Tuesday June 21st, 2011

For those who ever wondered, the investing terms “alpha” and “beta” come straight off a page contained inside the chapter entitled “Simple Linear Regression Model” from any second level college statistics textbook.  The alpha, known as outperformance, corresponds to the y-intercept while the beta indicates the slope of the line plotted on the simple two dimensional graph.  I will not discuss the concept of R-squared, a gauge of the quality of fitness or correlation of the calculated line through sample data points, since it has less relevance to today’s discussion; however, Bloomberg presents all three metrics when dialing up a security using its nifty BETA function.

Hedge funds live in a world surrounded  entirely by the great alpha chase.  I find this ironic, for unless the beta of the portfolio sits close to 0, the most important decision, by far, of any manager is to determine how aggressively long or short he or she should dial the overall exposure of the firm.  Most long-short equity funds, some run by the best investors on the planet, unfortunately found themselves exposed with substantial long beta positions in the summer of 2008 which precipitated major losses.  Trying not to open any old wounds by reliving the past, I would argue that a simple decision to short the S&P 500, either through futures or ETFs, would have drastically altered the fortunes of such firms.  To be fair, a precious few knew what was being said behind the closed doors of the New York Fed, and some would suggest no one really understood the depth of dislocation of the balance sheets owned by America’s biggest financial institutions thereby making a confident decision to outright short the market counterintuitive given the earnings expectations of some of the more vanilla corporations.

Spending more time on the alpha component of returns appears logical, for investors demand it, and capturing it on a consistent basis requires tremendous expertise.  While one rarely finds a lively discussion about a specific healthcare stock at a typical cocktail party across the country, one certainly can engage in a heated debate about the future direction of the DJIA.  Everyone, including my 75 year old mother, has a strong opinion on where the index will move in the near term, and combined with the acceptance of many of the brightest minds in the business that the direction of the broader equity market is at best random, the decision on how to position one’s beta often does not receive the attention it deserves.

The truly world class managers can master both the alpha and beta of returns.  I do not even belong in the same room of such super-investors, so I decided early in my career to make it a passion to focus more on the choice of beta for a portfolio than on the alpha as it represents the biggest driver of absolute returns.  Fortunately and unlike in 2008, current market direction remains clear.  No, I will not thump my chest in saying I “know” which way stocks will shake out, for that would reasonably paint me a fool.  The clarity instead arises from distinct paths that the market will travel depending on the outcome of only a handful of events.

Specifically, the movement of the S&P 500, as well as that of other major indices, will be contingent mostly on the resolution of Greece and the slowing, if any, of profit growth because of the strength of the current headwinds in the global economy, most notably commodity inflation and waning consumer demand.  We receive the Existing Homes Sales data this morning at 10AM, yet the confidence vote in the Greek parliament later in the day dwarfs these numbers in importance.  Furthermore, the subsequent decision on whether to accept austerity measures likely will have a bigger long term impact equities more than any other event for the year.  Similarly, the comments and outlook of the world’s largest multinational corporations during the upcoming earnings season, commencing with FDX tomorrow morning, will go a long way in determining what level the blue chip index settles on December 31.

Since Greek officials do understand the consequences of inaction to their own domestic economy as well as those across the globe and in the absence of a deluge of major companies crying uncle from the pain of shrinking margins, I remain optimistic that market historians will view current price levels as an optimal buying opportunity.  I am not alone with my thinking as yesterday’s action ushered in a favorable environment of declining volumes, shrinking intraday ranges, a break of correlation from the Euro, and the strongest indication of real money being put to work in nearly four weeks.


S&P 500 SEP E-Minis Key Technical Levels

Support: 1275.25/1273.75, 1261.25, 1252.25/51.00, 1243.25, 1236.50/34.75

Resistance: 1287.00/88.50, 1290.00, 1292.75, 1303.75, 1311.75, 1335.50


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