Tuesday, April 22, 2014

"Did you expect GOOG to trade at a PE of 10?" & other "smart beta" and factor investing questions

This is another of an occasional series on how good quantitative investors use both the left and right brains to create robust investment processes. Elisabeth Kashner at ETF.com wrote an intriguing series of blog posts about smart beta and factor funds. In Part 1, she showed that the idea of "smart beta" is mostly a marketing concept, where commonly used "dumb beta" ETFs have "smart beta" features:
Many of our favorite “dumb” funds, it turns out, have smart-beta features.
  • The SPDR SP 500 ETF (SPY | A-98) and the iShares Core SP 500 (IVV | A-98) both share an index that screens components for profitability, just like the index underlying the FlexShares Quality Dividend ETF (QDF | A-78) does.
  • The PowerShares QQQ (QQQ | A-53) has a tier of equally weighted securities, partially mimicking RSP, thus giving it a smart-beta tilt to small-cap stocks.
  • The iShares Russell 2000 ETF (IWM | A-82) accesses the small-cap premium—that’s factor investing.
  • The iShares Russell 1000 Growth (IWF | A-89) has momentum exposure—that’s also factor investing.
The surprises go the other way, too—“smart funds” have some pedestrian features. VIG, the smartest-seeming of the top 10 above, is cap-weighted. So, what happened to alternative weighting as a hallmark of smart beta?
In Part 4, she went on to discuss the idea of "factor exposure":
Designer funds promote the smart-beta label. However, branding all funds with factor exposure as smart beta will start arguments. In terms of our ground rules, sorting ETFs by factor exposure produces results that are not widely acceptable to the ETF community.
If factor exposure defines smart beta, then all funds with factor exposure must be smart beta. As you will soon see, most funds have some kind of factor exposure.

Factor vs. smart beta investing
For non-quants, a factor is a way of ranking stocks. One simple example of a factor might be P/E, ranked from low to high. Kashner went on to demonstrate different flavors of value ETFs as way of illustrating the factor investing idea. She demonstrates that there is really little difference between "smart beta" and factor investing:
Look carefully at the table below. Which better captures the value premium: VLUE or IWD?

IWD beats VLUE with the lower P/B—the classic value metric. IWD also has the higher dividend yield. VLUE sports the lower P/E ratio. VLUE’s correlation with IWD is 0.98, with a .99 beta. The two are largely indistinguishable, but if I had to pick a value fund, I’d go with IWD.

Security selection can produce powerful portfolio tilts, just as weighting can, because any security not in a portfolio has a weight of zero percent.

If VLUE is a factor fund, then IWD is a factor fund.

Pitfalls of smart beta and factor investing
If "smart beta" is really another way of packaging active, or semi-active, factor investing, then you have to understand the pitfalls of the factor investing approach. The one valuable lesson I learned as a quantitative investor is that not all factors do not necessarily work well across sectors and industries.

BARRA taught us that one of the ways of determining the sources of equity risk is industry exposure. If a portfolio tilts away from the market index (however you want to define it) with different industry exposures, then that portfolio has an active bet, or exposure. The above examples of value ETFs, they have differing industry bets that form part of their active exposure. If it is marketed as a passive or semi-passive portfolio, then the investor has to make a decision of whether those more or less permanent industry bets make sense as a way of creating alpha.

One drawback of naive factor investing is that practitioners are overly analytical but have not subjected their ideas to practical sanity checks. For instance, some studies have shown that portfolio of stocks weighted by sales, rather than capitalization, have yielded better risk-adjusted returns. If you were to naively weight a portfolio of stocks by their sales, then you would tilt the portfolio towards companies with high sales and low margins. Do you want to necessarily bet that low-margin businesses, such as grocery chain stores, will outperform in the long-run?

Even if you were to engage in industry-neutral factor investing by neutralize the industry bets by setting the same industry exposure in the portfolio as the market portfolio, factors do not necessarily behave the same way across all industries. Let us suppose that you were to screen for low-PE stocks and overweight them in your portfolio. Low PE is a value factor and it does not necessarily work well in growth industries. For example, did you really think that a growth-oriented technology stock like Google would trade at 10 or 12 times earnings? If it were to trade at those kinds of multiples, would you really want to own it? A so-called growth stock sporting a low PE is really a busted growth company with a turnaround story (whatever happened to PALM?) which encompass a very different style of investing than the usual growth and momentum theme. For instance, see what Stan Druckenmiller thinks of Amazon.com (stratospheric PE) compared to IBM (trailing PE 13).

