It was only a few short weeks ago that I wrote the first part of this article—a time where the market tunnel only seemed to get darker, with no light in sight.  After one of the worst September starts recorded, we have just ended the 4th day in a row of market gains.  The truth of the matter is that neither one of the facts stated in the preceding sentence really has much value for long term investors.  There are so many unanswered questions and conflicting opinions from “authorities” surfacing the exchanges, investors, and markets alike, are starting to get some serious whiplash damage from all of this volatility.

All investors really want today is their confidence, finally attained just a few short months ago, back.  As discussed previously, confidence is not a tangible item, and can be gained just as quickly as it was lost—and [ironically] for the very same underlying reasons in some cases.   But in order for investors to get their confidence back, we must commit to looking at the facts at hand, in addition to ignoring the noise.

America is only an AA rated country now!

If this statement was really true, it would be widely accepted by the investment community, and not contradicted daily by the positive performance of the US treasury prices and weekly auctions following the downgrade.  I believe my wife was best at putting this rating downgrade in perspective by saying “we’re AA in comparison to what/who?” A rating of anything is always compared to a certain “par” standard if you will.  With that being said, who is better than the US right now? Not by some controversial rating agency, but reality.  Would you prefer to have your money held in the other countries that are still rated AAA, just because of their rating—ignoring the fact that they depend on our economy and currency more than we will ever be able to depend on theirs?

It seems to me that the S&P ignored their own systems and decided to publicize their personal opinions of our current administration and political situation by issuing this downgrade.  None of us were happy about the games our government has been playing recently, but I don’t think anyone else stopped doing their job in retaliation.

*Of course everyone knows the story about how this very same “Rating Agency” completely enabled the subprime market debacle by issuing AAA ratings to any issuer that would just pay them their fee, regardless of how horrifying the underlying securities were. To make matters worse, they issued a AAA rating on a subprime mortgage security right after they downgraded the United States of America just last month.  So let me get this straight, the S&P believes that a bunch of “individuals with a faulty credit history” are more likely to pay their debt off—in an economy where I would boldly assume some of them are currently unemployed—than the richest country in the world, that is coincidentally capable of printing their own currency?  Regardless of what your political opinion is (I’m not a fan either), think about the absurdity of that statement for a second. On one hand, we have individuals that have a proven faulty credit track record, and are likely collecting the government’s endless unemployment money.  While on the other, we have the richest country in the world, that can print more money if they are not successful at generating the money fast enough to pay their debts.  It seems to me that McGraw Hill (owner of the S&P) should take steps to completely shut down the agency (or at least replace everyone from top to bottom) before they make the move, recently announced, to split up the company.  To summarize, a rating is only as good as the quality of the rater.  Since the S&P has not only acted in what my wife believes to be borderline Treason, but also infected the markets with their stupidity, I feel like if we cannot force them to be shut down, we should at least ignore their ratings on the USA.

Meredith Whitney and the Municipal Blowup That Never Happened

It was just a year ago when analyst Meredith Whitney gave a prediction that the $3+ Trillion Municipal Bond market will have some 50 to 100 major blowups, totaling hundreds of billions.  Fortunately she was wrong.  As of May of 2011 (when I revised my 2009 Municipal Bond article with some recent facts), there were only a total of 64 Municipal defaults totaling $5.4 Billion (0.2% of the market)  since the start of the recent crisis.  This of course does not mean that other defaults are not a possibility, because as we all know “past performance is not a guarantee of future results.”  The point I am trying to make is that the fear of danger is sometimes more destructive than the danger itself.

There are quite a few municipalities that have to cut costs and explore multiple measures in order to address the current circumstances.  But I don’t believe we are quite at the point where Mrs. Whitney’s prediction is something to be concerned about.  It was not too long ago where the media wouldn’t shut up about the risk of default by the state of California (and others).  The way I looked at it then and now is that if the government was generous enough to bail out some private financial institutions, and foreign countries, at their time of need, I would expect them to lend a hand or two to one of their own states, especially when that state is considered one of the top economies in the world today (even after the crises).

Although Whitney’s prediction has not come to fruition, she’s not alone in this business.  As Vince Lombardi once said, “If you’re not making mistakes, you’re not trying hard enough.”  In this business, both bulls and bears are bound to be right at some point.  The tough part is the timing.  As a side note, Whitney recently announced on CNBC that she may be launching a new rating system to compete with the S&P, and other rating agencies.  Her timing on starting the new business couldn’t be more perfect, and the competition is too busy digging their own grave.

Is the Volatility Here to stay?

Though this may not be the most optimistic section of this article, I am afraid that the answer to that question is more important than anything else I have written, if you plan on investing in the market.   Simply put, the volatility is here to stay and will only get worse. In fact I have been predicting higher volatility and 1000+ point swings/day, as the new normal for some time now.  I believe that time is near, if not already here.  On a positive note, the volatility does not always have to be on the negative side of the market.  It could just as easily go up as it did go down recently.

