Sunday, July 5, 2015

Getting set for the market of 2011

Trend Model signal summary
Trend Model signal: Risk-off
Trading model: Bearish

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. In essence, it seeks to answer the question, "Is the trend in the global economy expansion (bullish) or contraction (bearish)?"

My inner trader uses the trading model component of the Trend Model seeks to answer the question, "Is the trend getting better (bullish) or worse (bearish)?" The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. In addition, I have a trading account which uses the signals of the Trend Model. The last report card of that account can be found here.

Update schedule: I generally update Trend Model readings on my blog on weekends and tweet any changes during the week at @humblestudent.

Choppy markets ahead
These markets are confusing. The binary risk posed by the Greek drama has induced a level of volatility that the markets haven't seen for a few years. I had been highly conflicted about stock market direction, until I began to categorize the bullish and bearish indicators by time horizon. The contradictory signals all made sense when I realized that the disagreement over direction was based on time horizon. These conditions are highly suggestive of a choppy July.

Here are my model readings, from the ones with the shortest time horizon, which is 1-3 days, to the longest, which is about 12-24 months.
Short term trading models: Bullish
Breadth: Bearish
Global markets, or inter-market analysis: Bearish
Macro and market fundamentals: Bullish

Tail-risk: Greece and China
There you have it. While short-term trading models correctly predicted the bounce that began last week, the technical picture and market internals remain weak, which suggests that stock markets may have unfinished business to the downside. However, the long term fundamental and macro picture looks positive, which indicates that investors should view any weakness to be buying. These readings are a recipe for the next few weeks to be volatile and treacherous.

So pick your time horizon and pick your poison. Let`s begin...

A short-term bounce
I wrote last week that the market was set up for a short-term bounce and I was looking for some follow-through to see how durable the rally was (see Time for a market bounce?). Indicators like the CNN Money Fear and Greed Index had deteriorated to levels where stock prices had seen a short-term rally in the past.

Similarly, the CBOE equity-only put/call ratio rose to levels that have signaled short-term market bottoms in the past:

In my blog post, I had also highlighted my Trifecta bottom model, which has had an excellent history of spotting buyable oversold bottoms in the last few years. In this case, only two of the three components had flashed a buy signal, which are marked by the blue vertical lines in the chart below. The red lines indicate where all three components had flashed buy signals.
I would add the caveat that this model did not perform perfectly in 2010 and 2011 where oversold markets got even more oversold. So the big question then becomes, "Is this the start of a major decline?"

In general, sustainable V-shaped bottoms are accompanied by bullish enthusiasm and follow-through. I wrote about watching for O'Neill follow-through days - and the window for this market action does not begin until Tuesday.

Dana Lyons also researched the topic of bullish follow-through after a V-shaped bottom. He studied the degree of retracement after a VIX spike and found that episodes more powerful retracements saw much higher market returns while weak retracements saw negative returns.

Unfortunately, I find the current anemic nature of the market action after the market bottom to be disturbing. SPY close was below its open on Tuesday, Wednesday and Thursday, which are hardly signs of positive bullish momentum. In fact, this was the only time in its trading history going back to 1993 that SPY had seen 10 consecutive times when the close was below the open. 

Moreover, the relative performance of high-beta groups during the three day rally has been disappointing. The chart below shows the SPX in the top panel and the relative performance of different high-beta groups in the others. High beta stocks had been either flat or in relative downtrends leading up to the recent market swoon, which arguably could be expected. However, their performance in the brief rally afterwards can be best described as "Meh!"

This kind of market action can hardly be described as wildly bullish.

Bad breadth
As we move from the ultra-short term trading models to models with somewhat longer time horizons, the outlook remains problematical. The chart below of the SPX, along with a variety of breadth indicators are not showing any bullish divergence. In addition, the SPX is showing the characteristic signs of a rounded top, which suggests that stock prices are likely to resolve themselves to the downside.

Bearish verdict from inter-market analysis
The Trend Model depends mainly on cross-asset and global market inter-market analysis to calculate its signals. While this is a trend following model and trend following models are terrible at market turning points, I am not seeing any signs of a bullish upturn in any of the components of my model.

Let's begin with risk appetite. One of the best recent indicators of market direction that I`ve seen for a 1-3 week time horizon has been the relative performance of junk bonds. The chart below shows the performance of HY bond prices relative to their equivalent-duration Treasuries (blue line). As the chart shows, credit market risk appetite is diminishing as it is showing a negative pattern of lower highs and lower lows, which is negative for the outlook for risky assets like US equities.

The global equity picture doesn't look very bright either. Starting with Europe, the UK FTSE 100, which in theory is more insulated from Greece than eurozone equities, has violated both its 50 and 200 day moving averages and the bears have taken control as the index is in a downtrend with lower highs and lower lows. The Euro STOXX 50, which represents large eurozone stocks, remains below its 50 dma but appears to be trying to stabilize at a support level. Its future is highly dependent on how the Greek drama unfolds in the days ahead. Score European equities as bearish.

Then we have Asia. Notwithstanding the casino called the Chinese stock market (more on that later), the stock indices of every regional exchange of China`s major Asian trading partners are below their 50 dma. These are not bullish endorsements of global growth.

Cyclically sensitive commodity prices are also telling a similar story. The cyclically sensitive industrial metals complex remains weak, regardless of what currency the commodities are priced in. This is especially disturbing as the USD Index has been relatively flat in the last two months. However, the CRB Index, which is heavily weighted to energy, has been flat as oil prices have stabilized in the same period. Score commodities as mildly weak.

Shanghai turns into a "margin clerk" market
I don`t want to get overly Zero Hedge apocalyptic about the implications of a possible crash in the Chinese stock market as the Shanghai market has been falling relentlessly and down -28.6% from its peak in June. However, global markets may not be prepared for a catastrophic crash in Shanghai and some contagion effects may be possible.

The Chinese stock market had been driven up by increasing amounts of margins loans and financial leverage and now we are seeing the downside of what margin debt can do. The effects of margin debt in China has been well documented, here is the WSJ:

These charts from Goldman Sachs tell a similar story:

But wait! That's just official account margin. Then you have to account for margin loans from the informal and shadow banking sector (via Callum Thomas):

One sign of desperation was when Beijing started hunting for manipulators who were driving down stock prices. Where were they when there were widespread reports of insider selling as stock prices got pumped up? Despite these initiatives, plus the PBoC measure to ease interest rates last week, the Chinese stock market continues to nosedive and has turned into a "margin clerk" market.

A couple of other measures have been announced to support the cratering stock market, First, Bloomberg reports that Bejing is allowing margin loans collateralized by real estate as a sign of desperation:
In China, you can now literally bet the house on the nation’s tumultuous stock market.

Under new rules announced Wednesday by the country’s securities regulator, real estate has become an acceptable form of collateral for Chinese margin traders, who borrow money from securities firms to amplify their wagers on equities. That means if share prices fall enough, individual investors who pledge their homes could be at risk of losing them to a broker.
We also saw the surprise announcement that  21 brokerage houses banded together to put 120 billion RMB (USD 19 billion) into the stock market (via Bloomberg):
The 21 brokers led by Citic Securities Co. will invest the equivalent of 15 percent of their net assets as of the end of June, or no less than 120 billion yuan ($19.3 billion) in total, the Securities Association of China said in a statement on its website Saturday. The fund will invest in blue-chip exchange-traded funds, it said.

The move comes after measures to shore up equities failed to stop margin traders from unwinding positions at a record pace, with the market losing more than $2.8 trillion of value in three weeks. The People’s Bank of China cut interest rates last week, while margin-trading rules were eased and trading fees were cut Wednesday.
A 120 billion yuan fund dedicated to buying blue chip stocks in a market that`s falling because of margin loan liquidation may not be enough:
The new fund to bolster equities may have only “a fleeting effect when daily turnover has reached 2 trillion yuan”, according to Hao Hong, China equity strategist at Bocom International Holdings Co. in Hong Kong.

