Chart of the Day - Extremely High Correlation of Stocks - Implications for Hedge Funds

I'm doing some work on risk measurement/management at a hedge fund management company. The investment strategy of the hedge fund is long/short equity. Most of the work revolves around measurements at the portfolio level, and the aim of measuring and controlling risk is to produce steady returns for investors. This is only possible on a sustainable basis with a diversified portfolio, unless the hit-rate is unusually high. Whilst  I have met managers with very concentrated portfolios based on very stringent selection criteria, and who have very high career hit-rates (as high as over 90% in one case), most mangers (probably more than the 80:20 rule would suggest) run portfolios diversified by stock, sector and to some extent theme.

Effective risk management is partly about being aware what has a high probability of working and when. One of the lessons of the Credit Crunch for many in hedge fund land is that there are market circumstances in which the previously assumed risk controls will not work. That is, the manager has a series of limits and stops and processes which in combination will produce the desired outcomes for most market conditions. The rub, as revealed in 2008-9, is in the conditional "most". Managers have to be aware of in what market circumstances their approach to markets will not work.

For most equity long/short managers most of the time the key decision variables at the portfolio level are about managing the net exposures to market, and specifically about managing the net beta-adjusted exposure to the market. There is a sub-set of equity managers for whom this is not true - those which have a limit on their net exposure to markets, and are structurally close to net neutral, say a band of 0-20% net long. Often the latter funds are quantitatively-driven equity long/short funds, but some discretionary managers choose to be close to net neutral. For these net-constrained funds returns have to come from stock selection to a much greater extent than funds with wider investment powers. The corollary is often a larger gross exposure to markets - consistent with the formulation of information ratios of managers. Typically, funds with a small net exposure limit target lower absolute returns, and implicitly rank risk-adjusted returns as a higher goal than absolute returns. 

The majority of managers in equity long/short try to use the additional degrees of freedom they have in balance sheet disposition to produce higher absolute returns (than a net-neutral manager) though nearly always with higher volatility of returns. The tactical shape of the fund should be a function of two things: the market regime and the opportunity set for the particular investment style of the manager. There is a considerable range of understanding amongst managers of the necessity of taking these two dimensions into account in setting the net exposure of equity hedge funds. The best managers are good at both, but the majority of equity hedge fund managers are not. Yes, the majority.

The successful shaping of the hedge fund balance sheet requires two attributes in the manager: an ability to read the market regime in multi-dimensions, and a high degree of self knowledge about the applicability (and effectiveness) of their investment processes. Around the time of the Tech Bubble the first required ability was demonstrated a lot by equity hedge fund managers. The monetary stimulus provided by Greenspan on fears of the Millennium bug was read by managers as a bull market condition green light, and most managers were very net long in 1999, and investors were gorged on the excellent returns produced. The reverse happened from March 2000 onwards. By the 3Q 2000 many equity hedge funds were net short on a tactical basis, i.e . the managers jobbed from the short side.  From 2003 to mid 2008 a net long bias and a buy-the-dips mentality were positive attributes for managers. Over the same period many new hedge fund managers joined the industry, and several big names closed down, citing the lack of shorting opportunities as a reason.

So coming into the Credit Crunch phase of 2008 only a minority of equity hedge fund managers expressed an ability to read the market regime by going net neutral or net short. A majority of managers had never been net short to that point, and many did not have that available as a choice because of their offering memoranda, or because the operational limits they gave themselves precluded it.  

Current market conditions have echoes of 2008-9: large daily declines in equity prices, volatility and rising fear gauges in the price of gold and the cost of interbank borrowing. These are difficult conditions in which to manage an equity hedge fund. Quite how difficult is in part reflected in today's chart of the day. Every manager can tell you about the level of market volatility reflected in the Vix Index. This captures the current level of volatility in the market on a traded basis. The actual volatility experienced in the market is lower than the traded level, though intra-day measured volatility can be higher than that indicated by the Vix.

All equity hedge fund managers are aware of how volatility shifts impact their style because they can see it in the daily P&L changes per position, and the same at the portfolio level, and they are aware of the Vix. Those managers who take risk measurement more seriously will be aware of the Value-at-Risk of their portfolios. The same portfolio will have a different measured risk dependent on market conditions - when markets are more volatile measured risk goes up for the same portfolio. What is less well explored is the other element that feeds into the risk measure VaR, that of correlation.

