What's Causing the Malaise in the IPO Market?

I have been reading a book titled "Dark Pools:  High-Speed Traders, A.I. Bandits and the Threat to the Global Financial System". 

Written by Scott Patterson, the book describes how the old specialist system of the stocks exchanges has been gradually and then completely co-opted by quantitative models written by computer specialists who have completely changed the way stocks are traded - and largely not for the good.

The book is an eye-opener for anyone who trades stocks.

The "old" system was typified by a specialist standing on the floor of the New York Stock Exchange, making a market in a group of stocks.  Trading was usually orderly, and prices moved in increments of eighths.

That changed in 2000, when the system of quoting stock prices moved from fractions to pennies, a process described as "decimalization". 

The thinking was straightforward:  being a specialist on the NYSE was largely a license to print money, since the firms were really only making markets, and pocketing the difference between the bid and ask prices.  Lower spreads would presumably put more money in the pockets of investors rather than the specialists.

But that's not how it has turned out, and the markets are the poorer for it.

Not only are the equity markets being dominated by computers trading shares in a time frame measured in nanoseconds, but smaller less liquid shares are being largely ignored, since the miniscule spreads make it unprofitable for dealers to traffic in all but the most actively traded large cap stocks.

By definition, most IPO's are small companies seeking to raise capital, but if the liquidity in the small cap market is gone it effectively closes the window on most IPO activity.

Regardless of your feeling about IPO's, they are an important part of our economy. Small successful companies need capital to grow and create jobs, but if the capital markets window is shut our economy is impacted.

Here's what author Robert Cringely - who has followed the technology industry for decades - wrote on his blog I, Cringely:

Decimalization made High Frequency (automated) Trading possible — a business tailor-made for trading large capital companies at the expense of small caps and IPOs. Add to this the rise of index and Exchange Traded Funds and all the action was soon in large cap stocks. Market makers were no longer supporting small caps by being a willing buyer to every seller. Big IPOs like General Motors flourished while little Silicon Valley IPOs dramatically declined.

There are 40 percent fewer U.S. public companies now than in 1997 (55 percent fewer by share of GDP) and twice as many companies are being delisted each year as newly listed. Computers are trading big cap shares like crazy, extracting profits from nothing while smaller companies have sharply reduced access to growth capital, forcing them at best into hasty mergers.

Yes, commissions are smaller with decimalization but it turns out that inside that extra $0.0525 of the old one-sixteenth stock tick lay enough profit to make it worthwhile trading broadly those smaller shares.

Decimalization pulled liquidity out of the market, especially for small cap companies, hurting those companies in the process. Markets and market makers consolidated, which also proved bad for small caps and their IPOs. Wall Street consolidation was good for big banks but bad for everyone else.

http://www.cringely.com/2012/09/05/ticked-off-how-stock-market-decimalization-killed-ipos-and-ruined-our-economy/

The debacle of the Facebook IPO earlier this year has been widely cited as the reason that the IPO market has been so weak this year.  But I suspect that the real culprit is the changing nature of the stock market trading mechanics, as Cringely writes.

Cringely cites a presentation by David Weild of Granton Thornton as the source for much of his data, including the chart shown above.  Here's the link to Mr. Weild's very informative presentation:

http://nowstreetjournal.files.wordpress.com/2011/03/weild-atlanta-presentation-dara.pdf

Revisiting Ned Davis's Three Rules of Making Money in Stocks

The Financial Times had a short article this morning describing the contrast between the relentless rise of the stock market and the sour mood in Corporate America.

Here's what the FT wrote:

Corporate America is more pessimistic about the prospects for short-term earnings growth at any time since the start of the financial crisis as a slowing global economy weighs on demand for the goods and services of U.S. companies.

Even as the US stock market hit a four-year high, year-on-year earnings growth for the S&P 500 slowed to just 0.8 per cent in the second quarter, while the consensus forecast among analysts is for growth to turn negative in the current quarter for the first time in three years.

http://www.ft.com/intl/cms/s/0/0d029d4c-f8d5-11e1-8d92-00144feabdc0.html#axzz264vTBFqv

Typically weakening fundamentals in the middle of a broad market rise should give rise to thoughts of reducing equity exposure.

Should you be selling now?

In the past I have found strategist Ned Davis's - founder of Ned Davis Reseach (NDR) - three rules of investing helpful in asset allocation decisions, so perhaps this is a good time to review.

