Call It a Hunch, We’re In For a Tumble

I don’t have any complicated quantitative models at my disposal. I read, I think, and then I have a hunch. Then I have lunch.

I think the market rose too far, too fast and that we are going to test the March 9 low. The economy is not growing as fast as many had expected.

This morning the Federal Reserve Bank of New York released its’ Empire State Manufacturing Survey. This index of general business conditions fell to -9.41 in June, down from -4.55 in May. Economists expected a slight dip to -4.6 in this measure of regional manufacturing conditions.

It’s midday Monday. After a 40% rally since the March lows, the S&P 500 is down 2.5% today. The Dow, which was just 5 points from breaking even for the year, is down 200 points, or 2.3%. The Nasdaq is down 2.7%.

The Wall Street Journal asks is this a bull or bear market? Signs Suggest Stocks’ Surge Is Blip Within a Bear; Still, There’s Opportunity.

This would seem to prove my theory from last week, when I decided that all the outflows from the large-cap U.S. stocks was a sign that the market had topped. I think we’re going to go back to near 7,000 on the Dow. Good time to take profits and wait for the sale to begin again.

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Net Cash Inflows Double; Large-Caps Lose, Emerging Markets Win

Net cash inflows into all exchange-traded funds (ETF) and exchange-traded notes (ETN) grew to approximately $17.1 billion in May, doubling April’s total, according to the National Stock Exchange (NSX). Despite the huge inflow overall, ETFs holding large-capitalization indexes such as the S&P 500, Dow Jones Industrial Average and the Russell 1000 posted significant cash outflows. Meanwhile, emerging-market ETFs recorded huge net inflows.

iShares remained the top ETF firm with $290 billion in assets under management. State Street Global Advisors came in second with half that, $142 billion. Vanguard took third at $54 billion. PowerShares’ $31 billion came in fourth and ProShares $26 billion claimed fifth.

The SPDR Trust (SPY) remained the king with $63 billion in assets. SPDR Gold Shares (GLD) came in second with a distant $35 billion.

I noticed a trend of heavy net cash outflows from the large-cap U.S. equity funds. So, even as the market rose in May, the SPDR saw $146 million flow out in May. The PowerShares QQQ (QQQQ), which tracks the Nasdaq 100 and is the sixth-largest ETF, had outflows of $435 million. Meanwhile, $639 million was pulled out of the Dow Diamonds (DIA), which tracks the Dow industrials. Surprisingly, the iShares S&P 500, (IVV) which also tracks the S&P 500 and is the fifth-largest ETF, saw net cash inflows of $441 million. However, all the iShares ETFs that track the Russell 1000 or an offshoot also saw outflows. Does this mean that traders think the U.S. stock market has peaked and have taken profits? I wouldn’t be surprised.

That money appears to be moving into emerging markets. The iShares MSCO-Emerging Markets (EEM) took honors as the third-largest ETF upon receipt of $1 billion in cash inflows in May. The only ETF with more net inflows was the iShares MSCI Brazil (EWZ) with $1.5 billion.

Year-to-date net cash inflows totaled approximately $29.8 billion, led by fixed income, commodity, and short U.S. equity based ETF products, says the NSX. Assets in U.S. listed ETF/ETNs grew 10% sequentially to approximately $594.3 billion at the end of May. The number of listed products totaled 829, compared with 767 listed products a year ago. This data and more can be found in the NSX May 2009 Month-End ETF/ETN Data Report.

Dow Kicks Out GM; S&P Still Holds It

Former GM CEO Rick Wagoner upon realizing what just hit the fan.

4 pm.

Late night I sent my story about General Motors and the indexes out to a few people, including some people at Dow Jones. This morning General Motors is pulled from the Dow Jones Industrial Average. Coincidence? I’ll let you decide.

