Did the Fed Add to the Fall in Stocks?

Today, Standard and Poor's lowered its outlook on long term U.S. Treasury debt from "stable" to "negative". What happened? U.S. Treasuries went up in value.

Huh?

Market forces would have dictated that Treasuries should have fallen. In fact, they did drop immediately after the announcement. But then they rose, even while stocks fell. If anything, one would have expected stocks to do comparatively well. Investors might logically ditch Treasuries and buy stocks.

So what happened? One serious possibility is that the Fed was buying in the Treasury market big time today, as part of its quantitative easing program and perhaps as part of its open market operations as well. The last thing the Fed wants to see is a rise in interest rates. If a downdraft hits the Treasury market, the Fed would move quickly to counteract it.

All that's understandable, given the Fed's statutory mandate to maximize employment. But it's possible that the fast traders on Wall Street--which would be most of the market today-- saw an arbitrage opportunity. If you know the Fed will be a heavy buyer of Treasuries, then you'd think about ditching stocks to raise cash, buying Treasuries quickly when they first drop, and reselling them at a profit to the Fed as it revs up its buying. The smart traders on the Street like to take advantage of large buyers and sellers, who often provide such arbitrage opportunities. The really cynical smart money would, indeed, short sell stocks to profit from the expected downdraft. That, if it occurred, would have added to the downward spiral of stocks.

The Fed also doesn't want stocks to drop. That might cool the consumption of the well-to-do and hamper the economic recovery. But the Fed is a lumbering cow in a market full of wolves, and today's weird market action indicates the wolf packs were probably voracious.

Be Wary of the Allure of Short Term Trading

The financial markets eagerly await the federal government's August jobs report, due to be released on Friday, September 7, 2007. If the number for job growth is low--less than 100,000, for example--the markets will probably rally. If job growth is high--200,000 or more--the markets will probably tank. The thinking is that a low number indicates a flagging economy, one in need of the fed funds rate cut that the market badly wants from the Federal Reserve. A high number, on the other hand, indicates a strong economy with the potential for inflation. That would very possibly lead the Fed to stay the course on interest rates.

Rate cut proponents point toward the subprime mortgage mess and the stagnant real estate market as reasons to expect lagging job growth. Mortgage bankers are being laid off with abandon, and real estate brokers are checking out new lines of work. Suppliers to the construction business are seeing revenues fall, and will cut employment. Manufacturers of home appliances are in the same fix. Even some investment banker and hedge fund types are getting pink slips, as deal flow and securities trading recede.

There are also reasons why job growth might be strong. Exports, helped by the falling dollar, have done well. The service sector has remained healthy. Wage pressure has eased and worker productivity has risen, making it more cost effective to hire workers. Not all of the predicted fallout from the real estate bust might happen. Some construction workers, like the skilled trades, can simply shift over to other building projects, such as hospitals and nursing homes. Unskilled construction workers can work on road projects. Many people that hold real estate broker's licenses have day jobs, and were brokers only on weekends and in the evenings. They can give up real estate without affecting job statistics. Or they can resume other careers they had set aside.

So how will the job growth number come out? We don't know. But we do know that the number really won't matter. Even if it pushes the market up or down 150 points on Friday, it won't matter. Within a few days, new statistics and news will have pushed the market to another level (maybe up; maybe down). At best, job growth in August 2007 will be one small datum in a sea of information that, in the aggregate, will determine what the Fed and other central banks do.

So why the fascination with the jobs growth number?

Because it will induce short term trading. People who hope to make money quickly will attempt to ride the volatility created by the job growth number. That sounds like day trading, a practice discouraged for individual investors because of its comparatively high expenses and low returns. But hedge funds, managed mutual funds, and institutional investors are often enthusiastic day traders. Professional money managers handle the investments for these entities, and must beat market averages if they are to keep their jobs. They can't beat the market by buying and holding. They could try to find investments that perform better than average. But, for every Warren Buffett or Peter Lynch, there are 10,000 Toms, Dicks and Harrys managing money who won't get to Lake Wobegon. Or, they can try to trade short term and generate some quick profits that boost their returns above their most dire competitors, the index funds.

Most of the trading in the financial markets today is done by institutional investors. The Norman Rockwell-ish image of the frugal individual, hunching over thick volumes of Moody's or Standard & Poor's in the public library reference room to uncover an investment diamond in the rough, is about as timely as the Edsel. An individual attempting to day trade can easily be overrun by the institutional tractor trailers barreling through the markets. (See our blog about stock market volatility at http://blogger.uncleleosden.com/2007/07/why-stock-market-bounces-around.html.) While some institutional investors may beat market averages, many and probably most don't. It's well known that most portfolio managers for managed mutual funds don't beat market averages. Statistics about hedge funds are harder to get, and perhaps less definitive. Certainly, after the subprime mess, hedge fund returns probably will not glow quite as brightly as they might have a year or two ago.

So what, then, is the appeal of short term trading?

