Saturday, September 20, 2014

Weekly Market Summary

SPX, DJIA and NDX all ended the week at new highs. For them, the trend remains higher.

What is most interesting is the small cap index, RUT. Not only did it lose 1.2% this week while the other indices gained, but it is now more than 5% off its peak. For the year, RUT is negative and SPX is up 9%.

Is this divergence between SPX and RUT bearish? It would seem it should be. When small caps underperform, it indicates weakness in breadth as investors concentrate their buying in a relatively small number of large companies.

The problem is these divergences have usually not been bearish in the past few years. The yellow highlights below are times when small caps underperformed large caps (lower panel). Each time, SPX continued higher (top panel). The main exception was in 2012 (in orange).

Moreover, there were several instances where small caps outperformed large caps right into a market peak (shown with arrows). If anything, that has been a better predictor of trouble for SPX. Why would this be? When small caps outperform, investors are chasing performance. It's a beta chase, and this indicates exuberance. At an extreme, this exuberance is punished with a market correction.

Thursday, September 18, 2014

Why Late 90s Euphoria Is Not Coming Back

A recurring meme in the stock market is that retail investors today are not as enamored with equities as they were in the late 1990s. The softly spoken corollary is that until we see that level of euphoria, stocks will continue to rise unabated.

If you missed the 1990s, here are two personal anecdotes to describe what it was like:

1. Online trading services like E-Trade were brand new. Our firm was hired to advise one such company in 1998. During the course of several focus groups, former policemen and teachers described how they had left their jobs to day trade. But it wasn't just their own capital; they were also trading the savings and retirement accounts of their neighbors and family members.

2. In late 1999, we sat down with the CEO of mid-sized technology firm in Silicon Valley. As the meeting started, the CEO bought stock. Two hours later, he sold for more than a million dollar gain. The next week he used that money to pay 30% over the ask for a $4 million property in Atherton. He razed the nearly new house on the lot three months later.

Imagine this: the Nasdaq nearly tripled between 1996 and 1998. Then, in the next 18 months, it quadrupled. How do you think that impacted investor psychology?

That was the investment climate attracting former policemen and teachers to day trading. In comparison, the market's 60% rise since the start of 2013 seems rather drab.

There was a legendary IPO frenzy in the late 90s. went public in November 1998 at a price of $9. On the first day, it traded up to $97. Side note: by 2000, it was trading at 10 cents.

VA Linux gained 700% on its first day of trading in December 1999. The company was valued at $9 billion. The year before, Linux had $5 million in sales and earned a total of $84,000 in profits.

Wednesday, September 17, 2014

Why The Economic Recovery Has Been So Slow

Many market watchers continue to express surprise over the modest pace of recovery in the US economy since 2009. Are they right to expect growth to have been more robust?

The short answer is no.

The 2008 recession is not comparable to other downturns since the end of World War II. Therefore, expecting the recovery to track the pace of prior recoveries is misguided.

With few exceptions, post-war recessions have primarily been led by inflation and monetary tightening. Some of these came as a result of war: the Korean War in the 1950s and the Vietnam War in the 1960s, when government spending contributed to price hikes. In the 1970s and early 1980s, the primary cause for inflation were sharp spikes in the price of oil. To a lesser degree, that was also the case in 1990.

While 2000-02 is remembered now for the substantial fall in equity prices, the economic downturn was actually mild. The dot-com bubble had burst and then 9/11 took place. But GDP contracted by just 0.3% and unemployment peaked at just 6.3%. It was a stock market recession more than an economic recession.

The economic contraction in 2008 was nothing like any of these recessions. Inflation and monetary tightening had nothing to do with the recession: core CPI peaked at just 2.5%.

Tuesday, September 16, 2014

Fund Managers' Current Asset Allocation - September

Every month, we review the latest BAML survey of global fund managers. Among the various ways of measuring investor sentiment, this is one of the better ones as the results reflect how managers are allocated in various asset classes. These managers oversee a combined $700b in assets.

First, here is a quick recap of the story over the past few months:

Fund manager equity allocations reached an extreme in July. At +61% overweight, it was the second highest since the survey began in 2001. This was a clearly identified risk to near term equity performance (post).

In early August, the Euro 350 dropped 8% and SPX dropped 5%. In response, equity allocations fell to +44% overweight.

Moreover, fund managers moved to cash, with cash levels shooting up to 5.1%, also an extreme. As we specifically noted a month ago (post), this was a strong positive: cash above 5% has been close to equity lows in 2002, 2003, 2011 and 2012 (green shading).

Which brings us to the current survey of fund managers' positions. SPX and the Euro 350 rose more than 5% in the past month. Fund managers have responded by raising their global equity exposure to +47% overweight and reducing their cash to 4.6%.

Monday, September 15, 2014

Business Insider: Top Finance People to Follow

Many thanks to the people at Business Insider for including us in their annual list of the Top Finance People to Follow for a second year. The full list is here.