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CARZ ETF Zooms Ahead On 10-Year High Auto Sales

In August, the automakers witnessed the highest rate of increase in light vehicle sales in the U.S. in 10 years. Sales on a seasonally adjusted annualized rate (“SAAR”) surged to 17.81 million units in August 2015 from 17.3 million units in August 2014. This was the highest pace since July 2005. Moreover, the SAAR finished above the 17 million mark for the fourth straight month in August. However, U.S. light vehicle sales nudged down 0.7% year over year to 1.51 million units in August 2015. Low oil price, a recovering economy, improving labor market condition, and easy availability of credit with lower interest rates and longer repayment periods were the main reasons behind the surge in sales on a SAAR basis. However, the inclusion of the Labor Day weekend in September this year, compared to August last year, resulted in a year-over-year decline in August sales figures. While Ford Motor Co. (NYSE: F ) registered the highest year-on-year improvement in August among the major automakers, General Motors Company (NYSE: GM ) recorded the best sales figure for the month in absolute terms. Auto Sales in Detail Ford reported a 5% increase in U.S. sales from the year-ago period to 234,237 vehicles, witnessing its best August sales in nine years. Meanwhile, FCA US LLC – controlled by Fiat Chrysler Automobiles N.V. (NYSE: FCAU ) – recorded a 2% year-on-year gain in sales to 201,672 vehicles, registering its highest August sales since 2002. This was also the 65th consecutive month in which the company reported a year-over-year gain in sales. However, General Motors recorded 270,480 vehicle sales in August, marking a 0.7% year-over-year decline. Though retail sales improved 5.9% to 224,978 units, the company witnessed a 24% plunge in fleet sales in August. Separately, sales performances from the major Japanese automakers were disappointing last month. Toyota Motor Corporation’s (NYSE: TM ) sales went down 8.8% year over year to 224,381 units. Sales also declined 5.3% on a daily selling rate (“DSR”) basis from the year-ago period. Moreover, Honda Motor Co., Ltd. (NYSE: HMC ) recorded a 6.9% year-over-year decline in sales on a volume basis to 155,491 vehicles in the month. Also, Nissan Motor Co. Ltd. ( OTCPK:NSANY ) reported a 0.8% year-over-year decrease in sales to 133,351 vehicles in August. Catalysts Behind the Surge The overall improvement in the U.S. economy has helped the auto sector to register solid gains in the past few months. The “second estimate” released by the U.S. Department of Commerce last month showed that the GDP in the second quarter advanced at a pace of 3.7%, significantly higher than the first quarter’s rise of only 0.6%. Though the economy created only 173,000 jobs in August, down from July’s tally of 245,000, the unemployment rate declined to 5.1% from July’s rate of 5.3%. Meanwhile, the market is witnessing a freefall in crude prices since the middle of last year. In fact, the price of West Texas Intermediate (WTI) fell nearly 60% as compared to mid-2014, when oil was trading above $100 each barrel. This oil plunge is also playing a major role in boosting auto sales. Moreover, automakers are aiming to increase market share by offering large incentives and discounts to customers. Additionally, banks are providing more car loans with lower interest rates and longer repayment periods. Further, the high average age of cars on U.S. roads has led to increased replacement demand both for cars and for parts. CARZ in Focus The auto ETF – First Trust NASDAQ Global Auto ETF (NASDAQ: CARZ ) – gained nearly 2% following the release of the auto sales report on Sept. 1 through Sept. 3, before losing 2.2% last Friday. It has a decent exposure to the above-mentioned stocks, excluding FCA US LLC, and is thus poised to gain from improving auto trends in the coming days. The ETF tracks the Nasdaq OMX Global Auto Index, giving investors exposure to automobile manufacturers across the globe. The product holds 37 stocks in the basket with Ford, Honda, Toyota, Daimler and General Motors comprising the top five holdings with a combined allocation of more than 40% of fund assets. In terms of country exposure, Japan takes the top spot at 36.6% while the U.S. takes the second spot having around 24.8% allocation, followed by Germany with 19.1% exposure. The ETF is unpopular with $32.4 million in its asset base and sees light trading volume. The product seems to be slightly expensive with 70 bps in annual fees and has a dividend yield of more than 1.7%. The fund has a Zacks ETF Rank #2 (Buy) with a High risk outlook. Bottom Line The improving auto industry has been one of the drivers of the recent economic growth in the U.S. Auto sales will continue to be a tailwind for the economy in the coming days. It is also speculated that the auto sector is poised for further gains given the favorable macroeconomic fundamentals. Original Post Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Are Risk Parity Funds ‘Mad, Bad And Dangerous To Know?’