“This 120 billion yuan won’t last for an hour in this market,” Hong said by phone from Beijing Saturday. “It might benefit blue-chip stocks, as investors may see them as value, but the bursting of the bubble in small-cap/tech stocks is likely to continue.”
Japan tried similar tactics in the early 1990's and it failed. Here is a NY Times article from February 27, 1990 (h/t Patrick Chovenac):
After a week of turmoil on the Tokyo Stock Exchange, topped by Monday's 4.5 percent plunge, the Government and the exchange itself intervened to restore stability...

On opening Tuesday, the market quickly bounced back an additional 600 points before heading downward again. At the mid-day close, the average had erased all of its gains and was down 171.30 points. The strong market in New York and signs that the Japanese Government's efforts were helping to stabilize the yen were credited for the small, temporary rebound, but the subsequent drop was taken as a sign that market confidence was still fragile.
For some context on the scale of the slide in Chinese stocks, Bloomberg reported on July 2 that the fall in Chinese equities was equivalent to 10 Greek GDPs (and that was before prices fell even further):
A dizzying three-week plunge in Chinese equities has wiped out $2.36 trillion in market value -- equivalent to about 10 times Greece's gross domestic product last year.

If the Chinese market continues to slide, the big question then becomes, "What`s the potential damage to global markets?"

We can categorize the possible damage as short-run and long-run. The short-term risk is a financial contagion that spreads throughout the global financial system. There is about $9 trillion in loans in the offshore USD market (see The key tail-risk that the FOMC missed (and you should pay attention to)). BIS statistics indicate about $1.1 trillion was directed to Chinese companies, mostly through Hong Kong conduits.

Let`s sketch out a worst case scenario with some back of the envelope calculations. Supposing that 25% of those loans go sour and lenders recover, on average, 70 cents on the dollar. Aggregate losses, would then amount to $83 billion, which is roughly the same order of magnitude as total Puerto Rico debt of $72 billion. (If you`re not panicked that a PR default would sink the markets, why should a Chinese market crash spook you?) To be sure, a $83 billion hit to the global financial system would be unpleasant, but not fatal, especially if the losses are spread around. Conceivably, we could see a major regional player like Macquarie Bank go belly up (that's just an example, I know nothing about Macquarie), but central bankers are much better prepared at these liquidity-driven panics than they were in 2008.

The long term effects of a crash in Chinese equities are far more serious as it will depress Chinese household sector wealth. Such an event will end the hopes of any consumer-based re-balancing that Beijing might have had. The rest of the world would see negative side effects in the form of falling Chinese demand for both consumer and capital goods. George Magnus, writing in the FT, outlined the possible fallout:
If there were another precipitous market decline, the effects on the economy might increase for three reasons. First, although Chinese households typically hold only about 20 per cent of assets in equities, exposure is rising for the new middle class. More than 10 per cent of the between 70m and 80m retail trading accounts were opened this year, about the same as in 2014. Second, any short-term balance sheet boost for SOEs will disappear, and non-financial company revenues and earnings will be put under pressure by weaker demand, overcapacity and deflation.

Third, and perhaps most important, another large drop will probably mark a loss of confidence in the government’s ability to underpin the market at a time when the economy is going through a tough time. Investment, except in infrastructure, is sliding in all sectors. In spite of easy monetary policies, real interest rates are high because of deflation in producer prices. Debt growth has fallen but is still growing at twice the rate of nominal gross domestic product. The anti-corruption campaign unleashed by President Xi Jinping is sapping growth and initiative and stifling economic reforms. As a recent World Bank report suggested, China’s capacity to grow and boost productivity will be compromised while the state interferes extensively and directly in resource allocation.
Business Insider highlighted a UBS report on the impact of a Chinese slowdown on developed market economies:
"With China's property construction deceleration set to deepen this year in a multi-year slowdown, we may see a longer-term decline in China's appetite for foreign industrial imports," said the report.

This is especially troubling to vehicle and machinery producers, as around 30% of all exports from the US in those industries go to China. Globally, Germany and the EU send nearly 50% of their goods in these industries to China.
An economic slowdown in China would be far more negative than crash-induced financial contagion from nosediving Chinese stocks. The global economy is relatively well prepared to weather shocks like a Russia Crisis, where if a long-term investor blinked and paid no attention for a few months, it was over. A major economic slowdown in China has the potential to slow global growth and the earnings outlook.

Bullish fundamentals
Despite all these bearish signals, my inner investor is jumping up and down and shouting, "But the US equity outlook looks great!"

Consider, for example, one of the most important long-term charts for US equities. This plots the SPX against the 4-week average initial jobless claims on an inverted scale. The Employment Report last week showed that the recovery remains on track, which is positive for the consumer and the economy overall. So what's not to like?

The Citigroup Economic Surprise Index has shaken off its weather and west coast port related 1Q doldrums and it is beginning to rise again, indicating that the beat rate of high frequency economic data is increasing.

The Atlanta Fed's GDPNow continues to advance and 2Q estimated GDP growth now stands at 2.2%:

Data from Factset shows that Street forward 12-month estimates have been steadily rising, though they suffered a hiccup last week and the advanced paused. The forward EPS drop could just be noise, but we will get better reads as we get deeper into Earning Season.

As well, the latest insider trading data from Barron's has been in the bullish zone for several weeks:
In conclusion, the fundamental and macro picture indicate that, barring a major negative global growth surprise, US equities should be bought on weakness.

The week ahead: Preparing for volatile markets
All of these cross-currents based on differing time horizons suggest that the weeks ahead could see some very volatile and treacherous markets. In many ways, it is reminiscent of 2011, when the markets were buffeted by news of a Greek crisis. .

Even if we were to use 2011 as a rough template for the markets, the chart below begs the question of where we are in 2011? The top panel shows the SPX and the other panels show the components of my Trifecta bottom model (for details Time for a market bounce? and Worried about a low VIX?). Is the market in the early parts of 2011, when the Trifecta bottom model flashed buy signals, or are we in the choppy period after the big fall in August, where it chopped around in a big range for two months before ultimately recovering?

Under the circumstances, my inner trader remains cautious. He tactically bought stocks about a week ago and went to cash on Thursday in order to reduce binary event risk heading into the Greek referendum.

*** All of the above were written before the results of the Greek referendum were known ***

In the wake of No vote in the referendum, equity futures are deeply in the red. If the Shanghai market doesn't at least stabilize, then global markets will get even uglier.

Current conditions call for keeping commitments lighter than usual as market moves are likely to be sharp and treacherous. My inner trader is staying highly tactical and watching his Trifecta bottom indicators for signs of a tradeable bottom. Needless to say, any possible bullish confirmation of the V-shaped bottom last week has gone out the window.

My best advice to traders right now is not to get mesmerized by the screen with, "OMG! OMG! What do I do?" Drawdowns are a way of life. Define your risk and sketch out a plan with different scenarios ahead of time. That way, you can react to events in a less emotional manner.

My inner investor remains constructive on stocks and he is waiting for the full downdraft to load up on equities.

Disclosure: No positions

Friday, July 3, 2015

June Trend Model report card: Back on track at +5.1%

This is the latest performance update on my long-short account based on my Trend Model signals (see An intriguing Trend Model interim report card). After a period where the Trend Model strategy experienced some difficult drawdowns, the trading account rose 5.1% in June; the one-year return was 25.8%; and the return from inception of September 30, 2013 was 22.5%.

I reiterate my disclaimer that I have nothing to sell anyone right now. I am not currently in a position to manage anyone`s money based on the investment strategy that I am describing.

