SP500 Index and Bovespa: The mechanics of the indexes and a performance evaluation

I will take a step from economic theories to explore the mechanics and current situation on the SP500 Index and the Bovespa.

Before diving into the details regarding the nature of  movements and what could happen in the very near term, I will comment on some important elements that affect market behavior and drives asset prices up or down

First and foremost, what drives asset prices UPWARDS is the inflow and outflows of funds, buying and selling of the stocks that comprise the Index. There are some other instruments that do affect indirectly the value of the Index, however these transactions are a bit more complicated from the stand point of a non-professional investor, and we will explore them in the future but is important that we understand that they do also have an impact on the SP500 cash & Futures index contracts value. 

In the case of the SP500, the price of all stocks traded in the exchange impact the total value of the exchange. Some Stocks have more weight than others do, but, their movements impact the total value of the index.

The Futures contracts is one of the most liquid instruments traded in financial markets. The movements of the SP500 stands basically as a proxy for equities markets performance in the US. They way it behaves or in professional lingo the way it trades, in a way represents the expectations of professionals regarding the overall market. 

Nothing is perfect in financial markets, therefore, the valuations do not represent a picture perfect evaluation of the Index  but rather the perceptions of Investors in general - professionals investors also called institutional money or smart money as well as private investors and small traders.

We can argue and discuss what leads prices up or down, however one cannot argue the following fact: Prices of stocks, commodities or Forex instruments move up when the current holders of inventory refuse to sell their holding at current prices therefore forcing new comers to Bid Higher prices in order to be able to acquire these products. There is scarcity of "goods" or lack of supply and in order to be able to acquire such goods, buyers most agree to pay higher prices.

The opposite is true for selling when current holders are willing to sell their inventories at current prices and there is lack of interest from buyers. At that stage buyers aren't interested and expressing a lack of demand, that drives the prices down. They are trying to buy at lower rates, and with inventory available they bid lowers prices for goods. therefore together driving the prices of instruments down.

What decides the given price of a financial instrument is not what Wall Street  single institution or Investor thinks; prices move up or down not driven by analysis or common sense. They fluctuate due to the willingness of participants to buy or sell instruments at given prices. several factors affect this decision process, but the hard reality is that what makes prices move up or down is the participation or lack thereof in market transactions for a given period. 

For the private investors, normally "trained" to buy stocks, the principles of short selling is sometimes difficult to understand. To allow one to better follow the mechanics of markets, here is an explanation. I will dedicate a post to Short Selling in the near future, but for the time being, let's try to make it simple: Investors operating as Short Sellers, are investors that take a stance (believe) that the prices of a given asset ( stock, commodities or foreign currency) will decline in Value.

For stocks, the investors will sell in the open market a number of stocks that they currently Do NOT OWN.  To do so they have to borrow from a source. Most of the time, this source is a brokerage firm. Here is a picture to describe the process.

The transaction ("short sale") is initiated by an individual or organization (known as a "short seller"), who desires to "short " a stock. Once the stock is sold short, the short seller must deliver the stock to the buyer. The buyer cannot differentiate whether the seller is a short seller or a long seller of stock -- nor do they care. The buyer is only interested in receiving the stock they have paid for. The short seller has a problem though. He or she does not own the stock sold to the buyer. Hence, the short seller must borrow the stock to be able to deliver it to the buyer. How? The short seller will utilize a selling broker to arrange to borrow the stock from a stock lender to be used to satisfy the short seller's sale of stock to the buyer.

This transaction takes place in a margin account and might have other economic consequences, which I will discuss later on. Please note that in some instances, the selling broker may in fact be the stock lender while in other circumstances, the selling broker must borrow stock from a third party securities lender.

When the buyer receives the stock and pays for it, he or she is satisfied and no longer has any involvement in the transaction. The other three parties (the short seller, selling broker and stock lender) are still linked together by the stock loan.

Since the stock lender has lent out securities, it will require that the borrower (the short seller) post collateral to secure the loan. This collateral is derived from the short sale proceeds, which the short seller receives from the buyer. However, the selling broker will actually receive the cash from the buyer and will not disburse it to the seller. Instead, the selling broker will withhold those short sale proceeds, make a "memo entry" in the short seller's account and then use the short sale proceeds to post as collateral against the stock that was borrowed from the stock lender.