Today, Dow Jones pulls GM and Citigroup out of the DJIA. The two companies will leave June 8 to give index fund investors time to adapt to the deletion and addition of two new components, Cisco Systems and Travelers. Since GM is getting knocked off the New York Stock Exchange tomorrow, GM will be going to an over-the-counter market, representatives for Dow Jones Indexes said they will use “the best available price source” for the next week. Can you imagine, the Dow being priced off the Pink Sheets. That’s the true Wild West of Wall Street. Oh, the humanity!

Since the DJIA is created by the editors of the Wall Street Journal, there’s no requirement for them to remove GM before today.

One thing to remember is that an index isn’t a portfolio. A fund or ETF is a portfolio. It lives in the real world and costs money to maintain. An index is just a construct that measures the market.

A Dow component since 1925, GM has been a significant part of measuring the stock market through the 1920s bubble, the crash of 1929, the Depression and every up and down of the American economy since. It’s only fitting that the index itself should suffer and be brought down by this once mighty component. If the index is the market and GM has been a huge part of the market and the American economy for so long, it’s appropriate that the Dow should hold it until today to give a proper measurement of the U.S. stock market and economy. But, that’s not good for funds that follow the Dow, such as the Dow Diamonds (DIA). They will probably suffer the loss even though they would have liked to get rid of the stock months ago.

However, the S&P 500 is rules based and a company needs to have $3 billion of market capitalization to remain in this “Large-cap index.” GM hasn’t had $3 billion since December. At the close on Monday, it was still in the index.

Here’s a great video from The New York Times: The Decline of G.M..

Meanwhile back at the other automobile bankruptcy in America, it appears Tommy Lasorda has been brought in as Chrysler’s vice chairman to make the Chrysler bankruptcy work. I wonder if they will bring in Joe Torre to fix GM.

Funds Hold GM to the Bitter End

What does a company need to do to get kicked off of an index around here?

As of Friday, General Motors was still in the S&P 500 and the Dow Jones Industrial Average. If the indexes hold the stock until the company declares bankruptcy are the index funds and ETFs that track indexes with GM as a component obligated to hold it to the bitter end? Are they are allowed to sell it ahead of time or do they have to suck up the loss, even though everyone saw this coming from a mile away?

According to AOL Money & Finance, all of GM’s shares are now owned by large block holders. Institutions hold 36%, mutual funds, which includes ETFs, hold 62% and the rest with others like the executives. State Street Global Advisors hold the most GM shares of any institution, 26.9 million, or 4.37% of all the GM shares outstanding. Surprisingly, only 5.26 million of those shares reside in the SPDR Trust (SPY). Still that’s a big loss for one fund no matter how you slice it. Vanguard Group has the second most shares, 23.99 million, or 3.93% of the shares outstanding. However, four of its funds are in the top 10 holders, the Vanguard 500 Index (VFINX) has the most shares of any fund, 5.8 million. This is followed by Vanguard Mid-Cap Index Fund (VO), Vanguard Total Stock Market Index Fund (VTI) and Vanguard Institutional Index Fund. Barclays Global Investors, owner still of the iShares ETF family, comes in third with 17.8 million shares.

The shocking part is that according to Standard & Poor’s, a component of the S&P 500 needs to have a market cap of at least $3 billion. With 610 million shares outstanding, GM would have to trade at $5 to make that. But GM last saw $5 on its shares on Dec. 8, 2008, more than five months ago. It’s not like S&P doesn’t remove stocks from the index. It’s deleted nine companies already this year.

Peter Cohan knows how to evaluate a company. He’s amazing at looking under the hood and breaking apart a company’s financial statements to see the rotting husk of a business. At Daily Finance, he says the failure of GM matters because it shows of success can lead to failure and how now the U.S. can’t even fail right. Companies can’t shut down without government intervention. He adds that the U.S. system of economic growth, venture-backed innovation, has been nearly snuffed out and that is not good news.

