Bullish Sentiment Declines!

From Bespoke Investment Group.com:  "According to the weekly survey from the American Association of Individual Investors (AAII), bullish sentiment declined from 37.45% down to 30.3% this week.  This remains well below the bull market average of 38.23%, but it is nowhere near the recent lows seen in mid-April."

Link:  As Expected Bullish Sentiment Declines. {Bespoke}

Base Case

We develop different scenarios around market probabilities and incorporate these into our portfolio planning process.  Here is the base scenario that we are currently using for the rest of the summer and likely into sometime after Labor Day.  A base scenario means that we believe these assumptions have the highest probability of occurring.  These are not predictions or guarantees and casual readers of this blog should understand that we bear no responsibility if you act on anything you read here.

For technical reasons first mentioned here  and then here we think the highest probability scenario is that stocks at best are locked in a range bound pattern, likely until sometime this fall.  Higher interest rates, some economic uncertainty and overhead resistance could potentially keep a lid on market advances during this period.  

We are not surprised that stocks have rallied from their lows on Monday into the end of the quarter tomorrow.  High to low stocks had declined about 7% with most of that coming in about a week's time.     In any trend {bullish or bearish}that's usually too much in such a short period.  Including today's open, stocks will have recovered about 3% of this decline and will now bump up against old support levels which are now resistance.  It won't surprise me if tomorrow is a flattish to slightly down day.  If that occurs we'll end the first six months of 2013 with all  major US averages  having recorded nice gains.

However we also think there's a possibility that stocks haven't seen their lows yet in this cycle.   The most obvious reason is the most recent past.  Since this bull market started back in 2009 stocks have developed a nasty habit of giving up most of their gains from the first part of the year over the ensuing summer and early fall months.  A market that would trade back to flat on the year would have still have to lose about 10%.  I am not saying for sure that this is going to happen.  For all I know stocks will turn around now and burst to new highs.  I am saying that I am mindful of what has previously occurred and have to commit that potential factor to memory as we develop the game plan for the rest of the year.  

If stocks are to trend lower the most natural area of consolidation is between 1,500 and 1,550 on the S&P 500 by our work.  A market that trades down to 1,500 would mark a correction of slightly more than 10%.  The S&P 500 at 1,500 would trade with roughly a 14 PE and a 7.1% earnings yield.  Again I will stress that I am not predicting this will occur, I am solely pointing out what our money flow work suggests.  If you trade on this analysis, particularly if you decide to sell securities or short the market based on anything you read here you do so at your own risk.

Irrespective of what may happen these next few months, we have added a few sector ETFs in client accounts based on areas of the market we find attractive and have also put some new client money into the markets.   While I won't go into specifics at this time, I will say that they are more cyclical in nature and these purchases are predicated on our belief that economic growth will favor these sectors in the 12-18 month time period that we typically invest in.  We are still of the opinion that stocks have the potential to resume their advance later this year, irrespective of what may prove to be a period of uncertainty and chop over the summer.  We'll pick up on why we think that longer term markets are better to buy after the 4th of July holiday week.  We're giving this investment thread a bit of a break until after the holiday but we'll continue looking at the markets longer term some time the week of July 8th.  We'll post next Monday-Wednesday next week and then break for the holiday.  Regular summer posting will resume on July 9th.  We'll break in of course if events warrant!

*Long ETFs related to the S&P 500 in client and personal accounts.

Valuation

The S&P currently trades with a  price to earnings ratio {PE} around 14.90 and a 6.7% earnings yield on our year end midpoint earnings estimate of $106.50.  Our year end 2014 earnings estimate for the S&P 500 is currently between $112-114.  If we use a midpoint of $113 for 2014, then the S&P trades around a 14 PE and a 7.1% earnings yield.  The ten year Treasury trades around a 2.60% yield.  It has been this parabolic rise in interest rates that has been one of the primary drivers of the stock sell off. The S&P 500 currently trades within our expected cone of probability  of 1,490-1,700.

I mentioned last week and previously discussed  back in April the possibility of raising my earnings estimate for 2013.  I will wait until we see 2nd quarter earnings before making any changes.   Right now given how quick interest rates have risen I think I'm unlikely to fool around with these estimates at this time.  With earnings season kicking off in earnest July 8th it's prudent to leave these alone at this time.