As the short seller has sold stock but not received cash he or she will miss out on the ability to reinvest the sale proceeds that are now in the hands of the stock lender. The stock lender appears to get a free lunch from this transaction by benefiting from the reinvestment of the sale proceeds. If you are an individual investor, then this is indeed the case. However, if you are an institutional investor , such as a hedge fund  or pension plan , then this inequality is cured by the stock lender paying a rebate to the selling broker. The rebate represents a sharing arrangement on the interest that the stock lender earns on the collateral, which it holds. For example, if the stock lender earns 3.5% on the cash it holds, it might pay the short seller 3.0%.

Furthermore, institutional short sellers may have to pay a fee instead of receiving a rebate on stocks that are hard to borrow (in other words, stocks that are in limited supply with large short seller demand). As an example, Apple Computers(AAPL_) may be a stock which is heavily shorted with a limited amount of stock that can be borrowed. So an institutional borrower of Apple might have to pay a fee of 2% instead of receiving a rebate in order to borrow Apple stock.

When all aspects of the short sale transaction and process are put together, this creates a "short position" for the short seller. 

Short Covering

At a later date, the short seller will "cover" the short position. When the short seller does this, he or she will buy the same stock in the open market and the entire process that I've described so far will unwind.

The short seller buys stock from another seller. The short seller's broker will then pay for the stock out of it's client account, by using the stock to then return the stock loan to the stock lender, freeing up the cash collateral and margin requirement in the process.

The Short Seller will generate profits when he will purchase the stock at lower prices than the prices that he originally sold his stock to open the position (transaction). If the Short Seller pays higher prices than the prices he originally sold the stock, he will incur a loss:

Example:

Sold Short 3 weeks ago Apple Computer for 610 dollars per share and bought the stocks back on the 27th of July for 580 dollars, the incurred a 30 gain on the sale ( 610 sold  short - 580 bought to cover = +30 US profit per share) per share.

If he waited longer and Bought back the stocks at the open market today, the investor would incur a loss of 10 dollars per share ( 610 sold - 620 bought = -10 dollars).

Investors wishing to sell short stocks, must hold margin accounts and have been cleared (allowed) by their broker to engage in this type of transaction.

When stocks are being sold, either by short sellers believing that they are over appreciated or investors liquidating positions, if part of an Index, they will influence the overall value of the Index. Some companies more than others, due to their importance and weight, but nonetheless they will.

Now that we have understood the process, let's take a down to earth assessment of the SP500 and equities markets at present:

At present, the SP500 has succeed to penetrate levels that it has not visited for a long period.

If we look historically, the last time that the SP500 was trading at this levels was 27th April last year. The participation in terms of volume of trades during this year has been similar to last year comparing the volumes from January till August 1st. In July the volume was lower than last year's July.

Looking back 5 years, the current levels are just above the 95% confidence level. The high level was 1397. The 1327 level is the level in which the highest majority of transactions occurred. 

As the market has breached the level from last year, all we can say is that currently, buyers are more aggressive and pushing the prices of stocks, therefore the prices of the Index. 

There are high expectations of further monetary easing that would prove positive for financial markets. Traders are Biased towards further monetary stimulus, therefore more funds available to be injected into financial markets.  with that picture in mind, we should also look at the opposite side is the scenario that could develop - below expectations performances by corporations in coming results and of course the possibility of no intervention  by Government officials and central bankers. If that would be the case, the mind set would switch by traders and selling could gain pace.

Nobody knows what will happen. Logic is a word that doesn't inhabit the minds of speculators when they are investing. The mind set changes on a daily basis. There are periods in which they are blindfolded and regardless how overvalued assets may be, there is nothing that stops their appetite for them. In other moments, fear takes over and assets drop at fast paced rates.

There are several types of investors: we have fundamental and technical investors; mechanical traders and behavioral traders (discretionary traders). There are as many systems and principles as there are investors willing to participate in financial markets.

Today's activity so far was a reflection of what is happening. There isn't much conviction on the current Rally. The Index reached 1417.92 on the futures market, with most of the activity taking place at 1411.92 were 76.227 contracts being negotiated.

There is a sentiment towards a further rally, however, we should not forget that the European Intervention will not come that easy. The Germans have their own problems and will have to dig deeper into their reserves - whatever that would mean at that stage - and will take very cautious steps to proceed.

