One of the long-term themes on Zero Hedge over the past two years has been that beginning in 2009, following the Fed's total incursion in all capital markets, mostly in equities due to the highest delta on consumer net wealth as a function of stock price upside, any type of traditional stock picking (long-short but also virtually everything) has ceased to matter. Various hedge fund manager retirements in 2010 merely confirmed the acceleration of this trend. The complete elimination of volatility in what has become a policy weapon merely means that day traders are also leaving stocks in droves and heading for places where the Fed's complete domination has yet to manifest itself, such as commodities, bonds and FX, where vol has surged over the past two years. Today, we present Iridian Asset Management's most recent market thoughts, which confirms the observations in the Morgan Stanley report posted a few days ago on Zero Hedge discussing the firm's fears that a 2007-like quant collapse is coming as there is no longer any normalcy in the market, on why stock picking as a business is now dead. Obviously, we couldn't agree more.
From Iridian Asset Management:
How bad is this combination of high correlation and low volatility for stock pickers? Consider the traditional factors of stock picking differentiation, factors such as momentum, growth, and value. The squelching of volatility in the equity market, which some have characterized as the shooting of a tranquilizer dart into an elephant, combined with the increase of risk-on / risk-off behavior, has led to a phenomenal muting of these factors. The Morgan Stanley quant team shows this result dramatically in the chart below.
In this way, then, the story of 2010 was very different from the story of 2009. In 2009 stock picking mattered, but the stock picking that worked was to pick the most beaten-down stocks possible, the cheaper the better, regardless of other characteristics. Any factor with price in the denominator was a big winner. Any other factor was a big loser. In 2010, however, there were no big winning factors or big losing factors. Everything was washed out in a tsunami of liquidity, so that the only winning bet was to be short volatility. Or as expressed earlier (and in some memorable You Tube cartoons), “Buy the dip!” In a year where 94% of total S&P 500 gains occurred in the first trading day of each month, where hedge funds portfolios traded en masse up and down more than ever before, where short selling has become the almost exclusive province of HFT algorithms, where trading positions and limit orders are arbitraged away faster than ever, can one really claim that fundamental stock picking mattered one bit?
The real question, of course, is whether this hostile environment for stock pickers is likely to change. We believe that that likelihood of a change in our favor is very high. Can 2011 be a repeat of 2009, where buying cheap stocks (and where “cheap” is understood purely as a function of price) is the winning allocation? We think it unlikely with an S&P 500 back over 1200, with stocks routinely trading at doubledigit multiples of sales and triple-digit multiples of earnings. Can 2011 be a repeat of 2010, where correlations continue to increase and volatility continues to decline? Certainly it’s possible, if QE 2 morphs into QE’s 3, 4, and 5, if the Plunge Protection Team re-defines its role as the No Down Day Protection Team, and if the Federal Reserve continues to engage in explicit asset bubble-blowing.
But the truth is that the world remains, to use Nassim Taleb’s terminology, a remarkably un-robust place. The truth is that volatility may have been driven out of the equity market, but is running rampant in the much larger forex, commodity, and US Treasury markets. The truth is that political risk – meaning the chances of a disastrous policy decision in the US, China, or Europe with enormous unintended consequences – has never been greater. The truth is that securitization is still dead, sovereign debt is systemically mispriced, and the Great Moderation is over.
We are not saying that the sky is falling. On the contrary, we believe that there is a meager but selfsustaining recovery taking root in the global economy. This is what we mean by muddling through. But the impact of unprecedented fiscal and monetary stimulus around the world has been to mask the winners and losers within this muddling through process, to make, in the words of Huey P. Long’s campaign slogan, “Every Man a King.” In a free money environment every financial asset is a king. It is impossible to short stocks and the only imperative is to buy. But at some point the stimulus ends. In fact, as anticipatory mechanisms, markets require only the expectation of a reduction in stimulus for a shift in dynamics to occur. When that occurs (not if, but when), synchronized co-movement in asset classes should decline. Volatility should, if not increase, at least achieve a level commensurate with real economic risks. Stock picking should matter because the natural separation between winners and losers in a muddle through world will be visible once again.
We submit that – unless you are prepared to believe that the relationship between State and Market has been permanently altered, such that volatility can be artificially squelched and correlations can be artificially maintained forever – then this is a good time to go long stock picking. From a top-down perspective, we believe that historic wide spreads between correlation and volatility provide a compelling risk/reward opportunity for portfolio managers who are naturally short correlation and naturally long volatility.
We are naturally short correlation because we are stock pickers, because we have non-consensus, divergent opinions on future winners and losers. We are naturally long volatility because these divergent opinions are based on event-driven and thematic catalysts. Typically, about half of our portfolio consists of stocks that may be principally understood as an expression of a theme, and the other half will be populated by individual names with discrete catalysts. Often events generate an investment theme and in this way they interact, although we caution our investors not to get too carried away with the distinction between events and themes and to remember that these are ways for us to bring what we hope is a divergent view to the companies we examine. Whether categorized as an event or as a theme, our catalysts can all be defined as idiosyncratic agents of change.
Full report, which to frequent readers will have little new to add...