Market Risk Aware Investors


market risk

April 08, 2012

Introduction to Market Risk

The holiday-shortened week seemed to be a case of the bulls going on holidays early! By the time the market closed on Thursday, a few of the favorite major equity benchmarks pulled up just short of psychologically significant round-number levels. There are many theories floating around as to why this occurred……such as……

• Spain's surging bond yields,

• the timing of the Labor Department's March payrolls report, etc.,

…..but traders simply weren't that interested in buying stocks last week.

However, looking ahead to the start of first-quarter earnings season, there appears to be evidence that this choppy trading range could eventually resolve itself to the upside -- even if hedge fund managers continue to sit on the sidelines as they have done so for quite awhile now!

Investors Are Reprogrammed for Market Risk

"Target-date funds have been one of the industry's bright spots. Total assets in the funds have swelled more than 380 percent since 2005, to about $343 billion as of September... Since the 2008 debacle, many providers have diversified their holdings and added investments designed to protect against falling markets and inflation... Pimco uses derivatives such as options and futures in its target-date funds 'to hedge against severe market dislocations and shocks,' says John Miller, head of the company's U.S. retirement business."
- Bloomberg Businessweek, March 29, 2012

"Investors pulled another $3.53 billion from domestic equity funds in the week ended March 28, according to data compiled by the Investment Company Institute... That marks the sixth consecutive week of outflows, during which investors have pulled about $13 billion from U.S. equity funds."
- The Wall Street Journal, April 5, 2012

"After two mostly positive months, all hedge fund strategies lost ground in March, according to the Credit Suisse Liquid Alternative Beta indices. The overall index dropped 0.83%, cutting its year-to-date gain to 2.21%. By contrast, the Standard & Poor's 500 Index rose about 3% and is up more than 10% on the year. Managed futures funds were hardest hit on the month, dropping 1.41% to wipe out its 2012 gains. The strategy is down 0.79% on the year. Event-driven funds shed 1.18% (up 3.11% YTD), global strategies lost 0.9% (up 1.04% YTD), merger arbitrage lost 0.35% (up 0.26% YTD) and long/short funds fell 0.12% (up 4.76% YTD)."
- FINalternatives, April 3, 2012

"However, as in the March 2009 rally, some CTAs' [commodity trading advisors] algorithms haven't taken advantage of the sudden rebound in equities, while they have also [been] caught out by choppy, volatile commodity markets. AHL said this week it was hit by a fall in energy prices... According to HFR, assets in the macro sector, which it defines as including CTAs and global macro funds among others, have swelled nearly 60 percent since 2008... Some funds have also cut market risk to attract clients, which reduces potential losses but also makes it harder to deliver the type of profits seen in 2008."
- Reuters, April 4, 2012

The U.S. equities market experienced impressive gains in the first quarter of 2012, and if you go back to October 2011, or even March 2009 -- periods that encompass six months and three years, respectively -- the gains have been equally impressive.

Contrarian Investors” should be quite excited about the continued prospects for further gains after reading the excerpts above – particularly in regard to the context of the strong price action during the recently concluded quarter, the previous six months, and the past three years.

”When sentiment is running countertrend, as it is at present, the chances increase that the current trend will persist far longer than expected.”

For further reading check the article on “Contrarian Trading.”

This article is based on an explanation as to how you can use analysis in contrarian trading to find out which stocks have the muscle to keep climbing in the suddenly wobbly market environment -- complete with a list of potential bullish and bearish picks.

Also included is a short summary of a contrarian philosophy, along with some simple indicators that can be used to determine the sentiment surrounding a stock.

Market Risk Strategies

Stocks have managed to advance amid an investment crowd that, after experiencing two bear markets and a flash crash over the past decade or so, has been reprogrammed to respect market risk and prepare for the worst. This growing appreciation for market risk has resulted in strategies that effectively act as headwinds for the market through asset diversification, as investors flee the equities market for other assets -- such as gold, bonds, currencies or emerging markets -- and/or welcome hedging strategies with open arms, with many directing money toward higher-fee hedge funds that are employed to manage risk.

Hedge Funds and Market Risk Management

As has been discussed frequently over the past few weeks, it appears that hedge fund managers have pulled back from equities, as analysis of the options market suggests that the hedging activity typically associated with accumulation of equities among these market participants has drastically slowed. The hedge fund performance statistics for March and for the year to date, which display significant under performance in a strong market, confirm the speculation that:

1. Hedge funds are underweight equities, with some increasing their bets against equities. Note that long/short funds were negative last month during a rally by the S&P 500 Index (SPX - 1,398.08).

2. Hedge funds are overweight underperforming sectors, such as commodities and energy, and underweight the outperforming groups.

However, with consideration of the above statements, the market is at its best when hedge funds become constructive on the market from an underweight position. For the past few weeks, these managers have been less constructive, and during such phases, the market has typically followed this change in sentiment by trading in a range or experiencing a short-term correction. Moreover, many technical indicators hinted at the growing possibility of sideways movement a few weeks ago. The markets are obviously experiencing a choppy phase now, with the S&P MidCap 400 (MID - 984.28) struggling with the 1,000 area, and the SPX wandering around the 1,400 level and experiencing its first close below its 14-day moving average since early March.

Weekly Chart of MID since February 2011

MID since Feb 2011

Sentiment Perspective for Market Risk

From a sentiment perspective, it may be that the choppiness at present will be resolved with an upside move, as the prevailing pessimism isn't consistent with the price action. For example, anecdotally, many are bracing for a 5%-10% correction -- suggesting cash is still on the sidelines, ready to be put to work. Hedge funds are underexposed to U.S. equities, and given the significant underperformance, fund managers will eventually have to move out of an underweight position and/or out of underperforming assets, such as gold.

Also, according to the most recent survey by the American Association of Individual Investors (AAII), only 38% of those surveyed are bullish, which is the lowest percentage of bulls so far in 2012.

Conclusion for Market Risk

Finally, as discussed last week, expectations are low heading into the upcoming earnings season, thereby setting the stage for positive surprises. An example of these reduced earnings expectations was reported in USA Today earlier last week:

"Analysts expect S&P 500 companies to report 0.8% quarterly earnings growth, down from the 4.5% growth they expected at the start of the year, says S&P Capital IQ."

The continued view is support for the SPX in the 1,370 -1,380 area, which is around the index's 2011 high and the current site of its rising 40-day moving average. Potential resistance is in the 1,450-1,470 area -- the SPX target after the inverse "head and shoulders" breakout above 1,260, and site of the May 2008 peak.

Daily Chart of SPX since April 2011
With 40-Day Moving Average

SPX since April 2011


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