Friday, September 12, 2014

How an independent Scotland could become prosperous

For your consideration as we approach the weekend: As we approach the Scottish Referendum on September 18, there have been lots of stories of the negative repercussions of a Yes vote. I had written from a Canadian's perspective about How a Scottish-UK currency union is an idiotic idea. I believe that Credit Suisse summed up the risks best with this paragraph (via Business Insider):
Risk of an economic crisis: In our opinion Scotland would fall into a deep recession. We believe deposit flight is both highly likely and highly problematic (with banks assets of 12x GDP) and should the BoE move to guarantee Scottish deposits, we expect it to extract a high fiscal and regulatory price (probably insisting on a primary budget surplus). The re-domiciling of the financial sector and UK public service jobs, as well as a legal dispute over North Sea oil, would further accelerate any downturn. In our opinion, as North Sea oil production slows, we estimate that the non-oil economy would need a 10% to 20% devaluation to restore competitiveness. This would wages, driven by a steep rise in unemployment.
The FT outlined an equally dire scenario:
A Yes vote will launch Scotland, and to a lesser extent the UK, into years of uncertainty. Among the biggest doubts are those hanging over the currency. Financial businesses that must be regulated and supported by the UK will flee. Scottish deposit insurance would be as worthless as the Reykjavik-run scheme that failed to cover Icelandic banks in 2008. Cautious Scots must already recognise that the pounds in their bank accounts may end up as something else. Far safer to move the money south.

Confronted with currency uncertainty, banks will need to balance their books within Scotland. This will surely force them to shrink the supply of credit to the Scottish economy. The UK government could try to prevent money from leaving Scotland, but this would require draconian controls, which it will not impose. Either Westminster or the Scottish government could offer to indemnify lenders against currency risks. The UK government will not do that. It will let the credit squeeze happen, blaming it on the Scottish decision. It will be Scotland’s choice, if it can meet the cost.
There will be a bad taste on everyone's mouths:
These negotiations will be complex, bitter and prolonged. However amicably a divorce begins, that is rarely how it ends. It is the safest possible bet that when this process is over, the English will resent the people who repudiated them and the Scots will resent the people who did not give them independence on the terms to which they believed they were entitled. A United Kingdom will give way to a deeply divided island.

The Scots will discover the taste of austerity. Scotland cannot sustain higher taxes than the residual UK; that would drive economic activity away. It will pay a higher interest rate on public debt because its government will be unfamiliar and dependent on unstable oil revenues (almost certainly smaller than Mr Salmond imagines). Fiscal fibs will be exposed.

By then it will be too late. If the vote is a Yes, it will be forever. But what about a narrow No? That too will be a nightmare. We could then look forward to more referendums. I would prefer a clean break than that. If Scotland cannot decide firmly in favour of union, let it choose “independence”. And then, enjoy!
While it is true that an independent Scotland, as a small country with an open economy, is subject to many risks that it would not face as part of the UK. But this analysis relies on overly conventional banker thinking. What if the Scots were to think outside the box?


A neutral Scotland?
Instead of thinking like a banker about resolving Scotland`s finances, Alex Salmond could think about the geopolitical dimensions of a potential divorce. Consider, for example, that the SNP's White Paper for independence has called for a nuclear free Scotland within the first term of parliament:
Scotland has been home to one of the largest concentrations of nuclear weapons anywhere in the world, despite consistent and clear opposition from across civic Scotland, our churches, trade unions and a clear majority of our elected politicians. Billions of pounds have been wasted to date on weapons that must never be used and, unless we act now, we risk wasting a further £100bn, over its lifetime, on a new nuclear weapons system. Trident is an affront to basic decency with its indiscriminate and inhumane destructive power.
That brings up the question of whether the armed forces of an independent Scotland needs to be part of the UK`s armed forces structure. Ireland has been neutral for many years - even during the Second World War. Why not Scotland?

Does Scotland even need to be part of NATO?


Military assets: From cost center to profit center
Let`s go down that road a little further. Supposing that the Scottish budget was under pressure, instead of worrying about the fiscal burden of funding Tornado and Typhoon squadrons at Lossiemouth, etc., why not negotiate leases for basing rights with rUK? Such a move would instantly transform those military assets from cost centers to profit centers.

In fact, a neutral Scotland could put the leases at its major bases such as Lossiemouth (air base) and Faslane (Trident) up for bids. What would the Russian navy pay for basing rights at Faslane? It would a Russian military planner`s dream. Russian SSBNs in the North Sea would give Moscow the option of launching a decapitation strike to take out the leadership in European capitals and NATO headquarters with little or no warning.

Notwithstanding the uproar in Westminster, how would Washington react (and pay) to avoid Su-27 squadrons at Lossiemouth and Russian ballistic missile subs roaming freely in the Atlantic and the North Sea?




I had suggested that there was a geopolitical risk element to the Greek crisis in 2011 (see Europe dodges another bullet (not the Catalan election)). Russia could have seized a historic opportunity to rescue Greece and achieve the long Russian dream of achieving a warm water port by funding a Grexit. The test case would have been Cyprus - but the Kremlin chose to pass on that opportunity.

Now Putin might have a second chance. Instead of infiltrating Spetnaz units into neighboring territories, Moscow could just buy the country instead. Already, the Russian press is planting stories like Economic Benefits of Faslane Nuclear Base in Scotland “Overplayed” - Official. What comes next? After all, are we not all good capitalists now?

While what I have outlined is tongue in cheek and fantasy (worthy of ZH), it nevertheless does illustrate the point that if an independent Scotland gets pushed too far economically, the gloves could come off and anything can happen.

Thursday, September 11, 2014

Big trouble in little Hong Kong?

I came across a couple of news items that appeared to be disturbing on the surface to which the markets haven't really reacted. First, there was this Reuters report of the meeting between China's representative with pro-democracy advocates in Hong Kong (emphasis added):
The setting at the Aug. 19 meeting was calm: A room with plush cream carpets, Chinese ink brush landscape paintings and a vase of purple orchids. The political mood outside, however, was fraught. Democratic protesters were threatening to shut down the global financial hub with an "Occupy Central" sit-in if Beijing refused to allow the city to freely elect its next leader.

After the formal smiles and handshakes with Zhang Xiaoming, the head of China's Liaison Office in Hong Kong, the mood soured. Pro-democracy lawmaker Leung Yiu-chung asked Zhang whether Beijing would allow any democrat to run for the city’s highest office.

Zhang, 51, dressed in a black suit and a navy blue striped tie, delivered a blunt response. “The fact that you are allowed to stay alive, already shows the country's inclusiveness," he answered, according to two people in the room who declined to be named.
The truth of the matter is that Hong Kong's share of Chinese GDP has been falling for years and it isn't as important to China as it was in the past.


Under the circumstances, China's leadership is probably in no mood on treating Hong Kong residents with kid gloves.
At the Aug. 19 meeting, Zhang said Beijing had been generous even allowing democrats such as Leung to run for legislative seats. He insisted that the next leader had to be a "patriot".

"We were shocked," said one person who attended the meeting. "But Zhang Xiaoming is only an agent who delivered the stance of the central government without trying to polish it."

Few were surprised, though, when China's highest lawmaking body, the Standing Committee of the National People's Congress (NPCSC), announced an electoral package on Aug. 31 that said any candidate for Hong Kong's chief executive in the 2017 election had to first get majority support from a 1,200-person nominating panel – likely to be stacked with pro-Beijing loyalists.
For now, the markets have shrugged off this development. The Hang Seng Index is currently testing an uptrend and other regional indices, such as the Shanghai Composite, South Korea and Taiwan indices remain in uptrends.