*Long ETFs related to the S&P 500 in client and personal accounts.

That Sell In May Thing Again

The price damage that has occurred to markets this last month indicates a very strong probability that stocks are range bound for the time being likely into some period after Labor Day.  Here's why I think this.

1.  Large amount of technical damage.  See yesterday's post below.

2.  Economic uncertainty.  2nd quarter earnings reports coming in early July may dispel some of this concern but there's a lot of time between now and the meat of earnings season which comes in mid-July.  

3.  Continuing concern with foreign markets.

4.  Seasonality.  We've spent an awful lot of time in the past discussing this.  Here's one of our original thoughts on this and for emphasis I'll repeat the part of that article that specifically addresses summer.  

"Stocks will fall of their own weight unless there are marginal new bidders for their shares. Summer is typically a down period for Wall Street as the news flow dries up {unless it’s bad news. It is amazing how many international crises begin in the late summer. Both World Wars, the Korean War, 9/11, the First Gulf War and the 2008-banking crisis are examples of this.} Summer is also when analysts begin to fine-tune their expectations for stock prices as clarity begins to enter the picture about year end economic activity. Stocks will also begin to discount any lower revisions or negative economic news during this period of seasonal weakness. Once this discounting process is completed stocks will usually begin to rally sometime in autumn. The cynical amongst us also know that the only print that matters for most money managers is the one shown when the market closes on December 31st. To put it simply Wall Street wants to get paid. So there is a strong incentive to boost share prices during the 4th quarter of the year." 

The chart above courtesy of Zero Hedge.com shows that once again seasonal patterns have thrust themselves into the investment matrix.  

5.  Markets will need interest rates to find some floor before they can begin to discount earnings in a new higher rate environment.  That will take some time I think as there has been similar technical damage to these markets as well.  Remember though that rising interest rates, particularly from the low levels we've seen is not necessarily a completely bad thing as long as rates don't parabolically rise higher from these levels.  Higher rates can indicate better economic activity.  

Tomorrow we'll discuss valuations and where we potentially see cones of probability for year end, twelve and eighteen months from now.  

They said sell in May.  They were right!!  {Source Zerohedge.com}

*Long ETFs related to the S&P 500 in client and personal accounts.

Cold Steel On Ice

I must admit that while we've been dealing with markets recently, we've also been following the Chicago Blackhawks in their quest for the Stanley Cup.  That ordeal ended last night when "Cold Steel on Ice" dispatched the Boston Bruins, scoring two goals 17 seconds apart in a come from behind win to take the series 4-2.

Congrats Boys!

The Open

I thought last week that markets would likely open lower today.  That looks to be the case.  We'll have to see what the rest of the day brings.  Probability would still indicate that end of the quarter portfolio window dressing  should take root the rest of the week now.

an tSionna {06.24.13: SPY}

I have no idea where the market will be at any given future point.  What I do is use a weight of the evidence approach which takes into account a wide variety of variables to try and gage different  market scenarios and then assign a probability to that event occurring.  I do this across a short, intermediate and longer term investment time frame.  The following is my attempt to explain what I see and give you an idea on what's going on.  If you are a casual reader of this blog then you act upon what you read here at your own risk.  There is no guarantee that what I am describing is correct as facts on the ground could change.  With that said, here's what I see.

The market seemed to change direction last week.  When we look back with the benefit of hindsight on what transpired, I think we're going to find that investors used Wednesday's Federal Reserve announcement as an excuse to sell and not as the reason to sell.  The reasons to sell can be many at this point.  Here a witch's brew of ingredients for lightening up:  Worries about domestic growth, rising interest rates, worries about growth overseas, lock in performance, markets not as cheap as they were, summer seasonality, concern over corporate earnings....Well you get the idea.  A year ago at this time when stocks were trading at something like 11 times what turned out to be 2012 earnings stocks had a larger margin for error.  At something over 15 times 2013 earnings right now that margin is paper thin.  Given where we are then in the cycle, it is perhaps reasonable that traders have hit the sell button.