Summary Various people from both the sell- and buy-sides have blamed risk parity funds as well as trend-following CTAs and certain “smart beta” practitioners for recent market volatility. While these techniques certainly could contribute to volatility in crisis periods — there are few investment techniques that couldn’t — to single them out is misleading and self-serving. Risk parity has its place in the markets, and its place may well be increasing, as investors understand it better. But it still is not fully tested. In particular, how it behaves in crisis situations is not fully understood. Its behavior over the last few weeks has, however, been reassuring. There is mounting and quite vocal criticism of risk parity and other investment techniques that seem to display option-like sensitivity to changes in market volatility. The argument against them is that, in certain conditions they can destabilize the market: as volatility increases, they may respond by trading in ways that increase volatility further. While this accusation may not be entirely unfair, this characteristic is hardly unique to these funds, and it is unreasonable to single out these investors for recent market volatility. Feedback loops between volatility and selling pressure have been built into many aspects of modern markets as well as human nature. The contribution of risk parity and similar products to the recent spasm of market volatility was not even a fraction of the tip of the iceberg. Without further investigation, this might have been ascertained simply by looking at risk parity AUM. In addition to somewhere between $400 and 600 billion in worldwide institutional assets managed according to risk parity principles, there are a handful of publicly-available mutual funds practicing variants of this technique, none of them very large. These include Salient Risk Parity Fund ( SRPAX ), Putnam Dynamic Risk Allocation Fund ( PDRFX ), AMG FQ Global Risk-Balances Fund ( MMAFX ), Invesco Balanced Risk Allocation Fund ( ABRZX ), and Columbia Active Risk Allocation Fund ( CRAAX ) and the AQR Risk Parity Fund ( AQRIX ). Background There are numerous bells and whistles that can be incorporated with risk parity techniques, so that the concept has become rather diffuse and easily slips over into “smart beta.” The basic idea grew out of dissatisfaction with the standard, mean variance optimization approach to portfolio construction, with its paraphernalia of efficient frontiers, etc . The objection was simple: optimization relies on return forecasts that are rarely realized by actual asset class behavior, and it tends to craft portfolios in which the most volatile asset class ─ typically the equity component ─ accounts for the overwhelming majority of their volatility. This suggests that diversification according to the standard formula is doing little to mitigate risk. Since it is precisely the returns on the most volatile component that have most consistently confounded forecasters, proponents of risk parity argue that mean variance optimization has led consultants, trustees and CIOs astray. They claim that portfolios with more consistent performance can be constructed by targeting volatility rather than targeting forecast returns. Assumptions must still be made about future standard deviations and coefficients of correlation among assets, but at least the shakiest assumptions, about returns, can be eliminated. In its simplest implementation in a two asset portfolio, this insight would drastically reduce equity exposure and substantially boost fixed income holdings compared to the rule-of-thumb 60/40 portfolio: to contribute the same level of volatility to the portfolio as fixed income holdings, equity exposure would have to be cut back to about 24%. Without leveraging the portfolio, however, in most circumstances this implementation would also produce drastically reduced returns and would attract few buyers. Naturally, things become more complicated as more assets are included in the mix, but the principal remains essentially the same: each component is weighted and if necessary leveraged so that it contributes the same amount of volatility as each of the other components. If expected returns for a targeted level of volatility are not satisfactory, performance is boosted not by overweighting the riskier assets, but by including more risky asset classes or leveraging the less volatile ones, for instance through the futures market. Thus risk parity portfolios often include commodities and real estate as well as equities, and are typically leveraged 1.5x to 3.0x. The example shown below on the left is unleveraged, which accounts for its somewhat lower expected returns than the example of mean variance optimization on the right. (click to enlarge) There is no agreement among risk parity practitioners as to how return objectives should be set, and consequently, what the “appropriate” level of portfolio leverage is. This is hardly surprising: any such decision is completely exogenous to the theory, as it should be . Theory is getting into dangerous territory when it attempts to dictate investors’ risk tolerances. It is clear, however, that reasonable leverage of the less volatile components of this sample portfolio could raise its projected returns to the levels expected of the portfolio on the right. The Root of Recent Criticism Obviously, a proposal as radical as risk parity has attracted considerable criticism from virtually all sides ─ after all, it rejects most of the basis of Modern Portfolio Theory, dating back to 1952 and enshrined in all finance