Introduction

 

The third quarter of 2011 was dismal for the U.S. stock market as investor panic reminiscent of the 2008-2009 financial crisis returned.  Despite $4 a gallon gasoline, the “Arab Spring,” ongoing European debt woes, and political turmoil, the U.S. stock market returned 6.02% in the first half of 2011 on the back of continued strong corporate earnings.  However, these gains quickly reversed in mid-July when a series of macro events evaporated what little investor confidence had returned in the last two years [including gridlock over the debt ceiling in U.S., Europe sovereign debt crisis, renewed fears of global recession].  The National Association for Business Economics, a panel of 52 economists, expects GDP to rise by only 1.5% at the end of the year.  That’s down from their 3.1% GDP growth forecast in May.  They have also lowered their 2012 forecast to 2.7% from 3.3% in May.  As a result, returns through the end of the third quarter for the S&P 500 were down 9.17%.  While results were weak in the U.S., you were hard pressed to find positive returns in any equity markets around the world.  In fact, out of 94 global equity markets this year, only 6 are in positive territory (Venezuela, Mongolia, Zambia, Jamaica, Mauritius, & Sri Lanka).   The following chart summarizes the confluence of events in Q3 that led the S&P 500 Index from a high of 1344 in July to a low of 1120 just 17 days later.

Over the past three months, a number of events contributed to the sharp stock market pullback.  Four are particularly relevant to our focus on generating returns going forward.  The first two, the European debt crisis and lack of job creation, “triggered” the pullback during the months of August and September.  Both of these issues created a level of anxiety and uncertainty in the marketplace which will only reverse when a credible plan by lawmakers is unveiled.  The next two issues, increased correlation between stocks and asset classes and high frequency trading programs, have exacerbated the pullback and increased volatility.

It is vital to investigate the short- and long-term implications and the trade-offs among each of these themes.  For example, with regard to legislative actions in Europe or a potential jobs bill/stimulus at home, there are outcomes that may relieve the short/immediate term crisis, but fail to get at the root of the problem and fundamentally solve the issue over the long term.  This letter will address these important issues and try to provide some insight from our perspective.

I. European Debt Crisis

 

Eighteen months after the European sovereign debt crisis first began attracting global attention, the situation is quickly unraveling.  On September 22, the yield on 1-year Greek government bonds closed above 135% and Greek 10-year bonds yielded 22%.  The bond market continues to expect Greece will default on its debt.  In July, European political leaders announced a set of proposals to address the crisis including a second bailout for Greece.  Under the reforms, a €440 billion fund called the European Financial Stability Fund (EFSF) was set up to facilitate low-cost loans for struggling EU members.  The overhaul had to be approved by all 17 individual governments, and on September 29, Germany (a lone and very important member of the EU on the fence) voted to approve the funding.  In essence, this fund will serve as a temporary lifeline for Greece while European leaders either use the time to better prepare for a default or find a more robust funding plan to prevent contagion (some analysts estimate €1-2 trillion in total funding would be necessary!). 

Debt problems in countries like Greece and Italy matter because they threaten to spill over into the European banking system and, potentially, to the U.S. banking system.  European banks face credit risk in their direct exposure to government debt that was issued by these struggling countries.  Shockingly, the European regulatory structure doesn’t require these banks to hold any capital against European government debt.  This allowance enabled European banks to reach for yield without raising capital that would have countered the risks they were taking.  In the United States, according to Fitch Ratings, almost half of the U.S. prime money market funds possess obligations issued by European banks.  Again, this is an issue of reaching for yield with the presumption that bank bailouts will serve as a backstop.

[Please note – The Federal Reserve set up the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) in 9/08 to foster liquidity in the commercial paper market and to assist money funds in meeting demand for potential money market redemptions by investors.  While the program closed in 2/10, we believe it would be reinstated should liquidity concerns reemerge.]

