Anytime I see a well-written article by another college student, I pay extra attention. Such is the case with Naufal Sanaullah’s piece on why he thinks this recent rally is unsustainable. It’s quite a comprehensive bearish argument, with good points about the technical aspects of trading and a number of shots at the accuracy of last quarter’s bank earnings – and it will also serve as a good starting point for me to assess my own view of where the market is going. Still, I couldn’t help but be struck by the conspiracy-heavy undertones (most of which were backed by links to Zero Hedge – which provides a lot of thought-provoking pieces, none of them ever being positive).

I’m not going to argue on points about CDS trades with AIG, because there are only anecdotes and circumstantial evidence about what’s going on there. What we do know is that the fear of imminent failure of many financial firms, a disastrous specter which has hung over the market for at least a year, has been lessened in the last two months – at least by judging from the values of the most closely-watched and heavily-traded financial stocks.

What I do want to make a point about is quant funds, whose troublesome positioning is a frequent topic at Zero Hedge and something Naufal focuses heavily on. Specifically, he states:

With such low volume, how is this market continuing its slow, yet upward ascent? Quant fund deleveraging has become the reason of choice to which this market movement has been attributed. Quants tend to short stocks with weak fundamentals and relative weakness versus indices, and quant deleveraging should manifest in weak stocks seeing dramatic share surges as quants scramble to cover shorts to lessen market exposure. And that’s exactly what’s happened. Stocks like XL Capital (XL), American Capital (ACAS), Vornado Realty (VNO), and Liz Claiborne (LIZ) showed massive rallies since March lows, leading the market and far outpacing stronger, more fundamentally-strong stocks, even ones with high beta. Even Crocs (CROX) enjoyed a 50 DMA breakout. This is highly indicative of a “short squeeze” bear bounce, rather than a sustainable bottoming rally, which is characterized by new market leaders and sectors showing relative strength against previous leaders and breaking out of tight bases formed over several months.

First point: what do quants do? Obviously, “quant” is a catch-all phrase to describe a variety of program trading activities. Perhaps a better question would be, what do successful quants do? Well, this, according to Congressional testimony:

Our trading models tend to buy stocks that are recently out of favor and sell those recently in favor. Thus, to some extent, our actions have the effect of dampening extreme moves in either direction, and, as a result, reducing volatility in those stocks. An example of this contrarian tendency is the fact that during the six week period ending this September, Medallion held long positions in many of the most troubled of the financial stocks, including Lehman Brothers (LEH) and Washington Mutual (WM). We of course lost money on those trades!
-James Simons, Chairman and CEO, Renaissance Technologies

Renaissance – the top quant fund family – thus tends to buy what is relatively cheap or oversold, and sell short what is relatively expensive or overbought. Now, Naufal points to leaked performance data from Renaissance’s RIEF fund suggesting it substantially underperformed during the recent market rally. Why could this be? Well, the obvious extrapolation to make from the above statement and observed price action is that “overbought” stocks rallied substantially beyond what they usually do, which hurt Renaissance as typically high-probability shorts keep pushing higher. Does that imply massive forced deleveraging (or something similarly ominous), or simply that markets occasionally make moves not predicted by a particular trading black box, especially at times of extreme stress?

Later on, Naufal talks about how the quant funds that focus on market-making (a different strategy than, say, long-short) have also had to deleverage, with the implication that this is going to set up a nightmare of illiquidity. Ignored in this is that the VIX has come down to test low levels not seen since last September.

Again, how quant fund deleveraging can simultaneously result in calmer markets as well as pending disaster is never fully explained. On one hand, deleveraging can be seen as a good thing – companies with more equity financing have a greater ability to withstand losses – but likewise, it results in dilution of existing equity. Nowhere is it acknowledged that the dilution is happening, as plenty of companies have raised capital (many at terms not beneficial to existing shareholders), and started to retain earnings by reducing dividends. The S&P 500 is down 45% since October 2007, and I’ll venture that the typical company raising capital is down by a greater-than-average amount.

A second point: yes, there has been a notable difference in the quality of companies and their relative returns during the rally. Just looking at the non-financial components of the Dow Industrials, there was an observable relationship between consistency of ROE components and returns from the market top in October 2007 to the March 2009 lows. The companies with consistent profits outperformed those with more variable profitability on the way down, and have underperformed during this rally.

There are plenty of basic explanations for this, but Cam Hui summarizes it the best, calling it the “phoenix effect” – companies with more operating and/or financial leverage outperform as things turn from negative to positive, because they have more to gain from such an environment. Like most other potential positive outcomes, this too is neglected.

If there’s any real point one can make to attack the sustainability of this rally, it’s a simple one – 30% up moves up in two months times, barring extreme inflation, simply can’t go on forever. So in that sense, no, this rally isn’t sustainable – point granted. But as to whether to be positive or negative, well, I try to be a realist, and I feel like many people have taken the extreme swings of late and painted themselves too far into one corner. It’s much easier to be optimistic now than almost any time in 2009, and that makes me wary. Likewise, it is very easy to see anything positive – particular in financials – as the side effect of nefarious government support. As is usual in the markets, the truth is probably somewhere in-between, and that makes me expect the indices will hold a tighter trading range than we’ve been accustomed to, although I’ll be waiting with a slowly-growing cash balance should any substantial breaks occur to the downside.

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