October Market Outlook | September & August Performance Review

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    IN REVIEW | August & September ROE Capital Performance
    I apologize for the lack of a September newsletter (reviewing August performance). I was traveling at the end of August and for much of September and was unable to produce one.

    The equity markets have been of two minds in 2010: rally on recovery and record profits or panic on sovereign solvency and fear of removal of central bank liquidity. The speed and strength of the price movement has been reflected in my results. When I have been caught long on the panic declines, my results have suffered. When price movement favors the long, I have soared. When I have been exposed on the short side to the rumor of central bank intervention, I have eaten crow. When my short positions line up with investor fear, I have benefited. There has been very little middle ground. The end result is that I have had substantial month to month volatility in my programs, which can also be seen in the major averages. The psychological profile of 2010 equity markets is a violently fractured one, a Dr. Jekyll and Mr. Hyde split personality—and it has been anyone’s guess as to who will show up in a given day. As a result, it has been difficult to build on a string of gains.

    In August, my systems were exposed to the long side when the market chose to focus on evidence that the recovery is faltering. As a result, we gave back recent gains and posted our biggest losing month end result of the year (for Jefferson and nearly so for Monticello). The waning weeks of August mirrored the waning weeks of May, as one poorly timed buy haunted me through the end of the month. We met September’s rally with much more time in cash, finding favorable trading setups in the margins of the strong rally in equities.

    A year over year comparison of monthly returns shows how difficult things have been. In 2009, my Monticello program had 3 months in which we experienced a percentage gain or loss of over 4% or more (2 winners and 1 loser). In 2010, 6 of 8 months have posted gains or losses of 4% or more (3 winners, 3 losers). For my Jefferson program, 2010 has produced 3 months gaining or losing 3% or more versus just one in 2009. The story of 2010 has been fierce back and forth, with no trend or stable range-bound market in which to find profitable trades. In short, it has been a very difficult year to trade. While I am pleased to be on the ‘happy side of par’ for the year, my performance numbers are not to my liking.

    However, there is much with which to be pleased. My programs’ recovery from drawdown lows has been quick. My systems squared off with several waterfall decline periods and whipsaw recoveries and have managed to gain for the year. Year to date, one program has returned twice the S&P 500, while the other lags closely behind. Conversely, there is much with which to be disappointed. My performance is below where I would like it to be—it is not good enough simply to be slightly ahead or behind the S&P 500. New equity highs have been brief, too far between and difficult to recapture.

    As we enter the final quarter of the year, I am hopeful as the macro conditions appear to be favoring my algorithms. Trade set-ups which have plagued my results this year are returning to profitability. Overnight ranges are contracting and intraday ranges are expanding. This can mean good things for my trading. We will endeavor to make the fourth and final quarter of a seesaw year a profitable one.

    IN FOCUS | October Market Outlook
    In my August market commentary, I speculated that equity markets would form a top and sell off. This indeed was the case, as macro conditions punished the markets through the last week of that month. Almost on cue, however, market pundits trotted out something called “The Hindenburg Omen.” This clumsily named market indicator was purported to be “behind” every market crash since 1928, though on closer inspection it is less accurate in predicting crashes than flipping the quarter in my pocket. Even still it made the rounds on CNBC, blogs and even a few serious financial news outlets. Analysts began predicting 20% declines in equities by the end of September. The end was nigh…again.

    On the first of September, the market bought a ticket on the Hindenburg and reversed, recapturing August’s decline and sending the market back toward the 1150 level it sought at the end of July. The Dow posted its best September in 70 years. This is in keeping with my contrarian view of equity markets—that when the short term focus of the market moves prices and sentiment too far in a given direction, prices are bound to reverse. It is also in keeping with the story of US equity markets in 2010. When the markets focus on macro conditions, a panic sell-off ensues. When the market keys in on central bank intervention or corporate profits, we go back to “climbing the wall of worry” and rally, but where are we ultimately headed?

    There are still strong headwinds facing equity pricing. Two of the largest components of GDP (real estate and health care) face regulatory uncertainty via Dodd-Frank and Obamacare. Consumer spending is under pressure. Rising commodity prices are inflating non-durable goods prices like food, which will grab a larger share of consumers’ disposable income, reigning in consumption. Consumption will be further constrained by unemployment and tax increases looming in 2011. Private sector investment is still being crowded out by government and Western sovereign solvency remains a heavy counterweight to growth.

    Yet, equity markets are grinding out higher prices. Companies continue to reign in cost structures and post near record profits on less revenue. Stocks remain cheap to cash (and almost anything else) and the global reach of blue chips ensures that meager US growth does not impact the bottom line the way it used to. The market could absorb even a disastrous September employment report. QE1 never stopped (see POMOs), QE2 is coming in some form (to stave off the brewing foreclosure crisis) and it will serve to further inflate asset prices and weaken the dollar. And as I have noted many times, if money is cheap (or in the current environment practically free)—why not borrow it and buy anything (especially commodities)?

    The market seems bound to climb higher into the November election. After the post-election FOMC announcement, we will sell off a little but we should continue our march higher from that pullback. Though the economic picture in the US has stalled or declined, the market has decoupled from the US economy. Stocks will move higher, while higher commodity prices continue to squeeze the consumer.

    In my 2010 outlook, I argued that equity markets were exhausted and would “struggle throughout the year.” This was based on my reasoning that “a crisis of public debt could expose the central structural problems in the US economy.” I postulated equities would move lower throughout the year. As a result of continued central bank intervention, even in the face of a change of power in Congress, I now believe that the fourth quarter of 2010 will be positive and equity markets will close higher for the year. Bernanke has punted a reckoning with the ‘new normal’ into 2011.


    John L. Roe
    ROE Capital Management, Inc.

    PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. An investment with ROE Capital Management is speculative, involves a high degree of risk and is designed only for sophisticated investors who are able to bear the loss of more than their entire investment. Read and examine the disclosure document before seeking ROE Capital Management’s services.

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