Most non-professional investors are passive on the day to day movement of the markets, and usually look at the closing prices for the market indices.  The Dow Jones ends up or down a couple of hundred, and the others are performing the same.  From that perspective, this is a movie we have seen countless times for over the past decade.  What many of these investors don’t realize are the huge tsunami swings that we have to navigate from the open to the close of business each day.  These swings can easily add up to over 5% in a matter of hours, and sometimes even minutes.

The cause of this volatility has nothing to do with the fundamentals of our economy or markets.  It has to do with the change in the infrastructure of our markets today, to cater to High Frequency Trading firms, who have taken control and responsibility for the majority of the daily trading in our markets.   When I first came into this industry in the late 90’s, this computerized trading monster was a very small part of the market, which was mostly unnoticed.  Today, HFT firms control close to 90% of the daily trading volumes. These HFT firms have created algorithm programs that allow their computer systems to make their trading decisions for them, and take action to execute those decisions without human interference.  What, when, how much to buy or sell.   Since a computer does not have the physical and emotional limitations that flesh and blood have, it can execute thousands of trades in seconds, in comparison to a typical trader that can just do a few.

The advocates of High Frequency Trading continuously argue that this additional volume has benefited investors by making the markets much more liquid, which has led to a rapid decrease in trading costs.  That sounds great and all, but “At what cost?”

What many investors and regulators have not yet realized is that High Frequency Trading has changed the markets’ infrastructure to such a degree that it has created a systemic problem that could overwhelm any crises we have yet to see. Although liquidity and lower costs are definite pluses for investors, the increase in volatility is something that will only get more extreme as more and more HFT firms open up shop, while existing ones increase their computer power.  To breakdown this complex new problem into very simple context, here is the root of the problem.  Despite the fact that each of these HFT firms may have different algorithms to use for their own trading, they’re all indirectly tied to each other.    So let’s say 100 computers have some XYZ Index on their radar screen.  Once XYZ reaches a certain target (whether a price target, percentage move, or any other trigger), many of these computers will end up executing the same trade at the same time, magnifying the effect dramatically more than any human can ever handle—think May 6th, 2010 flash crash.   These genius mathematical programs have a simple mathematical flaw—there can only be just so many trigger points.   So regardless of how each of these algorithms were calculated to come up with the trigger point, once that point is hit, they all take the same action—magnifying the effect on the (XYZ Index )market with very few limitations.

This magnified effect can happen in both directions so quickly that investors have been part of market swings of hundreds of points without even having enough time to realize that it even happened.   This systemic problem has changed the infrastructure of the marketplace to such a degree that I have recently come to the conclusion that most traditional investors are in such an uneven playing field, it would be close to impossible for many of them to make money in the market in the years ahead without making drastic changes. This is not because I believe the market won’t go up, but rather because the volatility from point A to point B is going to be so extreme, that most investors will not be able to survive the journey.

It’s not about one strategy or another.  Whether you buy and hold, like we have done for clients since I first started in the business, or trade in and out of the market, I believe any plain vanilla strategy is at a disadvantage.  Mutual funds that only depend on their investments going up, since they do not short any investments, are eventually going to either become obsolete or restructured.  Traditional buying and holding is still a good core foundation, but to be effective it must utilize additional tools most investors are just not familiar with, nor nearly active enough to truly utilize effectively.  Diversifying in everything (or some index) is not really investing in my opinion, and just says the investor has no clue what they’re doing.   Buying stocks because of their dividend yield does not make much sense to me either.  A 5% dividend is nice plus for some people, but does that really matter if the stock is down 40%?

Trading the market day to day may have become cheaper for investors to do on their own using discount brokers, but will inevitably lead to much higher losses for many.  This is not to say that HFT is going to be the only way to make money, but rather to say that the game is changed enough to force anyone interested in having a real chance to adapt to the markets regularly.  Of course I have always had a biased opinion about investors using professionals to manage their money, but something tells me that I won’t have to continue arguing that point for very much longer.

Long Term buy and hold is still my preferable choice of investment strategy.  But the only way this can be done effectively, is if we add countless tools to hedge our positions, use multiple asset classes, navigate the market opportunities carefully & regularly, and constantly tweak the strategy in order for it to adapt to the lightning speed changes we are racing against every day.

To say that the last few months have been a difficult market environment would be an understatement.    Few investors have escaped the market’s wrath unscathed, at least not intentionally.  But this leads me to my core point of this article, strategy!  One of the most difficult things for a money manager to do is to know when to second guess themselves, and when to just adjust.  Most investors that are losing money automatically believe that something is wrong with their investments.  This may be the case, but rarely is it the case for all of your holdings if your money manager did his job to begin with.  Although there are quite a few economic and political problems the world (and some businesses) is facing today, the facts show that the problems are not as great as it may seem.  It really matters how you view everything.  For some a 9% unemployment number is horrifying, while others can simply look at the fact that it also means we have 91%% employment.  Of course we can always improve, and I am optimistic that we will in time.  The adjustments necessary for most portfolios have more to do with the infrastructure of the market than the economic circumstances we’re in.  It is very difficult to convince the world (and investors) to take action before the problem is there, but hopefully many will take action before it is in fact too late.

All the best,

Yaron “Ron” Reuven

President & CEO