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HERON FINANCIAL
GROUP, LLC
FINANCIAL MARKETS
COMMENTARY
June 4th,
2010
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US stocks
lost 8.0% in the month of May, and dropped 1.5% on the year. European
markets are down 0.2-8.4% YTD, and Asian and South American markets are
down 1.4-11.2% on the year. No one seems to remember that world
stocks gained 70-100% over the previous 13 months. The number one
question on our clients' minds is "Are we gonna lose 45% like last
year?" The answer is emphatically, "No!" In
the era of the high frequency trader and the exchange traded fund, it
seems so quaint to remind our clients that 573,000 jobs were gained in
the first 4 months of 2010. The May jobs report disappointed in
that, after excluding 411,000 census jobs, only 20,000 jobs were added
for the month. However, initial jobless claims are falling, continuing
claims are falling, average hours are up, average wages are up, and
temporary hiring is up. Employment remains a trailing indicator on
the state of the US economy. GDP growth is in the 3.0% range,
inflation and interest rates remain near generational lows.
Earnings reports were spectacular, rebounding far better than expected
from the 2009 recession.
We tell our clients that it is reasonable to expect the stock market, net
of dividends, to grow 8-10% year, with our current forecast at the low
end of that range. The volatility is murder! The S&P 500
swings 1-3%/day, 5-10%/month. How can our clients have the courage
to commit to their stock allocations?
The Parable of the Lifeboat
The cruise ship sank. The passengers climbed into a lifeboat.
Dry land lies over the horizon 500 miles away. If the passengers
sit in their seats, pull on the oars and bail when necessary, they'll all
reach safety. Unfortunately, some of the passengers panic easily
when storms blow up. Other passengers have decided to steal food
and water. The passengers rush first to one side, then the other,
violently rocking the boat. With each roll, some passengers fall
out, while other decide to jump out, reasoning they can swim to shore
faster than the boat will carry them. The ship's officer in charge
of the life boat just sits in the bow doing nothing. Eventually the
lifeboat swamps and all drown.
Cute story, but what does it have to do with the stock market? Why
does the stock market exist? To enable savers to direct capital to
corporations, which will use those funds to expand sales and
profits. In retirement, the savers will pull their capital out of
the market, but younger savers will take their place. Financial
markets first appeared in Europe in the 12th and 13th centuries as debt,
agricultural and commodity markets. The first formal stock markets
appeared in 1602 in Amsterdam and in New York in 1792. Though not
immune to frauds and bubbles (the South-Sea Company prospectus
advertised, "For carrying on an undertaking of great advantage; but
nobody to know what it is,") the stock market mechanism enabled the
creation of real wealth at a rate far exceeding any previous experience
in human history.
In recent years, it seems that investors and regulators have forgotten
that the primary role of stocks markets is to facilitate capital
formation. If all investors, which include individuals and
families, pension plans and endowments, simply bought and held index
funds, they'd all achieve a reasonable long term return (like passengers
who sit still, row and bail, and eventually make dry land.) Not a
very glamorous strategy, and for sure investment advisors couldn't charge
outrageous fees for such plain vanilla.
So clever advisors came up with all kinds of schemes to enhance
returns. Some advisors have abandoned investing in individual
companies and instead rapidly shift their clients' assets among industry,
sector and long/short exchange traded funds (ETF's.) Other managers
increase their clients' returns through leverage (hedge funds and private
equity investors.) A whole generation of retail investors grew up
following the daily advice of Jim Cramer and the "Fast Money"
crowd on CNBC (and are now like passengers who jump back and forth with
each wave that rocks the life boat.) Meanwhile, the High Frequency
Traders bomb the market at every opportunity, taking profits (the
passengers who steal food and water) without creating value. The
SEC and exchanges have abandoned any pretense of regulating the markets
(the officer of the lifeboat won't discipline the passengers.)
The lifeboat hasn't swamped yet, but it sure is taking on water.
Average Americans were net sellers of stocks from March 2009 all the way
through the recent April high, and sold even more stocks over the last
month.
The last decade was the peak saving years for baby boomers born between 1950-1960,
but with stock returns negative over that time frame, those investors
have nothing to show for their efforts. Many of our clients are
hesitant to add to their stock allocations because, "it's all a game
rigged against me!" Problem is, what are their alternative
investments? Money markets yield close to zero nominal returns,
negative real returns (after factoring inflation.) Bond yields barely
cover inflation. Commodity prices are extremely volatile in the
short run, match inflation in the long run. Foreign (Europe, Japan)
markets are less attractive now that the dollar gains daily. The
best returns in emerging markets may well be behind us. Real estate
prices in the US should be flat over the next decade (sure prices have gained
modestly of late, but there is a vast overhang of property which will
come on market the moment seller think he or she can break even.)
Gold? Art and collectibles? Lottery tickets?
Why the Uptick Rule Matters
Neither the SEC nor NYSE and NASDAQ can come up with a convincing
explanation of why the Dow suddenly dropped and recovered 1000 points on
May 6th. The dirty secret is that the market performed exactly as
it was programmed.
 A retail investor
gets advice to buy Apple at $260 and enter a trailing stop at $230
"for protection." A trailing stop becomes a market sell
order if the stop price is breached, which means that the execution price
may be $230, or it may be a lot lower if that's the market price on
execution.
On May 6th, the fill on the $230 stop loss could have been as low as
$199.25, delivering the investor a 25% instant loss for no fault of their
own. (We never use stop loss orders, by the way. We regard
them as a.) a mechanism to "buy high, sell low" and b.) if
we've researched a company properly and someone offers us a 25% discount,
we'd want to buy more!).
