Dow Reconstitutes, Let The Trading Begin!

Suppose I gave advanced notice that on a particular day three stocks were going to have huge buy orders while three others would have enormous sell orders. What might happen?

We might reasonably expect that within milliseconds of that announcement, traders would begin to position themselves for an easy profit.

That's exactly what happens whenever an index reconstitutes. Staggering numbers of trades must take place on a particular day. These trades will be far in excess of normal volume for those stocks and won't reflect any fundamental change in the value of the underlying company.

In this case the Dow 30 Index will drop Alcoa (AA), Bank of America (BAC) and Hewlett-Packard (HPQ), while adding Goldman Sachs (GS), Visa (V) and Nike (NKD) on the close of trading September 20.

Because pure index funds must exactly mirror the holdings of their index they don't have any option but to trade on that day. Their marching orders are to have zero tracking error with the index.

The expectation that an index fund will get EXACTLY the return of the target index sets the stage for an interesting problem: Zero tracking error is achievable, but it comes at a very high price. In order to achieve zero tracking error, the fund manager must hold exactly the index for every second of the day. The managers must do trades NOW, which deprive them of any kind of negotiation power. The cumulative costs of these many trades are not trivial, and will be born by the fund's shareholders.

Stocks that are leaving the index will be under enormous sell pressure, while stocks being added to the index suddenly become widely sought after. The whole world knows the exact time the substitution must take place. Prices around the trading date go strangely haywire as not only fund managers but speculators place huge orders. In advance of the trade date traders will buy the shares to be added while selling short shares to be  deleted. Reversing those trades on the reconstitution date should yield a juicy arbitrage profit.

Stocks on the sell list will be depressed while stocks on the buy list will bounce. A few days later those stock prices will reflect normal volumes and return to the consensus price for their firms. None of this is good for the shareholder. They are almost guaranteed to lose money on shares leaving the index, while they must buy shares at high prices to replace them.

The index fund manager's problem is that anything less than perfect index replication will result in random tracking errors. The demand from consultants and clients for zero tracking error drives him to a sub-optimal solution. Zero tracking error trumps total return as the performance standard. While it meets the standard of mindless simplicity, in the greater scheme of things this isn't a particularly rational approach.

This reconstitution effect is widely documented, and a glaring exception to an otherwise efficient market. Speculators routinely make huge virtually riskless profits at the expense of index fund shareholders. While the Dow isn't as widely followed by institutions or funds as for instance the S&P 500, reconstitution will certainly have an impact. It happens in indexes around the world, sometimes to even greater cost.

Relaxing the definition

So, what's the alternative, and what might the benefits be? Suppose we relaxed the zero tracking error requirements in favor of avoiding reconstitution drag? A simple solution would be to execute the trades a week after reconstitution date. By that time the dust would have settled. Over time the cost savings will swamp any small tracking error. A number of fund families like Dimensional Funds Advisors (DFA) have adopted similar tactics to enhance performance. For institutions and individuals that value performance over zero tracking error that might be a very good choice.

Disclaimer: The author personally holds DFA funds and utilizes them for clients.

Frank Armstrong is the founder and principal of Investor Solutions, a Miami-based NAPFA fee-only registered investment adviser with more than $650 million of assets under management. He has more than 38 years' experience in the securities and financial services industry and has published four books and hundreds of articles on investments and retirement planning. Visit him atwww.investorsolutions.com.

 

 

Has Attention Shifted to the Debt Ceiling?

Has the argument over the shutdown of the government finally been replaced by the debt ceiling argument? MoneyShow's Jim Jubak, also of Jubak's Picks, thinks it may have and has some thoughts as to what may happen next.

Okay, it was just one basis point. But yesterday, Treasuries did move lower, ending what had been a four-day winning streak.

Maybe that was just a reaction to lower than expected initial claims for unemployment for the week that ended on September 21. Fewer people filing their first claims for unemployment means fewer firings and could mean an uptick in employment and economic growth. Faster growth reads right now as bad for bonds, since it brings the end of the Fed's $85 billion in asset purchases nearer.

But since ten-year yields have dropped from 3.05% in early September to just 2.64% Wednesday, September 25, we might be due for a turn in the trend. And if you've looking for a reason to take your gains in Treasuries—which would result in falling prices and climbing yields—yesterday's moves in Washington are all the reason that you need. (Adding to my sense that the trend has changed in the Treasury market is yesterday's weak auction for $29 billion in seven-year Treasuries.)

