Market Observations

11/2
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Volatile: 1) vaporizing or evaporating quickly, as
alcohol, 2) a) likely to shift quickly and unpredictably;
unstable; explosive, b) moving capriciously from one idea,
interest, etc. to another; fickle, c) not lasting long; fleeting
(Source: Webster's New World Dictionary)

Shakin' All Over...To say that current market movements are volatile is almost nothing short of an understatement. The fact is that we are witnessing an extraordinary rise in not only individual stock, but also index trading price volatility. You've often heard us describe the present day market as manic depressive. What we have clearly been referring to is inter and intra-day volatility.

Let's have a quick look at just how volatile is volatile. The following graphs are charts of the amount of time the NASDAQ and S&P have experienced 1% inter-day moves as a percentage of total trading days in the year. (Inter-day is close to close.) The charts reach back over the decade of the 1990's and just about speak for themselves.

We consider 1% inter-day movements as high volatility, especially compared to market experience over the last 50 years. Clearly these charts say that we have been in a highly volatile market environment over the last few years at least. More like half a decade, especially in the case of the NASDAQ. If this is high volatility, what is extreme volatility? Again, relative to historical experience, our definition would be 3% or greater moves. To show you just how volatile an environment in which we now exist, we have prepared the following table using intra-day volatility as opposed to inter-day. Clearly news events both pre-opening and post close can strongly effect inter-day index price movement. Intra-day, there just isn't a lot of news which should cause dramatic price swings. Although economic news often hits the tape just past the open, crucial company disclosures and earnings related news are most always pre and post close timed. The following table presents the number of days the NASDAQ has experienced 3% or greater intra-day movements literally since the inception of the NASDAQ itself. Have a good look:

3% Or Greater NASDAQ Intra-day Trading Range

1971 to 1997	40 days in total
1998	16 days
1999	20 days
2000 through Oct.	55 days

If this does not describe increased volatility, then we just do not know what does. In the first 27 years of the NASDAQ's existence, only 40 days across that entire 27 year time span experienced 3% or greater intra-day index price movement. As you can see, 3% intra-day swings this year alone total an amount greater than the combined experience of the first 27 years of NASDAQ life. As you know, today was a hair shy of day 56. We've heard the explanation that "prices are higher (market caps) than in the past so greater movements should be expected". That type of limited thinking only addresses absolute dollars. As we have shown you, it is percentage movements that count. Over the recent past, we would simply describe volatility as nothing short of chart topping. Or maybe we should be saying chart toppling.

Wag The Dog...Having given you this brief retrospective of volatility, we want to discuss the reasons this is the current circumstance in which we find ourselves and look ahead as to what may be appropriate to expect in the way of future price volatility.

Unquestionably in our minds, the proliferation in usage of equity derivatives is driving increased index price volatility. The actual trading of index futures and the perceptual institutional acceptance of index futures has increased markedly over the past few years alone. Have a look at the following chart and we'll have a few comments:

Institutional plan sponsor consultant Greenwich Associates was kind enough to have done the study from which this chart was derived. We're sure you get the picture. As you know, we report on bank derivative exposure quarterly (next one is due in mid-December). We always point out that the banks are simply not real "players" in the equity derivatives market. For the banks, it's interest rate derivatives that capture their fancy. The chart above clearly shows you who are the big players in equity derivatives land. It's institutional investors, mutual funds and the hedge crowd. Has this become one big group of speculators? Besides the obvious answer, the institutions themselves would respond no. Clearly the hedge clan can be considered to have a more speculative bent than not, but the mutual funds and institutional players are using index futures for three purposes - to get instantaneous exposure to the equity markets when needed, to maintain a certain indexed position or allocation, and to hedge against risk.