Just remember that "Value works. Growth works. Momentum works. Quality works. They just don`t all work at the same time." (see A quant lesson from a technician). To leave any of those factor sets out is to leave out part of the market and alpha generation opportunity set.

The moral of this story is, if you were to engage in factor investing, whether indirectly through "smart beta" concepts or directly in an active or semi-active fashion, you are making a deliberate bet against the market portfolio. Just make sure that your approach to factor investing is done in an intelligent way and it has not taken on any bets that do pass human sanity checks. In other words, use both your left (analytical and reasoning) brain as well as your right (creative and intuitive) brain to approach factor investing in an intelligent way.





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 20, 2014

Interpreting a possible volatility regime change

The job of a good market strategist is to use both the right and left brain to analyze the markets. The left brain is usually thought of as the analytical and reasoning side - and investors can always use the reason, rigor and discipline of investment models. The right brain is the creative and intuitive side. Here, investors can benefit from the observation, intuition and experience of the analyst to know when the underlying assumptions of investment model might be going off the rails and make the right kinds of adjustments.

Here is an example of what I have observed from the signals from the equity option market.


A possible volatility regime change
Left brain: In a previous post (see A case of "risk exhaustion"?), I had highlighted a comment from MacNeil Curry of BoAML that the stock market has not seen a meaningful bottom until the VIX spikes above 20 (via Zero Hedge):
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.

The analysis certainly makes sense, but...

Right brain: I was thinking about it was funny that the look-back window only went back to 2012, which was not a very long time. Just for fun, I charted for the last five years the VIX Index  (bottom panel), the equity only put-call ratio (in grey), its 21 day moving average (in blue) and the SPX (red).


True enough, the bottom panel showing the VIX verifies Curry`s observation that the market did not see a tradable bottom until the VIX spiked over 20. However, that rule would not have worked pre-2012 as the VIX traded at significantly higher levels. It appears that there was a regime change to lower vol in late 2011 or early 2012 and we may be seeing signs of a shift back to higher vol now.

The equity-only put-call ratio seems to provide an early warning sign of such a change. Note how its 21 dma rallied through a downtrend line in early 2011 while the VIX was falling during this period. Soon after, volatility rose dramatically and stock prices rolled over.

Note how we are experiencing a similar pattern of the 21 dma of the equity only put-call ratio rising through a downtrend and a rounding bottom in the 21 dma. This may be an early warning sign that equity volatility is set to rise.


Other signs of rising volatility
There is support for the idea of rising vol. SocGen has noted that hedge funds have changed to buying volatility from being a seller for a prolonged period (via FT Alphaville). It is interesting that hedge funds turned to be large sellers of vol in late 2011 and early 2012, when the vol regime seemed to have changed:


The SocGen team justified the change this way:
Somewhat lower levels of volatility recently, combined with a risk of a spike in volatility due to geopolitical tensions with Russia, are likely to have an influence, but alone do not explain the trend. Hence our conclusion that the period of low volatility is coming to an end.
Here is more "color" of the SocGen view, according to this Bloomberg report:
“You may be seeing the first indications that the days of very low volatility are numbered,” Arthur van Slooten, a strategist at Societe Generale SA, said in a phone interview from Paris on April 11. “Expectations for rate hikes may become more aggressive when the data from the U.S. starts heating up.”

While bearish contracts on the VIX have increased in the past two weeks, the level is about half the average from 2012 and 2013. They are net short 31,746 futures on the gauge, compared with a mean 61,953 in the last two years, data from a Commitment of Traders report by the Washington-based CFTC show.
A simpler explanation may just be a case of hedge funds getting into a crowded short position in volatility:
U.S. stocks had one of their most tranquil years in 2013 as investors became more confident in the bull market and began returning cash to mutual funds. The VIX averaged 14.3 last year, the lowest level since 2006. It has fallen more than 18 percent annually in four of the past five years.

The persistent decline lured hedge funds to short the volatility gauge, which is based on the cost of options on the SP 500. Large speculators had a record 116,000 net-short positions on VIX futures in August, CFTC data show.

