Its Time to Start Looking at Quality Again

By: John Rothe

It's time to start looking at quality again. Technical indicators are starting to show the first "buy" signals of the year. What does
this mean? Well first let's take a look at what caused the most recent decline in US equities.
As the end of the real estate boom became evident early last year, it became obvious that banks would be harmed from easy and speculative loans. In addition, the financial sector comprised almost one quarter of the S&P 500 index (at the peak of the tech boom, technology represented one quarter of the index as well). There would have to be a regression back to the mean, but
nobody had a crystal ball to tell us when and how fast.
Before I go further, let me briefly discuss hedge funds.

Since 2000, the hedge fund industry has seen massive growth. A typical hedge fund fee will be a 2% annual management fee plus 20% of profits. To a successful manager, this can mean a very large pay day. After the 90's many of Wall Street's brightest minds wanted to open a hedge fund with dreams of increasing their personal
wealth ten fold.
Hedge funds can use leverage. Sometimes this is a good thing, most times not. A large portion of new hedge funds ran quantitative models. Quantitative models are based on a combination of fundamental and mathematical research to create models that have historically shown an above rate of return. Once the model was created, the use of leverage would allow even more
spectacular results.
The problem occurred when the quantitative funds all owned the same stocks.
Once Wall Street realized the banks were going to be in trouble, the stock market started its decline. The leveraged hedge fund which is holding quality stocks is now forced to sell to meet margin calls. Now, since all the quantitative managers own the same stocks, voila -- quality gets decimated.
So why look at quality again? If we are on the verge of another leg up in the US stock markets, investors will be looking for value.
The value is not in the international markets, but in the US stocks that still show positive growth rates and little exposure to the
US banking system.

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