Attention is starting to shift—correctly or not (I say correctly)—from the budget shut down the government battle—to the struggle over raising the debt ceiling. It now looks like the Senate will strip out the defund Obamacare language in the continuing resolution the House sent to over and send back a clean continuing resolution to the House that would fund the government through November 15. The House, pundits now say (and I'm finding the Washington Post's Wonkblog a great resource in following the ins and outs of this mess) may attach a few symbolic measures to the continuing resolution, but is likely to pass something like a relatively clean continuing resolution in the early days of next week. That would turn the government shutdown into an annoyance of a few days.

The main reason to believe this scenario is that the House Republican leadership, including House Speaker John Boehner, looks like it's pivoting from the budget fight to the debt ceiling battle. It's that likelihood, and evidence that House Republicans are digging for that fight, that could easily reverse the post-Fed-meeting bond rally.

The National Review got a hold of a copy of the House Republicans' debt ceiling bill and as evidence of dig-in-your-heels strategy, it's pretty chilling to bond holders who don't think a default on US government debt is a good thing.

Here are the main provisions at the moment. In return for a one-year suspension of the debt ceiling, the bill demands, just to hit some of the highlights, a year's delay in Obamacare, the enactment of Rep. Paul Ryan's tax reform plan, approval of the Keystone pipeline, an expansion of offshore oil drilling, and the opening of more federal lands to drilling, a suspension of the Environmental Protection Agency's efforts to regulate carbon emissions, reform of the federal employee retirement program, an overhaul of Dodd-Frank, more Congressional control of the budget for the Consumer Financial Protection Bureau, more means-testing in Medicare, and repeal of the Public Health trust fund.

This isn't a serious opening bid in negotiations. It's a my-way-or-the-highway statement. And, if it truly measures the influence of the most conservative members of the Republican caucus in the House, this initial plan suggests a very bitter and long fight over the debt ceiling.

Treasury Secretary Jack Lew has told Congress that the Treasury Department would exhaust emergency measures to pay government obligations no later than October 17. That's a more pessimistic estimate than that of the Congressional Budget Office, which predicted that the Treasury would use up funds between October 22 and October 31. That would make it difficult for the government to pay the roughly $55 billion in Social Security, Medicare, and military pay due on November 1. After October 17, the Bipartisan Policy Center has concluded, government revenue—without borrowing—will cover 68% of its bills for the rest of October.

Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund's portfolio here.

Will Settlement Concerns Hurt JPMorgan Chase?

With shares of JPMorgan Chase (NYSE:JPM) trading around $51, is JPM an OUTPERFORM, WAIT AND SEE, or STAY AWAY? Let's analyze the stock with the relevant sections of our CHEAT SHEET investing framework:

T = Trends for a Stock’s Movement

JPMorgan Chase is a financial holding company that provides various financial services worldwide. The company is engaged in investment banking, financial services for consumers and small businesses, commercial banking, financial transaction processing, asset management, and private equity. Financial services companies like JPMorgan Chase are essential for well-functioning economies around the world.

JPMorgan Chase could pay between $3 billion and $7 billion to settle investigations into various suspicious practices that the bank is accused of. JPMorgan has offered $3 billion to end a probe into its mortgage business, The Wall Street Journal reports. According to the publication, the Justice Department has rejected that amount as too low due to the high number of cases involved. JPMorgan is facing a series of investigations by the Justice Department that include queries into its mortgage business, hiring practices in China, and energy trading.

T = Technicals on the Stock Chart Are Mixed

JPMorgan Chase stock has been doing well in the years extending back to the Financial Crisis. The stock is currently pulling-back to key levels. Analyzing the price trend and its strength can be done using key simple moving averages. What are the key moving averages? The 50-day (pink), 100-day (blue), and 200-day (yellow) simple moving averages. As seen in the daily price chart below, JPMorgan Chase is trading between its key averages, which signal neutral price action in the near-term.

(Source: Thinkorswim)

Taking a look at the implied volatility (red) and implied volatility skew levels of JPMorgan Chase options may help determine if investors are bullish, neutral, or bearish.