Bellow 2 graphs: A 5 year weekly graph and a daily one year graph.

The Index has reached his highest levels since last year April. That is an accomplishment, given current circumstances. Will that continue? It is impossible to determine with certainty, however, at present, with a mix of skepticism and hope mingled together, the Index is moving steadily and progressing. It should continue.


In regards to the the Bovespa index, it has had a different performance so far. I will use the most liquid and traded instrument representing the Brazilian Equities overseas, the iShares Morgan Stanley Country Index exchange traded fund EWZ, in order to evaluate the situation.

The iShares MSCI Brazil Index Fund seeks to provide investment results that correspond generally to the price and yield performance, before fees and expenses, of publicly traded securities in the Brazilian market, as measured by the MSCI Brazil Index.  

Here is a 5 year weekly graph:

This year, the EWZ has failed to do follow the steps of the SP500 index. Bellow, a year to date graph from the EWZ:

The Brazilian Market has struggled and I believe the current problems that very important companies such as Vale and Petrobras have faced, influenced heavily the overall perception of investors regarding Brazilian Stocks. Therefore the index performance has been poor.

Five companies almost determine the Bovespa's performance : Vale, Petrobras, Banco Bradesco, Itau Unibanco, e Companhia de Bebidas da America, They do so  due to their weight and importance; they basically dictate the performance of the index. 

These companies have had stellar performances in the recent years. However, the situation has changed. We rely heavily into exports to Europe and China; the overall picture leaves doubts on the ability to meet previously set targets. 

In regards to the banking sector, there are signs that they will have some difficult times ahead in  the domestic market. 

Does it mean it won't appreciate? Not at all!

If buyers are aggressively acquiring stocks and bidding higher prices, the index will appreciate. It has nothing to do with only facts; it is a matter of perception and having the means to back that particular strategy.

The process must start with professionals allocating funds into these companies. That will be a starting point. The most successful investors look for opportunities envisioning the future valuation of current assets. When they accumulate positions and hold them, shortening the supply, there is a great possibility for advances. 

Recently, speculators started to acquire positions on Brazilian companies. Will that guarantee that they will outperform? No. it won't. However, they place a Bet because for some reasons, they believe that these assets are being sold at discounts. Whatever metrics they use, varies, however, there is a certain degree of belief on further appreciations.

News tend to drive asset prices in a way of the other. The question is how long the news will fuel that particular movement. Last week's stimulus, has had a positive impact on the OVERALL perception of Brazil's potential. Will that hold? Will the plan become reality? Such questions are difficult to answer and always filled with speculation.

Here is a comparison between both exchanges performances:

Daily Performance Comparison: S&P 500 Index(^SPX) vs iShares MSCI BRAZIL INDEX(EWZ) Tuesday, August 21, 2012 05:50 (ET) U.S. Market open in 3 hours and 40 minutes. S&P 500 Index(^SPX) Charts -    iShares MSCI BRAZIL INDEX(EWZ) Charts -    Last Trade 1,418.08 Last Trade 55.38 Trade Time (ET) 08/20/2012 16:00 Trade Time (ET) 08/20/2012 16:00 Change 0.05(0.00%) Change 0.01(0.02%) Previous Close 1,418.13 Previous Close 55.37 Open 1,417.85 Open 55.21 High 1,418.09 High 55.46 Low 1,412.12 Low 54.74 Volume 1,995,633 K Volume 8,949 K YTD Performance Comparison: S&P 500 Index(^SPX) vs iShares MSCI BRAZIL INDEX(EWZ) S&P 500 Index(^SPX) Charts -    iShares MSCI BRAZIL INDEX(EWZ) Charts -    YTD Change 160.55(12.77%) YTD Change 2.01(3.50%) YTD High 1,422.38 YTD High 70.74 YTD Low 1,258.86 YTD Low 48.27 Average Daily Volume 2,627,437 K Average Daily Volume 15,329 K Average Daily Change 0.00 % (absolute value) Average Daily Change 0.00 % (absolute value) 52-week Performance Comparison: S&P 500 Index(^SPX) vs iShares MSCI BRAZIL INDEX(EWZ) S&P 500 Index(^SPX) Charts -    iShares MSCI BRAZIL INDEX(EWZ) Charts -    52-week Change 294.53(26.21%) 52-week Change 6.32(10.24%) 52-week High 1,422.38 52-week High 70.74 52-week Low 1,074.77 52-week Low 48.27 Average Daily Volume 2,799,305 K Average Daily Volume 15,998 K Average Daily Change 10.70 % (absolute value) Average Daily Change 1.49 % (absolute value)

5 year Graph EWZ VS. SPX

The EWZ has provided very strong returns to investors compared to the SPX in the past. This year the situation has changed and the SPX is outperforming the EWZ. 

