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Market Buzz: How the Divide Between Investing Strategies Amplifies Market Volatility


Posted by Ryan Irvine: Keystone Financial

on Saturday, 15 September 2012 00:00

One unfortunate habit that we commonly see with investors is the tendency to look to short-term market activity for investment guidance. In Behavioral Finance this is referred to as “herding” (or convoy behavior) which is the hardwired instinct of most human beings to flock together for perceived safety. When individuals are not confident in their independent position, they typically acquiesce to the group. Unfortunately this can also be true even when individuals do have confidence in their independence. Accordingly, there is a general understanding in the money management industry that it can be okay to be wrong when your peers are also wrong, but being wrong independently can cost you your job.

Over the past couple of years global stock markets have experienced levels of volatility never before seen in history. Recently the media has started referring to this as “risk-on/risk-off”. Regardless of what you call it, markets have inarguably been exhibiting symptoms, which exhibited in a person, would be diagnosed as manic depressive disorder. And there are some fundamental justifications behind this: High-public and private debt loads, the recessionary pressures of deleveraging, unstable short-term economic prospects....it has all been said a hundred times before. Regardless of the source of the volatility, it has investors at the edge of their seats ready to hit the sell button; frantically looking for any sign that the markets might fall of the proverbial cliff like they did in 2008. Real economics are a force in the recent volatility but there is also another force at play and it has nothing to do with fundamentals. This other force is investors’ own biases (private and professional) and how we make our buying and selling decisions, also known as investment strategy. And it plays a big part in the markets’ current volatility.

You can divide investment strategy (or investment mentality) into four main camps: 1) buy and hold; 2) momentum; 3) value; and 4) pure speculation. Each of these investor types makes buying and selling decisions based on a different set of rules, and the resulting actions impact the market in different ways. The buy and hold investor is the most benign of the camps. They don’t make investment decisions and asset allocation decisions based on overall market conditions. This type of investor passively purchases stocks when they have capital available, and looks to hold his positions through market cycles and varying conditions. Momentum and value investors, on the other hand, are not passive; they actively look for opportunities. Momentum traders will buy into market uptrends and then sell into market declines, without consideration for actual economic or company fundamentals. They are basing decisions purely on volume and price movement. Value investors will take a more contrarian approach, typically buying into market price weakness and selling into market price strength. In contrast to the momentum investor, the value investor will base decisions on fundamentals and not price chart formation. The characteristics of the fourth group, the pure speculators, are less relevant to this discussion but would typically exhibit buying and selling behaviour similar to the momentum camp.

The effect that momentum trader and value investors have on market volatility is polarized. When the market moves in one direction, the momentum traders exacerbate the movement, and therefore increase market volatility, by increased buying when the market is rising and increased selling when the market is falling. In fact, momentum investors unwittingly work together to generate market extremes. But when market prices move too far in either direction, value investors get involved. When prices get too high, value investors create a dampening effect by selling into the strength. Then, momentum investors begin to see the uptrend slowing, and they start to sell. As the market weakness persists, more and more momentum trades drive prices continuously lower until value investors start to see opportunities and move in to create support though increased buying. And so on and so forth, the cycle continues.

It may be apparent that not all investors fit neatly categorized into one of these investment types, because real world investment strategy involves a lot of human behavior and is too complex to be summarized into a few lines of text. Some investors will utilize multiple investment strategies. For example, an investor can purchase on value but then transition to a buy and hold approach. Investors can also purchase on initial momentum but then sell on value. Some investors will subscribe to one strategy in theory but another in practise. Some investors switch between strategies from trade to trade. And in the case of professional money managers, there is also the structural issue of investor contributions and redemptions: the fund manager may subscribe to a value strategy, but if the fund investors decide to redeem in down markets and contribute in up markets, the impact the fund has on the market may be more closely associated with momentum than with value.

