Near Record High Correlations: Is this the End of the Fundamental Value Investor?

As stimulus induced economic indicators drove financial markets
higher through the end of 2009 and into the middle of 2010, many
financial advisors and researchers believed the Great Recession was
taking its final breath and believed they bore witness to a forceful yet
successful example of a proper response to a endemic crisis by
policymakers around the globe. Fast forward to the present and you find
that the Eurozone solvency crisis, the US economic slowdown and the
Chinese real estate/lending bubble forces general economic consensus to
move from that of recovery and prosperity to a gloomier picture of a
return to output contraction or more realistically, realization that we
never really left the period of economic contraction sans hefty
government stimulus.  Although it was a while ride, much of what
BoomBustBlog has alleged has come to pass in terms of the condition of
global banks, global economic output, and the prospects of the companies
and countries that we cover. Most sell-side economists have lowered
their GDP growth outlooks to near 1% for the next quarter, and more
attention is being focused on central bank officials and the idea of new
stimulus measures – all pretty much in line with our prognostications
throughout 2008 and 2009.  The problems has been that regardless of
monetary policy, new stimulus and the growing need for them markets have
moved with incredible correlation and very low dispersion among stocks
over the past few quarters making it very difficult to monetize the fact
that we have been right all along. These recent events beg the
question, “Is this the end of the Stock Picker?” and if so, then “What
does this portend for the future of the investment markets when casino
style gambling has returned better results than adhering to
fundamentals, math and basic common sense?” “Has the Fed destroyed the
fundamental investor?” Let’s peruse the topic as illustrated in the
mainstream financial media:

Stocks Move with the Market: CNBC

• 78% of the S&P 500 simply moves with the market and ignores underlying fundamentals
• CNBC attributes this to the rise of algorithmic trading and death of
  traditional stock picking, however, correlations have been higher in
  eras that lacked heavy algorithmic trading

Correlation Soars on S&P 500: WSJ

• Individual stock correlations to the S&P have reached their highest point since the crash of 1987
• Movements have forced fund managers from examining long term
  fundamentals and into quick moves into cash, treasuries, and investment
  grade corporate debt

Fund managers continue to express discontent over this new market
behavior. Fundamentals do not matter for the time being, as the
prevalence of fear in the marketplace continues to reign regardless of
perceived economic progress.

Global Macro Funds Suffer Too: Marketwatch

• Rapid swings in market moves have caused some very prominent global
  macro managers to leave the business, despite a plethora of historical
  success
• Those who bet on deflation were punished in the first part of the
  year, while those who shorted treasuries have been punished to the tune
  of over 100 basis points since yields peaked

Correlation Matrix Tracking 12 High Volume Equities against the SPY

Notice that most major companies have seen significant correlation
with the broad market despite a wide diversity in performance and
economic outlooks. Although many have poo poohed hard fundamental
analysis, we at BoomBustBlog have still managed to hit quite a few home
runs by parsing those companies (and countries) prospects that are in
truly dire straits or are very significantly diverging from their
historical paths. Spain, Greece, Ireland and their respective banks come
to mind (see the Pan-European Sovereign Debt Crisis Series), and more recently our expose’ on the prospects of Research in Motion (see As
Research in Motion Continues Its Inevitable Downward Descent In Both
Equity Value and Market Share, Investors Should Tweak Their Assumptions
Accordingly)…

CBOE Data on S&P 500 Implied Correlation

Correlations are not exclusive to stocks.  Market movements have
resembled a pattern of “risk on” and “risk off” behavior for an extended
period of time.  This pattern has crossed global markets and even into
emerging markets, where indices seem to be tracking developed markets. 
This should pose a concern to investors who have turned to emerging
market investments for a variety of reasons.

Global Markets Fail to Differentiate for Two Years

Correlations have even crossed asset classes, specifically the
Australian Dollar and Japanese Yen pair have tracked the S&P 500 as
an indication of risk taking in the market (equity buying & carry
trading for FX).

