In graduate school I had two kinds of professors: practitioners who worked in the City, London’s Wall Street, and academics. I always preferred the former, as it’s a lot more engaging to hear how markets actually work than looking at what mathematical models say should happen under some sort of ideal circumstances.
As we learned during the crisis at Long-Term Capital Management (LTCM) in the late 1990s and during the recent credit crunch, mathematical models of risk and market behavior can only go so far toward protecting investors.
One of my favorite professors, and later my dissertation advisor, worked for a major US investment bank whose European headquarters was in the City. He did a few graduate level lectures on the side. He was famous for covering the material by the book and then telling us all how much trouble you can get into by ignoring reality and focusing on models.
The math-focused guys on the front row hated it because it didn’t involve calculus, but those of us in the back row ate up every word.
As a young bond trader, he was assigned the Canadian bond market in his first year on the desk. In analyzing the markets, he noticed that one particular Canadian government bond issue appeared to trade at an unwarranted premium. All of his models indicated that the bond was just too expensive relative to other Canadian bonds on offer with slightly different maturities. He concluded the only sensible option was to short the seemingly misaligned bond and hedge his risks by buying other Canadian issues that appeared to be trading at fair value.
He believed that the state-of-the-art models at his disposal had uncovered an obscure little quirk in the Canadian markets that others had missed.
After some time, it became clear that the trade wasn’t working out as planned. Not only had the bond not fallen into line, but the anomaly also had become more pronounced, producing a small loss in the trade; although this move hadn’t reached catastrophic proportions, you can imagine the nervousness of a young bond trader with a losing position.
At a conference, he mentioned the anomaly to a number of other traders some who also traded Canadian sovereign debt. One happened to take him aside and told him that he should cover his trade and take the loss. The bond he was shorting was different than all other bonds issued by the Canadian government at that time. Due to slightly different terms, this particular bond was more favorable to investors and would usually trade at a higher price.
As the old saying says, there’s always a patsy at the poker table. If you’ve been at the table for over 30 minutes and don’t know who the patsy is, you’re the patsy.
Investors have a natural tendency to their proverbial guns; unfortunately, this often leads to holding a losing stock too long or sitting out big gains because of some bearish or bullish bias toward the broader market. But you can’t keep fighting the tape and ignoring the reality of what the market is doing. After all, we don’t make money by being correct in theory.
You may find, as my professor once did, that there is a very good reason a holding is not moving in your favor. Of course, there’s also the frustrating possibility that you’re right, and the market is behaving irrationally–in case you hadn’t noticed, the stock market hardly passes the rational man test.
But as John Maynard Keynes once said, the market can be irrational a lot longer than you can remain solvent; even if you’re ultimately proved correct, you may not be able to hold on long enough to enjoys the fruits of your diligent analysis.
This is why I review the best- and worst-performing markets, market sectors and individual stocks each quarter. Sometimes this can help you uncover profitable trends or important biases that are holding back your profitability. The graph below offers a basic review of the S&P 500 and all 10 S&P 500 Economic Sectors’ first quarter performance.
Source: Bloomberg
The S&P 500 returned 5.4 percent over this period, its best first-quarter performance since 1998.
This meshes with my outlook–as longtime PF Weekly readers can attest, I have been generally bullish on the stock market. I also felt the February dip in stocks was an outstanding buying opportunity (see Revenues on the Upswing).
That being said, the US economy and markets face plenty of long-term headwinds. The threat list includes the potential for a spike in US interest rates caused by the reluctance of foreign buyers to fund America’s massive deficits and rising taxes, an issue I discussed last week in Health Care Fiction and Fact.
But investors aren’t giving enough respect to the cyclical trend in the economy. The economic indicators I watch and analyze in this e-zine, such as the Leading Economic Index, continue to suggest the economy is gaining steam. The market’s performance suggests that my analysis and market reality match up–at least for now.
A couple of sectors on this list really caught my eye: financials and energy. The former caught my eye because it performed so well, while the latter’s underperformance surprised me.
Although I’ve recommended a major financial in Personal Finance, the group’s strong performance in the first quarter suggests I’ve made a mistake–I simply haven’t paid enough attention to the financials this year. My bias has been that the US consumer faces unprecedented headwinds, making exposure to consumer lending a negative. But the data suggests my bias was wrong. To rectify that, I closely scrutinized the sector and found a few positive trends worth watching.
