Below please find HBK Sorce Financial LLC’s market commentary. This commentary is not prepared by me directly but is rather a collaborative effort of my firm prepared by our Asset Management Unit and approved by our firm’s Investment Policy Committee. I hope you find this information useful.
Another Positive Month on Low Volume
Equity markets were higher for the sixth consecutive month in August, extending the rally that began in early March. The S&P 500 and NASDAQ indices ended the month more than 50% ahead of March lows, with the Dow close behind with a “meager” 45% showing. YTD, the major US indices are up well over 10%, which is a welcome change from the 10% decline last year at this same point in time.
One interesting component of last month’s rise, which we have commented on since the beginning of the rally, is the low volume nature of the upward move. It is generally accepted that August is a mulligan month for the equity markets: Congress is in recess, and many traders and institutional investors use the time to get away from the ticker-tape. Even taking this into consideration, this August was particularly quiet.
Market pundits expected a low volume month, but no one thought that the evaporating volume would be dominated by just four financial stocks: AIG, Citigroup, Fannie Mae and Freddie Mac. At one point in August, the aforementioned accounted for nearly 40% of the New York Stock Exchange’s (NYSE) trading volume. What’s more, Citigroup by itself accounted for nearly 20% of trading volume over the last two weeks of August (last year, Citigroup accounted for about 3% of NYSE volume).
There was much speculation about the source of the volume spike, including a short-squeeze, high frequency trading and flash trading (flash trading allows certain traders to view trade orders a fraction of a second before the broad market). There was much outrage from market participants about flash trading, especially when allegations materialized that certain companies front-ran client trades (this debate was escalated when several accused firms reported record trading revenues in Q2). In fact, it had raised so many eyebrows that the NASDAQ OMX and the BATS stock exchanges banned flash orders outright in August. Meanwhile, the London Stock Exchange stopped rebates to high frequency traders (HFT) in order to quell accusations of unfairness. Despite all of the hoopla over flash trading and the curtailment thereof by automated exchanges, the NYSE had never allowed the practice, which means the volume spike for the abovementioned stocks likely came from another source.
Another possible cause for the concentrated volume was brought forth by Geoffrey Rogow of Dow Jones Newswire, who placed responsibility on basic portfolio hedging. “Part of the increased volume has to do with bets that Citigroup can come out of the credit crisis without further damage. A bigger driver, though, is that Citi’s recent higher share price – the stock gained 54% in August, and has quadrupled since March – has made it easier to short.” He goes on to say that many market participants are expecting an “inevitable pullback” for financial stocks and are therefore looking for a highly correlated stock to short. “If, for instance, a trader is going to hold an intraday position in Fannie Mae and Freddie Mac in a bet they are worth more than current market value, he limits his downside by shorting Citi…short volume, or the number of shares sold short over the course of a day, made up about 50% of overall volume in Citigroup shares Tuesday (September 1st), compared with less than 35% in early August.”
While trading irregularities pushed financials higher, “less negative” macroeconomic releases propped up the remaining sectors. Higher than expected ISM, GDP and Michigan Sentiment releases contributed to the positive news flow. Adding fuel to the fire, Washington added another $2 billion to the “cash for clunkers” program before heading into recess, ostensibly extending it through the summer break. Surprisingly, the auto & transport sector actually fell on the news, but still finished the month in positive territory and is up nearly 18% YTD.
While “less negative” releases drove markets higher, “less positive” data continued to trickle in. Recently released unemployment data was met with mixed reviews. Some market pundits heralded lower initial unemployment data while others pointed to the unemployment rate which increased to 9.7% (estimates were for 9.5%). Even more significant, total private job growth is now negative over the trailing 10 years. This means that the US private sector has lost more than 200,000 jobs since 1999. Another worrying point came from the FDIC, which announced that the number of “problem banks” had grown to 416 during the second quarter (a 36% increase from Q1). A total of 81 banks have been shut down so far in 2009, putting serious stress on the FDIC’s deposit insurance fund. The fund’s assets fell to $10.4 billion during the quarter, which is its lowest level since the savings & loan crisis peaked in the early 1990s.
Looking ahead, investors will likely face continued mixed signals. September is renowned for being one of the worst months (depending on the timeframe) for US equities. Investors only have to look at last year’s Lehman collapse for evidence of back-to-school selling. There is also evidence that insiders continue to sell into the recent market rally. In a Bloomberg interview, TrimTabs’ Charles Biderman said “insider selling is 30 times insider buying, while corporate stock buybacks are non-existent. Companies are saying they don’t want to touch their own stocks…when companies are heavy sellers (of their own stocks) and retail customers are borrowing to buy stocks; that’s always been a sign of a market top.”
