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Saturday, March 4, 2017

Phase 2 of the “Trump Rally” …. Getting Riskier?

There is no doubt that the markets have had a strong rally since election day. But the market movements since the turn of the year may indicate that the markets may have moved into a riskier phase where the forces of momentum, fear and greed have taken hold.

I always find amusing the explanations for short term expecially one day market movements. Often there are internal factors to the markets that are responsible for the large moves more than a news event; even though pundits point only to the news event. I am reminded of the episode described in a recent book on hedge funds in which the hedge fund needed to buy stocks simply to unwind a complex position that involved short positions in those stocks. As the stocks rose in response to their buying (which had absolutely nothing to do with the specific fundamentals of the companies) they laughed as they looked up at their television screens and watched as pundits gave “fundamental analysis” of the companies to explain the rise,

In my view, something similar happened during the one day move up of 1.7%   in the S+P 500 the day after Trump’s speech to Congress. Somehow a “more Presidential” tone a more businesslike blue tie substituted for the red ones he usually preferred and a list of proposals short on specifics and sure to face a tough time in Congress with at best implementation over a period of months if not a year “explained the move”.

A more nuanced approach would take account of internal issues within the market and behavioral factors.

 For example, the “implied volatility “(VIX) has gone up as the market has risen. The VIX is generally referred to as the “fear index”. But more correctly it reflects the price of options and while it is certainly a fear index when the price of downside protection options(puts) goes up, an increase in demand for options that increase in market value when markets rise (call options) can also cause an increase in the VIX. One popular strategy among investors has been the “covered call” in which the investor owns the stock and sells a call option at a strike price above the current market price with the investor collecting the option premium. Such a strategy is very attractive if the stock remains stable or rises modestly…the investor collects the extra money from the call premium and the call premium gives a bit of a cushion against falls in the stock’s value. But when the market rallies sharply and the stock price moves above the strike price the short call rises in price and the investor is unable to profit from the large rally in the stock price. As investors rush to buy back the short (sold) call options demand goes up as does implied volatility (VIX). And the call buying creates a cascading effect creating further demand for the underlying stock or index.

Other factors unrelated to the “more Presidential tone” in a single speech are related to investor behavior No doubt a one day market move leads to short covering by those leveraged traders that had positioned themselves to a market decline. And one cannot underestimate the behavior of investors “professional” and individual who anxious not to miss out on the party who “throw in the towel” and buy stocks…even at record highs.

During Wednesday’s rally, the Dow Jones Industrial Average shot up more than 300 points, carrying blue chips over 21000 for the first time in history. The Dow closed at 21005.71 on Friday.
On Wednesday, $8.2 billion in new shares were created in State Street Corp.’s SPDR S&P 500 ETF, the market’s oldest and largest fund. Daily fund flows can be volatile, particularly in this $250 billion ETF, which State Street said is the most-traded security in the world.

Big institutional investors use the ETF to put cash to work in a variety of ways while they select individual stocks.
That wasn’t necessarily the case Wednesday, said Matt Bartolini, head of SPDR Americas research for State Street. He examines daily flows in a larger context, looking at trading in options, futures and other ETFs to determine if a one-day flow is part of a larger trade. While there was some options activity Wednesday, it wasn’t enough to explain the big inflow, which was the ninth-largest in the fund’s history.
“One-day flows around market events, like [President Donald] Trump’s address to Congress, can be indicators of market sentiment,” Mr. Bartolini said.
Still, such enthusiasm on the part of retail investors, after years of apathy, could be a reinforcing sign that the yearslong rally is getting tired. Wall Street lore has it that individual investors are often late to step in or out of the market.

One way to see the difference in the market behavior in the period from election to year end and that of 2017 is to look at “factor/smart beta” ETFs. These ETFs some newer and some that have been around for quite a while overweight stocks with specific characteristics.

Evidence is quite strong that two factors: value and momentum have long term outperformance over traditional cap weighted indices. And the two factors can be complementary as each factor shows strong performance under different periods and market conditions.