1. Don't fight the tape - historically it has never made sense to bet against a strongly trending market, even if an investor is uneasy with the fundamentals.  As NDR's chief global strategist Tim Hayes wrote this morning, the most of the global equity markets are in confirmed uptrends:

Following a consolidation phase that returned the market to oversold conditions, global breadth has rebounded, with expanding percentages of markets at one-year highs...And a growing majority of markets have rising 50-day and 200-day moving averages...

http://www.ndr.com/scrndr/servlet/EProduct/BPK006/INF_C201209101.PDF?id=159123

2. Don't fight the Fed - when monetary conditions are easy, as they certainly are today, capital markets tend to rise in price. Moreover, an overwhelming majority of market participants now expect the Fed to be "on hold" until at least 2015, according to Bloomberg:

Just six months ago, money market traders expected the Federal Reserve to raise interest rates by the end of 2013. Now, they see borrowing costs staying at record lows for about three more years as the economic outlook worsens. 

Bond market measures from overnight index swaps, which indicate no increase in the federal funds rate until mid-2015, to a 62 percent decline in a measure of volatility in government bonds signal that rates will stay near zero for longer. The gap between two- and five-year Treasury yields, which decreases when traders expect benchmark rates to remain subdued, is more than 50 percent narrower than its average since 2008. 

http://www.bloomberg.com/news/2012-09-10/fed-stuck-at-zero-into-2015-seen-in-swaps-qe-odds-reach-99-1-.html

3. Be Wary of the Crowd at Extremes - when bearish or bullish sentiment become too widespread, markets will tend to react in the opposite direction of prevailing sentiment.

This one is tricky to measure, however.  While the retail investor continues to flee domestic equity mutual funds (which could be considered bullish), Wall Street is becoming decidedly bullish, which is cause for concern.

Here's what the blog Business Insider wrote this morning:

Markets are down a hair today, but the theme of the morning is clear: 

Uber-bullishness. Everywhere.

This is the most unanimously bullish moment we can recall since the crisis began.
Note that this comes as U.S. indices are all within a hair of multi-year highs, and the NASDAQ returns to levels not seen since late 2000.

Big macro hedge funds, who have been famously flat-footed this year, are now positioned for a continued rally

Read more: http://www.businessinsider.com/bullish-sentiment-widespread-2012-9#ixzz264zkKV9E

So, in my opinion, while the tape and the Fed continue to warrant a full allocation to stocks, I am slightly uneasy with the pervasiveness of the Street's enthusiasm for stocks.

Investors Continue to Flee Stocks Despite the Rally

Merrill Lynch global strategist Michael Hartnett wrote the following in his strategy piece this week:

Today, Nasdaq closed at the highest level since Dec '00 and {the S&P 500} closed at highest level since Jan '08.  And yet, weekly flows show largest equity outflows in 2012.

Investors have simply not been positioned for a rally.  They remain more willing to take risk in fixed income, which we think in in the early stages of a bubble.

http://rcr.ml.com/Archive/11202041.pdf?w=dglen%40bpbtc.com&q=8IodimVFfDgt1euImVSpwg&__gda__=1347029734_b28ee057a37d0b27036207a6e95c3e43

This truly has been a hated rally.  Bears offer a multitude of reasons why stocks should be sharply lower, but the relentless rise of the market has thus far proven them wrong:

 

With the exception of the market swoon in May, stocks have moved steadily higher this year, and the S&P 500 is up  +15.6% through yesterday.

Yet the drumbeat of negative newsflow and commentary continues.

This has been a consistent theme since the credit crisis of 2009.  Investor focus has been mostly on what can go wrong, rather than what might be working.  Most would probably surprised by just how well stocks have done - doubling in a little over three years time.

However, as the blog Business Insider writes, valuations in general are actually a little cheap to historic averages:

The S&P 500 is trading 13 percent below its average valuation since the 1950s and its price-to-earnings ratio has fallen throughout the rally since 2009, according to data compiled by Bloomberg. The benchmark gauge for American equities trades at 14.51 times reported profits, down from the 24.26 reached in December 2009, the data showed.

