1) Small cap ($IWM) vs Large Cap($SPY)

Small caps are more volatile as they are easier to move. They tend to outperform in periods of rising confidence and drastically underperform during corrections, when the bids for them simply disappear.

2) Emerging Markets ($EEM) vs $SPY

Emerging markets are synonymous to higher growth and higher yield. When the the fear of missing out is bigger than the fear of losing, emerging markets tend to outperform.

3) Consumer Discretionary ($XLY) vs Staples($XLP)

When the stock market is in a process of discounting potential economic slowdown, staples tend to outperform as money chases recession-proof, dividend paying companies like tobacco and healthcare, for example. Consumer discretionary stocks are cyclical plays and tend to outperform during periods of increased optimism.

4) Basic Materials ($XLB) vs Utilites ($XLU)

The ultimate leading indicator of rising inflation is price action in commodities. Highly leveraged, high dividend paying utilites tend to outperform in period of pessimism and deflationary expectations, and severely underperform during “risk-on” market periods.

5) $SPY vs Long-term Treasuries ($TLT)

When the return of principle is more important that the return on investment, U.S. Treasuries are considered the ultimate safe haven and capital flows to perceived security. When money is chasing return and market mood is improving, capital tends to favor equities.

For example, curently the 5-year U.S. Treasury note yields less than 1%, the 30-year treasuries yield 3.15%. No hedge fund  could justify its fees or pension fund reach its annual target by investing in these vehicles. Once the fear of losing principle subsides and inflation expectations kick in, equities tend to outperform.

Apple, the stock and the company, is everything but not typical

Most momentum stocks go through 3 main stages:

1) Earnings growth leads price growth. There is sudden acceleration in earnings growth that starts a process of repricing, but most investors are still cautious with the new name. They either don’t trust the sustainability of the story yet or haven’t heard about it. This period could continue anywhere from 6 months to 2 years. (think in terms of Hansen Natural in 2004 – 2005)

2) Price growth leads Earnings growth. At this stage the stock and its story are widely known and understood. The market projects the current levels of growth into infinity and it proactively discounts the best case scenario. This stage typically continues anywhere from 6  to 18 months. (think in terms of $MNST in 2006 – 2007 or $NFLX mid 2010 to mid 2011)

3) Either price growth and earnings growth start to go hand in hand or price growth drops below earnings growth ( as it is often the situation with ex- momentum leaders)

As you can see from the chart above, $AAPL is not following this pattern. While its market cap has increased 46 times for the past 10 years, its earnings per share growth has been even more impressive – 130 times. The EPS growth was offset by a 60% decline in the P/E multiple that the market is willing to pay. P/E often reflects investors’ expectations for near-term growth. As Nicholas Darvas liked to point out:

It is the anticipation of growth rather than the growth itself that leads to great profits in growth stocks. The biggest factor in stock prices is the lure of future earnings. The dream of the future is what excites people, not the reality

Walmart’s shareholders have experienced that personally. Over the past 10 years, $WMT’s EPS have more than doubled, while the market cap of the giant retailer fell 21%

The law of big numbers’ effect is commonly known and it is already discounted

For more than three years, investors have been pointing out that the gigantic size of Apple will limit the pace of its growth. Apple has proved them wrong, but Apple has been an exception. Historically, size has been an enemy of fast growth. Eventually, the naysayers will be right, but this might not matter.

Everyone and his grandmother has heard of this thesis and it is already discounted by the market in some form. How else would you explain the fact that $AAPL is trading at 15 times P/E while it is growing its earnings at 50%. The market clearly anticipates slowdown in earnings and if there is a surprise, it is likely to be on the upside.

Should Apple Pay Dividends – Not Today

There have been many discussions lately about the money hoarding by the big U.S. tech companies. The common denominator is that $AAPL  and $GOOG should start paying dividends. At this point, this suggestion is ill-advised and doesn’t make any sense.