Complexities aside, most investors, whether they know it or not, are largely loyal to their respective strategy. Equally true is the growing trend in favour of momentum strategies. This trend, which naturally increases volatility, is due to a number of reasons. The evolution of discount brokerages and low cost trading has made trading easier from a logistical and financial perspective. Many brokerages also encourage excessive trading by offering lower fees to high-frequency traders and platforms which provide momentum-based, technical analysis research tools. Next, a virtual explosion has occurred in the market for computerized trading programs that promise to automate the BUY/SELL decision for retail investors who have limited research skills. These retail trading programs are also based on momentum indicators. Of course, legitimate global economic risks have also reduced investor confidence in long-term stock market returns, and increased investor scrutiny. These factors make investors, on average, more willing to hit the sell button at the first sign of trouble and potentially the buy button when the market appears to be improving. And finally we have the onset of high frequency trading (HRT) companies, which have exploded in numbers and importance over the past several years. HRT uses sophisticated computing programs to execute (in some cases) thousands of trades per minute, resulting in profits of a faction of a cent per trade. The impact of HRT in today’s market is becoming more and more evident. Estimates will vary, but the research we have seen is staggering: in August 2011 (an extremely volatile period) Bloomberg reported that the percentage of average daily volume attributable to high frequency trading had exceeded 80% in the US markets.

We only need look to the Flash Crash of 2010 (also referred to as The Crash of 2:45) for a recent example of how momentum trading creates abnormal volatility. The Flash Crash occurred on May 6, 2010, when the Dow Jones Industrial Average plunged about 1000 points and then quickly recovered after a few minutes. This was the biggest intraday point decline in the Dow’s history. On September 30th, the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) issued a report on the crash after a five month investigation. The report "portrayed a market so fragmented and fragile that a single large trade could send stocks into a sudden spiral.” The report also discussed how immediately before the crash, a large institutional investor sold an unusually large number of S&P 500 contracts. The report concluded that this activity put selling pressure on an already weak market, which triggered high-frequency traders to start selling aggressively, causing a mini-crash to occur.

Put into context of the divide between different investor camps, the amplified market volatility we have seen in the past year becomes easier to understand. There has always been a divide between momentum and value investors. The difference today is that technology has facilitated a trend towards momentum trading, which in conjunction with real fundamental risks, has had the effect of amplifying market volatility. Since none of the trends that are facilitating momentum investing show any sign of slowing, it may be perfectly rational to conclude that higher volatility is the new normal, regardless of whether the world finds a solution to its financial woes. While this may be disconcerting for some value investors, it really shouldn’t be: remember, value investors move in to restore rationality when momentum investors distort valuations. When the Flash Crash occurred at 2:45 pm, it only took a few minutes for the Dow to recover from its 1,000 point decline. A market recovery requires buyers, and those value investors who recognized the opportunity of the Flash Crash were able to generate a nice profit on the momentum traders’ hysteria. Ultimately, a stock is a piece of a business, and as long as that business generates positive cash flow then it will be able to invest in growth, pay a dividend, and command a fair price in a takeover transaction. There is nothing disconcerting if momentum traders give value investors the opportunity to purchase these companies at discounted prices, and then potentially sell them right back when those prices become inflated.

KeyStone’s Latest Reports Section

9/13/2012
CASH RICH COMMUNICATIONS SOFTWARE COMPANY POSTS SOLID Q3 2012, ORGANIC GROWTH REMAINS CHALLENGING, EXPECT ACQUISITION INTEGRATION RELATED ITEMS TO AFFECT NEAR-TERM BUT TO PROVIDE GROWTH IN 2013 – MAINTAIN RATINGS

9/5/2012
UNIQUE INVESTMENT CO WITH PORTFOLIO OF ESTABLISHED BUSINESSES POST SOLID Q2 2012 - COMPANY ON TRACK TO GENERATE STRONG GROWTH IN 2012 AND MAKES $9.9 MILLION ACQUISITION OF KENDALL SUPPLY SUBSEQUENT TO Q2

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CASH RICH JUNIOR COPPER PRODUCER WITH OVER 50% OF MARKET CAP IN CASH, NO DEBT, SOLID CASH FLOW, AND ATTRACTIVE LONG-TERM LOW COST PROJECT IN PIPELINE – INITIATING COVERAGE: BUY (FOCUS BUY)

9/4/2012
HIGH GROWTH JUNIOR-OIL PRODUCER POSTS CHALLENGING Q2 2012 FINANCIALS, PRODUCTION STRONG BUT UNEXPECTED LOWER REALIZED PRICE FOR OIL SOLD IN CONNECTION WITH UNDER LIFT (OIL PRODUCED/DELIVERED BUT NOT PAID) POSITION PROMPTS NEAR-TERM DOWNGRADE

8/24/2012
HOUSEHOLD RETAILER CONTINUES ITS TURNAROUND, OUTPERFORMING PEERS IN Q2, RE-INSTATES DIVIDEND AND MID-TERM OUTLOOK IS TO OUTPERFORM IN TOUGH MARKET

Disclaimer | ©2012 KeyStone Financial Publishing Corp.



