Of rationality and window dressing

Hello everyone!

I hope that everyone’s weekend was relaxing. Here in Santa Fe we had our first Indian Summer weekend with temperatures in the high-70s/low-80s. It was awesome.

Last week’s stock market performance was the worst weekly performance since the beginning of July…thankfully. I say thankfully because it is evidence that investors are still cautious about investing. When there is fear of loss due to perceived over-exuberance it means that investors are behaving rationally. Rational investor behavior means that price does matter.

We have been discussing for some time whether or not the financial markets were ahead of themselves and whether or not there were still good values available. I have been saying that the market looked about fairly valued, but that individual stocks still looked attractive. That still looks true to me. Right now we don’t have enough new information to update our assessment of the state of U.S. businesses. But the third quarter comes to a close on Wednesday and then third quarter earnings season will kick off. Earnings season will bring with it a slew of updates and will give investors new evidence of recovery or stagnation. I’ll be watching.

Separately, another reason that asset prices might have fallen last week is due to “window dressing.” That is when mutual fund portfolio managers sell stocks that have done well during the course of a quarter in order to lock-in gains so that they can preserve the returns they generated in a good quarter. Please know that not every mutual fund manager does this, but many do.

The other less wholesome aspect to window dressing is that fund managers will sell stocks and buy ones that performed well in the quarter. The idea is that when the board of directors looks at the portfolio composition and asks, “Hey, where is Bank of America? Were you smart enough to buy B of A?” the fund manager can say, “Yes, look, there it is right there.” Sad, but true, this does happen at some fund companies.

Taken together, the two forms of window dressing have the effect of sell offs at the end of quarters – especially of successfully performing stocks in the quarter, as well as surges in successful stocks. It all depends on the quarter and the degree of the type of window dressing engaged in. So last week’s sell off might have been due to managers trying to lock in big gains during the 2nd quarter.

My preference is that the sell off occurred, not due to window dressing, but due to rational players paying attention to the prices they pay for assets.

Jason