Wednesday, July 31, 2013

Time to Buy the Emerging Markets?

With the S&P 500 continuing its relentless drive higher, investors are struggling to add new money to large cap U.S. stocks.

Most agree that the longer term outlook for stocks remains positive. Interest rates will probably not be significantly higher for at least the next couple of years, regardless of who is chosen as the new Fed Chairman.*

Quarterly earning reports have also been generally favorable. According to Tania Harsono-Cloney of Bernstein, as of last Friday, 50% of the companies in the S&P 500 have reported earnings.  Almost three-quarters of those reports have beaten Wall Street earnings expectations, and 55% of beaten revenue expectations.

However, with the S&P 500 up nearly +20% year-to-date, many investors have this gnawing feeling that the market is well overdue for a correction.

As I pointed out last week, the S&P is +50% over the last three years, while the stocks of the emerging markets are off -4%.  Sentiment on the group is mostly bearish; the strategists that were wildly optimistic on the markets of Brazil, Russia, India and China a few years ago have disappeared from the scene.

Strategist Michael Hartnett of Merrill Lynch has been suggesting that investors consider an allocation to the emerging markets for at least a trade.  Hartnett points out that any time sentiment is so widely bearish on a sector, any kind of positive surprise can spark a strong rally.

The Vanguard Emerging Markets Exchange-Traded Fund (ETF) is a good proxy for the emerging markets.  More than 70% of the value of this ETF (ticker: VWO) is comprised of China; Brazil; Taiwan; South Africa; India; and Russia. I have posted the price action of VWO above.

While I am not a technician, I do believe that sometimes charts can present an interesting story.  I have circled two sharp price drops that have occurred in VWO over the past three years: one in early October 2011, and the other in June 2013.

The sell-off in 2011 is interesting because it occurred at at time when the U.S. markets were just starting to rally.  Note too that the price decline was accompanied by a spike in trading volume; investors were selling in droves.

However, VWO quickly recovered, and by the end of October the ETF had jumped by +25% in a month.

Now look at the sell-off from last month.  The same market action:  a sharp decline on large volume.  Could we see another sharp rise in the next few weeks?

The stocks in VWO are trading a significant valuation discount to the U.S. market despite significantly stronger growth rates. VWO trades at slightly less than 13x P/E ratio, and sports a 2.5% dividend yield, compared the 17x P/E of the S&P 500 and 2% dividend.

For the intrepid trader, I would think hard about playing VWO for a trade until Labor Day.  While the trade is not without risk, if the past is any guide, the emerging markets stocks are poised for a bounce.

*What if Ben Bernanke decides that he would rather stay on as Fed Chairman?

Tuesday, July 30, 2013

An Election Driven by Data

I have written numerous times on this blog about the powerful impact that technology has had on the investing world.

The active use of "data mining" has extended to virtually every type of activity, and the sophistication of practitioners is growing expotentially.

I was struck by a couple of articles that appeared in the Washington Post recently discussing the differences in approach that the two candidates took in their use of data in the last presidential election.

President Obama made incredibly effective use of social media in his run for the White House in 2008.  While the traditional Democratic party bosses focused on the techniques that had worked in the past, the Obama team was able to communicate and execute its campaign in ways that had never been seen, with obvious success.

However, according to the yesterday's Washington Post article, the 2012 Obama campaign took a quantum lead in its use of technology, far surpassing what it had done in 2008.

Here's an excerpt:

The Obama campaign had the usual contingent of pollsters and ad makers and opposition researchers and, like all campaigns today, a digital director. But it also had a chief technology officer (who had never done politics before), a chief innovation officer and a director of analytics, which would become one of the most important additions and a likely fixture in campaigns of the future. 

The team hired software engineers and data experts and number-crunchers and digital designers and video producers by the score. They filled the back of a vast room resembling a brokerage house trading floor or tech start-up that occupied the sixth floor of One Prudential Plaza overlooking Millennium Park in Chicago.

No campaign had ever invested so heavily in technology and analytics, and no campaign had ever had such stated ambitions. “Technology was another big lesson learned from 2008, leap of faith and labor of love and angst-ridden entity and all the other things that you can imagine, because we were building things in-house mostly with people that had not done campaign work before,” {Deputy campaign manager Jen O'Malley} Dillon later told me. “The deadlines and breaking and testing — is it going to work, what do we do? . . . At the end of the day, it was certainly worth it, because you can’t customize our stuff, and so we just couldn’t buy off the shelf for anything and you know that, and fortunately we had enough time to kind of build the stuff. I don’t know who else will ever have the luxury of doing that again.”

