Correction or Flash Crash?

In the past several days in US equity markets, the tension thickened and suddenly the air was sucked out.  A panic or perhaps a flash crash gripped the market last Monday, which itself followed two days of selling at the end of the previous week.  It was the first serious test of the averages since 2011 and some openly wondered whether it was 2009 again.  At the start of trading last Monday, after a difficult weekend with no relief from developments in Asia, the Dow Jones Index dropped 1,000 points in 3 minutes.  The uncertainty of the developments perplexed TV journalists.  A storyline connecting the world events to a now correcting US stock market was missing dots.

Nevertheless it was harvest time for the business media as the headlines grew like apples on a tree: Chinese stocks crashing, emerging economies contracting, U.S. interest rates rising, oil prices falling and king dollar ruling them all. Opinions, speculations, and theories flew, but no one really “knew” the real cause.  All everyone knew was that the bears were having a quickie, and maybe more.

With a few days of hindsight and a little stability in equity prices, one can guess at what we were watching.  Monday revealed there is a new type of volatility risk in equity markets.  Combine high frequency trading, massive futures trading, reduced market making by banks and the elimination of the short uptick rule and suddenly JP Morgan can go from $60 to $50 in 3 minutes (with no news).  This is as stark an example of sudden crashes creating buying opportunity as can be imagined.

This is not to say that the most recent sell-off was only technical.  There are five major world trends rewriting capital flows around the world.

• A bubble deflation in the Chinese stock market.
• A growing US economy driving a move to higher dollar interest rates.
• A producer driven collapse in oil prices.
• A dollar strengthening raising the cost of borrowing across the world.
• A commodity price collapse affecting the BRIC nations and all those with similar commodity driven export economies.

The medium and long term truth is that most of these trends are good for the United States.  The US consumer is earning more and commodity declines mean those dollars will go even farther.  Deflation from commodity price declines is not as pernicious as deflation from demand destruction (from layoffs).  In the short run, though, there is a lot of worry about “gorillas”, or unseen financial catastrophes from over-levered commodity or hedge funds.  The name Long Term Capital, a massively levered hedge fund, which blew up in 1998 during the Russian debt crisis, has surfaced in the media as an example.  Who knows, there might be a Long Term Capital or Amaranth waiting to be unwound.

For Ategra, this last week was a chance to exercise our basic strategy of using lower prices without a change in fundamentals as buying opportunities.  We built cash and recycled the money into our best positions where the price declines made new purchases compelling.  Many of our small caps, being out of indices, were less affected.  This suggests the sell-off was highly technical and about liquidity as much as it was about valuation.  Even after our buying on Wednesday, we remain vigilant.  Who knows what the computers might sell in the next few weeks.

The fact that markets have sold off and remain tense is not all bad.  Too much money has been made (on paper) betting on low interest rates and low volatility remaining indefinitely.  A little shake-up before the Federal Reserve raises short term rates will lessen the problems when rates actually do rise.  Historically, markets are always tense approaching a rate hike and there is little reason to expect different this time.  An S&P 500 index trading at reasonably high levels with little prospect for near term earnings growth is a good reason for an investor gut check.

Ategra’s strategy remains uninterrupted by the technical factors other than the opportunity to buy.  Our companies have strong, improving core earnings and most will do better when short rates rise expanding their Net Interest Margins.  Over time the strong earnings will drive dividends, stock buybacks and price improvement from compressed levels.  This is a very different dynamic than a fully valued S&P 500 index where earnings growth may be running on fumes and which gave up a year’s winnings in a short three days.