Musing on the Markets : Financials

How to Beat the Market WITHOUT Even/Overweighting Financials

Vinny Catalano, CFA — Wed, 20 May 2009 15:02:00 GMT

The stock market parade in the US has been led by Financials (see first chart). As a result, many investors with well-diversified portfolios may have struggled to produce alpha since the bull rally began in early March, especially if they were underweight Financials - as many no doubt were. In the process of the rally and in an effort not to fall too far beyond in relative performance, these same underweight Financials investors have been forced to plunge headlong into that sector to try and keep pace.

For investors (as opposed to traders), part of the problem with even or overweighting Financials is the high degree of uncertainty facing the sector. With the US government forging ahead with new legislation and regulation designed to steer the financial services industry toward a more managed future (see recent articles on the credit card legislation, executive pay caps, mortgage regulators, and Gillian Tett’s (Financial Times) excellent article on derivatives) no one can confidently predict the future shape of the sector, let alone its sustainable growth and profitability. Therefore, what investments should/could the well-diversified investor consider that can generate alpha AND avoid the issues and uncertainty even/overweighting Financials bring?

One approach would be to increase the equity exposure in those areas where sustainable growth and profitability appears to be more assured AND will benefit from themes that will likely play out for many years to come. Two such areas are emerging markets and global infrastructure.

As the second chart shows, while not matching Financials in the current rally, having a sufficient amount of money in several attractive emerging markets (EEM, EWZ, FXI) and global infrastructure sectors (IGF, PHO), as well putting some funds in the higher beta small cap growth area (IJT), a well diversified portfolio can produce alpha while simultaneously reducing the aggregate beta in a portfolio AND avoid investing in a sector that is fraught with uncertainty.

And Now, For Another Soapbox Moment

For well-diversified portfolios with a longer-term time horizon, it's a relative performance game. This is what "diversification with a tilt" portfolio strategy is all about. The underlying assumption is that stocks have a longer-term upward bias and investors should exercise sound asset allocation and modified market timing principles (along with a healthy dose of patience) to achieve alpha. If this stocks-have-an-upward-bias assumption is correct, even a modest 2% per year outperformance will produce exceptional long-term results.

Note: Walking the talk is what you see in the second chart as it represents most of the larger holdings in a small fund run my firm and in the Model Growth Portfolio, both of which have year to date alpha of 293 and 484 basis points, respectively. Needless to say, past performance is not a guarantee of future results.

From Chaos to Sanity: The Imperative of Logic

Vinny Catalano, CFA — Wed, 17 Sep 2008 15:41:00 GMT

Rules Matter.

If the NFL changes its rules of play, does that not have an effect on the game? So, why would a rule change by the FASB or the SEC or a law by Congress not have the same game changing effect?

When the FASB said that illiquid and opaque assets should be valued at their last sale (or whatever could be approximated as such), were they cognizant of the impact it would have on financial institutions with their capital requirements.

When the SEC eliminated the uptick rule and looked the other way on naked short selling, were they cognizant of the impact it would have in facilitating the bear raids from short sellers? And were they aware that such bear raids would virtually take off the table any capital raising option via an equity sale?

When Congress let the financial innovation genie out of the bottle via various laws (mostly in the area of deregulation) and lax oversight, were they cognizant of the impact it would have financial engineers on Wall Street?

The answer to all of the above is apparently not.

Let me clear – the problems of excess amounts of leverage, animal spirits, and bad business decision-making are at the core of the credit crisis. There is no doubt that this is where the blame must lie. Be it no-doc, no-income mortgages, or homes purchased with the intent of flipping them in six months, or credit cards to teenagers in high school, the list is very, very long. However, the circumstances produced by such bad behavior are not the only culprits. For when coupled with virtually no oversight and the above noted rule, legislative, and regulatory changes, the bubbles that were blown are what the financial system is now struggling to unwind. Which brings us right to the single most important aspect of the crisis – will the unwinding of the excess amounts of leverage (the deleveraging process) be an orderly or disorderly one?

If left unchanged, the answer is what you see on your screens everyday. Firemen Hank and Ben rushing about to put out one financial wildfire after another.

But it need not be this way.

