The Lead Lag Report - October 2007
Source: Bloomberg
*Note: ETFs which may track indices such as those mentioned may be held long or sold short by portfolios managed by the author at time of writing. This list is provided for informational purposes only and is not intended as a recommended buy list.
Despite the continued volatility of the markets, October’s market leadership appears to have come from smaller-cap names, with the Small-Cap and Mid-Cap indices outperforming the broad market. Short-term sentiment may be shifting into riskier assets as we enter the ever-so-important November/December Holiday season. Historically, Small-Cap stocks have tended to perform better than their larger brethren in the latter part of the year. Much of this can be attributed to a general sense of optimism that occurs during the gift-giving period, resulting in more optimistic valuations and potentially higher risk-taking. Given the concerns which still remain regarding the sub-prime fallout, investor sentiment and perception of the future will likely dictate whether or not the historical outperformance of higher beta stocks in the 4th quarter will persist this year.
Sector Performance
Source: Bloomberg
*Note: ETFs which may track indices such as those mentioned may be held long or sold short by portfolios managed by the author at time of writing. This list is provided for informational purposes only and is not intended as a recommended buy list.
A big change in sector leadership occurred in October, with the Technology sector surpassing the other indices on a relative basis. The strength in the group is interesting, particularly when the dollar decline might indicate that the Energy and Materials sectors would benefit the most, and potentially continue the leadership we’ve seen from those areas since the beginning of the year. Meanwhile, the interest-rate sensitive Utilities area performed very well. I always like to watch the action in the Utilities sector for clues about future interest rate direction. Generally, Utilities perform well in a declining interest rate environment because of the high leverage these companies generally tend to have.
The back and forth behavior in the markets during the month might explain why the Consumer Staples and Healthcare sectors performed better than the broad market indices. These sectors are generally lower-beta “defensive” plays which tend to outperform in an uncertain and potentially bearish environment. However, their strength was not anywhere near as strong as the more aggressive Technology sector, indicating that the marketplace may not be convinced that a declining market is in the cards just yet. Furthermore, the strength in the smaller-cap areas of the market may indicate that the Staples and Healthcare sectors’ sentiment is not justified. Instead, their strength might simply be a reaction to the weakness in the Financials and Consumer Discretionary sectors, which continued their underperformance.
What Does it All Mean?
I believe we are at an important juncture in terms of sector leadership and where we are in the seasonal cycle. As noted, November and December have historically been a period of outperformance for the Small-Cap sector, and the Discretionary/Retailer sector. In addition, historically November has, on average, been the best performing month for the S&P 500 Index. However, there are a number of mixed messages the market is sending. The strength in Small and Mid-Cap companies indicates potential strength for the averages in the near-term, however the Consumer Staples and Healthcare sectors’ outperformances might indicate weakness. The direction of sentiment will hinge upon the strength/weakness of the
Disclosure:
Information presented in this commentary was obtained from sources believed to be reliable, but accuracy, completeness and opinions based on this information are not guaranteed. None of the information in this commentary is intended as investment advice or securities recommendations for any individual or entity. The writer and his or her firm(s) may, at any time, hold a trading position (long or short) in the shares of any company, whether or not discussed in this report, and may engage in securities transactions in a manner inconsistent with this report without notice or modification of this commentary. All data, information, and opinions expressed are subject to change without notice. Past performance is not a guarantee of future results. Neither diversification nor asset allocation ensures a profit or guarantees against loss. The content on this Site is offered for informational purposes only and is not intended to constitute either advice about appropriateness of obtaining advisory services or an offer to sell investment advisory services in any jurisdiction, nor a recommendation regarding any particular security, portfolio of securities, transaction, or investment strategy. All information and opinions expressed are made by the author and not by AmeriCap Advisers, LLC or any other related entity.
2007 – An Unusual Year for Sector Correlations
Proponents of asset allocation models argue that the most important determinant of portfolio performance is the mix of various asset classes (stocks, commodities, real estate, bonds, etc.) because the correlations of these broad asset classes is low. What this means is that if one asset class is performing poorly (real estate for example), then another asset class may do well (for example stocks), resulting in a portfolio of uncorrelated asset classes performing well as a whole. This, in effect, is key to true portfolio diversification.
Within an equity context, market sectors become the equivalent of asset allocation. Historically, the correlations of stock price movements within sectors (Energy stock to Energy stock) is higher than correlations of stock price movements between sectors (Energy to Technology…or Discretionary…or Financials, etc.). Thus, the mix of sectors within an equity portfolio, and specifically the mix of uncorrelated sectors, results in true diversification.
