Tuesday, April 15, 2014

A thought for Passover and Easter

Last night marked the start of Passover and this weekend marks Easter. I want to step back a little from my usual market commentaries and discuss about other things that matter.

I had written about this before. Margitta Krebs, the conductor of the Debut and Junior Orchestras of the Vancouver Youth Symphony Orchestra is retiring after 29 years. The VYSO has decided to honor her contribution to the organization with a bursary in her name to assist young VYSO musicians in need and we are wrapping up this fundraising campaign in early May.

The VYSO has four orchestras which go from age 8 to 22. I have found that adolescents in these formative years benefit tremendously from hard work, focus and discipline, whether it comes from sports or the kind of musical and orchestral training that comes from the VYSO.

I have had many comments over the years about the quality and uniqueness of my blog post insights. My Passover and Easter thought is to ask my readers to contribute to the Margitta Krebs Bursary in return.

You can find out more about the bursary here and you can contribute directly here. The VYSO is a registered charity and Canadian residents can get a tax receipt for contributions over $20.

On behalf of the young musicians at the VYSO, I thank you for any help that you can give.






Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Monday, April 14, 2014

A case of "risk exhaustion"?

Stock markets have been selling off for a couple of weeks, but there has been no apparent fundamental underpinnings to the decline. While I can point to technical reasons (see my last post Stocks: Short and medium term outlook), satisfactory fundamental explanations have been lacking. That is why we have seen commentary like this one from Matthew Klein with advice to ignore the market and watch the data:
There are also plenty of real economic data, such as tax withholdings, that indicate the economy is getting stronger.

My suggestion: Ignore the fear-mongers, the day-traders and the hysterical wing of the financial news media. Don't make big changes to your portfolio or hoard canned food just because a few expensive tech companies are now a little less expensive. If I'm wrong and we end up repeating 1929, just remember that I would have spent today relaxing on my super-yacht if I really knew what the markets were going to do, instead of writing this post.

A crowded trade in risk
Then I came upon analysis from Citi credit strategist Matt King whose explanation of the sell-off made the most sense to me. In essence, King believes that the market has been living on borrowed time (via Business Insider):


The one on the left shows credit spreads (light blue line) relative to corporate leverage (dark blue). As you can see, credit spreads remain extremely low (meaning corporations don't have to pay much more to borrow than the risk-free rate at which the US government borrows at) while corporate leverage is climbing. This, King worries, is in contravention of historical patterns, and evidence of an economy on borrowed time.

The left chart relates to the stock market and it shows that even though earnings revisions (dark blue) have been generally negative for the last few years, stocks have done quite nicely. Again, to King this represents a break from fundamentals, and he notes that the break in equity market fundamentals coincides with the break in credit fundamentals.
The markets could experience a Wile E. Coyote moment because fixed income investors had gotten overly long risk in a very uncomfortable way:
But with credit investors likewise mostly long and uncomfortable, could what starts as a position correction turn into something much more serious? After all, it’s not just tech where valuations have become disconnected from fundamentals. As our US HY strategist put it after seeing numerous CLO investors this week, “Whatever the asset class, the pattern is the same. Investors are long risk, invested in assets that aren’t their usual holdings, and wondering who is buying their old paper.” Wherever we go, investors think their market is expensive – but are forced to buy it anyway...
 The unwind could get very ugly:
Try a bit harder, and you could paint a bleaker picture still, in which investors may be coming perilously close to realizing that market levels owe everything to central bank stimulus and nothing to an improvement in underlying fundamentals. What if the much heralded “improvement in earnings to match the rerating in the market” fails to be delivered in coming weeks? How long till investors realize that extra stimulus in Japan might stem the Nikkei’s decline, but is unlikely to generate the economic recovery everyone is hoping for, no matter how large its size? And that the problem afflicting China – that the growth rates to which investors have become accustomed are utterly reliant on an unsustainable expansion of credit – is in fact a problem worldwide?
Star bond manager Jeff Gundlach agreed with King's assessment that the junk bond market had gotten very overpriced and he reducing his junk exposure. Indeed, the high yield market have started to roll over against high quality corporate bonds. As well, we have seen a similar kind of risk unwind in equities as the high flying IPOs, biotechs and other momentum stocks crater in the last few weeks.

Could this sell-off be just be a case of "risk exhaustion" by hedge funds and institutional investors? Under the circumstances, the rotation from Growth stocks to Value stocks makes perfect sense.




Correction timing and magnitude
BoAML strategist Michael Hartnett has also observed the de-risking effect, which he calls a  “hard reversal” (via Marketwatch):
January to April: The “hard reversal” period has seen emerging markets, bonds and gold, the losers of last year, become the winners of this year. They’re replacing 2013′s stars — Japan, Nasdaq and the U.S. dollar. But that reversal period ends in April. He cites two reasons:

1. So-called “extreme positions” are being eliminated fast. Since BofA’s last March Fund Managers’ Survey in mid-March, emerging-market equities have outperformed the Nikkei by nearly 1,000 basis points (in dollar terms).

2. Policy makers will turn dovish again. He says watch Nasdaq 4000 [the index closed below that level Friday], $2.20 on the Brazilian real, 66 on the PHLX/KBW Bank Index and 2.5% on the U.S. 10-year Treasury yield. “The biggest risk is that markets lose trust in vacillating Fed, the only policy maker the market truly trusts,” said Hartnett.
He went on to forecast a 10-15% correction in the stock market, but not yet:
September, correction time: Hartnett says bull markets don’t usually end with such high cash and low leverage, and also rarely end with tobacco being the only subsector at an all-time high. Bears looking for that big 10%-15% correction should wait until September and then buy volatility and up cash levels as Fed QE ends and rate-hike expectations grow for the Fed’s Sept.17/Oct. 29th policy meetings.
I agree that a 10-15% correction is in the right ballpark (my own estimate is 10-20%, but it's close enough for government work), but I do not necessarily agree on Hartnett's timing for the downturn.

David Kostin of Goldman Sachs pointed out that the current risk unwind has a lot further to go, if history is any guide (via Business Insider):


In addition, BoAML's ‎Head of Global Technical Strategy MacNeil Curry noted that the stock market has historically not seen a tradable bottom until the VIX rises above 20 (via ZeroHedge):
Since 2012 most tradable market lows have come only after the VIX has pushed north of 20%. It is currently only 17%.