The rest of the article goes on to describe how the Obama campaign used its incredible investments in technology to develop a detailed campaign strategy, right down to telling its campaign volunteers which calls to make, and who would benefit from a visit to a voter's house.

Meanwhile, while the Romney campaign was not unaware of technology, it would seem that many of their decisions were based on well-honed instincts and experience.

The Post's reporter Dan Balz has written a book about the Romney run, and an excerpt was published in Sunday's paper.  

The excerpt describes the emotional swings that Romney and his family experienced during his campaign.  Initially he was reluctant to run after losing in 2008, but his family eventually convinced him that he was the best man for the job.  

At the end, on Election Day, Romney believed he had won.  However, unlike the hyper data-driven Obama campaign, much of his belief was based on the crowds he attracted, and the enthusiastic reception he was receiving:

Romney believed the debates produced a fundamental change in his relationship with the party’s rank and file. “What had begun as people watching me with an interested eye had become instead more of a movement with energy and passion,” he said. “The rallies we’d had with larger and larger numbers and people not just agreeing with me on issues, but passionate about the election and about our campaign — that was something that had become palpable.”

As a result, he woke up on Election Day thinking he would win. “I can’t say 90 percent confident or something like that, but I felt we were going to win. . . . The campaign had changed from being clinical to being emotional. And that was very promising.”

His last hours on the trail, especially the arrival at the Pittsburgh airport on the afternoon of the election, where he was greeted by a spontaneous crowd of supporters, gave him added confidence. “We were looking at our own poll numbers and there were two things that we believed,” he said. “We believed that some of the polls that showed me not winning were just simply wrong, because they showed there was going to be more turnout from African American voters, for instance, than had existed in 2008. We said no way, absolutely no way. That can’t be, because this was the first time an African American president had run. Two thousand eight — that had to be the high point. . . . We saw independent voters in Ohio breaking for me by double digits. And as a number said, you can’t lose Ohio if you win independent voters. You’re winning Republicans solidly, you’re winning independents, and enthusiasm is overwhelmingly on your side. . . . So those things said, okay, we have a real good chance of winning. Nothing’s certain. Don’t measure the drapes. But I had written an acceptance speech and spent some time on the acceptance speech. I had not written a concession speech.”

 Whether technology decided the last election or not, it seems clear that future national campaigns will no doubt look at the 2012 elections as confirmation of the importance of using big data to develop winning campaigns.

Monday, July 29, 2013

How Quickly We Forget

Barry Ritholtz of the blog The Big Picture wrote a good editorial for the Washington Post which appeared in yesterday's paper.

Ritholtz points out that it was only a few years ago that the press was full of quotes from pundits proclaiming that cataclysmic events were just around the corner.

Whether it was the general hand-wringing over the political morass in Washington, or decrying the overall state of affairs in American society, it was taken almost as a given that the only safe place for investors was either in gold or ultra-safe Treasury bills.

Problem is, this advice turned out to be terrible, and cost investors and savers the chance to invest in high quality stocks at historically cheap prices.

Now, to be sure, some of these gloomier forecasts may yet play out, but one cannot help but be struck by the total lack of any sense of humbleness by these same sages.

Here's an excerpt from what Ritholtz wrote:

How many people have been calling for a market crash now for several quarters if not years? Cullen Roche of Pragmatic Capital describes what may be the biggest narrative failure: the Fear Trade.

“If you’ve been paying attention over the last few years, you probably remember how many people predicted hyperinflation, surging bond yields, soaring gold prices, a cratering U.S. dollar and a collapsing stock market. This was the fear trade. You overweight gold, short U.S. government bonds, short the USD, short equities and laugh all the way to the bank. On the whole, that trade has been a big disaster. In other words, fear lost out — again.”

He is right: None of those things has come to pass. Even worse, the fear traders have missed a 150 percent rally to all-time highs in the U.S. stock markets. While sell-offs are painful, over the long haul they tend to be temporary. The mathematics of asset class mean reversion is inescapable. Stocks will eventually recover, but if you fail to participate in a generational rally of this magnitude, it can set back your retirement by as much as seven years.

In the institutional investor world - home of the so-called "smart money" - it was an article of faith that a large chunk of an pension or endowment portfolio should be invested in hedge funds.

Lead by industry leaders such as David Swensen of Yale, the most common argument over the past decade was that the kind of buy-and-hold investing strategy was an old-fashioned concept.  Instead, investing with hedge fund managers whose investment acumen would shelter portfolios from volatility while earning out-sized gains was that only place for cutting edge investors.

So how has it worked out?

