"Somber August Days"

Sydney M. Williams

Thought of the Day

“Somber August Days”

September 1, 2010

A deep, dark gloom is bad enough, but when it is also silent it lends eeriness to an otherwise dismal month. August, which started so promising with a 208 point gain in the DJIA, saw the S&P 500 decline 52.27 points (- 4.7%), with volume on the consolidated tape running 31% below a year earlier. Volume has been ebbing since May and on Monday was the lowest of the year for the consolidated tape. Global equity markets have lost more than $2 trillion in value since Treasury Secretary Timothy Geithner termed this long, hot, dry period, the “summer of recovery.” “August Horribilis”, is the term Queen Elizabeth might use to describe the month should she be long U.S. equities. Of course, as the four-greats granddaughter of George III (and perhaps still bearing a grudge), she may consider the month “August mirabilis”, saying it serves us right and that money is simply quitting its wrongful owners.

Light volume may be principally a function of dispirited investors escaping the heat and despondency so familiar to those of us who have stuck it out in the City, but, as I wrote in an earlier piece, it may also reflect a retrenchment in high frequency trading programs. Providing some credence to the latter postulation, volume on the NYSE, while down, did not on Monday set a record for the year or the month of August. Two other Monday’s in August, the 9th and the 16th had lower volumes than that day.

Bearishness may not be rampant, but it is becoming more the norm. Over the weekend, Bob Farrell noted that the AAII Individual investor poll fell below .50 for the first time since early July, a number below which generally portends at least an interim low.

Economic news has been equally somber: unemployment continues to be weak, home sales are at multi-year lows, as are auto sales and banks remain cautious as to lending. However, curiously, while the S&P 500 is down 5.5% year-to-date, prices of high-yield bonds, using the FINRA-Bloomberg Index, are up, with interest rates declining from 9.57% to 8.50%, suggesting speculation is around, just not in stocks.

Into this dour world has arrived on my desk a report from Empirical Research Partners, a fascinating report on the state of the money management business. Words and phrases like bundling, commoditization, low-priced beta, liability-driven investing, absolute-returns, uncorrelated, volatility and complexity fill the pages – words that have become increasingly commonplace in investing and are attempts to describe what was once an art and which is now perceived a science. Responsibility for this change that has been underway for two or three decades comes from the confluence of a number of factors: the rise of consultants who have worked actively to narrow the benchmarks against which managers are measured (consultants earn their bread moving money from one manager to another), the advent of computer trading programs and the concomitant hiring of quantitative analysts, and more recently the rise in volatility and the abysmal performance of stocks over the past dozen years. I would add another qualitative factor and that is the unrealistic return assumptions of businesses and unions, who are responsible for defined benefit retirement plans. By using exorbitant return assumptions, a promise to employees could be made while the company could avoid making contributions which could hurt the profitability of the company. Similarly, unions have been able to promise guarantees without subtracting funds from the current earnings of their workers. The effect has been to kick the proverbial pail down the road, leaving the dirty work of cleaning up the mess to some future employer or union leader. In the meantime investment managers, as the authors of the report put it, “are slouching toward liability-driven investing”, a euphemism for watching one’s back.

I have been in this business long enough to be somewhat cynical as to anyone who can plan with precision the future course of events, especially when it comes to investing, a field which is notorious for attracting not only the bright, but the unconventional. The one thing we can say with certainty is that, as long as companies need markets to fund their operations, there will be stock and bond markets. The advent of indexing and ETFs – at 15% of assets, still a relative small slice of the equity world – does not eliminate the need for the underlying securities, in fact they require them. One could argue, that in an investment world increasingly populated by index funds, ETFs, HFT portfolios, etc. the analyst who can differentiate between an attractive investment and a poor one will become the “content provider” – the value link in the chain.

What is more important, as we enter a new month, is how and when do we exit this slough of despond. Like most questions of this sort, I have no answer, other than to quote Abraham Lincoln who when speaking in Milwaukee in 1859 quoted an “Eastern monarch”: “’And this, too, shall pass away’. How much it expresses. How chastening in the hour of pride – how consoling in the depths of affliction.” August ends; September begins.