Time to Get Exotic in These Rigged Markets?

Angela Moon of Reuters reports, Wall Street suffers worst loss in three weeks:

Stocks posted the worst day in three weeks on Thursday on mounting evidence that slowing manufacturing growth worldwide threatened corporate profits.

Shares of energy and materials companies led declines as commodity prices fell. U.S. crude futures slipped below $80 a barrel for the first time since October and the S&P energy sector index lost 4 percent. Investors said weak overseas demand was responsible for the decline in those industries.

Stocks' slide was accelerated by a bearish call from Goldman Sachs, which recommended clients build short positions in the broad S&P 500 index on expectations of more economic weakness.

"We are recommending a short position in the S&P 500 index with a target of 1,285," (roughly 5 percent below current levels), Goldman Sachs said in a note.

The investment bank cited the Philly Fed's mid-Atlantic factory index, which fell to minus 16.6 in June, an unexpected contraction in the region's factory activity.

Semiconductor stocks weighed on the Nasdaq after chipmaker Micron Technology Inc posted a net loss for the fourth straight quarter. Micron lost 7.8 percent to $5.65 and the PHLX semiconductor index dropped 4.1 percent.

Stocks had enjoyed a two-week run that brought the S&P up more than 7 percent on hopes for additional stimulus from the Federal Reserve.

Business activity across the euro zone shrank for a fifth straight month in June and Chinese manufacturing contracted, while weaker overseas demand slowed growth by U.S. factories.

"While we've seen only two of many regional manufacturing surveys for June, there is a clear deterioration taking place, with only the degree being the broad issue," said Peter Boockvar, equity strategist at Miller Tabak & Co in New York.

The KBW Bank Index fell 2.3 percent amid expectations Moody's Investors Service would announce downgrades in the banking industry.

The Dow Jones industrial average was down 251.35 points, or 1.96 percent, at 12,573.04. The Standard & Poor's 500 Index was down 30.19 points, or 2.23 percent, at 1,325.50. The Nasdaq Composite Index was down 71.36 points, or 2.44 percent, at 2,859.09.

The day's decline was the worst since June 1 when the S&P 500 fell 2.5 percent.

"The market was extremely overbought coming into this week, and the news gave it an excuse to sell off," said Jeffrey Saut, chief investment strategist at Raymond James Financial in St. Petersburg, Florida.

Softening data globally lifted hopes of central bank action to support the economy. The U.S. Federal Reserve announced on Wednesday it would extend one monetary stimulus program and said it was ready to do more to help economic growth if necessary.

"Although yesterday's FOMC delivered easing as expected, with a dovish statement, positive risk sentiment ahead of the FOMC had already buoyed markets. And we now think, with incremental US monetary policy on hold, the market will need to confront a deteriorating growth picture near term," Goldman Sachs said.

U.S. home resales fell in May and the four-week moving average for new unemployment insurance claims rose last week to the highest level since early December.

Celgene Corp slumped 11.5 percent to $59.45 after the company said it was withdrawing a European application for wider use of its big-selling Revlimid blood cancer drug.

Philip Morris International lost 3.3 percent to $85.62 after forecasting full-year earnings below Wall Street estimates, saying a strong dollar has hurt sales abroad.

After the bell, Moody's Investors Service cut the credit ratings of 15 of the world's biggest banks in a highly anticipated move that was part of a broad review of major financial institutions.

Among the moves, Moody's cut JPMorgan Chase & Co's long-term senior debt to A2 from Aa3 and assigned it a negative outlook negative. It also cut Morgan Stanley's long-term senior unsecured debt to Baa1 from A2 and also assigned it a negative outlook.

Shares of JPMorgan added 1.4 percent to $36.00 and Morgan Stanley added 3.2 percent to $14.41 in extended trade.

About 7 billion shares traded on the New York Stock Exchange, the American Stock Exchange and Nasdaq, below last year's daily average of 7.84 billion.

The dive in energy and mining shares sent Canada's benchmark TSX index plummeting by 350 points, its biggest one-day drop since November.