The questions become what could happen and what are the implications for investing?  The bond market is pricing in a Greek default.  David Zervos, Chief Strategist at Jefferies, suggests a scenario where Greece and perhaps a couple other countries are kicked out of the EU, and a stability fund is used to prevent contagion with other “too big to fail” countries like Italy and Spain.  Alternatively, the taxpayers of Germany and France either agree or are forced by lawmakers to subsidize a massive bailout to preserve the European Union.  Unfortunately, the consensus needed for this resolution makes a massive bailout an unlikely scenario. The repercussions for not acting in the short term would likely be dire; fears of a Lehman-like scenario could be pervasive.  However, an outcome that leads to a resolution of the crisis, no matter how ominous the consequences in the short term, will provide the clarity the market needs to move forward longer term.

 

II. Stubbornly High Unemployment

 

The President spoke to a bipartisan Congressional commission on September 19 and proposed a plan to reduce the budget and unemployment.  While purchasing power is the most important driver of economic growth, the main deterrent to reigniting purchasing power is stubbornly high unemployment. Jobs are a top priority, both economically and politically.  The plan provides for $447 billion in new spending which would allocate $65 billion for small businesses and job creation and another $49 billion for unemployment benefits.  However, the largest swath of the bill, $100 billion, is for an ambitious program to build and repair roads, bridges, airports, and other infrastructure.  The bill also proposes to create the National Infrastructure Bank: a $10 billion project that would offer loans to pay up to 50% of the costs for new transport, water, and energy systems.

There will be an ongoing debate as to whether a government funded stimulus is the right path to take at this time.  Assuming another government-induced spending bill is enacted, the emphasis on shovel ready jobs is a given.  Let’s examine the facts that are undisputable: 1) there is clearly a necessity for a U.S. infrastructure upgrade and this is understood and desired by the populous; 2) the easiest way to accomplish the goal of a quick shot of fiscal stimulus is through construction hires, production of building products, etc. 3) infrastructure spending would decrease the eye-popping 13.5% unemployment in the construction sector.  The problem is that the program seeks to re-inflate an employment bubble in the construction sector that occurred pre-U.S. recession.  While clearly a short term stimulus, this does little to promote sustained low unemployment for the long term (see chart).

                               Source: Bureau of Labor Statistics

The United States has been shedding manufacturing jobs for over a decade.  This was disguised for a large part of the 2000’s due to the housing boom, which created temporary, non-tradable construction jobs until 2008.  The only way these jobs come back is through government stimulus as a housing and private sector construction rebound is a long way off.  A long term solution would include a competitiveness program, investments in education, vocational training, and apprenticeships instead of “shovel ready” jobs that are here today gone tomorrow.  A serious jobs bill will not be a quick fix, but a reorientation of the economy that is positioned in an increasingly globalized economy.

 

III. Correlation Among Assets

 

In the world of behavioral finance “herding” is a term that is commonly used to describe investor behavior.  Herding, in an investing context, describes the tendency of investors to mimic the actions of the larger group.   In recent weeks, the correlation among U.S. equities in the S&P 500 has approached 90% (correlation between 1987 – 2011 averaged between 30-60).  This is even higher than the after Lehman failed three years ago.  Investors in “risky” assets such as stocks and commodities have abandoned, en masse, those assets in favor of traditional havens such as U.S. treasuries, the U.S. dollar, and the Swiss Franc.  This movement has been rapid and indiscriminate.  In other words, over the last two months, individual security selection has been far less relevant with selling in domestic equities occurring across the board with no regard for fundamentals.  Not only has this phenomenon occurred within stocks, but also among asset classes.  For example, JP Morgan found that risks from the sovereign debt crisis in Europe influence the move in gold.  They found that gold is 67% correlated with credit spreads on European government bonds like Greece, Spain and Portugal.

This herding behavior is amplified by changes over the years in how investors trade securities.  The increase in ETFs and index-linked products has increased the size of the “herd” and the speed and ease of liquidating assets.  Also, the globalization of financial markets has resulted in a more permanent correlation among global markets.  In fact, correlation between developed and emerging markets has increased from 10% in the early 1990s to close to 50% today.

