June 4th, 2010

Dear Clients & Friends,
US stocks lost 8.0% in the month of May, and dropped 1.5% on the year.  European markets are down 0.2-8.4% YTD, and Asian and South American markets are down 1.4-11.2% on the year.  No one seems to remember that world stocks gained 70-100% over the previous 13 months.  The number one question on our clients' minds is "Are we gonna lose 45% like last year?"  The answer is emphatically, "No!"  In the era of the high frequency trader and the exchange traded fund, it seems so quaint to remind our clients that 573,000 jobs were gained in the first 4 months of 2010.  The May jobs report disappointed in that, after excluding 411,000 census jobs, only 20,000 jobs were added for the month. However, initial jobless claims are falling, continuing claims are falling, average hours are up, average wages are up, and temporary hiring is up.  Employment remains a trailing indicator on the state of the US economy.  GDP growth is in the 3.0% range, inflation and interest rates remain near generational lows.  Earnings reports were spectacular, rebounding far better than expected from the 2009 recession. 
We tell our clients that it is reasonable to expect the stock market, net of dividends, to grow 8-10% year, with our current forecast at the low end of that range.  The volatility is murder!  The S&P 500 swings 1-3%/day, 5-10%/month.  How can our clients have the courage to commit to their stock allocations?
The Parable of the Lifeboat
The cruise ship sank.  The passengers climbed into a lifeboat.  Dry land lies over the horizon 500 miles away.  If the passengers sit in their seats, pull on the oars and bail when necessary, they'll all reach safety.  Unfortunately, some of the passengers panic easily when storms blow up.  Other passengers have decided to steal food and water.  The passengers rush first to one side, then the other, violently rocking the boat.  With each roll, some passengers fall out, while other decide to jump out, reasoning they can swim to shore faster than the boat will carry them.  The ship's officer in charge of the life boat just sits in the bow doing nothing.  Eventually the lifeboat swamps and all drown.
Cute story, but what does it have to do with the stock market?  Why does the stock market exist?  To enable savers to direct capital to corporations, which will use those funds to expand sales and profits.  In retirement, the savers will pull their capital out of the market, but younger savers will take their place.  Financial markets first appeared in Europe in the 12th and 13th centuries as debt, agricultural and commodity markets.  The first formal stock markets appeared in 1602 in Amsterdam and in New York in 1792.  Though not immune to frauds and bubbles (the South-Sea Company prospectus advertised, "For carrying on an undertaking of great advantage; but nobody to know what it is,") the stock market mechanism enabled the creation of real wealth at a rate far exceeding any previous experience in human history.