The inter-relatedness of positions has an impact on measured risk. The more related the positions the less diversification there is in a portfolio. Consequently managers structurally build diversification into their portfolios by having limits on sectors/industries/macro-related themes as well as limits to specific stock risk by constraining holding size. But correlation is not stable. Cross-sectional correlation varies through time. In up-trending markets (scenario 1) volatility drops and stocks tend to become less correlated. For sideways moving markets (scenario 2) two stocks in the same sector could quite feasibly act differently - one going up and the other staying the same price, or even falling. Scenario 1 is better for producing returns from net market exposure, and scenario 2 is a richer market opportunity for returns purely from idiosyncratic stock risk (selection).

However when markets fall for a period volatility rises and correlation increases. The correlation coefficients of stocks' betas go up - the market component of stock price changes goes up, and the sector effect increases and the idiosyncratic component of stock price changes declines. The chart of the day below illustrates that we are at an extreme for measured correlation amongst S&P500 constituents.

In such a market environment portfolio returns become a product of the net market exposure, driven by the weighted average of the portfolio betas. The extreme case illustrates the point - bank shares and commodity stocks have had the highest betas in the market for some years now. The return to the net exposure to these two sectors plausibly could have been the largest component of the return of individual equity hedge funds over the last three years. For net neutral equity hedge funds the net exposure decision on these two sectors over the last three years could have even been the decision that determined return outcomes.

For market conditions with high correlation between stocks it is just about impossible to drive returns from stock selection (idiosyncratic risk) alone. This has recently been explicitly recognised by one management team -  Ralph Jainz and Jonathan Sharpe of Ratio Asset Management wrote to their investors on closing their European equity hedge fund this month that "this year stock selection has not proved profitable." History suggests that it is difficult for diversified net neutral funds to make money when there is high correlation between stocks, and only managers who are adept at shaping the balance sheet of their hedge funds will actually make money, as opposed to defending their capital.  

Given that nowadays few managers can demonstrate an ability to read the market regime in multi-dimensions, and have a high degree of self knowledge about the applicability of their investment processes, I expect negative returns from the strategy for the current market. What is particularly disappointing is that the number of managers who can show they truly learned lessons from 2008-9, and can make money now, are so few. Maybe investors have to exhort their managers to take some off some of the net exposure restrictions - or do investors doubt that their managers have sufficient skills to handle wider investment powers?



   

Stocks over Bonds for 2011

Just over a year ago I featured as my Chart of the Day the mutual fund flows for U.S. bond funds and equity funds. At that point I summarised the attitudes of retail investors as "keep me out of Wall Street, I want the return of my cash, and I can only trust Uncle Sam with my money at the moment, thank you." The updated chart (Fig 1 below) shows that 2010 had more of the same, that is, huge inflows to bond funds and net outflows from equity mutual funds.

                                  Fig 1. Monthly Net New Cash Flows to U.S. Mutual Funds by Asset Class

As at the previous point of review (December 2009) the logical case now is very strong for a preference for equities over bonds based on valuation. Looking at the P/E ratio of American shares in isolation the case is not particularly convincing as Figure 2 shows. The S&P 500 trades at 13.6x forward four quarter earnings – this level is neither cheap nor dear in an absolute sense. But the context is very constructive: inflation is low at the consumer level; interest rates, whether real or absolute, are low and will remain so for some time; and earnings growth may be a positive surprise in 2011 as expectations are low.

                                    Fig 2. P/E Ratio of U.S. Stocks based on 12m Forward Estimates

The earnings surprise at the market level could come because expectations are low and the American corporate sector is well set in several regards. First the operating leverage is good after staying lean and mean, and hiring has only recently begun. Secondly the level of the Dollar makes the U.S. internationally competitive (and exports accounted for 1.1 percentage points of the 3.2% increase in real GDP in 2010). Thirdly, and this will be very important this year, unlike the consumer and the government, the corporate sector has a good balance sheet in aggregate. I place an emphasis on the balance sheet because there is good scope for capital spending as well as hiring, and, most importantly for investor psychology, conditions are good for a lot more mergers and acquisition activity this year.

However, even if the earnings growth for 2011 only turns out to be in line with the current consensus, a strong case can be made for a preference for stocks over bonds on the basis of relative valuation. This is illustrated in Figure 3.

