Download september 2016 investment letter - "nirvana, milli

DAVE JANNY SETEMBER 2016 INVESTMENT LETTER
2016 Volume 9
NIRVANA, MILLI VANILLI AND MORAL HAZARD
Here’s a series of former Federal Reserve Chairman Ben Bernanke quotes that are particularly
interesting and pertinent today:
“As we try to make the financial system safer, we must inevitably confront the
problem of moral hazard.”
“Most of the policies that support robust economic growth in the long run are
outside the province of the central bank.”
“Only a strong economy can create higher asset values and sustainably good
returns for savers. There are limits to monetary policy.”
“Market discipline can only limit moral hazard to the extent that debt and equity
holders believe that, in the event of distress, they will bear costs.”
Nirvana was the famous “grunge” band from Seattle that tore up the new music scene from 1987 to
1994 and became one of the most influential rock bands ever. Here’s a Nirvana lyric from their song
“Heart Shaped Box” that tries to respond to Chairman Bernanke’s above advice:
“Hey! Wait! I’ve got a new complaint/Forever in debt to your priceless advice”
Like Nirvana, from 1988 to 1991 German “R&B” duo Milli Vanilli was also a music sensation. Before we
compare and contrast, I ‘ll give you a Milli Vanilli lyric from their hit single ”Girl You Know It’s True” that
I’ll use an ode to Chairman Bernanke’s successor, Chairwoman Janet Yellen:
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“I’m in love with you girl/Cause you’re on my mind?/ You’re the one I think about
most every time?/...Your sophisticated hand knows how to sweeten things”
Lastly, I give you a definition of “moral hazard” from Wikipedia:
“In economics, moral hazard occurs when one person takes more risks because
someone else bears the cost of those risks. A moral hazard may occur where the
actions of one party may change to the detriment of another after a financial
transaction has taken place.”
What do “Nirvana”, “Milli Vanilli” and “moral hazard” have in common? Let’s discuss (possibly with a
dose of humor, sarcasm and cynicism).
” Nirvana”, besides being the name of the famous rock band I referenced above, is also a term according
to Wikipedia for a “liberated state of perfect quietude, freedom and highest happiness”.
It’s also a good description of the investing environment for the last 7 years. Continuously disappointing
global economic growth and underwhelming earnings growth (recently negative) hasn’t deterred global
stock markets much. A good example of market “nirvana” is the ongoing trend of “bad economic news is
good market news” because the Fed won’t raise interest rates. The band “Nirvana” had a tremendous
run of success that unfortunately came to a sudden end with the ultimate “moral hazard”, troubled lead
singer Kurt Cobain’s tragic suicide. What a sad irony!
In complete contrast to the hard edge of “Nirvana” was the catchy “synth-pop” sound of “Milli Vanilli”.
Over a couple of years, “Milli Vanilli” had a streak of monster hit singles. They too had much success, but
also succumbed to “moral hazard”. The band‘s sudden demise was attributable to the fact that they
were a “fake”, they were found to be” lip syncing” their songs.
Moral hazard can have stunning and rapid consequences, just like we’ve seen in the cases of Nirvana
and Milli Vanilli. In the case of global markets, there is no doubt in my mind that central banks have
created moral hazard. There is also a strong possibility that global economies and markets that are being
propped up by extreme central bank monetary policy could be “fake” like Milli Vanilli. They haven’t been
found out yet, but their addiction to stimulus without commensurate economic benefit has created the
buildup of significant moral hazard. If economic and earnings growth doesn’t start to materialize soon,
global markets may face the same untimely fate that those bands faced. I’ll explore some of the reasons
for that prognosis in this month’s Investment Letter
VOLATILITY
The big story for the markets since my last Investment Letter has been the lack of volatility. It’s been
downright boring. To put it in proper perspective, I’ll share a quote from asset manager Dana Lyons in
his 9/7/16 Zero Hedge posting:
“We note that, unbelievably, the high to low range in the Dow Jones Industrial
Average (DJIA) over the past 40 days is a mere 2.27%. For context, that is the
tightest 40 day range in at least the last 100 years. And in fact, the next tightest
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range – at 2.53%, occurring from December 1922 to February 1923 – is not really
even close.”
