China watchers focus on signs of economic rebalance, where domestic consumption gains ground over the traditional engine of export-focused investment in production and manufacturing. As a percentage of GDP, consumption in China is still about half what it is in the US. This month’s production numbers don’t do much to change that equation.
Commodities in Surplus
The record commodities purchases come at a time of overcapacity for many industrial inputs from iron ore to nickel and zinc. July’s activity may well reflect decisions by large Chinese enterprises to stock their inventories while prices are favorable, which in turn could indicate weaker demand in the months ahead, particularly if overall growth proves to be modest. Much of the global overcapacity comes from years of extensive investment in industrial commodities. As China grew at breakneck speed during the 2000s international metals and mining companies invested heavily into production of the raw materials that power Chinese factories. It may be awhile yet before the resulting surpluses abate.
Plenty of Ground to Gain
From an asset allocation standpoint there may be more to lose than to gain by calling the China turn now. The out of favor asset classes in commodities and emerging markets lag the S&P 500 in many cases by more than 20%. That’s a lot of ground to make up – and a lot of time to monitor successive data points to validate (or not) the directional trend. China will continue to be an important story over the remainder of 2013, and one that we will continue to monitor – carefully and prudently.
Volatility has been conspicuously absent from asset markets for most of 2013. Even during the brief pullback from late May to late June volatility levels didn’t come anywhere near where they have been during other flashpoints over the past several years. It’s been an unusually calm summer – but whether the gentle breezes of low volatility and rising asset prices continue to blow into the fall is up for debate. Here are some things that are on our radar screens as we look ahead.
The Fed: Who, What and When?
Markets this year have cared more about Ben Bernanke’s lexical propensities than about fundamentals. Right now there are three unknowns with which investors have to contend: Who is going to be leading the Fed after Bernanke retires in January, what is the plan for winding down the QE stimulus programs, and when – over what time period – will that plan be enacted? That’s a lot to digest. Of the two top candidates for the job, current Fed Board of Governors vice chairwoman Janet Yellen is seen as fairly close to Bernanke in outlook and temperament, while former Treasury Secretary Larry Summers has at times been critical of the effectiveness of monetary stimulus. The winding up of QE will require a deft balancing of prudent policy and market expectations.
Fundamentals in Focus
The uncertainty around Fed policy is shifting investor focus back to those fundamentals. We’re about 80% of the way through the second quarter earnings season and the results have been decidedly mixed. Apple gave a nice boost to the market when it made its numbers, but elsewhere in Big Tech the story has been disappointing. Median earnings per share growth for the companies that make up the S&P 500 technology sector came in at -8.1% for the quarter, versus analyst consensus expectations of -1.1%. In fact the only sectors to beat EPS growth expectations for the quarter so far are financials, healthcare and utilities. The economic recovery continues to show strength, but many companies are finding the sales and earnings growth climate to be challenging.
DC Dysfunction…It’s Ba-ack
It seems like ages since we watched clueless policymakers wrangle over the fiscal cliff, but unfortunately we are likely to be treated to more reckless brinksmanship this fall when that dreaded debt ceiling comes up again. The opening salvos are not promising, and if anything the political landscape appears even less conciliatory now than it was in the immediate aftermath of Obama’s re-election. If there’s one thing that could spark another spike in the VIX and a reversal of fortunes for equities it’s probably going to come from Washington.
With the S&P 500 up more than 20% for the year to date and earnings misses so far failing to make much of a dent in sentiment we continue to see strength in most areas of US equities and some potential for relative gains from certain non-US sectors. But we remain cognizant of the potential bumps in the road.
Hedge funds are back in the news this week. The latest Master of the Universe to be scorched by the sun and come crashing back to earth is Steven Cohen. Cohen, the sole proprietor of $15 billion hedge funds SAC, is in the crosshairs of a major insider trading scandal that has already taken down many of his closest colleagues. It seems that years of 30%-plus returns required a little extra “sauce” – yet another reminder to those who believe in free lunches and tooth fairies that if something looks too good to be true, it probably is. But while the humbled rogues are the ones who make the headlines, some real problems affect a much broader swath of hedge funds and indeed other asset classes that have long styled themselves as “alternatives” – as offering a refuge from the traditional world of stocks and bonds.
Liquidity: A Blessing and a Curse
We normally think of liquidity as a good thing. Liquid markets make it easier to buy and sell assets with confidence that the price you see is the price you get. But at the same time, the liquidity that comes from easier access – which has happened successively with historically low-correlation assets like commodities, REITs and now hedge strategies – makes it more likely that those assets will correlate more closely to traditional stocks and bonds.
Think of it this way: commodities used to be accessible only to investors with the means and the knowledge to invest directly in futures contracts – a small number of souls indeed. Now anyone with $500 can purchase a commodities ETF on eTrade. Hedge funds, too, have moved into the world of regulated mutual funds. That’s good for enabling more investors to build diversified portfolios: the catch is that those diversification benefits diminish when assets trade more on whether or not Ben Bernanke says “tapering” and less on the fundamental merits of individual assets or business cycle considerations.
More Fishermen, Fewer Fish
You can see this effect in the numbers. Over the last five years the correlation between the HFRI Fund of Funds Index and the S&P 500 has been 0.76 (where 1.0 represents perfect positive correlation). By contrast this value was 0.32 in the five years from 1991 to 1996. Even more strikingly, the correlation between the Dow UBS Commodity index and the S&P 500 was 0.02 in the 1991-96 period – basically implying no correlation at all – and had shot up to 0.81 by 2008-13. It is not a mere coincidence that the first ETF launched in 1993 and has since grown to a market worth nearly $1.5 trillion in total assets.
This makes it harder for intrepid money managers to discover untapped nooks and crannies in the global capital markets. It’s like a pond teeming with fish: a few folks stumble upon it, cast their lines and hook one fish after another. Then word gets out, the hordes descend and the fish disappear. The money managers find it increasingly hard to prove their prowess in delivering alpha. Some – like SAC – turn to more desperate measures to create the illusion of success, and fall hard when their luck runs out.