                                                      Fig 3. Yield Comparison for Stocks v Bonds 
                                               (Earnings Yield on S&P500 v Real Yield on 10 Year Treasuries)

The widening gap between the real yield on the highest quality bonds and the earnings yield on American blue-chip stocks (the inversion of the P/E ratio) reflects the neglect by investors of stocks relative to bonds. The risk premium for stocks now is higher than it has been for more than 80% of the last decade, and at nearly 3.9% is 1.6% higher than the average over the last 10 years. The logical case is very strong - on the basis of valuation investors should switch out of bonds and into stocks.

On the basis of investor psychology investors won't switch. The aversion of the man in the street to anything to do with Wall Street will continue. ETFs have continued to grow whilst equity mutual funds remain out of favour suggesting that Americans don't want to give money to stock-selecting money managers. Individual investors are dis-engaged with markets to an extent rarely seen before. In short, America has fallen out of love with stocks.

Chart of the Day – Funds of Hedge Funds Flat-line in Asset Flows in North America

My Chart of the Day comes from The Eurekahedge Report which looks at 2010 hedge asset flows and investment returns. The chart compares the monthly asset flows to North American hedge funds and funds of hedge funds since the start of 2008. The contrast in flows in the recovery phase is very striking: single manager hedge funds net redemptions stopped four months earlier than net redemptions to funds of funds; and there have been net subscriptions to single manager funds in most months since April 2009, and net subscriptions to funds of funds have flat-lined over the same period.

Monthly asset flows to North American hedge funds vs North American funds of hedge funds

The North American component of the hedge fund story is very constructive at the single manager level. Not only have NAVS recovered well since the Credit Crunch but in doing so last year the Eurekahedge North American Hedge Fund Index was ahead of the S&P 500 until the last month of the year. Over the last three years North American single manager hedge funds produced annualised returns of just over 7 1/2 %, versus 5 1/2 % for the Global Eurekahedge Index. Indeed American hedge funds produced better returns than funds managed from other developed regions in each of the last three years. So American single manager hedge funds have done better in performance terms than those in other regions.

The three year annualised returns of North American funds of funds are negative according to Eurekahedge, just as the MSCI North America had negative returns over the same period (to end November 2010). Further the 3-year annualised standard deviation of returns of funds of funds is the same as that for single manager hedge funds. So that on a three year basis funds of funds have not delivered absolute returns, and the volatility of returns over that period has not been lower than single manager funds (which historically had previously always been the case). So the return-for-risk argument is weak for funds of funds relative to single manager funds in North America.

As a source of capital for the whole hedge fund industry American investing institutions have become dominant. Survey evidence shows some recovery of appetite amongst institutional investors in hedge funds – questions on investment intentions produce a net positive balance from respondents on a consistent basis since the end of 2009, with US investors more positive than investors in other regions. But the "intentions" have turned into net positive flows only for single manager hedge funds in aggregate (though around 30% of funds of hedge funds report net inflows in the second half of last year). There several plausible explanations for the contrast in flows depicted in the chart.

The gap in performance between single manager hedge funds and funds of funds may have got too wide for investing institutions to bear. Historically there were a few years, over the course of decades, in which multi-manager hedge funds out-performed single manager hedge funds. So in those years there was a (relative) pay-off for strategy allocation and avoiding the under-performers and blow-ups – which is for what investors pay funds of funds. It was commercially crucial that funds of funds did that in the key year of 2008, and they didn't, as a whole. It is now many years since funds of funds in aggregate even got near single manager returns.

Given the return records for single manager and multi-manager hedge funds the additional layer of fees in the latter cannot be justified in the minds of institutional investors. Fund of funds' management fees have been falling for more than a decade, reflecting the balance of supply and demand over that time. In contrast single manager fees have held up much better, with the exception of the immediate post Credit Crunch period. Indeed Eurekahedge record that the average management fees for single manager start-ups in 2010 was higher than for 2009's start-ups.