Wow! That really is a lack of volatility. It certainly fits the “Bob Marley” complacency I described in my
August Investment Letter. The best measurement we have for “volatility” is the VIX index. It is better
described as a “fear index” as it rises when the markets go down. This calm stretch may have something
to do with a very dangerous “under the surface” threat that exists in the market. One of the nice things
about my Investment Letter is the feedback that I get from readers like you. That also includes readers
sending me interesting articles and research reports (I encourage you to do so). This included receiving
from one of my readers, one of the most interesting reports I’ve ever read. The report is from Chris Cole
of Artemis Capital Management. Artemis runs a “long volatility” hedge fund. Cole writes about how “the
volatility of the volatility” has picked up significantly in the last couple of years. Although it is hasn’t felt
like we’ve had that much volatility, interestingly and importantly there have been some of the largest
percentage moves both up and down in the VIX index over the last couple of years. The reason for it is a
big threat to the markets, it is the prevalence of investors “selling” or shorting” volatility. Here’s how
Cole describes it in his October 2015 report titled “Volatility and the Allegory of the Prisoner’s
Dilemma”:
“Moral hazard is institutionalized in the price of risk. A new generation of traders
has learned to buy every stock market dip, short every volatility spike, and releverage at the mere hint of government intervention. Yield starved investors are
forced to chase the expectation of government response rather than fundamental
returns and good business models. If central banks are constantly reacting to
market conditions the net effect is to crowd out value investors.”
“Moral hazard has contributed to a significant buildup in short and leveraged
volatility creating a shadow “volatility gamma” that reinforces the current trend in
volatility direction. Rising volatility is followed by more rising volatility and vice
versa. Volatility is crushed whenever a central bank responds to crisis and
thereafter leverage is re-applied in even greater amounts in a cycle of moral hazard.
The pattern is creating a pro-cyclical monster of short volatility that, if left
unchecked will contribute to a repeat of the May 2010 Flash Crash or 1987 Black
Monday Crash.”
Despite the fact that the report was written in October of last year, everything Cole writes about
continues in an even bigger way today. Shorting volatility has been an easy way for investors to make
money because central banks come in to “save the day” after a market pullback and VIX spike. The
success has brought in even more investors into the methodology. It also includes investors selling
“naked puts” on stocks and indices into these corrections. Investors don’t make a lot, but as I said it’s
been pretty consistently easy because we haven’t seen any really big market declines. This is another
good example of “Pavlovian” responses such as ”bad news is good news” that I also wrote about last
month.
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Let me point out the danger. Being “short” volatility can get really dangerous if a “short squeeze” in
volatility ensues. If one day, all of a sudden, the larger and larger “short” crowd in pursuit of an easy
small amount of money is forced into buying back that position in a rapidly rising “short squeeze”
working against them, the danger is that the spike in the VIX will force more broad stock market selling
and fear. Remember Cole said the VIX moves in both directions are getting historically larger and we
haven’t even had large stock market moves. So far central banks have continued to “save the day”.
When we get to the point that either central banks don’t step up or investors lose confidence in the
efficacy of those interventions, the short volatility will cause a potentially horrific reaction. The small
reward for the huge risk only needs one “backfire” to inflict a lot of pain.
To validate the premise, I’ll point to the fact that even after the recent historic non-volatile 40 day
stretch I referenced above; there was a record short position in VIX futures. As I was writing this Letter
on Friday September 9th, out of nowhere we got a 52 point S&P 500 down day to break the calm. The
VIX index according to Thomson went from 12.51 to 17.50 that day, a huge 40% move. I don’t know
when the “volatility short squeeze” scenario I described above plays out, but I do know that this is a
potentially dangerous market reeking of moral hazard. Long volatility strategies are a good way to help
protect your portfolio. I am implementing them in my “PM managed accounts” that I run in what I’ve
described before as an “unconventional asset allocation strategy”. I urge you to ask me about this
approach.
