Bill Miller Correct: "Value" Funds Burying Quants... For Now
Bill Miller is patting himself on the back for "burying" quant funds as this just released Bloomberg article notes: its timely appearance is critical as this is easily the most important theme in the current market dislocation, and thus Zero Hedge will post it in its entirety... Bill, after the worst year in his career, may be careful with the timing of his self-congratulations though...
By Alexis Xydias and Lynn Thomasson April 20 (Bloomberg)
Companies with the most debt and lowest returns on assets are turning the biggest six-week rally in stocks since 1938 into a bloodbath for last year’s best-performing trading strategy.
Investors in so-called “quantitative momentum” funds --which speculate that the worst stocks in the past 12 months will continue to decline -- have become this year’s biggest losers after banks and companies that rely on consumer spending surged. Quant momentum managers may have tumbled 27 percent this month in the U.S., the most since at least 1993, while those in Europe may have lost 20 percent in March and 24 percent in April, according to data compiled by JPMorgan Chase & Co.
“Not in a million years would we have expected this gyration to be as vicious and enduring as it has been,” Steven Solmonson, the head of Park Place Capital Ltd., a hedge fund that oversees $150 million, said in an interview from New York.“The quants got whipsawed badly.”
The turnaround battering investors who use mathematical models to pick stocks is making heroes out of last year’s worst-performing money managers. Bill Miller, who lost 55 percent in 2008 running the Legg Mason Value Trust after beating the Standard & Poor’s 500 Index for a record 15 straight years, is topping the measure again. Value investors buy companies that are the cheapest relative to their earnings or assets.
Man Group Plc’s AHL Diversified Futures Ltd., a computerized trading fund, lost 7.1 percent in net asset value since March 9 after surging 25 percent last year. In addition to futures on stock indexes, the fund invests in contracts linked to currencies, bonds, commodities and interest rates.
Skeptical of Rally
This year’s 28 percent rally in the MSCI World Index from its March 9 low is making everyone from Harbinger Capital Partners’s Philip Falcone to NYSE Euronext Chief Executive Officer Duncan Niederauer skeptical the gains will last. Profits at S&P 500 companies dropped six straight quarters through December and are forecast to decline until September, suggesting the stock market will struggle to extend its advance.
The 130 companies in the S&P 500 and Europe’s Dow Jones Stoxx 600 Index with debt-to-equity ratios above 50 percent and a return on assets of less than zero in the most recently reported period -- more than half of them banks and consumer companies -- rose an average of 82 percent from March 9 through April 17, data compiled by Bloomberg show. That compares with a 29 percent increase for the S&P 500 and a 25 percent jump in the Stoxx 600.
Last week’s 1.5 percent rise in the S&P 500 left it down 3.7 percent this year. The Stoxx 600 gained 4.7 percent, almost erasing its 0.7 percent loss for 2009.
Momentum strategies likely returned 14 percent in the U.S. and 35 percent in Europe in 2008 because industries that tumbled the most in the previous year continued to retreat, according to JPMorgan estimates. These managers sold stocks short, borrowing shares and selling them, hoping to profit by repaying the loans with lower-priced equities. Financial stocks in the U.S. peaked in February 2007, two months before any of the other nine industries in the S&P 500, data compiled by Bloomberg show.
The MSCI World Financials Index slumped 79 percent from its May 7, 2007, peak through March 9, 2009, outpacing the MSCI World Index’s 57 percent drop as losses tied to subprime mortgages climbed toward $1.3 trillion. Since then, the rebound in banks has been almost twice that of the next-best industry.
Momentum strategies failed after government efforts to fix the financial system spurred speculation the first global recession since World War II will end.
$12.8 Trillion Pledged
Banks and other financial institutions in the S&P 500 pared their 2009 losses from as much as 52 percent as lenders from NewYork-based Citigroup Inc. to Bank of America Corp. of Charlotte, North Carolina, said they were profitable at the start of the year. Retailers surged on optimism that the $12.8 trillion pledged by the Federal Reserve and U.S. government will boost the economy and consumer spending.