A third plausible explanation for the difference in asset flows to the two hedge fund sectors in North America is the increased accumulated knowledge and experience of the investing institutions there. The model seems to have shifted. For most of the last decade funds of funds were the mechanism for investing institutions to allocate to hedge funds, but a knowledge transfer has taken place. The senior staff at institutions now have a familiarity with hedge fund concepts and can interpret hedge fund data readily. Whilst funds of funds companies can demonstrate advantages in due diligence process, depth of understanding of investment strategies, and risk management and portfolio construction of funds of funds compared to the dedicated resources available to most investing institutions, the latter can now comfortably find these capabilities on an out-sourced basis. External advisors for strategic decision making and tactical monitoring of hedge funds have usurped the role of the dedicated funds of funds. The same tasks are being carried out, but maybe by a combination of a very small dedicated in-house team with input from an external advisor on a fixed fee basis. A number of funds of funds companies may be retained by investing institutions to give a plurality of opinion and form of analysis, for benchmarking, but experienced investing institutions may not feel the need to pay the old fee scales. Plus the marginal increases in allocations to hedge funds by pension plans is increasingly going to direct investing in single manager funds.

In each of these regards the North American part of the industry is in the vanguard. Most of the assets of the hedge fund industry are managed by managers in the United States. For a U.S. investor to visit (and allocate to) an American hedge fund manager is a lot easier than for a Japanese investing institution – hence there will always be a place for funds of funds for Japanese investors in hedge funds. American investing institutions are the largest contributors of capital to the hedge fund industry at the moment, and will be for some time. Given all the above - relative performance, regional strengths, fee structures etcetera - plus the fact that large, branded hedge fund groups are highly likely to be American, is it any wonder that 85% of the global flows into hedge funds are going into American single manager hedge funds? 





To see more postings on multi-manager hedge funds click on "funds of hedge funds" in the LABELS gadget on the lhs of the page.
 

The January Effect v QE v Market Internals

December US equity markets have been typical in the shrinking of traded volume which makers them prone to being squeezed. At this point I hesitate calling it squeezing (hurting the shorts by mark-ups which forces closures (buying) of positions) as there have been 18 up-days out of 20 trading days in the MTD. Short squeezes are short-term phenomena. Although December began with a powerful rally, there has been anaemic follow-through as we near the end of 2010. As is common with the Christmas period, trade has been light, and price action muted. Based on market internals, institutional involvement has been clearly absent from the market over the past two weeks. In the last week or two of trading the broad market has exhibited indecision, and market internals (advancing volume to declining volume, for example) have differed between exchanges and indices. In addition there has been a noticeable flow of money into sectors that have significantly lagged the market over the past year (oil-related, homebuilders, banking, pharmaceuticals, and real estate). This is often a leading indicator that a rally may be nearing exhaustion. It is too early to definitively suggest that the market is about to change trend, but when laggards become leaders, caution is warranted.

There will likely be institutional buying early in the New Year as the whole staff comes back to work and markets are still hitting minor new highs. But will this persist? At this point the influence of QE on markets should be more important than calendar effects, but is the impact waning? Evidence from the bond markets suggests it may be.

As for the calendar effects I have reproduced below a long term study on the January effect. It comes from www.cxoadvisory.com/calendar-effects/



Does long term data support belief in exceptionally strong performance by the U.S. stock market during the month of January? Could this conventional wisdom be an artifact of data snooping or a victim of market adaptation? Robert Shiller's long run sample, which calculates monthly levels of the S&P Composite Stock Index since 1871 as average daily closes during calendar months, offers data for testing. Using monthly levels of the S&P Composite Stock Index for January 1871 through November 2010 (nearly 140 years) and monthly closes of the S&P 500 Index for January 1950 through November 2010 (nearly 61 years), we find that:

The following chart shows the average return by calendar month for the S&P Composite Stock Index over the entire sample period, with one standard deviation variability ranges. The average return for all 1,678 months in the sample is 0.42%. At 1.51%, January has the highest average return of all months. January has the lowest standard deviation of returns (2.86%), so this high return is not compensation for high variability.

October is the only month with a negative average return (-0.39%).

Is this apparent January effect consistent across subsamples?

The next chart compares the average return by calendar month for the S&P Composite Stock Index over the entire sample period and three approximately equal subperiods (46-47 years each). The performance of the stock market is consistently strong on average during January, and January is the best month for two of three subperiods. However, there is generally substantial variation in average returns by calendar month over the three subperiods.

For greater granularity and trend analysis, we examine relative performance during January by decade.