Today's Financial Times has an report which offers some clues.  Here's an excerpt from a front page article:

Since January 2010 the average equity hedge fund has produced profits for its investors, after fees, of just 14.5 per cent, according to the research group HFR. Over the same period  an investor in the S&P 500 earned, with dividends, a 55 per cent return.  Some 85 per cent of equity hedge funds are failing to match the market.

Now, to be sure, the past few years have been difficult for all active managers, and a large majority of the traditional managers have also lagged the S&P 500.  However, the magnitude of the shortfalls is not anywhere close to the hedge fund gaps, as the FT writes:

From the start of 2010 to the end of June this year, mutual fund managers have a higher investor return of 44.5 per cent, according to the research group Lipper.  Even though 83 per cent of mutual fund managers did not beat the S&P 500, few have failed the grade than among hedge funds.

There will always be a sense that somewhere, somehow, there is a "magic bullet" that will lead to investment success.

However, as Vanguard founder John Bogle is fond of saying, "Time is your friend, impulse is your enemy".

The large gains in investing have largely come from buying quality stocks and holding them for a very long time.  Not very "sexy", but historically this has proven to be the best strategy.

Friday, July 26, 2013

About that "Level Playing Field"

Financial reporter Bethany McLean is out this morning with an excellent editorial discussing the futility of trying to make investment world a totally fair place.

McLean wrote her piece in the wake of the government's indictment yesterday against SAC Capital alleging, among other charges, insider trading.

Here's a short excerpt from the New York Times this morning discussing the case:

At the heart of the government’s case is an attack on SAC’s pursuit of an edge in stock trading. Though it has pushed into other investment strategies, at its core SAC has traditionally been an information-driven hedge fund, aggressively trading stocks around market-moving events like earnings releases and merger announcements.

At the height of SAC’s powers in 2006 and 2007, Mr. Cohen is reported to have earned about $900 million each year, helping to give the firm a certain mystique. But it also generated whispers about whether the fund routinely crossed the line.

The idea of eliminating insider trading, or any other activity that seems to give someone an unfair edge, is an appealing one.  All of us were taught from an early age that we should "play fair" in the schoolroom and the playground.

But Ms. McLean argues that trying to make the stock market a "level playing field" where all investors have equal access to information is a fool's errand:

No, life isn’t fair, and as we all know now, the playing field hadn’t been leveled. Individual investors, whether operating via discount brokerages or with the dubious benefit of Street research, were just cannon fodder for the so-called smart money—including, not surprisingly, Cohen’s SAC Capital — which made fortunes by shorting dot-com stocks ahead of the crash. (The “smart money” isn’t necessarily smart, but it is well-connected)....

McLean goes on to discuss how well-connected investors were able to spot problems at Dell, and earlier Enron, well before any individual investor could have known - and it was all legal:

But the line between what’s insider trading and what isn’t is most definitely not the line between what information an average investor can access, and what information a hardworking hedge fund manager who can spend thousands of dollars and hundreds of hours on expert research can access. “I shudder to think how much of my alpha comes from failed individual investors,” one hedge fund manager tells me... 

“Edge,” as they call it in the hedge fund community, can refer to inside information, but it can also be that little bit of knowledge gleaned from incredibly hard work. And within those circles, “edge” gets shared — but not with you.

One of the lessons they teach you in business school is that the stock market is always a place of contrasting opinions.

If you think a stock is a "buy" at $25 a share, for example, there is someone else out there who is equally convinced that the identical stock is a "sell" at the same price.

In order to buy or sell a stock, then, you have to ask yourself:

What do I know that the other fellow doesn't?

And if you don't know the answer, perhaps the lesson from this week's stories on SAC Capital is that maybe you shouldn't be playing the game.

Thursday, July 25, 2013

Prediction is Very Difficult, Especially About the Future

Source: The Reformed Broker
The title of today's post is taken from a quote generally attributed to Niels Bohr, a Danish physicist who was among the pioneers in quantum mechanics.

However, it is also very apt in regards to most things in life. It seems almost human nature that we all try to forecast events, despite the dismal track record of most predictions.

Josh Brown of the blog The Reformed Broker has a good link this morning to a site that I had never visited before, but I plan to bookmarking for future reference.

Titled "Pundit Tracker", the site keeps track of past predictions, and compares them to actual events. As you might expect, the score card is not pretty.

Brown has an excellent table summarizing the whole punditry business, reproduced above.  It does a very good job of summarizing the (career) risk/reward of making predictions.

Being in the consensus, but wrong, is usually not job-threatening ("Who would have known?") but bucking the trend and being wrong is often a one-way ticket to the unemployment line ("It was so obvious!").