Pure stock pickers are certainly in trouble, and for a variety of
reasons.  First, many traditional stock pickers fail to “diversify”
their holdings, and will overweight their portfolios with long only (or
positive delta) strategies, with short interest coming in at record lows. 
Those that have been following BoomBustBlog for an extended period of
time know that the markets are overvalued on belief that an American
consumer recovery is right around the corner.  Not only is that not the
case, but following the research  published back in early May explicitly indicating  shorts in the US consumer market and retail stocks would have paid off incredibly.

Playing off the first problem with value investing, most value
managers fail to understand the difference between traditional academic
economics and value investing (and the voodoo speak oft heard in the
mainstream financial media) and the actual economic facts on the ground
and how they develop into the big picture.  Greenlight Capital’s David
Einhorn elaborated on this back in 2009 at the Value Investing
Congress.  Failure by bottom-up investors to recognize and prepare for
big picture economic events is one of the greatest downfalls of value
investing.  No one is exempt from the macro picture, regardless of
investing approach (the full speech can be found here).

So, how do stock pickers and value investors generate alpha in the
face of rising correlations, the apparent death of fundamentals in the
marketplace, and high frequency traders pumping prices using fuel from
markets synthetically elevated by the Fed?  Aside from the traditional
answers such as hedging using shorts, puts, and volatility instruments,
investors will have to develop some sort of systemic macro strategy as
buy and hold equity investing obviously shows the need to be tweaked
with 21^st century tools.  Historically, when correlations
have reached these levels, it is a result of some sort of fear related
to global systemic risk.  Herd mentality can put value investing,
research, and analysis in the temporary backseat while global events
become the talk of markets.  Understanding these events will be the key
to which portfolio managers become winners in the coming months and
years.

Through the past three years of BoomBustBlog research, we have
combined value, forensic fundamental research and macro analysis for
global equities across a variety of sectors ranging from consumer retail
to commercial banks.  Those that are willing to ditch the Modern
Portfolio Theory’s definition of “diversification” (which we have seen
over the last few years have provided nothing of the sort) and seek
assets that will return on macro events will be rewarded in terms of
absolute gains and will be among few managers and advisors who earn
alpha even as rising asset correlations cause some of the most
successful money managers to quit.  The next decade of investing in
financial markets will likely produce a new brand of success, exclusive
from those go-go momentum managers of the 1990’s and early 2000’s who
bought almost any stock and saw impressive returns for clients,
basically charging 2 and 20 for leveraged beta under the guise of
alpha.  The landscape of money management and financial research is
changing drastically from the days of traditional bottom-up value
investing, and the rise of managers who mix investment strategies
(bottom-up forensic analysis and fundamental value with global macro)
appears to be waiting to capitalize off an elongated Recession.

For those who lament the new difficulties of investing in these times
of extended global turmoil, consider it one of the very unpleasant side
effects of The Great Global Macro Experiment, BoomBust Cycles, and the Refusal to See the Truth

Comments

[Charlie Brown]

Besodemuerte: "Anyone with Downs could've made a fortune during Buffet's time just by blindingly throwing money at the stock market."

Sure, pal.

[Charlie Brown]

In fact, the article could not be more wrong.

The whole world having apparently ABANDONED the grunt-work of valuation (and now seemingly trading upon nothing but technical mumbo-jumbo) is EXACTLY what places the true value investor firmly into the driver's seat: the "technician" is actually ALWAYS at the mercy of somebody else, in reality -- while the value buyer is firmly in control of his own destiny.

Look, folks... back when Warren Buffett bought his $1 Billion worth of Coke (at under $5 a share), it was a badly out-of-favor stock -- the "technicals" were BEYOND horrible. In fact, after Warren had bought his fill, a reporter actually asked Warren if he'd perhaps made a mistake, and if he regretted buying a Billion Dollars worth of Coke -- since the stock had fallen even yet further since Warren had bought his shares.

"I only wish I could buy more," said Warren, calmly.

Price is nothing but what you PAY.

Value, however, is what you GET.