	Implied Volatility (IV)	30-Day IV Percentile	90-Day IV Percentile
JPMorgan Chase Options	27.86%	83%	81%

What does this mean? This means that investors or traders are buying a very significant amount of call and put options contracts as compared to the last 30 and 90 trading days.

	Put IV Skew	Call IV Skew
October Options	Flat	Average
November Options	Flat	Average

As of today, there is an average demand from call buyers or sellers and low demand by put buyers or high demand by put sellers, all neutral to bullish over the next two months. To summarize, investors are buying a very significant amount of call and put option contracts and are leaning neutral to bullish over the next two months.

On the next page, let’s take a look at the earnings and revenue growth rates and the conclusion.

E = Earnings Are Rising Quarter-Over-Quarter

Rising stock prices are often strongly correlated with rising earnings and revenue growth rates. Also, the last four quarterly earnings announcement reactions help gauge investor sentiment on JPMorgan Chase’s stock. What do the last four quarterly earnings and revenue growth (Y-O-Y) figures for JPMorgan Chase look like and more importantly, how did the markets like these numbers?

	2013 Q2	2013 Q1	2012 Q4	2012 Q3
Earnings Growth (Y-O-Y)	32.23%	33.61%	54.89%	37.25%
Revenue Growth (Y-O-Y)	13.67%	-3.57%	10.16%	5.82%
Earnings Reaction	-0.30%	-0.60%	1.01%	-1.14%

JPMorgan Chase has seen rising earnings and revenue figures over the last four quarters. From these numbers, the markets have had conflicting feelings with JPMorgan Chase’s recent earnings announcements.

P = Weak Relative Performance Versus Peers and Sector

How has JPMorgan Chase stock done relative to its peers, Bank of America (NYSE:BAC), Citigroup (NYSE:C), Wells Fargo (NYSE:WFC), and sector?

	JPMorgan Chase	Bank of America	Citigroup	Wells Fargo	Sector
Year-to-Date Return	16.76%	22.61%	25.05%	22.64%	20.63%

JPMorgan Chase has been a weak relative performer, year-to-date.

Conclusion

JPMorgan Chase is a bellwether in the banking space that forms an essential part of the United States financial system. Investigations continue as concerns rise on recent settlements. The stock has been doing well in the last several years but is now pulling-back to key price levels. Over the last four quarters, earnings and revenues have been rising, which has produced conflicting feelings among investors in the company. Relative to its peers and sector, JPMorgan Chase has been a weak year-to-date performer. WAIT AND SEE what JPMorgan Chase does this coming quarter.

Market Wrap-Up for Sept. 24 (KBH, LEN, AMAT, PRA, more)

Despite falling into negative territory in early trading, stocks bounced off their morning lows and edged into positive ground throughout most of the afternoon trading. It seemed that there had been a bit of a shift in investor sentiment early, even though the market received some underwhelming economic data to start the day. However, that momentum eventually reversed course once again, and stocks sold off into negative territory by the close.

Home Builder Earnings

Before the opening bell this morning, home builders Lennar Corp. (LEN) and KB Home (KBH) reported their third quarter earnings. Both companies reported a rise in profits for the most recent quarter, topping Wall Street expectations. As such, both stocks rallied today, finishing in the green by the close.

Other Stocks on the Rise

Aside from the home builders, shares of Applied Materials (AMAT) rose in the day’s trading after the company announced a merger with Tokyo Electron. The two firms will merge to form a new $29 billion semiconductor company. Also surging today were shares of Eastern Insurance Holdings (EIHI), after it was announced that ProAssurance (PRA) would be acquiring the company for $24.50 per share.

Top Gold Companies To Buy Right Now

In other news, The Jones Group (JNY) shares got a boost from rumors that private equity firm KKR is looking to acquire the fashion apparel and footwear company. Moreover, Illinois Tool Works (ITW) shares rose after it announced that it is planning to divest its industrial packaging segment.

As for Wall Street analyst upgrades, shares of Microchip Technology (MCHP), Church & Dwight (CHD), Sotheby’s (BID), Nike (NKE), and Goodyear Tire (GT) rose due to the positive commentary.

Stocks on the Decline

In negative territory today ere shares of Carnival Corp (CCL) after disappointing third quarter earnings. Also, Microsoft (MSFT) shares edg