A march to war?
In addition, the FT reported that a majority of the Chinese population believed that war with Japan is inevitable:
The Genron/China Daily survey found that 53 per cent of Chinese respondents – and 29 per cent of the Japanese polled – expect their nations to go to war. The poll was released ahead of the second anniversary of Japan’s move to nationalise some of the contested Senkaku Islands in the East China Sea.
I have written about how the Chinese and Japanese hate each other, but this latest poll indicating a belief of the inevitability of war is a serious matter. The combination of such attitudes in China and a scenario of rising tensions in the South China Sea would seriously freak out the markets worldwide.


At this point, these kinds of worries are highly speculative, but they have a way of not mattering to the market until they matter. Should Chinese growth weaken in the near future, there will be a temptation to play the nationalism card to distract the populace. In that case, the risk of rising geopolitical tensions will present tail-risk that is probably not in too many analysts' spreadsheet models.

Wednesday, September 10, 2014

Recall model assumptions before jumping to conclusions

I have written numerous times in this space about the importance of examining your assumptions before taking any action on quantitative research.

Here is another example. I came upon a study by Alpha Architect on the tradeoff between stock selection and diversification called Diworsification: Trade-off between portfolio size and expected alpha (h/t Tadas Viskanta). The article first laid out a number of assumptions and caveats:
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.
It went on to perform a number of simulations using Monte Carlo techniques (note key assumption in bold):


The spreadsheet conducts 1000 simulations. In each simulation run, a system can either take 1 bet, 10 bets, or 100 bets--all uncorrelated. As the chart above suggests, one can manage risk by pooling truly uncorrelated bets together. As the number of bets increases, the volatility goes to zero and the expected value becomes the observation.

In the real world stocks don't have zero correlation--correlations are much higher across equities. 
Here are the conclusions based on this Monte Carlo study:
What's the bottom line?

30-50 stocks seems to be a sweet-spot where an investor eliminates portfolio idiosyncratic volatility, as additional diversification beyond this point does not help reduce volatility in any dramatic way. However, by diversifying beyond 30-50 stocks, we also prevent our portfolio from concentrating on stocks we feel are "undervalued." In other words, we probably want Warren Buffett to hold 30 or so stocks to ensure he doesn't completely blow up, but we don't want to force him to hold more than that, because it is unlikely he has more than 30 good ideas. In effect, he would be "diworsifying."
How useful is the 30-50 stock answer?

I believe that while this was a useful first step and study illustrating the tradeoffs between the effects of stock selection and diversification, I would take the conclusion of 30-50 stocks as the "sweet spot" with a grain of salt. Consider the kinds of assumptions that are made in this study:
  • Individual stock returns are un-correlated
  • The study does not identify the source of alpha
The second point is particularly important as it ignores Richard Grinold`s Fundamental Law of Active Management.


The Fundamental Law of Active Management
Grinold's seminal paper on this issue outlined how a manager should size the bets a he should make in a portfolio.
where IR = Information Ratio
           IC = Information Coefficient
           N = Number of independent opportunities

What Grinold means by the above formula is that a manager’s value-added (Information Ratio) is a function of his selection skill (Information Coefficient) and the number of opportunities (N) he has. In plain English, the portfolio manager should make bets in accordance with the size of his edge, or alpha.

Even then, the formula, as outlined, presents a number of implementation problems (see my previous discussion Examining your assumptions: The fundamental law of active management). They relate to time periods and optimal re-balancing; and the definition of independent opportunities (which the Alpha Architect study assumes that each stock is independent of each other).

For example, if you buy a portfolio of 100 low PE stocks, does N=1 (all low PE), 100, or somewhere in between? How different N be if it was a portfolio of 20 low PE stock?

Under these circumstances, how applicable is the Monte Carlo simulation study that 30-50 represent the "sweet spot" of diversification?

The moral of this story: Know your assumptions before coming to conclusions.


Tuesday, September 9, 2014

Michael Pettis on the risks of the "long landing" scenario

I received an email from Michael Pettis on my recent post (see The Pettis China "long landing" scenario hits an air pocket). To recap my previous post, I outlined Pettis' views of China's growth path outlined in his most recent blog post:
The first stage of China’s growth story, which occurred mainly during the 1980s, consisted of liberalizing reforms that undermined the Communist elite and which were strongly opposed by them. Because power was highly centralized under Deng Xiaoping, however, including a loyal PLA, he and the reform faction were nonetheless able to force through the reforms.

The next two stages of growth, I argued, required policies that had a very different relationship to the interests of the Chinese elite. Because they involved the accumulation and distribution of resources to favored groups whose role was to achieve specific economic targets, they helped to reinforce the wealth and power of a new elite, many of whose members were, or were related to, the old elite. Not surprisingly this new elite strongly supported the growth model imposed by Beijing during these stages.

The fourth stage, I argued, is the stage upon which we are currently trying to embark. In an important sense it involves liberalizing reforms similar politically to those that Deng imposed during the 1980s, making it vitally important to their success that the current administration is able to centralize power and create support to overcome the inevitable opposition, which it seems to be doing.
He continued with an optimistic "long landing" scenario (emphasis added):
This is why, even though Beijing doesn’t seem to have yet gotten its arms around the problem of excess credit creation, I nonetheless think it is moving in the right direction. For now I would give two chances out of three that Beijing will manage an orderly “long landing”, in which growth rates continue to drop sharply but without major social disruption or a collapse in the economy. 
To achieve the Third Plenum objectives of re-balancing the source of economic growth to the consumer, or household, sector, financial repression needs to be eliminated, or at least drastically reduced.
Under these conditions it should be no surprise that borrowers with access to bank credit overuse capital, and use it very inefficiently. They would be irrational if they didn’t, especially if their objective was not profit but rather to maximize employment, revenues, market share, or opportunities for rent capture (as economists politely call it).

The second point to remember is that in a severely financially repressed system the benefits of growth are distributed in ways that are not only unfair but must create imbalances. Because low-risk investments return roughly 20% on average in a country with 20% nominal GDP growth, financial repression means that the benefits of growth are unfairly distributed between savers (who get just the deposit rate, say 3%), banks, who get the spread between the lending and the deposit rate (say 3.5%) and the borrower, who gets everything else (13.5% in this case, assuming he takes little risk – even more if he takes risk).

This “unfair” distribution of returns is the main reason why the household share of income has collapsed from the 1990s until recently. I calculate that for most of this century as much as 5-8% of GDP was transferred from households to borrowers. The IMF calculated a transfer amount equal to 4% of GDP, but said it might be double that number, so we are in the same ballpark. This is a very large number, and explains most of why the growth in household income so sharply lagged the growth in GDP.
By re-balancing growth from credit-led infrastructure growth, which has mainly benefited SOEs, to the household and consumer sector, Beijing addresses the problem of mis-allocation of capital. It all made sense...then I came upon this analysis from Anne Stevenson of YCapital (via FT Alphaville):
Consumer spending is second only to unemployment as the most atrociously tracked statistic in the economy, and the NBS numbers offer little insight. We have, however, been choosing two smaller cities per month as focuses of research, conducting interviews with vendors across commercial categories and triangulating the interview data with what we can see from the statistics. In each case, cities that have seen a decline in property sales almost immediately see a decline in spending in the industries we survey, with the sharpest downturns generally in property-related categories such as furniture and building materials. Next-weakest are usually consumer electronics and white goods, then food, while there is often growth left in clothing and personal care. The near identity between property and the consumer economy indicates that a slump in property must lead to a spike in investment in order to buoy the preferred areas.

The consumer segment, to the extent that it can be independently tracked, provides a clear trace for how capital moves through the economy at large and spills out in the form of commissions and kickbacks on contracts, higher compensation locally, and better liquidity for the housing market, leading individuals to spend.
In other words, property prices are intricately linked to consumer spending. If real estate prices tank, as they seem to be doing in the non-Tier 1 cities, so will consumer spending. In that case, how can re-balancing occur?


