Fund Blawg

The bear market that began in October 2007, is slowly taking out pockets of strength in the stock market. Until recently some international funds, primarily in Latin America, have been holding up. Recently though even these funds have begun to sell-off. The iShares Latin America ETF (ILF) is down around 20% from it's April 2008 highs.

Funds that invest in emerging markets in general have not held up as well as the Latin America region. The iShares Emerging Market ETF (EEM) fund topped out in October 2007, with the rest of the market and has not recovered yet.

The iShares Emerging Market ETF has Brazil stocks as it's largest country holding, but China and Korea follow as the largest representatives in the portfolio. The charts below show that China and South Korea have sold off in sympathy with the US markets.

Commodity ETFs, which have been leading the market, have been hit by a wave of selling in recent weeks. Specifically funds connected to the energy, steel and coal industries have sold off.

Leading the way down with a 22% decline is the Natural Gas ETF

The Coal ETF which invests in coal mining stocks has seen better days:

Finally the steel ETF peaked in mid-May and has seen steady selling since that time.

Comstock Partners wrote a great article entitled "Three Stages of a Bear Market" . According to Comstock the three stages are denial, concern, and capitulation. From the decline that begin last fall through March of this year there was denial. Wall Street denied there were problems with subprime loans. Then Bear Stearns failed. The buy and hold and hope crowd said there was no problem and the market will come back. They said to buy for the long term, even though the S&P 500 has underperformed the ten-year note for the last 10 years. The market rally from March through late April even renewed their optimism.

However with the persistent selling in the market over the past few weeks, the failure of a high profile bank, and the solvency concerns surrounding Fannie Mae and Freddie Mac, I think we have entered the concerned phase. I am being asked by more friends and colleagues about the market and what they should do with their investments. The financial media officially declared we are in a bear market last week with the Dow Jones off 20%+ from its peak. The market now has investors attention.

I think the third phase is yet to come as the major indices are breaking major support levels. As I have pointed out in previous articles breaking of major support levels tends to trigger more institutional selling. 

With the major indices down another 2% or more today, a major decline may be in the making. The chart of the S&P 500 shows that it made a new closing low today.

A decisive close below the January and March 2008 lows will signal a fresh round of new selling. There are two key takeaways from this chart: the rally off the March lows has been erased and the volume for the last six weeks (all down) has been higher than the volume on the rally. This is a sign of professional institutional selling. What do I mean by institutional selling? I define institutions as the players who trade in large blocks and have the ability to move stocks up or down.

Take a look at the chart of the mortage lender Freddie Mac, down 23% today.

The stock has traded 200 million shares this week, way above average volume. A sign that institutions believe worse is to come and that they just want out of the stock.

In reaction to rising oil prices, congress, the media and a naive public have erroneously blamed "speculation" in oil futures as the culprit. If only those speculators would go away oil prices would decline. Not true. Oil prices are responding to supply and demand inequalities and rising inflation.

The average american does not invest in commodities via futures contracts and is consequently not familiar with the inner workings of the futures exchanges. The New York Mercantile Exchange, Chicago Mercantile Exchange, and Chicago Board of Trade are not exactly household names. Senator Charles Schumer addresses this issue in a recent WSJ Article:

"Futures markets aren't some shadowy dangerous force, but are essentially a price discovery mechanism. They allow commodity producers and consumers to lock in the future price of goods, helping to hedge against future price movements. In the case of oil prices, they are a bet about supply and demand and the future rate of inflation. Democrats nonetheless now argue that these futures markets are generating the wrong prices for oil and other commodities...

And who are these "speculators" driving up prices? The futures market operator Intercontinental Exchange says that an increasing share of its customers are not financial houses but commercial firms that need to manage oil-price risks – refiners, airlines, and other major energy consumers. Another term for these "speculators" would be "American business.".

Southwest Airlines is one example of an American business that "speculates" in the energy futures market. Southwest buys jet fuel (derived from crude oil) at todays prices for delivery at some time in the future. Southwest does this to reduce the risk of rising fuel prices to it business. This process is known as hedging. This quote from an article about Southwest and its hedging program shows just how extensively it hedges in he futures market:

"The airline, one of the largest at Los Angeles International Airport, locked in more than 70% of the fuel it expected to consume this year at about $51 a barrel, far below Thursday's closing crude price of $126.62 a barrel. With the huge cost advantage, Southwest hasn't had to hike air fares or like other carriers impose new fees, including last week's decision by AMR Corp.'s American Airlines to charge domestic fliers $15 for checking a single suitcase and to increase other fees."

If Southwest did not hedge in the futures market they would have to pass higher fuel prices on to consumers.

The futures market in oil is working exactly as it was intended to: provide a free and open marketplace where buyers and sellers ultimately determines the fair market price. The high price of oil is telling is that we must ration this scarce resource, find cheaper alternative sources or pay higher prices. If only people would just listen to the market instead of shooting the messenger.