curricula. It is not my intention to review these criticisms, which is far too technical an undertaking for a short article, and many of them are unpleasantly contentious or self-serving. Rather, I confine myself to discussing the recent criticisms offered by Chintan Kotecha and Marko Kolanovic, sell-side analysts at Merrill Lynch and J.P. Morgan respectively, as well as some investors, including the well-known hedge fund manager Lee Cooperman of Omega Advisors. Their criticism has been given wide currency through the attention they have attracted in The Financial Times , Barron’s , Bloomberg , the Wall Street Journal and elsewhere. The issue involves rebalancing in crisis conditions. If the volatility of one asset class included in a risk parity or similar portfolio suddenly jumps, while that of the others remains more or less as before, this will inevitably trigger sales to rebalance the portfolio. The critics argue that these sales are destabilizing for the asset that is already suffering from heightened volatility. The implicit warning is that further increases in assets managed according to risk parity principles, in addition to those managed according to trend-following and some (but not all) “smart beta” strategies, could result in a death spiral of rebalancing giving rise to liquidations, which raise volatility, catalyzing further liquidations which in turn raise volatility and so on. The critics claim to have seen evidence of precisely this sort of behavior during the recent market drama; Mr. Cooperman goes so far as to blame some of his fund’s weak August performance on it. Otherwise, it would be difficult to see why this alleged problem should so suddenly crop up as an issue. After all, trend-following strategies are at least as old as Dow Theory, and I have found evidence for them in Dutch trading practices in the first half of the seventeenth century. While the commissars of MPT orthodoxy were never able completely to stamp out technical analysis and similar heresies, they drove them into narrow and secretive corners, out of sight of polite society for most of a generation. A few firms, such as Merrill Lynch, even continued to employ technicians in their research departments. Their return to respectability is something comparatively new to equity markets, developing gradually since the introduction of equity index futures in 1982 attracted people who had never had much use for portfolio theory (after all, Fisher Black did not believe that commodities are investments) into the equity community. The modern instantiation of trend following as algorithmic trading strategies is only a difference in degree rather than in kind from the days of eyeshades, sleeve garters and three New York baseball teams. “Smart beta” is an even more amorphous concept than risk parity, embracing portfolio construction techniques from equal weighting to fundamental indexing (for detailed discussion see this article ). However, the critics are presumably directing their fire toward those strategies which focus their efforts on maximizing a portfolio’s Sharpe Ratio. Since the denominator of the Sharpe Ratio is standard deviation, the sensitivity of such approaches to changes in volatility is obvious. Even though they may differ significantly from risk parity strategies, they share the need to rebalance if heightened volatility manifests itself in one portion of the portfolio but not the rest. Analysis of the Criticism The critics have, in fact been rather equivocal in their criticism: they do not make it clear what asset allegedly suffered from a feedback loop between its volatility and sales, nor do they make it clear when this allegedly occurred. Detailed data on the trading of the recently most volatile assets of all, Chinese ‘A’ shares, is unavailable. But surely some of the attempt to rebalance risk parity portfolios must have occurred in U.S. markets. And since there are claims that such sales affected other funds’ August performance, some of must have occurred while volatility was particularly high and markets most vulnerable to forced sales. The August spike in volatility was certainly dramatic, but it was by no means a record, nor has volatility remained at highly elevated levels as it did in 2008/9, 2010 and 2011/2. Coming as it did after an extended period of relative market quiescence, however, the return of volatility came as a considerable shock, for which many investors were unprepared. (click to enlarge) The VIX peaked at 40.74 on August 24th. At what point the alleged forced selling due to rising volatility occurred is unclear, since no one except their managers knows the details of risk parity funds’ rebalancing protocols. Some of the critics’ comments imply that these sales may not even have occurred yet, two weeks after that peak, although this begins to look implausible. In any case, the behavior of that portion of U.S. volume reflected in NYSE statistics, while reflecting the usual sharp increase in trading that accompanies a volatility event, does not suggest an abrupt, destabilizing flood of selling:   Average Value of Transactions % Change in NYSE Volume % Change in SPY ETF Volume 8/14/2015 $8,739     8/15/2015 $8,863 3% 9% 8/18/2015 $8,511 0% -9% 8/19/2015 $8,370 22% 141% 8/20/2015 $8,677 9% 12% 8/21/2015 $9,599 41% 78% 8/24/2015 $7,937 26% 46% 8/25/2015 $8,332 -23% -27% 8/26/2015 $7,754 4% -8% 8/27/2015 $8,056 -5% -19% 8/28/2015 $8,158 -20% -41% 8/31/2015 $8,937 5% 2% sources: NYSE, State Street Granted, it is not clear to me how a flood of volatility-induced selling is to be distinguished from rising