Cohan also list the five big reasons why GM didn’t have to fail and squarely lays the blame at the feat of managers who were overly impressed with themselves for no good reason. The five reasons: 1) bad financial policies, 2) Uncompetitive vehicles, 3) ignoring competition, 4) failure to innovate, 5) managing the bubble. Ignoring the competition and failure to innovate are the worst crimes and that should justify Rick Wagoner’s firing pretty easily.

Making the Case for Index Funds

Investing is long term. Speculation is short term.

Can you watch the market every day? If not, you should invest, rather than speculate. Without a doubt indexing is the way to invest. The crash of 2008 has not only highlighted the risk of owning single stocks, but also exposed the dirty underbelly of actively managed mutual funds.

Going for the index avoids getting stuck with the stocks that might be left behind. If you believe in the concept of diversification, then single stock risk is just too huge of a risk to take. And while you might be able to buy 20 stocks and build out a nice portfolio, one bad stock can wipe out 5% of your portfolio and two bad stocks decimate the fund. (Get it? Decimate? Remove 10%. Ok, moving on. …)

If you want to own financials, 30 are better than two stocks. If the two financials you owned last year were Bear Stearns and Lehman Brothers, you, my friend, have completely lost your portfolio of financials, and maybe your entire portfolio. Buying an index fund tracking the financial sector of the S&P 500, such as the Financial Select Sector SPDR (XLF), gives you 80 stocks, about 11% of the S&P 500. You can get more exposure to one narrow niche of the market and diversification at the same time, hence less risky. Sure, the financials took a hit, but considering most of them are still in business, you still have some of your investment.

So, single stock risk is out if you’re not buying for dividends. But what about actively managed mutual funds? The whole point of the actively managed fund is to give you, the investor, alpha, those extra percentage points of return that comes from the fund manager’s skill and intellect. The financial crisis has shown how hard it is to find true alpha.

It’s pretty much common knowledge these days that only about 20% of active fund managers beat the major market benchmarks. Considering many active funds are essentially index fund copycats, you will never beat the market with their huge management fees. Fund managers counter that even if they don’t beat the market going up, they at least have the ability to post narrower losses on the way down, because they can sell off the worst performing sectors while the index can’t. I think a little bit of research will show they are also posting returns worse that the indexes on the loss side as well.

And even those that don’t post worse losses, is a 35% loss that much of an improvement over a 37% loss?

So, if you eliminate single stock purchases and actively managed funds, deductive reasoning says you must go with the index. Of course, this mostly applies to U.S. equities. In some markets, such as emerging markets, a smart manager might have some market knowledge that hasn’t disseminated widely, but in the U.S. that kind of information gets spread around pretty quickly.

Indexes can be volatile and risky. If the stock market falls, an index tracking the stock market will fall. However, with the index fund you can rest in the knowledge you matched the market and didn’t do worse than most of the market.

If you really want a lesson, John Bogle, the inventor of the index mutual fund, explains why indexing is better than stock picking in “The Little Book of Common Sense Investing.” Essentially, Bogle says you can maximize returns and lower risk by not buying single stocks but mutual funds. Followers of Bogle have written a book called “BogleHeads” which expands on this theme.

Now in a shameless plug for myself, my book ETFs for the Long Run takes Bogle’s argument one step further. I agree with Bogle that indexing is the way to invest. Bogle likes the mutual fund structure, but I think Exchange Traded Funds are the mutual fund for the 21st century. In the book, I explain indexing, the advantages of buying mutual funds instead of single stocks and then why ETFs are better than mutual funds. The key reasons being they are cheaper, more tax efficient, more transparent and more flexible. I also explain how to buy and sell ETFs and how to use them to build a portfolio.

Since you don’t know what sector of the market will rise, you should own a broad market index, such as the Vanguard 500 mutual fund, (VFINX), or buy an ETF such as the SPDR, (SPY), or the iShares S&P 500 Index (IVV). The Diamonds Trust (DIA) tracks the Dow Jones Industrial Average and the PowerShares QQQ (QQQQ) follows the technology heavy Nasdaq 100 index. The Vanguard Total Bond Market (BND) is a broad bond index.