Pettis' comments
After I published my blog post, I received the following email comment from Pettis, which I reproduce in its entirety with permission:
Cam, thanks for your excellent analysis and kind words. I think you have hit precisely upon the main vulnerability in my "best-case scenario" argument, and because I am a big fan of Anne Stevenson's work (JCapital), I read her reports with the same trepidation you do.

My "best-case" rebalancing scenario, as I think you know, consists of an upper limit to average GDP growth of 3-4% over the presumed decade of President Xi's administration (2013-23), driven by growth in household income of 5-7% and commensurate growth in household consumption. Although when it comes to China I have been the big, bad bear for so long that perhaps I tend to want to understate my pessimism, I nonetheless always try to remind my clients, sometimes not very loudly if I am in a public forum, that this is not my expected "most likely outcome".

In fact I don't really yet have a "most likely outcome" because I think the final result is likely to be highly path dependent, and it is too early in the reform process and, more importantly, in the process of political centralization, to make anything but a rough guess. My "best-case" scenario is just one of the plausible ways in which rebalancing can take place, and, obviously enough, it is the one with the highest average growth rate I am able to work out arithmetically, given the logic of rebalancing and the constraints China faces.

I stress "plausible" because I can also propose "better" outcomes, but these would require policies that although not impossible are, I think, pretty unlikely. For example if Beijing were able to implement policies that transferred every year the equivalent of roughly 2% of GDP directly or indirectly from the state sector to median households, my simple arithmetic allows me to show GDP growth rates of perhaps 6% or even higher.
At any rate whether or not my claim that the upper limit of average growth during 2013-23 is 3-4% is credible depends on at least four factors:

1. China must not run up against debt capacity limits. My guess (and it is only a guess), is that China can continue the current pace of credit growth for another 3-4 years at most, after which it cannot grow credit fast enough both to roll over what Hyman Minsky suggested was likely to be exponential growth in unrecognized bad debt (and WMP and other shadow banking assets will almost certainly be absorbed into the formal banks), and to provide enough new lending to fund further economic activity. If there is less time, as I think Anne Stevenson might argue, or if Beijing cannot get credit and rebalancing under control before then, I think we can probably assume my "orderly long landing" scenario is less likely.

2. Beijing has largely squeezed out the main mechanisms for both rapid growth and the "unbalancing" process (financial repression, currency undervaluation and low wage growth), but tight rebalancing timetables still require direct or indirect state transfers to the household sector, as proposed during the Third Plenum (hukou reform, financial sector governance reform, interest rate and currency liberalization, land reform, privatization, environmental protection, etc.). These will be politically tough to implement, as you know.

3. Even if the above happen, the uncertainty, especially political uncertainty, can cause nervous households to restrain spending, so that even 5-7% growth in household income might not translate into similar consumption growth, which would reduce potential GDP growth.

4. Finally, and this the point you make about Anne's work, if declining home prices cause a negative wealth effect, (and indeed if consumption growth is positively correlated with investment growth, as Murtaza Syed at the IMF found, especially in the poorer western provinces), it will be hard to maintain current levels of consumption growth as investment growth and housing prices decline.

The wealth effect argument may seem obvious by the way, but it might not be complete. Remember that declining home prices have a negative wealth effect on those who are long real estate, especially speculatively long, and the impact is likely to be immediate, but as these people are likely to be relatively wealthy, the impact on consumption might be limited. For Chinese who are effectively "short" real estate (young people, poor people, renters, migrant workers), declining home prices will have a positive wealth effect which, because they are poor, may affect consumption more, but may take longer because declining prices might not be immediately as credible to non-owners as to owners. I wouldn't suggest that the wealth effect impact of a real estate slump could be positive, but it might not be as negative as it was in Japan or the US.

This is a long way of saying that while Anne's research is first rate, mainly, I think, because she identifies and untangles chains of risk rather than build the data-intensive and largely misapplied math models that much of the sell-side prefers, I think the jury is still out. On the whole I still think the long-landing scenario is more likely than a collapse because Beijing does have levers and a stable, if inefficient, banking system, but my 3-4% number is for me a likely upper limit, not the expected growth rate. At any rate we shouldn't doubt that rebalancing is always the hard part, and because it was too long postponed, any distribution of predictions should come with very fat left-side tails.

Sorry for such a long comment, but because you seem to explain even my own arguments better than I can, I thought I would exploit your blog and get your reaction.

Regards,
Michael Pettis

A lot of moving parts
I have had the greatest of respect for Pettis and I have been following him for many years. Because of his work, I have adopted his "long landing" scenario as my base case outlook for China. However, I did find a number of his comments to be interesting.

First, while he remains optimistic, the projected "best-case" rebalancing scenario of "average GDP growth of 3-4% over the presumed decade of President Xi's administration (2013-23), driven by growth in household income of 5-7% and commensurate growth in household consumption" is not his "most likely outcome".

As well, but he stated that he really does not "have a most likely outcome because (he) thinks the final result is likely to be highly path dependent". (Maybe he has been listening to Janet Yellen too much)

Notwithstanding the issues raised by Anne Stevenson, Pettis outlined a number of positive effects from a falling real estate prices, namely that the consumers who were priced out of the market will benefit, even though the effect will be longer term.

There are a lot of moving parts here. On one hand, Beijing appears to know what steps to take in order to rebalance growth. They appear to be taking the right steps in order to achieve their longer term objectives. On the other hand, near-term speed bumps, such as the buildup of credit, falling real estate prices, etc., serve to heighten the risk that the growth path slips over the precipice.

Under these circumstances, I believe that the most appropriate viewpoint comes from the most recent Howard Marks memo on risk:
The future should be viewed not as fixed outcome that's destined to happen and capable of being predicted, but as a range of possibilities and, hopefully on the basis of insight into their respective likelihoods, as a probability distribution.
The "long landing" scenario remains in play, but its probability has retreated a bit in view of the most recent developments.

Monday, September 8, 2014

Finally, academics discover technical analysis!

It is good to see academics catch up with how traders think. I recently came across this summary of a research paper called "A New Anomaly: The Cross-Sectional Profitability of Technical Analysis" by Han, Yan and Zhou in CFA Digest published in the Journal of Financial and Quantitative Analysis:
The authors use a common trend-following strategy to measure the predictive ability of technical analysis. They apply their method to portfolios arranged by idiosyncratic volatility and variables related to information uncertainty. They document high abnormal returns relative to standard pricing models that are unexplained by investor sentiment, market timing, or liquidity risk. Such findings, according to the authors, establish a new anomaly.
Han et al tested whether using moving averages to time trades added value:
The authors use a set of 10 volatility decile portfolios as the underlying assets for their technical analysis. For each of the portfolios, the authors focus on the cross-sectional profitability of the MA timing strategy relative to that of the buy-and-hold strategy of the volatility decile portfolios. In the main study, the lag length is 10 days. The authors also test the alternative strategy with lag lengths of 20, 50, 100, and 200 days for the MA portfolios (MAPs).
Moving average strategies added value on a risk-adjusted basis:
The authors find that the 10 MAP returns are positive and increase with the volatility deciles (excluding the highest decile); returns range from 8.42% a year to 18.70% a year. In addition, the capital asset pricing model (CAPM) risk-adjusted returns, or abnormal returns, increase with the volatility deciles (also excluding the highest decile), ranging from 9.31% a year to 21.76% a year. When the authors apply the Fama–French three-factor model, they find the familiar pattern of monotonically increasing returns across 9 of 10 volatility deciles.