volatility as a result of a flood of selling. But the evidence I can see for U.S. stocks does not suggest that, this time around, things were notably different from what has occurred during other sudden bouts of heavy selling. The decline in the size of the average trade on the day of maximum volatility suggests that the selling pressure was not, or at least not entirely institutional. This view is reinforced by changes in the trading activity of the SPDR S&P 500 Spider ETF (NYSEArca: SPY ), which of course attracts a great deal of retail attention. The critics do not mention this, but volatility-induced ETF liquidation is likely to be at least as destabilizing as the behavior of the trading strategies with which they are at pains to find fault. And without the aid of algorithms it is as likely to result in a toxic feedback loop, as dropping prices encourage panicky holders to sell, pushing prices down further. During the period shown in the chart above, SPY suffered $10.2 billion in net redemptions ─ and that was just from a single ETF, albeit the world’s largest. Other ETFs, and some conventional mutual funds, had similar experiences. Different risk parity, “smart beta” and trend-following CTAs are each likely to handle portfolio rebalancing in different ways. Some may even apply judgment to the problem: Salient says that its portfolio management “…attempts to capitalize on momentum…” which it does through algorithms, but this suggests an overlay on the rebalancing signals it receives. More explicitly, AQR notes that it reserves for itself “…the ability to exploit tactical opportunities by making modest adjustments, or “tilts,” toward assets that we believe are relatively attractive…,” a practice that might even involve human beings. However, second-guessing can create difficulties of its own ─ as a systematic investor once remarked to me, “If I ignore the machine, from where will I receive the signal to pay attention to it again?” It is likely that all these sorts of investors build some measure of tolerance for changes in relative asset volatilities into their thinking, if only to keep transaction costs in check. A few, such as Columbia, engage in periodic rebalancing ─ once a month, in its case ─ rather than responding immediately to every observed change in volatility. How the critics purport to disentangle these threads is unclear to me ─ I frankly doubt that they can. And if volatility-induced selling only occurs well after the maximum volatility event, it is unclear to me how it can be especially destabilizing. Conclusions, Cautions, and a Thought from Lord Byron I am always willing to bow to contrary evidence, but I have seen none that really suggests that risk parity, either on its own or in combination with trend-followers and “smart beta” aficionados, is any more responsible for recent equity market volatility than other instruments that, in a crisis, are likely to be forced to sell portions of their portfolios. Mr. Cooperman in particular should be aware that restrictions that Chinese authorities imposed on sellers may have forced some of his hedge fund brethren to sell elsewhere, simply in order to meet margin requirements. And I am not aware of any touchstone by which a forced sale can reliably be identified as such from outside the premises of the seller. The unfortunate truth is that panicky human beings are quite able to destabilize the markets without help from machines ─ they have managed to do so since markets were first invented, and doubtless will continue to do so. Risk parity, trend-following and “smart beta” have attracted criticism because they are easy targets: generally misunderstood if they are known at all, mysteriously computer-driven and, worst of all, associated with hedge funds. Risk parity is the brainchild of Bridgewater Associates, the largest hedge fund of all. Since the Crash, populists have ensured that anything that they feel requires discrediting need only be associated with any one of these bogeymen. Stock-pickers such as Mr. Cooperman feel unappreciated, after a long period during which their undoubted talents have gone comparatively unrewarded. And they have a right to object to the fact that markets have been so unrewarding for them, if not perhaps to feel bitter. The markets depend on them: if fundamental values are not ultimately recognized, there is no rational basis for investment at all. But as Keynes noted, macro conditions can swamp the influence of security-specific fundamentals over surprisingly long periods of time, and that has been our unfortunate situation for most of the period since the Crash. Global fiscal irresponsibility, regulatory overstretch, mounting social and military tension, ever more imaginative monetary experimentalism and a host of other issues: why should investors be surprised that their investments have tended to react more to the exogenous market environment than to their own fundamentals? Yet this cannot last forever: fundamentals will out, even if it is a matter of a company surviving Fall of Rome conditions when hundreds of others fail to. Before the China crisis broke out there were signs that the returns to stock-picking were increasing relative to macro trading strategies. I believe that China is merely an interruption in, rather than the death-knell for the recovery of fundamentally-based investment strategies. Not the least of the gifts that recent market volatility has given us is a general reduction in valuations. Judicious picking among them, rather than frantic trading in and out of risk, is the way forward for investors. Which