Apple’s current ROE is 41%, which means that it makes 41 cents for every $1 of its capital. Logic says that if Apple’s shareholders cannot find an investment with higher than 41% return, they should not want to get paid dividends. Apple is still using their capital wisely.

Expectations Going Forward

Over the past few quarters, it has become a tradition  for $AAPL to appreciate in front of its earnings report, reflecting general expectations for positive surprise. The price action after the report hasn’t been that inspiring as “buy the rumor, sell the news” effect has dominated. I don’t expect this quarter to be any different, but anything is possible.

Disclosure: At this point of time, I don’t have a position in $AAPL

Acting like you know everything is more dangerous than accepting your limitations.

Macro forecasting is not critical for investment success.

The only constants in capital markets are change and uncertainty

Being on the crossroad between the risk of losing money and the risk of losing opportunities

These are some of the tidbits from Howard Marks’s latest investors letter, which is among my favorite reads. There is always something insightful to learn.

Oak Tree

2)      Plethora of high-volume breakouts to major new highs, representing different industry groups. The so called “market of stocks” environment.

3)      Low correlation market, which produces both winners and losers. There are good ideas for both bulls and bears.

4)      Defensive sectors underperform. Capital leaves perceived safety and rotates into more economically sensitive sectors.

5)      High beta names outperform as the fear of missing out becomes higher than the fear of losing. Small caps, emerging markets, low priced stocks outperform.

6)      The financial blogosphere will be filled with skepticism. Six months of trend-less , volatile market that was dominated by mean-reversion could certainly condition even the most experienced market participants to be extremely cautious with new breakouts. The rule of thumb is that during pronounced uptrends, there will always be people who will complain that the market is overbought and warn for an impending correction. As Schopenhauer stated long time ago: ““Every truth passes through three stages before it is recognized: In the first it is ridiculed; in the second it is opposed; in the third it is regarded as self-evident.”

7)      There are so many breakouts that you are confused which ones to take. You feel like a kid in a candy store or like an adult in front of a cheese stand with 200 options to choose from. This is normal – the human brain is meant to operate in an environment of scarcity. To cope with a situation like this, we have invented shortcuts that mean different things for different people. Technical analysis is one form of a short cut.

8)      Breakouts stick and have a follow through.

9)      Most of the dips you buy, turn out profitable.

10)   Major market indexes are trading above their rising 50dma. The moving averages are typically lagging indicators, but they often play the role of a good point of reference.

11)   Market indexes are rising on increasing volume. The pullbacks are on lower volume

12)   People ask why such and such stock is up 15% today on now news. Sometimes the only news you need is the lack of bad news. Positive sentiment and money flow are powerful catalysts that could continue longer than most expect and have bigger impact than most are willing to comprehend.

13)   Your confidence increases substantially and you honestly believe that you are the best trader in the world. Don’t confuse brains with market uptrend. Overconfidence is the single biggest reason for investors’ demise. The second biggest reason is ignorance, but this is a topic of another conversation.

No matter the market environment you trade in, paying attention to risk management is of utmost importance. You don’t have to be right, you don’t have to be original, you don’t have to be first, but you have to take favorable risk to reward trades. If you don’t have a plan, you will become part of someone else’s plan.

I know 13 is an odd number, but this is all I could come up with at this point. Add yours in the comment section, if you will.

The earnings season is still young and it is early to draw any major conclusions. With that in mind, the truth is that so far the reports have been weak at best, but market participants have managed to see a silver lining.

Alcoa ($AA) and JP Morgan ($JPM) missed, but both are hovering close to their pre-earnings levels.

$CROX merely guided in line last week, but its stock appreciated 20% on the news.

The security software company – Check Point Technologies ($CHKP) barely beat the estimates by a few cents. Those familiar with the games on Wall Street, realize that a few cents earnings beat is nothing abnormal. The result – 8% price appreciation on 3.5 times the average daily volume. And all this in a shaky tape, ruled by heavy profit taking.

Positive market reactions to vague earnings reports is a good sign of healthy risk appetite.