The main scenario I'm working through for the intermediate term now is that markets will at best be rangebound probably sometime into the fall.  I've laid out the main technical points why I think that in the chart above.  However, point number 3 listed above needs some further elaboration.  From the period after last fall's elections until late spring, stocks traded in a well defined upward sloping channel and investors were rewarded for buying market dips.  That started to change in May about the time the Federal Reserve hinted that they may be closer than previously thought to winding down their bond purchase programs.   Since then dip buying has not worked.  With last week's action we now have close to two months worth of buyers who are showing losses on their books.  Long term investors won't care so much about this especially if earnings come through and markets can resume their advance sometime later this year.  Traders however do care about the short term and they will be anxious to do something about this into market rallies.  Thus the period you see circled in blue above in the chart represents all those trapped longs.  That kind of resistance doesn't get cleared away in a day.  It has to be chipped away, usually in a consolidation pattern.  That type of pattern can unfortunately mean that the markets could see lower prices at some point before any uptrend resumes.

We'll talk some more about some more implications of the pattern we've seen since last week and some of our investment thoughts for the rest of 2013 starting to tomorrow.

A Few Quick Thoughts

I'm breaking in with a few quick thoughts on the market's these past few days.  As I'm doing this more as a reaction to the past few days there's not going to be a lot of detail backing up these comments.  I'll try to put more color on some of these ideas next week.  Also since these are more or less initial reactions to what's transpired, I reserve the right to change my mind in the next few days.  

Markets are currently trading higher this morning.  I would't be surprised if these gains are erased by the end of the day.  Too much uncertainty going into the weekend.  I also wouldn't be surprised if Monday was also a bad day.  Then I think markets will try to rally going into the end of the quarter.  Remember that's just a guess based on a lot of years watching days like these and not any sort of recommendation.  I could be totally wrong on this so don't make trades based on what you read here.  If you do you're on your own.

Markets have sold off ostensibly because the Federal Reserve reaffirmed what they've been saying for a month or so that they could start to taper bond purchases sometime next year as economic conditions permit.  First, they said nothing new the other day.  Markets have started pricing this in since mid-May. 2nd, the part that most people seem to be missing here is the part about those economic conditions.  I'm in hedge fund manager David Tepper's camp which is that stronger economic growth should be good for stocks.  3rd, I don't believe that the current back up in rates is enough to derail economic growth.  I DO think that markets were overbought {especially by our work} and these most recent events have been used by market participants as an excuse to sell securities.

That being said, I'm beginning to wonder if we are seeing a sea change in market asset allocation starting to take place.  I'm wondering if some of the strategies we've seen that have worked in the past few years might not be those that work as well going forward.  In particular we've all been living in a interest rate bull market since the 1980's.  That is, we've been in a period where the long term trajectory of rates has been down.  It seems to me that we are in the long term reversal of that now.  I don't think rates are going back to where they were back then, but I'm beginning to think that we've turned the corner, especially if the economy starts to improve.

Most US market indices are still up close to double digits for the year.  Overseas markets are punk.  Most are negative for 2013.  However, significant technical damage has been done this week to the markets.  I will post on this for Monday.  I am also of a mind that those seasonal factors we've discussed this year may now come into play.

I'm beginning to feel about foreign markets like I did about US equities last year around this time.

Back on Monday.

Fed Tells Us When They'll Take Away The Punchbowl. Market Throws A Tantrum

Technicians won't like the break of this trend line today.  Wags are calling this the "Taper Tantrum".

*Long ETFs related to the S&P 500 in client and personal accounts.

Earnings and the Price Earnings Ratio.

One of our main tenants is that stock prices follow earnings.  That is why we place such an important emphasis on developing an earnings hypothesis each year for the S&P 500.  Here's data courtesy of Moneybeat.com that shows why we find this to be so important.

As Moneybeat points out, "the S&P 500 has closely tracked expectations for future profit growth throughout much of the current bull market.  The volatility in the summer of 2011 marking the only sustained period of time where the two trends differed from one another."

Next we want to take a look at historic Price Earnings {PE}ratios.  This chart is courtesy of Chart of the Day.com and is one that we've shown before.