Trend Model description
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 and via Twitter @humblestudent as new developments occur.

The chart below shows the actual (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.

Trend Model Signal History

A proof of concept
While the results from the above chart representing paper trading is interesting, there is no substitute for actual performance. As a proof of concept, I started to manage a small 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, For more details on how the Trend Model or how the account is managed, see my post Trend Model FAQ).

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.

Returns were too good to be true
I had expressed my concerns in the past that Trend Model returns have been too good too be true. From some of the feedback that I had received, it was evident that expectations were driven up to excessively high levels. The 30-40% returns seen were supported by a stock market that went steadily up without a correction for several years.

My best guess of a sustainable long-term return for this strategy is in the 20-25% range.

The recent drawdown experience had been painful.  But for some context, here is what Peter L Brandt had to say about evaluating trading strategies in light of drawdowns:
Drawdowns are a fact of life for a trader. They happen. There will be bad days and bad weeks and bad months, and periodically even a bad year. A losing day/week/month is not an indictment against a trading plan. In fact, drawdowns are to be expected and a trader must learn to take them in stride without pulling the escape hatch whenever a position turns into a daily loser.

A benchmark metric maintained by many professional traders is their Calmar ratio. The Calmar ratio is calculated by dividing the worst drawdown (month-ending basis) into the average annual rate of return for some measure of time. A rolling three-year period is the most frequent time measure for determining Calmar. A Calmar ratio of 2.0 is considered outstanding — 3.0 is world class. Some short gamma traders (naked options sellers) can generate Calmar ratios of 5.0 or even higher — that is, until they go broke, which they eventually will.

The practical implication of a Calmar ratio of 2.0 is that to achieve an average annual ROR of 30% you will likely experience a worst-drawdown of 15% or greater (month-ending). Keep in mind that a month-ending worst drawdown of 15% probably equates to a week-ending worst drawdown of 20% or greater.
The maximum drawdown experienced by this strategy was -15.5%. I don't have a three-year track record, but using the return from inception of 22.5%, that makes a Calmar, or a gain-to-pain, ratio of 1.5. That's not bad in light of Brandt's comments.

Strategy characteristics still promising
Overall, the returns of this strategy remains promising:
  • The Calmar ratio is 1.5, which is still pretty good (see previous discussion)  By comparison, the drawdown for equities was in the order of 50% and most balanced funds saw losses of about 20% during the 2008-2009 period. Using even a 1 to 1 Calmar ratio and working backwards, it would be hard to envisage long-term return expectations of 50% for stocks and 20% for balanced funds today.
  • Long term returns are respectable, despite the recent volatility. The one-year return was 25.8% and return from inception (September, 30, 2013) was 22.5%.
  • Returns are highly diversifying compared to major asset classes. They are uncorrelated with equities (correlation of -0.24 with SPY) and bonds (0.02 with AGG).
  • Returns are consistently positive, with a 67% monthly batting average.

An acid test year
The market environment in 2015 has been challenging for the Trend Model trading strategy. So far, the Greek induced market turmoil is starting to look like a repeat of 2011, when stock prices fell dramatically in August and chopped around for about two months before beginning a volatile recovery. Trend following models don't perform well in such choppy periods. I will therefore be watching closely how the model behaves during what will likely be stressful conditions.

To summarize, investment results this year have been challenging but continue to be promising for this model longer term. I am comfortable with attributing the recent return hiccup as a characteristic of a difficult environment for this class of model, rather than anything fundamentally wrong with the modeling approach. 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.

Tuesday, June 30, 2015

Time for a market bounce?

I have written about my Trifecta bottom spotting model before (as an example see Sell Rosh Hashanah?). It consists of the following three conditions, which must occur closely (within a week) of each other:
  1. VIX term structure (VIX/VXV ratio) inversion
  2. NYSE TRIN more than 2
  3. My favorite intermediate term overbought-oversold model, which consists of the ratio of % of SPX stocks over their 50 dma/% of SPX stocks over their 150 dma less than 0.5
Each of these conditions, by themselves, are indicators of market fear. When used conjunction, however, they have been uncanny at calling short-term market bottoms.

The chart below shows the record of this Trifecta model in the last three years. I have marked in blue vertical lines where conditions 1 and 2 were satisfied, but not 3; and in red where all three were satisfied. In every one of the cases in the last three years, we have seen a short-term market bottom.

Trifecta Model: 100% accuracy in the last three years

We saw conditions 1 and 2 triggered yesterday, on Monday June 29, 2014, though the overbought-oversold model was not.

While the three year track record of this model has been remarkable, we need to put the results into context as the stock market has been rising steadily since the 2011 bottom. Such an environment is highly conducive to a class of models that spot oversold conditions, without worry that the market will get even more oversold.

I stress tested the Trifecta model in 2010 and 2011, when the market suffered major corrections and was far more choppy than it had been in the last three years. Though the results were still good, it was not perfect. The chart below shows the corrective period in 2010. In one case, the model signaled a minor rebound that petered out in two days. In another, it was too early as the market got even more oversold as the market fell to its final bottom about a week later.

We can see a similar pattern in 2011. The Trifecta model was too early in August 2011 as the market got even more oversold as it fell to its first bottom. September saw a number of multiple signals that were somewhat confusing. Though these multiple signals were consistent at flashing short-term bottoms, the stock market chopped around for several weeks before it began its ultimate rise.

So we can see that the Trifecta model is very good at flashing an oversold extreme, but does this represent THE BOTTOM for the current downdraft? That depends on a judgement call on the kind of market environment we are in. Are we still in the steadily rising market environment that we have seen in the last three years, or are we seeing the start of more serious market correction?

VIX spike bottom signal
Bill Luby at VIX and More had a slightly different take in a post where he wrote about stock market reactions to VIX spikes. Monday's 34% VIX spike was highly unusual and he found that it was generally an indicator of a short-term market bottom, but stocks tended to fall after a 3-5 day bounce (emphasis added)
Note that based on the data for the 23 VIX spikes in excess of 30%, the SPX has a tendency to outperform its long-term average over the course of the 1, 3 and 5-day periods following the VIX spike. Also worth noting that that 10 and 20 days following the VIX spike, the SPX has a tendency not only to underperform, but decline. Further, while the huge decline following 9/29/2008 VIX spike tends to dwarf the other data points, even when you remove the 9/29/2008 VIX spike it turns out that the SPX still loses money in the 10 and 20-day period following a VIX spike. When the analysis is extended out 50 trading days, the SPX is back to being profitable, but performing below its long-term average. On the other hand, when the analysis includes 100 days following the VIX spike, the SPX is back to outperforming its long-term average.

With the caveat that this is a limited data set, it is still worth flagging the pattern in which following a 30% one-day VIX spike, there appears to generally be a tradable oversold condition in stocks that lasts approximately one week, followed by a period of another month or so in which the markets typically has difficulty coming to terms with the threat to stocks. One quarter later, however, all fears are generally in the rear view mirror and stocks are likely to have tacked on significant gains.

Bill`s work with VIX spikes, whose history goes all the way back the the 1990`s, is suggestive that we are seeing a 2010 or 2011. If that`s so, it is consistent with the hypothesis that the market rallies into the July 4th long weekend and retreats afterwards.

The Greek referendum wildcard
We will see the results of the Greek referendum this weekend. The latest real-time signal from Lakdbrokes, indicate that the Yes side is leading with a probability of 63% compared to 37% for the No side. Such expectations are likely to create bullish tailwinds into the referendum on the weekend.

Even if the Yes side were to prevail, it is unclear how the markets might react to such a vote. Will it rally further because Greek tail-risk is off the table? Or will it retreat because the Syriza led government will likely collapse, which leaves Greece rudderless in the face a July 20 ECB repayment deadline which would implode its banking system (for more details see my post Time to buy GREK?).