How trend following models works
These results are not a surprise to me. I explained the economic basis for trend following models back in 2008 (see Sheeps can make money too!):
A few years ago, I managed equity market neutral portfolios at a firm that was mainly known for commodity trading using trend following techniques, which are well described by Michael Covel in his book. During my tenure there I noticed that while the commodity positions were spread out among various futures contracts they often amounted to a few macro bets (i.e. on interest rates, on the US$, etc.) I came to the conclusion that these models were identifying macroeconomic trends that are persistent and exhibit serial correlation, which creates investment opportunities for patient long-term investors. For example, if the Fed is raising rates the odds are they will continue to raise rates until they signal a neutral or easing bias, i.e. there is a trend to interest rates, which is information that investors can use. The key risk in this class of models is knowing when to exit the trend, as short and long term reversals can be devastating to the bottom line.

The whipsaw problem
What was a surprise, however, is that Han paper did not find that these models do not work well in trend-less markets as these kinds of models are suspectible to whipsaw. (That`s a feature, not a bug.)

For instance, the latest report card on my own Trend Model account (see Trend Model report card: August 2014) shows solid results. However, as the chart below of account and SPY returns shows, up-and-down stock markets in Q1 resulted in negative returns for the account - a classic whipsaw pattern.


As a reminder, the Trend Model account is based on the application of trend following principles to global equity and commodity prices. The chart below shows the actual real-time (not back-tested) buy and sell signals of the model. I further highlighted the instances when the model suffered from whipsaw. To address that problem, I supplement the trend following model signals with some short-term sentiment models in order to address the whipsaw problem of this class of modeling technique.

Trend Model signal history

Regardless, this research is a form of affirmation that moving average based technical analysis can produce superior risk-adjusted returns. Further, if academics were to further decompose capital market returns in an economic, instead of Fama-French, risk factor mapping, I bet that they will find that these kinds of models are picking up on the serial correlation in economic factor returns.

Sunday, September 7, 2014

Sell Rosh Hashanah?

Weekly Trend Model signal
Trend Model signal: Risk-on
Direction of last change: Positive

The real-time (not back-tested) buy and sell signals of the Trend Model are shown in the chart below:


A bullish uptrend
Despite the sideways pattern shown by the SPX last week, the index ended the week at another new high, affirming the uptrend identified on August 10 (see A tradable bottom?). In the past week, technical price momentum has been broadly improving. US equities have edged to a new high; European markets surged on news of the ECB stimulus that dare not speak its name; and commodities have been mixed, with positive performance from industrial metals offset by weakness in energy.

Another bullish sign come from the positive momentum shown by Street earnings expectations, which is a key fundamental driver of equity returns. I have long written about analysis from Ed Yardeni, who has shown a steady improvement in forward 12 month EPS estimates.

For a different perspective, this chart from Gavekal of the evolution of North American FY2014 EPS estimates shows that the US earnings outlook has been better than previous years. There is a seasonality effect to Street earnings estimates, as they usually start the year too high and then decline into year-end. I have drawn black horizontal lines showing where market expectations were at this time in the past three years. As the chart shows, current readings are at the top of the range relative to recent experience.


In other good news, the latest Beige Book survey shows that all regions are showing signs of expansion, indicating a steadily improving economy:
The U.S. economy strengthened in all regions of the country in July and August, in areas including consumer spending, auto sales and tourism, the Federal Reserve reported in a survey released yesterday.

All 12 of the Fed’s regions reported growth. Six — New York, Cleveland, Chicago, Minneapolis, Dallas and San Francisco — characterized growth as “moderate.” The other regions reported somewhat slower expansion. Four described growth as “modest,” and two noted signs of improvement.
What`s more, the economy seems to be in a “not too hot, not too cold“ expansion phase that would prompt the Fed to start worrying about inflationary pressures:
The survey found no clear evidence that the economy is expanding so fast that the Fed might soon begin raising interest rates to prevent inflation.
The disappointing August employment report prompted the WSJ's Jon "Fedwire" Hilsenrath to write that Jobs Report Leaves Fed in No Hurry To Alter Views on Slack or Rates (emphasis added):
When Fed officials said in their July policy statement that they saw “significant underutilization of labor resources” – a signal of continued low interest rates – they were looking at an unemployment rate in June of 6.1%. The rate rose a notch to 6.2% in July and returned in August to 6.1%, the Labor Department said Friday.

The fact that unemployment hasn’t fallen since the July meeting —and that job growth slowed in August— suggests Fed officials won’t make big changes to their policy statement and the signal they’re sending about rates when they meet Sept. 16 and 17.
In addition, risk appetite appears to be healthy after a brief scare in late July. As the chart below shows, junk bond spreads are falling again, which indicating a rising appetite for risk.

The combination of bullish trend in global equities, positive fundamental momentum from EPS estimates and a healthy risk appetite all suggest that equities are likely to continue to slowly grind upwards.


Faltering technical momentum
While the intermediate term picture remains positive, what bothers me is that the tailwind provided by the positive price momentum of the oversold rally from August 10 is starting to lose steam. In addition, the intermediate term trend indicator's market views parallels the "steady as she goes" bullish views of the 10 strategists interviewed by Barron`s. That makes me somewhat uneasy as that outlook is the consensus view.


None of the group, whom we survey each September and December, is bearish these days, although some strategists have toned down their optimism because of the market's gains. Still, the most bullish see the benchmark barreling toward 2500 in the next 18 to 24 months. That would be an increase of nearly 25% from last week's close.

Earnings drive stock performance, and the outlook is relatively rosy here, too. Our 10 savants expect SP 500 earnings to rise 7% in 2014, to a mean $117.83, after advancing 5.7% in 2013. They look for earnings growth to accelerate to 8.1% in 2015, for a total of $127.34. Industry analysts' forecasts, as usual, are even more upbeat than those of the big-picture crowd, at $119.31 for this year and $133.49 for next, according to Yardeni Research.
To explain my concerns about the possible loss of momentum, let's review some of the short-term technical and sentiment indicators in my August 10 post that identified the bottom (see A tradable bottom?).

For instance, I wrote about the combination of VIX term structure inversion and TRIN moving above 2 as a powerful tool for spotting previous bottoms (shown by the dotted vertical lines) in the chart below. As the rally from August 10 progressed, note how the VIX-VXV ratio (middle panel) is getting very close to the shaded target zone indicating excessive complacency. We are not quite there yet, but we are getting close.


As well, I wrote about my favorite overbought-oversold indicator (in green), which also flashed a buy signal August 10. Like the VIX-VXV ratio, that OBOS indicator is also nearing its target zone.


Option sentiment may also be getting a tad overly bullish. The 10 day moving average of the ISE Equity-only call-put ratio of opening transactions show that readings are getting elevated, which suggests that a crowded long condition.

I don't want to give the impression that all short-term models are indicating an overbought or crowded long condition. Rydex funds flows, which I referred to last week, are in neutral (see last week's post A sweet spot for equities). As well, the CNN Money Fear and Greed Index also moved from an extreme fear to an neutral reading. Both of these indicators suggest that the current rally may have more legs in the short run.



Nevertheless, I am starting to wonder when all this positive technical and fundamental momentum might start to falter. The chart below of the Citigroup US Economic Surprise Index shows that, notwithstanding the surprising miss by the August Employment figures (and August is notoriously flakey), economic releases have moved from an extreme of misses to an extreme of beats. Readings are nearing my "too much good news" zone - indicating that the momentum in positive economic news may near nearing a peak.


Right now, the Atlanta Fed's Q3 GDPNow estimate is 3.6%. .What if, as the Fat Pitch suggests, trend growth reverts to 2% real after a snap-back from a disappointing winter in Q1?
In May we started a recurring monthly review of all the main economic data (prior posts are here).