may include risk parity investors. The technique is a method for allocating among various asset classes, and for heuristic purposes is usually discussed in terms of indices for each asset class, but that does not mean that it actually requires a passive investment approach within any given asset class. Asset allocators can be stock-pickers, too, and in fact few of them, in normal conditions, are very active traders. The Putnam Dynamic Risk Allocation Fund provides an example of an active investment implementation of something resembling risk parity, while Salient, AQR, AMG, Invesco focus their portfolios primarily on derivatives, and Columbia combines derivatives with a fund of funds approach. Of all these managers, Sapient and AQR have the “purest” approach to risk parity, which would cause me to favor their funds over the others, all of which apply various tweaks and twists to the basic risk parity insight. But AQR is not accepting new investors, and of course, they and Salient will both miss out on any alpha to be obtained from stock-picking. I think a dose of risk parity or similar “smart beta” strategies will benefit most portfolios, although I would take a wait-and-see attitude toward total conversion of a portfolio to these techniques. The criticisms, however tendentious, indicate a real, if only potential problem for such strategies, and I would like more evidence on how they behave during crises before committing the entire portfolio to them. My preference for a “pure” approach to risk parity is in the spirit of empirical investigation: I want to learn more about how the strategy behaves. August has been tough, and it does not look as though the rest of the year will be a great deal easier. Some readers may recognize that my title borrows from a reference to Lord Byron. Among that poet’s many valuable pieces of advice was, “Always laugh when you can. It is cheap medicine.” Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Vacations, Correlations, Parasites And More Feedback Loops

Whenever people agree with me I always feel I must be wrong . – Oscar Wilde A few weeks ago we highlighted how Value-at-risk models can exacerbate movements in various markets, even ones seemingly unrelated. Since then, this has become the topic du jour, as different pundits catch on to the fact that something is not quite right in today’s financial markets. It’s not that stocks are going down – stocks have been going up and down for hundreds of years. Going down is good. It resolves periodic overvaluations, and creates opportunities for those that have cash or new money to invest. It cleanses the markets of its occasional excesses, and there will always be excesses. But smart investors, who have been around for awhile, are sensing that something is amiss. When Art Cashin, one of the best writers on markets I’ve read, is worried about “another Lehman event,” as he stated on TV last week, I pay attention. So why all the angst? This is a complicated question. As I set out to write this week’s Miller’s Market Musings, I kept getting dragged down different paths, all of them legitimate, and all of them somewhat inter-related. But writing about them all would make this piece a lot longer than I like these Musings to be, so I will explore them in more depth in this week’s Stockpicker newsletter. Some cause happiness wherever they go; others whenever they go. – Oscar Wilde A proximate cause of the recent volatility according to a subset of the financial press, particularly the talking heads on CNBC, is that a large part of the Street is out on vacation. I’ve heard this explanation for market drops many times in the well over 20 years I have been working on Wall Street, and I am convinced that this is simply not true. I’ve worked on the sell-side and the buy-side, and only once have I walked into the office or the trading floor and been like man, where is everybody? The one time I can recall this happening was the Blizzard of 1996, when New York was basically shut down. I was young and dumb and figured eh, I’ll go in, what’s a little snow? I lived in the West Village, and when I finally made it to our offices in the World Trade Center, I was literally one of about 6 people there. So I can see why volume was low that day. But who are these people that are a) so powerful that they move markets all by themselves – or, thought of differently, are so powerful that they calm markets by their mere presence and b) why are they on vacation all the time. I mean, I go on vacation occasionally, but even then I check the markets at both the open and the close and am able to monitor all my positions, in real time, from my Ipad and phone. If I was “the” person moving markets, the person able to arbitrage away the market mispricings and provide liquidity and dampen volatility, I’d like to think that not only would I be diligent and pay attention to markets, even from the Hamptons or St. Tropez, but that I’d have a few employees whom I trusted watching after things for me. You know, in case things happen that provide us the chance to make some money. Like a market selloff. And if things got interesting, and I do think the markets are quite interesting at the moment, and I was the person responsible for moving markets, I’m pretty sure I’d have spent the money on a nice computer and internet connection at my house in the Hampton of my choosing and be able to do the things that I do from there. So I’m not buying the vacation argument. The U.S. isn’t Europe. We don’t go away and do nothing for a month. We take a long weekend, we go away for a