In such an environment, US Treasuries should rally further. Indeed, US 10yr yields have broken below key resistance at 2.608%/2.632%, exposing the long term pivot zone of 2.469%/2.399%. The Japanese ¥ should benefit as well. The 200d in $/¥ is key (100.81) A break below would do significant psychological damage and force out many trend followers.


When I put it all together, the typical midterm election year scenario as outlined by Sam Stovall makes perfect sense and is the more likely outcome:



For now, the US macro fundamental outlook looks fine. In fact, we are seeing some evidence of a weather related growth snap-back from the cold winter. As well, Europe is recovering nicely. So there is no need to panic over falling stock prices.

This may just a case of the markets suffering a case of risk indigestion and exhaustion.






Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Sunday, April 13, 2014

Stocks: Short and medium term outlook

Last week was an ugly week for US equities. Though it wasn't that long ago that the SPX made a new all-time high, major averages fell, led by the NASDAQ and small caps. The decline of the SPX violated the 50 day moving average (dma) and ended the week at the bottom of a support zone.


The carnage was not just isolated in America. European equities, as measured by the STOXX 600, also violated its 50 dma, though its uptrend remains intact.


What's more, downtrending long Treasury bond yields have decisively broken technical support, which is bond price bullish and stock price bearish.



Earnings preseason weak
To add fuel to the bear case, Thomson-Reuters reported that the earnings preseason is coming in on the weak side, though results are very preliminary (emphasis added):
Looking at the companies that report before Alcoa, in the earnings preseason, the news isn’t much better. Only 52% of the companies that have reported so far have exceeded analyst earnings estimates, which is well below average. Historically, when fewer companies than average beat estimates, the trend continues throughout the full earnings season, and vice versa. Although the last two quarters have been exceptions, the current 52% beat rate is the lowest since the Q4 2010 preseason, as seen below in Exhibit 1.
Exhibit 1. SP 500: Earnings Estimate Beat Rates—Preseason and Full Season

They concluded:
First-quarter earnings have gotten off to a slow start. While it is still too early to draw any firm conclusions, history suggests that we may not see the high percentages of companies beating estimates that we have seen over the past several quarters. Although earnings expectations are very low, factors like poor weather throughout the quarter and a promotional retail environment may make it difficult for companies to surprise analysts as they have in the past.

A typical mid-term election year?
My best explanation for the equity market weakness is that this is a typical case of a mid-term election year swoon. Sam Stovall analyzed past market patterns in mid-term election years and found that the May to September period was especially weak. The silver lining is that the end of Q3 and the start of Q4 presents a great buying opportunity if this market follows the historical pattern:
In the second year of a presidential cycle, the average first-quarter gain in the SP 500 has been 1.2%, according to Stovall. This year has been no different; the SP 500 is up about 1.3% for the quarter. The problem is that midterm years during the second year of the presidential cycle tend to have lousy second quarters, with an average drop of 2.5%. The third quarter is somewhat less lousy, averaging a 0.3% decline.


Risk aversion is falling
Market psychology is definitely shifting. In my last post, I had constructed an equity-based risk appetite index and showed that it was rolling over (see Bears 2 Bulls 1):


Other non-equity based measures of risk appetite are showing a similar pattern of decline. Here is the relative performance of US junk bonds against investment grade corporate bonds:


Here is the relative performance of stocks (SPY) against long Treasuries (TLT), which shows a similar picture:


The relative performance of the high-beta small cap Russell 2000 against the SPX has broken relative support:


Groups that should lead the market up if this was a bull phase, such as the broker-dealers, are also turning down. The relative performance chart of the broker-dealer ETF (IAI) to SPY below shows both the breach of a relative uptrend and a breakdown from a relative consolidation range (shown in grey):


I could go on, but you get the idea. When I put all of these observations together, it suggests that we have seen the Spring highs in stocks and the next few months will be difficult for equity investors.


Sell everything ASAP?
Does that mean that you should sell everything right at the open on Monday morning? Not quite. Nothing goes up or down in a straight line and the stock market is getting oversold. Bearish sentiment is getting a little overdone in the short term and stock prices are poised for a counter-trend rally at any time.

As an example, Ryan Detrick wrote, "Our proprietary front month gamma weighted p/c ratio is scared to death." For newbies, the put/call ratio is a contrarian sentiment indicator and excessive put protection buying is contrarian bullish.


I am seeing other indications that the most vulnerable groups could be due for a bounce. As an example, the relative performance of QQQ against SPY shows that the relative decline of the pair is now sitting at about the 50% retracement of the relative up move that began about a year ago. As well, it is showing a positive divergence on the 14 day RSI, which indicates the loss of selling momentum. These are are signs that if the panic selling were to pause and a relief rally were to occur, this would be the ideal spot.


In addition, the poster child for panic selling, the NASDAQ Composite, formed an inverted hammer on Friday just as it tested a major support level at 4000:


The inverted hammer candlestick is a sign of trend reversal, especially if it appears near critical turning point levels, such as technical support.


The Candlestick Trading Forum explains it this way:
The Inverted Hammer is comprised of one candle. It is easily identified by the small body with a shadow at least two times greater than the body. Found at the bottom of a downtrend, this shows evidence that the bulls are stepping in, but the selling is still going on. The color of the small body is not important but the white body has more bullish indications than a black body. A positive day is required the following day to confirm this signal.
Given the events in eastern Ukraine over the weekend, a rally on Monday to confirm the inverted hammer could be a challenge. However, we do have a blood moon eclipse, which could mark the high tide of bearishness, and Turnaround Tuesday to look forward to.

Should the NASDAQ Composite stage a relief rally, an examination of the COMPQ chart shows that the bear case can remain intact even if the index rises to the pictured downtrend line, which is also roughly the level of the 50 dma. The distance from Friday's close to the aforementioned targets at the 4220-4230 level, this represents potential upside of about 5%, which is beyond the threshold of many short-term traders.


Sell on strength
In summary, it appears that the intermediate term trend for stock prices is down. It would not be unusual at all to see a mid-term election year correction of 10-20% on a peak-to-trough basis. After which, equities typically present a great buying opportunity into 2015.