They’ve all but disappeared as equities suffered the biggest weekly decline in almost two years. Investors are questioning stock valuations as the Federal Reserve reduces stimulus during a strengthening economy.

Model re-calibration under a regime change
If there is indeed a change in vol regime, then there are a number of important implications for investors. For one, analysts like MacNeil Curry may have to re-calibrate their models. We may not see a tradable bottom in stocks until the VIX Index rises much higher than just 20.

Other analysis, like this observation from Sheldon McIntyre about the VIX-VXV ratio flashing a buy signal may not necessarily be applicable under the new vol regime. The VIX-VXV ratio measures the term structure of volatility and McIntyre observed that when the ratio falls below 0.92, especially if it had inverted (risen above 1), it has been a good buy signal for the stock market:


I had studied this ratio in the past (see Waiting for a Santa Claus rally) and came to a similar conclusion as McIntyre. However, a possible change in vol regimes raised some concerns of the "buy when VIX-VXV falls below 0.92" rule. I backtested a simple trading rule based on the VIX-VXV ratio for the last five years. The buy rule is based on the following two conditions:
  1. The VIX-VXV ratio falling below 0.92; and
  2. It had inverted, ratio more than 1, in the recent past.
The results of the backtest are charted below. The black line shows the VIX-VXV ratio, the red line the SPX and the vertical lines are the signals generated by the system. I then classified the signals as being successful (blue vertical line) if the market was higher one month after the signal, while the unsuccessful signals were in red and flat returns colored in black.

Backtest of VIX-VXV trading system

Pre-2012, the batting average for this trading system was so-so as all of the red vertical lines occurred during that period. The win-loss-tie rate in the period was 4-3-1, which is ok but not enough to build a trading system from. In the post-2012 period, when vols were much lower, the buy signals showed a 100% win rate.

Now that we have a buy signal from this system but a possible vol regime change, what success rate should be applicable to this latest signal?


Other implications of a vol regime change
Since volatility is inversely correlated to stock market returns, another important implication of a vol regime change is the expectation of a correction in stock prices. The recent change in market leadership from growth to value stocks is further evidence of a sea change occurring in the markets.

J.C. Parets at All Star Charts recently highlighted analysis by JC O’Hara from FBN Securities expressing concerns over the shift in sector leadership (emphasis added):
The recent sector performance has been troublesome. It is not an encouraging sign to see the market being led by utilities. Even more concerning is the lack of performance in Discretionary, Industrials and Financials. The last 90 days we have seen just that. Examining prior market peaks (too early to confirm we are currently at one), we note that Discretionary weakness combined with Utility outperformance was a forewarning of market weakness to come. Smart money hides in Utilities, Staples, Health Care and Energy, while Financials, Discretionary and Technology get hit the hardest. While there has certainly been active sector rotation from 2013, the market has not turned lower yet. If the recent sector performance is a canary in the coal mine, we expect to see shallow bounces where traders lighten up on their riskier assets, and continue to rotate money into the historical sectors that held up the best.
I have observed a similar effect about risk appetite (see Bears 2 Bulls 1). I constructed a risk appetite index 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). As the chart below shows, risk appetite is rolling over:


What's more, I further created my own composite index of small cap vs. large cap relative performance, consisting of the an equal weighted composite of the Russell 2000, SP 600 small cap index and the equal weighted SP 500 index relative to the SP 500. The signs of falling momentum in high-beta small cap relative performance (and therefore a regime change) is unmistakable.


What was more disturbing about O’Hara analysis is his historical parallel with the sector market leadership change at the market top in 2007, which also showed a major leadership shift from Financial and Consumer Discretionary to defensive sectors:


A similar pattern occurred at the market peak in 2000:


Parets concluded:
JC O’Hara sent this over to me at what I think is the perfect time to point out this rotation. This seems all too similar to prior market peaks. We’re going to want to see Financials, Tech and Discretionaries start to turn back up on a relative basis in order to take this scenario out of the equation. But the consistent underpermance out of these sectors and money flow into Utilities and Energy can’t be ignored. The market is speaking. Are you listening?
To be sure, we are not seeing the same fundamental backdrop that could cause the sort of bear markets that began in 2000 and 2007, but I am seeing preliminary signs that earnings growth are starting to face headwinds because of the lack of capex revival (see Capex: Still waiting for Godot). Nevertheless, these kinds of warning signs of regime shift from changes in sector leadership should not be ignored.