According to the folks over there.  "Generally speaking, when the PE ratio is high, stocks are considered to be expensive. When the PE ratio is low, stocks are considered to be inexpensive. From 1900 into the mid-1990s, the PE ratio tended to peak in the low to mid-20s (red line) and trough somewhere around seven (green line). The price investors were willing to pay for a dollar of earnings increased during the dot-com boom (late 1990s), surged even higher during the dot-com bust (early 2000s), and spiked to extraordinary levels during the financial crisis (late 2000s). Since the early 2000s, the PE ratio has been trending lower with the very significant but relatively brief exception that was the financial crisis. More recently, the PE ratio has moved significantly higher and is fast approaching the low 20s -- a level around which several stock market rallies stalled (e.g. 1929, several from 1958 to 1972, and 1987)".

While I don't know exactly what the fellows that composed this chart use as data, I strongly suspect that these are trailing earnings as according to our 2013 estimates stocks are trading with approximately a 15.5 PE on our forward midpoint estimate of 106.50.  Either way this data would seem to argue for a more neutral stance on the market.

However we should note two things.  Stocks can expand their PE's, particularly if investors sniff out better economic prospects.  We have seen periods in the past where stocks in an economic expansion traded with forward PEs between 16-18.  During much of the 1980's-90's bull markets stocks traded this way.  A higher PE may also be justified in an extremely low interest rate environment. The other possibility is that the "E", the earnings part of this equation is wrong.  If for example S&P 500 earnings actually approach something closer to what seems to be Wall Street consensus estimates of around $110 for 2013 on the S&P 500  then stocks are currently trading with a PE under 15.  This can work the other way as well.  If investors start to believe that earnings estimates are too high then stock prices are vulnerable to a correction.  

The more elevated PE given the experience of the past five years is one of the reasons that we think this will be a very important upcoming earnings season.  Stocks have much less room for error if the economy or companies start to disappoint.

Links:  Marketbeat.com  Rally in Three Charts.
            Chart of the Day:  PE Ratios

*Long ETFs related to the S&P 500 in client and personal accounts.

an tSionna: Cash

From Blackrock a chart illustrating the cost of holding cash in a portfolio.  They point out that, "it is worth reminding ourselves that inflation is the major downside of holding cash.  Even in the low-inflation environments in much of the developed world, returns on cash have not kept up with consumer price increases.  So the value of cash diminishes in real, or inflation-adjusted terms over time."

I never think of cash as an investment per se, especially in this low interest rate environment.  However, there are times that it acts as a hedge particularly when equities are declining.  Cash may be a zero return asset in this environment but zero return beats a negative one sometimes!  I tell clients that they can gage my view of the markets by how much cash they have in their portfolios.  Here's a rough guide:  0-12% is a bullish view.  12-18% is neutral.  Anything above that is a bearish view.  In 2008 in many accounts we had above 30% cash positions.  Today on average we hold 12-15% cash.  This is in keeping with our current  NET MARKET NEUTRAL environment.

Link:  Blackrock: The Cost of Cash.

Valuation {06.18.13}

The S&P 500 closed last night at 1,639 down about 3% from its highs.  At 1,639 the index trades with roughly a 15.4 price to earnings ratio {PE} and a 6.5% earnings yield on our year end midpoint earnings estimate of $106.50.  Our year end 2014 earnings estimate for the S&P 500 is currently between $112-114.  If we use a midpoint of $113 for 2014, then the S&P trades at a 14.5 PE and a 6.9% earnings yield.  The ten year Treasury trades with a 2.18% yield.  The S&P 500 currently trades within our expected cone of probability  of 1,490-1,700 although it is above our original midpoint estimate of 1,625.

I had discussed back in April about the possibility of raising my earnings estimate for 2013.  I will wait until we see 2nd quarter earnings before making any changes.   It does not particularly bother me that we are currently trading above our midpoint target price, especially if earnings come in better than expected for the quarter.  However, there is less margin for error at current trading levels.  Earnings season starts just after the 4th of July so we'll begin to get a better feel for things around then.

*Long ETFs related to the S&P 500 in client and personal accounts.

