MarketDNA September 25th, 2009

This week the market finally finds some resistance at new relative highs (1080), a level consistent with last year’s October breakdown. Whether this is the beginning of the much awaited correction it is way too early to say; the bears have been faked out so many times this year that I feel it will not be so easy to break the upside fever.



I have been reluctant to increase long exposure for a couple of months as valuations seemed to get more and more disconnected with reality. David Rosenberg quoted a few interesting stats on FT yesterday on market valuations: an unprecedented 8 point p/e ratio expansion in the last six months of rally which made the SP the most expensive in seven years – 26 times operating earnings and 160 times reported profits. Rosenberg goes on mentioning some history: every time the p/e ratio on trailing earnings goes above 25, the average total return after a year is a negative 0.3% and a median negative 6.2%.



The bulls argue that after a deep recession GDP grows north of 6%, even 7%, and stocks now are pricing forward 12 month growth of only 4%. Frankly I think 2% next year will be a blessing (which coincidentally is what the corporate bond market is pricing) which would put the SP500 at 850, maybe 900 at best. In any case, there are so many cross-currents that forecasting forward EPS is more uncertain than usual which does not warrant a huge multiple expansion. The other perma-bulls who constantly quote low inflation and interest rates as major elements explaining p/e expansion must have missed the last 24 months of economic history and what those low levels really mean.



All this considered, this year highs should not be pierced significantly, if at all, but, again, I am not so convinced the correction will be hard and scary as performance anxiety, huge levels of cash and good ol’ greed will probably lead the show into year end. 2010? I fear a whole other story. Perhaps 2010 will usher back two way trading and alpha driven money managers will be useful again (I know I know I am spinning my story…).



Another potential scenario for 2010 is a continuation of the major rally as a nominal increase in price will be met by a constant devaluation of the dollar, abysmal monetary policy by the FED and a rally in gold. This plays contrary to my idea that USA is now spelled Japan and our own deflationary cycle is only getting started. Marc Faber and a few other managers I respect are out there building portfolios around this scenario.



In currencies, I think the Euro is overvalued but it does have a tendency of finishing the year strong so I would like to buy any substantial pull-back into November for an EOY rally. The Yen is getting stronger, seemingly on Japanese corporations profits repatriation, and if that is indeed true, it should be a very fleeting move. I cannot make any intelligent case for the Yen getting stronger.

Disclaimer:

The above writing is not intended as a trading or investing recommendation

The Danger with High Frequency Trading

The Danger with High Frequency Trading

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MarketDNA Blog September 3rd, 2009

The telegraphed day of reckoning has finally arrived and many commodity ETFs (ETNs) are now finding themselves in the regulatory line of fire.

I have been on the record with my MBA students and with many of my colleagues in the investment business for quite some time on the multitude of problems associated with commodity ETFs and now it seems corrective actions are being taken.

Just recently UNG, the ETF which attempts to track nat gas futures performance, was subject to massive price distortions. UNG built a premium in its price versus its NAV of as much as 20% due large inflows of money; these inflows reflected investors’ bottom fishing but UNG was suddenly unable to expand its position due to an abrupt fear of breaching position limits in the futures pit. When an ETF cannot deliver on its strategy for regulatory fear, the model is pretty much broken.

Along the same lines, today we hear Deutsche Bank will close down its leverage long oil ETF due to similar concerns. D Bank is not having a very good streak as its agricultural commodity ETF was also stripped of its exemption on speculative limits in the correspondent futures markets and therefore will find it more arduous to continue with the same business model.

Since their inception, I have been a great advocate of ETFs in general but commodity ETF specifically were always ridden with issues. From a regulatory point of view, these were hybrid products, which were backed by derivatives and yet traded like securities avoiding proper scrutiny. By using futures to manufacture tracking performance for the equity investor, they were also inherently leveraged bypassing leverage restrictions normally applied to equity products (this is an issue with index ETFs as well and not only with commodity related products).

Commodity ETFs, furthermore were practically built on the wrong assumption of permanently long only products with obvious price distortion ramifications in markets like commodities built for hedging purposes. Commodities have really no beta because they are consumable, transformable and perishable asset. Frankly, I am beginning to think that the concept of beta is one massively flawed idea in every market…but this is material for another blog. The idea that equity investors should passively include this asset class indiscriminately in their portfolios was another one of those brilliant, self-serving ideas of Wall Street – always driven by the never ending search for a way to needlessly repackage risk and earn fees. If an equity investor feels the need to incorporate inflation hedging in his/her portfolio or seeks an edge in overweighting the commodity sector, there are already plenty of proper choices: TIPS, Commodity Stocks, Gold etc.

Commodity trading is just that: trading, exploitation of anomalies, price arbitrage and it should be approached in that way. Futures traders, CTAs, hedgers are the natural players in this game; ETFs…not so much.

From a strategic perspective, it is reasonable to expect a potential dull period in commodities as these ETFs may be forced to close or downsize for quite some time.

Welcome to a New Normal in commodities as well?