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October 15, 2011 FOURTH QUARTER COMMENTS

GONE AGAIN

Stocks had a bad third quarter. First quarter GDP was revised from 1.9% to 0.4%, sparking concerns of a double dip recession. The debt ceiling debate in Washington showed  the ineptitude and paralysis of our government and as most European financial institutions tried to prevent a monetary meltdown in Greece, Spain, Portugal  and Italy, the S & P 500 lost 14% for the quarter, the NASDAQ lost 13%, and the Dow lost 12%. 

Volatility resembled the 2008 financial crisis. For the first time ever, the Dow moved 400 points over four straight days and from August 8 until the end of the quarter, it moved over 100 points in 30 of 39 trading sessions.  When the quarter began, 3,165 mutual funds owned Bank of America stock despite having reported six quarters of negative sales, negative earnings, a 4% return on equity, and 196% debt. Management did not own any of the stock and the bank held assets from Merrill Lynch they could not value and mortgages from Countrywide they could not refinance or collect. By the end of the quarter, the stock lost $50 billion in equity or half of its value.

Since 1977, five of the best fourth quarters for the S & P 500 followed a negative third quarter. The Dow has had four of its best five fourth quarters after a negative third quarter, and three of NASDAQ best fourth quarters came after a negative third quarter. It is typical for the third phase in a four phase bull market to display lower returns and slower advances. Despite the pain experienced this quarter, we should continue the uptrend as we head into the political uncertainty of next year’s election.

GOING UNDER

Government is spending 100% of our GDP. The countries in Europe most likely to default have a debt to GDP ratio of 140%. The Federal Reserve has kept interest rates low for three years, created $2 trillion in new money, tried quantitative easing twice and is buying long term bonds with short term money  to reduce long term interest rates.

During the Depression, FDR smothered businesses with regulations, spent unprecedented sums of money, raised taxes on high income earners, and blamed his economic problems on his predecessor. His policies created austerity and prolonged the misery. While he too blamed his predecessor, Reagan did the exact opposite, and but his approach created wealth and prosperity.

The private sector is spending $1.8 trillion annually or 13% of its output to comply with existing federal regulations. Now, in order to help 4% who chronically lack health insurance, bureaucrats are planning to take over 17% of the economy and provide low quality health care that will cost $1 trillion over the next decade.  Government interference in the free market always ends badly.

In 2007, the SEC activated Regulation NMS (National Market System) to increase competition amongst the financial exchanges. The goal was to reduce costs and make the stock market friendlier for long term investor. What this regulation did however was open the floodgates for high frequency trading and the stock market has never been the same. 

SUMMER CANNIBALS

In 2005 NASDAQ and the NYSE controlled 74% of daily US stock market volume. Today they have 34%.
Regulation NMS increased the number of electronic exchanges and trading venues that execute security transactions. It also allowed brokerage firms to internalize their trades, which is executing customer order with their own customers, provided they improve on the price, shown on the tape, by at least one hundredth of a penny over the best bid and offer at the time.

High frequency trading (HFT) is practiced by 2% of market participants, and generates 70% of daily trading volume. Firms using sophisticated computers that are programmed with advanced statistical and pattern recognition software can identify the algorithms institutions use to buy or sell stock and with this knowledge, machines are making trading decisions with other computers without any direct human intervention. 

HFT computers trade millions of shares of stock each day, holding positions for seconds, trying to earn pennies per share on millions of shares. They have increased market volume from 3 billion shares each day to 10 billion. The average trade size has fallen from 724 shares to 268 shares and small trades which took 10.1 seconds to execute in 2005 now take .002 seconds.

The technology exists that connects the stock, bond, commodity and futures markets, with these trading venues. When the price of one asset moves, its impact on related asset is calculated in milliseconds and trades are made. These computers can monitor multiple markets simultaneously and they react faster than humans. By targeting institutional investors the techniques used in HFT is hurting those patrons of mutual funds and pension plans, also known as the small investor. 

The three techniques most widely used by these high frequency traders are referred to as:

• Momentum Ignition – entering many orders, to make it appear a stock is moving in one direction.
• Spoofing – entering many small trades to bid up a stock, so institutions will chase it. When a peak is reached, the stock is shorted, and usually falls to the institutions original support level.
• Pinging – entering many orders, most are cancelled immediately to determine any institutional interest.  For every 100 trades executed, several hundred to a million orders get entered.