The next chart shows the outperformance of the average return for January relative to the average monthly return by decade over the entire sample period, along with a best-fit linear trend line. The trend line indicates that the magnitude of any January effect is declining, but the sample size in terms of number of decades (14) is small.

For even greater granularity, we examine the effect by year.

The next chart shows the outperformance of the return for January relative to the average monthly return by year over the entire sample period, along with a best-fit linear trend line. The trend line again indicates that the magnitude of any January effect is declining. Outperformance appears to disappear, or even reverse, during the past two decades.

A plausible interpretation of the above results is that there used to be a somewhat reliable January effect, but the market has adapted to extinguish it.

Since the Shiller data calculates monthly index levels as average daily closes during months (perhaps representing typical investor experience) rather than monthly closes, we compare the above results to those for monthly closes of the S&P 500 Index.

The next chart shows the average return by calendar month for the S&P 500 Index during 1950-2010, with one standard deviation variability ranges. For this calculation, we approximate the January 1950 return using the opening level for that month (since the December 1949 close is not available). The average return for all 731 months in the sample is 0.69%. At 1.10%, January has the fifth highest average return of all months, behind December, November, April and March. January has the second highest standard deviation of returns (4.84%), trailing only October.

Is performance during January consistent across sub-samples?

The next chart compares the average return by calendar month for the S&P 500 Index during 1950-2010 and two approximately equal subperiods (30-31 years each). During the first (second) subperiod, the performance during January is tied for third (seventh) place among the 12 calendar months.

For greater granularity and trend analysis, we examine relative performance during January by year.

The final chart shows the outperformance of the return for January relative to the average monthly return by year during 1950-2010, along with a best-fit linear trend line. The trend line indicates that any outperformance during January disappears or reverses during the past two decades.

In summary, evidence from long run data suggests that the conventional wisdom regarding outperformance of the U.S. stock market during the month of January derives either from snooping of an insufficient sample of older data or a real effect that the market has recognized and extinguished. Recent January returns are relatively weak.

Another Year Another Challenge for Funds of Funds

In 2008 the fund of funds industry had a tough time producing returns for investors because only 30% of hedge funds produced a positive return. For 2009 things were tough for funds of funds as they couldn't get out of the hedge funds that had let them down by making losses in 2008, because of limited liquidity in the funds, suspended redemptions, and sidecars. Further, few of the funds which made money in 2008 made good money in 2009. So if funds of hedge funds stayed loyal to their winners of 2008 it probably cost them in 2009. There was even a reversal of the size effect on hedge fund returns in moving from 2008 to 2009. 

Before looking at hedge fund returns in 2010, and factors that will impact fund of funds returns, let's look at single manager hedge fund returns in 2008 and 2009 from an absolute and relative perspective.

2008 was an absolute disappointment in terms of hedge fund returns- a loss of around 16%. Last year hedge funds produced their best returns since 1997, at up 19%, by the Greenwich Global Hedge Fund Index. And year to date through July, the same hedge fund index has a small positive return (up 1%), which is not good in isolation as an absolute return over seven months. 

The returns from equities put the absolute returns of hedge funds into some context. Using the S&P500 as a proxy for the equity asset class, the hedge fund returns of 2008-9 look very different. The S&P500 was down 38.5% in 2008, the year hedge funds at an index level lost 16% in a liquidity crisis with high volatility and fraud in the industry, and even so 30% of hedge funds were up.

In 2009 the S&P500 was up 23.5% and hedge funds were up 19%, which given the constrained directionality (beta to markets) is as good as it gets for the alternative funds. Over 70% of hedge funds produced positive returns in 2009.  

This year the S&P is down 4.3% at the time of writing, whilst representative indices of hedge funds are up a small amount.  However the context for hedge fund returns in 2010 is even tougher in some regards than the previous two years. To begin with, let's look at the trajectory of the equity market this year. Below is a one year chart of the S&P500.

source:stockcharts.com

The rally of the second half of 2009 actually peaked in the first few weeks of 2010, and thereafter the stock market has been a rollercoaster of epic proportions, meaning a serious of precipitous falls followed by sharp rises. Monthly index level changes of 7-8% have not been unusual since the outbreak of the Credit Crunch, but the sequences have changed: we had a string of big down months in the bear market to the low in March last year, then a series of big up moves in the massive rally of the last three quarters of last year. In 2010 we have had big up and big down moves alternately. Given that managing the net exposure is typically the biggest risk control variable of most hedge fund strategies (bar the market neutral strategies), this year has been amongst the most difficult market direction background I can recall, as the market was aggressively moving one way and then the other by turns.