If some technical-minded chart-reading dumbass wants to sell me eBay for $5 a share because he feels that the "technicals" are somehow bad, I'll buy all the shares he wants to sell at that price. After all, any idiot can see that eBay is essentially debt free, has a massive free cash flow, and has cash (and equivalents) of $6 or so per share ON HAND.

Sell me your eBay at $5 a share because you think you see some spooky ghost in the charts, Mr. Technical Dumbfuck, and I will, as a value investor, take you straight to school.

A value investor in a world of technicians is like a shark in a sea of schooling fish: the unthinking herd will always group together, basing their decisions upon whatever the rest of the herd happens to be doing at the moment. That places them in a position of horrible weakness -- and leaves the independent mind of a true value player fully able -- and well-positioned -- to skin them alive.

Show me the technical "analyst" with a net worth of Warren Buffett.

Show just one guy, just one technician with Warren Buffett's net worth.

Yeah.

That's what I thought.

There ain't one.

[wackyquacker]

okay, Becky

[Reggie Middleton]

I fail to see how you have shown the article to be wrong.

[besodemuerte]

Agree Reggie.

All I gathered from Charlie Brown's post was a lot of Warren Buffet dick-riding.  Anyone with downs could've made a fortune during Buffet's time just by blindingly throwing money at the stock market.  Nowadays though, since upwards of 60% of market volume is done through HFT algos, I can assure you Charlie Brown that nobody gives a shit about fundamentals and 'value' anymore. 

If I were a fundamental value investor I would short the market until it hits 600 on the S&P, and barring massive money creation it very well may soon enough.  The problem is that even though fundamentals always win out in the end, it's impossible for one to predict all the shenanigans that banks/Fed/governments will do to flip-flop this market six ways from Sunday.  My philosophy every day is leaning towards what 'they' want the market to do rather than what actually has value or what technicals tell me.

[doolittlegeorge]

This is by far the most cogent expression of your thoughts Mr. Middleton and for what it's worth I applaud you for it.  It is not easy to express let alone be heard and as a consequence make money from it, no!  The "technical" expression is called "getting blood from a stone" and I've seen the rare man who is capable of such things though I am not that man myself.  I take note that the word "fundamental" appears quite often in this string and I am sure you have noted that as well.  Needless to say "nothing is more fundamental than a sovreign debt crisis" as you have so consistently reported.  I cannot speak to your analysis other than to say "when dealing with the government you deal with a unique set of realities."  The least of these is of course that "government determines reality in all things."  In my view I always remember this:  I am but one man.  "They" are much more than that.

[williambanzai7]

CONSIDER THE ALTERNATIVE

http://williambanzai7.blogspot.com/2010/09/what-could-be-worse.html

[tom]

Correlation increases as more and bigger ETFs trade the whole index not its parts. Lots of people don't trust money managers (I wonder why) and prefer to scrimp on fees with a robotic index tracker.

[RockyRacoon]

I reiterate my position:  Screw the stock market.   Gimme gold.

[Yikes]

They'll return in time. However, it'll require a take down of the equity markets first and then real financial reform (ie not the Dodd/Frank type).

[andyupnorth]

RIMM is from Canadia, eh?

[geno-econ]

You said all it---Investing has become casino style gambling with relevant characteristics such as;

mathematical modeling ,use of computers and anomolies 

insider trading, tips and leaks

leveraging bets, using icon hedgefund gurues 

enormous increase in side bets, use of derivatives, swaps and collateralizing

reliance on house chips to retain value---US$

All this is counter to fundamental long term investing and efficient use of capital but wonderful for enriching  short term gamblers.

[Sudden Debt]

Can you remind me again what fundamentals are? It's been a while.

[williambanzai7]

It's a buy call from Cramer and Warren

[williambanzai7]

75% of trading volume is done by machines programed by people who scoff at fundamental analysis. Should we be surprised at the outcome? SAFE TO RETURN http://williambanzai7.blogspot.com/2010/09/safe-to-return.html