Then you break it down into sector specific indexes that you want to follow.

Finally, you need to watch fees. ETFs typically charge smaller expense ratios than mutual funds. However, if you are dollar cost averaging, which in this market is the only way to go, the ETF’s commission will significantly eat into your returns if you invest less than $1,000 a pop. If you are investing less than $1,000 a pop, then go with a no-load index fund. Buying an index fund with a load is like paying for your own security in a gated community. It’s a waste of money.

Qubes Celebrate 10th Birthday

The Qubes, one of the most famous ETFs in the world, celebrated its 10-year anniversary yesterday.

The PowerShares QQQ (QQQQ), formerly known as the Nasdaq 100 Index Tracking Stock, hit the market March 10, 1999, in what remains the biggest most successful launch of a single U.S. ETF. Today, it is one of the most actively traded securities in the world.

“It is the most traded security in shares and dollar volume over the last ten years,” says John Jacobs, executive vice president of NASDAQ OMX Global Index Group and the man who created the fund.

While it currently trades on the NASDAQ Stock Market, originally it launched on the American Stock Exchange with the ticker symbol QQQ. This gave the ETF, then called a tracking stock, the nicknames of the “QQQ”, the “Triple Q” and the “Qubes.”

Launched at the height of the Internet stock market bubble, the Qubes fed the investing public’s desire for an easy to trade instrument that held the fastest growing stocks in the world. The NASDAQ 100 index holds the 100 largest non-financial stocks listed on the NASDAQ. That’s a lot of technology, biotechnology and retail.

It’s first day, it traded 2.6 million shares, 53 percent more than the record set two years earlier by the DIAmond Trust (DIA), the first ETF to track the Dow Jones Industrial Average. After just two hours, the NASDAQ 100 ETF, blew away the DIAmond’s first-day total volume of 1.7 shares. Within two weeks, it had traded 30 million shares. At the end of 2000, the Qubes held more than $6 billion in assets. A little more than two months later, on its first anniversary, the Qubes held more than $12 billion.

For a while, it surpassed the assets and daily volume of the first ETF, the Standard & Poor’s Depositary Receipts, or SPDR Trust, (SPY). Yesterday, it held $10.26 billion in assets.

“The Qubes stellar rise signaled to Wall Street that exchange-traded funds were not just a one-hit wonder. It showed potential sponsors there was a market for these products if the index was right.” (For more on the birth of the Qubes, the history of the ETF industry, and why the NYSE refused to let this ETF use the single “Q” ticker symbol, grab a copy of ETFs for the Long Run.) A little more than a year later, Barclays Global Investors launched its iShares family of ETFs. By the end of 2000, there would be 55 iShares.

Ironically, on the Qubes’ first anniversary, March 10, 2000, the NASDAQ Composite Index, which tracks every stock on the NASDAQ, hit its all-time high of 5048.62. The Qubes posted a 12-month return of 125%. The next trading session, the Internet bubble popped, sending the entire stock market into a two-year decline.

On the tenth anniversary, the Nasdaq soared 89.64 points, or 7.1%, to 1358.28, and the ETF jumped $1.59, or 6.2% to $27.33 on volume of 175 million shares. Did the excitement over the Qubes anniversary spark a huge rally in the market? Don’t laugh so quickly. Currently, the NASDAQ-100 Index is the basis for more than 900 products in 34 countries with about $490 billion dollars in notional value tied to it. To date, the index has traded more than 600 million futures contracts with a notional value of more than $25 trillion. Options experts SchaeffersResearch.com says the Qubes saw call buying activity early yesterday.

Of course, Citigroup (C), one of the country’s largest banks, did raise its head from its deathbed to say it was doing very well the first two months of the year, sparking a huge rally in the financial sector. The Dow Jones Industrial Averaged surged 5.8% to 6926 and the S&P 500 leapt 6.4% to 720.

