Investors Should Use Microscopes - Weekly Blog # 513

Introduction

Learning experiences occur everyday for investors with an active, searching mindset. We can see their importance more clearly if we utilize a number of tools. At this point in the market's evolution from a combination of volatility and no forward progress for many stocks, we should be searching for some guides for both our investment emotions and our considered actions. I am suggesting there may be some valuable insights being offered by looking through a microscope as to very recent investment performance for equities and fixed income.

Current Views through a Microscope - Equities

One of the basic beliefs supporting market analysis is that from time to time the ownership of stocks rotates from "strong" sound, long- term holders to short-term oriented momentum trading "weak" players. Strong and weak are applied loyally to their current holdings. In theory, the market's purpose for periodic meaningful declines is to shake out the weak holders selling at indiscriminate prices; e.g., offering bargain prices to strong buyers who foresee longer term value at these depressed prices. Historically, after a low price is followed by a rally, the question comes up whether the low price is actually the bottom of the move. Often a second or even a third down move "test" is required to convince some strong investors to be buyers. These tests can be at or somewhat near the prior low price. For me it is not only the price move that is critical in declaring a bottom. What I look for is a dramatic change in attitude on the part of the sellers who are exhausted from the emotions of the decline and proclaim they are leaving the game, often calling it "fixed." At the moment I am not hearing this lament from the sellers. Thus, I believe the February bottom to be a weak bottom. Most of the time weak bottoms are not when the base for subsequent, substantially new highs are generated.

With the above thoughts in mind I wonder whether the stock market, not individual stocks, has seen its high in January, which would fit the pattern of performance from a prior good year.

For Those Committed to Equities for the Long Term

Many of us have responsibilities to be largely invested in stocks or stock funds because the history of successful large macro bets is poor for many that have tried. Getting three successive correct decisions (Buy-Sell-Buy) in a row has proved to be difficult for most who try. Thus for the rest of us professionals we try to produce the best returns that we can within our prescribed market.

One of the reasons that all institutional investors should pay attention to the results of mutual funds is in aggregate they are the best contemporaneous record of institutional money. (Bear in mind many of the mutual fund management shops manage a great deal of money in non-mutual fund accounts, but use many of the same securities and strategies.) By using a microscope on the very small number of average mutual fund performance through March 1^st, one can see some useful patterns. The average US oriented diversified fund declined only -0.31% where the average sector fund fell -3.13% and the average world equity fund gained +0.11%. What these numbers suggest to me is that during periods of volatility liquidity is important. Further, that an important part of short-term global investing are the inputs from currencies.

There are some other lessons from this study. The best diversified US oriented fund category was the Large-cap Growth funds, which gained +4.02%. (Part of the gain is probably due to investments in a small number of globally oriented tech companies; the average Global Science & Tech fund rose +6.36%) What is significant about the leading performance of the Large Cap Growth funds is that in most weeks it has the largest redemptions. Contrary to the popular view that redemptions are a sign of disappointment in returns, (as these are often the oldest funds many investors own) the redemptions are the completion of particular phases in an investor's life cycle; e.g., retirement.

Fixed Income through the Microscope

Utilizing the mutual fund data through March 1^st, the average domestic fixed income fund was down -0.91%. Not particularly helpful to balanced accounts that were looking to fixed income gains for stability to offset equity losses. Institutional investors and some retail investors did find better investments than the general bond market in Loan Participation funds (Bank Loans) +0.97% and Emerging Market Debt funds in local currencies +2.65%. To emphasize, the importance of currency in Emerging Market Debt fund investing, bonds traded in dollars were down -0.63%.

In reading the annual reports of fixed income funds that our clients own, I found the following statement, "Credit sector is less compelling." This particular fund has a long history of providing slightly above average income with less downside than most of its peers. Currently, they are sitting with shorter duration bonds or higher quality.

I have written in the past of my unease with the growth of credit funds, both in the US and globally. The leading bank distributing syndicated loans is Bank of America (BAC), not one of the leaders that I know of in credit research. The search for yield has been a trap in the past.