The net asset value of Man Group’s AHL Diversified fund dropped to $38.71 a share on April 13 from $41.66 on March 9. The MSCI World Index of 23 developed countries rose 26 percent in the same period. London-based Man Group is the world’s largest publicly traded hedge fund manager.
The AHL Diversified Futures fund climbed 25 percent in2008, according to data compiled by Bloomberg. The MSCI World slumped 42 percent last year, the biggest drop since the index was created in 1970.
“Momentum is one factor that does not work in turnarounds,” said Juri Sarbach, a Zurich-based quantitative fund manager who uses the technique and other strategies at Clariden Leu AG, which oversees $81 billion. “When you seek momentum and you have a shift like the one we saw since March, you may find yourself positioned in all the wrong places.”
Worst to First
While momentum investors have suffered in 2009, last year’s worst performers, Miller’s Legg Mason Value Trust and Harry Lange of the Fidelity Magellan Fund, are making comebacks with bets on technology companies.
Both lost more client money than 98 percent of their rivals in 2008 by clinging to or doubling down on shares of financials.
Now, Miller is outperforming 68 percent of his peers with a 1.2 percent gain in 2009 after boosting his stake in Hopkinton, Massachusetts-based EMC Corp. in the fourth quarter. Shares of the world’s biggest maker of storage computers have added 22 percent in 2009.
Lange’s holdings of Corning Inc. contributed to Magellan’s 14 percent jump in March. Corning, New York-based Corning, the largest producer of glass for flat-panel televisions, is up 60 percent this year after saying in March that volumes will exceed its previous estimate.
‘Far From Stabilization’
Maria Rosati, a spokeswoman for Baltimore-based Legg Mason Inc., didn’t return a telephone call seeking a comment. Lange wasn’t available for an interview, said Alexi Maravel, a spokesman for Boston-based Fidelity Investments. Man Group’s Armel Leslie declined to comment.
This year’s gains are making some investors uneasy. Markets “are far from stabilization” because rising unemployment will hold down earnings and consumers have too much debt, Harbinger’s Falcone wrote in a letter to investors on April 15. Harbinger oversees about $7 billion in New York.
The U.S. jobless rate climbed to 8.5 percent in March, the highest in 25 years, and is forecast to rise to 9.5 percent in the fourth quarter, according to the median estimate of 59 economists surveyed by Bloomberg. The Fed’s index of consumer credit outstanding hit a record $2.58 trillion in September and was $2.56 trillion in February.
Profits at S&P 500 companies dropped 38 percent in the first quarter and may slide 32 percent in the second, according to analysts’ estimates compiled by Bloomberg.
66% Beat Estimates
So far, first-quarter incomes have fallen less than forecast. A total of 66 percent of the S&P 500 companies that announced results since earnings season began two weeks ago beat Wall Street projections, the data show.
While credit markets are improving, they haven’t completely recovered. The difference between what banks and the Treasury pay to borrow money for three months, the so-called TED spread, is at 0.97 percentage point, down from 1.35 points at the end of2008. It averaged 0.36 points in 2006.
Equity volatility also remains elevated as options dealers resist lowering the price of insuring against losses. The Chicago Board Options Exchange Volatility Index has averaged 44 this year. While down from a record close of 81 in November, that’s still more than twice the average in its 19-year history.
‘Waiting and Watching’
Last month’s surge in equities was accompanied by a jump in trading for Citigroup and Bank of America. The five most active shares on U.S. markets last month accounted for an average of 18 percent of total volume in March and April, compared with 11 percent from June through December of last year, according to data compiled by Bloomberg.
“The majority of institutional investors are waiting and watching, and we need to see a rally with good volume that is more broadly distributed for them to really get back in,” NYSE’s Niederauer said in a telephone interview on April 17. “I’d love to believe that this is the rally that is the precursor of economic recovery in six to nine months, but I’m just trying to keep people from getting too carried away.”