And yet, as the article continues:

Even as the S&P 500 doubled, investors pulled money from mutual funds that buy U.S. stocks for a fifth year in 2011, the longest streak in data going back to 1984, according to the Investment Company Institute, a Washington-based trade group. Withdrawals were $135 billion last year, the second-highest total after 2008, and about $75 billion has been pulled in 2012.

Read more: http://www.businessinsider.com/bloomberg-M9Y64S0D9L3501#ixzz25nUN3jM4

Although I do not have any hard data to support this, I think there currently is an inverse relation between an investor's age and the way they view the stock market.

Younger investors - which I define as under the age of 40 - see the stock market either as a trading vehicle or something to avoid altogether.

This is not surprising, in a way:  After the strong gains in 1980's and 1990's, stocks have been mostly in a broad trading range.  The S&P, for example, has traded at around 1550 twice over the last 12 years (in 2000 and 2007) only to pull back sharply each time.

Older investors, on the other hand, survey the current investment landscape, and tend to see stocks as really the only viable investment for anyone with a longer term time horizon.  Buying bonds, or holding funds in reserves, may feel right on certain days, but the odds overwhelmingly favor the stock market in most scenarios.

And, given the fact that I am, ahem, well into my 50's, you can guess which camp I fall into.

Are Money Market Funds Toast?

Yesterday I posted a short note discussing the possibility that interest rates in this country might go negative. 

While I still think this is unlikely - the practical implications of paying a fee to simply park your money in a savings account seems too unwieldy - negative interest rates are already a reality in several European countries.

Short term government rates in Germany, France and Denmark are all negative at the present time.  The level of anxiety and fear over the fate of the euro, and the shaky status of the banking system, have lead a large group of investors to prefer to pay for the safety of northern European government paper.

However, this is creating a real problem for money market funds, as the Financial Times wrote this morning.

Money market funds have been subsidized by their sponsors since 2009, but this subsidy has taken the form of waiving management fees, not paying out actual cash.

However, if the funds are not able to earn a positive return, they face the choice of either shutting their money market fund down (which Bank of America has already done in Europe) or "break the buck" on the net asset value of their fund.

The latter means that for the first time in most investors' history, they would lose money by investing in a money market fund:

Here's what the FT wrote:

The €1.1tn money markets funds industry invests in “ultra-safe” short-term debt and puts money on deposit at banks on behalf of corporations and other investors looking for a safe harbour, rather than strong returns, for their excess cash. 

But with interest rates on German and French short-term government paper now negative, the funds are already struggling to provide any returns at all. 

According to Crane Data, which tracks the industry, the average European money market fund now yields zero, and fund managers have cut fees sharply in the past year to prevent yields turning negative. 

Were the ECB deposit rate to turn negative and be backed by other controls to ensure that banks could not sidestep the penalty rate, the knock-on effect on short-term government paper and bank deposit rates might force funds to give up the fight. “Negative rates on high quality cash will just destroy the money market industry,” says Andrew Bosomworth, head of portfolio management in Germany for the bond investor Pimco. 

http://www.ft.com/intl/cms/s/0/c6455d4a-f69a-11e1-9dff-00144feabdc0.html#axzz25dAYOH7t

Money market funds are a relatively recent innovation.  In this country, money funds started in the mid-1970's when federal regulations prevented banks from paying depositors more than 5 1/4%.  However, this regulation - Regulation Q - did not apply to large depositors, who could earn prevailing market rates which were much higher than 5 1/4% at the time.

Thus the mutual fund industry came up with the brilliant idea to pool the funds of smaller investors, and allow them to earn the same money market returns as their wealthier cousins.

SEC regulations were enacted to allow the industry to create the accounting fiction that the value of the shares of in a money market were unchanged (even though the market reality was different) so that investors could enjoy a bank-like stability and earn good returns.

When short term interest rates soared in the 1980-81 period in the wake of the Fed's effort to wring inflation out of the system, money market funds boomed, and the banking system never the same since.

Until now.

I'm not sure that most central bankers would be all that sorry to see money market funds disappear.  In the credit crisis of 2008 the Fed had to ride to the rescue to save the money market fund industry even though they did not fall under any sort of central bank regulation.

And recent efforts to try to force some sort of regulatory oversight on the money fund industry was beaten away by industry lobbyists just two weeks ago.  SEC Chairman Mary Schapiro had planned on enacting new rules on money market funds that would take effect on August 29, but industry insiders have recently forced her to reconsider.