Of course, if you miss the estimates by a mile (as $C did) or if you guide below the consensus (as $EDU and $CREE did), the market will be merciless as it has always been.

For the first time in a long time, we trade in a “market of stocks” environment, where individual companies’ catalysts are more important than macro headlines that usually take the front pages of financial media.

Here are some of my favorite quotes from the letters:

The prevailing casino atmosphere must certainly put a damper on trips to Las Vegas or Atlantic City, where there are more losers than winners. In Internet- land, there have been no real losers as of yet; the illusion of a positive-sum casino is an attractive lure for the gambler. Recent exuberance notwithstanding, at today’s valuations it is clear that Wall Street is certain to continue issuing shares of new Internet companies until the supply of shares overwhelms the resources of the buyers…

Sentiment, existing only in the minds of investors, is subject to change quickly and without notice…

The financial markets have been so strong for so long that fear of market risk has mostly evaporated. People who used to hold bank certificates of deposit now maintain a portfolio of growth stocks. It is not really within human nature to comprehend that you may not know everything you think you know, and, further, that what you believe in could change on a dime…

Unprecedented gains in large capitalization growth stocks continue to generate a mistaken faith among individual investors in the safety of owning stocks, as well as an erroneous impression of the potential future returns from equity ownership. Success begets additional success as investors project future results from the rear view mirror. One particularly irksome development is that fundamental research is today a significant impediment to good short-term results, as the most overvalued securities have steadily been the best performers and the most undervalued the worst. More and more, stocks are seen as apart from the businesses underlying them, with capital gains a product of investor money flows rather than corporate profit growth…

Very few professional investors are willing to give up the joy ride of a roaring U.S. bull market to stand virtually alone against the crowd, selling overvalued securities without reinvesting the proceeds in something also overvalued. The pressures are to remain fully invested in whatever is working, the comfort of consensus serving as the ultimate life preserver for anyone inclined to worry about the downside. As small comfort as it may be, the fact that almost everyone will get clobbered in a market reversal makes remaining fully invested an easy relative performance decision…

Our concern is that we cannot know when the current love affair with large capitalization growth stocks will end, and what sort of havoc this will wreak on smaller stocks, however inexpensive. As we have explained before, the only logical way to hedge against this risk is to protect an investment in these undervalued smaller stocks with a put option on or short sale of more expensive stocks. We have ruled out short selling for a number of reasons, including the unlimited downside risk that short selling poses. With puts, at least, your cost is limited to the up-front premium. Such a hedge, however, is historically quite expensive and, as we learned last year, far from perfect…

The gravitational force of the Internet and technology stock bubble is exerting a strong pull on the assets of investors. Money is draining from other sectors of the market into these strongly performing ones, causing share prices of more mundane companies not merely to underperform but actually to decline…

The Investment challenge of providing liquidity to out-of-favor asset classes is more complex than simply identifying areas that others are avoiding. First, it is important to never be blindly contrarian, betting that whatever is out of favor will be restored. Often, investments are disfavored for good reason, and investors must consider the possibility that recovery may not occur. Second, it is important to gauge the psychology of other investors. How far along is the current trend, what are the forces driving it, and how much further may it have to go? Being extremely early is tantamount to being wrong, so contrarians are well advised to develop an understanding of the psychology of the sellers. Finally, valuation is extremely important in reducing risk. Investors must never mistake aninvestment that is down in price for one that is bargain-priced; undervaluation is determined only by
a security’s price compared to its underlying value…

A great many value investors suffered terribly during the Internet stock mania of 1999 and early 2000. In a market dominated by money flows, the stocks of mundane companies were abandoned for those that offered growth, the more explosive the better. These value managers experienced poor performance, resulting in investor outflows, which necessitated additional selling. Although value managers have recently outperformed growth managers, they have only started to narrow the performance gap of the last several years.