Our key message has so far been that (a) growth is positive but modest, in the range of ~4% (nominal), and; (b) current growth is lower than in prior periods of economic expansion and a return to 1980s or 1990s style growth does not appear likely. This is germane to equity markets in that macro growth drives corporate revenue and profit expansion and valuation levels.

This post updates the story with the latest data from the past month.

The overall message remains largely the same. Employment is growing at less than 2%, inflation and wages are growing around 2% and most measures of demand are growing at roughly 2% (real). None of these has seen a meaningful and sustained acceleration in the past 2 years. The economy is continuing to repair, slowly, after a major-financial crisis. This was the expected pattern.
A 2% growth rate would be an enormous miss:
With valuations at high levels, the current pace of sales growth is likely to be the limiting factor for equity appreciation. This is important, as the consensus expects earnings to grow at 8% in 2014 and 12% in 2015.


Sell Rosh Hashanah, buy Yom Kippur?
All of these concerns are not fatal to the current bullish undertone of the US equity market - yet. Given the positive momentum shown by the US, international equities and industrial metals commodity markets, I expect that the SPX can continue to grind upwards for a few more weeks.

However, the positive momentum tailwind from the oversold condition in August are likely to start to peter out in the near future. In that case, the strategy of adopting the Wall Street adage of sell Rosh Hashanah, buy Yom Kippur may not be a bad idea. Bespoke showed the profitability of such a strategy in 2011 below. Though the sample size is relatively small, the strategy did show a negative bias in equity returns during such a period.


Even though I am not a big fan of seasonal trading strategies, my wild-eyed guess is that at least the "sell Rosh Hashanah" part (on Sep 24) of the strategy may be a decent bet this year. For the moment, I remain cautiously long the market.


Disclosure: Long SPXL, TQQQ

Friday, September 5, 2014

The Pettis China "long landing" hits an air pocket

Noted China watcher Michael Pettis recently wrote a new blog post entitled "What does a good Chinese adjustment look like?". In it, he details his growth scenarios for China:
The choice...is not between a hard landing and a soft landing. China will either choose a "long landing", in which growth rates drop sharply but in a controlled way such that unemployment remains reasonable even as GDP growth drops to 3% or less, or it will choose what analysts will at first hail as a soft landing - a few years of continued growth of 6%-7% - followed by a collapse in growth and soaring unemployment.

A "soft landing" would, in this case, simply be a prelude to a very serious and destabilizing contraction in growth. Rather than hail the soft landing as a signal that Beijing is succeeding in managing the economic adjustment, it should be seen as an indication that Beijing has not been able to implement the reforms that it knows it must implement. A "soft landing" should increase our fear of a subsequent "hard landing". It is not an alternative.
Pettis believes that the "soft landing" is the "this will not end well" scenario for China. The so-called "long landing" is the optimistic scenario in China's four stages of growth:
The first stage of China’s growth story, which occurred mainly during the 1980s, consisted of liberalizing reforms that undermined the Communist elite and which were strongly opposed by them. Because power was highly centralized under Deng Xiaoping, however, including a loyal PLA, he and the reform faction were nonetheless able to force through the reforms.

The next two stages of growth, I argued, required policies that had a very different relationship to the interests of the Chinese elite. Because they involved the accumulation and distribution of resources to favored groups whose role was to achieve specific economic targets, they helped to reinforce the wealth and power of a new elite, many of whose members were, or were related to, the old elite. Not surprisingly this new elite strongly supported the growth model imposed by Beijing during these stages.

The fourth stage, I argued, is the stage upon which we are currently trying to embark. In an important sense it involves liberalizing reforms similar politically to those that Deng imposed during the 1980s, making it vitally important to their success that the current administration is able to centralize power and create support to overcome the inevitable opposition, which it seems to be doing.
Pettis remains optimistic that Beijing can pull it off:
This is why, even though Beijing doesn’t seem to have yet gotten its arms around the problem of excess credit creation, I nonetheless think it is moving in the right direction. For now I would give two chances out of three that Beijing will manage an orderly “long landing”, in which growth rates continue to drop sharply but without major social disruption or a collapse in the economy. In this issue of the newsletter I want to write out a little more explicitly what such an orderly adjustment might look like.
The one key ingredient of the "long landing" scenario is achieving the Third Plenum objective of rebalancing from credit-driven infrastructure driven growth to the consumer driven growth. This involves the ending, or at least, the reduction of financial repression, which lowered the cost of capital for SOEs at the expense of the household sector as regulated banking interest rates were driven to below zero in real terms by the central government.
Under these conditions it should be no surprise that borrowers with access to bank credit overuse capital, and use it very inefficiently. They would be irrational if they didn’t, especially if their objective was not profit but rather to maximize employment, revenues, market share, or opportunities for rent capture (as economists politely call it).

The second point to remember is that in a severely financially repressed system the benefits of growth are distributed in ways that are not only unfair but must create imbalances. Because low-risk investments return roughly 20% on average in a country with 20% nominal GDP growth, financial repression means that the benefits of growth are unfairly distributed between savers (who get just the deposit rate, say 3%), banks, who get the spread between the lending and the deposit rate (say 3.5%) and the borrower, who gets everything else (13.5% in this case, assuming he takes little risk – even more if he takes risk).

This “unfair” distribution of returns is the main reason why the household share of income has collapsed from the 1990s until recently. I calculate that for most of this century as much as 5-8% of GDP was transferred from households to borrowers. The IMF calculated a transfer amount equal to 4% of GDP, but said it might be double that number, so we are in the same ballpark. This is a very large number, and explains most of why the growth in household income so sharply lagged the growth in GDP.
As financial repression gets reduced, China enters a virtuous growth cycle:
Over time this means that households will retain a growing share of China’s total production of goods and services (at the expense of the elite, of course, who benefitted from subsidized borrowing costs) and so not only will they not be hurt by a sharp fall in GDP growth, but their consumption will increasingly drive growth and innovation in China.
Pettis ended his post with a hopeful prescription and outcome for the Chinese growth path and social stability (emphasis added):
If China can reform land ownership, reform the hukou system, enforce a fairer and more predictable legal system on businesses, reduce rent-capturing by oligopolistic elites, reform the financial system (both liberalizing interest rates and improving the allocation of capital), and even privatize assets, 3-4% GDP growth can be accompanied by growth in household income of 5-7%. Remember that by definition rebalancing means that household income must grow faster than GDP (as happened in Japan during the 1990-2010 period).

This has important implications. First, the idea that slower GDP growth will cause social disturbance or even chaos because of angry, unemployed mobs is not true. If Chinese households can continue to see their income growth maintained at 5% or higher, they will be pretty indifferent to the seeming collapse in GDP growth (as indeed Japanese households were during the 1990-2010 period). Second, because consumption creates a more labor-intensive demand than investment, much lower GDP growth does not necessarily equate to much higher unemployment.
In other words, the economy does not necessarily have to grow at a breakneck pace in order to maintain social cohesion for Chinese society. As long as the average household sees a decent increase in its standard of living, Beijing can keep a lid on social tension and maintain the Mandate of Heaven.


Watch out for the reverse wealth effect
I had long been a disciple of Michael Pettis and I was optimistic that "long landing" scenario could be achieved. That was until I saw David Keohane of FT Alphaville highlight a note from JCapital indicating how consumer spending was intricately tied into the health of the property market:
Consumer spending is second only to unemployment as the most atrociously tracked statistic in the economy, and the NBS numbers offer little insight. We have, however, been choosing two smaller cities per month as focuses of research, conducting interviews with vendors across commercial categories and triangulating the interview data with what we can see from the statistics. In each case, cities that have seen a decline in property sales almost immediately see a decline in spending in the industries we survey, with the sharpest downturns generally in property-related categories such as furniture and building materials. Next-weakest are usually consumer electronics and white goods, then food, while there is often growth left in clothing and personal care. The near identity between property and the consumer economy indicates that a slump in property must lead to a spike in investment in order to buoy the preferred areas.