Some HFT are market makers for their exchanges and collect rebates of sub-pennies per share on the millions of trades they execute each day. They trade on news events to predict the direction and reactions of the markets to headlines and as markets are ruled by herd mentality, HFT can move herds. If an algorithm is triggered during a market decline, and sell orders are activated, extreme moves occur. Currency fluctuations also influence stock prices so if the dollar makes a move against another currency, hedged positions may unwind and liquid assets like stocks are usually sold. 

Some HFT firms will hook up their servers to those of the exchanges, allowing them enter orders faster because they can get price and trading data before other market participants.  Firms pay steep fees to install their computers and ongoing monthly service fees to the exchanges. In return, some exchanges have removed the safeguards that will stop program trading if the stock markets move by more than 2% in any direction since this type of volatility creates the greatest opportunities for their HFT clients.

FREE MONEY

According to Tabb Group, a HFT consulting firm, in 2009, the combined profit of all firms that engage in high frequency trading was $21 billion. This includes rebates received when they act as market makers.
The profits broker dealers receive for internalizing trades is estimated to be $100 billion a year.

ONE VOICE

An Exchange Traded Funds (ETF) is a basket of securities that are passively managed with low operating expenses. They trade during the day like stocks and can also be shorted, use leverage, and trade options. Institutions will use ETF’s to hedge portfolios cheaply and investors will use them to invest in a specific sector or investment strategy, make bearish bets, or access foreign markets.

Created in 1993 to counter lost business to no load mutual funds, an ETF is a cross between an index option and a mutual fund. They can track a benchmark index, commodities or stock index futures. They can reflect the price movement in a number of securities with one single trade. When the ETF’s which represent the broad indexes are bought or sold at the same time, the markets will make extreme moves.

The ETF is the favored vehicle for day traders and High Frequency Traders and 40% of the daily exchange volume comes from ETF trading, which contributes to the recent volatility.  In 2010, the U.S. markets had 985 ETF’s holding $797 billion in assets. By July 2011 there were 1,077 ETF’s holding $1.086 trillion in assets. During this past August, 70 billion ETF shares were traded, and this was an 86% increase from the previous month and a 110% increase from a year ago.

SO YOU WANT TO BE (A ROCK 'N' ROLL STAR)

The following Quotations are from “The Tao of Warren Buffett” written by Mary Buffett

I made my first investment at age 11. I was wasting my life up until then. Our method is simple. We try to buy businesses with good to superb underlying economics run by honest, able people, at sensible prices.  In searching for companies to buy, we adopt the same attitude appropriate in looking for a spouse. It pays to be active, interested, and open minded, but it does not pay to be in a hurry.

Look at stocks as pieces of a business.  If the business does well, the stock will follow. The stock market is only there as reference to see if anybody is offering to do anything foolish. The market sets prices and exists to serve you, not instruct you. The market, like the Lord, helps those who help themselves, but unlike the Lord, does not forgive those who know not what they do.

To many on Wall Street, companies and stocks are seen as raw materials for trades. Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be mis appraised. Look at market fluctuations as your friend not your enemy-profit from folly rather than participate in it. Someone is sitting in the shade today because someone planted a tree a long time ago.

Most people get interested in stocks when everyone else is. The time to get interested is when no one is. You can’t buy what is popular and do well. People take their cues from price action, not values. Price is what you pay. Value is what you get. At the beginning, prices are driven by fundamentals and at some point, speculation.  It’s that old story, what the wise do in the beginning, the fool does in the end.

I like to put meaningful amounts of money in a few things. Diversification is protection against ignorance and makes little sense for those who know what they are doing. You only have to do a very few things right in life so long as you don’t do too many things wrong. Risk comes from not knowing what you are doing.  The great fortunes in this country were not built on a portfolio of 50 companies but by someone who identified a wonderful business. I can’t be involved in 50 or 70 things-that’s a Noah’s ark way to invest and you end up with a zoo

DREAM OF LIFE

A well-managed profitable business increases in value over time and creates wealth for the owners. Investing in stocks allows those who do not own their own business the same opportunity by owning a piece of someone else’s business.

Companies providing superior products or services in growing industries, with little competition often become market leaders. The best stocks are those companies that consistently improve earnings and increase sales, generate a high return on equity, maintain strong profit margins, keep low levels of debt and have a high degree of management ownership.