Conversely, the recent commitment by the G20 to continue spending until the global economy recovers is a positive indicator. Another positive, which has been touted ad nauseam by every outlet, is the material amount of money on the sideline. “There’s a large amount of money on the sidelines waiting for investment opportunities; this should be felt in market when ‘cheerful sentiment is more firmly entrenched.’ Economists point out that banks and insurance companies ‘never before had so much money lying idle’.” Ironically, this quote came from the Wall Street Journal in the August 28, 1930 edition, and was followed by yet another recession. What is not ironic, however, is that money on the sideline can quickly and materially move markets in a fundamentally weak environment. Investors should not ignore this fact; especially in an upwardly trending market that has, at least recently, ignored market skeptics.
Sources: Bloomberg.com; Bespoke; Ritholtz.com; ISM; NYSE; Reuters; TheLFB Trade Team; Dow Jones; Financial Times; Zero Hedge; Ritholtz.com; BusinessWeek; TrimTabs
Europe Leads Performance as EM Takes a Rest
International stocks had another strong month, with the MSCI ACWI ex-US rising 3.7% in August (and now up 30.2% YTD). For a change, developed markets led performance, while emerging markets experienced a decline (primarily Asia ex-Japan). EM investors are plenty happy though, with returns exceeding 50% YTD. Stocks in Europe rose 6.3%, led surprisingly by Italy (up over 9%). Australia was the standout performer in Asia Pacific, returning over 8%.
Asian stocks took a breather in August, led lower by China and Hong Kong. The Chinese government attempted to reign in bank lending that exploded in the first half of the year. The MSCI China Index (the index of primarily H-Share stocks available to non-residents) fell 7% in August, while the MSCI China A Index (A-Shares available to residents) fell 23%, led by a decline in financial stocks. The A-Share index is generally more volatile since investors are more short-term oriented in China. The MSCI Hong Kong fell 7.1% in August.
Frontier markets rose 5.7% in August, after lagging emerging markets so far in 2009 (up 20% vs. 50%). Lithuania and Estonia returned 48.3% and 28.9%, respectively, in August. Like most Eastern European countries, these are experiencing large GDP contractions. IMF support for the region has been encouraging to investors though, reducing perceived risk. Further, telecom industry acquisitions by Sweden’s TeliaSonera AB in the Baltics drove up prices of the index dominant companies in the two small countries. The 80% YTD gain by Lithuania is higher than that of the performance leaders in emerging markets – Turkey (+75.9%), Brazil (+75.5%) and India (+69.6%). Indonesia has the highest YTD returns in the MSCI Emerging Markets Index (+93.6%), while China (up “only” 41.8%) is lagging the index.
Europe in Favor: The European Central Bank upgraded its growth outlook slightly, but it did not indicate when it would raise the interest rate above the 1% level prevailing since May. Uneven growth is expected, and a meaningful GDP upturn is still not likely until mid-2010. Germany and France, the two largest economies in Europe, are the only two countries in the region to post slightly positive GDP growth in Q2 2009 on a sequential basis. The OECD also raised growth estimates slightly for both the Eurozone and Japan, which is the third major developed economy to have positive GDP growth in Q2 2009.
In Germany, lending growth remains anemic and unemployment is rising, but exports have risen sequentially during the summer and consumer sentiment has been on an uptrend. In the UK, Europe’s third largest economy, the Bank of England (BOE) kept its interest rate level set at 0.5% while continuing its quantitative easing program. Unfortunately, unemployment is still rising across Europe – now averaging 8.9% in the EU. The one significant outlier was Spain, Europe’s fifth largest economy, with
unemployment close to 18%. Unemployment had shown some improvement earlier in the summer, but unfortunately rose again in August on slow tourism. The OECD estimates unemployment will exceed 20% in 2010. Spain is likely to have the deepest and most prolonged recession in Western Europe, with Ireland and the UK also severely challenged.
End of Conservative Rule in Japan: After ruling Japan since 1955, the conservative Liberal Democratic Party (LDP) lost the election in Japan on August 30. The center-left political party, the Democratic Party of Japan (DPJ), won 308 of 480 seats in the powerful lower house of the Diet. While the political and economic goals are not yet entirely clear, the DPJ would like to shift its stimulus efforts toward consumer demand, including child care, education and employment. The critics are deeply concerned that higher government spending will eventually result in higher taxes and higher fiscal debt (relatively high at 220% of GDP), similar to the concerns in the US. The stock market in Japan has not experienced much of a post-election adjustment during the first week of September, though Japanese stocks continue to lag the broad global indexes.
