Those who have read these market commentaries for the past several years know that I am a big soccer fan. I was a member of the original Sam’s Army, the U.S. national team’s official supporters group, and made my wife pledge she will travel to the World Cup every four years before agreeing to marry me. Although I gave her a free pass for the last few tournaments given the age of our children, I expect her to fulfill her spousal obligations in 2014 in Brazil.
Former German international superstar and now California resident Jurgen Klinsmann made waves this past week by accepting the head coaching position for the U.S. men’s squad. He had performed a drawn out mating dance for the job during the past five years such that soccer federation officials effectively had told the former World Cup champion “whenever you are ready, we will be here for you.” Perhaps with Mr. Klinsmann’s agreeing to the position with much fanfare, large institutional investors will follow his direction and discover a bit of temerity to insert themselves back into the markets. Certainly, we are all waiting patiently for them to return.
Immediately after experiencing the most painful session of the year, traders often try to digest the cause and ramifications of such a selloff. Upon examining the price action, I can conclude that big vanilla institutions remain steadfastly on the sidelines while the more nimble hedge fund community, seeing year-to-date returns quickly dwindle down to a few ducats, protected P&L more aggressively. According to HFR, the average long-short equity strategy finally popped its head above its 2007 high water mark last December. Any positive numbers these firms can generate in 2011 will garner the fat incentive fees that have been absent in the past three years. Consequently, managers will remove risk faster than normal when a violent move in the market threatens these gains as the typical fund posted a meager 1% return for the first half of the year.
They accomplish this goal using two different means. The more classical approach entails simply selling stock. We witnessed that on Tuesday as performance suffered worse when traveling down the market cap weighted indices. Hedgies typically play in small caps because those names offer better opportunities to obtain an edge. Thus, when these tickers suffer more than the blue chips, it implies selling from these funds.
The second approach I alluded to in yesterday morning’s commentary entitled “The Pajama Collective.” With the rapid expansion in electronic trading, access to the E-Minis has become almost universal. Reducing risk up to $200MM with little or no market impact is now only one click away. As a result, open interest for the S&P futures have exploded upward by 268K contracts in the past week to surpass a consistent threshold of an oversold environment. In addition, this nervousness has widened the average daily range in the E-Minis during the past week to over 25 handles which also signals an imminent bottom.
To be sure, large institutional firms added some pressure by selling out of positions, but their influence remained quite muted in comparison. The net difference between the instances of NYSE TICK readings that exceeded +1,000 from those that fell below -1,000 only measured 46 and falls within one standard deviation from the mean over the past 13 months since I began tracking the data. Extending this analysis further, one would have expected a drop of only -3.9 points for the S&P 500, as opposed to the actual 32.9 handles, when plotting a simple linear regression using this statistic as the independent variable. In other words and even despite acknowledging the loose fit of this line, the big behemoths, unlike the hedge funds, did not panic yesterday.
Perhaps these portfolio managers refuse to jettison positions at current valuations. Using $108 earnings consensus for the blue chip index over the next 12 months, the forward P/E has dropped to 11.65x. Although expected profits have continued trending higher thanks to a solid reporting season, current price levels imply estimates closer to $89, or only marginally better than actual 2010 figures.
Some bears argue that a significant risk premium pervades the market thanks to sovereign debt issues at home and in Europe. I counter by arguing those exogenous shocks have largely disappeared. For example, when Moody’s affirmed the U.S.’s Aaa rating last night, the overnight futures markets did not move. In addition, Jean-Claude Trichet indicated last week that anyone buying credit default swaps on Greek debt does so as a losing proposition. I am confident the ECB President feels the same about Irish, Portuguese, Italian, and Spanish CDS’s as well.
A fear of new recession then is what currently shrouds the market. I agree that the recovery has stalled over the past few months; however, nothing suggests an imminent double dip is upon us. Certainly the data has taken a step backwards, but I wholeheartedly believe traders have placed too much weight on the numbers which always reflect the past as opposed to more forward looking statements from companies who broadly remain optimistic. In my ten years in this business, I have never seen so much undeserved chatter about Personal Spending figures as we had yesterday. I will make note of the disappointing information, but temper its influence as some of the data reflected statistics two months old while this very survey also printed a negative number in June, 2004 and May, 2005 when stocks sat far below their all time highs.
One silver lining is that anything released close to consensus on any economic survey should provide a nice tailwind for stocks. Perhaps that comes with the ADP Estimate at 8:15 AM today or the Non-manufacturing ISM at 10AM. For the former, the data series achieved some of its necessary reversion to the BLS Private Payroll figures last month as it had been under reporting jobs by 475K since March, 2010. The gap, however, remains wide enough to expect ADP to continue to trend above the BLS data over the next several months. Of course, the current level of skittishness makes Friday’s Jobs Report the most important in recent memory and will dwarf today’s survey in importance. Regardless, save Nonfarm Payrolls stretching to a significant negative outlier, equity valuations remain too enticing for institutional fund managers to remain on the sideline much longer. When they feel their time has come just as Coach Klinsmann did recently, we will all welcome them with open arms. Unless you are short of course…
S&P 500 SEP E-Minis Key Technical Levels
Support: 1246.75/47.25, 1243.25, 1236.50/34.75, 1228.00/27.25, 1221.50/19.25, 1216.25, 1206.75
Resistance: 1265.00, 1280.00, 1304.75, 1309.75, 1313.00, 1316.25