I would caution, however, the market is short-term oversold so don`t be overly eager to get short the high flyers. You could get your face ripped off by a counter-trend rally.

My inner investor is preparing himself to raise some cash on strength and my inner trader is preparing himself to get short this market should prices rise as anticipated.





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Saturday, April 12, 2014

Risk control, not just for investors

I know that I am behind the times sometimes, but take a look at this video. It was made in support of the PR campaign for the remake of the film "Carrie":




As I watched the so-called prank, it occurred to me that the producers should be careful not to stage this stunt in a jurisdiction where there is a "stand your ground" law. Let's just suppose that a so-called weapon carrying patron came upon this scene. Would he feel justified to shoot the actress playing the Carrie-like character, especially if he saw the demonstration that she had unknown psychic powers and he felt that his personally safety was threatened?

When you life in a country where citizens have a constitutional right to bear arms, a little risk control goes a long way. Just remember the motto on the New Hampshire license plate:


Just something to ponder as you read your weekend paper.



Wednesday, April 9, 2014

Bears 2 Bulls 1

After two days of US equity market rally after the bloodbath in the momentum stocks, where are we now?


Market facing technical resistance
Here is my take on the current technical position of the market. As the chart below shows, the SPX bounced off support at 1840 and rallied for two days. However, the rally was on declining volume, which is never a good sign, and the index is approaching a couple of technical resistance levels. One is shown by an uptrend that stretches back to early February; and the other is a well defined resistance zone at the 1874-1884 level.


If you are scoring this at home, chalk one up for the bears.


Risk appetite is rolling over
The recent carnage in the high flying Biotech and Social Media stocks are well-known, but the technical effects of the damage is likely to be long lasting. The chart below shows a composite index that I built based on an equally-weighted long position in the NASDAQ 100 and Russell 2000 (high beta risk-on index) minus an equally weighted short position in the defensive sectors of Consumer Staples, Telecom and Utilities (low beta risk-off index), where the composite Risk Appetite Index is set at 100 on December 31, 2011.


As the chart shows, the Risk Appetite Index has violated an uptrend and has started to roll over. This picture of fading risk appetite forms a negative divergence when compared to the SPX, which remains in an uptrend.

Score another for the bears.


CapEx Index still constructive
I wrote on Sunday that in order for the bull market to continue, we need to see an acceleration in capital expenditures at this part of the cycle and the acid test will come this Earnings Season (see What equity bulls need for the next phase). While it is still very early, the initial report by Alcoa was well received by the market.

My CapEx Index, which is composed of an equal weighted relative return index of the Industrial sector (XLI) and the Morgan Stanley Cyclical Index (CYC) against SPX, remains in an uptrend, which is a constructive signal for the stock market. For now, Mr. Market is giving the cyclical recovery story the benefit of the doubt.


Score one for the bulls.


Game not over
So far, the score is Bears 2 and Bulls 1. The bears have the upper hand, but the game by no means over. In order for the correction to continue, we need to see a combination of further technical deterioration, such as a decisive violation of the 1840 level, a downturn in the CapEx Index or some exogenous event, such as further tensions in eastern Ukraine or heightened fears of a China crash.

The bulls, on the other hand, need to sidestep these risks and convince the market that a cyclical acceleration of growth is indeed at hand. Their cause could be helped by further dovish pronouncements from the Federal Reserve or news of a decisive stimulus program out of Beijing.






Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Monday, April 7, 2014

A quant lesson from a technician

J. C. Parets of All Star Charts wrote a summary of the events at the MTA Symposium last week. One quote from Jeff DeGraaf caught my eye as the comments pertained not only to technical analysis, but quantitative analysis:
When talking about the difference between trend following and mean reverters, DeGraaf says that trend following works. Mean reversion is extremely difficult for career longevity. With respect to indicators, you can’t look at the whole picture as one environment. Because it’s not one environment, you have uptrends and downtrends, bull markets and bear markets. So DeGraaf uses a quantitative model to define which “regime” the market is in within a trend – bull or bear trend. Then based on which regime we’re in, he adjusts how he uses certain indicators. He says that making these adjustments depending on uptrend and downtrends improves results. Ned Davis likes to use the relative strength in Financials as an indicator for the US Stock Market. DeGraaf actually said that he feels the relative strength in the Industrial sector is even more important than the Financials relative strength. I thought that was interesting. DeGraaf also talked about how not every indicator needs to give buy and sell signals. A lot of the indicators we look at can simply help to add and remove conviction which helps with position sizing and hedging strategies. That was an awesome point that I rarely hear mentioned. A good indicator he likes is the IPO Index vs the S&P500 to get a food feel fro the underlying credit environment.
I have been following DeGraff`s work since the 1990`s and I have a great deal of respect for him as a market analyst. We were briefly competitors for a time. He was at Lehman and I was working at Merrill. Let me annotate his MTA comments for you as it pertains to how investors and quantitative analysts should approach market analysis. First:
DeGraaf says that trend following works. Mean reversion is extremely difficult for career longevity. 
Trend following is mostly growth and momentum investing. That`s why people like to hear the hot stories and jump on them. Classic mean reversion is contrarian and value investing. That's why value can be difficult from a personal psychology viewpoint. True contrarianism is hard and often you are alone in your beliefs.

On modeling:
With respect to indicators, you can’t look at the whole picture as one environment. Because it’s not one environment, you have uptrends and downtrends, bull markets and bear markets. So DeGraaf uses a quantitative model to define which “regime” the market is in within a trend – bull or bear trend. Then based on which regime we’re in, he adjusts how he uses certain indicators. 

No quant model for all seasons
During the course of my career, I have seen many quantitative analysts try to make a model for all seasons. Most failures occur because of regime shifts. When DeGraaf talks about changes in environment, he refers to market direction, but there are other kinds of regime shifts that happen that affect the way alpha is generated.

Let me explain what I mean: Value works. Growth works. Momentum works. Quality works. They just don`t all work at the same time. A combination of these factors work most of the time, but there are times when a single factor is dominant.

For instance, the Tech Bubble of the late 1990`s was dominated by momentum investing, It wasn`t just growth investing, because momentum stocks had zero or negative earnings so growth factors did not fully capture the performance effect. In effect, the more junky the concept stock, the more it went up.