The consumer segment, to the extent that it can be independently tracked, provides a clear trace for how capital moves through the economy at large and spills out in the form of commissions and kickbacks on contracts, higher compensation locally, and better liquidity for the housing market, leading individuals to spend.
Here is the problem:
Now, the decline in spending we are seeing in each of the cities we survey is going hand in hand with the reduction in investment in new property. Absent a miraculous new source of fast wealth, there is no reason why consumption should not return to the pre-boom level, where it was in about 2006. The land-driven bonanza is over.
Keohane added:
That’s the tricky thing. Consumption is really rather tightly and obviously linked to property investment (and inequality) so forcing a new middle class into existence isn’t going to be easy if/when this round of investment-led money dies off and the property market corrects.
What we have seen is a wealth effect in action as property prices in China have boomed. Analysis from George Magnus shows that while investments in a number of Tier 1 cities look fine, Tier 2 and 3 cities are showing signs of oversupply.

China: Investment and growth by city

Already, the cracks are showing. The latest figures from JP Morgan show that house price declines are spreading to 91% of the cities. In particular, prices in Tier 3 cities are cratering.

What we are seeing, in effect, is the reversal of the wealth effect in China. Because regulated bank interest rates were negative in real terms, savings went either into wealth management products or real estate - and there was leverage in much of those real estate holdings.

When consumer spending is "tightly and obviously linked to property investment", how does rebalancing occur? How can China, as David Keohane puts it, "force a new middle class into existence"?

These conditions call for a serious re-evaluation of China`s growth path. The Pettis "long landing" scenario just hit a major air pocket and its likelihood is quickly diminishing.






Thursday, September 4, 2014

Why a Scottish-UK currency union is an idiotic idea

Speaking as a Canadian who has seen several Quebec referendums on sovereignty, let me put in my two cents worth on the prospect of a Scottish currency union with the rest of the UK. Business Insider recently published an alarmist article about the implications of a Yes vote for Scottish independence:
Three separate reports published by economic experts warn a separate Scotland would require deep public spending cuts and lead to higher interest charges for mortgage holders.

Scottish independence would herald a new wave of painful public spending cuts, an increase in mortgage costs and a eurozone-style currency crisis, economic experts have warned amid claims “the penny is finally dropping” about the dangers.

City analysts from Goldman Sachs and Berenberg, a German-based multinational bank, published reports concluding a Yes vote would force Scotland into deeper austerity, requiring a “significant reduction in the provision of public services” to gets its finances in order.

In a separate analysis, Iain McLean, professor of politics at Oxford University, predicted every Scot would be £480 worse off under independence now thanks to sharply declining oil revenues.

All three agreed that a separate Scotland would pay a higher interest rate on its borrowing, an additional cost that would be passed onto borrowers and mortgage holders.

David Cameron on Wednesday warned this hike would be even higher if Alex Salmond made good his “chilling” threat to refuse to accept a share of the U.K.’s national debt, adding the consequences would be “crippling” for the Scottish people.

Goldman Sachs also predicted a eurozone-style financial crisis could hit both Scotland and the remainder of the U.K., with uncertainty over a currency union causing a run on assets and deposits based north of the Border.

Alex Salmond has said the three main U.K. parties are bluffing by ruling out a formal deal to share the pound, but the global investment bank concluded the warning was “credible.”

Scotland can use the Pound
First of all, if an independent Scotland chooses to use the Pound, no one can stop them, as the Yes side points out (emphasis added):
The Scottish Government proposes that an independent Scotland will continue to use the pound and enter into a formal currency agreement with the government of the United Kingdom – as explained in this article.

In adopting this policy, the Scottish Government has accepted the recommendation of a group of independent and internationally renowned economists -the Fiscal Commission - that a formal currency union is the best way ahead. A formal currency union would provide the right balance of autonomy for government and stability for business, as well as straightforward access to markets in the remainder of the UK.

It is important to remember, however, that Scotland cannot be stopped from continuing to use the pound, which is a fully tradeable currency. As No leader Alistair Darling was forced to admit recently, "of course Scotland can use the pound".

Considerable costs to using GBP
However, there are costs. The first is the issue of whether Scotland adopts a de facto currency peg or enters into a currency union with the rest of the UK. If so, what does the currency union look like?

For instance, Hong Kong has pegged the HKD to the USD for decades. The USD is also freely used as a second currency in many countries around the world. However, the HKMA does not have a seat at FOMC meetings and the Fed does not take into consideration the effects of its monetary policy decisions on HK or other countries that use the USD. Hong Kong tycoons are acutely aware of US monetary policy. At times, Hong Kong may either be importing either inflation or deflation from the US depending on the differential in growth rates.

Would the BoE go so far as to allow Scotland representation at MPC? If not, Scotland could see a wildly inappropriate monetary policy for its economy. If the UK economy heats up, but Scotland is weak, the act of BoE tightening would send the Scottish economy into a deeper recession than if it had its own currency. No doubt Scots saw first hand in the last few years the effects of a currency union in the eurozone without a political union.

Is this what "independence" would look like? To see the Scottish economy be at the whims of BoE decisions?

On the other hand, would the BoE actually allow representation from a foreign government or entity at to have sway on its monetary policy decisions? Even so, how much influence does Greece or Portugal have on ECB deliberations?

Mark Carney, the Canadian head of the BoE who undoubtedly understand these issues, noted that while there could be negotiations, a currency union requires "some ceding of national sovereignty" (vias the Guardian):
Any negotiations on a currency union would involve major concessions by both sides. The UK would have to abandon the clear commitments of Osborne, Alexander and Balls. But Salmond would have to acknowledge for the first time that joining a currency union would involve the loss of some sovereignty after Mark Carney, the governor of the Bank of England, said in Edinburgh in January: "A durable, successful currency union requires some ceding of national sovereignty."
During the debate leading up to Quebec referendums, the Oui side has always held out the siren song of an independent Quebec using the Canadian Dollar as a currency. Nothing will change, they assured the Quebecois. However, serious sovereigntists who have studied the issue have concluded that Quebec needed its own currency in order to be truly independent.

If the referendum were to pass, adopting the another currency for use in a newly independent country is an idiot idea, for both Quebec and Scotland. An currency and economic union without a political union is a potential disaster in the making. But then, the last time Europe saw both an economic and political union was in 1941 under Hitler - and look how well that turned out.

Wednesday, September 3, 2014

The One Big Bet made by most buy-and-hold portfolios

Recently, there has been a lot written about active vs. passive investing and, as part of that debate, asset allocation. As an example, Barry Ritholz wrote about the effects of market timing and concluded that the "time" in market is more important than timing the market:
What of an ordinary investor who is a dollar-cost averager into broad indexes? He has a huge advantage over the world’s best market timer, in that he really exists. What he does is possible. The perfect market timer does not and cannot exist. There is no crystal ball or a magic formula that allows for perfect market timing. Instead, our dollar-cost averager simply makes regular contributions to his portfolio. It is a simple, powerful strategy that requires no special prescience into the future, and is a formula that actually exists.

What about risk?
There is a key underlying assumption behind the strategy of determining an asset mix and then buying and holding (with or without re-balancing) as an investment policy.

The assumption is that risk is mainly defined by portfolio volatility, which is the basic tenet of MPT. There is also an excellent discussion of the shortfalls of volatility as a measure of risk by Micah Spruill here, which is well worth reading.

There are other elements of risk for investors with long time horizons. When I write about the risk in an investment policy, I refer to:
  • Volatility, which is the metric most investment professionals focus on; and
  • The risk of the permanent loss of capital, which is split into the following two categories:
    1. The risk of loss from confiscation and conflict; and
    2. Legal framework uncertainty risk, otherwise known as, "How do you know you have a legal claim to what you own, or think you own?"