CONTINUED WEAK U.S. ECONOMIC STATS
The volatility description above gives further evidence to the inane and dangerous fixation markets have
on central bank policy where every single central bank word and statement gets parsed and microanalyzed. The Fed after telling us in December 2015 that we will have 4 rate hikes in 2016, has so far not
managed to implement one hike. Fed “language” all year has fluctuated from “dovish” (no hikes) to
hawkish” (hike imminent) and back and forth again. To illustrate the illogical market reaction, on Friday
9/9/16 (the 52 point S&P 500 down day) the commentary was “hawkish” from Fed governor Eric
Rosengren in regard to the September 20-21 meeting . On Monday 9/12/16 the S&P 500 bounced back
31 pts. because of “dovish” commentary from Fed Governor Leal Brainard.
I think the Fed would like to raise rates, but I think they’ll have a tough time doing so. Here’s a list of
recent U.S. economic stats I’ve gleaned from various sources that argue against a rate hike:
According to Briefing..com on 9/1/16 “The ISM manufacturing Index for August produced a
big headline disappointment , falling to 49.4 (Briefing.com consensus of 52.2) from
52.6 in July. A number below 50.0 denotes a general contraction in the
manufacturing sector.”
According to BofA analyst Michael Contopoulos, “The 9/6/16 ISM non-manufacturing
(services) index came in considerably lower than expectation, falling to 51.4 in
August from 55.5 in July, for the lowest index value since February 2010. Since at
least 1997, the only time the ISM services index has been this low outside of a
recessionary environment was a brief two month dip in 2003.”
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Morgan Stanley currency strategist Hans Redeker reported on 8/10/16, “Yesterday’s release of
the third consecutive decline in quarterly U.S. productivity – the worst run since at
least 1980 – does not bode well for prospects for the U.S. Dollar. 2Q productivity
declined by 0.5%, coming in way below consensus expectation of +0.4%, suggesting
that the growth potential of the U.S. economy may have declined substantially.”
We’ve known that for the last couple of years that capital and business investment has been very low.
According to SocGen strategist Albert Edwards, “The year 1986 has been the only case where
a business investment recession did not cause an outright US GDP recession. Why?
Because the economy had recently emerged from 1982 recession and it was
growing very strongly indeed when the hit to capital spending came. In addition,
households were leveraging up aggressively, which boosted consumer spending.
Neither of these things is the case now. Indeed the current consumer/GDP
conjuncture has echoes of Q1 2007 when robust consumption only temporarily
offset extreme weakness in the data elsewhere. But within six months, by
November 2007, the NBER recorded that the economy had fallen into outright
recession.”
According to Hoisington Investment Management’s Second Quarter 2016 quarterly review released in
July 21016 , “Real per capita GDP has risen a paltry 1.3% annualized since the current
expansion began in 2009. This is less than half of the 2.7% average expansion since
the records began in 1790. One of the most persistent impediments to growth has
been the drag from fiscal policy, a constraint that is likely to become even more
severe in the next decade. The standard of living, or real median household income,
has only declined in the 2009-2016 expansion and stands at the same level reached
in 1996.”
Obviously there are plenty of weak links in our economy. This weak data is all on top of the last 3
quarters of approximately 1.0% GDP growth. The income statistics noted above continue to reflect that
most Americans haven’t participated in this weak recovery that is already long in length relative to the
history of economic recoveries. This may have political implications here and abroad that could present
shocks to the markets.
As far as earnings are concerned, market research firm FactSet announced on 9/2/16, “The blended
earnings decline for Q2 2016 is -3.2%. The second quarter marked the first time the
index has seen five consecutive quarters of year-over-year declines in earnings
since Q3 2008 through Q3 2009.”
The FactSet earnings stats above show that this 5 quarter earnings decline also occurred in 2008 to
2009. The big difference is that the 2008/2009 decline was occurring in a stock market and economy
that was getting crushed. In this decline the stock markets haven’t even declined yet. I’ll also add that
the quality of these 2016 earnings (I discussed this extensively in my August Letter) is even being aided
by significant financial engineering that wasn’t as rampant back then. Take a look at this FactSet chart
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that shows how the stock market has been moving up since 2014 while earnings expectations have been
stuck going nowhere.