Energy & Commodities

"Monetary Bazooka" Gooses Commodity Bulls


Posted by Hard Assets Investor

on Friday, 14 September 2012 16:30

Commodities surged broadly after this week’s Fed announcement of QE3. Only corn ended the period in the red due to the latest supply and demand data from the USDA.  Stocks, as measured by the S&P 500, rose 2 percent to the highest levels since 2007. The stock index is now up almost 17 percent year-to-date.

The Federal Reserve unveiled what some characterized as a “monetary bazooka” in this week’s policy decision. The central bank said it would buy $40 billion worth of mortgage-backed securities per month, indefinitely. The purchases will begin today. Total purchases could conceivably end up at over $1 trillion.

On the other hand, it could be much less. But in either event, the U.S. Central Bank has made it clear it will provide an extremely accommodative monetary backdrop as long as economic growth remains sluggish. Commodity bulls couldn't have asked for more.

Week In Review: Gold, Silver, Platinum Jump After Unprecedented Fed Move; NatGas Spikes 12%

 

Macroeconomic Highlights

The Federal Reserve unveiled what some characterized as a “monetary bazooka” in this week’s policy decision. The central bank said it would buy $40 billion worth of mortgage-backed securities per month, indefinitely. The purchases will begin today.

The Fed also extended its pledge to keep its benchmark overnight interest rate—the federal funds rate—near zero from late 2014 to mid-2015.

Importantly, the central bank promised to add to purchases if the labor market doesn't improve.

The open-ended nature of QE3 and the Fed's flexibility in terms of adding to purchases if growth doesn't improve is a particularly bullish combination for commodities. Total purchases could conceivably end up at over $1 trillion. On the other hand, it could be much less.

But in either event, the U.S. Central Bank has made it clear it will provide an extremely accommodative monetary backdrop as long as economic growth remains sluggish. Commodity bulls couldn't have asked for more.

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.....read page 2 HERE

 



Stocks & Equities

Incredible Times: Grandich Market Update: Stocks, Bonds, Oil, Gold, US Dollar


Posted by Peter Grandich - Grandich.com

on Friday, 14 September 2012 11:44

The Fed’s “All-In” move may keep the house of cards from folding until 2013 and greatly help Obama limp over the finish line, but it shall prove to be the last silver bullet before a long period of economic, social, political and spiritual upheaval grips America for years to come.

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While the junior resource market left egg on my face this year, I’m very pleased with how I approached the rest of the markets I follow. Here’s a quick update on them.

U.S. Stock Market – It’s worth repeating my constant cry that many times it’s not what you make but what you don’t lose that makes you a winner over time. Despite numerous questioning on why I still won’t short the U.S. stock market and almost daily emails showing me why such a decision shall prove wrong, the fact is the market has reached highs not seen in years.

The marginal new high I spoke of is well within reach now. But as it has been since day one, such a feat would be the completion of the greatest bear market rally in a secular bear market that can eventually retest the lows made in early 2009. It shall have to endure a long period of economic, social and political upheaval that shall be longer and harder than most could ever imagine.

Such a period is still months or even a year or so away but starting to plan for it while the “Don’t Worry, Be Happy” crowd runs wild with the FED’s “All-In” is strongly suggested.

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U.S. Bonds – The very fact that many in the last 18 hours or so expressed a belief that bonds can’t lose during this “All-In” phase is the icing on the cake I desired for fulfilling my “worst investment for the next 10 years” belief of bonds. There’s no rush to establish a short position but the closer the 10-year T-Bond drops towards a 1.25% yield, the more I would want to be short. When the dark days come (and in my book it’s a question of when, not if), rates shall rise like they did through Europe the last couple of years despite overall weak economics.

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U.S. Dollar – Direction? Go and see how many people dare suggest the Euro could see a major short covering rally well over $1.25 just a couple of weeks ago. Try to understand how almost 96% bulls on the U.S. Dollar in the currency futures markets are now getting crushed.

USD

Gold – While we can see a period of consolidation on either side of $1,800, the upside remains wide open. Go back and look and see what was being said when gold was in the low $1,500’s. Bears were running wild and the vast, vast, vast majority of gold commentators had turned very cautious, if not outright bearish. Let it not be said that at a critical point, yours truly was willing to bet $2 million reasons why gold was going over $2,000.