In the US, improving credit quality is the main trend to keep an eye on. During the nasty 2008-09 recession, delinquency rates on consumer loans spiked far higher than in recent downturns. Lenders were forced to charge off bad loans and struggled to raise capital and maintain their reserves.
But signs suggest these headwinds are reversing. Part of this improvement undoubtedly stems from the fact that the worst borrowers have already defaulted on their loans, and lenders have taken charges to cover those losses. As for new loans, lenders have tightened credit standards significantly.
I expect this trend to continue throughout 2010. And as credit quality improves, lenders will reduce accounting reserves they’ve created against credit losses.
In fact, the trend seems powerful enough to warrant further upside; Yiannis Mostrous and I are adding a financial recommendation to our Stocks on the Run service. That recommendation is due out Tuesday, April 6.
I’ve been bullish on energy, a group that’s served us well over the past year. But energy stocks in the S&P 500 only managed a 0.08 percent gain in the quarter, well under the performance of the broader market.
But careful analysis reveals that this lackluster return doesn’t reflect the actual performance of energy stocks this quarter. The S&P 500 Energy index is heavily weighted in large-cap integrated oil companies like Exxon Mobil (NYSE: XOM), a stock that actually fell in the first quarter.
Exxon and other super oils are not the best play on rising oil prices. With a few notable exceptions, the integrated oils have not shown much production growth in recent years. And the group has heavy exposure to refining, a business that has offered pathetic profitability for most of the past year.
Oil-focused producers with strong production growth potential are more leveraged to the upside in oil than Exxon. For example, Anadarko Petroleum Corp (NYSE: APC) surged nearly 17 percent in the first quarter and was among the S&P’s best performers in 2009.
I also continue to like the prospects for oil-services firms. These companies own the technology needed to produce the world’s increasingly complex oilfields located in the deepwater and other hard-to-produce areas. As the world’s easy oil runs out, producers will need to step up spending, which spells more demand for services. I’ll be highlighting my favorite oil-focused plays in this week’s issue of The Energy Strategist.
Stocks focused on natural gas were the other big losers in the energy patch. The group enjoyed a nice run-up at the end of 2009 and into early 2010 due to the cold winter weather and excitement about the tie-up between ExxonMobil and XTO Energy (NYSE: XTO). But concerns about rising gas storage levels as winter draws to a close hit the stocks toward the end of the quarter.
An interesting quirk: the US Energy Information Administration (EIA) has admitted that it has been overestimating US natural gas production due to flaws in the way it collects data. Because strong gas production has been one of the main arguments against higher prices, this could prove to be a major catalyst for the group. The EIA will soon issue revisions to recent data and will provide a more detailed revised production history later this year.
Government Gone Wild
For much of my life, I’ve lived near Washington, DC. It’s a beautiful city, especially with the cherry blossoms in bloom.
But I’m sick and tired of seeing and hearing about the nation’s capitol on television. It seems that every day there’s news about various politicians assaulting some industry or aspect of the economy in an effort to fix perceived ills. All too often, the cures proposed in Washington are even worse and have a longer-term impact than the targeted problems.
I’ve always felt that investing and politics are best kept separate. Sadly, every time a photo of the Capitol or the Washington Monument shows up on business television, investors cringe. It’s impossible to invest these days without considering what’s going on in Washington and the implications of political decisions on the long-term health of the country.
And although Washington’s largesse creates plenty of losers, other companies will benefit from changes underway. Some companies are raking in cash from federal stimulus programs, while others will benefit from loan guarantees and research grants.
That’s why I’ve decided to host a special audio conference on April 21 to discuss recent policy from Washington and how it’s likely to affect your bottom line. We’ll cover the impact of health care reform, energy policy and stimulus spending. And we’ll also take a closer look at how you can protect yourself from rising taxes, the declining value of the dollar and eye-popping fiscal deficits. In addition, I’m offering all attendees a one-year subscription–24 issues–to my newsletter, Personal Finance.
Click here to find out how to participate in the first-ever Personal Finance Audio Conference.
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