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Answers & Observations

Stay up to date with the latest personal finance developments, financial planning advice, investment news and retirement planning tips from our team of certified financial planners and experienced wealth advisors here in New York City.

Stock market overall stays cheap

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Stocks looked pretty healthy right up until May 10th when the Federal Reserve Bank raised rates for the 16th time to 5.0%.  The increase was widely anticipated, but investors read the attached commentary and noted with alarm that the Fed feared core inflation was on the rise as higher energy and commodity prices finally percolated into the general economy.  The conclusion was that the Fed would continue raising rates indefinitely.  Over the next month, the S&P 500 fell 7.5%, the NASDAQ 10.7%.  Damage in US markets was limited compared to certain indexes such as the gold index, down 28.8% and the oil index down 13.6%.  The decline was more dramatic in emerging markets – for example, India declined 34.3%, including a 14% decline in a single day.  Commodity, energy and emerging markets have been the hot plays of the last 18 months.  In a no or slow growth environment, these sectors would do poorly.  It seems that investors reached the same conclusion and all tried to exit those investments simultaneously.

At the June 29th meeting, the Fed raised rates yet again, to 5.25%, but this time the attached commentary suggested that economic growth was easing, with the implication that the Fed might raise one more time at the next meeting and pause after that.  US markets soared, retrieving half the losses of the previous 5 weeks,

Pushing back from the day to day activity, what’s really going on here?  We’ve made some comments in the past about the trading of hedge funds exaggerating price moves in the markets, and we did some research recently to try to quantify the size of the effects.  First off, what is a hedge fund?  In principal, a hedge fund eliminates the contribution of overall market moves to a portfolio’s return (beta) while providing an overall absolute return (alpha).  In theory, this strategy should provide more stable, yet on average lower, returns compared to simply buying an index fund.  In practice, hedge funds have become highly leveraged long/short trading vehicles pursuing any number of strategies.  Their returns can be sharply higher compared to a conventional strategy, but losses can be total.  Because of the leverage component (hedge funds borrow against assets to enhance returns), hedge funds can be forced to liquidate positions if a market goes against them and make things worse by selling into a falling market.  Over the last 5 years, hedge funds have soared from 1,000 to 8,000 firms, and assets under management have grown to $1.5 trillion, compared to $8.4 trillion invested with traditional money mangers.

By one statistic, hedge funds account for 25% of all trading on the New York Stock Exchange.  Another statistic, “program trades” as a percent of overall trading, is even more telling. Hedge funds, and banks/dealers copying hedge fund strategies, often send baskets of trades amounting to at least $1 million principal value of at least 15 stocks, to the NYSE for execution.  The percentage of program trades recently hit a record 76.3%, versus an average of 55.1% for the previous 12 months, an average of 40% in 2003, and an average of 20% in 2000.  We conclude, therefore, that the ever more volatile daily returns are being driven by a handful of frantic traders.  More traditional investors including registered investment advisers like HCMI, mutual funds and the average retail investor are sitting on the sidelines scratching our heads.  The only defense against such swings is to not get oneself in a leveraged situation where you have to sell into downturns, and simply ride them out.

Other than the sharp sell-off and recovery, not much else happened in the second quarter.  Earnings growth was fine, averaging 15.3% for Q1 and expected to grown 9-12% for Q2.  The final GDP report showed growth of 5.6% for Q1, and growth is expected to slow to 2.75% for Q2.  Inflation is running a little hot at 3.1%, employment is at a record, unemployment is at a cyclical low of 4.6%.  The housing market is clearing cooling.  Prices haven’t fallen year over year yet, but average time on market is up 50% in many markets, and nationwide there’s a 37% increase in the number of home for sale.  So far, we don’t see signs of collapse in real estate but we continue to monitor that situation closely.  In Iraq, there was some good news on the death of Abu Musab al-Zarqawi, but the US administration has learned not to get too hopeful that the situation there will be resolved any time soon.