In the Charles Dickens classic, "A Christmas Carol", Ebenezer Scrooge is visited by the ghost of Christmas past who makes him realize his misdeeds and warns him of the impending miserable end to his life unless Scrooge mend his ways.
Over the course of the last few years, our investors (both individual as well as institutional) have shared with us their investing tales, some merry and some somber. Here we summarize some of the lessons we, and our investors, have learned from the years past with the hope of avoiding future misery.
Trend is your friend
2013 started with a lot of skepticism. Between the bumbling bureaucrats in Washington who had the economy headed for the fiscal cliff and the Federal Reserve Bank which was trying desperate measures to sustain and stoke economic growth, investors decided to generally stay on the sidelines rather than venture into the equity markets. Some brave souls even tried shorting the equity market. It is, therefore, no wonder that the 5.1% rally in January caught a lot of skeptics by surprise and the rally of nearly 28% of 2013 completely flabbergasted them. Here in lies the first lesson.
"The market can stay irrational longer than you can stay solvent." - John Maynard Keynes
Trying to outguess the markets can be costly. It is better to follow a trend and let the price action dictate the next course of action, than try to time that action. This is where a systematic approach comes in handy. With the benefit of a model that is based on measuring price trends and their strengths, an investor can take the guessing work out of the equation.
A trend almost always comes to an end (Bonds and Gold)
Bonds, whether government, agency, municipals or corporate, have been on a tear since 2010, with 2011 being the stellar year when 30-year US Treasury bonds returned nearly 28%. This was fueled by the government Quantitative Easing program which was designed to lower the yield on long-term bonds to make credit cheaper for individuals and companies. That party came to an end in 2013 when we saw a collapse in bond prices that started in May. But the uptrend ended in 2012 when bond prices stopped rising and were stuck in a broad sideways range or what we term as a "noisy market". A "noisy" market is generally followed by a "shock" or a down market, which is what happened in 2013.
The other big trend changer in 2013 was gold. Gold had been in a massive uptrend since 2003, it peaked in 2011, went sideways in 2012 (a noisy market) and fell sharply in 2013 (shock market).
This pattern of trend followed by noise and then shock has been observed in almost all asset classes for decades, which is why our systematic models rely heavily on determining the upcoming volatility cycle. If 2014 is to mark an end to the trend in equity markets, we should see a similar "noisy" period before we can call an end to the equity market rally.
Rising tide floats all boats
Or to quote, Warren Buffet, "You never know who's swimming naked until the tide goes out".
The equity market rally since 2009 has lifted all S&P 500 sub-sectors in unison. The following table shows the cumulative returns of 9 S&P 500 sub-sectors from 1/1/2009 to 12/14/2013. Market sectors supported the most by government policies have done far better than for example the financial sector, which has been at the receiving end of the policy and regulatory stick.
Source: MA Capital Management, Yahoo Finance
At a macro-economic level, the outperformance of XLY versus XLF of 126% is in marked contrast to the period prior to 2009. For example, from 1/1999 to 1/2008, the performance of the 2 sectors was almost identical. Once the policy brunt, i.e. Volcker rule implementation, fines emanating from 2008 financial crisis are behind the sector, the performance gap between the 2 sub-sectors will most likely reverse.
At a micro-economic level the investor has to be wary of the relative strength of companies that have benefited from this broad based rally as a stumble could see the weaker balance sheet companies fall the hardest.
First In- First Out - Follow the smart money
Smart money, e.g. pension funds, hedge funds, sovereign wealth funds have access to more capital and resources than individual investors do. They tend to be the first ones into a new trend and the first ones out at the exhaustion of that trend. We could even go so far as to say that this massive movement of capital is the cause of the birth and death of trends in the market. While it is never possible to have complete transparency into the holdings of large investors, it is important to pay attention to the rhetoric. The latest rhetoric points to a continued rally in the markets, but the first signs of a re-balancing should be a sign to lighten the exposure to equities.
The other sign of topping markets is a pickup in IPO activity. Company insiders have the most information on the financial health of their company. So they are likely to sell their stock to the general public when they feel that they have extracted the most value out of the stock. According to market news, the technology sector is set to see a pickup in IPOs in the first half of 2014. This is another sign of where relative richness might lie in the market.
Credit is a double-edged sword
Ability to access cheap credit and the ability to invest it in a bull market can make overnight millionaires if the timing is right and paupers if the bull turns into a bear and the investor is overleveraged.
There have been 2 pervasive trends in the market for the past 5 years, cheap credit and rising equity markets. A similar phenomenon was present in the markets from 2002 to 2007, when the Fed had lowered interest rates after the internet bubble had burst. But during that period it was the housing market that had benefited the most from cheap credit. This time around it seems that the US equity market has been the best beneficiary.
Hedge fund leverage in the equity markets is the highest currently since 2004. Which means that when hedge funds decide to exit the market en-masse, the effect on the market will be magnified, resulting in large and sudden moves. This might catch individual investors, especially those who entered the market late, on the wrong foot. It would definitely be prudent to start reducing leverage if it appears that the market is starting to lose steam.
"I will live in the Past, the Present, and the Future. The Spirits of all Three shall strive within me. I will not shut out the lessons that they teach!" - Charles Dickens, "A Christmas Carol"
Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by MA Capital Management, LLC unless a client service agreement is in place.
Nothing in this presentation should be construed as a solicitation or offer, or recommendation, to buy or sell any security, or as an offer by MA Capital Management, LLC to provide advisory services. Investment management services are offered only pursuant to a written Customer Agreement, which investors are urged to read and carefully consider in determining whether such agreement is suitable for their individual facts and circumstances.