Watching for the O'Neill follow-through
If the market were to see a bounce into the weekend, one way to decide if we have seen a durable bottom is to watch for a William O'Neill follow-through day, which is believed to be the sign of an intermediate term market bottom:
Summarizing the rules:

Day 1: Once a low has been established (after a correction), Day 1 occurs if the close is near the high of that day or a higher close occurs on the day after the low.
Day 2: The price must remain above the established low. If the price moves below the Day 1 low, then the pattern has been invalidated.
Day 3: The price must remain above the established low. If the price moves below the Day 1 low, then the pattern has been invalidated.
Days 4 - 7: Follow-through day must occur, with a gain greater than 1.7%, heavier volume than the previous day and heavier volume than average.
Traders often make the mistake believing that they can accurately forecast the future. A better approach might be to create a trading plan by keeping several scenarios. Define your risk parameters and pain thresholds, the potential reaction to developments under each scenario and act accordingly to the trading plan.

These markets are potentially treacherous. Under these conditions it especially pays to have a plan ahead of time.

Disclosure: Long TNA

Monday, June 29, 2015

Time to buy GREK?

With Greece in turmoil and the Athens Stock Exchange closed, one of the few ways investors can get exposure to Greek stocks is through the Global X FTSE Greece 20 ETF (GREK), in addition to a number of listed ADRs.

As of the close on Monday, GREK was down 20% from Friday's close. Does this mean that speculators should step up and buy GREK in anticipation of a likely "Yes" vote in the upcoming referendum?

A quick glance at the chart gives us some good news-bad news readings. On one hand, the ETF did rally through a downtrend and the price has start to stabilize and go sideways, which is constructive. On the other hand, it did break support today on high volume, which is a bad sign.

Decomposing the portfolio
How about trying to value the ETF by looking at the components? My analysis of percentage holdings is based on Friday night's close, before the surprise referendum call and serves as a useful benchmark for valuation as that was the last time we had actual Athens Stock Exchange prices to compare against. The following table from Yahoo Finance, shows the top three holdings to be the local Coca-Cola bottler at roughly 20% weight, the local telecom at 10%, followed by the lottery operation at about 10%. While the first three holdings appear to have some stability and somewhat defensive in nature, the next few are banks, all of which have significant risk attached.

This table from Morningstar gives us some idea of the sector weightings and another overview of ETF holdings. Based on some quick back of the calculations, I get an estimated range of $6.57 to $7.56 per share.

Here`s how I did it. Consider a worst case scenario where the No side prevailed in the referendum and Grexit looms. I assume that the financials all get wiped out (24% weight), the Consumer Cyclical sector gets cut in half (18% weight) and everything else takes a 20% haircut. Based on Friday`s closing price of $11.78, that would give us a downside target of $6.57 per share.

A big bet on the banking sector
Monday`s closing price was only 20% below Friday`s level and the financial sector represented roughly 24% of the value of GREK. Therefore the current valuation of the ETF, which is blind because there are no market prices of the underlying share in Athens, is based on the dubious assumption that the banking sector won`t get wiped out.

Yves Smith at Naked Capitalism has the details of what might happen if and when Greece defaults:
In any case, enough about the past, let’s run through the most likely end game for this Greek saga as a deal never gets agreed before default.

1. Greece misses its IMF payment on the 30th of June. This could be a trigger but it may not be. The IMF has 30 days to call Greece in arrears so technically Greek government guaranteed collateral, and hence the Greek banks, are still solvent after the 30th. However on the 20th of July the Greeks will surely default to the ECB without a deal. This is the official d day.

2. Upon default, the collateral at Greek banks cannot be posted any longer to the Euro system. The Greek banks then become insolvent and the ECB, through the newly created Single Resolution Mechanism (SRM), is obligated to resolve the Greek banks.

3. So the ECB goes to Tsipras and tells him – we are immediately instituting capital controls and we will begin resolution of your banks unless u sign the agreement and re-enter a program. Without a bailout program in place the Greek government, and banking system, are both insolvent. So Tsipras says – what do you mean resolve my banking system? And then Mario explains as follows. First we wipe out all equity and bond holders. And then, as in Cyprus, we bail in depositors. There are 130b in Greek deposits against 90b in ELA. And while those deposits are technically insured up to 100,000 euro, there is no pan European bank insurance yet in place. That only comes in 2016. Right now Greek deposits are only insured with a Greek deposit insurance fund that has about 3b in it. This Is hardly enough for the 130b in deposits. So we take the 130b against the 90b in ela. Any remaining deposits go to fund a bad bank that begins resolving all the NPLs. The good loans of course will go into a good bank which will be funded with German capital and most likely will have a German name. Of course depositors will get 2 to 3 euro cents on the dollar for their existing balances from the 3bio in the insurance fund. So you have that going for you!
The big question then becomes, "When does the ECB decide to blow up the banking system, where the bank shareholders get wiped out and depositors recover 2-3 cents on the euro?"

Even the optimistic case looks ugly
Let`s construct a best case scenario. Suppose that the Yes side wins the referendum. Will all be forgiven and will Greece re-enter a bailout program and the banking system gets revived?

Not so fast! When Greece asked for a last minute extension to the bailout program so that it could wait for the results of the referendum, what upset the Eurogroup ministers was not just the surprise referendum call, but that the Tsipras government would be actively campaigning for the No side. Notwithstanding the fact that the Eurogroup offer expired on June 30, the active campaign for No by the Greek government made the Syriza government an unreliable partner in the Eurogroup`s eyes. How can such an organization be expected to implement any reforms that may have been agreed to. A Yes vote will likely cause the current Greek government to collapse and new elections called. Prime Minister Tsipras has indicated that he would resign should the Yes side prevail in a TV interview on Monday night (via CNN):
"If the Greek people want to move ahead with austerity ... for young people to move abroad in their thousands, for us to have unemployment and for us again to be moving towards new programs, new loans... if that is their choice we will respect it, but we will not carry it out," he said in an interview with Greek TV.

"I am telling you that I cannot be a prime minister under all circumstances."
While I could envisage a scenario where the IMF and ECB bent over backwards to keep supporting Greece and its banking system in the run-up to the referendum, there are some real drop-dead deadlines. There is a payment to the ECB on July 24 and, if Christine Lagarde is willing, there is a 30-day grace period for the missed payment to the IMF on June 30.

If we were to get a Yes vote, which is likely given current polling, and the Syriza government were to collapse. It is unclear whether there would be enough time to call new elections, form a new government and see the new government agree to a new bailout program before the July 24 ECB payment deadline. While the ECB could conceivably bend the rules and keep the banking system going at the current ELA levels until July 24, there would be no justification to do so if a payment to the ECB is missed. The ECB has no choice other than to resolve the banking system,

There are two groups in Greece who would get badly hurt under that scenario. Ordinary citizens who do not have the means or sophistication to move their money abroad and businesses with operating accounts with daily cash flows. Both would collapse and so would the Greek economy. Business collapses have cascading effects that cannot be reversed immediately.

Under such a seemingly *ahem* "optimistic scenario", bank shareholders would still get wiped out. So assume that GREK takes a 24% haircut on its position in financials and a 20% haircut on everything else, we get a target price of $7.56 based on the Friday close of $11.78.

In conclusion, the Monday closing price of GREK of $9.42 is well above my target range and Mr. Market is making a bet that the banking system remains intact. I am not willing to make such a courageous assumption.

Sunday, June 28, 2015

A study in volatility: Chillax, or sell everything?

Trend Model signal summary
Trend Model signal: Risk-off
Trading model: Bearish

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. In essence, it seeks to answer the question, "Is the trend in the global economy expansion (bullish) or contraction (bearish)?"