In the short term, this is a major challenge for asset allocators and risk managers since it’s tougher to achieve diversification as correlations rise.  However, what do other high correlation events such as the 1987 crash, Lehman Brothers failing, the Flash Crash, and the Japanese Tsunami teach us?  At the minimum, in the short term, the markets rebounded sharply following these market crises.  Investors were rewarded for sticking to their guns or acting contrary to the “herd,” granted there were other negative, mutually exclusive events that followed in months after.  In the long term, correlations should return toward historical norms with security selection becoming more important to portfolio performance.   That is why we believe that consistency in investment discipline and a focus on fundamentals will win out once the dust settles.

IV. Impact of High Frequency Trading

High frequency trading is the use of technology to make trades in a matter of microseconds.  This technology is used because it can process large quantities of information that individual human traders can’t process.  The idea is to capture, through large volumes of trading, very small discrepancies in prices at a rapid pace.   This is counter to the notion of human portfolio managers making investment decisions for the longer term based on fundamentals. According to the NYSE, in the early 2000s, high frequency trading accounted for less than 10% of all trades, but has since grown by 164% between 2005-2009.  Furthermore, in the U.S., high frequency firms represent 2% of firms operating today, but account for roughly 50-60% of all equity orders volume. The advantages of high frequency trading are that it has brought increased liquidity to the markets, lowered trading commissions for the individual investor, and decreased the bid-ask spread.  However, as SEC Chairman Mary Shapiro said in a speech on September 22, 2010, “…. high frequency trading firms have a tremendous capacity to affect stability and integrity of the equity markets.”

During the last two months, we would argue that high frequency trading has exacerbated the volatility surrounding the sell-off.   The role of this type of trading is controversial and while there’s lots of talk about regulation, high frequency trading firms are the best customers of the stock exchanges as they compete for a shrinking piece of the pie.  This unfortunately may curtail the pace of regulation as the exchanges are highly regarded as a national institution.  Furthermore, many blame the SEC for intensifying the volatility brought about by high frequency trading by eliminating the uptick rule on July 6, 2007 when they concluded that “the rule modestly reduces liquidity and does not appear to prevent manipulation.”  The uptick rule was a trading restriction that disallowed short selling of securities except when the price of the security “ticked” above the last traded price.  The argument is that the elimination of this rule allowed the short sellers (including trading programs) to pile on during a declining market, increasing volatility.  While there was bipartisan support for re-implementation of the uptick rule, the SEC only went as far as to enter a public comment period on 4/8/09.  Over the past two years the rule has not been reversed, and political pressure has subsided.  We believe that a reinstatement of the uptick rule would aid in restoring investor confidence in the market by reducing volatility.

The bottom line is that the extreme volatility that we’ve witnessed is brought upon by noise exacerbated by high frequency trading.  This is a reality that we face from a short term perspective.  However, it is our belief that in the long run, fundamentals still play a key role. High frequency trading simply makes the road to get to back to the place where fundamentals matter, bumpier. 

 

Conclusion

The major debate in the financial markets today revolves around whether or not the U.S. is going to experience a “double-dip” recession, and what that means for expected earnings growth. We do not expect a recession, but if that does happen it should be a shallow one. There are massive amounts of liquidity in the financial system today and corporations are in the best shape in years. The economy is burdened by too much debt in the consumer and governmental sectors of the economy, and an anemic trend in job creation. We remain cautiously optimistic that the politicians in the U.S. and Europe will eventually wake up and “do the right thing” as the consequences of not acting in a prudent and responsible manner are not pretty.

We anticipate that markets will continue to be volatile until Europe finds a resolution for its problems and until politicians across the globe learn to compromise across party lines.  Unfortunately, this uncertainty and irrationality can last for protracted periods.  As a result, we have looked to raise some equity cash across accounts to help mitigate these risks and to leave us with dry powder to deploy when opportunities arise. Our continued advice is to take a long term perspective and to maintain a disciplined approach when basing asset allocation decisions.  This approach is particularly valid for equity investing.

 

 

 

 

(c) Hester Capital Management

www.hestercapital.com