The Weighted Trade

3rd Quarter 2010

We are bottom-up investors and focus our research on companies and industries.  We make no forecasts with regard to interest rates, currencies, economic growth or major stock market indexes.  We search for companies that we believe are undervalued relative to their normal earnings and have the ability to drive their return on invested capital higher.  That said, we do pay attention to what is happening in the world and, at the risk of straying too far from our circle of competence, we will comment here each quarter on things we see in the marketplace that we believe are important.

You may have read that correlation in the stock market has reached historic highs.  Stock prices appear to be moving in unison without discrimination for quality or value.  We believe this high correlation has implications for all investment strategies and below we discuss the reasons for it and potential future outcomes.

Index driven investing, whether passive or benchmark-sensitive, has played an important role in growing correlation, in our opinion.  Index-oriented investors look at the world in a very different way than we do.  They generally view risk in a relative manner as their mandate is to match or squeeze out small incremental returns over the benchmark and not owning an index stock represents risk.  When handling contributions and withdrawals, they do not necessarily buy the most undervalued or sell the most overvalued; they tend to buy/sell them all in proportion to the index.  Accordingly, the index stocks tend to rise and fall together.

When index investing was a smaller part of the market this did not matter so much.  But times have changed.  Jeffrey Wurgler, Nomura Professor of Finance at the NYU Stern School of Business, estimates in a recent paper(1) that roughly $8.0 trillion of investors’ money is currently benchmarked to either the S&P 500 or the Russell indices.  That is about 55% the $14.5 trillion that makes up the aggregate market capitalization of the stocks which trade on US exchanges.  It has become a weighted trade and it is no surprise that flows into/out of indexed pools appear to drive correlation.

The correlation problem has also been accentuated, according to a report from the derivatives desk at J.P. Morgan(2), by a macro-driven environment where traders use equity index futures contracts and exchange traded funds (ETFs) to place bets on the equity market’s direction as each new macro data point is unveiled.   It is believed that derivative trades indirectly impact the market.  Should the market price of the futures contract or the ETF deviate from the aggregate value of the underlying stocks, index arbitrageurs with high powered computers will swoop in and buy/sell proportionally  all the stocks in the index to close the valuation gap, thereby promoting correlation.  The use of futures and ETF’s has grown substantially over the past couple of years; J.P Morgan estimates that the combined daily trading volume of these derivatives (equity index futures/ETFs) is equal to about 140% of cash equity volume.  We believe this activity has created substantial new demand for basket trades of the “index”.

What does this all mean?  We believe history has shown that Wall Street frequently takes what may appear to be a good idea and pushes it to the edge of destruction.  The dominance of these benchmarking practices makes us worry.  When too much money gravitates to a certain strategy (a “weighted trade”) it can be hard to generate acceptable future returns from that strategy.  Secondly, a market that becomes driven by “blind” buying and selling could cause the stock prices of individual companies and sectors to only weakly reflect their fundamentals, creating opportunities for those able to pick their stocks carefully.  The tail has been wagging the dog and that won’t last forever in our opinion.  We are set up and fully intend to capitalize on this opportunity if it presents itself.

As challenging as this highly correlated environment may be, we believe investing in the equity of individual companies within a concentrated portfolio will provide the best opportunity for investors to build wealth.

S&P 500 Index is an unmanaged composite of 500 large capitalization companies.  This index is widely used by professional investors as a performance benchmark for large-cap stocks.  You cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges.

Russell 2000® Index is an unmanaged index that is a widely recognized indicator of small capitalization company performance

Russell 2500 Index:  measures the performance of the small to mid-cap segment of the U.S. equity universe, commonly referred to as “smid” cap. The Russell 2500 is a subset of the Russell 3000® Index. It includes approximately 2500 of the smallest securities based on a combination of their market cap and current index membership.

Derivative: A security whose price is dependent upon or derived from one or more underlying assets.  The derivative is a contract between two or more parties and the value is determined by fluctuations in the underlying asset.

The material provided herein has been provided by Linde Hansen & Co. and is for informational purposes only. Linde Hansen & Co. serves as investment adviser to one or more mutual funds distributed through Northern Lights Distributors, LLC member FINRA. Northern Lights Distributors, LLC and Linde Hansen & Co. are not affiliated entities. 0396-NLD-3/16/2012