The equity market seems to have found some legs. After bouncing around at the 1120 level, the S&P put in five out of six days in the green to close at 1210, down about 6.3% on the month and up 8% from its lows.

So are we out of the woods? Well, despite wading back into equities (per my last blog), there are a few things that make us nervous here. First, things are still volatile. We added one more >4% move since our last blog post on the topic of volatility, and the last two weeks have traded at an annualized volatility north of 40%. It’s been our experience that sustained rallies aren’t made from big up moves. Rallies happen when a large short base is in place, and the market grinds higher; the proverbial pain trade. The short base isn’t small, but this market is jumping, not grinding.

More concerning, however, is the apparent disconnect between equities and the funding market. Three month Libor has been on a steady march upward this month.

Libor goes higher…this time with equities (source: BBG)

A rise in Libor when funds are pegged at zero indicates stress in the banking market. That’s generally bad for equities, as it was in early 2010. However, recently equities have bounced off the bottom despite Libor’s unabated advance.

Libor can be a lagging indicator, so there are other places we look for to find funding stress. The first is the FX market. Currently, the implied 3-month dollar borrow rate (buying Euros and swapping to dollars) is about 1.10%. That’s versus 0.32% for cash 3-month Libor. Not what we would call “easy conditions”.

Implied funding rates suggest demand for dollars (source: BBG)

Next, we look at how financial commercial paper is trading. While it’s been trending higher, it’s lower than it has been and the spread between commercial paper and Libor is shrinking. While there has been very little financial commercial paper trading, we have seen a thaw in the market recently. We even see buyers wading back in to buy European paper, and that’s a good sign for the market (though we question the buyers – see below).

CP looks to be behaving better than Libor – but is it trading? (source: BBG)

So what do we make of all this? Let’s start with what we know: European banks are insolvent. However, they don’t appear to be illiquid. Will Europe force a recapitalization ala the US in 2009? Don’t bet on it. This is a slow motion train wreck, and the challenge is we don’t know if it ends in six months or six years. In the mean time, US and EM equity sure look cheap, so we’re keeping our longs and hedging with CDS protection on our least favorite European periphery countries. We also really like Asia FX (as we have) against USD here, and expect any hint of further easing measures in the September Fed meeting to be yet one more nail in the dollar coffin. We also like synthetic oil (our product), and are recommending an increase in allocation to this secular play.

So on to the wine. This was a lineup from two weeks ago, but worth posting.

I’m going to tell you the big winner and the big loser. The Clio rocked. 2008. Buy all you can, for under $40 a bottle. This rivals the big napa cabs. Tons of fruit, still heavily oaked – uniformly wine of the night. Avoid the QuintaSardonia. I don’t know why I buy this 2003 – I’ve tried it a few times – Parker loves it – but it was bad. Think compost piles. Not the ill-attended aquarium we like with good French wines, but actual compost. Everything else was mediocre.

 

 

 

 

 

 

With the recent market volatility, one is bound to hear discussions about how the markets are broken. It’s hard to stomach a week of daily 4-5% moves up and down and not feel that way. Historically, dealers such as Goldman sat in between trades making a market for clients. They often used firm capital to make the bid or offer when no bid or offer existed. In doing so, they acted as a “shock absorber” for the market. Post 2008, dealers cut trading capital and limited their roles as market makers. Now, dealers act more like brokers – finding bids and offers and connecting them for a fee. Often, these bids and offers are far apart, and they scare easily. The result is higher volatility.

The following shows a chart of the number of times the S&P moved in excess of 4% over the trailing 6 months.

(Source: Cabezon, BBG)

Last week’s turmoil is analogous to market gyrations from the bear market in 2002. However, it isn’t even approaching the nearly 40 occurrences during the credit crisis, and is far removed from the zero occurrences through the middle of last decade.

With all this discussion on market movements, one needs to ask – does it even matter? Isn’t the buy-and-hold mantra immune to the gyrations of the week-willed? Well this is where things begin to unravel. The following shows the total net return on the S&P over the past 5 years.

(Source: Cabezon, BBG)

If you held the S&P 500, you were about flat before taxes. If you invested in hedged funds, you lost money. You might think five years isn’t sufficient history. Over 10 years, you compounded total returns of 1.72% on the S&P 500, before taxes (and exclusively through dividends, as price returns were negative). The hedge fund data doesn’t go back that far.

So maybe buy-and-hold is no good. Maybe one needs to time the markets, buying the dips and selling the peeks. It sounds good, but in practice it rarely works for retail investors. I am chairman of a company called ReFlow. ReFlow provides liquidity to mutual funds, so I get a good perspective on fund flows. Mutual fund investors seem to be a day late (and probably a dollar short). Without fail, we see big redemptions from funds the day after a sell-off – generally right before a market rebound. When (and after) the market rebounds, we see big subscriptions. This supports the countless academic studies that show that retail investors generally do worse than the funds they are invested in.

So as an equity investor, you get to suffer through ulcer-inducing volatility to yield zero returns. Want to let the professionals manage things? With hedge funds, you give up liquidity for the privilege of paying someone 2% management fees and 20% performance fees to group-think their way into netting you zero returns. Want to try timing the markets? Chances are, you won’t be good at it.

I have never been a fan of traditional asset allocation, though I run portfolios for people who are. If you want me to beat US large cap equity – no problem – I can do that year in and year out. But underlying that objective is “why do you care about US large cap equity?” What one should care about are total returns. In this kind of market volatility, I believe returns tend to come from brief (and sometimes prolonged) periods of significant dislocation. My personal philosophy is that one should hold cash waiting for these occurrences, and the hurdle for allocating capital – the cost of liquidity – is in the double digits.

Enough of my rant – on to some macro data. We had a mixed bag today, but what caught my eye was capacity utilization. After a few months of falling, capacity utilization is now at the highest level since before the credit crisis. The softening in the prior months supports the lower ISM figures we had, and this uptick suggests stronger numbers down the road. A far cry from inflationary levels (think low 80′s), but progress none the less.

Ticking up to the good old days…maybe (source: BBG)

And finally, the wine. Fun lineup last week.

The big winners here – 2008 Textbook and the Malbec – big downers were the Pontet Canet (maybe asleep?), Tablas Creek, Double Diamond and Ramey. The 1997 Pine Ridge was dead, unfortunately. But I thought it was French.

I promise more detail on this Friday’s wine lineup – I need to take higher resolution pictures (and not lose my notes…)