There seems to be a big disconnect between the stock market and disappointing economic and earnings
news. Moral hazard? I believe so. To put the nail in the coffin, I’ve included some comments from UBS’
Art Cashin’s 9/8/16 “Cashin’s Comments where he cites one of my favorite economic observers Danielle
DiMartino Booth:
A Bit More On The Labor Market Conditions Index – We recently remarked on the
continuing weakness in the LMCI. Yesterday, the super savvy Danielle DiMartino
Booth put out a note on the topic to some friends and clients. Danielle, as you know
is writing a book on the Fed and runs her new invaluable website Dimartino Booth –
Money Strong.
Here’s a bit of what she recently wrote on the LMCI:
With a hat tip to Peter Boockvar for the friendly reminder, in a June 6th speech Chair
Yellen had this to say about the disastrous May jobs report, “Although this recent
labor market report was, on balance, concerning, let me emphasize that one should
never attach too much significance to any single monthly report.”
One thing is certain, Yellen’s one-month honeymoon on the jobs data ended
abruptly with Tuesday morning’s release of the August Labor Market Conditions
Index, a 19-indicator index of her own creation to best gauge the health of the job
market.
If one month does not make a trend, seven surely qualifies; that’s the number of
months the LMCI has been in negative territory in the last eight months. The index
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fell to -0.7 in August from a revised reading of 1.3 in July. For some historic
context, the median reading since the series data began exactly 40 years ago, in
August 1976, is 2.1
This past summer, Chair Yellen testified to Congress that negative readings indicate
the labor market is losing momentum. During that same testimony, she downplayed
the LMCI as an, “experimental research product,” which no doubt came as a
surprise to many in the economics community who associate the index as being
Yellen’s ‘baby’.
It will be interesting to see if FOMC voting members continue to jawbone for a 2016
rate hike in light of the emergence of such a distinct trend in the most critical data
on hand. Dismissing the contraction in manufacturing was apparently acceptable
headed into last December’s rate hike. It would be astonishing behavior for the Fed
to also be dismissive of the clear slowdown that’s emerged in the service sector as
evidenced by the worst print in the ISM since February 2010.
BERNANKE SAID WHAT?
Please take another look at the Bernanke series of quotes at the beginning of this Letter. Keep in mind
that Bernanke is arguably still the “leader of the band” as far as today’s global central bankers are
concerned. Despite the fact that he is no longer the Chairman of the Fed, it was Bernanke’s lead during
the financial crisis that helped stabilize global markets. It was also his lead that has continued to
influence the “emergency” central banking interventions that not only continue to this day but
potentially could be on the verge of expanding to his now famous more radical last resort “helicopter
money” approach. Now go back and really read his quotes.
What gives? Those quotes don’t make much sense in the context of today’s global markets and
economies. Let’s start with “As we try to make the financial system safer, we must
inevitably confront the problem of moral hazard”. As I mentioned in my August Letter,
global “QE” is currently running at its’ fastest rate ever. That’s saying a lot since we’ve had an incredible
8 years of global “QE”. I don’t know about you, but that doesn’t give me a feeling of safety. You would
think that with the multi trillions of dollars of global stimulus dumped into the financial system since the
financial crisis that global economies would be humming along not trudging along. Many market
commentators have started to argue that the “QE” has even become counterproductive. There’s no
doubt asset prices across the board have not only benefited, but as a result now seem to be dependent
on more intervention.
The Thursday September 8th ECB (European Central Bank) meeting was the perfect example. Market
expectations going into the meeting were for Mario Draghi and the ECB to increase and extend their
massive QE program. Firstly by extending the March 2017 end date, then increasing the current monthly
purchase amounts and finally widening the scope of their purchase to even include equities. Yes
equities. Why would the market think that the ECB would buy equities? Because other central banks are
already doing it! Everyone knows about the massive bond buying that the Fed, ECB and BOJ have
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undertaken. I and many other people have written extensively about the massive stock purchases and
market manipulation that the Bank of China has been implementing since last summer’s Chinese stock
market crash. But check out these articles that document how much stock buying the BOJ and the SNB
(Swiss Central Bank) have been doing.
According to research firm CLSA, the BOJ is now buying Japanese ETFs at the rate of $58 billion annually.