It benefits Wall Street stock brokerage firms. Short term trading generates income for them. They get commissions from the buyers, as well as commissions from the sellers. They get commissions when a short term trader buys. They then get commissions when the short term trader sells. For some stocks, where the brokerage firm (or an affiliate) makes a market, they may also get trading profits (which you might see disclosed on a trade confirmation as a "markup" or "markdown"). If a customer buys on margin, they also get interest income from the margin loan. Excess cash balances in the customer's account are often invested in money market funds operated by an affiliate of the brokerage firm.

The brokerage firms have a lot of incentive to make the jobs growth, inflation, trade deficit, manufacturing sector, non-manufacturing sector, jobless claims and GDP data, and a host of other statistics, appear significant for a day. If they can get investors ginned up, they will make a bunch of money from transactional charges. It doesn't matter whether the market goes up or down, as long as investors trade.

Friday's Data Queen for the Day will be the jobs growth report. But the investor planning for a 25-year retirement that will start 20 years from now, or for a child's college education that will start 12 years from today, shouldn't give a rat's left ear what the report says or how the market reacts. An investment strategy of diversified long term investment remains the best move--see our blog about why the average investor does well, at http://blogger.uncleleosden.com/2007/06/why-average-investor-does-well.html. That probably doesn't involve any trading tomorrow.

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Exchange Traded Funds for Beginners

A relatively new product of the financial services industry has been getting a lot of publicity lately. That's the exchange traded fund, or ETF. The ETF is type of mutual fund that you can buy or sell while the stock market is open. By contrast, traditional mutual funds are bought or sold only after the stock market closes. (You can send in an order for shares of a traditional mutual fund any time, but the order will be filled only after the market closes, at a price based on the closing prices of the stocks and/or bonds that the mutual fund holds.) Although ETFs have been around for about 15 years, they have attained widespread popularity only recently. If you're unfamiliar with them, here are a few basic points.

1. ETFs generally have low costs and expenses, but you have to buy them through a stockbroker. That means you pay a commission. In addition, ETFs have two prices in the market: the "ask" price at which you buy them, and the "bid" price at which you sell them. The "ask" price will be higher than the "bid" price, and the difference between the two--called the "spread"--is a cost of investing. That's because if you buy at the ask price and immediately sell, you'll lose some money from selling at the lower bid price.

Consequently, ETFs are not always the lowest cost product. A low-cost traditional mutual fund may actually be cheaper, because you can buy it without paying a commission or incurring the "bid-ask spread" as a cost of investing. If you're saving small amounts at a time (e.g., $100 or $200 a month), a traditional mutual fund is a cheaper way to invest than an ETF.

2. ETFs are based on market indexes--in other words, the stocks or bonds they hold are the same ones that comprise a market index. For example, an ETF that mimics the S&P 500 will hold the 500 stocks in that index. ETFs started off with broadly based market indexes, like the S&P 500, and were often good choices for long term investment. However, more recently, ETFs have been created to represent increasingly narrow sectors of the stock markets--like just telecommunications stocks or stocks of one particular country. The narrower the index, the more risky the ETF, because it is less diversified. It may provide excellent returns, or terrible losses. The more you invest in narrowly-based ETFs, the more attention you'll have to pay to the overall diversification of your portfolio. In other words, the more work you'll have to do managing your money.

3. ETFs are often tax efficient, in that they are not required to distribute capital gains each year to investors. Investors report gains on their tax returns only when they sell their ETF shares at a profit. But a carefully managed mutual fund can also achieve a high degree of tax efficiency.

4. ETFs theoretically should trade at the same price as the aggregate prices of their underlying assets. This, however, doesn't always occur. Variations in supply and demand at any particular moment can cause an ETF to trade at a discount or premium to the value of its underlying assets. In addition, technical market problems can cause pricing problems. Trades that occur in the underlying stocks and bonds necessarily are reported after they occur. There is always a time lag between trade prices of the underlying assets and the trade price of the ETF. While the time lag may be minor in normal market conditions, when things become hot and heavy, trade reporting in the underlying assets may become delayed, and discrepancies between the value of the underlying assets and the price of the ETF can occur. If this happens, you could pay too much (or get a bargain) on ETF shares. Conversely, you might sell at a price that either is too high (good for you) or too low (bad for you). But, because you won't know about the trade reporting problems, you won't have any idea until after-the-fact whether you got a good or bad price.

5. You can trade an ETF like a stock. In other words, you can own it for minutes, or even seconds, and then sell it. You can sell it short, buy it on margin, use a limit order and the like. Some people may be tempted to trade ETFs short term because they have so many trading options. Stock brokers may encourage such short term trading because it generates commission income for them. However, the history of the stock markets teaches that short term trading generally is less profitable than long term buying and holding. Indeed, many people lose money, rather than make it, when engaged in short term trading. Be cautious using ETFs for short term trading. With their commission expenses, the bid-ask spread, interest charges on margin debt and the risks of trading short term, ETFs probably offer the typical individual investor few advantages, if any, for short term trading.

The ETF is a good long term investment option. If you buy and hold it, you get the most out of it. If you trade ETFs short term, you might money. But you might lose it. You wouldn't use a spoon to eat a steak. Don't use an ETF in ways that aren't likely to help you.

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