Sector Leadership: Financials outside the US continued to rally in August, rising 6.6%. and are now up 43.3% YTD. Other cyclical sectors – energy and consumer discretionary – also performed better than the broad international index (MSCI ACWI ex-US Index). In August, materials and consumer cyclicals lagged, as more conservative utilities and healthcare stocks performed well. Three defensive sectors – utilities, healthcare and telecom – are performance laggards YTD.
As we enter September and October, those months that have historically negative connotations for the markets, a wider dispersion of opinions may become prevalent. The bulls will latch on to the bright spots of a recession ending in Germany and France, and the surprising bounce in GDP and industrial production in emerging Asia. Also, favorable cross-border M&A trends in Europe coupled with relatively high dividend yields (over 3.5%) are supportive of European stocks. The bears will continue to be fearful of “brown shoots” and uncertainty in the direction of government policies – especially in the US, UK and Japan. They will also point to the huge performance run in Asia and Latin America, as well as higher beta stocks in general. A widening dispersion of opinions can create a range-bound market. While we do see some evidence of institutions rebalancing from bonds into equities, high-net worth investors are barely dipping their toes back into the water with equities. Many investors have focused on the question of when to get back into the market, forgetting about the strategies of dollar cost averaging and scheduled rebalancing, which allow investors to sleep better at night.
Sources: MSCI Barra, New York Times, The Economist, Bloomberg News, Forbes.
Fixed Income Provides Solid Positive Returns
Economics: Positive news from July carried over into August, especially within the housing markets. The inventory overhang that existed early in the year is slowly being worked down as home sales are picking up, and sales prices are stabilizing. This recession was amplified by weakness in housing, so stabilization in that market is critical for a return to normalcy in the broader economy.
New home sales for July registered at 433,000 on a seasonally-adjusted annualized basis, an increase of 9.6% from the previous month, but still 13.4% below the prior year. The positive news is that the supply of new homes fell from 12.4 months in January to 7.5 months by July, a marked improvement and a level that is much more in line with historically normal levels. Existing home sales rose 7.2% in July to a seasonally-adjusted annualized rate of 5.24 million. Contrary to new home sales, the inventory glut of existing homes is still at an abnormally high level, at 9.4 months.
The corollary effect of bottoming sales figures is a slowdown in the rate of decline in the Case-Shiller Home Price Index. Seasonally-adjusted, the composite 10-city index was up 9% in June. While this is far from great news, as the index is still down 33% from its peak, it does represent another sign that the housing market is beginning to finding a bottom.
On the consumer front, personal bankruptcy filings for the month of July reached the highest level since 2005. As a reminder, the bankruptcy law changed in 2005, making it more difficult for consumers to file and also encouraging many to file in advance of the deadline. This time around, consumers are being forced to file for lack of a better alternative, with mounting debts and rising unemployment making it difficult for individuals to stay afloat. Bankruptcy filings were up 34% from July 2008 to July 2009. The total number of filings was 126,434 in the month, signaling increasing fiscal stress for the US household. Delinquency rates for residential real estate and consumer credit cards also rose in the month, hitting 8.8% and 6.7%, respectively.
Federal Reserve: The early August meeting of the Federal Reserve contained little in the way of surprises. The target Fed Funds rate was held at a 0-0.25% range, which economists are expecting to continue through 2009 and into most of 2010. In addition, the Fed announced that the purchase of $300 billion in Treasury securities will slowly abate in September and October. This program is not likely to be extended given the improved nature of the broader economy, but an unforeseen economic collapse could lead to this program being reinstated.
The other major news concerning the Fed in August was the nomination of Ben Bernanke for another term as Chairman of the Federal Reserve. Regardless of one’s opinion for his efficacy leading up to the most recent crisis, his reappointment at least provides market participants an idea as to his intended course of action for the future of monetary policy. In times like these, markets reward stability and will happily avoid the unknown.