Any and all excess was washed out in the almost year-long correction/consolidation so it shall likely be a long period before we get seriously overbought again. The perma-bears have never grasped the earth-shattering changes to the gold market and much of the financial media shall continue to follow these pied-pipers over the cliff as gold marches towards and over $2,000.

Gold

Oil and Natural Gas – No changes here.

And finally, the junior resource market has seen its horrific lows and while it can work higher for the balance of the year, the wounds are deep and the need to finance great. This shall limit the rebound but once we get near years-end, the rebound can gather a longer-lasting head of steam and help 2013 make 2012 just a bad memory. Remember, I never said to assign anything more than capital that you’re mentally and financially prepared to lose part or all of. These vicious bear markets in a business where failure is the norm always ends up showing most didn’t meet this requirement. How do I know this? A sampling of the hate mail does it all the time. I just wish my wife stop writing-lol

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Ed Note: Be sure to check out Peter's website for updates on markets, the economy and individual stocks: Grandich.com

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About Peter Grandich:

Though he never finished high school, Peter Grandich entered Wall Street in the mid-1980s with no formal education or training and within three years was appointed Vice President of Investment Strategy for a leading New York Stock Exchange member firm. He would go on to hold positions as a Market Strategist, portfolio manager for four hedgefunds and a mutual fund that bared his name.

His abilities has resulted in hundreds of media interviews including GMA, Neil Cavuto’s Your World on Fox News, The Kudlow Report on CNBC, Wall Street Journal, Barron’s, Financial Post, Globe and Mail, US News & World Report, New York Times, Business Week, MarketWatch, Business News Network and dozens more. He’s spoken at investment conferences around the globe, edited numerous investment newsletters, and is one of the more sought after commentators.

Grandich is the founder of Grandich.com and Grandich Publications, LLC, and is editor of The Grandich Letter which was first published in 1984. On his internationally-followed blog, he comments daily about the world’s economies and financial markets and posts his views on social and political topics.  He also blogs about a variety of timely subjects of general interest and interweaves his unique brand of humor and every-man “Grandichism” expressions with his experience gained from more than 25 years in and around Wall Street. The result is an insightful and intuitive look at business, finances and the world, set in a vernacular that just about anyone can understand. In his first year, Grandich’s wildly-popular blog had more than one million views. Grandich also provides a variety of services to publicly-held corporations on a compensation basis.

Grandich’s autobiography, Confessions of a Wall Street Whiz Kid, was publiched in fall 2011.

He is the also the founder of Trinity Financial Sports & Entertainment Management Co. [www.TrinityFSEM.com], a firm with a Christian perspective which he started in 2001 with former NY Giant and two-time Super Bowl champion Lee Rouson.  The firm offers services to celebrities, athletes and average folks.  Peter Grandich is a member of the National Association of Christian Financial Consultants, and a long-standing member of The New York Society of Security Analysts and The Society of Quantitative Analysts.

Grandich is also very active in Christian sports ministries including the Fellowship of Christian Athletes and Athletes in Action.

He resides in New Jersey with his wife Mary and daughter Tara.

 


Timing & trends

A Perfect Storm


Posted by Mark Leibovit - Charts of the Day

on Friday, 14 September 2012 08:23

Screen Shot 2012-09-14 at 7.27.53 AM

"Mario Draghi and Ben Bernanke have willingly opened the floodgates and allowed their respective printing presses run 24/7. No surprise here. This is all Central Bankers know how to do and it had been forecast by many (myself included)."

"My Annual Forecast Model (below) along with Equityclock.com’s ‘seasonal’ studies all pointed to the time band from mid-summer forward as being friendly to the metals. So, for now, we need to sit back and enjoy it!"

"Depending on which forecast chart you look it, it is clear we’re overall headed higher. However, there is theoretical ‘cyclical’ risk of a pullback both here in September and again in October. Use pullbacks to establish or to add to current positions if you don’t feel you allocation to the metals is great enough."  

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Quote & Chart above from Mark Leibovit's Hot off the Press Sept. 14th 25 page VR Gold Letter . IF YOU HAVE NOT SIGNED UP FOR THE LEIBOVIT VR GOLD LETTER, HERE IS YOUR CHANCE. HERE IS THE LINK: WWW.VRGOLDLETTER.COM. YOU GET A 50% DISCOUNT FOR THE FIRST MONTH.

Miners Catching Up To Metals — Huge Run

Coming?