A gauge of non-financial stocks in Europe with characteristics such as an increasing returns on assets, declining debt-to-asset ratios and cash flow that exceeds net income underperformed companies with the opposite criteria by about two-thirds since March 9, data compiled by Bloomberg and New York-based Morgan Stanley show. Morgan Stanley uses a system for analyzing balance sheets developed by Stanford University Professor Joseph Piotroski in 2000.
Companies that Piotroski ranked highest have outperformed the lowest-rated stocks every year but two since 1994, data from New York-based JPMorgan show.
“Buying bad stocks never pays,” said Marco Dion, a London-based quantitative analyst at JPMorgan. Still, “this start of the year will turn out to be quite challenging for the quant community. Most quant managers use some flavor of price momentum in their process and noticing that this factor is failing and in such a significant manner is therefore not good news.”
It is gratifying that Bloomberg, which some consider borderline Mainstream Media, is finally catching on to this most critical of topics. We hope Bill Miller enjoys his likely last 30 seconds of fame as he relishes in the "crap" stocks of his "value" fund. Unfortunately, for him he is caught in a cul-de-sac: i) If marginal buyers continue purchasing stocks into oblivion, the implision of the biggest quants will spell the end of the capital markets as we know them, ii) if and when fundamentals finally catch up with the rally before too much damage can be done to the topology of the market, his positive YTD results will swing back down so violently he won't know what hit him.
To point i), Zero Hedge would like to present our readers data we have received compliments of Innovative Quant Solutions, LLC, which performs the tricky task of calculating quant fund performance based on various models. The March data should result in plethora of red warning signs.
IQS Commentary for March 2009
The IQS model was down -16.8% over the past 5 weeks, while the sector-neutral model was down 16.9%. [TD: discussion with the appropriate people indicate that April is on par for even worse performance, which is why Zero Hedge has been sounding the clarion call for normality - if market neutral Quants drop 40% in two months, it is truly game over]
Balance Sheet and Value added to performance, Improving Financials underperformed slightly, while Sentiment and especially Momentum underperformed.
What does it mean when momentum stops working? The stocks that lost the most over the past few months (dogs of the dow and S&P 500?) outperform the most. (See IQS S&P pdf report for astonishing examples and IQS analysis.)
Without an economic catalyst, fundamentals based model would not predict (nor should they) this “dead cat” bounce. Are we witnessing a sustainable rally for these stocks? It’s possible, but not very likely. Some of these companies are financials, and the “risk” to this industry changes daily, but remains high. However, some of these companies are not financials, and investors are buying up these low priced stocks with the hope that the economic turnaround has started and will continue to improve. With reporting season upon us, guidance will help determine the direction and magnitude of the market during this period. If financials show an improvement, the market may take off. If most
companies continue to post low or negative earnings without a clear picture of a turnaround, the market may retract.
The IQS dynamic weighting system made small changes this month to the weights. With the market and economic conditions still weak.
Some weight was added to Improving Financials (mid), while a little weight reduced Momentum (mid), from Value (low), Balance Sheet (mid).
What is the IQS Model telling us about Sectors? No significant changes from last month.
Best – Aerospace, Retail, Medical, Utilities, Consumer Staples
Middle –Business Services, Oils/Energy, Industrial Parts, Transportation, Technology, Basic Materials
Worst – Autos, Finance, Construction, Conglomerates, Consumer Discretionary
We are at a critical crossroads for the future of efficient markets. If the bear market rally persists, Bill Miller and 401(k) holders will be happier temporarily, however the end result would be a broken market. Readers who took offense to the photo of the Challenger explosion earlier, should wake up and realize that we are on the verge of the very same event occurring within the fabric of the free and efficient market system. The threat to the equity markets is not being exaggerated. If the powers that be are intent on rising stock prices one day at a time continually, then even as retail investors enjoy another day of moderate gains, in a few short days/weeks markets will reach a point of no return, and the resultant collapse in confidence in the free market system will force the majority of investors to forever depart from investing in equity markets. The consequences of this would be beyond the scope of even this blog.
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