John Authers

Just a brief post to pass on a thing of beauty. Critics of market-capitalisation weighting for indices always complain that you are in effect always buying the companies that are most overvalued. There is a lot of truth in this.

In the chart, Ned Davis Research create an index with just one stock in it: the biggest by market value at the time. As soon as a company is overtaken it is replaced in the index of one by the new leader. Trivia devotees may like to know that there have only been nine such stocks in the last four decades: Apple; AT&T (though not in its present incarnation); Altria (once known as Philip Morris); Cisco Systems (beneficiary or victim of the most absurd episode of equity overvaluation in history); ExxonMobil; General Electric; IBM; Microsoft; and Wal-Mart. All are undeniably great companies that at some point since 1972 the market thought to be worth more than any other. Here is how these companies performed compared to the S&P 500, starting in 1972: Read more

John Authers

Is there really any way that financial engineering could cure cancer? That was the argument that MIT’s great Andrew Lo made during a visit to London last week, and being an entrepreneurial finance professor he is now trying to bang the drum to get his idea off the ground. If he has his way, he will end up creating a $30bn cancer “super-fund” that will invest in 150 different anti-cancer projects.

It is if nothing else a fascinating idea. I wrote a Monday column on it, while the Economist’s Buttonwood (in real life a former Long View writer) blogged on it. Both of us came out broadly in favour. My video interview with Professor Lo appears here:

 

Andrew Lo on Cancer

 

Virtually all of us as humans would like it to work. Does it actually stand a chance? More on that after the break. Read more

John Authers

Today’s Note video is with the MIT economist Bob Merton – famous both for winning a Nobel memorial prize for his part in drawing up the Black-Scholes options-pricing theory, and for his part at Long-Term Capital Management, the hedge fund that nearly brought down the world credit markets when it came to grief just a year later in 1998.

Prof Merton was talking about a profoundly important subject. We know that the world’s credit markets were dangerously interconnected entering the crisis. He and a team at MIT are now working out how to measure that interconnectedness, in the hopes that by understanding the phenomenon we might be able to get to grips with it better this time. The alarming finding is that credit is even more interconnected now than it was before the crisis. The video appears here:

 

Connectivity-climbs-post-crisis

 

As we tried to cover a lot of ground in under five minutes, some extra detail on how Merton produced his findings might be useful – see after the break. Read more

John Authers

Yet again, it is time to rain on the parade of the many people who are excited by the new high set on Tuesday by the Dow Jones Industrial Average. The rally in US stocks is impressive, however you measure it. But the Dow remains a fatally flawed index, and there is no reason why anyone should pay any attention to it. I said this as the Dow hit landmarks back in 2006 and 2007. Here goes again.

As an index of only 30 stocks, the Dow is not broadly diversified and is not representative of the US stock market as a whole (the S&P 500, by far the world’s most widely followed index, is more important for that purpose). Its stocks are not uniformly large enough to qualify as a “mega-cap” index (try the Russell Top 50 instead). Neither are they sufficiently dominated by industrials (despite the name) to qualify as an industrial index (the S&P 500 industrials sub-index might work better for that). Read more

John Authers

Today sees the publication of Credit Suisse’s annual Global Investment Returns Yearbook, a mammoth piece of research into global long-run returns overseen by the London Business School academics Elroy Dimson, Paul Marsh and Mike Staunton. It is an invaluable resource, and this blog is likely to mine its contents for some days to come.

Revisions for this year help ram home one quick and spectacular lesson from history. Baron Nathan Rothschild is widely believed (wrongly, according to historian Niall Ferguson) to have said that you should “buy when there’s blood in the streets”.

Much of the time this advice works. Buying into Japan or Germany after the second world war would have worked out extremely well, and the greatest buying opportunities almost by definition come when it seems almost mad to buy.

But the aphorism is not infallible. This year, the academics tried to address their concern that their global stock market index suffered from “survivorship bias”. So they have recalculated them including three new countries that were not previously covered in their attempts to calculated the global equity risk premium: China, Russia and Austria. Adding these nations hugely changes the perception of long-term risk.

Let’s start in Russia. Any bold contrarians who decided in the late 19th century to bet on Tsarist Russia to outperform the US for the long-term, and held on even during the great political unrest of the attempted revolution of 1905, would for a long time have looked very clever.

