The Peloton Position / 3rd Quarter 2011

Driving Too Fast

I’m a car guy. You just are, or you aren’t. I attempted to be an SUV driver for years, but after 275,000 miles of practicality and the realization that very few serious, off-road situations present themselves in the metro Indianapolis area, I returned to a “car” car. Now I drive a sedan (not exactly impractical and far from racy, but four doors is the fewest I could get away with given the size of our family — and it is red, so that’s something). It’s sporty for a sedan and truly fun to drive. I imagine it could reach 150 mph if pushed, but I will never know its full capabilities because 1) there are laws against my finding out and 2) I am not crazy.

Since August 2, when Congress begrudgingly agreed on a last-minute debt ceiling deal to avoid default, financial markets have experienced incredible turmoil. August is a seasonally volatile month for markets — mostly because trading volume is often low, and because many senior traders are vacationing before schools restart in the Northeast. In thin markets, strange things can happen. In the past, simply understanding this seasonal nuance made the dog days of August (and the potentially nonsensical market action) tolerable — because everyone could look forward to the seasoned pros returning after Labor Day.

Some of the recent knee-buckling volatility is simply attributable to this seasonal pattern, but other factors are amplifying price swings. This year’s summer shenanigans have been nothing short of spectacular, much to the discomfort of rational investors. Most blame the traders and pure speculators for the dizzying moves, and some of that blame is justified. Here’s where a car metaphor fits: large institutional trading outfits have extremely fast “cars” (fewer than four doors for sure) and they are testing their limits. So called “high-frequency trading” (HFT) or algorithmic trading programs employed by large institutions and some hedge funds are the capital market equivalents of Aston Martins, Ferraris, and Lamborghinis. They are fast, sexy and no doubt fun to drive. But just because you can drive a car 200 mph does not mean you should.

But what is stopping the kids from joyriding dad’s Porsche like Tom Cruise in Risky Business? Unfortunately, very little. Regulators have raised the speed limit on Wall Street, and many investors are being run off the road. The unintended consequences of making markets faster and “deeper” (as advocates suggest) are shaking confidence at a time when trust in capital markets is already waning. To be fair, there are laws against reckless driving on Wall Street, but regulators are unable to enforce many of the rules that make the road safe. The SEC is out-manned, out-horsepowered, and is being outmaneuvered.

(Very literally at the time of this writing, Doug Kass, fellow money manager and president of Seabreeze Partners Management, and CNBC contributor, tweeted: “machine gunning hft [high-frequency trading] robots took us up mid afternoon and then took us down near close — kill the quants [purely quantitative traders] before they kill us.” August 30, 2011)

SMART REGULATION

Peloton is generally against increasing regulation — and unequivocally opposed to it when it is cumbersome and/or misdirected. In this case, however, we believe there are simple and appropriate steps that Congress, the SEC, and the exchanges themselves should take immediately to reduce frivolous and unnerving price volatility. At a time when confidence is low and uncertainties abound, we want to share with our readers a letter we recently sent to the U.S. Senate Committee on Banking, Housing and Urban Affairs. It’s one step we’ve taken to encourage the implementation and enforcement of effective regulations:

The Honorable Tim Johnson, Chairman
The Honorable Richard Shelby, Ranking Member
U.S. Senate Committee on Banking, Housing, and Urban Affairs
534 Dirksen Senate Office Building
Washington, DC  20510

September 1, 2011

Dear Senators Johnson and Shelby:

We are writing you on behalf of our clients, mainly private investors, who hold securities traded in U.S. capital markets. The elevated price volatility currently plaguing the options, futures, equity, and debt markets is only partially the result of investors contemplating a slowing global economy. As professional investors, it is our opinion that this extreme volatility is mainly a function of poor and out-dated trade practice regulation.

Specifically, there are four current trading practices which are exacerbating this volatility and, as a consequence, destroying investor confidence in our markets’ abilities to accurately price the economic value of the securities traded therein. In particular, we have identified excessive leverage, momentum short-selling, naked short-selling, and high-frequency trading as detrimental to the health of our markets. Contrary to conventional wisdom, we believe these practices actually inhibit real value discovery and destroy liquidity as they breed cynicism among participants.

We believe there are four actions which regulators and officials of exchanges and electronic markets can undertake that will help restore capital market integrity.

Raise Margin Requirements
To combat excessive leverage, we recommend raising margin requirements significantly on a temporary basis while legislators explore the viability of permanently higher requirements. In doing this, the benefits of speculation would still accrue to the marketplace, but with substantially fewer systemic risks.

Reinstate the “Uptick Rule”
Secondly, short-selling acts as an important mechanism for value discovery. However, we believe that security price declines acquire momentum as program trading executes automatic short-sales. We advocate a permanent return of the “Uptick Rule” (SEC Rule 10a-1(a)1), whereby investors selling a security short may do so only following a trade at a higher price.

Enforce “Naked Short-Selling” Regulations
Similarly, the proliferation of naked short-selling — which is already prohibited by Regulation SHO (SEC rule 201) — and the SEC’s inability to police it, contributes significantly to targeted raids on certain companies’ securities, including large financial institutions. We hope that SEC Chairman Shapiro will emphasize enforcement of laws prohibiting naked short selling and that Congress will provide her department resources necessary to adequately staff those targeted efforts.

Institute Minimum Bid-Offer Spreads
Finally, the emergence of high-frequency trading programs has allowed certain speculators the ability to buy and sell securities within a small fraction of one second. As such, speculators profitably trade rapidly, extracting exceptionally small gains in great repetition. This hyper-rapid trading breeds volatility. What it does not do in any way, is accurately reflect the economic value of the securities being traded. We believe that exchanges could institute minimum bid-offer spreads of five or ten cents without reducing liquidity. This would reduce the economic viability of very large, rapid trades by forcing speculators to consider more significant losses on each tick up or down. The desirable and, in our opinion most probable, outcome of such action would be the re-direction of these traders toward achieving profits through fundamental investment analysis, and away from market manipulative trading tactics.