Treasury Markets: For the second consecutive month, Treasuries realized positive total returns across the maturity spectrum as the yield curve adjusted 7-10 basis points lower in a mostly parallel fashion. The Treasury market generated approximately 90 basis points of return for the month. Similar to July, the end result masked volatility within the month. Yields initially backed up in anticipation of the monetary policy meetings held on August 11th, with the 10-year Treasury reaching a yield of 3.85% at one point. Confirmation from the Federal Reserve that the economy is improving, and the announcement of a measured end to the US Treasury purchase program, seemed to justify this higher yield. However, later in the month yields dropped precipitously as large auctions were well received and economic reports were met with healthy skepticism, thus creating a solid bid for Treasuries. The 10 year note ended the month with a yield of approximately 3.4%.
The term structure itself remains steep, with an incremental yield pickup of nearly 350 basis points between the 2 and 30-year Treasuries. Market consensus suggests the current yield advantage will stay in place for the near term as short term rates are anchored and long term yields continue in their current trading range.
Yields on TIPs generally held steady in the face of more volatile nominal Treasuries. The net result was a slight drop in the implied inflation rate across the maturity spectrum, with the 10-year rate settling in at 1.7%, 10 basis points lower as compared to the end of July.
Municipal Market: The municipal market remained heavily influenced by structural forces. YTD nearly $50 Billion in new money flowed into the market as the prospect of higher taxes continues to drive investment. Flows were slightly lower through mid-August but, as the month progressed, volume returned to record setting levels. As expected, trading volume was markedly higher relative to past August results. In early August, investments into the municipal market followed the trend of previous months and targeted investment grade, short to intermediate
maturity bonds. Healthy demand has gradually reduced the attractiveness of this area of the municipal market, driving yields lower and valuations, relative to Treasuries, ‘back to earth’ and below 10 year averages. As August progressed, it was apparent investors recognized this fact, and shifted their focus in search of yield. The shift in attention led to a strong rally for longer duration and lower quality/ high yield bonds. The net result was a slight flattening of the municipal yield curve, and a drop in yield offered for lower rated bonds. The municipal sector itself returned 1.7% led by a 4.3% return for longer dated bonds and a 4.2% return for bonds rated BBB. Despite this activity, from a long term perspective, the yield curve is steep and lower rated credits continue to price in a decent spread premium.
YTD through August, primary issuance from municipalities has not met the record setting pace of investment into the market. This is a break from tradition as municipalities usually have the wherewithal to take advantage of investor demand, and the resulting lower yield environment. Municipal finance departments are likely dealing with a lack of fiscal clarity, as well as an adjustment in the dealer community, causing them to be reluctant to issue new bonds. Primary issuance has also been affected by federal government intervention through the Build America Bond (BAB) program. Since the creation of the program, nearly 1/3 of new municipal issuance has come in the form of this federally subsidized, taxable bond program.
Corporate Market: Investment grade spreads tightened approximately 10 basis points as momentum in the sector continued, albeit at a slower pace. Investor fund flows remained strong and were matched by equally strong primary supply as highly rated corporations took advantage of the low yield environment by issuing new debt. Total return for the sector was approximately 1.8%, with lower quality credits leading the way.
Source: Barclays
The high yield market continued its string of solid performance, generating a total return of 1.9% as lower quality – CCC rated names – pushed the market higher. The month ended with the option-adjusted spread (OAS) for the Barclay’s high yield index at approximately 850 bps above comparable Treasures. This
represents a relatively decent premium compared to the indices’ longer term average OAS of 620 bps.
Overall credit quality in the high yield sector has shown some signs of stabilizing. The downgrade to upgrade ratio for both major rating agencies has turned down, suggesting that defaults experienced by the sector may turn down as well. This could prove to be an interesting catalyst for further spread tightening.
Sources: Bloomberg; Barclays; Municipal Market Advisors; Moody’s; Standard & Poor’s.
Alternatives Trend Higher
Alternative investment strategies continued their general uptrend in August, buoyed by positive performance in the credit and equity markets. With the S&P 500 index up 3.6%, the Russell 2000 up 2.9%, the MSCI EAFE up 5.5%, and the BarCap High Yield index up 1.9%, those strategies with directionally long exposure were generally positive for the month. Market directional strategies gained 1.6% in August, leaving YTD returns at 18.8%. Other strategies with less market exposure, such as absolute return and market neutral, fell marginally in the month as they struggled to keep up with the bull rally.