Confiscation and conflict risk
When investment professionals study past returns to determine future risk and return expectations, they often focus on US assets. As per the Credit Suisse Global Investment Yearbook 2014, here is a typical chart of US asset return considered by planners:


A survivorship bias problem
There are a number of serious problems with this analysis. First, it ignores the risk of confiscation and conflict. The above chart suffers from a severe case of survivorship bias. CS shows this chart of capitalization weights of global equity markets in 1899:


Here is the same pie chart in in 2013. The US went from a 15% market cap weight in 1899 to an astounding 48% in 2013. The UK market, which represented one of the dominant political powers of the early 20th Century, shrank from a 25% weight to 8% in 2013, France, another Great Power, went from 11% to 4%. Notwithstanding the fact that most investors invested in the bond market at the turn of the 20th Century instead of stocks, trying to project returns based on the US experience is like projecting returns based on AAPL`s returns since its 1980 IPO.




In 1899, which was 15 years before the start of World War I, the Major Powers were:
  • Britain
  • Germany
  • France
  • Austro-Hungary
  • Russia
The US was still a promising emerging market country, as was Argentina (how did those Argentine railway bonds work out?).

As per the Credit Suisse review, here are some of the returns of the markets of some major markets in the past 115 years. Here is the old Austro-Hungarian Empire, which has since broken up into modern-day Austria, Bosnia-Herzegovina, Croatia, Czech Republic, Hungary, Slovakia, Slovenia; large parts of Romania and Serbia; and small parts of Italy, Montenegro, Poland and Ukraine. (Bear in mind that, as the per above US asset real return chart, $1 invested in US equities in 1899 = $1,248 in inflation-adjusted dollars today).


What about Germany? That country underwent a couple of severe dislocations in the form of two World Wars in the past 115 years, the worst of which involved losses of over 90% if you invested in German equities.


The same pattern of 90% losses held true for Japan:


Of course, there is China, which has been a recent favorite among emerging market investors. The Shanghai market suffered a severe *ahem* dislocation in the wake of Mao Zedong's takeover Liberation of China and didn't turn around until the Deng Xiaopeng era.


The same kind of *ahem* dislocation occurred in Russia. In the cases of Russia and China, the personal experience of a resident of those countries as a capitalist investor likely paralleled that of most European Jews in World War II.



Legal framework risk
In addition, to the risk of permanent or severe loss of capital from confiscation and conflict, investors with long time horizons face the risk of legal framework uncertainty. Gold bugs will point to FDR`s Executive Order 6102, which effectively banned the private ownership of gold by individuals and companies in 1933.

A more modern example can been seen today in possible sanctions that have been proposed against Russia. FT Alphaville recently highlighted a Bloomberg article indicating proposals to cut Russia off from the western banking system, as the West did with Iran:
The U.K. will press European Union leaders to consider blocking Russian access to the SWIFT banking transaction system under an expansion of sanctions over the conflict in Ukraine, a British government official said.

The Society for Worldwide Interbank Financial Telecommunication, known as SWIFT, is one of Russia’s main connections to the international financial system. Prime Minister David Cameron’s government plans to put the topic on the agenda for a meeting of EU leaders in Brussels tomorrow, according to the official, who asked not to be named because the discussions are private.
Such a move could be devastating to the Russian economy:
The FT also reports that Swift is on the table, although it would be an “extreme measure”.

After all, if Europe did decide to press Belgium-based Swift, and thus financial globalisation itself, into service — it places Russia into a tricky spot this time round.

Swift doesn’t clear cross-border banking transactions itself. But it does open doors for relatively isolated banking markets (like Russia’s is, still) to connect to clearing systems such as Target2 or, in the US, Fedwire. The Kremlin has seen the risk coming and moved to create a local replacement. But as Reuters notes, less than 10 per cent of transactions involving Russian banks stay within Russia.

The model is Iran. EU sanctions in 2012 effectively obliged Swift to comply with disconnecting Iranian banks from its processes. The use of Swift allowed what’s become quite a familiar dynamic in US and European financial sanctions.
In other words, you may own those assets, but can you access them? If you are restricted from accessing them, what is their value (emphasis added)?
Some foreign investors might always stick with Russia as the assets are so cheap. Gazprom and Rosneft, two enormous companies with a combined enterprise value above $270bn (the Moscow bourse’s market cap is $560bn), are respectively trading 3 and 4 times forward earnings.

Sberbank, market cap $42bn, trades below book value despite a return on equity western banks would kill for, and having survived the financial crisis with barely a dent. Is it cheap even with Swift risk? Would any of these companies appeal to a minority shareholder, if the Russian state interest in them may mean they can also be tools of this ‘hybrid’ warfare?

Interesting questions, but the cheapness is almost irrelevant if the plumbing breaks. And then, there is what happens if Russian money flows home. That end-point presumably has to be factored into the sanctions strategy, and how the EU’s policymakers believe it would pressure Putin. Would it? Putin’s power rests partly on distributing resources at home to a selected elite group. Would returning capital change, weaken or strengthen this? What about the localised bank transfer systems which Russia would try to create — would it consolidate the Kremlin’s control?

A bet on World Peace
I began this post discussing the active vs. passive question, along with the asset allocation issue. Most investment professionals erroneously start with an asset allocation that is has a significant home bias (and therefore represents an active bet away from the global portfolio pictured below).


For most Americans, their portfolio allocations would be highly US-centric. For other developed market investors, their allocations will typically have a home-country bias. Such so-called "passive" allocations represent a big bet on continued world peace. For the foreseeable future, that appears to be a reasonable bet. JP Morgan Asset Management shows the effect of war in the world today (via FT Alphaville):
  • 11.7 per cent population
  • 9 per cent oil production
  • 3.8 per cent foreign direct investment
  • 3 per cent GDP
  • 2.6 per cent trade
  • 2.4 per cent gross capital formation
  • 0.8 per cent corporate profits
  • 0.7 per cent equity market capitalisation
  • 0.5 per cent interbank claims
  • 0.4 per cent portfolio investment inflows
Even though it involves 11.7% of global population, which is devastating to those involved, it only involves 3% of global GDP and 0.7% of equity market capitalization - which are not large figures that would overly disturb financial markets.


Doubling down on Pax Americana
In summary, most investment policies today are Big Bets on world peace. For Americans, they represent an even bigger bet - the continuation of Pax Americana. To illustrate my point, here is the CS chart of real returns on UK assets from 1899. Britain was a dominant global power at the dawn of the 20th Century. The sun never set on the British Empire as it had possessions around the world. The real return of $372 based on $1 in British equities in 1899 looks reasonably good, but it`s dwarfed by the 1,248 figure shown by US equities in the same period.



France, which was overrun by Germany in 1940, had an equity market that did much worse, though it did not suffer the 90% losses that the German and Japanese stock markets did.


If you wanted to project equity risk and return expectations, what figure would you use? The US 1,248 real return, the British 372 or the French 36 real return figure?

The history of the 20th Century has shown that previously dominant empires can fall. We don`t know what the future holds. Do investors with very long time horizons want to make an bet on the continuation of Pax Americana?

Tuesday, September 2, 2014

Trend Model report card: August 2014

Further to my description of the long-short account run based on my Trend Model signals (see An intriguing Trend Model interim report card), here is the report card for that account for the month of August 2014.

I reiterate my disclaimer that I have nothing to sell anyone. I am not currently in a position to manage anyone`s money based on the investment strategy that I am about to describe, nor am I contemplating offering an advisory service based on Trend Model signals. (If nominated, I will not run. If elected, I will not serve.)