Invesco PowerShares bought the NASDAQ’s ETF business in 2006. It changed the name of the ETF to the PowerShares QQQ in honor of what most people called the fund. However, the ticker has changed to QQQQ because it trades on the NASDAQ Stock Market, which uses four letters in its tickers. The NASDAQ says its market share of U.S. ETFs is more than any other U.S. exchange. In January 2009, volume grew 22% year-over-year to 655 million shares.

The NASDAQ OMX Global Index Group, a unit of the NASDAQ’s parent company, the NASDAQ OMX Group, remains a global leader in creating and licensing strategy indexes. Its most recent being the Government Relief Index and the European Government Relief Index, which include companies currently being bailed out by their governments.

World Map of Financial Turmoil

For people who want their bad news in one large dose vs. many small doses, the Global Indices Map is like a world map of financial turmoil. This constantly updated global map from Google lists almost all the major stock market indices around the world and gives a feel for how the world markets are doing at any point in time. It’s a cool idea.

However, I already noticed the map is missing the S&P 500 index, which is considered by most market participants to be the true benchmark of the U.S. market.

On needs only to look at where investors are putting their money. The SPDR (SPY), the largest ETF in the world with $83.8 billion in assets, tracks the S&P 500, while the Dow Diamonds (DIA), which tracks the Dow Jones Industrial Average, holds only $7.76 billion.

Which Will Win? January Effect or Super Bowl Effect?

Wall Street traders are lot like professional athletes. Apart from getting paid salaries unfathomable by the average American, these are both very superstitious groups of people. Athletes may seem almost obsessive compulsive in the routines they must perform before a game or in their belief in lucky underwear and such. Wall Streeters meanwhile believes in collection of traditional sayings, maxims and old saws that can give people direction and actually govern many investing strategies; sayings such as “Don’t fight the Fed.”

One of the less logical but apparently excellent prognosticating sayings is “As goes January, so goes the year.” In short, if the stock market rises in January, it will have a good year, if it falls in January, watch out.

Well, CNNMoney reports that this was the worst January ever for the Dow Jones Industrial Average, down 8.8%, and the S&P 500, off 8.6%. The Nasdaq tumbled as well, 6.4%, but not as much as last year. The Nasdaq’s 9.9% plunge January 2008 seems a pretty good predictor of the year to come.

Howard Silverblatt, senior index analyst at S&P tells the New York Times in 60 of the last 80 years, the S&P 500’s performance in January reflected how the index fared that year.

Standard & Poor’s market historian Sam Stovall tells CNNMoney about the correlation going back to 1945. “Since then, whenever the S&P 500 gained in January, the market continued to rise during the rest of the year 85% of the time. But the stats are less consistent when the market fell in January. Since 1945, a decline in that month yielded a decline in the next 11 months only 48% of the time, for an average loss in that period of 2.2%.”

Meanwhile another famous market Wall Street myth, the Super Bowl Stock Market Predictor, says the market will rise this year. This forecast tool says when a team from the original NFL wins the Super Bowl the market will rise experience just such an occurrence. This has happened 34 times out of 42 Super Bowls for an accuracy rate of 81%. Last night’s team, the Pittsburgh Steelers, was a member of the original NFL before the AFL merger. The year of each of the Steeler’s previous five wins, the stock market rallied, even during the horrible 1970s.

Stuart Schweitzer of J.P. Morgan Private Bank told the New York Times. “It’s unlikely that the broad market has yet seen its lows. There are more disappointments ahead.” And when Wall Street can’t even believe its own hype that the market will go up this year, you better pay attention.

Peter Cohan of BloggingStocks says, “If you need your money in the next six years, it probably makes sense to sell.” He recommends money market funds. Unfortunately, I don’t think there are any ETF money market funds.