My inner trader uses the trading model component of the Trend Model seeks to answer the question, "Is the trend getting better (bullish) or worse (bearish)?" The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. In addition, I have a trading account which uses the signals of the Trend Model. The last report card of that account can be found here.

Update schedule: I generally update Trend Model readings on my blog on weekends and tweet any changes during the week at @humblestudent.

A bet on volatility
After the posts that I had written in the last week, where I examined the bull and bear case for stocks (see And now for something completely different: The Hegelian Dialectic) and a discussion of the possible causes of the current low equity volatility environment (see Will the quants blow up the market again?), I realized that I should be approaching the market in a different way. Instead of trying to forecast market direction, I should be trying to forecast the volatility regime.

As the chart below shows, US equities have been in a very tight trading range for all of 2015. As of the close Friday, the SPX was up a whopping 2% from year-end, with lots and lots of whipsaws. As an indication of the choppy market, I have marked with arrows the extraordinary number of instances the SPX has crossed its 50 day moving average. Further, the top panel shows the RSI(14) indicator, which is an overbought/oversold measure. This indicator has not flashed an overbought (over 70) or oversold reading (under 30) all year. In fact, it has stayed in a range even tighter than the more traditional 30-70 upper and lower bounds.

Think scenarios, not just direction
These are the characteristics of a low volatility equity market environment. Though volatility has spike in other markets, such as the fixed income and foreign markets, the realized vol of US stocks remains low. The key question then becomes, "Will this continue?"

When trying to forecast volatility, it is helpful to think about scenarios, one where volatility stays low and another where it breaks out.

On one hand, macro risks are high as the weekend ends, with Greece on the verge of default and the Chinese stock market on the verge of meltdown, which argues for a breakout in volatility and the start of a correction. On the other hand, the US macro and fundamental outlook has been improving, which is supportive of a rebound in stock prices.

The US bull case
Since the main focus is the direction of US equities, let us begin by assessing the US outlook. As an overview, the Atlanta Fed Nowcast of 2Q GDP growth has advanced to 2.1%, which is a significant improvement of 0.7% seen in mid-May.

Last week also saw better than expected retail sales data. As New Deal democrat pointed out, this represents unambiguous good news. The American consumer is back and spending.

The latest earnings outlook update from John Butters of Factset also brought good news. Forward EPS continues to advance and, as the chart below shows, forward EPS estimates have been highly correlated with stock prices (annotations in red are mine).

What about Greece? Butters showed that Greece was not mentioned in a single earnings call. In fact, eurozone countries were far down the list mentioned as issues in company earnings calls, which indicate that a Greek default or Grexit has little direct contagion effect on US corporate earnings.

From a technical perspective, here are the charts of the US and major European averages on Friday after the close, but before the news of a Greek referendum hit the tape. The Euro STOXX 50 had been rallying and testing its 50 dma, which is an indication that the eurozone is weathering the Greek crisis well. The UK FTSE 100 could also be construed as being in turnaround mode.

Bottom line: The Trend Model was on the verge of a trading buy signal. Even minor improvements in stock prices in the US and Europe would have moved the needle to bullish. Based on this analysis, US equities have room to rally in the absence of tail-risk.

As US stock prices have descended last week, such a bullish interpretation translates to a rally and therefore a likely continuation of the low volatility regime, where stock prices rise but get capped by other factors.

Chaccident and Graccident risks
As investors are well aware, the world is not without risks. The two immediate tail-risks that face the markets come from China and Greece.

The Shanghai market nosedived 7.4% on Friday and it is now down over 20% on a peak-to-trough basis, which puts it into bear market territory. The development was not a surprise (at least to me) as there have been reports of widespread insider selling. The stock indices of the regional exchanges of China`s major Asian trading partners staged rallies last week, but all were unable to break through their 50 dma, which would be indications of renewed strength.

The bearish and high volatility implication of these charts is that Mr. Market remains concerned about the outlook for Chinese growth. Should the Chinese stock market implode further, we could see a leakage of financial contagion spread throughout the region.

On the other hand, the PBoC reacted by cutting interest rates (via Bloomberg):
In the fourth reduction since November, the one-year lending rate will be reduced by 25 basis points to 4.85 percent effective June 28, the People’s Bank of China said on its website Saturday. The one-year deposit rate will fall by 25 basis points to 2 percent, while reserve ratios for some lenders including city commercial and rural commercial banks will be cut by 50 basis points, according to the statement.
The bullish interpretation is that the PBoC has reached its pain threshold and it is acting. A rally in the Chinese and regional markets are supportive of a continuation of the mean reverting low volatility environment of 2015.

Greece: Acropolis Now?
After the market closed on Friday, Greek PM Tsipras shocked the world (and his own negotiating team in Brussels) by announcing that he would be calling a referendum on July 5 to put the latest eurozone proposals to a vote. There are a number of problems with that course of action.
  1. The European bailout program of Greece expires on June 30 and the negotiations were centered on what the conditions are for an extension. The Eurogroup meeting on Saturday rejected a Greek request for an extension of the program. Extensions are subject to approval by the parliaments and legislatures of member EU states it appears that the member states were unwilling to expend the political capital to get an extension with such an uncertain return.
  2. Greece is scheduled to pay the IMF €1.6 billion on June 30, money which it wouldn't have without the bailout.
  3. It is unclear what the Greeks will be voting on in their July 5 referendum, as the extension offer expired on June 30 - a point that was confirmed by IMF chief Christine Lagarde to the BBC, though she did not completely close the door to the resurrection of the offer in the event of a "Yes" vote.
  4. As Greece will no longer in a bailout program after June 30, the ECB will have no choice but to terminate its ELA assistance to the Greek banking system. The banking system will implode and depositors will get 2-3 cents on the euro (for further details see my discussion last week And now for something completely different: The Hegelian Dialectic). As the news of the referendum spread on Saturday morning, there were widespread reports of lines at ATMs in Greece. A bank run has begun.
  5. On Sunday, the ECB has capped their Emergency Loan Assistance (ELA), which is the rough equivalent of the Fed window, to the Greek banking system at last Friday's level. In response, the the Greek government has imposed a bank holiday and capital controls.
The last point is of immediate concern for the financial markets. It means, at the very least, capital controls and, at worst, the vaporization of the Greek banking system. Yves Smith at Naked Capitalism faults both sides and calls the creditors "known thugs", but she believes that the referendum is a sham and a political fig leaf for Tsipras' failures in negotiation, leadership and governing:
So the only conceivable excuse for waiting this long is for Tsipras to attempt to save himself. If he were to reject the bailout, the decision is unquestionably his and that of his allies. That it precisely the sort of decision that government leaders are expected to make. Or he could just as well accept the bailout, recognizing that as bad as things are, that the country would be plunged into an even deeper economic sinkhole, putting the survival of even more citizens at risk. It would take forming a new coalition with To Potami and New Democracy, and that would mean that his and Syriza’s position would become far more tenuous and he would be fiercely denounced by many if mot most Syriza MPs.

Thus the referendum ruse looks to be about trying to spare Tsipras and Syriza the worst consequences of his having underestimated the creditors and not preparing for worst-case scenarios, which is another responsibility of leadership that he and his party have neglected.
Sounds dire? Is this the start of a market crash?

Consider the flip side of the coin. These risks have been well recognized for months and Bloomberg reports that contagion hadn't spread to other peripheral eurozone countries, though this report was penned before the referendum news (emphasis added):
Those warnings hadn’t thus far sparked a panic among bondholders.

Spain’s 10-year bond yield fell 16 basis points, or 0.16 percentage point, this week to 2.11 percent as of 5 p.m. London time on Friday, the steepest decline since Feb. 27. The 1.6 percent security due in April 2025 rose 1.395, or 13.95 euros per 1,000-euro ($1,115) face amount, to 95.51.

