HOME OF "PICTURES OF A STOCK MARKET MANIA"
August 18, 2004
Longboat Global Advisors CROSSCURRENTS
Alan M. Newman, Editor
We maintained a bearish slant in the last issue, although we took no positions. Our comments included, “We continue to believe that the bear case is intact” and “we still see a far higher probability of very negative news catalysts than positive events.” Oil prices, lackluster economic stats, poor job growth and the booming trade deficit proved that point in spades. Unfortunately, our vacation loomed and we decided that any position was a position we would not be able to follow in the mountains of Tennessee. At this juncture, it is extremely difficult to find reasons to turn to the bullish case, although we suspect the market “deserves” some kind of brief rally attempt. Trouble is, most of our work can easily support further downside, short and intermediate term. We would not be surprised by a few days of recovery but will be sorely tempted to short, especially if short term sentiment begins to turn optimistic. There has been precious little expansion in volatility and we find nothing in our work yet to suggest any huge moves on the horizon. The most likely case dead ahead appears to be the same; not enough volatility to make position taking a great idea. Even the typical fall swoon is now somewhat in doubt. We may even soon adjust our “2004 low” case detailed below to somewhat higher levels. About all we can do here is lay the groundwork for position opportunities. The Trading Stance feature will take a 30% short position in the SPY if the SPX achieves 1105, but in any case, we will certainly issue a Special Update when our confidence improves. The highs for 2004 have likely already been put into place at Dow 10753, SPX 1158.98 and Nasdaq Composite 2152, all print basis. Continued lack of volatility seems likely. Please don’t shoot the messenger.
Every quarter, Morgan Stanley releases a report on the growth of Exchange Traded Funds ("ETFs") and every quarter we examine the implications. Growth has been spectacular. Total assets of ETFs have risen at a better than 45% annualized rate since 1999 and the number of ETFs have risen at a comparable rate. Thirteen of the ETFs trade an average of over one million shares per day and the total annual dollar trading volume of ETFs traded is now more than $3.25 trillion, approximately 13.2% of all trading on U.S. markets, a percentage that grows with each passing day. The Nasdaq QQQ trust is unarguably the most popular stock trading entity ever developed, averaging over 105 million shares every day and by itself is now responsible for roughly one of every $27 traded in the stock market. Despite the many arguments put forward by academics concerning the legitimacy of derivatives and their importance in coercing an "efficient" market, we strongly believe the evidence is to the contrary. By far the most rapid development of ETFs has been in the period from 1999 to date, and instead of stock prices benefiting from efficiency, both Nasdaq and the S&P 500 ballooned into a manic peak and then collapsed and still remain depressed, yet overvalued. Given that ETFs are all indexes, the proclivity towards indexing has increased hand-in-hand with their extremely rapid growth. Tacked on to the effects of plain vanilla S&P indexing, we have ensured an environment where stocks cannot be efficiently priced, except by accidental occurrence. To very briefly explain the paradox, which we have gone over countless times before, the vast majority of indexing favors higher capitalization issues. Regarding this circumstance, assume an index of three stocks; stock A is capitalized at three times stock C and stock B is capitalized at two times Stock C. For every $6 invested in the index, $3 must necessarily be invested in Stock A, $2 in Stock B and $1 in Stock C. The investments are made totally with respect to capitalization and each company's fundamental prospects has absolutely no bearing on the amount invested. Thus, more money is eventually thrown at companies with poor prospects and less money is invested in companies with superb prospects. The result: pricing inefficiencies. Over time, the inefficiencies must grow and eventually corrupt the investment process, rewarding and penalizing companies in relation to their size. To those who are quick to defend the derivative environment, particularly the rapid growth in indexing and ETFs, we can only demur by pointing out that all movements, however small, create inefficiencies. The proof is that prices constantly change, even from moment to moment. In the past, and at least in theory, inefficiencies could eventually be corrected by investors or speculators acting on fundamentals and pricing securities appropriately to account for new or ongoing developments. As indexing and growth in ETFs continues unfettered by any notion of fundamental prospects, the ability for investors and speculators to act on the prospects for individual issues is simply overwhelmed by indexing and other trading, including but not limited to program trading activity. There are 160 ETFs trading today. Growth is so phenomenal that there are plans in place for an additional 37 ETFs to be listed before the end of the year. Where does it end? The U.S. stock market is 99% represented by the Wilshire 5000, correct? Yet, there are 4600 mutual funds and as many as 6000 hedge funds trading not only the very same 5000 issues, but virtually hundreds of sectors and indexes comprised of the very same shares! Question: where is the fiduciary responsibility for money managers to invest in the best company - the company with the best prospects? Answer: missing, for the most part. A significant reason why tech weightings ballooned during the mania was growth in indexing and the creation of ETFs. There are now almost 615 million shares of the QQQ Trust outstanding. Each share of the trust is comprised of one share of each of the 100 constituents. Those shares were either purchased and deposited or simply deposited to exchange for shares of the trust. Either way, a tremendous demand was created. Enter the mania until finally, the mania exited, stage left. ETF growth explodes, financial stocks take center stage. Total Stock Market VIPERs are now comprised of 22.2% Financial issues; iShares Russell 3000 are now comprised of 21.6% financial issues; iShares S&P 1000 Index is now comprised of 20.3% financial issues. Can someone say "encore?"
Alan M. Newman
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ABOUT ALAN M. NEWMAN
Alan M. Newman has been the Editor of CROSSCURRENTS since the first issue was published in May of 1990. Mr. Newman is also a member of the Market Technician's Association and has been widely quoted for years by the financial press, media, and other newsletters and has written articles for BARRON'S.
The newsletter is published 22 times per year and focuses on economic and stock market commentary, often covering controversial subjects. Several proprietary technical indicators are usually featured in every issue accompanied by current interpretation. Every issue features at least one technical perspective, which may have either bullish or bearish implications. Broad samples of our work can be viewed at http://www.cross-currents.net/.
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