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At Arm's Length: 09.28.05
Without reform to the Alternative Minimum Tax, any discussion about making the 2001 tax cuts permanent would not only be misguided but sad to say, typically Bush.
October finds us feeling smug. We survived a month where history suggests that the markets flounder. We have survived a month that saw two hurricanes rip through a major energy producing and refining area of the country and all we felt was a steady uptick of oil prices - which had been happening steadily before the storms made landfall. We have survived a month where Greenspan continued on his geriatric pace of raising rates which added strength to the dollar while the yield curve on the Ten-year Treasury began to price in more short term, overnight rate hikes in the future.
September did nothing in the way of adding incentive to invest. It did end the third quarter on the plus side, which is the case so far for the year, but the upside feels only slightly better than even. How we got to that point is a completely different matter, complicated by the possibility that we may be wholly unable to stay there.
The S&P 500 added a gain of about 3.1% for the third quarter. Not bad until you consider how tight a range the year's activity has been. As if stuck in the mud, the index of popular large cap names has been bouncing around the 5% plus or minus range for the entire year. This is not the kind of activity that spurs investor confidence and barely warrants a sideways glance.
Sure we survived September and the optimists are out in full force suggesting that the fourth quarter will be the one that solidifies those paltry gains. But I'm not so sure. October has been a month of huge market disasters and we seemed more poised for just such an event than a sudden, year-ending rally.
The markets seem to be chasing short term positions on an increased basis. This flight to risk comes with a believable set of reasons. The high quality names, the one you buy and hold for more than three months are showing signs of increased strain under the pressure of higher energy prices, a less accommodative borrowing environment, and the specter of increased inflation. Those high profile members of the S&P 500 are most susceptible to consumer dissatisfaction.
It pays to keep two things in mind as we move into the last quarter of the year. First and not least of which is the fact that September did not pull back as expected. Used as a comparison and a sort of market adjustment, September pull backs usually make the fourth quarter look better than it really is. It didn't happen. Instead of celebrating the accomplishment, investors should begin to worry.
Their worry would be well founded in next quarter's earnings. Expect companies to be flush with cash again and unwilling to spend it, except of course, on themselves. Buying back shares simply shows investors that there are no good reasons to try and grow the business. Share buybacks will become the straw that broke the beast's back.
The strength that should have waned as the summer months ended did not and this will find traders with nothing but self-congratulations for savvy speculation and fancy footwork. Although, the last week's rally was more window dressing for professional money managers who are sending out performance updates to their investors, it is indicative of how this whole year has gone. Who, and I ask this rhetorically, would commit any money to a market full of fits and starts and anemic returns.
The second mental note any good investor should make is the growing presence of program trading. This type of activity is not based on fundamentals, the kind of research that delves into the strengths and weaknesses of the a company and purchases shares based on a whole slew of data. Referred to as "macro plays", program trading involves buying stocks in groups and has, somewhat quietly, become one of the dominate features of this market.
This is in part because of the growing presence of Exchange Traded Funds or ETFs. Program trading involves rebalancing of stocks within certain indexes on a regular basis, depending on weighting, a fancy term used to adjust how much each index owns at a given moment in time. Following indexes such as the S&P 500 and the ten subdivisions of the index makes the individual investor seem archaic. ETFs keep expenses down to a bare minimum, an advantage individual investors do not have.
Is it the death of the stock picker? Unlikely. Currently, ETF trading amounts to about half of the market activity but their influence on specific sectors can be quite impressive. If one company reveals a problem ahead, ETFs can effectively bail on similar investments bringing the pain of one to many.
There is also a fine line to walk for these types of funds. Mimicking an index too closely can allow eagle-eyed investors to literally beat you to the trade. Fail to be transparent enough and the SEC will be interested in what you are doing. And with the advent of truly actively managed ETFs on the horizon, expect more and more of the market to be moved not just by external events such as weather, retiring Fed chairmen, inflation and deficits but by fund managers moving stealthy in the background.
Feel smug while you can, this market through the end of the year will not be as easy to predict as you might think.
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