Extending yesterday’s baseball analogy, the market hit one deep into the gap on Thursday. Before other bulls start doing cartwheels, let me remind them that a double does not score any runs with no one on base and over the past three weeks the bears have outscored us 12-3. I certainly can run through paragraphs of analysis on the milestones the TICK data reached yesterday, but I ask that you take it on faith that the information suggests investors put money to work aggressively. Instead, I want to focus more on the psychology of this promising bounce off the bottom in an effort to determine if stocks can extend this move.
Given the extremely elevated volatility and uncertain macro environment, the large long only institutions will not aid in pushing equities higher, for they fear realizing heavy losses on new positions in a matter of hours while retail inflows tend to dry up as well. Thus, the machinations of hedge funds will go a long way in influencing direction of the near and intermediate term. I will not regurgitate the fundamental backdrop as there are a thousand analyst reports out there that do just that. We all know of the fears coming out of Europe and how potential contagion can spread like wildfire and quickly jump across the Atlantic despite encouraging news on the employment picture over the past week indicating that a double dip recession for the U.S. is not a fait accompli.
I would rather offer up a lesson in history to act as a guide for predicting the market’s movement going forward. Almost all of us are familiar with the economics of hedge funds, especially the hefty 20% incentive fees on all trading profits that exceed last period’s (typically annual) high water mark. According to Hedge Fund Research, after the post-dot com low, the average long-short equity fund annualized 12.1% returns from 2003-2007 to produce fat profits regardless of AUM level. Unfortunately, the rapidity and violent nature of the financial crisis left most managers stranded as average returns for that year plummeted -26.7%. After eating crumbs for three years, hedge funds finally nudged above their 2007 high water market by a mere 90 bps this past December.
Although still cautious, managers, content with the return of incentive fees, started 2011 solidly with an average gain of 3.6% through the first third of the year to approximate closely the pace of performance from the good old days of 2003-2007. Thanks to a barrage of macro shocks around the globe, P&L has suffered as returns have slipped below 1% for the first seven months of the year. With the S&P 500 and Russell 2000 selling off over 9% and 12% respectively month-to-date for August, I will extrapolate that the typical long-short equity portfolio is currently down approximately 3-4% for 2011 pushing them below last year’s high water mark. In my estimates, I am assuming that these funds pared losses by quickly eliminating risk thanks in large part to the massive hedging in the futures market as evidenced by the $77B notional increase in the open interest figures.
Remembering the pain from 2008***, firms have aggressively reduced exposure for fear of digging a new deep hole beside the one they just crawled out from. This has accelerated the market’s descent and has encouraged speculators, discretionary or systematic, to profit handsomely from the short side. Speaking from experience, I recognize a smaller book does not assuage one’s angst at these inflection points. Instead, it augments it as the anxiety gnawing at managers arises from two different sources. First, if the portfolio increases its risk and the market subsequently sells off, the fund has a lot of ground to make up just to get even again. For those more arithmetically inclined, the following statement is obvious: an x% loss requires a subsequent greater than x% gain to return to original NAV. For example, a 20% drop requires 25% percent upside to complete the performance roundtrip.
Secondly, if the firm remains underexposed, then any violent move higher leaves them behind relative to the competition and to an S&P 500 benchmark which threatens the stability of investor assets. Consequently, given this double edge sword and the absence of large vanilla buyers, the market has had massive convexity with its most influential players short gamma. In other words, managers have sold and bought with the crowd on dips and rallies respectively in order to mitigate their firms’ business risk. This has clearly exacerbated volatility.
Resolving this torturous dilemma, funds must invest with conviction and rely on their superior analysis which allowed them to manage external assets in the first place. Admittedly, that is far easier said than done, but the reward if right and the peace of mind of at least swinging at a pitch one likes even if wrong ultimately should steer their emotions toward this path.
Regardless, my above analysis suggests that momentum, always an important factor in direction, reigns supreme. While both the fundamentals and technicals keep me bullish, I am a bit concerned with the scheduled economic releases this morning. I rarely like to predict data versus consensus, but both Retail Sales and the University of Michigan Sentiment survey both have uphill climbs. With a headline prediction of +0.5%, the former, which will print at 8:30 AM, historically reports negative growth during months of a weak stock market or the presence of an externality, such as July’s bitter debt ceiling debate in Washington. This, along with the sharp drop in market capitalization in August, should make a dent in the consumer confidence figures from Ann Arbor released after the Open despite analysts’ predicting only a modest decline versus last month. If I am right, I remain hopeful that smart investors will shrug off the economic news as transitory and view any blip in the market as a buying opportunity. This will then force the hands of managers eager to realize the benefits of 20% incentive fees in wishing the market higher.
S&P 500 SEP E-Minis Key Technical Levels
Support: 1146.76, 1142.50, 1123.00, 1113.75, 1100.00/1099.25, 1090.00, 1080.50/77.00
Resistance: 1184.00, 1200.00, 1212.75/15.50, 1219.00/19.50, 1228.50, 1241.00, 1258.00
***The various short sale bans across Europe enacted Thursday evening served as another reminder.