Take a close read of this Zero Hedge article:
http://www.zerohedge.com/news/2016-08-23/clsa-bank-japan-has-nationalized-japanese-stock-market
Wolf Richter of WolfStreet.com adds that if you include the Japanese Government Pension investment
Fund (GPIF), the BOJ and GPIF combined are now the largest shareholders of 474 big Japanese
companies:
http://wolfstreet.com/2016/08/29/qe-end-of-private-sector-japanese-government-now-largestshareholder-of-474-companies/
According to Reuters, the SNB owns around $130 billion worth of global stocks:
http://www.reuters.com/article/swiss-snb-stocks-idUSL8N1B7383
According to Zero Hedge, the U.S. portion of that equity portfolio is around $61 billion:
http://www.zerohedge.com/news/2016-08-04/mystery-buyer-revealed-swiss-national-banks-us-stockholdings-rose-50-first-half-rec
No wonder the markets were disappointed that Draghi didn’t move in the same direction. Think for a
moment about the implications of central banks buying stocks in real companies. We’re not talking
about troubled banks that need a cash injection. This is very dangerous stuff and the market is expecting
a whole lot more of it. This is unprecedented moral hazard. If this is such a great idea, central banks
should have been doing this since their inception and they might as well buy up all corporate stock
that’s out there. This despite what I quoted Bernanke saying at the beginning of this Letter: “Only a
strong economy can create higher asset values and sustainably good returns for
savers. There are limits to monetary policy.” My guess is that the higher asset values may
only be temporary and those good returns may not be sustainable for savers unless they sell. My advice
is to sell early.
At the recent August Jackson Hole Symposium where the world’s central bankers gathered and at the
early September G20 meeting in China, the consistent outcry was for more fiscal policy and structural
reform. Howard Schneider of Reuters summed up Jackson Hole this way:
“Mired in a world of low growth, low inflation and low interest rates, officials from
the Federal Reserve, Bank of Japan and the European Central Bank said their efforts
to bolster the economy through monetary policy may falter unless elected leaders
stepped forward with bold measures. These would range from immigration reform
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in Japan to structural changes to boost productivity and growth in the U.S. and
Europe.”
“Without that, they said, it would be hard to convince markets and households that
things will get better, and encourage the shift in mood many economists feel are
needed to improve economic performance worldwide. During a Saturday session at
the symposium, such a slump in expectations about inflation and about other
aspects of the economy was cited as a central problem complicating central banks'
efforts to reach inflation targets and dimming prospects in Japan and Europe.
Fiscal policy was not on the formal agenda for the conference, but it was a steady
part of the dialogue as policymakers thought through policies for a post-crisis
world. One of the central worries is that households and businesses have become
so cautious and set in their outlooks - expecting little growth and little inflation that they do not respond in expected ways to the efforts central banks have made.”
That seems to agree with one of my initial Bernanke quotes: “Most of the policies that support
robust economic growth in the long run are outside the province of the central
bank”. The only problem is that markets are hooked on monetary policy and any transition to fiscal
policy may be too little too late and potentially difficult to engineer politically.
In the world of bonds, I’ve spoken for months about the incredible amount of bonds that were negative
yielding (at one time recently estimated to be somewhere in the neighborhood of a staggering $13
trillion). Here’s a great quote from the very astute Jim Grant of Grant’s Interest Rate Observer from a
recent Bloomberg interview:
“There is not quite a bestseller, but a very substantial book called “The History of
Interest Rates”. It was written by Sidney Homer and Richard Sylla. Homer is no
longer with us, but Richard Sylla is alive and well at NYU. So I called him and said
“Richard, I’ve read many pages but not every single page in your book which traces
the history of interest rates from 3000 B.C. to the present. Have you ever come
across negative bond yields? “He said no and I thought that would be kind of a
major news scoop. For the first time in at least 5000 years we have driven interest
rates below the zero marker. I thought that was an exceptional piece of intelligence.
But I notice however that nobody seems to have picked up on it.”
The first time in 5000 years! This time seems to be different! Can you say bubble?
“Bond king” Bill Gross of Janus in his monthly newsletter put it this way in regards to Janet Yellen and
other central bankers:
“She is opening the door to creating even greater asset bubbles as have the BOJ and
ECB and SNB by purchasing corporate bonds and stocks. This is not capitalism. This
is providing a walker or a wheelchair for an ailing economy. It may never walk
normally again if monetary policy continues in this direction.”
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Ouch! That might be painful.