I believe that there are two reasons for the shift. The business cycle and models. Next to it, expectations play a role.

There are thousands of professionals and Guru's that profess to be able to determine where the markets will go and why. The only ones I think we should listen to are those that have their money where their mouth is. Simply put, those that have capital at risk and make honest assessments of situations, without bias.  

Has the situation globally improved that much to see stocks performing well recently? Not really, but does it really matter? Obviously the market perceives that things have improved and have showed that in their actions.

I believe that common sense professionals, acknowledge that there are significant fractures in the structure that one day will weigh on investments and will have an impact on financial markets. The ones I believe to see things within a great degree of insight/clarity are also humble and down to earth enough to immediately recognize that Markets in itself are not erratic; Investors that make the decisions influencing the markets are.

The problems are there and we are all aware of them. However, what a down to earth and shrewd investor or trader must do, is try to find the conditions that fulfill their investment style, and apply their technique being aware that upon starting that particular transaction, there are only 3 possible outcomes: Generate Profits or Losses, and in some isolated cases Break Even.

To Invest or speculate, one must accept risks. It is a fallacy to believe that there are safe investments. Those who wish to believe that they can make money without assuming any kind of risks have lost touch with reality. The best fail; they all incur losses and make mistakes. That is part of the process. What distinguishes the very successful from the unsuccessful, is the ability to accept that they are wrong. The ego gets on the way and the markets are to blame, not them.

Accept being wrong is a difficult thing to do principally when we all strive for success and hate to accept failures. More so in an industry where so many myths exist and the public believe that many in Wall Street have either a way to manipulate markets or a hidden secret that will never be exposed.

There are people who utilize whatever means they have to their advantage, however today, the field is leveled. Nobody professes that it is easy to make money. The ones that believe are fooling themselves. looking at things in a simplified fashion helps tremendously. There are no magic indicators that will always be right. They all have pitfalls and shortcomings. 

The fundamentals often take longer than expect to kick in... Simply due to the reluctance of those participating in markets to accept or acknowledge facts. Human Beings that drive the markets. Even the computers, High Frequency Trading machines, are programmed by humans and reflect in a way or the other someone's ideas about market behavior.

So, all we can do to try to make money or extract profits from financial markets is: try to find opportunities in which according to our risk tolerance and our portfolio size can generate profits. It is often called finding the EDGE, an advantage, however small that may be, that can lead us to profitability.

The markets are not different from going into an auction to buy antiques or goods. It is not that different in fact, contrary to what many try to make us believe. People pay irrational prices for houses, for clothing and for cars. So why shouldn't they do the same with stocks. What makes stocks special? Nothing.

Stocks, in essence are also Goods. It is analysed and evaluated by humans, professionals, trying to make a living and to generate profits.Nothing different from a real state broker or a second hand car salesman.

The financial markets are certainly far more stylish and flashy than the consumer market. There is kind of Aura fluctuating around financial professionals. In society, it is far more respectable and fancy to be a Investment Analyst or Broker than a second hand salesman. Yet, both have merits and shortcomings. Their pay rate may be very different for several reasons, however, the process of marketing goods is quite similar.

Insiders, that being stock or commodities markets insiders, fruit, clothing or cars, have a lot in common. They know things first hand that we don't know; however that doesn't mean that they are all successful.

They both strive to do the same: sell their inventory generating profits. If we think about markets from that perspective, things change quite a bit and instead of looking at wall street with a sense of intimidation or awe, we start to believe that they are nothing more than human. 

There is an Edge being a professional. The edge exists for the car sales man that can take advantage of holding for purchasing the best vehicles at car auctions enabling him to sell at a premium  as there is for the Stock Broker who would hold the able to purchase stocks at very competitive prices. That is a fact of life. 

However, both can make mistakes. Both can be wrong. They can make mistakes and even us, the little guy down the street can take advantage of the situation if we commit to it. 
  













.