Posting Schedule

Graduations have my schedule all messed up.  We're posting today even though we won't be doing so on a regular basis on Fridays over the summer.  I will not be posting on Monday next week unless events warrant as I will be out on business.  I will post Tuesday-Thursday next week and revert to the regular summer schedule of nothing on Friday.

Emerging Markets & Interest Rates.

Business Insider posted two charts today showing why emerging markets have been clobbered recently.

The first chart shows the recent rapid back up in interest rates.  This has been a rapid increase with a ripple that has been felt in all sorts of different asset classes.  For example, the bond mutual funds that I follow have lost between 1-2% in the past month.  It has been worse for other areas of the bond market.    We've been warning for quite awhile that this could happen to bonds.  See here, here, here and here for  my thoughts over the past year or so.

Which brings us to the 2nd chart again courtesy of Business Insider and James von Simson via Merrill Lynch:

Business Insider thinks that as interest rates declined in developing market all that excess liquidity went into emerging markets looking for higher yield.  Now with rates more attractive in the US and the developing world all that money is rushing back in here.

Not sure I buy that argument although that may be part of the puzzle.  Here's two monthly charts for comparison purposes, both courtesy of Finviz.com.  The first is the iShares MSCI Emerging Markets ETF {EEM}.  Notice that after recovering from its 2008/2009 lows this ETF representing emerging markets has in essence gone nowhere.  This is likely due to the fact that these markets are still feeling the pain from the global slowdown.  Note that EEM has a large exposure to both China and Taiwan.  Chinese ETFs look a lot like this chart.

Now here's the chart of the US S&P 500 ETF {SPY}

Notice that since the end of 2011 the US has been in a bull market, again likely reflecting better economic prospects here.  I think that trend has become much more pronounced in the past few months and has finally been noticed by investors.  Since money flows to where it's treated best it is perhaps not surprising that a lot of it has been coming here.   I don't know when that trend ends.  I will say that probability suggests we are later in the game in this divergence amongst these two areas because the financial press all of a sudden is giving this more attention.

I think a part of a clients portfolio needs to be overseas, somewhere between 5-15% depending on a client's risk/reward perimeters.  That can be a harder sell after three years on under performance.  However, longer term there is higher growth over there than here and having some exposure via ETFs likely makes sense to investors with the right portfolio allocation.  This kind of divergence is beginning to be much more intriguing to me on a longer term basis.

By-the-way take a look at the green bars on the SPY monthly chart.  Green indicates that month was positive.  Since the fall of 2011 when stocks bottomed there have only been three months where stocks have declined {red bars}.  Thats roughly 20 months.  A quick glance at a longer term chart seems to show that you have to go back to the late 1990s to find a similar period like this, although there was a period in 2004-2006 that was close to this.

Link:  Business Insider:  In 2 Charts You'll Understand the Gigantic Tidal Shift in Global Markets.

*Long ETFs related to the S&P 500, emerging markets and China in client and personal accounts.

Jobless Claims

In the "Things Are Getting Better" department, here are initial jobless claims.  Chart and commentary from Bespoke Investment Group.

"This morning's release of initial jobless claims for the latest week came in better than expected.  While economists were looking for claims to come in at 346K, the actual reading came in at 334K.  Although it was only the lowest reading since May 3rd, it was also the third lowest reading since the Financial Crisis.  While most economic indicators have been coming in weaker than expected in recent weeks, initial claims continue to be a bright spot.  With this week's increase, the four-week moving average also saw a nice decline, falling from 352.5K down to 345.3K.  This reading is also low enough to qualify as the third lowest weekly reading since the Financial Crisis."

Link:  Bespoke:  Initial Jobless Claims.

an tSionna: US Markets Vs. Europe

From Abnormal Returns.com via Barrons {Subscription required}:

Richard Bernstein, “The Standard & Poor’s 500 has outperformed emerging markets now for five years. Nobody cares, and it pains people to admit that the U.S. market has been outperforming.”  

Link:  Abnormal Returns.com:  Sunday Links;  Quote of the Day.

*Long ETFs related to the S&P 500 and emerging markets in client and personal accounts.

As a reminder, I'm out the next two days due to graduation obligations.

One of Our Employees is Leaving!

One of our original employees is transferring away from "Global Headquarters" of Lumen Capital Management, LLC on Sunday.  