week, but if you go to the places where people like to vacation, you’ll see lots of people still on their computers and their phones. Is this healthy? I don’t know, probably not, but that’s how Wall Street works, and you don’t get to be the man behind the curtain by leading a healthy and balanced life. You get to be the man behind the curtain because you’re willing to work harder and longer and sacrifice things, like your vacations. Sure, at the end of the movie the Wizard is revealed to be old and sad and not that powerful, but for the time he’s the Wizard, he’s the man, and he likes it, so he does it. And the Wizard of the market has a good internet connection on vacation. To understand the driver of the recent market volatility, I think we need to understand the cast of characters in this movie. Markets have changed, and what we used to think of as the “investor” really has changed. In the 1800s, markets were dominated by syndicates of related investors who would sometimes corner markets, manipulate them, and profit from them at the expense of somewhat less sophisticated “punters”. In the 1920s, markets became dominated by speculators trading on extremely thin margins who resembled the momentum investors of the late 1990s. They mostly disappeared in the Crash of 1929, to be replaced by more sober investors like the great Paul Cabot, who founded State Street. As the markets churned through the aftermath of the Great Depression, they became slightly more institutionalized, and a diligent and smart investor like John Neff or a young Warren Buffett could thrive on the inefficiencies. A little sincerity is a dangerous thing, and a great deal of it is absolutely fatal. – Oscar Wilde The institutionalization of the stock market in the U.S. in the 1980s was initially a good thing, as an element of the guesswork involved in picking winners and losers was squeezed out. Peter Lynch and other star stock pickers became as well known to the investing public as sports figures were to sports fans. The lingering inefficiencies in the market, mainly due to a lack of easy access to data and information, were mostly removed with the advent of the internet and the widespread availability of financial data. Now, a database of comparable company data that used to take reams of analysts month to build can now be bought for a few hundred dollars, and be searchable and screenable in ways that were literally unimaginable 25 years ago. Today’s active stock picker has more fundamental data available to her than the head of research at a large investment management did at a fraction of the cost. This should have created greater understanding about the true value of a business, as estimating current and future cash flows becomes easier and more widely dispersed. But a funny thing happened along the way. This dispersed information and computing power led to the rise of a two parallel universes of investors who do not make judgments about the value of companies and their securities, but instead simply use the prices of those securities and/or the variability of those prices to judge their value and riskiness. Here is where the market’s structural weakness resides, in funds that have gotten too large relative to their strategy’s capacity. A parasite only survives so long as it doesn’t kill its host. A man who does not think for himself does not think at all. – Oscar Wilde The “Chicago School” refers to a group of professors that came up with the Efficient Market Hypothosis and effectively set in motion the odd market movements we are seeing today and will continue to see in the future. These professors basically stated that all information is immediately reflected in security prices, so there is no advantage to be gained from studying companies or markets. One can simply take a security’s price, at face value, as being correct at all times. This has generally been proven to not be the case, as all information isn’t generally known, some information is hard to ascertain, and some information requires judgement and experience (along with investors willing to give the manager sufficient time and variability in returns to extract this return – but that is a story for another letter) to understand. But unfortunately this idea, however misguided it may be, found a champion in Vanguard, which built one of the largest investment firms in the world based on this idea. Vanguard’s simplistic notion is that since the average investor can’t beat “the market” (whatever that may be defined as), then the average investor shouldn’t try. The only differentiator is cost in the Vanguard world. This is based on some really shoddy statistics (of course the average investor can’t beat the average investor by definition, just like the average person can’t outlive the average person, but that doesn’t mean that eating well and getting some exercise are fruitless endeavors either) and lazy thinking (why use market capitalization except that it is easy?), but nonetheless it has come to define a world called Index investing that has come to increasingly drive markets. Index investors don’t think. They take perverse pride in not thinking. Thinking is bad, it leads to bad decisions, and anyway, it’s not necessary – just define a “market” and then replicate that market. Simple, easy, done. One of the many lessons that one learns in prison is, that things are what they are and will be what they will be. – Oscar Wilde Except that there is a problem. When the parasite, aka, the world of index investors, was small, it didn’t really matter that it was relying on a flawed Efficient