For readers who are unfamiliar with my Trend Model, it is a market timing, or asset allocation, model which uses trend following techniques as applied to commodity and global stock market prices to generates a composite Risk-On/Risk-Off signal (risk-on, risk-off or neutral). I have begun updating readers on the Trend Model signals on a weekly basis (for the last comment, see A sweet spot for equities).


Trend Model description
The chart below shows the real-time (not back-tested) changes in the direction of the signal, which are indicated by the arrows, overlaid on top of a chart of the SP 500. You can think of the blue up arrows, which occurred when the trend signal changed from negative to positive, as buy signals and the red down arrows, which occurred when the trend signal changed from positive to negative, as sell signals. Note that this is a real-time (not back-tested) signal record.

Trend Model Signal History


A proof of concept
While the results from the above chart, which represents paper trading, is always interesting, there is no substitute for actual performance. As a proof of concept, I started to manage a small (about 100K) account that traded long, inverse and leveraged ETFs on the major US market averages and, on occasion, sector and industry ETFs. Trading decisions were based on Trend Model signals combined with some short-term sentiment indicators. The inception date of the account was September 30, 2013 and the chart below represents an interim report card of that account.


When evaluating the performance of this trading account, keep in mind that this is intended to be an absolute return vehicle. While I do show the SPY total return, which includes re-invested dividends, for illustrative purposes, the SP 500 is not an appropriate benchmark for measuring the performance of this modeling technique.


A solid mark in the August mid-term: +3.9%
We saw solid results in August as the account showed a total return of 3.9%, which matched the SPY total return of 3.9%.  The account was up 17.2% YTD and 31.2% from inception, which amounts to a track record of only 11 months. However, I would also like to point out that turnover averaged about 180% per month, so this strategy is not for everyone, especially the faint of heart.

I had been concerned about how the Trend Model would behave at turning points, such as a market correction. While I cannot say that it passed the correction test, it seemed to scored a solid mark in its August mid-term. Market participants saw a minor equity market pullback in August, with the SPX down about 4%, though small cap stocks were down considerably more.

The Trend Model was fortunate in spotting the inflection point in the stock market in August. The sentiment models were able to pick up critical turning points in the pullback by calling the top in late July (see Global growth scare = Trend Model downgrade) and the bottom on August 10 (see A tradable bottom).


Results continue to be promising
As with last month, these results continue to be promising:
  • Returns are strong and the Trend Model is performing as expected.
  • Returns are uncorrelated with equities (correlation of -0.12 with SPY), bonds (-0.20 with AGG).
While these results are promising, I consider the Trend Model to be untested by stressful markets. The stock market has more only less steadily risen in the test period that began in September 2013 and, though the Trend Model returns during the minor August pullback was encouraging, we have yet to see how this model behaves when the stock market undergoes the stress of either a major correction or bear market.

Readers who want to monitor the signals of the Trend Model to subscribe to my blog posts here, which include Trend Model updates, or follow me via Twitter @humblestudent.

Monday, September 1, 2014

A sweet spot for equities

Weekly Trend Model signal
Trend Model signal: Risk-on
Direction of last change: Positive

The real-time (not back-tested) signals of the Trend Model is shown in the chart below:

Expecting the market to grind higher
The US equity market remains in bull mode on an intermediate term basis. The Trend Model looks at markets globally and conditions have marginally improved from last week, which was at an already "risk-on" signal. The SP 500 remains in an uptrend, with the index staging an upside breakout to new all-time highs.


Despite the disappointing growth outlook and heightened geopolitical risk from Russia-Ukraine, European markets weathered the bad news last week relatively well and remains in a weak uptrend.


Commodity markets were mixed. The broadly-based CRB Index (in black) remains in a downtrend, though it appears to be trying to stage a rally. Industrial commodities, which are even more cyclically sensitive than the CRB, are showing more strength and appears to be undergoing a high-level consolidation.


More encouraging is the bullish engulfing pattern shown by the monthly SPX candlestick chart. This pattern has historically led to further advances in the past.





Sam Eisenstadt`s bullish call
The bull case was bolstered by Mark Hulbert`s column outlining how Sam Eisenstadt remains bullish with an SPX target of 2150 by year-end:
This incredible bull market, which pushed the SP 500 above 2,000 earlier this week, is still alive and well. By the end of the year, the benchmark index may rise to around 2,150, about 8% higher.

So says Sam Eisenstadt, who has more successfully called the stock market in recent years than almost every other market timer I can think of — including many who I have featured in this column.

Eisenstadt, for those of you who don’t know of him, is the former research director at Value Line Inc. Though he retired in 2009, after 63 years at that firm, he continues in retirement to update and refine a complex econometric model that generates six-month forecasts for the SP 500 — and he shares them with inquiring columnists.
Hulbert wrote that one reason Eisenstadt's model is bullish is because of low interest rates:
Though it is proprietary, he does say that one of the most bullish inputs to his model right now is low interest rates. Since the Federal Reserve has signaled that it could begin raising short-term interest rates in 2015, Eisenstadt’s model could as early as next year start forecasting a less rosy six-month outlook.
However. rate pressure might be less than Hulbert postulates. The latest Dallas Fed releases of the Core PCE and Trimmed Mean PCE inflation rates show that these (Fed's favorite) measures of inflation, are moderating. The one-month Core and Trimmed Mean PCE Inflation Rates had been elevated but they have fallen back in June and July. The more annual figures have either remained steady or stayed level for the past four months:


Low inflation readings from the Fed's favorite inflation gauge has the potential to keep the Fed on hold longer, which is bullish for equities on an intermediate term basis.


Growth outlook positive
In addition, the growth outlook remains positive. The latest Q2 GDP report shows a picture of slow and even growth. More importantly for equities, Factset reports that forward EPS estimates continue to climb at a steady rate.


The combination of uptrends in global equities and industrial commodities; a benign interest rate environment and rising EPS growth expectations represent a sweet spot for equities.


Sentiment models are mixed
Last week, I called for either a minor pullback or choppy consolidation as the SPX approached the round-number 2000 level (see The easy money has been made). Instead, the SPX staged an upside breakout through 2000 and consolidated in a tight range during the week. As a result, the overbought conditions that I observed last week remain in place.

The near-term overbought condition doesn't necessarily mean a pullback is a foregone conclusion as short-term sentiment model readings are mixed. The latest AAII survey (via Bespoke) show the percentage of bulls to be above 50 and bears at historical lows - which appear to be a worrisome development. However, these readings are highly volatile and unreliable. As an example, I inserted vertical lines into the Bespoke charts indicating similar extremes in sentiment. While some of these signals were accurate warnings of near-term tops, in other cases the market shrugged off these excesses in the past to advance higher.




We saw a contradictory reading in option sentiment last Thursday, when the put-call ratio spike to an extreme. Such spikes have signaled market rallies in the past. However, previous spikes in the put-call ratio have occurred when the market had been falling, not rising as it had been last week. I therefore interpret last week's put-call ratio as an anomalous reading that could be ignored, despite its bullish implications. One possible explanation for the put-call ratio spike was that traders were seeking protection from negative Russia-Ukraine developments over the long Labor Day weekend - which is a one-time event.


When I see contradictory readings from sentiment models, it's useful to survey what other sentiment readings are showing. Rydex fund flows show a picture of a market that has recovered from a panic with sentiment readings normalizing, but have not moved to the other extreme of a crowded long.


The equity-only put-call ratio (not shown) shows a similar picture of recovery from panic and normalization. I interpret these conditions as a market that could see a minor (1-2%) pullback but the risk of a major correction as being low. The path of least resistance for stocks is still up.


Bottom line: Both my inner investor and inner trader remain bullishly positioned. We are in the middle of a sweet spot for US equity prices. Sit back, relax and enjoy.

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