Persistence of market movement, or propensity to trend, is different from volatility in traded markets. It turns out that the actual volatility of the S&P500 index, as a proxy for global equity markets, has been both unusually low and then high  this year. The chart below shows 30-day historic or actual volatility of the S&P500.

source: Bloomberg LLP

A level above 25% historic volatility (as opposed to traded volatility) has been uncommon in equity markets, except for short periods, and except for the last two years. The shifts in volatility seen this year would probably have hurt more hedge fund strategies than they helped. Pure volatility strategies should have benefited from the April/May shift in volatility, and the delta hedging of CB arbitrage funds should have had a good background in March and after the June peak in volatility . Overall 51% of hedge funds by number had produced positive absolute returns at the half way point of the year. This hurdle was exceeded by 68% of hedge funds at the end of the first quarter of the year, so the year has got progressively tougher as it has gone on - that falling success rate persisted into the end of August

Hedge Fund Returns by Strategy

source:Greenwich Alternative Investments

Returns by strategy are for the most part marginally profitable or loss making this year. As this is the case, differences in index and sub-index construction and scope have produced different outcomes. What one index provider has as a strategy with a positive return, another shows a negative return for.  Lipper's series of hedge fund strategy indices has only two strategies out of 13 given producing positive returns this year.  Greenwich Global Hedge Fund Indices show only three strategies with negative returns in the YTD (out of a total of 15). Both index providers agree that Long/Short Credit and Convertble Bond Arbitrage are amongst the best strategies for returns so far this year.

Looking across other index providers (Dow Jones Credit Suisse, and Hedgefund.net) it looks as if a small majority of hedge fund indices for strategies produced positive returns in the first seven months of the year. This hit-rate for positive returns by strategy in combination with the dispersion of returns within the strategy has some interesting implications. 

Dispersion of Hedge Fund Returns Within Strategies January-July 2010

source: Lipper, a Thomson Reuters company, TASS database

The dispersion of returns within the investment strategy categories of hedge funds is lower this year than last year. However this year the dispersion ranges for each strategy includes a significantly proportion of negative returns. This is a very different outcome from 2009, when the spread of returns by strategy may have been wider than this year, but returns were overwhelmingly positive. 

The read through to funds of hedge funds will be interesting. Another way of looking at the last two calendar years is that positive returns came from CTA and global macro in 2008, and those two strategies significantly lagged the other hedge fund strategies in 2009. So there were significant returns to active strategy allocation/weightings for investors in hedge funds in both years, though the positively contributing strategies were not consistent through time.

This year, given the dispersion of hedge fund returns within strategies, and with a fair amount of funds with losses as well as funds with profits within each strategy, fund of funds relative returns will be impacted much more by manager selection within each strategy silo than we have seen for a while. Strategy allocation will still have a part to play, but the 2010 ranking of returns from funds of funds will be about old style returns - driven from the bottom up.     

Of course all funds of funds claim that manager selection is a key skill. It will be interesting to see if those managers that make a special play of their abilities at manager selection in their client presentations come through with top ranking returns in 2010.

After An Unusual Month

Listening to Hugh Willis of BlueBay Asset Management on a conference call on Monday I was struck that twice he mentioned that May was a very unusual month in markets. Indeed it was; and in equity markets it resulted in losses of 8% (SPX) to 10% (MSCI Emerging Markets). Willis noted that such monthly losses had occurred only 5 or 6 times in his career.



So how infrequent are such losses? To find out I looked at the S&P over the last three decades. There were 34 months for which the monthly loss was 5% or greater. Below is table showing all these losing months.

Monthly Losses of 5% or More on the S&P500 Index from 1980 and Onwards

(Note that the great bull market started in August 1982)

A few observations:


• There is increased clustering through time and far more observations of big losses in the neutral decade of the Noughties compared to the bull decades of the ‘80s and ‘90s.


• The frequency of subsequent 1 month positive returns was lower post-2000 than in the great bull market.