In today’s environment, money flows rule, trumping all other factors in determining security prices. From any starting point, money flowing into one category and away from another can wreak havoc with accustomed levels of valuation and can cause egregious mispricings, both too high and too low…

Seth-Klarman-Baupost-Group-Letters

This quote illustrates perfectly the nature of the current market. Yes, some of the 52week high breakouts have been holding as of late, but the real money has been made in the beaten down stocks that staged a comeback. The laggards of 2011 are just killing it YTD  - January effect in its full prime.

Last week, the spotlight was at rare earth metals ($REE), consumer discretionary ($NFLX, $WTW, $NTRI), home furnishing ($CPWM $SCSS), non-European Financials ($GGAL, $BAC), biotech ($DNDN, $JAZZ)

This week, the hot groups have been: education ($STRA), solar ($WFR, $STP, $YGE), China ($DANG, $RENN, $CGA, $BORN), recent IPOs ($FRAN, $ZIP, $Z, $P)

Keep in mind that when such laggards start to run like crazy, the probability of general market correction increases. Enjoy the party while it is going, but make sure that your gold BMW doesn’t turn into a pumpkin. As Brian Shannon wisely points out:

There are no concrete signs of an imminent pullback, this is just an observation about the nature of risk management.

• 5%+ movers
• on higher than the average volume
• if they make new 20-day high, this is a bonus that improves the odds of success

The same criteria could be reversed and used to find short candidates.

This equity selection approach involves higher risk, but the potential reward could sometimes be justified, because you could catch a new trend at the very beginning of its development. In today’s fast paced market, “repricing” tends to happen lightningly fast. 80-90% of the move happens in 15-20% of the days one trend is sustained. The rest is nothing else but noise in a range. The fastest price appreciation or depreciation happens at the beginning and at the end of a trend.

It is true that you don’t have to be first to notice a new investment theme in order to profit from it, but in today’s environment of frequent fading the 52week high breakouts, it is wise to have another approach to find trading candidates.

Don’t buy anything blindly. Always think in terms of risk to reward. Risk a $1 to make $4.

The most important trading or investing advice I have ever received was to “never say never”. It helps me not to argue with the market when it tells me that I am wrong.

My “change of character” list from today follows below:

$BID – Auction house for high-end art. Missed earnings last quarter.
$BWA – Auto parts supplier. Very cyclical business.
$IPI – US potash producer. The whole fertilizer group has staged a comeback as of late
$MPEL – Casino operator in Macau. Asia continues to be the single bright spot for the industry.

1. U.S. Financial stocks have their issues, but in 2012 they are like a breath of fresh air compared to their European counterparts. The number of regional U.S. bank stocks ($KRE) near 52week high continues to expand, while in Europe the most popular bank has become the mattress ($EUFN). Maybe this is why all home furnishing stocks are doing so well at the start of the year ($SCSS, $TPX, $LZB, $PIR..)

2. U.S. equities and the Euro Index ($FXE) are parting ways for the first time in years. Over the past 6-7 years, there has been very strong correlation between the two, backed by trillions of dollars of carry trade money. The divergence here is certainly a major change of character that will impact the capital allocation of a lot of macro managers.

3. The U.S. Dollar Index ($UUP) and gold ($GLD) are rising together. This has happened before, but not for an extended period. No major conclusions to make here. Just a temporary blip that will be arbitraged over time.

And finally for dessert, $SPY and the Shanghai Composite have separated paths once again. In the past, $SPY has been the index to follow Shanghai. Only time will tell if the situation today will be any different. As the saying goes, divergences could continues longer than you could remain solvent.

For example, the first two trading days of 2012 were especially beneficial for some Argentinian bank stocks that were beaten down in 2011:

Weight loss stocks are also having a comeback. Not surprisingly, after taking into account many people’s New Year’s resolution to get in shape and the fact that $MCD went up 30% in 2011. A lot of calories have to be burned

Some of the declining stocks reverse course near the end of the year as the selling for income tax purposes subsides. Typical recent example is $OPEN.

This is something that happens consistently every year. A good setup to keep in mind.