Here she is as head janitor in the chair.

Here she is {with her sister, another ex-employee} as the junior trader of stocks! 

                   

After a brief stint as a counselor at Red Pine Camp for Girls in northern Wisconsin this summer, she will be opening for us at a new branch office come August at  St. Louis University.

Due to an influx of family and friends we will be out of the loop until mid-week.  We will of course break in if something dramatic occurs.

She is very excited about these new opportunities but her "Boss" is sure gonna miss her!

an tSionna {S&P 500}

I've said recently that a correction wouldn't surprise me.  The market being down 4% in the last two weeks makes us take a deeper look into our charts and money flows into stocks.  The chart above shows a few lines in the sand that should give us some idea as to where we might be headed.  

Of course back in April the markets also looked like they were poised to break down.  Instead they turned around and posted this last leg up.  This time may be a bit different.  The sharp gyrations we've seen the last week or so have reintroduced volatility into trading and posts such as this from Pragmatic Capitalist indicate that small investors may be starting to return to the markets.  Markets feel a bit heavier now as well, as if there's been some real selling in the last week or so.  

We've been at a little higher cash positions for awhile right now and so no reason to change that.  We are also currently NET MARKET NEUTRAL in the shortest and intermediate time frames that we measure and have been that way since the end of February.  You can go here to see what that term suggests but basically it means we have been neutral in our purchases of stocks except for new money from clients where applicable.  It is not nor should it be interpreted to be a market timing device.  

Stocks are not oversold enough quite yet to get us to review our positions in terms of potential buys except where mandated to do so by new money.  As we mentioned last week we do have the defensive pages of the playbook nearby.

*Long ETFs related to the S&P 500 in client and personal accounts.  

Update:  Thursday Morning 8:05 Chicago time.  I should have mentioned yesterday that another juncture on this chart is the 50 day moving average.  It's hare to see above but it's that orangish line that rests just below trend line 1 that I've drawn.  Thanks to Business Insider.com citing research from Miller Tabak for pointing this out.

I'd also like to remind folks that stocks don't have to necessarily decline during a correction.  Stocks can correct by time, a period of churning in a trading range, as well as price.  The devils advocate in me would also note that in every year since 2010 we've seen a summer fall correction that has wiped out all or virtually all of the gains stocks made in the first half of the year.  Not saying that's going to happen this year but thought I'd throw it out there.

Financial Innovation and ETFs.

There was a great article last week on ETFs published over at the financial blog Abnormal Returns.  It's too long for me to excerpt but everybody who either owns ETFs or has an interest in these should go read this.  Here's the intro to author Tadas Viskanta's article......

"True, long-lasting innovations ares a rare thing in the world of finance. In my book I argue that the introduction of the ETF or exchange-traded fund was exactly that. It has taken two some decades but we are now seeing real changes in how people invest due to ETFs. I wrote:

Like all upheavals, the ETF revolution has both its benefits and its drawbacks. On the whole, ETFs have made investing easier, more diverse, and cheaper. On the other hand, the introduction of ETFs has changed the actual underlying nature of some markets, and the rapid introduction of new ETFs has diluted the benefits seen early on. Unlike many revolutions, we are not likely to see a counterrevolution unseating the ETF regime any time soon."

...Now go read the rest of the article here.

Ritholtz On Hedge Funds

Barry Ritholtz who is CEO of FusionIQ, a quantitative research firm, the author of “Bailout Nation” and runs a finance blog, the Big Picture also publishes what I think is a weekly Sunday column in the Washington Post.  Here's an excerpt of an article he published on May 24, 2013 in the Post on hedge funds.  Hint:  It's not complementary to the Hedge Fund Industry.  {My highlights in Green.}

...."Despite all the media coverage, glitz and glam of hedge funds, they have not done well for their investors. They have high — some say excessively high — fees; their short- and long-term performance has been poor.......

