Despite all the positive press that China’s “Economic Rising” has garnered lately, investing in China has been a slog since August of last year. As one can see from the chart of the Shanghai composite below, China’s equity markets have been pretty sloppy since last August. China shares are not particularly cheap with most consensus forecasts suggesting P/E’s in the mid 20’s for a slice of the action.

From the System’s point of view, the high volatility and lack of upward direction has relegated China assets to the bottom half of the rankings for all the portfolios that include China for several months. However, after losing 13 plus percent in a month, China this week has tipped into the Short column in our Asian Index Long Short portfolio.

Source: Bloomberg

Why is this happening when the press reports are in near universal awe of China’s ability to navigate through the Global Financial Crisis? China, after all was swift to turn on the liquidity pumps at the banks to inflate a property bubble of impressive proportions. Despite the continued weakness in China’s primary export markets of the US and Europe, companies were eventually compelled to restock shelves in the past few quarters leading to a nice snapback in export orders.

But the markets are forward looking and if one scratches beneath the veneer of good news, there are problems a plenty. The largest problems are tied to inflationary pressures (primarily from an overheated property market) and the sustainability of economic recovery in China’s two biggest export markets (the US and Europe). But the latest drop appears to be anticipating something more specific. China’s banks have all been ordered to raise more capital (slowing down loan growth is not really an option) and China’s Agricultural Bank is slated to become the largest IPO ever at US$20-30bn. The initial idea is a dual listing in Hong Kong and Shanghai in July but over the past few sessions, there has been enough talk about Plan “B”s to suggest a bit of indigestion ahead. A shaky launch could be the catalyst to send China shares into a swoon (with impact on the Hong Kong market in general).

So what is the bet?

Defining what you are trading on is very important because there can be several outcomes. If you are unclear about the original conditions, it is unlikely that you will be able to react properly to the outcomes. The bet is that China’s regulatory officials feel comfortable pushing ahead with the Agricultural Bank IPO and other fund raising activities at a time when international appetite for risk is waning. That doesn’t mean the IPO has to fail miserably or even get launched at all. It means that the presence of the deal (the overhang) will cause indigestion in the market and cause prices to fall. Why are the Chinese authorities feeling confident? For one thing, property prices are rising in double digits in almost all the cities. For another, China’s leaders are busy trying to batten down talk of the “Beijing Consensus” or “China Model” as they swan around the world with a bit of a G2 swagger. In short, the bet is about a bit of hubris in the market which will be corrected in the time honored fashion of falling prices.

How to play this opportunity?

For the average investor, it is quite difficult to short the market. Products do exist. Proshares offers YXI and FXP, the inverse and double inverse of the FTSE Xinhua 25 index, FXI. However, one should read the well written and un-camouflaged health warning on the Proshares site carefully. Because the inverse ETFs are designed to track one day movements in the underlying index, a volatile market like China can lead to large tracking errors between the ETF and the target index over relatively short stretches of time. Some investors will choose to short FXI in a margin account to try to obtain a better tracking over periods of one month or so.

Should you play this opportunity?

If you decide to short anything, you need to pay closer attention to it than a long trade. For many investors, the extra attention to detail is the dealbreaker. If you are not sure, err on the side of caution. If you are ready to play, you first need to consider how FXI will diverge from SSEC (the Shanghai composite index). While it is true that the FXI is made up of the bluer chip companies that are able to meet Hong Kong’s listing standards and that the P/E ratio is lower (16.7 at the end of April) than those in Shanghai, the FXI is heavily weighted in precisely the same financials that will be impacted by a less than stellar Agricultural Bank launch.

For those who are unwilling or unprepared to go short, there is still a good opportunity on the long side. If IPO indigestion tanks the market, there will be a good chance to pick up shares in the second largest economy (and largest exporter) on the cheap. When will that happen? Watch the System rankings in the coming months. When China starts to move off the bottom of the list, there may be a good opportunity to catch a rebound. Why do we think there will be a rebound on the other side? Because our central investment premise is that markets move in cycles. If this cycle is a down one for China, it makes sense that the next one will move in the opposite direction.