• For longer holding periods after a fall of 5% or more in stocks in a single month the outcomes have been distinctly worse in the Noughties than in the bull market decades. Holding stocks for a month or up to a couple of quarters after a 5% fall in stocks would tend to make you money in the ‘80s and ‘90s and lose you money in the last ten years or so.


• As a mechanistic strategy, buying for a month after a 5% fall in markets would have cost you money in the Noughties.


• As a mechanistic strategy, buying stocks after a monthly 5% fall in markets and holding for a quarter or two quarters would have cost you money in the Noughties, and made a ton of money in the ‘80s and ‘90s.

Non-Confirmations Multiply according to Prechter

Although I am not an Elliott Wave technician, they do have market influence. Hence awareness of leading practitioners is a useful background input. Robert Prechter is such a practictioner. Bob Prechter's "Elliott Wave Theorist" newsletter published the 23rd November notes that the DJIA has achieved a 50% retracement of the fall from the 2007 high to the 2009 low, and has done so in 50% of the time it took to fall.

The following is taken from the same publication:

"Non-confirmations continue to multiply, as no other significant market index – among the S&P, NASDAQ, Transports, Utilities and the broader Value Line indices – joined the Dow in making a new intraday high today.

This morning's high occurred 39 minutes into the session, immediately after an upside gap in the DJIA during the session (his italics), an extremely rare event…I am betting that it was an exhaustion gap, not a continuation (wave 3 of 3) gap.

After 8 months of rally and a 52% retracement, I believe I have seen enough to recommend that traders move to 200% short. Those who were "maximum leveraged" for the 2007-2009 decline and reinstated half their positions on the recommendation in the August 5^th issue may return to their full former holdings now."

Prechter's services can be found at http://www.elliottwave.com/

The NYSE cumulative advance/decline indicator is a measure of market breadth. It is giving a non-confirmation at the moment - the NYSE Composite hit a minor new high a week ago, but the advance/decline did not then or since. Non-confirmations are useful to give confidence for high conviction calls on the market. The evidence is building for a high confidence bear entry point.

Two-Way Battle Continues Between Buyers and Sellers

The Greenwich Alternative Investments Macro Sentiment Indicators are based on the outlook of hedge fund managers employing a macro view and who manage, in aggregate, in excess of $30 billion in assets. The purpose of the indicators is to reveal how these managers believe the S&P 500, the U.S. Dollar and the U.S. Treasury 10-year Note will perform over the current month. There is an interesting trend in the results over the last three monthly surveys.

Greenwich Alternative Investments Market Sentiment Indicators
for U.S. Equities (S&P 500)





The survey is released on the 2nd of the month and this month shows that those who use a macro view to run their hedge funds are in one camp or the other – nobody is neutral. The neutrals have tended to become more bullish, and a minority of those that were formerly neutral have become bearish.

There have been two distinct phases in the rally to date. The first phase (March to end May then a month of consolidation) had a much steeper ascent than the second phase (early July to mid October). These have been two phases of a liquidity-fuelled rally from a massively oversold bear market low. The later stages of phase two were accompanies by some recovery in the real economy - 3Q GDP was up after all. Classically the real economy will continue to draw money from financial assets – the liquidity push and then cushion will be defused over time.

The breadth and volume in equity markets reflect this gradual withdrawal of liquidity – there is less buying power evident now, and selling has more of an impact on prices. The declining momentum is picked up in the lower peaks of the (14-day) RSI on the top of the S&P chart below.

I am grateful to Bernie Schaeffer for pointing out that the 80-day moving average has been significant to this market this year. Having touched it in July the S&P 500 has flirted with it at the turn of this month. The upside this month to minor new highs has caught some market-watchers: chartist Greg Troccoli wrote this week “I didn’t see this type of strength coming. The bigger picture at this juncture is quite interesting. The resiliency of this market is admirable, however, as can be viewed in the chart the major portion of a possible head and shoulder top has already formed. The right shoulder is coming together at this time- only time will tell if in fact this topping formation will come to fruition. Note that the right shoulder is usually higher than the left- which is taking place now.”

A head and shoulders is a reversal pattern that takes place over a period measured in weeks or months. For my part I see a distribution taking place – less buying power accompanying the market going up this month – the volume has noticeably dropped as the markets climbed from the 80-day MAV. If a head and shoulders does emerge, many participants and commentators will be on it. The measured target for a H&S on the S&P is the 950 area – exactly where the first phase started to consolidate from in the first half of June, and a good support level.