An out-of-favor strategy
Finally, if volatility were to increase, investors may wish to consider a highly hated strategy to consider - trend-following managed futures. These strategies have shown good long-term results, but their short-term results have been so terrible that even the legendary hedge fund manager Paul Tudor Jones shut down his managed futures Tudor Tensor Fund after its asset base collapsed (via AllAboutAlpha):
The Tensor Fund went from over $1 billion ($1.5 per our numbers) down to just $120 million times over the last three years, and that is the reason the fund is closing, not anything to really do with performance, the skill of the manager, or expertise of the team. The closing of Tensor is more of a commentary on investors buying in at the top of a cycle and getting out at the bottom than anything else.
It does appear to be a business decision rather than purely an investment decision. Here is the performance of Tudor Tensor:


Longer term, the numbers looked ok:


Now consider the fact that trend following models have an implicit long-volatility bet (see analysis via Attain Capital Management). This chart tells the story by defining volatility as global volatility rather than just VIX:


Today, we have an instance of a hated strategy that has been abandoned by investors and a possible regime change that favors that strategy. What more could you ask for?


Left and right brained analysis
The bigger point I am trying to make here is that experienced quantitative analysts have to combine both their left and right brains to make investment processes that create alpha. You can't simply rely on models that have worked in the past, you have to use your observation, intuition and market experience in knowing how to use those models.

I may be wrong on this, but I am seeing evidence of a regime change going on in the markets. Volatility is poised to rise and sector leadership is shifting. Are you and your models prepared?





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 19, 2014

Is greed truly good?

Here is something to ponder on Easter weekend, when Christ was said to have sacrificed himself for the Sins of Humanity. You don't necessarily have to be Christian, or even religious, to consider these questions. You just have to consider the trade-offs between the ideas of self-sacrifice and self-interest.

David Brooks wrote a New York Times piece called "The Moral Power of Curiosity" about HFT, but framed as a morality tale (emphasis added):
As you’re probably aware, this book is about how a small number of Wall Street-types figured out that the stock markets were rigged by high-frequency traders who used complex technologies to give themselves a head start on everybody else. It’s nominally a book about finance, but it’s really a morality tale. The core question Lewis forces us to ask is: Why did some people do the right thing while most of their peers did not?

The answer, I think, is that most people on Wall Street are primarily motivated to make money, but a few people are primarily motivated by an intense desire to figure stuff out.
Brooks concluded that greed isn't necessarily good, but greed could be defeated by the pure thirst of knowledge:
One lesson of this tale is that capitalism doesn’t really work when it relies on the profit motive alone. If everybody is just chasing material self-interest, the invisible hand won’t lead to well-functioning markets. It will just lead to arrangements in which market insiders take advantage of everybody else. Capitalism requires the full range of motivation, including the intrinsic drive for knowledge and fairness.

Second, you can’t tame the desire for money with sermons. You can only counteract greed with some superior love, like the love of knowledge.

Third, if market-rigging is defeated, it won’t be by government regulators. It will be through a market innovation in which a good exchange replaces bad exchanges, designed by those who fundamentally understood the old system.

And here’s a phenomenon often true in innovation stories: The people who go to work pursuing knowledge, or because they intrinsically love writing code, sometimes end up making more money than the people who go to work pursuing money as their main purpose.

Greed is good?
Brooks' thoughts are herectical to the tenets of capitalism, at least in the purest Libertarian form. If the profit motive alone, or greed, is insufficient to create an efficient economic system, then what is? Do we need to depend on *gasp* altruism?

Here is what the high priestess, Ayn Rand, had to say about altruism:
What is the moral code of altruism? The basic principle of altruism is that man has no right to exist for his own sake, that service to others is the only justification of his existence, and that self-sacrifice is his highest moral duty, virtue and value.

Do not confuse altruism with kindness, good will or respect for the rights of others. These are not primaries, but consequences, which, in fact, altruism makes impossible. The irreducible primary of altruism, the basic absolute, is self-sacrifice—which means; self-immolation, self-abnegation, self-denial, self-destruction—which means: the self as a standard of evil, the selfless as a standard of the good.

