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Do You Have A Plan For This Market Environment?

Daily State of the Markets
Wednesday, July 11, 2012

Good morning. For as long as I can remember, the general public has been viewed as the "dumb money" while the 2-and-20 crowd (i.e. the hedge fund industry) has been considered to be the "smart money." Although the public actually gets a bad rap on this score, it is true that inflows into equity mutual funds - the preferred vehicle of "Main Street" - have nearly always peaked when the market indices were reaching their bull market highs and outflows generally are the most extreme at bear market lows. However, the other side of the street (Wall Street, that is) has a reputation for printing money in all kinds of environments, which, of course, is how these market wizards are able to justify their 2-and-20 (2% of assets under management and 20% of profits) fee structure.

History is replete with the legends of Wall Street and their massive scores in the markets. There's John Paulson's trade of the century achieved by shorting sub-prime in 2007-08, Paul Tudor Jones' short position in '87, and of course, the tale of George Soros breaking the Bank of England. There are the extravagant lifestyles of hedge fund managers (cars, boats, planes, etc.), their big-money poker habits, and their notorious philanthropic efforts. And because of this, just about everybody who has ever been paid to manage OPM (other people's money) has wanted to run a hedge fund. Well, up until 2008 anyway.

Remember, the basic premise of a hedge fund (at least as far as the average investor is concerned) is that management's job is to "just win, baby" in all kinds of markets. Investors in hedge funds don't care how these financial magicians do it (as long as it's legal, of course), they just expect to see their account go up every quarter. And up until 2008, the hedge fund business was booming because this is precisely what the hedgies were able to do.

However, given the massive paydays hedge fund managers received (if you managed $100 million and you made 20%, your take was $22 million) the business got more crowded. There are now scores of style categories for hedge funds and thousands of funds managing a couple trillion dollars. But the problem is that since 2008, the smart money hasn't looked quite so smart.

Recall that 2008 was a REALLY bad year for the stock market as the S&P 500 lost -38.49%. And while hedge funds are generally expected to be hedged against such a cataclysmic event, the industry as a whole had its worst year on record as, if memory serves, the average fund lost nearly -20%. The problem, as even the ivory tower investors at Harvard and Yale's endowment funds learned is that in a true crisis, the correlation of asset classes goes to one (meaning that EVERYTHING goes down). Therefore, even the sophisticated strategies that had earned hedge fund managers millions failed in spectacular fashion.

Please accept my apologies for rehashing some not-so pleasant stock market history this fine Wednesday morning. However, the point is that ever since 2008, the "smart money" has appeared to be anything but. For example, HFR's Global Hedge Fund index is up just +10.35% cumulatively since the beginning of 2009 (and is up just +1.51% this year), which pales in comparison to the S&P 500's gain of +49.72% over the same period.

I know what you're thinking; that's the global index and everybody knows that investing globally has been tough lately. So, looking at Hedge Fund Research's domestic indices, we find that the Equity Hedge Index has gained just +1.06% in the last 3.5 years, the Directional Index actually sports a loss of -0.69% on a cumulative basis, and HFR's Absolute Return (the ultimate "just win, baby" approach) is actually off -7.1% in total since the beginning of 2009.

The problem appears to be that not even "the smart money" has been able to deal effectively with the "new normal" market environment that's been with us since the financial world got turned upside down in 2008. An environment where stock correlations remain at or near record highs (depending on the time-frame you choose to look at), where the market is driven by headlines of summits and bailouts, and where volatility drives even experienced investors to the bar early in the day.

So, with yet another "summer of discontent" on our hands, the are some key questions to ask yourself. For example, do you have a plan to deal with the "new normal" market environment? Do you have a risk management strategy? Do you know when to raise cash? Do you know what to do if Mr. Bernanke decides to that the Fed will launch into yet another bond buying binge? Are you aware of what's happening to gold? To the euro? And to Oil? And will you know when to get back into the pool when the storm clouds eventually clear?

If you have a plan or a strategy to deal with this market, then give yourself a gold star. And then don't beat yourself up too badly when your plan doesn't work perfectly (the ultimate goal of this type of environment is to survive it). Because, as our review of the hedge fund results has shown us, no strategy or approach works perfectly all the time. The bottom line is if you have a plan to try and keep your accounts on the proper side of the really meaningful trends, you should be able to sleep well at night and wave off much of the market hysteria that occurs in between those big moves. So, ask yourself...

Turning to this morning... Lower yields in Spain on the back of Prime Minister Rajoy's fourth austerity package has European bourses and U.S. futures modestly higher this morning.

On the Economic front... We'll get Wholesale Inventories at 10:00 am and then the minutes from the latest FOMC meeting later this afternoon.

Thought for the day... Smooth seas do not make skillful sailors. -African Proverb

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

  • Major Foreign Markets:
    • Australia: -0.07%
    • Shanghai: +0.50%
    • Hong Kong: +0.12%
    • Japan: -0.08%
    • France: -0.27%
    • Germany: +0.47%
    • Italy: +0.13%
    • Spain: +1.10%
    • London: -0.06%
  • Crude Oil Futures: +$1.13 to $85.04
  • Gold: -$3.90 to $1575.90
  • Dollar: higher against the yen, lower vs. euro and pound
  • 10-Year Bond Yield: Currently trading at 1.522%
  • Stock Futures Ahead of Open in U.S. (relative to fair value):
    • S&P 500: +2.01
    • Dow Jones Industrial Average: +31
    • NASDAQ Composite: +2.48

Positions in stocks mentioned: none

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