Wednesday, December 22, 2010

Russell 2000 Up 34% Since Jackson Hole Wyoming, S&P Up 6.4% in December Alone

Many times over the past few years I've written about the changing nature of the market as it becomes increasingly dominated by ETFs and HFT (high frequency trading) at the margin.  There is still far more money in mutual funds ($11.5T) and pension funds, than ETFs (which just cleared $1 Trillion in assets last week) but the marginal buyer is the hedge fund community, many of which are now the 'hot money'.  One of the main changes we see in markets are the shape of uptrends (and to some degree downtrends) - they are far more linear now than those of us who have been around for some time, are used to.  We've had long uptrends before but they were punctuated by much more volatility in the past and pullbacks were seen more often within the uptrend.  Now, we see "V shaped" moves constantly - once a trend begins, it just continues with little to no rest.  We are experiencing one of those moves in December, after just coming off one in September and October.  Indeed you could make a case we've had a 4 month "V shaped" move only interrupted by a few weeks of European issues that dragged the market down 5%.   If not for that event, perhaps this would be 4 straight months without a 1-2% drop.

There are many theories on why things act the way they do but I believe the dominance of the ETF as the hedge funds weapon of choice has changed the game tremendously.  Trading in SPY ETF (which tracks the S&P 500) often makes up 10% of ALL volume on any particular trading day.  I believe what is happening is the tail is wagging the dog.  When hedge fund and other institutional traders want to "put on exposure" it is a very different experience than 6-7 years ago.  One can quickly pile in (or in theory out of) to one of the most popular ETFs instantly - they provide immense liquidity.  Hence, rather than having to scramble to buy 150 stocks or 50 stocks or 250 stocks, one can instantly buy 500 stocks with this ETF.   And as money flows into the ETF, it flows through to the stocks.  Hence, the tail wags the dog.

I also believe this tail wagging the dog has an even more dramatic effect in smaller cap stocks and sector funds.  (Commodity markets are a whole 'nother discussion - the 'financialization' of commodities is another dark side of 'financial innovation')  While S&P 500 stocks are very liquid, when large institutional pockets of money want to buy smaller cap exposure, rather than having to pick and choose amongst thousands of smaller companies they can go into an ETF like Russell 2000 iShares (IWM).  That money than flows through to all associated stocks and lifts them up en masse.  Very different than the past when ABC hedge fund would buy a basket of 18 small caps, and XYZ hedge fund would buy a basket of 22 completely different small caps, and so forth.  Sector funds work the same way, and I've noted many times we see "student body left" trading where everything in a sector moves together, regardless of individual metrics - especially if there is an ETF involved in that sector.

We can bemoan the fact that this is the new structure of the market, but the reality is one must adjust.  Observing the market the past 3-4 years - both up and down, what was once the natural human herding behavior is now only reinforced by the ease of moving in (and out) of a large number of stocks at once via these instruments.  As ETFs continue to grow in popularity and more money flows into the relatively few popular ones, it is probable that this issue only continues to grow.  Hence "V shaped" moves - once the exception - now may become the rule.  In physics terms, once a body is in motion it truly seems to remain in motion, due to the changing dynamics of our markets.

To that end, the Russell 2000 is up a remarkable 35% since Jackson Hole, Wyoming (the infamous hinting strongly of QE2) - this is under 4 months.  Annualized, we're talking a 105% gain in the small cap index.  There have been no serious pullbacks in this time.

The S&P 500 is up 6.4% in December alone and we're not yet finished with the month.   That's a 77% pace.  (and up 20.5% since Jackson Hole)  Again, with no serious pullbacks.

I do believe statistics like this (this is not the first time we've seen such incredible statistics in short periods of time since the March 2009 bottom), support the view that HFT + EFT have changed the nature of our markets substantially.  Of course, this also means the next time there is a dislocation in markets, the downside moves could be just as spectacular.

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