To demonstrate the point that sectors are more often than not uncorrelated to each other, I’ve included below some sector correlation charts for 2005 and 2006. Each line of each chart represents the correlation of a particular sector to the S&P 500 Index over a moving 20 day period.
2005
2006
Notice that correlations move within a range of being near perfectly correlated (1) to near negatively correlated (-1). More importantly, when one sector’s correlation is positive, quite often another sector’s correlation is negative in the same time period. This constant fluctuation of sector correlations is key to diversification.
Now let’s take a look at the same sector correlation chart for this year.
2007
Does anything seem unusual here? It appears as though the fluctuations of sector correlations among each other have been more muted this year, specifically beginning from March forward. Sector correlations have not reached for perfect correlation (1) as many times as they have in the past. Even more curiously, it appears as though sector correlations have converged, meaning that sectors are moving more similarly this year in terms of overall direction than historically was the case.
Why have correlations so drastically changed this year, and what is the implication of this on portfolio diversification and volatility moving forward?
Disclosure:
Information presented in this commentary was obtained from sources believed to be reliable, but accuracy, completeness and opinions based on this information are not guaranteed. None of the information in this commentary is intended as investment advice or securities recommendations for any individual or entity. The writer and his or her firm(s) may, at any time, hold a trading position (long or short) in the shares of any company, whether or not discussed in this report, and may engage in securities transactions in a manner inconsistent with this report without notice or modification of this commentary. All data, information, and opinions expressed are subject to change without notice. Past performance is not a guarantee of future results. Neither diversification nor asset allocation ensures a profit or guarantees against loss. The content on this Site is offered for informational purposes only and is not intended to constitute either advice about appropriateness of obtaining advisory services or an offer to sell investment advisory services in any jurisdiction, nor a recommendation regarding any particular security, portfolio of securities, transaction, or investment strategy. All information and opinions expressed are made by the author and not by AmeriCap Advisers, LLC or any other related entity.
The Asymmetry of Emotion and the Uptick Rule
Would you rather make $100 dollar, or lose $100 dollar?
Think carefully about this question…
Now let me ask another question.
Would you rather have the hope and joy of possibly making $100, or the fear and regret of possibly losing $100?
The difference between the two questions is crucial to our understanding of the asymmetry of emotion. I use the word “asymmetry” because of the difference in behavior when one feels hope for the future, versus when one feels the fear of what’s to come. Hope tends to be much longer lasting than fear. In the context of the stock market, hope pushes markets higher, while fear drives them distinctly lower.
But the asymmetry of the reaction to hope and fear also makes markets asymmetric in the way advances and declines happen. What I mean by this is that markets tend to go up (hope) over long periods, whereas declines (“corrections” characterized by fear) tend to occur swiftly, and can conceivably remove months of positive returns in just a few weeks.
So, a fundamental question to me is whether or not this asymmetry results in short to intermediate term market inefficiencies. After all, people tend to “underreact” to hope (leading to markets moving higher over long periods), and overreact to fear (leading to sharp and potentially brutal losses in much shorter periods, barring a recession of course!).
Overreaction is an inherent form of inefficiency – it completely counters the idea that investors exhibit utility traits, i.e. don’t feel any difference between gaining a dollar versus losing a dollar. In reality, people would rather not lose a dollar than make one (“loss aversion”), making their reactions to loss have greater magnitude.
What does the Uptick Rule have to do with any of this? For a moment, let’s go with the not so far-fetched assumption that the emotion of fear is fundamentally not only destabilizing to the market, but also causes overreactions and subsequent pricing inefficiencies. If that assumption is true, then doesn’t the Uptick Rule actually make markets more efficient by putting a barrier on the overreactions caused by fear?
The Uptick Rule was removed in early July of 2007, allowing traders and investors the ability to short stocks on a declining price tick. Does its removal make fear happen more frequently by allowing traders and investors to bet on a declining market freely, and does that snowball into even lower prices, more fear, more shorting, more market inefficiencies, more overreactions etc., etc.?
Markets do seem to be a lot more volatile these days…
Disclosure:
Information presented in this commentary was obtained from sources believed to be reliable, but accuracy, completeness and opinions based on this information are not guaranteed. None of the information in this commentary is intended as investment advice or securities recommendations for any individual or entity. The writer and his or her firm(s) may, at any time, hold a trading position (long or short) in the shares of any company, whether or not discussed in this report, and may engage in securities transactions in a manner inconsistent with this report without notice or modification of this commentary. All data, information, and opinions expressed are subject to change without notice. Past performance is not a guarantee of future results. Neither diversification nor asset allocation ensures a profit or guarantees against loss. The content on this Site is offered for informational purposes only and is not intended to constitute either advice about appropriateness of obtaining advisory services or an offer to sell investment advisory services in any jurisdiction, nor a recommendation regarding any particular security, portfolio of securities, transaction, or investment strategy. All information and opinions expressed are made by the author and not by AmeriCap Advisers, LLC or any other related entity.