 

Gold bugs are a generally happy bunch this week. But they’d be a lot happier if precious metals mining stocks kept up with the metals themselves. Since early 2011 the largest gold miners have underperformed gold  by about 40%, while the junior miners have done even worse (I’m talking to you, Great Basin).

Thanks to this divergence between the metals and the miners, it was possible to clearly understand the monetary destruction endemic in the developed world, conclude that gold and silver were the places to be, make a decisive bet on this thesis — and still end up losing money.

There are two possible conclusions to draw from this: Either mining as a business has changed fundamentally and will be unprofitable forever –  in which case we should just own physical metal and forget about paper proxies. Or the past couple of years were one of those inexplicable divergences from established relationships that produce huge gains when they snap back to normal.

The past month has offered a taste of what the second possibility might look like. The chart below shows that the big miners (represented by the GDX gold miner ETF, red line) have outperformed gold itself (the GLD bullion ETF, blue area) since July. But the two-year gap, like I said, is about 40%, so parity is still a long way  off.

Now that the miners have some momentum, it wouldn’t be surprising if they made up this ground in no time at all.

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Above by DollarCollapse.com managed by John Rubino, co-author, with GoldMoney’s James Turk

Perspective on the current Dow rally

 

The Dow made another post-financial crisis rally high Thursday on the news that the Fed will embark on a third round of quantitative easing (a.k.a. QE3). To provide some perspective on the current Dow rally, all major market rallies of the last 112 years are plotted on today's chart. Each dot represents a major stock market rally as measured by the Dow -- with a rally being defined as an advance that followed a 15% correction (i.e. a major correction). As today's chart illustrates, the Dow has begun a major rally 28 times over the past 112 years which equates to an average of one rally every four years. Also, most major rallies (78%) resulted in a gain of between 30% and 150% (29.8% to 150.5% to be exact) and lasted between 200 and 800 trading days (9.5 months to 3.2 years) -- highlighted in today's chart with a light blue shaded box. As it stands right now, the current Dow rally (hollow red dot labeled you are here) which began in October 2011 (since it followed a 16.8% correction), would be classified as well below average in both duration and magnitude.

20120914

Notes:
Where's the Dow headed? The answer may surprise you. Find out right now with the exclusive & Barron's recommended charts of Chart of the Day Plus.



Currency

Fed. Up. - Looking Ahead


Posted by Jack Crooks - Black Swan Capital

on Friday, 14 September 2012 07:28

Quote

“Rather than stimulating a real recovery by focusing on a strong dollar and market interest rates, the Fed's announcement today shows a disastrous detachment from reality on the part of our central bank.”

– Ron Paul

(Ed Note: Jack Crooks is this weeks Money Talks Guest)

Of Interest


Commentary

The Federal Reserve was set-up to disappoint; but they didn’t. And why would they have? Bernanke’s received more than a few pats on the back for his decisions to date:

“QE has made a massive difference,” said Tim Congdon from International Monetary Research. “If they had not done it we would have gone into another Great Depression.”

There were high expectations for Fed action yesterday. They delivered mostly at those expectations, except for one thing – they put no end-date on their operations. Twist ... to infinity and beyond.

And that may be the difference maker.

We’d seen several indicators and pieces of analysis to suggest Fed expectations were priced in. That may be true; and the price action yesterday (following the announcement) and this morning may be a blow-off squeeze of sorts. In the recent history of QE and Twisting, the rumors and expectations in the months leading up to the actual action have created the environment for risk assets to rally. These assets, however, have sold off in the periods after the actual action. It is the classic “buy the rumor, sell the news” dynamic.

Action

As of now, that dynamic seems to make the most sense. The market is ripe for a downturn. But once that downturn runs its course (maybe lasting a month or so), there is little reason right now to expect anything but an extended uptrend for risk assets. Certainly this unlimited monetary accommodation will juice up inflation expectations and liquidity, justifying investments in commodities and stocks.

But what about the fundamentals? The Fed’s comments suggest there is nothing horribly worrisome about US growth potential, barring continued pressure on jobs. So has our fundamental analysis been horribly misguided? We don’t think so. Actually, recent Fed action seems to validate our pessimism. But our expectations for price action have been off target. Looking ahead, we are considering ways to hedge current bearish positioning. And unless a real crisis in confidence materializes soon, it will likely make sense to adopt a bullish stance on the markets. Stay tuned. 

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