Not perfectly correlated

Price Source: Reuters

Other trades this week

Not a lot has changed from last week. Emerging Europe, Japan, India, US Small Caps, Biotech and High Yield are still hanging in there. One subsector which has scored well lately is the Homebuilders (XHB) in the US. Homebuilders are reported optimistic despite phased out government incentives to new home buyers. In our commodities only ETF portfolio, Gold (GLD) and Silver (SLV) shine in an otherwise dull clutch of investment opportunities. However, in mixed portfolios, neither precious metal ranks highly.

That was a brutal start to May!

This week, we look at two factors which drove market behavior last week: the vastly increased speed of trading and the emotional transmission mechanism.

The speed of trading

For several hundred years, the laws of physics pioneered by Sir Issac Newton were the foundation of the industrial revolution. By measuring, understanding and harnessing the natural forces all around us, inventors, entrepreneurs and others were able to build machines, power plants, factories and all the modern conveniences that we take for granted today. However, as we started to explore the very small (atomic scale) or the very fast (speed of light) or the very massive (the universe), Newtonian physics broke down. It failed to explain our observations. As a result, Albert Einstein was compelled to invent a new set of laws. Those laws did not invalidate Newtonian physics (an apple falling out of a tree can still hit you on the head) but it recognized the old physics as a set of rules that work when things aren’t moving extremely quickly or are extremely small or large.

Moving over to the financial markets, we are in the same place as Einstein and others found themselves in the early 20th century.

The Efficient Markets Hypothesis and Modern Portfolio Theory were crafted in the middle of the 20th century when the speed of financial markets were within normal human scale. Transactions were initiated and executed by humans using telephones, scraps of paper, pens, order books, haggling and time stamp machines. In physics, it was still about the apple rather than the subatomic particles which make up the apple.

But, now speed forces us to reevaluate our understanding of the financial markets. According to an article in the FT, transactions can now take place in as little as 16 microseconds. To understand how fast that is, note that the average human eye blink takes 350,000 microseconds (ref). So, we have entered the age of Algorithmic Trading in general and we are seeing how one cutting edge product, which has been christened “High Frequency Trading” (HFT), has changed the nature of the market.

HFT is estimated to account for 50%-70% of the daily volume in US equities. It is a heady period not dissimilar to the excitement that surrounded the dawn of the atomic age. Scientists in a number of countries raced to turn the new physics theories into real world applications in the 1930’s and 1940’s. Success in the atomic race translated into superpower status in the post-WWII period. Success in HFT has already translated into outsized profits at firms like Goldman Sachs.

And just as regulation did little to stop the proliferation of nuclear technology, one should not expect too much to come from efforts to control this latest advance in the science of trading financial assets. The SEC has tried to curtail “flash trading” but it will be difficult to convince market participants to not seek ways to profit from their high speed machines.

Unfortunately, just like early experiments in harnessing the power of the atom, occasionally the chain reaction process gets out of control. Last Thursday, the computers got stuck in a loop, cratering the market before anyone could hit the “reboot” switch.

The emotional factor

So, how does a computer loop translate into a global phenomenon? In our interconnected world, assets are constantly being measured against one another. The ability to move from emerging market equities to short term US Treasuries or Gold is almost frictionless for a medium sized institution. All the excess cash created by our Central Banks is sloshing around the financial markets chasing returns. So, when Institutional investors smelled smoke, they had to assume that there was a fire nearby. Given the speed issues explored above, a “shoot first, ask questions later” attitude has emerged. In short, traders pushed the panic button. In the US, they pulled their bids and let the computers find out just how low they could go. In the rest of the world, they dumped “beta” and dove for safety.

That’s it?!?! There must be more behind the story than that! Part of the emotional component of the markets is our need for an explanation that we can grasp; we need a scapegoat. We must have a cause and effect in order to feel that we have control over the universe or at least our corner of it. So, where was the fire? Was it Greece, which has been exposed as a financial basket case for months now? Was it the Euro, which is showing the strain of the substantial political compromises that accompanied its creation just over 10 years ago? Was it the UK elections where observers have been calling for a hung parliament since the beginning of March? Was it a “fat finger error” where a junior clerk sent an order for billions instead of millions? One thing is for sure: this story is too good for the media and congress to ignore. But as investors, we should not spend much time with these historic events that were well discounted. The markets look forward and so should we.