The HFRX Equity Hedge index gained 1.0%, as increased positions in the beleaguered financial sector (up 11.2% for the month in the Russell 3000) lifted returns in August. Signaling again that the worst may be behind our financial institutions, John Paulson, who made a fortune betting on the housing collapse in 2008, scooped up shares of troubled names such as Citi and Bank of America in 2009. Paulson is not alone, as hedge fund managers increased their financial holdings by 55% in the second quarter, representing over 3.5% of the sector’s market capitalization, according to Goldman Sachs research. Long-short managers continue to increase their gross and long exposures as fundamentals return to the markets.
Convertible arbitrage strategies posted strong performance once again, gaining 3.6% in the month to bring YTD performance to 33.2%. The BarCap Convertible index was up 3.9% in August, posting its sixth straight month of positive performance. Relative value strategies jumped 3.7%, similarly benefiting from the lengthened thaw in the credit markets. While the HFRX Distressed index continues to suffer (down 0.4% in August and down 10.2% YTD) due to concentration issues discussed in previous Flash Reports, it is worth noting that the well diversified HFRI Distressed/Restructuring index was up 12.1% through the end of July.
The HFRX Macro index, down 0.8% in August and 6.7% YTD, lagged primarily due to the pains of the systematic trend following CTA managers included in the index. While macro and CTA strategies are grouped together in the HFRX Macro index, they are separated into distinct strategies under the Credit Suisse/Tremont Hedge Fund category system, providing insight into the divergence of returns. Through July 2009, global macro strategies were up 5.2% for the year according to CS/Tremont, while CTA/managed futures strategies declined 7.8% over the same time period. This is reflective of the whipsaws and reversals in trends that are proving problematic for CTA managers who rely on continued trends in order to generate performance. As a point of reference, the long-only DJ UBS Commodity index declined 0.6% in August and is up 0.7% YTD.
All remains relatively quiet in hedge fund land – perhaps a little too quiet. It has now been a year since the collapse of the venerable Lehman Brothers, the event which seemingly sparked the massive onslaught of hedge fund redemptions as 2008 came to close. Fast forwarding to September 2009, the hedge fund industry remains intact, albeit forever changed.
One noticeable change is smaller size of the industry following the wave of redemptions in the second half of 2008. HFR estimates the industry’s total assets were $1.43 trillion as of month end June 2009, compared to a peak of $1.93 trillion as of June 2008. Fund of funds assets declined in size by $95 billion to $735 billion (approximately 40% of the total hedge fund industry) in the first half of 2009, representing a 13.5% decline, according to the InvestHedge Billion Dollar Club survey. For managers who were responsive in meeting investors’ liquidity demands, the crisis appears to have abated as many are now seeing net inflows once again. For other managers, specifically those who either gated their funds, suspended redemptions or those with annual liquidity, the future is less certain. Cerberus, which refused to return cash at the end of 2008 after well publicized struggles with GMAC and Chrysler investments, recently announced that clients are withdrawing over $4.75 billion (70% of assets) in response to lackluster results and liquidity needs. Cerberus is not alone, as other large funds such as Atticus and William Von Mueffling’s Cantillon Capital announced the shuttering of a portion of their hedge fund businesses in the first half of 2009.
Year end 2009 may prove to be the finale in the redemption saga, as those hedge funds and fund of funds with annual liquidity provisions may suffer the final blow stemming from the 2008 credit crisis, especially if performance is lagging and lapses in due diligence have not been remedied. Firms that made the necessary infrastructure improvements – be it increased operational and investment due diligence staffing and systems, improvements in back office administration or the hiring of qualified third party administrators – are more likely to weather the storm.
Sources: InvestHedge; HFRX; FactSet; Bloomberg
This report is for illustrative purposes only. Past performance is not indicative of future results. The information contained in this report has been gathered from sources we believe to be reliable, but we do not guarantee the accuracy or completeness of such information, and we assume no liability for damages resulting from or arising out of the use of such information. The performance numbers displayed herein may have been adversely or favorably impacted by events and economic conditions that will not prevail in the future. The indices discussed are unmanaged and do not incur management fees, transaction costs or other expenses associated with investable products. It is not possible to directly invest in an index.
Disclosure:
Dean Piccirillo offers insurance products through HBK Sorce Insurance LLC, investment advisory services are offered through HBK Sorce Advisory LLC and securities are offered through Purshe Kaplan Sterling Investments (PKS), Member FINRA/SIPC. PKS is headquartered at 18 Corporate Woods Blvd., Albany, NY 12211. HBK Sorce Insurance LLC and HBK Sorce Advisory LLC are not affiliated with Purshe Kaplan Sterling Investments. Mr. Piccirillo is not able to transact business in a state that he is not licensed or registered.
