October 2007 Rewind – The Fed Beat Rolls On

This October, a good deal of daily market movement involved speculation regarding the possibility of further Federal Reserve rate reductions. Once again, the Fed moved to the beat of the market and met expectations with a quarter point reduction in both the discount window and federal funds rates. At 4.5%, the funds rate now stands at its lowest level since January of 2006. In a likely nod to on going credit uncertainties and unprecedented real estate declines, the cut was made in-spite of continued dollar weakness, record commodity prices, and a strong third quarter Gross Domestic Product (+3.9%).

Although it was a rocky month, the rate reductions together with end of month buying, the passage of quarterly reporting jitters, and the reemergence of merger and acquisition news, all of the broader indices managed to close positively. In fact, in a wide divergence, the NASDAQ 100 had its best monthly showing in nearly two years (+7%). Interestingly, it was Internet stocks that led these gains as semiconductors suffered badly. Similarly, in-spite of all of the recent international large-cap talk, small- and mid-cap growth stocks were the big winners this month.

We may get a rate induced end-of-year earnings multiple expansion after all; we will have to see if $100 oil or the Fed's hints that it may be done for now take an eventual toll -- Happy Halloween!

The Style Box below was calculated using the following PowerShares™ ETFs: PWT (Small-Growth), PWY (Small-Value), PWJ (Mid-Growth), PWP (Mid-Value), PWB (Large-Growth), and PWV (Large-Value).

The Standard & Poors 500, Dow Jones Industrial Average and NASDAQ 100 may be traded through ETF proxies, including the SPY or IVV, DIA and QQQQ, respectively.

Sentiment: Mixed to Positive
Volatility: Medium/Reduced (VIX 16-22)
Direction: Positive/Split

China Pairs Redux

Recognizing that my last post was somewhat controversial based on seekingalpha.com commentary, here is a follow up article reporting how the hypothetical China Rebalancing Pairs Trade would have performed through yesterday's close: a) since posted on the morning of October 11th; and, b) since the FXI's short-term moving average first reversed.

a) Since Posted (10/11)-

> Short CAF/ Long EWH +14.9%
> Short FXI/ Long EWH -00.1%

b) Since First FXI 3-Day MA Reversal (10/22)-

> Short CAF/ Long EWH +8.0%
> Short FXI/ Long EWH +5.4%

These results assume equal dollar weightings and no commissions. A proposed change by the Chinese government to allow share classes to float together no doubt helped significantly. A few "comments on the comments":

1) Note how the use of the long/short combination reduced the risk of "being early" with this trade idea (FXI is actually higher since the 11th).

2) It is true that the CAF is a closed-end ETF trading below its NAV. It has been my observation; however, that such NAV mispricings often persist and shouldn't necessarily preempt a short-term trade backed by a well thought out rational.

3) Whether or not you agreed with the original rational, a good long/short pairing exhibits a highly correlated, mean reverting return series (i.e. cointegrated). This pairing fit the bill and paid handsomely.

China Rebalancing Pairs Trade

As reported in today’s Wall Street Journal, late this summer the Chinese government announced a new policy permitting its mainland citizens to invest in Hong Kong equities. Although the specific timing remains unknown, this would be the first opportunity for mainlanders to diversify their equity holdings without obtaining special government approvals. In addition, the government is reportedly exploring easing restrictions on short-selling.

While the two markets are clearly correlated, as shown below there has been an obvious and widening gap in performance between them. A prospective rebalancing trade here using an ETF pair would be to: (1) go short the FXI (iShares FTSE/Xinhua China 25); and, (2) go long the EWH (iShares MSCI Hong Kong Index).

The CAF (Morgan Stanley China A-Shares) ETF is another short candidate with even higher returns year-to-date (+124%), but would make for a significantly less correlated pairing against the EWH (2007 correlation coefficient of 64% versus 87%).

I don't pretend to know the local investment psychology, but if I were a mainland citizen, I might think hard about diversifying my holdings after this year’s tremendous run, how about you?

FXI ~ YTD Return = 81%; P/E Ratio = 24.6; 20-Day Z-Score = +2.4
EWH ~ YTD Return = 39%; P/E Ratio = 16.3; 20-Day Z-Score = +2.3

Pivot Breakout

The market's blew right through the resistance pivot points on the very first trading day of the month. As a pivot primer, once "resistance" has been penetrated, it is thought to become "support" for subsequent pullbacks. The coming week will tell us whether or not this was merely a new quarter/month effect.

Either way, look for good support between the 10- and 20-day moving averages in the coming month for as long as they remain positively sloped. Obviously, earnings and any news impacting anticipated Fed actions will play an enormous role here.