Without taking the type of actions we describe above, we are profoundly concerned that the public’s confidence in our capital markets is at risk of becoming permanently impaired. Most regrettably, this teetering confidence in our capital markets could certainly, if it remains un-stemmed, spill over into broader public distrust of our free enterprise economic system.  

To begin restoring investor confidence and for the sake of the economic health of our nation, we urge you to take up debate of these practices in your committee meetings this fall.

Respectfully,
Matthew K. Bradley, Principal & Executive Director
Kenneth W. Kaczmarek, Principal & Managing Director
Stephen P. Carr, CFA, Director of Research

RIGHT, BUT FOR ALL THE WRONG REASONS

It is alarming enough to regular investors that equity markets are rising and falling multiple percentage points in minutes or hours, instead of months or years. Many individuals dislike huge one-day gains almost as much as they jeer significant single-day drops — perhaps because even the good days feel more like a ride in a Hummer over cobblestones than a Bentley on a marble freeway. The fact that most of the wild movement in July and August has been to the downside is particularly disconcerting. Market corrections, even by as much as 10-20%, are common in bull and bear markets and should be expected. The sharpness of latest pullback — down close to 20% in just a few weeks — has understandably left even stalwart investors stunned.

During the first half of the year, stocks proved resilient in the face of many challenges. Toward the end of June it became clear that some potential disasters had been averted (e.g., a full meltdown at Japan’s Fukushima nuclear plant) and some still loomed (e.g., a full meltdown of the debt ceiling negotiations in Washington). Nonetheless, bearish forecasters had plenty of reasons to call for a summer swoon, including the end of QE2. No one foresaw the steepness of the August decline, and paradoxically, the bearish short-term calls on the markets were right, but for all the wrong reasons.

  • Reason 1 (Wrong): The end of the Fed’s QE2 program on June 30 was going to lead to higher interest rates and the economy would suffer as a result. Reality: Since the Fed stopped purchasing longer-dated bonds at the end of June, 10-year Treasury yields have declined from 3.16% to 2.18%, and the average 30-year fixed-rate mortgage is down almost half of a percentage point from 4.71% to 4.31%.
  • Reason 2 (Wrong): Second quarter corporate reports were going to fall short of expectations and second half guidance would be materially lowered. Reality: For the quarter ended June 30, 71% of reporting S&P 500 companies beat consensus earnings expectations, and profits grew 17%, on average.
  • Wrong Reason 3: Congress would be unable to agree on a debt ceiling deal before Treasury’s August 2 deadline to avoid default. Reality: A last-minute deal was struck and the United States was not forced to miss any scheduled obligations.  Incidentally, this result was accurately anticipated by the bond market in the weeks leading up to August 2.
  • Wrong Reason 4: The United States’ credit rating would be lowered by one or more primary ratings agencies. This would worsen the debt situation by leading to higher borrowing costs for the United States. Coincidentally, higher market interest rates would negatively impact the economy at a time when growth was already weak and potentially slowing. Reality: On July 16, lesser-known rating company Egan-Jones downgraded U.S. ahead of much of the debt ceiling circus. S&P cut its U.S. rating one notch to AA+ on August 5. Since S&P’s downgrade, yields on two-year and 10-year Treasurys have declined (i.e., prices are up) and mortgage rates are lower across the board.

Absent the fruition of any of the “obvious” reasons for a market crash, the most likely rationale is simply heightened fears of another recession, mundane as that sounds. What started as an orderly stock pullback in early July accelerated throughout the month as the debt ceiling stalemate became increasingly acrimonious. At the same time, already-cautious businesses and consumers were frozen by the threat of an impending default on U.S. debt, and economic activity screeched to a halt. By the time the debt ceiling deal was actually inked, it didn’t matter that none of the “obvious” negative catalysts had occurred. Global markets were frenzied, investors were panicked, and the trading programs where whipsawing markets with incredible trading volume and little to impede them.

No one likes extreme volatility, especially when there appears to be no news that would make stocks worth 5% more or less than they were worth hours earlier. The question for us is not whether the U.S. economy is headed for another recession. For stock investors, a recession is simply a more challenging environment for generating profits. So the better question is whether or not stocks’ current valuations (after a significant decline) accurately reflect profits likely to be earned — actual recession or not. Stocks were not expensive at the end of June when the market was trading at 14-15 times forecasted earnings for the year. Following the ensuing six-week drubbing, stocks stood at 11-12 times downwardly-revised profit forecasts. Even if companies miss current projections by 15 percent or more over the next several quarters, which is certainly not our outlook, stocks are cheap. Markets have already re-priced to reflect an overly negative scenario, in our view.

We concede that our earlier forecast of four percent annualized GDP growth will not materialize soon. But unlike speculators’ “all in” or “all out” mentality, we think the most likely path is something between deep recession and strong growth — a sideways movement as the economy de-levers painfully. Fed Chairman Bernanke seems to agree. Unlike August a year ago, when the Fed saved the day with early hints of Quantiative Easing 2 (QE2) to combat deflation, this year’s message from Jackson Hole on August 26 is right in line with Peloton’s thinking. First, things are not as bad as markets suggest. Second, the Fed still has options and should maintain maximum flexibility. And finally, the rest of Washington can and should do things to engender confidence rather than playing politics. After all, the Fed already has two mandates, but saving the world is not one of them.

The Peloton Position is a compilation of original insights and writings by Peloton Wealth Strategists. This issue features articles by Matthew K. Bradley, Executive Director and Chief Investment Officer.