And yet, it was yesterday that I wrote about how pension funds flight to safety is skewing markets, warning investors to start taking intelligent risks in this market as I see another melt-up ahead.

Am I wrong? Are we headed toward a repeat of last summer or worse? The short answer is no but we are entering a phase where coordinated policy action, especially in Europe, is becoming ever more crucial. Without a resolute policy response, market turbulence will only get worse.

Having said this, I had to laugh late yesterday morning when Goldman Sachs came out to 'warn' its clients to short the market. Got to love Goldman, their timing is always impeccable! They waited roughly 24 hours after the Fed's announcement to put out this silly call. Goldman does this all the time.

So why did they do it? Probably because their biggest hedge fund clients aren't making enough money so they needed a catalyst to shake things up. In comes Goldman with their 'prescient' market call. When Goldman says "Go Short", I can guarantee you top hedge funds, all of which I covered in their Q1 13F filings, are licking their chops, scooping up high beta shares on the cheap.

And Moody's downgrading big US banks after the close was the icing on the cake. If Goldman's call was silly, Moody's was a total joke. Senior Canadian pension fund managers who are much better informed than anyone at Moody's have all told me that big US banks are ridiculously cheap, with valuations at historic low levels.

Of course, in these markets dominated by the latest macro news out of Europe, cheap valuations don't mean much as oversold stocks can become excessively oversold in a high-frequency trading millisecond.

Speaking of which, Reuters reports that the the CFTC is aiming to release later this summer a "draft concept release" on potential risk controls and system safeguards for high-frequency trading to help ensure the safety and soundness of the markets.

Not a moment too soon but my bet is this regulation will do nothing to stop the onslaught of high-frequency trading roiling global markets. It's funny but earlier this month, none other than Institutional Investor published an article on how high-speed trading is slowing down, claiming "not easy being a high frequency trader these days."

Give me a break! Stop insulting our intelligence! These high-frequency trading scam artists hiring PhDs in math, physics and computer science are wreaking havoc on US markets and now they're going global. It's the biggest scam in markets, everyone knows about it and yet everyone turns a blind eye because the big banksters and big hedge funds are all in on this scam.

The structural volatility we're witnessing in markets isn't only about low interest rates, quantitative easing, European policy blunders. We live in an era where computerized algorithms are trading all risk assets hundreds of thousands of times a day. And they are wreaking havoc on all markets, not just the stock market.

Many pension funds have had enough. They are increasingly allocating away from volatile public markets, into private markets, searching for stable cash flows. I wrote a recent comment on how the Caisse is cutting its public holdings, moving more into real estate, infrastructure and private equity. Ontario Teachers' just announced a $400 million investment in a private Korean insurance firm.

Now, before I get a barrage of emails from Public Markets portfolio managers telling me that "this is all bullshit", let me defend some of these actions but warn pension funds thinking of shifting more into private markets. There are many risks in private markets and they typically don't show up until well after the storm hits public markets.

There are no easy solutions to dealing with volatile markets, but I think large Canadian pension funds are approaching it wisely, making direct investments into private markets or co-investing with top funds, reducing fees and reaping the long-term benefits of stable cash flows for their beneficiaries.

Is this approach risk free? Of course not but it's a lot smarter than investing in some fund of funds that will rape you on fees or trying to beat your benchmark in public markets.

Let's face it, the performance in public markets at most Canadian pension funds has come from fixed income in the last few years, and most of that is beta. With few exceptions, most stock portfolio managers have been severely underperforming their indices.

The Caisse is now shifting its strategy, hiring "industry experts" for its stock market group, but in these macro dominated markets, my feeling is this will be a losing strategy. Instead, the Caisse needs to find more people like Claude Langevin, a portfolio manager with a long track record of making money in all types of markets (one of the few outperformers in public equities).

Across the money management industry, there is a panic among active managers who can't seen to beat their benchmarks. Even top hedge funds are giving up on these rigged markets. Laurence Fletcher and Tommy Wilkes of Reuters report, Hedge funds get exotic in hunt for profits:

Investors fed up with losses from their mainstream hedge fund holdings are eyeing some exotic alternatives.