How to deal with high speed markets

Although the price of computing power has come down through the decades, the systems that drive HFT are still well beyond most investors’ budgets. And, even if we had access to those systems, success is not assured. As we saw on Thursday, even the traders whose job it is to watch the markets on a tick by tick basis were powerless in the face of a rogue wave of computer generated trades. Developing a system that works in increments of 10s of microseconds is not a viable option.

Since we have been comparing the new market to modern physics, perhaps we should take a page from the physicists’ handbook at the atom smashers in the US and Europe. Contrary to popular imagination, the scientists as CERN do not throw the switch and see what comes out the other end (maybe a black hole!). They spend years planning for their experiments so that when the near light-speed collisions occur, they already know what to look for. Once the protons start ramping up to 7 trillion electronvolts, there are no technicians scrambling around the tunnels with socket wrenches.

Investing should be the same. One should have an investment plan and universe of assets firmly in mind before investing in the financial markets. If your goal is to fund retirement in 10 or 20 years, days like last Thursday are non-events. Using a systematic approach that allows you to regularly review and rebalance your portfolio will allow you to keep well positioned for whatever the market decides to throw at us.

One of the tools which helps one to maintain a longer term perspective is the Weekly Leading Indicators from ECRI. The ECRI is founded on the study of the Business Cycle which has managed to survive many announcements of its demise. As you can see from the chart, we are still expanding. There is no doubt that we will hit corrections along the way but until the WLI turns negative, the chances of a double dip recession are limited.

But what about the impending collapse of Europe?

The problems in Europe are significant as the internal contradictions of the Euro come sharply to the surface. But two things are likely to happen. First, Germany and France are going to find ways to bail out their banks. If that means saving Greece and Portugal at the same time, then that is what will happen. Second, a weakened Euro will help export related companies in the core industrial center of Europe (Germany, France, Northern Italy…). Although European leaders will denounce “market speculators” a 10% shift in the value of the Euro vs. the Dollar will have a significant impact on exports in the coming months. A bigger shift will have a proportionally bigger impact. So, while one might shy away from Greek sovereign bonds in the coming few weeks, there should be significant opportunities for the former Eastern European countries that supply the German export machine. That is why you will find Emerging Europe on top of the System Rankings and near the top in many of the portfolios.

Other Picks

In our international mutual fund portfolios, Japan and India still rank highly although EPI, the Indian ETF does not make it into the top rankings of our ETF portfolios. US Small Caps, High Yield, Real Estate Related, Biotech, Technology and even Financial Services feature in the top rankings as well.

Wisdom of the ages or a silly superstition? Besides being a catchy rhyme, does it have any basis in reality? Along with the January Effect and the concept that equity markets tend to outperform from October to May, this old market saying returns every year as regularly as Mother’s Day.

While every year is slightly different and most of the studies on calendar variations of market performance conclude that the anomalies are too small to make consistent profits, there is good reason to pause this May and decide what we want to watch for in the coming months. As regular readers will notice, we have our doubts about how well the efficient market hypothesis explains market movements. Those doubts are based on observations of how investors’ emotions can have a significant impact on the direction of money flows and asset prices. That doesn’t mean we are ready to embrace every market superstition but let’s look at some of the reasons why Sell in May might hold some validity.

1. Earnings Cycle
   By the end of May, most corporates will have reported first quarter earnings. Generally 1Q earnings closely follow the release of the previous years’ fully audited earnings report. March, April and May are very busy periods for analysts. And this year is no exception as they scramble to upgrade their earnings estimates to current trend. The next significant set of earnings won’t come until August/September and the second quarter is a great quarter for booking bad news. So the start of our Sell in May period is a relative data vacuum followed by potentially disappointing 2Q earnings as the summer drags on.
2. Summer in the Northern Hemisphere
   The saying originally came from England as London stockbrokers and fund managers prepared for the English summer (horse racing, Wimbledon, summer holidays). Market volumes traditionally fall off in summer months and lower liquidity often brings lower stock prices.

So, mark your calendar to take some time this month to review your portfolio. Equity markets have run hard and while equity analysts are falling over themselves to revise their S&P500 earnings numbers upward you should try not to get caught up in the false enthusiasm. Who will be the first to reach $100? (current forward earnings estimates have already broken into the high 80’s/low 90’s). The correct answer is: “Who cares?” Earnings mania could give us just the short term top that makes people remember the “Sell in May” adage.