Market Hypothesis because it was “good enough” and the money invested in related strategies was small enough to not really matter. It was truly a parasite along for the ride. But the index fund industry forgot that eventually it will kill its host if it grows too large relative to the host. Trillions of dollars now reside in index funds and their related products, Exchanged Traded Funds (ETFs). ETFs are index funds on steroids, because while an index fund only needs to worry about inflows and outflows once a day, ETFs are constantly adjusting their holdings based on supply and demand during trading hours. Again, when the parasite was relatively new and small, the host market didn’t really notice them. They added volume but, critically, not much volatility. But as ETFs have come to be an asset class in and of themselves, somewhat removed from the underlying assets, the feedback loop has been reversed. Whereas once upon a time, the value of the underlying companies determined the price of the ETF, increasingly today it is the trading supply and demand for a particular ETF that is moving the underlying securities. I see it all the time – all the components of say, the Alerian MLP ETF (NYSEARCA: AMLP ) or the KBW Regional Bank ETF (NYSEARCA: KRE ) will rise or fall together. A change in an investment firms’ allocation to an “asset class” will immediately ripple across all the stocks or bonds in the ETF, regardless of whether or not all the stocks and bonds deserve to be treated the same. The defining characteristic of how their securities will behave in the short-term is now almost always their sector and their market cap, not their product or prospect for future success or failure. Absent the 4 times a year when companies report their earnings (in which case fundamentals do determine the near-term stock movements), the day-to-day movements in stocks have become more synchronized. Correlations are up because the driver of prices over short periods of time is simply money flows into an ETF. As index funds and ETFs have become the investment of choice for many investors, price movements within sectors have become more homogenous, and securities in them are more correlated to one another. However, I believe that the weird feedback loops markets are experiencing lately is because all financial markets are now tied to one another as a second parallel universe of investor – the “risk-parity” investor, has garnered more assets under management. These investors look at asset classes, like foreign bonds or emerging market equities or currencies, as just things to be modeled and leverage applied to based on expectations for future returns and volatility. I read an article last week where the head of a firm with hundreds of billions of dollars in risk-parity investments said, effectively, that his firm doesn’t make judgments about securities individually, but only about asset classes and their theoretical returns and the variability of those returns. They then lever up the asset classes with lower expected volatility to get to a “market” level of volatility, and they then do this across asset classes globally. Which led me to ask myself – if everyone is now an indexer, or a derivative of an indexer (ETF) who assumes that the prices being generated by the other indexers, none of whom actually thinks about things like the businesses these companies are in, or their values, or what the possibility of disruption to the business is, then who is driving the bus? In other words, who’s deciding what these companies are worth now that the parasites have taken over their hosts? Consistency is the last refuge of the unimaginative. – Oscar Wilde After initially being alternately annoyed and scared by the realization that multi-billion dollar businesses have been built on top of a faulty foundation and then new, even more fragile businesses have been built on top of them, I’m now quite happy that this has happened, because while it has made my job much more frustrating on a day-to-day basis (“Why is that stock down 4% on no news?), it is also creating many more opportunities for intelligent, rational, and most important, active fundamental investors to make money over time. I believe that we are nearing, if we haven’t already reached, a tipping point in markets in which the parasites have become the hosts, and the prior hosts can now become the parasites (in a good way of course, because I’m one of them), feasting off of the market disturbances that are occasionally created by these feedback loops and VAR model driven selloffs. Index investors and their risk-parity cousins have become the hosts for a new version of parasite ( fundamental, active investors who are not benchmark huggers ) that takes advantage of these dislocations to buy great companies at distressed prices. The opportunities that await those that are flexible enough to take advantage of them will be tremendous. This week’s Trading Rules: Twelve month predictions are worthless; play the game in front of you. Playing the game requires self-discipline. Observe the moment to moment changes in the market and then compare them with your beliefs. Act when opportunity arises. If you’re going to panic, panic early. It’s a lot less painful. Last week’s market action was a bit ragged, but stayed within our support and resistance levels. The S&P 500 ended the week on a sour note, falling into the close on Friday. This weeks levels: Support: 191, 188/189, then 183.50/184. Resistance: a lot at 197.50/199, then 201 and 205. Positions: Long and short U.S. stocks and options, Long SPY Puts.