Question. How do you get $500 million to work in individual equities in a few hours without disrupting individual stocks prices too much? Answer: You don't. Very often, funds or fund families will get large amounts of inflows in a short period of time. Assuming a bullish posture and a sense for not wanting to let cash become a performance "drag" in the portfolio(s), one would naturally gain large exposure to the generic equity market through the purchase of index futures. As individual issues are purchased over time, the futures position is gradually reduced or removed. This is but one of the many uses of equity futures to the institutional players. In the study recently done, Greenwich found that approximately 40% of the largest domestic equity portfolios (plan sponsor) in the US are indexed or invested in index futures and options. Index futures has been an area of incredible growth in trading volume over the past few years. Again, the chart above clearly spells that out.

So what is the effect on index price volatility as a result of the increase in equity derivatives? As is so often the case in the new era market in which we find ourselves, the futures tail can and does wag the cash market dog. The arbitrage (mostly quant driven) community will act to close a cash market vs. futures "arbitrage opportunity" in a heartbeat and on both sides of the trading table, buy and sell. Moreover, the herd instinct at work in the market today is nothing short of powerful. If you are a portfolio manager holding cash that hit the books last night and the market bolts out of the starting gates, do you wait for things to quiet down or do you buy some futures to protect your performance rear end? (Don't worry, it's only your job we're talking about here.) Likewise, if you are long futures and the market starts a momentum run for the southerly border, do you a) go to lunch, b) grab another latte, or c) blow out the futures position in the next two seconds? Lastly, assume you are the ultimate tea leaf reader. You shorted the living heck out of NASDAQ futures to protect your tech centric portfolio. The NASDAQ bounces off the magic 3000 level and rockets skyward. You know the rest. You unwind the position without taking another breath and contribute to the upward trajectory of the NAZ futures themselves, dragging all the NASDAQ sheep behind you. So many moves in the current market become self reinforcing. The proliferation of equity derivatives usage is a prime suspect in the "volatility files".

MO, MO, MO. How Do You Like It?...Quite frankly, we have just never seen the kind of volatility in individual stocks that we witness today. 50% dive bombs at the open for sneezing too hard. 20% gaps up on sound bite information coupled with a little CNBC cheerleading routine. When we hear Maria talking about momentum in the utility stocks, we know things are getting carried away. Momentum as an investment strategy has gripped the financial landscape. And it's not just in stocks. To us, this type of action is symptomatic of overvaluation and the fact that equities are being treated as mere commodities. We have always known that stocks and real businesses are two different things, but what happens in the equity market today in terms of individual stocks is again what we would term extreme volatility.

This type of action has to be emotionally wearing on the day trading crowd. One unlucky move and you are bleeding, sometimes profusely. Mom and pop investors in the US have to also be feeling a bit queasy when former bulletproof icons such as Intel can lose incredible amounts of market value in short periods. Up dramatically one day. Down substantially the next. For seemingly no rhyme or reason. At some point, momentum psychology will be broken. Why is this happening? Our simplistic and possibly naive answer is one, too many emotional players in the game, and two, the widespread availability of instantaneous information and trade execution capabilities. The current state of technological innovation has created a breeding ground for group thinking and herd action. As with any new technology, as a society we need to learn how to use it responsibly and thoughtfully. Lastly, the almost insatiable desire for near term performance seems to be hitting an unsustainable fever pitch. "Get me into something that's working". How many times have you heard this? Too many, that's how many. The media fans the flames by always touting the "best performing funds" or the "best performing manager". How come they are always different funds or people? Will it take a "financial event" to kill momentum psychology or will it just die a natural death? As you would imagine, we do not have the definitive answer. We just know that the financial markets are about nothing if not change.

The market place has changed over the last decade or so. Primarily over the last five years or so. This isn't good and this isn't bad, it just is. Extreme volatility is now a daily fact of life. Last comments. Maybe we can liken stocks to the bond world. In bonds, the longer a maturity, the more price volatility a bond experiences as interest rates change over short periods of time. Have participants in the current stock market environment looked out too far to the ultimate "maturity" of stocks (long term time horizon) in trying to value them? The new mantra of "I'm a long term investor" may more correctly be "I'm too long of a long term investor" given the type of volatility we are experiencing in the current environment. Only the longest of "maturities" experience excessive volatility regarding short term news events. Are investors looking out way to far in trying to value stocks? Quite possibly that coupled with overvaluation is volatility's message to market participants. Don't worry, when stocks drop 50% at the open, it's a good bet that the time horizon of the holder shrinks with digital speed.

