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Five Things You Need to Know: The Worst Case Is the Least of Your Worries

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Those focused on individual stock selection here face a far more difficult headwind than indexers and ETF investors.

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Kevin Depew's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:

1. "The Worst Case Is the Least of Your Worries"

Apparently the debt crisis has spread to student loans. Bundles of long-term student loans used as collateral for short-term investments owned by money-market investors, also known as Auction Rate Securities, are failing to draw interest on the street.

According to the Wall Street Journal, auctions for ARS's by Goldman Sachs (GS), JP Morgan (JPM) and Citigroup (C) have failed to draw bids, leaving about $3 billion of these securities in limbo. This goes back to something we wrote about at the end of January here: See Five Things Number Three.

At that time Bristol-Myers (BMY) was the victim of a $275 million loss related to their investment in Auction Rate Securities. How? Simple, they were using ARS's to pick up a little extra yield for their cash. The problem is that these are supposed to be very liquid short-term securities, when in fact corporate cash managers are now learning that the liquidity was very superficial.

The market for ARS's, although large in nominal dollar volume, is quite thin, controlled often by one dealer. Under ordinary circumstances, if there are too few bids the dealer will prop up the market by entering to place a final "clearing" bid. Now, given credit issues, there is far less incentive for the dealers to step in, especially if the underlying asset quality is in question.

As one banker involved in the market put it in the Journal, "We're not a liquidity provider." What the banker meant by that is they are not required to be a liquidity provider. The fact that the banks were during the good ol' days may have led some ARS investors to conclude otherwise. Now they are on their own.

Keep in mind that these ARS's are not new. For nearly a decade companies have been using them. What's new is the rapid deterioration in the perception of the credit quality of the underlying. The vast majority of the securities in this market, more than 90%, are rated AAA. But, increasingly, they are simply not trading that way, and at the end of the day that's what matters. The AAA rating is only as good as its perception in the marketplace.

The computer age helped pushed credit markets into an era of supposedly sophisticated modeling techniques that were presumably able to strip out and isolate credit risk. These models gave investors false confidence that, barring some kind of unforeseen event, the risk of default on credit assets was foreordained. Well, now we have that unforeseen event.

It doesn't take an overactive imagination to reconstruct the gist of thousands of conversations between salespeople and investors about the expected behavior of these models:

Investor: So what's the worst case?

Salesperson: There is no worst case.

Investor:
Right, but just suppose...

Salesperson:
Ok, the worst case is that if something were to happen, nobody knows what that could be, but just if... then the worst case will be the least of our worries.

Investor:
What do you mean, least of our worries?

Salesperson: I mean it would be like jumping out of an airplane without a parachute and worrying about what kind of shoes you're wearing.

Investor: Well, I'm not jumping out of any airplanes.

Salesperson: That's my point. And that's exactly what the models tell us.


2. Market Participation Narrowing: What It Means

Taking a look at S&P 500 component returns year-over-year, there are now only about a third of the member components outperforming the index, a sign of increasingly narrow participation. Looking at it year-to-date, the percentage of components outperforming the index plummets to about 10%. This is a sign of increasingly narrow participation.

What does that mean for the market and the average investors? Two things. One, those focused on individual stock selection here face a far more difficult headwind than indexers and ETF investors. Two, portfolio losers will cause a greater drag on performance than usual.

How does that work? Well, there's an old market saw that a rising tide lifts all boats. During periods of narrow participation, however, that old saw falls apart. Investors who cling to underperformers will find their overall portfolio performance seriously degraded by the magnitude of underperformance.

Periods of narrow participation also tend to cluster around shifts in secular performance trends. Take a look at what we mean in today's Number Three...


3. Large vs. Small: Who's In Charge?

If you've never considered whether weighting your portfolio toward large cap or small cap stocks makes sense, consider the following:

The last cycle where small caps outperformed large caps (using the Russell 2000 and the S&P 500 as our base indexes for large versus small) was 1991-1993. During that period the Russell 2000 doubled the performance of the S&P 500, up 95%, compared to 41% for the S&P 500.

The cycle changed in 1993, however, and between 1993 and 1999 the S&P 500 gained more than 214% while the Russell 2000 gained "just" 95%. The narrowing effect was pronounced during the final runup to the conclusion of the dotcom bubble, and participation in the major indices began to sharply narrow during 1999.

Even given the unified decline in equities from late 2001 to the fall of 2002, the Russell 2000 was able to sharply outperform the S&P 500 from 1999 to 2006. In fact, while the S&P 500 shows a 3.5% decline over that span, the Russell 2000 gained a whopping 56%.

Indeed, it pays to know where market performance is coming from.

Now, what about today? So far, as the participation in the markets continues to narrow, the game now is about relative outperformance. From 2006 to present, both the S&P 500 and Russell 2000 are actually down. The difference is that the Russell 2000 has lost 11% while the S&P 500 is down a little more than 5%.

So, how do we know which index to weight going forward? The chart below is a quarterly chart of the S&P 500 divided by the Russell 2000. When the ratio is moving higher it means large caps are in control, when moving lower, small caps are in control. It appears a long term trend change has occurred.




4. ETFs vs. Individual Stocks

As mentioned in Number 2 today, another consequence of narrowing participation is that the probabilities of outperforming the market decreases. Intuitively this makes sense; if fewer and fewer stocks are participating in the upside, then the greater the number of portfolio potholes one can encounter in their stock selection.

One way an investor can combat this is to focus more heavily on ETFs. During the last cycle of narrowing performance 1997-1999, as large cap outperformance was concluding, there were relatively few ETFs to choose among. Now there are literally hundreds. Investors have far more choices available and can easily target specific sectors. The question is, which sectors to target?

As we noted above in how one can evaluate large cap performance versus small cap, we can use the same process to determine ETF sector performance versus the S&P 500.

The chart below simply plots the Consumer Staples ETF (XLP) versus the S&P 500 on a quarterly basis. It too seems to show a trend change that is noteworthy.




5. The Green Monkey, That Funky Monkey

It's not just stock selection that's getting more difficult these days, it's bloodstock selection too. Remember that record price for a thoroughbred colt we wrote about a couple of years ago? A two-year-old son of Forestry, later named The Green Monkey, sold at Calder's Fasig-Tipton sale for a world record $16 million in 2006.

Well, two years and just three losing races later, with earnings of only about $10,000, The Green Monkey has been retired and will begin stud duties in 2009 for an undisclosed fee. (Hint: The stud fee won't total $16 million).

The previous record auction price for a thoroughbred was $13.1 million set in July 1985 at Keeneland in Kentucky for a half-brother to Triple Crown winner Seattle Slew, named Seattle Dancer. Compared to The Green Monkey, Seattle Dancer was a huge success, winning twice and earning $150,000, though that's a far cry from his purchase price.

Although the $16 million price for The Green Monkey exceeded the old record in nominal terms, adjusted for inflation it would take $24 million to equal the 1985 mark of $13.1 million.

No positions in stocks mentioned.

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