Another example of a single-factor regime occurs when an economy comes out of a recession. When that happens, the shares of the nearly bankrupt companies that made it through the downturn rocket upwards. In the 1982 bottom, shares of Chrysler bottomed at 1 7-8 and rose to over 30 about a year later. In the 1990 bear market, shares of Magna International, the auto parts manufacturer, bottomed  below 2 and then shot up to over 80. I dubbed it the Phoenix Effect. DeGraaf showed that the one single factor that worked best in the 2003 stock market was low stock price as the lowest decile of stock price beat the top decile by some astounding amount (I don`t have the exact figure but I recall it was in the order of 80%). It was a factor that I will bet no quantitative analyst had in his factor set.

These are just a couple of examples when most fundamentally driven investment managers who focus on well run companies with good cash flows and good business underperform badly. Were the markets irrational or stupid, or was it a regime shift that the manager missed?


Barriers to entry to quant investing are falling
Over time, I have seen the barriers to entry to quantitative analysis fall. When I joined Batterymarch in the early 1990`s, it was difficult for an investment manager to become a quant. You could buy subscriptions to some of the databases, but the task of integrating databases, e.g. fundamental Compustat data, with their quarterly and annual data series, weekly IBES estimate data, and daily price data, as well as resolving company identifiers with stock ticker identifiers, since some companies had dual class shares, was a gargantuan task. You had to have an entire IT and data team to scrub and manage the databases and put them into a usable format. During the 10 year tenure at Batterymarch, we went through at least three different research platforms - just imagine the development costs!

When I joined a hedge fund in 2001, I was able to recreate the same research platform and subscriptions for roughly 250K a year - and that was using a premium data service. Today, I can get 80% of the functionality using data from free sources like Google and Yahoo.

Today, most quants are all looking at the same data. US quants all use Compustat for fundamental modeling, First Call, IBES, or Bloomberg for their analyst estimate revision models and so on. We saw how crowded the quant trade was in August 2007 when equity quant funds melted down (see Are quants victims of their own success?). Here is a difficult question for the management of quant investment firms: If the barriers to entry have fallen so far and you are all looking at the same data, where is the alpha going to come from?

I believe that one source of alpha comes from integrating top-down modeling to bottom-up stock picking techniques. You have to be able to recognize the regime shifts and deploy the right combination of models out of your toolkit accordingly. In other words, you have to learn to be a market savvy strategist - because good quant techniques aren`t going to cut it anymore.

Call it what you will - factor rotation, top-down modeling, etc. The bottom line is, quants have to learn to be more intuitive about how they model.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Sunday, April 6, 2014

What the equity bull need for the next phase

In a recent post, Carl Swenlin calculated the trailing GAAP P/E ratios of the SP 500. He used on a simple rule of thumb that the market is undervalued at a P/E of 10 and overvalued at 20. Based on that simple metric, he declared that the market is vulnerable to a pullback because valuations are nearing the top end of the historical range of a P/E ratio of 20, which would amount to a SPX level of about 2000.


Does that mean that stock prices are about to roll over and play dead? Not necessarily. What the bull market needs to keep going is the E in the P/E ratio to expand. The US is in the mid-cycle of an expansion and what typically happens mid-cycle is an acceleration in capital expenditures. Josh Brown eloquently summarized this point of view in a TV interview here.

To put Brown's comments into my own words, the economic doctors at the Fed have decided that the patient is stable and ready for the gradual withdrawal of the heavy cocktail of stimulus drugs being pumped into his system. Soon, he will be recovered enough to start walking on his own. One of the key signs of a true recovery is sufficient business confidence to start investing more into their own operations.

That's why, this Earnings Season, I will be carefully monitoring the tone of the guidance from capital goods giants such as GE, Caterpillar and so on.


Waiting for Godot?
Unfortunately, waiting for the capex cycle to revive itself during this economic recovery has been like watching Waiting for Godot. Larry Fink recently complained about the lack of capital expenditures among American companies:
Laurence Fink, chief executive officer of Blackrock Inc., the world’s largest money manager with more than $4 trillion in assets, recently issued a warning to U.S. companies: Stop focusing on short-term returns at the expense of longer-term investments.

“It concerns us that, in the wake of the financial crisis, many companies have shied away from investing in the future growth of their companies. Too many companies have cut capital expenditure and even increased debt to boost dividends and increase share buybacks.”
Fink complained that companies were overly focused spending cash on buybacks and dividends rather than investing in their own businesses:
Companies only have a finite amount of cash to invest. Whatever gets spent on buybacks and dividends is that much less available to be spent on investments in employees, research and development, and capital expenditure. It's basic arithmetic.

When will the next round of capital investment begin in earnest? As soon as you figure out the answer to that question, you will have gained significant insight into the direction of the economy as well as the next phase of this stock-market rally.
The following chart (via Business Insider) of capex by sector provides some perspective to the puzzle and also raises some interesting questions.


So far, the heavy lifting in capital expenditures in this cycle has come from the Energy sector, which makes sense given the level of spending on the shale oil and gas plays in the US. Depletion rates in tight oil and gas formations are horrendously high so companies have to keep spending in order to maintain production levels (see this analysis from James Hamilton). By contrast, the share of capex investments by the Consumer Discretionary sector has dropped by roughly half compared to the heady days of 2006-2007, the top of the last cycle. Moreover, the capex share of other sectors, such as Financials, Consumer Staples and Industrials have declined as well.