How exotic? How about portfolios betting on Chinese companies embroiled in fraud probes? Or funds looking to arbitrage prices in the electricity market?

At this week's GAIM hedge fund conference in Monaco, investors were shaking their heads about where to generate returns, with many viewing so-called safe havens such as German Bunds and U.S. Treasuries as overvalued while equities look too volatile.

No surprise then that funds trading in niche areas, where profits are less to do with general market trends and more a manager's skill, are on investors' radar.

One hedge fund investor at the conference said he had achieved double-digit returns from investing in a range of more esoteric funds, such as those involved in electricity arbitrage, where a manager tries to profit from fluctuating prices by buying and selling electricity, and those trading the volatility of option prices.

He said the outlook for returns was "very unattractive to us in the mainstream strategies: long-short equity, event-driven, distressed, credit, CTA (commodity trading advisor), global macro", seeking instead less popular areas.

"We largely see the world as saturated," said the investor. "Basically, I don't want to be in a crowded room."

He also has money in funds shorting stocks of Chinese companies caught up in fraud scandals, and in funds involved in lending securities to borrowers for a fee.

Another example: the pension fund of UK bank Barclays is looking at investments in sub-Sahara Africa's fast-growing economies, and in hedge funds which play the reinsurance industry - a sector where insurers look to unload risk.

Big-name managers such as Dan Loeb, Steve Cohen and John Paulson have recently set up reinsurance firms, while pension funds are fuelling demand for "catastrophe bonds", which offer an income in return for agreeing to pay some of an insurer's claims if a hurricane or earthquake strikes.

Reinsurance prices often jump in the wake of big payouts by the industry after natural disasters - such as Japan's Tohoku earthquake in 2011 - as less well-funded players are forced to retrench, freeing those still in the market to charge more.

"It's truly uncorrelated," Barclay's chief investment officer Tony Broccardo said, referring to how little prices in the industry are linked to traditional equity or bond markets.

"After one of these big events, the pricing of securities becomes much more favourable for us."

"REAL VALUE"

The hunt for newer strategies - particularly those that don't lose money when stock markets fall - has become more desperate after a 2011 in which the average fund lost 5.3 percent while the S&P rose 2.1 percent, according to Hedge Fund Research.

Some of the most popular strategies fared particularly badly - long-short equity funds, which bet on rising and falling stocks, lost 8.4 percent on average, the researchers say.

Some see falling returns, and the need to look harder for profits, as inevitable as the $2 trillion industry develops having sucked in tens of billions of investor dollars in recent years.

"As an industry gets more mature, it gets harder to find real value," said one prominent hedge fund executive, who spoke to Reuters on condition of anonymity.

Delegates at the conference were particularly unimpressed with long-short equity funds.

However, finding alternatives can be tricky.

"At the moment it's easy to find a lot of (assets) that are quite unattractive," said Ian Prideaux, chief investment officer at Grosvenor Estates, which manages money for the family of the UK's Duke of Westminster, one of Britain's richest men.

One panel at the conference saw funds pitch their niche strategies to around 30 intrigued delegates.

They included the Directors Dealings Fund, run by Athanasios T. Ladopoulos, which tries to trace patterns in the buying and selling of shares by directors, in the belief that executives vote with their wallets when it comes to what they really think about the strength of their own company.

Funds accepted that while there were huge risks with some niche strategies, there were also big rewards on offer from those successfully pursuing a distinct or individual approach.

"People originally got into alternatives (assets) for alternatives," said Jeff Hudson, a partner at a fund trading U.S. municipal debt. "And if you look at everybody today, they all look the same ... Nobody does what I do."

Some of these 'exotic' strategies merit consideration, others are a bunch of fluff and so non-scalable that no serious institutional investor will invest in them.

Below, Joseph Saluzzi, co-author of Broken Markets, discusses how high-frequency trading is ruining markets. Also, another Yahoo interview with Scott Patterson, author of Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It, and an expert in the way that technology and markets interact. He warns about how computerized trading threatens global markets.