In recent years, it seems that investors and regulators have forgotten that the primary role of stocks markets is to facilitate capital formation.  If all investors, which include individuals and families, pension plans and endowments, simply bought and held index funds, they'd all achieve a reasonable long term return (like passengers who sit still, row and bail, and eventually make dry land.)  Not a very glamorous strategy, and for sure investment advisors couldn't charge outrageous fees for such plain vanilla.
So clever advisors came up with all kinds of schemes to enhance returns.  Some advisors have abandoned investing in individual companies and instead rapidly shift their clients' assets among industry, sector and long/short exchange traded funds (ETF's.)  Other managers increase their clients' returns through leverage (hedge funds and private equity investors.)  A whole generation of retail investors grew up following the daily advice of Jim Cramer and the "Fast Money" crowd on CNBC (and are now like passengers who jump back and forth with each wave that rocks the life boat.)  Meanwhile, the High Frequency Traders bomb the market at every opportunity, taking profits (the passengers who steal food and water) without creating value.  The SEC and exchanges have abandoned any pretense of regulating the markets (the officer of the lifeboat won't discipline the passengers.) 
The lifeboat hasn't swamped yet, but it sure is taking on water.  Average Americans were net sellers of stocks from March 2009 all the way through the recent April high, and sold even more stocks over the last month. 
The last decade was the peak saving years for baby boomers born between 1950-1960, but with stock returns negative over that time frame, those investors have nothing to show for their efforts.  Many of our clients are hesitant to add to their stock allocations because, "it's all a game rigged against me!"  Problem is, what are their alternative investments?  Money markets yield close to zero nominal returns, negative real returns (after factoring inflation.) Bond yields barely cover inflation.  Commodity prices are extremely volatile in the short run, match inflation in the long run.  Foreign (Europe, Japan) markets are less attractive now that the dollar gains daily.  The best returns in emerging markets may well be behind us.  Real estate prices in the US should be flat over the next decade (sure prices have gained modestly of late, but there is a vast overhang of property which will come on market the moment seller think he or she can break even.)  Gold?  Art and collectibles?  Lottery tickets?
Why the Uptick Rule Matters
Neither the SEC nor NYSE and NASDAQ can come up with a convincing explanation of why the Dow suddenly dropped and recovered 1000 points on May 6th.  The dirty secret is that the market performed exactly as it was programmed. 
Apple 30 day chartA retail investor gets advice to buy Apple at $260 and enter a trailing stop at $230 "for protection."  A trailing stop becomes a market sell order if the stop price is breached, which means that the execution price may be $230, or it may be a lot lower  if that's the market price on execution.
On May 6th, the fill on the $230 stop loss could have been as low as $199.25, delivering the investor a 25% instant loss for no fault of their own.  (We never use stop loss orders, by the way.  We regard them as a.) a mechanism to "buy high, sell low" and b.) if we've researched a company properly and someone offers us a 25% discount, we'd want to buy more!). 
If you're a clever HFT trader, you use "flash orders" (small offers to buy and sell that are canceled before execution) to sniff out where the stop loss orders are.  Then, around 2:30 in the afternoon, you load up a sell program on a thinly traded industry ETF.  At 3PM, you fire off the sell program knowing that other HFT traders are doing the same thing.  The price of the ETF plummets, then arbitrage programs kick in, buying the ETF while shorting the underlying stocks.  As the stops are breached, a huge surge of sell orders hits the market, further dragging down the ETF, which triggers more underlying stock sells, which cascades into more stop loss orders.  The granddaddy of arbitrage meltdowns was the
Dow Industrials 10 day chartmeltdowns October 1987 stock market crash, which dropped stocks 22% in a day.  But we have seen mini-crashes almost daily for the last month (stocks up at 2:30PM, down sharply by 4PM) and we saw similar mini-crashes in the October 2008-March 2009 timeframe.
In principal, a trader may not short a stock or ETF without first borrowing the security.  In practice, as long as a security is on the "easy to borrow" list, traders can naked short at will knowing that they'll have a flat position at day's end.  These traders do an end run around the SEC's Regulation SHO, which acted to curb short-selling ("bear raid") abuses in April 2005.  Since 1934, markets were patrolled by the uptick rule, which stated that a short sale must s execute one tick higher than the last sale.  In historic times, an uptick might be a quarter or eighth of a dollar and these days might be only a penny, but the effect was to apply a certain amount of "friction" to the shorting process, which investors like and traders hate.  On the NASDAQ, the rule was slightly less restrictive: short sale had to take place a tick above the prevailing bid, not necessarily above the last execution.
This chart shows the volatility of markets before and after July 2007, when the uptick rule was suspended:  The VIX
measures volatility of S&P 500 stocks and is a good proxy for NYSE volatility, while VXN measures volatility of NASDAQ stocks.  Some companies such as Microsoft and Intel contribute to both indices.  Bottom line, we see that after mid-July both indices became dramatically more volatile, leading to record levels in late 2008 and jumping up pretty sharply in May 2010.  Prior to the demise of the Uptick rule, volatility of NYSE stocks was dramatically less than volatility of NASDAQ stocks; now both categories of stocks are equally volatile.
There are a number of academic studies that "prove" the uptick rule has no affect on downward volatility.  These studies were done when half of stocks were exempt from the uptick rule in the 2004-2007 time frame.  We believe that moving from half stocks exempt to all stocks exempt surpasses a "tipping point" which explains the unprecedented volatility.  The SEC, however, appears dead set against commissioning a post 2007 study of the uptick rule.
Stocks over-valued or under-valued?
Stock prices are a function of future expectations of earnings discounted by current interest rates.
Fair Value
At present, earnings for the S&P 500 are expected to grow 25% over the next yea, in the context of the ten year treasury at 3.3%.  Stocks obviously were at a deep discount in March 2009, but rapidly approached fair value towards year end as stock prices rallied.  Stock prices are unchanged since the start of 2010, but earnings estimates continue to move higher.  Meanwhile, the European debt crisis has pushed interest rates back towards post-war, implying that the S&P 500 is 58% under-valued.
What if you believe that estimates are grossly high?  Given low interest rates, if earnings grow only 13%, stocks are still 54% undervalued.  What if you believe that the risk free treasury rate is not the appropriate discounting factor; you prefer to be more conservative with corporate bond yields.  At present, the Moody's average Baa corporate yield is 6.2%, implying that stocks are still undervalued by 22%.  As we have seen, the Fed model is more sensitive to changes in interest rates than changes in earnings expectations.  Variations on this model developed by Morningstar and Moody's also show stocks undervalued by 6% and 15% respectively.  
Saber rattling
Turkey and Israel are on diplomatic showdown over last week's botched interception of a Turkish aid flotilla heading towards the Gaza Strip.  Israel's 2006 invasion of Lebanon led to the deaths of 1500 civilians and billions of dollars of damage, but made no significant changes to the Middle East balance of power. 
North Korea threatens war with South Korea over accusations that the North recently torpedoed a South Korean destroyer.  If North Korea did in fact attack South Korea, civilian casualties could be in the tens if not hundreds of thousands of South Koreans.  However, the North Korean government would be unlikely to survive the retaliatory counter-attack.  The conflict could put the US in direct conflict with China, who would then have to decide between its commercial interests and political interests in coming to the aid of North Korea.  It's always something, but meanwhile corporations do what they're supposed to do, which is produce goods and services.  War has rarely been bad for stock prices.
We're fully invested with our current clients and have cash from new clients.  We would like to put that cash to work quickly, and are simply waiting for the day to day volatility to ease.  Dow 10,000 appears to be a hard floor, despite investors' fears.  Markets are thinner and more easily manipulated during the summer time, but July earnings reports should paint a rosy picture.  NASDAQ is implementing expanded "circuit breakers" to sideline stocks with unusually large moves - anything that reduces volatility will get investors interested in stocks again.
As always, please don't hesitate to call with questions and concerns.
                                                                                   Yours sincerely,                      
                                                                                   David Edwards

The HERON FINANCIAL GROUP Financial Markets Commentary is published following month end and when market conditions require comment. The views expressed in this letter represent HFG opinion and strategy as of the date published and can change at any time upon receipt of new information. Data quoted in this letter are from sources deemed reliable, but no guarantee of such data is implied.
HERON FINANCIAL GROUP, LLC, is an SEC registered investment advisor providing fully managed investment and wealth management services to individuals, families, trusts, defined benefit plans and corporations.
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