Do not hide behind such superficialities as whether you should or should not give a dime to a beggar. That is not the issue. The issue is whether you do or do not have the right to exist without giving him that dime. The issue is whether you must keep buying your life, dime by dime, from any beggar who might choose to approach you. The issue is whether the need of others is the first mortgage on your life and the moral purpose of your existence. The issue is whether man is to be regarded as a sacrificial animal. Any man of self-esteem will answer: “No.” Altruism says: “Yes.”
Rand came down on firmly on the affirmative side of the question of whether greed is good.




No room for altruim?
From personal experience, I would agree with Brooks' assertion that most people on Wall Street are primarily motivated to make money. While not everyone is cut from that mold, but Wall Street does have more than its fair share of people for whom avarice is the primary motivation. I can say that it is the purest embodiment of capitalism in its rawest form. It attracts a lot of bright young men and women who hope to get paid well - and they do.

This video presents a contrasting tale of another profession that has attracted a lot of young men (and a few young women) - the training of United States Marines. This story is about training people to be prepared for self-sacrifice, which is antithetical to everything that Ayn Rand advocated.



There is a key passage which starts at about the 28:00 mark, It shows the DI telling the young recruits a story about a marine who is wounded in a rice paddy. Another marine who is sheltered behind a dike crawls out to drag the wounded soldier to safety, even though one or both are likely to get die. The reason: You do it because he is a marine. Then watch the reaction - the story moves the recruits to tears.

The video is somewhat cynically entitled "Anybody`s Son Will Do", because it is about the business of training young soldiers. That is because the idea of self-sacrifice doesn't come naturally to most people and they have to be indoctrinated that way. Soon after the passage about story of the wounded marine in rice paddy, the narrator Gwynne Dyer sums up the indoctrination process for soldiers this way:
Armies everywhere try to catch their recruits young, because they are vulnerable and more easily influenced about dying. You CAN train older men to be soldiers - and it's done in every major war, but you can never get them to believe they like it.
"Anybody`s Son Will Do" is well worth watching in its entirety. But are you offended by the cynicism of the video? Now consider your comments in the context of Ayn Rand`s thoughts about suicide, altruism and self-sacrifice. Who is right? Either these recruits are unwitting pawns (as per Rand) and you would have to be either an idiot or desperate to enlist, or they are the noble representatives of the American citizenry and United States Marine Corp.


Greed vs. Altruism or...
Here is some questions to ponder for this Easter weekend:  Is greed good? Can the profit motive alone be relied on to create a well functioning economic system? If not, then do we have to depend on the ideas of altruism and self-sacrifice? If you, like Rand, do not believe in the power of altruism, then is the mythic value of self-sacrifice of soldiers mean nothing and it is a curtain that needs to be pulled back like the story in the Wizard of Oz?

To be sure, David Brooks tried to skate around these issue by declaring that the antidote to pure greed is “some superior love, like the love of knowledge, but that sounds like a cop-out to me as it represents altruism in another form.

I can tell you that there are no right answers to these questions. The answers just define what kind of person you are.

(Philosophy lesson over. Back to your regular programming tomorrow...)




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.

Friday, April 18, 2014

CapEx: Still waiting for Godot

In a recent post, I wrote that the US economy is mid-cycle and we need to see signs of capital expenditure acceleration for stock prices to meaningfully advance from current levels (see What equity bulls need for the next phase). One of the clues would be the earnings reports from companies in capital goods conglomerate like GE.

GE reported on Thursday and Honeywell, another capital goods conglomerate, reported on the same day. The best description of my reaction of both reports is, "Meh!"


GE: Flat top-line growth
The GE earnings report was a solid report for shareholders, but I was not looking at it from a shareholder perspective, but using it to look for clues of global, or at least American, capex acceleration. The presentation, which can be found here, left me a little wanting. 

In particular, this page showing the progression of their order backlog was a little disappointing. Backlog growth from 4Q to 1Q was flat, having increased from $23.6 billion to $23.7 billion. 



The oil and gas division provided much of the source of capex growth, but that should be no surprise. David Kostin of Goldman Sachs broke out capex by sector and showed that the energy sector had been increasing its share of capex within the SP 500 for several quarters (via Business Insider). While there were some bright spots in the other GE divisions, there appears to be no broad based capex acceleration an ex-energy basis.