August 2007 – A Case of "Get-Evenitis"?
As a student of Behavioral Finance, I believe a somewhat simple answer might explain at least partly what happened during the decline, and why a large number of prominent and successful money managers underperformed despite the market actually being up for the month. You'll notice in earlier posts that I've highlighted the clear distinction between the performance of more global sectors (Energy, Materials, Industrials, Technology) and more domestic sectors (Healthcare, Staples, Discretionary, Financials). So far, it would appear as though the only way to have outperformed the broad market indices this year was by being consistently in the four main "globalized" sectors, with a large-cap tilt.
The word "consistently" is important in this regard. The outperformance of the "Global" sectors has been pervasive almost on a monthly basis year-to-date. This means that managers who have been consistently outperforming this year may have, from a sector allocation standpoint, been overweighting those leading sectors.
By the same token, managers may have been underweighting the domestic-oriented sectors, specifically Financials and Discretionary, possible because of the sub-prime fallout and its consequences with respect to the housing market. If managers have been underweight these groups, and these areas of the market have actually produced negative returns on average, then why did these areas of the market decline less than those sectors that had previously been the strongest?
Behavioral Finance poses a potential explanation. When people own a money-losing investment, they generally like to keep holding on to that position in order to get back to their initial cost, even if it means they have to add more money to average down. Once they regain their original cost investment and begin to actually make gains, they tend to walk away from that situation or sell out their position.
This is an example of "get-evenitis" – the idea that people tend to keep trying to "get back to breakeven" when they are at a loss, but tend to call it quits when they are at a gain. Much of this has to do with prospect theory and subsequent psychology, which at its core argues that individuals feel the pain of a dollar of loss more than the joy of a dollar of gain. In other words, people tend to exhibit "loss aversion," whereby they would rather hold on to a losing position longer than a winning one so as to avoid realizing poor returns.
Is it possible that because of the losses in the Financials and Discretionary sectors so far this year that managers had a case of get-evenitis, whereby they were unwilling to sell their losing positions at a loss, and instead sold off their winners first to avoid the pain of "giving back their gains"? If managers, on average, did act this way in the portfolio decisions-making during the decline, could this perhaps explain why the Energy, Materials, Technology, and Industrials sectors, all of which are generally less sensitive to sub-prime and credit concerns, lost the most during the August decline, while the Financials sector, which had lost the most up to that point, was one of the best performers during the decline?
Disclosure:
Information presented in this commentary was obtained from sources believed to be reliable, but accuracy, completeness and opinions based on this information are not guaranteed. None of the information in this commentary is intended as investment advice or securities recommendations for any individual or entity. The writer and his or her firm(s) may, at any time, hold a trading position (long or short) in the shares of any company, whether or not discussed in this report, and may engage in securities transactions in a manner inconsistent with this report without notice or modification of this commentary. All data, information, and opinions expressed are subject to change without notice. Past performance is not a guarantee of future results. Neither diversification nor asset allocation ensures a profit or guarantees against loss. The content on this Site is offered for informational purposes only and is not intended to constitute either advice about appropriateness of obtaining advisory services or an offer to sell investment advisory services in any jurisdiction, nor a recommendation regarding any particular security, portfolio of securities, transaction, or investment strategy. All information and opinions expressed are made by the author and not by AmeriCap Advisers, LLC or any other related entity.
The August Correction Revisited Part 2 – Looking at Sector Performance
But there is more to this than just market cap performance. Which sectors of the market would one expect to ultimately be affected the most from the sub-prime fallout and a potential
Source: Bloomberg
As you can see in the table above, it turns out what some might say should have happened, actually did the complete opposite. The Financials sector barely declined in the face of so-called sub-prime fears. With daily reports about credit concerns and discussions of the impact of the housing recession on lenders, it turned out the Financials sector was actually a defensive group during the decline, in the same league as Consumer Staples and Healthcare. Meanwhile, the Materials, Energy, and Industrials sectors, which might be least impacted by a domestic
This decline which does not appear to have been justified furthers the argument that something else was happening beneath the surface of the market during the August correction. Stay tuned for some possible explanations, and an analysis of how behavioral finance might describe the cause.