 I think the best explanation is behavioral: value stocks outperform because investors tend to get over pessimistic on stocks pushing their prices down below levels that could be justified by their fundamentals. As the great value investor Benjamin Graham wrote “in the short term the market is a beauty contest in the long run it is a weighing machine”. Value ETFs include Vanguards large cap Value ETF (ticker VTV) and small cap value ETF (ticker VBR)

Momentum strategies form a way to take advantage of the “beauty contest” aspect of markets by holding stocks that have strong upside price momentum and selling them when the momentum slows even before the stock declines in value or selling when the price movement reverses. The largest momentum factor: ETF has ticker MTUM
So, it is interesting to see the two phases of the post-election market rally by comparing the overall US stock market (ticker VTI) with the large cap value ETF VTV the small cap value ETF VBR and the momentum ETF VBR.
Here is what the price movements looked like from the day after the election through end 2016 (the line graph shows performance, the bar graph both performance and volatility. The colors are same in both charts). Value performance massively exceeded momentum which increased in value only .5% far below the overall market and the value indices which also outperformed the overall market (Vanguard total stock market ticker VTI)

The market since the beginning of 2017 shows a totally different story: a massive outperformance for momentum stocks…in other words a major reason for the stocks that are outperforming is that they are already going up….in other words a major reason for the market going up since the turn of the year is the “beauty contest”.

during the day from its IPO price. The bulls are counting on Snap performing post IPO like Facebook

 while bear race concern ti will look like twitter post IPO.


There are plenty of cautionary signs.

The IPO is unusual in that investors aren't granted voting rights for the shares on offer. Instead, Spiegel and Murphy own the bulk of shares with such power.

Snap isn't making money, even though it's a huge hit with mobile users, averaging nearly 160 million visitors daily and nearly 10 billion video views daily. The company lost $514.6 million on sales of $404 million in 2016, and user growth has slowed. Investors can't tell if it's another Facebook, on the way to giant user growth, sales and profits, or the next Twitter, whose tepid user growth has disenchanted advertisers and kept it in the red.

Among the optimists, Doug Clinton, an analyst with Minneapolis-based Loup Ventures, thinks Snap could grow revenues 100% to $800 million in 2017 and says Snap is smart to position itself as a camera company.

I have no idea how SNAP stock will perform in the future nor do I place much faith in short term market forecasts. Mine or anyone else’s. But I am sure that long term investors benefit from the following:

Not market timing

Sticking to a long-term allocation

Rebalancing their portfolios which leads to selling parts of their portfolio that have increased in value and buying those that have underperformed.

But time after time shows that investors professional and otherwise tend to chase markets and buy high and sell low…. phase two of the “Trump rally” may be one of those examples.

A recent research paper for Financial advisors from Vanguardbased on their research on fund flows through January 2017(and those trends doubtless continued) reached similar conclusions:

Investor risk: Pedal to the metal ... or not so fast?

Key highlights
Our risk speedometers show that recent months echo a common trend: As stock prices rise, so does investor willingness to take on risk.
·         The strong inflows to riskier assets can further increase investors' risk profiles, exposing their portfolios to even greater downside risk. This is particularly concerning, given the current market conditions and our guarded outlook.
·         This may be a good time to review your clients' portfolios to make sure they're not overly vulnerable in the event of a market correction. Rebalancing can help reduce downside risk.


We've long tracked industry cash flows to develop insights into what investors, collectively, are doing with a substantial portion of investable assets.1 Our risk speedometers—our unique lens on investor behavior that we introduced last month and have updated with January data below—and related cash-flow research also highlight trends that may not be apparent in raw cash-flow data. The result is a nuanced picture of how investors are responding to market developments. These nuances sometimes reveal that the reality of investor behavior is more complex than conventional wisdom suggests.

Global equity markets continued their upward trajectory in January, with the FTSE Global All Cap Index returning 2.7% for the month and 6.2% for the three months ended January 31. To no one's surprise, industry cash flows favored riskier asset classes, including U.S., international, and sector equities. In January, these funds and ETFs, netted more than $31 billion, bringing their three-month net cash flow to nearly $100 billion. This is the largest three-month net investment since December 2014 and the ninth-largest in history.