Nudge, nudge. Wink, wink. Know What I Mean?...And now for something completely different. No more nudging. No more winking. No more "knowing"? Ladies and gentlemen, welcome to SEC ruling FD (Fair Disclosure). Under the ruling, companies most now disclose material non-public information in a public forum. No longer can management's "tip off" their favorite analysts about "soft" earnings or "guide" the analysts to either a correct or beatable number well before a quarterly report. We were quite pleased to see some of the following language in the final ruling:

   As discussed in the Proposing Release, we have become increasingly concerned about the selective disclosure of material information by issuers. As reflected in recent publicized reports, many issuers are disclosing important nonpublic information, such as advance warnings of earnings results, to securities analysts or selected institutional investors or both, before making full disclosure of the same information to the general public. Where this has happened, those who were privy to the information beforehand were able to make a profit or avoid a loss at the expense of those kept in the dark.

   We believe that the practice of selective disclosure leads to a loss of investor confidence in the integrity of our capital markets. Investors who see a security's price change dramatically and only later are given access to the information responsible for that move rightly question whether they are on a level playing field with market insiders.

   Issuer selective disclosure bears a close resemblance in this regard to ordinary "tipping" and insider trading. In both cases, a privileged few gain an informational edge -- and the ability to use that edge to profit -- from their superior access to corporate insiders, rather than from their skill, acumen, or diligence. Likewise, selective disclosure has an adverse impact on market integrity that is similar to the adverse impact from illegal insider trading: investors lose confidence in the fairness of the markets when they know that other participants may exploit "unerodable informational advantages" derived not from hard work or insights, but from their access to corporate insiders. The economic effects of the two practices are essentially the same. Yet, as a result of judicial interpretations, tipping and insider trading can be severely punished under the antifraud provisions of the federal securities laws, whereas the status of issuer selective disclosure has been considerably less clear.

   Regulation FD is also designed to address another threat to the integrity of our markets: the potential for corporate management to treat material information as a commodity to be used to gain or maintain favor with particular analysts or investors. As noted in the Proposing Release, in the absence of a prohibition on selective disclosure, analysts may feel pressured to report favorably about a company or otherwise slant their analysis in order to have continued access to selectively disclosed information. We are concerned, in this regard, with reports that analysts who publish negative views of an issuer are sometimes excluded by that issuer from calls and meetings to which other analysts are invited.

This changes the "game" (and we do mean game). Analytical contact with company managements between quarterly earnings dates and subsequent conference calls will be sparse. No more direction to the analytical community. No more managing earnings expectations through the outlet of so-called Street research. Many corporate managements are now spooked about talking to the Street without putting out a corresponding press release or filing an SEC 8K informational document. Street brokerage analysts will now have to adopt a tactic that will be a first in the new era period - actual investment research. Grassroots research. Talking to company suppliers. Talking to company customers. You know, dirty work like that. Don't expect miracles overnight. Most of the analysts that used to practice this ancient craft were fired long ago.

Getting back to the matter at hand, just what do you think a diminishment in overall corporate communication to the Street will mean to stock price volatility over the short run? As investors adjust to these new norms for behavior, we would surely expect volatility to increase. Especially around earnings season. No more gentle guiding from management's may mean that the world might possibly be full of surprises ahead. Revenue surprises. Earnings surprises. Perceptual surprises. On a brighter note, we do expect much of the corporate hype to settle down. In fact that should be just the opposite of what corporate communications efforts will shoot for. This one piece of pretty classy action from the SEC should make corporations think twice about hype as they contemplate not so pleasant classy actions of their own, legal classy actions that is. For a lot of modern day Street analysts, this pretty much FD'ed up the easy life, now didn't it?

Until we experience a shift or a change in the predominance of momentum thinking that characterizes the current stock market environment, expect volatility. Anticipate volatility. Possibly continued excessive volatility.