The chart compares the St Petersburg stock exchange’s composite index performance with that of New York. After 1917, of course, the value of any equity investment in Russia was wiped out. This might appear to be an exceptional example. But it is not. China also had a revolution that led to the closing down of its stock market (and of capitalism for a while), and that happened within living memory. On the eve of the second world war, China’s returns looked very healthy. With the arrival of Mao, shares went to zero (and international investors have had a rough ride even since Chinese stock markets reopened).

Using the MSCI China index, covering stocks available to international investors, those who bought in 1993 have actually lost money. But Chinese stock markets have been recovering recently. And, deliciously for those who like historical ironies, the Shanghai Composite, the main domestic index, bottomed last year at 1949, the year of the revolution. Read more

John Authers

Has the Great Rotation already started? A couple of startling data points from the last month, covering treasury yields and flows into equity funds, certainly suggest so. But the picture is maddeningly unclear under closer examination.

First, there is the treasury bond market, as discussed in last week’s video with Mike Mackenzie, before 10-year yields had risen above 2 per cent (they’re back below today). Significant rises in yields would be an obvious sign of a rotation. You can see that video, and Mike’s emphatic argument that if the equity rally makes any sense at all then the rotation out of bonds must be coming, here:

Note that even with the brief move above 2 per cent, there is still a way to go before the inexorable downward trend in yields that has now lasted more than a quarter of a century is breached.

The other obvious data to look at concerns flows into equity mutual funds and exchange-traded funds. Until very recently, the trend to pull money from equities and transfer it to stocks has continued unabated. Stephane Deo of UBS discussed this with Ralph Atkins in the Note video available here:

Again there are signs of change, but not enough to make the call that the “Great Rotation” has already begun. Most startlingly, TrimTabs, which can publish flow data quickly because it uses algorithms to derive estimated flows from funds’ performance, found that inflows to all equity mutual funds and ETFs this month have already topped $55bn. That beats the previous monthly record, set ominously in February 2000 on the eve of the dotcom crash. Read more

John Authers

Active investment still has some active defenders, at least in the UK, to judge by the reaction to a recent Long View on the subject. And digging into the reasons for active funds’ persistent problems, it is easy to see why. Despite the claims of the Efficient Market Hypothesis (EMH) that it is impossible to beat the market other than by luck, it appears that an impressive number of managers do achieve the feat.

The problem is that they do not manage to beat the index by enough to be able to pay themselves and still pass on a decent performance to their clients. In other words, to quote Jack Bogle, the founder of Vanguard and the spiritual father of index investing, the case for passive investing rests on the CMH (Cost Matters Hypothesis), not the EMH. Read more

John Authers

Hedge fund returns should not be compared directly to equity benchmarks. Hedge fund marketers will always say this, and with some reason: hedge fund strategies have a different risk-return profile from equities. Many allocate a lot of money to “short” positions, betting against the market. So it is not necessarily that surprising or damning when equity hedge funds suffer a very bad year compared to the index, as happened last year. That was a big part of my discussion with Hedge Fund Research’s Ken Heinz in the latest Note video:

But it is interesting to look at how hedge fund investors seem to have behaved. And in aggregate, they look a lot like classic retail mutual fund investors, chasing performance and piling in after a good run. Inflows to hedge funds last year were slightly lower than they were in 1993, according to HFR (and obviously far smaller in percentage terms). The great boost to hedge funds’ assets came in the years after the dotcom crash of 2000, when many funds managed to rise. Read more

John Authers

Goldman Sachs’ strategists are currently roaming Europe on their annual Global Strategy roadshow. As nobody can lightly ignore what Goldman is saying, the themes emerging from the London event were interesting.

Of particular concern are the prospects for corporate earnings; Japan; and the hope that 2013 will at last be the year for a “great rotation” out of bonds and into stocks.

On earnings, David Kostin, their US equity strategist, explains their view in the video below. In a nutshell, margins are high, but without a recession (which nobody expects) there is no need for a sharp reversion to the mean. Instead, forces such as shale gas will help profitability, but there will be little increase in margins as in many sectors they are already at historical highs. So margins stay at their plateau, and earnings rise gently thanks to the gentle recovery of the economy.

On Japan, bullishness is what might almost be called a “consensus contrarian” call. Many people are talking bullishly about Japan, despite its decades of under-performance. So many, indeed, that it is hard to call this call contrarian any more. Read more

John Authers

How is the US election affecting markets? Well, it seems that investors expect re-election for President Barack Obama, and their degree of confidence about this has increased remarkably in the last week. Mitt Romney’s bad stretch, as far as the markets are concerned, seems to have finished him off. That is the subject of today’s Note video, with Gideon Rachman.

 Read more