Disclosure:
Information presented in this commentary was obtained from sources believed to be reliable, but accuracy, completeness and opinions based on this information are not guaranteed. None of the information in this commentary is intended as investment advice or securities recommendations for any individual or entity. The writer and his or her firm(s) may, at any time, hold a trading position (long or short) in the shares of any company, whether or not discussed in this report, and may engage in securities transactions in a manner inconsistent with this report without notice or modification of this commentary. All data, information, and opinions expressed are subject to change without notice. Past performance is not a guarantee of future results. Neither diversification nor asset allocation ensures a profit or guarantees against loss. The content on this Site is offered for informational purposes only and is not intended to constitute either advice about appropriateness of obtaining advisory services or an offer to sell investment advisory services in any jurisdiction, nor a recommendation regarding any particular security, portfolio of securities, transaction, or investment strategy. All information and opinions expressed are made by the author and not by AmeriCap Advisers, LLC or any other related entity.
The August Correction Revisited Part 1 – Looking at Market Cap Performance
Source: Bloomberg
As you can see in the image above, the S&P 600 Small Cap index actually outperformed the Large-Cap S&P 500 index during the decline, suffering only minor losses! This seems quite counter-intuitive, even from an economic and fundamental standpoint. After all, a squeeze on the credit market should affect smaller companies who need that funding the most. On the other hand, larger companies might be somewhat less affected because of their generally healthy balance sheets and cash reserves. What does market-cap performance imply about the decline and the way investors behaved? What truly caused the market decline to begin with? In the days ahead I will try to make sense of the data to see what can be learned about investor psychology during such unusual periods.
Disclosure:
Information presented in this commentary was obtained from sources believed to be reliable, but accuracy, completeness and opinions based on this information are not guaranteed. None of the information in this commentary is intended as investment advice or securities recommendations for any individual or entity. The writer and his or her firm(s) may, at any time, hold a trading position (long or short) in the shares of any company, whether or not discussed in this report, and may engage in securities transactions in a manner inconsistent with this report without notice or modification of this commentary. All data, information, and opinions expressed are subject to change without notice. Past performance is not a guarantee of future results. Neither diversification nor asset allocation ensures a profit or guarantees against loss. The content on this Site is offered for informational purposes only and is not intended to constitute either advice about appropriateness of obtaining advisory services or an offer to sell investment advisory services in any jurisdiction, nor a recommendation regarding any particular security, portfolio of securities, transaction, or investment strategy. All information and opinions expressed are made by the author and not by AmeriCap Advisers, LLC or any other related entity.
The Lead Lag Report - September 2007
*Note: ETFs which may track indices such as those mentioned may be held long or sold short by portfolios managed by the author at time of writing. This list is provided for informational purposes only and is not intended as a recommended buy list.
Sector Performance
*Note: ETFs which may track indices such as those mentioned may be held long or sold short by portfolios managed by the author at time of writing. This list is provided for informational purposes only and is not intended as a recommended buy list.
With the U.S. dollar reaching for new lows against other major currencies, the related prices of oil and other commodities have increased on a dollar-adjusted basis, bolstering the Energy and Materials sectors in particular. If the interest rate cut failed to make Financials and Discretionary outperform, that might signal that the Fed might not be able to ultimately stave off a Consumer Recession.
Disclosure:
Information presented in this commentary was obtained from sources believed to be reliable, but accuracy, completeness and opinions based on this information are not guaranteed. None of the information in this commentary is intended as investment advice or securities recommendations for any individual or entity. The writer and his or her firm(s) may, at any time, hold a trading position (long or short) in the shares of any company, whether or not discussed in this report, and may engage in securities transactions in a manner inconsistent with this report without notice or modification of this commentary. All data, information, and opinions expressed are subject to change without notice. Past performance is not a guarantee of future results. Neither diversification nor asset allocation ensures a profit or guarantees against loss. The content on this Site is offered for informational purposes only and is not intended to constitute either advice about appropriateness of obtaining advisory services or an offer to sell investment advisory services in any jurisdiction, nor a recommendation regarding any particular security, portfolio of securities, transaction, or investment strategy. All information and opinions expressed are made by the author and not by AmeriCap Advisers, LLC or any other related entity.
Have We Reached the Historical Average Pre-Election Year Return?
This year seems to be following the historical trend so far. 2007 is a pre-election year, and despite all of the headlines about the sub-prime fallout and the "credit crunch," the S&P 500 Index is nearing all-time highs (although it is fairly far away from producing the average historical return of 19% it has had in Pre-Election years).