No doubt, there are many ways to achieve the same end result – a more orderly transition of the deleveraging process – but we’ve got to get beyond the reactive mode and become more proactive to begin to move from chaos to sanity. So, let me humbly offer a few immediate solutions to the credit crisis:

1 - Modify FAS 157

Change the rule from the insanely destructive and academically illogical mark-to-market to mark-to-moving average. By shifting the “fair value” reading from the last sale to the average of the past six months, you will get the closest thing to a reasonable compromise between the market fundamentalist ideologues (with their quaint notion that markets are always efficient) and the realists who know that in the short term investors can be anything but rational, especially when it involves illiquid, opaque assets.

2 – Require more transparency in illiquid assets

The FASB’s recent rule change for FAS 133 appears to be one such solid step in the right direction. More needs to be done.

3 – Begin the process of creating standards for derivatives

Financial innovation is not going away. And when conducting properly, financial innovation can be a very positive force for the real economy. However, when so much is constructed in the dark, in times of stress it becomes impossible to determine where the bodies are buried.

4 – Restore the uptick rule

Since the SEC has finally woken up and instituted sanity into the naked short selling arena, they now need to revisit their laissez-faire, market fundamentalist ideology and restore the uptick rule. By doing so, it will significantly the incentive for the pre-Depression era bear raids that are wrecking such havoc.

5 – Move with a sense of urgency

I began this commentary with a reference to football, so let me return to that metaphor.

In a football game, there often comes a point where time is of the essence. And those teams that are prepared for such times act with clarity and a strong sense of urgency. They may not always succeed but the process is the correct one. The current crisis requires such a sense of urgency. If left unchecked, however, the bear forces at work will continue their bear raids (on equity and debt) until the threat to the system becomes more than it can withstand. Frankly, financial Armageddon is not too strong of a phrase.

Investment Strategy Implications

The impact on the economy has now become so significant that lives are being impacted, most dramatically within the companies that are being driven out of business or into the arms of the US Government and for why? Because rule changes have altered the game.

The laissez-faire, market fundamentalism Reagan doctrine is dead. Over. Finished. Kaput. In its place will be (not is) a return to regulatory and oversight environment that preceded it. The danger is this is if the pendulum swings too far the other way and restrictions are imposed that severely limits the US’s ability to compete. Given the populist rant of the two presidential candidates, such a move to overregulation is not out of the question.

As I noted yesterday and Mr. El-Erian stated in his interview, transitions can be very messy. Let’s hope that some degree of clear thinking will produce the kind of results needed.

The Fear Side of the Greed and Fear Cycle

Vinny Catalano, CFA — Thu, 11 Sep 2008 17:22:00 GMT

“The only thing new in this world is the history that you don't know” Harry S. Truman

Just as day follows night and spring follows winter so, too, does investor psychology follow the seasons of emotions from greed to fear and back. Behavioral finance rules and the Efficient Market Hypothesis remains a hypothesis. Loss aversion over risk aversion.

So, to help investors in need of a little timely perspective, the two charts posted reflect the ever reliable greed/fear cycle quite nicely.

Investment Strategy Implications

The contrarian in me believes in the Baron Rothschild saying, "The time to buy is when there's blood in the streets". It is an investing example of President Truman's quote and a testament to the reliability of the greed/fear cycle. Therefore, since the epicenter of the current fear cycle is the Financials, I can't help but notice the recent relative strength in Financials in the midst of outright panic.

"Sectors and Styles Strategy Report" provides a weekly investment strategy perspective on key trends and themes. To learn about "Sectors and Styles Strategy Report" and other subscriber benefits, click here.

One Year and Counting

Vinny Catalano, CFA — Tue, 12 Aug 2008 08:01:00 GMT

commentary from this week's "Sectors and Styles Strategy Report:

“Of all the newfangled financial creations that have caused problems this past year, arguably the most nerve-wracking are derivatives traded over-the-counter…” Economist August 8, 2008

And the beat goes on.

On several occasions over the past year, hopes rose that the credit crisis was about to abate only to be dashed by yet another set of surprisingly large bank write-downs. Surprising to some but not on these pages. The risks from the credit crisis are far broader than originally thought and only now becoming grudgingly clear. And there is truly no end in sight.