Little sales growth at Honeywell either
The Honeywell report, which is available here, was also somewhat disappointing. The company beat Street expectations on earnings but missed on sales (remember we are looking for sales acceleration). Sales was up only 1% on an organic basis YoY. The environment in the Defense and Space division was problematical and HON saw good top-line acceleration in Europe from sales of their turbochargers.

The company expected organic sales growth, my key metric, is 3% in the next quarter and 4% in the 2H2014, ex-Defense and Space. While they did raise earnings guidance, sales guidance was unchanged.

If HON were to be representative of the capex outlook, 3-4% isn't a bad number, but it falls short of a picture of capex acceleration that the Street has been expecting. The same comment would also apply to GE. To top it all off, Bill McBride at Calculated Risk recently highlighted an environment which features a sluggish recovery for US heavy truck sales:


In short, waiting for a capex revival can still be likened to Waiting for Godot.






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.

Wednesday, April 16, 2014

EM tail-risks are rising

As the events in Eastern Ukraine unfold, Ambrose Evans-Pritchard wrote about the risks of a an American-Russian confrontation:
The United States has constructed a financial neutron bomb. For the past 12 years an elite cell at the US Treasury has been sharpening the tools of economic warfare, designing ways to bring almost any country to its knees without firing a shot.

The strategy relies on hegemonic control over the global banking system, buttressed by a network of allies and the reluctant acquiescence of neutral states. Let us call this the Manhattan Project of the early 21st century.

"It is a new kind of war, like a creeping financial insurgency, intended to constrict our enemies' financial lifeblood, unprecedented in its reach and effectiveness," says Juan Zarate, the Treasury and White House official who helped spearhead policy after 9/11.
The weapon is not military, but financial in nature:
The stealth weapon is a "scarlet letter", devised under Section 311 of the US Patriot Act. Once a bank is tainted in this way - accused of money-laundering or underwriting terrorist activities, a suitably loose offence - it becomes radioactive, caught in the "boa constrictor's lethal embrace", as Mr Zarate puts it.

This can be a death sentence even if the lender has no operations in the US. European banks do not dare to defy US regulators. They sever all dealings with the victim.
In a different article, Evans-Pritchard outlined Russia's financial vulnerability:
Russia is at increasing risk of a full-blown financial crisis as the West tightens sanctions and Russian meddling in Ukraine pushes the region towards conflagration.

The country’s private companies have been shut out of global capital markets almost entirely since the crisis erupted, causing a serious credit crunch and raising concerns that firms may not be able to refinace debt without Russian state support.

“No Eurobonds have been rolled over for six weeks. This cannot continue for long and is becoming a massive issue,” said an official from a major Russian bank. “Companies have to roll over $10bn a month and nothing is moving. The markets have been remarkably relaxed about this, given how dangerous it is. Russia’s greatest vulnerability is the bond market,” he said.
In particular, he singled out the Russian external debt of $714 billion as a source of vulnerability:
A report by Sberbank said Russia has $714 bn of foreign debt: $427bn for compaines, $207bn for banks, and $62bn from state bodies. The oil group Rosneft relies on foreign debt for 90pc of its funding. Foreigners also own 70pc of the free-float of Russian stock market, which has not yet dropped heavily but has been held back by 15pc relative to emerging market peers since late February.
While financial sanctions would no doubt hurt the Russian economy, Evans-Pritchard indicated that Russia is not helpless and she could respond with other means, such as cyber-warfare:
Chancellor George Osborne must have been let into the secret of US plans by now. Perhaps that is why he issued last week's alert in Washington, warning City bankers to prepare for a sanctions fall-out. The City is precious, he said, "but that doesn't mean its interests will come above the national security interests of our country".

The greatest risk is surely an "asymmetric" riposte by the Kremlin. Russia's cyber-warfare experts are among the best, and they had their own trial run on Estonia in 2007. A cyber shutdown of an Illinois water system was tracked to Russian sources in 2011. We don't know whether US Homeland Security can counter a full-blown "denial-of-service" attack on electricity grids, water systems, air traffic control, or indeed the New York Stock Exchange, and nor does Washington.

"If we were in a cyberwar today, the US would lose. We're simply the most dependent and most vulnerable," said US spy chief Mike McConnell in 2010.