And although talks between Greece and its creditors had whipped up intraday volatility, the yield difference, or spread, between Spanish and German 10-year securities, seen as a marker of investors’ demand for safer assets, narrowed. It decreased to 119 basis points on Friday, from 152 basis points at the end of last week.

The spread widened to as much as 650 basis points in July 2012, when contagion from the region’s debt crisis that had its epicenter in Greece threatened to break up the currency bloc.

“The logic is that if a Grexit is postponed then contagion is less of a problem, so that goes to the benefit of Spain and the rest,” Marius Daheim, a senior rates strategist at SEB AB in Frankfurt, said before the referendum was announced. “But these are news-driven short-term moves which could reverse if something goes wrong.”

The yield on Italian 10-year bonds fell 13 basis points to 2.15 percent this week, the biggest drop since March.
A report from Deutsche Bank (via FT Alphaville) showed that Greek contagion is far more ring-fenced that it was in 2012. In particular, the second chart (figure 11) hints at the ECB turning on the QE and OMT taps to counteract any Greek contagion effects.

Indeed, the latest ECB statement on capping Greek ELA at current levels ended with this ”whatever it takes” paragraph (emphasis added):
The Governing Council is closely monitoring the situation in financial markets and the potential implications for the monetary policy stance and for the balance of risks to price stability in the euro area. The Governing Council is determined to use all the instruments available within its mandate.
While history doesn't repeat itself, it does rhyme and we can also look to the Cypriot crisis as a guide as to what might happen next. As the chart below shows, the farther a region was from the epicenter of the crisis, the more insulated the market was. US equities (top panel) didn't respond at all to the imposition of Cypriot capital controls and the resolution of its banking system. Greece was the most exposed (see bottom panel) and Europe (top panel) was somewhere in the middle.

As the Cypriot capital control episode showed, the Greek and European markets fell initially on the news and bottomed soon afterwards. US markets barely reacted at all. The Cyprus example suggests that volatility will likely breakout, but in the form of upside volatility.

One last thing. Reuters reports that the latest polls indicated that the majority of Greeks want a deal:
A majority of Greeks favor accepting a bailout deal with international lenders, according to two opinion polls conducted before Prime Minister Alexis Tsipras announced a surprise referendum on the issue.

The survey by the Alco polling institute published in Sunday's edition of the Proto Thema newspaper, said 57 percent of 1,000 respondents were in favor of reaching a deal, while 29 percent wanted a break with creditors.
A second poll also showed similar results and Ladbrokes is quoting odds of 1/3 for a "Yes" referendum vote and 2/1 for a "No" vote.
Pollsters Kapa Research said 47.2 percent of respondents were in favor of an accord and 33 percent against, according to To Vima newspaper. Its 1,005 respondents were asked how they would vote if a new "painful" agreement were put to the vote in a referendum.

Some 48.3 percent of respondents in the Kapa poll said they would not support any move by the government which could place Greece outside the euro zone.
These sets of analysis argue for a rally after any initial market decline, which would be a continuation of the up-and-down low volatility environment that we have been seeing for all of 2015.

The week ahead: Watching and waiting
Here is how I am approaching the holiday shortened week ahead. First of all, I would like to give my wishes in advance all my Canadian friends for Canada Day (July 1) and all my American friends for Independence Day (July 4).

My inner investor is watching all this macro drama in a somewhat bemused fashion. The fundamentals for US equities are improving and downdraft constitutes a summer sale on stocks that he would be happy to participate in.

My inner trader, on the other hand, is approaching the week by watching and waiting to see how the volatility scenarios are developing. He profited last week from what was in essence a bet on a low volatility regime by:
All of those trades were profitable. On Friday, he dipped his toe in on the long side on the basis of a bet on a low volatility range-bound market, the news that Greece was inches away from a deal, the "oversold" readings of the market by 2015 standards:

,,,and a longer term analysis indicating that the NYSE Summation Index (bottom panel) and NYSE common stock only Summation Index (middle panel) were turning up. These readings are highly suggestive that the bulls will see tailwinds for the next few weeks.

As my inner trader watches the event-driven volatility in the week ahead, he will keep his position commitments light. He will evaluate the market action using the framework of the two possible volatility regimes as well as his own risk control parameters. Will we see SPX RSI(14) break out, either on the upside or downside? If SPX were to sell off hard, will it break the key support level of the 150 dma at 2078, which has put a floor on the market for the last couple of years?

As I write these words, equity futures are deep in the red, but Sunday night futures markets have a way of changing dramatically by Monday's open. Next week`s market will be full of twists and turns (and I haven`t even mentioned the US Employment report Thursday). Should you chillax, or panic and sell everything?

The market will not seem so chaotic as long as you have a plan. Keep commitments light, define how much risk you want to take and don't go overboard on your positions. Good luck.

Disclosure: Long TNA

Thursday, June 25, 2015

Are HFTs responsible for low market volatility?

I received a number of thoughtful responses from last post about falling equity volatility (see Will the quants blow up the markets again?). One of the themes that was repeated several times in the comments pointed to HFT algos as a possible culprit for the low volatility regime.

On the surface, the HFT explanation does make sense. HFTs are supposed to provide liquidity to the market during "normal" markets (and the current market regime is "normal"). Bloomberg reported that a study on HFT behavior based on Norway`s SWF trading activity and found that, in aggregate, HFT algos were providing liquidity to orders and not front-running them (emphasis added):
High-frequency traders are more prone to first go against the flow of orders by large institutions, according to a study based on trade data provided by investors including Norway’s $890 billion wealth fund.

The study found that HFTs “lean against the order” in the first hour and then turn around and go with the flow in the case of multi-hour trades, the study by University of Amsterdam professors Vincent van Kervel and Albert J. Menkveld released Thursday showed. Trading costs are 39 percent lower when the HFTs lean against the order, “by one standard deviation,” and 64 percent higher when they go with it, they said.

“The results are inconsistent with ‘front-running’ in the sense of HFTs who detect a large, long-lasting order right from the start and trade along with it,” van Kervel and Menkveld said. “We speculate that HFTs eventually feel the imbalance caused by it. In response, they trade out of their position as they understand that leaning against such order as a market maker requires a long-lasting inventory position. HFTs prefer to be flat at the end of the day.”

How fat are the tails?
Another way of thinking about market volatility is to see if stock returns have fat-tails. One statistical measure is kurtosis, which is explained this way:
Having discussed the shape of a normal distribution, we can talk about kurtosis and what it means to have fat tails and peakedness. The total area under a curve is by definition equal to one.

With that in mind, think about what having fatter tails might mean. If you were to think of a curve having three parts (all imaginary) – the peak, the shoulder (or the middle part), and the tails, you can imagine what happens if you stretch the peak up. That reduces variance, and probably sucks in ‘mass’ from the shoulders. But in order to keep the variance the same, the tails rise higher, increasing variance and also providing fatter tails.

Fat tails would imply there is more area under the tails, which means something else has to reduce elsewhere – which means that the ‘shoulders’ shrink making the peak taller. In order to compare kurtosis between two curves, both must have the same variance. At the risk of being repetitive, note that the variance has an impact on the shape of a curve, in that the greater the variance the more spread out the curve is. When we say that kurtosis is relevant only when comparing to another curve with identical variance, it means that kurtosis measures something other than variance.

For the non-geeks, here is how you interpret kurtosis. A standard normal distribution has a kurtosis of 0 and fat-tailed distributions have positive kurtosis.

Here is a chart of the rolling one-year kurtosis of daily SPX returns going back to 1990. First, the median kurtosis is 1.34, indicating that stock returns have fatter tails than a typical normal distribution (and option traders using the Black-Scholes model, which is based on a normal distribution, know that fact well). As well, kurtosis has been falling since 2011, indicating that the tails are getting thinner. This is not unusual as there has been episodes in the past when kurtosis has been even lower than they are today.