The key question is, "Why?" Unfortunately, the answer to this question is way above my pay grade (see my previous discussion He who solves this puzzle shall be king),


Capex bulls roam the Street
Cardiff Garcia of FT Alphaville pointed out that the Street remains optimistic that an upturn in capital expenditures is just around the corner. RBC noted that the corporate intentions are supportive of an upturn in investment spending:


Goldman's top-down macro indicators are also suggestive of rising capex:


What's more, credit conditions are relatively easy and therefore debt financing is available if corporations are willing to invest:



Andrew Lapthorne: Capex bear
While most of the Street remains sanguine about an upturn in capex, the biggest bear has been Andrew Lapthorne of Societe Generale. His principal contention is that there has been little growth in cash flow to support a corporate investment revival. He looked at different measures of earnings and cash flow growth in 2013 and found that most measures showed low levels of growth:


Lapthorne pointed out that Y/Y net income growth was distorted by write-downs in previous periods (via Business Insider):
"Looking behind these headline numbers we see that the biggest increase in reported net income in 2013 came from Hewlett Packard," noted Lapthorne. "This improvement was courtesy of the large 2012 $19bn goodwill write-down (from the EDS and Autonomy acquisitions) dropping out of the 2013 figures. Indeed if we compare the biggest positive contributors to reported net income the list is very much different to the pro-forma net income figures. The top 10 biggest positive net income contributions are dominated by companies affected by write-downs in 2012."
He concluded that cash flows may not be supportive of a capex expansion in the near term:


Indeed, the results of a recently published Deloitte survey of CFOs confirmed Lapthorne's contention that reduced growth expectations may serve to restrain corporate investment. As the chart below shows, CFOs' earnings growth expectations have been on a gentle downward incline since Q1 2013.


The other key highlight of the Deloitte survey contradicts the results of the investment intentions survey cited by RBC above (emphasis added):
Capital-investment expectations held nearly steady from the prior quarter at a 6.5% gain, but were below year-earlier levels. Sales expectations for the next 12 months did advance to 4.6% in the first-quarter survey, from 4.1% the prior quarter.
In addition, analysis from Brian Belski of BMO (via Marketwatch) shows that the Consumer Discretionary sector showed a high level of negative guidance, which creates capex headwinds for a sector that has lagged its historical pace of corporate investment. As well, capital goods sensitive market segments such as Industrials and Technology were the next two sectors that showed the highest levels of downward guidance.



What does Mr. Market think?
While these bull and bear arguments are interesting, but what does the market think? I am watching the market expectations of two key characteristics of a mid-cycle expansion, namely the acceleration in inflationary pressures, which the Fed is carefully watching, and capex acceleration.

On the first score, Mr. Market is signaling asset inflation. The relative performance of the inflation-sensitive Energy sector is starting to turn up:


As well, the relative performance of Materials is constructive as it shows a relative breakout after period of relative consolidation:



One of the key charts that I am watching for that Mr. Market is signaling a capex upturn is the relative performance of the capital goods heavy Industrial sector (XLI). As the chart below shows, the picture is mixed. Industrial stocks had been in a relative uptrend against the market since last May. The relative uptrend was broken in early February and the sector has since been consolidating sideways, which indicates a lack of capex acceleration.


A broader, though slightly less capital goods intensive, indicator to watch is the relative performance of the Morgan Stanley Cyclical Index (CYC). The chart below of CYC shows that cyclical stocks remain in a relative uptrend against the market. Though there were some minor violations of the trendline, the new relative high exhibited by the index last week can be said to negate the trend violation.



At a crossroad
Today, US equities stand at a crossroad. On one hand, technical indicators are showing signs of froth (see The Chanos Sotheby's Indicator flashes a warning) and risk appetite is starting to roll over, as evidenced by the carnage in the high flying Biotechs and NASDAQ favorites such as Netflix, Tesla, as well as small cap Russell 2000 (also see my previous comment It IS about the risk premium!). On the other hand, top-down fundamental macro indicators are turning to a capex revival (notwithstanding Andrew Lapthorne's objections). What's more, Mr. Market's expectations are similar to those of the Street's capex bulls.

Who will win this argument?

I am not sure. That is why it is important to closely monitor the tone of the capital goods companies' upcoming earnings reports. Either capex intentions live up to expectations and the bull market continues to charge ahead to further new highs, or we see disappointment. In that case, the relative performance of XLI and CYC would roll over - which will be a signal that the bears have taken charge of the tape.





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Saturday, April 5, 2014

The Chanos Sotheby's Indicator flashes a warning

Last week, hedge fund manager Jim Chanos appeared on CNBC and pointed to the price action of Sotheby's as a warning of an overheated market (emphasis added):
Closely watched hedge fund manager Jim Chanos says he has the best barometer for gauging where 1 percenters are putting their money, given the Federal Reserve's easy money policies that have been fueling their portfolios to record highs. During an interview Thursday on CNBC's "Squawk Box," he pointed to the stock chart of Sotheby's.

"That's what people are buying," Chanos said.

The chart shows that shares of Sotheby's have peaked before every major financial bubble since 1987, starting with the leveraged-buyout spree that fueled the stock market before the Black Monday crash that year.


As the price of Sotheby's (BID) appeared to have peaked, Chanos' comment was an intriguing observation. But how good is this Sotheby's Indicator? Just for fun, I charted the BID against SPX. True enough, BID (in purple below) generally peaked out before the stock market (in black) did, but the lags were uncertain. While BID appears to be rolling over now, the mildness of the pullback of BID may not necessarily constitute a definitive sell signal for the equity market.


As an alternative, the BID/SPX ratio worked well in the post-NASDAQ peak period as timing indicator. As well, the decline from the most recent peak is more pronounced. However, the ratio was in decline for much of the late 1990`s during the Tech Bubble and thus made it a poor standalone market timing model.


I did find a better fit by de-trending  the BID/SPX ratio by comparing it to its own 1 year moving average. As the chart below shows (SPX in black, left scale, de-trended BID/SPX ratio in blue, right scale), whenever the BID/SPX ratio was above its long-term moving average and then fell below its 1 year moving average, it usually marked a significant top in the stock market.

(click chart to enlarge)

In the chart, the dates of the BID/SPX ratio peaks are shown in red while the dates of the subsequent SPX peaks are shown in black. Peaks in the de-trended BID/SPX ratio led the actual market peak by between 0 months (1990) to 11 months (2000).

What about Chano's warning on CNBC last week?

My modified Sotheby's Indicator peaked out in October 2013, though the highs it reached was not as high as levels seen in previous significant market peaks. However, the chart shows that this indicator is not very useful as a tactical timing model as the lags between the peaks in the Sotheby's Indicator are uncertain. Nevertheless, it does provide a warning of the investment environment.





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Thursday, April 3, 2014

It IS about the risk premium!

