As always, RealMoney's bloggers were all over the market action this week, and we'd like to share the best of their recent commentary with readers of TheStreet.com. These posts best capture the intent of these blogs, which is to provide intelligent discussion on the issues each writer sees as most pressing that day.
Let's take a look at
on aggressive small investors,
on the good and bad of volatility and
on bearish sentiment's effect on bonds.
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Rev Shark's Blog: Smaller Traders, Smaller Caps
Originally published on 6/06/2007 at 1:55 p.m.
Bob Marcin has an interesting post regarding the shutdown of a $550 million small-cap hedge fund by Tudor Investment. The reason given for the move is a lack of opportunities in the small-cap sector.
So should the average individual investor/trader also exit the small-cap sector and start focusing on bigger-cap stocks instead?
Absolutely not. The problem for a fund like Tudor is that it has too much money and can't move fast enough. It needs to find undiscovered "value" situations in which it can build positions that pay off over time.
Individual investors don't have that handicap. They can aggressively move in and out of these small stocks, and don't have to worry about the illiquidity that big funds face.
There is one thing to keep firmly in mind when considering the relative merits of big-caps vs. small-caps. Small stocks will always be the bigger movers because they have more risks. Even in the worst market for small stocks, there will be plenty of them that are moving 10% or more a day. The opportunities for the aggressive small investor will always be in the small stocks.
The arguments about the relative merits of big-cap vs. small-cap are important for fund mangers and buy-and-hold-type investors. Aggressive individual investors and traders need not concern themselves with that distinction because the best stocks for their purposes will always be the small-caps.
Steven Smith's Blog: The Double-Edged Sword of Volatility
Originally published on 6/7/2007 at 5:26 p.m.
Last night I attended an event held by Saxo Bank, a Denmark-based financial firm specializing in foreign currency that is looking to expand into the U.S market.
In the course of his presentation, the company's CEO made some astute observations, such as one of the reasons U.S. investors are less knowledgeable and less active in regard to trading currencies is that the dollar has long enjoyed benchmark status and a fairly stable valuation, meaning we essentially take it for granted. This is unlike many emerging markets, in which double- and even triple-digit inflation can devastate one's nest egg in a matter a months and put your very ability to survive at risk.
Now with the recent decline in the dollar and the euro firmly established as a rival for the crown as the default international currency of choice, investors are becoming more attuned to the impact of changes in valuation, making the U.S. market ripe for growth in forex trading.
Volatility and Its Effects
But before I go off on a tangent, the comments that caught my attention, and are of more immediate pertinence, had to do with the use of derivatives and the general lack of volatility in most of the leading currencies.
The two are not unrelated, in that the increased use of options and other instruments for hedging -- which usually takes the form of selling or writing the derivative to reduce risk, but enhance returns, through incremental income -- leads to a decline in volatility.
A similar phenomenon has been occurring in the stock market, as hedge funds and cover-call funds that use premium selling strategies have proliferated. Saxo's CEO does not find this good for business and said he hopes and believes that volatility will increase in the near future.
Today we certainly saw a lift in volatility, and this brings up the point that the desire for a more volatile market is a double-edged sword for financial firms. Certainly, professional traders, both institutional and individuals, welcome it as more price swings provide more opportunity for short profits.
But for the retail investor, who is crucial for the long-term health and viability of the market and whose commitment comes mainly through mutual or sector funds or core stock holdings, volatility is not viewed as good thing.
Just as those in some countries are seeing the value of their savings accounts get discounted on a daily basis due to a decline in their currencies' value, if stocks are not perceived as a somewhat reliable storage place for holding assets, investors will look for a new home. This is just what occurred after the dot-com bubble burst when people started plowing their money into homes and real estate, causing prices to surge. Now that doesn't look like a sure thing anymore.
It's important to be aware that one of the drivers creating the recent low-volatility environment has been the use of options and hedging strategies that take advantage of perceived price discrepancies and valuations "in line." This may make for a wonderfully trending market for buy-and-hold investors, but as more funds pile into this type of trade, their returns have been diminishing.
It also creates something of a tinderbox of people with short option positions, so if something occurs to cause people to unwind these positions and look for a new home for their money, it can create a volatile price move at the same time.
The question is what level of volatility is "just right," in that it can both entice professional traders and still offer retail investors decent returns at an acceptable risk so the two can have symbiotic relationship to maintain a healthy market environment. I don't have the answer, maybe the bond market is finding one right now.
Tony Crescenzi's Blog: Fueling Bonds' Fall
Originally published on 6/7/2007 at 1:10 p.m.
Adding fuel to recent weakness in Treasuries is a key dynamic related to the mortgage-backed securities market, which at $6.6 trillion is the biggest segment of the $28 trillion U.S. bond market.
When yields rise, mortgage rates also rise, usually by more than the rise in Treasury rates because credit spreads tend to widen when interest rates rise. When mortgage rates rise, fewer people refinance their existing mortgages and housing demand weakens, reducing the amount of mortgages that are prepaid. This affects holders of mortgage-backed securities, who have assumptions about the amount of so-called mortgage prepayments that will take place over a given time period.
For example, a holder of $10 million of mortgage-backed securities might assume that 20% of the securities will be prepaid over the next year because of refinancings and housing turnover. This would bring the investor's holdings down to $8 million by the end of the year.
If, however, prepayment expectations were to fall to 10% because of a rise in mortgage rates, the investor would be left with $9 million in securities, an excess of $1 million, requiring either an outright sale or a sale of Treasuries as a hedge against a further rise in mortgage rates and hence, reduced prepayments.
This said, it is important to recognize that as an institutional market, the bond market is not subject to the capriciousness that often causes volatility in the stock market. With this in mind, it will take data and news that go beyond the current set in order to push yields up significantly more in the short run.
A bounce in bond prices therefore seems likely relatively soon, possibly as early as today. In short, sentiment has probably gotten too bearish given the current set of news. This won't stop the move back to the funds rate, but it will stop it from happening overnight.