That said, we still see strength in certain segments of the equities markets. At the top of the ETF list (found here) is the REIT ETF (RWR), followed by Consumer Discretionary (VCR & XLY), Biotech (XBI) and Homebuilders (XHB). The rest of the top 20 is filled with various flavors of US Small Cap indices.

It’s time to take a reading of where we are on the Fear and Greed curve. If we want to be better investors, it is critically important to take stock of where we are in the cycle from time to time.

Source: Investment Postcards Blog

This week, I am borrowing the chart shamelessly from Prieur du Plessus who runs a very informative investment blog from his base in Cape Town. If you would like to receive his thoughts, he offers a free email subscription (follow this link).

The Fear and Greed Cycle is a classic and has been around for decades at least.

What is a classic?

According to Mark Twain, a classic is “Something that everybody wants to have read and nobody wants to read.”

OK, many of the “classics” we were forced to read in school were pretty dry but that’s not the reason we ignore the Fear and Greed cycle. We ignore it because it reminds us that our emotions play a strong role in our investment decisions. When the market is low, so are our emotions and we fail to buy (or worse, we dump at the bottom). When the market is at the top, our emotions are bubbling over and we fail to sell (or worse, we buy more). Since this is the core argument behind the IRP System, we won’t belabor the point here other than to say that we believe emotions are the key driving factor behind price movements.

So where are we today?

Globally speaking, we are in the middle of the left hand side of the curve, somewhere in the region of Caution. Some markets are more confident than others but there are many investors who still bear the emotional scars of the Global Financial Crisis. We are edging in on Enthusiasm but we are a long way from Conviction.

One of the interesting features of this recovery is the unevenness of it. Because the Global Financial Crisis was largely a G-7 event, the normal order of recovery has been scrambled. Usually, the global heavyweights in the developed markets lead the market recovery followed by smaller caps, emerging markets and exotic themes. This time, the financial markets were led out of the woods by the BRICs (Brazil, Russia, India, China) economies that were able to sidestep the worst of the recession. Countries like Poland did extremely well by not falling into recession at all. So, our normal “rules of thumb” may be a bit stretched but the emotional state driving investor decisions remains the same. Therefore, when we point out that US Consumer Discretionary Spending stocks look promising (VCR & XLY) while China (FXI) Brazil (EWZ) and India (EPI) have come off the boil, it should be noted that market sector leadership was very different this time around.

So what can we expect?

Given the ferocity of the bounce from last March, it is tempting to conclude that this trip up the left side of the curve will happen very quickly. In economic terms, that would be anticipating a double dip recession or W shaped recovery. That outcome is still quite possible but we are preparing for a longer, messier, uneven recovery similar to what we have experienced over the last 12 months. Economically, this more likely but messier scenario would see growth returning in fits and starts around the globe. On the Fear and Greed curve, it would leave us struggling between Caution and Optimism for the next 12 to 18 months.

What should we watch out for?

One should be on the lookout for signs of hubris and in the case of China’s recent property bubble and the potential bubble that has built up in Sovereign Debt, those signs of overconfidence are already here. Bubbles in one or two asset classes are not a sign of the end and with all the stimulus cash sloshing around the global economy, it is to be expected. However, when the majority of asset classes look bubbly, it will be time to look for the exit. We are not about to embark on a 20 year bull run in asset prices, not at these starting levels anyway.

What looks good this week?

This week, our international portfolios are still positive on Emerging Europe (GUR/GMM), India (EPI) and Japan (EWJ). Our mixed US/International portfolios are positive on Consumer Spending (VCR & XLY), Biotech (XBI), Pharmaceuticals (XPH), US Small Caps (VB, IJR & IWM) and Homebuilders (XHB).

New ETF Pages…

We are building up our ETF information pages (starting with AWCI) so please click through and check them out. Any suggestions (ETFs you would like to see, different presentation or any other comments) would be most appreciated.

“Let the Buyer Beware”

is the first lesson any investor should learn. The SEC complaint against Goldman Sachs with regards to a synthetic CDO deal is only the latest reminder of why this old Latin phrase still has instructive powers today.