A little over a month after the then Fed chair Ben Bernanke dropped hints about Fed tapering of its QE program I wrote that the likely effect of Fed tapering would be a compression in risk premium (see It's the risk premium, stupid!). That's because the initial purpose of QE was to encourage risk taking:
The message from the Fed was: "We want you take take more risk." Greater risk taking meant that businesses would expand, buy more equipment, hire workers, etc. It hoped to spark a virtuous cycle of more sales, more consumer spending and to revive the moribund real estate market. Moreover, banks could repair their balance sheets with the cheap capital.
Fast forward to May 22, 2013. When the Fed signaled that it was going to considering tapering off its QE purchases, risk-taking effects would be reversed (emphasis added):
In effect, the Fed threw several giant parties. Now it is telling the guests, "If things go as we expect, Last Call will be some time late this year."

Imagine that you are the bank in the earlier example which bought risk by borrowing short and lending long, or lending to lower credits in order to repair your balance sheet. When the Fed Chair tells you, "Last Call late this year", do you stick around for Last Call in order to make the last penny? No! The prudent course of action is to unwind your risk-on positions now. We are seeing the start of a new market regime as risk gets re-priced.

That's the message many analysts missed. The Fed is signaling that risk premiums are not going to get compressed any further. It will now be up to the markets to find the right level for risk premiums.
I got a lot of push-back from that post. The general feeling, especially after the first round of Market Taperitis, that the effects of tapering had largely been discounted. Yet much of the de-risking had occurred in emerging market economies and the initial shock of even the prospect of QE tapering nearly caused an EM currency crisis.


IMF: Tapering did matter to EM
Now new research from the IMF appeared to have vindicated my analysis. While there was a view that the EM currency crisis was idiosyncratic and rapid currency outflows are largely the product of local government and central bank policy, the new work from the IMF indicates that global portfolio flows can overwhelm local country effects (emphasis added):
We find that the structures of both the investor base and local financial systems matter. The new mix of global portfolio investors is likely to make overall portfolio flows more sensitive to global financial conditions. The share of more volatile bond flows has risen, and larger foreign participation in local markets can transmit new instability. Growing investment from institutional investors that are generally more stable during normal times is welcome, but these investors can pull back more strongly and persistently when facing an extreme shock. While domestic macroeconomic conditions matter, investor herding among global funds continues, and there are few signs of increasing differentiation along macroeconomic fundamentals during crises over the past 15 years. Nonetheless, the progress made by emerging markets toward strengthening their financial systems reduces their financial asset prices’ sensitivity to global financial shocks.
A recent FT article commented on the IMF study and highlighted the effects of hot money on EM economies (especially when individual investors were chasing yield in the current low interest rate environment):
One reason for this new vulnerability is the rapid growth of emerging market bonds flows – especially from retail investors. The IMF found that bond mutual funds typically used by retail investors are far more sensitive to global sentiment than institutional bond investors such as pension, insurance or sovereign wealth funds. Moreover, bond mutual funds are twice as sensitive as equity mutual funds.
When investors decide to de-risk in the face of the prospect of Fed tapering, there was a rush for the exits:
One way of interpreting the IMF’s results is that global capital markets have become too big for many emerging markets. When capital is pulled out by fund managers there are insufficient local buyers to step in. Turbulence inevitably ensues.

As such, the IMF’s research helps us understand the dynamics at play as the Fed tapers and moves towards eventual interest rate increases.

At last August’s Jackson Hole, Wyoming, summit of central bankers, Hélène Rey, a professor of economics at London Business School, presented a paper identifying how the Fed drives a common global financial cycle influenced by investors’ risk appetites that often renders impotent actions by national authorities. The crucial role played by bond funds identified by the IMF helps explain those linkages.
So, yes, the EM sell-off was triggered by the anticipation of Fed tapering, which led to a compression in risk premium.


What is happening to risk premiums now?
Now that the Fed is well into its tapering program, whose schedule is well anticipated, what does that mean for the price of risk?

I can offer good news and bad news. The good news is, barring some external event such as a financial blow-up in China, the risk premium shrinkage in the emerging markets appears to be largely over. I had been monitoring the relative performance of the EM bond ETF (EMB) against US junk bond ETF (HYG) as a measure of risk appetite for EM bonds in the junk bond (EM) vs. junk bond (US) space. As the chart below shows, the relative performance of EMB has stabilized against HYG and has started to recover a little.


Similarly, the EM currency ETF (CEW) displayed a similar bottoming pattern of a rally out of a downtrend:


Now for the bad news. Risk aversion has moved on from EM bonds and equities to other markets. As an example, the chart below of the relative performance of US junk bonds (HYG) against corporate debt (LQD) shows the formation of a broad top. HYG broke down from a relative uptrend against LQD and started to trade sideways. Such consolidations are often preludes to a rollover in risk appetite.


Other signs, such as the recent carnage in the high flying biotech and internet stocks are part of typical topping patterns in overall risk appetite. While breadth indicators, such as the Advance-Decline Line remains healthy as it has confirmed the new SPX highs by making new highs of its own, which indicates that further new highs in the major US market averages are possible, the decline in risk aversion has to be regarded as a cautionary signal for stock investors.


Unless we start to see blowout macro data, such as the upcoming jobs report, or Earning Season brings such surprising good news as to boost the earnings growth outlook, investors may wish to think about selling in May and to go away.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Tuesday, April 1, 2014

In praise of clear thinking over blind modeling

I have been a long advocate of clear thinking over blind obsessions over modeling techniques (see my last post Being forced to think for yourself...priceless).


Friedman vs. Yellen
Consider the difference between the approaches taken by the late Milton Friedman and the current Fed chair Janet Yellen. Friedman used to quip that the Fed could be replaced by a computer. Monetary policy could be set using a simple formula of targeting money supply growth. His concept was based on the equation:
PQ = MV

Where
P = Price
Q = Quantity
M = Money supply
V = Monetary velocity
In other words, you could control the rate of growth in the economy by controlling the money supply, since monetary velocity is constant over the long-run.

Good quants know that all models have limitations. As we found out during the Great Recession, velocity plunged despite the best efforts of central bankers to raise the monetary base. Even though money supply grew at what might have been thought as an alarming rate during normal times, growth was anemic or nonexistent as velocity plunged. The moral of this story: All models have limits, or worse, they can be gamed.