If you're a clever HFT trader, you use "flash orders" (small
offers to buy and sell that are canceled before execution) to sniff out
where the stop loss orders are. Then, around 2:30 in the afternoon,
you load up a sell program on a thinly traded industry ETF. At 3PM,
you fire off the sell program knowing that other HFT traders are doing
the same thing. The price of the ETF plummets, then arbitrage
programs kick in, buying the ETF while shorting the underlying
stocks. As the stops are breached, a huge surge of sell orders hits
the market, further dragging down the ETF, which triggers more underlying
stock sells, which cascades into more stop loss orders. The
granddaddy of arbitrage meltdowns was the
 meltdowns
October 1987 stock market crash, which dropped stocks 22% in a day.
But we have seen mini-crashes almost daily for the last month (stocks up
at 2:30PM, down sharply by 4PM) and we saw similar mini-crashes in the
October 2008-March 2009 timeframe.
In principal, a trader may not short a stock or ETF without first
borrowing the security. In practice, as long as a security is on
the "easy to borrow" list, traders can naked short at will knowing
that they'll have a flat position at day's end. These traders do an
end run around the SEC's Regulation SHO, which acted to curb
short-selling ("bear raid") abuses in April 2005. Since
1934, markets were patrolled by the uptick rule, which stated that a
short sale must s execute one tick higher than the last sale. In
historic times, an uptick might be a quarter or eighth of a dollar and
these days might be only a penny, but the effect was to apply a certain
amount of "friction" to the shorting process, which investors
like and traders hate. On the NASDAQ, the rule was slightly less
restrictive: short sale had to take place a tick above the prevailing
bid, not necessarily above the last execution.
This chart shows the volatility of markets before and after July 2007,
when the uptick rule was suspended: The VIX
measures
volatility of S&P 500 stocks and is a good proxy for NYSE volatility,
while VXN measures volatility of NASDAQ stocks. Some companies such
as Microsoft and Intel contribute to both indices. Bottom line, we
see that after mid-July both indices became dramatically more volatile,
leading to record levels in late 2008 and jumping up pretty sharply in
May 2010. Prior to the demise of the Uptick rule, volatility of
NYSE stocks was dramatically less than volatility of NASDAQ stocks; now
both categories of stocks are equally volatile.
There are a number of academic studies that "prove" the uptick
rule has no affect on downward volatility. These studies were done
when half of stocks were exempt from the uptick rule in the 2004-2007
time frame. We believe that moving from half stocks exempt to all
stocks exempt surpasses a "tipping point" which explains the
unprecedented volatility. The SEC, however, appears dead set
against commissioning a post 2007 study of the uptick rule.
Stocks over-valued or under-valued?
Stock prices are a function of future expectations of earnings discounted
by current interest rates.
At present,
earnings for the S&P 500 are expected to grow 25% over the next yea,
in the context of the ten year treasury at 3.3%. Stocks obviously
were at a deep discount in March 2009, but rapidly approached fair value
towards year end as stock prices rallied. Stock prices are
unchanged since the start of 2010, but earnings estimates continue to
move higher. Meanwhile, the European debt crisis has pushed
interest rates back towards post-war, implying that the S&P 500 is
58% under-valued.
What if you believe that estimates are grossly high? Given low
interest rates, if earnings grow only 13%, stocks are still 54%
undervalued. What if you believe that the risk free treasury rate
is not the appropriate discounting factor; you prefer to be more
conservative with corporate bond yields. At present, the Moody's
average Baa corporate yield is 6.2%, implying that stocks are still undervalued
by 22%. As we have seen, the Fed model is more sensitive to changes
in interest rates than changes in earnings expectations. Variations
on this model developed by Morningstar and Moody's also show stocks
undervalued by 6% and 15% respectively.
Saber rattling
Turkey and Israel are on diplomatic showdown over last week's botched
interception of a Turkish aid flotilla heading towards the Gaza
Strip. Israel's 2006 invasion of Lebanon led to the deaths of 1500
civilians and billions of dollars of damage, but made no significant
changes to the Middle East balance of power.
North Korea threatens war with South Korea over accusations that the
North recently torpedoed a South Korean destroyer. If North Korea
did in fact attack South Korea, civilian casualties could be in the tens
if not hundreds of thousands of South Koreans. However, the North
Korean government would be unlikely to survive the retaliatory
counter-attack. The conflict could put the US in direct conflict
with China, who would then have to decide between its commercial
interests and political interests in coming to the aid of North
Korea. It's always something, but meanwhile corporations do what
they're supposed to do, which is produce goods and services. War
has rarely been bad for stock prices.
Strategy
We're fully invested with our current clients and have cash from new
clients. We would like to put that cash to work quickly, and are
simply waiting for the day to day volatility to ease. Dow 10,000
appears to be a hard floor, despite investors' fears. Markets are
thinner and more easily manipulated during the summer time, but July
earnings reports should paint a rosy picture. NASDAQ is
implementing expanded "circuit breakers" to sideline stocks
with unusually large moves - anything that reduces volatility will get
investors interested in stocks again.
As always,
please don't hesitate to call with questions and concerns.
Yours sincerely,
David
Edwards
President
The HERON FINANCIAL GROUP Financial Markets
Commentary is published following month end and when market
conditions require comment. The views expressed in this letter represent
HFG opinion and strategy as of the date published and can change at any
time upon receipt of new information. Data quoted in this letter are from
sources deemed reliable, but no guarantee of such data is implied.
HERON
FINANCIAL GROUP, LLC, is an SEC registered investment
advisor providing fully managed investment and wealth management services
to individuals, families, trusts, defined benefit plans and
corporations.
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HERON FINANCIAL
GROUP, LLC
www.HeronCapital.com
(800) 99-HERON
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