Whilst we see which camp becomes dominant on a multi-month basis, the waning buying power at work suggests that the bears will soon dominate, but there is not a clear sign that the bulls are out of it yet. So we could see a minor new high on the S&P shortly. That would be an untrustworthy further rally given what has unfolded over the last month.

The distribution referred to in these posts could be a trading range market for a while. It doesn’t have to be a dramatic fall to the bear market lows. After this year’s gains a visit to 950 on the S&P would be neat technically. But the consolidation of the gains could be a longer lasting sideways band – say 150 points trading up and down on the S&P lasting 6 months. There is more than one way to consolidate a rise, even a major liquidity-fuelled one.

S&P at resistance, Volume fallen on rise

Yesterday the S&P500 traded up by nearly 2%, completing a four-day up sequence from the intra-day lower low of Monday. On the New York Stock Exchange 2501 issues advanced and 541 issues declined for a ratio of over 4.6 to 1. Advancing to declining volume was better than the ratio of issues A/D at 6 to 1. Overall volume has fallen through this week as the market has risen – not a good sign. Falling volume on rising prices in the first half of October at the exchange/index level provided a good set up for the top formed in the second half of the month.

The S&P index is now in a resistance zone, and after four up-days and being a Friday, which has a tendency to be a reversal day (profit taking ahead of the weekend) expect a dull day at best today. Beyond today we are still in distribution mode – trading down on bigger volume and up on lesser volume. The 10 and 50 day moving averages should cross today (a dead cross as opposed to a golden cross). Investors can come back to the market in January and not have missed any major upside in prices – this is highly likely. That is not to say that that equity markets have to go down a lot. The liquidity cushion is still under financial assets, so markets can consolidate the huge gains from the March lows by moving sideways, hence the distribution rather than collapse to lower levels.

Tactically today is as a week ago – a good day for lightening longs, adding to shorts and overwriting call options. Beyond a day tactics should be focussed on selling into strength when the index gets into resistance levels.

Equity Market Distribution to Continue

Last week I wrote a piece headed “Interim Top on S&P Signalled on Close on Wednesday”. Market activity since could be characterised as topping action. Over the week the market broke to the downside the 20-day moving average on the indices (a MAV watched by traders), and traded back beneath the previous month’s highs. In four of the last five sessions the markets closed near their lows of the day. This is a change from how the markets traded earlier in October. Over the whole of October volume has gone up in the latter part of the month (as markets traded down) compared to the earlier part of the month. Not a healthy sign for bulls. Wednesday was a short-term selling climax for stocks as volume of selling expanded. So the market was ready for a reversal day, and got one yesterday.

Yesterday the Dow jumped 200 points, and the S&P500 rose by over 2% on the “end of recession” GDP release. Did this make me change my view that the markets are topping? No, because of breadth and volume yesterday. Overall volume for the big up-day was in line with the previous 10 trading days, to be more bullish needed a volume expansion.

Then the breadth was not particularly constructive yesterday. What do I mean by that? Yesterday (Thursday) the volume of shares trading up was somewhat concentrated in the number of names participating to the upside. The NYSE is still the best exchange to look at for technical data for the broad market. On the NYSE yesterday advancing volume was 1.3bn shares compared to 150m shares declining, a ratio of over 8.5 to 1. However in looking at the number of issues: 2,504 issues advanced and 552 declined, a ratio of less than 1 in 5. So the reversal day was not fully in gear to the upside.

A good counter-trend reversal day is useful for tactical positioning. Yesterday near the close was a good time to be locking in some gains, trimming long positions and over-writing portfolios with short call options.

Interim Top on S&P Signalled on Close on Wednesday

On Wednesday there was a new high followed by a close at the low of the day on the S&P. This is a sign of an interim top. Sometimes there can be a weak minor new high after, but over the course of weeks we are going down on the basis of this one signal. Other signals are already in place on momentum, and valuation has been in a warning zone for a while (high but can go higher).

Yesterday's market action of up 1% net on the day, finishing just under the high of the day, did not negate the call of an interim top. Yesterday also had a lower opening than the previous day's close and the close (and intraday high) were some way below the previous day's high of the day.