Fed Policy feels like Chinese water torture


On May 19th, we wrote, “Stocks rallied into this afternoon’s close, which we believe marks the bottom of this particular pull back.  Most likely we’ll be investing recent client deposits on Monday.”  In fact, we held off investing those deposits until Wednesday of this week and are now satisfied to be fully invested.

It’s been quite a roller coaster the last few days.  At 2PM on Wednesday, US markets were up 1%, but by the close at 4PM, were down 1%.  Thursday, despite some good news out of Iraq regarding the death of terrorist Abu Musab al-Zarqawi, the slump of oil prices below $70/barrel, the decline of the 10 year treasury below 5% and a rally in the US dollar, US markets opened down 2% but rallied to a slight rise by day’s end.  This morning, stocks opened 1% higher, fell into negative territory by noon, before closing slightly lower on the day (and down 2.8% on the week, the worst one week since April 2005.)

These are the days when it helps to believe in one’s systems, models and experience, to have an iron stomach, and to be prepared to buy when everyone else is selling.  As we have outlined over the last year and a half, the overall stock market is pretty cheap.  However, the only active investors these days appear to be hedge funds (the average retail investor still not prepared to buy stocks or mutual funds after the 2000-2 bear market.)  The hedge funds tend to buy the momentum stocks, which in the last year and a half have been energy, commodity and housing stocks, and have also been buying hard assets like oil and gold.  Furthermore, the hedge funds tend to buy with borrowed money.  The key difference between the investment strategies of registered investment advisors like our firm and the strategies of hedge funds is that RIA’s try to buy low and sell high (five years later) while hedge funds attempt to buy high and sell higher (5 days to 5 months later.) 

The problem with the hedge fund strategy is that if the manager calls the trend wrong, margin calls force the manager to sell into a falling market, which exacerbates the downturn but has nothing to do with the fundamentals of the market.   For example, on May 11th, gold hit a 20 year high of $725.  Today, gold closed at $610, a 15.9% decline in a month.  The XAU Gold Index, which is comprised of 15 mining company stocks, fell 24.9% in the same time frame.  If the hedge funds can’t sell the energy stocks, the commodity stocks and the gold stocks fast enough, everything else in their portfolios get dumped as well.  Once the selling stops, stocks rally as we saw on Thursday.