One new tactic that is worth keeping an eye on is the recent BOJ policy of trying to “steepen” the yield
curve. In other words they would like to see the spread between long term rates and short term rates
rise. A “flattening” yield curve where spreads between long term and short term yields are compressing,
is what we’ve been experiencing in most global markets over the last couple of years. “Flattening” yield
curves are historically a sign of a weakening economy. I guess the plan is to pyschologically “trick”
investors and consumers into thinking that their economy is stronger than it really is. Central banks are
hoping and praying for inflation, so far they’ve been very disappointed. If they keep going more and
more towards even more radical policy they might eventually succeed in producing inflation. If
economic growth doesn’t come with it, we may be talking about stagflation. In the meantime this
attempted “steepening” of the yield curve has caused some short term problems in global fixed income
markets that is now causing selling in stock markets and other assets as well. This is definitely
something to keep an eye on. Based on the fact that market consequences so far haven’t been good, I’d
be surprised to see them continue those actions. I’ll update you again on this topic next month.
I’ll leave you with the last of my initial Bernanke quotes: “Market discipline can only limit
moral hazard to the extent that debt and equity holders believe that , in the event
of distress, they will bear costs.” Right now, it doesn’t seem like investors feel that they will
have to bear costs. At some point investors ultimately will have to bear those costs. The smart ones will
be early in realizing this. I hope that we will be amongst the start ones. Nirvana and Milli Vanilli
succumbed to moral hazard. Markets will as well, if we don’t get economic and earnings growth soon. It
will be interesting to see how long it takes to play out. Stay safe and stay cautious as far as these
markets are concerned.
David Janny
Senior Vice President
Financial Advisor
NMLS# 1279369
Morgan Stanley Wealth Management
200 Nyala Farms Rd.
Westport, CT 06880
203 221-6093
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An investment cannot be made directly in a market index.
NASDAQ Composite Index is a market-value-weighted index of all NASDAQ domestic and non-U.S. based common stocks listed
on NASDAQ stock market.
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Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents
approximately 11% of the total market capitalization of the Russell 3000 Index.
VIX: This is a trademarked ticker symbol for the Chicago Board Options Exchange Market Volatility Index, a popular measure of
the implied volatility of S&P 500 index options. Often referred to as the fear index or the fear gauge, it represents one measure
of the market’s expectation of stock market volatility over the next 30-day period.
Euro STOXX: Provides a blue-chip representation of supersector leaders in the Eurozone.
Shanghai Stock Exchange Composite: A capitalization-weighted index. The index tracks the daily price performance of all Ashares and B-shares listed on the Shanghai Stock Exchange. The index was developed on December 19, 1990 with a base value
of 100.
The Nikkei-225 Stock Average is a price-weighted average of 225 top-rated Japanese companies listed in the First Section of the
Tokyo Stock Exchange. The Nikkei Stock Average was first published on May 16, 1949, where the average price was ¥176.21
with a divisor of 225. *We are using official divisor for this index
DAX Index: A stock index that represents 30 of the largest and most liquid German companies that trade on the Frankfurt
Exchange. The prices used to calculate the DAX Index come through Xetra, an electronic trading system. A free-float
methodology is used to calculate the index weightings along with a measure of average trading volume.
The FTSE 100 is an index composed of the 100 largest companies listed on the London Stock Exchange (LSE). These are often
referred to as 'blue chip' companies, and the index is seen traditionally as a good indication of the performance of major
companies listed in the UK.The Hang Seng Index (abbreviated: HIS) is a freefloat-adjusted market capitalization-weighted stock
market index in Hong Kong. It is used to record and monitor daily changes of the largest companies of the Hong Kong stock
market and is the main indicator of the overall market performance in Hong Kong.
A price-weighted average of 20 transportation stocks traded in the United States. The Dow Jones Transportation Average
(DJTA) is the oldest U.S. stock index, compiled in 1884 by Charles Dow, co-founder of Dow Jones & Company. The index initially
consisted of nine railroad companies - a testament to their dominance of the U.S. transportation sector in the late 19th and
early 20th centuries - and two non-railroad companies. In addition to railroads, the index now includes airlines, trucking, marine
transportation, delivery services and logistics companies.
Morgan Stanley Smith Barney LLC. Member SIPC.
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