The US defence secretary Leon Panetta warned of a cyber-Pearl Harbour in 2012. "They could shut down the power grid across large parts of the country. They could derail passenger trains or, even more dangerous, derail passenger trains loaded with lethal chemicals. They could contaminate the water supply in major cities, or shut down the power grid across large parts of the country,” he said. Slapstick exaggeration to extract more funds from Congress? We may find out.
While some analysts may have factored the economic and financial effects of western sanctions on Russia, I bet that the consequences of the shutdown of the US power grid is not in anybody's spreadsheet.


Another giant with gargantuan external debt
Incidentally, when I read the $714 billion external debt figure, I had to laugh. Can you guess who other EM country has external debt in that order of magnitude?

If you guessed China, you win the prize. This chart comes from an article by Ambrose Evans-Pritchard in October 2013:
Foreign loans to companies and banks in China have tripled over the last five years to almost $900bn and may now be large enough to set off financial tremors in the West, and above all Britain, the world’s banking watchdog has warned.

“Dollar and foreign currency loans have been growing very rapidly,” said the Bank for International Settlements in a new report.

“They have more than tripled in four years, rising from $270 billion to a conservatively estimated $880 billion in March 2013. Foreign currency credit may give rise to substantial financial stability risks associated with dollar funding,” it said. China’s reserve body SAFE said 81pc of foreign debt under its supervision is in dollars, 6pc in euros, and 6pc in yen.


Note that the last date of the chart is in early 2013. Given the pace of the increase, Chinese external debt could easily be very close to $1 trillion or more today. To put the $1 trillion external debt into context, the most recent Chinese GDP release came in at 7.4%, which was ahead of expectations of 7.3%. However, the issue is not whether is China is growing at 7.0% or 7.5%, but whether it will experience a financial crisis. China bulls have pointed out that most of Chinese debt is in RMB and therefore it is unlikely to experience an external debt crisis given the size of its foreign exchange reserves. Nevertheless, an external debt position of roughly $1 trillion is nothing to sneeze at, even if your reserves is a multiple of that figure.

Under a scenario where China undergoes a financial crisis, no doubt western banks would get hurt - and that would spook markets. That tail-risk is probably not in too many analysts' spreadsheet models either.


Remember the "tail" in "tail-risk"
I am not trying to engage in fear mongering. I only bring up these possibilities of events in Ukraine or China spiraling out of control not because they represent my base case scenarios, but as tail-risks. Just remember the "tail" in the term "tail-risk".

To be sure, the latest economic releases out of China suggests that the economy may be turning up and therefore financial risks are receding, as per Tom Orlik at Bloomberg:


A WSJ report came to the same conclusion:
Official data shows China’s economy in the first quarter grew at its slowest pace in 18 months, but two proxies point to some resilience.

Electricity output—an indicator favored by Premier Li Keqiang over gross domestic product—and crude steel production grew faster in March than in the preceding two months. In addition, steel output in March hit a record high, the National Bureau of Statistics said.

Back in 2007, when he was party boss of Liaoning province, Mr. Li quipped that when it comes to growth data, officials might lie—but volts do not.

Electricity output in March was up 6.2% from a year earlier to 453 billion kilowatt-hours, faster than the combined 5.5% pace of January and February (the two months were counted together to limit distortions from the Lunar New Year holidays). Steel production was up 2.2% to a record 70.3 million tons. That compares with a 0.6% expansion in February and a contraction of 3.2% in January.

The data added to a sense China’s economy may have stabilized in March. Other data released Wednesday—including retail sales and industrial production—edged up from the previous two months.
As well, speculation about asymetric warfare like cyber attacks is just that - speculation. If Moscow orchestrated the initial provocations in Eastern Ukraine, the military response by Kiev was no doubt expected and the Kremlin has a plan to deal with what comes next. We will just have to watch how this elaborate dance plays itself out.

Nevertheless, the technical picture of the stock market is starting to look like the Spring of 2011. Market internals are deteriorating and risk appetite is rolling over. The crisis then came from the combination of a political impasse in Washington and the eurozone crisis. It was a volatile mixture which eventually sparked a major market sell-off. In 2014, investors have to be aware of the nature and the rising level of tail-risks that could affect financial markets in the months to come.





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 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.”

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