If HFTs are coming into the market and providing liquidity by buying the dips and selling the rips at a micro level, then we should expect kurtosis to fall.

An HFT Bataan death march?
The hypothesis that HFT algos were the cause of the low volatility environment is intuitively attractive from a data standpoint, but illogical from a business viewpoint. That's because HFT profitability has been tanking for the last several years. This Bloomberg story from 2013 (two years ago) show how HFT industry profitability has cratered over the years:
According to Rosenblatt, in 2009 the entire HFT industry made around $5 billion trading stocks. Last year it made closer to $1 billion. By comparison, JPMorgan Chase (JPM) earned more than six times that in the first quarter of this year. The “profits have collapsed,” says Mark Gorton, the founder of Tower Research Capital, one of the largest and fastest high-frequency trading firms. “The easy money’s gone. We’re doing more things better than ever before and making less money doing it.”

“The margins on trades have gotten to the point where it’s not even paying the bills for a lot of firms,” says Raj Fernando, chief executive officer and founder of Chopper Trading, a large firm in Chicago that uses high-frequency strategies. “No one’s laughing while running to the bank now, that’s for sure.” A number of high-frequency shops have shut down in the past year. According to Fernando, many asked Chopper to buy them before going out of business. He declined in every instance.
This slide from an HFT presentation in 2014 tells the same story (annotations in purple are mine):

Given how industry margins has fallen over the years and the reports of diminishing HFT profitability came out in 2013, it would be illogical for the industry to engage in a further arms race to drive down volatility further. Such an act would amount to a Bataan death march for HFT.

Based on this analysis, HFT algos may have contributed to the decline in equity volatility since 2011, but I cannot conclude that they were the main culprits. The mystery of equity market volatility compression still remains a mystery.

Tuesday, June 23, 2015

Will the quants blow up the markets again?

Josh Brown had a fascinating post which postulated that the quants pose a significant systemic risk to market volatility:
There’s an interesting idea going around that asset management – specifically the metastasizing quantitative strategies run via black box are where the next big scare is due to come out of. Volatility has been so low, for so long, that winning trades have become crowded and leverage is bountiful. And the kicker – they’re all running the same playbook, loading up in the same trades.
Josh referred to a post by Dominique Dassault at Global Slant and he drew the conclusion that it may all collapse as it did in 2008:
Dassault, in referring to “ten years ago”, is referencing the subject of Scott Patterson’s excellent book, The Quants, in which a handful of genius mathematicians were blown up in a 2006 incident which presaged the global market meltdown that would begin a year later.
I think that Josh missed the point. The incident that Dassault referred to was not the crash of 2008, in which quants made erroneous assumptions about their model inputs (house prices don't fall). Instead, she was referencing a little known quant meltdown that which occurred in August 2007 in which equity quants got into a crowded trade when someone tried to liquidate - in size. I wrote about this episode before (see Are quants the victims of their own success?). The chart below shows the HFRX Equity Market Neutral Index (in blue) and a different strategy (in red) that I was involved in which used some very different factors that did not land us in the crowded long.

From discussions with former colleagues and other equity quants at the time, the meltdown was very ugly. Long-only quantitative accounts with relatively low turnover portfolios suddenly saw relative performance tank to -10% to -15% against their benchmarks in a matter of days, as per the above chart. Moreover, factors that were uncorrelated by design, e.g. value vs. growth, all suddenly saw their return correlations converge to 1.

How models blow up
Dassault explained the fatal design flaw of these models in her blog. She had been interviewing with a leading hedge fund manager about 10 years ago who expressed concerns about the stability of quant models:
While in Greenwich Ct. one afternoon I will never forget a conversation I had with a leading quantitative portfolio manager. He said to me that despite its obvious attributes “Black Box” trading was very tricky. The algorithms may work for a while [even a very long while] and then, inexplicably, they’ll just completely “BLOW-UP”. To him the most important component to quantitative trading was not the creation of a good model. To him, amazingly, that was a challenge but not especially difficult. The real challenge, for him, was to “sniff out” the degrading model prior to its inevitable “BLOW-UP”. And I quote his humble, resolute observation “because, you know, eventually they ALL blow-up“…as most did in August 2007.

It was a “who’s who” of legendary hedge fund firms that had assembled “crack” teams of “Black Box” modelers: Citadel, Renaissance, DE Shaw, Tudor, Atticus, Harbinger and so many Tiger “cubs” including Tontine [not all strictly quantitative but, at least, dedicated to the intellectual dogma]…all preceded by Amaranth in 2006 and the legendary Long Term Capital Management’s [“picking up pennies in front of a steam-roller“] demise one decade earlier.
My circle of quants at the time of the August 2007 were not the Citadels and DE Shaws, but traditional long-only quant shops around Boston like SSgA, GMO and so on. The results were the same. Everyone blew up.

At the time, most of the equity quants more or less had the same approach to modeling, though the details of the models were different. They were multi-factor models with a little bit of growth, a little bit of value, sprinkle in some momentum (fundamental in the form of estimate revision and earnings surprise), technical in the form of PRICE momentum, usually some form of relative strength with a one-month price reversal. They might toss in other exotic ingredients like insider trading activity or buybacks. These multi-factor models used uncorrelated factors by design, so that when you combined them, they were supposed to give you a stable alpha.

Then they overlaid extensive risk control. Dassault explains what she saw at her hedge fund:
First of all, a large number of variables in the stock selection filter meaningfully narrowed the opportunity set…meaning, usually, not enough tickers were regularly generated [through the filter] to absorb enough capital to tilt the performance meter at most large hedge funds…as position size was very limited [1-2% maximum]. The leaders wanted the model to be the hero not just a handful of stocks. So the variables had to be reduced and optimized. Seemingly redundant indicators [for the filter] were re-tested and “tossed” and, as expected, the reduced variables increased the population set of tickers…but it also ramped the incremental volatility…which was considered very bad. In order to re-dampen the volatility capital limits on portfolio slant and sector concentration, were initiated. Sometimes market neutral but usually never more than net 30% exposure in one direction and most sectors could never comprise more than 5% of the entire portfolio. We used to joke that these portfolios were so neutered that it might be impossible for them to actually generate any meaningfully positive returns. At the time of “production” they actually did seem, at least as a model, “UN-BLOW-UP-ABLE” considering all the capital controls, counter correlations and redundancies.
As a general rule, hedge fund alphas tended to be shorter lived than long-only alphas, but everyone had portfolios risk controlled 18 ways to Sunday. Yet they all blew up in August 2007.