After noting how wildly wrong most Wall Street forecasts have been for the S&P 500 over the past few years, here's what Josh Brown writes:

The mean S&P estimate was considerably off-target each year: by +960 basis points in 2011, -700 basis points in 2012, and -960 basis points so far this year...  the clustering effect was very pronounced, with five of the six analyst predictions each year falling within a 100 point range (1350-1450 in 2010, 1250-1350 in 2011, and 1500-1600 in 2012) – ranges which failed to capture the actual result in every instance.

So what is behind the errant clustering? The biases of anchoring and recency are likely culprits, with analysts anchoring to a baseline...and extrapolating from recent trends. We believe career risk is also at play: as investor Joel Greenblatt put it, “It’s much safer to be wrong in a crowd than to risk being the only one to misread a situation that everyone else had pegged correctly.”

But how do we reconcile the incentive for pundits to not stray from the consensus – and thus minimize career risk – with the bombastic pundits that we all love to rail on? ...Why aren’t they concerned about career risk? Well, here’s the catch:

In punditry, if you are going to be wrong, it pays to be spectacularly wrong.

Wednesday, July 24, 2013

What Now?


I have long been a fan of Michael Hartnett, Merrill Lynch's chief global investment strategist.  He was in town yesterday, and with the S&P 500 hovering just below 1700 I was eager to hear his thoughts.

Unfortunately, Michael seemed to be struggling like the rest of us to figure out the next move for the markets.

There is a significant disconnect between the message from the U.S. stock market - which has rallied +50% over the past three years - and the fundamental U.S. economic picture, which is mostly one of tepid growth.

Globally, the picture is not much cheerier. For example, Caterpillar just reported its quarterly earnings, and management commentary was not particularly optimistic.

Here's how the blog Business Insider reported on Cat this morning:

Caterpillar is a global supplier of construction and mining machinery. As such, it's considered to be a reliable bellwether of global economic activity. In other words, what's bad for Caterpillar is good for almost no one.

Among other things, management downgraded its forecast for global growth.
"World economic growth slowed in the first half of the year, and we are revising our growth estimates downwards," they said. "Although we expect some improvement in the second half, the improvement will be less than previously expected. Currently, we expect that world economic growth for 2013 will be a little over 2 percent, slightly slower than in 2012."

Here are some key bullets from their comprehensive economic outlook:
  • In the first half of 2013, industrial production in over half the countries in the world remained below pre-recession peaks and unemployment remained high. These factors have slowed inflation, and we do not expect inflation to be a problem for the world economy in the second half of 2013.
  • We expect weak growth, high unemployment and low inflation will encourage most central banks to continue pro-growth policies. Eighteen central banks cut interest rates this year, reducing average short-term rates to levels lower than 2009. We expect average interest rates to remain near record lows in the second half of the year.
  • Near-zero interest rates are causing some central banks to inject funds (quantitative easing) into financial systems to promote lending and economic growth. Japan recently adopted more aggressive policies, which appear to be effective in improving economic growth. We expect these results will encourage other countries to take similar actions.

Hence the struggle that Michael Hartnett and other global strategists are facing.

Hartnett pointed out that the U.S. market stands alone in having avoided any significant decline in the past couple of years.  Bond prices have fallen in most major markets, and commodity prices have also moved sharply lower from earlier levels.  

Gains in the U.S. stock market have also eclipsed the returns for nearly every other major market over the past three years, as the chart above indicates.

A couple of years ago, Hartnett was one of the few bulls on the U.S. dollar and U.S. stocks.  Now this is the consensus, which is worrisome to him. 

Basically Hartnett argues we are at a crossroads.

One possibility - and the most likely, in his opinion - is that the fledgling economic recovery in the U.S. and Europe gathers momentum.  GDP growth moves sharply higher, and interest rates follow suit. The Fed begins to "taper" its presence in the credit markets, but no one really cares - the economy is doing just fine, even with higher rates. In this case, global stocks continue to do well.

The other possibility is less likely but still very possible, according to Hartnett. If the only reason for the recovery in housing has been central bank intervention, the economy will once again stall.  Interest rates will tumble lower once again, as investors focus on safety, and not total returns.  Stocks in this scenario move sharply lower.

Hartnett thinks that the emerging markets could offer a good trading opportunity for the remainder of the summer. Sentiment is so bearish (see my post yesterday, for example) that any sign of a positive "surprise" could see a sharp rise in emerging markets stocks.  But this would only be a trade - Hartnett feels the fundamentals do not warrant a long-term commitment.

In other words:  Who knows?