I'd like to pose a hypothetical scenario analysis of how the S&P 500's performance might have performed at the time of writing this article if the Financials and Consumer Discretionary sectors had produced their respective average annualized returns from 12/31/1989 – 12/31/2006, all else being equal:
Using the sector weights of the S&P 500 Index from the beginning of the year, you can see how the actual weighted year-to-date performance of the index has performed in the face of negative returns coming from the Financials and Consumer Discretionary sectors. If, however, this were a Pre-Election year where sub-prime risk, the credit crunch, and fears of a consumer spending retrenchment didn't exist, and assuming that the Financials and Consumer Discretionary sectors had performed this year similar to their respective average annualized returns since 1989, the S&P 500 Index's performance might have been nearly double what it actually is today under current conditions.
This might imply that the market might be nearing its historical average return in pre-election years, and that the pre-election year cycle has been powerful enough to push the market higher in the face of a potential
Disclosure:
Information presented in this commentary was obtained from sources believed to be reliable, but accuracy, completeness and opinions based on this information are not guaranteed. None of the information in this commentary is intended as investment advice or securities recommendations for any individual or entity. The writer and his or her firm(s) may, at any time, hold a trading position (long or short) in the shares of any company, whether or not discussed in this report, and may engage in securities transactions in a manner inconsistent with this report without notice or modification of this commentary. All data, information, and opinions expressed are subject to change without notice. Past performance is not a guarantee of future results. Neither diversification nor asset allocation ensures a profit or guarantees against loss. The content on this Site is offered for informational purposes only and is not intended to constitute either advice about appropriateness of obtaining advisory services or an offer to sell investment advisory services in any jurisdiction, nor a recommendation regarding any particular security, portfolio of securities, transaction, or investment strategy. All information and opinions expressed are made by the author and not by AmeriCap Advisers, LLC or any other related entity.
What is Pushing the Market Higher?
I was recently asked by a very well respected individual an important question – what is causing market indices to move higher this year in the face of the large underperformance we’ve seen in the Financials and Consumer Discretionary sectors? To answer this, let’s take a look at how various S&P sectors have performed year-to-date so that we can better understand performance attribution so far this year:
As you can see, the sectors of the market which have performed the best are the ones primarily leveraged to global marketplace demand, and possibly less dependent upon
This has resulted in a tale of two markets with respect to the behavior of the broad market indices. On one hand, you have the Financials and Consumer Discretionary sectors being the only negative sectors year-to-date, a factor which might have negative implications on the
Now comes a question which I think is quite important to ask – is it possible in today’s global marketplace that the
Disclosure:
Information presented in this commentary was obtained from sources believed to be reliable, but accuracy, completeness and opinions based on this information are not guaranteed. None of the information in this commentary is intended as investment advice or securities recommendations for any individual or entity. The writer and his or her firm(s) may, at any time, hold a trading position (long or short) in the shares of any company, whether or not discussed in this report, and may engage in securities transactions in a manner inconsistent with this report without notice or modification of this commentary. All data, information, and opinions expressed are subject to change without notice. Past performance is not a guarantee of future results. Neither diversification nor asset allocation ensures a profit or guarantees against loss. The content on this Site is offered for informational purposes only and is not intended to constitute either advice about appropriateness of obtaining advisory services or an offer to sell investment advisory services in any jurisdiction, nor a recommendation regarding any particular security, portfolio of securities, transaction, or investment strategy. All information and opinions expressed are made by the author and not by AmeriCap Advisers, LLC or any other related entity.
Are We in a Stealth Consumer Recession?
Similar to the way the Financials/S&P 500 ratio looks, the current level of the Retail/S&P 500 ratio is around the same level it was at back in 2002. I might add that this chart encompasses market action that followed after the Fed rate cuts of September 18th. What is the implication of retailer performance year-to-date in terms of consumer strength going forward? While I make no conclusions, the above chart certainly cooks up some food for thought!
Disclosure:
Information presented in this commentary was obtained from sources believed to be reliable, but accuracy, completeness and opinions based on this information are not guaranteed. None of the information in this commentary is intended as investment advice or securities recommendations for any individual or entity. The writer and his or her firm(s) may, at any time, hold a trading position (long or short) in the shares of any company, whether or not discussed in this report, and may engage in securities transactions in a manner inconsistent with this report without notice or modification of this commentary. All data, information, and opinions expressed are subject to change without notice. Past performance is not a guarantee of future results. Neither diversification nor asset allocation ensures a profit or guarantees against loss. The content on this Site is offered for informational purposes only and is not intended to constitute either advice about appropriateness of obtaining advisory services or an offer to sell investment advisory services in any jurisdiction, nor a recommendation regarding any particular security, portfolio of securities, transaction, or investment strategy. All information and opinions expressed are made by the author and not by AmeriCap Advisers, LLC or any other related entity.