.....Most hedge funds are “go anywhere” funds — they can own derivatives, mortgage-backed securities, credit-default swaps, structured products and illiquid assets. They also can use nearly unlimited leverage.  Gee, that sounds kinda hazardous. Why would anyone want to assume all of that risk? Originally, hedge funds earned their outsize compensation by, well, hedging their investments. This is a risk-mitigation strategy that can reduce the gains investors reap when markets are up but avoids much of the losses when markets are down.  That no longer seems to be the case with modern hedge funds. They have morphed into “absolute return” funds — more aggressive, greater leverage, more speculative, all in an attempt to generate returns that outperform their benchmarks. Not surprisingly, they have become riskier than the overall market.

Given these increased risks (and higher fees), how have hedge funds performed?

By most measures, not well. They have failed to keep up with major averages when markets were up — and they got mangled (like nearly everyone else) during the 2008-09 downturn. It turns out, most hedge funds are not very hedged.

The latest performance data (via the HFRX Global Hedge Fund Index) reveal that hedge funds haven’t fared well at all: They returned a mere 3.5% in 2012, while the S&P 500-stock index gained 16 percent. Over the past five years, and the hedge fund index lost 13.6 percent, while the indices added 8.6 percent. That’s as of the end of 2012; it has only gotten worse in 2013. Most hedge funds have fallen even further behind their benchmarks this year, gaining 5.4 percent vs. the market’s rally of 15.4 percent. As a source of comparison, the average mutual fund is up 14.8 percent.

Which brings us to fees. Most hedge funds charge an industry standard “2 and 20.” This is a 2 percent annual management fee against the original investment, plus 20 percent of the investment profits. Compare this with annual mutual fund fees, which average about 1.44 percent. Fees for an index ETF are typically under 0.25 percent.

Those outsize hedge fund fees are an enormous drag on performance. But they do create wealth — for the managers.....“Two and twenty” as the industry calls it, is why even middling hedge fund managers can become billionaires. According to Simon Lack, author of “The Hedge Fund Mirage,” this fee arrangement is effectively a wealth transference mechanism, moving dollars from investors to managers. As he puts it: “While the hedge fund industry has generated fabulous wealth and created many fortunes, it has largely done so for itself.”

Lack is no ordinary critic — he spent his career at JPMorgan Chase, where he allocated more than $1 billion to emerging hedge fund managers. Some of the statistics he amassed in the process are nothing short of astonishing:

●From 1998 to 2010, hedge fund managers earned $379 billion in fees. The investors of their funds earned only $70 billion in investing gains.

●Managers kept 84 percent of investment profits, while investors netted only 16 percent.

●As many as one-third of hedge funds are funded through feeder funds and/or fund of funds, which tack on yet another layer of fees. This brings the industry fee total to $440 billion — that’s 98 percent of all the investing gains, leaving the people whose capital is at risk with only 2 percent, or $9 billion.

What other concerns should investors have? Hedge funds are not especially liquid. Many are “gated” — meaning there are only small windows when you can withdraw your money. They typically have a high minimum investment and often require investors keep their money in the fund for at least one year....

....The Lebron James of hedge fund managers are few and far between. This is the crux of the issue with hedge funds. A small percentage have significantly outperformed the markets; an even smaller percentage have done so after fees are taken into account. While we all know which ones have outperformed over the past few decades, no one has even the slightest clue which ones will outperform over the next one. It is akin to picking out from the ranks of high school sophomores who will be the next NBA superstar. Best of luck with that.

Every fund in the world warns that past performance is no guarantee of future results. It is too bad that investors refuse to believe it.

Link:  Ritholtz:  I Hedge Fund for You and Me?  The Best Move is to Take a Pass.

Fund Flows {Addendum}

As an addendum to our post from Thursday {two postings down from here}, there is this information  via NBC News regarding the most recent money flows into funds.

"NEW YORK (Reuters) - Investors in mutual funds based in the United States pulled $475 million out of funds that hold U.S. stocks in the latest week amid fears the Federal Reserve could scale back its easing, data from the Investment Company Institute showed on Wednesday."

This may mark the beginnings of a short term top in stocks {again see our post from yesterday}, but fund flows are hardly forming the stuff that looks like a cyclical long term market top at this juncture.  If you want to see what money flows look like when that's occurring then go back to 2001 when more money went into equity mutual funds than any other time since.  Much of that entered the market in March of that year right when stocks started rolling over.