But, don’t expect much commentary on Caveat Emptor in the coming weeks. Why? Because it is human to get a guilty pleasure from watching the misfortune of others. The Germans even have a proper term for it: Schadenfreude.

One cannot blame the financial media (newspaper, magazine, television, blog) for feasting over every little detail. This story has only just begun. As Professor Bill Black points out in a series of YouTube videos, there were over a thousand criminal convictions in the wake of the Savings & Loan Crisis that wiped out an entire segment of the US financial industry in the late 1980’s. The most stunning statistic to date is that there have been no convictions in the wake of the much bigger and more widespread Global Financial Crisis despite the widely reported fraud that occurred at many levels of the subprime and Alt-A mortgage origination process. Now that the SEC has fired an opening shot at the biggest target on Wall Street, State Attorney Generals will jump on the band wagon. Unlike SEC officials, AGs need to run for reelection. Pursuing the alleged perpetrators of the crisis that has pushed millions of homeowners into negative equity and driven the underemployment rate to 16% will prove popular amongst the voters for several years to come.

Sure, it is fun to watch the mighty fall (or at least get in deep trouble). But, if you want to become a better investor, you need to tear your eyes away from the media circus and learn an important lesson from this affair. The lesson is that “Wall Street” or if you prefer, the sellers of financial products, are not necessarily on your side.

That statement needs to be looked at very carefully. It does not mean that the sellers of financial products are always out to cheat you. It does not mean that all financial markets are a zero sum game where every winner must have a loser on the other side of each transaction. However, it does mean that the firms and the employees of the firms who sell you financial products have priorities that may not always align with yours. It’s called agency conflict.

How does this conflict arise? We need to divide it into two batches:

In the olden days when brokerages and fund managers primarily made their money from selling products and gathering assets, the agency conflict largely arose because financial professionals were compensated by moving product. While the vast majority of investment professionals enter the business to help their clients make money, compensation systems are not set up with that goal in mind. That conflict between the need to make money for the firm and the hope of making money for the client was largely but imperfectly bridged by prospectuses, disclosure, regulation and professional standards. The theory was that transparency should allow investors to make informed choices. In practice, greed and laziness (and sometimes darker motivations) overcame good intentions from time to time.

More recently, however, the large investment banks have come to depend more and more on proprietary trading to pay the bills. This has set up a more serious agency conflict because it is now in the bank’s direct and immediate financial interest to trade against its clients. The relationship runs the risk of turning into that of the casino owner and his customers. And, where prime brokerage relationships allow the “house” to peek at the customer’s cards before placing its bets, the odds appear to be unfairly stacked in favor of the “house”.

Will new regulations fix the problem? Agency problems exist wherever there is a market. Unless the new regulations do away with markets, the answer is no.

What can an investor do?

That brings us back to the title of this article. The lesson of this “train wreck” is that investors must constantly strive to make themselves aware of what is really going on. Investors must not abdicate responsibility for their investment decisions whether for reasons of laziness or greed. The investor must be aware of the risks involved both at the individual asset level and in the portfolio as a whole.

We think the best way to achieve this is to develop a systematic approach to investing. A systematic approach should include at the very least a robust and unemotional investment screening process and a regular review mechanism. The investment screening process is critical to choosing investments based on rational criteria rather than the latest rumor, hot tip or “gut feel”. The review process is equally important because markets are cyclical and even the best investments go down sometimes.

The Fund King System is designed as an asset selection system with a built in review process by investment professionals who have dealt with agency conflicts for several decades. Unlike less independent research operations, we do not have a financial interest in the recommendations of the Fund King System. The system works with your investment universe to unemotionally select assets that have the most likely chance for outperformance in the medium term. Because it refreshes on a weekly basis, mistakes (and there will be mistakes) are caught before they do too much damage to your portfolio. Your assets are regularly redeployed away from underperforming assets and towards those with the best prospect of performing. At the end of the day, that is what investing is all about…positioning your assets so that they can work hard for you.

How does that help you with agency conflict? When you are in control of the asset selection and review process, the Financial Industry’s role is reduced to that of a product and execution services provider. Agency conflicts still exist but the opportunity for abuse is reduced.

If you would like to learn more about how the System works, there is information on this website or you can contact us directly with any specific questions you might have.