Up and out is my way of characterizing what Nouriel Roubini has accurately described as the full scope of the financial Frankensteins created over the past decade. UP in the form of write-downs moving up the quality spectrum within an asset group. And OUT to other financial instruments created by the wizards of Wall Street.

Exacerbating the situation is the accounting rule change instituted last November, FAS 157, in which assets impacted by diminished demand produce lower values requiring mark-to-market write-downs thereby requiring new capital to meet banking related capital requirements leading to further pressure across the entire banking system. A vicious circle.

The equity markets are beset with multiple layers of issues – some, such as inflation, likely to not be an issue for much longer. However, fears of a global economic slowdown are now more real than ever, particularly when we get to 2009 and corporate default rates begin to rise as noted in the following chart* from last week’s NYSSA Market Forecast event (courtesy high yield expert Marty Fridson):

Moreover, according to Marty, the peak isn’t projected until 2010 at an 11% rate. This is the origin/catalyst of the $250 billion (net) credit default swap pain noted by PIMCO’s Bill Gross back in January of this year. So, if you want to see how banking losses get into the $1 to 2 trillion range, this is one contributing component.

Investment Strategy Implications

Last week’s so-called “Olympian rally” in equities must be taken with a huge grain of salt. As noted in several areas of this report*, the contradictory nature of the recent market rally is hardly the stuff of sustainability. Highly fragmented market action with little to no sustained and coordinated leadership provides no real investment comfort beyond riding the bear rally from its undervalued levels.

Until there is more market structure, an overall market neutral approach is advisable to take. Scalping any “lunch money” is also a good short-term course of action for a modest amount of money. Given the looming danger of a no-end-in-sight credit crisis and a 2009 that may stress test more than the banking system, the deleveraging process on multiple levels (banking, US consumer) warrants an above average level of caution.

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Financials in a Larger Context

Vinny Catalano, CFA — Thu, 03 Apr 2008 14:35:00 GMT

To elaborate on my Tuesday BNN TV interview and to provide a technical analysis perspective as to why the Financials are a value trap for investors, here are a few thoughts. As stated in the interview, from a fundamental perspective any sector that is about to undergo regulatory change is by itself sufficient reason for longer-term investment pause. And in a highly charged election year, this risk becomes of greater concern. However, it is longer-term consequences of a changed business model that is the greatest risk to investing in the sector. For example, the specific risks to the Financials sector pales in comparison to the likely impact that a changed business model will have on the US and global economies - and then in turn back to the sector. There is a larger economic consequence to the changed business model, one that few seem to be focusing on – the effect that a deleveraged, changed business model will have on credit creation. If the global economy was aided and abetted in the recent years by financial innovation, it is logical to assume that a dramatic (radical?) shift away from that business model of easy credit and financial innovation (securitization, for example) will result in a lessened degree of capital for consumers and businesses. Therefore, economic activity, particularly domestic activity in the US, will ratchet downward, influenced also by the need for US consumers to rebuild their depleted personal balance sheets. As this relates specifically to financial institutions, the risk of competition (financial institutions in other regions of the world less burdened by regulatory constraints) due to a changed US regulatory environment for US financial institutions will also almost certainly create growth and profitability difficulties in the years ahead. While all this real economy stuff gets absorbed by fundamentally-oriented investors, the technicals of the market may paint a different picture. It does not, as the two charts** above show. The first chart provides a longer-term picture of the sector, which plainly shows a sector that is solidly in a negative mega trend, based on my Moving Averages Principle*. The second short-term chart provides a few reasons why the near term trend is modestly positive. Specifically, momentum and MACD are both positive. And the slow stochastic is not in high overbought territory (above 80 for both trend lines). Moreover, both MACD and the slow stochastic lines have not crossed, which would indicate the end of the near term uptrend. Investment Strategy Implications As stated on Tuesday, Financials should participate in the current spring rally. However, beyond this point in time, it is hard to conceive of the longer-term investment case for a sector undergoing a change to the core of its business model. As noted above, the technicals also reflect this longer term concern. *See prior blog entries and reports for definitions and examples **click images to enlarge

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