If the trillions of dollars now parked in money funds flow back into the banking system it could be a serious blow to the entire mutual fund industry.  At the same time, it would be a huge earnings impediment on the banking industry, which already has more capital than lending opportunities.

What to do With Stocks in September?

Lately I have noticed a blizzard of articles and news commentaries letting investors know the "happy" news that September has historically been the weakest month for stock market returns.

Here's how Ned Davis Research describes it:

Since 1928, the S&P 500 Index has risen only 44% of the time with an average return of -1.11% and a median return of -0.42% during September. The statistics show September as one of the worst months for the stock market historically.

http://www.ndr.com/clients/products/ERB201209021.HTML?source=CRH201209041.HTML

So, after digesting the most recent batch of soft economic data, and recognizing that September is usually a pretty crummy month for stocks, should investors be selling?

I would not, for several reasons:

1. Any widely followed Wall Street metric often has the nasty habit of being wrong, especially when it is so broadly discussed.  Remember the "sell in May and Go Away" mantra you heard last spring?  It worked for exactly one month (May) and then stocks moved steadily higher.  
2. While it is true that the historic average return for stocks in September is -1.1%, is only -0.45% in Presidential election years;
3. According to Ned Davis Research, going back to 1900, stocks typically rally in the period after the election if the incumbent wins.  Even if the challenger wins, stocks move sideways or slightly higher;
4. The alternative to stock investing - cash and bonds - offer very meager returns to a longer term investor.  

This is not to say that we might not be setting up for a correction - after moving steadily higher since the end of May a retreat of -5% or so in the broader averages would not be a shock - but rather to say that market timing is a very tricky business.

Look at it this way:

Let's just say that you were trying to decide asset allocation in September 2002, and were blessed with perfect foresight into the upcoming events in the next 10 years.

You would see, among other things:  an implosion of the housing market; two protracted wars in Iraq and Afghanistan; a ballooning of the federal budget deficit; a horrific credit crisis in 2008 that would lead to the worst economic period in 50 years; and an economic crisis in Europe that threatened the survival of the euro.

If you had seen all these events coming, you might have been tempted to stash all of your assets in cash, and "wait until the smoke cleared".

But this would have been the wrong decision.

For the 10 years ending August 31, 2012, stocks have returned +88%.  A $100,000 investment in the S&P 500 10 years ago would be worth $188,000, or nearly double the starting value. An investment in small cap stocks would have done even better.

Cash investments, meanwhile, would have offered some comfort, but little return.  Using the 3-month Treasury bill as a proxy, $100,000 parked in cash 10 years ago would be worth $120,000, or a total return of +20%.

Inflation over the past 10 years, by the way, is up +27%, meaning that not only would have a money market fund yielded punk returns, it also would have returned less than the rate of inflation, meaning that you would have lost money in real terms.

What If Interest Rates Go Negative?

During his speech last week's Jackson Hole, Wyoming, meeting, Federal Reserve chairman Ben Bernanke gave broad hints that the Fed was considering additional steps in trying to spur economic growth:

JACKSON HOLE, Wyo. — The Federal Reserve chairman, Ben S. Bernanke, signaled once again on Friday that the central bank was prepared to act if the economy continued to weaken, as yet another economic report confirmed that the recovery had slowed to a crawl...
 
While Mr. Bernanke announced no new steps that the Fed would take immediately, he said the central bank was determined to prevent the economy from slipping into a cycle of falling wages and prices, a situation he said he did not think was likely. Instead he predicted that growth would continue modestly in the second half of the year and pick up in 2011. 

http://www.nytimes.com/2010/08/28/business/economy/28fed.html?pagewanted=all

The Times article went on to describe a variety of different monetary tools the Fed might consider, but with interest rates a historic lows many observers are questioning how much firepower the Fed actually has left.

But other economists are looking at more innovative ideas to try to spur economic growth.

One of the more intriguing ideas was the subject of a paper written by two economists from the New York Federal Reserve.