Andy Lo explains August 2007
Some time after that fateful month in August, Andrew Lo of MIT made an extensive study of the topic. A subsequent paper by Amir E. Khandani and Andrew W. Lo asked the question: What happened to the quants in August 2007? Evidence from factors and transactions data. Here is the abstract:
Using the simulated returns of long/short equity portfolios based on five valuation factors, we find evidence that the “Quant Meltdown” of August 2007 began in July and continued until the end of 2007. We simulate a high-frequency marketmaking strategy, which exhibited significant losses during the week of August 6, 2007, but was profitable before and after, suggesting that the dislocation was due to market-wide de-leveraging and a sudden withdrawal of marketmaking risk capital starting August 8. We identify two unwinds—one on August 1 starting at 10:45am and ending at 11:30am, and a second at the open on August 6, ending at 1:00pm—that began with stocks in the financial sector, long book-to-market, and short earnings momentum.
Earlier iterations of this research postulated a large seller coming to liquidate what amounted to a crowded trade, otherwise known as the Unwind Hypothesis. In other words, the majority of quants were in the same set of stocks despite the apparent diversity of their models:
This hypothesis suggests that the initial losses during the second week of August 2007 were due to the forced liquidation of one or more large equity market-neutral portfolios, primarily to raise cash or reduce leverage, and the subsequent price impact of this massive and sudden unwinding caused other similarly constructed portfolios to experience losses. These losses, in turn, caused other funds to deleverage their portfolios, yielding additional price impact that led to further losses, more deleveraging, and so on. As with Long Term Capital Management (LTCM) and other fixed-income arbitrage funds in August 1998, the deadly feedback loop of coordinated forced liquidations leading to deterioration of collateral value took hold during the second week of August 2007, ultimately resulting in the collapse of a number of quantitative equity market-neutral managers, and double-digit losses for many others.
Fast forward to today. Dassault postulates a crowded long by the fast money crowd and their positions and returns have been exaggerated by leverage. What`s more, the assets are concentrated in just a few very large funds:
What has changed though is the increased dollars managed by these funds [now $3.5T] and the concentration, of these dollars, at the twenty largest funds [top heavy for sure]. What has also considerably changed is the cost of money…aka leverage. It is just so much cheaper…and, of course, is still being liberally applied but, to reiterate, in fewer hands.
Add in a dash of excess conviction and hubris and you get a potential time bomb:
1. Strong Conviction…aka Over Confidence +
2. Low Volatility +
3. High Levels/Low Costs of Leverage [irrespective of Dodd-Frank] +
4. More Absolute Capital at Risk +
5. Increased Concentration of “At Risk” Capital +
6. “Doing the Same Thing”

…Adds up to a Combustible Market Cocktail.
She concluded [emphasis added]:
Still a catalyst is needed and, as always, the initial catalyst is liquidity [which typically results in a breakdown of historic correlations as the models begin to “knee-bend”…and the perceived safety of hedges is cast in doubt] followed by margin calls [the ugly side of leverage…not to mention a whole recent slew of ETF’s that are plainly levered to begin with that, with the use of borrowed money, morph into “super-levered” financial instruments] and concluding with the ever ugly human panic element [in this case the complete disregard for the “black box” models even after doubling/trebling capital applied on the way down because the “black box” instructed you to]. When the “box” eventually gets “kicked to the curb”…that is when the selling ends…but not after some REAL financial pain.

Spotting the crowded trade
So far, we just have a "this will not end well" story, but we have no idea of what the crowded trades are and what the trigger for an unwind might be. Here is where things get more speculative (and comments from anyone who is closer to the situation are invited).

One of the crowded trades are algos that suppress market volatility, either by design or as a side-effect. Bloomberg reported that 2% stock market moves have disappeared in 2015 and Business Insider reported that the market hasn't seen a 1% in eight straight weeks:

This kind of low realized vol environment has made stars of managers who run risky long-tailed strategies that pick up pennies in front of steamrollers. Consider, for example, this account about a fund which holds cash and sells put options on stocks that is being marketed as (*shudder*) a fixed-income alternative. The lack of recent downside equity market volatility has made this strategy a stellar performer and put up a return of 12.7%, triple the stock market.

In a separate post, Dassault calculated the risk-adjusted returns of holding US equities in early 2015 and the results were extraordinary (recall that the Sharpe ratio = (return - risk free rate)/volatility):
Recently I constructed a model that required one, three and five year Sharpe Ratios for the SP 500. I also decided to include the Sortino Ratio. Prior to the results I hypothesized that the numbers ought to be pretty impressive given the endless equity “bull” since March 2009 but I was still curious to get the exact data. Plus, a weekly price chart of the SP 500, since 2009, visually reflects the anomaly of very limited draw-downs in the context of extremely strong returns. The calculations are as follows and as Mrs. Doubtfire once said…“Effie…Brace Yourself”.

Sharpe Ratio
1 Year = 1.37
3 Year = 1.86
5 Year =1.0

Sortino Ratio
1 Year = 2.65
3 Year = 3.41
5 Year = 1.69

Collectively, these numbers are clearly impressive but even more so in that they are calculated from a passive, long only strategy. This is a hedge fund manager’s worst nightmare as, for five years, most “hedging” has proved to be only performance degrading.

Furthermore, the Sortino Ratio data are nothing short of staggering. What they really say = Plenty of Gain with Very Little Pain.…and it really is unsustainable if only because it has become much too easy to generate positive returns with very little effort, pain or savvy.
To put these extraordinary Sharpe Ratios into context, the long-term Sharpe Ratios realized by legendary investors like Buffett, Robertson and Soros were in the 0.7 to 1.1 range. Yet a simple buy-and-hold strategy yielded 1, 3 and 5 year figures better than these investment giants!

These results are highly suggestive that equity volatility has been artificially suppressed in some fashion (no it probably isn't the Fed as QE programs had been well under way for years before volatility dived), As Captain Kirk might say, “Someone, or some thing, is suppressing market volatility to make it seem that stocks are safer than they are.“ Which brings us back to the Josh Brown comment earlier:
There’s an interesting idea going around that asset management – specifically the metastasizing quantitative strategies run via black box are where the next big scare is due to come out of. Volatility has been so low, for so long, that winning trades have become crowded and leverage is bountiful. And the kicker – they’re all running the same playbook, loading up in the same trades.
Could the culprit for low vol be the black-box algos themselves? Another characteristic, or side-effect, of the low volatility environment is the stock market appreciated steadily without a 10% correction since 2011.

I have written about this theme many times before (see the Jim Paulsen study indicating the steady market uptrend is breeding complacency and my own work at Why I am bearish (what would change my mind)). But now, the steady uptrend is starting to crack.

This is the daily SPX chart. Note how the RSI indicator (top panel) has not flashed an overbought reading over 70 and oversold reading of below 30 in all of 2015. The VIX Index (bottom panel) has been steadily declining. Both of these indicators are signs of a compressed volatility environment. On the other hand, the uptrend is starting to labor as the SPX index is losing momentum and appears to be rolling over.

The longer term 20-year monthly chart shows that the MACD histogram fell to a negative reading in January 2015, rose briefly and fell back into negative territory in March. These are the typical signs of a loss of price momentum cited in the Paulsen study. Every past instance in the last 20 years has resolved themselves in bear phases.

If these "black box algos" have been suppressing volatility either as a side-effect or by design, but they need a steadily rising stock market to make money, then could these indications that these models are starting to “knee-bend“?

We can make an educated guess. An examination of the returns of the HFRX equity market neutral hedge fund index*, which is how many of these algo strategies would be classified (though there would be other equity market-neutral strategies in that index) shows that these strategies have been struggling in 2015 with flat returns, though returns were positive in 2013 and 2014. The evidence is tantalizing and suggestive, but not conclusive as returns were not exactly stellar in past years.

Don`t panic on an algo unwind!
If I am correct in my hypothesis that these algos are both suppressing equity volatility but require a steadily rising market to achieve returns, then the day of reckoning may be near.

The damage level depends on how crowded the trade is. If the trade isn't very crowded, then we may see a quick ”flash crash”, where these strategies blow up and the market returns to normal within a day or two. On the other hand, if the unwind becomes a ”margin clerk” market that requires a liquidation period of several weeks, then we may see a LTCM or 1987 style crash and snapback.

Should we encounter such market turbulence, my inner investor believes that the best thing to do is nothing. Even if we suffered the the worst case of a 1987 event, the market came back to normal within a few months. On the other hand, those who panicked and blinked got hurt very badly.

* Astute readers will ask why a market-neutral strategy requires market direction to make money. I was the analyst who initiated and wrote the BoAML Hedge Fund Monitor, in which we developed a heuristic to reverse engineer the betas of various hedge fund strategies. We found that despite the name, equity market-neutral strategies were generally not market neutral and took directional beta bets.