As someone who does not watch CNBC unless I’m away from the office and utterly trapped in a small hotel room that only offers 5 stations and is located in a remote region of the country, I wasn’t aware that Jim Bianco was such a talking head. Despite this handicap, Bianco Research is one of the few third party subscriptions maintained by Cove Street Capital for its thoughtful macro comments combined with data research that does a nice job of supporting or rebuking the idiocies of the day. What follows is a few paragraphs that continue a major theme from comments he made over a year ago. In regard to yet another “surprising” rally in the stock market, Bianco notes:
Many assume this is a hated rally because so many managers have underperformed, as shown below. As we noted last January, 2011 was an unchanged year for the S&P (no price change with a total return of 2.1 percent thanks to dividends). However, it was a terrible year for money managers beating this benchmark. 84 percent of managers did not beat the S&P 500.
This underperformance by most managers is nothing new. It is a continuation of a trend that started in 2010. As we wrote last January:
When told of the bad performance detailed above, market pros instinctively assume these managers made a bad market call. They were too bearish as the market rallied or too bullish as it declined. However, the data does not support this theory. First, there was no market call to miss this year. The stock market is essentially unchanged, so neither the market bears nor bulls made a bad call. Second, in looking at the data day by day, there is no relationship between the direction of the market and these funds’ performance. Quite simply, they performed poorly in both rallying and declining markets. Finally, this poor performance extends beyond equity managers. As a group, macro managers, fixed-income managers, commodity managers and international managers also had a sub-par year. Not everyone can be right, but it is unusual to see so many be wrong.
In a free market system, money is supposed to be efficiently allocated to good ideas or companies while being denied to poor ideas or companies. Most money managers are not concerned with the overall trend of the market or macro themes. Instead, they are focused on each company’s fundamentals. Both long-only and long/short managers will construct their portfolios via an exhaustive company-by-company selection process.
In today’s highly correlated world, company specifics take a back seat to macro considerations. All that matters is risk-on and/or risk-off. Unfortunately this makes the capital allocation process inefficient. If the average stock is 80 percent correlated to the S&P 500, then bad ideas rally on risk-on days while good ideas suffer on risk-off days, causing a mispricing of assets. If the capital allocation process is inefficient, then the financial sector will suffer and the economy will struggle. That is exactly what is happening as the last six quarters have seen real GDP grow less than the economy’s perceived “potential” of 2.5 percent and financial firms have struggled to the point that they continue to seek out Warren Buffett for capital injections.
Statisticians like to say that correlation does not imply causation. So what is the cause of this high correlation? In short, the extreme moves of central banks and governments are being done on a scale unprecedented in modern financial history. It is not central bank/government intervention that is new, but rather its pure scope and size.
James Grant of Grant’s Interest Rate Observer calculates that the total fiscal and monetary intervention during the Great Depression (September 1929 to July 1933) was equal to 8.3 percent of GDP. That was enough to pay for the indelible images in our memories of WPA work camps, FDIC insurance to stop bank runs and government-run soup lines. During the Great Recession (December 2007 to June 2009) government intervention was 29.9 percent of GDP – three times larger than the stimulus seen during the Great Depression when taken as a percentage of GDP
Simply, the actions of people like Ben Bernanke or Mario Draghi matter far more than any specific fundamental of a company. It’s as if every S&P 500 company has the same Chairman of the Board that only knows one strategy, resulting in a high degree of correlation between seemingly unrelated companies.
Massive central bank/government involvement in markets risks returning us to a de facto centrally planned economy. Every time the Federal Reserve opens a swap line, the ECB hints at another program to stem the crisis, or successful American money managers wonder if the Federal Reserve could directly buy Italian bonds, the central banks/governments are trading a short-term fix that raises all boats, even the bad ones, for an even more inefficient capital allocation process. Winners must be rewarded and losers must fail. High correlations among markets leading to poor performance are an indication that this is not happening today and it is hurting the economy.