Co-authored by Kenneth Garbade and Jamie McAndrews, the article discussing the idea to charge banks a fee for excess reserves, i.e. negative interest rates.  The hope would be to try to force more lending and investing, and reduce the huge stockpiles of cash reserves, by making hoarding cash an expensive proposition:

 One way to push short-term rates negative would be to charge interest on excess bank reserves. The interest rate paid by the Fed on excess reserves, the so-called IOER, is a benchmark for a wide variety of short-term rates, including rates on Treasury bills, commercial paper, and interbank loans. If the Fed pushes the IOER below zero, other rates are likely to follow.

http://libertystreeteconomics.newyorkfed.org/2012/08/if-interest-rates-go-negative-or-be-careful-what-you-wish-for.html

If you follow the link, you will find the article, which generally comes out against a negative interest rate policy, because of the number of likely unwanted consequences a negative interest rate policy would carry.

But the idea still should be considered by investors, particularly if you believe that Governor Romney will be our next President.

Romney has strongly suggested that if he becomes President he will move to replace Ben Bernanke when Bernanke's term expires in 2013.  One of the leading candidates to replace the current Fed Chair would be Harvard professor Gregory Mankiw, who played a prominent role in advising President George W. Bush.

In 2009 Professor Mankiw wrote an editorial for the New York Times that suggested that the Fed discussed the concept of a negative interest rate policy.  While he agrees that the idea has a number of problems, he also suggested that there might be ways that moving interest rates to below zero might work.

Here's an excerpt:
 
The problem today, it seems, is that the Federal Reserve has done just about as much interest rate cutting as it can. Its target for the federal funds rate is about zero, so it has turned to other tools, such as buying longer-term debt securities, to get the economy going again. But the efficacy of those tools is uncertain, and there are risks associated with them. 

In many ways today, the Fed is in uncharted waters.

So why shouldn’t the Fed just keep cutting interest rates? Why not lower the target interest rate to, say, negative 3 percent?

At that interest rate, you could borrow and spend $100 and repay $97 next year. This opportunity would surely generate more borrowing and aggregate demand.

http://www.nytimes.com/2009/04/19/business/economy/19view.html?_r=1

A Different, More Optimistic View Of Spain

Last spring my wife and I traveled to Barcelona. We had a marvelous trip,  and found the city to be extremely welcoming and culturally exciting.

The timing of our April trip was propitious.

Only two weeks before we arrived, there had been a massive protest against the government's austerity programs right outside the Barcelona stock exchange.

Walking by the exchange during our visit you could still see the marks on the walls of the exchange where protestors had thrown rocks and paint.

But still:  the restaurants were full, and the shopping areas mobbed.  For all of the troubles that the international press had reported, Barcelona seemed to us to be a vibrant and bustling place.

We had coffee with a couple who live in Barcelona.  They confirmed that while beneath the surface economic conditions were less than ideal, the actual living experience of most citizens in Barcelona was not all that bad.

The Financial Times had an interesting piece about the contrast between life in Spain and the steady stream of poor economic data emanating from official sources:

For foreign investors arriving in Madrid, signs of economic duress are not always as obvious as they might have imagined.

Bars are regularly full, traffic appears steady and, most surprisingly, the country's youth, of which more than half are not in work, appear subdued.

"People who come from abroad for the first time are often surprised," a banker who organizes meetings for overseas managers says.  "They expect there to be young people rioting on the streets."

http://www.ft.com/intl/cms/s/0/b07ab6d8-f2bf-11e1-8577-00144feabdc0.html#axzz257zC4gIj 

So we were not alone in our puzzlement.

But what about 50% Spanish unemployment rates in people aged 16 to 25 that is often reported?

Well, as the article notes, it turns out that this figure is slightly misleading.

While Spain uses the methodology employed by all EU members to calculate youth unemployment, most recently at 53.5 per cent, the percentage of young people who are unemployed, looking for work and outside education or another form of activity stands at 23 per cent - a very large, but less alarming number.

"It is a diagnostic error to take these numbers at face value," {Spanish labor expert Angels} Valls says. "Fifty per cent youth unemployment is not the same as half of all young people being out of work."


I have read elsewhere that reported Spanish unemployment rates have always been higher than most other countries.  In 2007, for example, unemployment rates never got below 15%, despite the housing-fueled boom that was going on in Spain at the time.

The reason?  Well, let's just say that many Spanish workers share the same aversion to paying taxes similar to other Southern European nations.

This is not to belittle the very real financial problems that Spain faces.  Earlier this week Catalonia - the region in Spain which includes Barcelona - officially asked the Spanish government for 5 billion euro as emergency funding.

But the contrast between the strains in the Spanish financial system and its citizens' economic reality is striking nonetheless.