Yellen: Multi-factor modeler
By contrast, consider Janet Yellen's latest speech to the National Intragency Community Reinvestment Conference. Instead of relying on any single rule, e.g. Evans Rule or some other variation of the Rule, she used a far more nuanced approach to analyze the economy. Firstly, she considers the number of part time workers who would like a full time job as one measure of the degree of slack in the economy:
For example, the seven million people who are working part time but would like a full-time job. This number is much larger than we would expect at 6.7 percent unemployment, based on past experience, and the existence of such a large pool of "partly unemployed" workers is a sign that labor conditions are worse than indicated by the unemployment rate. Statistics on job turnover also point to considerable slack in the labor market. 
 Yellen then went on to point to the lack of wage pressure as another indication of economic slack:
A second form of evidence for slack is that the decline in unemployment has not helped raise wages for workers as in past recoveries. Workers in a slack market have little leverage to demand raises. Labor compensation has increased an average of only a little more than 2 percent per year since the recession, which is very low by historical standards.
She also referred to the plight of the long-term unemployed worker and noted that they appeared to be not very different from everyone else. Since the long-term unemployed find it very difficult to find a job, they could create real headwinds for the growth outlook:
A third form of evidence related to slack concerns the characteristics of the extraordinarily large share of the unemployed who have been out of work for six months or more. These workers find it exceptionally hard to find steady, regular work, and they appear to be at a severe competitive disadvantage when trying to find a job. The concern is that the long-term unemployed may remain on the sidelines, ultimately dropping out of the workforce. But the data suggest that the long-term unemployed look basically the same as other unemployed people in terms of their occupations, educational attainment, and other characteristics. And, although they find jobs with lower frequency than the short-term jobless do, the rate at which job seekers are finding jobs has only marginally improved for both groups. That is, we have not yet seen clear indications that the short-term unemployed are finding it increasingly easier to find work relative to the long-term unemployed. This fact gives me hope that a significant share of the long-term unemployed will ultimately benefit from a stronger labor market.
Finally, she highlighted how the falling participation rate skewing the unemployment rate, which could render the Evans Rule ineffective:
A final piece of evidence of slack in the labor market has been the behavior of the participation rate–the proportion of working-age adults that hold or are seeking jobs. Participation falls in a slack job market when people who want a job give up trying to find one. When the recession began, 66 percent of the working-age population was part of the labor force. Participation dropped, as it normally does in a recession, but then kept dropping in the recovery. It now stands at 63 percent, the same level as in 1978, when a much smaller share of women were in the workforce. Lower participation could mean that the 6.7 percent unemployment rate is overstating the progress in the labor market.
Past Fed chairs might have used such a venue to deliver an academically oriented speech, but not Janet Yellen. Notwithstanding the perceived dovish tone of the speech, this Fed chair demonstrated that she goes beyond the academic application of rules and models and uses a multi-factor approach in a thinking way to the conduct of monetary policy.


The regulator play whack-a-mole
The problem of model weakness creates a dilemma for regulators in applying standards, such as the EBA's stress tests or Basel standards for banking. On one hand, there is an urge to appear evenhanded by applying a one-size-fits-all approach to regulation. On the other hand, the banking industry is filled with people whose jobs is to get around rules and to game existing regulations.

As an example, I can understand the intent of the Volcker Rule is to minimize the risks taken by investment banks in a TBTF banking structure. However, its implementation has spawned a devil-is-in-the-details nightmare of rules upon rules as regulators play a game of whack-a-mole with bankers. Instead, a simpler approach might be to try and get at the heart of the problem by properly aligning incentives with risk taking. Bring back the partnership investment bank. If they want to lever up the balance to 40 to 1 and take risks, let them! If they fail, it will be the personal net worth of the investment banking partners on the line.


A multi-factor approach to regulation
In other cases, where it is difficult or impossible to get at the heart of the problem, a multi-factor approach of incentive alignment or characteristics measurement may be warranted, much in the spirit of what Yellen used to model the degree of slack in the economy.

For instance, I was talking to a friend about the problems that Vancouver faced with foreign property buyers. Vancouver, like London, which has become the preferred locale for billionaires, has seen an influx of foreign buyers drive up property prices to such an extent that puts housing ownership for many local residents. One American parallel that I am familiar with is the Hamptons - local residents cannot afford to live there as wealthy buyers from New York City have driven prices to stratospheric levels.

In my discussion, one proposal  on the table is to tax non-resident property owners at a higher rate than residents. Notwithstanding the debate on the merit of such a proposal, the implementation of such a scheme is highly problematical as most regulations can be easy to game. After all, there is an army of tax lawyers, accountants and other consultants whose job it is to try and get around these rules.

In such a case, one approach might be to employ a multi-factor approach to the problem in defining the activity that the regulator is trying to incentivize and dis-incentivize. Supposing that the intent of the regulations is to encourage owner-occupancy of single family housing and condominiums. One way to implement such a regulatory regime is to set the default property tax rate at a very high level. If the normal property tax rate is 1% of the property value per annum, set it higher at, say, 5% or 10%. Then create a system which grants owner-occupiers of the property tax credits for engaging in owner-occupier like activities. The taxpayer could accumulate tax credit points based on activities such as:
  • Having one or more children at the local school, whether private or public;
  • Showing utility bills over a certain amount which shows that the house is occupied and not vacant; and
  • Showing that you voted in the last municipal, provincial or federal election.
Accumulate enough points and your property tax bill goes back down to the normal rate for resident. Otherwise, you pay the non-resident rate.

Understand that I am not necessarily endorsing the philosophical approach underlying this tax proposal as the topic is up for debate. The proposal is also incomplete as it ignores the taxation treatment of rental housing stock. Regardless, I engaged in this exercise as an illustration of how to use a multi-factor modeling techniques to achieve a regulatory aim. As well, the factors should be relatively uncorrelated to each other, otherwise you wind up with a confusing mishmash of rules. Too often, regulators approach the problem from a legal framework and spend too much time obsessing over the details of a model or a regulatory regime while glossing over the intent of the regulations. That`s when you get rules piled on top of rules, much like the tax code.

When clear thinking triumphs over blind modeling and rule application, we all win.


Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Financial planning challenges in an unequal society

The topic of inequality has been a hot topic lately, I have been writing off and on about its effects for some time. There is no question that inequality has been growing for the last few decades in the United States. The debate is over whether the economic and social policies surrounding this change. Here is an informative if somewhat wonkish chart from Chart Book of Economic Inequality:


In Thomas Piketty's latest book, his thesis explaining inequality can be summarized as:
Whenever the rate of return on capital is significantly and durably higher than the growth rate of the economy, it is all but inevitable that inheritance (of fortunes accumulated in the past) predominates over saving (wealth accumulated in the present).... Wealth originating in the past automatically grows more rapidly, even without labour, than wealth stemming from work, which can be saved.
Today, we seem to be seeing those kinds of conditions. The returns to capital are durably higher than the returns to labor and they are "durably higher" than the economy's growth rate. It's no wonder inequality has grown.


The Downton Abbey asset management challenge
Regardless, this presents a whole new set of challenges for those working in the wealth management business. The New York Times had an interesting article about the intersection of growing inequality, Baby Boomer demographics and inheritances:
Rich families today are holding onto a big piece of the pie. The top 1 percent of households owns about 35 percent of American wealth, more than the entire bottom 90 percent does. But at least at the moment, growing inequality has not resulted in a big boom in inheritances. Since the 1980s, the value of inherited wealth has only drifted upward slightly. In fact, wealth transfers as a proportion of net worth have fallen, to 19 percent in 2007 from 29 percent in 1989.

But the baby boomers are only now retiring. Once that process accelerates and reaches its inevitable conclusion, get ready for a flood of princelings — and some potentially worrisome consequences for social mobility in the United States, as the immense earnings of an already stratified economy are entrusted to a new generation. The inheritance boom will come, eventually. What’s unclear is what the country will look like afterward.
The money will go to the children of Boomers, otherwise known as Generation X and Generation Y:
That money will flow into the bank accounts of the by-then-over-the-hill members of Generation X and Generation Y, and the United States might look a little more like aristocratic Europe, with its Downton Abbeys and super-hyphenated names — maybe with a few more tattoos. Lists like the Forbes 400 might be filled less with financiers and technology entrepreneurs and more with third-generation Waltons and second-generation Zuckerbergs and Bezoses or, perhaps, first-generation Walton-Zuckerberg von Bezoses.

Running a dynasty vs. retirement planning
This expected transfer of wealth presents a challenge for people who are in the wealth management business. Much of the discussion in the current low interest rate environment revolves around the right withdrawal rate from savings for retirees. For the super-wealthy, the withdrawal rate question is not relevant - and therefore financial planners and wealth managers need to deal with a paradigm shift in their business.

The current underlying model for retirement planning goes something like this. When you are young, you save for retirement, aided by tax-deferred vehicles like 401ks, IRAs, etc. When you cannot work anymore and retire, you draw down on those savings to fund your living expenses. Upon death, those savings are exhausted or nearly exhausted and the residual goes to the heirs.

While that model of retirement remains relevant for the mass affluent market, it's less relevant for the super-wealthy. This demographic will not need to draw down their savings to retire. The income generated by their wealth far outstrips their spending needs. After all, if you have $100 million, does it matter that much if your withdrawal rate is 2% or 4%? How much could you possibly spend? For this group, their savings will outlive them and the financial planning framework shifts from "will I outlive my savings" to "how do I maintain my wealth for my heirs after I die" . In other words, how do I sustain my dynasty?

If you are a financial planner and wealth manager, you have to be aware of these trends. America has been getting more unequal and the wealth distribution is getting more skewed. If you get caught with a business model that caters the to common man by on the idea that the American Dream is still relevant, then be aware that the size of your market is stagnant or shrinking. The growth market is serving the super-wealthy, which presents its own sets of challenges, massive changes in the infrastructure of your services and business model.

The NY Times article indicated that these clients often focused on philanthropy, so you need to have the financial planning infrastructure to service those needs.
For one, the wealthy tend to give away a big chunk of their money, leaving less for their heirs, Wolff says. Bill Gates, Warren Buffett, Mark Zuckerberg and many others, for instance, have signed onto the “giving pledge,” promising the bulk of their estates to charity.
For clients who look to maintain wealth in a dynastic framework, then the financial planning challenge shifts from attracting 401k and IRA savings to sustaining wealth for generations in a tax efficient fashion. Do you have the legal and tax planning resources to do that? Do you have the resources to diversify into other asset classes, such real estate development and management, for clients with such long time horizons? No longer are you dealing with the plain vanilla bonds and equity asset classes for the mass affluent market.

This Reuters article offers the example of one firm that is re-orienting itself towards new business model:
Baltimore financial adviser Lyle Benson describes his work as that of "Personal CFO" or chief financial officer.

His boutique financial planning firm manages money, but it also does everything from bill paying to estate planning, even assisting clients' adult children negotiate terms for their first automobile purchase or mortgage.

"We coordinate and work with all of our clients' advisers" including attorneys, accountants and insurance agents, says Benson. "We make sure everyone is on the same page and working together."

The services necessary to quarterback a client's complete financial life, often referred to as family office services, are not just for the ultra-rich. Benson says anyone with investable assets of more than $2 million can benefit from such comprehensive oversight. At his firm, those services are used by more than 30 percent of clients.
However, advisors should be aware of the business challenges of chasing after such accounts. A separate Reuters article outlines the issues and it is well worth reading in its entirety:
High-net-worth clients, especially those with $30 million or more, are different from garden-variety millionaires. They do not sweat the small stuff, like planning for their kids' education or retiring comfortably, so they do not value basic financial planning services as much as less-affluent clients.
Very wealthy clients often expect investment services and products beyond those offered by smaller wealth managers. They may require income- and estate-tax strategies that are more complex than the adviser can deliver.
This mismatch of client expectations and adviser services can actually hurt a wealth management practice that is not set up to manage all that money.

Regardless, the super-wealthy is an enormous growth market in an unequal America. The size of the market is exemplified by the CNBC report that American billionaires gained nearly $1 trillion in the bull market. The private banking divisions of a number of get it, even though the term "dynasty" is distinctly un-American and is far more reminiscent of Old Europe, it is a growth business that deserves to be addressed.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.